These Investments Warrant a Closer Look Part Two: TARP Banks
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By now, we all know the basic story of the 2008 bank bailouts:
- Bank makes bets.
- Bets go bad.
- Bank asks for bailout.
- Bailout dilutes shareholders who would otherwise get nothing.
One may think the remnants of the TARP program are gone, now that the government has sold off its interests in the largest banks. But one type of security was designed to last for 10 years after the bailouts. I am, of course, referring to long-term stock warrants.
Near the money
Although not in as bad a shape as many of its competitors, JPMorgan Chase (NYSE: JPM) had to take government loans during the crisis to maintain capital ratios. Part of these loan terms created a series of JPMorgan Chase warrants exercisable at $42.42 per share until Oct. 28, 2018. According to The New York Times, the government sold these 88.4 million warrants for proceeds of $936 million in late 2009, thus ending the government investment in the company.
As of this writing, the warrants trade just under $11 apiece, and the share price is less than $2 below the strike price. With these numbers, the warrant's strike price falls well within the 52-week range of JPM, and the small difference signals that the warrants could very well reach that strike price. At the current warrant price, investors can leverage nearly four times on JPM by choosing the warrants over the common stock. The company appears to be one of the more financially sound institutions based on its track record (although we never know when the next $5 billion bomb will go off), and JPM could reap the benefits of an economic recovery by sorting itself out ahead of time -- which is easier for healthier companies than stragglers.
Out of the money
Another participant in the TARP program, Bank of America (NYSE: BAC), created two classes of warrants with different expirations and vastly different strike prices. Just as with JPM, the government sold these warrants to reduce their involvement with the banks and quickly repay the bailout money.
B of A's class A warrants are exercisable until Jan. 16, 2019, and have a strike price of $13.30 per share. With the stock trading around $9 per share, these warrants represent a strong bullish bet on B of A.
B of A's class B warrants are exercisable until Oct. 18, 2018, and have a strike price of $30.79 per share. To reach breakeven with these warrants, the stock would have to more than triple its current worth by the expiry date. Compared to class B warrants, their class A counterparts seem like a conservative investment.
B of A certainly has potential, and investing mogul Warren Buffett has thrown his hat in the ring buying billions in preferred stock and warrants. However Buffett's warrants have a strike of $7.14, because they came from a separate deal with B of A, instead of an open-market purchase of TARP warrants. But the fact that Buffett is willing to trust this company with his billions shows he has strong faith that B of A will survive. If it does, stockholders stand to gain from the company's large discount to book currently being used. A return to book value would put the class A warrants in the money, and perhaps drive up class B warrants based on building speculation.
With the market failure in 2008, investors in large financials have been given an opportunity to leverage for the long term via warrants. A security often created through private placements and boardroom negotiations has now become available to any average investor with a brokerage account. While not without their risks, these securities can allow us to supercharge our returns if properly executed. If improperly executed, of course, we can crash and burn. But for bank bulls, these warrants may be just what they are looking for.
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