At the end of last year, the US Treasury proudly announced a $936 million gain from the sale of rights, called warrants, to buy common shares of JP Morgan at a price much lower than its current price. These warrants were received by Treasury during the fall of 2008 in connection with its purchase of $25 billion in preferred stock of JP Morgan. After JP Morgan redeemed the preferred stock a few months ago, the Treasury and the bank agreed to auction off the warrants to the highest bidder.
However, US taxpayers were shortchanged by $5 billion in this transaction. When most investors buy preferred stock, they receive warrants to buy common shares equal to 100% of the amount of the preferred stock. For example, when Warren Buffett bought $10 billion of preferred stock from Goldman Sachs during the fall of 2008, he received warrants to purchase $10 billion of that firm’s common shares.
By contrast, when the Treasury purchased $25 billion of preferred stock from JP Morgan, federal officials requested warrants to purchase the banks common shares equal to only 15% of the $25 billion. In other words, the Treasury received warrants to purchase only $3.75 billion of JP Morgan’s common shares, when most investors like Buffett would have received warrants to purchase $25 billion of bank’s common shares.
If the Treasury had received warrants to purchase $25 billion of JP Morgan’s common shares, US taxpayers would have reaped a gain last week of at least $6 billion from the auction of those warrants. That would have been $5 billion higher than the $936 million gain actually realized by the Treasury on its auction last week.
Moreover, the other terms of the preferred stock purchased by the Treasury were far worse than the terms of the preferred stock purchased by Buffett about the same time.
– The Treasury’s preferred stock paid an annual dividend of only 5%, while Buffett’s preferred stock paid an annual dividend of 10%.
– The Treasury’s preferred stock paid no premium if JP Morgan redeemed the stock early, while Buffett’s preferred stock paid an early redemption premium equal to 10% of the amount of the preferred stock.
– The exercise price of the warrants received by the US Treasury was the trading price of JP Morgan’s common shares at the time Treasury purchased its preferred, while the exercise price of the warrants received by Buffett was $10 below the trading price of the Goldman Sachs common shares at the time he purchased its preferred.
The JP Morgan transaction was typical of the capital infusions under TARP. The Treasury generally requested the same below-market terms when it purchased preferred stock plus warrants in over 600 financial institutions in the last 14 months. During this period, the Treasury spent over $200 billion in making these purchases of preferred stock.
As of December 4, 2009, the US Treasury sold warrants to buy common shares in these financial institutions for a total gain of $3.05 billion. However, if the Treasury had received warrants to purchase common shares equal to 100% of the amount of the preferred stock, instead of 15%, these gains would have been over $20 billion. The difference – almost $17 billion – would have gone to benefit US taxpayers, who will probably sustain large losses on the federal bailouts of other institutions, such as AIG and GMAC.
The lesson from these transactions is clear. If the Treasury bails out large banks in the future, it should demand the same terms as those received by sophisticated institutional investors. Some of the rescued banks will become profitable, while others will become insolvent. Taxpayers need to maximize their gains on the successful turnarounds to compensate for their losses on the bailouts that inevitably fail.
Robert Pozen is chair of MFS Investment Management, a senior lecturer at Harvard Business School and author of “Too Big To Save? How to Fix the US Financial System” (Wiley, 2009).