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Warren Questions Warrants

Just read through the details of the latest report of the Congressional Oversight Panel, chaired by Elizabeth Warren and charged with overseeing the TARP program.

The Panel concludes that tax-payers could lose out on $2.7 billion if the Treasury Department doesn't change how it values those warrants it got when it bailed out the banks.

The warrants were a way to let taxpayers share in the gains if the bank's stock price improves. The banks, however, are now eager to get out of TARP so Treasury has been selling the warrants back to them.

By the panel's calculations, the Treasury has been undercharging for them by as much as 66 percent.

The report is fairly technical, but here's a quick summary: The warrants give the government the option to buy some of the bank's stock at a fixed price for some period of time. If that price is say $10 and the stock price goes up to $20, the government can use the warrant to buy the stock at $10 and sell it for $20 making a profit.

Figuring out what a warrant is worth is tricky though, because its value depends on what happens to the price of the stock in the future, and the extent to which it bounces around (known as volatility.) The standard method for pricing one is something called the Black-Scholes formula.

The Congressional Oversight Panel got three Harvard professors to run the numbers. In the case of Old National bank in Evansville, Indiana, the Panel found that the warrants should be worth something like $2.1 million. Instead Treasury sold them back to the bank for just $1.2 million.

Why such a difference? One answer is that the models are somewhat subjective. But the Panel takes issue with the whole procedure. The way the warrant price is determined now, the banks and Treasury each come up with their own estimate and negotiate a compromise.

The Panel says a more transparent and fair approach would be to let the market decide, by auctioning the warrant: is hard to believe that an auction with a proper reserve value would ever achieve a lower valuation than a negotiation.

Ultimately, open market transactions are the only way to determine true "fair market value." In his testimony before the Panel on June 24, 2009, Assistant Secretary Allison
explained this in relation to the toxic assets on bank balance sheets: "We can have our theories, [but] in the last analysis that's why you have financial markets. You have to have liquid
interchanges and then the truth will come out as to what the assets are actually worth."

So far only a small fraction (the Panel says less than 1%) of the warrants have been repurchased so there is still time for Treasury to change its approach.

Not all panel members agreed with all the conclusions of the report. Richared Neiman, Superintendent of Banks for the State of New York, writes that "reasonable minds can disagree" about the price of the warrants.