So far, so good as TARP turns one

As TARP nears its one-year anniversary, the promise that taxpayer investments would be profitable has been fulfilled in some cases, and appears close in others.

By TheStreet Staff Oct 27, 2009 12:25PM

TheStreet.comBy Lauren Tara LaCapra, TheStreet.com

 

As the one-year anniversary of the government's capital injection program approaches, the promise that taxpayer investments would be profitable has been fulfilled in some cases, and appears close in others.

 

But other bailout programs apart from TARP look as though they will keep taxpayers in the red for many years to come. And a large part of why the TARP investments have been profitable is because of onerous dividends and favorable terms, not because the actual investments have seen a meaningful increase in value.

 

For instance, the terms of the TARP program provided the government with warrants to purchase common stock. The strike price for these warrants declines by 15% every six months for the first 18 months of the investment. The cheaper the strike price, the less the government would have to "pay" to enter the position, and the more theoretically profitable the investment will be when the common shares are then sold into the market.

 

Starting on Wednesday, the government will have benefitted from a 30% cumulative decline in the strike price of its TARP warrants. As a result, its entry price for Bank of America is $21.55 for the initial TARP investment, and $9.31 for the additional capital to cover Merrill Lynch losses, rather than the strike prices of $30.79 and $13.30 at the time of investment.

 

Bing: More on the Troubled Asset Relief Program

 

The difference is significant. If the government exercised the warrants and sold the new BofA shares into the market at yesterday's closing price of $15.40, it would have earned a total of $512 million.

 

Of course the government isn't ready to exit its position in BofA, and the companies would have to prove that they are adequately capitalized to pay back the initial investment, plus accrued dividends, before the discussion of warrants even comes into play. But if BofA's stock recovers further, the warrants will be even more profitable. The bank has also paid $1.8 billion in dividends so far on the government's preferred stake.

 

The investment in Wells Fargo is less complicated but tells a similar story. The government injected $25 billion in capital in exchange for preferred stock and common warrants with an initial strike price of $34.01.

 

That price will have come down to $23.81 by Wednesday, offering a 19.5% premium based on Wells' closing price of $28.45 on Monday. If the Treasury Department exercised its warrants and sold them back at that price, it would have netted $512 million on paper, not including the nearly $1 billion in dividend payments received to date.

 

Citigroup is sometimes held up as the touchstone of troubled banks, but given the Treasury's strike price of $3.25 when the preferred-for-common stock swap took place in September, its 34% stake may prove quite profitable.

 

Based on Monday's closing price of $4.27, the government would have netted $15.3 billion by selling the stock into the market. (That is, if Citi had already paid back the $50 billion investment.)

 

It's conceivable that, as Citi becomes healthy enough to repay its massive debt, its share price will improve, benefitting taxpayer shareholders even more. In addition, the bank has also paid $1.9 billion in preferred dividends to date.

 

It's worth pointing out, however, that if the TARP terms hadn't included the strike-price decline stipulation, and had the government not altered terms to provide Citi with a cache of tangible equity, the three investments would be far, far out of the money.

 

The BofA warrants would be $1.6 billion in the red, while Wells would be $613 million away from break-even. Had the government kept the initial strike prices of $17.85 and $10.61 for its Citi warrants (and not extinguished them via the conversion) those paper investments would be $5.7 billion in the red.

 

The TARP investments are eligible to last for up to 10 years, giving taxpayers ample time to earn more through dividends and stock improvements. The fate of the federal investments in healthier institutions may be accelerated examples of what will occur later with BofA, Citi or Wells. For instance, Goldman Sachs repaid the TARP investment and repurchased its warrants over the summer, for a 23% annualized return. While JPMorgan Chase is still haggling over what it ought to pay for its warrants, U.S. Bancorp, Bank of New York Mellon, State Street and others have thrown off the TARP shackles as well.

 

But the government's much larger bailouts of American International Group, Fannie Mae and Freddie Mac are a lot less certain.

 

The government has been a hospitable lender to AIG, extending $90 billion in credit, investing $40 billion in preferred stock and buying $50 billion worth of toxic securities that no one would else would touch. While the securities have recovered some value in the market, AIG hasn't paid any interest or dividends to taxpayers to date. Former CEO Edward Liddy said the insurer expects to repay part of its loans instead by offering the government stakes in its healthy, restructured businesses.

 

While Fannie and Freddie have paid dividends, those payments have been like throwing sand against the wind. The two mortgage finance giants posted $2.1 billion in dividend payments through the first half of this year, while the government has had to funnel another $66.6 billion in additional capital into the firms to cover escalating losses.

 

Former Treasury Secretary Henry Paulson promised TARP would prove "an investment, not an expenditure" and said "there is no reason to expect this program will cost taxpayers anything." That may be true, but TARP is just one piece of a complex bailout puzzle that includes not just the AIG, Fannie and Freddie investments, but trillions of dollars worth of liquidity pumped into the system by the Federal Reserve.

 

The Fed's balance sheet now holds $1.7 trillion in securities -- including Treasury bonds, mortgage-backed securities and Fannie and Freddie debt -- as well as tens of billions of dollars in asset-backed loans and commercial paper, and $61 billion in toxic assets collected from Bear Stearns and AIG.

 

A good chunk of the bad assets that taxpayers now own will simply go sour. Transforming these holdings from bailouts -- if not expenditures -- to investments may depend on an investor's time horizon. One hopes that taxpayers are patient.

 

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