By : Jared Levy | December, 10 2009
Last week’s first auction-style warrant sale was Capital One Financial (COF), which netted the Treasury (U.S. Taxpayers) $162.1 million, as a total of 12.7 million COF warrants were bought for $12.76 each. The new “open bidding” model seems to be working fairly well, at least better (more accurate pricing) than what many banks were able to repurchase their warrants for in the past. According to Pluris Valuation, 579 banks
received TARP money. This includes 290 publicly traded banks.
Common terms for these American-style warrants included long-date expiration dates, no voting rights, and pricing based off of the 20-day trailing average stock price before the Treasury Capital Purchase Program (CPP) application. There were other provisions in the agreements for piggyback rights, as well as dividend adjustments above a certain level and an anti-dilution provisions date.
Pluris found that many of the banks repurchasing their warrants typically were doing so at an extreme discount to fair value, based on several pricing models. These average discounts to fair value were fairly substantial earlier this year, starting at 68% on April 1, 2009 and coming down to 65% as of July 1, 2009.
This trend of a reduction in discount can most likely be attributed to several factors, one of which would be the Treasury possibly getting better with its modeling, but more likely due to the decrease in “optionality” as a percentage of price that occurs as options become more in-the-money.
When you think about it, which options have the highest percentage of volatility sensitivity relative to their price and thus would be the most sensitive to changes in implied volatility calculations as a percentage of the price of the security? Out-of-the-money options are completely comprised of time value and would have the highest sensitivity to changes in implied volatility as a percentage of price when compared to in the money strikes. This is followed by at-the-money options, then in-the-money options, which have the least amount of optionality as a percentage of price due to the higher intrinsic value.
So this year, as stock prices have risen 20%, or 30%, or 75% + in some cases, those out-of-the-money warrants are now in-the-money and thus will have less of the “time premium fudge factor” built into them.
Pluris also noted that as total bank assets increased, the discount the warrants were bought at decreased substantially. Banks with less than $100 million in total assets experienced an average discount of 72% whereas banks with total assets in excess of $10 billion experienced an average discount of only 51%.
Yesterday, the US Treasury auctioned off approximately 88,401,697 warrants to purchase the common stock of JPMorgan Chase & Co. (JPM) through a modified Dutch auction. The bidding began at 8:00 AM Eastern and went through 6:30 PM last night. The opening bid was $8.00 and bidders could bid anywhere above that in 25-cent increments. The JPMorgan warrant matures 10/28/2018 – that’s 3,234 days from today – with a strike price of $42.40. JPM closed at $41.27 on Thursday. This morning it was announced that the warrants were auctioned off at a price of $10.75.
Call me crazy, but the Jan 2012 40 calls are $8.00 mid-market and the 45 calls are $6.00. If we were to create a 42.50 strike, I’d call it $7.00 without even looking at a model. These JPM warrants go out another 6.8 years longer.
So what is fair value? How did the market arrive at a price of $10.75? The dividends are tricky, as is the volatility input, but if I drop my implied vol down to a 20 (I’d buy it all day long there), plug in 3.5% for a long rate and 3% for a short rate (because I would have to short stock to hedge these), and leave quarterly dividends at $0.05, the call should be worth at least $11.00.
So what happened? Did the government get a raw deal? Will this be cannon fodder for the talk shows this weekend? Not necessarily. The answer lies in the dividends, which is the biggest unknown in making this price. The rest of the variables have at least some hedge.
So the market told us with this price of $10.75 that it expects JPM to begin raising its dividend again soon. But if you don’t agree with the market that JPM will raise dividends, and you think the stock will still rally, you can go out and buy these warrants yourselves now. They are publicly traded on the NYSE.
