Big Payoff Via Bank Warrants

 | Feb 19, 2013 | 6:00 PM EST  | Comments
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aig

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wfc

In the never-ending quest of finding attractive places to deploy capital, the bank warrants that were born out of the TARP program created to provide temporary capital to the country's major financial institutions continue to remain highly attractive. Moreso, the risk adjusted returns are uniquely tilted in the investors favor, provided that -- and this provision is critical -- these warrants are held for several years.

The warrants born out of TARP differ from your typical long-dated options for several important reasons.

First, the time to expiry is significantly longer than even the longest dated LEAPS. Most of these particular warrants don't expire until 2019 or longer.

Second, and perhaps the most desirable aspect is tucked in the details. With the typical option, when the underlying stock pays a dividend, the option holder does not benefit from that payment. In other words, one of the costs of owning a typical option is that you forgo the dividend payment and in some cases that could equal another 3% to 4% a year.

These bank warrants are structured differently. At the time the warrants were issued to Uncle Sam most banks had to suspend or eliminate dividends as a provision of strengthening the balance sheet, regardless of whether or not a bank actually had the ability to pay. Tucked in the warrant legal documents was a provision that when a bank resumes or increases its dividend payments, the warrant strike price would decline by an equal amount.

I won't get into the mathematical details -- just take my word for it -- when the big banks start increasing their dividend payments, the warrants will become a lot more valuable; this an unbelievable catalyst. And I think it's safe to say that all major financial institutions want to return money back to shareholders via dividend payments; their CEOs have publicly said as much.

Bank of America (BAC) has two such warrants, the Class A and Class B. The Class B warrants have a strike price of $30.79, so I wouldn't go near those. The Class A warrants have a strike of $13.30 and don't expire until January 2019. Depending on what quotation service you use, the warrants go by the ticker BAC-WTA or BAC.WSA.

Another attractive warrant is the AIG (AIG) warrant which doesn't expire until January 2021 and has a strike price of $45. There, the warrants trade for $14.55 while AIG shares trade for $39. The underlying ticker is AIG-WT or AIG.WS.

Citigroup (C) and Wells Fargo (WFC) also have similar warrants that may also deserve a closer look.

It's finally becoming evident to the public and Mr. Market that banks are getting stronger with each passing quarter. As Bank of America's balance sheet continues to improve the bank will likely be approved for a dividend increase. Let's assume that in three years Bank of America is trading for $22, or about book value. Assume by then that the annual dividend is 50 cents a share, or 2.2%. The warrants would have a strike price of approximately $12.84. They would have an intrinsic value of around $9 and with three years of life remaining, perhaps a time premium of $2 to $3, so the warrants would be worth at least $12 if not more. Today the warrants trade for around $5.70 an upside of 110% or more compared with 80% for the common. And the higher Bank of America reaches, the warrant return is magnified.

For this trade to be successful, these long-term warrants have to be treated as long-term holdings. It's certainly possible that a quick advance in the underlying common can create a tidy short term trading gain but names like Bank of America and AIG appear to offer excellent long-term potential which equates to even better long-term potential for the warrants.

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