TARP Warrants Offer Huge Upside

 | Aug 31, 2011 | 3:30 PM EDT  | Comments
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One of the side effects of the U.S. TARP (Troubled Asset Relief Program) capital purchase, the issuance of warrants from TARP recipients, could very well turn out to be one of the best investment opportunities available to investors today.

Back during the height of the financial crisis, all the major financial institutions were infused with capital from the federal government in order to shore up balance sheets. In exchange, the companies issued preferred stock to Uncle Sam. As a kicker, the federal government also received warrants -- options -- to buy shares at a specified strike price within a specified date.

Rather than hold on to the warrants, the government began cashing out a year ago by selling the warrants to the investing public. In some instances, namely Goldman Sachs (GS) and Wells Fargo (WFC), the company itself bought back all or some of the warrants. However, in most cases the warrants were sold to the investing public and trade freely. For those investors who feel that financials are facing a cyclical downturn and will one day shine again, owning the warrants may actually be more advantageous than owning the stock.

Several attractive factors make these TARP warrants worthwhile investments:

1. They have an abnormally long time to expiry. The longest -dated options, LEAPS (long-term equity anticipation securities), are usually two years in duration. Most of these warrants expire between 2018 and 2019. Rest assured that if financials do recover, they will do so within the next seven to eight years, according to historical financial industry cycles dating back to the Great Depression.

2. Banks today have excess capital on the balance sheets. Sooner or later, this excess capital will be used to fund buybacks or dividend payments; shareholders will naturally demand it.

3. A specific feature to these TARP warrants is that the strike price is adjusted downward for any quarterly dividend above and beyond a set dividend payout. This is not typical of warrants, and this, while banks are waiting for approval to boost dividends, is a valuable provision.

While share prices of financials get hammered in 2010, the underlying TARP warrants have also fallen, creating an enormous upside potential. Bank of America (BAC) Class A warrants (BAC-WTA) give the owner the right to buy one BAC share at $13.30 any time before Jan. 16, 2019. They trade for $4 today. Two weeks ago, when BAC was trading for $6, the warrants were trading at $2. Since then, the common stock is at $8, up 33%, while the warrants are up 100%. Bank of America is itching to return capital to shareholders via an increased dividend. Assuming that happens in a year, the shares will likely rise, as investors would see that as confirmation that the company is healthy, and that would also reduce the warrant strike price.

American International Group (AIG) warrants (AIG.WT) allow you to buy a share of AIG for $45 any time before Jan. 13, 2021. They currently trade for $7.90, while AIG common is trading for $25. AIG shares are currently depressed by the government's sale of its majority equity stake into the public market. Major shareholders estimate intrinsic value of AIG to be north of $50.

I would avoid Citigroup (C) warrants. The Class A (C-WTA) have a strike price above $100, while Citi shares trade for $32. Even though the warrants don't expire until 2019, the gap is far too wide to make the warrants anything but a pure speculative bet.

These unique TARP warrants may be the best gifts the financial crisis has bestowed on investors. Normally, options investing can be dangerous, because even a correct bet can lead to loss if time runs out. But with nearly a decade of time on your side, it's hard to believe that the cycle won't improve by then.

Note: Depending on the quotation system you use, the warrant suffix may be "WT" or "WS."

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