No Way Out: Treasury and the Price of TARP Warrants

June 29, 2009 12:45 PM

Buried in the late wire news on Friday, June 26—and therefore barely registering in the newspapers over the weekend—the  Treasury announced the rules for pricing its option to buy shares in banks that participated in the Troubled Asset Relief Program (TARP).

The Treasury Department said the banks will make the first offer for the warrants. Treasury will then decide to sell at that price or make a counteroffer. If the government and a bank cannot agree on a fair price for the warrants, the two sides will have the right to use private appraisers.

This is a mistake.

The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part—e.g., people could submit sealed bids and the highest price wins.

In Treasury's scheme, there is significant risk of implicit gift exchange with banks—good jobs, political support, or other favors down the road—or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury's leadership want to be involved in price setting in this fashion?

Treasury apparently sees corruption as an issue about personalities (i.e., we aren't ever corrupt) rather than about institutional structure. For example, if you create an arrangement that easily permits corruption, such as through nontransparent decision making or negotiation around warrant pricing, you set up incentives to be corrupt. Either existing people change their behavior, or new people will seek appointment in order to participate in corruption.

This is also a point, by the way, that Treasury has been making for years through its representatives at the International Monetary Fund, including during the Clinton administration, when the same people were running US economic policy as now. It's a good point and never easy for countries with potential corruption to hear. It applies as much to the United States as to anywhere else.

Treasury will argue the disposal of warrants is a one-off event, but this is not a plausible line: It is part of a much longer series of nontransparent decisions over finance. The attitude that "we can be nontransparent because we will never be corrupt" creates reputational risk for both Treasury and participating banks. If extraordinary support for the financial sector lasts several years, we will likely have at least one time-consuming and damaging investigation into all the details of these settlements.

In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House—hopefully senior congressional leaders will quickly make this point behind the scenes.

There is obviously unappealing midterm election risk in this pricing scheme and making a correction now, before major banks have participated, would be relatively straightforward.

(Primer on option pricing, applied to warrants; background on how we got here)

The following were previously posted by Simon Johnson:

Hedge Funds Make a Political Mistake (June 26)

The political flavor of the month is to push back against even the Obama administration's mildly reformist inclinations on finance (e.g., Peter Weinberg in the Financial Times). And, of course, once you hire a lobbyist, he or she tells you that "winning" means stirring up Congress in favor of the status quo. Measured in these terms, the hedge fund industry has had a string of notable recent victories effectively preventing tighter regulation.

Advocates have a point, of course, when they argue that big banks rather than hedge funds were primarily responsible for crisis. But this misses where we are in the long cycle of regulation/deregulation. Look at this picture (source: Wall Sreet Journal; more on Ariell Reshef's webpage).

If we're at the top of the long deregulation wave and likely headed for tighter control of the financial sector—if not this year, then soon—where do you want to be in the political equation?

You can resist change, but this is just asking for trouble. You know that individual (lightly regulated) funds—whether or not these are officially "hedge funds" is irrelevant —will have high- profile trouble. The latest alleged tunneling details in the case of Danny Pang are a precursor to broader social fascination with this phenomenon—you know that a dozen screenwriters are already at work. Sooner or later, there will be a more focused backlash against specific practices revealed or implied in this kind of case.

At the same time, the broader Treasury attempt to respond with only milder controls over big banks will likely also run into trouble (see my latest Economix column), so more social pressure will appear from that direction also. Big banks repeatedly get into serious scrapes, but their political clout consistently allows them to deflect attention onto others. The idea that big banks and hedge funds have some natural congruence of political interests in this space is simply wrong.

In fact, if hedge funds dig in too deeply with "the crisis was not our fault" position, that is just asking for trouble—and to be scapegoated—down the road. It would be much smarter to get out ahead of the political dynamic, and to propose ways to measure, control, and regulate risk.

Voluntarily keeping hedge funds "small enough to fail," without endangering the system, would also make sense, particularly if accompanied by a complementary political strategy that emphasizes that it is big banks that have done almost all the damage.

It Takes a Citi (June 24)

Washington-based policy tinkerers seem increasingly drawn to the idea that greater reliance on market information can forestall future problems—e.g., providing input into an early warning system that can be acted upon by a "macroprudential system regulator." And while leading critics of the administration's proposed approach to rating agencies make some good points, they also seem to think that the market tells us when big trouble is brewing.

The history of Citigroup's credit default swap (CDS) spread [pdf] is not so encouraging.

It's true that in some instances during the past two years, CDS spreads have indicated pressure points, e.g., within types of lenders or across countries. And if you can tell me how Citi survives going forward with a CDS spread of around 450 basis points, I would be grateful.

The people who price CDSs obviously have every interest in assessing risk in a hard headed and accurate manner. But Greenspan's lament applies to CDS traders just as much as to incentives within mismanaged banks—where in the Citi CDS spread chart do you see the build- up of risk through the end of 2006? If anything, the market for default probability was saying that Citi—and by implication the financial system with all its growing subprime vulnerabilities—was becoming less risky.

You can hope that, in the future, the market will not be so generally exuberant, but 400 years of modern financial history begs to differ.

The Wall Sreet Journal gets this right: Regulatory capture is not only pervasive, it is by design. But what's the implication?

All regulators must ultimately fail and, when that happens, markets may well also misprice risk. The question is: When this Twin Failure occurs next time, how much will be on the line?

You cannot design a financial system that is immune to crash—this would be like declaring earthquakes illegal. But in the aftermath of unexpectedly high damage from a serious earthquake, it makes sense to completely overhaul your building code and retrofit vulnerable buildings. In fact, if you largely ignored what the earthquake revealed in terms of structural weakness, wouldn't that be negligence?