One of the by-products of the government sponsored Troubled Asset Relief Program (TARP) was the issuance of warrant securities to Uncle Sam in exchange for an infusion of capital. What many investors don't know is that over the past couple of years, the United States Treasury has sold off the warrants it received via a public offering. Those sales proved successful for the U.S. Treasury and actually turned TARP into a successful endeavor for the U.S. taxpayer. Now those same warrants may turn out to be a successful endeavor the average investor.
Long-Term Options
Warrants are essentially options to buy an underlying share of stock at a specified price. Where they differ from traditional call options is with respect to time. While the longest options have a two year life, warrants can be much longer in duration. In the case of bank warrants created from TARP, the time is as long as 10 years. Financials took a beating in 2011 as a result and so did the underlying warrants. With such a wide time horizon, these warrants could reap substantial gains if bank stocks recover nicely between now and then.
Bank of America (NYSE:BAC) today trades for $6.30 against tangible book of nearly $21. While today's share price reflects the market's concern with the accuracy of the tangible book value, Bank of America shares look very undervalued today compared with where shares could be over the next few years. CEO Moynihan has plans to reduce expenses by $5 billion over the next 3 years. Against a market cap of about $65 billion, that's a significant boost to the bottom line. Bank of America Class A Warrants (NYSE:BAC-WTA) currently trade for $2.75. Each warrant conveys the right to buy one share of BAC at $13.30 a share. The warrants expire in 2019. It is not unreasonable to assume BAC could be trading for $20 or more in 2014. If so, the warrants would be worth the amount they are in the money, $6.70 plus a time premium for the remaining life of the warrant. The warrants could easily trade for $10, or more than 300% today's levels. (For related reading, see A User's Guide To Warrants.)
More Options
Wells Fargo (NYSE:WFC), a bank more people are comfortable with also has warrants outstanding as another option. Wells Fargo, unlike many of its peers today, trades at a slight premium to book value with shares trading at a little over $29. It has warrants outstanding (NYSE:WFC-WT) that allow holders the right to buy one share of Wells Fargo for $34.01 up until Oct. 28, 2018. Today the warrants trade for $9.10. If Well Fargo boosts its dividend payout at anytime during the warrant life, the exercise price of the warrant will be reduced by the dividend amount. Wells Fargo is a large and favorite holding of Warren Buffett. Shares could be worth over $40 in two to three years, and the warrants could be worth twice what they trade for today. Insurance giant AIG (NYSE:AIG) has warrants outstanding (NYSE:AIG-WT) that don't expire until 2021 allowing owners to buy a share of AIG for $45. Currently, AIG shares trade for about $24 and the warrants trade for $5.77, respectively.
The Bottom Line
Bank warrants are a lucrative way to make a bet that U.S. financials will once again be respected by the investing public. The warrants pay off if the underlying share prices appreciate strongly over the next several years. Just the same, the warrants can decline precipitously if the underlying stock price trades lower. A warrant's return is magnified both ways in relation to the move of the underlying stock. But in seven to 10 years' time, financial warrants could be a jackpot investment.
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