Seeing Value in TARP Warrants

Editor's note: The original version of this column had errors on the breakeven level for TCB warrants and the warrant strike price and intrinsic value of CMA warrants. These figures have since been corrected.

One of the interesting points that came out of my discussion with the partners at PL Capital last week was their affection for the bigger banks. They also told me that it wasn't just the big banks that were cheap but also the big-bank TARP warrants that were publicly traded. Most of these warrants do not expire until 2018 or later and give enormous leverage to investors who believe these banks will recover over the next five years.

The discussion rang a few bells inside the more speculative side of my nature, and I pulled up a list of these warrants to see if there were any long-term opportunities.

The TARP warrants of several of the big banks do look like they offer a substantial trade. As Richard Lashley and John Palmer pointed out, most of the big banks' credit issues are behind them. They should be able to grind out returns going forward and begin to once again grow their book value. In addition to the banks themselves appearing cheap, the partners were quite correct that the warrants themselves appear cheap. Warrants, like options, are valued using a model in which interest rates and volatility are major components. Both are very low, as we all know, and as a result, the warrants themselves are cheap on the basis of historical parameters.

This path led me to look at all the TARP warrants that were trading, to see if I could find any good bets. One that leaps off the page is TCF Financial (TCB). The Minnesota-based bank is in the early stages of a turnaround as it focuses on niche markets such as auto loans and inventory financing. The warrants have a strike price of $16.93 and expire in 2018. They last traded at $2.49 this morning, so if the stock is above $19.42 at expiration, this warrant breaks even. I can easily see this stock back into the mid-$20s over the next five years. At $25, the warrant's intrinsic value would be $8.07, or more than three times the initial investment.

I really like the Comerica (CMA) warrants as well. The warrants also expire in 2018 and have a strike price of $39.92, with the stock currently trading below $30. The warrants traded this morning for $7.85, so break-even is $35.60. I think it's a no-brainer that Comerica trades well above that between now and November 2018. In fact, I would expect to see the stock somewhere near the old highs of $65, giving the warrants an intrinsic value of more than $25. The Texas-based bank has a strong balance sheet with adequate capital and trades at 80% of its tangible book value. Loan losses are less than 2% of total loans, and Comerica should see above-average loan growth as commercial markets pick up over the next five years.

One of the more intriguing warrant opportunities is Boston Private Capital Holdings (BPFH). The firm serves as one-stop shop for high-net-worth clients, offering banking services, real estate lending, asset management and trust services. Unlike most banks, Boston Private has a revenue stream that is fee-based and has fewer variables than ordinary banking. The warrants expire in November 2018 and have a strike price of $8. They traded today at $3.81, so break-even is $11.81. Boston Private is trading this morning at $9.29. If over the next five years the stock gets back to two-thirds of the 2008 highs, the warrants will trade for $10. That looks like a pretty good bet on a well-run institution with strong growth in an economic recovery.

The TARP warrants are an interesting speculation for more aggressive long-term investors. As with everything, I suggest you make the markets work for you and not against you with the warrant trade. Buy on down days and be patient. These are three that really stand out to me right now, but I would keep a list of the warrants handy for other developing opportunities.

At the time of publication, Melvin had no positions in stocks mentioned.