The painful rescue of the financial industry may yield a surprise gift: a new securities market that could become a lucrative source of capital for banks.
Warrants that give holders the right to buy stocks of bailed-out lenders at a set price over the next decade have become some of the hottest securities in finance in the past three months, traders and analysts said.
These novel financial instruments — which never really traded en masse before — started flooding the market in December. That's when the Treasury Department began auctioning off to qualified investors some of the warrants it took in more than 280 institutions under the Troubled Asset Relief Program.
The nearly 377 million warrants in JPMorgan Chase & Co. [JPM], Bank of America Corp. [BAC] and two other large banks that went to market through last week fetched favorable prices at auction and enjoyed robust secondary trading. If that trend holds — three more such auctions are slated for this week with potentially many more down the line — warrants could evolve into a common tool that banks use to raise equity and manage capital, experts said.
"Banks could have made a warrant market on their own, but the fact that it was made by the government created something" that wasn't there before, said Linus Wilson, an assistant professor of finance at the University of Louisiana at Lafayette. "It's possible that it could be such a popular market that banks start issuing warrants on their own without government influence."
If the warrant market matures, banks could issue them voluntarily to raise capital without immediately diluting their shares. That is because warrants are not converted into common stock until they're exercised, which could take years because of the way they are priced and structured.
For instance, Capital One Financial Corp.'s [COF] warrants drew $11.75 apiece at auction and have since risen about 14% in secondary trading. They give the holder the right to buy a common share in the company for $42.13 until 2018. Capital One's closing price was $38.66 on Tuesday. Since those warrants are not in the money yet, it could take some time before they're worth exercising.
Banks could also use warrants to take advantage of volatility in their shares, because warrants are worth more during wild swings in the stock market.
"In an optimal world, every CFO should be looking to monetize the volatility of his stock, to the extent that he can," said Nicholas Waltner, managing principal at Kulshan Capital Management LLC in Seattle. "If you had some view that volatility is high and the stock was going to bounce, [a warrant issuance] might make some sense."
Waltner said he has spoken with a derivatives trader at a large bank that is considering shopping warrant offerings to corporate clients, given how well the bank warrants have gone over with hedge funds and institutional investors.
He said a bank could also use a warrant sale to signal to Wall Street that it is bullish on its long-term prospects, especially if they are issued with an aggressive strike price. The downside: a warrant issue runs the risk of giving away equity for cheap if the strike price proves too low.
Either way, warrants could deliver new options when it comes to raising capital.
"We've never really had a wide range of 10-year warrants" before the recent auctions, said Clay Struve, a partner with the trading firm CSS LLC in Chicago. "These are solid prices that people are getting — there is a set of them. There will be a good bit of observation. It might open up the market for longer-term warrants."
Wilson, the Louisiana professor, said a warrants market would not be the first time that government intervention created a new securities market. The mortgage-backed securities market evolved from the regulatory overhauls of the mortgage industry in the 1930s.
Recent history has other examples of new markets starting modestly. The modern options market kicked off when the Chicago Board Options Exchange began offering options in 1973. On its first day, it traded just over 900 contracts on 16 stocks. At the height of the financial crisis in 2008, it moved nearly 10 million contracts in a single day.
It is far from certain that long-dated bank warrants will become as ubiquitous as options or mortgage securities. But traders and analysts say they have the potential to live on as an equity source after the last bank has returned its federal aid, which could take years.
"Once a market develops for whatever reason, oftentimes it does take on a life of its own," said Fred Cannon, co-director of research with KBW Inc.'s Keefe, Bruyette & Woods Inc. "Depending on the kind of valuation these warrants get over time, I could see them as a way that banks might want to start raising equity."
Cannon said he doubts that any bank will float a large number of 10-year warrants in lieu of a common stock offering anytime soon. More likely, he said, banks would start small by issuing them as a sweetener to something like an offering of 10-year bonds. That would drum up interest from bond investors that are already used to playing long.
The warrants have gone over well with investors, which is crucial to their long-term prospects.
There have been five warrant auctions involving four banks: JPMorgan Chase, B of A, Capital One and TCF Financial Corp. (B of A had two types of warrants.)
Wilson said TCF's warrants have outperformed its shares by a wide margin. Had an investor purchased TCF warrants at auction in December, they would have returned 27.3% if sold at the end of February.
Struve said the warrants have stayed liquid, too. JPMorgan Chase's warrants have on average traded 3 million times a week since December. That's not as high as they initially traded, he said, but it is still a healthy volume given the 88 million JPMorgan Chase warrants in circulation.