The Striking Price

Playing BofA’s TARP Warrants

STEVEN M. SEARS

Saturday, June 27, 2015

The bank’s January 2019 warrants may be a better buy than the stock.

Bank of America warrants that expire in January 2019 appear to be a better buy than the stock.

Due to an unusual pricing mechanism that lowers the warrant’s strike price, investors can buy warrants that convert into common stock at prices sharply below BofA’s (ticker: BAC) recent stock price.

These warrants are among the last vestiges of the credit crisis that almost toppled U.S. banks. The warrants were issued by banks that participated in the federal Troubled Asset Relief Program, or TARP. In return for those warrants, the banks received billions of dollars from the Treasury, which allowed them to stay in business when it was widely feared they might be forced to close.

Over the years, some banks bought back their TARP warrants, but not BofA, which needed every dollar to mend its wounds and settle massive mortgage-related litigation. The TARP warrants now offer a good opportunity for nimble, long-term investors.

Bank of America’s January 2019 TARP warrants were issued with a $13.30 exercise price, Oppenheimer says. The BofA TARP warrants traded recently at $6.22, well below the stock at $17.63. The warrant can be exercised at anytime, but the current pricing favors holding it for now. Why? So as to give BofA time to lift its dividend and profitability, which should allow warrant holders to realize a profit.

Unlike standard warrants, the TARP warrants’ exercise price declines for every quarterly dividend payment above a penny.

Assuming a quarterly dividend of five cents in 2015, 10 cents in 2016, 15 cents in 2017, and 20 cents in 2018, the January 2019 TARP warrant strike price would be $11.55, Oppenheimer says.

Like other banks, BofA is under intense shareholder pressure to increase profitability, dividends, and its stock-buyback program. If BofA’s stock trades at $24, the warrants would be $12.45 in the money, according to Oppenheimer.

Though the obvious merit of the TARP warrants is that they offer long-term investors the opportunity to cost-effectively control a major bank stock, they also provide relief to investors who bought BofA stock at precrisis price levels.

Investors who have lost money on the stock can use TARP warrants to “double up” and register a capital loss, says Michael Schwartz, Oppenheimer’s chief options strategist.

Doubling up involves buying warrants and selling the initial stock position after 30 days. The 30-day period is critical. The Internal Revenue Service’s wash-sale rule prohibits losses if the stock is sold before 30 days have passed.

INVESTORS INTERESTED in buying bank stocks to gain exposure to rising interest rates can purchase TARP warrants to cost-effectively increase the size of their stock positions or initiate new positions. Think of the warrants as extremely long-dated call options. The stock is less than $1 away from its 52-week high of $18.21 set on Dec. 31.

Schwartz says TARP warrants are attractive because they are priced without a significant time premium, even though they expire in four years. Also, the warrants are deep in the money, which means the exercise price is far below the stock’s price. Schwartz says this means the warrants will closely track the stock’s price.

Moreover, BofA may make some shareholder friendly moves. A recent report from Oppenheimer bank analyst Chris Kotowski advised clients that BofA should launch a $3 billion to $5 billion efficiency program to improve profitability and efficiency ratios, which would close BofA’s valuation gap with JPMorgan Chase (JPM). “If one believes this thesis,” Kotowski recently wrote, “the TARP warrants expiring in January 2019 strike us as the best investment vehicle for expressing this view.”

Reprinted by permission of Barron's Online, © 2015 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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