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Learn more and compare subscriptions content expands above. Full Terms and Conditions apply to all Subscriptions. Or, if you are already a subscriber Sign in. Other options. Close drawer menu Financial Times International Edition. Search the FT Search. World Show more World. With some he has already converted to common, and with others he still holds the warrants. The warrants work like options but they differ from options in two important ways.
First, they are much longer dated than options. While they were issued with even longer maturities, these warrants still have between three and five and a half years left until maturity. That is much longer than even the longest available options. Second, TARP warrants have dividend protection. Options do not have dividend protection and the value of dividends paid during the hold period are lost to the option holder.
The TARP warrants are different in this way: when a dividend is paid above a threshold amount which is different for each warrant the terms of the warrants are adjusted. The strike price actually decreases when dividends above a threshold amount are paid. Also, at issue, each warrant allowed conversion to one common share, but over time the warrant holder may be entitled to receive more than one common share per warrant depending on the amount of dividends paid over time above the quarterly thresholds.
This dividend protection has a very complex formula which I lay out in my larger summaries it takes a couple pages to explain… but it is very important as it will increase the return profile potentially substantially.
Their relatively long duration to maturity and partial dividend protection make them compelling investment opportunities for those who want to increase the return potential associated with large financial institutions. While they have added leverage to the upside, it should also be noted they also carry greater downside risks and tend to be much more volatile than the underlying common shares.
I would also point out that this dividend protection could become critically important in upcoming years. The large banks and AIG for that matter are generating a lot more capital than they can put to profitable use.
They now are buying back stock but there may reach a time when they pay out large, one time dividends. If that happens, the dividend protection in the warrants will protect against that value being paid out. Why not not just buy JPMorgan stock? I have long studied and owned the large banks and I find them to be highly compelling investments for those with a longer term perspective.
They face many challenges ranging from heightened regulatory burdens to persistent low interest rates.
Yet they are generating tremendous amounts of current earnings even in this difficult environment and, as the headwinds fade, they are likely to generate more normalized earnings at levels much greater than today. The large banks have also substantially increased their capital and liquidity levels.
The much greater levels of capital and liquidity provide a fortress-like foundation to withstand market and economic stresses. Banks generally fail through a lack of capital or a lack of liquidity, and all the banks have much greater levels of both today making them much safer investments than they have been in the past. The risk profile of the banks individually and the banking system more broadly has declined dramatically since the crisis.
In addition to substantially higher levels of capital and liquidity, there is only minimal short term funding amongst the large banks and they have exited many of the overly risky business lines and activities that contributed to the crisis. Set against all these positive developments, the large banks trade at historically attractive valuations allowing for an investment in safer and enduring businesses at very good valuations.
When we consider the much higher, more normalized earnings power of these businesses, the opportunity becomes unusually attractive and this is why they comprise by far the largest industry concentration in my core fund.
In following and studying the banks, I came across the TARP warrants which allow for amplified returns to the same underlying thesis of these banks returning to normalized earnings and normalized valuations. When I spoke at the SumZero-Institutional Investor InvestPitch event last November, I spoke of how JPMorgan could double in price by late , and given those same dynamics their warrants would increase by a factor of four--a tremendous opportunity over the then four years. Four times your money in four years.
Since then they have gone up in price but not by much, and thus the opportunity remains. The opportunity was so unique in fact that I opened a second fund focused exclusively on TARP warrants to better take advantage of this opportunity which will not come around again. SumZero: Do you think increased regulation has in fact helped banks become more profitable by requiring them to focus on safer core businesses?
What about huge increases in compliance overhead that these regulations also necessitate? There is no doubt about their increased safety and soundness compared to pre-crisis. The regulations have come with increased costs which have hurt recent earnings but the banks are becoming more efficient, are reducing expenses dramatically, and remain very well positioned for much higher earnings as the banking environment and rates normalize.
The current headwinds have really forced banks to run their business much more efficiently than in the past. They are making changes as if the current banking and rate environment will not get better.
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