What Are Warrants Issued by Financial Institutions?

BY busadmin  August 10, 2009 at 11:41 AM EDT

money; via Flickr

Question: If you have not already done so, would you please explain the warrants that seem to be troubling the financial institutions at the moment? If you’ve already done so, I apologize for asking unnecessarily.

Paul Solman: Hey, even if I HAD already done so, no harm in asking again. They say you need to forget a word in a foreign language seven times before remembering it. I’d guess the definition of warrants would take as least as many tries.

But in fact, I’ve never explained warrants on this page, or anywhere else. So here goes:

First, I assume you mean the warrants the government got in exchange for its capital infusions last year, KB. A warrant is simply a security (legal obligation) a company issues that entitles the holder to a payment, should the company’s stock rise past a certain level. It functions like a call option: an option to buy the stock at a certain price at a given time years into the future, or at any time, with no end date. (Think of stock options issued to executives.)

Functionally, it’s a sweetener for investors. Let’s say some entrepreneur wanted to create a Bill Moyers cable channel and pitch it to one of the big cable companies. Bill already has enough work to support such a venture, as long as there are plenty of re-runs. (But this is cable, remember.) It’s a lot of work, putting all those years of material together coherently. And there’s new work to be commissioned. So, how to raise the money?

Well, form a company (“Bill Moyers Forever”) and give a share of it to investors, price to be negotiated, just as with any start-up. The company issues the usual securities — shares of stock — and gets going.

A cable company signs on. Bill, 24/7, is a rip-roaring success. The company goes public, its stock now traded on a public exchange. Everyone’s happy.

But, this being a hard knock life, let’s imagine that competitors proliferate. There’s the Gwen Ifill Channel, the Ray Suarez Channel. Bill Nye the Science Guy gets one. Sylvia Poggioli. Marshall Efron. Plus, American Idol announces this is its last season, and every TV viewer in America is compelled to tune in, lest they be humiliated at the water cooler for not knowing who the next Kelly Clarkson is.

The Moyers Channel needs just enough money to tide it over until Idol ends, the competitors lose their novelty value, etc. But its stock price is so low, TMC can’t really raise much by issuing more shares. And banks are understandably leery to lend.

So maybe the company goes to a new investor and says, ‘Look, how about you buy some new preferred stock to give us the money we need? As a holder of preferred, you’ll get dividends and get paid back before the common shareholders if we go bankrupt and tell you what: We’ll give you WARRANTS so that if our stock price rebounds, you’ll get the UPSIDE.’ (That’s the word you almost always hear in sentences that include the word ‘warrants’: the ‘upside,’ meaning you share in the success your money may help spur.)

As with TMC, so with the banks that took (or were ‘persuaded’ to take) government money. As to why they would be ‘troubling’ the banks, as you put it? Only to the extent, I guess, that they don’t want the attached strings (read: oversight) that comes with government money.

Last Thursday, former investment bank Morgan Stanley, a recipient of $10 billion in government bailout money for preferred shares (since bought back), purchased the warrant it had issued to Uncle Sam late last October. It paid $950 million dollars to buy back its own obligation to sell as many as 65.25 million shares of Morgan Stanley at $22.99 per share any time in the next 10 years. (Morgan Stanley’s share price was $15.20 at the time.) When Morgan Stanley bought back the warrants, its stock was trading at about $31 a share, about $8 per share above the so-called “exercise” price. $8 per share times 65 million shares is only about $500 million dollars but remember, if MS stock keeps going up, the warrants keep rising in value.

CEO John Mack said the government’s take, including the dividends the company has paid on the regular shares the U.S. got for its $10 billion, has now totaled nearly $1.3 billion and provided “U.S. taxpayers a 20 percent annualized return on their investment in our company.”