Are TARP Warrants the Way to Play Banks?

By: Money_Morning

Tim Melvin writes: Believe it or not, the big bank rescue plan known as the Troubled Asset Relief Program (TARP) actually has created some of the best investments for profiting from a banking recovery.

As you may recall, the federal government gave money to troubled banks in order to shore up balance sheets wounded by falling real estate and mortgage security prices. As part of the program, the government took an equity stake in these institutions in the form of preferred stock and equity warrants.

When the funds were repaid, the securities - including the warrants - were auctioned off to the public.

Equity warrants are a form of derivative security that gives the holder the right to buy a stock at a certain price until the expiration date. This is much like a stock option but warrants are usually issued for a much longer period of time. They are usually traded on the exchange and are priced based on the strike price, current interest rates and length of time until expiration.

Most of the TARP warrants still have a long time to go until they expire. The majority last until about 2018.

And now is looking like a good time to buy in to these warrants.

That's because the U.S. banking industry is slowly recovering from the financial crisis. Most of them have shown improved credit trends and are in better shape than they were at the height of the crisis. Balance sheets have been rebuilt and hold capital in excess of the regulatory requirement.

Instead of buying banks' shares, you can use TARP warrants to get substantial leverage over owning the banks' common stock.

In some cases, owning the warrant creates a form of synthetic leverage as you can control shares of stock for an extended period of time for a fraction of the price of the underlying shares. Should the stock appreciate substantially over the next five years, the warrants could offer a return that is several multiples of the underlying stock's performance.

Some of the sharpest investors are using TARP warrants to take advantage of the improving situation in the banking industry and aggressive long-term investors might want to consider doing the same.

Best Investments 2013: How to Use TARP Warrants to Play Banks
Capital One Financial Corp. (NYSE: COF) is one of the banks that has paid back its TARP funding and has warrants trading in the marketplace. The warrants do not expire until Nov. 14, 2018 and have a strike price of $ $42.13.

With the stock trading at around $56 the warrants are in the money. With the warrants priced at $19.59 you are only paying a few dollars above the intrinsic value of the warrant to control the shares for the next five and a half years.

If the bank is able to meet analyst expectations of around 7% annual earnings growth in five years, Capital One could easily earn about $7.70 a share have a book value of about $85. At 15 times earnings and 1.3 times book value the shares would trade at around $110. The warrants would be worth about $67. That is about 3.5 times your original investment on the warrants in just five years.

TCF Financial Corp. (NYSE: TCB) warrants also offer an attractive profit opportunity. These warrants also expire in November 2018 and have a strike price of $16.93. The shares trade today at about $14.40 and the warrants cost just $2.12 to control shares until that time.

The Midwestern bank has seen its credit condition improve markedly over the past few years and it has one of the highest customer growth rates in the banking industry. Even with a very moderate growth rate the company could be earning $1.80 a share in five years and have a book value around $14. That implies a potential value of about $27 at 15 times earnings.

The warrants at that price are worth around $10.07 - around five times what investors would pay. The stock only has to reach about $21.20 for the warrants to at least double in value over the 65-month time frame. The leverage gained by using the warrants instead of the stock can pay off in multiples of your original capital.

For more of 2013's best investments, check out the emerging market that's returned the most so far this year.

Source :http://moneymorning.com/2013/05/01/best-investments-2013-are-tarp-warrants-the-way-to-play-banks/

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