    [House Hearing, 111 Congress]
    [From the U.S. Government Publishing Office]

                      TARP OVERSIGHT: AN UPDATE ON WARRANT

                     REPURCHASES AND BENEFITS TO TAXPAYERS

    =======================================================================

                                    HEARING

                                   BEFORE THE

                                SUBCOMMITTEE ON
                          OVERSIGHT AND INVESTIGATIONS

                                     OF THE

                        COMMITTEE ON FINANCIAL SERVICES

                         U.S. HOUSE OF REPRESENTATIVES

                         ONE HUNDRED ELEVENTH CONGRESS

                                 SECOND SESSION

                                   __________

                                  MAY 11, 2010

                                   __________

           Printed for the use of the Committee on Financial Services

                               Serial No. 111-132

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                     HOUSE COMMITTEE ON FINANCIAL SERVICES

                     BARNEY FRANK, Massachusetts, Chairman

    PAUL E. KANJORSKI, Pennsylvania      SPENCER BACHUS, Alabama
    MAXINE WATERS, California            MICHAEL N. CASTLE, Delaware
    CAROLYN B. MALONEY, New York         PETER T. KING, New York
    LUIS V. GUTIERREZ, Illinois          EDWARD R. ROYCE, California
    NYDIA M. VELAZQUEZ, New York         FRANK D. LUCAS, Oklahoma
    MELVIN L. WATT, North Carolina       RON PAUL, Texas
    GARY L. ACKERMAN, New York           DONALD A. MANZULLO, Illinois
    BRAD SHERMAN, California             WALTER B. JONES, Jr., North
    GREGORY W. MEEKS, New York               Carolina
    DENNIS MOORE, Kansas                 JUDY BIGGERT, Illinois
    MICHAEL E. CAPUANO, Massachusetts    GARY G. MILLER, California
    RUBEN HINOJOSA, Texas                SHELLEY MOORE CAPITO, West
    WM. LACY CLAY, Missouri                  Virginia
    CAROLYN McCARTHY, New York           JEB HENSARLING, Texas
    JOE BACA, California                 SCOTT GARRETT, New Jersey
    STEPHEN F. LYNCH, Massachusetts      J. GRESHAM BARRETT, South Carolina
    BRAD MILLER, North Carolina          JIM GERLACH, Pennsylvania
    DAVID SCOTT, Georgia                 RANDY NEUGEBAUER, Texas
    AL GREEN, Texas                      TOM PRICE, Georgia
    EMANUEL CLEAVER, Missouri            PATRICK T. McHENRY, North Carolina
    MELISSA L. BEAN, Illinois            JOHN CAMPBELL, California
    GWEN MOORE, Wisconsin                ADAM PUTNAM, Florida
    PAUL W. HODES, New Hampshire         MICHELE BACHMANN, Minnesota
    KEITH ELLISON, Minnesota             KENNY MARCHANT, Texas
    RON KLEIN, Florida                   THADDEUS G. McCOTTER, Michigan
    CHARLES WILSON, Ohio                 KEVIN McCARTHY, California
    ED PERLMUTTER, Colorado              BILL POSEY, Florida
    JOE DONNELLY, Indiana                LYNN JENKINS, Kansas
    BILL FOSTER, Illinois                CHRISTOPHER LEE, New York
    ANDRE CARSON, Indiana                ERIK PAULSEN, Minnesota
    JACKIE SPEIER, California            LEONARD LANCE, New Jersey
    TRAVIS CHILDERS, Mississippi
    WALT MINNICK, Idaho
    JOHN ADLER, New Jersey
    MARY JO KILROY, Ohio
    STEVE DRIEHAUS, Ohio
    SUZANNE KOSMAS, Florida
    ALAN GRAYSON, Florida
    JIM HIMES, Connecticut
    GARY PETERS, Michigan
    DAN MAFFEI, New York

            Jeanne M. Roslanowick, Staff Director and Chief Counsel
                  Subcommittee on Oversight and Investigations

                         DENNIS MOORE, Kansas, Chairman

    STEPHEN F. LYNCH, Massachusetts      JUDY BIGGERT, Illinois
    RON KLEIN, Florida                   PATRICK T. McHENRY, North Carolina
    JACKIE SPEIER, California            RON PAUL, Texas
    GWEN MOORE, Wisconsin                MICHELE BACHMANN, Minnesota
    JOHN ADLER, New Jersey               CHRISTOPHER LEE, New York
    MARY JO KILROY, Ohio                 ERIK PAULSEN, Minnesota
    STEVE DRIEHAUS, Ohio
    ALAN GRAYSON, Florida
                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on:
        May 11, 2010.................................................     1
    Appendix:
        May 11, 2010.................................................    27

                                   WITNESSES
                             Tuesday, May 11, 2010

    Atkins, Hon. Paul, Member, Congressional Oversight Panel, and
      former Securities and Exchange Commissioner....................    14
    Jarrow, Robert A., Ronald P. and Susan E. Lynch Professor of
      Investment Management and Professor of Finance and Economics,
      The Johnson School, Cornell University.........................    16
    Miller, David N., Chief Investment Officer, Office of Financial
      Stability, U.S. Department of the Treasury.....................     4
    Puvalowski, Kevin R. Deputy Special Inspector General, Office of
      the Special Inspector General for TARP (SIGTARP)...............    12
    Wilson, Linus, Assistant Professor of Finance, B.I. Moody III
      College of Business, University of Louisiana at Lafayette......    17

                                    APPENDIX

    Prepared statements:
        Moore, Hon. Dennis...........................................    28
        Atkins, Hon. Paul............................................    32
        Jarrow, Robert A.............................................    37
        Miller, David N..............................................    52
        Puvalowski, Kevin R..........................................    61
        Wilson, Linus................................................   138

                  Additional Material Submitted for the Record

    Moore, Hon. Dennis:
        United States Department of the Treasury, Office of Financial
          Stability, ``Warrant Disposition Report''..................   145
        Congressional Research Service report entitled, ``Government
          Interventions in Response to Financial Turmoil,'' dated
          February 1, 2010...........................................   201
    Atkins, Hon. Paul:
        List of field hearings held by the Congressional Oversight
          Panel......................................................   245

                          TARP OVERSIGHT: AN UPDATE ON

                            WARRANT REPURCHASES AND

                             BENEFITS TO TAXPAYERS

                                  ----------

                             Tuesday, May 11, 2010

                 U.S. House of Representatives,
                              Subcommittee on Oversight
                                    and Investigations,
                               Committee on Financial Services,
                                                       Washington, D.C.
        The subcommittee met, pursuant to notice, at 11 a.m., in
    room 2128, Longworth House Office Building, Hon. Dennis Moore
    [chairman of the subcommittee] presiding.
        Members present: Representatives Moore of Kansas, Adler;
    and Biggert.
        Chairman Moore of Kansas. This hearing of the Subcommittee
    on Oversight and Investigations of the House Financial Services
    Committee will come to order. Our hearing this morning is
    entitled, ``TARP Oversight: An Update on Warrant Repurchases
    and Benefits to Taxpayers.''
        This is our 10th Oversight and Investigations hearing this
    Congress, and our 4th focused on our top priority, TARP
    oversight. Today's hearing is a follow-up to our first TARP
    warrants hearing last July. We will begin this hearing with
    members' opening statements, up to 10 minutes per side, and
    then we will hear testimony from our witnesses.
        For each witness panel, members will each have up to 5
    minutes to question our witnesses. The Chair advises our
    witnesses to please keep their opening statements to 5 minutes
    to keep things moving so we can get to members' questions.
    Also, any unanswered questions can always be followed up in
    writing for the record.
        Without objection, all members' opening statements will be
    made part of the record. I now recognize myself for up to 5
    minutes for an opening statement.
        Leading up to our first TARP oversight hearing focused on
    the issues of warrant repurchases last July, there were a
    number of concerns raised that taxpayers were not seeing
    maximum returns on their investment. I wrote a letter to
    Secretary Geithner last June expressing that, ``I am concerned
    with recent reports that financial institutions that received
    TARP funds are lobbying to buy back warrants the U.S.
    Government received for providing taxpayer assistance at a
    reduced or minimal value. I strongly urge you to utilize your
    authority to maximize the best deal for taxpayers.''
        I copied on that letter our TARP oversight entities,
    including the Congressional Oversight Panel (COP) and SIGTARP.
    Within a few days, I received a response from both that they
    would investigate further.
        Before our July hearing, COP reported that at that time,
    taxpayers were receiving only 66 percent of warrants' value
    compared to their best estimate of their worth. With the
    mounting pressure from Members of Congress, the TARP oversight
    bodies, and the general public, I was pleased to learn the
    morning of our July hearing that Goldman Sachs announced they
    would buy back their warrants for $1.1 billion. That represents
    a 23 percent annualized return taxpayers received on the
    original $10 billion investment in the firm.
        At the hearing I said, ``That sounds pretty good, but is it
    good enough?'' Since that time, other large transactions
    include: Morgan Stanley agreeing to pay $950 million to
    repurchase their warrants; JPMorgan Chase auctioning their
    warrants for $950.3 million; and Bank of America auctioning
    their warrants for more than $1.5 billion.
        To answer my question from the July hearing, ``Are these
    returns enough'', I will read from the written testimony of our
    witnesses today.
        Professor Linus Wilson says, ``Oversight works.'' And that
    is a quote.
        Mr. Atkins, for the Congressional Oversight Panel says,
    ``The Panel has been pleased to see that Treasury's performance
    in this area has improved dramatically since we first analyzed
    its original warrant dispositions.''
        Professor Robert Jarrow remarks, ``It is my belief that the
    Treasury's warrant repurchase program has been a success.''
        In SIGTARP's audit that we will discuss today, they write,
    ``To its credit, Treasury has generally succeeded in negotiated
    prices from recipients for the warrants at or above its
    estimated composite value.''
        I will note that to the benefit of taxpayers, SIGTARP and
    COP rarely if ever hold back on being critical of various TARP
    programs and financial stability efforts, so those comments
    tell me that the program its really working pretty well.
        We should not lose sight of the forest for the trees, and
    before we focus on ways to improve this program, let me stress
    the TARP warrants program has worked and worked well, providing
    over $6 billion of additional returns for taxpayers, with
    billions more expected. And that is beyond the $181 billion
    repayments of the initial TARP investment. If you add the $14
    billion in total dividends, interest and distributions from
    TARP recipients today, taxpayers have received an additional
    $20 billion on top of the normal repayments.
        If Congress had enacted the Bush Administration's original
    3-page proposal for TARP, essentially a $7 billion blank check
    with no oversight and no strings attached, taxpayers would
    likely not have seen these additional returns today and would
    be left with the tab. But by authorizing the use of warrants,
    creating strong oversight entities like SIGTARP and COP, which
    have produced thousands of pages of oversight reports that are
    available online, and adding the requirement that taxpayers
    must eventually be fully repaid, TARP will have done its job to
    both stabilize the economy and fully protect taxpayers.
        And don't take my word for it. Consider what Professor
    David A. Walker from Georgetown University, a Republican
    witness at our Oversight and Investigations hearing last week,
    said, ``I believe that the TARP commitment was essential. It's
    my opinion that our economy would be rebounding much more
    slowly than it has if we had not implemented the TARP
    program.''
        While the TARP warrants have greatly benefited U.S.
    taxpayers, it is our duty to explore the program fully and
    ensure that it is as transparent and run as well as possible.
    For example, I hope we explore policy questions looking at the
    differences between the public auction and direct negotiations
    with Treasury. Is one option better than the other? How do we
    ensure there is consistency of outcomes over a subjective
    process in negotiating a fair value for the warrants? Also, how
    do TARP warrants work for smaller financial institutions
    compared to large ones?
        I look forward to hearing the testimony of all of our
    witnesses today as we continue working hard to provide tough
    oversight of TARP and to ensure taxpayers are fully protected.
        Chairman Moore of Kansas. I now recognize for 5 minutes the
    ranking member of the subcommittee and my colleague from
    Illinois, Ranking Member Judy Biggert.
        Mrs. Biggert. Thank you, Mr. Chairman, and thank you for
    holding this hearing which is a follow-up to our hearing last
    July. It is important that we continue to have hearings like
    this to ensure that taxpayers are getting the best return on
    their TARP investment. I have concerns that taxpayers may not
    be getting the best possible return, and some witnesses have
    noted that the Treasury lacks the internal controls needed to
    measure whether a high enough price was set for warrant
    repurchases or sales.
        I am also concerned that in addition to the 18 warrants
    Treasury holds in financial institutions that have exited TARP,
    Treasury still holds warrants for 237 companies that have yet
    to exit TARP. SIGTARP's April 20th quarterly report lists a
    number of companies that are late on their CPP dividend
    payments. EESA authorizes Treasury to appoint members to the
    boards of directors of such financial institutions.
        Does the Treasury plan to appoint government officials to
    these boards of directors of these delinquent financial
    institutions? I look forward to learning about Treasury's plans
    regarding these issues.
        And finally, I am concerned about the Administration's
    interpretation of the authority it thinks it has to use TARP
    funds. We have an auto bailout, a mortgage modification
    program, and potentially a small business program, all of which
    seem to stretch beyond the original intent of the use of TARP
    funds; and, coupled with AIG and the Fannie Mae and Freddie Mac
    bailouts, it caused a significant loss of TARP and taxpayers'
    money.
        What is Treasury's justification for these activities?
        In addition, what is the Administration's plan to end this
    program, end bailouts, including that of Fannie Mae and Freddie
    Mac, and what is the exit strategy and what is the timeline? We
    need to put an end to the government picking winners and losers
    in the marketplace, which has facilitated unfair competition--
    competitive advantages for some businesses and completely
    abandoned others.
        So I look forward to hearing from today's witnesses and I
    yield back the balance of my time.
        Chairman Moore of Kansas. Thank you to our ranking member.
        I am pleased to introduce our first witness this morning.
    Mr. David Miller is the Chief Investment Officer for the Office
    of Financial Stability in the Treasury Department. Without
    objection, sir, your written statement will be made a part of
    the record.
        Mr. Miller, you are recognized for 5 minutes.

    STATEMENT OF DAVID N. MILLER, CHIEF INVESTMENT OFFICER, OFFICE
        OF FINANCIAL STABILITY, U.S. DEPARTMENT OF THE TREASURY

        Mr. Miller. Chairman Moore, Ranking Member Biggert, thank
    you for the opportunity to testify before you today regarding
    warrants received in connection with the Troubled Asset Relief
    Program. The Emergency Economic Stabilization Act of 2008
    mandates that Treasury, with certain exceptions, receive
    warrants in connection with the purchase of troubled assets.
    These warrants provide taxpayers with an additional potential
    return on the Federal Government's investment.
        I will focus my testimony today on TARP's warrant
    disposition process, and I will highlight our consistency,
    commitment to transparency, and successful results on behalf of
    taxpayers.
        Of the $245 billion that was invested in financial
    institutions, $177 billion, or 72 percent, has been returned to
    pay down the deficit, and taxpayers have earned a modest profit
    on those investments, including more than $6 billion in warrant
    proceeds. These proceeds consist of approximately $3 billion
    from repurchases by issuers at agreed-upon fair market values
    and approximately $3 billion through public auctions. For these
    44 institutions, Treasury received an absolute return of 4
    percent on its investment from dividends and an added 5 percent
    return from warrant sales, for a total absolute return of 9
    percent.
        At this time, I will discuss our process for warrant
    valuation and disposition. Upon redemption of preferred stock
    issued to Treasury, a financial institution has a contractual
    right to repurchase its warrants held by Treasury at a mutually
    agreed upon price representing fair market value. Determining
    fair market value is challenging, especially given the limited
    comparable market data for long dated warrants. As a result,
    Treasury devised a comprehensive process to evaluate repurchase
    bids from financial institutions. Market quotations,
    comparables, independent third-party valuations and model
    valuations are the three primary valuation methods.
        Treasury aggregates the data from internal and external
    valuation sources to determine an estimated fair market
    valuation range. The Office of Financial Stability has
    maintained a consistent valuation process to treat each
    financial institution fairly and similarly.
        Treasury contracted Dr. Robert Jarrow, finance professor at
    Cornell University and noted options expert, to review
    Treasury's warrant valuation process. Dr. Jarrow concluded that
    Treasury's valuation methodology is fair to participating banks
    and taxpayers and consistent with industry best practice and
    the highest academic standards.
        Treasury has managed a transparent warrant disposition
    process. Treasury has published information on all CPP
    transactions, including investments, repayments, warrant
    repurchases, and auctions on financialstability.gov.
        This past January, Treasury released the Warrant
    Disposition Report. This report provides extensive analysis for
    each warrant repurchase and auction. We note that the SIGTARP
    audit release this week concluded that Treasury has
    successfully negotiated prices that were at or above Treasury's
    estimated range of fair value. This report also described
    Treasury's valuation methodology and it did not suggest any
    modifications. However, SIGTARP made recommendations regarding
    documentation of the negotiation process and ensuring that
    consistent information be provided to issuers seeking to
    repurchase their warrants.
        Treasury is carefully reviewing these recommendations and
    will make appropriate changes to its procedures.
        Throughout the warrant process, Treasury remains committed
    to providing the public with comprehensive detail and
    informative analysis.
        Following the repayment, a bank may notify Treasury that it
    does not intend to repurchase its warrants or it may not agree
    with Treasury on a price. As a result, Treasury has sold these
    warrants through public auctions. The warrant auctions have
    successfully attracted many bidders and have been
    oversubscribed multiple times. This has resulted in clearing
    prices in excess of the reserve price set by Treasury.
        These auctions have created a legitimate market, with
    abundant information and significant participation to determine
    a fair market value. Since auction warrants have achieved
    stable aftermarket prices, we believe the Treasury has received
    fair value.
        Implied volatility is one metric for measuring warrant
    disposition value. Generally, the higher the implied
    volatility, the greater the value Treasury receives. On
    average, Treasury has received better pricing, or higher
    implied volatility, for negotiated transactions than for
    auctions. In addition, the size of the warrant disposition has
    impacted the price Treasury has received. Treasury found that
    smaller warrant positions received, on average, a lower implied
    volatility. This differential is from a number of factors,
    including a larger liquidity discount and relatively higher
    transaction cost that would be incurred for smaller position
    auctions.
        Treasury intends to continue to execute a comprehensive and
    transparent process which achieves fair market values and
    protects taxpayer interests. This program has been extremely
    successful and Treasury will continue to strive for optimum
    results on behalf of taxpayers.
        I look forward to answering your questions. Thank you.
        [The prepared statement of Mr. Miller can be found on page
    52 of the appendix.]
        Chairman Moore of Kansas. Thank you, sir, for your
    testimony.
        I now recognize myself for 5 minutes for questions.
        First, Mr. Miller, let me commend you, Assistant Secretary
    Allison, Secretary Geithner, and the entire team at Treasury
    for the work that you do, especially as we review the success
    we have seen with the TARP warrants program.
        Before I focus on TARP warrants, I have a letter addressed
    to Secretary Geithner that I just signed today, discussing
    several items relating to TARP, but also my desire that
    Treasury redouble its effort and try to translate the success
    we have seen in the TARP warrants program to improvements in
    foreclosure mitigation.
        Will you be sure the Secretary receives this letter and
    responds in a timely manner, Mr. Miller?
        Mr. Miller. I will.
        Chairman Moore of Kansas. Thank you.
        Mr. Miller, I don't think it is a surprise that the
    negotiations with Morgan Stanley, as reported by SIGTARP, were
    difficult and not clear-cut. Major negotiations are rarely
    straightforward, and I am glad Treasury was able to obtain an
    additional $50 million more than the Warrant Committee
    originally approved.
        Will you discuss generally how difficult these decisions
    and negotiations are and what factors does Treasury consider
    when seeking maximum return for taxpayers?
        Mr. Miller. Thank you for the question.
        As I highlighted in my written testimony, there is a lot of
    uncertainty about the value of these warrants, particularly
    prior to launching the first auctions. Because there are no
    market prices, we employ a multipronged strategy which looks at
    market prices, looks at model valuation, and we also have a
    third-party independent contractor.
        When we create this range of valuation, there is still no
    single point estimate that one can nail down as the exact
    value. It is a range. There is uncertainty. We take this
    valuation after a lot of discussion and create a range. When we
    enter into the negotiation process, we have an idea of this
    range, and often some banks are way off, which requires a lot
    of conversations to explain how we arrive at the process and
    the inputs that go into it.
        The valuation ranges are highly sensitive to the inputs
    that go in. So it is quite important that we do have a
    discussion with the issuers if they want to repay. Some are
    more sophisticated. Larger banks tend to be more sophisticated
    than the smaller banks.
        Also, reasonable people can disagree about these inputs,
    which is why we use more than just our model. We like to go out
    to the marketplace and get a sense of where things trade. I
    also think the negotiation process is quite dynamic. It is
    going to be unique to each issuer, and one can't follow exactly
    a checklist of exactly the same information, the same schedule
    of conversations, because we are trying to get the best value
    for taxpayers.
        And I think the point regarding how have we done in these
    negotiations, again, what we are always thinking about is can
    we get a price that is as good as or better than what we would
    be able to sell these in the marketplace, understanding that
    there is no quote that we can look at, but getting a sense of
    what we can sell it for.
        Chairman Moore of Kansas. Thank you, Mr. Miller.
        Mr. Atkins from COP, on our second panel, points out that
    in their estimate, auctions yield 110 cents on the dollar,
    while direct negotiations with Treasury yield 93 cents on the
    dollar. But Professor Jarrow points out the added cost by
    setting up an auction, so the advantages may not be as clear-
    cut.
        Does Treasury have a preference between auctions or direct
    negotiations? And what considerations are made by Treasury in
    this regard, sir?
        Mr. Miller. Thanks for the question.
        We have looked at the comparison between our results from
    auctions and negotiations. And what we found--since we only do
    auctions for positions greater than $5 million, which is the
    threshold to list them on the New York Stock Exchange--is that
    on average, we have actually gotten 35 percent volatility for
    the negotiated warrants versus 33 percent at auction on the
    auction warrants, which suggests that we are doing slightly
    better in the negotiations, on average.
        We don't have a preference, contractually, in the CPP
    preferred stock agreement. The banks have a right to repurchase
    the warrants under this program where we have to agree on fair
    market. We believe there are certainly cases where we can do
    better than what something would be sold for in the
    marketplace. I think as we released in our January report,
    putting all the detail out on the negotiated transactions as
    well as the first three warrant auctions, that we have done so.
        Chairman Moore of Kansas. Thank you, sir. And I have a
    couple of additional questions, but my time is just about out.
    So we will submit those in writing and ask if you would respond
    to those, sir.
        Mr. Miller. Thank you.
        Chairman Moore of Kansas. At this time, I will recognize
    the ranking member for questions.
        Mrs. Biggert. Thank you, Mr. Chairman.
        Mr. Miller, does the Treasury Department have plans to
    place members on the boards of directors of the financial
    institutions that participated in the capital purchase programs
    but have missed the dividend payments? I think it was up by the
    time--the sixth quarter, you are supposed to put in two members
    of the board of directors?
        Mr. Miller. Thanks for that question.
        Just to step back, I think you are referring correctly to
    the Capital Purchase Program. If an institution misses its
    dividend payment for six quarters, Treasury has the right to
    nominate someone for the board of directors. There have been a
    number of firms that have missed their dividend payments for
    several quarters. We have not yet had one miss it for six,
    although we are currently considering our options.
        This is a standard covenant in many financial agreements
    that if the bank does miss dividends, the owner of that
    security would have certain rights. But as far as putting
    government officials on the boards, we are not considering
    doing that.
        Mrs. Biggert. So it would be just--who would you put on the
    boards?
        Mr. Miller. We are precluded from actually having a
    government official, the legal interpretation is, but we would
    consider, as we have done in other cases with larger
    investments, looking for independent board members to provide
    an independent voice.
        Mrs. Biggert. In regard to the legality of the foreclosure
    mitigation program, HEMP, the Treasury Department has cited an
    internal legal memorandum that explains the authority for
    Treasury to fund HEMP with TARP funds. The most recent COP
    report, however, explains that the Treasury Department has
    asserted the attorney-client privilege over this memorandum.
        Why wouldn't the Treasury Department simply disclose the
    memo describing its authority to fund HEMP through TARP?
    Shouldn't this be made available to the members of this
    committee? I know that portions of it have been made available,
    and with at least $50 billion of money, taxpayer money on the
    line, I think that this committee and the Congress deserve at
    least a Treasury memo explaining the legality of funding this
    program.
        It seems to me that the thing originally about TARP was
    that the money that would come back was going to go into the
    fund to pay back the deficit, to pay back the debt, rather than
    to fund other programs.
        Mr. Miller. The housing program--and you have raised some
    important questions--is not something that I have
    responsibility for, so I would be happy to take those questions
    back to Treasury.
        Mrs. Biggert. Would you take that back, so we can get an
    answer in writing?
        Mr. Miller. Sure.
        Mrs. Biggert. Thank you.
        The SIGTARP has issued an audit that was critical of the
    method the Treasury used to document its warrant negotiations,
    and I think the chairman addressed this a little bit, but they
    cited the lack of any internal controls in the negotiation
    process.
        What are the internal controls?
        Mr. Miller. I would be happy to discuss a little more about
    the report, because we have gotten a chance to review it.
        First, we feel we have quite robust controls, as far as we
    have something called the Warrant Committee where staff
    prepares memos to review the valuation, all the three methods.
    That committee will meet and discuss it and ultimately provide
    a recommendation to the Assistant Secretary for Financial
    Stability, Herb Allison. He may accept or reject that
    recommendation, but there is a lot of interaction along the
    way.
        As far as the negotiation process, we--again, each
    negotiation is dynamic. We are currently reviewing the
    recommendations made by the SIGTARP which really entail better
    documentation of the negotiation process, and it is something
    we are certainly--
        Mrs. Biggert. Would this include testing of whether
    Treasury was able to acquire a favorable warrant sale price or
    whether the taxpayer lost money on the negotiations?
        Mr. Miller. I think we certainly look at it--it is very
    hard to make a comparison, as valuations done solely by model
    are going to be subjective. People will have different views,
    which is why we use multiple inputs. You can't both do a
    negotiation, if successful, and sell them into the market. And
    so you don't have a perfect market price.
        But we do evaluate very closely what price we receive, and
    if we believe that will be better than what we get in the
    market price. So that is what guides our negotiating. And we
    have been very consistent in how we apply our valuations,
    although each negotiation is going to be different.
        Mrs. Biggert. But isn't SIGTARP wanting to have testing to
    see the result?
        Mr. Miller. I believe the focus of his report was really
    two areas. And again, I think we are always supportive of our
    oversight bodies helping us to improve the process. The first
    one is regarding our Warrant Committee and the minutes that are
    taken. And just to provide a little context, the committee
    minutes itself detail who is present, the recommendation made,
    the date, and the time. Attached to that committee minutes is a
    detailed memo that goes through how we arrive at our valuation
    ranges, and really is the basis for discussion of that
    committee meeting. So it is quite a lot of detail.
        However, the SIGTARP noted that it was a little bit
    difficult in the audit of that to find out exactly the key
    decision point, so we are certainly going to review that and
    look to add more information so it is easier to follow along.
        Mrs. Biggert. Thank you.
        Chairman Moore of Kansas. We don't have any other members
    present besides myself and the ranking member, so I think we
    have agreed that we would like to each have up to 5 additional
    minutes for additional questions, if you would, sir. And I
    thank the ranking member for her agreement.
        We learned a lot from the report Treasury released in
    January on the warrants program. Is that something Treasury
    could release semiannually? And before you respond, Mr. Miller,
    have the recommendations and oversight provided by SIGTARP,
    COP, GAO, and Congress been helpful over the past year-and-a-
    half in improving the administration of TARP and our mutual
    goal of stabilizing our economy while trying to fully protect
    taxpayers?
        Mr. Miller. I will take the first one first. The report was
    certainly something that we had always wanted to do. Leading up
    until January, we certainly were concerned about releasing too
    much information too early because we were concerned that the
    banks that we negotiate with would take advantage of it and
    that could potentially hurt taxpayer returns.
        As we were able to successfully launch the auctions, we
    felt very comfortable that if we could not reach an agreement
    with the bank, we had an extremely viable alternative to sell
    them in the marketplace, so we did not have to in any way lower
    our standards or accept prices that we did not think were fair.
    So once we did that, we felt comfortable releasing a report. We
    certainly plan to release additional reports like that going
    forward.
        Chairman Moore of Kansas. Thank you, sir.
        And finally, Mr. Miller, Professor Wilson raises concerns
    with regard to the proposed small business lending fund and
    small firms being able to get rid of their warrant without any
    benefits to taxpayers. Would you discuss this issue generally
    of how TARP warrants relate to small and big firms? And I have
    said throughout financial regulatory reform that responsible
    community banks should not be subject to enhanced scrutiny. The
    new oversight system should focus on the Wall Street banks and
    nonbanks, like mortgage brokers, that did the most damage.
        Should we focus on the larger institutions to achieve the
    maximum gains for taxpayers?
        Mr. Miller. First, with regards to what is known as the
    SBLF, the Small Business Lending Fund, that is in a proposal
    stage. The Administration put forth a proposal which is meant
    to allow banks to get attractive capital so that they could
    increase their small business lending. That is still in the
    design phase, and I understand it is still with Members of
    Congress.
        With regards to the warrants, it makes no indication--we
    certainly have not indicated that we would cancel any warrants,
    so I am not sure where that view is coming from. That was never
    an intention.
        Regarding small and large institutions, I think clearly the
    bulk of the dollars went to the largest institutions. Those are
    also the institutions that have repaid the lion's shares of the
    $177 billion that has been repaid to date.
        The 650 or so remaining institutions in the Capital
    Purchase Program are small institutions. We still treat them
    equally. They are certainly more difficult to value the
    warrants. Many of them are private institutions which don't
    have warrants that are the ones we are talking about today. But
    the smallest ones certainly trade differently if we were to
    sell them into the market, so that is a challenge we are
    certainly working through as we go forward in the best way to
    monetize those if we don't reach agreement on repurchase as
    these banks continue to repay.
        Chairman Moore of Kansas. Thank you, sir.
        And the Chair now recognizes again the ranking member for
    up to 5 minutes.
        Mrs. Biggert. Thank you, Mr. Chairman.
        Just going back a little bit to the previous question that
    I had, I think that SIGTARP found that unless there are
    sufficient internal controls and documentation--and I am glad
    to hear that they are going to do more of that because, really,
    fairly or unfairly, the criticism of the third parties, it is
    really subjecting themselves to the fact that they can be
    criticized for picking winners and losers unless there is
    that--that the price can be properly scrutinized, even though
    it is after the fact of the negotiation, and to ensure that
    taxpayers receive top value for their investments. Would you
    agree with that?
        Mr. Miller. I think analysis of the value we are getting is
    absolutely important, and we welcome that. We do our own, and
    we welcome others to do so as well. But I would also add that
    these ultimate model valuations that people would use to test
    are highly sensitive to the volatility, which is one of the
    major inputs into determining that value, and so can be used,
    really, any result sum, if they were wanting to get to a number
    that was either very high or very low. What we are trying to do
    is find fair market value; what would the market pay for this?
    And so that is a slightly different process than some might go
    through.
        We have seen a number of reports out in the press where
    people will make sort of outrageous claims that we could have
    gotten ``X,'' but they can't substantiate it.
        Mrs. Biggert. So what is the Administration's plan,
    including the time-lining for ending the TARP program? And when
    will this be revealed to us?
        Mr. Miller. That is a very important question. And I think,
    as you know, the authority to make new investments expires on
    October 3rd of this year. We have also already wound down a
    number of programs, the Asset Guarantee Program, the Target
    Investment Program. The Capital Purchase Program ceased making
    new investments in December of last year, and we have already
    seen a huge amount of repayment which we are very encouraged
    by.
        I think the principle is clearly that we are reluctant
    holders of these securities and will look to monetize them as
    soon as is practicable, but taking into consideration,
    certainly, the prices we could get, financial stability
    overall. But again, we are working towards that, but we are
    doing it prudently and sensibly.
        Mrs. Biggert. One last question, Mr. Miller. If ever
    implemented, do you know where the funding for the
    Administration's proposed small business lending fund will come
    from? I think that the first proposal was for $30 million--a
    $30 billion fund to come from TARP. I understand that a revised
    plan has been issued, but it is silent on how the program is to
    be funded. And some people say that this is nothing but TARP II
    without any potential benefit or payback to the taxpayer.
        Mr. Miller. I don't know the status, as well. I know
    initially it was proposed to come out of TARP. There were good
    reasons why it should not be part of TARP; namely, over time,
    the stigma associated with banks taking TARP money became quite
    difficult, and they were concerned about some of the issues,
    both stigma and some of the restrictions that came with it. And
    that was really hurting the system overall for small banks that
    may benefit from that capital and be able to lend more. But I
    don't have a view on certainly which would be a better way to
    fund it, and I don't know the status of it.
        Mrs. Biggert. Is there a projection of losses? I think some
    people have said $8.4 billion or 28 percent of the fund?
        Mr. Miller. Depending on how it ends up getting structured,
    there have been a number of estimates that show varying degrees
    of subsidy or loss.
        Clearly, if you are giving capital that may be below market
    rate to encourage banks to take that capital, it is not going
    to be 100 cents on the dollar, if you will; there will be a
    subsidy. But I don't think there is a final estimate of that
    for the Small Business Lending Program.
        Mrs. Biggert. Thank you. I yield back.
        Chairman Moore of Kansas. Thank you.
        And thank you, Mr. Miller, for your service and your
    testimony here today. You are now excused, and I will invite
    the second panel of witnesses to please take your seats. Thank
    you sir.
        I am pleased to introduce our second panel of witnesses.
    First, we have Mr. Kevin Puvalowski, Deputy Special Inspector
    General for TARP.
        Second--while we normally have Professor Elizabeth Warren
    testify on behalf of the Congressional Oversight Panel on
    TARP--we are pleased to have a Republican appointee, the
    Honorable Paul Atkins, and a former Security and Exchange
    Commissioner represent COP today.
        Next, we will hear from Professor Robert Jarrow, the Ronald
    P. and Susan E. Lynch professor of investment management and
    professor of finance and economics at the Johnson School of
    Cornell University.
        And finally, we will hear from Professor Linus Wilson,
    assistant professor of finance, B.I. Moody III College of
    Business at the University of Louisiana at Lafayette.
        Without objection, the witnesses' statements will be made a
    part of the record.
        Mr. Puvalowski, you are recognized, sir, for 5 minutes.

      STATEMENT OF KEVIN R. PUVALOWSKI, DEPUTY SPECIAL INSPECTOR
       GENERAL, OFFICE OF THE SPECIAL INSPECTOR GENERAL FOR TARP
                               (SIGTARP)

        Mr. Puvalowski. Chairman Moore, Ranking Member Biggert, and
    members of the committee, it is a privilege and an honor to
    testify today concerning SIGTARP's audit of Treasury's warrant
    disposition process which is being released today before this
    committee.
        The audit, which focuses on the process and procedure that
    Treasury uses to sell warrants that it obtained through TARP,
    was intended to complement the Congressional Oversight Panel's
    July 2009 report that examined the warrant valuation
    methodologies themselves.
        To its credit, Treasury has generally succeeded in
    negotiating prices for warrants at or above its internal
    estimated values. Our audit, however, identified two
    significant problems in Treasury's warrant disposition process
    that have led to failures in transparency and consistency that,
    if left unaddressed, could result in significant harm to the
    program.
        The first deficiency is that Treasury does not sufficiently
    document important parts of the negotiation process. Treasury,
    for example, lacks detailed documentation supporting the
    decisions of the Warrant Committee, the committee that reviews
    TARP recipients' offers. Significantly, committee minutes
    generally do not reflect the factors considered by the members
    when making determinations whether to accept a bank's offer or
    their justifications or explanations for their decisions. Even
    more troubling, Treasury does not document the substance of its
    conversations with recipient institutions when it negotiates
    warrant repurchases, making it extremely difficult, if not
    impossible, to determine what actually happened.
        This lack of documentation significantly limits the ability
    to test the consistency of Treasury's decision-making. Memories
    fade, Treasury officials leave office, and with the passage of
    time and the occurrence of intervening negotiations, different
    parties to a meeting or a conversation may have different
    recollections of what occurred.
        When a committee decision or a brief telephone conversation
    can mean the difference of tens of millions of dollars for
    taxpayers, it is a basic and fundamental element of
    transparency and accountability that the substance of that
    meeting or call be recorded contemporaneously.
        SIGTARP was unable, for example, to determine with
    certainty what occurred during a key telephone conversation
    between Treasury and Morgan Stanley, a conversation that
    resulted in a $50 million swing for the taxpayer. Treasury
    failed to document the call, and the recollection of the
    participants as to what happened during that call differed very
    significantly.
        The second significant deficiency is that Treasury does not
    have established guidelines or internal controls over how the
    negotiations proceed, and, in particular, as to how much
    information is shared with recipient institutions about the
    price Treasury is likely to accept for the repurchase of its
    warrants.
        Descriptions provided to SIGTARP by several of the banks
    that engaged in negotiations with Treasury confirmed that
    Treasury was willing, for some banks, to provide clear
    indications as to what price it was prepared to sell the
    warrants. For other banks, Treasury was unwilling to share
    similar details.
        Indeed, as detailed in the audit, the amount of information
    provided, the circumstances of what information would be
    provided, and the results of the negotiations were all over the
    lot.
        While there may well be good reasons for treating different
    institutions differently in the context of the negotiation,
    because Treasury does not document the negotiations with
    financial institutions, and because there are no established
    guidelines or criteria for what information is shared or when
    it will be shared, it is impossible to determine with
    certainty, after the fact, whether the difference in the
    sharing information was justified or consistently applied, or
    if those different approaches were, in the final analysis, good
    or bad for taxpayers.
        Until Treasury addresses these deficiencies, it risks
    subjecting itself once again, fairly or unfairly, to criticism
    from third parties that through TARP, it is favoring some
    institutions over others, picking winners and losers,
    irrespective of whether, in fact, it had legitimate reasons to
    take the negotiating positions that it did.
        To address these deficiencies, SIGTARP's audit recommends
    that: one, Treasury should ensure that more detail is captured
    by the Warrant Committee meeting minutes; two, Treasury should
    document in detail, contemporaneously, the substance of all
    communications with recipients concerning warrant repurchases;
    and three, Treasury should develop and follow guidelines and
    internal controls concerning how negotiations will be pursued,
    including the degree and nature of information to be shared
    with repurchasing institutions concerning Treasury's valuation
    of the warrants.
        We await Treasury's formal response to these
    recommendations.
        Chairman Moore, Ranking Member Biggert, I want to thank you
    again for this opportunity to appear before you today, and I am
    pleased to answer any questions that you may have.
        [The prepared statement of Mr. Puvalowski can be found on
    page 61 of the appendix.]
        Chairman Moore of Kansas. Thank you Mr. Puvalowski. I
    appreciate your testimony.
        And the Chair will next recognize Mr. Atkins. You are
    recognized, sir, for up to 5 minutes.

     STATEMENT OF THE HONORABLE PAUL ATKINS, MEMBER, CONGRESSIONAL
          OVERSIGHT PANEL, AND FORMER SECURITIES AND EXCHANGE
                              COMMISSIONER

        Mr. Atkins. Thank you very much, Chairman Moore, Ranking
    Member Biggert, and distinguished members of this subcommittee.
    My name is Paul Atkins. I am a member of the Congressional
    Oversight Panel, and I appreciate very much this opportunity to
    testify about the Congressional Oversight Panel's work
    assessing the performance of the Treasury Department in
    managing and disposing of stock warrants that it has acquired
    in conjunction with the Troubled Asset Relief Program. I should
    note that the views expressed today in this testimony are my
    own. I will do my best to try to convey the Panel's views, but
    my statements cannot always reflect the opinions of our five
    very diverse thinkers.
        The Panel is charged by statute to review the current state
    of the financial markets and the financial regulatory system
    and provide monthly reports to Congress assessing the
    effectiveness of Treasury's implementation of the TARP,
    including its disposition of stock warrants.
        When Congress authorized the commitment of $700 billion to
    rescue the financial system, it also required that taxpayers
    participate in the upside if assisted financial institutions
    returned to profitability. This is achieved through Treasury's
    receipt of warrants to purchase common stock, or other
    securities, from the banks party to any transaction in which
    those banks received TARP capital, mainly through what is
    called the Capital Purchase Program or CPP.
        In May of 2009, CPP-assisted banks began to repay their
    TARP assistance. The Oversight Panel in July 2009 evaluated the
    prices that Treasury negotiated for; at that time, 11 banks had
    purchased their warrants. We used the industry standard Black
    Scholes option pricing model adjusted to reflect the particular
    characteristics of the warrants that Treasury received under
    the CPP, and specifically the dividend yield and the 10-year
    duration. The Panel's analysis concluded that Treasury had
    received approximately 66 percent of our best estimate of the
    value of TARP warrants for these banks.
        However, we acknowledged as well that these repurchases
    represented less than one-quarter of 1 percent of our best
    estimate of the value of all the CPP warrants that Treasury had
    acquired as of that time.
        We also knew that Treasury's own valuation of warrants of
    these smaller banks incorporated an adjustment for the likely
    relative illiquidity of a stock of these banks, a step that the
    Panel did not apply because of the subjectivity of that
    particular factor.
        The July report recommended that Treasury give serious
    consideration to employing auctions to dispose of warrants
    rather than relying heavily upon one-to-one negotiations with
    individual banks. Using a public auction for warrant
    repurchases would leave no room for speculation that Treasury
    either was too tough or too easy on a TARP recipient
    institution, while allowing banks to repurchase their warrants
    in competition with other market participants. The report noted
    the need for greater transparency in the Treasury warrant
    valuation and negotiation process and called for Treasury to
    publish periodic reports that provide details on the value
    determinations for the warrants that are being sold.
        I should note that committee member Jeb Hensarling, at that
    time a member of the Oversight Panel, emphasized in particular
    his unease with Treasury's lack of disclosure. And I should
    also express my own concern with Treasury's lack of openness in
    its dealings with the public and with the Oversight Panel, as
    Representative Biggert raised.
        The opinion that you mentioned, Representative Biggert, was
    addressed to me in my capacity as an Oversight Panel member,
    and as far as I am concerned, it is a public document. Treasury
    should not attempt to assert an inapplicable privilege to keep
    information submitted to a congressional oversight body out of
    the public domain.
        In addition to the warrants received under the Capital
    Purchase Program and the Targeted Investment Program, Treasury
    also receives stock warrants in conjunction with the Auto
    Industry Financing Program. Warrants received as part of the
    initial assistance to General Motors and Chrysler were
    extinguished as part of the credit bid process in bankruptcy.
    As in the case of other private institutions, the warrants that
    Treasury received in relation to GMAC for a variety of
    preferred securities were immediately exercised on the
    investment date.
        So in summary, the Oversight Panel is pleased to see that
    Treasury's performance in this area has improved dramatically
    since we first analyzed its initial warrant dispositions. The
    use of public auctions have clearly allowed for taxpayers to
    receive a solid return on their investments in these
    institutions and the transparency provided by public auctions
    allows transactions to take place in full public view. The
    panelists urge the Department to continue publishing the
    details of its internal valuations for each warrant disposition
    transaction, as it did most recently in January this year.
        The Panel has also urged Treasury to provide more assurance
    that it is achieving consistency in the negotiated warrant sale
    price process.
        The issues of transparency and consistency of outcomes will
    each become more important as Treasury moves to dispose of the
    warrants for the many remaining TARP-assisted small banks whose
    stocks are thinly traded. Taxpayers expect and deserve no less
    for the integrity of the process.
        Thank you very much Mr. Chairman.
        [The prepared statement of Mr. Atkins can be found on page
    32 of the appendix.]
        Chairman Moore of Kansas. Thank you, Mr. Atkins, for your
    testimony.
        The Chair next recognizes Professor Robert Jarrow. Sir, you
    are recognized for 5 minutes.

      STATEMENT OF ROBERT A. JARROW, RONALD P. AND SUSAN E. LYNCH
    PROFESSOR OF INVESTMENT MANAGEMENT AND PROFESSOR OF FINANCE AND
           ECONOMICS, THE JOHNSON SCHOOL, CORNELL UNIVERSITY

        Mr. Jarrow. Good morning. I would first like to thank the
    committee for my invitation to testify.
        Some relevant background on myself. I am an expert on risk
    management modeling and implementation. I wrote the first
    textbook on option valuation over 25 years ago. And since that
    time, I have continued to do research in this area. My models
    are currently used by the financial industry to value and to
    hedge both interest rate and credit derivatives. I have
    extensive consulting experience implementing derivative models,
    in practice.
        I was engaged as an independent contractor by the U.S.
    Treasury during the summer of 2009 to audit their warrant
    valuation procedure. A summary of my valuation is available on
    the Treasury's Web site.
        It is my belief that the Treasury's warrant repurchase
    program has been a success. It has generated sales fair to both
    U.S. citizens and to the banks and the TARP program. The
    Treasury warrants repurchase process is well constructed,
    containing two components, a negotiated repurchase and/or an
    auction sale to third parties.
        In the negotiation process, the Treasury determines a
    warrant's fair price using the judgment of Treasury's internal
    experts in conjunction with three different price estimates,
    quotes from market participants, third-party valuations, and an
    internal model.
        The Treasury's internal valuation model is based on best
    industry practice and the highest academic standards.
        Early in the warrant repurchase program, in the summer of
    2009, criticism of the Treasury's fair valuations appeared in
    the financial press and in the July 2009 Congressional
    Oversight Panel report. This criticism was unjustified because
    it was based on price estimates obtained from poor model
    implementations.
        Since that time, the Treasury's valuations have converged
    to those of their critics. This convergence was due to changing
    market conditions. It was not due to a modification of the
    Treasury's methodology, except perhaps for the reduced use of a
    liquidity discount.
        Let me explain these statements in slightly more detail. As
    it is well known, the top warrants are American-type call
    options on a bank's common stock with a 10-year maturity date.
    Valuing these warrants is a complex exercise involving the
    modeling of stock prices, stock price volatilities, dividends,
    and interest rates over the next 10 years.
        Industry best practice is to use a modified Black Scholes
    model which assumes very simple evolutions for these
    quantities.
        The crucial input is a stock price volatility used. The
    correct volatility input should be a forecast of the average
    stock price volatility over the next 10 years, and this is a
    very difficult quantity to estimate.
        The early criticism of the Treasury's valuation estimates
    was mostly based on disagreements concerning this input. The
    correct approach is the one used by the Treasury and not that
    of the critics.
        Since the early warrant repurchases in the summer of 2009,
    the stock market's volatility has declined. This decline in
    volatilities has caused the differences between the stock price
    volatility inputs of the critics and the Treasury to narrow,
    resulting in more similar warrant valuations.
        As is typical of most option pricing techniques, the Black
    Scholes model also assumes that markets are frictionless, with
    no transactions cost and with infinite market liquidity.
        Obviously, these assumptions are not satisfied for large
    sales of nontraded warrants. In this case, a liquidity discount
    is appropriate.
        In the early repurchase of TARP warrants, the Treasury
    applied such a liquidity discount. As market conditions
    stabilized, liquidity discounts were less necessary in
    subsequent warrant sales. The critics' valuation estimates
    never included such a liquidity discount. This was the second
    important difference.
        I am running out of time. I am used to lecturing.
        I will conclude my testimony here, and I welcome questions
    from the committee.
        [The prepared statement of Professor Jarrow can be found on
    page 37 of the appendix.]
        Chairman Moore of Kansas. Thank you, sir, very much, for
    your testimony.
        The Chair next recognizes Professor Linus Wilson.
        And I will remind each of the witnesses that your testimony
    will be received into the record. Thank you.
        Mr. Wilson.

    STATEMENT OF LINUS WILSON, ASSISTANT PROFESSOR OF FINANCE, B.I.
       MOODY III COLLEGE OF BUSINESS, UNIVERSITY OF LOUISIANA AT
                               LAFAYETTE

        Mr. Wilson. I am honored to be invited to appear before the
    subcommittee today. Thank you, Chairman Moore and Ranking
    Member Biggert.
        While I teach and conduct research and finance at the
    University of Louisiana at Lafayette, the views that are
    expressed today are my own and not necessarily the views of my
    university or the State of Louisiana.
        I received my doctorate of philosophy in economics at
    Oxford University in England in 2007. In addition to my other
    academic research in finance economics, I have written 14
    academic papers on the TARP warrants government plans to buy
    so-called toxic assets from banks, the effectiveness of various
    types of capital in encouraging bailed-out banks to make good
    loans, and the ``too-big-to-fail'' problem.
        Half of those papers on the bank bailouts have, to date,
    been accepted or appeared in peer-reviewed academic journals.
    We meet today on almost the 1-year anniversary of the first
    warrant transaction with Old National Bank Corp.
        Much to my surprise, my research into the Goldman Sachs
    warrants and the first warrant repurchase with Old National
    Bank garnered considerable interest.
        I argued that only through third-party sales and auctions
    could taxpayers hope to get the best prices. With pressure from
    this committee, the Congressional Oversight Panel, and me,
    Goldman Sachs announced its $1.1 billion repurchase of the
    taxpayers' warrants. That price was the closest price to my
    estimated fair market value of any bank up to that time.
    Several other very good negotiations for taxpayers followed.
        Yet one outlier among the big investment banks was Morgan
    Stanley, which repurchased the taxpayers' warrants for $950
    million, or $450 million less than the amount that I estimated
    for the Financial Times and Reuters.
        It is alleged in the SIGTARP report released today that the
    top Treasury official for the TARP, Herb Allison, a Wall Street
    veteran, told the chief financial officer of the Wall Street
    investment bank Morgan Stanley the minimum price which the
    Treasury would accept for the taxpayers' warrants.
        Homeowners don't want their real estate agents telling
    potential buyers what the minimum price is that they would
    accept for their house. Yet Mr. Allison, the taxpayers' agent,
    did just that, telling Morgan Stanley that he would accept $950
    million to prevent private investors from pricing these very
    valuable securities at auction.
        We need leadership in the U.S. Treasury that looks after
    taxpayers, not Wall Street investment bankers. Mr. Allison
    should be here to answer for these allegations made in the
    SIGTARP report.
        The first auctions were in December 2009. Before December
    2009, there were no traded options or warrants with expiration
    dates later than 2014. In December, taxpayers got higher prices
    than they were offered in negotiations. Since then, the auction
    and secondary market prices have increased in March, April, and
    May of 2010.
        In addition, we have seen that in-the-money warrants, like
    those of Morgan Stanley and Goldman Sachs, have traded at
    premiums to short-term options with higher implied volatilities
    than short-term options.
        We need to let markets, not backroom deals, price the big
    bank warrants. The Administration is asking Congress to give
    away taxpayers' warrants. The U.S. Treasury and the
    Administration today plan to squander a fair market value of
    warrants and preferred stock of approximately $3 billion by
    allowing almost 600 existing Capital Purchase Program
    recipients to cancel their warrants and convert their preferred
    stock in subordinated debt into the proposed small business
    lending fund.
        If we add in the subsidies to new banks entering the fund
    which are not in the CPP, the subsidy to small banks and their
    shareholders would increase by $5.5 billion. That is, for a $30
    billion fund, taxpayers should expect to lose $8.4 billion, or
    28 percent of their investment, on the day the typical
    investment is made into the fund.
        TARP was an emergency legislation enacted to stop a banking
    panic. I think policymakers can design better ways to stimulate
    growth through tax cuts, government spending or deficit
    reduction. Giving handouts to banks does not make any economic
    sense.
        I think taxpayers should be rewarded for the investments
    they have made.
        With the recovery in bank shares, the U.S. Treasury has
    collected $6.1 billion for the repurchases and auctions. I
    estimate that the fair market value that over 200 publicly
    traded banks and insurance company warrants, excluding AIG,
    which have not been sold prior to this hearing, were worth $4.1
    billion on March 31, 2010.
        Thank you for having me today. I look forward to your
    questions and perspectives.
        [The prepared statement of Professor Wilson can be found on
    page 138 of the appendix.]
        Chairman Moore of Kansas. Thank you, Professor Wilson, for
    your testimony. I will now recognize myself for up to 5 minutes
    for questions.
        Mr. Puvalowski and Mr. Atkins, since you represent SIGTARP
    and COP, would you discuss your views as to whether the
    Treasury Department has been receptive to criticisms and
    recommendations to improve the Tarp Warrants Program? And has
    their performance improved over time? Mr. Puvalowski or Mr.
    Atkins?
        Mr. Atkins. I think they have worked to try to increase
    their accountability and transparency and, as the SIGTARP's
    report and as the Congressional Oversight Panel's report from
    last year indicate, they have been making strides to that goal.
    Is it perfect yet? Probably not, but I think the transparency
    obviously is a thing that we want to try to achieve. Also, an
    equivalence of outcomes is ultimately the goal.
        Chairman Moore of Kansas. Thank you. Mr. Puvalowski?
        Mr. Puvalowski. One way in which Treasury has done a much
    better job over time is in terms of transparency. The
    Government Accountability Office, the Congressional Oversight
    Panel, and SIGTARP were all quite critical of Treasury in the
    early days of the warrant disposition process as to almost a
    complete lack of transparency. Treasury has done a pretty good
    job in responding to that criticism and the warrant report that
    was published in January was a significant step forward in
    terms of transparency in the program.
        With respect to SIGTARP's recommendations in the audit that
    was released today, they are, in our view, very
    straightforward, very commonsense recommendations--that the
    process be documented better, that communications between
    Treasury and the recipient institutions be documented better.
    Right now, they are not documented at all. And that Treasury
    have some guidelines as to how the negotiations take place.
    Treasury has not yet responded to those specific
    recommendations, so we look forward to getting the response,
    and we will report an update on that in our next quarterly
    report.
        Chairman Moore of Kansas. Thank you, sir.
        Professor Jarrow, I appreciate your perspective as an
    authority on model evaluations. Will you go into more detail as
    to how difficult it is to value warrants and address issues
    that these warrants values decay over time. While models are
    valuable, we know they don't always work as we saw in the
    recent financial crisis. Should Treasury be careful not to rely
    on mathematical formulas too much to ensure maximum returns for
    taxpayers, sir?
        Mr. Jarrow. Thank you for that question. So let's start
    first with the models, the models are approximations to a
    complex reality. And as an approximation, they contain errors.
    You need judgment to adjust the model for these errors.
        Relying on a model alone to make judgments with respect to
    repurchase and sales would be a big mistake, especially for
    these financial instruments. They are what we call loan dated,
    they are what we call American type options. American type
    options are options that have a decision embedded within them
    to value them. You have to decide when over the 10 years you
    want to exercise the options. Those are very, very complex
    financial instruments and modeling them is correspondingly
    complex.
        Chairman Moore of Kansas. Thank you, sir. I would like to
    hear from each of you as to which provides the most value for
    taxpayers through the TARP Warrants Program, direct
    negotiations or options? And what public policy issue should
    Treasury and the Congress keep in mind as lessons from the use
    of these warrants and the TARP program. Professor Jarrow, we
    will start with you, sir.
        Mr. Jarrow. Thank you. One of the big issues in valuation
    is deciding what is called the amount of the liquidity
    discount. When you sell a large quantity of shares in the
    market, you don't get the price that you would get, you get a
    lower price than if you sold only a few shares and this
    liquidity discount is a key factor. When you do negotiation,
    you can avoid this market impact potentially. And secondly,
    when you do an auction, you have a third party cost you have to
    pay to the investment bank. So as a rule of thumb, you should
    always do negotiation first, and if negotiations fail, then I
    think having as an alternative an auction process is a very
    good idea.
        Chairman Moore of Kansas. Mr. Puvalowski, do you have any
    comments, sir?
        Mr. Puvalowski. The options that have taken place thus far
    did return a slightly better return just in terms of
    calculation investment return, but there haven't been enough
    options thus far to compare against the negotiated results, we
    haven't drawn a firm conclusion on that one way or the other.
        Mr. Atkins. And by definition, an auction obviously is a
    market price, it is better than any modeling price so that is
    ideally I think what we should strive for. It has been
    relatively easy with the big banks, as we get into the smaller
    banks it may get more problematic.
        Chairman Moore of Kansas. My time has expired, and I will
    have to yield now to the ranking member, please.
        Mrs. Biggert. Thank you, Mr. Chairman.
        Commissioner Atkins, a number of the Capital Purchase
    Program recipients have missed the dividend payments, it might
    not have reached six yet, but there is a whole list of those
    that have missed some of the payments. And after missing a
    sixth quarterly dividend payment, Treasury will have to place
    members on the board of directors of the financial institutions
    that participated, does this concern you?
        Mr. Atkins. Well, it does, obviously having the government
    even more involved in these sorts of private entities, we see
    it already with respect to GM, Chrysler, GMAC, and AIG. And I
    think the importance will be the process of choosing those
    particular directors by Treasury, how open and transparent a
    process it is, and what sort of direction those directors will
    have.
        Mrs. Biggert. And do you have any concerns regarding the
    Treasury's small business lending fund? You know what the
    original proposal was for TARP, but the latest iteration
    doesn't specify how it will be funded.
        Mr. Atkins. Yes, I think you brought up a very good point.
    I think the reason why it is probably not clear how it will be
    funded is that I don't believe that it can be funded from TARP
    under the statute, which is one of the issues for HAMP and HARP
    as well, and I think one of the reasons I asked for Treasury
    for that opinion.
        Mrs. Biggert. I am glad you did bring that up. And that is
    why we want to probe further, and hopefully we will get a
    written response on that authority, thank you.
        Has the Congressional Oversight Panel adopted a budget?
        Mr. Atkins. Well, apparently, we have one, I haven't
    actually seen it. I understand it has $5 million or so, but the
    specifics I am not--
        Mrs. Biggert. How is it funded?
        Mr. Atkins. Apparently, the money comes through the Senate
    Rules Committee, from the Senate side.
        Mrs. Biggert. I am glad they are paying for it. I am sure
    it is the taxpayers, but wouldn't it make sense to adopt a
    budget where the taxpayers know how much is being spent, and
    not just the Senate?
        Mr. Atkins. I agree; I think transparency is good.
    Obviously, that is, I think in your bailiwick as Members of
    Congress.
        Mrs. Biggert. If possible, can you or the COP staff provide
    this panel with a full list of congressional field hearings at
    which a member of the COP has testified since the Panel's
    creation? Are there a lot of field hearings?
        Mr. Atkins. There have probably been about half a dozen or
    so field hearings. There is one, in fact, up in New York today.
    I am sure we can get that to you.
        Mrs. Biggert. We would appreciate that. Then, given that
    large banks comprise a significant higher share of loans under
    $1 million, do you worry that the Administration's small
    business lending fund proposal to inject capital into the
    community banks will not have the desired effect of
    significantly increasing credit for small businesses?
        Mr. Atkins. Well, I think there is a big debate, in fact we
    are coming out with a report this week with respect to
    commercial lending. But I think there is a big debate as to
    whether it is demand or supply that is really affecting small
    business lending.
        Mrs. Biggert. Thank you.
        Professor Wilson, you compared the Treasury's first version
    of the small business lending fund to TARP 2, I think that is
    where it came from without any of the benefits to the taxpayers
    that TARP 1 had. Have you had an opportunity to examine the
    revised version of this program and how it would affect the
    Capital Purchase Program?
        Mr. Wilson. I was looking at the fact sheet that was put on
    whitehouse.gov, which I think was dated February 2nd--if there
    is a more recent version I haven't seen it, and I would love to
    look at it.
        Mrs. Biggert. Thank you.
        Mr. Wilson. I would also say my thoughts about the small
    business lending program, my research has shown that if you
    give banks preferred stock that is senior to common, and
    managers try to maximize the value of common stock, not
    preferred stock. So, in essence, preferred stock adds leverage
    to their incentives and doesn't have desired incentives for
    banks that are undercapitalized.
        Mrs. Biggert. It certainly didn't when they purchased
    Fannie and Freddie preferred stock, did it, as they were asked
    to do.
        Mr. Wilson. Yes. I don't think that the government programs
    have necessarily been as successful as people had hoped.
        Mrs. Biggert. Thank you, I yield back.
        Chairman Moore of Kansas. Thank you, Mr. Puvalowski, for
    showing your office's audit. What was the most troubling
    finding in your report? And if Treasury made only one change to
    improve the TARP warrants program what would that be, sir?
        Mr. Puvalowski. It would be the development of guidelines
    or criteria to put some framework around how the negotiation
    process is conducted. SIGTARP's audit identified very
    significant differences in how different banks were dealt with
    during the negotiation process, particularly with respect to
    how much information was provided to the institutions about
    Treasury's estimated value. Obviously, the negotiation process
    is a dynamic thing that requires some flexibility, but without
    some form of guideline or criteria, there is a real danger of
    arbitrariness of different banks being treated differently, of
    frankly just having one person, whether it is the analyst or
    assistant secretary or someone else at Treasury having a very
    significant discretion in terms of decisions that make the
    difference of tens of billions of dollars of taxpayer return.
        When a Wall Street bank goes out and decides to do a bare-
    knuckled negotiation with a counterparty with one kind of party
    and a more accommodating approach with another counterparty
    that is business, that is what business is all about. Treasury
    is not a Wall Street bank. And when Treasury is administering a
    government program, it is fundamental to accountability, to
    transparency that there be some ground rules to make sure that
    banks are being treated the same.
        Chairman Moore of Kansas. Thank you, sir. Mr. Atkins, or
    other witnesses, what key change should Treasury focus on with
    respect to TARP warrants?
        Mr. Atkins. I would have to echo what Mr. Puvalowski has
    said. I think the potential allegations of favoritism or other
    things that might come up by disparate treatment of
    institutions need to be headed off before they happen.
    Obviously, there is a lot of cynicism in the public, and more
    openness and more documentation to be able to replicate the
    determinations as necessary.
        Chairman Moore of Kansas. Mr. Jarrow and Mr. Wilson, do
    either of you have any comments?
        Mr. Jarrow. I would just echo that transparency is a good.
    And I think the Treasury, at least from my perspective, has
    been very accommodating in regard to that, so I expect that
    they will continue to do so in the future.
        Chairman Moore of Kansas. Mr. Wilson?
        Mr. Wilson. I think the SIGTARP report reveals very
    interesting details about how different banks were treated in
    different ways. And the way that Treasury communicated its
    minimum prices to different banks, and not all banks were
    treated the same. So American Express was not told anything and
    we got the highest price that I have estimated as a percent of
    fair market value. Treasury thought that was a very high price
    too.
        In contrast with Morgan Stanley, there was supposedly,
    according to the Morgan Stanley executive, there was a lot of
    communication about the minimum price they were willing to
    accept, and taxpayers lost between $375 million and $450,0000,
    whether you take my estimate at the time or my estimate after
    looking at the auction warrants. One of the things that we
    found from the auction warrants is that in-the-money warrants
    trade for a lot more than out-of-the-money warrants. And this
    is well-known in option markets; it is called the volatility
    smile. The volatility smile is working in the favor of the
    Treasury with American Express, Goldman Sachs, Morgan Stanley,
    but Morgan Stanley paid less than the implied volatility short-
    term options or at-the-money option, but Goldman Sachs and
    Morgan Stanley paid significantly higher implied volatilities.
        Chairman Moore of Kansas. The Chair would next recognize
    Mrs. Biggert if you have questions for up to 5 minutes.
        Mrs. Biggert. Yes, thank you, Mr. Chairman.
        Mr. Puvalowski, when we were talking about how there is the
    auction and the negotiation, is there a third way to do this
    and with the third party valuations, or is that folded into the
    other two?
        Mr. Puvalowski. Part of Treasury's process is a series of
    steps, and the first is the negotiation process. The bank
    essentially gives its first offer, Treasury will assess that
    offer, and reject or accept it. If it is rejected, the bank has
    an opportunity to provide additional offers, sometimes there
    are multiple offers that are provided.
        If a price cannot be determined through that process, the
    parties do have the option of entering into an appraisal
    process where essentially each side would pick an appraiser,
    they would try to agree, if they couldn't agree a third
    appraiser would be selected. So there is a kind of intermediate
    step. The appraisal process has not been invoked in any case
    thus far. The banks would have to incur the cost of the
    appraisal, which is one of the reasons that has been
    identified, that the appraisal process hasn't happened thus
    far. So there is an intermediate step that is built into the
    process, but it has not yet been used.
        Mrs. Biggert. Thank you. You know the regulatory reform
    bill said in the Senate right now and soon to be the House
    again, I suppose the bills allow for a permanent government
    intervention into ``too-big-to-fail'' for any financial
    institution or business deemed a problem to the Federal
    regulators. Is there a moral hazard in making these programs
    permanent if the financial institutions, or any business thinks
    that if they make poor decisions, then the government will
    simply take over and taxpayers will pick up the tab, does this
    give businesses more or less the green light to engage in risky
    activities? This is a question for anybody who wants to answer.
        Mr. Atkins. Well, I can take a stab at that. I think there
    are certain aspects to that Senate bill as it is moving on the
    Floor that raise a lot of the concerns that you have mentioned,
    particularly the flexibility that is still within the
    government to determine who is systemically significant and
    make those determinations sort of a star chamber type of group
    that would make that determination, there is an appeal process
    and things like that. But I am not sure how that is going to
    work in practice and it is quite concerning, I think.
        Mrs. Biggert. Anybody else? Okay.
        Then Mr. Jarrow, in your testimony, you state that you
    believe that Treasury warrant repurchase program has been a
    success. In the interest of full disclosure, were you
    compensated for your warrant valuation consulting services to
    the Treasury?
        Mr. Jarrow. Yes, I was.
        Mrs. Biggert. Then having served as a consultant to the
    Treasury last year regarding the valuation of the TARP
    warrants, can you comment on SIGTARP's recent audit finding
    regarding the lack of documentation or internal controls? For
    example, how did we know that the Goldman warrant repurchases
    were the best deal for the taxpayer?
        Mr. Jarrow. I can't really comment on the transparency of
    the negotiation because that isn't what I was really looking
    at. I was looking at the process for the valuation and whether
    or not the internal models were good. And I found, and I
    concluded that the process itself was fair and the internal
    models were good.
        One way you could check to see whether or not the resulting
    sale was fair is to get market quotes before the fact and
    compare them to the ultimate sale, to have an internal model
    and to see whether or not the estimates that come out of the
    model are close to the sale. And on those latter criteria, I
    judge that to be quite good and therefore a success.
        Mrs. Biggert. Thank you. Let's see, I have a minute here.
        Professor Wilson, you said in your testimony that we should
    be contracting State ownership of the banking sector, not
    expanding it, and I couldn't agree more. Recently revised small
    business lending fund leaves open the possibility that Congress
    could still fund the program through TARP. What harm to the
    taxpayers could come from implementing this program?
        Mr. Wilson. Right now, we have made investments in over 700
    banks and other institutions. Most of those are preferred stock
    or subordinated debt. The subordinated debt lasts 30 years,
    preferred stock you never have to pay that back. So that the
    taxpayers to exit the TARP will eventually have to sell that or
    convince those institutions to pay that back. I believe that
    the institutions that have paid back early were most likely the
    ones to paid back early, they are also the most healthy
    institutions.
        There are many institutions that have received preferred
    stock or subordinated debt that are not paying dividends or
    interest if it is subordinated debt. And last count, it was 82.
    Three of those have been restructured in bankruptcy and there
    may be more in the future. But it would be very hard to exit
    these preferred stock injections if we don't convince the banks
    to do that. And I think the adverse selection problem will be
    even worse if we are offering a 1 percent dividend to banks
    that have not participated in the Capital Purchase Program
    because we have really exhausted all the banks that are really
    willing to participate and only really desperate institutions
    would want to enter into government ownership.
        Mrs. Biggert. Thank you. Thank you, Mr. Chairman. I yield
    back.
        Chairman Moore of Kansas. Thanks again to the ranking
    member. And again, I want to thank all of our witnesses for
    your testimony here today. Today's hearing was helpful in
    getting an update on where things stand for the United States
    taxpayers with respect for TARP and warrant repurchases. While
    it is good to celebrate the success of the TARP Warrants
    Program, this subcommittee will not and should not rest easy.
    We must keep pushing for greater transparency and
    accountability while maximizing return for taxpayers.
        I ask unanimous consent that the following reports be
    entered into the record: Exhibit 1, the Treasury Department's
    January TARP Warrant Disposition Report; and Exhibit 2, a CRS
    report, ``Government Interventions in Response to Financial
    Turmoil.'' Without objection, those 2 reports will be made a
    part of the record.
        The Chair notes that some members, whether they are here or
    not, may have additional questions for our witnesses which they
    may wish to submit in writing. Without objection, the hearing
    record will remain open for 30 days for members to submit
    written questions to these witnesses and to place their
    responses in the record. This hearing is adjourned, and again,
    I thank very much the witnesses who attended today to give
    their testimony.
        [Whereupon, at 12:21 p.m., the hearing was adjourned.]

                                A P P E N D I X

                                  May 11, 2010

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