[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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58-042 WASHINGTON : 2009
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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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