Oct. 22 (Bloomberg) -- The U.S. Treasury Department is fairly valuing warrants received through the $700 billion bank rescue program, according to a finance expert the government hired to address criticism taxpayers are getting a bad deal.

The Treasury hired Robert Jarrow, an economics professor at Cornell University and former managing editor of the journal Mathematical Finance, to review its approach. Warrants are stock options the Treasury received when it bought stakes in banks through the Troubled Asset Relief Program. Warrants must be sold or exercised before a bank can repay its TARP funding.

“It is my belief that the Treasury’s modeling methodology for valuing the warrants is consistent with industry best practice and the highest academic standards,” Jarrow wrote in a paper dated Sept. 22 that he prepared for the Treasury. “The valuation process results in a warrant valuation that is fair to both the participating banks and the U.S. taxpayers.”

Jarrow, who has a Ph.D. in finance from the Massachusetts Institute of Technology, was enlisted to address concerns from the Congressional Oversight Panel and other groups that argue the government hasn’t valued the warrants correctly. “We wanted an independent evaluation of our methodology,” said Treasury spokesman Andrew Williams.

Jarrow was hired by Bank of New York Mellon Corp., the Treasury’s financial agent, for a pricing project that started in late June and early July. Jarrow received about $26,000 for his services and is not contracted for further work, the Treasury said.

Improved Methods

The Treasury’s warrant valuations have improved significantly since July, said Linus Wilson, a University of Louisiana finance professor. He said that banks such as Goldman Sachs Group Inc. and Morgan Stanley paid the Treasury a fair value to repurchase the warrants, in contrast to earlier deals with U.S. Bancorp and State Street Corp.

“They’re doing a much better job,” Wilson said in a telephone interview yesterday. He said the Treasury began seeking better terms once Herb Allison was confirmed as assistant secretary for financial stability, and also in response to pressure from Congress and others.

In July, the Congressional Oversight Panel issued a report asserting that the Treasury sold warrants it obtained from rescued banks for about two-thirds of what they are worth. The panel said taxpayers should have recovered $10 million more from warrant sales with 11 small banks.

At the time, the Treasury disputed the conclusion, saying the government has rejected as too low most proposals from the largest banks seeking to retire the warrants.

Goldman’s Warrants

Banks that want to pay back their capital injections must also dispose of the warrants that the Treasury received, either by repurchasing them or allowing the department to hold an auction. Goldman Sachs redeemed its warrants for $1.1 billion, while JPMorgan Chase & Co. has said it will allow the government to auction its warrants after the Treasury rejected an appraisal as too low.

Banks have 15 days after retiring government stakes to propose a “fair market value” for the securities, which triggers a Treasury appraisal process. If the bank and the government can’t agree on a price, the Treasury will sell them at auctions.

The process of selling warrants will occur within “several months” of eligibility rather than the government holding them for a “substantial period,” Allison said in July.

To contact the reporter on this story: Rebecca Christie in Washington at rchristie4@bloomberg.net

Last Updated: October 22, 2009 00:01 EDT