July 1 (Bloomberg) -- The Treasury’s plan to sell warrants back to banks that are exiting the U.S. aid program undervalues the securities by $525 million, said a University of Louisiana professor who has studied the process.

The anticipated value of warrants for 10 of the largest banks that repaid their Troubled Asset Relief Plan funds is $3.3 billion using the Treasury’s valuation process, compared with $3.82 billion with a more conventional method, Linus Wilson, a finance professor in Lafayette, Louisiana, said in an interview.

Investors are debating whether taxpayers will be fairly compensated for the risk they took by providing rescue funds for the banking industry. Wilson contends prices on 10 buybacks so far were too low; bankers say the U.S. shouldn’t get a short- term windfall. The Treasury said June 26 it will employ “well- known” financial models to come up with fair values that use a range of assumptions about market conditions and dividends.

“Treasury should be making assumptions that favor taxpayers,” Wilson said. “With this statistical sleight of hand, the Treasury’s approach favors the banks.”

Estimates of the total value of all warrants outstanding vary from $5 billion by the Treasury to Wilson’s projection of about $11 billion. The Congressional Budget Office sets the value at $6 billion.

The Treasury’s formula corrects for “well-documented” biases of some pricing models, the agency said. The regulator’s approach is more appropriate for estimating the volatility of a three-month option that won’t be actively traded, Wilson said. It’s less useful for determining the volatility of a 10-year warrant such as the TARP securities, he said.

Exit Strategy

Policy makers want to speed the withdrawal of the government from the banking industry, rather than attempt to maximize returns for the taxpayers by waiting for share prices to rise, Washington banking lawyer William Sweet of Skadden, Arps, Slate, Meagher & Flom said last week.

“The president has clearly stated that his objective is to dispose of the government’s investments in individual companies as quickly as is practicable,” the Treasury statement said.

The Obama administration gave approval in June for 10 of the biggest U.S. banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley, to repay $68 billion of TARP funds. When the money was first obtained, banks had to give the Treasury preferred stock plus warrants to buy stock at a future date at a specific price, called the strike price.

JPMorgan Warrants

Wilson values JPMorgan’s warrants at $1.55 billion using the traditional method of determining how much the stock may gain in the next decade, compared with $1.33 billion set by Treasury, he said. The strike price for JPMorgan is $42.42, about 25 percent higher than yesterday’s closing price of $34.11 in New York Stock Exchange composite trading.

Banks will have 15 days after retiring government stakes to propose a “fair-market value” for the warrants, the Treasury said last week. Should officials object to the estimate, up to three “independent advisers” will help set a price. If lenders don’t make an offer, the warrants will auctioned.

Negotiations as planned by Treasury open the door to political favoritism and corruption, Simon Johnson, an economist at Massachusetts Institute of Technology, said in an interview. Johnson favors public auctions.

“The question is why wouldn’t you sell these on the open market and the answer is that the banks would probably lose,” he said.

Treasury is bound by contracts with the banks that set out a specific negotiating process, spokesman Andrew Williams said.

Rile Congress

Valuing the warrants may rile Congress because lawmakers including Sen. Jack Reed, a Rhode Island Democrat, have warned Treasury Secretary Timothy Geithner not to let banks buy back government stakes at discount prices.

“I will be watching closely to ensure Treasury’s pricing system works both fairly and efficiently for the benefit of taxpayers,” Reed said in a June 26 statement.

At least 10 smaller banks have negotiated warrant buybacks with Treasury, including First Niagara Financial Group Inc., which paid $2.7 million, according to a statement this week. It’s among the best prices Treasury has received so far, equal to 65 percent of what the warrants were actually worth, compared with an average of 48 percent for the 10 previous repurchases, Wilson said.

To contact the reporter on this story: David Mildenberg in Charlotte at

Last Updated: July 1, 2009 10:25 EDT