These Bank Bets Put Even Bitcoin to Shame

Metal circular bank vault door, with bars showing the inside of the vault in the background.

The financial industry has gone through a lot in the past decade. After having come to the brink of collapse during the 2008 recession, bank stocks have made a lot of headway since early 2009. Those who were brave enough to buy stock in big banks have done well over that time.

Yet for those who were willing to take even more risk, an alternative to the common shares of big bank stocks has in some cases done even better. By using an investment that became available as a result of the government bailouts of big banks during the financial crisis, some investors have earned huge returns recently that rival even the monumental gains that bitcoin has generated over the past year.

Metal circular bank vault door, with bars showing the inside of the vault in the background.

Image source: Getty Images.

The origin of TARP warrants

Most people remember that the U.S. government bailed out many major banks during the financial crisis as part of what was known as the Troubled Asset Relief Program , or TARP for short. Under the program, the government accepted preferred stock in exchange for providing immediate cash financing to help the banks stay afloat. At the time, the move was controversial because it left taxpayers potentially on the hook for hundreds of billions of dollars of capital infusions into the nation's biggest banking institutions.

Almost as an afterthought, the federal government also received warrants that allowed it to purchase shares of common stock of the banks to which it provided financing. The warrants had an unusually long period of 10 years during which holders could exercise them, paying a fixed predetermined price to buy common shares. Again, few believed that those equity kickers would be of much value at the time, given the huge slides that bank stocks had seen.

Yet as hindsight clearly shows, banks were able to get back on their feet quickly. Some banks simply repurchased their preferred stock and warrants directly from the U.S. Treasury. But in some cases, the government auctioned off their warrants to private investors. They then started to trade publicly alongside the common stock into which they were convertible.

How TARP warrants have done

As you can see below, investing in bank warrants issued under TARP has been quite lucrative in many -- though not all -- cases:

Data source: * Class A and Class B warrants, respectively. ** Since April 2013.

The returns above show something of the aggressive nature of warrants. The TARP warrants were structured to allow holders to buy shares at the agreed-upon price at their option, with no obligation to do so. As such, they trade a lot like options.

The key to understanding these returns is that the agreed-upon strike prices of the warrants varied from stock to stock. For JPMorgan, each TARP warrant currently gives the holder the right to obtain about 1.02 shares of stock for a price of $41.764 per share. With JPMorgan common stock trading well into the triple digits, the TARP warrant has been in the money for years. By contrast, for Bank of America, the Class B warrants call for an exercise price of $30.79 per share, a level that B of A common stock only recently regained.

The variation in strike price created the opportunity for truly colossal returns for some warrants. As recently as early November 2016, Bank of America Class B warrants traded for just $0.09, as most were predicting a Democratic victory in the presidential election that would put an end to any hopes that the bank stock could climb from prices in the mid-teens to make warrants finish in the money. Yet the surprise election result led to an immediate pop in the stock . Shares have roughly doubled, but the warrants have vaulted higher, producing returns of more than 3,000% in just over a year's time, rivaling the rise in bitcoin.

Note, however, that not all warrants are likely to pay off for investors. For Citigroup, the strike price of the Class A warrant is around $106 per share. With the common stock in the mid-$70s, it would take a huge rise within the next year for the warrants to finish in the money, which is why their price has fallen so sharply over the past five years. The odds are good that holders of those warrants will suffer a complete loss when they expire.

Available for a limited time

The bad news for those wanting to invest in TARP warrants is that they're not going to be around for much longer. JPMorgan and Bank of America warrants will expire this coming October, with several others coming due during 2019.

Nevertheless, for those who think that bank stocks have further to climb after a strong 2017, TARP warrants offer a way to get leveraged exposure to future share-price movements. Further gains are possible despite the fact that much of the potential profit from TARP warrant investments has already gone to those who have held them over the past several years.

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Dan Caplinger has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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