[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 U.S. GOVERNMENT PRINTING OFFICE 58-042 WASHINGTON : 2009 ----------------------------------------------------------------------- For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 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. 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