A Better Way to Buy Bank Stocks?

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Financial stocks have traded all over the map lately. Early in 2012, bank stocks performed very well, as positive news about the economy and the Federal Reserve's latest round of stress tests seemed to bode well for the banking sector in general. But more recently, fears about increased regulation in the wake of the JPMorgan Chase derivatives-trading debacle have sent shares plunging.

Even at lower levels, buying shares may seem like a risky proposition. But an alternative to buying shares outright has become increasingly popular, with some Wall Street money managers choosing to hedge their bets and protect against huge losses while still giving themselves considerable upside potential.

Going back to the financial crisis
Almost four years ago, the U.S. government gave banks billions of dollars in capital infusions to keep them solvent during the worst of the financial crisis. In exchange, the banks gave the government preferred shares that paid dividends and were convertible into common shares.

But the Treasury also got an equity kicker as a way to sweeten the deal for taxpayers. Banks issued warrants to the government that allowed the Treasury to buy additional shares of stock at a fixed price. The warrants gave the government up to 10 years before it had to exercise the warrants, effectively giving it a free ride on any upside above the agreed-upon price.

In the following years, as the banks recovered, they took steps to pay back their TARP money. But even after redeeming their preferred shares, the banks still had the warrants outstanding. A few banks, including US Bancorp (NYSE: USB  ) and Goldman Sachs, chose to make private deals with the Treasury to repurchase their warrants. But for the remaining TARP recipients, the Treasury auctioned off the warrants it held. As a result, many of them trade on public stock exchanges and are available to any investor who wants to buy them.

The pros and cons of warrants
Even though they trade similarly to stocks, warrants are a different type of investment. Warrants most closely resemble options in that they give you the right -- but not the obligation -- to buy shares at a given price within a specific time period. So if a stock's price is still less than the price specified in the warrant -- also known as the strike price -- at expiration, then the warrant holder can just let it expire worthless. But if the stock's price rises, owning the warrant lets you buy it at a relative bargain.

The warrants for each financial institution have different strike prices. For Hartford Financial (NYSE: HIG  ) , the strike price of $9.79 is well below the current price of the stock, and so the price of the warrant already reflects the value of the bargain opportunity. For others, though, including Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) , the warrant price is higher than the current share price, meaning that the stock would have to rise further -- much further, in Citigroup's case -- to avoid having the warrants expire worthless.

The very real possibility that warrants will expire worthless shows the risk involved, as you could easily lose your entire investment. But the amount you invest is less than it would cost you to buy shares -- in some cases, much less. And because most of these warrants don't expire until 2018 or 2019, investors have a lot of time for shares to rise.  

Warrants allow you to spend less to get exposure to a stock, but they do have downsides. One is that generally, they don't give you the right to receive dividend payments. Unlike most warrants or similar options, the TARP warrants include provisions to adjust their strike prices downward to account for dividend payments that exceed a certain amount. But so far, several TARP recipients have paid only insignificant dividends, and even Wells Fargo (NYSE: WFC  ) and other banks that now pay more sizable yields are still below their threshold amounts. In no event will warrant holders get actual cash dividends, and unless those yields rise further, TARP warrants won't let you benefit from common-stock dividends even indirectly.

Take a look
Many investors are nervous about financial stocks but nevertheless see opportunity there. If you want a different way to play the banking sector, take a closer look at TARP warrants. They have risks of their own, but their risk-reward profile may give you more of what you want from your investment.

If you're interested in banking stocks, you won't want to miss The Motley Fool's latest special report on the banking sector. Inside, you'll find out why Warren Buffett likes bank stocks right now, along with the name of one particularly promising institution. The report is free, but don't wait -- read it today.

Fool contributor Dan Caplinger is always looking for a better way. You can follow him on Twitter, @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Bank of America, JPMorgan Chase, Wells Fargo, and Citigroup, as well as having created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never needs a bailout or a warrant.

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