Win Where the U.S. Treasury Lost

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As the financial crisis approaches its fourth anniversary, many investors are just now starting to get past the impact that the crisis and the attendant market meltdown had on their portfolios. But for the U.S. Treasury, the crisis is still alive and well, thanks to its ongoing role in the billions of dollars in bailouts it handed out during the fall of 2008.

One of the most controversial responses to the crisis was the government's decision to provide liquidity to hundreds of banks through the Troubled Asset Relief Program. Although the program has recovered a substantial amount of the money it invested in banks, the Treasury still retains some of their investments, especially in smaller institutions.

Later in this article, I'll look at what the Treasury's planning to do with these investments and whether they make a good bet for regular investors. But first, let's take a closer look at exactly what the Treasury did and why it's still dealing with TARP four years later.

How TARP worked
At the time, many critics saw TARP as a giveaway to financial institutions. But the way that the government structured TARP funds was as an investment modeled on similar investments that Warren Buffett-led Berkshire Hathaway (NYSE: BRK-B  ) made to Goldman Sachs and General Electric (NYSE: GE  ) independently.

Specifically, the Treasury made investments of capital in banks in exchange for two things: preferred stock paying dividends of 5%, and warrants that allowed the Treasury to share in profits if the share prices of the banks rose beyond certain levels over the ensuing 10 years. The structure of the investment gave banks the capital they needed to operate, and they gave the Treasury a potential return on the money they advanced to those banks.

Since then, many big banks have redeemed their preferred stock, and in some cases have also repurchased the warrants the Treasury received. But many tiny banks haven't yet repaid the Treasury, even though the clock is running on their preferred shares. If they don't repay them within five years, their rate rises from 5% to 9%. That gives most banks until late 2013 or early 2014 to get their shares paid off before their cost of capital soars.

Many small banks simply can't afford to repay their TARP money. As TARP's own special inspector general pointed out in her quarterly report to Congress in April, small banks have had trouble raising funds, with falling profitability due to changes in regulation and technology that tend to favor economies of scale and make small banks less competitive.

Selling it off
The Treasury apparently doesn't want to be in a position of being a collection agency on those banks that still haven't repaid their TARP money. As a Barron's article discussed over the weekend, the Treasury has begun to auction off the preferred shares they own -- even though in some cases, investors have only been willing to buy the shares at a steep discount to their original par value. For instance, Ameris Bancorp (Nasdaq: ABCB  ) had its preferred shares auctioned off at $0.93 on the dollar, implying a yield of 9.6% if the bank pays off the shares in February 2014.

But as attractive as a high yield may sound, many small banks are delinquent on dividend payments on their preferred shares. As a result, there's no guarantee that investors buying these preferred shares at auction will ever receive any return on their investment.

What to do
Investing in small banks is speculative and requires the recognition that each of these institutions faces different conditions. Despite the risk, at least some of these auctioned preferreds may make a good deal.

But I still believe that the other securities involved in TARP, warrants, make a better bet. With warrants available on Wells Fargo (NYSE: WFC  ) , Bank of America (NYSE: BAC  ) , and several other big banks, you don't have to scramble to do brand new research on banks you've never heard of in order to evaluate them. For many investors, picking up warrants -- or just buying common stock in banks directly -- will make more sense.

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 looks for profits wherever he can find them. He owns shares of Berkshire Hathaway. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Bank of America, Ameris Bancorp, Wells Fargo, and Berkshire Hathaway, and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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 makes you lose.

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