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Financial stocks haven't gotten much lift from the recent stock market rally. But if you believe in the long-term prospects for the U.S. financial industry, then you'll want to check out this lesser-known way to profit if their stocks move upward between now and the end of the decade.
Profits for taxpayers
Two years ago, during the worst of the financial crisis, the Troubled Asset Relief Program, aka TARP, extended billions of dollars in capital infusions to financial institutions across the nation to help keep them afloat. As part of the program, TARP recipients agreed to pay back the money, along with dividends on the shares they issued to the government in exchange for the government's support.
As additional compensation for the risk that taxpayers took, the Treasury received a type of security known as warrants. These warrants gave the Treasury the right to buy additional shares of TARP recipients' stock at a fixed price. Under the terms of the warrants, the Treasury had up to 10 years before it had to exercise the warrants. Moreover, the warrants are fully transferable, allowing the Treasury to sell them.
A tale of two warrants
Selling is exactly what the Treasury has been doing with TARP warrants. But the way it initially did so was controversial. Last year, several TARP recipients, including Goldman Sachs (NYSE: GS ) , American Express (NYSE: AXP ) , and US Bancorp (NYSE: USB ) , entered into private transactions to buy back their warrants. Although those deals created big profits for the government, many argued that the financial institutions didn't pay the full value of the warrants.
As a result, with its other warrant holdings, the Treasury started auctioning the warrants rather than simply selling them back to the TARP recipients. Just last month, Hartford Financial (NYSE: HIG ) had its warrants auctioned off, following big banks Wells Fargo (NYSE: WFC ) and JPMorgan Chase (NYSE: JPM ) . After their respective auctions, these warrants now trade on public stock exchanges, meaning that you can use them to invest in a wide variety of financial institutions.
The pros and cons of warrants
Warrants carry certain advantages over buying regular shares of stock. The biggest one is that the warrants give investors leverage with limited downside risk. For instance, holders of JP Morgan's warrants have the right to buy common shares for $42.42 anytime between now and October 2018. Right now, the warrants trade for around $12.50 per share, while the stock trades at $38. So the same money that would buy a share of JPMorgan stock could buy three warrants -- or an investor could buy a single warrant and commit less than a third of the capital of buying a share outright.
On the other hand, as with more traditional options, warrants carry substantial risk. Even if JPMorgan's regular shares rise from their current levels, warrant buyers could lose money if they don't rise far enough. At a price of $12.50 for the warrants, the shares would have to rise 45% just for current buyers to break even on their warrant investment.
Moreover, warrant buyers aren't entitled to any of the dividend payments that common shareholders receive. Although that's not a major issue for many former TARP recipients, it may well become one in the future. Before the crisis, financial stocks were among the highest yielding and most consistent dividend payers in the stock market.
Despite these negatives, the extremely long time periods for these warrants makes them less of a timing play than most options. And given the huge uncertainty that the latest foreclosure crisis has created for Bank of America (NYSE: BAC ) and other big players in the mortgage loan business, the value of the long-term downside protection that warrants provide may outweigh their shortcomings.
Look for the best investments
With their higher risk profile, TARP warrants definitely aren't for everyone. But for those trying to balance the potential profits from investing in financial stocks while they're down versus the risks those institutions face now, warrants may be the best solution for your investing needs.
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