Although often risky, these securities may be a good bet for investors since they’re offered by a motivated seller.

When Warren Buffett, the world’s most famous investor, plunked money down to buy preferred shares in Goldman Sachs and GE during the worst of the financial crisis, he insisted on getting a little something extra for his troubles.

In return for making his highly publicized investments, Mr. Buffett demanded the companies give him warrants to buy their stock as a sweetener to clinch the deal. The example was not lost on the U.S. Treasury, which also asked for warrants when it later bought bank preferred stock as part of its controversial bailout of the financial industry.

Now, investors are getting an opportunity to buy the Treasury’s warrants and mirror Mr. Buffett’s approach. Over the next few weeks, the Treasury is auctioning off warrants it received in return for investing in a number of top-tier banks, including Wells Fargo & Co., Comerica Inc. and PNC Financial Services Group. The government has already sold those it held in JPMorgan, Bank of America, and Capital One Financial, and will likely sell warrants of dozens of other banks – it holds the securities in about 240 institutions – over the next few years.

The Treasury said on Monday that it was selling some of its Citigroup shares, but that sale doesn’t include any of the U.S. government’s hoard of nearly half a billion warrants in the banking behemoth.

Warrants aren’t as well known as stocks and bonds, but if the world’s money-making maestro insists on owning them, they’re definitely worth a look by investors. Warrants are what might be termed a business person’s risk – leveraged, highly volatile securities that offer a possibility of spectacular payouts. More Discussions in our Globe Investor forums

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Warrants are long-term options to buy shares in a company at a set price, known in the trade as the exercise price. The securities resemble options, but generally aren’t as expensively priced and have much longer periods to run before they expire, a feature that gives investors a fairly long horizon during which to shake the dice and possibly make money.

The chief attraction of warrants is their huge leverage compared to the common shares for which they can be exchanged. If a company’s fortunes are improving and its stock has the good fortune to rise by 50 per cent, warrants typically rally 100 per cent, or even more. The rewards do come with risk, however, so the securities are definitely not for the faint of heart. On their expiry date, warrants end up being worthless, if the shares trade below the exercise price.

“You’re not really buying a Treasury bill here,” says Linus Wilson, a finance professor at the University of Louisiana at Lafayette, who has studied the Treasury’s warrant program. “You have to … have the money that you can lose if you’re investing in warrants.”

Top-flight companies, such as JPMorgan, rarely issue warrants and the U.S. banking industry lobbied the government to rescind the securities. Lower-rated or more speculative companies typically are forced to issue them, as enticements to unload new bond and equity issues.

Besides offering the rare chance to buy some of the best-known brands in banking, these warrants have another unusual, investor-friendly feature: They run for the next nine to 10 years. The warrants consequently provide decent odds for a winning bet: That at some point over the next decade bank shares will trade at substantially higher levels than they are today.

While a long warrant life is a boon for investors, it has caused headaches among market pros trying to figure out what these securities should be worth. Most existing warrants have terms of well under five years. Where there is uncertainty, investors are often unwilling to bid aggressively, raising the possibility the securities may be underpriced by the market.

“There is nothing else out there like that, so how do you price something like that?” says Espen Robak, president of Pluris Valuation Advisors, a firm that specializes in pricing illiquid securities.

For the upcoming sales, Mr. Robak estimates Wells Fargo’s warrants should be priced in the $11 to $14 (U.S.) range, Comerica at $13 to $15, and PNC $20 to $23.
Companies generally try to sell securities when the timing is most favourable to them. But the U.S. Treasury is a motivated seller, another plus for investors. The Treasury, for ideological reasons, is dumping the warrants whenever the banks issuing them redeem their preferred shares.

The Treasury is of the view that it isn’t the business of the U.S. government to be a part owner of the banking system, or to be speculating on the long-term direction of share prices, so it isn’t trying to time the sales to its advantage.

The merits of buying any warrant, of course, depend on the outlook for the issuing company.

While the U.S. banking system is still fragile, the banks with warrants are among the most solvent, an important safety factor after the 2008 meltdown. That is because the banks, to be allowed into the government’s investment program, had to be deemed by regulators to be viable. And to get out of the program, institutions have to have enough capital strength to buy back the government’s preferred shares.

Although Mr. Wilson, as an academic, isn’t willing to forecast bank share prices, he observes that buyers of the warrants are “taking a levered bet on banking stocks and bank stocks are still relatively depressed” compared to the highs they reached before the financial crisis. v

Many of the banks that issued warrants to the government have been reluctant to let the public have them, another allure of the securities. Investors would have had the same opportunity as Mr. Buffett to own Goldman warrants, for instance, but the bank had other ideas. Goldman bought its warrants back from the Treasury under a provision in the bank investment program that allows institutions to sidestep auctions of their warrants and repurchase the securities privately at a negotiated price that reflects their fair market value.

The allure of warrants

The big attraction of warrants is that they can give juicy returns, compared to owning stock in the same company.

Consider the warrants of banking giant JPMorgan. They give investors the right to buy the bank’s shares at $42.42 (U.S.) apiece, any time up to Oct. 28, 2018. JPMorgan shares last week were trading around $44.50, while the bank’s warrants changed hands for about $15.50.

If JPMorgan does well at any time over the next eight years and its shares double to $89, the warrants will do even better: They’ll triple to $46.58. (The math works like this: $89, minus the $42.42 exercise price, equals the $46.58 warrant price.)

Not all of the bank warrants offer as much leverage to a rising share price. Bank of America has two classes of warrants outstanding, known as A and B. If its shares rise 100 per cent, the A warrants will do moderately better, rallying about 118 per cent, but they’re definitely not as attractive as the securities from JPMorgan, based on leverage alone.

While the upside of warrants can be enormous, any time there is the possibility of super-sized returns, there are also large risks. If the economy tanks and Morgan’s shares trade at or below $42.42 on the expiry date, the warrants will be worthless, in which case investors will experience a 100-per-cent loss.
Details of the exercise prices and terms of the bank warrants are filed with the U.S. Securities and Exchange Commission.