Contrarian View: HR 1586 (T.A.R.P. Surtax Bill) will Create Millionaires

This is  just a  few quick thoughts, but I believe, in a few years, we’ll be able to take this bill and place it’s effects high on the list of unintended consequences. Let’s wonder what a reasonable firm would do in order to protect it’s people as much as possible from this legislation… I would put forth the proposal that a firm would give it’s employees the most “bang for the buck.” This seems to clearly be by paying in options. Now, I don’t know all the technical details behind how finance companies have to account for and value options given as compensation, but, using the CBOE option pricer and volatility from Morningstar, I get around $0.50 as the option price for a strike of $2.50 at the time Citi was giving bonuses out, around the time it was at $1.00. Or, if we use $2.50 for the equity price and the strike price, we get $1.62 option price.

Since those prices are per share for lots of 100 option, we get anywhere between 500,000 and 155,000 options, depending on when Citi’s rules would require it to re-cast it’s payments to employees. That’s obviously a huge range. However, for some context, when Citi was trading at $50 / share, having 500,000 shares would have meant you had $25 million in the bank. And 155,000 shares would have meant you had $7.75 million in the bank. However, let’s look at some more likely scenarios. Citi is currently trading at $3.00. As these options are longer dated (I believe the prices quoted above were for 3 year options), could one see a world where Citi is at $10, $15, or even $20 3 years in the future? I think so. So, 155,000 options would be worth between $1.55 million and $3.1 million.The other option is some combination of cash and restricted stock. As we see above, the total shares one would get, if merely receiving restricted stock (at the current trading level) is approximately half to two-thirds.

Now, obviously there are risks. Citi might not be around in three or more years–that is anyone’s guess! This assumes share price increases quite a bit (although the numbers look good even for more modest scenarios). However, all of these would be issues with restricted shares as well–which Wall St. heavily relies upon for compensation. Also, this is just for Citi, which is clearly in a more precarious position than some of it’s peers. For a firm like Goldman, Morgan Stanley, or even Merrill/BofA, the probability of defaulting is way lower. And, for those firms, volatility is lower, making options less valuable, and increasing the ratio of options to restricted shares. the purposes of comparison, Goldman is currently trading at approximately $100 and it’s two year volatility is around 60%. This yields an option price of around $39, or 3x as many options as restricted shares. So, for every $20 Goldman’s shares go up, one would make 3x as much if they had options.

You see where I’m going with this? Now, I don’t know the specific rules surrounding a firm’s ability to re-cast their payments once they’ve been made, or how they compute strike prices, restricted share award prices, or other details. But, I would bet that these firms go back to their employees and let them re-think some of their options (no pun intended).

Fun Super Irony Fact: HR 1586, in the 110th congress was the “The Death Tax Repeal Act of 2007”!!!

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