Spring 2010 Seminar Series

DATE: April 15th
LOCATION: E51-376
TIME: 4:15pm
Reception immediately following in the ORC Conference Room, E40-106

SPEAKER:
Paul Glasserman

TITLE
Valuing the Treasury’s Capital Assistance Program

ABSTRACT
The Capital Assistance Program (CAP) was created by the U.S. Treasury in February 2009 to provide backup capital to large financial institutions unable to raise sufficient capital from private investors. Under the terms of the CAP, a participating bank receives capital by issuing preferred shares to the Treasury combined with embedded options for both parties: the bank gets the option to redeem the shares or convert them to common equity, with conversion mandatory after seven years; the Treasury earns dividends on the preferred shares and gets warrants on the bank's common shares. We develop a pricing framework in which to estimate market values of these CAP securities. The interaction between the competing options held by the buyer and issuer of these securities creates a game between the two parties, and our dynamic programming formulation captures this strategic element of the joint valuation problem. We apply our method to the eighteen publicly held bank holding companies that participated in the Supervisory Capital Assessment Program (the stress test) launched together with the CAP. On average, we estimate that, compared to a market transaction, the CAP securities carried a net value of approximately 30% of the capital invested for a bank participating to the maximum extent allowed under the terms of the program. We also find that the net value varies widely across banks. We compare our estimates with abnormal stock price returns for the stress test banks at the time the terms of the CAP were announced; we find correlations between 0.78 and 0.85, depending on the precise choice of period and set of banks included. These results suggest that our valuation aligns with shareholders' perception of the value of the program. We also discuss broader implications of the program.

 

Joint work with Zhenyu Wang, Federal Reserve Bank of New York