Warrants May Influence Big Bank Shorting

NEW YORK (TheStreet) -- Rising short interest in Bank of America (BAC) and Citigroup (C) may in part be attributable to investor hedging ahead of the Treasury's plans to auction off warrants in the companies, according to a professor who has done extensive research on the U.S. financial bailout.

As part of the government investments in various U.S. companies under its Troubled Asset Relief Program (TARP), the Treasury received warrants to buy shares in those companies at a later date. In most instances, including Goldman Sachs (GS), Morgan Stanley (MS) and U.S. Bancorp (USB), the companies have chosen to negotiate privately with the Treasury, though JPMorgan Chase (JPM), Capital One Financial (COF) and TCF Financial Corp. (TCB) have allowed the Treasury to auction off their warrants.

The warrants have so far proven to be a good investment in most cases, handily outperforming common shares, according to Wilson's research. Capital One's warrants, which trade under the ticker symbol COF-WT, were up 14.9% from when they started trading on Dec. 4 versus a 2.5% loss for Capital One stock. JPMorgan stock gained 1.7% through Friday from Dec. 11, the date its warrants (JPM-WT) began trading. The warrants, by contrast, gained 25.4% over that time period. TCF Financial's warrants (TCB-WT) showed similar outperformance relative to the common shares, Wilson found.

The Treasury is set to auction off its Bank of America warrants Wednesday. Citigroup hasn't said whether it plans to let the Treasury auction off its warrants.

One way for investors to take advantage of the current track record of the warrants outperforming versus the stock, Wilson explains, would be to buy the warrants and short the stock, a strategy known as "delta hedging," he says.

"It hedges out the stock exposure (delta) and allows investors to bet on the warrants rising in value independent of the stock price," Wilson explains.

Citigroup and Bank of America have seen a sharp increase in short interest over the past few months. Much of that increase may be attributable to higher outstanding share counts, as both banks sold several billion dollars worth of new stock in December as part of their TARP repayment plans. Bank of America has paid back the Treasury in full. The government still holds a large stake in Citigroup.