UPDATE 1-US audit urges controls on Treasury warrant deals

(Adds testimony from hearing on warrants program)

By David Lawder

WASHINGTON May 11 (Reuters) - The U.S. Treasury has managed to negotiate prices for stock warrants from bailed-out banks at prices largely at or above estimated values, but it needs better controls over its bargaining process, a government watchdog said on Tuesday.

The Special Inspector General for the Troubled Asset Relief Program said in a new audit report that Treasury has failed to document the decisions that an internal panel made on banks' offers to repurchase warrants from Treasury.

Nor does Treasury document the substance of its conversations and negotiations with banks, potentially jeopardizing the return realized by taxpayers, it said.

"When a brief telephone call can mean the difference of tens of millions of dollars, it is a basic and essential element of transparency and accountability that the substance of that call can be documented contemporaneously," the inspector general, Neil Barofsky, said in the report.

At a U.S. House of Representatives Financial Services subcommittee hearing on the Treasury warrant program on Tuesday, an expert witnesses testifed the Treasury still holds stock warrants worth at least $4.1 billion, but cautioned taxpayers could be at risk if banks are shifted to a proposed new small-business lending program.

Linus Wilson, an assistant finance professor at the University of Louisiana at Lafayette, said a plan to shift some 580 banks that hold government bailout funds to the new program -- intended to spur lending to small businesses -- would cancel warrants and reduce the dividend rate paid on preferred shares to one percent from five percent annually.

The Obama administration envisions a $30 billion lending fund, using TARP funds, that would see smaller community banks take capital on more favorable terms while institutions that now have TARP capital could convert to the new program.

Wilson estimated the loss of warrants and lower dividend rate would cost taxpayers nearly another $5.5 billion, bringing the total increase in taxpayer subsidy to about $8.5 billion for banks and their shareholders.

CITE MORGAN STANLEY TALKS

In his report, Barofsky said Treasury inadequately documented negotiations with Morgan Stanley (MS.N), in which the Treasury's warrant committee had approved an initial bid of $900 million from the bank for its warrants, but it was only after Treasury Assistant Secretary for Financial Stability Herbert Allison interceded that the price was renegotiated to $950 million.

"What actually occurred on the critical call between the Assistant Secretary and Morgan Stanley?" Barofsky asked. "Could similar tactics by Treasury have resulted in similarly favorable prices for taxpayers from other large institutions?"

The Treasury has been negotiating with banks repaying their TARP funds for several months to decide whether to sell stock warrants back to institutions or auction them off to the highest bidders.

The Treasury received the warrants to purchase common stock in the 282 publicly traded banks that received government capital under TARP, the $700 billion bailout program. As of May 6, the Treasury reported $4.91 billion in net proceeds from warrants, including both direct repurchases and auctions.

The warrants were issued at no cost to the government in an effort to allow taxpayers to share in the financial sector's recovery after the bailouts in 2008 and 2009.

In the most recent auction, Treasury took in $181.1 million from auctioning warrants in Comerica Inc. (CMA.N).

PRICING IS PROBLEMATIC

But pricing the warrants has been tricky, involving an initial buy-back bid from the bank and the Treasury's determination of "compositive value" through market quotes, financial modeling and third-party financial modeling estimates. The Treasury can accept or reject a bank's offer, launching a negotiation phase that for larger banks has recently led to auctions.

The inspector general's report said Treasury had "generally succeeded" in negotiating prices from recipients that were at or above the estimated composite value. Of 33 warrant direct repurchases analyzed, 20 of the final negotiated prices were at or above composite value, and nine were just under.

In a written response from Treasury, Allison wrote that while he disagreed with some of Barofsky's findings, he welcomed the audit report and would review the Treasury's procedures "to ensure that there is sufficient consistency in our process." (Reporting by David Lawder; Editing by Chizu Nomiyama)