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Warren Buffett Invests in Bank of America: Not a Buy Signal

By Jim Fink on August 26, 2011

Options let me make money on stocks even when they don’t go up.

Jim Fink — Options for Income

Bank of America (NYSE: BAC), the largest bank in the United States, has had a horrible year so far. At its worst point this past Tuesday (Aug. 23rd), the stock had collapsed 55% year-to-date and was trading at less than one-third of its “stated” book value of $20.29. I emphasize the word “stated” because nobody really believes that Bank of America’s net assets are worth that figure. And that’s a real problem for Bank of America because regulators require banks to maintain capital ratios above a certain level and Bank of America doesn’t meet these capital standards if its assets are written down. Speculation has grown that Bank of America will be required to raise new equity capital, which could significantly dilute current shareholders.

Is Bank of America Going to Dilute Stockholders?

An analyst at Jefferies has estimated that Bank of America will need to raise between $40 and $50 billion in new capital even after it divests itself of a 5% stake in China Construction Bank worth upwards of $9 billion. Given that the bank’s total equity market cap is less than $80 billion, raising that much capital would dilute current BAC shareholders by more than 40%! And to make matters worse, former Merrill Lynch Internet analyst Henry Blodget chimed in that the required capital raise might actually be much larger – up to four times larger at somewhere between $100 and $200 billion. Wait a minute: what does an Internet analyst know about banks? Never mind.

Needless to say, if Blodget’s numbers are anywhere close to accurate, BAC shareholders would be blown to smithereens. Estimates of the capital write-downs Bank of America may need to make include:

  • $15-$20 billion in increased mortgage-litigation reserves
  • $48 billion in increased “second mortgage” reserves
  • Significant – but unspecified — writedowns in:
    • $47 billion of commercial real estate loans
    • $78 billion in goodwill from failed acquisitions
    • $17 billion in European sovereign and bank debt exposure

Bank of America lashed out at Blodget, not only by misspelling his name (intentionally?) but also calling his analysis “exaggerated and unwarranted.” Bank of America CEO Brian Moynihan has continually insisted that the company will not need to raise any additional equity capital.

CEO Brian Moynihan Backtracks and Accepts Money from Warren Buffett

But wait a minute . . . yesterday (Aug. 25th), Bank of America announced that it was accepting a $5 billion capital infusion from Warren Buffett’s Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) in exchange for preferred stock (a form of equity) paying a 6% annual cash dividend. In addition, as a bonus, Berkshire received 10-year warrants (a type of call option) to purchase 700 million shares of Bank of America common stock at a strike price of $7.142857 per share. In other words, Moynihan has reneged on his promise not to raise equity capital. In defending his change of heart, Moynihan stated:

I remain confident that we have the capital and liquidity we need to run our business. At the same time, I also recognize that a large investment by Warren Buffett is a strong endorsement in our vision and our strategy.

Bank of America’s stock initially jumped more than 25% on the news before falling back to a rise of only 9.4%. I think the initial investor euphoria was relief that the bank probably isn’t going bankrupt. After all, Buffett wouldn’t invest $5 billion if he thought bankruptcy were an option, right?  Five-year credit default swaps (CDS) on Bank of America have skyrocketed recently to levels almost has high as during the worst days of the 2008-09 global financial crisis on worries that a Bank of America bankruptcy could actually be a possibility :

Source: Bloomberg

Despite Buffett’s investment, the price for a five-year Bank of America CDS remains extremely elevated, reflecting some investor skepticism surrounding Buffett’s investment. Don’t forget that Buffett recently spoke with President Obama about the economy. Could Obama have asked Buffett to bail out Bank of America? One former hedge fund manager speculates that Buffett agreed to risk $5 billion on Bank of America in return for Obama agreeing to top any EPA regulations from interfering with the natural gas shale fields that Berkshire’s Burlington Northern railroad runs through. Another theory is that Obama assured Buffett that the government was going ahead with plans to offer government-insured mortgage refinancing at 4% to millions of U.S. homeowners, which would significantly reduce Bank of America’s bad loans. Pure speculation to be sure, but the fact remains that Buffett is a strong supporter of Obama and has agreed to host a September 30th campaign fundraiser for the president.

Warren Buffett’s Investment is Expensive and Dilutes Common Shareholders

Even if bankruptcy is off the table, Bank of America stock has come back down because investors realize that Buffett’s investment was made on almost confiscatory terms that include almost 10% equity dilution. First, the 6% interest rate paid on the preferred is much higher than the virtually zero percent Bank of America can borrow at from the Fed or in the inter-bank market – not to mention from collecting new interest-free consumer deposits.

Granted, the average investor can buy Bank of America preferred series V at 7.5% (NYSE: BAC-PV), but this preferred is callable at par at any time and the bank has the right to defer interest payment for up to 20 consecutive quarters (five years) at no penalty. In contrast, Buffett’s preferred series T can only be redeemed at a 5% premium to par ($250 million) and if interest payments are deferred for a single quarter, the interest rate jumps up to 8% in perpetuity (p. 3).  Furthermore, it looks like the exchange-traded series V preferred is subordinate to Buffett’s series T, so Buffett gets paid back first.

The big expense, however, are the 10-year warrants priced at $7.14, which were issued at no premium to the current stock price. To get a sense for how much these warrants are worth, I looked at Bank of America’s exchange-traded January 2013 $7.5 calls (symbol: BAC130119C7.5). They are currently trading at about $2.30 per share. Let’s bump up the value of Buffett’s warrants to $3.50 per share to take into account the additional 8.5 years of time value that they have. Multiply 700 million shares by $3.50 per share and you get a $2.45 billion valuation for the warrants Buffett is receiving, which is almost exactly half of Buffett’s entire $5 billion investment. So Buffett is really only injecting $2.55 billion of new capital into Bank of America and receiving $300 million per year in interest (6% * $5 billion). If you divide $300 million by $2.55 billion, you get an effective interest rate on Buffett’s investment of 11.8%. That’s pretty expensive for a bank that claims it doesn’t need any new capital!

Bottom line: Buffett’s investment probably signals that Bank of America will not be going belly up, but it does not suggest to me that the common stock is a screaming buy. Either CEO Moynihan was wrong when he said in July that the bank doesn’t need to raise any equity capital – which would suggest substantial equity dilution ahead – or he is willing to renege on his promise and pay Buffett an exorbitant interest rate as a public relations stunt, which suggests a management philosophy I don’t want to be associated with.

Investing on News of Warren Buffett’s Goldman and GE Deals Has Not Been Profitable

Either way, I think I’ll pass. Remember, Buffett made similar investments in Goldman Sachs (NYSE: GS) and General Electric (NYSE: GE) back in the fall of 2008. The strike price on the Goldman Sachs warrants was $115 and $22.25 for the GE warrants. If you had bought Goldman or GE stock back then based on the belief that the strike prices on Buffett’s warrants represented good value, you would still not have recouped your initial investment. Goldman is currently trading at $111.38 and GE is trading at $15.60.

Keep this history in mind the next time you let yourself start thinking that the $7.14 strike price on Buffett’s Bank of America warrants represent a steal. Buffett’s warrants on common stock are just icing on his preferred-stock cake. For the average investor buying Bank of America’s common stock today, the stock is the entire cake.

The European banking crisis continues to percolate, which could affect U.S. banks. There are some scary predictions being thrown around, so that is another reason it may be prudent to hold back for now.

Magnify Your Stock Profits By Using Options With the Help of Options for Income!

Rather than buy stock in Bank of America and wait to see if future equity dilution waters down your returns, an alternative way to play Bank of America is to sell a put option at a strike price significantly below Bank of America’s current stock price. With Bank of America currently trading for $7.73, you could sell a January 2013 $5 put option (symbol: BAC130119P5) for $0.95 ($95 per contract). HP could fall an additional 35% — down to $5 — and you could still make the maximum profit on the trade! That demonstrates the power of options.

For example, in Options for Income, my new option trading service, on June 2nd I recommended selling put options that expired in July on biotech company United Therapeutics (NasdaqGS: UTHR). The stock didn’t go up and even declined about 10% by July expiration, but my subscribers still pocketed a 26% profit in less than two months!

If you are interested in earning double-digit returns like this on stocks that go nowhere or even decline, give Options for Income a try today!

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