Is Buffett Feasting on Bank of America?

A reader has asked me to comment and explain Warren Buffett's purchase of Bank of America preferred shares in the amount of $5 billion.

Bank of America has a need to raise about $100 billion and has approximately $50 billion in overvaluation of its second loans as well as other mortgage and mortgage related legal exposure.  Like Yves Smith at naked capitalism, I have no love for Bank of America, because it is too big, systemically dangerous, and needs to shed the risks of combined commercial banking and investment banking activities.  I have asserted, that since the global financial crisis, U. S. banks have been allowed legally to present public accounting statements which, if presented by any other U. S. business entity, would be considered fraudulent.  It has recently been selling business segment, such as its Canadian credit card business, and other assets to raise money.

I have indicated when discussing European banks, and it holds true for all banks globally and in the U.S., that the recent market downturn has reduced bank stock prices and bank equity, which puts pressure on them to raise money to maintain Tier I and Basel III liquidity ratios.  Bank of America's stock has declined steadily from 1/14/2011 at $15.25 to $6.42 on 8/23 and then rose to $7.76 on 8/26 with the Buffett deal.


If you compare the Goldman Sachs deal Buffet made with this Bank of America deal, you will find it is not as good as the Goldman Sachs deal.  Both were for $5 billion in preferred shares, but the Goldman dividend was 10% while Bank of America is paying 6% (8% accumulation if it suspends dividend payments); Bank of America is callable at a 5% premium while the Goldman Sachs shares were redeemable at a 10% premium; with Goldman Buffet received $5 billion in common share warrants with a strike of $115 and exercisable over five years while Bank of America gave Buffett 700,000,000 warrants for common shares with a exercise price of $7142857 ($5 billion) for a seven year period.  Some sources have characterized this as a $3 billion gift to Buffett from Bank of America, but the correctly calculated amount of the gift is $1.435 billion with the total value of the assets received at $6.45 billion.  Buffett extracted a substantial "fee" from Bank of America. Warren Buffett got a 22.5% discount on total value.

Bank of America preference share class x (Tier 1 equity) had a 7% coupon and was trading at $21 with a $25 par value on the day of this deal for an 8.3% yield.  Buffett's Bank of America preferred shares are Tier 2 debt/loss reserves and should have had a market yield of 9%; he is getting 6%.  At the time of the deal Bank of America shares were $6.88 and his exercise on the warrants were higher at $7.14 rounded.  Linus Wilson, a finance professor, has calculated the market value of the warrants to be $3.17 billion and would be dilutive, of course, of common shares outstanding if exercised.

Since Bank of America needs to raise $100 billion or more, if this deal brings the Buffett imprimatur to Bank of America, it could able to lower financing costs.  If their financing costs would be70 basis points lower, it would save $1.4 billion.

With Goldman Sachs, Buffett took the deal on the fixed side and with Bank of America he is taking it on the equity side.  Does this make Bank of America an attractive stock?  There are hedge funds and mutual funds betting that Bank of America will never be allowed to fail and they are presently losing money.  If eurozone banks develop serious liquidity problems and eurozone austerity dries up the European economy with global ramifications as the U.S. economy continues to slow down with continuing high unemployment, because U.S. political leaders refuse to provide fiscal policy to stimulate aggregate demand, then the global, and that includes the United States, economy is going to contract and stay contracted for a significant period of time.  If that serious economic decline begins to manifest itself, one of the early signs will be bank liquidity stress.

This is not a market for individual investors to be in individual stocks.  Even mutual funds with high financial exposure should be evaluated for the risk of their investments and role within a given portfolio.  This is a time for a well diversified mutual fund portfolio individually consistent with age, assets, risk tolerance, income needs, and affordable quality of life.  All of the big banks are facing headwinds.

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