Thursday, August 25, 2011


BAC - Either Moynihan lied that the company didn’t need capital or he and the board of directors are just plain stupid.

Bank of America is good at two things:

1. buying high (Merrill Lynch); and
2. selling low (its stock).

It looks to me like Moynihan got fleeced on this Buffett deal.

"If I knew for a certainty that a man was coming to my house with the conscious design of doing me good, I should run for my life, as from that dry and parching wind of African deserts called the simoom, which fills the mouth and nose and ears and eyes with dust till you are suffocated, for fear that I should get some of his good done to me -- some of its virus mingled with my blood. No -- in this case I would rather suffer evil the natural way. A man is not a good man to me because he will feed me if I should be starving, or warm me if I should be freezing, or pull me out of a ditch if I should ever fall into one. I can find you a Newfoundland dog that will do as much."
-- Henry David Thoreau

If BAC can borrow at close to zero percent, many are justifiably now questioning why the company agreed to pay a 6% dividend on the $5 billion preferred issued to Berkshire Hathaway (BRK.B).

In reality the cost of capital on the $5 billion Berkshire investment is well in excess of the 6% annual dividend. As was the case in similar deals with Goldman Sachs (GS) and General Electric (GE) several years ago, Berkshire receives a large warrant. (In today's transaction, Berkshire gets the right to buy 700 million shares of BAC at an exercise price of $7.14 a share over a 10-year period).

By my calculation, Berkshire Hathaway is receiving an annual rate of interest on its $5 billion investment of about 10.5%, when incorporating the value of the attached call options on top of the 6% annual dividend on the preferred and the redemption premium of 5%.

Assuming BAC's share price is at $7.72/share and a 45 vol, a 10-year option on 700 million shares of BAC that mature on Sept. 1, 2021, that are exercisable at $7.14/share is valued at about $3.40/share (times 700 million shares), or about $2.4 billion! Add another $250 million of redemption premium -- that makes $2.650 billion in value (or immediate profits today!) incurring to Berkshire.

In other words, the current value of the warrants -- taken over the 10-year period -- provides an additional 4.5%-per-year return on top of the 6% dividend on the preferred, for a total cost of capital per year to Bank of America of nearly 10.5%. (Taken another way, deducting from the exercise price of $7.14/share the value of the call option ($3.40/share) means that Berkshire Hathaway may be paying, if exercised, less than $4/share for BAC!)

If Bank of America didn't need the extra capital (as CEO Brian Moynihan reportedly told Warren Buffett), was the imprimatur of Berkshire Hathaway really that valuable?

From my perch, Moynihan got fleeced by Buffett, the savviest of wolves who slipped out of his bathtub wearing sheep's clothing.

Investors are applauding Warren Buffett's Bank of America investment today. As well, the media is putting a positive spin of the deal.

I, too, believe that the financials are attractive. I have expressed admiration for Bank of America and for the banking sector.

Nevertheless, a more objective assessment of his move is in order now.

Buffett's widely heralded previous buys of General Electric (GE) and Goldman Sachs (GS) were done when the common share prices were at levels that were much higher than current prices. I suspect if one did the analysis of those purchases, we would find that both GE and Goldman common have been massive underperformers as their share price changes are likely in the bottom decile of stock performers since his "preferred" purchases.

The Oracle's investments in GE and Goldman did well not because the underlying share prices appreciated -- they did not; they declined -- they did well because of a preferred structure that included a high-yielding paper with enormous warrants attached.

In the media, I am seeing a lot of flag-waving about Buffett's move today but little in the way of substance. Based on reports, it appears that Buffett did not have a deep knowledge or perform an extensive analysis of Bank of America. Indeed, “Squawk Box's” Becky Quick reported that Buffett told her he got the idea while in the bathtub. When he emerged from the tub, Buffett initiated a call to Bank of America's Moynihan and spelled out his interest in making an investment in the bank.

In other words, it appears that there was little due diligence done and that Buffett, similar to his previous deals, is relying on the preferred structure of the Bank of America deal.

If Warren Buffet was a real believer, wouldn't he simply buy the common stock like other investors? Now that would have been a reason for investors to rejoice.

It would be disingenuous for Buffett to say and for the media to conclude that in making a "preferred" investment in Bank of America that he is making a statement on the U.S. and that he is, once again, buying America.

Warren Buffett is a brilliant investor -- the best there ever was -- but the Bank of America deal is another example of how Buffett benefits from his unique stature in the world's financial community.

Here is how Oaktree Management's Howard Marks draws a colorful parallel between gold and religion, over the past weekend in his always-thoughtful commentary on the markets:

My view is simple and starts with the observation that gold is a lot like religion. No one can prove that God exists ... or that God doesn't exist. The believer can't convince the atheist, and the atheist can't convince the believer. It's incredibly simple: either you believe in God or you don't. Well, that's exactly the way I think it is with gold. Either you're a believer or you're not.

What we do know is that gold is valued in an auction market based on the price where buyers ("the believers") and sellers ("the atheists") meet.