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Analysis on Buffett’s Bank of America Billion-Dollar Bathtub Ball

August 25th, 2011 Comments off

08.25.2011

Analysis on Buffett’s Bank of America Billion-Dollar Bathtub Ball

Original article written by Net Advisor

Increased concerns over Bank of America’s (NYSE: BAC) possible need for new capital sent Warren Buffet to the rescue with a $5 Billion sweetheart loan?

Bank of America CEO Brian Moynihan has said at least three times (January 28, 2011 Video, 06-01-2011 PDF, and August 11, 2011) that Bank of America has no need to raise capital.

“There is no capital raise needed here,” Moynihan said, speaking at the Sanford Bernstein Strategic Decisions Conference in New York…

— Source: Wall Street Journal (PDF), 06-01-2011

Just last week on August 11, 2011, B of A’s CEO reiterated how they don’t need new capital and how great the bank is doing. Yet on August 25, 2011, Bank of America accepted costly loan terms from Berkshire Hathaway (NYSE: BRK.A). [wikichart align=”right” ticker=”NYSE:BRK.A” showannotations=”true” livequote=”true” startdate=”25-02-2011″ enddate=”25-08-2011″ width=”300″ height=”245″] The deal is a potential win for Berkshire, but investors in B of A common stock don’t get the same deal.

Here is the deal summary:
1. Bank of America agreed to sell 50,000 shares of BAC “Cumulative Perpetual Preferred Stock” to Berkshire Hathaway, Inc. The preferred stock will have a liquidation value of $100,000 per share. This means Berkshire has essentially loaned $5 Billion to Bank of America.

2. Berkshire will receive 6% (six percent) interest per year (or $300 million/ year paid quarterly) for up to 10 years.

3. Berkshire will also receive a boatload of “warrants to purchase up to 700 million shares of Bank of America common stock at an exercise price of $7.142857 per share (about $7.14). The warrants may be exercised in whole or in part at any time, and from time to time, during the 10-year period following the closing date of the transaction.” If the warrants are exercised, the move gives Berkshire to potentially become the bank’s largest shareholder.

4. Bank of America can buy back the preferred shares anytime but it will cost them an additional 5% (five percent) or an additional $250 Million interest paid to Berkshire on their $5 Billion investment.

5. The deal is a private transaction between B of A and Berkshire. This means public investors cannot get in this deal specifically.

Official Deal Terms: Press Release from Bank of America (PDF)

Billionaire Bathtub Ball
Warren Buffet said that he came up with the idea for the B of A deal when sitting in his bathtub on 08-23-2011. The next day Buffet reportedly called B of A’s CEO Brian Moynihan to propose the deal. Moynihan accepted the deal terms.

“Buffett said he conjured the idea while in the bathtub on Tuesday. He called Brian Moynihan, chief executive officer of Bank of America, on Wednesday, he told CNBC.”

— Source: ABC News

B of A’s stock initially jumped nearly 26% on the news, which I would argue was mostly short covering. B of A’s stock lost most of the gains from the on-sought to end up +9.44% by the end of the trading day to close at $7.65 per share. Berkshire Hathaway, Inc., the most expensive stock in terms of dollars needed to purchase, saw its stock fall $2,859 or -2.78% today to close at $103,491 per share.

Berkshire Hathaway's Chairman, Warren Buffett

Analysis
The first question should be: If B of A doesn’t need capital as their CEO repeatedly states, then why would they need to pay 6% to get new capital plus an additional 5% cost to get out of that deal, plus the cost of giving up 700 Million shares of stock in the process?

If B of A needed to borrow money they can do this from the FED directly at near 0.00% interest rates (technically under 1% or 0.8% Fed Fund Rate as of today). That move would save the bank 5.02% a year plus another $250 Million to get out of the deal, plus saving them from having someone come in to takeover and become the largest shareholder in BAC stock with cheap options (warrants) to boot.

[wikichart align=”right” ticker=”NYSE:BAC” showannotations=”true” livequote=”true” startdate=”25-02-2011″ enddate=”25-08-2011″ width=”300″ height=”245″]

What investors need to understand is that Buffett did not go in today and buy B of A stock. He is effectively lending the bank money, being paid a stellar interest rate in this low interest-rate environment, and getting favorable terms on his investment that no other investor could ever get.

The stock warrants are the true gem in this deal if BAC’s stock can rebound over the next 10 years. With that time-frame, it’s hard to imagine that Buffett almost can’t lose – as long as the bank doesn’t collapse before then.

Sweetheart Deal
Buffett has the right but not the obligation to buy 700 million BAC common shares about $7.14/ per share anytime over the next 10 years. Again, BAC stock closed today at $7.68, and down 1.44% in after-hours trading. Buffett could just exercise (sell) the warrants and pocket the difference between the strike price ($7.14) to any price above $7.14 times 700 million.

Thus, let’s say over the next 10 years BAC’s common stock goes to $10 – Buffet’s Berkshire Hathaway picks up an extra $2 Billion profit [Math: BAC’s stock (hypothetical) $10 future price less cost of warrants ($7.14) =  $2.86 x 700 million (the number of warrants available to Berkshire) = approximately $2 Billion+ extra profit].

If an investor wanted to buy 10 year warrants on Bank of America or any company – they can’t. The best one can do on most major companies is go out up to 2 years, using options. As of the close today, a two-year option of with a $7.50 strike price (expiring: January 19, 2013) of BAC stock cost $2.36 per contract (each contract = 100 shares of stock, thus 1 contract costs $236.00).

Thus, investors who bought these January 2013 options at $2.36 would need to see BAC stock climb to $9.86 or 31.47% to just break even. If BAC stock does not get to $9.86 or higher by Jan 19, 2013, they lose their entire principle investment.

Options Education Note:
Investors can sell out of stock options contracts at anytime at the current market price which may be higher or lower than one’s purchase price. The value of the option is determined in part by the underline value of (in this case) B of A’s common stock plus other factors including volatility in the stock price and how much time is left before the option expires.

In the Buffet deal, he only needs to see BAC stock above $7.14 and he has 10 years instead of two for this to happen. Now we know another reason why Warren Buffet is one of the world’s richest persons. Who wouldn’t want that deal? And if BAC’s stock doesn’t go higher than his $7.14 price in this deal, Buffet doesn’t have to buy any BAC stock! That’s why they call these options (or warrants in this case). Buffet still makes 6% a year plus 5% extra if BAC wants out of the deal. Buffet still keeps his warrants (or options) in any case.

S&P Downgrades Berkshire Hathaway on Insurance Risks
Earlier this month Standard & Poor’s lowered its outlook on Berkshire Hathaway’s debt from “stable” to “negative.” The move by S&P was not related to B of A, but due to concerns over “sovereign credit rating constrains” and the potential impact on insurance companies. Berkshire Hathaway’s primary business is insurance & insurance related.

B of A’s Capital and Risk Concerns Not Over After Buffett Investment
We recently published a report that included discussions of concern for Bank of America. The sweetheart deal that Berkshire received does not change our view on Bank of America, the U.S. economy, Euro contagion risks or the U.S. deficit issues coming again this fall.

Our biggest concern for B of A is its $1 Trillion in problem mortgages. The housing market is still at risk, unemployment is not improving, the U.S. economy is showing ongoing signs of slowing, thus all this plays risk to banks. I would and have argued that B of A is at greater risk because of its acquisition of Countrywide Mortgage and Merrill Lynch.

Until the U.S. economy can show positive real job growth, show stability in Europe and their government and EU banks, show stability in the U.S. housing market, and that the U.S. government gets a firm hold of their deficit spending, we don’t see any change of risk in the banks in general based on current data.

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Disclosure: Net Advisor™ and or clients currently hold short positions in Bank of America via options as discussed in this report.

For further reading about options:
Options come with a high degree of risk and are not suited for everyone. For those who have never invested in options and are considering such, do lot of reading, attend live and on-line classes and consider using a veteran (10+ years active experience) as an options specialist (or Series 4 License broker) for assistance before venturing on your own.

A must read before considering investing in options:
Characteristics & Risks of Standardized Options

Industry Direct Educational Resources: (FREE)
CBOE Options Institute
Options Industry Council (OIC)

Credits:
B of A logo is a registered trademark of Bank of America Inc., N.A.
Charts courtesy: Wikinvest
Warren Buffett image: public domain, may be subject to copyright.
Bathtub image courtesy: lyring.com
Original Content Copyright © 2011 Net Advisor™ All Rights Reserved.

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Categories: Bank Watch List