Thursday, August 25, 2011

Issuing high credit ratings...Buffett's new profitable job. BAC's pound of flesh.

 At first, it was great seeing Buffett had made an investment in Bank of America. I felt a great deal of validation, but after a night thinking about this, I have developed very mixed feelings about his investment.

Basically, I feel Brian Moynihan had payed a very dear price for capital that's both expensive and disadvantageous for the common equity holder. For one, Buffett purchased preferreds not common, so if reps & warranties do go out of hand, Buffett's investment could still be safe. Also the capital from preferreds is not nearly as flexible as capital from an equity raising. In fact, with current low interest rates, Buffett's preferreds will help eat up BAC's NIM . Also the amount of capital Buffett has invested in preferreds is negligible to the overall company...only 5 billion dollars. The company can basically self generate this capital in two months.

Of course, it isn't just the preferreds Buffett bought, which tick me off, it was the 700 million dollars in warrants at a 7.14 dollar strike.....they have a TEN YEAR EXPIRATION.  Those warrants Bank of America gave out were instantly profitable. I'm not an expert on warrant pricing but, the 2019 BAC-A warrants with a 13.30 strike price and an Jan 2019 expiration sell for 4 dollars.  In all likely hood, Buffett could go around and sell 700 million warrants anywhere for 6-12 dollars (depending if the strike decrease with dividends. )  Now it would be very unBuffett of him to turn around and sell the warrants like that. To add insult to injury, Buffett isn't going to exercise those warrants until the very end (due to time value, and the ability to use his capital for other opportunities for the next 10 years without it being preoccupied)  and when he does, BAC surely won't have needed the additional capital.

Looking at the cost and I am a bit cynical about Buffett's investment. If Moynihan believes in the 12.60 net tangible equity per share number and no need for capital raising. Then Moynihan should have never taken Buffett's call. I mean first of all, if Buffett's calling know you are going to get screwed on the price. Call it the Buffett Bite, and it's a big one.
So why the hell would Moynihan do such a deal? I'm guessing it's because Bank of America is willing to pay lots of money for a high credit rating. If you don't want people calling you up about your perceived counter party risk, you are tired of taking phone calls from analysts and you just want the talking heads on TV to say something good about your can give Buffett millions if not billions of dollars for his seal of approval.

Granted, Buffett called Moynihan, it wasn't Moynihan who called Buffett, but I would have been much happier of Moynihan took the phone call, told Buffett Bank of America wasn't interested raising capital at those nose bleed levels, and then issue an (unscrupulous) press release stating Warren Buffett offered to invest money in Bank of America, but we turned him down because we don't need the capital.  That's a much cheaper seal of approval.

I'm off to see the doctor about this pound of flesh missing from my portfolio.

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