Buffett and Bank of America: Playing Poker with Patsies...

Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...

So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:

Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well.  It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.

Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America. 

http://on.wsj.com/nUOWBS

Here were the terms of the deal:

- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.

- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.

- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.

Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market)  and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know..  Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year.   That is an incredibly sweet deal! 

What did Bank of America get out of this deal? Let's look at what it did not get first:

1. It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. (Update: I have been getting mixed responses on this issue from those who are well versed in bank regulatory capital rules, some saying that I am right and others that I am wrong. The fact that it is cumulative preferred stock, according to some, makes it ineligible for Tier 1 capital, whereas others note that Citi was allowed in 2008 to count cumulative preferred as Tier 1. Here is one article that seems to provide clarity  on the topic. My final response. Whether this passes the regulatory rule requirement or not, it does not pass the common sense rule for Tier 1 capital. If financing results in a commitment of $ 300 million each year that you have to meet, or roll over, it cannot be true Tier 1 capital, no matter what the rules say... )
2. It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.
3. It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal.

The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).

• First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management? 
• Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"?

Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.

I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price.  I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.

In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led...