BUFFETT´S DEAL WITH BANK OF AMERICA IS ABSOLUTELY TERRIBLE.... / SEEKING ALPHA ( HIGHLY RECOMMENDED READING )

Buffett's Deal With Bank Of America Is Absolutely Terrible...


by: Geordy Wang

August 25, 2011


... for Bank of America (BAC) that is. For Warren Buffett, this is easily one of the most ruthless, aggressive, and ultimately profitable deals he's struck on behalf of Berkshire Hathaway (BRK.A, BRK.B) since the financial crisis began. Buffett always laments the difficulty in finding good investment opportunities when you're running a company the size of Berkshire, but as this deal shows, sometimes it pays to be a fat cat that can toss around $5 billion at a moment's notice.


To demonstrate just how ridiculously good this deal is for Berkshire, let's compare it to another one of Buffet's famous bailouts that has paid off handsomely for his company: his investment in Goldman Sachs (GS).


In October 2008, Buffett bought $5 billion worth of GS preferred stock paying 10% that was redeemable for a 10% premium. Goldman recalled those shares last quarter, roughly two and a half years later. Buffett has made about $1.75 billion just from the preferred stock, but he also received warrants to purchase 43 million GS shares at $115/share. These warrants expire in 2013. As of today, GS is trading for $111 on the open market. Let's assume the stock grows at the historical average CAGR of 9.5% for the entire market over the past century. In one year, it'll be worth roughly $122/share. If Buffett exercises all his warrants, he would make a cool $473 million on top of the $1.75 billion he's raked in from the interest payments of his preferred stock, for a total profit of $2.22 billion on a $5 billion investment. Not too shabby, huh?


Now let's take a look at what Brian Moynihan is giving him. Buffett's investment gets him a 6% annual dividend on $5 billion worth of preferred stock. For simplicity's sake, let's assume Bank of America redeems these shares after 2.5 years just like Goldman Sachs did. Buffett would pull in $750 million in dividends and $250 million in redemption premium, for a total haul of $1 billion.


But wait, the best prize is yet to come. Bank of America also gave Buffett warrants to buy a whopping 700 million shares of common stock at $7.14, with an exercise period of 10 years. BAC is trading at around $7.85 right now. If it grows at 9.5% a year, in ten years it'll be worth $19.45/share. Upon exercise of his warrants, Buffett will recognize a gain of $8.6 billion. On top of his preferred stock profits, that's almost $10 billion on his $5 billion investment. Compared to all the similar deals Buffett has made with companies like Goldman, General Electric (GE), and Dow Chemical (DOW), Buffett's deal with Bank of America takes the cake by far.


BAC didn't drop 35% in the past month for no reason. One of the things that shareholders were getting antsy about was the possibility that the bank might need to issue more stock in order to raise funds to meet more stringent capital requirements. Moynihan vehemently denied that shareholders will be forced to suffer additional dilution, but this is exactly what happened here. The bank currently has about 10 billion common shares outstanding. Buffett's 700 million shares will carve out a full 7% of the float. If this isn't dilution, I don't know what is.

Business is very often a zero-sum game, with a winner and a loser on either side of a big transaction. Sometimes the loser has no other choice, he must take the offer on the table in order to stem even heavier losses, but there's no question that he's getting a raw deal. Buffett walked out of the negotiating room the winner on this one, and he won big. Many often wonder if the Oracle of Omaha is losing his touch in his advanced age. It's maneuvers like these that show that the old man is as good as he ever was, and it'll be wise not to underestimate him, because he can still think circles around hotshots many generations younger than him.