Warren Buffett is the most successful investor on the planet and a very smart fellow. His core team also gave me a job in October 2000 at GenRe Financial Products, and I have always held him in high regard.
He has invested $5 billion in Bank of America on 25th August. But was the Wall Street Journal correct to headline the deal a “Vote of Confidence” in the bank?
My analysis is based purely on the facts presented in this weekend’s WSJ.
In return for his $5bn cheque, Buffett will receive:
- Preference shares bearing a ‘coupon’ of 6%. Technically, preference coupons are dividends; the payment can only be made out of profits. Allow me nonetheless to use the term ‘coupon’ in order to compare the risks and returns of this deal with a bank deposit. The structure here is as close to a coupon as preference share terms allow. Even if the bank experiences a choppy ride, so long as it survives and returns to profit at some future point, any unpaid dividends in loss making years are payable under a contractual cumulation provision.
- Warrants (these are options to buy shares at a pre-agreed price) over 700 million shares of BofA common stock at a strike price very close to Thursday’s share price. The WSJ values these warrants at about $3 billion. Assuming that is correct, Mr. Buffett could either sell them for $3 billion or retain them as he sees fit.
- The deal is not even Tier 1 equity for BofA and is considered expensive ‘bridge financing’ . However, Mr Buffett has secured a 5% penalty charge ($250 million) should BofA redeem the preference shares.
Short term deposit rates are 1% or less in US banks. On this basis, the deal can be characterised as a net investment of $2bn at a coupon of 15% (5/2x 6%). This equates to about 15 times the return on cash short term deposit accounts. Similarly, the redemption premium becomes not 5% but 12.5% of net invested funds.
Let us consider the ranking of the investment in a potential liquidation of BofA. Secured creditors of the bank take precedence over depositors. Preference Shares rank below depositors but above common equity. And yet banks have pledged so many assets to each other via repo and “failed sale” transactions that who can tell how much quality collateral could be viewed as actually supporting the deposit base?
Bearing in mind the recent history of western Bailouts, consider the following range of possible outcomes:
- BofA survives and thrives. Happy days for all stakeholders, excellent return for Mr. Buffett;
- BofA fails. Either there are enough assets in liquidation to redeem deposits or depositors are rescued by a possible Heurta De Soto or Baxendale plan or fresh taxpayer bailout;
- BofA fails and (2) above extends to pay off unsecured creditors but not preference shares;
- BofA fails and preference shareholders are covered by (2) above;
- BofA fails and (2) above extends to protect common shareholders.
Politicians have rarely breathed the words “moral hazard” and “perverse incentives” when they are actually engaged in formulating the bailout package, so outcomes (4) and (5) cannot be completely dismissed, but surely they are unlikely.
But how likely are outcomes (2) and (3)? I just cannot see how governments can attempt a second bailout given that Ireland is now on its fifth. But I don’t know. I suspect Mr Buffett does not know either.
Mr Buffett, like the rest of us, knows that the banking system is in a critical state. Yet like many of us he has a problem: we all need to keep some cash in banks. When you have the quantum of funds under management that he has, you can forget about deposit insurance.
What a smart deal he appears to me to have made. A good chunk of the cash element of his investment portfolio can be parked at a fixed coupon of 15% for the foreseeable future.
Either paper money collapses, in which case all of his cash funds are in turmoil, or there will be another rescue attempt, or hyperinflation, or QE 3,4,and 5 or some ‘unknown unknown’ attempt to prop up the banking system. It is possible that a future rescue might specifically wipe out common and preference equity, and so Mr Buffett’s is seeking a huge upside against the risk of that specific downside.
So what of the headline? I concede that he picked BofA rather than another US megabank, but it is still rather a stretch to term this a “Vote of Confidence” in BofA.