Macaskill on markets: Investors should beware of Buffett’s Bank of America bounty

Warren Buffett’s stick-up of Bank of America in late August was a classic of opportunistic investment.

The $5 billion deal marked an evolution in Buffett’s signature approach of renting his reputation to troubled financial companies in return for a near-extortionate fee. Rather than waiting for a firm like Salomon or Goldman to come to him begging for protection, Buffett this time foisted a deal on Bank of America.

Brian Moynihan, Bank of America’s embattled CEO, did not have to accept the terms proposed by Buffett, of course. But a bank management team that was flailing in the face of a stock slump and credit spread explosion to pre-default style prices quickly decided that Buffett had made them an offer they couldn’t refuse.

If news had leaked that Moynihan had turned down a substantial proposed cash injection from the most respected investor in America, then the head of its biggest bank could quickly have found himself out of a job.

Both parties to the deal were able to declare victory in the immediate wake of the trade. Bank of America’s stock rebounded from its lows and its credit spreads tightened, while Buffett saw a swift paper profit on the warrants he bought as part of the deal at a strike price of just over $7.

Buffett secured terms that were well in excess of what he could have obtained on the open market. His preferred shares in Bank of America come with a 6% dividend and are only redeemable at a 5% premium, while the warrants have a relatively long 10-year exercise period.

Bank of America can point to the effect of a public vote of confidence in its future from Buffett as a significant benefit from the deal, but that is an intangible gain that could evaporate quickly.

Warren’s immediate win

Buffett, by contrast, has an immediate measurable return on his investment in the form of an above-market rate. As the preferred shares are callable at 105, rather than 100, Bank of America will pay a hefty premium if it returns to health and wants to replace the funds.

Although future conditions will determine the eventual impact of the warrants, existing Bank of America shareholders face 3% to 7% dilution as a consequence of the Buffett trade.

That represents a significant potential dilution for shareholders, especially as the investment will not count as core capital under the incoming Basel III regulatory regime.

The issue of whether or not the Buffett investment counts as capital was among a number of areas that were fudged by Bank of America during its most recent crisis.

As is often the case with beleaguered management teams, Bank of America executives deployed sophistry to avoid admitting weakness, without addressing the key concerns of investors.

Moynihan and his lieutenants spent the week preceding Buffett’s proposal that they pay protection money for an endorsement by strenuously denying that the bank was in need of extra capital.

Farcical denials

This effort became farcical at times. A firm that was notorious for its closed-book approach to communications under dour former CEOs Hugh McColl and Ken Lewis took a sudden swerve into hands-on press management when it engaged in a public debate with former stock analyst Henry Blodget over his claim that the bank might need as much as $200 billion of extra capital.

Bank of America was quite right to point out that Blodget was banned for life from the securities industry in 2003 – for his work as an analyst at Merrill Lynch, now part of Bank of America.

Its accusation that Blodget was making “exaggerated and unwarranted claims” – in a quote from his SEC banning order - could also be correct. But the abrupt shift from silence to detailed rebuttal of claims made by a blogger did nothing to correct the growing impression that panic had set in at the bank’s headquarters.

The statement also did nothing to refute analysis from more reputable sources concluding that the bank might well face a serious capital shortfall.

Capital shortfall

JPMorgan analysts estimated Bank of America’s capital need at $12 billion to $25 billion on the same day as the response to Blodget, while other analysts weighed in with much more significant estimates of the gap, which could be as high as $40 billion to $50 billion, according to Jefferies.

At the moment there is no way to gauge exactly how much capital is needed by Bank of America, because it is still unclear what it will cost to settle its mortgage liabilities.

With a mortgage servicing portfolio of $1.6 trillion that is over three times as large as that at Citi, and a vast array of legal cases still in their early stages, there is simply no way to know the size of Bank of America’s eventual mortgage bill.

The firm’s managers cannot be condemned for downplaying the need for external capital while they pursue sensible ways to raise cash. Bank of America has taken steps to sell credit card assets outside the US and on August 29 it finally managed to unload around half of its stake in China Construction Bank to a group of investors, for example.

The CCB sale did have a tangible effect on Bank of America’s balance sheet, as the $8.3 billion price resulted in a gain that generated $3.5 billion in Tier 1 capital and a reduction in risk-weighted assets of $7.3 billion under Basel I rules. That brought Tier 1 capital generation via asset sales in August to $5.8 billion, as CFO Bruce Thompson noted.

Moynihan caves in

But the signs of progress in legitimate capital boosting steps do not explain why Moynihan and Thompson caved in to Warren Buffett’s proposal a few days earlier.

If the Bank of America chiefs were really confident that their asset disposal plan was on course to meet all capital needs then they should have sent Buffett packing, or at least politely suggested that he buy stock like a regular investor, as he has with the bank’s shares in the past.

The acceptance of Buffett’s terms represented at best a gimmicky decision to pay for an endorsement and at worst a disregard for the bank’s existing shareholders.

The Buffett seal of adequate housekeeping has not worked against companies in the past. But one buy-side official said that the decision to accept off-market terms for the $5 billion deal left a sour taste that made him less inclined to work with Bank of America Merrill Lynch managers in the future. “Is this some kind of stupid game for them?” he asked. 

Bank capital: BofA sells CCB stake, takes Buffett’s cashSeptember 2011