Bank of America: some comment on the Buffett deal

Warren Buffett got a sweetheart deal.

The deep discount on Warren Buffett's investment proves Bank of America was desperate.

All lines I have heard this morning. And I think they are mostly wrong.

Clearly the deal involves dilution - about 7 percent according to some of best specialist analysts on banks I know. But I thought I would try to quantify on the back-of-an-envelope just how much of a sweetheart deal Warren got and how much it will cost Bank of America.

The analysis surprised me and will probably surprise you.

The deal has two parts. 

• Buffett has purchased $5 billion of perpetual tier-1 equity that yields 6 percent, can have its dividend suspended at any time (whereupon it accumulates at 8 percent) and can be repurchased at any time at a 5% premium. 

• Buffett also received gratis options to buy 700 million shares (5 billion dollars face value) at $7.14 per share.

Lets try and back-of-the-envelope work out what each part is worth. I want to judge this against the market prices that prevailed before Buffett did the deal ... I want to work out how much of a discount Bank of America gave Warren Buffett.

The Tier 1 equity is not worth anything like 5 billion dollars. Bank of America preference share class X (a 7 percent coupon) was trading at about $21 (against par value of $25) the day before the Buffett deal. In other words it had an 8.3 percent yield. And it had slightly better terms than the Buffett deal (it is Tier 2 equity, not Tier 1 equity). Adding another 70bps to that yield to compensate for the worse (Tier 1) terms and you get my guess as to the market yield for the fixed coupon part of the deal. To be worth par it had to carry a 9 percent coupon.

Its a perpetual and it only yields 6 percent when the going market yield at the time was 9 percent. So it worth two thirds of par. So $5 billion of it was worth $3.33 billion at then market.

The equity option is harder to value - but we have some market indicators. The day before Buffett purchased Bank of America $13.30 warrants were trading at about $3.30. These were the warrants created as part of TARP and have fairly nice terms.

Buffett got $7.14 warrants with slightly longer albeit less nice terms. They are clearly worth more than $3.30 per share. But they are clearly worth less than $6.88 per share because BofA was trading at $6.88 in the middle of the day before the warrants were issued and you could actually own the stock at $6.88 which is obviously better than a warrant at $7.14.

So we have a lower bound for the warrants ($3.30) and an upper bound ($6.88). You can use fancy financial maths and the like - but I think a round number of $4.50 per warrant seems about right. Buffett received 700 million warrants - $3.15 billion dollars worth. That number - picked by my usual "scientific method" is very close to estimates made by Linus Wilson an assistant professor of finance. His number was 3.17 billion. 

So I pick a total value that Buffett received versus market prices the day before the transaction as $6.45 billion. If you want to phrase that differently Bank of America gave Buffet a $1.45 billion "gift". Or a 22.5 percent discount on his investment.

That number is quite a bit lower than the estimates in the press. Reuters for instance estimates it as $3 billion "gift". They are wrong - they have not figured on the low coupon for the preferred.

Now lets work on the 22.5 percent discount. If you had purchased Bank of America at a 22.5 percent discount to the price the day Buffett did the deal (that is a 22.5 percent discount to $6.88) then you would have got a deal just as good as Buffett. That would be a price of $5.32. BofA stock price bottomed at $6.01. If you could (miraculously) pick the bottom you had an opportunity to buy on terms nearly as good as Buffett. My best purchase was within about 30c of that but my average purchase - well that sucked.

Its a sweetheart deal no doubt - but less outrageous than it looks.

I think it will make Buffett a fortune. Why? Because the deal was cheap - but it was cheap primarily because the stock is cheap and not because of a 22.5 percent discount.

Now lets look at it from Bank of America's side.

It is fair to say that over the next couple of years Bank of America will roll over or issue more than 100 billion dollars of debt with maturities of 2 years (or some variant thereon - say larger debt shorter maturities or smaller debt longer maturities).

If the Buffett imprimatur lowers the funding cost by 70bps then Bank of America will save $1.4 billion - roughly the discount they gave to Buffett. That seems highly likely - indeed it seems a low-ball estimate. So from Bank of America's perspective the deal saves them money versus say just issuing $5 billion of equity at market.

There is of course dilution. You will earn less on your shares because the total shares outstanding are higher.

But dilution only matters if they issued the shares to Buffett cheap. They did I think but you could have had within 22.5 percent of the price issued to Buffett and if you really think that the dilution matters - that is if you really think the shares are cheap then there is a solution: buy more.

So for all those people complaining about the dilution put your money where your mouth is and buy. The stock is still only about 35 percent more than the deal Buffett got and the deal Buffett got came with ancillary benefits such as cheaper funding and regulatory cover.

Finally I can't go past a comparison with the deal Buffett struck with Goldman Sachs. That deal had more value in the fixed coupon and less value in the equity. Buffett could have structured the deal either way and he chose to take the value in the equity upside. I think that might be saying something.

Just for thought.

J

PS. In full disclosure I trimmed some shares before market about at about $8.30. These were roughly the same number of shares I purchased below $7. Its just that the position was too big - so risk management rules apply. And we are still losing on Bank of America - just not as much as before.

PPS. David Reilly at the Wall Street Journal made the same valuation error as Reuters. Peculiarly they also quote an analyst who thinks the warrants were worth "conservatively $4.40 to $5.60". The upper end of that range is a bit peculiar.