Warren Buffett’s magical fairy dust lands on BofA

By Felix Salmon
August 25, 2011
$5 billion investment which will pay him $300 million per year in perpetuity, Warren Buffett has managed to boost the share value of Berkshire Hathaway by something north of $12 billion.

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Behold the power of Buffett! With a $5 billion investment which will pay him $300 million per year in perpetuity, Warren Buffett has managed to boost the share value of Berkshire Hathaway by something north of $12 billion. Oh, and Buffett also gets a massive free option on BofA stock — the right to buy 700 million shares at $7.14 apiece, at any point over the next decade. If exercised, that would give him 7% of the company.

This is very reminiscent of the time when Buffett did something similar with Goldman Sachs, in the immediate aftermath of the collapse of Lehman Brothers. That too boosted the stock in the short term (although not as much as this), and the investment turned out to be an excellent one for Buffett, even though Goldman’s common shares are still trading below that September 2008 level.

There are basically two aspects to these deals. One is the capital raise itself, and the other is the magical Buffett fairy dust. The capital raise, in this case, is extremely expensive: Buffett drives a hard bargain. But the deal is worth it, for BofA, because of the magical Buffett fairy dust aspect. If BofA had simply brought this deal to market, offering $5 billion in preferred stock with generous attached warrants, I can guarantee you that the market would have come down harshly on the bank. It’s not enough money to move the needle when it comes to BofA’s capital; it’s extremely expensive; it’s potentially enormously dilutive to shareholders.

But the fact is that Bank of America isn’t playing a financial game, it’s playing a perceptions game. As John Hempton says, the standard analysis of BAC stock right now is a game where analysts “are fitting their analysis around the stock price”. I plead guilty to that: like many people, I think that Bank of America needs to raise capital largely because the stock price is screaming, loudly, that Bank of America needs to raise capital. This is not an unreasonable stance to take: especially when it comes to leveraged financial institutions, the stock price can be, and often is, a self-fulflling prophecy.

But Hempton’s point is well taken: by the same token, the stock price is not a particularly good guide to the value of a bank. And that means that when a bank’s shares are severely depressed, as BofA’s were yesterday, there’s a lot of room for Warren Buffett to come along and give them a nudge up to the next eigenstate.

The big question now, then, is what happens next. Does this investment singlehandedly turn BofA around and set its stock path on a lovely upward trajectory? In order for that to happen, BofA will need a steady stream of good news to ratify today’s stock boost. A settlement with the US attorneys general, for starters, would be wonderful. So I hope that BofA Brian Moynihan is being strategic here, rather than just tactical. If he has a medium-term plan for getting the market’s respect, and just wants to start it off with a bang, then this is a great way of getting there. But if he thinks this is a magic bullet, I think he’s going to be very disappointed.


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But didn’t Goldman buy out Buffett’s stake back in March when the stock was around $160?

Posted by jmh530 | Report as abusive

I think you mean igonstate.

Posted by minderbender | Report as abusive

Eigenstate? Awesome.

Posted by Faraday | Report as abusive

“Room 714 She’ll be waiting…”

Just in case anyone was wondering about where the strike price came from…

Posted by klhoughton | Report as abusive

What would be nice would be to see BofA take the 5 billion at 6% and use it to buy back their highest coupon bonds which are trading at like 90 cents on the dollar. That would boost their earnings in the next quarter which they could probably use!

Posted by y2kurtus | Report as abusive

One of your fellow bloggers just argued that BoA should be nationalized (well, GM-ified, with top management replaced) on the grounds that (among many other things) it is in serious do-do over robo-signed mortgages. Does this $5 billion change that argument?

Posted by David239 | Report as abusive

From a fundamentals perspective, I don’t see how this deal significantly improves the situation for BoA. They are paying a rich premium for that capital infusion (more than their peers need to pay), which puts them at a competitive disadvantage.

The Buffett fairy dust effect on BAC stock will wear off after a while, perhaps in less than a day. Warren Buffett is betting that BoA will survive, and helping to ensure that they do so, but all signs point towards some seriously bad news coming down the road.

Posted by TFF | Report as abusive

Remember when Charles Schwab sold his company to Bank of America for ten percent ownership? He was on the board of directors but when they called BOD meetings they would not tell him. It was a different era.

He ended up buying back his company out of disgust.

Posted by bidrec | Report as abusive