On the BAC Deal

A few random thoughts on the BofA – Buffett deal.

This deal is $5b. A fair bit of change. But it is also small beer for a bank with $2.2 Trillion of assets. The stories that went around re BAC were related to the following issues:

Litigation risk
Second lien mortgages
Commercial Real Estate
Good will on the balance sheet that is in question
Direct sovereign debt exposure and indirect risk from CDS
Countrywide

Business Insider summed up the various concerns. The number came to as high as $200b.

It looks as though we could easily come up with, say, $100-$200 billion in write-offs and exposures to “clean up” Bank of America’s balance sheet.

I don’t know what BAC has on its books, so I won’t hazard a guess on these numbers. I can’t believe there is no fire with all this smoke. Buffet’s 5 bill will cover 3-5% of the nut. Not much of a margin if there is, in fact, some big ticket issues.

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BAC could have done a public deal for common and pref under much better terms than Buffet is charging. To me, the only conclusion is that BoA bought Buffett’s name. Admittedly, Warren does have a lot of clout. I have no doubt but that many small investors are thinking, “If Warrens in, it’s gotta be good!” I’m thinking that Buffett is just an expensive show pony.

Just a question, How many times have we heard that there was no need to raise equity? I guess that was just a bluff.

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This is perpetual cumulative Pref. I find that interesting. There is no intention to pay a cash dividend. The 6% will be paid in more pref script. What does this structure mean to common shareholder and the hopes they might see some dividend action out of BAC? I think it means they will see very little (if anything) for a long time to come. It will be interesting to see (if we ever do) what covenant restrictions the Buffet Pref has regarding dividend restrictions on the common shares. If I were doing the deal I would get some capital ratio hurdles and restrictions that would limit future payouts (and stock buybacks). WB’s got sharp lawyers, so I expect he has language in the deal that protects his preferred position. Again, this is an “evergreen” deal. It doesn’t go away.

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Common shareholders (especially in a leveraged company like BAC) ALWAYS have to ask the question:

“What’s above me?”

By this I mean, “What are the obligations that must be satisfied before common shareholders see a dime?” Whatever your thoughts of being a shareholder today, you should keep in mind that $5b just got ahead of you.

Good old Warren Buffett is not sitting side by side with you at this table. He is sitting at the head of the table. That is a very big difference.

Speaking of dilution, another 700,000,000 shares have joined the table you are sitting at.

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This is crony capitalism at its best and worst. We have created a situation where wealth and power is concentrated in just a few hands. Buffet shows up as a white knight. Maybe. I think this guy is a predator. I think of him like an Oligarch in Russia a decade ago.

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Buffet met with Obama the other day. I have to wonder if this came up in those talks. My suspicion is that it did. What if it went down like:

O: We’re a bit worried about BofA. The last thing I need right now is another problem with a big bank.

WB: I might be willing to plug that dyke. But it will cost. I need a pound of flesh from the boys at BAC. I want something from you.

O: I’m all ears.

WB: I’ll put up 5 large in fresh equity for the bank. But I want a Preferred position. I’m not taking an equity risk on this dog. In addition, I want stock options deep in the money. My investors have to eat, after all.

O: Sounds fair. What do want from me?

WB: I want you to be neutral on the Marcellus gas field. I have train lines running all through the area. I stand to make a bundle moving fuel. Don’t take a stand either way on this for the next couple of years. By then the momentum will be unstoppable.

O: Do nothing and win? Who can say no?

BK: Of course I’m just making this up, but if you think deals are not being cooked on the side, I’ve got a bridge for you.

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Even after the Buffett ‘bucks’ BAC remains on the top of the list of the TBTFs that is most vulnerable. That fact hasn’t changed. The stock is a target if things go wrong that are outside of BAC’s control.

Consider what market conditions would be like if we had something unthinkable like a credit squeeze in Europe that led to a second or third tier Euro bank being forced into a merger. Something like this could trigger a flight to quality in bank stocks and their preferred securities. As the market cap of the mid-sized banks shrunk, more forced mergers would happen.

In this type of environment global investors would pull back from those institutions that are perceived (rightly or wrongly) to have a capital adequacy issue. In the US market, that would make BAC a target of opportunity.

Just a reminder, we are in the midst of a credit squeeze for EU banks. There was a forced Greek bank merger in the past week. Very possibly the tip of a big iceberg. The destruction of market cap equity is what brought the big global banks to their knees in 2009. That was what took out Lehman. If that cycle repeats itself we will see it in full force on the weakest banks standing.

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There are tremendous opportunities in front of us to trade BAC stock. Both from the long and short side. One thing that I would not recommend is to think of the shares as a buy and hold.

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