Friday, August 26, 2011

Regarding Warren Buffett's Investment in BofA Preferred Stock

Yesterday's other major business news story, aside from Steve Jobs' resigning as CEO of Apple, was Warren Buffett's Berkshire Hathaway buying $5B of BofA preferred stock with a 6% dividend, plus warrants- terms set by Buffett.

As with his prior capital infusions to Goldman Sachs ($5B @ 10%, plus warrants) and GE ($3B @ 10%, plus warrants) during the 2008 financial crisis, Buffett capitalized on BofA's weakness in the eyes of investors, but carefully avoided buying common equity.

Despite Moynihan's and Buffett's comments that this represents the latter's vote of confidence in the bank, that's not strictly true. If it were, Buffett would have purchased common equity in the market. It's more a case of Buffett extracting a hefty price- the 6% dividend and warrants- for being an unofficial credit rating agency whose selective investments calm other investors. 

It's crucial to understand that in all three cases- Goldman, GE and, now, BofA, Buffett focuses on preferred stock, which is senior to common equity, and on which he can demand a special premium, plus warrants, just in case the firm pulls out of its problems.

Think of him as a sort of reverse greenmailer. Instead of the greenmailers of old, like Carl Icahn, whom companies paid to go away, these companies pay Buffett to come on in. In short, it's crony capitalism, because you'll never get access to the deals Warren Buffett does. But don't expect the SEC to be investigating him anytime soon for extracting such a high dividend rate on his preferred shares. Or, apparently, the BofA board for being so wasteful with its shareholders' money.

However, as the nearby chart illustrates, and at least one Bloomberg talking head had the guts to say yesterday, Buffett's equity kickers, the warrants, have been busts. Neither his GE nor Goldman warrants are in the money.

I've included in the nearby price chart Wells Fargo, as well, since Buffett is known to maintain a large position in that bank. I don't know when he began building his position, but it, too, has underperformed the S&P500 Index for the past five years.

In searching for articles with information on the date of Buffett's initial Wells Fargo investment, the best I could do was to estimate that he's been invested in the bank since at least 1999. He says he bought equity prior to the 1998 Norwest merger. The second price chart displays WFC's and the S&P500 Index's prices since 1985. If Buffett bought Wells in, say, 1995, then he's done better than the index. But if he bought later than sometime in 1997, he's probably no better off than he would have had he bought the index.

So much for Buffett's fabled equity selection skills, and back to the BofA preferred equity buy.

Late this afternoon, a family office manager and guest on Bloomberg explained that he had done much the same as Buffett only about a week or so ago. Not wanting to risk his capital on BofA equity, he found the preferred to yield an acceptable dividend with much less risk. But his yield is not as great as the one demanded by Buffett.

One of the Bloomberg anchors jokingly asked a pundit if he thought the administration asked Buffett to shore up BofA by investing in it. I don't think that's just a joke.

It also focuses on the lack of risk in Buffett's position, which is different than that of the bank or its common equity holders. First, Buffett has so ingratiated himself with this administration that it's unlikely to take any actions toward BofA which would endanger Buffett's investment.

Second, Buffett knows that BofA is one of the 'too big to fail' institutions, so chances are it will be bailed out by the government before Buffett loses his investment.

Recall, if you will, that freely-operating markets are supposed to result in neither buyer nor seller having sufficient power to dictate price or terms. Buffett's move, the third such example of his dictating investment terms to his targets in three years, demonstrates how our financial markets aren't fair. Buffett can engage in crony capitalism, using his name and resources to extract expensive terms for his borrowers, while other market participants have to resort to the markets to buy their investments.

On that subject, I learned yesterday that Buffett had insisted, as part of the terms of his Goldman Sachs investment, that no Goldman senior executives could sell shares in the firm until he had his money back. In that case, I suspect Buffett realized he was playing with some very sharp operators who wouldn't think twice about leaving him holding an empty bag.

In BofA's case, it was reported that no such terms were required. I suspect that speaks both to Buffett's sense that the firm's management is mediocre, and that the government will unquestionably step in to save his investment before it would vaporize amidst a bankruptcy.

Watching this sort of activity by Buffett, while generating no whiff of impropriety, validates for me how useless the SEC has become.

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