The Real Cost Of Buffett’s BofA Investment

Several times watching CNBC this morning they are editorializing that the 6% coupon Buffet will get on his preferred stock investment is “not cheap”. Fox News has a similar report.

This simply is not correct – the 6% rate is actually 350 basis basis points or more cheaper than where other BofA preferreds were trading in the market.  It is not the coupon that makes the deal expensive, it is the warrant component. What Buffet did with a preferred plus warrants is essentially a form of convertible security.

Like any convertible offering the issuing company (BofA here) is paying less than it would if it issued straight preferred or debt. Also the Buffet preferred is perpetual giving it about the same sensitivity to
interest rate risk as a 30 year bond, which increases the risk to the investor and why the yield would be higher than say on a 10 year note.

BAC had some short term debt that was yielding 6%, so a 6% coupon on a perpetual preferred which is
lower in the capital structure, has more sensitivity to interest rates and more credit risk because preferred payments are optional, debt payments are not – is not expensive here.

Buffet is getting warrants to purchase 700 million shares of stock at essentially no premium to where the stock closed Wednesday. A typical convertible would have a premium of 22-24%, meaning the stock would have to rise 22-24% before the equity kicker had any value.

In Buffet’s case he starts participating on the first movement up. This is what makes the financing expensive, not the 6% coupon. BAC has January 2013 calls that are trading at around $2.50 when I looked today, obviously higher than they were before the deal. But it also tells you that Buffet’s warrants which have a 10 year term, have to be worth no less than $ 3 -4 per share by implication.

Given it is only a $7 stock, there is a limit to what people will pay for an option on it. But if you take the mid-point and call it $3.50 – it means Buffet’s warrant value is $2.45 billion – almost exactly half of the $5 billion he is putting in.

Now the 6% coupon is on the the whole $5 billion, so it is a $300 million income stream. But if the warrants are worth call it $2.5 billion – the preferred really is worth the other $2.5 billion.

So a $300 million dividend on $2.5 billion is actually 12% – so the cost of the Buffet capital is 12% per annum – and that is high – but what makes it high is “equity kicker” via the warrants, not the 6% coupon in and of itself.