B of A Gets Buffett's Backing at a High Cost

Warren Buffett's $5 billion public vote of confidence in Bank of America, happily for him, does not require actual confidence.

The terms of the legendary investor's deal, which grants Buffett's Berkshire Hathaway Inc. $5 billion in perpetual preferred stock and warrants to buy B of A stock at just over $7 a share, include no lockup period.

Barring the bank's failure, Buffett will earn about $300 million in dividends annually for his public endorsement and far more if its stock recovers over the next decade.

For Bank of America, the deal's primary attraction may be the prospect that Buffett's attention will prompt other investors to more favorably re-evalaute its management, legal risk and capital adequacy. To the folksy but hard-nosed Buffett, the deal likely appears a far less risky proposition.

"It's not a vote of confidence for the company because he [Buffett] has no downside risk," says Paul Miller, managing director of FBR Capital Markets. "We know Bank of America's not going to fail. The question is, can it perform?"

Buffett's upside is substantial: Berkshire will earn its $300 million in annual dividends until Bank of America buys it out at a premium; Berkshire has also received warrants valued at more than $3 billion, according to the Black Scholes options pricing model.

Based on current prices for Bank of America's perpetual preferred stock, Buffett's $5 billion investment bought him more than $7 billion in value.

Large numbers aside, Buffett's capital won't do much to help the bank pay for mortgage problems or to raise its capital levels. Instead, the investment may offer the bank respite from the near-panic selling that drove its market cap down to one-third of its book value.

"[We] believe concerns around B of A had hit a point where they were driven more by emotion than logic, and this [Buffett's investment] should temper those emotions, at least for now," wrote UBS analyst William Tanona in a note to clients.

"This is nothing more than 'Hey, Warren Buffett's here,' " says William B. Smith, the president of Smith Asset Management, which owns shares in Bank of America and other banks.

"I don't think they need help going forward. They've got half a trillion dollars in short-term deposits and cash," Smith says. But Bank of America was "in a real tailspin. Like back in 2008. Fundamentals don't matter, and I think this has put an end to it."

Making the Buffett bounce last will depend on convincing investors that Bank of America can weather its mortgage losses and get back to making money. Brad Golding, a managing director at the money manager Christofferson, Robb & Co., says he believes the company's problems are more than cosmetic.

Since the preferred stock is cumulative — meaning all dividends must be paid in full ahead of any payout for common stockholders — the investment does not qualify as "real, loss-absorbing, Basel III-compliant capital," Golding says.

Among the clear winners from Buffett's deal are previous owners of Bank of America preferred shares, which do not face dilution from the new investment. Len Blum, a managing partner of the investment firm Westwood Capital, and a personal owner of B of A preferred shares, favorably compared the Bank of America deal with Buffett's famous 2008 injection into Goldman Sachs Group Inc.. The market's first take appears to be in agreement; Bank of America gained 10% the day of Buffett's investment, or triple the gain that Goldman enjoyed the day in 2008 that it announced his stake.

"Buffett is giving Bank of America better terms" than he did Goldman, Blum says. "I think that's a positive sign."

For preferred holders, Bank of America's profitability is less of a concern than its ability to pay off preferred stockholders. Blum acknowledges that Bank of America and its competitors are facing issues beyond plunging common stock prices.

"The abundance of litigation going on in the sector gives investors uncertainty," he says.

For the broader industry, Buffett's investment doesn't imply that the Oracle of Omaha has gone bullish on banks.

After rising 6% shortly after its Thursday market open, by early afternoon the KBW Bank Index had retreated to its previous day's close.

"We have a slowing economy and a flattening yield curve, which isn't good for banks," says Marshall Front, the chairman of the investment firm Front Barnett Associates, which owns B of A stock and debt. "It's undervalued because it's been subjected to a constant barrage of negative commentary. The only thing that will change that is improved performance."

Front figures Buffett may do the trick in turning around Bank of America's public image problem.

"For a long time, [Citigroup CEO Vikram] Pandit was being vilified by the media as incompetent … but you don't hear a word about him today. You have the same visceral media reaction to [Bank of American CEO Brian] Moynihan. But if you look at what he has done, he has been disposing of noncore assets and they are trying to operate the bank much more effectively."

B of A's decision to do the Buffett deal suggests that, despite internal memos and public statements to the contrary, the company's market cap plunge has spooked top managers. Having paid a price to reassure the market, they now have to prove investors like Front right.

"By our calculation, Bank of America has earning power of about $1.75 per share" annually, Front says. That compares with a $1.58 per-share loss over the past year.

"If it earns even $1.50 the stock will double or triple."

That would no doubt do a nice job of burnishing Buffett's reputation further.

Paul Davis and Marc Hochstein contributed to this story.