August 28, 2011
Buffett BofA buy no seal of approval—A Commentary by Jonathan Macey ’82
The following commentary was posted on Politico.com on August 28, 2011.
Buffett BofA buy no seal of approval
By Jonathan Macey ’82
The lead news story across America on Friday was Warren Buffett’s $5-billion investment in Bank of America. Bank of America’s value has been plummeting on concerns about its ability to raise the necessary capital to continue business in the face of a massive litigation and regulatory burden, a crushing portfolio of poorly performing assets and costly acquisitions of under-performing companies — particularly Countrywide.
Buffett’s investment surprised many market watchers because Bank of America — like many other giant U.S. banks — is in no better shape now than during the financial crisis of 2007 and 2008. Not only do massive toxic assets still remain on their balance sheets, which they’re working off over time, but the Dodd-Frank Act now requires that banks maintain higher capital levels than ever before. These new requirements actually discourage banks from cleaning up balances — because purging bad assets means write-downs that make it harder to meet the new capital levels.
The question that everyone is now asking is what Buffett’s investment tells us about the state of the U.S. financial system.
Certainly the Obama administration wants to assert that Buffett’s investment means that giant financial institutions — like Bank of America and Citigroup — have finally turned the corner. This interpretation would bode well for the economy.
Because these behemoth institutions are both considered “systemically important,” as well as “too big to fail,” Buffett’s investment might also indicate that the government is finally out of the bailout business. It won’t have to inject funds to keep these large financial institutions going if private sector players — like Buffett’s Berkshire Hathaway — are willing to provide these companies with the capital they require to stay in business.
Unfortunately, while Buffett’s $5 billion likely was a savvy investment from the billionaire’s point of view, it doesn’t tell us much, if anything, about the financial health of the nation’s biggest banks. In fact, on closer analysis, what little it does tell us is discouraging.
Buffett’s investment likely signals not that he is confident that Bank of America is a good bet, but rather that he is confident that the government will again step in and bailout the bank if his bet turns out to be a bad one.
To understand why, it’s important to know that Berkshire Hathaway is not buying the regular, so-called “common” stock available to ordinary investors. Instead Bank of America is to issue Buffett 50,000 preferred shares, for which Berkshire Hathaway is paying $100,000 each.
Unlike the paltry returns available to most other investors these days, Bank of America is promising to pay Buffett’s investment a whopping annual dividend of 6 percent to be paid out quarterly.
This translates into Bank of American making cash dividend payments to Berkshire Hathaway of $300 million a year. And, of course, these payments come out of the pocket of the company’s lowly common stockholders.
In addition, Bank of America has sweetened the pot by giving Berkshire Hathaway securities, called warrants, that give him the right to buy an additional 700 million shares of BofA over the next 10 years, for around $7.14 per share. When Buffett made this deal Bank of America’s shares were trading at around $8.15. This valuation translates into an immediate profit to Berkshire Hathaway of approximately $1 billion profit — assuming that Buffett exercised his warrants immediately.
This is a stunning return on a $5 billion investment. It doesn’t even include the 6 percent promised return that Buffett’s Berkshire Hathaway will receive on top of that.
The exceedingly generous terms that Buffett was able to extract from Bank of America in exchange for his investment is hardly the vote of confidence that Bank of America is claiming — or that regulators and analysts were hoping to see. The investment is so cheap that it may actually dilute the value of the company’s already battered common stock.
But it is not merely the price of Buffett’s investment that suggests that the banks are still in big trouble. Having put $5 billion into Goldman Sachs in September, 2008, and $3 billion into General Electric in the spring of 2010, Buffett is no stranger to the practice of making large strategic investments in critical American businesses.
But as Buffett emphasized in his 2010 interview with the Financial Crisis Inquiry Commission, the American public believes that the government will do whatever it takes to prevent mega-firms like Bank of America from failing.
From this perspective, Buffett’s investment looks even smarter. His warrants give him a huge upside – because, if things go well for Bank of America, his right to buy stock at this low price will be worth many more billions than it already is.
Yet if things continue to go poorly, Buffett is sure that the U.S. taxpayer will again come to Bank of America’s rescue — providing a nice cushion for the billionaire on the downside.
The lesson here is: Don’t look at Buffett’s investment as a vote of confidence.
Instead, if you want to know the real financial health of the U.S. mega-banks Bank of America and Citibank, look at the price of these firms’ common stock. Both companies’ common shares are selling for less than half of their book value. This means that the market values these companies at less than half of the values depicted in their public financial statements.
In addition to the crushing burdens of litigation, and regulations like Dodd-Frank, and a litany of poorly performing assets, and costly acquisitions of under-performing companies, the struggling economy means that the U.S. mega-banks cannot grow out of the crisis.
Moreover, their sluggish, long-term assets are still being funded by short-term liabilities. This perennial problem makes the banks extremely vulnerable to runs and panics — and only increases the likelihood of yet another bailout.
Jonathan Macey is the Sam Harris professor of corporate law, corporate finance and securities law at Yale Law School. He is also a member of the Hoover Institution Task Force on Property Rights.