Warren Buffett will invest $5 billion in Bank of America, stepping in to shore up the largest US bank in the same way he helped prop up Goldman Sachs and General Electric during the financial crisis.
Bank of America shares rose nearly 26 per cent at one point, but gave up most of those gains by early afternoon, closing 9.4 per cent higher at $7.65.
Trading was so heavy that, at one point midday Bank of America shares made up nearly 13 per cent of the composite volume for the entire stock market.
Mr Buffett and Bank of America said he made an unsolicited call to the bank on Wednesday morning offering to make an investment. Mr Buffett told CNBC the idea came to him while taking a bath and the deal was done in 24 hours.
The deal entails Mr Buffett's insurance company, Berkshire Hathaway, buying $5 billion (€3.5 billion) of preferred shares and receiving warrants to buy 700 million shares. The warrants helped lift Berkshire Hathaway's paper profits on the deal to more than $3 billion, although the transaction has not yet closed.
The deal is expected to close on September 1st and includes provisions barring Buffett from raising his total BofA stake past 14.9 per cent. Fully exercised, at the most recent share count the warrants represent a 6.5 per cent stake.
Even though the bank has said it did not need to raise capital, investors widely believed it needed more money and to show it could raise funds easily. Employees were also relieved by the news. On at least one BofA trading floor, traders cheered when the news crossed the wires.
Bank of America has been plagued by fears that bad mortgage loans and legal liabilities from loans packaged into bonds by its Countrywide unit could drag it into tens of billions of dollars in fresh losses that would stretch its capital.
The deal proved again that Berkshire Hathaway has become something of a lender of last resort to the financial system, as when it invested in Goldman Sachs Group and General Electric. Buffett's role in aiding the economy and the financial system has become symbolically important, given the lack of policy options left for the US government and the Federal Reserve to stimulate demand.
"This proves to the market that, if the bank needs additional capital, which we don't believe they do, but if they needed to calm the market by raising capital, they could do it within 30 minutes with a quick call to Uncle Warren," said Sean Egan, managing principal of Egan-Jones Ratings.
The deal comes at a cost for Bank of America. The $300 million of annual dividend payments it makes will cut into earnings per share and the deal will influence its outstanding share count.
Putting together these factors, analyst John MacDonald of Sanford C. Bernstein estimated the company's earnings per share will fall by roughly 5 per cent for 2012 and 2013.
For Berkshire Hathaway, it is a better deal.
Berkshire gets warrants to buy 700 million shares of common stock at just over $7.14 per share, with an unusually long 10-year exercise period. One Berkshire holder said the warrants were by far the best part of the deal.
"He could well make a 100 per cent return on his investment in a few years," said James Armstrong, president of Henry H Armstrong Associates. "It's amazing how much a little hug from Buffett is worth these days."
Linus Wilson, an assistant professor of finance at the University of Louisiana at Lafayette, who has studied the pricing of warrants for large bank stocks, said warrants were worth $3.17 billion before the deal was announced, while the $5 billion of preferred shares were worth $4.46 billion, giving Buffett a total paper profit of $2.63 billion at the outset of the deal.
As the bank's shares soared, the profit on the position jumped.
Bank of America is selling to Berkshire 50,000 shares of cumulative perpetual preferred stock with a 6 per cent annual dividend. The bank can buy back the investment at any time by paying Buffett 5 per cent more than the face value of the securities.
It is virtually a mirror of the deal Berkshire did with Goldman in the depths of the financial crisis in fall 2008, except Goldman paid a 10 per cent dividend and had a 10 per cent redemption premium. The Goldman deal paid Berkshire $15 a second in dividends until Goldman bought out Mr Buffett earlier this year.
"It's a reasonably priced deal for Buffett. It's opportunistic," said Tom Russo, a portfolio manager at Gardner, Russo & Gardner who holds Berkshire shares.
As of June 30th, Berkshire had 39 per cent of its equity investments in the financial sector, according to Standard & Poor's.
Reuters
