Bank of America Merrill Lynch shares bucked losses on Friday after Warren Buffett struck a deal to invest in $5 billion worth of preferred stock with warrants to buy 700 million BoA Merrill shares at $7.14 a share.
“I remain confident that we have the capital and liquidity we need to run our business,” said BoA Merrill chief executive officer Brian Moynihan, while announcing the investment. The reference to BoA Merrill being well-capitalised is a mantra Moynihan has chanted often this year. “At the same time, I also recognise that a large investment by Warren Buffett is a strong endorsement in our vision and our strategy.”
The preferred stock carries a 6% dividend, payable quarterly, and is redeemable at a 5% premium to face value. In case BoA Merrill is unable to pay the preferred dividend, the dividends cumulate at 8% annually and the bank is restricted from paying dividends or buying back stock. The options can be exercised at any time during the next 10 years. Both the preferred stock and the warrants are subject to a five-year lockup and there are also some transfer restrictions on the shares that will be issued once the warrants are exercised. The warrants translate to a shareholding of 6.5% based on current capital levels of BoA Merrill, and Buffett has agreed not to own more than 14.9% of BoA Merrill in total.
Moynihan stressed that BoA Merrill was comfortable at its existing capital levels while declaring second-quarter earnings on July 19. However, analysts seemed unconvinced. In a transcript of the call posted on financial blog SeekingAlpha, analysts asked many times about the potential for BoA Merrill to have to raise more capital. CLSA’s Mike Mayo was specific in his question: “The other potential events that could cause a capital raise would relate to funding or rating agencies or CDS spreads. What are you seeing from those areas? I mean, I guess CDS spreads are a fraction of where they were at the crisis peak but they’re up from the low. If rating agencies threaten a downgrade, might you have to raise capital? And what I’m really getting to and you talked a lot about it already, Brian, is just what’s your level of conviction that you don’t need to raise capital?” Mayo also asked how the situation that was unfolding in Europe would affect BoA Merrill’s capitalisation. But Moynihan repeated that BoA Merrill did not need to raise capital.
After the earnings announcement, both macroeconomic events and company-specific events that unfolded made investors start hammering BoA Merrill shares. Investors who were already spooked by the $20 billion of charges related to the mortgages business which BoA Merrill had announced it was taking were then presented with a lawsuit filed by the American International Group (AIG) against BoA Merrill in early August. AIG is seeking to recover more than $10 billion of losses on mortgage-backed securities. This news, coupled with negative investor sentiment following a downgrade by Standard & Poor’s of the United States, pushed BoA Merrill’s share price down by 20% on August 10 to below $7, levels it last saw in 2009.
Coincidentally, Moynihan had on August 10 scheduled a 90-minute conference call with Bruce Berkowitz of Fairholme Capital Management, one of BoA Merrill’s largest shareholders. “The purpose of the call was to better understand how the US bank was navigating the economic environment and positioning its balance sheet for the long-term benefit of customers, creditors, and shareholders,” said Fairholme before the call, adding that it also hoped the conversation led to a better understanding of why BoA Merrill is a core portfolio holding for Fairholme. “Sceptics are invited to participate on the call,” said Fairholme.
“Our capital levels are among the highest they’ve ever been in this institution’s history,” said Moynihan in his preamble to the call. “They’re sufficient to run the company even after we took $20 billion in the second quarter, which Bruce will discuss later, to help with the mortgages issues behind us.”
Investors did not buy into Moynihan’s reassurances and the shares kept losing ground. The situation became so bad that wild rumours started flying in the US last week about J.P. Morgan being called on to take over BoA Merrill.
“Bank of America is a strong, well-led company, and I called Brian to tell him I wanted to invest in it,” said Berkshire Hathaway chairman and CEO Warren Buffett on Thursday, while announcing the investment. “I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them.” Buffet told CNBC subsequently that he thought about the BoA Merrill investment while in the bathtub on Wednesday.
The investment has prompted reminders of Buffett’s 2008 investment in Goldman Sachs, whereby he bought $5 billion of perpetual preferred stock carrying a 10% annual dividend and warrants to acquire another $5 billion worth of stock at a price of $115 per share. Earlier this year Goldman shelled out $5.65 billion to buy back the preferred shares.
Fitch said it would not change BoA Merrill’s ratings. “Notwithstanding today’s news, Fitch views [BoA Merrill’s] capital position as the most pressured of the large US banking institutions to the implementation of Basel III capital requirements,” said Fitch on Friday. However, Fitch conceded that the potential for a downgrade to BoA Merrill’s rating had reduced following Buffett’s investment. Analysts shared the guarded optimism of Fitch, with most highlighting that Buffett’s investment does not qualify as tier-1 capital.
Some other specialists also expressed scepticism that the deal was good for BoA Merrill. “Perhaps, this has become Buffett’s competitive advantage. Rather than buy and hold under-valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price,” said NYU Stern finance professor Aswath Damodaran in his blog Musings on Markets, while suggesting that the deal could well make money for Buffett, but does not make sense for BoA Merrill shareholders.
Notwithstanding the mixed reaction from some quarters, Buffett’s endorsement seemed to be just what investors needed. BoA Merrill gained 15% on the NYSE in early trading on Friday and closed at $7.76. The improved sentiment also had a cascading effect on other financial stocks, which mostly gained.