The FDIC, Buffett, Bank of America, and the Attorney General of NY

Friday’s injection of $5 billion in capital into B of A by Warren Buffet made the headlines in a way that few stories do in late August when most traders are hanging out in the Hamptons.  Today’s announcement by B of A that they were divesting $7.3 Billion in CCB (China Construction Bank) shares added fuel to the bullish B of A sentiment.  So much so that BAC ran up an astounding 8.1% today.

With the “Oracle” of Omaha’s (tongue firmly inserted into cheek) bathtub revelation and the CCB deal combining to add $12.3 Billion in capital to a bank that continues to scream, to anyone who is still listening, that they don’t need anymore capital…  the huge gains make sense.

Right?

But now there is a twist, or two, that brings into question the rally we saw in BAC today.  Most importantly, after the market closed the FDIC filed an objection with the Supreme Court of NY against B of A’s proposed $8.5 billion settlement with mortgage bond holders.  While the FDIC’s objection is based on the fact that they don’t have “enough information to evaluate the settlement” the development is significant.  You see, the FDIC is the receiver of many failed banks and certificates that would be covered by the proposed settlement.  For the past few years, the debate has focused on whether B of A’s problems were due to the economic downturn scuttling their mortgage book or whether mortgages were sold to people who hadn’t the faintest chance of every paying their debts (the Countrywide acquisition, to wit).  Without the settlement, the toxic Countrywide acquisition will weigh heavily, and potentially terminally, on BAC.

Added to this, almost below the radar, is the filing by the Attorney General of NY.

To quote Forbes, “New York Attorney General Eric Schneiderman is attempting to block the settlement. Earlier this month he urged a state judge to reject the proposed calling it unfair and that Bank of New York Mellon, the trustee representing the investors, committed fraud for failing to ensure that the mortgage securities were created in accordance with state law and for failing to act in the investors’ best interest.”

This is a messy situation.  And I point it out, not only because of my disdain for the charade that is the Buffett cult of personality, but because Bank of America may very well be the canary in the macro-economic coalmine.  BAC is too big to fail.  But, the political environment makes them too big to rescue.  At this stage in the stock market’s history, financial stocks rule the day.  Be they two insolvent Greek banks combining to become one really large insolvent Greek bank (very bullish, apparently), or Bank of America being saved (or not) by the bathtub revelation, the market will go as the financials go.

The FDIC and the AG of New York getting involved can’t be viewed as a catalyst for new highs.

Pass me a Dilly Bar, a Coke, and 700 million Bank of America warrants, please.

Today, the Ogre… I mean, Oracle… of Omaha made another red, white, and blue investment on behalf of the good old USA.  And in true down-home, golly-gee fashion, Buffett claims he didn’t come up with this investment idea immediately after his recent economic conversation with Mr. Obama.  Rather, it came to him yesterday morning as he soaked in the modest porcelain bathtub of his even more modest Nebraska home (try not to visualize it;  you can’t gouge out your mind’s eye!).

According to CNBC’s Becky Quick, “He says he just dreamt this idea up on Wednesday morning while he was in the bathtub.”

Gosh, that’s a swell story, Mrs. Quick.

Good ol’ Warren has a bathtub revelation and the most endangered bank in the country ends up with $5 billion in new capital.

And everytime a bell rings an angel gets her wings.

Now might be a good time to take a look at the details of the deal… just to make sure Buffett has our best interest in mind.

  • First, he bought $5 billion of preferred stock.  That puts his claim ahead of all the common stock shareholders of BAC.  Point, Buffett.
  • Second, based on the 6% dividend on the preferred stock, Buffett will receive $300 million in income each year. If I remember the crazy rules of corporate accounting, these dividends paid to Berkshire Hathaway bring a major tax advantage known as the dividends-received deduction.  This particular aspect of the tax code allows corporations to exclude 70% of the interest they’re paid when calculating taxes.  On the back of a napkin this means that good ol’ Warren’s tax rate on these dividends will effectively be about 10.5%.  Wait…That’s not the kind of tax rate he was proclaiming he and all his rich friends should be paying.  So  I guess, he’s going to add a little extra $ to his 4/15 payment lest his secretary pay a higher tax rate than he.  Or not.  Point Buffett.
  • Third, the “bathtub revelation” gave Buffett warrants to purchase 700 million shares of Bank of America at $7.14 over the next 10 years.  Today alone, the gains in BAC’s stock (largely and circularly due to the Buffett cash infusion) already generated about $400 million in profits if the warrants were executed right now.  And those gains are capital gains.  This time next year they will only be taxable at the 15% rate.  It’s a shame that this simple man, who only wants to pay his “fair share, ” keeps falling into a plethora of tax-favored transactions.  Point, Game, Match, Buffett.

So, what can be deduced from an investment perspective?  I’ll go with the following:

  • Despite their claims, Bank of America needed capital.  And $5B may not be enough.  Looking at their mortgage book, another $10B may be called for.
  • The government was unable or unwilling to step into another bank recapitalization.  So, Warren “independently” solved the immediate problem while contemplating in his tub.
  • Buffett did what Buffett does.  He successfully pulled a similar maneuver on Goldman Sachs a few years ago, and he did it again (only larger) this time with Bank of America.  He seldom makes stupid decisions, so one has to raise the probability that Bank of America will survive.  But the larger, and more bearish, issue is the same as that which was in place when he bailed out GS…  How bad is the environment when one of the world’s largest banks needs to strike an asymmetrically poor deal with a private investor to stay afloat?

While on the surface, Buffett’s infusion of cash could easily be interpreted as a bullish signal for the banks (“Buffett is investing, so banks must be a good investment for me”), I’d postulate that it may well be an indication of banking trouble…  perhaps even deeper than we realized even yesterday.