Warren Buffett's Preferred Difference

Warren Buffett's $5 billion investment in Bank of America BAC spawned a lot of heated debates on whether this was a bullish or bearish act for Bank of America, and the banking sector in general. The bullish argument was that this showed that BAC is now blessed by the Oracle of Omaha, and Buffett is only getting 6% dividend from its preferred stock investment, versus the 10% he got when he invested in General Electric GE and Goldman Sachs GS in 2008. This infusion of capital would help shoring up BAC's balance sheet and bolstering investors confidence. The bearish argument was that this act directly contradicted BAC's repetitive claim that it did not need any capital infusion, and the price that BAC paid to Buffett was too steep. Other than the 6% dividend that it has to pay, it also issued massive amount of warrants to Buffett for him to buy 700 million shares of BAC at $7.14/share. This was a steep price to pay for a bank who claimed that it did not need capital, and imagine what would happen if it indeed needed capital badly. Of course, both arguments had their merits, and the market so far agreed with the bulls, as BAC stock rose from $6.99/share to close at $7.62/share the day after the news unveiled. Nonetheless, regardless of whether one is bullish or bearish on this act, an investor should understand the difference that Warren Buffett is getting versus what an investor will get by investing in BAC. First of all, when Warren Buffett bought preferred stocks from BAC, he was buying cumulative preferred stocks, vs non-cumulative BAC's preferred stocks trading on exchanges such as Bank of America's Preferred Series D. In good times, there's not much difference between cumulative and non-cumulative preferred, as both get paid their due dividends. However, in bad times, such as in the time of a credit crunch, the difference is substantial. For example, BAC may decide one day that it has to conserve cash and choose not to pay any dividend on its preferred stocks. For non-cumulative preferred stocks holders, those dividends are gone and cannot be reclaimed, not to mention that their preferred stocks would have tanked in value, and their holdings usually get no voting rights and there's nothing they could do. However, for cumulative preferred stocks holders, such as Warren Buffett in this case, BAC may not pay dividends for now, but it is obligated to pay the owed dividends when they start paying dividends again, and so Buffett will get his deserved dividends as long as BAC does not go bankrupt or have a capital restructuring, and intend to pay dividends sometime in the future. The second part, which is the real part that Buffett got his money worth, was the warrants that Buffett received from the investment deal. A warrant is similar to an option in that it allows the holder of the warrant to purchase the underlying company's stock at a certain price prior to the expiration of the warrant. In this case, Warren Buffett's warrants can be exercised within a 10 year period, and the exercise price is at $7.14. To give an idea of what the value of a warrant can be, consider that BAC now trades at $8/share, we can look at a longer term option such as a Jan $10 2013 option, which is only about 1½ years away, and out-of-the-money by 25%, trades at ~$1.4/contract. For a ten year option, the premium would be much much higher. If Warren Buffett could sell his warrants then and there when he invested his $5 billion in BAC, he would be putting very little money into the deal. Such is the deal that the Oracle gets vs a normal investor. The Buffett's blessing might very well have rescued Bank of America from the downward pressure on its stocks, and BAC, as well as the entire banking sector, may be on the upward move from then on. However, investors should not mistaken the risk that Warren Buffett was taking versus the risk they are taking. If not, they can get up from their bath tub, and give Mr. Brian Moynihan a call, and see if he will take it.