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You Can Bank Better Than Buffett

08/31/2011 7:30 am EST

Focus: BONDS

Neil George

Editor, Profitable Investing

Warren Buffett’s $5 billion deal for the beleaguered Bank of America wasn’t was cunningly sweet, writes Neil George of The Pay Me Strategy, who explains in this special exclusive for how you can join him in the fun.

Who doesn’t do some of their best thinking in the shower? After all, you’re typically by yourself and your cranium is being massaged by hopefully one of Speakman’s best showerheads. No wonder so much gets done on the creative front.

That is, of course, the storyline on the recent decision by Berkshire Hathaway’s (BRK-A) current CEO to put some $5 billion into Bank of America (BAC) stock—the whole thing came to him in the bath.

But Buffett didn’t buy just any stock in the company. He’s not daft.

Instead, Berkshire Hathaway did a private investment in a public entity known on Wall Street as a PIPE deal. This way, the company could cut its own deal on its own version of stock, on its own terms, that mere mortals like you and me aren’t allowed to buy.

Even existing Bank of America stockholders don’t get to get in on anything like the deal that Berkshire wrangled. And instead, their holdings—as bad as they are—get diluted all along the way.

The special stock consists of preferred shares that pay a fixed dividend of 6%, and can be converted to common stock at a 5% premium. And even though that’s awfully nice compared to the current debt markets for bank bonds, Berkshire’s PIPE deal also came with warrants attached to the preferred stock that give the company the right to buy more common stock at a price of $7.14 a share.

So, for $5 billion, Buffett’s Berkshire gets 50,000 preferred shares at $100,000 per share, with warrants as a bonus. In turn, Bank of America will pay dividends annually amounting to $6,000 each—or $300 million.

Add in the additional capital costs of the convertible structure of the preferreds and the bonus warrants, and the truer cost to Bank of America’s slammed shareholders is looking more like 8% to 10%, depending on tax conditions over the coming years.

This isn’t the first time that Buffett did such a deal. In 2008—Goldman Sachs (GS) was sucked into similar (if not worse) terms. The bank was under political attack for its predatory trading and proprietary investments in the mortgage and asset-backed bond markets and needed a bit of a capital boost in a hurry.

Berkshire did another PIPE deal with a 10% dividend from the bank. However, Goldman—being a bit shrewder—did manage to negotiate a call on the preferreds that got recently executed, ending the pain for shareholders and the sweet deal for Berkshire Hathaway.

NEXT: Risk? Only to Common Stock Holders


Risk? Only to Common Stock Holders
The real reason for Berkshire Hathaway’s investment in banks isn’t because the company and CEO Buffett are big believers in rising profits and bigger bank-stock valuations. In fact, it’s the reverse.

Thanks to the deleveraging of banks and the phasing in of the Frank-Dodd Act, banks are rapidly becoming a shadow of their past selves. Going or gone are a host of profitable, but more risk-intensive activities—everything from merchant banking to proprietary trading and portfolio investing.

And finally we are beginning to see some enforcement (at least symbolically) of bank oversight by the FDIC, OCC, SEC, and other state and Federal regulators, which is having a dampening effect on banks' earning capabilities.

But while the earning capabilities are waning, the balance sheets are getting much stronger. And in the process, traditional, FDIC-insured commercial and consumer banks are rapidly looking more and more like financial utilities.

This means that for those making bets on the banks' recovery by buying common stocks, it should mean little for their portfolios other than more risk of either meager gains or none at all.

But for bond investors and preferred-stock investors like Buffett and Berkshire—who are able to grab big, locked-in dividend yields from the big banks—it’s less risk for a lot more yield for them, especially in their private PIPE deals with Bank of America and Goldman Sachs.

Pipe In The Profits
Now, you’re not going to be able to get in on these PIPE deals. But that won’t stop you from cashing in on most of same heavy cash and increased collateral that Buffett’s been getting in the past and (most likely) will get in the future.

There are plenty of big banks with a host of publicly traded preferreds—and even better, publicly traded bonds—that you can buy right on the New York Stock Exchange. And you don’t have to pony up $100,000 for any of them, because they trade in sums under $25 per share.

Why not start with the banks where Buffett and Berkshire have already done their good work?

  • Bank of America has a bond trading as IKM that has a 5.875% dividend, trading at a discount under $24 each—giving you a yield even higher that what Buffett bought at over 6.11% paid quarterly. Buy it under $25.50.
  • Then look at Buffett’s other favorite bank/dividend payer—Goldman Sachs. It too has a nice bond trading under the symbol JZS. It has a dividend of 5.8%, and is trading at an even bigger discount than the Bank of America issue. At its current price around $23, it has a yield of over 6.3%. Buy this under $25.

Neil George can be reached at You can subscribe to The Pay Me Strategy here.

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