Wednesday, October 26, 2011

Munger on B of A's Moynihan: 'Back to Basics'

From this short Bloomberg interview Monday with Charlie Munger:

Bloomberg article:

"He has the right attitude, back to basics," Munger said of Moynihan.

For Bank of America (BAC) investors, it's a matter of how much time it will take and what it will cost to fix what's broken.

What happens to shareholder value if the bank's problems persist right into another financial crisis or another recession?

Will liabilities (legal, mortgage, other credit losses etc.) in the short to medium run become so large that it inhibits the kind of focus and energy needed to clean things up?

Could this force expensive share dilution and the sale of vital assets?

The bank is built to absorb a lot but it's important that the costs are spread out over time and the economic environment remains somewhat stable.

It would seem very likely that time measured in years will be needed to fix something this large and complex.

Ultimately, there's a pretty good franchise inside what is a very messy situation. Between here to where they need to be lies many hard to estimate risks.

In an interview back in August, Buffett said that Wells Fargo (WFC) and Bank of America had the best deposit franchises in the country. He also said that his investment in Bank of America wasn't unlike past investments in American Express (AXP) and GEICO.

In other words, messy situations that once cleaned up have a pretty good core franchise inside. Those have worked out very well for Berkshire Hathaway (BRKa) in the long run.

Still, Buffett's unwillingness to buy the common stock of Bank of America says a lot. Instead of buying the common shares, he purchased $ 5 billion in preferred stock with a 6% yield sweetened by warrants to buy $ 5 billion of the common stock at $ 7.14/share (700 million shares). These purchases can happen anytime over the next ten years.

Not a bad deal. More than enough time to see how it plays out and a price locked in for the common stock that will look very cheap once you know things worked out okay. That price (and the current market price) will look quite cheap if material dilution doesn't occur, and they aren't forced to sell too many key assets in the process of fixing the bank. Things that obviously cannot be known today.

By structuring the deal this way Buffett doesn't have to know.

So if only modest dilution occurs (the warrants, if exercised, actually would cause some dilution) and the core franchise remains in tact the price to normalized earnings will look more than very reasonable.

I'm just not convinced enough that, at the current share price, getting from current B of A to future B of A is worth the risk of the common stock (and I can't, of course, buy the preferred shares).

Now, if the price of the common shares continued to fall...

Adam

Long position in all stocks mentioned
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