5 Things to Remember About Buffett's Deal With Bank of America

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Warren Buffett often talks about waiting by the phone, hoping someone will call him offering a good deal to invest in. Yesterday, he did the calling, investing $5 billion in Bank of America (NYS: BAC) after reaching out to CEO Brian Moynihan.

"Bank of America is a strong, well-led company, and I called Brian to tell him I wanted to invest in it," Buffett said. "I am impressed with the profit-generating abilities of this franchise, and that they are acting aggressively to put their challenges behind them."

A nice, big hug, as one analyst put it.

Here are five things to keep in mind about this deal.                                        

1. You can't get the terms he got.
B of A's stock surged as much as 25% yesterday after the deal was announced. That wasn't surprising: Buffett's stamp of approval is worth more than anyone else's.

But Buffett invested on terms you can't get. The $5 billion was done in special-issue preferred stock, with free equity warrants to boot. The risk-reward characteristics are far different than just buying common stock. By the terms of the deal, Buffett could still make a nice profit even if B of A's stock plunges. It's classic Buffett: Little downside and tremendous upside. Us mortals can hardly dream of those deals.

There may be good reasons to buy B of A stock, but "because Buffett is, too" isn't one of them. Put simply, he's not.

2. He's done it before.
Buffett invested billions in Goldman Sachs (NYS: GS) and General Electric (NYS: GE) in 2008 in deals structured just like yesterday's B of A transaction. The results highlight how easily Buffett can win while his lemmings lose.

With preferred stock yielding 10% and a 10% repayment premium, Buffett made about $1.2 billion on GE, and $1.7 billion on Goldman -- returns of over 30% in just over two years.

But anyone who bought GE or Goldman's stock on the day Buffett announced his deals has since lost 40% and 19% of their money, respectively.

Buffett also received warrants to purchase each companies' stock. With shares down, both sets of warrants are currently underwater. The thing is, it doesn't matter: he didn't pay anything for the warrants to begin with.

The deals Buffett strikes with these companies are basically heads he wins, tails he wins even more. Those who try to ride his coattails flip a whole different set of coins.

3. Another way to look at it: This deal could be an epic success.
Of course, B of A's common stock could surge from these prices. Just returning to book value -- still a low valuation by bank standards -- would bring shares up to around $20, from less than $8 today.

With warrants to buy 700 million shares at a strike price of $7, a move that size would net Berkshire Hathaway (NYS: BRK.B) a gain of $9 billion. And that's just from the warrants; dividends and repayment premiums from the preferred stock could add up to $2 billion more over the next few years. Not bad for a deal Buffett allegedly devised in his bathtub.

4. Why did Bank of America do this deal?
Moynihan insists B of A doesn't need capital. Looking at the latest quarterly numbers, he's probably right.

So why'd he do it? Simple: to stem panic and instill confidence.

But who is he trying to placate? A plunging stock price shouldn't matter -- a bank's market cap doesn't impact its capital ratios. The problem is when a falling stock price spooks depositholders and or bondholders, causing them to flee. That's essentially what took down Bear Stearns and Lehman Brothers.

It makes me wonder: Is Moynihan just being preemptive with this deal, or did B of A start seeing deposit outflows in recent weeks as fear and panic spread? Or, perhaps a few large hedge funds pulled assets just to be safe? There's no way of knowing, but with wounds of 2008 still fresh in people's minds, it wouldn't surprise me.

(On that note: Your FDIC-backed deposits are safe at B of A.)

5. Buffett's renting his name to B of A. That could backfire.
When Goldman Sachs was mired in a fraud scandal last year, Buffett biographer Alice Schroeder argued that having Berkshire's name linked to Wall Street corruption outweighed any financial gains.

"Buffett swapped his reputation at a cheap price," she wrote. "Goldman is holding him to the deal, hanging onto the preferred stock while Buffett's reputation is still useful. It is painful to watch Buffett behaving like a hostage to Wall Street, damaging himself by defending investment banks and saying flattering things about Goldman in a way that contradicts any principled view of the securities business."

Something similar could happen with B of A. Most of the bank's problems surround how its Countrywide unit bamboozled borrowers and flubbed foreclosures. It's Wall Street plundering Main Street -- an emotional topic for many.

Having Buffett's name linked to those allegations could ding his reputation of being an ethical bastion. B of A wins by being associated with Buffett. Buffett has to be careful that he doesn't lose by being associated with B of A.

What do you think? Share your thoughts in the comments below.

At the time this article was published Fool contributorMorgan Houselowns B of A preferred and Berkshire Hathaway. Follow him on Twitter @TMFHousel.The Motley Fool owns shares of Bank of America and Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.

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