Why Did Warren Buffett Change Berkshire's Bank of America Investment?

U.S. stocks are little changed on Wednesday morning, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average up 0.11% and 0.15%, respectively, at 10:15 a.m. EST. As the earnings season draws to an end, it's interesting to note that, according to Barclays Capital, "relative performance following misses was lower than prior quarters and [earnings] beats were rewarded less." I think that the Financial Times is right to suggest that "it's a sign that, as the S&P 500 again sits at a new summit, there remains some wariness over how sustainable it might be without a rebound in US growth and the faster earnings and revenue growth it should bring." And speaking of companies "making their numbers," Berkshire Hathaway has agreed to modify the terms of its Bank of America preferred shares so that they are counted as "tier one capital," thereby improving the bank's capital ratios.

It's worth looking at the gist of the modifications -- when Warren Buffett last year modified the terms of Berkshire Hathaway's Goldman Sachs warrants, the nature and implications of the changes were widely misunderstood in the financial media.

Here's the background: In August 2011, Berkshire Hathaway invested $5 billion in Bank of America in the form of preferred shares paying a 6% dividend. The investment conformed to a formula that has been tried and tested by Berkshire, whereby Buffett effectively loans out his good name and credibility to a troubled institution. In this case, Bank of America was struggling to rid itself of concerns regarding the size of its exposure to mortgage losses. Berkshire Hathaway made similar investments at the height of the credit crisis to shore up confidence at Goldman Sachs and General Electric.

Unfortunately for Bank of America, it found that, although the investment appears to have done the job in repairing investor confidence, the preferred shares don't qualify as Tier 1 (i.e., "high grade") capital, and, as such, don't boost its Tier 1 capital ratio (one of the ratios that regulators look at under new international bank capital norms). BofA could replace this "missing" capital by retaining earnings or doing another capital raise, or it could find a way to modify the terms of the preferreds so that they could be anointed Tier 1 capital. Which is what happened.

The two main amendments to the preferreds are as follows:

• The preferred dividends will no longer cumulative, which makes them more risky for Berkshire.

• The preferreds, which were originally redeemable by BofA at any time at a 5% premium, will only be redeemable after the fifth anniversary of the effective date of the amendment. I figure this change suits Buffett well -- he is likely to be pretty happy to earning a 6% dividend on a safe investment. Furthermore, if this change weren't to his advantage, why would he have agreed to the previous amendment, which is disadvantageous? Buffett isn't the type of investor to give something up for nothing.

Lest we forget, the 6% dividend return isn't the only source of return on the investment. As a sweetener, the preferreds were assorted with warrants to purchase 700 million shares of BofA's common stock at an exercise price of $7.14 per share. Bank of America's stock closed at $16.20 on Tuesday.

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The article Why Did Warren Buffett Change Berkshire's Bank of America Investment? originally appeared on Fool.com.

Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Bank of America and Berkshire Hathaway. The Motley Fool owns shares of Bank of America and 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 that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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