ERICOPOLY

Let's stop pretending that we all aren't in this for a rising stock price. Raise of hands, can anyone tell me what happens to a put option price as the common stock skyrockets? I'm not the one who started a huge thread on how X is better than Y... The stock price going up is obviously good news for both leaps and warrants, but doesn't change the fact that this whole thread is mostly nonsense. Why don't you just plug in the value of a 6 year out-of-the-money put using Black Scholes and compare it to an at the money put? The cost of leverage in the at-the-money put is sky high compared to the out-of-the-money put. So despite the fact that almost everyone here is expecting a big repricing in the common when the underlying earnings shine through this fog of expenses, in about two years time, I can't seem to hammer it into your head that there will still be a 4 year put here at that time. And the cost of leverage for me to buy it at that time will be far less. Go back to your academics -- they'll tell you that a stock isn't undervalued in the first place because the market is efficient. Why are you even here if you believe that stuff? They brought you Black Scholes too by the way.

Let's stop pretending that we all aren't in this for a rising stock price. Raise of hands, can anyone tell me what happens to a put option price as the common stock skyrockets?

Who gives a shit, honestly, what the LEAP is worth in two years? It's value is the non-recourse leverage on an asset at 10% interest rate. Suppose I instead take out a 10% loan to finance BAC? What the value of the sunk-cost of my monthly interest payments in 2 years? It's called, an "interest expense" on balance sheets. Here, it's prepaid interest. EDIT: I meant to say it's "interest expense" on income statements, but it's "prepaid interest" on my fictional balance sheet. It amortizes at varying rates from time to time based on passage of time and implied volatility, but I'm not a trader -- that doesn't matter to me. I'm using it for financing the leverage of the asset -- not to make money timing when Black Scholes volatility goes up or down.

That's a trader's mentality. The businessman's mentality is to keep the eyes wide open: 1) we are using leverage here, no fooling around 2) let's keep the costs down for the leverage You don't get to that level of thinking if all you worry about is theta decay, black scholes, etc... Think in terms of... what if the market shuts down and I'm forced to hold (not trade this thing)? How much value am I getting versus what I'm giving? And that's what I am doing. I am breaking down all the fancy Wall Street lingo and asking the most important of questions: "am I prepared to be in this option until the end, and is it a worthwhile cost of leverage"? Or if you were an athlete, let's use a track and field analogy: Do you want to run around a racetrace with 8 ft hurdles or 13 ft hurdles? Think of the annual cost of leverage as the height of the hurdles.

Then you've completely misunderstood me. Look, if you invest $12 in the warrant at $5.50 per warrant, then you have 2.18x leverage. You own upside on 2.18 shares of common. I'm simply saying that to purchase 2.18x leverage it's far cheaper leverage to go with the LEAPS. Or go with a mixture of common+at-the-money LEAPS until you have 2.18x leverage of upside (equivalent to owning the upside on 2.18 shares of common). I'm not saying go put the entire $12 into the LEAPS right now for 6x leverage with the 2-year LEAPS when the stock is priced at $12. I'm not an effing idiot ;D That would be completely insane!

I believe when the stock gets near 1.5x tangible book value and trades at P/E of 10x, the leverage in the warrant will be a lot cheaper than 10% annualized. The $13.30 put will be worth very little to people, and they won't pay you very much for it. So that's when I might buy it again.

No one, including Eric, is sanctioning investors use LEAPs, options or any other sort of leverage. But Eric's numbers are extraordinary and there are naturally going to be questions about how he did it, how did he get comfortable with it, and the reasoning behind it. I wouldn't expect any greater significance put to options or LEAPs because of Eric's results, as anyone levering up Berkshire in their portfolio like Allan Meecham did at Arlington Value. It's an investment strategy, based on underlying fundamentals, but can carry a significant amount of risk because of the leverage and time arbitrage involved. I think that is what the interest is from the people asking questions...how did Eric, if you can do it, minimize that risk. And that's all it is...people are inquisitive, otherwise you wouldn't be on here either. ;D Cheers! Warren has been telling his shareholders about the 500,000+% over time that he's made for the company, but the key takeaway is just that this is fascinating he did it. He's not trying to tell you all to go and start insurance companies and leverage yourselves writing insurance policies. He's not advocating that you invest the premiums in equities, and he's not promising those returns if you purchase Berkshire. He's merely just observing a historical fact. Those are his returns. Fairfax does the same thing.

Yes, Sanjeev was right about the rally and he got paid today.

Stock price is zero a year from today because world financial system collapses. Lose $2 from the LEAPS or lose $5.50 from the warrants. Which strategy is riskier again? The LEAPS are cheaper besides, so lower cost as well as lower downside.

Yes, that's all I'm saying -- shop around for the cheapest cost of leverage. Just like when you look for a home mortgage, you shop for a lower rate.

I typically wake around 6 am and check the pre-market quotes while in bed. Then I drink coffee and walk my daughter to her public elementary school where there are only 14 kids in the class in addition to 2 full-time paid assistants. So that's 3 paid adults for just 14 kids. I'm not kidding! And that's a public school in California. Then lately I've been going on a two hour walk (foot surgery two years ago worked out). I get back from that walk and go swimming for a half hour (one thing we splurge on is we keep the pool heated to 90 -- but some of that is solar heating). Then I walk the dogs. Or sometimes I go for a walk with my wife on the beach (she is usually doing her ceramics hobby in her studio). If I don't go for my two hour walk, I'll be the one driving my son to his pre-school. It's about 100 yards from the beach, so I'll leave the car in his school parking lot and go walk the beach, see the pelicans, watch the surfers (his pre-school is basically my parking spot for Hammond's Beach). I go on fishing trips (flyfishing). I've taken horse riding lessons -- we went for a trail ride last night in Death Valley (awesome!). For my 40th birthday my wife is giving me surfing lessons -- so perhaps less watching the surfers from now on and I'll be doing more surfing. Death Valley is hot! Man, it was like 98 degrees yesterday. It's bizarre -- this is winter!

Hopefully a lot of money is made for the warrants! I've found a cheaper way to finance the leverage, so what's great for them is going to make me extremely happy! Agree with that. I'm thinking cost of leverage for the warrants should be divided over more shares. That's my response to this entire thread. LOL. Got it. However the cost of financing the leverage is still 13% annualized no matter where the collected dividends go. All you are seeing in the 1.5x adjustment is the effect of large dividends being reinvested into more shares of stock. Where you shove the dividend doesn't matter to the good lord -- you've still pre-paid your 13% annualized cost of leverage. Yes, they might pay far more significant dividends and adjustment could be 1.5x vs 1.2x. I hope that doesn't happen if the warrant holders live in California. I understand the confusion, because it is rather hard to think about, however a person who just holds the leveraged common on margin (hedged by puts) will also have 1.5x more shares if he reinvests the dividend in the common. No matter where dividends are invested, you still have to pay the same interest rate on the money borrowed. Unless you use your dividends to pay down your loan, but that's not the case here with the warrants. The warrants force you to reinvest your dividend into the stock no matter how high the stock is. Why do value investors love that? It's perverse.

Hopefully a lot of money is made for the warrants! I've found a cheaper way to finance the leverage, so what's great for them is going to make me extremely happy!

I shouldn't have bought them in the first place... what made me nervous was getting 52% from the warrant vs 29% from the common during the 5 months that I've held them. That was pure luck. Compared that luck to the guy who paid $2 for the warrants back when the common was trading at $5 less than a year earlier. For him, the common outperformed the warrants slightly! Common went up by 86% and warrants went up by 85%. He gets nothing at all for his leverage and sells to me, then I get a great bang for the buck and sell it back to him. Hope he makes money going forward vs the common (my interests are aligned with his).

That would be getting much better if they were priced with a 10% rate vs a 13% rate. I believe they will be priced with a 10% rate or less once the stock gets moving towards the $20 range. Take a look at how puts are priced -- they decline significantly when the stock rises a lot (like 50% for example). Today BAC's at-the-money puts are expensive -- cost roughly 10% annualized to protect $12 strike. But Wells's Fargo's puts only cost about 5% annualized to protect $37 strike. However with Wells Fargo's dividend maybe that's actually 8% annualized. However keep in mind that's for the cost of at-the-money puts! This is important, because once BAC's stock rises 50% the BAC warrants will no longer contain at-the-money puts -- the puts in the BAC warrants will be way out of the money and should be worth nothing remotely close to 5% annualized if they are priced on par with Wells Fargo. Think about how cheap BAC's calls will be when the uncertainty is lifted and the shares are trading on normalized earnings with their owners sleeping like babies. The phrase "more Wells Fargo than Wells Fargo" that Berkowitz coined will kill the value of the embedded put in the warrants.

No, the warrants do not adjust for the buybacks today. Neither do the LEAPS. Both benefit from more intrinsic value per underlying common share, but that's as far as it goes. I invested my approximate 60 cent "default dividend" in the stock at $12 though :D The 3% I'm saving in interest costs over two years with the LEAPS is where I come up with my "dividend". One might say the warrant holder speculated on greater than 60 cents of dividends cumulatively for this year and next -- they purchased them upfront hoping to get more? Backfired so far. Oh, I see what you are saying. I didn't understand the 13% and 10% costs for the warrants and LEAPs. I thought you were using the cost of capital over the six years respectively for each, but your actual cost to buy on margin is 13% and 10% respectively. Or am I even more confused here now? Cheers! Scenario we all find a reasonable possibility: Over the first two years, warrants and at-the-money LEAPS are pricing in their leverage like this: 1) warrants 13% cost 2) LEAPS 10% cost In two years' time (the second two years of warrant life) stock is above $20. 1) We use margin to exercise the LEAPS 2) we hedge the margin loan with $12 puts You and I both know that $12 puts cost a lot when the stock is trading at $12 (like today) but will become very cheap when the stock is trading at $20. So, under the scenario that we are all gunning for, the cost of hedging the $12 strike embedded leverage will plummet for the last 4 year lifetime of the warrant. So why the f**king he** do people want to lockup the cost at 13% for all six years when we are all bloody well expecting that cost to plunge over the remaining 2/3 of the warrants' life???? That's what gets me :) And that's where I see the opportunity to do way better than the warrant by my strategy. And I'm taking less risk along the way.

No, the warrants do not adjust for the buybacks today. Neither do the LEAPS. Both benefit from more intrinsic value per underlying common share, but that's as far as it goes. I invested my approximate 60 cent "default dividend" in the stock at $12 though :D The 3% I'm saving in interest costs over two years with the LEAPS is where I come up with my "dividend". One might say the warrant holder speculated on greater than 60 cents of dividends cumulatively for this year and next -- they purchased them upfront hoping to get more? Backfired so far.

The common would win out over the LEAPS if BAC flatlined for the next $2 years. But if I spend $4 on LEAPS today, am sitting on $8 of cash for the next two years, then if stock is back at $8 again I will now own: 1 share of common (or 2 shares if the stock goes down to $4) 2 LEAPS It's not straightforward that the BAC common would be the best route if the stock is still at $12 in two years. Depends what happens between now and then. We don't think it's likely that the stock will go below $8, but it might. Anyways, you are right that the common shareholder will live to fight another day if he just sits tight through all that comes. The warrants will have a better chance of living if they didn't face such a hurdle rate. Although, if you are going to leverage at a $13.30 strike with 13% cost of leverage paid for with all 6 years upfront, then you are already extremely confident that failure is nearly impossible. So based on the theory of invincibility that the warrant holders already ascribe to, I embark on my LEAPS strategy to reduce the risk while also increasing the upside.

The warrants cost me 13% a year for the leverage, but the LEAPS cost me just 10% a year for the leverage. So what sort of dividend protection are we talking about here? The guys with the warrants are buying their dividend upfront, then getting it handed back to them. The only way they win is if the dividend is larger than the options market expects -- but today, I'm the big winner as the warrants got no dividend even though they paid for one! And Sanjeev, I get to invest my dividend today at $12 but the warrant holder is at the mercy of what we both expect to be higher stock prices next year. A 60 cent dividend reinvested today at $12 (my dividend for two years combined) is worth 90 cents if reinvested at $18 later on. So I totally win -- kicked butt on that one relative to the warrants. Later, when the stock is trading at $20 in two years: either A) I'll take delivery for my shares, pay likely a 30 cent cost for a $12 put to hedge my margin loan for another two years (much cheaper than it costs today), and kick back getting the full cash dividend. The fact that the puts get cheaper and cheaper as the stock rises is really the secret sauce to my strategy. or B) not use a margin loan. Just sell the 2015 calls and replace with $20 at-the-money 2017 LEAPS. They'll also be priced for roughly 3% dividend protection. They'll likely be priced similar to the way the WFC at-the-money LEAPS today are priced -- only about 5% annualized. 5% annualized cost of leverage embedded in the put vs the 13% people are paying upfront for the leverage in the warrants. That's a spread of 8%. What I ask again??? Is BAC going to be paying an 8% dividend when it trades at $20 in two years? Hell no it won't! The craziest thing I've discovered about these warrants is that people are buying their dividends upfront, then calling it "dividend protection" if they get part of that dividend back. By not paying 13% for this year's leverage (I'm paying on 10%), I effectively get a 3% dividend. Warrant holders per today's announcement get nothing! Not my 3%, they get nothing! ;)

I believe you are asking why the warrant and stock growth rate have to match... so let me explain. Compare two accounts: account A) has 1 share of common purchased at $12 account B) has 2.18 shares of common both purchased on margin at $12 per share (one financed with borrowing on margin) Margin rate is 13% in our example. You'll find that both accounts are worth $25 in six years if the stock compounds at 13% annualized (dividends included). The leverage added nothing because the stock didn't appreciate faster than your interest rate paid for the cost of the leverage. Because it added nothing, you might as well have just bought the common with no leverage. It didn't matter that you had leveraged the account -- you took on all that risk for nothing because you didn't come out ahead versus the common in the un-leveraged account. Now back to the real world. If you instead stuff account B with $12 worth of warrants it will also be worth $25 in 6 years under the same rate of stock price appreciation assumption (13% dividends included). The warrants don't have a risk of margin call between now and then -- that's their only advantage over the account leveraged at 13% on margin. Granted, it's a big advantage to not have to suffer the fate of a margin call -- it's a huge advantage. However, it's important to recognize that the shares face a hurdle rate of 13% before your warrants perform any better than the common. So getting the hurdle rate down is what I'm focused on.

That summarizes my position nicely. I want the stock to go up fast, or I wouldn't have bought Leaps. I like to see a company succeed but I have bought all the stock I will ever buy and now I want that share price up. Raising the dividend to 0.50 instead of the buybacks would have pushed the stock above $15.00 quickly, possibly even up to $20.00. Now we wait another year which means another cycle of leaps, and the frictional costs involved. That's the risk with LEAPs...there is always a time arbitrage involved and hell of a lot shorter than the warrants. Do you still hold any common or warrants? Or did you switch it all to LEAPs? Cheers! Sanjeev, Do you concur with Eric's assessment that tarp warrants in longer run (yr 3 to 6) are losers game? And, what are your view on bac warrants going forward ? Thanks. No, I don't think they are a loser's game. Also, I don't think that's what Eric meant. I think he's saying that the normal degradation of the warrants when you get to years 4 and on, mean that they won't provide any sort of advantage over LEAPs. At the moment, I think LEAPs are the loser's game, since you are relying on a 2-year time arbitrage. Why do you think Al and Eric wanted dividends! ;D We bought the April 5th $12 Calls on March 4th for 17.5 cents each. They will be anywhere from 75-90 cents tomorrow! You aren't going to get that type of return with the warrants, but the warrants at present are proxies for equity...at least the A warrants. I think the B warrants may be tough to make alot of money on. Cheers! The warrants and LEAPS are both loser's games if the stock doesn't appreciate. The warrants decay and so do the LEAPS. But I grabbed the $12 LEAPS on the theory that the bank is (and this will sound fancy so brace yourself!) now "earning the cost of capital" embedded in the LEAPS. So I can keep on buying $12 LEAPS every two years even if the stock is still at $12. The shares might not appreciate, but at least their value is growing at the speed at which I'm throwing money into the LEAPS. Eventually the accumulated value will start to show in the stock price as ROTE shines through to earnings (and cover the cost of the LEAPS) -- that's when I get the moment I've been waiting for, which is the speculative rise in stock price up to 1.3x or 1.5x tangible book.. $12 invested in the warrants give the upside of 2 shares. Two shares of upside invested in the $12 strike LEAPS would cost $4 (2x$2). So $4 invested in the 2015s, then $4 more invested in the $2017s, then $4 more invested in the 2019s. Same 2x upside as with the warrants. Only, I don't blow the whole wad all at once. I spend a third, and wait. Then perhaps in two years spend another third and wait. Then perhaps in 4 years I spend the final third. Hopefully now I'm understood. At all times I have far less money on the table (except in year 5 and 6), and less money on the table means less risk guys! Yes, same upside!

That's the risk with LEAPs...there is always a time arbitrage involved and hell of a lot shorter than the warrants. Do you still hold any common or warrants? Or did you switch it all to LEAPs? Cheers! Sanjeev, Do you concur with Eric's assessment that tarp warrants in longer run (yr 3 to 6) are losers game? And, what are your view on bac warrants going forward ? Thanks. I know the question wasn't ask to me, but I am very comfortable with the warrants. Eric is a smart guy but options are not for the faint of heart. I believe many on this board may be following him out of greed and do not understand the risks involved. IMO, the TARP warrants offer excellent returns if held to maturity and the economy resembles any sense of normalcy. Six years is an eternity for some investors. Judging by the low expectations on the other thread regarding the share price in 2019, the ultimate return on the BAC warrants may surprise many on this board. Kevin, You are correct that the warrants will likely significantly outperform the common by expiry, because I too am expecting a common stock price above $25. Hey, maybe it's $40 as Berkowitz suggests. Whatever it may be, I'd rather do it with lower cost of leverage! Were the warrants to have lower cost of leverage, they'd be even better! So that's the direction I'm heading.

This is a thought provoking discussion, but I found it confusing to refer to the 13% as a cost of borrowed funds. The conventional usage of the term relates cash flows to a net present value of zero, so that you have to beat the rate to make any money. The 13% in this thread refers to the rate at which the warrants do not receive excess return over the common, and below which the common outperforms the warrants, or cost of capital. Maybe this is obvious to everyone else, but some people get stuck on semantics. It's important to use the proper terminology to avoid losing people, but in this case I wasn't aware of a better way of expressing myself. I never really knew what the phrase cost of capital refers to. So if I had said the BAC warrants have a cost of capital of 13% then everyone would have understood me clearer? You see, if I were the reader I would have been lost right there by the phrase "cost of capital". But I don't work in the industry so... I don't know what people are used to hearing.

I thought more about this tonight at dinner... I probably will pay roughly a 40% tax rate on my $2 gain from selling the warrants in my taxable account. That's 80 cents. Some people are expecting a $3.00 cumulative dividend from the common over the next 6 years, a warrant strike of $10. That full $3.00 would be taxable, and at probably a 30% tax rate for me. So I would own 90 cents tax liability in the future on the dividend from the warrants. This dividend tax is a tax I can completely avoid from my strategy of owning calls if I decide to roll the calls along instead of taking delivery of the shares. So that 90 cents of dividend tax is actually greater than my present year tax bill for my short term capital gains. And I completely dodge the possible $1.10 hit to the warrant valuation if the cost of leverage in the warrant were to fall to 10% (which is still more expensive than the other TARP warrants). So that $1.10 revaluation hit in addition to the 90 cent dividend tax would be $2 altogether -- that would have completely wiped out the gain that I just realized.

You've given a couple of reasons why the warrants might remain expensive, or even get more expensive, but speculating on these things is not something I want to take on my plate. I'm concentrating my betting only on BAC getting their ROTE up to 13% to 15%, and I'll make a big gain as the stock revalues to 10x P/E based on those metrics (which would occur between 1.3x and 1.5x tangible equity value). While I wait for that to happen, I'm trying to make it as cheap as possible to finance the leverage.