ERICOPOLY

I can't lose my $10 in cash if I go the route of the calls, the guy with the warrant is only protecting $6.65. Now what was that you are telling me about my subjective opinion?

Are the calls you own hedged? What about the risk that BAC may trade below $12 and you lose the whole investment? Are you saying that you are only putting up $2 instead of $12, so the risk of losing the $2 is ok? The calls have the embedded put that StubbleJumper has been talking about. That is the hedge. But I prefer to think of this in terms of what it costs, annualized, for the non-recourse leverage. I think like a businessman in this regard, not in terms of casino language. What will it cost me if I hold these calls to duration? It will cost me 10% annualized for the non-recourse leverage. The word "non-recourse" implies the put. Which is why it's not necessary to tell me about the put. The only reason to speak of the put is that the 13% cost of leverage that you calculated sounds expensive. But expensive compared to what? It's hard to find non-recourse leverage in other fields of life to reasonably compare it to (ie, you can't compare it to a mortgage rate, or a margin account rate....would a credit card be the best comparison?). We naturally say, wow, a 13% interest rate is ridiculous in a near-zero rate environment, but that's because few of us ever borrow on a risky, non-recourse basis. So what else can you compare it to? Well, you've correctly gone through the process of comparing LEAPS to the warrants to quantify the comparative cost of those two sources of non-recourse debt. And you are absolutely right, that's probably the best reference point. The only issue is that the term is much different because the leaps are 2 years and the WTs are 6 years, so it's not a surprise that the cost is higher for the warrants. I don't think anyone has any disagreement about any of this. I think you are clear about what you are buying when you speak of non-recourse leverage. But, not all readers will understand it the same way. IMO, it's important to explicitly state that you can't compare the 13% cost to a margin account interest rate, and that 6-year non-recourse leverage should cost much more than 2-year non-recourse leverage. None of this means that you are incorrect in your assessment that the six-year warrants are mispriced relative to the LEAPs or common. It just means a comparison to a risk-free or low-risk rate would be a big mistake! Cheers, SJ SJ, Compare the 13% to the 8% cost (9.5% if dividend restored) cost of the leverage in the AIG warrants. It's not like we don't have anything to compare it to. And those AIG warrants have 33% more life in them -- so if you think the leverage should be more expensive when of longer duration , then this is truly Alice In Wonderland. We could alternatively compare it to the cost of the BAC calls, as I am doing.

Are the calls you own hedged? What about the risk that BAC may trade below $12 and you lose the whole investment? Are you saying that you are only putting up $2 instead of $12, so the risk of losing the $2 is ok? The calls have the embedded put that StubbleJumper has been talking about. That is the hedge. But I prefer to think of this in terms of what it costs, annualized, for the non-recourse leverage. I think like a businessman in this regard, not in terms of casino language. What will it cost me if I hold these calls to duration? It will cost me 10% annualized for the non-recourse leverage. The word "non-recourse" implies the put. Which is why it's not necessary to tell me about the put.

But it's not just theta, it's also sigma is relevant. As we have discussed at length on this thread, BAC has faced a great deal of litigation over recent years, and still faces a number of suits. Reasonable people can reasonably disagree about the outcome of those suits (and future suits that we might imagine). A potential outcome of this litigation is a permanent impairment of BAC's equity. Obviously we who hold the stock believe this to be a remote outcome, but it's still a possibility which contributes to the value of a long-term put. Similarly, there is a view (legitimate or otherwise) that the future may not be rosy for the banking industry if QE is wound-down...which again contributes to the value of a put. We can clearly see the potential for multiple bags in BAC. We have dissected the risks and concluded that a downside is improbable. But in our enthusiasm for the multiple bags, we shouldn't forget that there could legitimately be a downside! Correct, let's not pay for all six years upfront smugly believing nothing will go wrong. Ironically though, you seem to be defending the idea of buying the warrants. Let's pay for two years upfront (with the 2015 $12 strike calls) and wait and see. Should things be going well, we'll take delivery of the shares and protect the loan with a new purchase of puts.

AIG leverage costs 9.5% if you weigh the cost of not getting that part of the dividend (missing the dividend costs 1.5%). Assuming we miss the dividend from day one, which is a bit exaggerated given there is no dividend yet.

I think the threshold of 0.01 (quarterly) for BAC versus 0.17 (quarterly) for AIG is a big deal, especially given that we have a timeline/ability to estimate amount for BAC's dividends in the future versus AIG's indication there will be one of some undeterminable dividend in the future. Thus, I find it very difficult to figure out what kind of adjustments AIG warrants will have over the next 6 or so years compared to BAC--this should account for some difference in the relative prices. Paying 8% for the AIG leverage vs paying 13% for the BAC leverage. I think what this means is you purchase a lot more leverage in the first place with AIG (because you can afford a lot more leverage, because it's more affordable). That's leverage you get at the $45 strike on AIG -- compare that to the prices at which BAC's extra dividends will get reinvested at. $20, $25? Better to get the leverage at the down-low price.

The AIG warrants are 8% annualized cost of non-recourse leverage (a bit higher if dividends are paid given that you miss out on part of the dividend with the AIG warrants) The "put" is also more valuable in the AIG warrants because it's for 8 years, not 6 years as with the BAC warrants.

This is why I compared the no-recourse leverage of the warrant to the no-recourse leverage in the options market. Should the common stock go to zero over the next two years, the warrant holders is losing $5.65 (cost of warrant) but the guy paying $2.10 for the $12 strike call is only out $2.10 (cost of the calls). So the guy with the warrant lost more than twice as much. Better to have $9.90 remaining on the side with the call rather than $6.35 with the warrant.

I did not make the mistake of ignoring the dividend strike adjustment. Rather, I waved it off as not relevant to the discussion (implicitly waved off by not mentioning it). The common also gets the dividend. In my example, I am comparing the economic value of the two -- one with a share of common embedded in the warrant (and cash on the side to grow at 13% annualized), and the other with straight common. In both examples, the common (whether actual common share or whether it be synthetically embedded in the warrant) gets a dividend that gets reinvested in more shares of common. Here is the deal -- if you are getting 1.2 shares per warrant by expiry, then the guy who went straight vanilla common will also own 1.2 shares of common by expiry (reinvesting his dividends).

Layups are nice too.

I also think it's a long-shot for the stock to be beyond $30 at warrant expiry. Being long 1.2x the stock (at no borrowing cost) is the same outcome at $30 stock price as being 1.55x long the stock at 13% borrowing cost. I know my borrowing cost via the options route might very well not be cost free, but I don't think it will be anything like 13% annualized either. So I won't need as much leverage. And less leverage means less dividends collected. Less collected means less dividend taxes owed. So that's another way that I might save if I switch from the higher leveraged warrants to the lower leveraged common+options. Besides, it's nice to be running with less leverage when the outcome is the same. Based on an assumption that it won't be beyond $30 at expiry. I might just go 1.2x with the common (using margin), hedge maybe half of the leverage with puts. Now it's getting the cost of the leverage way down, and it will be almost the same gain as going with the warrants to $30 stock price. But much less risky! Less leverage is less risky.

Simplest explanation. You have $12. You can buy 1 share and you have one share of upside. Or you can buy a warrant for $5.65 and have one share of upside... as well as $6.35 in cash on the side. What to do with that cash? Well, it needs to grow to at least $13.30 (starting warrant strike price) just to break even with buying the common stock outright for $12. It takes a 13% annualized compounding rate for 6 years to grow the $6.35 cash pile to $13.30. So therefore the implied cost of the leverage in the warrant is 13% annualized.

However I am strongly considering it (I have decided to sell it, but the market isn't open and I still might waver). I just mentioned how a 13% cost of leverage could change to a 10% cost of leverage as the stock nears $20. That could eat up 20% of the current value of the warrant. Right now my warrants in my taxable account carry a cost basis of $3.40. $2.25 is the size of the capital gain. The short term tax rate might be 20% higher, but that only kills off 50 cents of value, or roughly 9% of the present value of the warrant. So holding for long-term capital gains rate might mean losing 20% in an effort to not lose 9% to the higher tax rate. So it's a coin toss. The 20% is going to be lost, IMO, when the stock gets near $20. So perhaps I may as well just eat the 9% value come tax time next year and sell the warrants tomorrow. EDIT: Actually, forget what I said above. If I pay a 40% tax rate on $2.25 of short-term capital gain, that's only 90 cents of tax owed. That's less than the amount of damage that the warrant will suffer if the rate of leverage goes from 13% to 10% as the stock nears $20. So selling today is certainly the right decision. The total tax bill is less than what I believe will be lost by holding the warrant until $20 stock price.

What if people instead want a 10% annualized cost of leverage? Given a stock price of $12 (today) that would drive the value of the warrants down to $4.50. That would be a 20.5% decline from today's price. That's the drag that the value of the warrants will face as the price climbs to the point where people don't want to pay more than 10% cost of leverage. That might happen when the shares hit $17. So you have this 1.5x leverage juicing your gains, but you have this leverage revaluation headwind to fight against your gains.

At the time that I write the call I'll still either be holding the original $12 calls that I purchased today, or I'll have exercised them and will be holding the underlying common. One offsets the other. At some point a decision will be made that the stock is no longer discounted enough to justify borrowing money at high rates for leverage in order to greedily squeeze another percentage or two. If the stock were at $20 right this friggin second, would you want to leverage it at 13% annualized rate? That's what I'm talking about. Nobody is going to want to. Thus, the warrants will no longer be commanding a premium that costs 13% annualized for the embedded leverage. People are paying a very dear price for the leverage in the warrants today, but later after the stock has run up... will they still come? Thus, I want the calls instead.

I'm effectively saying that when the $12 call matures, take delivery of the stock and own the common. Using margin loan. Then hedge the margin loan at same $12 strike. It should be really cheap to do this (buying the put) if the stock is indeed in the $17 - $20 range by 2015.

Plus, if for example we get to $17 by Christmas 2013 I should be able to write covered calls for 2015 to recover most if not all of the $2 premium I'm paying today for the $12 calls. Thus, this leverage might not be costing me 10% annualized. It very well turn up more like 5% annualized cost. Depends on how soon the stock rises -- if there's a bit more than a year before expiry then I can recover quite a bit of the sunk cost of the premium. It's important to note that when WFC was trading at $10 in early 2009, the premium for calls was very high -- 30% of at-the-money strike. But later, the premium was a lot lower, 15% or so of at-the-money strike. 30% of $10 is $3, and 15% of $20 is $3. It seems that you can often get back your premium if there is a big run. Non-recourse leverage that winds up costing you nothing is wonderful.

I put most of the cash in BAC common stock and some in 2015 calls. There are the $10 strikes that I purchased for $2.65 when the stock was at $11.15 last week, and I bought some $12 strike 2015 calls today for roughly $2.10. Incidentally, those $12 strikes are non-recourse that cost 10% annualized for the leverage (higher if there are dividend increases). So in the first couple of years, that will feel almost the same as with the warrants. But beyond those two years (like when the stock is up at $17-$20 and beyond), the cost of $12 puts will be laughable. And I'll defray their laughable cost by writing far out of the money calls. For example, today the $22 strike calls cost almost the same as the $7 puts. And I might just be out of the stock entirely in 2 years if the price is $20. Will the market still be willing to pay 13% annualized for the cost of leverage when the stock is $20? It's a fair question -- if not, like if it only is willing to pay 5% for deep-in-the-money leverage, it may be that you don't get much advantage over the common as the stock rises from $12 to $20. Then, when perhaps it only costs 5% for the leverage in the warrant, maybe that's the time I'll move from the call options back to the warrants. ;D ;D ;D

Take $12 and instead of buying 1 share of stock, buy 1 warrant. You have about $6.35 in cash left over. Now buy stock with that cash. You can buy .529 shares of stock with that. You have leverage of 1.529x in this example.. Okay, now instead of buying the warrants, use some other form of financing the leverage to purchase a 1.529x long position in the common. Take a loan from your parents if you only want a few hundred thousand worth of leverage (sorry, bad Mitt Romney joke). Anyways, whatever form of financing you come up with, purchase a position in the common leveraged 1.529x. And make sure you reinvest all dividends back into the stock (same as the warrants). The lower price at the time and bigger the dividend payouts, the more shares you purchase with your reinvested dividends. Mechanically, this is exactly what goes on inside the warrants. Now, I guarantee you will do better than the warrants as long as your financing rate is less than 13% annualized. Maybe your parents aren't such loan sharks and only charge you 13%. Anyways, the reason why this leverage is so damned expensive is because it's non-recourse. However, there is other non-recourse leverage available in the options market. Also, notice you it takes 13% annualized rate to grow that $6.35 in cash to $13.30 over six years?

Would you mind explaining that in a little more detail--I haven't quite figured out the cost for leverage model yet. I've always just compared the break-even price between common and warrants (currently ~$25) and then decided if I thought it would be greater than that price at expiry, so I'm curious as to if/why I shouldn't think of it that way. It's easy to compute -- just take today's stock price, compound it by 13% for 6 years, and you get that $25 price (break even with the common). Were the leverage to cost less than 13%, the breakeven point would be lower.

The only class A warrants that I didn't sell last week were the remaining taxable ones. Paying 13% annualized for leverage just isn't that great -- recourse or not. I wonder if anyone yet has bought the common and shorted the warrant just to pick up that 13%.

March 2009 taught me that the time to dump all FFH is during the market bottom. FFH is only 0.5x long the stock market at such a time, and has names like JNJ which simply aren't going to move that much. Get ye' out of yer FFH matey and into WFC at $8. Much more bang for the invested buck.

We're staying at Furnace Creek Resort in Death Valley N.P. later this week. Back when we booked it, the weather was looking like it would be in the high 70s - mid 80s. Now it's going to be 90s! Plenty hot, don't need the nukes. This is still winter.

Happily enjoying the sunshine in Santa Barbara today despite the California taxes -- as you say, "even climate" matters :D

I posted it on this thread back in either Nov or Dec, but this is one heck of a long thread! Moynihan was speaking at a financial conference, it was audio only. They had it up as a webcast on the Bank of America website. Sanjeev I know remembers it. Maybe he can comment. I had specified the exact minute for people to advance the webcast to -- so to hear Moynihan utter the words. However, I don't have the time to read all of this thread for Nov/Dec to find the exact place.