BAC-WT - Bank of America Warrants

[MVP444300]

I bought the commons/A warrants last year with the intent of not selling either for some time unless I can find some better bargains.  What I'm confused about is why is anyone selling the warrants?  They  seem to me to be at fair prices--not to mention don't have to worry about paying capital gains taxes (it would be short term in my case if I sold them now as some are doing). 

 

 

[stahleyp]

mvp, the leverage from the warrants is more expensive than the leverage in the options. from my understanding, eric hasn't changed anything in his taxable accounts for the warrants.

[enoch01]

I bought the commons/A warrants last year with the intent of not selling either for some time unless I can find some better bargains.  What I'm confused about is why is anyone selling the warrants?  They  seem to me to be at fair prices--not to mention don't have to worry about paying capital gains taxes (it would be short term in my case if I sold them now as some are doing).

 

Think of it another way: to hold the A warrants over the common at these prices, you have to expect the common to appreciate quickly, because otherwise the cost of the leverage could eat you up.  But if you accept the implied assumption of quick price appreciation, go with options, because they are are now the cheaper leverage.

 

Of course, it's also helpful to think about what can happen if prices stay flat / go down for a little while.  Look at what happened when BAC got down to a small fraction of it's value at the end of 2011 - it snapped back pretty quick.  It's not going to be as snappy nowadays:

 

http://bigcharts.marketwatch.com/kaavio.Webhost/charts/big.chart?nosettings=1&symb=bac&uf=0&type=2&size=2&sid=147233&style=320&freq=1&entitlementtoken=0c33378313484ba9b46b8e24ded87dd6&time=9&rand=2104815071&compidx=&ma=0&maval=9&lf=1&lf2=0&lf3=0&height=335&width=579&mocktick=1

[ERICOPOLY]

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.

 

 

[Mephistopheles]

Eric, thanks for your explanation. Even after putting these numbers into Excel to test out this "borrowing below 13%", I'm still trying to wrap my head around why the warrants are overvalued vs. the common (or too expensive of leverage). I understand that borrowing below 13% and investing in BAC is cheaper than owning the warrants (as I crunched the numbers in a spreadsheet), but I'm having trouble seeing the connection between the stock having to rise 13% annualized in order for the warrants to be more profitable, and 13% being the cost of the leverage. I'm sure it's simple and obvious, but I just can't see it lol. Can you or anyone explain this in simpler terms? I'm just trying to learn here, thanks!

[ERICOPOLY]

mvp, the leverage from the warrants is more expensive than the leverage in the options. from my understanding, eric hasn't changed anything in his taxable accounts for the warrants.

 

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.

 

 

 

[ERICOPOLY]

Eric, thanks for your explanation. Even after putting these numbers into Excel to test out this "borrowing below 13%", I'm still trying to wrap my head around why the warrants are overvalued vs. the common (or too expensive of leverage). I understand that borrowing below 13% and investing in BAC is cheaper than owning the warrants (as I crunched the numbers in a spreadsheet), but I'm having trouble seeing the connection between the stock having to rise 13% annualized in order for the warrants to be more profitable, and 13% being the cost of the leverage. I'm sure it's simple and obvious, but I just can't see it lol. Can you or anyone explain this in simpler terms? I'm just trying to learn here, thanks!

 

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.

[ERICOPOLY]

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.

[ourkid8]

Eric, your assumptions are assuming the strike price will NOT decrease due to dividend payments over $.01. (By my calculations it should get down to about $10)  You are also assuming you will only be able to buy 1 share per warrant which is not the case either due to the reinvestment options inherent in the warrant.  (Most calculations believe we will be able to buy 1.2 shares per warrant at expiry)

 

If BAC is able to significantly reduce their share count UNDER TBV there is a real possibility the common could cross the $30 mark by 2019. Buffet did mention, it should trade over TBV if ROA crosses 1.2-1.3 x and we are still not there yet.  I am hoping it languishes around this price for another year!!!

 

S

 

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.

[wescobrk]

If BAC is able to significantly reduce their share count UNDER TBV there is a real possibility the common could cross the $30 mark by 2019. Buffet did mention, it should trade over TBV if ROA crosses 1.2-1.3 x and we are still not there yet.  I am hoping it languishes around this price for another year!!!"

 

Do you recall when Buffett said it should trade above tbv if roa1.2-1.-3? That sounds like an awfully high number for a hurdle. I dont have the B/S in front of me but with about 2 trill in assets if yiuare waiting for a hurdle of 1.2 roa that is about 2.40 a share and tbv is about 13.30, therefore if it was at roa 1.1 it would be earning about 2.20 a share or about 6x earnings. That sounds awfully low. I would think the hurdle would be closer to .80 to hit or exceed tbv instead of 1.2-1.3.

[dcollon]

wescobrk,

 

He discusses ROA & TBV in this clip from the other morning.

 

http://video.cnbc.com/gallery/?play=1&video=3000151816

[wescobrk]

Ok, thanks, that makes sense, he doesn't discuss it as a hurdle and the verbiage is a bit vague from the transcript. He kinda trails off as he is answering the question. I still stand by my statement that 1.3-1.4 is way too high a hurdle for tangible book. I would argue it should be trading above book not tangible book if ROA is 1.3%.

[jay21]

Eric, thanks for your explanation. Even after putting these numbers into Excel to test out this "borrowing below 13%", I'm still trying to wrap my head around why the warrants are overvalued vs. the common (or too expensive of leverage). I understand that borrowing below 13% and investing in BAC is cheaper than owning the warrants (as I crunched the numbers in a spreadsheet), but I'm having trouble seeing the connection between the stock having to rise 13% annualized in order for the warrants to be more profitable, and 13% being the cost of the leverage. I'm sure it's simple and obvious, but I just can't see it lol. Can you or anyone explain this in simpler terms? I'm just trying to learn here, thanks!

 

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.

 

IDK if this line of thinking makes sense to me (it probably is right given how little I think about options vs. Eric).  First, to breakeven with the stock at $12, wouldn't you need to turn the $6.35 into $12 not $13.30? 

[Liberty]

Ok, thanks, that makes sense, he doesn't discuss it as a hurdle and the verbiage is a bit vague from the transcript. He kinda trails off as he is answering the question. I still stand by my statement that 1.3-1.4 is way too high a hurdle for tangible book. I would argue it should be trading above book not tangible book if ROA is 1.3%.

 

My understanding when I watched it (didn't rewatch, so I could be wrong) is that he meant above book.

[racemize]

Eric, thanks for your explanation. Even after putting these numbers into Excel to test out this "borrowing below 13%", I'm still trying to wrap my head around why the warrants are overvalued vs. the common (or too expensive of leverage). I understand that borrowing below 13% and investing in BAC is cheaper than owning the warrants (as I crunched the numbers in a spreadsheet), but I'm having trouble seeing the connection between the stock having to rise 13% annualized in order for the warrants to be more profitable, and 13% being the cost of the leverage. I'm sure it's simple and obvious, but I just can't see it lol. Can you or anyone explain this in simpler terms? I'm just trying to learn here, thanks!

 

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.

 

IDK if this line of thinking makes sense to me (it probably is right given how little I think about options vs. Eric).  First, to breakeven with the stock at $12, wouldn't you need to turn the $6.35 into $12 not $13.30?

 

It should be 13.30 since that is the strike you have to pay to get the share, I believe.

[StubbleJumper]

Eric, your assumptions are assuming the strike price will NOT decrease due to dividend payments over $.01. (By my calculations it should get down to about $10)  You are also assuming you will only be able to buy 1 share per warrant which is not the case either due to the reinvestment options inherent in the warrant.  (Most calculations believe we will be able to buy 1.2 shares per warrant at expiry)

 

If BAC is able to significantly reduce their share count UNDER TBV there is a real possibility the common could cross the $30 mark by 2019. Buffet did mention, it should trade over TBV if ROA crosses 1.2-1.3 x and we are still not there yet.  I am hoping it languishes around this price for another year!!!

 

S

 

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.

 

 

kid,

 

You've hit it bang on.  We cannot forget put-call parity theory.  The stock could actually decline. 

 

Eric's cost of leverage is not just a cost of leverage, but also the cost of an embedded put.  In Eric's example, the worst outcome for a wt-holder is that you walk away with your $6.35+interest.  That's your put option.  The worst case for those of us holding the stock is that we lost our $12 in its entirety.

 

SJ

[ERICOPOLY]

Eric, your assumptions are assuming the strike price will NOT decrease due to dividend payments over $.01. (By my calculations it should get down to about $10)  You are also assuming you will only be able to buy 1 share per warrant which is not the case either due to the reinvestment options inherent in the warrant.  (Most calculations believe we will be able to buy 1.2 shares per warrant at expiry)

 

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).

 

 

[ERICOPOLY]

Eric's cost of leverage is not just a cost of leverage, but also the cost of an embedded put.  In Eric's example, the worst outcome for a wt-holder is that you walk away with your $6.35+interest.  That's your put option.  The worst case for those of us holding the stock is that we lost our $12 in its entirety.

 

SJ

 

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.

 

[Cardboard]

Ericopoly,

 

I think that one factor influencing what you are seeing is implied volatility. It is at 53% right now for the warrants "A" while it is at 30% for the Jan 2015 $12 strike calls. However, the implied volatility back on November 1 on the warrants or around when I think that many people backed up the truck was 50%. I don't know what the volatility was on the calls at the time, but I assume that it was also significantly lower than the warrants.

 

For comparison, implied volatility on the AIG warrants is currently at 34% and Jan 2015 $40 strike calls are at 30%.

 

Of course, my implied volatility calculation does not take into account strike price and dividend adjustments on the warrants which I think is a major factor driving up the % much higher on the warrants, especially on the BAC ones. However, are the adjustment features so much better on the BAC ones vs AIG to justify such difference?

 

Also, these warrants are marginable securities which is not a worthless feature when compared to calls that are worth nothing in a margin account. On the other hand, AIG warrants are also marginable and don't seem to get much higher pricing than their calls for that feature. So for their very long duration and margin characteristics, I tend to consider these warrants as equity vs calls, but that is just me.

 

That fact about really high implied volatility was bugging me at the time that I bought the "A" warrants. However, what I was observing at the time was that the stock had moved up while the warrants were remaining flat or not keeping up and that this implied volatility had declined some from previous months. Unlike calls which trade mostly based on the underlying, implied volatility and put-call parity rule, these warrants will also go up and down based on supply and demand. It seemed like a rebound on the warrants price was in the cards and assuming some reasonable price for BAC in the future, they showed more upside than straight BAC common. I actually thought at the time about margining BAC to get the same result, but it meant a lot of capital into one stock.

 

Anyway, buying them was somewhat an act of faith that implied volatility would remain in the 50% range. If it had decline to the 30% range like the AIG warrants it would have been a bad deal. It would be interesting to hear more thoughts as to the huge difference between AIG and BAC warrants.

 

Cardboard

[StubbleJumper]

Eric's cost of leverage is not just a cost of leverage, but also the cost of an embedded put.  In Eric's example, the worst outcome for a wt-holder is that you walk away with your $6.35+interest.  That's your put option.  The worst case for those of us holding the stock is that we lost our $12 in its entirety.

 

SJ

 

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.

 

 

Sure, that's all true.  But we need to remain cognizant of what we are buying at all times.  With the warrants, we are effectively buying a multi-year embedded put.  If any ridiculous thing happens to the U.S. banking industry in 2017 or 2018 warrant holders can exercise their put.  In the particular case of BAC, there is room to argue about the value of that long-term embedded put, but it does exist and the warrants have big-time theta.

 

Cheers!

 

SJ

[ERICOPOLY]

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.

 

[jay21]

Thanks for the post Cardboard. 

 

I don't think you can compare the options and warrants easily in terms of implied vol.  One way I like to look at the warrants is that they have an embedded option on the strike price through the dividend adjustments.  I haven't come up with a way to price that option, but I expect it would explain a good chunk of the implied vol difference. 

[racemize]

Of course, my implied volatility calculation does not take into account strike price and dividend adjustments on the warrants which I think is a major factor driving up the % much higher on the warrants, especially on the BAC ones. However, are the adjustment features so much better on the BAC ones vs AIG to justify such difference?

 

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.

[ERICOPOLY]

Of course, my implied volatility calculation does not take into account strike price and dividend adjustments on the warrants which I think is a major factor driving up the % much higher on the warrants, especially on the BAC ones. However, are the adjustment features so much better on the BAC ones vs AIG to justify such difference?

 

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.

 

 

 

[ERICOPOLY]

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.