BAC leverage

[racemize]

This discussion has been way beyond my level of understanding.  However, I'm curious how the discussion has quickly changed from essentially that the TARP warrants are the greatest thing ever to the common is now considered a much better deal.  Or am I misinterpreting things?

The common has actually done better over the last year.

 

I just went back and looked at my BAC-A versus common returns:

 

I bought BAC-A at $3.00 in July 26, 2012, which has a return of 84% versus 71% of the common

I also bought at $4.00 on November 9, 2012, which has a return of 38% versus 29% of the common

 

So at least for me, the warrants have done relatively better thus far. 

[zippy1]

This discussion has been way beyond my level of understanding.  However, I'm curious how the discussion has quickly changed from essentially that the TARP warrants are the greatest thing ever to the common is now considered a much better deal.  Or am I misinterpreting things?

The common has actually done better over the last year.

 

I just went back and looked at my BAC-A versus common returns:

 

I bought BAC-A at $3.00 in July 26, 2012, which has a return of 84% versus 71% of the common

I also bought at $4.00 on November 9, 2012, which has a return of 38% versus 29% of the common

 

So at least for me, the warrants have done relatively better thus far.

I think the point is with BAC-WTA having done better than BAC common, it implies that BAC-WTA is getting more expensive relative to BAC.

 

I think you would find the break-even stock price now is higher than that on July 26th, 2012.

[racemize]

This discussion has been way beyond my level of understanding.  However, I'm curious how the discussion has quickly changed from essentially that the TARP warrants are the greatest thing ever to the common is now considered a much better deal.  Or am I misinterpreting things?

The common has actually done better over the last year.

 

I just went back and looked at my BAC-A versus common returns:

 

I bought BAC-A at $3.00 in July 26, 2012, which has a return of 84% versus 71% of the common

I also bought at $4.00 on November 9, 2012, which has a return of 38% versus 29% of the common

 

So at least for me, the warrants have done relatively better thus far.

I think the point is with BAC-WTA having done better than BAC common, it implies that BAC-WTA is getting more expensive relative to BAC.

 

I think if you calculate the break-even stock prices, due to the fact that warrant has done better than common, you would find that the break even common price has moved higher.

 

You are right, the break even was ~23 at purchase and has moved up to ~25 now.  25 starts to be the point where I get a little more nervous, conservatively, but I see the potential for >30 pretty easily in that time frame.

 

I guess we shouldn't expect to see the effects of the leverage until later in the warrant life, but now Eric is indicating that it may not grow as fast as the common in the 18-20 range--I'm still working out what the "rational" behavior would be along the path to 25, but it is tough to figure out. 

[zippy1]

This discussion has been way beyond my level of understanding.  However, I'm curious how the discussion has quickly changed from essentially that the TARP warrants are the greatest thing ever to the common is now considered a much better deal.  Or am I misinterpreting things?

The common has actually done better over the last year.

 

I just went back and looked at my BAC-A versus common returns:

 

I bought BAC-A at $3.00 in July 26, 2012, which has a return of 84% versus 71% of the common

I also bought at $4.00 on November 9, 2012, which has a return of 38% versus 29% of the common

 

So at least for me, the warrants have done relatively better thus far.

I think the point is with BAC-WTA having done better than BAC common, it implies that BAC-WTA is getting more expensive relative to BAC.

 

I think if you calculate the break-even stock prices, due to the fact that warrant has done better than common, you would find that the break even common price has moved higher.

 

You are right, the break even was ~23 at purchase and has moved up to ~25 now.  25 starts to be the point where I get a little more nervous, conservatively, but I see the potential for >30 pretty easily in that time frame.

 

I guess we shouldn't expect to see the effects of the leverage until later in the warrant life, but now Eric is indicating that it may not grow as fast as the common in the 18-20 range--I'm still working out what the "rational" behavior would be along the path to 25, but it is tough to figure out.

But if you buy 2015 call strike at 12, the break even price is about 14.4 for the call.  So you can take the same amount of money and buy a combination of common plus the 2015 call.

[enoch01]

Eric (and others), what are your thoughts about the TARP warrants vs. the common without any extra leverage?

 

...

 

But did the warrant just go from the bee's knees to total dirt, or is it just sub-optimal compared to this new approach (common + LEAPS, etc)? Or is even the unleveraged common a better deal in your opinion? In other words, if you could only own the common or only the warrant, which would you take?

 

 

This is how I think about it:

 

I still expect the warrants to perform better over their lifetime, but the additional, important question is: what is the trajectory they take to get to their endpoints when the warrants expire?  Since the warrants have a limited life, the trajectory really does matter, whereas it doesn't matter hardly at all with the common.

 

Right now it's getting more expensive to hold the warrants versus the common, unless you are assuming substantial price increases in the short term.  Maybe it's worth it.  But it is getting harder to justify the cost.  That's not because the thesis has changed, but because the cost of the leverage has gone up relative to the expected return.

 

I hold common, warrants, and options.

 

EDIT: I didn't say the above quite right.  If you are certain of the value of the endpoint at expiry, then the trajectories don't matter for any security.  Otherwise, the paths matter in terms of the cost of your exposure.

[racemize]

But if you buy 2015 call strike at 12, the break even price is about 14.4 for the call.  So you can take the same amount of money and buy a combination of common plus the 2015 call.

 

So, the calls are ~2.18 a piece so for the comparable break-even price of the warrants, it would be more $14.70 right?  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

[jay21]

But if you buy 2015 call strike at 12, the break even price is about 14.4 for the call.  So you can take the same amount of money and buy a combination of common plus the 2015 call.

 

So, the calls are ~2.18 a piece so for the comparable break-even price of the warrants, it would be more $14.70 right?  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

 

Agreed, this is more a lesson in opportunity cost than anything for me.

[Cardboard]

Investmentacct,

 

"Annual volatility 50%"

 

Black Scholes works and I think it would save a lot of time to the members here trying to compare cost of various options of various strikes and expirations. The formula gives you that via implied volatility. This cost of leverage idea is really the same thing, but quite tedious to calculate at times. We are reinventing the wheel here. Black Scholes is not casino talk!

 

Now, here is the problem with these BAC "A" warrants and it is the implied volatility being at around 53% currently. That is why Ericopoly is finding out that they are very expensive leverage relative to other call options which show 30% implied volatility. It is also worth wondering if your assumption of holding 50% in the future would hold or why I have highlighted your quote.

 

If the market is truly dumb enough to pay this kind of premium for nothing then there is an arbitrage solution here and it is to short them and buy calls and you would not even have to worry about what BAC does to make money. It seems highly unlikely to me considering that there are people and powerful computers hunting constantly just for that. These are not mysterious securities and a couple million $ worth of these change hands daily. Such a difference would not be ignored and would not have lasted for as long as it has. Implied volatility is what they use to compare options pricing and they arbitrage accordingly.

 

There is something bigger at work here and it has to be in the adjustment features that some have mentioned. I imagine that someone (many indeed and algorithms) out there has modeled that using a modified Black Scholes version and that is why there is a premium paid for said warrants. I also mentioned that warrants are different than options since there is more of a supply/demand dynamic at work vs straight options, but the difference here is just too large and has lasted for way too long.

 

Maybe also that it is the expectation of dividend growth and strike adjustment that is out of whack in the model, but that seems awfully odd since it would be the expectations of all market participants which are not that warm after all on BAC at a price of $12. Like for options that re-price when a dividend is increased or paid, the same apply to the warrants. They are derivatives too and priced based on what information is there today.

 

Cardboard

[zippy1]

But if you buy 2015 call strike at 12, the break even price is about 14.4 for the call.  So you can take the same amount of money and buy a combination of common plus the 2015 call.

 

So, the calls are ~2.18 a piece so for the comparable break-even price of the warrants, it would be more $14.70 right?  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

 

Agreed, this is more a lesson in opportunity cost than anything for me.

What if we take the $5.56 per warrant, sell it and then buy $2.18 for call and spend the rest on common?

[value-is-what-you-get]

 

  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

 

Two years ago today it was trading at $14.50 and heading down into the abyss!

[racemize]

 

  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

 

Two years ago today it was trading at $14.50 and heading down into the abyss!

 

Exactly--although we "know" that the legacy costs should come off pretty heavily over the next 12 months, so there is more of an upside catalyst now. 

[ERICOPOLY]

 

  In any event, I'm still not sure if I'm comfortable moving down to a 2 year time frame, though these discussions are making me think a lot more.

 

Two years ago today it was trading at $14.50 and heading down into the abyss!

 

Thus, you don't want to go with the warrants.  This is a no-brainer if you are defensively minded.

 

The warrants were trading at $8 two years ago.  Then they declined all the way to $2.  A market decline of $6.

 

The calls were priced at around $3 -- impossible to decline by $6.

 

Be defensive if you are defensive!  Walk the walk if you talk the talk, so to speak.

 

And is $0 per share completely impossible?  Yet you would think it to be lower risk to pay for all six years of leverage upfront?  Hrm...

 

$14 -$3 is $11.  So you had $11 in cash on the side.  Then you could have purchased common stock (without leverage) at $5.  You would have been able to utilize your $11 in cash to purchase a bit more than 2 shares of stock (without leverage) for every one share of warrant you have today (well, with your $6 in cash you could have bought a bit more than 1 share of common, but 2 shares of common is better than 1 share of common plus 1 warrant).  And don't forget you still had those calls in your inventory for additional possible upside!  So my strategy would have netted you 2 shares of common in addition to a call, and your warrant strategy would bring you 1 warrants plus 1 share of common.

 

StubbleJumper thinks my criticism of the warrants doesn't consider the possibility of disappointing declines to below $6 in the common, but I assure you my strategy is the better one of the two if the stock does indeed go that low.

[ERICOPOLY]

Bird in hand worth two in the bush.

 

Capital plan approved, no dividend.

 

I have my 60 cent dividend upfront already invested at $12.  You might get a fully 60 cent dividend next year, but I doubt both that high of a dividend number and this low of a stock price!

 

A 60 cent dividend at $12 is worth the same as a 90 cent dividend at $18.  Even more than $1.10 if you are a US taxpayer holding your warrant in a taxable account.

 

60 cents is the new 1.10.  Hey, that's almost a 50 cent dollar!

[Studesy]

I must say...the ideas and brainstorming being generated here with respect to options/warrant strategies via BAC and AIG are incredible!  Eric....your thought process, reasoning, and explanations in determining an optimal strategy with risk in mind are TOP SHELF!...Love it.

 

Something I was thinking about is writing insurance policies (ie PUTS) on great owner-operators (BRK or LUK) then using the proceeds to purchase BAC / AIG LEAPS or warrants.  This way the premiums collected would be levered up with non-recourse debt.  Obviously the potential upside wouldn't be as high as a Long Common/Long Leap strategy but I think your downside would be greatly protected.

 

For example:

 

LUK 2015 $22 Strike Put = $3.00

LUK price today= $27.15

 

With no leverage...the $22 could be invested at the risk free rate for the remaining 22 months of the contract.

The $3 premium could then be put into 2015 LEAPS, AIG LEAPS, AIG warrants...etc. then rolled over and added to as the LUK puts expire and are re-written.

 

In the scenario that the LUK price declines 24% and the shares are put to you.....the funds are sitting there waiting and you have acquired LUK at a great price as a long term holding. + the upside of the purchased LEAPS/warrants etc.

 

Upside could be further juiced by levering the long options by setting less than $22 aside for the potential LUK PUT and adding to the LONG options.  But I think this would essentially be the same as writing closer to the money puts and collecting higher premiums.

 

 

I love the idea of intelligently writing insurance policies and collecting premiums to invest.  Does anyone have an opinion on whether or not above average returns could be assumed using such a strategy with 0 leverage? How much leverage do you think is acceptable? ie How much of the $22 for LUK should be set aside at the risk free rate? I assume most margin accounts only require 25% or so to be set aside.....but would be too much leverage for me.

 

 

 

 

 

   

 

 

 

 

[ERICOPOLY]

 

I love the idea of intelligently writing insurance policies and collecting premiums to invest.  Does anyone have an opinion on whether or not above average returns could be assumed using such a strategy with 0 leverage? How much leverage do you think is acceptable? ie How much of the $22 for LUK should be set aside at the risk free rate? I assume most margin accounts only require 25% or so to be set aside.....but would be too much leverage for me.

 

 

You could make 13% annualized for six years by purchasing the common and shorting the A warrant (covered short). 

 

Only risk is of taking the downside on the stock below $6.50 ($12 minus $5.50).  So that would be around $6.50 on the stock.

 

You collect the 13% annualized return for 6 years unless:

1)  The stock finishes at less than $13.30 in 6 years

2)  There might be a borrowing cost for shorting the warrant (I have no idea)

 

 

This is the same downside risk as writing $7 LEAPS puts for 50 cent premium, but if you do that you don't get 13% annualized.  So I'm suspicious that there must be an interest cost to borrowing the warrants.

[ERICOPOLY]

Investmentacct,

 

"Annual volatility 50%"

 

Black Scholes works and I think it would save a lot of time to the members here trying to compare cost of various options of various strikes and expirations. The formula gives you that via implied volatility. This cost of leverage idea is really the same thing, but quite tedious to calculate at times. We are reinventing the wheel here. Black Scholes is not casino talk!

 

Now, here is the problem with these BAC "A" warrants and it is the implied volatility being at around 53% currently. That is why Ericopoly is finding out that they are very expensive leverage relative to other call options which show 30% implied volatility. It is also worth wondering if your assumption of holding 50% in the future would hold or why I have highlighted your quote.

 

If the market is truly dumb enough to pay this kind of premium for nothing then there is an arbitrage solution here and it is to short them and buy calls and you would not even have to worry about what BAC does to make money. It seems highly unlikely to me considering that there are people and powerful computers hunting constantly just for that. These are not mysterious securities and a couple million $ worth of these change hands daily. Such a difference would not be ignored and would not have lasted for as long as it has. Implied volatility is what they use to compare options pricing and they arbitrage accordingly.

 

There is something bigger at work here and it has to be in the adjustment features that some have mentioned. I imagine that someone (many indeed and algorithms) out there has modeled that using a modified Black Scholes version and that is why there is a premium paid for said warrants. I also mentioned that warrants are different than options since there is more of a supply/demand dynamic at work vs straight options, but the difference here is just too large and has lasted for way too long.

 

Maybe also that it is the expectation of dividend growth and strike adjustment that is out of whack in the model, but that seems awfully odd since it would be the expectations of all market participants which are not that warm after all on BAC at a price of $12. Like for options that re-price when a dividend is increased or paid, the same apply to the warrants. They are derivatives too and priced based on what information is there today.

 

Cardboard

 

30% volatility vs 50% volatility means nothing to me.  Having computed that with Black Scholes, I've wasted my time because I still need to compute the cost of the leverage expressed in human terms (like an annualized cost of non-recourse leverage).

 

Imagine if you went to go and get a mortgage and they quoted you some arcane number spit out by Black Scholes -- most people, myself included, would have no idea what that translates to in terms of leverage costs.  So they'd have a class action lawsuit saying that the options market unfairly charged them too much and deceptively wouldn't just tell them what the leverage costs in plain English -- they'd say they were "predatory lenders" or something similar.

 

Okay, joking aside...

 

I'm interested in one main event here -- BAC getting to 15% ROTE and the market putting a 10x multiple on those earnings.  That would be a $20 stock price based on current tangible equity value.

 

So that runup of valuation is what I want to leverage.  That's the part of the road I want to drive on with leverage.  I don't want to drive on the flat part of the road that bumps along at 10% per annum, I want the supercharged slope of the road that captures all that speculative gain from revaluation to normalized 15% ROTE.

 

So I don't want to overpay for those 10% years to come afterwards.  The only way I can manage this is by paying for it in bits and pieces and then stop using leverage after we've climbed that steep slope of revaluation.  The surest way of getting this wrong is to pay for all 6 years at 13% rate -- guaranteed to overshoot.

 

 

Black Scholes doesn't know that the stock is going to rocket to $20 (or 1.5x tangible equity value) upon earnings normalization at 15% ROTE.  It has no insight into this.  So it's pricing all years cost of leverage exactly the same as the first two years (as the options market does it for the 2 year calls).  This all will change if we are at that 1.5x tangible book valuation in two years -- the next 4 years of leverage will be much cheaper.

 

I don't want to pay a rate of 13% for years 3-6 only to have happen what we know will happen once the stock is valued at 1.5x tangible book.  Look at WFC -- it's options don't cost 13% annualized -- there isn't the volatility in them that BAC enjoys because nobody expects a big revaluation.

 

The two year WFC leaps cost slightly BELOW 10% of strike for at-the-money $37 strike leverage.  Exactly what is going to happen for BAC.  You guys will be sorry when that happens.  That's 10% of strike, not 10% annualized.  Annualized, it's only a bit more than 5%.  Compare that 5% to the 10% that BAC is currently priced for!  And that 5% is really 8% including the WFC dividend.

 

8% for WFC leverage (including dividend) vs 13.3% for BAC leverage (including dividend).  Were BAC to be quickly revalued, I'm absolutely positive that BAC's leverage costs will look more like WFCs.

 

 

[Guest Dazel]

 

 

Congrats to all...especially you Ericopoly...you believed...you deserve to be rewarded.

 

 

Dazel.

[meiroy]

Plus, don't forget for you US taxpayers, they'll tax you on your warrant dividend adjustments even though it's a "cashless" dividend.

 

1. That's good for non US taxpayers as they are taxed on the common dividednd.

2. Then again, how do you expect to be taxed on a cashless dividend? A DTL would be similar to 1. for compounding.

 

 

[sswan11]

There is a borrowing cost to shorting warrants.

[ERICOPOLY]

Plus, don't forget for you US taxpayers, they'll tax you on your warrant dividend adjustments even though it's a "cashless" dividend.

 

1. That's good for non US taxpayers as they are taxed on the common dividednd.

2. Then again, how do you expect to be taxed on a cashless dividend? A DTL would be similar to 1. for compounding.

 

1.  Yes, a non-US taxpayer would appreciate the cashless dividend.

2.  The cashless dividends are taxed in the US.  There will be a little statement about how much dividend you own tax on.  The IRS also taxes the inflation adjustment to principle when you hold TIPS securities -- that adjustment is also cashless.

 

In short, US taxes suck with respect to the warrants.

 

I mentioned this shortcoming to the warrants before.  You wind up with a lot more dividend to be taxed on because you have a lot more leverage.  You could have 60 cents of dividend from holding $12 worth of stock, but you would have more than $1.20 worth of dividends if you hold that $12 fully in the warrants.

 

What if you are in California and have to pay state tax on that dividend as well as Federal tax.  Yikes!

 

It was a 60 cent dividend on the common, and the warrant holder might be writing a 40 cent tax bill to the Treasuries of the State and the Feds.

 

Nothing like leveraging up on the tax bill.  Haven't modeled what that does to the breakeven price between the warrants and common.

 

This was one more way that the calls are better -- you get to keep your dividend in cash upfront so you don't get taxed on it (you get the dividend by implicitly paying less for the leverage in the first place).

[ERICOPOLY]

There is a borrowing cost to shorting warrants.

 

Then a warrant holder can lend them out.

 

Maybe that's the key to why they are so expensive if people are defraying that cost by lending them.

 

How much annualized is the cost to borrow them?

[sswan11]

The last time I lent them out IB grossed 2.7% on 2/13/13 -- so I assume the borrower paid equivalent %. 

[sswan11]

2.7% annualized, that is

[menlo]

I found this online warrant calculator - still playing around with it to determine its utility, but fyi for those who are interested.

 

http://numa.com/derivs/ref/calculat/warrant/calc-wta.htm

[Rabbitisrich]

 

We all agree that if we are to tread water (for no net gain nor net loss) on borrowed money, the investment must compound at the rate at which interest is paid.  Right?

 

So if you have borrowed money at 13%, in order to break even you must have your asset compound at a 13% rate.

 

Well, keeping that in mind, first figure out the point where the BAC common and the BAC warrant wind up the same.  The breakeven point where one is no better than the other is $25.  Given that one is no better than the other, then at that point the asset must have compounded at the rate of borrowed money.

 

And $12 (today's common stock price) compounds at 13% rate for 6 years in order to reach $25.

 

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.