BAC leverage

[kmukul]

Buy the .50 cents puts and get risk free money would that make sense?

[Aberhound]

I could not figure out which was better so I bought both 50/50. I love your analysis as it is both logical and sophisticated. Now I understand better how you have the guts to invest so much in options. Thank you for writing your analysis in such a clear fashion. What a great education. Here are some of my thoughts to argue the other side.

 

After retiring the expensive preferred shares and resolving the disputes won't BAC choose to us their capital to buy the TARP warrants or Buffett's warrants like WFC bought the TARP warrants? They will be under immense pressure to raise dividends but doing so only makes the warrants more expensive. I wonder if Buffett would sell? If you are right he should be a willing seller and you might have yourself a job offer from Omaha.

 

If your analysis is correct, the commons will rise so shouldn't the TARP warrants be a better buy for BAC? Further, won't management probably be far more optimistic of their future prospects than the public who tend to be biased towards expecting the continuation of the past, especially if the past had lots of bad news? Management buying should arbitrage price differences and the management bias should cause the warrants to trade at a premium depending on the difference between the expectations of the two groups.

 

Won't BAC be forced to divest Merrill before 2018 and we shareholders will make a ton of money when they do so as we will be selling the bull during a bull run? This is part of the reason why I chose to hold the TARP warrants.

 

Finally, aren't we experiencing the start of another bubble which is going to burst? A 21% increase in RE prices in S. Cal combined with capital flight from Europe and a new treasury secretary who believes in easy money? Could it possibly get better for BAC? The bubble should inflate the warrants more because of the greater upside. The trick will be to sell them before the burst as the downside is worse.

[Studesy]

Given that the cost of leverage is lower on the 2015 Leaps than on the 2019 warrants...what would be the best way to manage the time decay element of the leaps? I know rolling the leaps over helps solve this...but at what point in time would be best to roll them....as soon as the next series comes out or is there a point in time when the rate of decay begins to increase significantly?

[mcliu]

 

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.

 

Thanks for clarifying. That was what I was trying to get at earlier in my post as well as I couldn't understand why the borrowing cost was 13%. The way you described it makes it much clearer. :)

[ERICOPOLY]

I could not figure out which was better so I bought both 50/50. I love your analysis as it is both logical and sophisticated. Now I understand better how you have the guts to invest so much in options. Thank you for writing your analysis in such a clear fashion. What a great education. Here are some of my thoughts to argue the other side.

 

After retiring the expensive preferred shares and resolving the disputes won't BAC choose to us their capital to buy the TARP warrants or Buffett's warrants like WFC bought the TARP warrants? They will be under immense pressure to raise dividends but doing so only makes the warrants more expensive. I wonder if Buffett would sell? If you are right he should be a willing seller and you might have yourself a job offer from Omaha.

 

If your analysis is correct, the commons will rise so shouldn't the TARP warrants be a better buy for BAC? Further, won't management probably be far more optimistic of their future prospects than the public who tend to be biased towards expecting the continuation of the past, especially if the past had lots of bad news? Management buying should arbitrage price differences and the management bias should cause the warrants to trade at a premium depending on the difference between the expectations of the two groups.

 

Won't BAC be forced to divest Merrill before 2018 and we shareholders will make a ton of money when they do so as we will be selling the bull during a bull run? This is part of the reason why I chose to hold the TARP warrants.

 

Finally, aren't we experiencing the start of another bubble which is going to burst? A 21% increase in RE prices in S. Cal combined with capital flight from Europe and a new treasury secretary who believes in easy money? Could it possibly get better for BAC? The bubble should inflate the warrants more because of the greater upside. The trick will be to sell them before the burst as the downside is worse.

 

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.

 

[ERICOPOLY]

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.

[ERICOPOLY]

 

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.

 

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.

[hyten1]

i am a little lost either way :)

 

i understand 13% is where the common and the warrant grow before they meet (BAC = BAC/A + STRIKE) at expiration

 

if % is less than 13%, warrant will grow less than that in order to have BAC = BAC/A + STRIKE

 

if % is more than 13%, warrant will need to grow faster than 13% in order to have BAC = BAC/A + STRIKE

 

one thing i don't quite understand why does the warrant and stock's growth rate have to match? why can't they grow at different rates while they can still satisfy BAC = BAC/A + STRIKE upon expiration.

 

EDIT: sorry for my ignorance

[ERICOPOLY]

i am a little lost either way :)

 

i understand 13% is where the common and the warrant grow before they meet (BAC = BAC/A + STRIKE) at expiration

 

if % is less than 13%, warrant will grow less than that in order to have BAC = BAC/A + STRIKE

 

if % is more than 13%, warrant will need to grow faster than 13% in order to have BAC = BAC/A + STRIKE

 

one thing i don't quite understand why does the warrant and stock's growth rate have to match? why can't they grow at different rates while they can still satisfy BAC = BAC/A + STRIKE upon expiration.

 

EDIT: sorry for my ignorance

 

 

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.

 

 

 

 

[sampr01]

Hi Eric

 

Are you the one dumping BAC-WT left and right?. ;).Now, I am scared to think where BAC-WT will be priced, once entire board follows you.  ;). Please no more free ed on BAC-WT until I am out. Thanks for LEAPS discussion we had one or two weeks  back.

 

i am a little lost either way :)

 

i understand 13% is where the common and the warrant grow before they meet (BAC = BAC/A + STRIKE) at expiration

 

if % is less than 13%, warrant will grow less than that in order to have BAC = BAC/A + STRIKE

 

if % is more than 13%, warrant will need to grow faster than 13% in order to have BAC = BAC/A + STRIKE

 

one thing i don't quite understand why does the warrant and stock's growth rate have to match? why can't they grow at different rates while they can still satisfy BAC = BAC/A + STRIKE upon expiration.

 

EDIT: sorry for my ignorance

 

 

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.

[hyten1]

eric the fact we are using 13% (this is the percent were common and warrant meet in 6 years) is due to the current price of warrant and common (5.6 vs 12.11)

 

lets say the prices are 4 (wararnt) vs 12 (common) instead?

 

the % will change, right?

 

i guess at some point the leverage cost  will go below 10% which you state is the cost of the LEAPS (i am still trying to understand this #, but i'll assume it is what is is and move on so i can make my point here and get back to it later)

 

under this scenario would the warrants become more advantages again?

 

hy

 

 

[ERICOPOLY]

eric the fact we are using 13% (this is the percent were common and warrant meet in 6 years) is due to the current price of warrant and common (5.6 vs 12.11)

 

lets say the prices are 4 (wararnt) vs 12 (common) instead?

 

the % will change, right?

 

i guess at some point the leverage cost  will go below 10% which you state is the cost of the LEAPS (i am still trying to understand this #, but i'll assume it is what is is and move on so i can make my point here and get back to it later)

 

under this scenario would the warrants become more advantages again?

 

hy

 

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.

[racemize]

Ok, a couple of questions:

 

1) Eric (or anyone), would you mind posting the situations where this LEAPS strategy doesn't work out too well, e.g., versus the warrants?  I'm getting the picture on the upside, but certainly there is a benefit for a stable security for 6 years rather than 2.  I can imagine a few such scenarios, but I'm sure you can enumerate them much better than I can, and I don't really understand how options' prices change in different scenarios, other than to consider what makes sense, but that takes a while when it is your first time thinking about it.  In any event, I'd love to hear the other side of the equation.

 

2) (Still Eric), thanks for all this analysis, the situation wasn't dramatically different when you bought the A-warrants earlier (at least I don't think), so in retrospect would you have never bought the A's?

 

Thanks very much!

[Kraven]

Time to start a dead pool for some of the posters on this thread.

[abyli]

Time to start a dead pool for some of the posters on this thread.

 

+1  :P

[racemize]

Time to start a dead pool for some of the posters on this thread.

 

What's a dead pool?  a pool of money for when people lose their shirts?

 

Personally, I'm only considering this stuff for the very small position I have for B warrants, and it is an amount I'm willing to lose anyway.  Mostly, it has been very fun/challenging to think about, so I've enjoyed it.

[Kraven]

Time to start a dead pool for some of the posters on this thread.

 

What's a dead pool?  a pool of money for when people lose their shirts?

 

Personally, I'm only considering this stuff for the very small position I have for B warrants, and it is an amount I'm willing to lose anyway.  Mostly, it has been very fun/challenging to think about, so I've enjoyed it.

 

A dead pool is a game in which people bet on who will be the next person to die.  Usually it relates to celebrities or famous individuals.  In this case, it wouldn't mean literal death, but figurative death (i.e. blowing up).

 

This thread has been entertaining to me as well, although I've only skimmed it.  It's like a train wreck that I can't avert my eyes from.  It's dangerous, but in that high wire without a net kind of way.  The greed and envy pours from this thread like water from a tap.  On the one hand you have Eric who is a brilliant, self taught investor.  While there has been some luck involved in his results (there is always some luck for any of us), he put himself in a position to take advantage of the situation and had the stones to do it. 

 

So how many people are (1) brilliant and (2) fearless?  Not too many.  I think there are a lot of particularly younger posters who have stars in their eyes and the investment equivalent of a huge man crush.  I suspect there will be some casualties along the way as "regular" folks try to attempt to split the atom in their basement. 

 

Believe me, I don't pretend to understand half of what is said here, but I know my limitations.  I think too that while we all have much we can learn and the education never stops, in these kinds of situations if you have to ask, it's probably not for you.  But hey, what do I know?  Go forth and blow thyself up!

 

p.s. This response is generic and Racemize is not addressed to you, you just asked the question. 

[nkp007]

Time to start a dead pool for some of the posters on this thread.

 

What's a dead pool?  a pool of money for when people lose their shirts?

 

Personally, I'm only considering this stuff for the very small position I have for B warrants, and it is an amount I'm willing to lose anyway.  Mostly, it has been very fun/challenging to think about, so I've enjoyed it.

 

A dead pool is a game in which people bet on who will be the next person to die.  Usually it relates to celebrities or famous individuals.  In this case, it wouldn't mean literal death, but figurative death (i.e. blowing up).

 

This thread has been entertaining to me as well, although I've only skimmed it.  It's like a train wreck that I can't avert my eyes from.  It's dangerous, but in that high wire without a net kind of way.  The greed and envy pours from this thread like water from a tap.  On the one hand you have Eric who is a brilliant, self taught investor.  While there has been some luck involved in his results (there is always some luck for any of us), he put himself in a position to take advantage of the situation and had the stones to do it. 

 

So how many people are (1) brilliant and (2) fearless?  Not too many.  I think there are a lot of particularly younger posters who have stars in their eyes and the investment equivalent of a huge man crush.  I suspect there will be some casualties along the way as "regular" folks try to attempt to split the atom in their basement. 

 

Believe me, I don't pretend to understand half of what is said here, but I know my limitations.  I think too that while we all have much we can learn and the education never stops, in these kinds of situations if you have to ask, it's probably not for you.  But hey, what do I know?  Go forth and blow thyself up!

 

p.s. This response is generic and Racemize is not addressed to you, you just asked the question.

 

I'm guessing Eric made his money not because of these fancy (and thoroughly confusing options strategies), but because he had huge exposure to extremely cheap companies.

 

 

 

[ERICOPOLY]

Ok, a couple fo questions:

 

1) Eric (or anyone), would you mind posting the situations where this LEAPS strategy doesn't work out too well, e.g., versus the warrants?  I'm getting the picture on the upside, but certainly there is a benefit for a stable security for 6 years rather than 2.  I can imagine a few such scenarios, but I'm sure you can enumerate them much better than I can, and I don't really understand how options' prices change in different scenarios, other than to consider what makes sense, but that takes a while when it is your first time thinking about it.  In any event, I'd love to hear the other side of the equation.

 

2) (Still Eric), thanks for all this analysis, the situation wasn't dramatically different when you bought the A-warrants earlier (at least I don't think), so in retrospect would you have never bought the A's?

 

Thanks very much!

 

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).

 

 

[nkp007]

What happens if by 2019 each warrant gets you 1.5 shares?

[ERICOPOLY]

What happens if by 2019 each warrant gets you 1.5 shares?

 

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!

 

 

[nkp007]

What happens if by 2019 each warrant gets you 1.5 shares?

 

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.

[zippy1]

Interstingly, the AIG warrant vs. AIG call appear to show the opposite situation?

[zarley]

This thread has been entertaining to me as well, although I've only skimmed it.  It's like a train wreck that I can't avert my eyes from.  It's dangerous, but in that high wire without a net kind of way.  The greed and envy pours from this thread like water from a tap.  On the one hand you have Eric who is a brilliant, self taught investor.  While there has been some luck involved in his results (there is always some luck for any of us), he put himself in a position to take advantage of the situation and had the stones to do it. 

 

So how many people are (1) brilliant and (2) fearless?  Not too many.  I think there are a lot of particularly younger posters who have stars in their eyes and the investment equivalent of a huge man crush.  I suspect there will be some casualties along the way as "regular" folks try to attempt to split the atom in their basement. 

 

Believe me, I don't pretend to understand half of what is said here, but I know my limitations.  I think too that while we all have much we can learn and the education never stops, in these kinds of situations if you have to ask, it's probably not for you.  But hey, what do I know?  Go forth and blow thyself up!

 

I have exactly this same sense.  I can't/don't do what Eric does.  I suspect I'm not nearly as smart, and I know I don't have his risk tolerance.  Plus, I never got comfortable with my ability to really understand the big bank balance sheets.  So, while I do sometimes kick myself for not going into BAC with leverage, I know it isn't in my wheelhouse. 

 

What Eric, in particular, has done does remind me of what Charlie Munger has said from time to time -- that you may only see one or two really great opportunities in your lifetime.  When you see them, you must be willing to act in as much scale as possible.  Eric may be a walking example of actually doing this, to his significant financial advantage.

[ERICOPOLY]

What happens if by 2019 each warrant gets you 1.5 shares?

 

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.