BAC leverage

[Investmentacct]

Eric,

are 2016 calls better deal in terms of leverage?

 

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

[ERICOPOLY]

Eric,

are 2016 calls better deal in terms of leverage?

 

I just can't believe the cost of leverage is over 10% a year again in the $13.30 strike BAC warrants.  So weird.  Such a bad deal.

 

Suppose you leveraged up with common stock using portfolio margin, and you hedged with the $17 strike 2016 puts ($2.97 at the "ask").

 

That would cost 10% a year for the put.  You then pay margin interest (very cheap at IB).

 

However, that's a $17 strike put .  Considerably more price protection than a $13.30 strike put!

 

There should be a wide difference in leverage cost for a $17 strike put versus a $13.30 strike put.  But there isn't.  It's a very narrow spread.

 

Actually, the 1 cent dividend threshold on the warrants costs 30 bps per year.  IB charges something like 50 or 60 bps for margin interest on large loans -- so... in cost the $17 strike 2016 put strategy is nearly identical to going with the warrant.  Bizarre.

[ERICOPOLY]

And then if you play a game like.... what if the Second Great Depression really does come along?

 

How much can you lose on a $13.30 strike warrant by January 2016 if you are paying $8 for it today?

 

Okay, you can in fact lose $8.  But if the stock is at $12, let's just say you lose 50% to 60%.  Something like that.  It will only have 3 years left on it by then... it will be priced similarly to LEAPS as there will be no special attraction left.  No more mystique at that point.

 

So you can lose a ton on the warrant.

 

But you can only lose $2.12 on the $17 strike 2016 put (plus interest on the loan).

 

So... well that just highlights how risky the warrant is versus the safer LEAPS strategy.

 

Price of the leverage is the same (roughly).  Safety level is not the same due to the wide range between strike prices.

[gary17]

except the warrants expire much later than 2016 -  so while it has a greater short term risk that is negated by the longer duration.... which i don't know how to price.  the market appears to think that is worth $7.95

[Daytripper]

the BAC A warrants expire in 01/2019

[ERICOPOLY]

except the warrants expire much later than 2016 -  so while it has a greater short term risk that is negated by the longer duration.... which i don't know how to price.  the market appears to think that is worth $7.95

 

I don't understand your point about risk reduction.  You have a longer term which just means you incur the high cost of the leverage for a longer period of time.

 

But that doesn't reduce any risk versus the higher strike put that costs the same on an annualized basis.  The higher strike ensures that you are risking less by going with the shorter term option -- and the leverage itself costs the same on an annualized basis.

 

I think if you stress test it, you'll see my point.  Let's say BAC goes to $0.  Have you reduced risk by having $8 riding on the line in those longer term warrants?  You'll lose the entire $8.  That's more risk.

 

 

 

 

 

[ERICOPOLY]

Shorter duration options can just be rolled out to a future date.

 

So what you are effectively dealing with is:

 

warrant has fixed-rate leverage costs for next 5 years

LEAPS have fixed-rate leverage costs for next 2 years, and then it "floats" with the market when you roll them.

 

Both are long-duration strategies... you can roll either one for the next 50 years if you wish.

 

The only difference is the duration of the fixed term.  It's like having a 5 year fixed rate mortgage, versus one where the rate resets in 2 years.  You would be ecstatic to lock in a long term rate if the rate is good... but in this case the rate REALLY sucks, so I have no enthusiasm for it.

[gary17]

you explained it way better than i can - i like the fixed mortgage rate example

 

BUT - if BAC is looking really bad in 2 years.....  do you not think the FIXED mortgage rate is starting to look good? I'd think it'd be expensive to roll the puts then?

[gary17]

just to be clear - when you say LEAPS you mean you are buying commons + 2 year put options -- the 'artificial leaps' right?

[ERICOPOLY]

just to be clear - when you say LEAPS you mean you are buying commons + 2 year put options -- the 'artificial leaps' right?

 

Yes that's what I'm doing with them -- just the puts with common.

 

[ERICOPOLY]

Roughly 12% cost annualized to the warrants' leverage today.

[gary17]

The 2016 $15 puts are 14%  (2.18/15)  -- and then there's the cost of money itself...  so that's about the same, no?

[ERICOPOLY]

The 2016 $15 puts are 14%  (2.18/15)  -- and then there's the cost of money itself...  so that's about the same, no?

 

 

The 2016 $15 strike puts cost goes like this:

 

Today's closing price $14.97, less $2.15 for the "ask" price on the put leaves you with $12.82.

 

At what annualized rate does $12.82 climb to $15 strike price on the put?

 

Well, it climbs at roughly 8% annually.  So that's your annualized cost for the put itself.

 

Then the margin interest currently costs anywhere from 50 bps to 140 bps, depending on the size of your loan (at IB).

 

Oh yeah, and the warrants miss out on the dividend, so they're almost 12.5% annualized costs.

 

Did I forget to mention that the more expensive choice has a $13.30 strike embedded put, versus the $15 strike put?

 

It's totally whacko that the much lower strike put carries the far more expensive leverage.

 

 

[gary17]

Thanks for clarifying this!! I have a major conceptual error on this calc!

 

I'm wondering if you know what would cause the premium to decrease? Have the warrants always carried this premium? 

 

If bac goes to 20 - I know the puts will drop, but will the warrant premiums drop?

[gary17]

Hi Eric

 

Not sure if this has been asked --

IF your timeframe is very very long and one is quite certain one day all of this mess will be behind BAC.... then why not just leverage without the puts?  If I borrow at 3% from my home equity - which I shouldn't run into margin calls - then really that's the cheapest cost of leverage & the term is the longest - it's almost indefinite.  I suppose the risk is a very severe recession then I don't have the insurance. 

 

So the insurance costs 8% - 

 

There's gotta be a price for BAC that the risk is so ridiculously low that there is no need for this insurance.  Perhaps that's $8 (just a guess).  And perhaps at $16 it makes sense to buy some insurance and at $30 one puts a lot of insurance on. 

 

Gary

[ERICOPOLY]

Hi Eric

 

Not sure if this has been asked --

IF your timeframe is very very long and one is quite certain one day all of this mess will be behind BAC.... then why not just leverage without the puts? 

 

In the first quarter of 2009, Wells Fargo dropped from $30 to $8.  I was quite certain in December 2008 that there was nothing wrong with Wells Fargo.  But leverage without near-the-money puts would have been fatal.

 

 

[gary17]

i was going to say then all these stress tests are basically BS if we gonna see WFC drop from $40 -> $10 -  but given anything is possible I suppose you are right.

 

Gary

[compoundinglife]

i was going to say then all these stress tests are basically BS if we gonna see WFC drop from $40 -> $10 -  but given anything is possible I suppose you are right.

 

Gary

 

When crazy things happen forced selling can occur. People panic selling or selling to good assets at fire sale prices to raise cash so they meet margin commitments or return cash to their investors who are running for the exits. "Markets can remain irrational longer than you can remain solvent."

[gary17]

I agree - so this comes down to a test of psychology than anything else....

 

As per my example... my leverage is from home equity - and as long as I have a job in Canada & paying the interest.... that loan is basically not affected by the BAC share prices (unlike a margin account) - so it really comes down to in those hours of market panic, will I have the guts to double down OR run like everyone else & suffer permanent capital loss?  IF - if the answer is that I am able to analyze this properly and not get emotionally involved, then I should, theoretically, not require any puts to protect me, and take the opportunity to double down......  So it comes down to: do I trust the insurance offered by the puts or my own intellect?  LOL  Gary

[tombgrt]

Your intellect can deceive you. We generally react differently in times of high stress than we anticipate.

 

N/O but why would anyone go heavily leveraged on BAC now anyway? The time has come (twice) and it passed. Maybe you'll get a third chance, maybe not.

[gary17]

i think what you just said applies to many stocks in the market today!

[tombgrt]

I don't disagree.

[nodnub]

I agree - so this comes down to a test of psychology than anything else....

 

As per my example... my leverage is from home equity - and as long as I have a job in Canada & paying the interest.... that loan is basically not affected by the BAC share prices (unlike a margin account) - so it really comes down to in those hours of market panic, will I have the guts to double down OR run like everyone else & suffer permanent capital loss?  IF - if the answer is that I am able to analyze this properly and not get emotionally involved, then I should, theoretically, not require any puts to protect me, and take the opportunity to double down......  So it comes down to: do I trust the insurance offered by the puts or my own intellect?  LOL  Gary

 

Hi Gary,

 

Would that be home equity line of credit?  I think I remember reading that some people's HELOC lines were reduced during the 2008/2009 financial crisis.  It might be uncomfortable during a crisis to have your HELOC credit limit reduced to the amount outstanding so you don't have any additional credit... and your outstanding loan is concentrated in company shares you are underwater on. Then say you lose your job at the same time.

 

I don't think it's a question of trusting your intellect. Lots of high-IQ people get into trouble using leverage. Leverage works great on the way up.

 

--

Maybe you are talking about a home equity loan?  What term length can you get in Canada on these? What conditions do you have to meet to renew the loan at end of term?  Is there any risk they wont renew the HELoan if the housing prices have dropped, say 25%, during the term of the loan?

[rkbabang]

I updated my spreadsheet that I've posted here before with the 2016 calls as well as the warrants.  This has the crude cost of leverage calculation (I use exactly 5 years for the A warrants, 4 for the B and 2 for the 2016 calls), and the expected return at expiry (no time value) at BAC stock prices from $0 - $200 (that should cover all possibilities).

 

https://docs.google.com/spreadsheet/ccc?key=0AplMpIBKwRbvdHQ2a1dYTzdvTHpQc3ltYjR0V0UwWUE&usp=sharing

[racemize]

I updated my spreadsheet that I've posted here before with the 2016 calls as well as the warrants.  This has the crude cost of leverage calculation (I use exactly 5 years for the A warrants, 4 for the B and 2 for the 2016 calls), and the expected return at expiry (no time value) at BAC stock prices from $0 - $200 (that should cover all possibilities).

 

https://docs.google.com/spreadsheet/ccc?key=0AplMpIBKwRbvdHQ2a1dYTzdvTHpQc3ltYjR0V0UwWUE&usp=sharing

 

This one has all the TARP warrants as well as most of the LEAPs for BAC and is fairly exact, although not formatted the same:

https://docs.google.com/spreadsheet/ccc?key=0AhTPR9eP5nWedEF1SGVLdllJTnBMSDMzM3lYZ2d0SlE&usp=sharing