Financial Play Up Over 125% Since July

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In the middle of the financial crisis, American banks went to drastic measures not to become the next Lehman Brothers or Bear Stearns.  Citi sold off business units and was partially taken over by the US Treasury.  Goldman Sachs (NYSE: GS), after making billions shorting sub-prime housing, gave Berkshire Hathaway an amazing preferred share deal for $5 billion in fresh capital. Berkshire received a 10% dividend plus warrants for the investment in Goldman.  The warrants have a strike price of $115 that expires in 2013.  They are currently in-the-money for Buffett and clan with GS at $127.  Bank of America (NYSE: BAC) issued warrants as part of the TARP bailout in 2008 and 2009.  These warrants have become an attractive way to play a recovery in financials and the shares of Bank of America for many investors.  The warrants are attractive for a few reasons.  Warrants are similar to options, but have longer expirations associated with them and can be executed at any time.  Warrants in this case require less capital and magnify any changes in the price of the underlying share prices. 

There are two different classes to the warrants.  The first offered are the Series B warrants that were issued on October 28, 2008, have a strike price of $30.79 and an expiration date of October 29, 2018.  The Series A (NYSE: BAC-WTA), with a strike price of $13.30, were issued in January 2009 and expire on January 16, 2019. 

Key is the adjustment to the strike prices of the warrants for dividends issued by Bank of America.  The Series A warrants adjust the strike price for any dividend paid by BAC over $0.01, the amount of the last dividend prior to their issuance.  The Series B warrants are less attractive with a higher strike price, a dividend threshold of $0.32, the amount of the last dividend prior to their creation, and a slightly earlier expiration.

Since being publicly traded, both the Series A and Series B warrants have sold off significantly and with underlying shares of BAC.   However, the Series A warrants have performed well in 2012 after finding a bottom at the end of last year at around $2.00.  The Series A warrants now trade at $5.14 and have followed an upward trend since late July of this year.  The Series B warrants are trading relatively flat due to their high strike price, higher threshold for dividend adjustments to the strike price and their earlier expiration. 

Since the bottoming in late July, the shares of BAC common stock have increased by about 50% while the Series A warrants have increased by over 125%.   The Series A warrants are still $2 out-of-the-money but have more than 6 years until expiry.  The tangible book value of Bank of America is currently $21/sh.  The share price is significantly below this indicating the values of assets on BAC’s books remains inflated.  That said, an improved macro outlook, indications that interest rates will remain low and improving profitability within financials due to cost cutting measures should help drive the warrants and shares higher. 

Many hedge fund managers, including Mohnish Pabrai and Guy Spier, have been long financials for a while and so far the market has proven their analysis correct.  However, can after Bank of America's big run continue over the next 6 years to make the Series A warrants profitable for investors buying today?

mthiessen has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America. Motley Fool newsletter services recommend Goldman Sachs Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus