How Warren Buffett Wins From Bank of America's Capital Plan

By Markets Fool.com

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Warren Buffett has a sizable stake in Bank of America , even if it's hidden from plain view. Berkshire Hathaway owns warrants that entitle it to purchase 700 million Bank of America shares for $7.14 each at any time before 2021.

At the current price, it's as if Berkshire has an $11.2 billion stake in Bank of America, making it one of Buffett's largest investments.

Owning warrants is not exactly like owning stock, however. Because Buffett hasn't exercised his right to buy the shares, Berkshire Hathaway isn't entitled to any dividends Bank of America pays on its common stock.

In fact, every time Bank of America pays its quarterly dividend of $0.05 per share, Buffett gives up a little bit of a return. Berkshire Hathaway is missing out on $140 million in annual dividends by holding on to the warrants.

Buffett contends this is a good play for Berkshire Hathaway. Exercising the warrants would require the company to hand over nearly $5 billion in cash to Bank of America in exchange for the 700 million shares.

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Berkshire could part with the $5 billion and start collecting $140 million in dividends -- a yield of about 2.8% on the cash outlay -- but Buffett isn't budging. He has said on numerous occasions that he likes the warrants as they are, and he intends to hold them until expiration in 2021, unless Bank of America starts paying out a really big, really tempting, dividend on the common stock.

Why hold out?
It's no secret that Buffett likes to keep a lot of cash at Berkshire Hathaway for acquisitions and a rainy day fund for his insurance companies, which will irregularly be faced with large insurance losses. The pre-tax, 2.8% yield Buffett is giving up amounts to a cheap form of financing to have $5 billion in extra cash on hand. But there's more to it.

By holding the warrants, Buffett is reducing his downside risk. If he exercised the warrants, Berkshire Hathaway would have $5 billion in additional capital at risk in Bank of America in exchange for only $140 million in incremental dividend income each year. Exercising the warrants gives Berkshire very little upside for a tremendous amount of additional downside. Perhaps he's not as in love with Bank of America as he purports to be, given his preference for the warrants over the common stock.

It also helps that Bank of America doesn't seem to be in position to force his hand. The bank's 2015 capital plan includes keeping its quarterly dividend at $0.05 per share, plus $4 billion in share repurchases. So long as Bank of America diverts excess capital to repurchasing shares rather than for paying out big dividends, Buffett can happily remain a "warrantholder" instead of a shareholder.

Tripling the dividend
Bank of America's $4 billion repurchase authorization in 2015 amounts to about $0.38 per share. If the Federal Reserve were to give the bank the green light for dividends instead of repurchases, it could theoretically pay out nearly three times more in dividends in 2015 than 2014. At that point, Berkshire Hathaway would miss out on roughly $0.58 in dividends per share, or $406 million each year.

One would think such a substantial dividend increase would make Buffett think twice about retaining the warrants. Lost dividends would amount to a roughly 8.1% yield on Berkshire's incremental investment of $5 billion. Forgoing such a large yield would be folly, particularly since a big dividend will inevitably cut into the stock price, and the ultimate return on the warrants.

Luckily for Buffett and Berkshire, the Federal Reserve is hesitant to allow banks to make big dividend payments. It prefers that banks repurchase shares in lieu of dividends, since dividends tend to be treated as ongoing commitments whereas stock buybacks can be stopped and restarted at any time. Score one for the Buffett column.

You know, if Buffett weren't a world-class investor, I might be surprised at how frequently the cards fall in his favor. But for Buffett and Berkshire, it's just another day at the top.

The article How Warren Buffett Wins From Bank of America's Capital Plan originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apple, Bank of America, and Berkshire Hathaway. The Motley Fool owns shares of Apple, Bank of America, and Berkshire Hathaway. 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.