Will Bank of America Buy Out Buffett?

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Exactly one year ago today, shares of Bank of America (NYSE: BAC  ) , the nation's second largest bank by assets, traded for the princely sum of $5.80 a share, a staggering 72% discount to book value. Today, they're more than double that, exchanging hands at just under $12 a share as I write.

This, folks, is not a fluke. As I've written on numerous occasions now, B of A turned the corner last year. It's dealt with legal liabilities, reduced operating expenses, and is currently the best capitalized of its too-big-to-fail brethren. On the third-quarter conference call, its CFO even went so far as to acknowledge that the bank is now free to focus on profitability and driving business -- a remarkable, yet underappreciated, admission. These factors led me to proclaim two months ago that it was time to buy B of A.

The situation is so much better, in fact, that the Wall Street Journal recently mused that B of A should now consider buying out Warren Buffett's $5 billion preferred position in the bank, amassed when it was near its lowest point in 2011. Because this would constitute such a momentous move, I thought it'd be helpful to weigh the pros and cons of such a decision from an investor's perspective.

The pros
There are numerous benefits to retiring Buffett's position. Most importantly, the preferred stake is expensive. In the third quarter of last year, B of A's average yield on long-term debt was 3.07%. This is half of what it pays Buffett, whose preferred shares yield 6%, and would equate to an annual savings of $300 million -- though B of A would have to pay a one-time 5%, or $250 million, charge to exit the deal.

In addition, retiring Buffett's preferred shares would further cleanse its balance sheet. Under the international regulatory regime, banks are obligated to maintain a certain level of capital relative to their risk-weighted assets. Because preferred shares don't qualify as Tier 1 capital, however, the most important and stringent category, the benefit associated with the extra expense seems clearly outweighed by the cost.

Not to mention, the mere ability to buyout the stake would serve as an enormous sign of strength. Just as investors rejoiced when Buffett announced his decision to stake a claim, interpreting the move as evidence that the bank would survive, a similar response would likely accompany B of A's self-initiated decision to part ways. By means of comparison, when Goldman Sachs (NYSE: GS  ) exited a similar arrangement with Buffett in March of 2011, the investment bank's shares immediately rallied on the news.

The cons
There are nevertheless costs associated with retiring Buffett's stake. Under the original terms of the deal, for B of A to buy him out, it must pay a 5% premium on the face value of the preferred securities -- equating to a cost of $250 million. Buffett also received warrants to buy 700 million shares of the bank's common stock at $7.14 per share. If Buffett were to exercise these warrants (which he will), it'd take a $3 billion common stock buyback just to neutralize the dilutive impact.

Also, by presumably replacing Buffett's stake with long-term debt, the move would decrease B of A's net interest margin -- the difference between its yield on earning assets and its cost of funds. But, while this may at first appear bad on paper, it'd be a wash for shareholders, as the interest on preferred shares gets deducted before trickling down to common stockholders anyway -- this is one reason the former are "preferred."

Finally, because of the short-term costs associated with the buyout, coupled with the dilutive impact of Buffett's warrants, the move would impact B of A's ability to return capital in a meaningful way -- I say "meaningful," because, as I noted above, it'd take a $3 billion buyback of common stock just to neutralize Buffett's inevitable exercise of his warrants. Thus, even if B of A gets the go ahead from the Federal Reserve to return capital this year, which I think it will, shareholders may still have to wait before they see any appreciable impact on earnings and book value per share.

The net result
In my opinion, despite the known costs, shareholders of B of A would be best served if the bank were to take the Journal's advice and buy out Buffett's preferred stake. Call me crazy, but, at this point, it's just a matter of time before B of A's shareholders truly start to reap the benefits of the lender's hard work over the last couple of years. Consequently, any decision that further removes barriers between common stockholders and the bank's profits should be welcomed with open arms.

If you're thinking about buying shares of B of A but don't know if now is the time, check out our recent in-depth report on the lender. In it, our senior banking analyst Anand Chokkavelu explains why shares in the bank could "double or triple over the next five years." To access your own copy of this valuable report instantly, simply click here now.

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