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Warren Buffett's Genius Plan to Milk Millions Out of Bank of America

By John Maxfield – Mar 2, 2014 at 1:21PM

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If you've ever wondered about Warren Buffett's ability to negotiate extremely lucrative deals for Berkshire Hathaway, then his latest move with Bank of America should put any questions to rest.

While Warren Buffett cultivates an easygoing and downhome demeanor, make no mistake about it: He's a ruthless negotiator.

This is why my interest was piqued when I came across an unusual paragraph in Bank of America's (BAC -2.42%) annual report explaining that Berkshire Hathaway (BRK.A -0.64%) (BRK.B -0.45%) has agreed to give the Charlotte-based bank the equivalent of a $2.9 billion break.

According to the filing, Berkshire and Bank of America have entered into an updated agreement with respect to the former's already lucrative $5 billion investment in the bank.

Under the amended terms, Berkshire's $2.9 billion position in a specific series of the bank's preferred stock (1) will no longer accrue dividends in the unlikely event they aren't paid, (2) is subject to a fixed dividend rate of 6%, and (3) cannot be redeemed by Bank of America earlier than the fifth anniversary following approval of the amendment by the bank's shareholders.

The net result is twofold.

For Bank of America, its Tier 1 capital will increase by approximately $2.9 billion, which will benefit both its Tier 1 capital and leverage ratios.

This is because under new capital rules set to go into effect over the coming years, cumulative preferred stock -- i.e., preferred stock, which accrues unpaid dividends -- does not qualify as Tier 1 capital because the "instruments that allow for the accumulation of interest payable are not likely to absorb losses to the degree appropriate for inclusion in Tier 1 capital."

At first glance, the $2.9 billion addition appears to be merely a drop in the bucket, given that Bank of America reported a total of $161.5 billion in Tier 1 capital as of Dec. 31. The amended agreement with Berkshire, in turn, would only increase this by 1.8%.

But critically, it would ratchet up Bank of America's Tier 1 capital ratio by 22 basis points. Using the current figures as a guide, this important metric would increase from 12.44% to 12.66% once the $2.9 billion is included.

For a bank as big as Bank of America -- its balance sheet boasts a staggering $2.16 trillion in assets -- this isn't small potatoes.

So, what does Berkshire get out of the deal?

In short, it gives the Omaha-based company another five years to reap profits from the investment. Under the original terms, Bank of America could have redeemed the preferred stake at any time so long as it paid a 5% premium. Under the amended terms, as I've already noted, the bank won't be able to do so until 2019.

This possibility has been at the forefront of Buffett's mind lately. "Buffett has even joked with Berkshire shareholders that he's made a point of avoiding the phone for fear companies are calling to give him his money back," noted a writer with the San Francisco Business Times.

On top of this, it's worth observing that Berkshire effectively gave up nothing in return for Bank of America's concession, as it's highly unlikely at this point that the nation's second largest bank would miss a dividend payment on its preferred shares.

Once again, in other words, Buffett has quietly made out like a bandit.

John Maxfield owns shares of Bank of America. The Motley Fool recommends Bank of America and Berkshire Hathaway. The Motley Fool owns shares of Bank of America and Berkshire Hathaway. 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.

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