GS - Berkshire Hathaway: I Smell A Bank Deal

2023-03-20 13:02:49 ET

Summary

• Recently, Seeking Alpha reported that Warren Buffett was in talks with the Biden administration regarding how to solve the Bank crisis.
• Before that, a Twitter account observed large numbers of planes flying from regional bank HQs to Omaha.
• There are strong signs that Berkshire Hathaway Inc. may be providing rescue financing to banks.
• If it does, then it will likely be in the form of high-yield convertible preferreds.
• Berkshire Hathaway made a lot of money investing in banks at the bottom in the 2008/2009 financial crisis.

Berkshire Hathaway Inc. (BRK.A) BRK.B ) may be on the verge of making a deal with a regional bank. It’s too early to say for certain that it is, but we have two data points (one fairly strong, the other weaker) that point to it happening.

First, flight data showed that, on Friday, an unusual number of planes departed from cities where regional banks are headquartered, heading for Omaha. Second, Bloomberg reported that Berkshire CEO Warren Buffett was speaking with members of the Biden administration regarding the banking crisis.

The first of these facts is a pretty strong hint that something is about to transpire between Berkshire Hathaway and the regional banks. The second fact doesn’t mean much on its own, but does lend credence to the idea that Buffett is negotiating with banks when you consider it alongside the airplane data.

So, is Warren Buffett about to do a deal with one of the struggling regional banks?

It’s hard to say, but it is known that the current period is similar in some ways to the 2008-2009 period, in which Buffett bailed out The Goldman Sachs Group, Inc. ( GS ). There are differences between then and now. Back then, big banks were the problem, today it’s mid-sized banks. However, it’s the same situation where you’ve got banks that are trading way below book value and would basically be safe if they could get access to a few billion dollars extra in capital – which is just what an investor like Buffett can supply.

Buffett started his career as a pure Benjamin Graham-style value investor, buying stocks on virtually no criterion other than numerical cheapness. Later, he branched out into Munger-esque “quality” investing, doing well with bets like Apple Inc. ( AAPL ) where the cheapness wasn’t mathematically obvious but was there if you factored in the company’s future prospects. Bailing out a struggling but not insolvent bank would be similar to Buffett’s older Graham-style investments. If you know that giving a bank $5 billion will save it from collapse, and you buy 10% yielding preferred shares from the bank, you make a safe investment. If interest rates are 5%, and the preferred shares never mature, then your investment is worth $10 billion ($500 million divided by 0.05). So, your investment is profitable too.

We are, therefore, in a situation in which Warren Buffett could profitably bail out one of the now-struggling regional banks. If he does as well with it as he did in 2008, then it will be a boon to shareholders. In this article, I will explore the potential impact on Berkshire Hathaway’s stock value if Warren Buffett does a $5 billion deal with a regional bank.

What Would a Deal Look Like?

Having established that a deal between Berkshire Hathaway and a regional bank could occur, we now need to ask, “what would such a deal look like?” There’s a good chance that, if a bank was really struggling, Buffett would seek some kind of high yield preferred stock, maybe with a conversion option, rather than common stock. This is what Buffett bought when he bailed out Goldman Sachs in 2008. It’s also similar to the deal Buffett worked out with Bank of America ( BAC ) in 2011 – that deal wasn’t a bailout, but Buffett got Brian Moynihan to agree to the issuance of preferreds and warrants anyway.

Based on Buffett’s past deals with beaten down banks, what can we say about a future deal with one of the struggling regional banks?

Here’s what it would look like, if the GS and BAC deals are any guide:

• Buffett would likely purchase preferred shares rather than common stock.

• The amount would be about $5 billion.

• The yield would be between 5% (the BAC yield) and 10% (the GS yield).

• There would likely be included warrants to buy the common stock at a predetermined price.

The yield on any preferred shares Berkshire might receive would have bearing on how much value the investment would have. The present value of a preferred share is simply the cash flow divided by the discount rate, since preferreds do not grow. A $5 billion 5% yielding preferred is worth $5 billion if the discount rate is 5%. A $5 billion 10% yielding preferred is worth $10 billion if the discount rate is 5%. So, a deal similar to the Goldman Sachs deal would add value to Berkshire Hathaway regardless of whether the warrants ever proved valuable. A deal similar to the Bank of America deal would require that the common stock appreciate, in order for it to be worth anything.

Would the warrants prove to have any value?

That would depend on whether Berkshire managed to turn around the fortunes of the bank it invested in, and return it to a positive trajectory.

Let’s imagine that Berkshire Hathaway invested in First Republic Bank ( FRC ). According to its investor presentation, FRC had, at the end of last quarter:

• $176.4 billion in deposits.

• $17.4 billion in shareholder’s equity.

• $4.28 billion in cash .

As you can see, it wouldn’t take much for FRC to start running out of money to pay depositors (I mean as of the fourth quarter of 2022, with no mention of the recent rescue deposits ). Only 2.4% of FRC’s deposits would have to be withdrawn for that bank to run out of cash to pay depositors. Were that to occur, it would have to start selling assets. This is where the “unrealized losses” come into play. FRC had $470 million in net unrealized losses on available for sale securities, and $4.77 billion on held-to maturity securities. FRC had $50.6 billion worth of these at the end of the fourth quarter. Assuming that the securities haven’t declined in value since the end of Q4, FRC could sell them for $50.6 billion, realizing a $5.2 billion loss.

We’ve got $4.28 billion in cash and $50.6 billion in securities that can be sold fairly easily at a 9.31% loss. So, FRC could survive a $54.88 billion bank run. I’m not going to consider the possibility of FRC bundling some of its mortgages and other loans into securities and selling them in order to raise the cash, because that takes a lot of time. It couldn't be done fast enough to pay off impatient depositors.

Could a $5 billion investment from Berkshire Hathaway make a difference here? Potentially, yes. The $30 billion in deposits FRC got from its fellow banks gave it a cash infusion. If it got another $5 billion by selling 10% yielding preferreds to Berkshire, it would increase that amount by 16.66%, but without a possibility of it being withdrawn. The preferreds would create a $500 million annual cash outflow, which is much more manageable than the cash drain created by billions of dollars' worth of withdrawals in a week.

So, yes, a $5 billion investment from Berkshire could potentially tip the scales enough to make FRC an investable stock. If Berkshire got warrants with a $23.03 exercise price along with the preferreds, and if FRC common stock appreciated, then there’d be some value on top of the $10 billion that just holding the preferreds would be worth.

Impact on Berkshire Hathaway’s Valuation

What would the impact of a bank rescue deal be on Berkshire Hathaway’s finances?

If the deal were structured like the hypothetical one above, then Berkshire would get:

• $500 million in cash per year.

• Potentially a one-time windfall of common stock were the warrants exercised at a good price.

As of its most recent quarter, Berkshire had:

• $480 billion in book value .

• $37.2 billion in trailing 12 month cash from operations.

A $500 million per year payment would increase cash from operations by 1.3% per year. If Berkshire simply collected the cash for 20 years, it would add $10 billion in cash to Berkshire’s equity.

Initially, the $5 billion investment would cause the book value to go down to $475 billion. However, after 10 years the investment would “breakeven” (on an un-discounted basis), after 20 years it will have added $5 billion to book value on a net basis. If nothing else about Berkshire changed in 20 years, then book value would grow to $485 billion.

If the preferred shares had a maturity date, then eventually a one-time payout of $5 billion would be made to Berkshire, and would increase Berkshire’s book value.

If the stock that Berkshire invested in made gains, there’d also be a potential lump sum from exercising the warrants. To return to the FRC hypothetical example above: that stock was $23.03 at the time of this writing. If Berkshire’s preferreds cost the same, then Berkshire would own 217 million worth of them. If FRC stock appreciated by $40 from the exercise price, then Berkshire could exercise the warrants for a total of $8.68 billion–of which $3.68 billion would represent a profit.

So, if Berkshire could successfully rescue a bank through a $5 billion, 10% preferred share investment with warrants attached, it would increase the value of Berkshire Hathaway shares. Using today’s stock price, the price/book and price/cash flow ratios would both come down, yielding a cheaper valuation.

The Bottom Line

The bottom line for Berkshire Hathaway shareholders is that, given Buffett’s track record with financials, a regional bank deal would be a welcome development. I can’t say for sure that First Republic Bank would be good enough for Berkshire to invest in, but I know that there are many banks right now that would like to access some of that Buffett money. If even one of them could be rescued by a $5 billion cash injection, then Berkshire may be able to do a deal.

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