Warrants on banks

[Guest Bronco]

I believe there was some chatter here regarding warrants on banks.  Has anyone followed through on this?  It seems that if someone was looking at BAC now would be a good time to start a position.

 

 

[RRJ]

I was hoping the seemingly overblown foreclosure / repurchase of mortgage securities scare would take WFC and JPM down another 10%, and was contemplating how best to take advantage of this.  WFC's back up 5% today, so I guess people weren't too freaked out by the short analyses coming out. 

 

I decided that the TARP warrants (which I own for long-term purposes, and still think are a very compelling low downside / high upside play) are not the best way to play a short-term scare, because so much of their value right now is the time value of the option.  I was considering LEAPS instead, which I decided would probably show the adjustment back upward more dramatically. 

 

To me, if you consider the large banks undervalued at current prices, and get comfortable with a conservatively estimated normalized earnings figure in line with historical valuation multiples (or even a bit lower to be conservative), then you would have to expect a 1930s or Japan deflation scenario to not be in the money 8 years from now.  While that's possible, I think it's unlikely.  So low downside, high to very high upside.  Less money put at risk.  It amounts to a leveraged, long-term bet on the bank in question.  With a kicker in the form of a lowering of the strike price if dividends are raised beyond a certain high water mark.  For Wells, my warrants give me an all-in price (warrant plus strike price) of $42 a share, not counting any dividend adjustments.  If WFC common goes above that before October 2018, then I'm in the money.  They're undervalued at $25 or so today.  What am I missing?

[Uccmal]

Unfortunately, no where near as good as I am hoping for.  I bought the BAC warrants over a month ago for cheaper than today.  

 

I posted my somewhat simplistic calculations on another, earlier post.  They are very easy to hold for the long term.  Day to day, month to month, and even, year to year, crises will have little effect on the long term conversion value.  Only the forward grind of the respective banks will make a difference.   

[Guest Bronco]

I just started looking at the banks again and don't own any warrants. 

 

However, in the back of my mind (but without doing homework) - in 10 years, is BAC going to be worth only $100B?  It seems like an all or nothing to me.  They could go to zero, which may have happened without TARP after the MER shotgun wedding.  But the franchise is so big, that there is huge earnings potential some day.  I don't buy the arguments that people will get a free house b/c of the securitization mess.  If this mess takes time to work out, so be it.  I agree that calls (the ones that leap) may be the way to go.

 

Same with JPM. 

 

WFC I never look at b/c if I am going to own them it will be indirectly through BRK/FFH.  C I don't bother with either, but that is b/c of my biased against Chuck Prince and that is old and cold. 

[Guest Bronco]

BTW - to all you rich folks on this board, who wants to start up a mortgage documentation and identification company for securitized loans?  Seriously.

 

We will be printing money.

[vinod1]

For every dollar that you are putting into either WFC common or WFC warrants, the equation seemed to be

 

1. If WFC trades below $54 around the expiry of options in 2018 - WFC common has the higher expected return

2. If WFC trades above $54 around the expiry of options in 2018 - WFC warrants has the higher expected return

 

The downside seems to favor WFC common as long as WFC trades above $0. So if you are expecting a price of about $54 in 2018 I would think common is the better option. If you have higher expectations on WFC price then the warrants are the way to go.

 

Vinod

[biaggio]

RRJ,  re WFC

"They're undervalued at $25 or so today."

 

Have not researched much, somewhat outside my circle of competence. How do you value banks?

 

Have read you can base valuation on return on asset, or multiple of book value. I know this is some what simplistic but I try to get a guestimate to see if something I should learn more about.

 

(I would love to invest in banks as it burns me the low interest they pay and all the fees the charge)

 

IV (present value) Based on return on asset:

 

1.8% (peak ROA over last 10 years) x $1.3 T in assets (assuming no growth)  divided by 5.2 billion shares outstanding x 10 multiple=$45/per share.

[Guest]

The problem is that banks are very hard to estimate an intrinsic value when so much of their balance sheet is made of stuff I can't spell, let alone understand. It's hard to say what if anything book is worth nowadays. The warrant I'm referring to is the A class.

 

With that being said, BAC's 5 year average price to book is 1.2. Let's say the bank doesn't grow, no dilution, etc,  but merely gets back up to book value of the average 5 years of 1.2 within the next 9 years. Right now it's .6.

 

It's price 9 years from now would be $24.68.

 

$24.68- $6.60(warrant) - $13.30 (strike) = $4.78 profit.

 

$4.78/$6.60 = 72.4% return. That's roughly a 6% annualized return. That's not earth shattering. Also gotta take into consideration that if dividends are paid, it reduces the strike. Given that stocks aren't cheap and that it could be much higher than 6% (or lower for that matter), it's something to certainly consider!

 

 

If we assume that book value doubles over the next 9 years and it's trading at book...we'll then, that's something to really like.

[bookie71]

If you want to understand banks, then read up on your local and regional banks.  The statements are much easier toread and the numbers will tie to your local economy.

[RRJ]

RRJ,  re WFC

"They're undervalued at $25 or so today."

 

Have not researched much, somewhat outside my circle of competence. How do you value banks?

 

Normally, banks are too hard for me, because I don't know what's in their book of business.  On Wells, I piggy back on Prem and WEB a bit to be honest, in the sense that I trust them to understand the book of business and have access to management that I'll never have.  And, they have a conservative, retail banking culture, and they did not want or need TARP money because of that culture, and they are pretty consistent on what they reserve and how it ends up playing out (with a few misses). 

 

Banks are best valued, according to the Great One, using "an intelligent view of return on assets", meaning make sure you understand and adjust for what the assets really are.  The best analysis is on Joe Ponzio's website fwallstreet, which is convincing to me.  I've run alternative scenarios on return on assets / return on book, but those are not with me and I can't reproduce those right now.  At the end of the day, I became convinced that (1) "normalized" earnings (based on the oft-quoted $40 billion in pre-provision earnings, and actually a little more conservatively than that) will probably be $18 to $19 billion, not counting increase in market share, which I think has to happen to some degree as the regional banks are decimated; (2) At a P/E of 12, that would mean a market value of $216 to $228 billion; (3) current market cap is $128 billion.  I used similar simple calculations to your ROA to get a sensitivity analysis.  I saw low downside, and high upside.  Agree with the previous poster that the common might have better return at lower upside scenarios, which is why I split my investment between the common and the warrants.  Sorry I can't be more quantitative right now. 

[RRJ]

Oh, and I used several ROAs -- 1.8%, yes, but I also used 1.6 and I believe even 1.5, figuring new regulations would slow things down a bit.  I still came up with a value north of $30 today under just about any reasonable scenario.  Even at a $30 intrinsic value now, and below long term average growth at 8% for 8 years, I get a value of $55.50, which would put me significantly in the money for the warrants and a decent return.  I think they'll do much better than that, barring a complete Japan scenario.  There is some intelligent speculation here though, just because there is so much that is unknowable in the banking world right now. 

 

I just think the upsides outweigh downsides for WFC by a good bit.  I don't know how you take away their deposit base or their physical footprint or brand or momentum of culture for instance.  This is a necessary business, and as one of the too big to fails, it enjoys some downside protection other players don't have and without as much exposure to investment banking and regulatory risk as the other major banks.  And damn good management.  These guys are monsters at cross selling.

 

One thing I'd like help from the board with is the repeated references to a statutory "cap" that the banks face once they get to 10% of total US deposits.  Wells is right at that, and Citi is above it I think.  I believe this refers to a cap at which the regulators would not let you do inorganic purchases, but does not prevent organic growth.  Does anyone have more insight into that.  It does not seem to be enforced right now, but I never got totaly satisfied with that issue (which shows I did not do ALL the homework I should have on this). 

 

 

[biaggio]

I am not an expert by any means. My understanding is that once you hit the statutory cap rate (capitalization divided by total assets I believe) then you re not allowed to expand the denominator, the total assets/loan portfolio without raising more statutory capital.

 

In one of Peter Lynch's book he described looking for banks with high cap rates because these would be the ones that could grow. e.g. if you had a cap rate of 20% then you could double your assets i.e make loans etc + hence double your profit (in other words you should prefer a bank selling at X earning with a larger cap rate than a bank selling for the same earning multiple but a smaller cap rate). does that make sens. Its been >10 years since I read that.