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BAC leverage

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ERICOPOLY:

--- Quote from: Olmsted on March 13, 2013, 05:27:15 PM ---I may be looking at this the wrong way - but I am getting a 2-year option leverage cost that is a bit above the warrants. 

25 is the warrant-common break-even - ignoring the dividend readjustment but also ignoring dividends on the common - which is probably the right way to look at it (the readjustments should cancel each other out).  That implies an annualized cost of leverage of about 13%.

The two-year option at $2.10, ignoring dividends, gives you a 10% cost of leverage.  But the two-year options don't benefit from the dividend adjustment.  So the leverage cost of the options is 10% plus lost dividends over the next two years.

If you wanted to make an apples-apples comparison, one could use the post-adjustment strike and shares/warrant and compare that to the options.  Guessing at an $11 strike and 1.2 shares/warrant I get a break-even at $19 versus the common stock - implying a leverage cost of 8% plus lost dividends over the next 6 years (stock price at 12.06, warrant price at 5.54 as write).

Now of course we don't expect the bulk of the capital return in the next two years - so the 2015 options look ok in that regard.  But unless I am way off, the warrants look a little cheaper than the options.

EDIT: since you're paying for dividend protection up front, options could be cheaper over the next two years since serious dividends won't kick in until later.

Is this totally wrong?

--- End quote ---


Put it this way...

If $2.10 is the cost of the 2015 $12 strike call at a cost of leverage rate of 10% annualized, then at a 13% rate it would cost what... roughly 60 cents more (I'm not being exact, just winging it after 4 drinks in Death Valley and no calculator).

I have 60 cents of cash still in my pocket from paying a 10% rate instead of a 13% rate.

So I decide to invest that 60 cents in the stock at $12 per share.

Call it... a certain dividend that I get paid upfront.

Meanwhile, other people buying the warrants are implicitly speculating that the dividend over the next two years will exceed 60 cents.  So confident are they that they are paying the 60 cents upfront, hoping to get a dividend that exceeds 60 cents.  They'll lose money on that if it comes in below 60 cents (cumulatively over two years).

But it's better.  My way, I'm investing my 60 cents into the stock at $12 per share.

The warrant holder?  Maybe a some of the dividend gets invested at $12, maybe some at $15, maybe a good chunk of the 2nd year dividend gets invested at $18.

Hmm...  a 45 cent dividend invested at $18 is no better than a 30 cent dividend at $12.

Does anyone really want to throw away a certain 60 cents dividend reinvested at $12 today just to gamble on a bigger dividend that will probably get invested at a much higher price? 

So yes, the warrants ostensibly have "dividend protection" -- me, since I have the calls at 10% cost of leverage I have that approximate 60 cent dividend already invested in the stock at $12.



ERICOPOLY:

--- Quote from: mcliu on March 13, 2013, 07:44:36 PM ---Sorry, I know we have a new thread, but I just wanted throw my 2 cents in here.

I couldn't really follow Eric's idea about the 13% as the cost of borrowing, so I thought about it a different way, that seems to make sense to me, would like to hear your thoughts.

When you buy a warrant, you're essentially paying the premium $5.65 and the present value of the $1.30 difference between the strike and the current price ($13.30 strike minus $12.00 current price). So the total cost is somewhere around $6.85. This cost allows you to borrow the $12.00 (that you would have otherwise needed to pay to purchase the stock) for 5.8 years, which works out to around a 10% borrowing cost.

--- End quote ---


We all agree that if we are to tread water (for no net gain nor net loss) on borrowed money, the investment must compound at the rate at which interest is paid.  Right?

So if you have borrowed money at 13%, in order to break even you must have your asset compound at a 13% rate.

Well, keeping that in mind, first figure out the point where the BAC common and the BAC warrant wind up the same.  The breakeven point where one is no better than the other is $25.  Given that one is no better than the other, then at that point the asset must have compounded at the rate of borrowed money.

And $12 (today's common stock price) compounds at 13% rate for 6 years in order to reach $25.

ERICOPOLY:
Plus, don't forget for you US taxpayers, they'll tax you on your warrant dividend adjustments even though it's a "cashless" dividend.

My (approximate) 60 cent "dividend" is tax-free.  That's worth a lot more than 60 cents in a California taxable account.

meiroy:

Ericopoly,

1. You mentioned that you also prefer the AIG warrants which come at a lower cost (~8%)? In this sense, the WFC warrants are under 6% (5.75%?), wouldn't that make it an even better choice?

2. What if we use the leftover cash to leverage again and buy another warrant instead of buying the common?

3. Some brokers allow the purchase of TARP warrants in non-margin accounts.

ERICOPOLY:

--- Quote from: meiroy on March 13, 2013, 09:02:56 PM ---
Ericopoly,

1. You mentioned that you also prefer the AIG warrants which come at a lower cost (~8%)? In this sense, the WFC warrants are under 6% (5.75%?), wouldn't that make it an even better choice?

2. What if we use the leftover cash to leverage again and buy another warrant instead of buying the common?

3. Some brokers allow the purchase of TARP warrants in non-margin accounts.

--- End quote ---

1.  I own the AIG warrants -- 8% seems reasonable cost for non-recourse leverage.  I look at the notional value of my total portfolio and would rather take on the leverage where it's cheaper.  So if I wanted to hold both AIG and BAC, and I wanted leverage, I'd juggle it so the leverage lies in the warrants that have lower cost.  What matters in the end is total portfolio leverage, so use the leverage where it's cheaper.   You mention WFC warrants being cheaper still, but I'm not invested in WFC.  Thing is, WFC is cheaper leverage because it has less (market believes) upside.  Same reason why I'm saying the BAC borrowing costs embedded within the warrant will drop like a stone as BAC approaches $20.  This will happen when the earnings normalize and uncertainty is lifted.  So why fight that headwind!!!  Today BAC is just below tangible book and they might earn 13%-15% on tangible book, as well as a premium to tangible book based on that coming out to 10x P/E.  So people are willing to pay a higher price for leverage.  Once it's at P/E of 10x normalized earnings and potential gains above 10% annualized in the common are difficult, then nobody (I assume) will want to leverage at 13% cost.  The people who pay 13% annualized today for all 6 years will be pissing fire when they realize they paid 13% annualized for years 3,4,5, and 6 but the market only wants to pay 10%, or maybe only 8% -- all because the stock went up which is what they were hoping for.  Be careful what you wish for, I guess.

2.  The break-even point is still $25 -- so it still costs you 13% annualized for the leverage.  Only... now you have more leverage.  What happens if I buy two calls for $2 apiece for a total outlay of $4?  Same story...  the leverage in the calls still costs me 10% annualized no matter how much I leverage it (same with the warrants).  You can't change the cost of the loan by borrowing more!  You just have more risk for more potential gain.  Works great if the stock (dividends included) compounds more than 13% annualized... otherwise, maybe not so good.

3.  Yes.  A RothIRA is a non-margin account and I currently hold AIG warrants there (and just sold my BAC warrants there).  But I also hold my BAC calls there.  Why did you raise this point?  Were you not realizing that you can hold options in cash-only accounts?


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