Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Warren Buffet Gets It

Warren Buffett’s decision to call the CEO of Bank of America, Brian Moynihan, to invest $5 billion in newly issued preferred shares reveals how a canny investor can take advantage of market psychology.
 
The decline in bank stocks reflects latent fears. It was driven, at least in part, by the experience of 2008, when the credit markets froze up and banks suffered large, unknowable losses on their mortgage portfolios. The fear of today is that the same thing could happen, notwithstanding that domestic banks have raised huge amounts of capital, have already written down very large losses on their mortgage assets, have become vastly more liquid, and are producing profits that will enable them to take even more losses in the future, if necessary. Also, banks have been reviewed more intensively by regulators since the 2008 credit meltdown and been subjected to periodic stress tests. Bank that failed these tests were forced to raise more capital or go out of business. Some banks now have excess capital, since all the major banks must get prior approval from the Fed to increase dividends or buy back shares. So, why are investors so cautious?
 
The credit problems in Europe are clearly a major source of concern. Unlike U.S. banks, their counterparts in Europe did not raise a lot of capital following the market meltdown in 2008. This was a major failure, since they could have done so easily in 2009 and early 2010. Once Greek default risk became an issue in the spring of 2010, the European banks became highly vulnerable once again, since every major European bank owns plenty of sovereign debt, either of Greece, Ireland, Portugal, or Spain. It is very clear to investors that European banks do need to raise more capital. But, U.S. banks have rather limited exposure to those sovereign borrowers. So, any damage to U.S. banks will be quite indirect, for example, by a weaker European economy.
 
Some have suggested that U.S. banks, especially Bank of America, need to raise capital even now, pointing to the possibility that large settlements over mortgages with various parties could impair bank capital. This is quite conjectural. The settlement might even be smaller than the provisions the bank has already made for them. We don’t know yet. So it is rather interesting that none of the bank analysts who actually cover the company share this fear and all expect solid earnings over the next several quarters. The CEO has also stated publicly that the company can easily meet the heightened capital requirements of Basel III with retained earnings and some asset sales. In this context, Warren Buffett’s decision to approach Bank of America to invest $5 billion is a strong statement that he believes the shares are undervalued, especially since he rejected many such investment opportunities in other banks during the credit crisis of 2008. It is also notable that the terms of the deal were not as generous as Buffett was able to obtain during the credit crisis. As Buffett noted, conditions today are not like 2008. When one of the savviest investors of modern times asks to buy into a downtrodden bank and accepts a lower yield on the preferred shares in order to get warrants that will give him a large return only if the share price increases, the bullish nature of the investment is rather clear.
 
I think Ben Bernanke is another one who gets it and we’re fortunate that he’s leading the Fed. He sees the economic recovery as anemic and unsatisfactory, so requiring more policy support. But weighed against this is a desire to avoid disrupting markets any more than necessary. Bernanke also noted that U.S. banks are far healthier now. He expects growth to improve. If growth were to falter, there’s no doubt that that additional steps would be taken by the Fed. But fiscal policy is also likely to be used. In fact, many investors are now speculating over the nature of the stimulus proposals that President Obama is planning to announce in early September. In the meantime, the economic data hasn’t been as weak as feared. There is plenty of talk about how much the probability of recession has increased, with some suggesting a recession is already underway. There is enough disruption here and elsewhere that such an outcome is certainly possible, but many of the conditions that normally precede or cause a recession are absent.  Thus, forecasts of recession are out ahead of the data. But it is a safe bet that Bernanke will respond forcefully if the economic data do not reveal improvement in the near future.