Big banks

For several months now the various financial experts have expressed concerns about the big banks. Even though they received large handouts from the government they were still saddled with huge debt from the mortgage fiasco and so their health was in question. Recently Warren Buffett talked with President Obama about the situation at Bank of America and this week Berkshire Hathaway, (Buffett’s company) invested 5 billion in the bank. For his 5 billion he received 50,000 shares of preferred stock valued at $100,000 per share. Understand that if the bank gets in trouble the preferred stock holders take preference over the common stock holders. This stock pays a dividend of 6% so Buffett gets $300 million per year and dividends are currently taxed at 15%. In addition he gets the right to purchase 700 million shares of common stock at $7.14 per share. Now when he made this deal the stock was selling at $6.50 but when the deal was announced the stock rose to $8.00. If this infusion of cash saves the company and the stock rises he can sell and make a handsome profit and if he waits one year or more to sell his profit will be taxed at the long term capital gain rate of 15%. This is the upside, but what about the down side. If the junk mortgages are more than the bank can handle and it goes under all stock holders are in jeopardy so why would Buffett take such a risk. Some have suggested that in the conversation Buffett had with the president, Obama assured him that the federal government would not allow Bank of America to go under. In other words when it comes to the old adage risk determines return Buffett found a way to get the upside of the deal and pass on the downside to the government. It is the same game of moral hazard that has been played by the too big to fail idea. The investors take the profits when they guess right and the tax payers take the losses when they guess wrong.