Is Bank of America Doomed?

Warren Buffett doesn't seem to be worried about the firm's survival, but its actions show a sense of urgency

While most big U.S. banks appear to have recovered fairly well from the financial crisis, Bank of America continues to struggle. Its instability stems in large part from its acquisition of mortgage giant Countrywide in 2008. Recent lawsuits and other legal action over mortgages written during the housing bubble continue to plague the firm and highlight the uncertainty surrounding when its real estate-related losses will finally subside. The firm has recently attempted to add some cushion to its capital base to prepare for future losses and to calm fearful investors. But should these recent signals only worry investors even more?

China Construction Bank $8.3 Billion Share Sale

The most recent news came on Monday. BOA will sell 13.1 billion shares it holds in China Construction Bank Corp., about half of its 10% stake. The sale will produce $8.3 billion in fresh capital, of which $3.3 billion will be profit for BOA.

Even for a bank as large as BOA, $8.3 billion is real money. The cash will help to neutralize some of the bank's mortgage losses and to comply with stricter global bank capital requirements.

But the move also shows a hint of desperation. It's hard to believe that BOA could have wanted to sell this stake. After all, if it wanted to be rid of its position in the Chinese bank, then it would have sold its entire stake, not just half. Instead, the bank appears to be cashing out some chips because it needs the money. And there are other ways that the bank could have generated cash besides selling its stake in one of the biggest banks in one of the world's fastest growing economies.

Buffett's $5 Billion Bet

Indeed, that $8.3 billion wasn't enough. Just four days earlier, the bank sold $5 billion in preferred shares to billionaire investor Warren Buffett. And the terms weren't too shabby for Buffett. First, he would receive 6% interest for 10 years, which amounts to $300 million per year, or $3 billion over the term of the investment. Bank of America could repay Buffett earlier, but would have to pay a $250 million penalty.

Perhaps the most lucrative part of the deal, however, was its stock warrants. They would allow Buffett to buy 700 million shares of stock at the strike price of $7.14 per share. While that was a little more than shares were trading for before Buffett made the investment, after it was announced the share price rose to $7.65. In other words, those warrants were $357 million in the money almost immediately. On Monday afternoon, four days later, the share price was up to $8.35, which puts the warrants $847 million in the money -- not a bad return in two trading days. Well done Mr. Buffett, well done.

Such generous terms also show how badly Bank of America must need this capital. But perhaps the bank thought all that interest and those warrants would be a small price to pay in order to send the market a signal that the "Oracle from Omaha" had faith in the institution.

But What Does Buffett's Investment Really Mean?

That, of course, assumes that Buffett really does have faith in the bank. Nobody -- not even Buffett -- knows how high its mortgage losses will ultimately be. That lies mostly in the hands of the courts and regulators. Meanwhile, the investment banking business is slowing. Consumers are proving profitable again, but BOA's mortgage losses continue to overshadow any improvement in the rest of the bank's consumer loan portfolio. Its business lending has likely been profitable recently, but the bank faces fierce competition in the space, particularly from its chief and more stable rival JPMorgan.

But surely Warren Buffett didn't get this one wrong, did he? He may be right that BOA will survive, but possibly not for the reason that investors would prefer. This may be more of a bet that the government hasn't actually solved the too big to fail problem and would rescue the bank again if it got into trouble. The Washington Examiner's Tim Carney reminds us:

When Wall Street nearly collapsed in September 2008, Buffett rallied behind the Troubled Asset Relief Program, and bet big on its passage. He put $5 billion into failing investment bank Goldman Sachs. "If I didn't think the government was going to act, I would not be doing anything this week," Buffett said on CNBC at the time.

Although Buffett hasn't made any similar comments regarding his recent stake in BOA (that I've read anyway), you have to imagine that his view here remains the same. As Carney explains, Buffett is an important friend of the Obama administration, and it stretches the imagination to think that the president would allow Buffett to lose millions or even billions by allowing BOA to fail if losses overwhelm the firm. Indeed, we're already seeing the administration trying to steer the states away from prosecuting the banks for their mortgage misdeeds, so seeking to stabilize BOA wouldn't even be a change of course.

Ultimately, the result is the same either way. Whether the government ensures BOA's survival or if the institution manages its losses effectively and finds its way back to stability on its own, investors will be spared. But in terms of the bank's long-term growth, another rescue will hardly instill confidence in the firm's ability to compete. That leaves BOA in the position that you might have guessed: a precarious one, but one in which we shouldn't expect the bank to fail. Even if its losses do continue to pile up, the government probably won't let that happen.