Buffett Treads Lightly With Goldman Sachs Investment

If one of your first reactions upon hearing of Warren Buffett's $5 billion investment in Goldman Sachs (GS) was, "Wow, I didn't think Goldman was a Buffett-type company," you are probably not alone. Warren has typically preferred consumer-related businesses with wide moats (high competitive advantage and barriers to entry). He often tells people that he would feel perfectly fine owning Coca Cola (KO) or Wrigley (WWY) if the stock market closed down for five or ten years. It would be hard to have the same level of confidence with Goldman Sachs.

So before you go out and load up on GS common stock on this news, let's review exactly what Buffett is getting, and more importantly, the price he is paying. The $5 billion deal involves two parts:

1) $5 billion in preferred stock

These preferred shares are senior to common stock and pay a 10% annual dividend. Think of them as unsecured bonds paying 10% interest. He is not buying common shares with the initial $5 billion. In addition, if Goldman ever wants to retire these preferred shares (companies typically "call" preferred shares when they have excess cash), they have to pay Buffett a 10% premium to their face value. The vast majority of normal preferreds are callable at par, not at a premium.

2) Warrants to buy $5 billion of common stock at $115 per share

Buffett has the option to buy $5 billion of common stock at $115 per share at any time over the next five years. Keep in mind that while this part is common stock, there is absolutely no risk for Buffett on these warrants. Five years from now, Buffett earns a profit of $43 million for every dollar GS stock trades above $115 per share. If the stock is below $115, he does not lose a dime, as there is no risk on his part. These warrants are essentially call options he is getting free of charge.

From the terms of this investment, we can see why Buffett has decided to invest in an investment bank even though he typically goes for much safer and predictable operating businesses. Goldman does have a superior management team and great talent, but investment banking is not a business I would expect Berkshire to expand into anytime soon.

While he is taking a bit more risk by banking on Goldman's survival, consider how the landscape has changed for Goldman in recent days. Not only has the government indicated they are willing to take dramatic action to help these firms survive, but it also has allowed Goldman to become a bank holding company. Goldman may very well use this new capital to build out their commercial banking operation.

With this deal, Buffett is banking on government intervention succeeding in greatly lowering the risk that Goldman Sachs gets into deep trouble. For such a bet, I'd say Buffett got a great deal by waiting things out and not investing until he figured the odds were stacked strongly in his favor.

Full Disclosure: No positions in the companies mentioned at the time of writing

Morgan Stanley Becomes A Bank, Gets Overseas Investment

Thanks to the Fed's actions last week, Morgan Stanley (MS) has averted an emergency sale to Wachovia (WB), received permission to become a bank holding company, and has sold a minority stake to Japan's Mitsubishi. The company is going to try to remain independent, for now anyway.

With the competitive landscape having changed in recent days, namely fewer competitors in the investment banking marketplace, the stronger players who can whether this liquidity storm will clearly be in a great position to take market share in this volatile environment.

It will be interesting to see if Goldman Sachs (GS) seeks a partner of some kind, or simply builds its bank holding company on its own. Outright mergers with banks are less likely now with the Fed's intervention, but leverage ratios and funding sources still need to be refined to protect against future shocks to the financial system, which are certain to occur.

Given the uncertainty of how all of these things play out, my view on the investment banks has not changed (see my piece entitled Investment Banks Nothing More Than Black Boxes). I still prefer commercial banks due to more transparency of how they make their money, as well as far lower leverage ratios. If leverage falls meaningfully and investment banks disclose more in the future about what they hold, that opinion could potentially shift, just not yet.

Full Disclosure: No position in GS, MS, or WB at the time of writing

Short Selling Ban Is Dramatic, But U.S. Can't Allow Firms To Fail For No Reason

The SEC's 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let's be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company's fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It's that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don't have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they'll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country's largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won't be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

What To Do In Times Of Panic

Is "panic" too strong of a word to describe the markets in recent days? I don't think so. Consider a couple of examples outside of the investment banking space:

1) Constellation Energy (CEG)

My old utility company when I grew up in Baltimore, Constellation is the parent of Baltimore Gas & Electric. CEG gets 20% of their earnings from energy trading and had contracts with Lehman Brothers. Although CEG's net exposure to Lehman's bankruptcy was immaterial, investors panicked and sent the stock down from $60 last week to as low as $13 on Tuesday. Today Warren Buffett's 88% owned MidAmerican Energy agrees to buy CEG for $26.50 in cash, or about 75% of the company's book value, in a deal that alleviates counterparty concerns over CEG's liquidity.

2) State Street (STT)

State Street fetched $68 before 10:00 this morning and hit $29 shortly after 1:00pm. State Street is listed as a large holder of all the troubled financial stocks, which worried people, but STT is a custodian for their clients and index funds and does not own the vast majority of the stocks in question. They simply act as custodian and collect fees for doing so. STT issued a press release this afternoon trying to clear things up and assured investors their money market funds had not dropped below $1 in NAV.

There is no doubt in my mind that we are simply in the midst of a worldwide financial panic. The UK just restricted all short selling in financial stocks until the dust settles. Fear and mostly unsubstantiated rumors are driving price action right now.

So what should an investor do in this environment? It might surprise you, but I have been making very few moves during all of this craziness. Trading when fear, panic, and rumors have taken over doesn't make much sense because prices are not based on reality but rather perception. Lack of confidence and uncertainty about what is true and what is not is a deadly combination for financial markets and many firms. It doesn't matter if Morgan Stanley (MS) is not in trouble. If clients think they might not be, they will pull their money and set off a "run on the bank"scenario. That very situation will likely forced them to sell the company in the heart of the panic, regardless of what the reality is.

As long as you know and understand what you own and have done adequate fundamental analysis, I would suggest standing pat and waiting for things to settle down. Like LTCM, the Asian financial crisis and every other financial market panic, this one too will be over at some point. When that happens we can get back to good ol' fundamental investing. Fortunately, most of the people reading this blog, as well as myself and my clients, can wait for the storm to pass.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

One By One, Financial Firms' Issues Being Resolved

The recent leg down in the markets has been due, in large part, to the fact that specific firms have been forced to seek individual solutions to survive, whereas before we were more focused on general economic statistics. We are attacking each one and the list I came up with above is almost completed. What are the next shoes to drop after these are resolved? If there aren't any/many more, could that mark a short-term bottom?

Commercial Banks Ready To Pounce On Goldman Sachs And Morgan Stanley If Market Forces Them To Deal

People are correct when they point out that the market is forcing the stronger investment banks, Goldman Sachs (GS) and Morgan Stanley (MS), to do a deal with a deposit institution even though they are making money and aren't liquidity strained. It is a shame, but when your business model requires short-term funding sources from the market, and at the same time the market is crushing your stock based on fear and not actual problems with your business, you might have little choice.

Today we are hearing that Morgan Stanley is talking with several parties about a capital investment or an outright merger. Wachovia (WB) is on the short list of potential merger partners. If Goldman and/or Morgan are forced to do a deal by the marketplace, you can bet that the buyer will be getting a steal (like the one many thought Ken Lewis could have gotten if he waited a day or two to buy Merrill Lynch).

The result is that investors should look at any deal for Goldman or Morgan as a potential opportunity. The Wachovia story is interesting because they clearly have their own issues to deal with right now (notably $120 billion in Pick-A-Payment mortgages in California they are trying to rework with borrowers). A bank like Wells Fargo (WFC) would be in much better position to take on one of the two remaining investment banks, or a troubled bank like Washington Mutual (WM).

At any rate, any deal for GS or MS done because of market reaction and not on business fundamentals is likely going to be done at an absolute bargain basement price (even better than the Merrill Lynch deal).

Full Disclosure: No positions in the companies mentioned at the time of writing

Ridiculous Item of the Day

Have these people been alive and breathing in recent days? Hilarious...

From the San Jose Business Journal:

Merrill Lynch & Co. Inc. shareholders have filed suit against the brokerage firm's chief executive, John Thain, and its board over Bank of America's proposed $50 billion buyout of the company. The lawsuit, filed in New York State Supreme Court, claims the deal is wrong, unfair and harmful to Merrill shareholders. The suit says the defendants have clear and material conflicts of interest and are acting to better their own interests at the expense of Merrill public shareholders.

Americans: Add AIG To Your Investment Portfolio!

As one of ~300 million Americans, we each now own about 0.000000002663333% of AIG.

I think the Fed did the right thing here by requiring some financial benefit in return for such a huge loan. Not only do taxpayers get a 79.9% equity stake in AIG, but we also are collecting some hefty interest on the deal, to the tune of LIBOR plus 8.5 percent.

Why The Fed Should, And Probably Will, Give AIG A Loan To Help Fight Off Bankruptcy

The Federal Reserve Bank serves as the "lender of last resort" in this country, meaning they stand ready to lend when nobody else will. For this reason, I think the government will give AIG the bridge loan it believes it needs to try and avoid filing bankruptcy.

Keep in mind that this is not a bailout. A bailout is a hand out. A loan is money that needs to be paid back, and in AIG's case, probably within a relatively short amount of time. The Fed should even be able to charge interest on such a loan to make some profit for the taxpayers.

Reasonable minds can argue whether Bear Stearns and Lehman Brothers should have been treated equally or not, but given that AIG is solvent and simply needs a short term loan to sell some of its assets to eager buyers, the Fed should step up and play its role of lender of last resort. With the Dow up now, after being down 175 this morning, it appears Wall Street is pricing in some kind of resolution sooner rather than later. Let's hope so...

Full Disclosure: No position in AIG at the time of writing

Market Says Bank of America, Merrill Lynch Deal Fails

*BAC closing price: $26.55
*Share exchange ratio: 0.8595
*Implied MER purchase price: $22.82
*MER closing price: $17.06
*Discount to deal value: 34%

Full Disclosure: Long shares of BAC at the time of writing