Can Buffett Rescue Bank of America?

Could Warren Buffett's $5 billion investment turn Bank of America (symbol BAC) into Wall Street's latest Cinderella story?

That was the question that analysts were grappling with in the wake of Buffett’s potentially game-changing move, which eliminated the bank’s short-term capital worries but left continuing questions about the long-beleaguered bank, the nation’s biggest. “This is a company that faces a lot of uncertainties,” says Erik Oja, an analyst with Standard & Poor’s. “But, at least for the moment, this takes away the uncertainty about having adequate capital.”

On August 25, Buffett agreed to buy 50,000 shares of newly issued Bank of America preferred stock, which will pay a 6% dividend. As part of the deal, Buffett’s Berkshire Hathaway (BRK.A) also received warrants to purchase 700 million common shares at an exercise price of $7.14.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

News of the agreement initially caused BofA stock to shoot skyward, but within hours the stock price had lost most of those gains, reflecting analysts’ mixed views about the troubled financial-services company. “The Buffett investment definitely gave the stock a shot of confidence, but it doesn’t really change the side of the fence that you sit on,” says Jefferson Harralson, banking analyst with Keefe, Bruyette & Woods. The stock closed at $7.76 on August 26, so Berkshire’s warrants are already “in the money,” meaning that the company would earn a profit if it exercised them and immediately sold the shares. BofA shares traded at $54 in 2007.

Harralson rates the stock a “hold,” although he says he’s been “agonizing” about whether he should be recommending it. “It’s a stock that looks inexpensive, but the company is facing such strong headwinds from the economy and litigation. There are still some big unknowns.”

The fate of Bank of America is inextricably intertwined with that of the economy and the mortgage market, thanks in part to the bank’s disastrous 2008 purchase of Countrywide Financial Corp., once the nation’s largest mortgage lender. The $4 billion purchase, completed as the real estate market was already melting down, has cost the bank some $30 billion in write-offs and litigation costs so far. And the Countrywide-related litigation is far from over.

In early August, American International Group (AIG) filed a $10 billion suit claiming that BofA’s Merrill Lynch and Countrywide subsidiaries misled investors about the risks of buying their mortgage-backed securities and should be forced to reimburse investors’ losses. AIG, another key player in the financial crisis, is also threatening to object to the adequacy of a previously announced settlement agreement that would require Bank of America to pay $8.5 billion to another group of angry investors. That deal is pending, awaiting a court hearing in November.

Between write-offs and settlements, the bank has been awash in red ink, posting a $2.2 billion loss in 2010 and losing another $6.8 billion during the first six months of 2011. Worse, just as it appeared that the stream of litigation might come to an end, the economy started to sour, which could prove challenging to all banks. If that wasn’t enough, regulators will soon tighten capital requirements, putting some companies, including perhaps Bank of America, in the position of having to scramble to raise money.

That’s one reason why investors initially reacted so positively to the Buffett investment, believing it could help pick the company out of the ash heap. But as analysts looked more closely at the deal, they became less enthused. “It was a much-needed vote of confidence, but it came at a high price,” says Joe Morford, an analyst with RBC Capital Markets. The 6% dividend will put pressure on BofA’s profits, he says, and if the warrants are exercised, existing shareholders will see the value of their holdings diluted by about 7%.

Still, because the stock has been so badly hammered, some analysts consider it a bargain. At their current level, BofA shares trade between 60% and 70% of tangible book value (that’s assets minus “intangibles,” such as goodwill; the figures vary because some analysts subtract their guesses of upcoming write-offs). That makes the stock look cheap, says Morford -- especially if you are optimistic about the economic outlook. “In many respects, BofA is a bellwether for the U.S. economy,” he says. The economy is certainly tenuous, he adds. But at these prices, he thinks investors in BAC are well compensated for taking risks. He predicts that the stock will trade at $10 a share within 12 months. “Despite all the issues, they’re attractive from a risk-reward standpoint,” he says.

Follow Kathy on Twitter