Buffett the Enabler of 'Too Big to Fail'

BOSTON (TheStreet) -- Warren Buffett's $5 billion deal to backstop Bank of America (BAC) is a sure bet for the billionaire investor. But given his warnings about the dangers of too-big-to-fail banks, Buffett is displaying hypocrisy as an enabler.

Bank of America on Thursday announced an agreement to sell 50,000 preferred shares with an annual dividend of 6% to Buffett's Berkshire Hathaway ( BRK-B), as well as warrants to purchase 700 million shares at an exercise price of $7.14 per share, exercisable at any time.

In exchange, Bank of America, which has fought allegations it is staring at a massive capital hole, gets $5 billion and the Buffett seal of approval. The stock, which was down nearly 50% this year through Wednesday, rallied today. However, the shares have pared gains. Investors are correctly beginning to realize that Buffett's grand endorsement does little to benefit them.

"Investors may see this and say they need to be in Bank of America since Buffett is in," says Paul Nolte, director of investments with Chicago-based Dearborn Partners. "Sure, Buffett's in, but he's in on Buffett terms. He does a really good job at structuring deals for Warren Buffett. If you buy the common stock of Bank of America, you're not in on Buffett terms. Hooray for Warren, but it doesn't help the individual investor or the bank."

This deal also shows that Buffett is doubling down on his belief that the government will backstop too-big-to-fail banks. During the height of the financial crisis in 2008, Buffett engineered similar sweetheart deals in which he received preferred stock in both Goldman Sachs ( GS) and General Electric ( GE). Both transactions gave Buffett hefty 10% dividends and favorably priced warrants without exposure to common stock.

It's ironic that Buffett has said too big to fail is a problem regulators can't stop, and yet he continues to plow money into the largest of U.S. banks with very favorable conditions for himself. Buffett told the Financial Crisis Inquiry Commission last year that too big to fail will never be resolved, and that taxpayers will always bail out the troubled. This is the same person who told CNBC in January 2010 that the government shouldn't have backstopped Goldman or Morgan Stanley ( MS).

"You will always have institutions too big to fail and sometimes they will fail in the next 100 years," Buffett told the FCIC in May 2010, saying the system is powerless to stop too-big-to-fail banks. Instead of helping to solve the problem, it seems Buffett is doing a pretty good job at propping up banks in dark times. He continued this tradition today with Bank of America, and he'll be handsomely rewarded.

"Too big to fail is alive and well with this Buffett investment," says Nolte. "We haven't resolved too big to fail. All of those companies are much bigger now than they were in 2008. They're even more intertwined and there are even more potential problems. And now Buffett is coming in at a position where the government could come in and bail him out."

James Dailey, manager of the TEAM Asset Strategy Fund ( TEAMX), says the concept of too big to fail "is a cancer on the financial system in the U.S. and Buffett is an enabler."

"He's a viper," Dailey says of Buffett. "I'm not saying that in an insulting way. If you look at his actions and not his words, Buffett is a viper as far as a cutthroat capitalist. He's got a sweetheart deal for himself again. He's playing the realities of Washington and that we're not going to get any structural reform."

To investors like Dailey, this is part of the complexity of Warren Buffett. The image of a buy-and-hold value investor philanthropist from Omaha goes a long way with the public, but Buffett has proven that he'll put his money where he sees reality unfolding even if he talks about something in other conceptual terms. Dailey says Buffett is among the greatest traders in history.

"Buffett has been one of the more brilliant PR machines in modern times. His public persona is so different from what he does," Dailey says. "Like any other human being, he's very complicated. Some have called it hypocrisy, at times. Legitimately, you could argue he's one of the best crony capitalists. That's the brilliance of his 'aw shucks' PR branding."

For now, Buffett has the upper hand on everyone from retail investors to hedge fund and mutual fund managers. Buffett gets a 6% dividend on preferred stock, and he's in line after the bondholders if anything befalls Bank of America. Investor Bruce Berkowitz, who headed up a conference call with Bank of America CEO Brian Moynihan two weeks ago to calm investor fears, can't be happy with the threat of dilution from this Buffett deal.

Using back-of-envelope math, Buffett could have converted those warrants at an exercise price of $7.14 per share to common stock trading at $8.80 today for a quick profit of nearly $1.2 billion. The warrants are exercisable at any time.

The kicker: If he converted those warrants, Buffett would have only paid about 15% in taxes on the realized gain, as Buffett helpfully reminded everyone about a few short weeks ago.

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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