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Buffett: The One-Man Blue-Chip Bailout Machine Strikes Again

Warren Buffett is a one-man bailout machine. For pretty much every major institution, the Oracle of Omaha is the guy you go to when you want some validation. When Democrats and the White House turned to him for intellectual succor over the need to raise taxes on the wealthy, he complied with a New York Times op-ed last week on how Congress should stop coddling billionaires. And when blue-chip American financial institutions suddenly face harsh market realities, they also turn to Buffett.

That's what Goldman Sachs and General Electric did in the fall of 2008. And that's what Bank of America, the behemoth still struggling to get out from under the mortgage mess, is doing today. It announced Thursday morning that Buffett's Berkshire Hathaway would invest $5 billion as my Daily Ticker colleagues discuss in the accompanying video.

The playbook is simple. Do a deal on terms that are favorable to Buffett. That sends a signal to the marketplace, and to your own investors. After all, if things were as bad as all the critics were saying, why would the most savvy investor of our era put his capital at risk? Armed with the Buffett seal of approval (and some new cash), the company then goes out and raises more cash from the public. This two-step has proven to be beneficial to the companies, and profitable for Buffett. But ordinary investors should be careful about blindly following Buffett's lead.

In the fall of 2008, General Electric was listing, in part because of the troubles its massive finance arm, GE Capital, had encountered. And so in the fall it turned to Buffett. Buffett agreed to buy $3 billion of preferred shares, which carried a 10 percent annual dividend. What's more, GE could only retire the shares by paying Buffett a 10 percent premium. He also received warrants entitling him to buy a large chunk of shares at $22.25 per share. The warrants were to expire in five years. With the market temporarily calmed, GE also announced it would sell about $12 billion in common stock to the public at $22.50 per share. In other words, GE was able to leverage Buffett's $3 billion (on pretty tough terms) into $12 billion more of capital (on relatively easy terms).

A few weeks later, Goldman Sachs struck a similar deal with Buffett. On October 23, Berkshire Hathaway agreed to invest $5 billion into the investment bank. The terms were quite similar to the GE deal. The shares bore a 10 percent annual rate, Goldman would have to pay a 10 percent premium to retire them, and Buffett received warrants entitling him to buy a chunk of Goldman shares at $115 per share. The next day, its stock having been buoyed by the Buffett investment, Goldman said it would raise another $5 billion by selling shares to the public at $123 per share.

The GE and Goldman deals worked out well for Buffett. In April, GE said would pay Buffett back entirely by October. In return for his $3 billion investment, he's going to get about $900 million in interest payments, plus $3.3 billion for the original shares — a total of $4.2 billion, or a 40 percent return in three years.

Buffett made out similarly well on the Goldman transaction. In April, Goldman paid back his original $5 billion investment. Factoring in dividend payments and the 10 percent premium, he received a total of $6.664 billion in return for the original investment, or a 33 percent return in about 30 months.

And of course, since Buffett retains warrants in both firms, his total returns could be substantially higher. At the moment, since the stocks of both GE and Goldman are below the strike price, the sweeteners Buffett received aren't worth much. And therein lies the rub for ordinary investors.

Generally, mimicking Warren Buffett's stock-purchasing moves is a brilliant call. But in the case of GE, Goldman, and Bank of America, Buffett is investing on terms that aren't available to ordinary investors. GE sold common stock to the public at $22.50 in the wake of the Buffett seal of approval, but the stock trades today at about $16. And while Goldman sold common shares to the public at $123 in the wake of the Buffett seal of approval, its stock today trades at about $116.

If history follows its recent pattern, Bank of America will quickly aim to monetize the credibility it purchased from Buffett on tough terms by selling new shares to the public. That's good news for Bank of America, for its customers, and for the U.S. banking system at large. Raising more equity is a good move for any bank at any time, and especially for Bank of America at this time. Despite the significant progress made in restoring the system to health (see the FDIC's most recently quarterly report), it is troubling and disconcerting that gigantic institutions like Bank of America still haven't fully come to grips with housing-related woes. Every time Bank of America moves to boost capital, it's a plus. At the very least, this should calm some of the wilder speculation about Bank of America's near-term future.

The idea to invest in Bank of America apparently came to Buffett while he was taking a bath. Lets hope individual investors who follow Buffett's lead don't wind up taking one too.

Daniel Gross is economics editor at Yahoo! Finance.

Email him at grossdaniel11@yahoo.com; follow him on Twitter @grossdm.