Memo to Warren: AmEx Preferred at 15%, Warrants at $12

Barron's is suggesting that Warren Buffett might come to the rescue of American Express (AXP). Since Berkshire Hathaway (BRK.A) already owns 13% of the troubled credit card issuer, a rescue might make sense. If, that is, Mr. Buffett can price his entry in line with the new reality governing yields and valuations.

On Monday, Fed officials announced that an application to transform American Express into a bank holding company had been approved. Two days later, the company confirmed that it was seeking $3.8 billion in government aid. But that is only part of the story. Besides needing $4 billion from the commercial paper market, American Express must raise nearly $7 billion in longer-dated debt within six months, and another $15 billion within the next year. Quite clearly, Chief Executive Ken Chenault’s strategic decision to rapidly expand the domestic credit card portfolio from $38 billion, in 2004, to $70 billion failed to incorporate the prospects of a serious economic downturn.

American Express shares are down 60%-plus so far this year. So the challenge facing Warren Buffett, or any other investor with deep pockets, is to determine whether (a) the inevitable increase in credit card delinquency rates, domestically and globally, has been factored in at current price levels and (b) the 10% yield on Goldman Sachs (GS) and General Electric (GE) preferred stock investments adequately reflects the reality in this instance, on a company-specific and comparative basis, of today’s fluid bond pricing environment.

If American Express and Berkshire Hathaway longer-dated CDS spread trends are any guide, Mr. Buffett should provide around 850 basis points for default risk alone. Then, given the nature of the yield curve, a more prudent fixed rate benchmark is about 5%. After adding execution costs, a rationally priced preferred should yield 15%.

Of course, as Barron's pointed out, the 5% preferred-with-warrants proposition from the Treasury appears, at first glance, to be a decidedly better alternative for American Express, particularly when the credit card company could also access the FDIC guarantee programme for near-term and medium-term debt issues. But the finer print of the FDIC’s Interim Rule has received serious objections relating to fees, maturity restrictions, guarantee quality and even capital adequacy guidelines. When, if and at what cost the FDIC programme begins is still an open question. In the interim, there is certainly room for Berkshire Hathaway to increase its stake in American Express.

Which brings us to the task of establishing a strike price for the warrants. When Moody’s cut its rating on American Express last month, from “A2” from “A1”, it placed the company on negative watch. And for good reason. Moody’s statement warned that since American Express derived much of its income from fees, as opposed to interest from revolving credit balances though “its lending exposures have increased significantly over time.” Note the important shift in key value drivers.

The statement went to on to point out that “with this shift, eroding economic conditions across the US will likely pose a higher burden on Amex’s asset quality and profitability. In its latest disclosure documents, Citigroup (C) conceded that it is virtually impossible, at this point in time, to assess how the fate of the global economy will influence the quantum of credit card default provisions required during 2009. Note the uncertainty.

This writer’s bearishness on American Express shares (Friday close: $19.90) is firmly rooted in the belief that unless Washington can resolve the crisis in jobs (including job quality) and housing on a high-priority basis, consumer delinquencies must rise exponentially in forthcoming weeks and months. Believe the optimists, who invariably talk of 5-year and 10-year time horizons, if you must. For the record, if this is any comfort to AXP bulls, Barron's is of the view that the market is presently over-reacting, and that American Express has ample liquidity to ride out whatever tough economic conditions lie ahead.


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