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Warren Buffett and Berkshire Hathaway released their annual letter to shareholders last Friday. There were plenty of useful comments on a wide variety of topics revolving around investing, and this document will be a major part of the conversation of investors over the following weeks ahead.

Warren Buffett touched upon one area in his letter to shareholders revolving around the type of investment that very few investors have in their portfolio: stock options. Buffett has used options to boost the profits of Berkshire Hathaway, and in his shareholder letter, he talks about his belief that options can produce profits of a greater magnitude later on in the future. By making this claim, Warren Buffett calls into question if the entire open market for this type of investment is potentially mispriced – and it creates other opportunities for intelligent long-term investors.

Let’s now take a look into Buffett’s argument a little bit further, and overturn some stones by discussing ways to take advantage of this untapped opportunity.

The Big Bull Market Bet

During the years 2004 until 2008, Warren Buffett and Berkshire Hathaway took massive exposure upon themselves within the options market. They were selling put options on the major stock market benchmarks covering Europe, Japan, the UK and the US. By doing so, Berkshire Hathaway was extending its traditional insurance business to provide protection that is stock market related for its counterparties. Berkshire Hathaway brought in $4.2 billion by selling these put options, and just like the other premiums Berkshire receives from its insurance businesses, they turned around and invested these billions of dollars in sales into its stock holdings and operating companies.

When the market melted down in 2008 and throughout the early part of 2009, the put options looked like a really bad move. At the time, Berkshire Hathaway was sitting on what appeared to be a potential $10 billion loss, with the possibility that the losses would be even greater if the market stayed low past the options expiration dates, which range from the years 2018 through 2026. But at the time of this writing, the current intrinsic value of the options are now below the premiums Berkshire Hathaway received, thanks to the large bull market that’s happened over the last four years. Overall, Buffett expects the final amount due under the options to be a lot less than the current figure of $3.9 billion.

Is There a Flaw in Long-Term Option Pricing?

Brendan Conway of Barron’s posted a fantastic blog post last Friday afternoon, which reminded investors of Berkshire Hathaway of the history behind these Buffett puts. As commonly noted, Buffett has gone to tremendous lengths in one of his previous shareholder letters to describe the inefficiencies and pricing of the options market and how Buffett planned to exploit it.

The root of the options problem lies specifically in the volatility assumptions made in the very commonly used Black-Scholes formula. From year to year or day-to-day, stocks can move rather abruptly, and the assumptions of volatility often are baked into the price of options. But when you look at them over longer periods of time, stock market returns are much smoother, and Black-Scholes will value options more highly than it is actually appropriate – which makes them much better to sell instead of buy, and this is especially true when you have puts expecting the market to continue to trend upward.

Warren Buffett’s behavior points to a much different view toward trading options for the long term on the buy side. When Buffett has previously provided financing to large corporations like General Electric and Goldman Sachs, he used warrants that are options like, and they provide a long-term equity kicker to Berkshire Hathaway with this investment. By being willing to hold onto these warrants strongly points to Buffett’s belief that volatility on the downside is overestimated, then the upside volatility is also underestimated, which will make long-term call options the better buy for investors.

Can Anyone Take Advantage of This?

The short answer is no. The deals put together by Warren Buffett are not typically available to your average investor. The long-term options available to the public will normally only run just a few years into the future, but that is not a long enough time for an entire bull – bear cycle to run its course for reversion to the mean to take place.

The one place where long-term options are available at this time is in financial stocks. This is thanks to the TARP bailouts, so five to six year warrants are currently available from several major banks and other financial institutions. For Capital One and Hartford Financial, these warrants are already in the money – which means that the current price of the shares already exceeds the exercise price of the warrant. This will limit the impact of volatility estimate errors on the warrant price.

But on the other hand, Bank of America and Citigroup still have warrants where the strike prices are well above the share value at the current market price. With the bulk of the value coming from the time value and the estimates of volatility that are generated, the warrants for these shares are very susceptible to the type of mispricing that Warren Buffett is discussing.

Take a Look for Yourself

Remember that options and warrants are a very specialized type of investment and they present a substantial risk. But regardless, the questions revolved around proper pricing for the long term bring up the possibility that you can use this type of option to your advantage, which means you might want to take a closer look.

The long-term track record of Warren Buffett’s success has made him the best investor of our time, but currently Berkshire Hathaway shares are trading at their all-time high. Is it the right time to buy Berkshire right now? You decide.

Warren Buffett says that US banks are “in the best shape in recent memory,” as he mentions this to Bloomberg News recently. He also believes that they will not cause the next big financial meltdown.

As the CEO and chairman of Berkshire Hathaway Inc., based out of Omaha, Nebraska, Warren Buffett has earned billions of dollars over the past four years when he started investing in Wells Fargo and Company, Goldman Sachs, U.S. Bancorp and Bank of America. Let’s not forget about General Electric as well. They are all companies that operate in the finance industry, and they each fall under the banking category.

And if he wanted to, Warren Buffett could earn another $3 billion right now by cashing in discount stock purchase warrants from Bank of America. He chose to wait instead, and here’s why:

“We’re in no hurry,” said Buffett to Bloomberg. “Nine years from now I would think that Bank of America as well as Wells Fargo and probably the other major banks will be worth considerably more money than they are now.”

Mister Buffett says that the banks are so much more healthy right now since the financial crash during 2008 because they have cleared out the bad loans on their books, rebuilt their capital, lowered their risk, cut their expenses and repaid the taxpayer bailouts throughout a very fragile real estate market.

There are many experts that still worry the biggest banks in the US are too big, and they can easily repeat the same problems that triggered the recession that we went through recently. Buffett doesn’t believe this.

“The banks will not get this country in trouble, I guarantee it… We do not have an unusually concentrated banking system compared to the rest of the world, and there are certain advantages in the largest capital market in the world to having banks that are somewhat consistent with the size of those markets.”

Warren Buffett is a billionaire investor who has taken out stakes in some of the largest United States banks, who tells us that the lenders have rebuilt their capital to the levels where they aren’t a possible threat to the economy any longer.

“The banks will not get this country in trouble, I guarantee it,” said Buffett – the CEO and chairman of Berkshire Hathaway, based out of Omaha, Nebraska – in an interview that he gave over the phone last week. “The capital ratios are huge, the excesses on the asset side have been largely cleared out.”

Major lenders including Citigroup Inc. and Bank of America Corp. have sold off their assets, bolstered their balance sheets and cut many jobs after they repaid the 2008 taxpayer bailouts, when these companies were truly overwhelmed by losses on housing market related securities. All of those actions helped raise the value of Berkshire Hathaway’s holdings, and increase financial stocks at the same time.

Berkshire Hathaway has invested in at least four of the seven biggest lenders in the United States of America by assets, and has also taken out more than a $14 billion stake in Wells Fargo and Co., based out of San Francisco. They have a $5 billion stake in Bank of America, and they have $5 billion worth of warrants to purchase shares of Goldman Sachs Group Inc. Berkshire Hathaway has a stake in U.S. Bancorp as well.

“Our banking system is in the best shape in recent memory,” said Buffett.

Past bank regulators and executives tell us that the biggest lenders still pose some risk to the United States economy even four years after the bailout, plus 2 1/2 years since legislators passed the largest major reforms to regulation on Wall Street since the Great Depression.

Trading Loss

Last year, J.P. Morgan Chase and Co. took a trading loss of $6.2 billion, which reminded America of our concerns for the banking industry. Sandy Weill, former CEO of Citigroup, mentions that lending money and taking deposits should be split off from investment banking as a way to prevent another major financial crisis.

Other investors have also spoke about their doubts and the accounting of banks. Even after the stock rally last year, J.P. Morgan, Bank of America, Goldman Sachs and Citigroup are all trading at less their book value, which is a calculation of how much a company’s assets should be worth if you subtract their liabilities.

There were mergers taking place during the financial crisis that brought about criticism, saying that too big to fail banking companies are getting even larger. Buffett mentions that this shouldn’t worry investors at all. Canadian banks managed to get through this crisis a lot better than other banks in many nations, as the biggest firms in Canada took hold of more market share than their counterparts in the United States did.

U.S. Advantages

“We do not have an unusually concentrated banking system compared to the rest of the world, and there are certain advantages in the largest capital market in the world to have banks that are somewhat consistent with the size of those markets,” said Buffett.

The biggest United States banks are going to face another round of Federal Reserve stress tests to figure out whether or not they have enough capital to raise dividends and buy back shares of their stock. Brian T. Moynihan, CEO of Bank of America, tells us that he’s confident BOA is going to pass even though they failed in 2011, when he did not receive the approval to increase the dividend.

Buffett also lent Bank of America credibility by providing the bank capital during 2011, after the company saw a 45% decline in share price during an eighth month period. This trade also followed moves during 2008 that Warren Buffett made by helping out General Electric Company and Goldman Sachs during the financial crisis. Both of the companies bought back the preferred shares that they sold to Warren Buffett. He also expects that Bank of America may potentially do the same.

Improved Condition

“Their condition has improved so significantly, and interest rates are so low, that they have the chance to do a number of things in that respect,” said Buffett. “I may like to keep it, but if it makes sense for them to call it, they’re going to call it.”

The preferred shares that Berkshire Hathaway owns of Bank of America pay an annual dividend of 6%, and they can redeem them at any time for the amount of $5.25 billion, according to the terms of the deal that was made. The deal also gives Warren Buffett 10 year warrants to buy 700 million shares of common stock from Bank of America at $7.14 apiece. Bank of America recently closed at $11.43 per share. If Warren Buffett were to exercise that option at those prices, he would make about $3 billion.

Buffett mentions that Berkshire Hathaway is most likely going to wait toward the end of the contract before they exercise that option.

“We’re in no hurry,” said Buffett. “Nine years from now I would think that Bank of America as well as Wells Fargo and probably the other major banks will be worth considerably more than they are now.”

A spokesman for Bank of America named Larry DiRita chose not to comment on Warren Buffett’s Bank of America investment.

Their Tier 1 capital ratio has almost reached 9% as of September 30 based on the newest standards internationally, and it’s up from about 8% just three months earlier. Their long-term debt dropped to $286.5 billion by the end of the third quarter, and this is down from $399 billion just one year earlier.

It’s always very popular to check in on Warren Buffett during the new year for whatever reason. One of the reasons is that many people potentially want to invest like Warren Buffett, and they make it a New Year’s resolution. That’s at least one potential reason why this happens. So how’s Buffett doing anyway?

Warren Buffett’s big bet on Bank of America, as well as a very generous buyback plan put into place, helps Berkshire Hathaway beat the S&P 500 index during 2012. He didn’t even make a major acquisition during this time.

Berkshire’s class a shares rose by 17% during 2012, and this beat out the 13% gain that the Standard & Poor’s 500 made. As well, an estimate made on December 31, 2012, says that book value rose to $113,579 per share. This estimate comes from Meyer Shields, who is an analyst at Stifel Nicolaus and Co. Based on this estimate, Berkshire Hathaway has earned a seven-point percent annual growth rate over the last five years ending in 2012. This is compared to the 1.7% growth rate of the S&P 500, and this includes dividends.

It’s also worth paying attention to that the Warren Buffett buyback was controversial when it was first announced just three weeks ago. But, the stock rose 6.5% since that time, earning Mister Buffett and company a $80 million profit in just three weeks.

Berkshire Hathaway also made a very large sum of money in their Bank of America investment in preferred shares and warrants during the year 2011. If you take a look at this passage from “Heard on the Street” where they go on about whether or not Bank of America should buyback the preferred stock from Buffett, you might learn some clues. Here’s why:

“Granted, retiring Mr. Buffett’s preferred shares might cause BofA to cut back on plans to ask for capital returns. That could cause unease for common shareholders, especially since Mr. Buffett’s preferred stock is also equity.

Yet the particular structure of the preferred shares means it doesn’t qualify toward the bank’s Tier 1 ratio under the new Basel rules. So it is akin to debt for capital purposes.

On that basis, 6% is expensive. The average yield on BofA’s long-term debt as of the third quarter was 3.07%. And the bank, awash with deposits, has been aggressively reducing long-term debt as it seeks to bolster its net interest margin.

So it wouldn’t be tough for BofA to replace Mr. Buffett’s preferred stock with cheaper, long-term debt. The catch: Any additional debt issuance chips away at the bank’s net interest margin, while the preferred payment doesn’t because it is deducted from net income.”

There is a very funny video on the Internet where Bill Ackman is talking about how he is going to open up a lemonade stand, and he mentions a fun exercise where he will try to explain exactly what it is that Bank of America is thinking about. But you really have to have financial knowledge in order to understand some of the terms that he’s talking about within the video. Some of the things being mentioned are: is Bank of America trying to bolster its net interest margin, or its tier 1 capital, or is it just looking to buy low and sell high?

If you have an a B Warren Buffett, you might wonder something like this: is buying the preferred shares a very good deal economically, when you compare to other things that Bank of America might choose to do with its money instead?

When reading the journal, you can’t get the sense that that isn’t a question they are going to be asking themselves anytime soon. But that doesn’t mean Bank of America is any less smarter than Warren Buffett. They just happen to be in the middle of many different accounting knots and regulatory tangles, and they can only unravel these issues one or two at a time. Mister Buffett on the other hand is a regulatory regime unto himself.

When looking at this from the perspective of Warren Buffett, the motives of Bank of America by trading their preferred shares to him are pleasantly uneconomic for the bank. The initial trade was actually conceived in a bathtub, and looking at it from an economic standpoint, this is a pretty big gift to Buffett. They give off the vibe of they are not going to vanish anytime soon.

So all in all, it looks like Warren Buffett really made out like a bandit on this deal. That doesn’t surprise me at all, since he was able to make hundreds of billions of dollars for himself and his clients over the years. This is nothing new, so why would anybody think otherwise?

To start this off right, I’d like to point out that Warren Buffett is extremely optimistic about the future of America. “Tomorrow’s always uncertain,” he mentions while on CNBC this morning. “But the future, the longer future, is always very certain. And that’s what you have to keep your eye on.”

It’s this very attitude that allows Mister Buffett to continue building astronomical stakes in businesses that he feels are worthy through the best of times and the worst of times. But how does Warren Buffett choose these particular companies to begin with? Let’s look at Wells Fargo, and find the evidence in this stock which he continues purchasing the most.

Wells Fargo

Wells Fargo has entered into Warren Buffett’s portfolio way back in the 1990s, and it is a great representation of his philosophy of long term investing. Plus, you can see a steady trend of continual buying of this stock since the first quarter of 2009. From that point until the present day, Berkshire Hathaway has bought 1 million 119,940,333 shares of Wells Fargo. This has brought the total position up to more than 422 million shares in all.

Warren Buffett made three very important moves in his portfolio during 2011, and Wells Fargo was one of them, along with Bank of America and IBM purchases. He provides shell holders several different reasons why this was important during his annual letter: “the banking industry is back on its feet, and Wells Fargo is prospering. Its earnings are strong, its assets solid and its capital at record levels.”

Wells Fargo is also extremely large – since it currently serves about one out of every three households in the United States of America from its 12,000 ATMs, it’s 9000 branches and their website. They are also prominent in 35 different countries. This company is also the first in market value of its common stock out of all of the United States banks, and the fourth in assets.

Even though Warren Buffett requires a high ROI from a bank, he also insists that the return on investment be gained in a conservative manner. This is great, because Wells Fargo has a very well maintained and controlled operating environment. It has excellent ground rules in place to manage credit risk, and they monitor their loan portfolio performance very closely. It also has set ranges for its interest rates and market risks in its liabilities and assets, while it is able to fuel growth with ample capital levels and liquidity.

In addition, Wells Fargo will continue to remove nonperforming loans from its assets. During the third quarter of 2012, loans that were 90 days past due or more totaled in the amount of $1.5 billion. This is down a half $1 billion from the $2 billion at the end of 2011.

As well, Wells Fargo also solidified its position with capital. The equity earned in the third quarter was increased by $6.6 million from the second quarter numbers, and rose to $156.1 billion. Its tier 1 common equity reached the amount of $105.8 billion, which is equal to 9.9% of the risk-weighted assets. Wells Fargo also has a nice tier 1 capital ratio of 11.5% in their total capital ratio of 14.51%, as well as the tier 1 leverage ratio that they possess of 9.4% which rounds out the third quarter.

The other results that they gained during the third quarter are testament to showing that they are a strong company that can easily withstand economic uncertainty. The bank overall reported a total of $4.9 billion and earnings, which is up 8/10 of 1 billion from last year’s $4.1 billion at the same time.

The improvements that Wells Fargo gained this year were basically brought on by fee income and balanced net interest. They also have a strong credit performance, a diversified loan portfolio and further diversified sources of their fee income. They also grew across many of their businesses.

Wells Fargo’s third-quarter revenue grew to $21.2 billion, which is up from the $19.6 billion that it saw at the same time last year. The revenue was strictly sparked from noninterest income growth in the mortgage banking industry, and you can combine that with a mild increase in their income from that interest. They also originated 56% more loans this year than they did at the same time last year.

Also during the same quarter, Wells Fargo decided the buyback 17 million shares and they also paid a $.22 dividend. The previous year’s dividend was only $.12. During Warren Buffett’s 2010 letter, he predicted that Wells Fargo would have a dividend increase. He also expected that his largest gain in dividend would come from Wells Fargo. They were forced to lower it at one point, though it was “consistently prospering throughout the worst of the recession.”

Buffett seem to have a crystal ball so to speak, but he really knew that the fundamentals and Wells Fargo’s strategy of execution would easily survive the economic turmoil. He made his biggest stock purchases throughout the five years by buying shares during the biggest stock dips. Those took place during the first quarter of 2009, the third quarter of 2009 and the third quarter of 2010. But he’s actually made his biggest purchases over the last year, all while the stock has been rising by almost 23%.

It’s a bit surprising, and possibly even offensive that Warren Buffett is trying to get the most wealthy people in the nation to pay much higher taxes in order to restore the nation’s finances to a much more stable situation.

During 2008, people are accusing Berkshire Hathaway and Warren Buffett of receiving bailout money in order to save their company during the financial meltdown. It is claimed that he made a really great deal that gave his company $95 billion worth of TARP money from the government.

But here’s the real truth. Berkshire Hathaway and many other shareholders of four really large financial institutions, including American Express, Bank of America, Goldman Sachs and Wells Fargo were claimed to all receive their own piece of government TARP funding to stay afloat during the biggest financial crisis that we’ve seen since the Great Depression.

When you add up all the different bailouts, it amounts to $95 billion. But here’s the real kicker. None of that money actually went to Warren Buffett or Berkshire Hathaway. Berkshire and Warren Buffett received absolutely nothing.

But, on the other hand, the employees and shareholders of American Express, Goldman Sachs, Bank of America and Wells Fargo all received benefits from the TARP funds during this very difficult time.

But it’s 100% false to try and blame Berkshire Hathaway and Warren Buffett for taking $95 billion that they didn’t need. And anyone thinking otherwise really isn’t paying attention all that much to the financial world. As a matter of fact, the majority of Americans are possibly illiterate to what is going on financially and economically. This intelligence gap and lack of understanding needs to be corrected some day if America will continue to thrive.

When most people think of Warren Buffett and bank stocks, they usually think about the ever-expanding Wells Fargo and Company. But if you happen to take a look at the last 13 – F, you’ll see that Warren Buffett decided to triple his overall position in another bank stock. This actually suggests to me that there’s more than one mega-bank worth looking at right now. This particular bank is a low credit risk, and also has a lot of cash on hand, and there is a lot of room for it to expand internationally. So get those checkbooks out right now, bank stock buyers.

Difficult sector

It is not easy to invest in banks at the moment. I know you don’t want to hear this, but it really is the truth. It’s not like investing in a manufacturing company where you can predict what will happen during the next 10 years because it’s an easy to figure out revenue model. Banks are large, multifaceted and convoluted organizations. You should really only have them in your portfolio if you truly understand the ins and outs of the banking business. Otherwise, if you own them, you should have it on incredible authority that they are poised to make a consistent profit. That’s why a lot of people tend to often look to Warren Buffett and his investments as a good authority.

Not long after the financial crisis began, Berkshire Hathaway and Warren Buffett took out a few positions in some of the largest banks. One position they took out was in Bank of America, but this was more of a necessity to help out the ailing bank.

Warren Buffett also raised his position in Wells Fargo at this time, and is currently considered the best bank around right now. Wells Fargo is known to be a lot more conservative than its fellow competitors, such as J.P. Morgan Chase and Citigroup, and it has quite a bit of home mortgages currently on its books, which is excellent for the rebound in the housing market that is about to take place.

As a matter of fact, it looks like the housing market rebound has already begun at this point in time. It’s no secret that Warren Buffett’s Wells Fargo investment has already paid off big time for Berkshire Hathaway and the Oracle of Omaha. But there’s still one more bank that has quite a bit of room to go up in value in the foreseeable future, and Buffett is ready and waiting for his company to benefit when it does. Will you be waiting with him?

What a melon

As we review the latest 13 – F from Berkshire Hathaway, you will notice that Warren Buffett basically tripled his position in Bank of New York Mellon at this time. Bank of New York Mellon perfectly fits the investing style of Warren Buffett since it is a very conservative company, it has tendencies for cash printing, and the management in this business is very sound. There are a lot of appealing factors if you happen to be somebody looking for a cheap bank stock to purchase, and you are looking for exposure in the banking industry while keeping a very conservative approach.

The good thing for you conservative investors out there is that BNY is not one of these banks that make its money from banking practices that are morally wrong, as well as fly-by-night trades. About 75% of the revenue of this company comes from servicing fees that are recurring, and this is an excellent model which is obviously a perfect revenue model for a bank, or any company for that matter. BNY is actually the custodian of more than $27 trillion on a global level, and they are directly managing $1 trillion at the current time. I obviously do not need to point out that the servicing fees on $27 trillion are clearly going to be a really large chunk of change that is a fantastic recurring fee for Bank of New York Mellon.

The good old US of A

Another excellent thing that you might want to know about Bank of New York Mellon is that over 60% of their business takes place in the United States of America. But the company has a global presence that is expanding, and it is currently looking to earn more future revenue from other sections of the world as it expands. This is a really good opportunity for BNY because it has the ability to grow its business very fast since there are many different untapped markets all around the world just waiting for them. This is one of those rare cases of a stock that looks good for value investors, but the growth potential is also very strong as well.

Let’s stay on the topic of value for one second longer, because BNY trades pretty much like all of the other bank stocks are trading these days. As an investor in BNY, you only have to pay 0.78 times book value, which in my estimation is practically a fire sale. This is much less than 10 times its forward earnings, so it is only a little bit higher than Citigroup and J.P. Morgan as we speak, but the risk in this stock is considerably less than both of those mega-banks.

Since interest rates are increasingly low and basically staying there for the unforeseeable future, it obviously makes a great deal of sense to look into stocks that aren’t relying on the low interest rate to make its money. You want to look at banks that are focused on servicing the investments of its customer, which is exactly what BNY does. And they have drastically reduced their credit risk and interest rate, so they are able to offer their investors a really great business model of long-term revenue which is tough to pull off in the banking industry.

I want to remind you that it is not always really easy to invest in banks. You have to do a great deal of due diligence when evaluating a financial institution like this, and the only exception is with the local savings and loans. If you follow Warren Buffett’s lead by purchasing the stock because you feel it is an excellent choice, then you’d be in good hands since Bank of New York Mellon is very transparent with their current revenue streams, and they are also a exceedingly conservative business by nature. It obviously makes sense to follow the best in the world, and that is the exact opportunity that you have if you decide to follow Warren Buffett down this path.

Warren Buffett’s railroad Burlington Northern Santa Fe, which was recently bought by Berkshire Hathaway in year 2010, just sold $1.25 billion worth of bonds for the purposes of general corporate needs.

The bonds that Burlington Northern issued were split up into different parts. The first set of bonds, which went for the amount of $600 million, were at 3.05%, and they were 10 year securities which yielded 125 basis points more than other ponds that are similar. The second type of bonds were for $650 million and they were 4.375%, 30 year bonds and the basis points were 150 more than current benchmarks. This was gathered according to data presented by Bloomberg. Moody’s Investors Service is going to rate these bonds as A3, which is the fourth lowest investment grade that they have. Standard & Poor’s is going to be rating these bonds BBB+ which is even one level lower than the Moody’s rating. This is also according to information that was gathered by Bloomberg.

Burlington Northern has not sold any bonds since February. At the current time, the $625 million bonds they have at 4.4% that are due in 2042 in the month of March, are trading at 101.3 cents on the dollar, and a yield 4.32% as of yesterday. This information is presented by the company name Trace, which is a reporting system for bond prices of the Financial Industry Regulatory Authority.

Goldman Sachs Group Inc., Citigroup Inc. and Bank of America Corp. are the companies that managed the sale for Burlington Northern Santa Fe, which is a company based out of Fort Worth, Texas. The basis point is 0.01 percentage point.

The bank stock investors definitely have some choices that they are going to need to make since the largest banks in the nation have just reported their quarterly earnings.

Do these investors want to take a risk and chase the earnings rebound that is bound to happen at the major banks like Citigroup, Bank of America, and J.P. Morgan Chase Bank? There’s the potential for their shares rising well above single digit price-to-earnings multiples. Or better yet, would it be a better idea to invest in the safer premium priced lenders like U.S. Bancorp, BB&T, M&T Bank and Wells Fargo?

The one thing I can say for sure is that if you followed Warren Buffett’s lead, and invested in the traditional lenders such as Wells Fargo, then you would have implemented a very effective yet simple strategy. This industry is normally marked by high risk and earnings numbers that are very hard to understand.

To put it quite simply, Warren Buffett who is also known as the Oracle of Omaha, made the choice to invest his money in banks that were growing earnings through mortgage lending rebounding a bit, as well as low-cost share repurchases that are now going up in value.

On the flip side, Warren Buffett has hesitated when it comes to putting more money behind the players more oriented toward the capital markets such as J.P. Morgan, and he’s even backed off of the Wall Street investment banks such as Morgan Stanley and Goldman Sachs since they are at risk from the malaise on Wall Street, as well as the European debt crisis and new regulations that are coming into play each and every day.

Buffett has been sticking with the mid-teen price multiples of U.S. Bancorp, M&T bank, and Wells Fargo, as opposed to going after the single digit P/E ratios of some of the previous banks mentioned in the paragraph above.

Buffett chose to avoid making common stock bets in investing banks, which is why the investments Buffett made in the financial sector are outperforming those of his peers by a wide margin. The second quarter earnings of the bank stocks that he owns definitely reaffirmed that his way of investing is certainly the smart way to go. Wells Fargo and J.P. Morgan Chase Bank both started off this earnings season with much stronger than expected numbers, and Wells Fargo even outperformed expectations, which I learned according to data released by Bloomberg.

When you take a close look at Buffett’s portfolio of bank stocks, the outperformance is a marked improvement which you will certainly notice.

The top performers in the banking sector of the Standard & Poor’s 500 index, since earning season began are both M&T Bank and U.S. Bancorp. And the laggards in the banking sector are Bank of America, Goldman Sachs and Morgan Stanley.

That doesn’t mean that Buffett doesn’t have any investments in either Goldman Sachs or Bank of America. But he made preferred share investments which are extremely safe loans that will guarantee him a return on his investment. This has nothing to do with the regular trading of the common stock, and it’s a totally different type of investment opportunity which is paying off for Berkshire Hathaway.

It’s probably not a great idea to base your investment strategy off of the bank stock gains that have been taking place since the second week of July. But I’d like to point out that the performance of shares is actually reinforcing trends over the last few years which you also see reflected in earnings statements.

Buffett and company are continuing to hold their bank stocks because they believe in the investment in the US economy and recovery, but he did it wisely by smartly placing his money in banks like Wells Fargo (they are projected to be the most profitable bank in 2012 according to computations and analyst estimates from Bloomberg.) There are many other investors who are being lured into subpar investments by placing their money into the large financial banks that have troubled balance sheets and uneven earnings.

The Wall Street crash in 2008 hammered most of the bank stocks, but then in March 2009 the bottom of the stock market crash is where the bank shares began to triple in value for Bank of America and Citigroup, and Goldman Sachs and J.P. Morgan all doubled in value in a one-month period. There are lots of analysts and investors in the financial sector who believe that those mega gains could be duplicated once again in the very near future.

But the truth is that our nation’s biggest investment banks have totally underperformed, but that didn’t stop their shares from rising higher due to some deal making and misplaced optimism.

Between the months of March 2009 through May 2009, the nation’s biggest investment banks were actually the top performers at the time. But things have changed, and since that three-month period, Citigroup, Goldman Sachs, Morgan Stanley and Bank of America have all lost more than 15% of their share value. All of these stocks are part of 10 bank stocks on the S&P 500, out of a total of 85 bank stocks in all, that have taken double-digit losses since May 2009. This information was obtained through Bloomberg data.

J.P. Morgan on the other hand has gained about 20% since that time. But Bloomberg data also shows us that the financial stock picks that Buffett made in M&T, U.S. Bancorp and Wells Fargo have all gained much better returns, and outperformed Chase by a wide margin during that same time.

If anything, I hope this market data will show investors that these large banks with volatile earnings aren’t necessarily the smart play, no matter what the big financial media reports show you. If you were to follow the less glamorous bank stocks that Warren Buffett chose, then you would’ve been much better off and gained some great exposure to consumer and mortgage lender growth.

The strategy is definitely confirmed by the earnings reports that have recently come out in the financial sector. The truth is that the strength in the lending gains are the reason why these earnings have propelled at Wells Fargo, and the reason why they outperformed expectations. The same holds true for J.P. Morgan.

When the second quarter earnings were released, it was learned that Wells Fargo beat the street because of a 35% increase in their quarterly profits. This number was bolstered by housing related activity and mortgage lending. J.P. Morgan, on the other hand, showed major growth in the area of new and existing homes, and they had a 30% year-over-year growth in the mortgage loan origination revenue department. The growth was also 14% sequentially which rose to $43.9 billion. But they showed a sharp drop in profits in the investment bank area.

The fact that J.P. Morgan had a major boost in their home lending earnings was actually a major bright spot throughout the entire second quarter. This was an earnings season that showed a sharp drop in revenue from the investment banks, and the $4.4 billion “London Whale” trading loss. Traditional revenues in investment banking fell a great deal on Wall Street, and in Morgan Stanley’s case they dropped about 50%, and the large bank earnings were unfortunately clouded by a lot of accounting items that only represent a onetime situation. There’s also the possibility that the rate fixing scandal going on at Barclays is going to spread and that will negatively affect the large banking conglomerates.

“With roughly 80% of the banking industry by assets having reported 2Q12 results, the overarching theme of earnings has been continued impressive mortgage banking revenues, surprising [net interest margin] resilience, and modest loan growth,” said Paul Miller who is an FBR Capital Markets analyst in a July 23 earnings wrap. “Given a sustained low rate environment, government mortgage programs, and constrained market capacity, we believe that mortgage banking will continue to be a dominant earnings driver through the end of 2012,” he added.

Banks such as Wells Fargo, Fifth Third, PNC Financial, J.P. Morgan and U.S. Bancorp, who all have large mortgage banking platforms, will all continue to be supported by home buying activity and refinancing, mentioned Miller.

As a matter of fact, the recent earnings numbers actually reinforce some of the things that Warren Buffett forecasted about the housing market in an interview that he gave on CNBC on July 12. He mentions that our economic growth in this country has basically stopped dead in its tracks, but he’s noticing that there is a pickup in the residential housing area, which was a comment that he made in regards to bank earnings.

“The general economy in the United States has been more or less flat, and so the growth has tempered down. But the residential housing, we’re seeing a pickup. It’s noticeable. It’s from a very low base,” Buffett said, who stated that he recognizes that he sort of flip-flopped with his optimism when he was very bullish on this topic of housing in 2011.

There are lots of housing sector analysts and banks that also agree with him. The analysts from Goldman Sachs actually raised their earnings estimates on two of the homebuilders which included MDC Holdings and KB Home, because the analyst believes in a “strong US housing recovery.”

If you are a stock investor that trusts in the fundamentals, you should also consider following Buffett. According to the results of the stress test of the Federal Reserve in March, Buffett led the way with his investments in such areas as U.S. Bancorp and Wells Fargo, and this also pushed forward some share buyback plans and dividend boosts. The Wells Fargo dividend was raised by 83%, and this was followed by an accelerated buyback program which began in the year 2011. U.S. Bancorp, on the other hand, also boosted their dividend by a total of 56%, and they even plan to buy back $3.3 billion worth of shares.

There aren’t many Americans who are aware of this fact, but the truth is that Berkshire Hathaway has been steadily and quietly putting themselves in a position where they will play an important role in the mortgage market that Bank of America, and others, are currently shying away from at this time.

Did you know that Berkshire Hathaway is actually in a bidding war with Nationstar Mortgage Holdings? They are bidding to receive the assets of ResCap, which is actually the fifth-largest mortgage servicer in the nation, behind such major financial institutions as Citigroup, J.P. Morgan Chase Bank, Bank of America and Wells Fargo.

Whoever wins this bid is going to instantly become a large player in the mortgage servicing industry, and they will have the ability to collect the debts of 2.4 million home loans once this deal is complete. The significance of the move they’re trying to make is that many of the other larger banks, with the one exception being Wells Fargo, is that they are all choosing to pull out of this facet of the financial services industry. In particular, Bank of America has been regularly selling off the rights to their mortgage servicing business.

This week is very important for the United States housing market, and we are looking for a quiet shift in this industry as new details come about. How is this going to happen? Ocwen Financial Corp., which happens to be the 13th largest mortgage servicer, and Fortress Investment Group, the company that owns a Nationstar, are going to be reporting the results of their second quarter earnings this Thursday in the morning.

You can definitely expect that Fortress is going to be asked plenty of questions about Warren Buffett’s battle for ResCap, and I wouldn’t be surprised if Ocwen management also gets questions about the specific topic, since they have expressed their own interest in purchasing the assets of ResCap.

Another potential area you might want to find out more details is with Bank of America selling off their mortgage servicing rights. They have sold the rights to over 15,000 loans so far, even though the United States Justice Department is currently reviewing them which is holding up the sales. This is according to the CFO of Bank of America, Bruce Thompson, on July 18 when his company reported their earnings.

When asked about the delay in loan sales, Thomas predicted that it would last between one to two quarters. What would really be interesting is finding out what Fortress and Ocwen have to say in regards to purchasing MSRs from Bank of America.