Updated with correct name of SPDR S&P Regional Banking ETF and add information on Hanmi Financial Corp. on page two
NEW YORK (
) -- Many banks rebounding from the 2008 crisis have been able to get an extra boost to earnings by using past losses to reduce their tax bills once they return to profitability.
That ability to offset taxes on profits is known as a deferred tax asset (DTA) and, as the name implies, it is considered an asset for accounting purposes.
The catch, however, is that in order to claim a DTA, a company must be able to argue it has a better than 50% chance of earning enough in future years that it will be able to make use of it. In other words, who cares if you can reduce taxes by $50 billion in the future if you never earn enough that you would actually be assessed $50 billion in taxes?
That is the controversy that has surrounded
(C - Get Report)
in recent years, as CLSA analyst Mike Mayo and tax consultant Robert Willens have argued Citigroup should not be able to claim the $52 billion deferred tax asset recorded at the end of 2010 because it has not shown consistent profitability that would justify such a large DTA.
Bank regulators have not been as generous as Citigroup's accountants when it comes to the bank's DTA.
"Of Citi's approximately $52 billion of net deferred tax assets at December 31, 2010, approximately $13 billion of such assets were includable without limitation in regulatory capital pursuant to risk-based capital guidelines, while approximately $35 billion of such assets exceeded the limitation imposed by these guidelines and, as 'disallowed deferred tax assets,' were deducted in arriving at Tier 1 Capital," Citigroup states in its 2011 10-K.
Bank of America
(BAC - Get Report)
has also been aggressive in calculating its DTA, according to Willens. The bank recorded net deferred tax assets of $27 billion at the end of 2010 and a gross DTA of more than $50 billion.
"They're very similar to Citigroup," Willens says of Bank of America. "They feel very confident that they're going to generate more than enough taxable income to utilize those deferred tax assets. Now you could question whether that confidence is realistic or unfounded but that's certainly what they're telling us."
Spokesmen for Citigroup and Bank of America declined to comment.
Companies that cannot argue they will be able to earn enough to justify large DTAs record something called a valuation allowance. Once those companies demonstrate steady profitability, they can begin to recapture a portion of that valuation allowance in the form of a DTA, resulting in a boost to their tangible book value and tangible common equity. Four banks that recently accomplished this feat, according to a report on Tuesday from Keefe, Bruyette & Woods, are
Mercantile Bank Corporation
(MBWM - Get Report)
Taylor Capital Group
West Coast Bancorp
The rewards can be big. Mercantile, for example, saw tangible book value (TBV) increase by 24% versus the third quarter, while tangible common equity (TCE) increased by 2% after it recaptured its DTA in the fourth quarter. Taylor, meanwhile, saw a 47% rise in TBV after it recaptured the DTA in the fourth quarter.
Such increases clearly get investors' attention in some cases. Shares of Mercantile rose by more than 17% in January, while Taylor's shares jumped by more than 27% in the month. That compares to a less than 6% gain in January for
SPDR S&P Regional Banking
, an exchange-traded fund that tracks the regional banking sector.
KBW analysts argue "no bright-line test exists" for recapturing the DTA.
"Institutions must build a case and prove to their auditors that they have returned to sustainable profitability," the report states, contending that "the companies that recaptured their DTAs during [fourth quarter] earnings generally shared common traits, including improving credit trends, consecutive quarters of profitability, and a positive earnings outlook."
While KBW's analysts note that recapturing DTA is "primarily an accounting adjustment," they argue that in cases "where the valuation allowance against the DTA is a meaningful percent of stated TCE, or those institutions who would see the greatest jump in TBV and TCE, are poised to benefit the most when recapturing the DTA."
four other stocks
KBW analysts believe could reclaim DTAs in 2012: