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
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
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
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."
KBW analysts believe could reclaim DTAs in 2012:
Hanmi Financial Corp
Hanmi's valuation allowance against its DTA is 20% of TCE, making it the least compelling name on this list by that measure.
On the plus side, Hanmi has been profitable for five straight quarters, and its auditor, KPMG, also audited three of the seven banks followed by KBW that had recaptured their DTA in the fourth quarter as of Monday's close.
KBW believes Hanmi will recapture the DTA some time in 2012, but was not more specific than that. KBW analyst Julianna Balicka has a "market perform" rating on the stock.
"Many things are aligning well for Hanmi but hurdles remain until the bank returns to 'healthy bank status'; as such, we prefer to remain on the sidelines in the name, although the downside at this point is limited and the risk profile of the bank significantly improved, in our opinion," Balicka wrote in a Jan. 26 report.
Hanmi is a Korean-American company offering banking services throughout California, with loan production offices in other states.
Synovus Financial Corp.
Synovus's valuation allowance against its DTA is 44% of TCE, more than double the ratio of Hanmi and it also has KPMG as an auditor. It has been profitable for just two straight quarters however. KBW's analysts expect Synovus to be able to reclaim its DTA in late 2012.
KBW analyst Jefferson Harralson has a "market perform" on KBW shares, and he sounded slightly less optimistic about Synovus recapturing the DTA in a Jan. 25 report following the bank's fourth quarter earnings report.
In that writeup, Harralson stated that Synovus "has seemingly corralled its credit expenses enough to hopefully report a consistent profit."
"Next up," he continued "it would like get the valuation allowance removed from the DTA, which in turn takes the tangible book value toward $3.00 -- and then repay TARP."
The kicker, however: "It will need the economy to continue its slight
improvement and both the equity and debt markets to accommodate to get this done by year-end.
United Community Banks
United Community Banks' valuation allowance against its DTA is 72% of TCE, suggesting the shares could see a nice pop if it reclaims the DTA. However, Jefferson Harralson, who allows follows this stock, thinks early 2013 is a more likely time frame for such an event.
Harralson also has a market perform on the stock. He cited the bank's return to profitability in the quarter and "credit progress," as non-performing assets continued to come down. Non performing assets fell to $160 million 3.87% of loans.
On the negative side,Harralson cautioned about "still high" levels of non-performing loans. Performing classified loans declined to $328 million from $341 million and loans placed on nonaccrual increased to $45.6 million from $26.8 million in the previous quarter.
Following the report, Harralson raised his 2012 operating earnings per share (EPS) estimate to $0.67 from $0.46. For 2013, he assumed a normalized tax rate and raised his EPS estimate to $0.80 from $0.75. He lowered his price target to $9 from $10, however.
Citizens Republic Bancorp
Citizens Republic's valuation allowance against its DTA is 76% of TCE, and KBW analyst John Barber expects the bank to recapture it in the first half of the year.
Barber, who has an outperform on the stock, was "encouraged by strong core
fourth quarter resultsas credit trends remained favorable." Net interest margin "held steady" While Barber wrote that net charge offs "NCOs remained elevated and were down only modestly" versus the prior quarter, he attributed this to three "larger-sized commercial real estate loans on classified status that were resolved during the quarter."
The "solid" fourth quarter results "capped off a year of significant transition for Citizens Republic as the company wrapped up an aggressive credit remediation strategy that significantly reduced problem loans and subsequently reported three consecutive quarters of profitability," Barber wrote.(Still, Citizens Republic lost money in 2011 due to a $1.88 loss in the first quarter.).
Barber upped his price target to $15 from $14 following the bank's fourth quarter earnings report.
Written by Dan Freed in New York
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