Deferred Tax Assets Another Shoe That Has To Drop

Shares of Citigroup fell 5% Friday along with the broader markets. Lets forget for the moment that Commercial Real Estate is awful. Lets forget for a moment that bank balance sheets still have toxic assets. Lets forget momentarily that even though foreclosures are slightly slowing down, the delinquencies have soared. Lets forget that the banks have to bring back OBS items back onto balance sheets. Lets forget for the time being that SIVS have to incorporated back unto balance sheets. Lets finally forget about HELOC, Auto Loans, and Credit Card write offs. If that is not enough to worry about. How about this? TAX ASSETS!

The banks have been very weak of late for a myriad of reasons, but the new virus in town is Deferred Tax Assets. Investors are becoming increasingly worried about a new wave of write downs on bank balance sheets. We have seen a few banks report earnings and in the process written down assets which essentially represent cash flow expected from future tax benefits. If this is a trend then major banks must also write them down as well if they are unsure that they will generate enough taxable income in the future to realize the benefits.

When a bank posts a big loss like they have been doing for the better part of the last year, the result is a theoretical reduction in their future tax bill, which they can record as an asset on their books. You got to love accounting! After multiple quarters of losses, many banks have big deferred tax assets on their books. But then again, you can only claim these benefits if you actually make net income. If you don't, the ledger has got to balanced out and these tax credits have to be minimized.

In the case of Citi, analysts are estimating that the company will have to take a $10B hit to this credit. Write downs can have a substantial impact on a company's net worth and Citi which has $38B of these deferred tax credits on its books needs to adjust. The $10B write-down is about 7% of their capital.

The rules for writing down these assets are complicated and really depend upon auditors. But the banks could be pressed to write down their deferred tax assets if they have recorded losses for the past several years, and are likely to in the future. Banks can follow strategies to retain tax assets, such as selling assets that can generate taxable income. This is the case for Fannie Mae this morning as they are looking to sell their tax credits to GS.

Just one more thing to think about.