Is There a $10 Billion Hole in Citi's Balance Sheet?

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On Friday, a Calyon Securities analyst dropped a bomb on Citigroup (NYSE: C) in a note warning investors the bank may have to take a $10 billion writedown on its deferred tax assets in the fourth quarter -- equivalent to nearly 10% of its tangible common equity. The reaction was immediate -- shares fell more than 5% on Friday. If we needed any more proof, this demonstrates the challenge of investing in complex and opaque financial companies.

What is a deferred tax asset?
When a bank incurs losses -- such as the $28 billion Citi lost in 2008 -- these can be offset against future earnings in order to reduce income tax expense. This is recorded as a deferred tax asset on the balance sheet, which contributes partially to the bank's Tier One capital.

In order to create this asset, firms must estimate their future profits; however, if they go on to lower their estimates, they may be forced to write down the value of the deferred tax asset. Another circumstance that could trigger a writedown is a "change of control"; in fact, Citi is concerned this could apply when the government moves to offload its 34% stake in the bank. To this end, Citi recently held discussions with U.S. Treasury officials.

Citi's at the top of the table -- the wrong table
As the following table indicates, Citi looks particularly vulnerable among its peers to a revaluation of its deferred tax assets:

Bank	Net Deferred Tax Assets (Calendar Q2 2009)	As a % of Tangible Common Equity	As a % of Common Equity
Citigroup (NYSE: C)*	$44.0 billion	175%*	39%
Bank of America (NYSE: BAC)	$28.9 billion	49%	19%
Morgan Stanley (NYSE: MS)	$6.2 billion	25%	18%
JPMorgan Chase (NYSE: JPM)	$13.7 billion	21%	14%
Goldman Sachs (NYSE: GS)	$3.9 billion	8%	7%

*Note that this ratio has fallen to 37% at the end of the third quarter.
Source: Capital IQ (a division of Standard & Poor's) and the author's calculations, based on data from the same.

Citi: What investors should be aware of
In "Sell This Bank" (Oct. 23), I wrote: "The banks that are the most vulnerable to a short-term revaluation are, to my mind, those that have risen the fastest and sport the weakest fundamentals: Bank of America (+341%) and Citigroup (+325%)." I continue to believe that. In the same article, my colleague Morgan Housel also singled Citigroup as the large bank to sell for several reasons.

This latest report adds another dimension of uncertainty to holding Citi shares. As I write this, they are off approximately 3% today, compounding Friday's decline; unfortunately for investors, there is nothing deferred about those losses.

As we emerge from the recession, this is exactly the time to buy these stocks.