If the Senate's tax reform bill becomes law, Citigroup (NYSE:C) would be a $20 billion loser -- at least on paper.
At a conference on Wednesday, the bank's chief financial officer, John Gerspach, told analysts that the company believes the passage of the Senate tax bill would force it to take $20 billion of accounting charges on tax assets stemming from its financial crisis losses.
Setting records for losing money
In January 2008, Citigroup rattled the markets when it reported a $9.8 billion fourth-quarter loss, driven primarily from subprime write-offs. It was only the start of a flurry of bad news and big losses, as the financial crisis was really just getting started.
As disastrous as Citigroup's performance in the financial crisis may have been, those losses are a treasure trove now. Citigroup has spent the last few years cashing in on its historical losses by using them to avoid taxes on today's profits. At the annual investor day this year, the company said it expected to benefit by skipping out on $2 billion in taxes per year for a long time to come.
How much tax Citigroup can rightfully and legally avoid is quantified directly on its balance sheet as a deferred tax asset, or DTA. Last quarter, Citigroup reported that it had $43 billion of deferred tax assets in the U.S., representing taxes it won't have to pay on future profits.
There are many moving parts in valuing DTAs, but one of the most important drivers is the tax rate. Citigroup's U.S. DTAs are valued based on the assumption of a 35% corporate tax rate. If corporate taxes are cut to 20%, as the Senate plan would do, the value of Citigroup's U.S. DTAs would have to be cut down, too.
At Wednesday's conference, Gerspach told analysts that a reduction in the corporate tax rate to 20% would necessitate a $16 billion charge on Citigroup's income statement. A charge for deemed repatriation, per Citi's CFO, would cost another "$3 to $4 billion." All in, that's a $20 billion hit in a single quarter.
If you knew nothing about GAAP accounting, you might first panic at the thought of an 11-figure ding to Citi's income statement and a similarly large drop in book value. But this is one case where accounting doesn't really reflect economic reality. Though its book value may plummet by $20 billion if the Senate's version of the tax bill is made law, it's difficult to argue that Citigroup is truly $20 billion poorer. If corporate taxes were increased, rather than decreased, would Citi be worth more? Of course not, but the accounting would say so.
Based on what Gerspach knows about the Senate tax bill now, he anticipates the $20 billion write-down to be noncash in nature. He also said that the impact will be trivial when it comes to important regulatory capital levels, suggesting that the impact to Citigroup's common equity tier 1 (CET1) capital would amount to just $4 billion.
While as investors we may think in terms of simple book value or tangible book value, CET1 capital is what really matters to banks. It's especially important to large banks like Citi, since CET1 capital levels are a key factor in whether a bank gets Fed approval to pay dividends or buy back stock.
Make no mistake, $4 billion is a lot of money, but it's a rounding error to Citi, which had $162 billion of CET1 capital at the end of the most recent quarter. Gerspach said that a $4 billion change in Citi's capital levels wouldn't affect a goal it outlined earlier this year to return as much as $60 billion to shareholders in the form of dividends and repurchases over the next three years.
Yes, if the Senate tax bill becomes law, Citigroup will lose a lot of money, but only on paper.