deferred taxes and corporate tax reform

I wrote a couple of posts several years ago explaining in some detail what deferred taxes are.  The short version: when a company makes a gigantic loss, the loss itself has an economic value.  That’s because the firm can almost always use it to shield future earnings from income tax.

 

The IRS and the Financial Accounting Standards Board have different ways of accounting for deferred taxes.  For the IRS, they only appear on a return when the company has sufficient otherwise taxable income to use them.  At the other extreme, financial accounting rules allow the company to recognize the entire value of these potential savings immediately.  That’s even though the actual use of tax losses may be far in the future.

An example:

A company has pre-tax income of $1,000,000 from ordinary operations.  It also closes down a subsidiary, incurring a pre-tax loss of $11,000,000.  For IRS purposes, the firm has a total pre-tax loss of $10,000,000.  Ignoring the possibility of carrybacks (recovery of previous years’ tax payments because of the current loss), the company has no taxable income.  It also has a loss in the current year of $10,000,000, which it can potentially use to shield future income from taxes.

Financial accounting presents a much rosier picture.  The pre-tax loss of $10,000,000 is the same.  But financial accounting allows the company to recognize the possibility of future tax recovery right away, as a reduction of the current loss.

The financial accounting income statement reads like this:

pre-tax loss        ($10,000,000)

deferred taxes    +$3,500,000

net loss                 ($6,500,000).

The $3.5 million is carried as a deferred tax asset on the balance sheet until used.

Auditors are supposed to certify that it’s actually possible for the company to generate enough future income to use up the tax losses during the limited period of years tax law allows.  I can’t think of a company where auditors have held a firm’s feet to the fire on this point, though.

Where does the  tax bill come in?  The tax rate assumed in writeoffs up until now is 35%.  However, from now on, the top tax rate in the US is going to be 21%.  Therefore, deferred tax assets now being held on corporate balance sheets are only worth 21/35ths (about 57%) of their current carrying value.  Because they’re clearly, and significantly,  overvalued, they must be written down.

This may well throw algorithmic value investors for a loop, since the writeoff of deferred taxes will be reductions to book value.

What sector does this change affect the most?

Major banks.

Banks took major writeoffs in 2008-09 because of speculative trading and lending losses piled up after the Glass Steagall Act was repealed in the late 1990s. These losses were gigantic enough to require a huge government bailout of the industry in 2009.

Note:  Glass-Steagall was passed in the 1930s to prevent a recurrence of the financial meltdown that triggered the Great Depression.  Banks claimed in the 1990s that they were too mature to do anything like this again.  In this instance, it took over a half-century for Washington to forget why the law was in place.  However–and oddly–Washington already appears eager to to dismantle Dodd-Frank.

 

 

why are higher interest rates good for banks?

There are two factors involved:

behavior of bank managements:  To a considerable degree, commercial banks are able to use changes in interest rates to their money-making advantage.  When rates are declining, banks immediately lower the interest they pay for deposits but they keep the rates they charge to borrowers high for as long as they can.

When rates are rising, as is the case in the current economic environment, banks do the opposite.  To the degree they can, and given that most loans are variable-rate that is considerable, they raise rates to borrowers immediately.  But they keep the interest rate they pay for deposits low for as long as they can.

A generation ago, banks had a much greater ability  than they do now to maneuver the interest rate spread.  That’s because money market funds were in their infancy.  There were no junk bonds to serve as substitutes for commercial loans.  There was even a Federal Reserve rule, Regulation Q, that prevented banks from paying interest on checking accounts and put a (low) cap on what they could pay to holders of savings accounts.

Nevertheless, especially as rates are rising, spreads still can widen a lot.

economic circumstances:   bank lending business tends to tail off in recession, since most companies don’t want to take the risk of increasing their debt burden during bad times–even if the potential rewards seem enticing.  The credit quality of existing loans also worsens as demand for capital and consumer goods flags.

The opposite happens during recovery.  The quality of the loan book improves and customers begin to take on new loans.

stock market effects

The market tends to begin to favor banks as soon as it senses that interest rates are about to rise.  Wall Street was helped along this time around when perma-bear bank analyst Mike Mayo turned positive on the group for the first time in ages last summer.

After the anticipatory move, banks have a second leg up when the extent of their actual earnings gains becomes clear.  It seems to me the first move has already come to an end   …but the second is still ahead of us.

Trump and the big banks

banks and their social function

Banks aren’t ordinary corporations.  In addition to being private, for-profit organizations, they also carry out important social economic functions.  They’re the primary instrument the government uses to carry out national money policy.  Through letters of credit, they also underpin the workings of the international trade of multinational firms that is increasingly important for economic growth.

This is why the major banks are considered “too big to fail.”

bank failures

US banks have been on the brink of failure twice during the past hundred years–in the late 1920s and in 2007-09.  Both times this has been the result of rampant speculative financial market activity coupled with reckless lending, both driven by the search for earnings per share growth.

Glass-Steagall, and its repeal

In the 1930s, Washington enacted legislation, including the Glass-Steagall Act that barred the banks from non-banking activities (like brokerage, proprietary trading and investment banking).  The new laws ushered in a period of relative stability for the banks that lasted until the late 1990s, when their intense lobbying succeeded in getting Glass-Steagall repealed.

(An aside:  yes, the banks manufactured periodic crises through imprudent lending to emerging economies–the Walter Wriston-led binge of the 1970s being a prime example–but these were relatively tame in comparison.)

Less than ten years later, many big banks were broke.  World trade had come to a standstill as manufacturers refused to accept banks’ guarantees that shipped merchandise would be paid for (the worry was that the guaranteeing bank would file for bankruptcy while the goods were en route, reducing the shipper to being an unsecured creditor).  The deepest peacetime period of world economic decline since the Great Depression began.

This, in turn, spawned Dodd-Frank, the 21st century equivalent of Glass-Steagall.

repeal again?   so soon?

While it took more than half a century for the memory of the Depression to fade enough for Congress to consider removing restrictions on bank activity, we’re now less than a decade away from the 2007-09 collapse.

Despite this, despite campaigning on an anti-establishment platform, and despite warning that Hillary Clinton should not be elected because she would be a creature of the big banks, during his first few days in office Donald Trump is proposing to restore to the big banks the tools of self-destruction they have wielded to devastating effect twice before.

How odd.

 

refinancing/repricing bank loans

One way that an investment bank can win merger and acquisition business is to offer financing to bidders through what are called bank loans.  These are essentially long-term corporate bonds that carry high variable-rate coupons based on libor.   The successful bidding company issues them to the bank to pay for an acquisition.  The bank resells the loans to institutional investors.

There has been strong interest in such loans over the past couple of years for two reasons:  yielding, say libor +4%, they offer high current yields; and, at least in theory, there’s the possibility of rising income as libor increases.  Some of these bonds have the further fillip that the variable (libor) portion can’t go below a fixed amount, say 1%, no matter what the actual libor rate is.

Three-month libor is now approaching 1%, up from as low as 0.2% in 2015.  This benchmark rate is certainly heading higher.

Fro the perspective of holders, one flaw with these bank loans, however, is that they offer little call protection.  What’s now happening on a massive scale is that banks are approaching institutional customers who bought high-yielding bank loans and offering to replace a loan yielding, say,  libor +4% with an equivalent loan from the same borrower yielding libor +3%.

Customers are taking up such deals in droves.  How so?  Technicially, the original loan instruments are being called, meaning the issuer is exercising its right to pay the loans off at par.  The customer can either get his money back in cash–and therefore be forced to find a new place to invest the funds–or accept payment in a new, less lucrative, loan.

The customer has two incentives to take the latter:  the new terms are still attractive; and the borrower will have developed deeper confidence in the issuer through continuing study of company operations and a history of on-time coupon payments.

 

The real winners here are the banks, who collect another round of fees for providing this service. In all likelihood, this won’t be the last round of repricing, either.

 

US corporate tax reform (iii)

For years ago I wrote in detail about today’s topic, which is deferred taxes.

The basics:

–deferred taxes are an accounting device that reconciles the cheery face a company typically present to shareholders with the more down-at-the-heels look it gives the IRS, while accurately reporting to both parties the cash taxes paid

–look at the cash flow statement, which, as the name implies, shows the cash moving in and out of the company or in the income tax footnote to get the particulars for a firm you may be interested in.

accounting for a loss

The issue I’m concerned about in this post is what happens when a company makes a loss.

reporting to the IRS

The income statement  for the IRS looks like this:

pre-tax income (loss)      ($100)

income tax due                          0

after-tax income (loss)     ($100).

reporting to shareholders

Financial accounting books, in contrast, look like this:

pre-tax income (loss)         ($100)

deferred tax, at 35%                 $35

after-tax income (loss)        ($65).

what’s going on

The financial accounting idea, other than to cosmetically soften the blow of a loss, is that at some future date the company in question will again be making money.  If so, it will be able to use the loss being incurred now to offset otherwise taxable future income.  Financial accounting rules allow the company to take the future benefit today.

It’s important to note, however, that the deferred tax is an estimate of future tax relief, based on today’s tax rates.

why does this matter?

Profits add to shareholders’ equity; losses subtract from it.  Under the GAAP accounting used for reports to stockholders, a loss-making company only has to write down its shareholders’ equity (aka net worth, book value) by about two-thirds of the actual loss.  To the casual observer, and to the value investor using computer screening, it looks stronger than it probably should.

Financial stocks typically trade on price/book.  This is also the sector that took devastatingly large losses during the financial crisis (that they caused, I might add).

Suppose the corporate tax rate is reduced to 15%.

This diminishes the value of any tax loss carryforwards a firm may have.  It also may require a substantial writedown of book value, making that figure more accurate.  But the writedown may also underline that the stock isn’t as cheap as it appears.

 

ZipCap

ZipCap, short for Zip Code Capital, is a San Diego-based startup alternative lender featured in the Business section of today’s New York Times.  It provides low-cost loans to local businesses that aren’t able to get credit from traditional banks–presumably either because they’re not (or not very) profitable or because they don’t have a good enough financial handle on their enterprise to know whether they make money or not.

ZipCap helps a client business form an “Inner Circle” of customers who pledge to buy a minimum amount of stuff from the client over a specified period.  ZipCap lends against that commitment.  In the case of the restaurant/coffee house featured in the NYT article, 130 entities pledged to spend $475 each ($61,750 in total) over the following year.  That got Beezy’s Cafe a $10,000 loan at 3.99%.

If all of this were new spending, my back-of-the-envelope guess is that it would bring in $40,000 or so in fresh operating income, far in excess of what would be needed to repay the debt.  For Beezy’s to be better off simply from forming the Inner Circle, a quarter of the pledges would have to be new spending, or about $2.50 a week per Inner Circle member.  That figure would need to be adjusted up if not everyone keeps his word.

 

It seems to me, from the limited data in the NYT and on the ZipCap website, that ZipCap isn’t really about lending.

It’s not a social service, either.  Chances are that Beezy’s would be better off getting, say, business students from a local college to create financial tracking to help figure out what makes money for the cafe and what doesn’t.

What ZipCap does do, I think, is provide a socially acceptable, non-toxic way for a struggling business to proclaim that, though it might appear to be thriving, it isn’t   …and, at least implicitly, that it won’t be around for long unless it gets more community support.

Of course, there may be unintended consequences of the Inner Circle creation.   Assuming the extra spending doesn’t come out of thin air, IC creation at Cafe A may force Cafe B to close its doors.  Or it may make it extra hard for a new Cafe C to get started.

It will also be interesting to see how ZipCap deals with rising interest rates, as and when they occur.

 

cooling the Chinese stock market fever

In the 1990s, Alan Greenspan, the head of the Fed back then, famously warned against “irrational exuberance” in the US stock market, but did nothing to stop it   …this even though he had the ability to cool the market down by tightening the rules on margin lending.  This is the stock market  analogue to raising or lowering the Fed Funds rate to influence the price of credit, but has never been used seriously in the US during my working life.

The  Bank of Japan has no such compunctions.  It has been very willing to chasten/encourage speculatively minded retail investors by tightening/loosening the criteria for borrowing money to buy stocks.

 

We have no real history to generalize from in the case of China.  But moves in recent weeks by the Chinese securities markets regulator seem to indicate that Beijing will fall into the stomp-on-the-brakes camp.

Specifically,

–at the end of last month, the regulator allowed (ordered?) domestic mutual funds to invest in shares in Hong Kong, where mainland-listed firms’ shares are trading at hefty discounts to their prices in Shanghai

–highly leveraged “umbrella trusts” cooked up by Chinese banks to circumvent margin eligibility requirements have been banned,

–a new futures product, based on small and mid-cap stocks, has been created, offering speculators the opportunity to short this highly heated sector for the first time, and

–effective today, institutional investors in China are being allowed to lend out their holdings–providing short-sellers with the wherewithal to ply their trade (although legal, short-selling hasn’t been a big feature of domestic Chinese markets until now, because there wasn’t any easy way to obtain share to sell short).

What does all this mean?

The simplest conclusion is that Beijing wants to pop what it sees as a speculative stock market bubble on the mainland.  It is possible, however, that more monetary stimulus–to prop up rickety state-owned enterprises or loony regional government-sponsored real estate projects–is in the pipeline and Beijing simply wants to dampen the potential future effects on stocks.

I have no idea which view is correct.

It’s clear, however, that Hong Kong is going to be a port in any storm, and that it is going to be increasingly used as a safety valve to absorb upward market pressure from the mainland.  So relative gains vs. Shanghai seem assured.  Whether that means absolute gains remains to be seen, although I personally have no inclination to trim my HK holdings.