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Citigroup (NYSE:C) has been losing tens of billions of dollars over the past two years as the financial crisis has unfolded. If one considers the government capital that Citi has not paid back, the bank is clearly the weakest of the four largest legacy banking behemoths in the U.S. Earnings results this year demonstrate that its raw earnings power is no match for the likes of JPMorgan Chase (NYSE:JPM) or Wells Fargo (NYSE:WFC). Moreover, its capital base has been impaired, causing the bank to have to sell assets, reducing its earnings power further still.

Unless something miraculous happens over the next few years, Citigroup is not going back to the glory days of $20 billion yearly net income. That’s why its mountainous $38 billion deferred tax asset is a problem.

Reuters explains:

Citigroup has a roughly $38 billion deferred tax asset, which essentially represents expected cash flow from future tax benefits. Accounting expert Robert Willens said on a conference call late last month that he expects the bank to write the asset down by about $10 billion in the fourth quarter. That would represent about 7 percent of the bank’s net worth as measured by the reported value of the company’s shareholder equity.

What is going on here is a result of the fact that companies keep two sets of books – one for the taxman and one for public statements. On the tax books, they pay more taxes upfront than we see in its public accounts (I know it sounds dodgy but I am sure a tax accountant can explain). By deferring the tax liability, companies reduce the net present value of the tax charges. Everybody wins except the taxman, right?

Well, not exactly. If Citigroup cannot make enough taxable income in future periods to cover these deferred tax assets, they are going to have to take a charge and write down the asset immediately. That is what Robert Willens is pointing to. If he is right, Citigroup would have $10 billion less capital as soon as Jan.1, 2010. And given they are perhaps the least well-capitalized of the 'stress test 19' - except GMAC - that’s a problem. It would certainly constrain their lending capacity.

But, of course, Citi officials have already come out to put any fears to rest.

"We are comfortable with the valuation," Kelly said, adding that the bank looks at its deferred tax asset at the end of each quarter. About $16 billion of the deferred tax asset must be realized by around 2016, and the rest has a much longer time frame, Kelly added.

Whew. For a second there, I was starting to think Citi needed another bailout.

By the way, Bank of America (NYSE:BAC) has a similar problem. They have a huge net operating loss (NOL) carry-forward from their acquisitions of Merrill Lynch and Countrywide Financial. If BofA cannot make enough taxable income to use all of their NOLs which are now assets on their balance sheet, they too will have to take a ‘valuation allowance’ a.k.a a hit to earnings. The deferred tax assets at BofA (incl. NOLs) was $19.6 billion according to their 3Q 10-Q filing. See the note below (Click to enlarge).

bofa 2009-3q-net-deferred-tax

As you would suspect,

The Corporation has concluded that no valuation allowance is required.

Source: Bank of America SEC filings – BofA website

Author's disclosure: None

Source: What About Citigroup and BofA's Billions in Deferred Tax Assets?