U.S. President Barack Obama plans to implement a tax on financial institutions to offset taxpayer losses stemming from the Troubled Asset Relief Program (TARP) and help reduce the deficit. But Obama's new bank tax is no reason to turn bearish on financials, which staged an impressive comeback last year.
At a time when many financial companies are gearing up to announce fourth-quarter and full-year earnings, as well as details regarding employee compensation and bonus payments for 2009, the government is considering charging banks fees to recover as much as $120 billion in lost taxpayer money.
While most of the big banks have started paying back their TARP investments, the government has yet to recoup large swathes of money that went to American International Group Inc. (NYSE: AIG), General Motors Corp., and Chrysler LLC. Last month, the Treasury estimated that the net cost of TARP to taxpayers would be $41.4 billion.
However, a person familiar with the matter told The Wall Street Journal that it's unlikely the new tax will apply to auto companies or AIG, all of which are still struggling. Taxing these companies would make little sense, anyway, because the government owns such large stakes in each company that it would, in effect, be taxing itself.
The details of the new tax will be contained in the fiscal 2011 budget that the president will submit to Congress next month. What banks will be charged, how much those banks will have to pay, and when will they be required to pay are all questions that have so far been left unanswered.
One option under consideration involves placing a fee on a bank's liabilities, a number that theoretically represents the amount of risk a bank takes on, officials familiar with the matter told The Journal. An income surtax or an excise tax would also be options.
The fee would likely be designed to avoid hitting certain segments of the financial industry that are still struggling, these officials said. There's also a concern that any additional costs to the banks will be passed on to the consumer – something else the government would like to avoid.
"In our industry, costs are typically passed along to institutions and individual investors, so the burden will likely fall on them," said Timothy Ryan, president of the Securities Industry and Financial Markets Association, told The Journal.
There's also the possibility that banks will sidestep the tax entirely, or find a loophole.
"Any new tax is always more complicated than the designers anticipated," Ed Kleinbard, the former staff director of Congress' non-partisan Joint Committee on Taxation who is now a law professor at the University of Southern California, told Bloomberg. "When the numbers involved are this large, it's very difficult to design on the fly."
Kleinbard pointed out that Britain and France are already struggling to enforce their respective "super-taxes," which amount to 50% of any discretionary bonuses greater than $40,000 (25,000 pounds or 27,000 euros).
"There's always a substantial risk of unintended consequences and the risk of simple ineffectiveness," Kleinbard said.
Bank Stocks Bouncing Back
Meanwhile, banks that were beaten down by the financial crisis have seen their earnings bounce back in a big way, and they could be poised to collect another round of strong earnings in the coming year.
Analysts say earnings at financial companies rose 120% in the fourth quarter, accounting for all of the income increase in the Standard & Poor's 500 Index, according to a report by Bloomberg News. According to the report, analysts are more bullish on financials than any other sector, with earnings expected to triple by 2011 to $19.51.
If those forecasts prove correct, financial companies are trading at a 15% discount to the broader S&P 500. The S&P 500 Financials Index is still down 60% since peaking in February 2007 – more than twice the decline suffered by the benchmark index, which is down 27% from its October 2007 record.
"You have to understand that banks and financial services companies plummeted so much during the 2007-2009 collapse that the 143% advance made by the big-caps in the group last year still left them 60% below their February 2007 highs," Money Morning Contributing Writer Jon D. Markman said in a recent column.
How inexpensive are they?
"The median bank trades for just 1.1 times book value, vs. 2.2 times for the broad market," Markman said. "That means the average financial institution could double just to get to the average value of all their peers. Normally you would be happy to find a group that is just 50% cheaper than the market."
According to Markman, surviving regional banks like Fifth Third Bancorp (Nasdaq: FITB) have leveled off in the past six months after massive initial recoveries from the 2008 credit disaster, and now look poised for a new leg higher.
"This would really shock most investors, who consider the regional banks largely bankrupt due to large portfolios of non-performing loans," he said "It is something that can happen because most people believe that it can't happen."
Jennifer Thompson whose ratings for New York-based research firm Portales Partners LLC returned 31% in the past two years, eight times the gain for all the companies she follows, also likes Fifth Third Bancorp and thinks that PNC is poised to rally as well.
Credit Suisse noted that Bank of America is the "cheapest of our large cap banks" and is trading at 6.1 times normalized earnings versus the 7.6 times that its peer group trades at. Moreover, the analysts noted that the recent full repayment of the government's $45 billion in bailout funding "relieves a significant overhang on the shares" and has positive near-term financial implications by contributing to both earnings per share and book value.
Credit Suisse analysts continue to be skeptical about the bank industry, however, as Congressional reforms and a potential calamity brewing in commercial real estate pose a significant downside risk.
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