Make losses and prosper, AIG edition | FT Alphaville

Make losses and prosper, AIG edition

Dear American International Group, can’t you do anything in a small way? The gigantic numbers make our heads bleed and ruin any sense of scale we once had.

A $182bn bailout, $467bn net notional of super senior credit default swaps written, and now, in AIG’s fourth quarter results, $17.7bn of $19.8bn of fourth quarter net income is down to… a “release of valuation reserves”?

It’s a huge one-time accounting gain.

AIG’s announcement of a 82 per cents per share operating profit beat the consensus of 63 cents. Uncle Sam, a 77 per cent owner of the insurer, should be well pleased. Or should he?

To understand what this valuation reserve is, think first about the massive losses AIG made over the crisis. When a company is loss-making, it can’t pay tax. Obvious enough. But it also gets to store up the losses to lower its tax bill in the future. The fact that the company will pay less tax in the future is placed on the company’s balance sheet as a “deferred tax asset” (DTA).

In the case of European banks, they even get to list their DTAs as core tier one capital. Well, that’s better than a kick in the nuts for a bank making losses, isn’t it?

Have you noted the issue yet? It’s that the company has to become profitable again in order to realise the value of the asset. Once the company, or bank, is making a profit, they start receiving tax bills again, and then they get to send the bill back saying, “taxes? Me? Oh no, Sir! Here are my loss carryforwards, go away, we don’t pay you this year.”

Or, as Reuters put it concerning AIG:

The move [of reversing the valuation reserve], which sent the company’s shares up by about 6 percent, essentially means AIG will not pay tax on tens of billions of dollars in income in the coming years, thanks to benefits that stem from its financial crisis-era losses.

But, if AIG isn’t going to pay taxes for years, why’d it get such a big boost in one quarter?

Well, for a while there, the accountants weren’t sure that AIG was going to get financially better anytime soon, even with the intravenous cash injections from Uncle Sam. And were the company to get better, say over a quarter without any environmental catastrophes, then it might not be able to turn a sustainable profit.

As such, the losses that would lower the tax bills had a valuation reserve booked against them. This is not unlike having to put money aside for loans that are highly likely to default, or booking impairments on sovereign bond holdings.

Good news in the fourth quarter though! The bean counters think it’s now “more likely than not” that AIG will actually be able to turn a profit in the future and that it will sustainably be able to do so, meaning that the DTAs can indeed be used to lower the tax bill. The massive insurance company that was bailed out by taxpayers is going to pay less taxes!!! Woo-hoo!!!

We asked one taxpayer how she felt about that:

Geez! What’s with all the drama?

Ok, we might have told her that the valuation allowance still has $11bn in it as of the end of 2011, according to the 10-K (page 395). So, AIG could do more of this in the next quarter.

And another thing, “accumulated tax attributes”, aka the remnants of the trail of destruction, are so valuable to AIG, that they had to implement a plan to make sure that they are preserved. The Internal Revenue Code dictates that the “attributes” can be taken away if there are certain ownership changes in the company. The motivation of this part of the code is to prevent the abusive practice of buying out loss making companies purely for their tax attributes, rather than running them as a going concern.

What about the holding by the Treasury? Won’t that present a problem, leading to the disallowance of the DTAs? From the FAQs about the plan:

9. Doesn’t the United States Department of the Treasury already own more than 50 percent of AIG common stock?

Yes. Under guidance issued by the IRS, AIG is not treated as having experienced an ownership change as a result of such ownership.

Let us harness our inner five-year old as we ask, “but why?”

Answer, “CAUSE WE SAY SO!”

Now the question is, given that AIG’s stock should, in theory, price in the tax savings, can the Treasury back out of its holdings in such a way as to harness the gain?

Frankly, we would have preferred the taxes…

Related links:
AIG Profit Surges on Tax Benefit – WSJ
Bailed Out AIG Posts Huge “Beat” On Tax Gimmick, Will Avoid Paying Taxes For Years – Zero Hedge
Want to boost tier one capital? Make losses and prosper – FT Alphaville