GOP Tax Proposal Expected to Benefit Wall Street Firms
A lower corporate tax rate as called for in the tax framework unveiled by the Trump administration Wednesday should immediately boost banks’ own profits. Bankers expect some pain points, but are confident the benefits will outweigh them.
Morgan Stanley Chief Executive James Gorman said at an industry conference in June that a 25% corporate tax rate would lift his bank’s earnings by 15%, assuming no changes to the business mix. The Trump framework calls for a 20% rate, so the benefit could be even greater.
Citigroup Inc. has said that a cut to a 25% rate plus a tax holiday on foreign earnings would have boosted its annual net income by $800 million, or by about 5%. It would also improve the bank’s return on equity by more than 1 percentage point, estimated John McDonald, an analyst at Sanford Bernstein.
Any fillip in economic growth could potentially help reverse a decline in business-loan growth experienced since late last year. Some bank executives have attributed this slowdown to clients waiting for a tax overhaul to be finalized before ramping up borrowing and investing in their businesses. A lack of clarity has also been cited as a slowing factor for deal-making on companies’ part.
Smaller banks could also reap bigger gains since they have relatively high effective tax rates and businesses that are almost purely domestic, Evercore ISI analysts said in a note. A potential tax cut from 35% to 28% could boost 2018 earnings for regional banks by a median 9%, they said.
The Trump proposals also spare an important business for banks and other lenders: mortgages. The administration’s document calls on Congress to retain the deduction for mortgage interest. A change to that could have disrupted housing markets.While the framework would leave unchanged certain taxes on investments, including those on capital gains and dividends, the money management industry stands to benefit.
If a lower corporate tax rate lifts profits at many U.S. companies, this should add fuel to the stock-market rally and goose returns on equity funds. Smaller and midsize companies should make out particularly well since they tend to pay a higher-tax rate than larger peers, said Joseph Amato, president of $271 billion asset manager Neuberger Berman Group LLC.
Some money managers such as WisdomTree Investments Inc. would also benefit directly. Last quarter, it reported a 45.5% tax rate largely due to overseas losses it couldn’t deduct. Executives have said a lower rate would benefit that, as well as help support the company’s dividend.
Not that there won’t be some downsides.
Among them: A number of banks have what are called “deferred tax assets.” These are created by losses, in many cases huge ones racked up during the financial crisis, and act as IOUs that can be used to offset future tax bills. Those will lose value.
Citigroup Inc., for example, had $46 billion of the assets at the end of the second quarter. A reduction in the corporate tax rate to 20%, plus a shift to a territorial regime that only taxed income generated in the U.S., could reduce the assets’ value by more than $15 billion, according to figures the bank has provided. Citigroup would have to take that charge as a one-time hit to profits.
Bank of America had $19.2 billion in net deferred tax assets at the end of 2016. Only about $7 billion of these apply to the U.S. and so would be subject to revaluation. That would lead to a write-down of around $3 billion if the tax rate was lowered to 20%.
The benefit of lower rates, though, would likely make up for that within a year or so through higher profits, a person familiar with the matter said.
Another issue is a proposal to partially limit companies’ ability to deduct net interest expense. The administration didn’t define what partially limited meant.
That is important. Bank executives have said that they hope this will mean that financial institutions are exempted. If not, their business model would be under threat.
Financial firms borrow huge amounts of money to lend out and invest. In that sense, money is their raw material. If banks couldn’t deduct the interest expense, which is akin to nonfinancial companies’ cost of goods sold, that would create a huge tax hit.
For bank clients, limiting the deductibility of net interest expense could make debt issuance less attractive. That, in turn, could crimp the business of helping companies raise and sell bonds and loans.
So-called debt-capital-markets businesses accounted for $10.4 billion in revenue at the dozen biggest global banks in the first half of 2017, or 13% of their total investment-banking and trading revenue, according to industry data tracker Coalition.
That figure grew 18% from a year earlier. And it was the only investment-banking business to have done better in 2016 than it did in 2015.
“Changing the deductibility of interest will have a profound impact on the foundations of corporate finance,” said Reuben Daniels, managing partner at EA Markets LLC, which advises companies on capital raising.
For the private-equity industry, which relies heavily on debt financing, that change could translate into firms paying lower prices for assets.
That corporate interest is deductible but dividend payments aren’t has skewed how companies fund their operations, creating a bias toward debt. In the 1980s, it enabled the rise of leveraged buyouts in which financiers borrowed heavily to buy companies, then wrote off the interest payments.
More recently, it has underpinned stock buybacks. Apple Inc., for example, has borrowed nearly $100 billion in recent years, much of it to repurchase shares. Just this week, investment bank Greenhill & Co. said it would borrow $300 million to buy back stock whose dividend payouts had become a burden.
What’s more, many American companies borrow in the U.S. to avoid having to repatriate overseas cash, which would be taxable.
Putting equity and debt on more equal footing—especially if coupled with changes that allowed companies to bring home overseas cash at no or lower taxes—would likely decrease debt-underwriting levels.
But banks might make that back in higher stock issuance, where fees are fatter. They could also find work helping companies adjust to the changes through, say, issuing preferred equity to replace debt, EA’s Mr. Daniels said.
And debt issuance wouldn’t disappear if the interest-expense deduction is curtailed. Companies will still need to finance themselves.