Wall Street, amid Record Gains, A Major Beneficiary under Trump Tax Code (Jan. 17)

Update 242 — Wall Street, amid Record Gains,  A Major Beneficiary under Trump Tax Code
The nation’s largest banks are turning out record profits in the Dodd-Frank era.  The last several years have seen big banks make substantial gains; all indications are that 2018 will be no exception to this trend.   With passage of the Republican tax bill in December, good times are about to become great across the financial sector.

A slashed corporate tax rate, the repatriation of foreign corporate earnings, boosts in stock buybacks, and an uptick in mergers and acquisitions all are likely to cut big firm tax bills by billions. Details below.

Best,

Dana

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Initial Profit Hit

Big banks will certainly see a hit to fourth quarter profits as they move to comply with the new tax law. Accounting rules stipulate that because tax reform was signed into law in the fourth quarter, companies must reflect the law’s impact for that same period.  There will be large upfront charges for many banks as they write down their deferred tax assets and account for the one-time repatriation tax on foreign earnings.  In total, the fourth quarter revenue generated from the nation’s five largest banks will be around $31 billion, with Citigroup contributing a whopping $20 billion to this total.

Long-Term Gains

Don’t expect investors to be overly alarmed by such a substantial hit to fourth quarter earnings. Bank CEO’s were some of the tax reform’s most vocal cheerleaders, and for good reason.  For big banks, short-term nuisances will be more than offset by their long-term gains.

  • Less Direct Taxation — Banks will most directly benefit from reduced corporate tax rates. Before tax reform, the financial sector paid a relatively high effective tax rate of 27.5 percent compared to other sectors of the economy. This means that reducing the corporate tax rate from 35 percent to 21 percent will have an outsized benefit for large banks — so much so that banks will likely be able to make back the losses from accelerated tax asset write downs within a couple of years. Over the long term, expect U.S. banks to see an average 13 percent increase in earnings per share values from the lower rate, despite losing the ability to deduct fees paid to the FDIC.

            SOURCE: Americans for Financial Reform, Penn-Wharton Budget Model

  • More Cash, More Buybacks — Banks will also stand to benefit from the tax bill’s effect on the stock market. Even before the bill was passed into law the stock market priced in a five percent boost since mid-November, and analysts predict that a reduced corporate tax rate will boost the S&P 500 by 9.1 percent. The biggest wall street firms will see their taxes immediately cut by a third.

A portion of this gain will come from the reduced taxes on repatriation and the shift to a territorial system of international taxation.  U.S. firms are sitting on more than two trillion dollars of offshore profits which they stashed abroad to avoid paying high corporate taxes. Now that they can repatriate at rates between 8 and 15.5 percent, analysts expect upward of $1.2 trillion to pour into the balance sheets of S&P 500 companies.

The administration touted the move to territoriality as necessary to spur private investments in infrastructure and jobs, but most analysts expect the bulk of this money to flow towards stock buybacks and executive pay.  Bank of America expects $450 billion of repatriated profits to flow to shareholders and (indirectly) the financial sector through buybacks.

Smaller Institutions — Gains and Gripes

Big, name-brand banks aren’t the only ones excited about the Tax Cuts and Jobs Act, smaller advisory-focused investment banks will also receive substantial profits.  Companies like Evercore, an investment banking firm with $1.4 billion in total revenue, would benefit greatly.

CEO Ralph Schlosstein predicted the tax bill would increase his firm’s profits by about $35 million. Last quarter, Evercore enjoyed revenue totaling $407 million and more than $46 million in profits.

  • Asset Managers — Franklin Resources (with $7 billion in assets) and Federated Investors (with $980 million in assets) previously paid higher effective rates than other financial actors because they could claim fewer deductions. While equity markets are at record highs already, dividends and stock buybacks will increase the value of these investments even further.
  • Private Equity —  Some analysts expect private equity firms to use their tax windfall to fund more merger and acquisitions activity. However, to the extent that debt is used to fund such acquisitions, limiting interest deductions to 30 percent of earnings could increase the cost of acquisitions and decrease the amount and size of these types of deals.

Macro. Lens:  Good Growth vs. Bad Growth

Soaring profits in the financial sector will only exacerbate the country’s already massive wealth inequality.  Wealthy Americans own the vast majority of stocks.  This means that as banks reinvest in dividends and stock buybacks to increase the value of their assets, more and more wealth will be concentrated in the top deciles of the income distribution.

The bottom 60 to 80 percent of Americans do not invest nearly as much.  High household debt and decades of stagnant wages leave little disposable income for the stock market.  What little growth is generated by the Tax Cuts and Jobs Act will largely accrue to the top income earners and the already wealthy.  The GOP is chasing bad growth with tax “reform” — the kind that will enrich, e.g., the President’s wealthy friends and leave the most vulnerable Americans behind.

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