Ambac's deferred tax assets could punish the firm

By Dan Wilchins - Analysis

NEW YORK (Reuters) - Ambac Financial Group Inc's (ABK.N: Quote, Profile, Research, Stock Buzz) net worth is shrinking as it writes down bad assets linked to subprime mortgages, but another potential problem elsewhere on its balance sheet could also eat into the company's value.

The issue of Ambac's net worth is important, both because it has already dipped below the minimum net worth required to maintain a $400 million credit line and because too low a net worth will make it harder to raise additional capital.

Ambac said last week its shareholder equity, an accounting measure of net worth, shrank about 40 percent in the first quarter. The company now has about $1.3 billion of shareholder equity and writing down insurance on risky securities such as subprime mortgage bonds could further reduce Ambac's net worth.

But the company could also see shareholders' equity hit by a $3.57 billion deferred tax asset -- which can be seen as a type of prepaid tax -- that currently sits on the company's balance sheet.

Ambac must generate enough taxable income in future years to take advantage of its deferred tax asset, or else it could be forced to essentially write that asset down.

Those write-downs -- which show up on the balance sheet as valuation adjustments -- could conceivably be big enough to leave Ambac with a negative net worth, at least on an accounting basis.

"The question with deferred tax assets in general is, if the company will not be highly profitable in the future, how will they generate the taxable income to take advantage of the asset?" said Theodore Sougiannis, a professor of accounting at University of Illinois at Urbana-Champaign who has worked on deferred tax assets.

That proved to be a problem for General Motors Corp (GM.N: Quote, Profile, Research, Stock Buzz) in November, when it recorded a $39 billion loss driven largely by a deferred tax asset valuation adjustment, leaving it with a negative net worth.