The Wall Street Journal reports that Exxon-Mobil’s recent $31 billion purchase of natural gas exploration firm XTO Energy confirms a recovery of merger and acquisition activity over the past 2 months. It reports that November and December had the most M&A activity since the summer of 2008, with values 4 times greater than a year ago. Also leading this charge were Warren Buffet’s largest ever $26 billion investment in the railroad industry, and the $4.6 billion merger of Stanley Works and Black & Decker. November alone saw the announcement of 41 U.S. deals worth a combined total of approximately $47.5 billion, benefiting mostly large Wall Street banks and boutique financial firms. Sources within the chemical industry also expect a 2010 rally in the number of deals.

Many experts believe these increases in M&A activity signal good news for the health of the broader economy in 2010. Indeed, the recent surge seems to be the result of increased access to capital markets, the stagnation of which has been cited repeatedly as the cause of the continued lagging of a broader recovery. Accompanying these positive indicators are the apparent stabilizing of economies world-wide, financing becoming more available in the broader spectrum, and the narrowing of the gap in price expectations between buyers and sellers. Consistently, a large regional bank representative recently said at a lunch meeting that their bankers have been directed to increase lending dramatically in 2010 as underwriters loosen standards for loan approval.

Until recently, any positive indicators of recovery always have seemed to accompany at least as many negative ones. As 2009 ends, however, the negative indicators appear to be waning strongly in favor of the positive. Also, while many experts claim, perhaps too definitively, that this recession is over, others hinge their disagreement mostly on lagging unemployment data. Yet unemployment typically is the last area to improve after a recession as companies tend to wait until they clearly are understaffed before resuming hiring. Moreover, early 2010 should provide great opportunities for companies to contact their previously obstinate bankers again to seek (or refinance) lines of credit and other financing.

On October 1st, the Internal Revenue Service amended Section 382 of the Internal Revenue Code to facilitate bank mergers and acquisitions.  IRS Notice 2008-83 reads:

“For purposes of Code Sec. 382(h), any deduction properly allowed after an ownership change of a corporation that is a bank with respect to losses on loans or bad debts, including any deduction for a reasonable addition to a reserve for bad debts, shall not be treated as a built-in loss or a deduction attributable to periods before the change date. This guidance does not affect the application of any provision of the IRC except Code Sec. 382. Banks may rely on this guidance until further guidance is issued.”

The effect?  Two days later, Wells Fargo swooped in to buy Wachovia for $15 Billion Dollars.  Citibank had previously been offering a mere $2 Billion and had depended on the FDIC to backstop potential losses. 

Under United States tax law, Section 382 limits the scope to which operating and “built-in” tax losses can be used to offset an acquirer’s income after an ownership change.  Prior to October 1, only a small portion of a bank’s losses from distressed loans were available to offset income in future tax years. 

IRS Notice 2008-83 substantively change’s the effect of Section 382.  Now, Section 382 is does not apply if loan losses are recognized for tax purpose after an ownership change.  In effect, a bank may acquire a target, write-down the fair value of the loan portfolio, and apply the losses against its future income. In this case, Wells Fargo was able to write-down $74 Billion dollars in losses arising from Wachovia’s plagued loan portfolio. According to the Associated Press, this loss generated $19.4 Billion dollars in tax savings for Wells Fargo.  In effect, Wells Fargo was paid $4 Billion dollars to buy Wachovia.

This example illustrates a clear lesson to banks:  Sec. 382 can have powerful rewards for local financial institutions contemplating a merger or acquisition.