S Corporation Community Banks Warrant Better Treatment from the U.S. Treasury
June 4, 2009
It was good the hear Secretary Tim Geithner state that 'Community banks play a vital role in our financial system and a central role in our economy.' This is indeed true and important for all to understand. Of course, it would have been much better if he made such comments to a wider audience than the Independent Community Bankers of America. But, of course, 'preaching to the choir' is always much easier than speaking to the whole congregation.
Scott E. Hein and Timothy W. Koch
A similar version of this opinion piece ran in the May 22, 2009 issue of American Banker
It was good the hear Secretary Tim Geithner state that "Community banks play a vital role in our financial system and a central role in our economy." This is indeed true and important for all to understand. Of course, it would have been much better if he made such comments to a wider audience than the Independent Community Bankers of America. But, of course, "preaching to the choir" is always much easier than speaking to the whole congregation.
Moreover, while it was reassuring to hear Secretary Geithner state, "Our goal is to limit the extent to which community banks and tax payers are forced to bear the burden of those institutions that take irresponsible risks," it would have been nicer to see more actions announced to help limit this burden, especially on community banks.
Now, the Secretary probably thought that his announcement during this same speech, re-opening and extending the deadline of the Capital Purchase Program (CPP, aka TARP) for community banks (with less than $500 million in total assets), would be taken as evidence of such strong actions. However, in our opinion the terms of the CPP for Subchapter S (S) Corporations are onerous and not very attractive to such banks, which make up the majority of small community banks in the country.
To understand why we take a dim view of the CPP terms for S corporation banks recall that as originally structured in October 2008, the Treasury set the terms so it earned a 5% annual dividend on its preferred stock injections for large C corporation banks, which increases to 9% after the fifth year until maturity.[i]
In January 2009, the Treasury released the terms of the CPP for S corporation banks. Because S Corporations are prohibited from having more than one class of stock, the Treasury proposed to purchase subordinated debentures in S Corporation banks that are senior to common stock, but subordinated to deposits and other debt. These securities have a 30-year maturity and carry a 7.70% annual interest rate for the first five years, which increases to 13.8% after the fifth year. For regulatory capital purposes, the senior debentures are treated similarly to preferred stock.
Thus, while the Treasury will receive 5% annually in dividend income from C Corporation banks over the first five years following the capital injection; it will receive 7.7% annually in interest income from S Corporation banks that participate. Of course, to individual or corporate investors it makes a difference if one is receiving dividends, as opposed to interest income, as they are taxed at different rates. But, the Treasury pays no taxes so the distinction between dividends and interest income is irrelevant to it. In fact, the Treasury is better off from its treatment of S Corporation banks because it receives 54% more for the equivalent capital injection than they are receiving from C Corporation banks. Is this fair? The differential payment is potentially staggering. With $411 billion in outstanding CPP preferred stock, the Treasury expects to receive $20 billion annually in dividend income. It would earn $31.7 billion, however, if it invested solely in S corporations debentures. Of course, S Corporation banks are much smaller in total size, such that they cumulatively do not qualify for this amount of CPP assistance. But, given this perspective, is it any wonder that S Corporation banks have not clamored to participate in the CPP capital purchase program? Is this really appropriate? Isn't this increasing the burden on community banks that the Secretary said he wanted to limit?
When the Treasury set the annual interest rate on the senior debentures at 7.7%, well above the 5% dividend yield on preferred stock for C Corporations, it argued that interest on the debt is "tax deductible," while the preferred stock dividends are not. This argument is indeed true for C Corporation banks. Such a corporate bank, with a marginal tax rate of 35%, would find the after-tax cost of either form of capital to be 5% and would thus be indifferent between the two. However, because S Corporation banks pay no federal income taxes at the corporate level, it is not appropriate to claim that interest expense is tax deductible at the corporate level. As such, the concept of "tax deductibility" is not relevant at the corporate level.
To be fair to S Corporation banks, the Treasury should have properly understood that it really does not matter to itself or S Corporation banks that "debt is tax deductible", so its cost should not have been increased from 5% to 7.7%. Increasing the cost simply increases the burden placed on community banks in this financial crisis, much like the increased in FDIC assessment.
[1] Scott Hein is the Robert C. Brown Chair in Finance at Texas Tech University and the Faculty Director of the Texas Tech School of Banking. Tim Koch is the Finance Department Chair at the University of South Carolina and the President of the Graduate School of Banking at Colorado.[i]
Treasury also receives warrants equal to 15% of the amount of preferred stock, which we ignore in this discussion.