Small Bank's Surprise Decision May Threaten Treasury's Tarp Return

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WASHINGTON — A bank's decision to balk at paying dividends to a private investor that bought its Troubled Asset Relief Program shares may reduce investor interest in future auctions and weaken returns for the government.

Basswood Capital Management won a Treasury bid in October to buy a portion of preferred Tarp shares of $114 million-asset CenterBank in Milford, Ohio.

Although the bank had never missed a dividend payment to Treasury and appeared in healthy condition, the financial institution sent a letter Nov. 13 to Basswood Capital saying it would not pay its quarterly dividend.

The move caught the investment firm by surprise, especially when the bank's CEO gave his reasoning to a local paper, telling a reporter that the bank simply wanted to "keep our capital local as opposed to sending it to New York."

The bank's decision is likely to have far-reaching consequences, however, including potentially spooking other investors away from future Treasury auctions and reducing the government's return.

"It will open the eyes to some investors that the dividend deferral feature is not merely a theoretical possibility," said Kip Weissman, a partner at law firm Luse Gorman Pomerenk & Schick. "It will probably depress prices."

It has already cost the Treasury one bidder on certain shares. Matthew Lindenbaum, the principal of Basswood Capital Management, is furious about the bank's decision.

After he received the letter, Lindenbaum called Stewart Greenlee, CenterBank's CEO, who then offered to buy back the shares through internal investors — but at 10 cents less than what Lindenbaum paid in the Treasury auction.

"I told him ‘just pay me out at my basis and I'll never speak to you again'," Lindenbaum offered, to no success. "It was the most outrageous phone call I've ever had in my 20 years of business."

While Lindenbaum said the amount he invested is "trivial," it's the first case re-affirming investors' fears about the power banks have once they are freed from the Treasury.

"The problem is going to be that investors will become wary of bidding on noncumulative paper if they're worried that banks may try to game the system," Lindenbaum said.

The Treasury has auctioned Tarp funds of 84 banks for $1.5 billion in 10 auctions as of Dec. 10. In the case with CenterBank, Basswood purchased noncumulative preferred shares, meaning the bank can pass on paying dividends without it cumulating to a later date, thereby leaving Basswood in a larger hole.

Some observers argue investors should be well aware of the risks associated with noncumulative shares, even if the bank showed consistent dividend payments beforehand. Smaller banks, in particular, are traded less in the public markets, making them less liquid investments.

"This is a good lesson as to what risks buyers need to be aware of with small banks," said Doug Faucette, a lawyer at Locke Lord. "That's why they call it stock."

Faucette argued it will not have an impact on future Tarp auctions. In fact, he called the Treasury the real winner in this particular deal since Basswood paid nearly 83 cents on the dollar for less than half of CenterBank's $2.3 million in Tarp. Typically, bidders pay 50 cents on the dollar for a small bank, he said, "so hooray for Treasury."

A Treasury official said this is the first known case of its kind, but it does not mean other banks will follow suit.

"Ultimately, it's the decision for the board to make in the way the contracts are structured but you have to weigh what an action like this means for their long term reputation," the official said.

Despite repeated attempts, Greenlee could not be reached for comment. But he confirmed with the Cincinnati Business Courier last week that the company is not obligated to pay a dividend. Like many banks, CenterBank also bid on its own Tarp shares, but it was the minimum bidder at nearly 73 cents on the dollar.

Greenlee's comments to the paper about wanting to keep "capital local" also have enflamed the situation – nor does it bode well for many other investment groups based in New York.

 "Our issue here is just principle and the precedent this is setting" about Tarp auctions, Lindenbaum said. By doing this "you basically screw up the bank's reputation in the capital markets, and the money is so trivial here so why do it?"

The bank is not legally obligated to pay dividends, lawyers say. But it does need a "stronger" financial reason beyond not wanting to pay dividends to New Yorkers for it to hold up in court, Weissman said.

Faucette said the potential for future litigation is high.

"From the standpoint of the bank, it probably knew exactly what it was doing," Faucette said. However, "you're buying yourself a lawsuit when you do something like that, which I don't think a bank that small can afford."

The larger impact of the bank's move may soon become clear. Treasury said Tuesday it would hold its 11th auction with seven more Tarp banks.

Lindenbaum said his firm will be picky about what it bids on going forward.

"We're participating," said Lindenbaum, who bid on 9 out of the 10 previous auctions. "We're just not bidding on any noncumulative preferred stock."

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