It was good to hear Treasury Secretary Timothy Geithner state that "community banks play a vital role in our financial system and a central role in our economy."
Of course, it would have been much better if he had made his comment to a broader audience than the one at the Independent Community Bankers of America Annual Washington Policy Summit last week.
Moreover, though it was reassuring to hear Secretary Geithner say, "our goal is to limit the extent to which community banks and taxpayers are forced to bear the burden of those institutions that take irresponsible risks," it would have been nicer to see more actions being announced to help limit this burden, especially on community banks.
Now, Geithner probably thought that his announcement in this same speech of the reopening and extension of the deadline for community banks (with less than $500 million of total assets) to apply for Capital Purchase Program infusions would be taken as evidence of such strong action. However, the CPP's terms for Subchapter S corporations are onerous and not very attractive to such banks, which are a majority of small community banks.
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 terms for capital infusions were set so that the Treasury earned a 5% annual dividend on its preferred stock injections for large, C corporation banks, rising to 9% after the fifth year until maturity.
This January the Treasury released its CPP terms for S corporation banks. Because S corporations are prohibited from having more than one class of stock, the Treasury proposed to buy subordinated debentures in S corporation banks that would be senior to common stock but subordinated to deposits and other debt. These securities have a 30-year maturity and pay a 7.70% annual interest rate for the first five years, rising to 13.8% after the fifth year. For regulatory capital purposes, the senior debentures are treated similarly to preferred stock.
Thus, while the Treasury would get 5% annually in dividend income from C corporation banks during the first five years after the capital injection, it would get 7.7% annually in interest income from participating S corporation banks. Of course, to individual or corporate investors it makes a difference whether one is receiving dividends or interest income because 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 gets 54% more yield for an equivalent capital injection than it gets from C corporation banks. Is this fair?
The payment differential is potentially staggering. With $411 billion of outstanding CPP preferred stock, the Treasury expects to receive $20 billion a year in dividend income. It would earn $31.7 billion, however, if the same amount were invested solely in S corporation 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? Isn't this increasing the burden on community banks that Geithner 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" but 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. So the concept of tax deductibility is not relevant at that level.
To be fair to S corporation banks, the Treasury should have properly understood that it really does not matter to itself or these banks that debt interest is tax-deductible, so the capital infusions' cost should not have been raised from 5% to 7.7%. Increasing the cost simply increases the burden on community banks in this financial crisis, much as the higher Federal Deposit Insurance Corp. assessment does.