To TARP or Not to TARP

June 30, 2009

Authored by: Robert Klingler

As noted by the Wall Street Journal (subscription required), a steady stream of small banks are still lining up for government money.

Since May 31, 20 small banks have received a total of $164.1 million in taxpayer-funded capital, according to the Treasury’s latest available figures.  Half of those banks got the money in the same week that 10 big financial institutions gave theirs back.

Analysts see no end in sight to the trend.  The recession and borrowers are squeezing most of the 8,200 federally insured commercial banks and savings institutions in the U.S., so even a dollop of TARP funds could make a difference.  Some banks are turning to the government to fill a void left by investors who are leery about pouring money into the sector, despite the rebound by bank stocks since early March.

Meanwhile, the rules and stigma of TARP that turned some executives such as J.P. Morgan Chairman and CEO James Dimon against the program are irrelevant to small institutions.

Their employees usually don’t fly on corporate jets or collect hefty bonuses that trigger outrage from taxpayers, customers and Congress.  And curbs on dividend payments are a modest price to pay for greater assurance that the banks can plow ahead with their core mission to gather local deposits, lend them nearby and support local charities, some recent TARP recipients said.

It’s certainly a stretch to say the executive compensation restrictions are “irrelevant” to small institutions, but community banks generally don’t have the excesses that have drawn public and congressional scorn.  With the deadline for smaller community banks to apply to participate under the TARP Capital Purchase Program extended until November 9, 2009, many institutions are taking a fresh look as to whether to apply, even as larger institutions are making a decision as to whether to seek to redeem the TARP investment they’ve already received.

As indicated by the sheer number of banks still accepting TARP funds and the number (and dollar volume) of banks returning TARP funds, there are good reasons for both courses of actions.

Reasons to Accept TARP Funds/Not to Seek Redemption

  1. The Economy is Still at Uncertain.    While we have come a long way last October in stabilizing the credit markets, the economy continues to show increasing weaknesses.  Accordingly, the TARP funds can serve as a nice insurance policy in the event that the economy (and a bank’s loan portfolio) shows further deterioration.
  2. The Market for Bank Offerings has Not Fully Recovered.  Especially for smaller community banks, the capital markets have not fully recovered.  Accordingly, there are few sources of capital (at least at reasonable pricing) other than the TARP funds.  Moreover, to the extent the economy worsens from expectations (as noted above), the capital markets may again completely freeze.

Reasons Not to Accept TARP Funds/to Seek Redemption

  1. TARP Stigma and/or Making a Statement.  Although it doesn’t match reality for community banks, TARP is perceived by most as a bailout.  As noted in the Wall Street Journal, private institutions are somewhat buttressed from this social stigma, as customers are less likely to know (or possibly care) that the institution has received TARP funds (although the bank will still be named in Treasury’s transaction reports).  The experience of our clients seems to match those that the Wall Street Journal spoke with; shareholders and customers are likely to have questions, but unlikely to move their business.
  2. The Cost of the TARP Investment.  Emphasizing the fact that receiving TARP funds is not a bailout, one of the primary reasons for banks not to accept TARP funds is the financial costs of the investment.  In addition to paying a quarterly dividend (5% annualized initially, rising to 9% after five years), the Treasury also receives warrants (with no additional compensation to the receiving bank).  Accordingly, a bank recipient generally needs to have a plan in place to generate income as a result of the investment.  With the economy stalled, the demand for lending has also significantly declined.  Accordingly, banks that are comfortable that their capital levels are sufficient without TARP funds are likely to not accept, or to seek to redeem, a TARP investment.
  3. Executive Compensation and Dividend Restrictions.  While not necessarily particularly onerous for most community banks to comply with, these restrictions to represent an intrusion by the Treasury into the boardroom, limiting the bank’s ability to determine how to best compensate its employees and shareholders.
  4. Political Philosophy.  Despite the fact that financial institutions are heavily regulated by the federal government without regard to whether the government has made an investment in the institution, many community bankers (and many citizens) simply find it contrary to personal political and economic philosophies for the federal government to make a direct equity investment in private enterprise.  While this reason would preferably take a backseat to concerns over the best interests of the bank and its shareholders, these philosophical objections are likely heard in every board room.