AA large number of community banks have purchased General Market (GM)/Non-Bank-Qualified tax-exempt municipal securities for their investment portfolio over the past 5-10 years. General Market munis offer an attractive yield/spread over comparable Bank Qualified (BQ) munis, and up until recently, the historically low-cost-of-funds environment for banks mitigated the federal TEFRA penalty imposed on General Market munis. However, the significant increase in interest rates over the past year and a half makes the purchase of General Market munis much less attractive unless banks consider forming an investment subsidiary to hold them. TEFRA Act In the early 1980s, the U.S. Congress enacted the Tax Equity and Fiscal Responsibility Act (TEFRA), which levied a penalty on community banks seeking tax-free income through municipal bonds, limiting the amount of tax-free income earned on these investments. The federal government felt the banking industry was “doubledipping” — earning tax-free income on munis while enjoying a deductible business expense for interest paid on deposits funding these investments. General Market vs. Bank Qualified Municipal Bonds To lessen the blow, Congress allowed a smaller penalty, or discount, to be applied for tax-exempt municipal bonds for a newly created subset of the muni market — BQ munis. BQ munis are for municipal bond issuers that issue no more than $10 million in tax-free bonds in any given calendar year. Congress set this qualification to provide a ready market for the “smallest TEFRA Haircut Calculation is a function of 3 areas: 1. TEFRA haircut (20% for BQ or 100% for GM) 2. Federal tax rate 3. Bank cost of funds BQ TEFRA Haircut Formula: 20% (TEFRA disallowance) * 21% (tax rate) * 2.50% (cost of funds) = 0.11% BQ TEFRA-Impact: (3.50% - 0.11%) / (1 – 21%) = 3.39% / 0.79% = 4.29% TEY BQ Not Subject to TEFRA: 3.50% / (1 – .21%) = 3.50% / 0.79% = 4.43% TEY (+14 bps) GM TEFRA Haircut Formula: 100% (TEFRA disallowance) * 21% (tax rate) * 2.50% (cost of funds) = 0.53% GM TEFRA-Impact: (3.70% - 0.53%) / (1 – 21%) = 3.17% / .79% = 4.01% TEY GM Not Subject to TEFRA: 3.70% / (1 – 21%) = 3.70% / 0.79% = 4.68% TEY (+67 bps) Investment Subsidiaries Offer Solution For Municipal Securities By Larry Wood, Executive Vice President — Financial Institutions Group, The KeyState Companies Colorado Banker 18
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