issuers” in the muni marketplace, ensuring steady and permanent demand for those smaller towns and municipalities that qualified. When TEFRA was enacted, a Bank Qualified muni issuer bringing $10 million to market was a considerable issue size, and these issuers made up approximately 30% of the entire municipal bond market. Today, the $10 million limit has not increased with inflation, so the Bank Qualified share of the entire tax-exempt muni market has declined to less than 5% of the total municipal bond market. Banks purchasing BQ bonds pay a premium to do so because only a limited number are issued. This premium has created a permanent yield advantage for General Market munis. The yield differential for comparable maturities and credit quality BQ munis vs. GM munis is generally 20-50 basis points. Beyond a significantly better yield, the GM municipal market is superior to the BQ muni market in other aspects. The GM muni market is considerably larger, which creates greater liquidity and provides an opportunity to create a more diversified municipal portfolio since there is a much larger pool of municipalities that issue GM muni bonds. The larger pool also provides a significantly larger population of bonds with higher agency ratings. Also, GMs are not limited to the $10 million annual issuance limit that applies to BQs, giving banks the opportunity to purchase larger block sizes. Without this, most regional banks have avoided building large municipal bond portfolios. Finally, these bigger, more sophisticated municipalities with larger issues provide more complete, transparent and timely financial data to investors and ratings agencies. This additional yield has enticed community banks to purchase GM munis over the past 10 years. During the same time period, banks have experienced a relatively low cost of funds, so banks have taken advantage of the steep municipal bond muni curve with less concern about how the TEFRA penalty could degrade their tax equivalent yield. Now, with the prospects of “higher for longer” interest rates, the penalty can meaningfully reduce a bank’s effective yield on new or existing GM municipal holdings. An Investment Subsidiary Solution In the current interest rate environment, banks are unable and unwilling to sell their GM munis and recognize losses. And as banks’ cost of funds continues to increase, the larger TEFRA penalty will greatly reduce the tax-equivalent yield on a bank’s GM muni portfolio. One solution is for a community bank to form a wholly-owned subsidiary to hold their GM municipals — a General Market Investment Subsidiary (GMI sub). In 2007, the U.S. tax court ruled in PSB Holdings v. Commissioner of Internal Revenue that a bank investment subsidiary is not itself a “bank” and therefore is not subject to the TEFRA haircut for BQ or GM munis. This case resulted in banks with investment subs revisiting GM munis as a potential sector for investment. The court noted that, other than simply avoiding the TEFRA haircut, a bank must have a business purpose or reason for forming an investment sub, e.g., minimizing state taxes. The investment sub allows a bank to consolidate management of the investment portfolio, provide access to highly skilled investment officers (through the service provider it hired to manage its investment subsidiary) and provide greater purchasing power for portfolio services like custody and bond accounting. Decision to Form a GMI Subsidiary Banks have been utilizing investment subsidiaries for decades. In the current market environment, many banks may look to municipal bonds to enhance the yield of their portfolio. Banks with muni portfolios should evaluate forming an investment sub so that they can hold and build a GM muni portfolio. Interested community banks should always consult with their tax advisors and also with professionals experienced with forming and managing investment subs for banks. Larry Wood is Executive Vice President — Financial Institutions Group for the KeyState Companies. He oversees KeyState’s Investment Advisory and Bank Investment Subsidiary group with over $16 billion in assets under management. Founded in 1991, KeyState manages taxadvantaged investment and insurance structures for over 120 financial institutions across the country. For more information, please contact Larry Wood at lwood@key-state.com or visit www.key-state.com. KeyState is not a tax advisor — please consult your bank’s tax advisor before proceeding with any strategy. WE'VE GOT YOU COVERED WWW.CP2LAW.COM DENVER | FORT COLLINS | GREELEY Coan, Payton & Payne, LLC provides a full range of legal services to the banking industry. 19 Colorado Banker
RkJQdWJsaXNoZXIy MTg3NDExNQ==