PAUL TOTINO
‘Flat business growth’

New legislation that retroactively prohibits tax deductions on banks’ real estate investment trust holdings as a tax shelter has affected 2003 first-quarter earnings for some Bay State financial institutions.

As Banker & Tradesman reported in February, banks saw heightened tax-free profits after setting up REIT subsidiaries in the 1990s, and bankers argued that Gov. Mitt Romney’s legislation prohibiting tax deductions related to REITs retroactively to tax year 1999 is unconstitutional and unfair.

Unfortunately for many bankers, as well as officials at the Massachusetts Bankers Association and Associated Industries of Massachusetts – who strongly opposed the passing of the legislation – the REIT proposal was approved. As a result, beginning with first-quarter earnings, banks were forced to pay back to the state any REIT deductions since 1999.

With first-quarter earnings reports being announced this month, banks have acknowledged million-dollar losses as a result of the REIT tax law.

“[REIT tax provisions] reduced our [first-quarter] earnings by $11.2 million,” said James R. Rice, senior vice president of marketing and investor relations at CompassBank, a $3 billion-in-assets bank based in New Bedford. “The loss for the holding company as a result of the loss of the [REIT] reduction is $3.1 million.”

Seacoast Financial Services Corp., the holding company for CompassBank and Nantucket Bank, announced a net loss of $3 million, or 13 cents per diluted share, for the quarter ended March 31, 2003, compared to net income of $8.8 million, or 38 cents per diluted share, for the quarter ended March 31, 2002.

Included in the first-quarter 2003 earnings results is an $11.2 million charge to earnings due to the retroactive REIT tax law implemented on March 5, 2003.

“In March, we announced we were reserving $11.2 million and that represents an estimate of the additional state tax liability, including interest,” said Rice. “There is a component of REIT’s that can affect the rest of the year because of the adjustment of the effective tax rate, and it’s possible it will impact all of 2003 earnings.”

Dull Earnings

Brighton-based Port Financial Corp., the holding company for the $1 billion-in-assets Cambridgeport Bank, has reported a first-quarter increase in net income despite the effects of REIT deductions.

Excluding REIT deductions, Port Financial said earnings would have been at 84 cents per diluted share.

With REIT withdrawals, the company reported net income for the period ended March 31, 2003, of $3.3 million, or 67 cents per diluted share, compared to $2.8 million or 55 cents per share in the first quarter of 2002.

“One of the major effects on first-quarter [earnings] was the REIT tax provision, but when we take that out, we felt quite good about the quarter,” said Jane Lundquist, president of Port Financial and Cambridgeport Bank. “We continue to see very strong core growth, particularly in our deposits, and we are still seeing a very strong customer growth in branches.”

Lundquist said she is not concerned about future REIT effects on bank earnings.

“Already in 2003 we’ve been using a new effective tax rate, so we’re not too concerned about future REIT payments,” said Lundquist. “Our continued core growth is coming from the fact that our commitment is from service and quality.”

On April 17, Port Financial entered into a merger agreement with Citizens Bank of Massachusetts. Under the terms of the agreement, Citizens will acquire Port Financial in a cash merger transaction for $54 per share and Cambridgeport Bank will become part of Citizens Bank.

Citizens Bank was among the REIT-effected banks in the Bay State, but a Citizens spokesperson said the REIT deductions would have very little impact on the bank, as opposed to other financial institutions in the area.

REIT taxes will not have an effect on Citizens earnings at the time of the merger with Cambridgeport Bank, which is set to close in late summer.

Smaller banks, including $400 million-in-assets Hingham Institution for Savings, also felt the effect of REIT deductions at the end of the first quarter.

The Hingham bank closed the quarter on March 31, 2003, with a net income of $197,000, or 10 cents per share, as compared to net income of $1.4 million, or 68 cents per share, for the same period last year.

“Net income for the first quarter of 2003 was impacted by a charge against current earnings of $1.4 million in state income taxes, net of federal tax deductions, arising from a retroactive change to Massachusetts tax law pertaining to dividends from real estate investment trusts,” said bank President Robert H. Gaughen Jr.

Gaughen said the bank strongly objects to the retroactivity of the legislation and will continue to challenge the law, but in the meantime, he said Hingham Institution for Savings is predicting a positive earnings year.

“We did take a hit with the REIT legislation and we will continue to contest that. There have been reports of settlement discussions, but we’ll see how that works out. We question the constitutionality of the retroactive legislation and will vigorously challenge the retroactive nature of the law,” said Gaughen. “However, pre-tax earnings saw a significant increase and in terms of the fundamentals, we’re growing core deposits and putting good loans on the books. We have a pretty positive outlook and earnings from our underlying core business remain quite strong.”

However, not all banks in Massachusetts felt the effects of REIT legislation in their first-quarter earnings, and instead continue to blame dull earnings on a sluggish economy and hesitant consumers.

Middlesex Savings Bank Chief Financial Officer Paul Totino said the minimal first-quarter earnings are partly due to a decline in loans.

“Loan growth overall is relatively flat at 1.2 percent, and that will probably continue throughout the year,” said Totino. “We don’t predict commercial loan growth will be strong in the future. There is a lull in the business spending side, which impacts negatively on commercial loan growth.”

Middlesex Savings, a $2.8 billion-in-assets bank based in Natick, reported a net income of $5.7 million for the first quarter of 2003, down from $7 million for the first quarter of 2002.

While loan growth grew from $1.2 million in 2002 to $1.3 million for the first quarter of 2003, Totino said the loan volume overall was stagnant because of a lack of consumer confidence in the economy.

“There is a tremendous growth in the deposit side and it’s primarily because people are putting their deposits into money market accounts,” said Totino. “There really hasn’t been any change, negatively, in terms of loan delinquency, but on the business side, earnings aren’t there because of a lack in consumer optimism.”

Despite dreary first-quarter reports, bankers remain optimistic and place emphasis on growing deposits and loans throughout 2003.

“We see a flat business growth … we wouldn’t expect any bank to be very strong this year,” said Totino. “Interest rates are at all-time lows but if earnings aren’t there and liquidity isn’t there, or consumer optimism isn’t there, consumers aren’t going to invest, but we are not holding back. We are looking to make commercial loans and actively pursuing business. Business is hard to find and it’s a competitive industry.”

And as far as the controversial REIT legislation, bankers say they will continue to fight the retroactive law and hope future earnings are not affected.

According to Rice, CompassBank “is hoping to put this [REIT] issue behind us” so that the bank will not “require any additional hits for future quarters.”

“On an ongoing basis, the REIT effects are a difficult assessment and there will be an increase in our overall effective tax increase of around 4 percent,” said Gaughen. “We don’t like the retroactive taxation, but we’ve taken the hit and whatever happens down the road will be reflected in future earnings statements.”

Melanie Nayer may be reached at mnayer@thewarrengroup.com.