The Great Savings Scramble

By Alexander L. Taylor III

Promises of high interest and low taxes dazzle everyone except the IRS

Savers weary of such incentives for opening a new bank account as toasters, popcorn poppers and electric frying pans last month received a new and different kind of bonus: high interest rates. Banks and savings and loan associations across the U.S. unleashed massive advertising campaigns to induce customers to sign up early for the new All Savers Certificates. The A.s.C.s were devised to help ailing S and Ls attract business by offering higher interest rates than those given on passbook accounts and a partial tax exemption on yields. Banks and S and Ls have been promising depositors annual interest rates of 20%, 30% and even 50% until Oct. 1, when the All Savers accounts officially start.

It all sounded too good to be true, and it was. The Internal Revenue Service ruled last week that the big cash bonuses in most cases nullified the tax-free status of the savings certificates. Moneymen were outraged by the ruling, while consumers were left more bewildered than ever by the jabberwocky of interest rates given by banks and S and Ls. In recent weeks financial institutions have paid between 5.25% and 50% annual interest on various deposits.

The origin of last week's IRS action was a congressional measure earlier this year designed to make it easier for the S and Ls to get deposits that could be used for mortgages. During the first seven months of 1981, S and Ls and savings banks lost upwards of $25 billion in funds. Some lending institutions have now virtually stopped making mortgage loans because they no longer have money available. Much of the missing investment is going into money-market funds, which gained $75.7 billion in the past eight months.

The reason for the cash flow is simple: S and Ls pay only 5.5% annually on passbook accounts, while money-market funds last week were yielding 16% and more per year. The A.s.C.s, which require that money be deposited for one year, were legislated to aid the S and Ls in their attempts to win customers back from the money funds.

Critics charge, however, that the A.s.C.s are a giveaway to the savings institutions because the tax-free provision is just a way of lowering the amount of interest that they have to pay in order to attract depositors. Opponents also point out that the financial firms are under no obligation to put the new funds into mortgages.

Banks and S and Ls can pay on the A.s.C.s up to 70% of the average interest on the most recently issued one-year Treasury bills. On the basis of last week's Treasury offering, the yield on the accounts in early October will be 12.61%. The A.s.C. is more attractive than money-market funds for some investors because the first $1,000 an individual earns on it ($2,000 for a couple) is tax free.

The A.S.C. is most beneficial to middle-and upper-middle income people. Investors must be in a relatively high tax bracket, about 30%, for the tax saving to compensate for a return that is lower than from a money-market fund. For instance, a family with an income of $50,000 a year and normal deductions would have to receive a taxable return of about 20% to equal the tax-free yield of 12.61%. For people making less money, however, the A.S.C. is not as attractive. For a family earning $19,000 annually, that same 12.61% would be equivalent to a taxable return of only approximately 16%. Thus, those people might do as well by putting their cash into a money-market fund.

Savings institutions saw the A.s.C. as a potential bonanza that could yield $250 billion in new deposits, and they began offering the big interest bonuses as a way to sign up customers early. The key to the deal that the bankers used was an obscure financial instrument known as repurchase agreements or repos, which are short-term loans to financial institutions backed by Government securities. Early A.s.C. depositors were actually buying part of a repo with their money, and the funds were to be turned into an A.S.C. automatically on Oct. 1. Repos are currently paying a return of about 18%, but savings institutions were willing to give the 40% or 50% annual interest for one month in order to get customers into the yearlong A.S.C.S.

A competitive scramble among banks quickly broke out. The bidding war began in Massachusetts, for example, when the Boston Five Cents Savings Bank pledged an 18% annual interest. Of course, that return would be paid for just one month, so customers were actually getting a yield of only 1 1/2% on their money for that period. Charlestown Savings Bank followed with an offer of 18 1/2%. Then the Home Savings Bank in

Boston said that it would top the offer of any other major local bank by one percentage point. But all Boston savings institutions were outbid by Merchants Bank of Burlington, Vt., which promised to pay 50% on an annual basis--for one month. Said Merchants Bank President Dudley Davis: "This is one of the few opportunities to guarantee a margin of profit for the bank, attract new customers and provide a profitable return to the investor."

Some bankers were unhappy about he bidding battles. Said one Massachuetts S and L executive: "There is no doubt hat some institutions have reacted in an undignified manner." Edward Melcher, enior vice president of Atlantic Federal Savings & Loan Association in Fort Lauderdale, Fla., which did not join the fray, said it reminded him of a price war.

But for many savers the lure of 50% interest rates was almost irresistible. In ust a few days, an estimated 10,000 customers signed up for the A.S.C.s at Dime Savings Bank of New York, which was offering interest rates of up to 18% plus an up-front cash bonus of $100 or more. Jefferson Federal Savings and Loan Association in Washington, D.C., received the $1 million it had decided to accept under the new plan in 1 1/2% days.

Most of that scrambling came screeching to a halt, though, when the Internal Revenue Service vetoed many of the offers. The IRS ruled against the plans because some banks and S and Ls were tying together the repos and the A.S.C.s. By doing so, the moneymen hoped to channel the new money they had attracted directly into the certificates. But the IRS decided that both offers tied together became, in effect, one big financial package. The interest paid on that deposit, it ruled, would exceed the maximum rate of return set by Congress: 70% of the average interest on one-year Treasury bills.

The IRS acted quickly to prevent confusion on the part of savers, who might think the package of repos and certificates was entirely tax exempt. No bank had advertised the plan that way, but the fact that the interest on a repo is fully taxable tended to get lost amid the noisy promotions.

Nonetheless, the IRS ruled that savings institutions are still free to offer the repos at high interest rates if they unbundle the package and do not require buyers of repos to invest in certificates as well. After the IRS announcement, many banks said that they were going to continue giving their bonuses.

What about those thousands of customers who had already purchased repos and certificate packages before the IRS decision? They will be permitted to cash in the repos and purchase A.S.C.s, but only if their bank frees them from the package agreement. The banks must give their customers the right to redeem the repos and take the high interest without investing in the A.S.C.s. Otherwise, their whole repos-All Savers deal will not be considered tax free.

While federal rulemakers were knocking down the high interest offers, they were giving another ruling that was favorable to the A.S.C.s. Banking regulators decided that the $480 billion invested in the popular six-month money-market certificates in denominations of $10,000 or more can be converted into A.S.C.s without a charge for early withdrawal. The penalty is usually the loss of three months' interest.

Despite last week's setback on the A.S.C.s, financial institutions are getting ready to push another account that provides a tax break for savers. A separate provision of last summer's tax bill allows people who already have a company pension program to set up their own Individual Retirement Accounts (IRAS). These had previously been limited to people who did not have a company pension plan.

The law permits people to put up to $2,250 in a special account created by a savings institution, a brokerage house or a life insurance firm, or to place that amount in certain special government bonds. Savers do not have to pay tax on the earnings or interest on the deposit until it is withdrawn at retirement. By then, the income of most people has declined, and the tax on the money earned is reduced. Experts expect that as many as 10 million people will now open some type of retirement account.

The change in the IRA regulation does not take effect until Jan. 1,1982, but banks are already making plans for the new deposits. New York's Citibank will market the accounts in so-called Tax Shelter Centers and at its branches.

Americans in recent months have become increasingly canny savers, who search out the highest available returns and the best tax advantages. In turn, banks and savings and loans are becoming much more aggressive in selling new services. Indeed, last week's developments showed that financiers may never be able to go back to the days when they could win a new account just by offering the depositor a Teddy bear or a toaster. --By Alexander L Taylor III.

Reported by Jonathan Beaty/Washington and Christopher Redman/Detroit

With reporting by Jonathan Beaty, Christopher Redman

This file is automatically generated by a robot program, so viewer discretion is required.