G4
Getting paid to borrow
Te U.S. tax code encourages companies to borrow large amounts of cash because funding investments with debt can actually result in a negative effective tax rate:
SOURCE: Federal Reserve Tax code encourages companies’ huge debt debt from G1
sums of borrowed money. Big banks that lend out all this bor- rowed money have come to play an outsize role in the economy. Debt in itself is not harmful, fi- nancial analysts say. But they also question whether the gov- ernment should be prodding companies to borrow and favor- ing businesses that heavily rely on debt. “The tax code is interfering
dramatically with the choice of how you finance and how you de- liver returns in the corporate sec- tor,” said Douglas Holtz-Eakin, an economist who heads the American Action Forum. “Why would you build into the tax code a permanent bailout for corpo- rate debt-financed investments?” The lineage of Macy’s runs back to a retailing powerhouse named Federated Department Stores, which once wielded so much influence that it persuaded President Franklin D. Roosevelt to extend the Christmas shop- ping season by moving Thanks- giving forward a week. During the following decades, Federated swallowed up nearly every other big name in the business, includ- ing Marshall Field, Filene’s and Macy’s — and then took the Ma- cy’s name.
But along the way, Federated
accumulated so much corporate debt that in the early 1990s the storied retailer ended up in bankruptcy. After it reemerged and took on billions of dollars more in debt to buy out a major rival, the company fell into trou- ble again and had to renegotiate its agreements with its lenders in 2008. Federated was among dozens of companies in the 1980s that had a AAA credit rating — the highest given by credit rating agencies — and lost it after drowning their books in debt. Now there are only four. “We’ve seen a complete trans-
formation of corporate America,” said Nick Riccio, a former man- aging director at Standard & Poor’s who retired after more than 30 years of evaluating the health of companies. In the early 1980s, chief executives “were debt averse,” he said. “All of them were aspiring to the top ratings we could give them. By the time I left, it was a completely different
picture.” A heavy debt burden can also come with severe consequences, some more obvious than others. It makes companies far more
vulnerable to shocks — for in- stance, a severe recession. It also can be more expensive than oth- er ways of raising money because failing to return the loan, or even missing a few repayments, can force a company into a costly bankruptcy. In the wake of the financial
crash, corporations, including Macy’s, have been urgently pay- ing down debt and hoarding cash. Non-financial companies have saved up to $1.8 trillion in cash, about one-quarter more than when the recession began in early 2007. But without correct- ing the imbalance in the tax code, according to a wide range of tax analysts, the government will continue to encourage new cycles of debt-fueled booms and busts.
So far, there has been no effort by the federal government to curb the role of the tax code in in- flating the economy’s debt levels. A bipartisan bill in the Senate that would do so has stalled. The financial regulatory overhaul ap- proved by Congress last month does not address the matter. Macy’s executives acknowl-
edged that the company became overly indebted in the late 1980s. They said more recent borrowing levels have been manageable, even after the firm’s debt rose to $10 billion as part of the mam- moth acquisition of its competi- tor May Department Stores five years ago. But several retailing analysts said that deal left Macy’s on shaky ground when the recession began in late 2007. After the take- over, Macy’s “had big slugs of debt the next couple of years,” said Ken Stumphauzer, an ana- lyst at Stern Agee. “They will be able to refinance now because credit markets have opened up . . . but it was scary for a little bit.”
Debt no longer taboo
For decades, the memory of the Great Depression, with its devastating toll of defaults and bankruptcies, made executives wary of piling up debt anew. High credit ratings from Moody’s and Standard & Poor’s were viewed as a badge of success.
Total corporate debt In trillions
$8 6 4 2
0
’75 ’80 ’85 ’90 ’95 ’00 ’05 ’09 $7.1 trillion
That changed radically in the
1980s. The rise of the junk-bond market offered companies the chance to borrow enormous sums of money, often for taking over other firms, in return for paying exceptionally high inter- est rates. Federated Department Stores was a poster child of this era. Hailed as one of the most stable companies in the nation in the early 1980s, Federated was bought out by Canadian real es- tate magnate Robert Campeau in 1988 for $6.6 billion. Campeau borrowed most of that money and then put it on the company to pay it back. After the buyout, for every dollar in cash that Fed- erated held, it had $32 in high- interest loans. From Campeau’s point of view, all this leverage came with a big benefit, compliments of the fed- eral government. Under the tax code, the company he took over could deduct its high interest payments from the taxes it paid on its income.
If Campeau had used the bor- rowed money to build, say, a new warehouse, rather than take over an entire company, he could have won yet another kind of tax ben- efit. Many firms use borrowed money to pay for buildings and equipment and are entitled to a second tax deduction under an accounting principle known as “accelerated depreciation.” As the value of buildings or equip- ment declines over time, a com- pany can use this depreciation to reduce its tax liability. The combined impact of those
two deductions can be tremen- dous, according to the Congres- sional Budget Office. Together, they can free a company from paying tax on any income pro- duced by projects financed with debt. But that’s not all. The com- bined deduction can be so large that a company may also be able
to apply some of it to its other in- come, reducing the overall tax bill even further. The CBO calculated the effect and found that across corporate America companies on average face an effective tax rate of nega- tive 6.4 percent on investments financed with debt. That means, in essence, that Washington is actually paying firms for borrow- ing money. (By contrast, if a com- pany raises money by issuing stock, it faces the standard cor- porate tax rate of 35 percent.) “The government is writing you a check to buy that greasy machinery,” said Ed Kleinbard, a law professor at the University of Southern California. Still, Federated’s massive debt would prove costly. The rating agencies deemed the company to be a risky investment and down- graded it several notches, mak- ing it very expensive for the firm to borrow any more in a crunch. Its existing loans were expensive — some had interest rates of 17 percent or higher — and the re- tailer was counting on spectac- ular sales of clothes, purses and shoes to keep pace with the pay- ments. That didn’t happen. In the ear-
ly 1990s, the savings and loan cri- sis triggered a recession, and Federated wasn’t ready for it. Just 21 months after the Cam- peau buyout, Federated filed for the biggest bankruptcy in retail- ing history. More than 5,000 em- ployees lost their jobs. Share- holders were wiped out. A company that virtually no one had thought could fail had collapsed.
Calls for change
Warnings about perverse in- centives for corporate borrowing have long sounded in Washing- ton. “The tax at the corporate level provides a strong incentive for debt rather than equity finance,” said Congress’s Joint Committee on Taxation, adding that this in- creases “the possibility of finan- cial distress.” That statement was issued more than 20 years ago. During the 1990s, corporate debt went on to grow by 60 percent. Then, over the next decade, it nearly doubled. Wall Street found new ways of making it easier to bor- row while the Federal Reserve
kept interest rates exceptionally low. By the end of last year, cor- porate America had nearly $11 trillion to pay off, according to the Fed.
Senior advisers to both presi- dential nominees in 2008 called for change. Holtz Eakin, who was John McCain’s chief economist, warned that the tax code was “subsidizing leverage.” Barack Obama adviser Jason Furman, now an economist at the White House’s National Economic Council, similarly wrote that the debt bias “encourages corpora- tions to finance themselves more heavily through borrowing. This leverage in turn increases the fi- nancial fragility of the economy, an effect we are seeing quite dra- matically today.”
So far, there has been no effort by the federal government to curb the role of the tax code in inflating the economy’s debt levels.
Sens. Judd Gregg (R-N.H.) and
Ron Wyden (D-Ore.) have draft- ed a bill to address how the tax code treats corporate debt. But the legislation is stalled, caught up in a much wider dispute over the taxes Americans pay. After Federated emerged from bankruptcy in 1992, the company bought Macy’s — which had also gone bankrupt after borrowing too much. The combined retailer committed to keeping its debt levels low, winning an upgrade from ratings agencies. But Federated’s diet from big debts lasted only so long. Facing competition from big-box retail- ers, Federated decided in 2005 to pull off one of the largest deals in retailing history by buying May Department Stores for $11 bil- lion, combining the biggest play- ers in the business. The name of the company was changed to Ma-
cy’s. At the time, company exec- utives talked of making the red Macy’s star as well known as Tar- get’s bull’s-eye or Wal-Mart’s smi- ley face. To complete the deal, Federat- ed agreed to absorb $6 billion of May’s debt. While Macy’s ben- efited from the interest deduc- tion on those loans, the com- pany’s executives said that was not the reason the deal was made.
Some retailing analysts ques- tioned whether the move would actually brighten Macy’s outlook, with one writing the company had become “a bigger dinosaur.” Wall Street, however, cheered the move, and Macy’s stock rose steadily for the next two years. Then, another recession struck. Macy’s was vulnerable to the economic shock caused by the financial crisis. The downturn in sales forced
Macy’s to acknowledge in 2008 that the May deal was worth less than it had paid. The write-down was so large — totaling $5.4 bil- lion — that it significantly re- duced the overall value of the company below a level that was allowed by its banks. That, in turn, forced Macy’s to renegoti- ate the agreements it had with its lenders. Macy’s Chief Financial Officer Karen Hoguet said in an inter- view that the company was never in danger because it began those talks in advance of the write- down. “We are always conscious of the balance between debt and eq- uity,” Hoguet said. “Life is about balance, so you try to develop your capital structure so you can withstand the downturn. We have not had any issues. We’ve had significant amounts of cash.” Macy’s has cut its debt to $8 billion — still about double the level before the deal for May — and the company continues to fo- cus on shedding even more, exec- utives say.
But the costs have been signifi-
cant. In 2009, executives announced
that 7,000 jobs would be cut. Ma- cy’s also saw its borrowing costs soar. And the ratings agencies again stripped the firm of the in- vestment-grade rating it had worked for years to restore.
chod@washpost.com
1
K
KLMNO
A company borrows $1 billion in loans to buy a factory, payable at a 10 percent interest rate.
$100 million in interest is owed the first year.
$100m interest 2
Te factory earns $250 million a year in taxable income.
$1 billion loan
EARNINGS $250m
3
Te company can deduct a fiſth of the value of the factory each year for five years under a principle known as accelerated depreciation. Tis allows it to deduct $200 million from its earnings.
EARNINGS $200m deduction
$300m total tax
deductions 4
Te company also gets to deduct its $100 million interest payment from those profits. Te effective tax rate for the factory’s earnings is negative because the tax deductions are more than the profits.
$100m deduction $200m deduction
EARNINGS $200m
SUNDAY, AUGUST 8, 2010 5
Te remaining $50 million can be deducted from profits made outside of the factory.
Te company has essentially made money by taking on debt.
$50m deduction remains THE WASHINGTON POST
MassMutual skips retained accounts, cuts beneficiaries a check by Alexis Leondis Massachusetts Mutual Life In-
surance Co., Aflac and Hartford Financial Services Group are among U.S. life insurers that buck the industry practice of automat- ically holding onto death ben- efits. MassMutual, a policyholder- owned carrier in Springfield, Mass., Aflac in Columbus, Ga., and Hartford in the Connecticut city of the same name, automat-
ically send survivors a bank check for insurance proceeds af- ter death claims are approved, ac- cording to company spokesmen. Other insurers generally keep the cash in their retained-asset ac- counts and issue the survivors checkbooks, which are essen- tially IOUs. “These accounts were invented not to help consumers, but to help insurance companies,” said Bob Hunter, director of insurance for the Consumer Federation of America in Washington. “I can’t
think of any reason why you wouldn’t want a lump-sum pay- out.” MetLife in New York, the big-
gest U.S. life insurer, and No. 2 Prudential Financial usually keep the money in retained-asset ac- counts, which aren’t backed by the Federal Deposit Insurance Corp. and may pay uncompetitive rates.
If survivors ask for lump-sum distributions, Prudential will write them a check, said Bob De- Fillippo, a spokesman for the
Newark-based company. They can also withdraw some or all of the money immediately from the account by writing a check to themselves and depositing or cashing it at their local bank, De- Fillippo said. A spokesman for MetLife could not be reached for comment. Beneficiaries of policies with
New York Life Insurance, Mil- waukee-based Northwestern Mu- tual Life Insurance and Gen- worth Financial in Richmond can elect lump-sum payouts of death
benefits, and if they don’t, the money will be placed in the ac- counts, according to company spokesmen. More than 70 percent of benefi- ciaries at New York Life select the lump-sum payment, according to William Werfelman, a spokes- man for the New York-based firm. More than 90 percent of benefi- ciaries choose the lump-sum dis- tribution at Genworth, said Deb- orah Pont, a spokeswoman for the insurer. At TIAA-CREF Life Insurance,
the New York-based carrier, sur- vivors also can opt for a lump- sum payment, said Jennifer Compton, a spokeswoman. If they don’t, they’ll receive a check- book for an account that is cur- rently paying 4 percent interest and resets annually, she said. Beneficiaries may want to weigh the rates offered on re- tained-asset accounts and decide whether the rate is high enough for the risk of forgoing FDIC in- surance, said Lawrence Baxter, professor at Duke University School of Law. If insurance companies fail,
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state insurance departments are supposed to back life policies by raising money from other carri- ers that do business in their state. No states keep track of how much money insurers are holding in re- tained assets. USAA Life Insurance, a subsid-
iary of San Antonio-based USAA, has a payout policy that differs from some other insurers. Ben- efits are paid in a lump sum or deposited into the company’s sav- ings bank, which is FDIC insured, said Eric Smith, president of USAA Life. The firm provides in- surance primarily to the military and their families. Unum Group pays all policies under $10,000 as a lump-sum disbursement. Benefits from in- dividual policies also are paid out
directly to survivors, while the proceeds from group policies purchased by employers are ad- ministered via retained-asset ac- counts. About 60 percent of claims are kept in these accounts, which currently pay 1 percent in- terest, said Mary Clarke Guenth- er, a spokeswoman for Unum. The practice of retained-asset accounts allows more than 100 carriers to earn investment in- come on $28 billion owed to life insurance beneficiaries. Insurers market the accounts as a service to allow bereaved beneficiaries time to think about what they’ll do with the funds. Carriers make money by investing the funds in bonds and keeping the difference between returns and the interest they credit to the accounts. About 40 percent of these ac- counts at the insurance compa- nies still have money in them a year later. Since the checks may resemble actual bank checks, beneficiaries often assume the money is in bank-insured ac- counts when it isn’t. “There needs to be improved disclosure requirements,” said Jane Cline, president of the Na- tional Association of Insurance Commissioners. “We will be ramping up our consumer-educa- tion initiatives on this.” N.Y. Attorney General Andrew Cuomo subpoenaed MetLife and Prudential last week amid a fraud investigation into what he called “secret profits.” Genworth, Unum, an insurer acquired by France’s AXA, New York Life, Northwestern and Guardian Life Insurance Co. of America were also ordered to turn over infor- mation, a person briefed on the demands said last week. U.S. leg- islation requiring profit disclo- sure was also introduced last week by Rep. Debbie Halvorson, an Illinois Democrat.
— Bloomberg News
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