Deleveraging Can Save Jobs
Dec 18, 2008
Publisher: The Wall Street Journal

A simple change in tax policy would make it easier for companies to retire debt.

Amid talk of "the biggest financial crisis since the Great Depression," few of today's market participants recall 1974, perhaps the most important year in post-World War II U.S. financial history.

In the mid-'70s, interest rates nearly doubled, the stock market fell 45%, energy prices skyrocketed, and regulations restricted lending. Companies with the highest returns on capital, greatest amount of innovation and fastest growth rates in market share were denied access to capital. Unemployment, 5.1% in January 1974, rose to 9% by spring 1975.

There was a crisis of confidence on Wall Street in 1974 as a credit crunch deepened an already serious recession. The governments of New York City and state, as well as utilities such as Con Edison, were supposedly on the verge of bankruptcy. The debt of many great companies sold for pennies on the dollar. Yet over the next two years both the stock and bond markets moved steadily upward, providing total returns of as much as 100%.

The experience of those years is important not because it predicts what might happen in today's markets, but because it was the beginning of a revolution in capital access and capital structure. Companies whose primary source of funds had been bank lending could increasingly turn to the IPO, venture-capital and high-yield debt markets to finance growth and create jobs.

They also enjoyed flexibility in adapting their capital structures to market conditions -- selling debt or equity, or exchanging one for the other when market conditions were most receptive, without tax consequences, to strengthen their balance sheets. In particular, the opportunity to deleverage, i.e. to reduce debt, was a fundamental reason why relatively few companies defaulted in the 1970s and 1980s. They were able to attract investors, maximize shareholder value and, for many of them, forestall bankruptcy, preserving jobs when the economy stalled.

Many companies whose debt was considered extremely risky in the 1970s -- such as Westinghouse, Tandy, Chrysler and Teledyne -- found ways to manage their capital structures and return to profitability. In the early 1980s, companies like International Harvester, Allis-Chalmers, Mattel and Occidental Petroleum were able to deleverage by issuing equity in exchange for debt. That flexibility to deleverage has been lost in the current economic malaise, partly because of market conditions and partly because of tax rules.

Leverage in capital structure is inherently neither good nor bad. For some companies, debt is an important and effective part of their capital structures; other companies in volatile industries should avoid debt entirely. Finding an optimum and flexible ratio of debt and equity as market conditions change helps create jobs and bolsters the economy.

Uncertainty, the enemy of capital markets, always increases during economic crises. Suppliers become reluctant to ship materials to any enterprise struggling under a heavy debt load; many demand cash on delivery because they fear becoming a long-term creditor of a company whose debt is selling at a deep discount. Formerly routine credit transactions are increasingly unavailable even to solvent firms because suppliers worry that their bills may not be paid.

The economic effect of this pessimism ripples through every state in America with a serious adverse impact on employment in industries ranging from raw materials to manufacturing to retailing. Yes, the big auto companies and other giant manufacturers suffer; but so do corner stores, community hospitals, hotels and restaurants.

What's needed is prompt, decisive action to restore transactional trust among institutions, increase liquidity, expand credit, and build consumer confidence. It's especially important that small and medium-sized businesses -- the source of virtually all job growth -- regain access to affordable credit so they can make capital purchases, restock their inventories, pay their suppliers, and hold on to their employees.

Legislative and regulatory actions to date have begun the process, albeit at a staggering cost. Yet more action is needed, especially in tax policy, to encourage deleveraging.

One part of the solution to the current crisis is for Congress and the Treasury to restore, temporarily, the option for companies to deleverage by retiring debt at a discount without incurring tax liability. Tax-code and regulatory changes in the 1980s limited this option by treating the difference between the original issue price of debt and the lower amount for which it's repurchased as taxable income. The resulting tax liability on this "phantom income" decreases liquidity and blocks necessary restructuring of distressed corporate balance sheets. It also creates a perverse preference for bankruptcy that destroys asset values, jobs and customer relations. Finally, it puts American companies at a disadvantage relative to their competitors in nations with more accommodating tax structures, such as Germany and France.

We believe American enterprises should be encouraged to deleverage, whether by exchanging newly issued or existing stock for debt, or using cash from asset sales. This is the worst possible time to impose a tax liability on companies trying to avoid layoffs by reducing their interest payments on debt. Freed from a tax on phantom income, thousands of companies will become stronger through deleveraging.

As companies pay down debt, the yield premiums on their remaining debt will decline, and investors will tend to focus on the higher potential returns from equity. Mindful of fiscal pressures, we suggest that the suspension of the tax on this repurchased debt expire after a reasonable period, perhaps two years.

Too many financial institutions and industrial companies are struggling under the wrong capital structure. It's time to encourage them to pay off their debt.

Mr. Barth is a senior fellow, Mr. Klowden is president/CEO, and Mr. Yago is director of capital studies at the Milken Institute.