Look at Macy's
By David Cho | Sunday, August 8, 2010; G01
Washington Post Staff Writer
Macy's has become the great American department store, with 850 locations scattered across all but four states. And it has gotten there the great American way, by running up huge debts and flirting with default, or worse.
Like other U.S. corporations, it also has had a uniquely American incentive for its borrowing habits: the nation's tax laws.
These rules offer extensive tax breaks to companies that borrow money and penalize those that raise cash in safer ways, such as issuing stock. Yet despite the recent financial crash, which exposed the perils of excessive borrowing, the rules are likely to persist in federal law because nearly all businesses in America would oppose eliminating these tax deductions, lawmakers say.
U.S. companies have had a long love affair with debt, and Washington has tacitly approved. Although the tax benefits are not the only driver of corporate America's preference for loans -- cheap rates and corporate strategy, as in Macy's case, are other major factors -- the tax code often tips the scales toward using debt for deals or for expanding a business.
Over the past generation, debt in America has exploded, becoming a way of life in nearly every sphere of society. And the tax code has been its handmaiden. Home buyers, towns and corporations all enjoy tax breaks that grow as they borrow more. Indeed, federal officials have found that the deductions for business debt are so generous that the government is, in many cases, essentially paying companies to borrow.
The surge in borrowing has opened new markets and financial industries. It has also at times powered economic growth -- for instance, the boom preceding the housing bust -- and activities that wouldn't have been possible under other conditions. Commercial developers build projects they otherwise wouldn't. Private equity firms are able to buy out companies with huge sums of borrowed money. Big banks that lend out all this borrowed money have come to play an outsize role in the economy.
Debt in itself is not harmful, financial analysts say. But they also question whether the government should be prodding companies to borrow and favoring businesses that heavily rely on debt.
"The tax code is interfering dramatically with the choice of how you finance and how you deliver returns in the corporate sector," said Douglas Holtz-Eakin, an economist who heads the American Action Forum. "Why would you build into the tax code a permanent bailout for corporate 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 shopping season by moving Thanksgiving forward a week. During the following decades, Federated swallowed up nearly every other big name in the business, including Marshall Field, Filene's and Macy's -- and then took the Macy'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 trouble 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 transformation of corporate America," said Nick Riccio, a former managing 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 instance, a severe recession. It also can be more expensive than other 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 paying 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 correcting 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 inflating the economy's debt levels. A bipartisan bill in the Senate that would do so has stalled. The financial regulatory overhaul approved by Congress last month does not address the matter.
Macy's executives acknowledged 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 mammoth acquisition of its competitor 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 takeover, Macy's "had big slugs of debt the next couple of years," said Ken Stumphauzer, an analyst 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.
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 interest 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 estate 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 Federated 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 federal 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 borrowed money to build, say, a new warehouse, rather than take over an entire company, he could have won yet another kind of tax benefit. 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 equipment declines over time, a company can use this depreciation to reduce its tax liability.
The combined impact of those two deductions can be tremendous, according to the Congressional Budget Office. Together, they can free a company from paying tax on any income produced by projects financed with debt. But that's not all. The combined deduction can be so large that a company may also be able to apply some of it to its other income, 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 negative 6.4 percent on investments financed with debt. That means, in essence, that Washington is actually paying firms for borrowing money. (By contrast, if a company raises money by issuing stock, it faces the standard corporate 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 downgraded it several notches, making 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 retailer was counting on spectacular sales of clothes, purses and shoes to keep pace with the payments.
That didn't happen. In the early 1990s, the savings and loan crisis triggered a recession, and Federated wasn't ready for it. Just 21 months after the Campeau buyout, Federated filed for the biggest bankruptcy in retailing history. More than 5,000 employees lost their jobs. Shareholders were wiped out.
A company that virtually no one had thought could fail had collapsed.
Warnings about perverse incentives for corporate borrowing have long sounded in Washington.
"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 increases "the possibility of financial 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 borrow while the Federal Reserve kept interest rates exceptionally low. By the end of last year, corporate America had nearly $11 trillion to pay off, according to the Fed.
Senior advisers to both presidential 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 corporations to finance themselves more heavily through borrowing. This leverage in turn increases the financial fragility of the economy, an effect we are seeing quite dramatically today."
Sens. Judd Gregg (R-N.H.) and Ron Wyden (D-Ore.) have drafted 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 retailers, Federated decided in 2005 to pull off one of the largest deals in retailing history by buying May Department Stores for $11 billion, combining the biggest players in the business. The name of the company was changed to Macy's. At the time, company executives talked of making the red Macy's star as well known as Target's bull's-eye or Wal-Mart's smiley face.
To complete the deal, Federated agreed to absorb $6 billion of May's debt. While Macy's benefited from the interest deduction on those loans, the company's executives said that was not the reason the deal was made.
Some retailing analysts questioned 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 billion -- that it significantly reduced the overall value of the company below a level that was allowed by its banks. That, in turn, forced Macy's to renegotiate the agreements it had with its lenders.
Macy's Chief Financial Officer Karen Hoguet said in an interview 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 equity," 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 focus on shedding even more, executives say.
But the costs have been significant.
In 2009, executives announced that 7,000 jobs would be cut. Macy's also saw its borrowing costs soar. And the ratings agencies again stripped the firm of the investment-grade rating it had worked for years to restore.
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