Temporarily Suspending DOI Rules on Repurchase of Below-Par Business Debts

Everett Ehrlich has posted Temporarily Suspending the Recognition of Income from the Repurchase of Below-Par Business Debts on the U.S. Chamber of Commerce web site.  Here is the Executive Summary:

The economy is contracting rapidly. At the heart of this contraction are the twin problems of plummeting demand and a “liquidity crisis” in which banks, having suffered immense losses and waiting for the next shoes to drop, are strapped for capital and afraid to lend.

One feature of the current crisis is that the debts businesses owe to banks have plummeted in value as economic conditions worsen; the implicit value assigned to business risk in the economy today is, by some measures, at an all-time high. This poses a unique opportunity – businesses could use their cash to buy back their debts at a fraction of their face value. This would have a series of significant benefits. It would cut their interest costs and free up cash for employment and investment; it would support the prices of business debt and improve banks’ balance sheets; it would create a more liquid credit market and add to confidence; it would make the job of the TARP rescue program easier and more efficient; and, perhaps most significantly, it would protect more businesses from defaults and bankruptcies, allowi ng them to preserve and create jobs in their own enterprises and economy-wide through their capital expenditures.

The most significant obstacle to this wave of refinancing is the tax code. If a business can buy back a dollar’s worth of its own debt for 75 cents, the tax code now stipulates that it must recognize the 25 cent difference as income and tax must be paid on it. This creates a significant penalty on this type of transaction. A proposal that would suspend this type of income recognition for two years is now before the Congress. (Households who can renegotiate the face value of their mortgages have been given equivalent relief.) Such a suspension would do much to preserve employment and investment while supporting financial asset prices and the institutions that hold those assets. Moreover, by helping to support bank balance sheets and rebuilding the market for business debt, this proposal would do some of the work now being asked of the TARP, without having to make serial guarantees or capital grants.

(Hat Tip: Bruce Bartlett.)