Editor's note: The following story ran Oct. 22, 1991, on Day Three of the nine-day "America: What went wrong?" series published in the Inquirer.
* * *
Once upon a time, in a faraway land called Texas, two men owned a bank. They called it Guaranty Federal Savings & Loan.
The two men paid themselves lots of money and loaned other people lots of money.
But they wanted to make even more money, so they met with people from a distant kingdom with very tall buildings, called Wall Street.
They liked the Wall Street people very much and decided to buy pieces of paper from them called bonds.
They bought and sold the pieces of paper over and over again.
When they made money doing this, they kept it for themselves.
When they wanted even more money to build castles of sand in yet another kingdom, they just took it out of the bank.
This worked OK. Until one day the bank ran out of money.
Then some government people came to Dallas to look into the way they ran the bank. These people called the two men crooks and put them in a building with bars on the windows.
The government people took the bank away from the two men and sold it to a big Texas company.
Then the government people gave the big Texas company lots of money so the bank wouldn't run out again. Best of all, the government people also gave the company a very special magic wand that came with the bank.
The wand is called NOL, and it is wondrous.
It makes taxes disappear.
The government actually invented the wand.
By waving the wand, the big Texas company that now owns the bank can make taxes vanish for years and years and years. The money it used to pay in taxes it can now keep for itself.
Isn't this a nice deal for the big Texas company?
Nicer than you think.
First of all, the wand invented by the government people is available to only a select few.
You, for example, can't have one.
What's more, you pay for the wands that do get passed around.
NOL stands for net operating loss deduction, a tax break that allows corporations to reduce this year's taxes - and next year's taxes, and so on - because of money lost last year.
Through the 1980s, the NOL enabled corporations to escape payment of more than $100 billion in income taxes.
But it is not the largest of the many generous writeoffs available to businesses.
The deduction that corporations can take for interest paid on borrowed money costs the government nearly $100 billion in a single year, dwarfing the amount that NOLs diverted from the U. S. Treasury.
The deduction for interest on corporate debt has long been part of the U.S. tax code, but in the unchecked frenzy of the 1980s, as merger-minded companies took on enormous debt, it ballooned out of control.
A catalogue of other deductions - ranging from the writeoff for so-called intangibles, to special deals that exempt select businesses and investors from payment of taxes - runs to many more billions in lost tax revenue.
All these are reasons that individual taxpayers are picking up an ever- larger share of the U.S. tax burden, while corporations pay a steadily decreasing share.
Corporations such as Temple-Inland Inc., the big Texas company that got the magic wand when it acquired Guaranty Federal Savings & Loan Association of Dallas.
That's the savings and loan run by the two men from Dallas, Paul Sau-Ki Cheng and Simon Edward Heath. The Wall Street people were from Drexel Burnham Lambert Inc. and E. F. Hutton & Co. Inc.
By the time Cheng and Heath had finished working their financial wizardry, Guaranty Federal was insolvent. Federal regulators seized it in 1988 and turned it over to Temple-Inland.
As a result of what the government has charged was "fraudulent bond- trading" transactions, along with illegal dealings that led to the conviction of Cheng and Heath, the savings and loan ended up with a net operating loss of more than $300 million.
Now, and for many years to come, Temple-Inland can use those old losses incurred by the S&L's former owners to reduce its taxable income and avoid paying taxes.
What makes the Guaranty Federal story so remarkable is this:
First, taxpayers are paying, and will continue to pay, to bail out the failed savings and loan - that is, to restore depositors' money.
Then, taxpayers will pay yet again, to make up for the taxes Temple-Inland won't be paying because its profits can be offset by the savings and loan losses incurred years earlier by two men now in jail.
Direct cost of the bailout: An estimated $3.9 billion, which will go straight from you and other taxpayers to Guaranty Federal and its new owner, Temple-Inland.
Indirect cost: An estimated $590 million in lost tax revenue. That missing revenue will be made up by you and other taxpayers - or be added to the federal debt, in which case you'll pay the interest charges on it.
The tax beneficiary, Temple-Inland, is a diversified corporation based in Diboll, Texas. The firm's interests, which include forest products, building materials, mortgage banking and insurance, generate more than $2 billion in annual revenue.
Its largest stockholder is Oppenheimer Group Inc., parent of Oppenheimer & Co. Inc., the Wall Street investment banking and securities firm.
In 1990, the first full year that Temple-Inland took advantage of the Guaranty Federal tax breaks, its federal income tax payments plummeted 66 percent.
According to a report filed with the U. S. Securities and Exchange Commission (SEC), the company's profits rose from $207 million in 1989 to $232.5 million in 1990. But its taxes fell from $84 million to $29 million.
If you were in the $30,000 to $40,000 income group and received a similar tax break, you'd have an extra $48 every week in your pay.
Guaranty is only one of hundreds of savings and loans that taxpayers are rescuing, Temple-Inland only one of scores of companies profiting from the bailout. The ultimate cost to taxpayers: A half-trillion dollars.
If you make $20,000 to $30,000 a year, you might think of that sum this way:
Every dollar that you and all others in your income group pay in federal income taxes for the next decade will, in effect, go to the savings and loan industry.
For this, you can thank the people in Washington - a succession of Congresses and presidents, administrators and regulators, Democrats and Republicans - who write the government rule book.
The rule book is the accumulation of laws and regulations that provide the framework for the country's economy, affecting everything from the taxes you pay to whether your job is moved to Mexico.
As The Inquirer has reported over the last two days, that rule book is responsible for your eroding standard of living, for the decline of the middle class, for the inability of those at the bottom to improve their economic lot.
All this has happened through:
- The enactment of laws and regulations crafted for the benefit of special interests.
- The failure to enact laws and regulations that would ensure a level economic playing field for everyone.
- And the refusal to rescind long-outdated laws that favor selected interests.
Thus has the balance been tilted.
As might be expected, some people profit handsomely from this system. Like Ted Arison of Miami Beach, Fla., and Tel Aviv.
You may not recognize the name. But you've probably seen the TV commercials for his company. The ones starring Kathie Lee Gifford (co-host of the syndicated TV show, Live With Regis and Kathie Lee), who, in assorted costumes, dances across the decks of the "fun ships" of Carnival Cruise Lines Inc. singing "Ain't We Got Fun. "
From 1985 to 1988, Carnival Cruise Lines, which promises evenings of ''dazzling entertainment, romantic dancing and fast-paced casino action" aboard a fleet of ships with names such as Fantasy and Ecstasy, produced total profits of $502.5 million.
The corporate income tax rate during those years ranged from 46 percent in 1985 to 34 percent in 1988, meaning that Carnival paid about $200 million in federal taxes.
Carnival paid not a cent in U.S. corporate income taxes on that half-billion dollars in profits. Its corporate tax rate was zero.
That's because Carnival benefits from a government rule book that exempts shipping companies incorporated in foreign countries from having to pay U.S. income taxes.
Although Carnival's offices are in Miami, and its Caribbean-bound ships leave from Miami, the company is incorporated in Panama. Its subsidiaries are organized in Liberia, the Bahamas, the British Virgin Islands and the Netherlands Antilles.
Carnival's situation is not unique. Hundreds of corporations have eliminated or drastically reduced their federal tax bills through similar special-interest tax laws.
But the immunity from federal corporate income taxes helps explain why Ted Arison, 67, the Israeli-born founder of the company, was designated by Forbes magazine in 1991 as one of the 15 richest people in the United States, with wealth estimated at $2.3 billion.
How is it possible for any corporation to escape paying taxes after passage of the 1986 Tax Reform Act, the legislation that members of Congress hailed as restoring fairness to the American tax system?
The legislation that Sen. Bob Packwood (R., Ore.), one of the two chief architects of the tax law, said was so tough that "there will not be a profit-making corporation in the country that can escape taxation. "
The legislation that Sen. John F. Kerry (D., Mass.) said "will make that kind of unfairness a thing of the past" and permit "the American people to move once again to trust their federal government. "
They said it.
The tax act did not do it.
For the five years preceding passage of the tax act, Carnival recorded profits of $279 million, and paid no federal income taxes.
In the two years following passage, it recorded profits of $349 million - on which it paid no federal income taxes.
In June 1987, several months after the sweeping tax-overhaul legislation was signed into law, Carnival Cruise Lines issued a stock-offering document confidently predicting that its tax-free status would continue.
The registration statement, filed with the SEC, states: "The company is not subject to United States corporate tax on its income from the operation of ships, and the company does not expect such income to be subject to such tax laws in the future. "
The 1986 act did make one change that affected Arison personally.
It required large shareholders like him to report a portion of their company's earnings on their individual income tax return.
But the company had a solution for Arison's personal tax bill, as it disclosed in a report filed with the SEC in March 1990.
As Carnival explained it, if the company's taxable income amounted to, say, $200 million, a stockholder who owned 80 percent of the company's stock (as Arison, in fact, did at the time) would be required to report $160 million in income on his personal tax return.
At an effective tax rate of 30 percent, he would owe taxes of $48 million.
Not to worry. Carnival would declare a dividend equal to the $48 million and give it to the stockholder (that is, to Arison) to pay his taxes.
As Carnival put it in the SEC report:
"The company anticipates that it will pay quarterly dividends aggregating with respect to each year an amount at least equal to the principal shareholder's tax rate . . . "
If there were a comparable deal for you, it might function something like this:
Let's say you work for Strawbridge & Clothier and earn $35,000 to $40,000. At the end of the year, your federal tax bill is $3,710. So Strawbridge & Clothier declares a special dividend and gives you a check for $3,710.
In the real tax world, you must pay your own taxes, and Strawbridge & Clothier must - and does - pay corporate income taxes.
For Carnival and companies like it, the rules are different.
Today, Arison's company still pays no federal income taxes on its cruise operations, which accounted for 78 percent of its overall revenue last year.
But when Carnival acquired Holland America Line in January 1989, it was obliged to begin paying some income taxes.
The reason: Holland America operates tours and hotels within the United States that do not enjoy the same tax immunity granted to the cruise business.
Thus, in 1989 and 1990, Carnival paid $11 million in federal income taxes on profits of $411 million.
That's a tax rate of 2.7 percent, about half the rate paid by individuals and families with incomes of $7,000 to $9,000.
Carnival's tax-free status for its cruise operations has been one of its big selling points with Wall Street, driving up the stock price and helping make Arison a billionaire.
Time and again, securities analysts have singled out Carnival's tax advantage and assured investors that there was little reason to fear that Congress would end the preferential treatment.
In October 1987, the securities firm Bear Stearns & Co. issued an investment report advising its clients:
"We are not aware of any initiatives now being considered by Congress to amend the 1986 tax changes in ways that will be detrimental for Carnival.
"In fact, when sponsors of the bills were working out final provisions last year, several interested parties were aiming to include language that would have further solidified exemptions . . . "
Translation: Friendly members of Congress were prepared to write an amendment to the IRS code guaranteeing the tax exemption of Carnival and similar companies.
This exemption is but one of the thousands of provisions that make up the government rule book, for which you pick up the tab.
* * *
To understand why you pay the taxes you do, think of your paycheck as part of two government pies.
The first pie is made up of total income taxes collected from all individuals and all corporations. The amount that you, as an individual, pay is determined, in part, by the amount Congress says companies should pay.
If Congress collects more from businesses, you pay less. If Congress says some businesses may pay reduced taxes, you pay more.
The second pie is made up of combined income taxes and Social Security taxes collected from individuals. The amount that you pay if you earn, say, between $25,000 and $35,000 is determined, in part, by the amount that Congress says people who earn more than $100,000 should pay.
If Congress collects more from people at the top, you pay less. If Congress says people at the top should pay less, you pay more.
Now consider a few statistics drawn from an Inquirer analysis of a half- century of government tax and economic data. They will explain why you are accounting for an ever-larger slice of the two government pies.
ITEM. During the 1950s, when more Americans than ever attained middle-class status, the federal government collected $478 billion in combined individual and corporate income taxes in the decade.
Of that, corporations paid 39 percent, individuals 61 percent.
During the decade of the 1980s, individual and corporate income tax collections soared to $4 trillion.
Of that $4 trillion, the corporate share dwindled to 17 percent, the individual share swelled to 83 percent.
ITEM. Corporations have succeeded in reducing their share of the tax burden, in part through a provision in the government rule book that permits a virtually unlimited deduction for interest on debt.
During middle-class America's golden years, the 1950s, corporations paid $44 billion in interest on borrowed money and more than four times that amount, $185 billion, in federal income taxes.
By the 1980s, an era of frenetic corporate borrowing and unabashed congressional support of special interests, that pattern was reversed.
During that decade, corporations paid out $2.2 trillion in interest on borrowed money and $675 billion in income taxes.
Thus, in the 1950s, companies paid $4 billion in taxes for every $1 billion they paid in interest. In the 1980s, they paid $3 billion in interest for every $1 billion paid in taxes.
That means if your income was less than $30,000 a year during the 1980s, every penny that you - and the other 70 million people who are in that income bracket - paid in federal income tax the entire decade went just to offset the taxes lost from the deduction for interest on corporate debt.
ITEM. Congress has written the government rule book so that Social Security taxes consume an ever-larger share of the weekly paychecks of low- and middle- income Americans, while the affluent are exempted from similar increases.
As a consequence, the average family or individual has less money to spend for housing, food, clothing and education.
Look at the plight of median-income families, those who fall in the middle of the American economy, with half of all workers earning more, half less.
During the 1950s, median-income families paid Social Security taxes equal to 1.7 percent of their income. In the 1980s, they paid 7 percent.
For more affluent families - say, those with incomes of 10 times the median - the Social Security burden also increased, but it remained below 1 percent of their income.
ITEM. While maintaining or increasing the tax burden on middle- and low- income workers, Congress has cut taxes for many of the nation's wealthiest people by one-third or more.
In 1970, individuals and families with incomes between $500,000 and $1 million paid, on average, $304,408 in combined federal income and Social Security taxes.
By 1989, individuals and families in that income group paid $168,714 - or $135,694 less than 19 years earlier. That amounted to a tax cut of 45 percent.
By way of comparison, during the same period, the combined income and Social Security taxes of people in the $25,000-to-$30,000 income group fell from $5,092 to $4,645 - a decline of 9 percent.
If the 7.6 million individuals and families in that middle-class group had benefited from the same tax-rate cut as the more affluent taxpayers, they each would have received a tax reduction of $2,291 - instead of the $447 they got.
As you might expect, the people who write the tax laws have painted a different picture.
Rep. Dan Rostenkowski (D., Ill.), chairman of the House Ways and Means Committee and one of the two principal authors of the 1986 Tax Reform Act, portrayed himself as the defender of the middle class during debate on the legislation.
At one point, Rostenkowski posed these rhetorical questions for his colleagues:
"Today's vote is very straightforward. Do we want to give this country tax reform - or don't we? Do we want to give back to middle-income taxpayers the fairness they do not believe will ever come? Or do we want to stand for the status quo which goes hard on the poor - and easy on the rich? "
The answer - documented in an Inquirer analysis of tax data - is that Congress has stood for the rich.
In 1985, the year before the tax overhaul bill was passed, those with incomes between $30,000 and $40,000 paid combined federal income and Social Security taxes of $6,663. That was 19 percent of their income.
In 1989, three years after "tax reform," they paid $6,177, or 17.6 percent. That amounted to a 7 percent cut in tax rates.
By comparison, during that same period, those with incomes between $500,000 and $1 million saw their combined taxes fall from $243,506 to $168,714.
That amounted to a 31 percent cut in tax rates - nearly five times the rate-cut for middle-class taxpayers.
If Rostenkowski and his colleagues were adamant about the good deeds they were doing for the middle class in 1986, they were equally insistent that the pending bill would transfer the tax burden from individuals to corporations. Rostenkowski said:
"The bill will shift more than $120 billion in tax liability from individuals to corporations - restoring a balance that existed at the start of this decade. "
Sen. Jay Rockefeller (D., W. Va.) said that "what the bill really does is broaden the tax base and shift the tax burden from individuals to corporations . . . "
In February 1986, months before passage of the 1986 tax act, Congress estimated that corporate tax collections under existing law would amount to $410 billion from 1987 through 1990.
The new tax law, which Congress sold as transferring taxes from individuals to corporations, resulted in actual corporate collections of $375 billion during the four years.
Instead of generating $120 billion in new corporate tax revenue, the law produced $35 billion less than had been projected under the old law.
As for Rostenkowski's claim that the act would restore the balance between corporate and individual tax payments that had existed in the early 1980s, consider this:
In 1980, corporations accounted for 21 percent of total income taxes collected from individuals and corporations. In 1990, corporations accounted for 17 percent.
That was down 4 percentage points. Not up.
It is such creative math that has led to an exploding U.S. deficit, which is a major factor in your falling standard of living.
Despite three laws passed by Congress mandating a phased elimination of the federal deficit by 1991 - and then by 1993, and then by 1995 - the red ink this year will approach $300 billion, a record.
To better appreciate the consequences of congressional arithmetic, you might consider that in 1960, $9 of every $100 that individuals paid in federal income taxes went not for education or health or social services, but for interest on the debt.
This year, it's $29 of every $100.
The interest payments represent the largest transfer of wealth in this century - with the money going from middle-class job holders to the investors who own the debt.
To put what is happening in more personal terms, think about the federal debt this way.
Some years ago, your parents borrowed money from your rich uncle and now you must pay back the loan.
Let's suppose that, as in most families today, both you and your spouse work, and your combined paychecks total $600 a week, which makes you a certified member of the middle class.
Now, give your rich Uncle $175 - or 29 percent of your income. Give him another $175 next week. And every week, for the rest of your life.
And presume that when you die, your children will keep paying it. Except they'll make the payments to the rich uncle's children.
It is the ultimate loansharking operation, one that organized crime leaders could only dream about.
For all that money will go for interest on the debt. The debt itself will never be paid.
Oh, that uncle? He may be American. But chances are increasing that he is Japanese, Swiss, German or Arab, since foreign nationals own a growing share of the U.S. debt.
* * *
Long ago, businesses borrowed money to build plants, to buy equipment and to make new products, thereby creating jobs. In those times, there was a certain logic to allowing companies to write off the full interest expense on their tax returns.
But in the 1980s, the interest deduction became an instrument to dismantle America - not to build it.
Businesses borrowed money to raid other businesses and sell off their assets. That led to the closing of factories, the elimination of middle-income jobs, and the paying of astronomical sums to owners, investors and corporate executives who brought it all about.
All this was subsidized by taxpayers - through the deduction for interest payments.
Consider the interest and tax payments of two companies, as compiled from reports filed with the SEC.
USG CORP. The company, based in Chicago, was founded in 1901 and is better known by its former name, United States Gypsum Co. USG manufactures and markets building products and is the country's largest producer of gypsum wallboard.
Over the last two years, USG reported total operating income of $487 million.
Interest expenses totaled $589 million, wiping out all of the operating income.
Federal income taxes paid: zero.
BURLINGTON HOLDINGS INC. The company, based in Greensboro, N. C., makes an array of textiles, including fabrics for clothing, carpets, upholstery and draperies.
Over the last two years, Burlington reported operating income of $389 million.
Interest expenses totaled $504 million, wiping out all of the operating income.
Federal income taxes paid: zero.
Those two companies are not exceptions. They are, rather, representative of many corporations.
Remember, too, this was after passage of the 1986 Tax Reform Act, which was so widely hailed as restoring equity to the tax system and assuring that corporate America would pay its fair share.
Beyond corporations that do not pay their fair share of taxes because of a preferential government rule book, there is yet a darker side to the story, one with bleaker implications for the American middle class.
The expenditure of those hundreds of millions of dollars borrowed, and the millions of dollars that were - and will be - paid in interest did not create a single new job.
In fact, to meet their interest payments, USG and Burlington Holdings, whose debt grew out of the corporate takeover wars encouraged by the government rule book, did what so much of the rest of corporate America has done in the same situation:
They slashed their workforces.
And they received a tax break for doing it.
What's more, the very deduction that wipes out tax bills now - the interest writeoff - creates yet another tax-avoidance mechanism to shelter future profits for USG, Burlington Holdings and many others.
The net operating loss deduction - the magic wand that makes taxes disappear.
* * *
As with so many sections of the tax law, Congress originally agreed to the net operating loss deduction as an "emergency" measure to promote fairness.
It was enacted in 1919 specifically to help ease business recovery from World War I.
Rep. Claude Kitchin, a North Carolina Democrat who was chairman of the House Ways and Means Committee, explained what he called the "net loss relief provision" during debate on a pending tax measure in February 1919.
Kitchin said that the tax writers "agreed that it was wiser and safer" to limit the deduction to one year, "for the transition period from war conditions to peace conditions . . . "
The provision, he asserted, would be "just for this year, 1919. "
Seventy-two years, to be precise, and Kitchin's "loss relief" amendment is embedded in the Internal Revenue Code.
For most of those years, the net operating loss deduction was not widely used by businesses and thus did not represent a significant loss of tax revenue.
That changed in the 1980s, when investors, speculators and takeover artists saw an opportunity to turn the tax code into instant profits for themselves.
One company charted the course.
In 1970, the Penn Central Transportation Co., which had been formed two years earlier with the merger of the old Pennsylvania Railroad and New York Central, collapsed into bankruptcy court.
When it finally emerged from bankruptcy proceedings in 1978, the reorganized company, now called the Penn Central Corp., bore scant resemblance to the railroad of old.
Gone were the rail cars, freight yards and train stations. In their place were diversified holdings in housing, recreation and energy.
But the new Penn Central kept one "asset" from its dying days as a railroad:
Two billion dollars in net operating losses - thanks to that temporary 1919 ''emergency" provision.
To make full use of it, Penn Central acquired profitable companies and began using the old Penn Central's losses to reduce taxes owed by the newly acquired companies.
While the operating income mounted, adding up to $1.8 billion from 1978 to 1984, the company paid no federal income taxes.
"Our income stream is not subject to current federal income tax as a result of our loss carryforwards," the company said in its 1983 annual report.
Since coming out of bankruptcy in 1978, Penn Central has written off more than $1 billion of the net operating losses, avoiding payment of hundreds of millions of dollars in federal income taxes.
Today, Penn Central still has about $1 billion in net operating losses left over. Making use of them remains one of the company's primary objectives. As its officers told stockholders in 1989:
"We must . . . fully utilize the value of the company's remaining $1 billion in net operating loss carryforwards. "
Then there is the Chicago-based Itel Corp. The company generates annual revenue of $2 billion from its interests in rail-car and marine-container leasing, dredging, and the distribution of wiring and cable systems.
It also generates hefty tax-free profits, courtesy of the net operating loss deduction. Those profits have helped secure a spot on the Forbes directory of 400 richest Americans for Samuel Zell, the Chicago investor who controls the business.
From 1984 to 1989, according to SEC reports, Itel recorded $563 million in operating income - that's income before interest payments and taxes.
Its federal income tax payments: zero.
"Federal income tax is not accruable or payable by Itel," the company's 1988 annual report said, "because income that would otherwise be taxable is offset by the utilization of its substantial . . . tax loss carryforwards. "
Lest you believe that the people responsible for the government rule book - and who make all this possible - are troubled by the consequences of their handiwork, ponder the words of Ronald A. Pearlman, one of those rule writers.
Pearlman was assistant secretary for tax policy in the Treasury Department for the Reagan administration. That's the executive-branch office that recommends the tax contents of the government rule book.
Later, Pearlman became chief of staff of Congress' Joint Committee on Taxation. That's the committee with overall responsibility for the rule book's tax contents.
Now, he is a member of Covington & Burling, a Washington law firm that often succeeds in influencing the rewriting of the rule book for the benefit of its clients.
Earlier this year, during an interview with Tax Notes, a Washington publication, Pearlman was questioned about the net operating loss deduction.
Echoing the views of many members of Congress, Pearlman said: "Others may say the tax system is too generous in the way it deals with loss carryovers. That's not a concern I share. "
So what's the bottom line for the net operating loss deduction, which proponents defend as necessary to help start-up companies through their early money-losing years and to even out the tax bills of companies whose income fluctuates from one year to the next?
At best, it has evolved into a device to transfer payment for a corporation's ill fortune from its stockholders and managers to individual taxpayers.
In many cases, it also has become a lucrative tax-avoidance scheme enabling shrewd investors to use others' losses to cut their own corporate tax bills.
Actually, with the net operating loss deduction, a company can do more than avoid payment of future taxes. It also can go back in time and collect a refund of taxes paid.
Losses incurred in 1991, for example, can be subtracted from taxable income for three previous years, enabling a company to obtain a refund check from the U. S. Treasury for taxes paid in those years.
By now, you may be wondering how you can do the same.
But your loss is someone else's gain.
In 1969, corporations wrote off $2.5 billion in net operating losses, or 3 percent of their taxable income.
By 1988, those deductions had soared to $51.4 billion, or 13 percent of their taxable income.
Thus, net operating loss deductions increased 1,956 percent during those years.
This is just the beginning.
Absent a change in the rule book, the deduction will grow larger in years to come because more corporations are winding up in U.S. Bankruptcy Court, creating yet more net operating loss deductions for future use.
This means middle-class individuals and families will continue to subsidize the failed business practices of the 1980s - practices that produced massive profits for corporate managers and investors, and bankruptcy, unemployment and reduced wages for workers.
Even unlawful business dealings that produced net operating losses are now being converted to tax savings for the favored few.
The new owners of Guaranty Federal, for example, are benefiting from the fraudulent losses of their predecessors, who went to jail.
* * *
The story begins with Guaranty's former owners, Paul Sau-Ki Cheng and Simon Edward Heath, Dallas real estate promoters.
One-time classmates at Southern Methodist University in Dallas, Cheng and Heath had gone into the real estate business after graduation from college in 1977.
In 1984, their real estate company, Pacific Realty Corp., acquired Guaranty Federal Savings & Loan Association, a savings bank in Galveston that dated from 1938.
Then, Cheng and Heath, encouraged by Drexel Burnham Lambert's Beverly Hills office, staged a raid on U.S. Home Corp., according to a federal complaint later filed against them. There was some irony; earlier, Drexel Burnham had underwritten $50 million in junk bonds for U.S. Home., a Houston-based home builder.
Cheng and Heath's takeover bid for U.S. Home ultimately collapsed, along with the value of the stock they had acquired, leaving them $7 million in the hole.
A solution soon appeared.
According to a Federal Deposit Insurance Corp. (FDIC) lawsuit, it was a ''fraudulent bond-trading" scheme involving speculation in U.S. Treasury bonds that worked like this:
The two businesses that Cheng and Heath controlled - Guaranty Federal, their government-insured thrift, and Pacific Realty, their real estate company - opened brokerage accounts with Drexel Burnham and E. F. Hutton to handle buy-and-sell orders for U.S. Treasury bonds.
The crux of the scheme was to manipulate Treasury bond trading between the two accounts at each brokerage house - assigning losses to the federally insured savings and loan association, and profits to Cheng and Heath's private real estate subsidiary.
Drexel and Hutton installed special phone lines in Cheng's Dallas office and home connecting him directly to their trading desks.
From September 1986 to April 1987, Cheng made nearly 1,500 transactions, buying and selling more than $21 billion in Treasury bonds for Guaranty Federal and an additional $16.8 billion for Pacific Realty.
"From the very beginning of the trading scheme period," the FDIC contended, "the excessive trading resulted in significant and constant losses to Guaranty Federal, the insured institution, while (Pacific Realty) consistently realized significant gains. "
Guaranty Federal lost money every month and Pacific Realty made money every month through what the FDIC described as "unsafe and unsound speculation. "
The strategy worked nicely for Cheng and Heath. According to the FDIC complaint, they earned $11.1 million for Pacific Realty and two family trusts.
Drexel Burnham and E. F. Hutton also prospered, earning an estimated $49.6 million in commissions and markups from the nearly 1,500 trades. Individual brokers collected between $7.5 million and $15 million for their services.
The big loser was Guaranty Federal.
The savings and loan lost $28.5 million on the trades and an additional $40 million later when it sold bonds at depressed prices, bringing the overall loss to $68.5 million.
In its pending civil lawsuit, the FDIC is seeking judgments against Cheng, Heath and the brokerage firms for $130 million in actual damages and an additional $390 million in punitive damages.
Drexel Burnham and Hutton have contested the FDIC allegations.
The federal agency, if it proves its case against Cheng and Heath, may have difficulty collecting. On Aug. 6, 1990, both men filed for protection from creditors under the U. S. Bankruptcy Code.
And nine days later, on Aug. 15, 1990, a U. S. District Court jury in Dallas convicted Cheng and Heath of defrauding Guaranty Federal in transactions unrelated to the bond-trading scheme.
They were found guilty of bank fraud, wire fraud, misapplying Guaranty Federal money and making false entries in the thrift's books in connection with a $10 million loan on a Florida property. Cheng subsequently was sentenced to 30 years in prison, Heath to 20 years, and both are currently in jail.
All these transactions helped to undermine Guaranty Federal, adding it to the growing list of savings and loans that have collapsed and now are being bailed out by the federal government at a projected cost to taxpayers of a half-trillion dollars.
On Sept. 30, 1988, the Federal Home Loan Bank Board declared the thrift insolvent.
That same day, the federal agency merged Guaranty Federal with two smaller failed Texas thrifts. The surviving entity was renamed Guaranty Federal Savings Bank and sold to Temple-Inland Inc.
As part of the federal rescue plan, Temple-Inland agreed to put in $75 million in cash and to buy $50 million worth of Guaranty Federal preferred stock in 1990 and 1991.
The Federal Savings and Loan Insurance Corp. (FSLIC), in turn, agreed to cover any losses on Guaranty Federal assets, which had a book value of just under $1.7 billion.
That meant if Guaranty Federal owned an office building that was worth, according to its books, $10 million, but could be sold for only $5 million, the FSLIC would kick in the $5 million difference.
Better still, to make the sale of the failed thrift more attractive, the government gave a note to Guaranty Federal's buyers promising to pay $700 million - and to pay interest on that note. Even better, the interest income is tax-free.
Temple-Inland put up $125 million.
The FSLIC - courtesy of the taxpayers - put up $700 million, plus a promise to make up any losses suffered on assets valued at $1.7 billion.
Those are the highlights. There are other subsidies.
Like the fact that the interest payments that the FSLIC makes to Guaranty Federal on the FSLIC's promissory notes may be excluded from income for tax purposes.
You can't do that. If you could, it would be like collecting the interest on $10,000 in your savings account - and then not having to report the money as taxable income.
And then there is, of course, the magic wand, as explained in the report to the government's S&L bailout agency, the Resolution Trust Corp.:
"The (Internal Revenue Code) also permits the consolidated entity to use accumulated net operating loss carryovers and other loss carryovers of the failed institutions to offset taxable income of the acquiring association following the acquisition. "
Translation: The losses suffered by Guaranty Federal, due, at least in part, to the criminal conduct and the bond-trading activities of its former owners, may be used to reduce the taxes owed by its new owners.
From the beginning, Wall Street liked the deal.
Donaldson, Lufkin & Jenrette, a Wall Street brokerage firm, in a report issued in May 1989, commented on why Temple-Inland's stock was selling below what the investment house believed the price should be:
"We attribute the market's hesitancy in valuing the transaction to date to management's reluctance to advertise just how lucrative the deal is. . . . Temple-Inland will not have to pay taxes on S&L earnings until after 2000. The three units are currently carrying over $550 million in operating loss carryforwards. "
So how much is this going to cost you?
The meter is still running, but an August 1990 report to the Resolution Trust Corp. placed the estimated total cost of the Guaranty Federal bailout - cash and tax breaks - at $4.5 billion.
That means that the equivalent of every penny paid in federal income taxes by all the residents of Philadelphia for the next three years will go to rescue Guaranty Federal and to reimburse its new owners for losses.