ataxingmatter Linda Beale asks the neglected question of the day

cross posted from ataxingmatter

Madoff’s ponzi scheme tax losses and union workers’ home losses

Wall Street has not had a good year (and of course, the taxpayers have borne the brunt of the resulting chaos). Credit default swaps, for several years the darlings of the industry, have become a giant albatross around taxpayers’ necks, especially through the AIG bailout. Stocks have plummeted, as financial institutions’ speculative hayday that funded unmerited, oversize executive bonuses (see, e.g., On Wall Street, Bonuses, not Profits, were Real, NY Times, Dec. 17, 2008) has crashed with the shaky mortgages at the foundation of so many CDOs and other securitizations, which of course means many individual homeowners are out in the cold.

And then there’s the Madoff scandal–a highly respected figure on Wall Street (he was once on the SEC advisory council) who has admitted to defrauding investors to the tune of at least $50 billion in a ponzi scheme that the SEC was warned about, investigated, and then decided, just a year ago, not to pursue. The SEC has egg on its face (not the first time under Republican-appointed pro-industry commissioners), and investors have pockets with big holes rather than lots of gold coins. See, e.g.,

* SEC Release 2008-293, SEC Charges Bernard L. Madoff for Multi-Billion Dollar Ponzi Scheme, Dec. 11, 2008;
* Berenson & Enriques, SEC Says it Missed Signals on Madoff Fraud Case, NY Times, Dec. 16, 2008;
* Scheer & Westbrook, Madoff ‘Tragedy’ Said to have Escaped Investigation by SEC,, Dec. 16, 2008 (no inspection of books since registration as investment adviser in 2006);
* Neumiester, Fallout over Madoff Ripples through Washington, Wash. Post, Dec. 18, 2008;
* Editorial, Swindle of the Century, Wash. Post, Dec. 17, 2008;
* Haughney, Madoff Scandal Shaking Real Estate Industry, NY Times, Dec. 17, 2008;
* Greenwell, Area Jewish Groups Take a Hit Financially, Wash. Post, Dec. 17, 2008;
* SIPC Chief: Madoff Falsified Books to Hide Losses, AP, Dec. 16, 2008;
* Reuters, FACTBOX: Firms Exposed to Madoff Fraud (lists major firms with losses);
* Reuters, Madoff Bad Omen for Fund of Hedge Funds Industry, Dec. 17, 2008.

And why, pray tell, can a guy who is caught stealing a piece of pizza go to jail for life in California on a “three counts and you are out” rule, while Madoff is not even in jail after stealing $50 billion even though he couldn’t put up the bail set by the judge? See Alex Berenson, Authorities Ease Madoff’s Bail Terms, NY Times, Dec. 17, 2008).

What’s the tax angle (gotta get that in somewhere, haven’t I?)? Investors who’ve lost money to Madoff get a chance for relief under the tax code. See Donmoyer, Madoff’s Victims May Recover Losses Through Tax Code,, Dec. 18, 2008.

Capital-gains taxes paid by investors [already too low, in ataxingmatter’s opinion] may be refundable for 2005 through 2007, lawyers said. In addition, they said investors probably can convince the Internal Revenue Service they are victims of theft, which would let them deduct losses from their income taxes dating back to 2005. Any unused theft losses could be used to reduce tax liabilities for the next 20 years.

In other words, investors–the darlings of the Wall Street world and the darlings of the tax code because of their preferential rate on capital gains and other provisions like the charitable deduction for untaxed value rather than just investment basis–have an existing remedy that will likely provide substantial relief. Another bailout, if you will, through tax code provisions–especially if the IRS permits the “theft” deduction. (Note that theft losses would be deductible against ordinary income, usually taxed for wealthy investors at the top rate of 35%, whereas investors have been paying only the very low preferential rates when they have tax gains–nifty, huh? Should the “theft loss” be able to trump the investment loss provision in this context to provide that benefit? Seems like an answer based on a coherent interpretation of the Code provisions should be “no” in this context.)

Once again, worth pointing out a few things here.

The country has spent a lot of money and a lot of time talking about shoring up Wall Street (oops, the financial system). There are various “escape valves” (such as the loss deduction) that provide relief of some sort for wealthy investors who have, undoubtedly, also lost money as financial institutions and other companies lose market capitalization and even go into bankruptcy. But the country hasn’t done much to get at the heart of the problem–providing relief to homeowners with mortgage debt that is driving them out of house and home, letting homeowners modify their mortgage loans in bankruptcy, and setting standards for the TARP money so that banks are not allowed to continue the high-falutin’ lifestyle of huge bonuses built on speculative bets in the financial markets but rather are required to modify some loans and use the money to find a way to refinance some loans on better terms for the homeonwers, and, in the cases of subprime loans that were pushed on people who should have been offered better terms, requiring the banks to “eat” the difference and modify the loans to reasonable terms.

For instance, bonuses, not quite as big as before but still extraordinary in scope, are still flowing on Wall Street.

Critics say bonuses never should have been so big in the first place, because they were based on ephemeral earnings. These people contend that Wall Street’s pay structure, in which bonuses are based on short-term profits, encouraged employees to act like gamblers at a casino — and let them collect their winnings while the roulette wheel was still spinning. See On Wall Street, above. (I might add–and let the taxpayers take the brunt of the damage in a nifty scheme for privatizing gains and socializing losses.)

Meanwhile, homeowners continue to lose homes. Here’s an anecdote to bring this down to the “real people” level. I spoke at length with a union member in Detroit two days ago who told me of a recent meeting of about 1300 union members. Of the 1300, only a handful said they were not in danger of losing their homes to foreclosure! More than half were already in foreclosure. Many were facing imminent default. And the rest were very worried that they would end up defaulting before 12 months passed, including the person with whom I spoke. He’d bought a modest home several years ago, prudently basing his mortgage on his base pay without taking into account the extra pay he often received for overtime. Yet he says most have already seen their take-home go down, and he expects their base pay to go down by at least one-fourth before this is over. And if that happens, he simply won’t be able to make his mortgage payments.

Let’s hope the new Congress reassesses the TARP program and makes modifications that should have been included in the beginning–harsher terms retroactively, along with much more stringent oversight, for the banks that get the money; much more consideration and problem resolution for the homeowners at the heart of the crisis.