The U.S. government has provided more than $1 trillion of support to financial companies in a bid to keep credit flowing to the U.S. economy.

But a new law may give billions of dollars to bankrupt financial companies that will never make another loan. Instead of allowing lenders to keep credit flowing, these subsidies could mainly help hedge funds that buy distressed debt and equity.

This past week, for instance, Washington Mutual Inc and subprime lender Downey Financial Corp, both bankrupt, said the new law will allow them to apply for an estimated $2.75 billion combined in tax refunds.

It is not clear if the companies will get that refund, but investors are betting there is a good chance they will.

The tax benefit was tucked into legislation late last year that broadened unemployment insurance and extended tax credits for homeowners. The provision allows companies of all sizes to apply losses in 2008 or 2009 to prior income over five years to receive tax refunds. The previous standard allowed them to apply losses back two years.

Chief executives and industry groups representing manufacturers, homebuilders and retailers pressed for that tax benefit, although economists expect businesses from across the economy to reap some gain.

Part of the money paid out as 2010 refunds is expected to be recouped in the next few years when businesses turn a profit and begin paying taxes again.

But some of the companies that plan to seek a refund will never pay tax, because they have no future.

The professionals who are liquidating bankrupt companies including Circuit City Stores Inc and Linens 'n' Things are going through the corporate books in anticipation of getting cash back from Washington. The refund money will be used to pay off creditors.

What's a genuinely targeted stimulus to one person is a windfall to another, said Jack Butler, a partner in the corporate restructuring practice at Skadden, Arps, Slate, Meagher & Flom. He emphasized the law will provide capital and liquidity to many companies that are struggling to avoid bankruptcy.

Where it becomes a potential windfall is in liquidating situations, said Butler.

CORPORATE LOSERS

Arguably, helping creditors of bankrupt retailers, such as clothing suppliers, has some social benefit.

But for bankrupt financial companies, their suppliers are mainly investors that gave capital to the company. And at this stage, most of the original investors have sold their claims to hedge funds that specialize in navigating complicated bankruptcies.

Speculators have been scrambling for Washington Mutual's stock over the past week. The preferred shares of Washington Mutual nearly doubled in the span of a few trading sessions, after the defunct bank holding company said it stands to receive another $2.6 billion of new tax refunds.

If Washington Mutual gets the extra refund, the company could have enough money to pay off creditors and have some left over for preferred shareholders, even those who just bought the common or preferred stock.

Claiming the money does not mean the companies will get it. The Federal Deposit Insurance Corp has already indicated that it believes it and not the liquidating estate should get Downey Financial's refund.

And regulators seized Washington Mutual's banking operations, so they may also claim the company's refund. JPMorgan Chase & Co Inc , which bought Washington Mutual's lending business, could claim some of its refund as well.

Companies that applied for money under the Troubled Asset Relief Program are ineligible, but some distressed financial companies may also gain.

Ambac Financial Group Inc , which applied for TARP money through a subsidiary but did not receive bailout funds, could receive more than $900 million in tax benefit, according to Chris Senyek, an analyst with ISI Group in New York.

The bond insurance company, which suffered big losses when the housing crisis cut walloped the subprime bonds it guaranteed, has a market value of $238.7 million and a negative net worth approaching $3 billion, as measured by the value of the assets on its books minus liabilities. It has warned it could file for bankruptcy.

Some critics of the law question the wisdom of giving tax refunds to any bankrupt company.

Congressman Lloyd Doggett, a Texas Democrat, said expanding the tax benefit carryback provides only 19 cents of economic growth for every dollar spent. Expanding unemployment benefits provided $1.61 of growth for every $1 spent, he said, citing economic studies.

Understand that this bill now directs the Treasury to now write checks to corporations for more than $10 billion -- checks to corporations that committed fraud, that exist now only on paper. It rewards some of the very corporate losers who have brought us to the brink of economic ruin, Doggett said in a statement.

Several lawyers and tax professional noted the broader economic benefit of the law. They emphasized the law returned money that companies had paid and essentially brought forward a tax refund that would have been claimed in future years anyway, providing immediate liquidity during an absence of lending.

It was very helpful to get back refunds to fund current operations. It could have avoided some layoffs in restaurants and retail and other industries. It was intended to be a positive economic response, said Andy Short, a partner with Paul, Hastings, Janofsky & Walker in New York.

(Editing by Gary Hill)

Jpmorgan chase Citigroup