3274 1 UNITED STATES OF AMERICA Before the 2 OFFICE OF THRIFT SUPERVISION DEPARTMENT OF THE TREASURY 3 In the Matter of: ) 4 ) UNITED SAVING ASSOCIATION OF ) 5 TEXAS, Houston, Texas, and ) ) 6 UNITED FINANCIAL GROUP, INC., ) Houston, Texas, a Savings ) 7 and Loan Holding Company ) ) OTS Order 8 MAXXAM, INC., Houston, Texas, ) No. AP 95-40 a Diversified Savings and ) Date: 9 Loan Holding Company ) Dec. 26, 1995 ) 10 FEDERATED DEVELOPMENT CO., ) a New York Business Trust, ) 11 ) CHARLES E. HURWITZ, ) 12 Institution-Affiliated Party ) and Present and Former Director ) 13 of United Savings Association ) of Texas, United Financial Group,) 14 and/or MAXXAM, Inc.; and ) ) 15 BARRY A. MUNITZ, JENARD M. GROSS,) ARTHUR S. BERNER, RONALD HUEBSCH,) 16 and MICHAEL CROW, Present and ) Former Directors and/or Officers ) 17 of United Savings Association of ) Texas, United Financial Group, ) 18 and/or MAXXAM, Inc., ) ) 19 Respondents. ) 20 21 TRIAL PROCEEDINGS FOR 10-16-97 22 3275 1 A-P-P-E-A-R-A-N-C-E-S 2 ON BEHALF OF THE AGENCY: 3 KENNETH J. GUIDO, Esquire Special Enforcement Counsel 4 BRUCE RINALDI, Esquire RICHARD STEARNS, Esquire 5 and BRYAN VEIS, Esquire of: Office of Thrift Supervision 6 Department of the Treasury 1700 G Street, N.W. 7 Washington, D.C. 20552 (202) 906-7395 8 ON BEHALF OF RESPONDENT MAXXAM, INC.: 9 FRANK J. EISENHART, Esquire 10 of: Dechert, Price & Rhoads 1500 K Street, N.W. 11 Washington, D.C. 20005-1208 (202) 626-3306 16 12 DALE A. HEAD (in-house) 13 Managing Counsel MAXXAM, Inc. 14 5847 San Felipe, Suite 2600 Houston, Texas 77057 15 (713) 267-3668 16 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO. AND CHARLES HURWITZ: 17 RICHARD P. KEETON, Esquire 18 of: Mayor, Day, Caldwell & Keeton 1900 NationsBank Center, 700 Louisiana 19 Houston, Texas 77002 (713) 225-7013 3 20 21 22 3276 1 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO., CHARLES HURWITZ, AND MAXXAM, INC.: 2 JACKS C. NICKENS, Esquire 3 of: Clements, O'Neill, Pierce & Nickens 1000 Louisiana Street, Suite 1800 4 Houston, Texas 77002 (713) 654-7608 5 ON BEHALF OF JENARD M. GROSS: 6 PAUL BLANKENSTEIN, Esquire 7 MARK A. PERRY, Esquire of: Gibson, Dunn & Crutcher 8 1050 Connecticut Avenue, N.W. Washington, D.C. 20036-5303 9 (202) 955-8500 10 ON BEHALF OF BERNER, CROW, MUNITZ AND HUEBSCH: 11 JOHN K. VILLA, Esquire MARY CLARK, Esquire 12 PAUL DUEFFERT, Esquire of: Williams & Connolly 13 725 Twelfth Street, N.W. Washington, D.C. 20005 14 (202) 434-5000 15 OTS COURT: 16 HONORABLE ARTHUR L. SHIPE Administrative Law Judge 17 Office of Financial Institutions Adjudication 1700 G Street, N.W., 6th Floor 18 Washington, D.C. 20552 Jerry Langdon, Judge Shipe's Clerk 19 REPORTED BY: 20 Ms. Marcy Clark, CSR 21 Ms. Shauna Foreman, CSR 22 3277 1 2 EXAMINATION INDEX 3 Page 4 TERENCE SMITH 5 Cont'd Cross-Examination by Mr. Nickens..3278 6 Redirect-Examination by Mr. Guido........3383 7 Recross-Examination by Mr. Nickens.......3411 8 JOEL A. HARGETT 9 Examination by Mr. Guido.................3426 10 11 12 13 14 15 16 17 18 19 20 21 22 3278 1 P-R-O-C-E-E-D-I-N-G-S 2 (9:00 a.m.) 3 THE COURT: Be seated, please. The 4 hearing will come to order. Unless there are 5 preliminary matters, I believe we were going to 6 resume the cross-examination of Mr. Smith. 7 MR. GUIDO: That's correct, Your Honor. 8 Terry Smith is prepared to resume. 9 THE COURT: Mr. Smith, I would remind 10 you you remain under oath. 11 THE WITNESS: Yes, Your Honor. 12 THE COURT: Mr. Nickens. 13 MR. NICKENS: Thank you, Your Honor. 14 15 CROSS-EXAMINATION 16 17 18 Q. (BY MR. NICKENS) Good morning, 19 Mr. Smith. How are you doing this morning? 20 A. Just happy to be here. 21 Q. Okay. That Southwest flight in the 22 morning in Dallas? 3279 1 A. Actually, American last night. 2 Q. Okay. Let me ask you a few questions 3 about your direct testimony and then I'm going to 4 move into some questions about the high-yield 5 bonds. 6 In your direct testimony, Mr. Guido had 7 asked you a question about the leverage that is 8 attain believe by use of reverse repos as opposed 9 to using deposits. Do you recall that testimony? 10 A. I recall that discussion vaguely, yes. 11 Q. All right. Well, at what has now been 12 labeled Page 2771 of the transcript in the 13 discussion about reverse repos, you were asked: 14 Did you get greater leverage by doing so than you 15 would by using deposits, referring to reverse 16 repos, and you answered you could get much greater 17 leverage, yes? 18 A. Uh-huh. 19 Q. And I'd like to ask you a few questions 20 to clarify that testimony, if I might. Now, if 21 you weren't using deposits, if you're just using 22 cash, let's say, the repo market required a 3280 1 haircut anywhere from 10 percent to 5 percent. 2 Isn't that accurate? 3 A. Depending on the security, that would 4 be about right. 5 Q. So, you could get leverage of 1 to 20 6 at the maximum with the market discipline? 7 A. That's correct. 8 Q. But if you were simply using deposits, 9 the deposit -- in order to do the same thing as 10 you were doing with the repo lender, the 11 regulatory requirement at that time, assuming that 12 you could take the maximum maturity matching 13 credit, was 4 percent? 14 A. That sounds about right. 15 Q. So, in fact, you could get leverage of 16 1 to 25 at the maximum under the regulations only 17 using deposits? 18 A. That's correct. I believe what I was 19 referring to is for marginal growth, while you 20 could potentially get 1 to 25 versus 1 to 20, you 21 would typically, to do any sort of sizable 22 securities purchase using deposits, have to drive 3281 1 up the cost of your deposits in order to attract 2 deposits away from other financial institutions. 3 In the repo market, by going from 1 to 4 20, you could probably do that without affecting 5 the rate at which you borrowed. So, if you were 6 trying to grow on the margin to fund in the 7 deposit market, typically the deposits would have 8 to be priced to the point that the economics would 9 go away and you couldn't reach the 25 to 1. 10 Q. So, you were talking about a practical 11 as opposed to a theoretical -- 12 A. Correct. 13 Q. -- consideration? 14 A. Correct. 15 Q. And -- but as -- in a theoretical 16 level -- and we saw this in Mr. Hjerpe's 17 article -- at a theoretical level, you could 18 actually acquire greater leverage through the use 19 of deposits than you could through repos? 20 A. That's correct with 5 percent haircuts. 21 Q. Right. And, in fact, according to his 22 analysis, he added the market discipline of the 3282 1 haircut to the regulatory requirement and got 2 9 percent? 3 A. That's correct. However, for deposits, 4 you would probably want to add that same issue 5 because you are still going to have a liquidity 6 concern. 7 Q. And he did that? 8 A. Right. 9 Q. He had a liquidity issue and he 10 eventually reduced what he called the prudent 11 level, as we discussed, to somewhere around 5 to 12 about 7 and a half multiples? 13 A. Roughly. I believe that's what was in 14 the article. 15 Q. I think it was 4.8. 16 A. Something like that. 17 Q. Okay. Now, you testified about a swap 18 agreement that USAT had with the Federal Home Loan 19 Bank in Dallas. Do you recall that? 20 A. There were swaps in place, yes. 21 Q. And you indicated that -- in your 22 direct testimony that the bank was merely a 3283 1 financial intermediary for that transaction? 2 A. Yes. 3 Q. Now, as far as USAT was concerned, the 4 swap agreement was with you, the bank. Right? 5 A. We were the direct counter-party to 6 USAT, yes. 7 Q. And they made payments directly to you? 8 A. Yes. 9 Q. And you made a decision to swap that 10 position that you had with them? 11 A. That was our policy at the time, was to 12 offset all transactions. 13 Q. But USAT didn't have anything to do 14 with that policy or decision, did they? 15 A. For the swaps that were on the books 16 when I arrived at the bank, I don't know. I 17 didn't do them. 18 Q. Okay. 19 A. For the -- any swaps that were done 20 after I was there, we may or may not have told 21 them that we were offsetting them. It depended on 22 the transaction. Sometimes we told customers. 3284 1 Sometimes we didn't. 2 Q. Well, let me show you a document that's 3 been marked as B715. B715 purports on its face to 4 be a document dated -- letter from Jonathan A. 5 Scott, senior vice president of financial 6 operations for the Federal Home Loan Bank of 7 Dallas directed to Mr. Joe Phillips dated 8 December 23rd, 1985. 9 A. Yes. 10 Q. Right? 11 MR. NICKENS: Your Honor, we offer 12 B715. 13 MR. GUIDO: No objection, Your Honor. 14 THE COURT: Received. 15 Q. (BY MR. NICKENS) Now, tell the Judge 16 if you can, Mr. Smith, what B715 is. 17 A. B715 is a confirmation. When you enter 18 into an interest rate swap agreement with any 19 counter-party, a confirmation is created that 20 essentially spells out the significant details of 21 the transaction. In this case, just to look down 22 the first four or five, you see what the notional 3285 1 amount is. That's the principal on which you're 2 calculating cash flows. The maturity date is -- 3 Q. If we can go through that, what was 4 that notional amount for these three? 5 A. The three in total were 180 plus 50, 6 which is 230 million. 25, 25, and 180. The 7 maturity dates were staggered. I guess they 8 were -- they looked to be roughly two-year, 9 three-year, and five-year swaps. The end dates 10 are a little different, but roughly that. They 11 all were going to start on Christmas Eve in '85 12 and that's the type detail that was confirmed. 13 When it was signed by both counter-parties, it was 14 assumed to create, at least from where I stand -- 15 I'm not sure what the legal term is, but a binding 16 agreement that both sides understood what the 17 terms of the transaction were and that they 18 fulfilled their obligations. 19 Q. And these particular three tranches 20 were serialized. Right? 21 A. They appear to have been, yes. 22 Q. Which is the practice you described for 3286 1 the Court earlier as being good practice in 2 risk-controlled arbitrage? 3 A. I don't know what was on the other 4 side. I can just tell you the swaps were 5 serialized. 6 Q. And if we look over at the second page, 7 does it indicate that USAT made a payment to the 8 Federal Home Loan Bank of Dallas for entering into 9 this agreement? 10 A. Yes, they did. 11 Q. And what were those payments? 12 A. There was a 31,000-dollar payment on 13 the first swap, Tranche 1. There was a 14 225,000-dollar payment on the third tranche, which 15 is Swap 3. And I can't -- there was no payment on 16 the third, but there is something written in here 17 that I can't read referring to that zero payment 18 and I don't know that those are later notes or 19 where those came from. 20 Q. Now -- and if interest rates moved 21 downward as we know they did after this date -- 22 right? 3287 1 A. Rates declined in '86, '87. 2 Q. Then USAT would have become obliged to 3 make payments to the Federal Home Loan Bank of 4 Dallas? 5 A. They would have most likely been 6 obliged to make payments whether rates changed or 7 not, if they had stayed constant or dropped. 8 Q. The payments would have become larger 9 to the extent that rates dropped? 10 A. That's correct. 11 THE COURT: Could I ask a question? I 12 see it says "fixed rate paid by Federal Home Loan 13 Bank." 14 THE WITNESS: Actually, we are paying 15 fixed and receiving floating on this particular 16 set of transactions. So, it's really the other 17 way around. 18 Q. (BY MR. NICKENS) Okay. I'm informed 19 that these are the mirror swaps that were entered 20 into in December of 1985. And that would have 21 been -- explain that. We've gone over that a bit, 22 but briefly tell us how that worked. 3288 1 A. Well, I can talk about mirror swaps. I 2 wasn't around when these transactions were done so 3 I don't know the details. But apparently, if 4 these are indeed mirrors, if you initially did a 5 swap where you were paying fixed, an institution 6 was paying fixed to the Home Loan Bank of Dallas, 7 rates moved and you wanted to offset those. You 8 had one of two options. You could either write a 9 check essentially that was the mark-to-market 10 difference between the rate you were paying and 11 the rate that the market was at then to terminate 12 the transaction. What that did was make, in our 13 case, the Home Loan Bank of Dallas financially 14 indifferent between the swap continuing or the 15 swap terminating. We would then turn around and 16 terminate the swap with our counter-parties and 17 make all positions go away. 18 Another option to terminating is to do 19 the mirror swap, which means you would -- if you 20 were -- if the Bank of Dallas was receiving fixed 21 from an institution, the Home Loan Bank of Dallas 22 could turn around and agree to pay fixed rates to 3289 1 the institution at current market and that current 2 markets rate -- the difference between what they 3 were paying us and what we were paying them, the 4 difference in those two rates would be effectively 5 the same as writing us a check up front. They 6 were just paying it off over time. 7 Q. Now, let me show you another couple of 8 documents. And I'm having trouble finding them in 9 this box, but it's B1333 and B1019. 10 MR. NICKENS: Your Honor, there is just 11 one set remaining but we will make additional 12 copies so that you can have two. 13 A. Can I clarify one thing off this last 14 set of confirms, also, before we go forward? 15 Q. (BY MR. NICKENS) Okay. 16 A. If you look at the floating rate source 17 on the second page, it says "Reuter screen LIBO 18 pages communicated to FHLB Dallas -- Federal Home 19 Loan Bank Dallas, by Salomon Brothers for Tranche1 20 Canadian Imperial Bank for Tranche 2 and City Bank 21 for Tranche 3." 22 Those were, I would bet, the 3290 1 counter-parties to the transactions so that we 2 made sure all the rates set up. So, my guess is 3 that USAT or whomever would have probably 4 understood that's who we were offsetting the 5 trades with since we specified that in the 6 confirmation. 7 Q. Well, in fact, USAT -- the arrangements 8 were made through Salomon Brothers with USAT? 9 A. Oh, okay. That may well have been. 10 Q. I think the evidence will show that 11 USAT thought that Salomon Brothers was the 12 financial intermediary and that the counter-party 13 was the Federal Home Loan Bank of Dallas. 14 A. I don't know what the records will 15 show, but one of your questions is did our 16 counter-parties know? And I think in this case, 17 since we specified that, it would indicate they 18 did. 19 Q. Now, tell the Court what B1333 is and 20 B1019. 21 A. The top copy -- the top page of B1333 22 is -- appears to be a transmittal letter for the 3291 1 interest rate payment exchange agreement which is 2 now called a swap agreement between Home Loan 3 Dallas and United. Also, copies of the collateral 4 delivery and pledge in a security agreement 5 related to those transactions and two copies of a 6 settlement agreement. I'm not quite sure what 7 that is. That's the transmittal letter on top. 8 Do you want me to go all the way 9 through the -- 10 Q. No. Let me offer B1333 at this time, 11 Mr. Smith. 12 MR. GUIDO: Your Honor, no objection to 13 the first page of B1333. I object to the last 14 three pages. We have no idea what the source of 15 the document is. It doesn't have a Bates stamp 16 number on it, nor has it been previously produced 17 to the respondents and we're at the point of 18 direct examination as opposed to cross-examination 19 of the witness about his testimony and we object 20 to the introduction of handwritten pages that we 21 don't know where they come from. 22 MR. NICKENS: Your Honor, I think 3292 1 Mr. Guido is just mistaken. These were documents 2 produced to them. That's the reason they have 3 this number B1333. In addition to that, I believe 4 there was a stipulation entered into as to the 5 source of those documents being the examination 6 reports from the Federal Home Loan Bank of Dallas. 7 And as far as the scope of the 8 examination, they raised the question about the 9 swap agreements and payments being made and I'm 10 simply demonstrating that USAT made substantial 11 payments to the Federal Home Loan Bank of Dallas 12 pursuant to these swap agreements. 13 MR. GUIDO: Your Honor, I think that 14 the first page of the document is sufficient for 15 Mr. Nickens' purpose because it indicates the 16 payments that were made were 543,750 which is 17 what's on the last three pages but we have not 18 agreed that this document is the document that we 19 have estimated to. 20 The documents that we have stipulated 21 to, Your Honor, are the documents that came from 22 the supervisory files of the OTS. We may have OW 3293 1 prefixes on them. These do not have any of those 2 prefixes. We have been asked -- given a 3 voluminous set of documents a few weeks ago by 4 respondents and have been asked to review those 5 documents to ascertain their authenticity and we 6 have not been able to do so as yet, Your Honor. 7 MR. NICKENS: There is an agreement on 8 that. But in order to move this thing along, Your 9 Honor, it is, in fact -- the only question I have 10 is to the first page. So, I'll withdraw the 11 second -- the second and third pages and we'll 12 deal with those at a later time. 13 THE COURT: All right. 14 MR. NICKENS: And we offer the first 15 page of B1333 which has been identified as the 16 November 26th, 1986, letter from Mr. Scott to 17 Marjorie Kulik, assistant counsel of United 18 Savings Association of Texas. 19 MR. GUIDO: No objection, Your Honor. 20 THE COURT: All right. First page of 21 Exhibit B1333 is received. 22 Q. (BY MR. NICKENS) Now, Mr. Smith, the 3294 1 first paragraph indicates -- identifies certain 2 swap agreements dated November 8th, November 12th, 3 and December 24th, correct? 4 A. Correct. 5 Q. And then it indicates here that they 6 were entering into some additional swap agreements 7 and a payment was to be made to the Federal Home 8 Loan Bank of Dallas. Right? 9 A. Yes. The additional swap agreements 10 were collateral agreements stating that United 11 Savings would agree to adequately collateralize 12 any market exposures. I'm not quite sure what the 13 settlement agreements are. And that as a result 14 of doing this transaction, United Savings was to 15 pay the bank $543,750. 16 Q. Now, let's turn if we can to B1019. 17 Would you identify B1019 for the Court. 18 A. This is again -- it looks like a 19 transmittal agreement where the bank is agreeing 20 to roll the collateral agreements together, the 21 November 8 transaction collateral agreements with 22 the December 4th transaction agreements. 3295 1 Q. And signed by Mr. Scott and addressed 2 to Ms. Kulik? 3 A. Yes. 4 Q. Dated June 2nd, 1986? 5 A. Yes. 6 MR. NICKENS: Your Honor, we offer 7 B1019? 8 MR. GUIDO: No objection, Your Honor. 9 THE COURT: Received. 10 Q. (BY MR. NICKENS) Now, Mr. Smith, the 11 first paragraph indicates "Enclosed for your 12 review are the interest rate payment exchange 13 agreements which you identified as what we used to 14 refer to as swap agreements." Right? 15 A. We currently agree to swap agreements, 16 yes. 17 Q. Pertaining to the interest rate swaps 18 executed on November 8th and 12th, 19 nineteen-eighty -- it looks like that's crossed 20 out to 1985. Would you agree with that? 21 A. It's crossed out, and it's either five 22 or six. 3296 1 Q. For a total notional principal amount 2 of 230 million and the reverse of these 3 transactions on December 24th, 1985? 4 A. Correct. 5 Q. Now, what would that indicate to you in 6 light of the other documents that we just looked 7 at? 8 A. Apparently, there were swaps that were 9 executed with the bank on November 8th and 12th of 10 '85 -- assuming that is a five -- and that the 11 B715 would be the confirmations related to another 12 set of reversing transactions on December 24th. 13 Q. Thank you. Now -- so, from USAT's 14 point of view, it made payments pursuant to these 15 swap agreements to the Federal Home Loan Bank of 16 Dallas? 17 A. Various types of payments. 18 Q. Okay. Now, I want to ask you some 19 questions, if we can, about the perceived 20 sophistication level of United Savings, USAT. And 21 I may have covered this before, and I apologize to 22 the Court if it's repetitious. But there never 3297 1 was any question about -- in your mind or was 2 raised to your knowledge about Mr. Phillips' 3 competence? 4 MR. GUIDO: Objection, Your Honor. 5 That wasn't his testimony. 6 MR. NICKENS: Well, then, if it's not 7 repetitive, I'll ask it anew. 8 Q. (BY MR. NICKENS) Was there any 9 question ever raised that you were aware of at the 10 Federal Home Loan Bank of Dallas about 11 Mr. Phillips' competence to handle either the 12 mortgage-backed securities portfolio or the junk 13 bond portfolio? 14 A. I was at one point on a conference call 15 with Mr. Phillips where we were talking about 16 management policies related to the junk bond 17 portfolio. And Mr. Phillips appeared to 18 understand the importance of properly managing the 19 junk bond portfolio. I was never involved, to my 20 knowledge, with Mr. Phillips in terms of running a 21 mortgage-backed securities portfolio or his 22 abilities to manage that portfolio. 3298 1 Q. But apart from that, it never came to 2 your attention that there was some question about 3 his competence to handle that portfolio? 4 A. I don't recall any discussions either 5 way. 6 Q. Now, in fact, there was some concern 7 expressed about -- when he left about the handling 8 of the junk bond portfolio, was there not? 9 A. There may have been. 10 Q. Let me see if we can -- do we have 11 1453? Let me hand you a document that has been 12 marked as B1453. 13 MR. NICKENS: And for the record, Your 14 Honor, B1453 purports to be a letter signed by 15 Mr. Neil Twomey supervisory agent, on the 16 letterhead, of the Federal Home Loan Bank of 17 Dallas to Mr. Art Berner, executive vice president 18 of United Savings dated January 28th, 1987. 19 Q. (BY MR. NICKENS) Did I read that 20 correctly, Mr. Smith? 21 A. Yes, it would appear. 22 MR. NICKENS: Your Honor, we offer 3299 1 Exhibit B1453. 2 MR. GUIDO: No objection, Your Honor. 3 THE COURT: Received. 4 Q. (BY MR. NICKENS) And I just want to, 5 Mr. Smith, bring your attention to the last two 6 sentences of B1453 where it reads "We understand 7 now that Mr. Phillips is no longer with United. 8 You should provide us with the name of the 9 individual now in charge of the high-yield bond 10 portfolio together with the resume which details 11 his or her past investment experience." 12 And if we can move up, I should have 13 read one sentence earlier. It says "In past 14 meetings and correspondence, the expertise of 15 Mr. Joe Phillips as the key individual in charge 16 of the high-yield bond portfolio was represented 17 as a major factor in United's success in 18 high-yield bond investments." You see that? 19 A. That is what the letter says. 20 Q. And does that indicate to you that 21 there was some concern expressed about 22 Mr. Phillips leaving and who was to replace him? 3300 1 A. Certainly with respect to management of 2 the junk bonds, that's what the letter indicates. 3 Q. Now, the investment sophistication of 4 the institution was something that the bank looked 5 at, was it not? 6 A. In transactions that I was involved in, 7 yes. 8 Q. Now, did it come to your attention or 9 your department's attention that there was a 10 proposal that USAT's money desk operations be 11 farmed out, if you will, to other institutions? 12 A. No, I did not know that. 13 Q. Let me ask you to look at B3766. B3766 14 is in front of you, Mr. Smith? 15 A. Yes. 16 Q. And it purports to be an internal 17 memorandum from Mr. Twomey and Ginger Baugh to 18 George Barclay dated January 28th, 1987? 19 A. Yes. 20 Q. And it shows a CC to Jon Scott? 21 A. Yes. 22 Q. Mr. Scott was a member of your group, 3301 1 your immediate superior? 2 A. Uh-huh. 3 MR. NICKENS: Your Honor, we offer 4 B3766. 5 MR. GUIDO: No objection, Your Honor. 6 THE COURT: Received. 7 Q. (BY MR. NICKENS) Now, let's look at 8 the first paragraph of this brief memo, Mr. Smith. 9 It says "This is in regards to an earlier request 10 made by the subject association to utilize its 11 money desk operations for the purpose of acquiring 12 funds for troubled institutions. Copies of 13 United's correspondence describing the proposed 14 service is attached. United has been very 15 successful in securing deposits through the 16 Deposit Referral Program at its subsidiary United 17 Capital Management Corporation." 18 Now, does that indicate that 19 consideration was given to having United Savings 20 use its money desk operations for troubled 21 institutions? 22 A. It appears at least from what you read 3302 1 that they have made a request to allow United to 2 do that or United has made the request to be 3 allowed to do that and that the regulators in this 4 case are indicating that they have been very 5 successful in securing deposits. 6 Q. And that would indicate -- what would 7 that have to say about their level of 8 sophistication? 9 A. In terms of securing deposits, 10 apparently they were supposedly -- let me start 11 over. 12 In terms of attracting deposits through 13 this program, they were doing a good job in the 14 regulators' view. 15 Q. Thank you. Let me show you a document 16 that has been marked as 2318, B2318. You have in 17 it in front of you, Mr. Smith? 18 A. Yes, I do. 19 Q. B2318 purports to be from Mr. Twomey 20 and Mr. Baugh -- I mean Ms. Baugh directed to 21 Jonathan Scott, the director of investment 22 services, in July 19th, 1988, correct? 3303 1 A. That's correct. 2 Q. And that was your department, 3 investment services? 4 A. No. Investment services was not my 5 department. I was financial analysis. 6 Q. Did you ever work -- you worked with 7 Mr. Scott. Are you saying you didn't work with 8 him in connection with investment services? 9 A. I don't think that job title was 10 correct for Jon at that time. 11 Q. Okay. So, we have the job title wrong 12 but you were still working with him? 13 A. I was working for Jon, yes. 14 MR. NICKENS: Okay. Your Honor, we 15 would offer B2318. 16 MR. GUIDO: No objection, Your Honor. 17 THE COURT: Received. 18 Q. (BY MR. NICKENS) Let me ask you to 19 turn over to Page 20 of the attachment to this 20 document. By the way, this is identified as 21 enclosing a copy of the report of examination as 22 of November 16th, 1988, correct? 3304 1 A. I'm sorry. I was reading and not 2 listening. I apologize. 3 Q. The transmittal or cover page indicates 4 that what was attached were pages within the 5 report of examination as of November 16th, 1988, 6 which contained the examiner's comments of 7 United's investment activities. Right? 8 A. That is the language in the letter. 9 Q. And then what is attached is beginning 10 at Page 14 and going on for -- through Page 28 and 11 then there is a letter from Mr. Berner to 12 Mr. Barclay at the back of the document. Does -- 13 A. I don't see the letter at the end, but 14 I appear to have the -- 15 Q. Okay. Well, maybe my copy got attached 16 inadvertently. Okay. Ms. Clark points out to me 17 if you look at the first page there after the 18 transmittal page, Page 14, it actually indicates 19 that this is dated as of 11-16-87, not 20 November 16th, '88. 21 A. There is a discrepancy. 22 Q. Now, let me ask you to turn over to 3305 1 Page 20 and the second full paragraph, the third 2 paragraph if you count the carry-over paragraph, 3 states as follows: "USAT appears to have 4 established adequate policies and procedures as 5 well as secured a competent staff which can 6 conduct its investment securities activity." Do 7 you see that? 8 A. That is what the paragraph states. 9 Q. And did any contrary indications ever 10 come to your attention? 11 A. Certainly not in this time frame. I 12 don't know that I was involved in any of this 13 analysis. 14 Q. Let me ask you to look over at Page 19 15 so that we can provide the Court with some 16 information as to what the examiner's knowledge 17 was concerning hedging caps, collars, and interest 18 rate swaps. You see there at the bottom of the 19 page where that's addressed? 20 MR. GUIDO: What page was that? 21 MR. NICKENS: Page 19 of the previous 22 page. 3306 1 Q. (BY MR. NICKENS) It says "As of 2 December 31, 1987, annual period, the association 3 experienced a net loss of approximately 4 $40,145,000 under its interest rate swaps, caps, 5 and collars agreements. The association had 28 6 fixed rate and two variable interest rate swap 7 exchange agreements outstanding at December 31, 8 1987. The aggregate nominal amount of these 9 agreements total approximately $1,150,350,000, 10 fixed rate 946,350,000, variable rate 205 million. 11 These swap agreements were initiated during 1983 12 and have expiration dates ranging from 1987 13 through 1995. 14 "Moreover, these swap obligations are 15 irreversible. However, the association is 16 attempting to mitigate the adverse impact of the 17 swap transactions by executing caps and collar 18 agreements which have lower fixed interest rates. 19 During March 1987, the association initially 20 entered into 23 caps and one collar agreement. At 21 December 31, 1987, the aggregate notional dollar 22 amount of its caps and collars totaled 3307 1 approximately $1,180,000,000. In addition, the 2 association recorded a net loss of approximately 3 3,793,000 for the ten months ended December 31, 4 1987." Do you see that? 5 A. I see that. 6 Q. And let me ask you to look over to -- 7 well, any suggestion that there wasn't any hedging 8 activity going on at USAT would appear to be 9 contradicted by this document. Would you agree 10 with that, Mr. Smith? 11 A. Would you repeat the question? 12 Q. Well, the purpose of the swaps -- of 13 swaps and caps and collars is generally hedging, 14 is it not? 15 A. Generally, but not always. 16 Q. And this would indicate that such 17 activities had been going on at USAT since 1983? 18 A. Yes, there were swap and cap 19 transactions on the books since 1983. 20 Q. And they had suffered losses as a 21 result of this -- of these hedging activities? 22 A. The swaps had apparently -- I'm not 3308 1 sure exactly what net loss is. I don't know if 2 that's referring to net of assets, but there was a 3 loss of 3.7 million that was booked in that 4 ten-month period. 5 Q. And, in fact, on the previous page, 6 they indicated that the swap agreements had 7 indicated a loss of, what, $40 million? 8 A. 40 million in the swaps. 9 Q. And that they were taking steps to try 10 to ameliorate that situation? 11 A. Right. They were trying to mitigate 12 the adverse impact. 13 Q. Now, it is in the nature of hedging 14 instruments that you may suffer losses on those 15 instruments. Right? 16 A. You may. 17 Q. The purpose is because you've got some 18 other assets that you're trying to hedge and 19 hopefully, they will show market gains? 20 A. That's correct. 21 Q. So, the purpose is to reduce interest 22 rate risk exposure? 3309 1 A. That is the purpose. 2 Q. Now, let me ask you to look over to 3 Page 28 of Exhibit 2318. You see there a 4 discussion about United MBS Corporation? 5 A. In the middle of the page? 6 Q. Yes. 7 A. Yes. 8 Q. And it says "United MBS Corporation is 9 100 percent owned by USAT. It was incorporated on 10 August 1st, 1986, for the purpose of entering into 11 mortgage-backed financing activities. USAT's 12 total investment in United MBS is approximately 13 250 million at September 30th, 1987, and 14 270 million at December 31, 1987. Mortgage-backed 15 securities make up 96 percent of UMBS' 1.6 billion 16 portfolio at December 31, 1987, while reverse 17 repurchase and dollar roll obligations make up 91 18 percent of UMBS' total liabilities of 19 approximately 1.5 billion. UMBS generates income 20 by entering into reverse repurchase and dollar 21 roll contracts collateralized by their Fannie Mae, 22 Ginnie Mae, and Freddie Mac mortgage-backed 3310 1 securities. UMBS is operating profitably at 2 December 31, 1987, with a year-to-date net income 3 of $37,479,000." And that was what was reported 4 on this November 16th, 1987, exam? 5 A. That's what's in the report. 6 Q. Then one other reference, Mr. Smith, if 7 I could ask you to turn over to Page 18. 8 A. Back to Page 18? 9 Q. Yes, sir. Back to Page 18. 10 A. Okay. 11 Q. Well, let me ask you to go back to Page 12 15, a few more pages. I'm sorry. 13 A. 15? 14 Q. Yes. Now, you see where it says 15 "hedging financial futures and options"? 16 A. Yes. 17 Q. And it says "In October 1986, UMBS" -- 18 that's the one we just described. Right? 19 A. I assume. 20 Q. -- "began to accumulate financial 21 futures contracts to establish what it describes 22 as a two-year anticipatory hedge program. The 3311 1 hedge program is centered around the anticipation 2 of a series of liabilities which would be used to 3 fund mortgage-backed securities. United MBS uses 4 Eurodollar Futures (short positions) to extend the 5 maturity of its reverse repurchase agreements. It 6 has, to a lesser degree, utilized put options 7 (Ginnie Mae/T bills) to hedge mortgage-backed 8 securities on the asset side of the balance sheet. 9 In order to ensure that the hedge continues to 10 qualify for hedge accounting, the association 11 performs linear regression analysis on a quarterly 12 basis to establish and determine that a sufficient 13 degree of price correlation exists between the 14 cash balance sheet items and the selected 15 financial futures market instruments. The 16 regression analysis has been reviewed and verified 17 by the association's independent auditor, Peat, 18 Marwick, Main & Company. In addition, the 19 examiners have reviewed the resulting price 20 correlation percentages for the quarters ended 21 September and December 1987. For example, the 22 review of two hedges" -- and they go on to discuss 3312 1 the degree of the correlation which they examine. 2 They find that in one hedge, it's 61.3 percent. 3 In another, 98 percent. That's on the right-hand 4 side of the page, and indicate that the price 5 correlation variance threshold was 80 percentile 6 then being used by the examiners and they go on to 7 discuss this hedging activity for United MBS. 8 Do you see that? 9 A. Uh-huh. (Witness nods head 10 affirmatively.) 11 Q. Now, would this indicate to you that 12 United MBS was in any way naked with regard to its 13 hedging? 14 A. They were certainly entering into 15 futures contracts. The low degree of correlation 16 in one of these hedges particularly would indicate 17 that they were either improperly hedged or 18 something significant had happened in the market 19 and they had not adjusted rapidly enough to it. 20 Q. Well, in fact, there was a large spike 21 up in interest rates in March of 1987, wasn't 22 there? 3313 1 A. I don't specifically recall. 2 Q. A hundred basis points in less than a 3 week? 4 A. '87 had two large interest rate events. 5 One in spring and one obviously in the market 6 crash. 7 Q. Right. In October of '87, there was a 8 crash? 9 A. Right. 10 Q. And March of '87 caught a lot of 11 sophisticated people unaware, didn't it? 12 A. It may have. 13 Q. And in any event, the examiner 14 certainly knows about this and is addressing the 15 problem? 16 A. I have to read a little bit more if you 17 want me to answer that be question specifically 18 so. 19 Q. Well, we can examine the document. But 20 this kind of hedging was a very sophisticated type 21 of hedging, wasn't it? 22 A. If what they were looking to do, if you 3314 1 go back to the previous page where you had me 2 reading -- 3 Q. Yes, sir. 4 A. If what they were attempting to do was 5 to hedge or lock in or attempt to preserve the 6 cost at which their future repurchase agreements 7 would occur when their reverse repos rolled off in 8 90 days, rates may be up or down and the futures 9 gain or loss would offset that change in funding 10 cost. If that was the strategy, that's a fairly 11 well understood strategy. And -- 12 Q. I'm sorry. I didn't mean to -- 13 A. And not terribly complex to operate. 14 Q. And the evidence will show that 15 Ms. Sandy Lawrenson was the one that was in charge 16 of this portfolio. You discussed her in your 17 earlier testimony and her qualification and you 18 would expect her to be competent to manage 19 something like this? 20 A. Sandy should understand -- I would 21 expect her to have understood the risks and how to 22 manage this. 3315 1 Q. Then one final item. If you turn over 2 to Page 18, and it's the second full paragraph. 3 It says "Drexel is a major brokerage firm where 4 the association conducts a substantial percentage 5 of its investment activity. Drexel is also an 6 affiliate of the association by virtue of its 7 stock ownership in the parent company, UFG. See 8 management comment." Do you see that? 9 A. I see the paragraph. 10 Q. So, the examiners in the end of 1987 11 were aware of the business relationship and the 12 stock ownership of Drexel? 13 A. That's being disclosed in the 14 examination report. Could we move down two 15 paragraphs from that? 16 Q. Well, let me retrieve my document 17 before we do that. Where do you want to look? 18 Page 18? 19 A. It says "An internal memorandum," two 20 paragraphs down on Page 18. 21 Q. Yes, sir. 22 A. -- "stated in part that the association 3316 1 attempted to establish a hedge on an 2 after-the-fact basis and VP McCann further 3 concluded this transaction was not appropriate 4 under hedge accounting rules." 5 It would appear from that language that 6 the assets in the hedge had not been executed 7 together, which is a fairly fundamental rule of 8 hedging that was violated in this. 9 Q. Well, in fact, it was common to 10 initiate an asset position and watch the market 11 and then hedge depending upon movements in the 12 market, wasn't it? 13 A. You may call that hedging. You may 14 call that trading. 15 Q. But that certainly wasn't unknown among 16 sophisticated people? 17 A. There were many institutions that did 18 that. However, the hedge accounting rules at that 19 time were fairly young in the sense of 20 sophistication, but one of the things I think was 21 accepted is that the -- to qualify as a hedged 22 position and if you were attempting to run a 3317 1 hedged portfolio, you would execute the hedge 2 simultaneously with the purchase of the asset. 3 Q. Yes, sir. But we'll try to distinguish 4 between the accounting rules and what was the 5 practice for financial managers. 6 A. Anyone I knew who was running a 7 well-hedged portfolio was executing simultaneous 8 transactions. 9 Q. Because otherwise, they couldn't get 10 the hedge accounting treatment that might be 11 desirable? 12 A. No. Because they were exposing 13 themselves to economic risk. 14 Q. Well, do you know what the facts are in 15 this particular situation? 16 A. I do not. I just -- 17 Q. You just know? 18 A. I just read that paragraph as we were 19 going through. 20 Q. And it was clearly known to the 21 examiners in 1987? 22 A. Yes. 3318 1 Q. Let me ask you to look over to Exhibit 2 A11011. Do you see, Mr. Smith, that this purports 3 to be from Ginger Baugh to the file dated 4 July 24th, 1986? 5 A. Yes. 6 MR. NICKENS: Your Honor, we offer 7 A11011 at this time. 8 MR. GUIDO: No objection, Your Honor. 9 THE COURT: Received. 10 Q. (BY MR. NICKENS) Now, this encloses a 11 memorandum from Mr. Joe Selby to Mr. Frank Haas 12 dated July 24th, 1986. Do you see that? 13 A. Yes, I do. 14 Q. Okay. And it indicates consideration 15 of an application by United Savings Association to 16 include the proceeds of 50 to $75 million of 17 subordinated debentures in regulatory net worth. 18 And a further application to modify the net-worth 19 guarantee as described in Federal Home Loan Bank 20 Board Resolution No. 84712? 21 A. That's the subject line. 22 Q. And it indicates that Federated and MCO 3319 1 were requesting a modification of that net-worth 2 maintenance provision. Right? 3 A. That's what the first sentence states. 4 Q. And this was giving Mr. Haas an 5 evaluation of that request? 6 A. That appears to be what this is. 7 Q. And if we go over to the second page of 8 the memorandum which is Page 2 and I'd like to -- 9 for you, if you will, to focus your attention to 10 the last paragraph on Page 2. It says "In 11 addition, MCO and Federated own an aggregate 12 97.5 percent of UFG's Series C convertible 13 preferred stock. After June 14th, 1987, holders 14 of the Series C stock may convert all or any part 15 of their shares to common stock at the rate of two 16 shares of common stock for one share of preferred 17 stock. MCO also has a call option to acquire 18 300,000 shares of UFG's common stock from an 19 unaffiliated third party on July 1, 1988. 20 Assuming that MCO and Federated, one, increase 21 their ownership to 35 percent of UFG's common 22 stock, two, convert all their Series C stock to 3320 1 common stock and, three, exercise the call option 2 for 300,000 shares of UFG common stock then MCO 3 and Federated will own a total of 46.6 percent of 4 UFG." 5 Now, did you ever become aware of 6 something called a Drexel option? 7 MR. GUIDO: Objection, Your Honor. 8 This is going far beyond the scope of direct 9 examination, Your Honor. And we have not seen the 10 document before and are not prepared to even 11 address the issue at this time. And we believe 12 that it goes far beyond what is permitted under 13 the Rules. 14 MR. NICKENS: Your Honor, this is 15 deposition Exhibit 29 to Ms. Baugh's deposition. 16 This comes from their own files. To say they 17 haven't seen it before -- plus it has just been 18 received over no objection. 19 MR. GUIDO: Your Honor, we had an 20 arrangement which we discussed with the Court 21 about getting notice of the use of documents at 22 least 24 hours before their use on direct 3321 1 examination. We have not had an opportunity to 2 review the document. I didn't object to the 3 admission of the document because it was a Federal 4 Home Loan Bank Board regulatory document and it 5 has the appropriate stamp on it. I'm objecting 6 to -- since after reading the document, it has 7 nothing to do with this witness' direct testimony. 8 And for that reason, we object to this line of 9 questioning as going far beyond the scope of 10 direct. This witness, as Mr. Nickens has said, 11 isn't anywhere near that document and he hasn't 12 testified anywhere near anything about a put call 13 option or the question of the modification of the 14 net-worth maintenance agreement that was sought by 15 MCO. For that reason, we believe that this is 16 just going far beyond the scope. We haven't been 17 given an opportunity to review the documents 18 beforehand and, second of all, we believe it 19 disrupts the progress of our case, Your Honor. 20 And for that reason, we think that Mr. Nickens 21 should wait until it's his turn to put on his case 22 and address these issues at that time. If I ask 3322 1 any witnesses any questions about the put call 2 agreement or MCO's ownership or subordinated debt 3 applications, then I think it's perfectly 4 appropriate for him to cross-examine them about 5 that. But I do not believe that at this point in 6 time in the proceedings it is appropriate for 7 Mr. Nickens to continue the way he's continuing. 8 Thank you, Your Honor. 9 MR. NICKENS: Your Honor, surely we're 10 not going to call back this witness for me to ask 11 a single question about whether he had any 12 information concerning the Drexel option. The 13 document is in evidence. It is from their files. 14 Mr. Guido misstates our agreement with regard to 15 the exhibits. Once again, we have discussed this 16 repeatedly. We have developed a process of trying 17 to provide the other side with documents to the 18 extent that they have not otherwise been 19 identified. But there has been no agreement that 20 I have to tell him everything I might ask the 21 witnesses about on cross-examination. This 22 document is a part of the record. It is a part 3323 1 of -- it has been identified as a record that 2 might be used in the proceedings. We specifically 3 made it a part of the A series by virtue of it 4 being a deposition exhibit to Ms. Baugh's 5 deposition. And so, it is on our exhibit list. 6 And so, you know, I have the single question. I 7 don't know what he knows because I have not 8 deposed this witness about the Drexel option. But 9 I do think, given his position, it could be that 10 we would develop useful information concerning 11 that option if he has any information. If he 12 doesn't have any information, then we'll move on. 13 THE COURT: All right. I'll deny the 14 objection. You may ask him whether he knows 15 anything about the Drexel option. 16 Q. (BY MR. NICKENS) Sir, I'll try and 17 rephrase the question. 18 Did it ever come to your attention that 19 there was an option agreement between MCO and 20 Federated and Drexel? 21 A. No. 22 Q. Let me ask you to look over at Page 8. 3324 1 And in the -- in the first full paragraph, the 2 author indicates "Moreover, in light of the 3 depressed economy in Texas, the high level of 4 scheduled items is not surprising. United's 5 management is aggressively pursuing a resolution 6 to its loan problems following collection 7 procedures and foreclosures rather than loan 8 workouts." 9 Then if we could move to the next 10 paragraph, it says "Further, while net operating 11 income does not meet the eligibility requirements, 12 United has enjoyed an increasing level of 13 profitability from its securities investments. 14 The sophistication of United's investment 15 department has been examined and documented by 16 Mr. Jonathan Scott of the financial services 17 administration division of the Dallas bank." 18 Now, that is your department. Right? 19 A. I worked for Jon, yes, under that 20 group. 21 Q. "It appears that a sufficient level of 22 net income can be generated by United's securities 3325 1 transactions to meet the estimated 6.75 million 2 annual interest expense of the proposed 3 subordinated debt." 4 Now, does that indicate that your 5 department specifically looked at the level of 6 sophistication at United Savings? 7 A. My department, if you mean the 8 departments under my control, did not. 9 Q. Well, I include -- 10 A. Nor did I. 11 Q. Well, Mr. Scott -- 12 A. This document says that -- or refers to 13 the fact that Jon did examine and document their 14 sophistication. 15 Q. And that documentation must have been a 16 pass in the context of the way this is used here. 17 Right? 18 A. In the context of this paragraph, 19 that's what it appears to say. 20 Q. And then it goes on at the very last 21 paragraph. It says "There is no indication that 22 the institution does not qualify on the basis of 3326 1 its management. The management of United is 2 considered to be acceptable in as much as United 3 is routinely approached regarding the utilization 4 of its present management for management contracts 5 with problem institutions. It should be noted 6 that many of the current senior management team of 7 United and UFG are also the senior management of 8 MCO and Federated." 9 A. That's a direct reading of the 10 paragraph. 11 Q. Right. And so, the -- it was known to 12 the examiners that there was this link between 13 senior management and it wasn't a disqualifier for 14 purposes of consideration of this application? 15 A. I think we have to go to the conclusion 16 recommendation to see if it's a disqualifier. 17 Q. Let's go to the next page. "Conclusion 18 and recommendation. We have considered the 19 related application by Federated and MCO to modify 20 the net-worth maintenance condition. The 21 companies appear well diversified, are profitable, 22 and have ready access to the established capital 3327 1 markets. Accordingly, we believe their position 2 as controlling shareholders of UFG will provide a 3 source of strength to United. And it would appear 4 to be preferable from a regulatory standpoint for 5 the companies to guarantee the net worth of United 6 to the extent of their pro rata share of UFG while 7 their ownership in UFG is below 50 percent. 8 However, the strength of the companies and 9 indirectly the insured institution is dependent in 10 large degree on the companies' standing in the 11 financial community. And then without this, there 12 would be no source of funds to provide required 13 capital for United even if the net-worth 14 maintenance provision remained in place." 15 And then it goes on and the last line 16 says "Based on these considerations, we have no 17 objection to the proposed modification or to the 18 inclusion of the proceeds from the subordinated 19 debt issuance in net worth and, therefore, 20 recommend approval of the applications." 21 Do you see that? 22 A. I see that. 3328 1 Q. Now, did you have anything to do with 2 that consideration? 3 A. None to my recollection. 4 Q. Now, Mr. Smith, let me ask you some 5 questions about the -- your testimony concerning 6 junk bonds. 7 Now, on your direct examination, direct 8 testimony, you indicated that you had had no 9 personal experience in looking at the 10 diversification of United Savings' junk bond 11 portfolio? 12 A. That's correct. 13 Q. And that you had not looked at their 14 trading activity -- 15 A. Not to my knowledge. 16 Q. -- on a personal level? 17 A. Yes. 18 Q. But you didn't mean to indicate that 19 the Dallas bank had not looked carefully at these 20 issues, did you? 21 A. I had been approached by the regulatory 22 side to provide them with some names of people who 3329 1 could possibly do that. 2 Q. Yes, sir. But what I'm -- you didn't 3 mean to suggest that the bank itself as opposed to 4 you personally had not looked at these issues? 5 A. I did not mean that. 6 Q. Okay. Now, let me ask you to look 7 at -- 8 MR. NICKENS: And, Your Honor, I'm 9 going to look at a series of letters. These 10 letters, although not identical, are all quite 11 similar in nature. And in order to expedite the 12 matter, I'm going to ask him about them as a 13 group; and I have prepared a list so that the 14 Court -- and I will identify for the record which 15 documents you're looking at. 16 Q. (BY MR. NICKENS) Mr. Smith, I have 17 handed you a series of letters that have been 18 identified in the record as Exhibits B1148, 1219, 19 1236, 1265, 1321, 1359, 1444, 1496, 1526, 1631, 20 1663, 1712, 1733, 1755, 1801, 1851, 1906, 2021, 21 2030, 2085, 2330, 2379, 2409, and 2463. 22 Now, can you look through that stack 3330 1 and identify this as a monthly report beginning in 2 June of 1986 to the Texas Savings and Loan 3 Department with a copy to Ginger Baugh at the 4 Federal Home Loan Bank of Dallas of United 5 Savings' junk bond portfolio and all of their 6 transactions in those portfolios? 7 MR. GUIDO: Which exhibit are you 8 addressing? 9 MR. NICKENS: The entire set. 10 MR. GUIDO: Well, there are a number of 11 these that are addressed to L.A. Anderson and not 12 addressed to Ginger Baugh. 13 MR. NICKENS: Well, they are copied to 14 Ms. Baugh. They are all addressed to 15 Mr. Anderson, but there is a copy -- 16 MR. GUIDO: Take a closer look at the 17 documents, Mr. Nickens. Your Honor -- 18 MR. NICKENS: Well, Your Honor, I 19 object to that. I identified the documents as 20 going to the Texas Savings and Loan Department. I 21 think Mr. Guido just must not have heard that. 22 But in any event, if I made a mistake, it wouldn't 3331 1 be appropriate for him to address a comment of 2 that sort to me. 3 MR. GUIDO: Your Honor, I have an 4 objection to the admission of the documents as 5 professed to be documents that were addressed to 6 Ginger Baugh. I have just looked at the last one. 7 I haven't, again, had the opportunity to review 8 these documents before they were just handed to 9 me. Exhibit B2463 says enclosures; and the CCs on 10 the second page of the document, it doesn't 11 mention Ginger Baugh anywhere in the document. 12 MR. NICKENS: Well, let's look at that 13 one. May I ask the witness a question, Your 14 Honor? 15 THE COURT: Yes, you may. 16 Q. (BY MR. NICKENS) If you look at the 17 last one which is October 14th, 1988, and you look 18 at the enclosures -- 19 A. The stuff stapled on the back, I 20 assume? 21 Q. Well, no. Just the enclosures of the 22 letter from Mr. Stodart. Who is Mr. Dunn? 3332 1 A. There was a Mark Dunn that was a 2 regulatory analyst in Dallas. 3 Q. So, at some point, instead of sending 4 them to Ginger Baugh, it appears that they sent it 5 to a different analyst in the Dallas bank. Is 6 that the conclusion you'd draw? 7 A. If that's the same Mark Dunn, yes. 8 MR. NICKENS: Your Honor, we offer 9 these exhibits at this time. 10 MR. GUIDO: Your Honor, if the 11 documents are being offered to show what the 12 Dallas regulatory or supervisory staff knew and 13 that they all indicate that either Ginger Baugh or 14 Mark Dunn received copies, we have no objection to 15 the introduction of the documents for that 16 purpose. 17 THE COURT: All right. Received. 18 Q. (BY MR. NICKENS) Now, I don't 19 propose, Mr. Smith, to go through each one of 20 these documents. Let's just look at the first 21 one. They appear to be basically in the same 22 format. Right? 3333 1 A. They change near the end, and there's 2 some months missing. But -- 3 Q. Okay. But it says -- this is in June 4 of '86. The letter addressed to Mr. Anderson with 5 a copy to Ms. Baugh states that "During the month 6 of May, the association experienced excessive 7 liquidity and purchased the non-liquidity 8 securities shown in Enclosure 1. Market 9 conditions during the month presented 10 opportunities to realize gains or preserve 11 capital. Sales of non-liquidity securities are 12 also shown in Enclosure 1. We request your 13 approval of these transactions. Enclosure 2 lists 14 the holdings of non-liquidity securities at the 15 end of May." Do you see that? 16 A. I see the paragraph. 17 Q. And so, through a combination of 18 Enclosures 1 and 2, USAT was disclosing all of 19 their transactions or purporting to disclose all 20 of their transactions in junk bonds as well as 21 their total holdings? 22 A. From that paragraph, I don't know if 3334 1 they are disclosing all or not. I'm not familiar 2 with the regulatory rules to know exactly what 3 those terms mean. 4 Q. In any event, that appears to have been 5 a practice that went on for every month beginning 6 in June of '86 through October of '88? 7 A. There are some months missing. 8 Q. Which months do you -- 9 A. August of '86 was the first one I saw, 10 or there is no letter dated in August. 11 Q. But there are two in September? 12 A. There are two in September. 13 Q. Okay. Any others that you believe may 14 be missing? 15 A. I didn't go through the whole stack. I 16 just noticed that on the first couple. 17 Q. Now, anyone bothering to look at these 18 letters would have known exactly what United 19 Savings was doing in its junk bond portfolio. 20 Right? 21 A. I can't state that. 22 Q. Mr. Smith, I'm going to ask you to look 3335 1 over at what has been previously received as 2 Exhibit B1042 and is at Tab 232 which is a letter 3 from Mr. Scott to Mr. Twomey that Mr. Guido asked 4 you about. 5 A. Yes. I don't know what the tab number 6 you had reference to is, but I have the 7 exhibit number. 8 Q. Mr. Guido asked you about the first two 9 paragraphs, and I would like for you to focus on 10 the bottom paragraph if you might with regard to 11 Mr. Phillips. The manager of the -- first of all, 12 this references a meeting that you had with 13 Mike Crow, Bruce Williams, Joe Phillips, and Art 14 Berner on or about June 10th, 1986. Right? 15 A. Correct. 16 Q. And it concludes there on the first 17 page "The manager of this junk bond portfolio is 18 Joseph Phillips. Mr. Phillips was formerly with 19 American General Insurance where, for eight years, 20 he managed the portfolio which included junk bonds 21 of both the plain vanilla variety as well as more 22 complex securities. Terry Smith" -- that's you, 3336 1 right? 2 A. That would be me. 3 Q. -- "asked Mr. Phillips several in-depth 4 questions about the junk bond market and was 5 satisfied of his knowledge about the market and 6 ability to administer this portfolio. 7 Mr. Phillips has a full-time credit analyst who 8 does nothing but financial statement analysis of 9 the names held by United and they also have a 10 fixed income trader who, along with executing 11 trades, keeps his, quote, 'ear to the street,' 12 close quote, regarding any information about the 13 companies whose debt United holds." 14 Then it goes on to say "The primary 15 element of risk management of this portfolio is 16 the financial statement analyses. The credit 17 analyst is responsible for closely monitoring 18 gross margins and cash flows of the companies 19 involved in an attempt to detect any deteriorating 20 trend. Moreover, United subscribes to all of the 21 major news services and attends management 22 presentations given by the firms whose debt they 3337 1 hold. The investment committee is ultimately 2 responsible for the management of this portfolio. 3 A copy of United Financial Group's investment 4 policy and investment committee charter are 5 enclosed. In summary, Terry Smith and I are of 6 the opinion that United Savings is responsibly 7 managing its less-than-investment-grade debt 8 portfolio. We were very impressed with 9 Mr. Phillips and feel he understands the risks 10 attendant in managing such a portfolio and is 11 capable of managing it." 12 Now, was that your conclusion back in 13 June of '86? 14 A. I believe that was the conclusion we 15 reached after discussions with Mr. Phillips. 16 Q. And you asked him any questions you 17 wanted to at the time? 18 A. I asked him at that point questions 19 about how the market operated and how he operated 20 in the market. I asked him questions about the 21 trading controls they had in place, about what 22 their trading strategies were. I don't recall 3338 1 getting into any detail about the exact 2 composition of his portfolio. 3 Q. Well -- but you didn't -- there wasn't 4 anything he didn't -- any information you asked 5 for that he didn't provide? 6 A. Nothing that I can recall. 7 Q. And your conclusion was, is it fair to 8 say, laudatory? 9 A. His -- the conclusion was that 10 Mr. Phillips had significant experience in the 11 junk bond market. He had worked for an 12 institution that had been a large player in the 13 junk bond market for a long time, which was 14 American General. And they seemed to know what 15 they needed to have in place to adequately manage 16 a portfolio. And specifically with Mr. Phillips, 17 we thought he handled himself very well and 18 answered the questions very well. 19 Q. And your joint conclusion was that you 20 were very impressed with him? 21 A. If that's what Jon wrote, that's what 22 we were. 3339 1 Q. Let me ask you to look at 1453 if I can 2 find it for you. 3 THE COURT: What's that exhibit number? 4 MR. NICKENS: Your Honor, it's B1453; 5 and I apologize to the Court. This is a document 6 I just asked him about a few minutes ago in a 7 different subject, and I had forgotten that. So, 8 it is in evidence as 253. 9 THE COURT: It's in evidence as 1453. 10 MR. NICKENS: I'm sorry. It is in 11 evidence as B1453 which, under our system, is 12 Tab 253. 13 THE COURT: All right. 14 Q. (BY MR. NICKENS) And I asked you 15 about Mr. Phillips' expertise a few minutes -- 16 several minutes ago. Let me ask you to look at 17 the second page. This is from Mr. Twomey to 18 Mr. Berner. "It is our understanding that Drexel 19 Burnham is considered the primary vehicle 20 nationally for high-yield bond investments. 21 Considering the company's involvement with the 22 Ivan Boesky case, it is reasonable to assume that 3340 1 Drexel will directly or indirectly experience 2 repercussions from the case." And it goes on. 3 And then at the end, it says "In addition to 4 comments addressing these possibilities, please 5 discuss the current and projected, if any, or 6 proposed programs, if any, arrangements made with 7 Drexel or other brokers with regard to the 8 purchase and sale of the high-yield bonds 9 including the minimum investment criteria." 10 Now, was it possible in the 11 mid-Eighties to have a significant high-yield bond 12 portfolio and not do business with Drexel? 13 A. I was not directly in the high-yield 14 market. I can only tell you what I read. 15 Q. What was your understanding then of 16 their position in the marketplace during this time 17 frame? 18 A. I believe Drexel was the No. 1 19 underwriter of junk bond issuance and that they 20 were a primary player. 21 Q. And here, it says "the primary vehicle 22 nationally." Is that consistent with your 3341 1 understanding? 2 A. That was what was written. 3 Q. Well -- 4 A. I mean in everything -- not just in 5 here, but that was generally what was written in 6 the press. 7 Q. I'm going to ask you to look at another 8 document: B1742. Now, did there come a time, 9 Mr. Smith, when you or Mr. Scott or the bank asked 10 that United have its high-yield bond portfolio 11 reviewed by a third party? 12 A. I did not. I don't know if Jon did. I 13 know that the bank -- I was -- I received a 14 request, I believe, from the regulatory side of 15 the bank asking for the names of companies that 16 had sufficient sophistication and market knowledge 17 to do a third-party review of United's portfolio. 18 Q. Okay. 19 MR. NICKENS: Your Honor, we offer 20 B1742. 21 MR. GUIDO: No objection, Your Honor. 22 THE COURT: Received. 3342 1 Q. (BY MR. NICKENS) Again, this letter 2 is a letter from Mr. Twomey to Mr. Berner at 3 United Financial Group and he is noting that there 4 is a discussion about the high-yield investment 5 portfolio and that United had discussed the 6 undertaking with representatives of Merrill-Lynch 7 Capital Markets and was objecting to their 8 proposed fee. Right? 9 A. That's what the letter states. 10 Q. That examination was, in fact, done by 11 someone else. Right? 12 A. I don't know that I ever saw a final 13 copy or anything. I gave them the names. 14 Q. Let me ask you to look at B1864. B1864 15 purports to be a letter addressed from William 16 Jacobs, vice president of Prudential Bache Capital 17 Funding, to Mr. Twomey dated November 24th, 1987. 18 Do you see that? 19 A. Yes, I do. 20 MR. NICKENS: Your Honor, we offer 21 B1864. 22 MR. GUIDO: Objection, Your Honor. 3343 1 This document makes a number of assertions and -- 2 about documents that were reviewed. There is no 3 indication of what those documents are. We don't 4 know what written investment objectives are being 5 addressed in this document. We don't know what 6 policies and internal review and procedures were 7 reviewed. We don't know what the diversification 8 was that this -- was provided to these people. We 9 don't know what the diversification was in terms 10 of brokers. And, in fact, the document has a 11 number of qualifications in it expressly for those 12 reasons and that the authors of the document have 13 that problem. 14 So, we object to the introduction of 15 the document to support a claim that the 16 procedures that were being followed by USAT were 17 appropriate. It seems that if the documents are 18 available or the individuals are available who 19 signed this and did the review, that they should 20 be brought before the Court to be heard. We 21 believe that this document just on its face 22 demonstrates its inherent unreliability as a 3344 1 review and approval of what happened at USAT with 2 regard to its junk bond portfolio. 3 THE COURT: Well, this is a document 4 that was sent to the Federal Home Loan Bank of 5 Dallas. Right? 6 MR. GUIDO: Yes, Your Honor. There is 7 no doubt about that. We don't have any 8 objection -- 9 THE COURT: Pardon? 10 MR. GUIDO: We don't have any objection 11 to the fact that somebody sent the letter to the 12 Federal Home Loan Bank and said that it reviewed 13 the policies and procedures that were provided to 14 them. But what we do object to is the use of this 15 document to support the claim that what happened 16 at USAT, what its policies were, what its 17 procedures were, what the diversification was in 18 the portfolio by industry group, what the 19 diversification was of the portfolio by broker 20 groups was appropriate in light of the fact that 21 the document doesn't indicate what policies and 22 procedures were relied upon. 3345 1 So, therefore, if the document is being 2 offered for the -- to prove the fact that all of 3 those things occurred in a way that was consistent 4 with what other entities were doing, we object to 5 the introduction of the document for that purpose. 6 We do concede that the Federal Home Loan Bank 7 regulatory staff asked for an opinion and got an 8 opinion. But it seems to me that if there is an 9 attempt to ask anyone about this document, the 10 appropriate person is whoever it was at the 11 Federal Home Loan Bank of Dallas that requested 12 this and whoever was -- who did this study. And 13 again, I object to this line of questioning with 14 regard to this witness. 15 MR. NICKENS: Your Honor, the next 16 document will show that Mr. Smith participated in 17 a discussion of Pru-Bache's review of the junk 18 bond portfolio. There was testimony on direct 19 that he had not participated in a discussion about 20 the diversification issue. The evidence is that 21 they -- that the bank asked that an independent 22 third-party review the high-yield bond portfolio, 3346 1 that that was done. This reflects the conclusion 2 of that third-party, independent person about what 3 they did and the conclusions they reached. And we 4 will then see in a few minutes how that was 5 reviewed with personnel of the board in addition 6 to the fact that, on its face, it indicates that 7 it was received at the bank board. 8 THE COURT: All right. I'll receive 9 it. 10 Q. (BY MR. NICKENS) Mr. Smith, you will 11 see that Exhibit B1864 is signed by Mr. Lemanski. 12 A. Yes. 13 Q. And you know Mr. Lemanski? 14 A. I don't recall meeting Mr. Lemanski. 15 Q. Well, do you recall that Mr. Guido 16 showed you some notes dated March 4th, 1988? It's 17 A11008. 18 A. Yes. Mr. Guido did show me these 19 notes. 20 Q. Now, this is one you indicated that you 21 had difficulty reading, but you can make out that. 22 This is a meeting or phone conversation -- some 3347 1 conference with Russell Pollard, who is identified 2 as an attorney for Pru-Bache, and Ray Lemanski -- 3 A. Uh-huh. 4 Q. -- along with Jon Scott and yourself 5 and then someone -- is it Larkin Bailey? 6 A. There was a Larkin Bailey there doing 7 security analysis for the bank. 8 Q. And Neil Twomey and Ginger Baugh, 9 correct? 10 A. Correct. 11 Q. And the first reference is "United 12 trading desk - quote, 'quite a good job,' close 13 quote, and analyzing credit," et cetera. 14 We discussed that earlier today. 15 Right? 16 A. That's what the letter says. 17 Q. And then you go down a couple of 18 paragraphs and it says "concentration - quote, 19 'relatively well-diversified,' close quote. Large 20 position in Memorex." Do you see that? 21 A. I see that. I didn't know that meant 22 Memorex until you said that, but I do read that. 3348 1 Q. Well, I guess I'm doing my best; but it 2 seems like it says Memorex. 3 Do you have any other suggestions? 4 A. No. 5 Q. And we can check the records as to what 6 the holdings were; but does that refresh your 7 recollection that, indeed, there was a discussion 8 about the diversification of USAT's high-yield 9 bond portfolio? 10 A. I still have really no recollection of 11 this meeting at all. 12 Q. So, we should rely on the notes as to 13 what was discussed at the meeting? 14 A. That's the only thing you can rely on, 15 I suppose, because I don't have any recollection 16 of this. 17 Q. Then a couple of paragraphs down, it 18 says "Terry and Larkin ask pointed, specific 19 questions regarding management of portfolio, if 20 OTC or public or both." 21 Now, what does that refer to? 22 Over-the-counter? 3349 1 A. Over-the-counter, I assume, is what 2 that was referring to. 3 Q. In other words, that would be the 4 source of the underwriting for the -- or the 5 trading on the junk bond portfolio? 6 A. I don't know if it's that or if that's 7 the listing -- if that's where the equity of the 8 company is issuing the debt trades. I don't know 9 what that's referring to specifically, or I don't 10 recall. 11 Q. I'm sorry. And it goes on to say "If 12 upper management" -- that's an abbreviation -- 13 "and board were adequately informed, how credit 14 analysis is performed. Moody's or S&P 15 underwriting info." 16 So, the person making these notes of 17 the discussion indicates that there was a 18 discussion of these issues. Right? 19 A. Yes. 20 Q. Including the fact that you, among 21 others, asked specific, pointed questions? 22 A. Uh-huh. (Witness nods head 3350 1 affirmatively.) 2 Q. And then down at the bottom, it says 3 "Jon suggests using Ben Franklin as comparable." 4 A. Yes. 5 Q. What would that mean to you? 6 A. Ben Franklin was a savings institution 7 also in the Ninth District that had large junk 8 bond portfolios. So, I assume he was referencing 9 them in some way. 10 Q. Okay. Then if we go to the next page, 11 it appears to say "Larkin not too comfortable. 12 Jon and Neil think 30 percent nonrated is high." 13 Is that the right word as far as you 14 can tell? 15 A. I assume that's what that means. 16 Q. "Terry says" -- 17 A. That would be high. 18 Q. Okay. Well, "Terry says may or may not 19 depending upon who." So, you couldn't simply look 20 at the concentration and determine whether or not 21 it was high. You wanted to look at the quality of 22 the people that were issuing the high-yield bonds? 3351 1 A. It would be a combination of that and 2 the number of institutions. 3 Q. And does that refresh your recollection 4 that these specific issues were looked at by 5 yourself and others at the Dallas bank? 6 A. It really does not. 7 Q. Do you have any reason to dispute -- 8 A. No. 9 Q. -- the accuracy of the notes? 10 A. No. 11 Q. And now, if you would, turn back to 12 B1864. And if you look over on the second page -- 13 it's actually the third page of the document. On 14 the second page of Mr. Lemanski's report, he 15 describes there the nature of his examination, 16 does he not? 17 A. On the previous page, it says "The 18 association requested that we review and comment 19 on the following matters." And I assume the five 20 things here were his scope of work. 21 Q. And he -- I'm not going to go through 22 each one of these, but he looked at whether or not 3352 1 their written objectives fit with what was 2 customary for other institutional investors. 3 Right? 4 A. Yes. 5 Q. He considered specifically the 6 respective backgrounds and experience of the four 7 individuals employed on a full-time basis in 8 connection with the management of the 9 association's portfolio of securities? 10 A. Yes. 11 Q. Right? 12 A. Yes. 13 Q. He looked at diversification -- 14 A. Yes. 15 Q. -- both among industries and in the 16 securities among different broker/dealers. That's 17 No. 4. 18 A. Yes. 19 Q. So, he looked at whether or not they 20 were doing all their business with one 21 broker/dealer or not? 22 A. Yes. 3353 1 Q. Or whether it was out of line with 2 their experience with what business they were 3 doing with those broker/dealers? 4 A. He looked at it, and I assume that's 5 what he would have been looking to see. 6 Q. And then he looked at their monitoring 7 procedures, No. 5? 8 A. Yes. 9 Q. Then we look over -- go over a couple, 10 three pages; and we get his conclusion. 11 A. Where am I going? 12 Q. If you go over to Page 4 of the letter 13 which is the fifth page of the document. 14 A. Okay. 15 Q. In each instance, with regard to each 16 of these five items -- diversification among 17 industries, diversification among issuers, the 18 backgrounds of the individuals, and their 19 perceived competence, the procedures that were in 20 place -- he found that they were comparable to and 21 consistent with those of most of our other 22 institutional clients investing in securities. 3354 1 Right? 2 A. Still reading. 3 Q. Okay. 4 A. They are comparable -- he found in all 5 five areas in this report that the association's 6 practices were comparable and consistent with 7 other institutional investors'. 8 Q. So, that's a pass. Right? 9 A. That appears to be a pass. 10 Q. Now, the bank board didn't just rely 11 upon the examination by this independent third 12 party, did they? 13 THE COURT: Mr. Nickens, we'll take a 14 short recess. 15 MR. NICKENS: Thank you, Your Honor. 16 17 (A break was taken at 10:31 a.m.) 18 19 THE COURT: Be seated, please. We will 20 be back on the record. I was informed that I may 21 not have received this index of letters on 22 high-yield bonds that you listed as exhibits that 3355 1 Mr. Nickens read off. Mr. Guido indicated no 2 opposition for certain purposes, and I thought I 3 had received them. If not, I will receive them at 4 this time. 5 MR. NICKENS: Okay. 6 THE COURT: There is another question 7 about Exhibit B1075 that was included with those, 8 but it's not on the list. 9 MR. NICKENS: Your Honor, I'm sure 10 that's because I had had that very first one. It 11 should be on the list as the very first one. And 12 when Ms. Richardson made this list, I probably had 13 that one. So, it's -- B1075 is the first in these 14 series. I am offering it, yes. 15 THE COURT: All right. I assume 16 Mr. Guido has the same qualifying -- 17 MR. GUIDO: That's correct, Your Honor. 18 THE COURT: -- objection? 19 MR. GUIDO: But no objection subject to 20 the qualifications. 21 THE COURT: All right. Mr. Nickens, 22 you may proceed. 3356 1 MR. NICKENS: Thank you, Your Honor. 2 (10:56 a.m.) 3 Q. (BY MR. NICKENS) Mr. Smith, when we 4 took our break, I was asking you some questions or 5 had been asking you some questions about the junk 6 bond portfolio. Let me ask you to look at a 7 document that we have marked as B3774. 8 Do you have B3774 in front of you, 9 Mr. Smith? 10 A. Yes, I do. 11 Q. And it purports on its face to be an 12 examination of the high-yield junk bond program 13 only? 14 A. That's written on the front. 15 MR. NICKENS: Your Honor, pursuant to 16 the stipulation as to the origin of these 17 documents, we offer B3774 at this time. 18 MR. GUIDO: No objection, Your Honor. 19 THE COURT: Received. 20 Q. (BY MR. NICKENS) Now, Mr. Smith, can 21 you look at the examination objectives and just 22 read for the Court what the objectives of that 3357 1 examination were to include? 2 A. The section that starts with 3 "determine"? 4 Q. Yes, sir. 5 A. "Whether the institution's security 6 transactions are financially sound, whether 7 security transactions are consistent with the 8 institution's cash flow needs and optimum yield, 9 whether the institution avoids speculation, 10 whether the institution's management personnel are 11 properly designated and qualified to manage this 12 activity, whether specific policies and plans are 13 adequate to monitor financial transaction 14 activity, whether internal controls are adequate, 15 the extent of any interest rate risk exposure." 16 Q. And then it indicates the work done, 17 and the person initials it as he does it and dates 18 it. And let me ask you -- it indicates that this 19 work was done by JPJ on October of 1988, correct? 20 A. JPJ is in most of the boxes; and there 21 is October '88 in a couple of places, yes. 22 Q. Let me ask you to look over to the 3358 1 third page. And in the comments under "expanded 2 scope," it says "Indicate examiner-designed 3 procedures in the spaces below" and there is 4 written "extensive review of history, personnel, 5 bonus problems, profitability to date" -- 6 A. Bonus programs. 7 Q. I'm sorry. I misread that. "Bonus 8 programs, profitability to date, exposure." Do 9 you see that? 10 A. I see that. 11 Q. And then the findings are listed below; 12 and in every instance except for No. 8, which is 13 not applicable, there is a "Y" in the "yes" 14 column? 15 A. Seven "Ys" and an "N/A," yes. 16 Q. Now, that's a pass. Right? 17 A. Excuse me? 18 Q. That is a pass? 19 A. I don't know how these are graded. 20 I've never seen one of these before. 21 Q. And then it's specifically written in 22 here -- it says "Does the institution avoid 3359 1 speculation" and written in there was "in junk 2 bonds"? 3 A. Where are you? 4 Q. On the same page, No. 3. 5 A. Okay. No. 3. Okay. 6 Q. Then in No. 4, it says "Does management 7 appear qualified to engage in these types of 8 transactions?" And someone has written in there 9 "very." 10 A. Yes. 11 Q. Right? Very qualified? Would that be 12 how you would understand that? 13 A. Could be. 14 Q. Then under that, "Are the institution's 15 policies and plans adequate to monitor financial 16 transaction activity?" And someone has written in 17 "good controls." 18 A. Yes. 19 Q. And then it is signed -- it appears to 20 be John P. Janitor, 11-1-88? 21 A. That looks like the signature. I can't 22 read the last name either. 3360 1 Q. Now, let me ask you to look at what we 2 have identified as Exhibit 3775. 3 MR. NICKENS: And I will tell the Court 4 that these are the examination notes having -- 5 associated with the examination of the junk bond 6 portfolio, and I would offer Exhibit B3775. 7 MR. GUIDO: No objection, Your Honor. 8 THE COURT: Received. 9 Q. (BY MR. NICKENS) Okay. Now, let's 10 turn over and read for the Court what the 11 conclusions were of the examiner. And I believe 12 you'll see that at OW156341, the beginning of 13 that. 14 A. What number again? 15 Q. 156341, yes, sir. 16 A. Okay. 17 MR. NICKENS: And I'll say to the Court 18 that there is an arrow on two of these pages which 19 was put there by the attorneys and should be 20 disregarded. They were not a part of the original 21 documents. 22 Q. (BY MR. NICKENS) And if you would 3361 1 just read along with me, Mr. Smith, "The program 2 has been financially successful thus far. In the 3 45 months this program has been operational, it 4 has generated a net interest spread over an 5 assumed cost of money of" -- did I read that 6 correctly? 7 A. That's probably "assigned." 8 Q. I'm sorry. "Over an assigned cost of 9 money of $36,607,000 on an average portfolio of 10 $469,088,000 and has achieved $38,172,000 of net 11 profits on sales -- on sales and/or redemptions of 12 securities." 13 Now, that's indicating that the 14 interest income was the 36-million-dollar sum; and 15 there would be gains of some $38 million. Right? 16 A. I believe that's what it says. 17 Q. Gains on sales? 18 A. Sales or redemption. 19 Q. "Deducting from this the 11 million 162 20 of mark-to-market losses indicated as of 21 September 30th, 1988, and the budgeted 22 600,000-dollar annual operating expenses estimated 3362 1 by the association's accounting department would 2 leave the association with realized cash net 3 income of $61,367,000 on its junk bond program 4 over this 45-month period." 5 Now, is that a good performance or a 6 bad performance? 7 A. Without knowing the risk of the 8 portfolios, it's hard to tell. 9 Q. Well, the examiner, we saw from the 10 previous document, was expressly required to look 11 at the risk profile, was he not? 12 A. Is that one of the things he's supposed 13 to check on here? 14 Q. It says something about interest rate 15 risk there. 16 A. It says "interest rate risk." It 17 doesn't -- from what I can tell, it doesn't 18 specify credit risk, which is the real issue 19 typically in junk bond portfolios. 20 Q. Do you know -- well, do you know of any 21 defaults on the junk bond -- the high-yield bond 22 program held by USAT? 3363 1 A. I don't know of any specifically. 2 Q. Now, Mr. Smith, I want to ask you a few 3 questions concerning the events in the last 4 quarter of 1988. 5 At some point in time, the Dallas bank 6 began to direct the operations of USAT in certain 7 areas, did it not? 8 A. It may well -- I don't know the date. 9 I know at some point, they did. 10 Q. Well, we know that the -- that the bank 11 failed on December 30th or 31st of 1988; and 12 sometime in the previous quarter, the Dallas bank 13 was involved in directing certain activities of 14 USAT. Do you recall that? 15 A. I was busy running my group at that 16 time. I can't tell you the dates, and I can't 17 even confirm those dates. 18 Q. Okay. Let me ask you to take a look at 19 Exhibit 3767. Do you see these notes indicating 20 that you attended a meeting? 21 A. I see my name on the top of the note 22 page. 3364 1 Q. And it's got Twomey? 2 A. Uh-huh. (Witness nods head 3 affirmatively.) 4 Q. And is that Bradlen? 5 A. Probably Bradley. 6 Q. Bradley? 7 A. Uh-huh. 8 Q. And what's the next name? Can you help 9 me? 10 A. Got me. 11 Q. Then Jon Scott? 12 A. Uh-huh. (Witness nods head 13 affirmatively.) 14 Q. Mark Dunn. That's who we talked about 15 before. Right? 16 A. (Witness nods head affirmatively.) 17 Q. And then yourself? 18 A. That's the names that are listed across 19 the top. 20 Q. And do you recall attending this 21 meeting? 22 A. I do not recall attending this meeting, 3365 1 no, I don't. 2 MR. NICKENS: Your Honor, we would 3 offer -- 4 Q. (BY MR. NICKENS) It does indicate 5 that you attended such a meeting? 6 A. My name is listed. There's no 7 attendees next to that list, but the document 8 seems to indicate I was there. 9 MR. NICKENS: Your Honor, we would 10 offer Exhibit 3767. 11 MR. GUIDO: Objection, Your Honor. I 12 have no idea where this document came from. There 13 is no indication of the authenticity of the 14 document. 15 MR. NICKENS: Your Honor, these numbers 16 are the identifying numbers; and I don't frankly 17 know what FHG designates, although we will be able 18 to get that from Mr. Griffith. And I don't -- I 19 only have one or two questions about this document 20 and if I could, with your indulgence, ask those 21 questions and then we will show for the record 22 what the source of the document was at a later 3366 1 time when Mr. Griffith is here where we can get 2 that information. 3 THE COURT: Well, you can ask the 4 questions. I'll defer ruling on receiving the 5 document. If there is absolutely no foundation 6 for it, I don't know how I can receive it. 7 MR. NICKENS: Yes, sir. I understand. 8 And we will endeavor to provide the source of this 9 document. 10 Q. (BY MR. NICKENS) I just want to ask 11 you, Mr. Smith, about the notation "signed consent 12 agreement." It says Scott and Twomey. 13 Did you understand that to be the 14 consent agreement by which certain operations of 15 United Savings were to be directed by the Dallas 16 bank? 17 A. I don't know if that's a consent 18 agreement or a confidential agreement. I can't 19 even read the writing. 20 Q. Okay. I see what you're saying. Let's 21 come back to that. I'm going to ask you to take a 22 look at B2443. It's going to convince you of your 3367 1 need for those glasses. 2 MR. NICKENS: Your Honor, for the 3 record, our indication is that this document, 4 B3767, that we were discussing bears the number 5 FHG which indicates it was produced by the law 6 firm of Hutcheson & Grundy as representing the 7 Federal Deposit Insurance Corporation and 8 presumably from which files? 9 MS. CLARK: Files of the receiver of 10 USAT. 11 MR. NICKENS: In any event, we will -- 12 that's what the designation indicates, and we will 13 make efforts to determine more about this 14 particular document. 15 Q. (BY MR. NICKENS) If you look at 16 B2443, Mr. Smith, that's the memo from Mr. Twomey 17 to Mr. George Barclay dated October 4th, 1988. 18 Subject matter: Reversal of interest rate swaps. 19 And it -- you can see from the beginning, it 20 relates to a conversation with you? 21 A. Yes. 22 MR. NICKENS: Your Honor, we would 3368 1 offer B2443. 2 MR. GUIDO: No objection, Your Honor. 3 THE COURT: Received. 4 Q. (BY MR. NICKENS) Now, this memo deals 5 with a plan to unwind some interest rate swap 6 transactions totaling $800 million which would 7 have produced, looks like, a 49-million-dollar 8 loss to the institution? 9 A. That's correct. 10 Q. Now, there came a time when the bank 11 ordered USAT to unwind these swap positions. 12 Right? 13 A. I don't know if those were ordered or 14 not. 15 Q. There did come a time when they ordered 16 USAT to dispose of its high-yield bond portfolio, 17 did it not? 18 A. I was not a party to any of the 19 regulatory actions that I know of relating to 20 disposing of assets or swaps. 21 Q. Well, what would have been the occasion 22 for you to be the person informing Mr. Twomey of a 3369 1 plan to unwind the interest rate swaps? 2 MR. GUIDO: I think the document says 3 United's plan. I think it's a misstatement of the 4 document. Objection, Your Honor. 5 MR. NICKENS: Okay. 6 Q. (BY MR. NICKENS) You were informing 7 Mr. Twomey of United's plan? 8 A. Yes. 9 Q. Indicating that you had received some 10 information about that plan from some source? 11 A. And since I was sending this to Twomey, 12 I would assume it was coming from United, that 13 they had called about terminating the interest 14 rate swaps in place with the Home Loan Bank. 15 Q. And indeed, if we look at the next 16 sentence, it says "Michael Crow, United CFO, 17 verified this and indicated the swaps which were 18 entered into in 1984 and '85 were being unwound in 19 order to eliminate the negative spread. United is 20 paying 10 and a half to 12 and a half percent and 21 receiving floating. And to loosen up collateral 22 pledged to the Federal Home Loan Bank of Dallas, 3370 1 United is already $32 million short on its 2 collateral requirement." 3 Now, does that help you explain what 4 your involvement would have been? 5 A. Oh, my involvement in this was when 6 United wanted to terminate the swaps, one of my 7 functions at that time was to be involved in large 8 swap either executions or terminations with 9 members or on behalf of the bank. As I recall, I 10 was contacted by United about marking these swaps 11 to market, determining how to get them out of the 12 swap positions, and the operational side, as well, 13 of what buttons and levers have to get pushed and 14 what documents have to get signed back and forth. 15 We also, I would assume -- I don't remember the 16 timing, but I do remember having discussions with 17 United about the fact that they were short 18 collateral against those interest rate swap 19 positions. 20 Q. And one of the Dallas bank's concerns 21 was that the repo lenders would pull their line of 22 credit because of the swap sales. Right? 3371 1 A. That was a concern, I believe, of the 2 regulators once I informed them of the magnitude 3 of the loss that bank United or that -- I'm 4 sorry -- United Savings may be incurring. 5 Q. And there was -- those swap positions 6 were, in fact, unwound. Right? 7 A. I believe all of -- all of them were 8 ultimately unwound. I'm not sure of the exact 9 time frames of all of them. 10 Q. And caused a very substantial loss? 11 A. There were significant losses embedded 12 in the swaps, yes. 13 Q. And when you say "embedded," what would 14 happen to -- what if interest rates moved in a 15 favorable direction? What would have happened to 16 that, quote, "embedded loss"? 17 A. Rates, I believe, would have had to 18 rise. And if rates rose, the loss would have gone 19 down; or depending on how much rates rose over 20 what time frame, the losses could have been lower. 21 Q. So, "embedded" doesn't mean that they 22 are inevitable? 3372 1 A. No. What I meant by "embedded" is at 2 that point in time, to terminate the transaction 3 or to take any sort of financial rebalancing of 4 that transaction would have forced or would have 5 made United Savings incur loss. 6 Q. And was it also the case that the 7 risk-controlled arbitrage programs reflecting 8 mortgage-backed securities were -- United was 9 forced to dispose of those at a loss? 10 A. I have no knowledge of that. 11 Q. Let me ask you to look at what we have 12 marked as Exhibit A1530, which A1530 purports to 13 be minutes of the meeting of the investment 14 committee of United Financial Group of 15 September 20th, 1988. And it indicates that 16 attending the meeting were representatives of the 17 Federal Home Loan Bank Dallas, Mr. Jonathan Scott, 18 as well as Mr. Neil Twomey and other members of 19 the staff of the Federal Home Loan Bank of Dallas. 20 Do you see that? 21 A. I see that. 22 MR. NICKENS: Your Honor, we'd offer 3373 1 Exhibit A1530. 2 MR. GUIDO: No objection, Your Honor. 3 THE COURT: Received. 4 Q. (BY MR. NICKENS) Did there come a 5 time when members of the Federal Home Loan Bank 6 began to attend both board and investment 7 committee meetings of United Savings? 8 A. I'm not privy to that. By this time, 9 Jon had moved on to another position and I was no 10 longer working with him. I do not know of -- I do 11 not know of any time I ever attended board 12 meetings or investment committee meetings. 13 Q. When did that relationship change, 14 Mr. Smith? 15 A. It was sometime around the middle of 16 1988. And I believe if you look at the third 17 paragraph, Jon in here says that he's setting up 18 his new department. 19 Q. Right. Okay. I was going to ask you 20 about that. It says -- well, first of all, in the 21 paragraph above, it refers to Maria Ramirez, chief 22 economist for Drexel Burnham, was guest speaker to 3374 1 review her thoughts on the economic outlook. 2 Was -- are you familiar with 3 Ms. Ramirez? 4 A. Ms. Ramirez had a daily comment that 5 she published on TeleRate that I would read from 6 time to time, and she was chief -- she was -- she 7 did have that title. 8 Q. Did you think it was good or bad 9 practice to consult with market representatives 10 such as Ms. Ramirez? 11 A. Anyone who can provide you with useful 12 information, you can consult. Ms. Ramirez 13 obviously is an economist and had a particular 14 view on how the economy was going to move. 15 Q. And then if we come down to the note 16 that you indicated, "Mr. Jonathan Scott of the 17 Federal Home Loan Bank then described his role in 18 the development of a new section for the Dallas 19 bank. This new function would have the 20 responsibility of working with the examiners on 21 investment policies and interest rate risk 22 policies of the association. He explained that he 3375 1 would be visiting the larger savings and loans in 2 the regions to meet with the various investment 3 managers and assist in answering questions from 4 the field for supervisors and examiners of the 5 Dallas bank. His new group was to be known as the 6 capital markets oversight group." 7 Was that -- that group was, in fact, 8 formed that? 9 A. That group was formed. 10 Q. And you were not a part of that group? 11 A. I was not part of that group. 12 Q. Now, what were the reasons for forming 13 that group? 14 A. Early on, I was in some discussions 15 with Jon and some of the regulators about how to 16 best address the growing reliance on capital 17 market transactions of the existing savings and 18 loan basin in the Ninth District. Prior to 1982, 19 '3, '4, the number of financial institutions that 20 were regulated and members of the Home Loan Bank 21 of Dallas that engaged in large capital market 22 transactions, whether they were swaps or whether 3376 1 they were investments secured by repos or 2 whatever, was fairly small. Over time, the 3 capital market positions grew. The institutions 4 were getting into, in many cases, more and more 5 sophisticated transactions; and there was a desire 6 to create a group in Dallas -- and I believe in 7 all the leaven banks -- that could, from a 8 regulatory perspective, address what was going on 9 in the institutions and to try to make some 10 determinations about the safety and soundness of 11 those programs. So, that's what the group was set 12 up to do. 13 Q. Now, this didn't just involve USAT. 14 You're saying this involved many institutions in 15 the southwest? 16 A. We have a five-state region, the Home 17 Loan Bank of Dallas. Capital market oversight 18 group as part of the regulatory functions of the 19 Home Loan Bank of Dallas had the opportunity to 20 deal with all 600-odd members at that time. 21 Q. Okay. I'm going to ask you to look at 22 Exhibit B2421 and Exhibit B2643. Exhibit B2421 3377 1 which also bears the identification Twomey 2 Exhibit 74 purports to be a memo from Mr. Twomey 3 to Mr. Barclay dated September 29th, 1988. 4 Subject: Mortgage-backed securities, United 5 Savings -- United S.A. of Texas. And it indicates 6 a copy sent to Mr. Jon Scott and Mr. Mark Dunn, as 7 well as others, correct? 8 A. Correct. 9 MR. NICKENS: Your Honor, we would 10 offer B2421. 11 MR. GUIDO: No objection, Your Honor. 12 THE COURT: Received. 13 Q. (BY MR. NICKENS) If you would focus 14 with me, Mr. Smith, just in the first paragraph, 15 "United's chief financial officer, Michael Crow, 16 informed me this morning that Michael Patriarca of 17 the San Francisco Bank has recommended that United 18 sell $1 billion in underwater MBS prior to the 19 anticipated receivership. This would result in a 20 70- to 110-million-dollar loss to the 21 association." Do you see that? 22 A. I see that. 3378 1 Q. Do you have any information about that 2 activity? 3 A. I do not. 4 Q. It is true that if you interrupt a 5 risk-controlled arbitrage before it is scheduled 6 to run off, that you run the risk of having 7 substantial losses, do you not? 8 A. It is possible to create substantial 9 losses depending on the time that you choose to 10 execute the early stoppage. 11 Q. It is expected with changes in interest 12 rates that you're going to get movements in market 13 value up and down in the arbitrage, correct? 14 A. What you -- the net market value of the 15 arbitrage will move over time, which is why 16 rebalancing transactions are recommended, to try 17 to retain some of the market value, yes. 18 Q. And it's just not possible to keep it 19 perfectly balanced for any extended period of time 20 because interest rates do move? 21 A. But I don't see -- in respect to your 22 specific question, interest rates will move. 3379 1 Prepayment speeds will vary, and there will be 2 times when the market values wander up and down on 3 a risk-controlled arbitrage over time. 4 Q. Okay. Now, if you would, take a look 5 at Exhibit B2643. And this is indicated to be a 6 letter from Mr. Twomey to the board of directors 7 of United Savings dated December 27th, 1988, and 8 indicates a copy to you and Mr. Scott, correct? 9 A. Correct. 10 MR. NICKENS: And, Your Honor, we would 11 offer B2643. 12 MR. GUIDO: No objection, Your Honor. 13 MR. RINALDI: What date is it? 14 MR. NICKENS: December 27, 1988. 15 THE COURT: Received. 16 Q. (BY MR. NICKENS) Now, it refers to a 17 series of A, B, and C bonds currently held by 18 Salomon Brothers. What were those bonds? Were 19 those the swaps? 20 A. Those were not swaps if they were A, B, 21 and C bonds. Either the letter -- if it's 22 referring to the bonds, the letter is not written 3380 1 properly or these are other types of transactions. 2 Q. But in any event, it indicates that the 3 board of directors of United Savings was directed 4 to prepay the aforementioned bonds at the 5 discounted figures previously submitted. Do you 6 see that? 7 A. I see that. 8 Q. And in this dissolution process, were 9 there points where United personnel objected that 10 the forced dissolution of these assets was going 11 to cause liquidity problems as well as other 12 market problems? 13 A. I don't recall hearing that. 14 Q. Let me ask you to look at B2652. Do 15 you see B2652 is a letter directed to Mr. Twomey 16 signed by Mr. Berner -- 17 A. Yes, I do. 18 Q. -- of December 29th, 1988, with a copy 19 shown to you and to Mr. Scott? 20 A. Yes, I do. 21 MR. NICKENS: Your Honor, we offer 22 B2652. 3381 1 MR. GUIDO: No objection, Your Honor. 2 THE COURT: Received. 3 Q. (BY MR. NICKENS) And it indicates in 4 the next-to-the-last paragraph in the first page 5 "As previously stated in the letter dated 6 December 21, 1988, the board of directors of 7 United Savings Association of Texas does not 8 believe that, in accordance with its fiduciary and 9 other duties, these transactions are in the best 10 interest of its shareholders, depositors, or the 11 FSLIC. As set forth on Exhibit 1 attached hereto, 12 these transactions could result in a liquidity 13 problem if the recapitalization is not consummated 14 and, in any event, could be costly to the FSLIC 15 and the association." 16 Does that refresh your recollection 17 that these issues were raised with you? 18 A. It does not. 19 Q. You don't have any doubt that they were 20 raised? 21 A. No, I don't have any doubt that I 22 received a copy of the letter. 3382 1 Q. You simply don't remember receiving 2 this letter back in 1988? 3 A. I do not remember receiving this 4 letter, no, I don't. 5 MR. NICKENS: Your Honor, we pass the 6 witness at this time. Thank you very much, 7 Mr. Smith. 8 THE COURT: How much redirect do you 9 have? 10 MR. GUIDO: Your Honor, I have a fair 11 amount of redirect. If it's appropriate, I think 12 that it would be a good time to take a break; and 13 then I will do the redirect. 14 THE COURT: All right. We'll adjourn 15 until 1:00 o'clock. 16 17 (Lunch break at 11:30 a.m.) 18 19 THE COURT: Be seated, please. We'll 20 be back on the record. Mr. Guido, you have some 21 redirect of Mr. Smith? 22 MR. GUIDO: Yes, Your Honor. 3383 1 THE COURT: Proceed. 2 3 REDIRECT-EXAMINATION 4 5 (1:02 p.m.) 6 Q. (BY MR. GUIDO) Mr. Smith, you were 7 asked on direct and redirect about leverage. Do 8 you recall that line of questioning? 9 A. Yes, I do. 10 Q. And you indicated that reverse repos 11 give you a 1 to 20 ratio maximum and that 12 deposits, 1 to 25, I think? 13 A. That's the theoretical maximums I think 14 we discussed this morning. 15 Q. Now, if deposits are taken 16 theoretically to generate -- to use to purchase 17 mortgage-backed securities, you end up with 18 4 percent capital. You can buy a hundred -- if 19 you have $4 million, you can buy $100 million 20 worth of mortgage-backed securities? 21 A. Yes. 22 Q. If you took that hundred million 3384 1 dollars and you financed through reverse repos the 2 purchase of mortgage-backed securities, how much 3 mortgage-backed securities could you theoretically 4 have in a portfolio? 5 A. 20 times that, I believe, which is 6 about 2 billion if I got the zeros in the right 7 place. 8 Q. So, if you used the deposits that you 9 get from the capital requirements, you end up with 10 a certain number; and if you use the reverse 11 repos, you could theoretically go up to a higher 12 level? 13 A. Yes. 14 Q. Now, there are limits on that, aren't 15 there? 16 A. There are limits because the total 17 capital of the institution becomes binding at some 18 point. 19 Q. So, at that point in time, you would 20 have too many assets vis-a-vis the size of the 21 institution? 22 A. Yes. 3385 1 Q. And so, the regulatory capital 2 requirement puts a cap on that leverage -- 3 A. The total amount. 4 Q. -- factor so that it makes them both 5 fairly comparable in terms of what the investments 6 can be? 7 A. Yes. 8 Q. Now, you were asked some questions 9 about the cost of swaps; and you have the 10 documents in front of you. B715 is the document I 11 want to direct your attention to. 12 A. I'm sorry. B what? 13 Q. 715. It's the one which you said was a 14 mirror swap. 15 A. Is that the one that was the actual 16 swap confirmation? 17 Q. Yes. December 23rd. 18 A. I know the one you're talking about. 19 B715. 20 Q. Now, if you look at Page 2, it talks 21 about the cost of the up-front payment of that 22 swap and it says it's .125 percent of the notional 3386 1 principal amount. Do you see that? 2 A. I do. 3 Q. And is that 125 -- how much is that for 4 a million dollars' worth of notional amount? 5 A. For a million dollars, it's going to be 6 1250, I believe, if I got my zeros in the right 7 places. 8 Q. But it -- so that that would be the 9 cost that would be incurred in the closing out of 10 a swap position by using mirrors, .125 percent? 11 A. That would be the -- yes. 12 Q. The up-front cost? 13 A. The up-front fees. 14 Q. And if you were going to alter the 15 liability side of the risk-controlled arbitrage, 16 that would be one of the costs that you would 17 incur if you were going to do so by adjusting the 18 liability side? 19 A. That's correct. 20 Q. And then -- was that the customary fee 21 if you wanted to also put on a new swap, that was 22 .125 percent? 3387 1 A. Yes. That was the fee to do a new swap 2 whether you were paying, receiving, offsetting, 3 whatever. 4 Q. So that the out-of-pocket cost 5 across -- that would be incurred with the 6 repositioning of a portfolio, risk-controlled 7 arbitrage portfolio, by readjusting the hedges 8 would be .125 percent -- 9 A. Yes. 10 Q. -- to close out the position by -- with 11 a mirror swap and put on a new position would be 12 .125 percent, as well? 13 A. That's correct. 14 Q. Those are the transaction costs? 15 A. Yes. Those are the transaction costs. 16 Q. And then the additional transaction 17 cost is the theoretical bid/ask spread price? 18 A. That's correct. 19 Q. But it doesn't require the recognition 20 of any of the losses embedded in the swap at the 21 time to readjust a liability side by using mirror 22 swaps and putting on a new swap? 3388 1 A. At that time, it did not. 2 MR. GUIDO: Now, the next set of 3 questions I have for this witness, Your Honor, 4 comes from Exhibit B1042 which has already been 5 admitted into evidence. It's the memorandum from 6 Jonathan Scott to Neil Twomey dated June 12th, 7 1986. 8 What tab is that? J.C., what tab 9 number is that so I can find it in here? 10 A. 1042? Is that what I'm looking for? 11 MR. GUIDO: Yeah. It won't be in your 12 stack. 13 MR. NICKENS: Tab 232. 14 MR. GUIDO: Okay. I'm sorry. 15 Q. (BY MR. GUIDO) Now, look at the 16 second paragraph where it says -- see the 17 11.6 percent? 18 A. Yes, I do. 19 Q. Okay. And then it picks up "While the 20 portfolio does require certain adjustments to keep 21 the durations matched, the management of the bond 22 portfolio does not involve bond swapping to pick 3389 1 up the yields or premature selling to capture 2 capital gains currently unrealized." 3 Do you see that? 4 A. I see that. 5 Q. Okay. Now, that's a stated policy. 6 Now, look at Exhibit B1864, which is the Pru-Bache 7 letter that we discussed. 8 A. Okay. 9 Q. And look at Page 4 of that letter. It 10 says "We did not investigate whether the 11 association actually followed and observed in 12 practice its various stated objectives, policies, 13 and procedures for investment and trading in and 14 monitoring and review of securities, nor did we 15 independently verify or investigate the 16 backgrounds and experience of the four individuals 17 described above." 18 Do you see that? 19 A. I see that. 20 Q. Would you conclude from that sentence 21 that Pru-Bache's representatives did not attempt 22 to ascertain whether the junk bond portfolio 3390 1 involved bond swapping to pick up yields or 2 premature selling to capture capital gains 3 currently unrealized? 4 MR. NICKENS: Your Honor, I object. 5 The document does speak for itself; and for him to 6 guess as to what was in the minds of the Pru-Bache 7 people, I think, is inappropriate. 8 MR. GUIDO: Your Honor, this witness -- 9 THE COURT: Let's get his 10 interpretation. Denied. 11 Q. (BY MR. GUIDO) Mr. Smith? 12 A. My interpretation is that they did not 13 look at any transaction data relating to the study 14 they did. 15 Q. Now, look at Exhibit B3774. 16 A. What does it look like? 17 Q. It's the cover page of some work 18 papers. 19 A. Okay. 20 Q. Now, isn't it customary in the work 21 papers of the examiners of the Federal Home Loan 22 Bank that they would have a cover sheet and then 3391 1 there would be a substantive discussion of what 2 was found in the examination? 3 A. I really can't speak to that. I'm not 4 familiar with what the exam practices were. 5 Q. So, you don't know whether or not there 6 is something that would elaborate on the 7 conclusions reached in this document? 8 A. I do not. 9 Q. Do you know what the phrase means "does 10 the institution avoid speculation" which you were 11 asked about? 12 A. The third bullet up there, whether the 13 institution avoids speculation? 14 Q. Yes. 15 A. My -- I believe what that means is are 16 they trying to take interest rate risk positions 17 or credit risk positions based on hoped for or 18 expected moves in the market. 19 Q. So, in other words, whether they are 20 putting any position on for the expectation of 21 changes in the market direction? 22 A. Yes. 3392 1 Q. Either because of undervaluation of 2 credit or expectations about interest rates? 3 A. Correct. 4 Q. To your understanding, does that 5 include ascertaining whether or not the manager of 6 a bond portfolio -- the management of a bond 7 portfolio does not involve bond swapping to pick 8 up yields or premature selling to capture capital 9 gains currently unrealized? 10 A. I'm sorry. Could you repeat that? 11 Q. I'm going back to B1042 again. 12 A. Okay. Go ahead. Got it. 13 Q. Okay. Remember the sentence that says 14 "While the portfolio does require certain 15 adjustments"? 16 A. Uh-huh. (Witness nods head 17 affirmatively.) 18 Q. Does the -- your understanding of what 19 speculation meant at that time to an examiner 20 include bond swapping to pick up yields or 21 premature selling to capture capital gains? 22 A. I believe that the sentence in 1042 3393 1 would be consistent with a speculative set of 2 transactions. 3 Q. Pardon? 4 A. I believe that if you were doing what's 5 defined in that sentence you read in B1042, that 6 would be considered speculation. 7 Q. Okay. Now, you also testified that 8 the -- there was formed -- I think it was in 9 relationship to a reference to Exhibit A1530 -- 10 that there was a reference to the creation of a 11 capital markets oversight group? 12 A. Yes. 13 Q. Do you recall that? 14 A. I have it. 15 Q. What problem was that group formed to 16 address? 17 A. As I stated earlier, because many of 18 the financial institutions that were being 19 regulated by the Dallas bank were beginning to 20 engage in more and more sophisticated securities 21 transactions, there was a general concern that the 22 regulatory group of the bank did not have 3394 1 sufficient expertise themselves to determine what 2 the risk in return trade-offs and what potential 3 risks the institutions were taking. 4 Q. And so, the purpose of forming that 5 group was to create a body of expertise to 6 supplement the examination staff's work? 7 A. That's correct. 8 Q. Now, are there any inferences that one 9 can draw from the fact that an examiner failed to 10 identify a practice with regard to junk bonds or 11 mortgage-backed securities in the course of an 12 examination? 13 MR. NICKENS: Your Honor, I object. Of 14 course there would have to be inferences that one 15 can draw from that. 16 MR. GUIDO: This witness has just 17 testified, Your Honor, that this capital markets 18 group was created to supplement the skills of the 19 examination staff and the supervisory staff 20 because it was felt that they did not have the 21 expertise to evaluate these portfolios on their 22 own. My question -- 3395 1 THE COURT: I'm not sure he said that, 2 but I'll deny the objection. 3 Q. (BY MR. GUIDO) You may answer the 4 question. 5 A. Okay. Can you repeat the question, 6 please? 7 Q. Is there any inference that can be 8 drawn from the fact that a member of the 9 examination staff or supervisory staff did not 10 raise a problem or a question about either the 11 management or the operations of a mortgage-backed 12 security or junk bond portfolio? 13 A. There are probably several inferences. 14 One is that the portfolio was being properly 15 managed. Another is that the examiner didn't 16 understand what he was looking at. 17 Q. And was one of the reasons for the 18 creation of the capital markets group in the 19 Federal Home Loan Bank Board in 1988 was that they 20 felt that the examiners and the supervisory staff 21 did not have the necessary expertise to ensure 22 that they would ascertain accurately the practices 3396 1 of the management of mortgage-backed securities 2 and junk bond portfolios? 3 A. Yes. 4 Q. Now, I'd like to ask you one more 5 question about the checklist on high-yield bonds 6 which is Exhibit B3774. 7 A. Got it. 8 Q. Does that checklist indicate a review 9 of whether or not any of the junk bond 10 transactions involved affiliated party 11 transactions? 12 A. I'm not sure exactly what you mean by 13 "affiliated party," and I'm not sure exactly what 14 No. 7 is referring to in this. "To determine if 15 any director, officer, employee, attorney, or any 16 members connected with any depositor or an 17 investment brokerage firm used by the 18 institution" -- I don't know what the definition 19 is of "affiliated party." I think this is trying 20 to look at conflicts of interest. I don't know 21 what the -- but I also notice -- 22 Q. So, you don't know whether or not that 3397 1 is the guidance that the examiner was operating 2 under? 3 A. I don't. But I do notice it's not 4 checked off "yes" or "no." 5 Q. Now, I'd like to move to Exhibit A11011 6 which is a memo from Ginger Baugh to the files 7 dated July 24th, 1986. 8 A. 11011? 9 Q. 11011. And I direct your attention to 10 Page 8 of that document again. In the middle 11 paragraph, it says "Further, while net operating 12 income does not meet the eligibility requirements, 13 United has enjoyed an increasing level of 14 profitability from its securities investments. 15 The sophistication of United's investment 16 department has been examined and documented by 17 Mr. Jonathan Scott of the financial services 18 administration division of the Dallas bank." 19 Is it your understanding that the 20 sophistication is in reference to the securities 21 that are mentioned in that paragraph? 22 A. It says "the sophistication of United's 3398 1 investment department." I think it was talking 2 about the people and the controls that were in 3 place to manage those. 4 Q. Okay. Now, do you know of any other 5 time that you or Jonathan Scott had reviewed 6 the -- or interviewed any of the personnel to 7 ascertain whether or not they had the 8 qualifications to manage a mortgage-backed 9 security portfolio prior to July 24th, 1986? 10 A. The only two things I remember that 11 we've already discussed in here are talking to Joe 12 Phillips about junk bonds and my meeting with 13 Sandy Lawrenson. 14 Q. Now, look at Exhibit A10566 which is 15 the July 12th, 1985, letter from United Savings 16 regarding liability growth applications. 17 A. I may not have it. Did we do it this 18 morning? 19 MR. GUIDO: There is nothing in the 20 folder. 21 THE WITNESS: It's A what? 22 MR. GUIDO: 10566. 3399 1 Q. (BY MR. GUIDO) Well, I can read it to 2 you. 3 A. I don't seem to have it. 4 MR. NICKENS: Is that what you're 5 looking for? 6 MR. GUIDO: Yes. 7 Q. (BY MR. GUIDO) Look at the paragraph 8 that has the number 1 in it. It says -- it refers 9 to the growth in 1985. It says "The association's 10 use of reverse repurchase agreements and purchase 11 of mortgage-backed securities has increased from 12 $60 million at the base period in November 30, 13 '84, to 539 million at June 30, 1985. All of 14 these investments are fully hedged, and the 15 related interest rate gap exposure has been 16 reduced to the maximum possible." 17 Do you see that? 18 A. I see that. 19 Q. Now, you've written about 20 risk-controlled arbitrages. You had the four 21 articles, and you were consulted by the bank board 22 on risk-controlled arbitrage questions. Right? 3400 1 A. Correct. 2 Q. Would a portfolio with $900 million in 3 mortgage-backed securities without any hedges in 4 your view have been the risk-controlled arbitrage 5 attempting to meet the objectives that we just 6 read into the record? 7 A. No. 8 Q. Would a mortgage-backed security 9 portfolio with $1,274,000,000 in mortgage-backed 10 securities and $360 million in caps have been a 11 risk-controlled arbitrage that included the 12 objectives that we just read into the record? 13 A. No. 14 Q. The same question with regard to a 15 portfolio with $1.64 billion in mortgage-backed 16 securities and $910 million in caps. 17 A. No. 18 Q. And the same question with regard to a 19 mortgage-backed security portfolio with 20 $1.7 billion in mortgage-backed securities and 21 1.1 to $1.2 billion in caps. 22 A. No. 3401 1 Q. Now, Exhibit B2318, can you take a look 2 at that, please? 3 A. B1238? 4 Q. That's the July 19th, 1988, memorandum. 5 A. Okay. I'm sorry for bad document 6 management. Can you read me that number one more 7 time? 8 Q. B2318. 9 A. 2318? B2318. Got it. 10 Q. Look at Page 15 of the document. 11 A. Okay. 12 Q. And do you see where it talks about 13 hedging financial futures and options? 14 A. Yes. 15 Q. And you were asked some questions about 16 the hedge accounting and the reference to the fact 17 that the association performs linear regression 18 analysis on a quarterly basis to establish and 19 determine if a sufficient degree of price 20 correlation exists between the cash balance sheet 21 items and the selected financial futures market 22 instruments. 3402 1 A. I see that. 2 Q. And is that linear regression analysis 3 an analysis that Franklin Savings Association 4 claimed it was doing to justify its actions 5 against the director of OTS in the case Franklin 6 versus OTS? 7 A. I don't know exactly the data points 8 that were being used, but linear regression was 9 being used by Franklin in order to determine 10 correlation between futures and cash instruments. 11 Q. Now, at the time that USAT was engaged 12 in its risk-controlled arbitrage portfolio, it was 13 engaging in a mark-to-market analysis of its 14 portfolio? Do you know? 15 A. I don't know. 16 Q. So, you don't know what methodology it 17 was using? 18 A. I do not. 19 Q. But at the time, the 1985 through 1987 20 time, to determine the sensitivity of a portfolio 21 to interest rate changes, did you write that one 22 should use mark-to-market analysis to ascertain 3403 1 what the sensitivity was? 2 A. Yes, I did. 3 Q. And did you advocate the use of linear 4 regression analysis for that purpose? 5 A. No, I did not. 6 Q. And to your knowledge, was linear 7 regression analysis used to ascertain the interest 8 rate sensitivity of mortgage-backed security 9 risk-controlled arbitrage programs? 10 A. Not to my knowledge. 11 Q. Now, we've talked a lot about roll-down 12 strategy in the last few days. Can you tell us 13 whether beginning a roll-down in mortgage-backed 14 securities at or after a 200 basis point decline 15 in interest rates was a responsible way to roll 16 down a mortgage-backed security portfolio? 17 A. In my opinion, it's not. I believe in 18 one of my articles I say it's too little too late. 19 Q. Now, was a rapid acceleration in 20 prepayment speeds with a decrease in interest 21 rates an expected or unexpected event in late 22 1985? 3404 1 A. I believe it was an expected event. If 2 rates declined precipitously, an increased -- 3 large increase in prepayment speed should have 4 been expected. 5 Q. You were asked about an article, do you 6 recall, in which there was made reference to value 7 trading by insured depository institutions by 8 Mr. Nickens? Do you recall that? 9 A. Was that the Institutional Investor 10 article? 11 Q. Yes. 12 A. Okay. 13 Q. This is the question. I'm going to ask 14 you about the third page of the article in the far 15 right-hand column down toward the bottom right 16 that says "most thrifts." It says "Most thrifts 17 that pursue risk-controlled arbitrage also 18 actively trade pass-throughs, buying those they 19 think are undervalued and selling the ones they 20 think are too dear to add incremental returns. 21 They view this as another means of obtaining 22 insurance against prepayment risk. They 3405 1 constantly sift through the peculiarities of the 2 different pass-through issues and track the 3 pattern of supply and demand in the market much 4 the same way active managers of fixed income 5 portfolios do to boost returns." And that 6 question was asked. 7 "Now, do you agree or disagree with 8 that observation?" 9 "I would agree the answer says that 10 many of the institutions that did risk-controlled 11 arbitrages or had them in place were trading the 12 securities based on rich/cheap." 13 MR. NICKENS: Can I get the page 14 reference, Your Honor? 15 MR. GUIDO: I'm sorry. It is 3944 and 16 3945. 17 Q. (BY MR. GUIDO) And then it says "They 18 had thought they had identified bargains and would 19 swap back and forth." That was a question, 20 although it reads as a statement. And answer, 21 "That was their expectations. That's why they 22 were doing the transactions." 3406 1 Question, "Do you know that -- is there 2 anything wrong with that?" 3 Answer, "The issue really comes down to 4 are the swaps that you're doing bringing back in 5 the securities that are sufficiently similar to 6 ones that went out to keep the liability structure 7 in place and appropriate so that you don't have to 8 rebalance. That's one. The other" -- 9 MR. NICKENS: I'm sorry. My copy of 10 the transcript stops at about Page 3000. There 11 isn't a 39 -- 12 MR. GUIDO: 29. I'm sorry. Did I say 13 39? 14 MR. NICKENS: Yes, sir. 15 MR. GUIDO: 2944 is where it begins. 16 THE COURT: Continue. 17 MR. NICKENS: I have the place, Your 18 Honor. Thank you. 19 Q. (BY MR. GUIDO) The other thing that 20 this talks about, it compares the way active 21 managers of fixed incomes boost returns. 22 "Rebalancing and active management are really two 3407 1 different things in risk-controlled arbitrages. 2 Rebalancing is generally in response to some 3 market shock as opposed to a richening or 4 cheapening of coupons. If you're trading on 5 richening and cheapening coupons, what you're 6 attempting to do is boost returns and hopefully 7 keep the transaction in place. So, you are -- at 8 least in my belief, you are trading the assets in 9 order to increase the returns from the asset 10 base." 11 Now, first of all, how did you learn 12 that thrifts were engaging in the trading that was 13 referred to in that article that Mr. Nickens read 14 to you? 15 A. There are really two ways. The 16 broker/dealers that covered us were also telling 17 us about rich/cheap trades and telling us about 18 transactions that other institutions were doing 19 where they were swapping out of coupons. And that 20 was in terms of trying to get us to do things with 21 our portfolio. 22 The other thing is from time to time, 3408 1 examiners would bring me lists of trades done by 2 particular institutions and say, "Given this set 3 of trades, can you tell if they are rebalancing, 4 if they are trading, or what they are doing?" 5 Q. And did you mean by your testimony that 6 you were saying that the act of trading was an 7 appropriate thing for a thrift to be doing in its 8 risk-controlled arbitrage? 9 A. I don't believe that I was saying that. 10 I think that trading inside the risk-controlled 11 arbitrage is not consistent with the overall goals 12 of the risk-controlled arbitrage. 13 Q. Now, how frequently were transactions 14 brought to your attention: Buy cheap/sell rich 15 transactions or sell rich/buy cheap transactions? 16 A. A lot of it depended on the market 17 volatility. When you saw a significant amount of 18 rate change in a short period of time, you would 19 start to see coupon -- different mortgage coupons 20 traded at different spreads to the treasury curve. 21 So, if you had a very, very volatile period of the 22 market, you may see, you know, once a week or once 3409 1 every ten days a more solid -- sorry -- in more 2 stable markets, it may be quarterly or every five 3 or six months before you would see enough movement 4 in the spread relationships to generate a 5 rich/cheap transaction. 6 Q. Now, when the examiners brought these 7 to you and they asked you whether or not it was 8 rebalancing or it was a trading, did they indicate 9 to you why they were asking you for your opinion 10 on the distinction? 11 A. Generally, they would come in and say, 12 "Is this guy trading his portfolio, or can you 13 tell if this is trading activity or if this is 14 rebalancing of a hedge" or something like that. 15 Generally, I didn't know what the institution was; 16 and generally, I didn't know where they were 17 headed with that question. 18 So, I'd look at the trades and probably 19 ask them, you know, what the securities were, what 20 the dollar magnitudes were, and try to see what 21 interest rates did over that time period and give 22 them an answer. 3410 1 Q. Do you have any idea of why they 2 thought that distinction was significant? 3 A. I think that excessive trading of 4 portfolios was certainly looked on by regulators 5 as being unsafe and unsound. 6 Q. Now, is active trading of a portfolio 7 in the range of 200 to 300 times turnover per year 8 consistent with active trading or rebalancing of a 9 portfolio? 10 MR. NICKENS: Your Honor, I object to 11 the form of the question. It assumes that such a 12 turnover rate does constitute active trading. 13 There has been no such evidence and no indication 14 that this witness could provide such evidence. It 15 would normally depend upon such factors as market 16 volatility, what the purpose of the trading was, 17 and things that would have to be put in context. 18 THE COURT: Well, I thought that was a 19 question. Let's get the answer from the witness. 20 MR. GUIDO: Thank you, Your Honor. 21 A. It would take an extremely volatile 22 market for an extremely long period of time to 3411 1 justify -- did you say a two or 300 -- 2 Q. (BY MR. GUIDO) 200 to 300 percent 3 turnover on an annualized basis. 4 A. That would be an excessive amount of 5 transactions in a stable market; and it would take 6 a tremendous amount of volatility to justify that, 7 I think. 8 Q. Thank you. 9 MR. GUIDO: I have no further 10 questions, Your Honor. 11 THE COURT: Recross, Mr. Nickens? 12 MR. NICKENS: Yes, sir. 13 14 RECROSS-EXAMINATION 15 16 (1:39 p.m.) 17 Q. (BY MR. NICKENS) Mr. Smith, you 18 haven't looked at USAT's portfolios to determine 19 what their turnover was, have you? 20 A. No, I have not. 21 Q. You haven't looked at the time frame as 22 to its volatility during that period either, have 3412 1 you? 2 A. No, I have not. 3 Q. So, you have no way of knowing whether 4 or not their turnover was excessive, do you? 5 A. And what I said is it would take market 6 events much as those in order to make that exact 7 determination. 8 Q. You just have no way of doing it. You 9 haven't studied the question, have you? 10 A. I have not looked at the portfolio. 11 Q. All right. And the people that did 12 study the question would presumably have been 13 those examiners. Right? 14 A. Among others, I guess. 15 Q. Well, I thought you told us that if 16 they saw excessive trading, they -- that would be 17 unsafe and unsound, correct? 18 A. That would generally be considered 19 unsafe and unsound if they saw excessive trading. 20 Q. And sort of a fundamental part of their 21 training was if they saw something unsafe and 22 unsound, they were to report it? 3413 1 A. That's part of their training. 2 Q. And if they were there and they 3 examined all the books and records and they 4 examined the trading and they didn't report it, 5 what conclusion would you draw as to whether or 6 not there was unsafe and unsound practices going 7 on? 8 A. That either they understood the context 9 of the transactions and believed them to be 10 appropriate or they didn't understand the 11 transaction. 12 Q. Now, you're not telling us that the 13 examiners at the Federal Home Loan Bank of Dallas 14 were incompetent, are you? 15 A. No. But what I am saying is that many 16 of them were not -- they were not trained or that 17 educated about security transactions specifically. 18 Q. Well, what do you know about their 19 training? 20 A. I know about their training, that there 21 was a training school that was run nationally out 22 of Dallas. The guy who ran it is someone I used 3414 1 to teach with. The school ran programs -- I know 2 some of the specific course offerings which were 3 real estate classifications, real estate 4 valuation. There were AL courses. And then later 5 on -- I don't know the date it started -- they 6 started programs in financial institutions, 7 futures, and options. 8 Q. Did you ever participate in any of 9 these training sessions? 10 A. I did not participate in any through 11 the school. I did do some training sessions for 12 OTS in Washington. 13 Q. And did the Washington people try to 14 evaluate whether your examiners were competent? 15 A. I don't know. 16 Q. Did you ever -- with regard to 17 Exhibit 3774 and Mr. Guido's questions about 18 speculation -- 19 A. 3774, yes. 20 Q. Yes, sir. If you look at Item No. 2, 21 you're to determine whether the institution's 22 policies are designed to reduce net interest rate 3415 1 exposure and whether the institution is 2 speculating? 3 A. Yes. 4 Q. Does that appear to indicate a 5 determination should be made on that point? 6 A. It indicates that, I believe. 7 Q. Right. And it indicates that this 8 examiner had done that work? 9 A. His initials are by it. 10 Q. And that's what it indicates. Right? 11 A. I assume that's how you fill the form 12 out. 13 Q. If you go down to No. 8, it says 14 "determine whether transactions involve apparent 15 risk or speculation, investigate, and prepare a 16 work paper identifying significant or unusual 17 items." 18 A. Uh-huh. (Witness nods head 19 affirmatively.) 20 Q. And it indicates that that this 21 examiner had so examined the portfolio? 22 A. Uh-huh. (Witness nods head 3416 1 affirmatively.) However -- 2 Q. Sir, is that what it indicates? 3 A. It does. This says "junk bond program 4 only," and I thought we were talking about the 5 mortgages. Am I confused? 6 Q. We're now talking about junk bonds. 7 A. Okay. 8 Q. Because that's what Mr. Guido asked you 9 about with regard to this document. Right? 10 A. Okay. That's fair. 11 Q. And if we go over to No. 14, it says 12 "Determine whether the institution is attempting 13 to overstate income or understate profit by 14 recognizing income too rapidly or by deferring 15 losses over too long a period." 16 A. Uh-huh. 17 Q. That would be, what, gains trading? 18 A. That's probably what that would be. 19 Q. It indicates that this examiner looked 20 at the portfolio for that purpose? 21 A. Yes, it does. 22 Q. Then No. 15 is "Evaluate the effects of 3417 1 purchases of securities and prices 2 substantially" -- and, by the way, there is a note 3 there. Right? 4 A. Uh-huh. (Witness nods head 5 affirmatively.) 6 Q. It says "not noted"? 7 A. Correct. 8 Q. Then it indicates "Evaluate the 9 effects" -- that indicates that he had examined it 10 and didn't find it. Right? 11 A. I don't know what that means. 12 Q. Then No. 15 is "Evaluate the effects of 13 purchases of securities at prices substantially 14 above market due to adverse interest changes 15 occurring subsequent to issuance or commitments. 16 Not noted"? 17 A. Yes. 18 Q. Now, you were asked questions about 19 Exhibit 2318, the Twomey/Baugh memo to Mr. Scott. 20 A. I'm sorry. The number again? 21 Q. 2318. 22 A. Got it. 3418 1 Q. And we were focused on Pages 15 and 16. 2 A. Right. 3 Q. Was there anything wrong with 4 correlation analysis? 5 A. There is nothing wrong with correlation 6 analysis. 7 Q. And it was one of the accepted means of 8 trying to find out whether the hedge was 9 appropriate? 10 A. It was one of the means that people 11 used to determine if correlation existed in the 12 hedge, and high correlation generally implied a 13 good hedge. 14 Q. And this indicated here -- it says -- 15 go back. At the top of the page -- 16 A. I'm sorry. Which page number? 17 Q. Page No. 16. At the top of the page, 18 "However, the aggregate performance" -- that is, 19 price correlation of Hedge 1 -- "does raise some 20 concern. This is because the association/UMBS has 21 actively managed the hedge by executing futures 22 positions where the contract delivery month is far 3419 1 in advance of the designated hedge period and 2 rolling back and forth to capture favorable market 3 changes, basis spread, and in some instances, 4 holding positions were opened in excess of the 5 designated hedge period month. Therefore, the 6 price correlation percentages should be viewed 7 with these facts in mind." 8 Do you see that? 9 A. I see that. 10 Q. Now -- so, this examiner was observing 11 trading in the hedges? 12 A. It appears that way, yes. 13 Q. And that was the explanation that was 14 given for the low correlation? 15 A. That is what's indicated by this, yes. 16 Q. And then if you go down to the bottom 17 part of the page, the next-to-the-last paragraph, 18 "The association's price correlation percentages 19 for Hedges 1 and 2 using the aforementioned 20 regression analysis formula represents 82 and 21 93 percent respectively. The association's 22 formula is based on cumulative performance of the 3420 1 hedges since their inception." 2 Do you see that? 3 A. I see that. 4 Q. That indicates that over a longer time 5 frame, the correlation was much higher? 6 A. Correct. 7 Q. And that, too, was indicated by this 8 examiner as a basis for explaining why the 9 61.3 percent could be understood? 10 A. If -- yes, because that's with respect 11 to price correlation for Hedge 1. I believe 12 that's the -- I'm not sure what this is referring 13 to because I don't understand exactly how this is 14 constructed because there is a star above it. It 15 says "Price correlation for Hedge 1 is 85.4," and 16 then there are the two paragraphs under it. So, 17 I'm not sure what I'm referring specifically to 18 here. 19 Q. The numbers we were looking at was the 20 percentage price variance over there that I had 21 asked you about. Right? 22 A. I believe so, yes, the 61.3 percent; 3421 1 and that's referenced as going with Hedge 1. And 2 then it says "Price correlation for Hedge 1 based 3 on 14 months is 85 percent," which I think is 4 where the cumulative regression comes in. 5 Q. Okay. Now, you said if rates declined 6 precipitously back in nineteen -- we were talking 7 about the expectations back in 1983, '84, and '85. 8 And you told Mr. Guido that if rates declined 9 precipitously, one would have expected, during 10 that period, significant prepayments? 11 A. Yes, sir. 12 Q. Do you recall that testimony? Now, do 13 you recall I asked you in your -- in the 14 cross-examination to look at a document. I 15 believe it was a Waldman article in 1983 -- 16 A. Yes. 17 Q. -- which indicated that if you had a 18 decline of 400 basis points, one would expect 19 significant prepayments? 20 A. I remember looking at that, yes. 21 Q. And do you recall that Mr. Waldman also 22 said that if you had a decline of 250 basis 3422 1 points, one would expect to begin to see some 2 decline -- or some acceleration in prepayments? 3 A. I do. 4 Q. And do you recall that I asked you 5 questions about whether that reflected the 6 thinking at the time? 7 A. Yes. And I believe I also referred 8 back to the chart on the prior page that showed 9 the volatility in prepayment rates over various 10 interest rate -- over various interest rate 11 environments that indicated greater volatility 12 than Mr. Waldman was using in his analysis. 13 Q. And wasn't that testimony that had come 14 about after you had told us that you thought the 15 sort of rule of thumb was 150 basis points? 16 A. 125 to 150 is where I believe 17 prepayment speeds would start to accelerate, or 18 prepayment rates. 19 Q. And you thought that that was the 20 thinking at the time? 21 A. Yes. 22 Q. And I had pointed out this article and 3423 1 another article to indicate that many people were 2 publishing drops greater than that? 3 A. Yes. 4 Q. Now, Mr. Guido asked you some questions 5 about Exhibit A10566 which is at Tab 176; and it's 6 the letter of July 12th, 1985. 7 A. Sorry. The number again is A -- 8 Q. 10566, Tab 176. 9 A. If you can shortcut that a little bit 10 for me here. Is that one I read out of your book? 11 Q. Could be. Let's get another one here. 12 176. Ignore, if you can, the marks on the 13 document. 14 A. Okay. Got it. 15 Q. Now, this was Mr. Williams' letter to 16 Mr. Bonczak of July 12th, 1985? 17 A. Yes. 18 Q. Do you know when United MBS began to 19 build its portfolio? 20 A. I do not. 21 Q. Well, Mr. Guido asked you about whether 22 certain scenarios would be consistent with the 3424 1 representation in Paragraph No. 1 about the 2 investments being fully hedged? 3 A. Correct. 4 Q. Now, if the evidence showed that Joe's 5 portfolio at that time was approximately 6 $500 million of face amount MBS and approximately 7 $500 million of swaps, notional amount, that would 8 be fully hedged, correct? 9 A. That would meet one of the criteria for 10 fully hedged, yes. 11 Q. And the examples that Mr. Guido gave 12 you, do you have any idea where he got those? 13 A. I do not. 14 Q. Or what time frame? 15 A. I do not. 16 Q. Or that they have any relationship to 17 the facts of this case? 18 A. I do not. 19 Q. If it turns out that United MBS' 20 portfolio wasn't started until November of 1986, 21 would you think that that could have -- that this 22 letter written in July of 1985 could have any 3425 1 possible application to it? 2 A. It's possible that it could, but one 3 would expect another letter closer to the time 4 period. 5 Q. This is looking retrospectively, is it 6 not? It's talking about what exists at that point 7 in time. 8 A. Has increased, yes. 9 MR. NICKENS: No further questions, 10 Your Honor. 11 THE COURT: Mr. Guido, do you have any 12 redirect? 13 MR. GUIDO: No redirect, Your Honor. 14 THE COURT: Thank you, Mr. Smith. You 15 may step down. OTS has another witness? 16 MR. GUIDO: Yes, Your Honor. We're 17 going to get him now. 18 THE COURT: Let's take a short recess. 19 MR. GUIDO: Thank you, Your Honor. 20 21 (A break was taken at 1:55 p.m.) 22 3426 1 THE COURT: Be seated, please. We'll 2 be back on the record. Mr. Guido. 3 MR. GUIDO: Yes. At this time, Your 4 Honor, the OTS would like to call Mr. Joe Hargett. 5 6 JOEL A. HARGETT, 7 8 called as a witness and having been first duly 9 sworn, testified as follows: 10 11 THE COURT: Be seated, please. 12 13 EXAMINATION 14 15 (2:20 p.m.) 16 Q. (BY MR. GUIDO) Will you state your 17 full name for the record, please. 18 A. It's Joel A. Hargett. I go by Joe. 19 Q. And where are you employed? 20 A. Peterson Consulting, Limited Liability 21 Corporation. 22 Q. And where were you employed prior to 3427 1 Peterson Consulting? 2 A. Immediately prior, I was employed by 3 the Office of Thrift Supervision on a two-year 4 fellowship between 1989 early and early 1991. 5 Q. And prior to joining the Office of 6 Thrift Supervision, where were you employed? 7 A. I was employed by Peat Marwick, an 8 international accounting firm, beginning at the 9 entry level in 1984 and eventually ending up as a 10 manager in 1989. 11 Q. And where did you do your post-high 12 school education? 13 A. At the University of Alabama. 14 Q. What degrees did you receive? 15 A. I received a bachelor of science degree 16 from the business -- the School of Business and 17 Commerce Administration with a major in 18 accounting. 19 Q. Do you have any certifications as -- 20 A. Yes. 21 Q. -- a specialist? 22 A. Yes, I do. 3428 1 Q. What are those? 2 A. I'm a certified public accountant in 3 the state of Virginia. 4 Q. Now, you indicated from 1984 to early 5 1989, you worked at Peat Marwick, the accounting 6 firm; is that correct? 7 A. That's correct. 8 Q. And what did you do there? 9 A. I worked in the audit department, and I 10 concentrated in the financial services industry. 11 Q. Did you do any teaching while you were 12 there? 13 A. Yes, I did. I believe in 1987, I was 14 designated as an industry expert in financial 15 institutions, and I taught one class involving 16 financial institutions for the firm. 17 Q. Now, at the Office of Thrift 18 Supervision, under the two-year fellowship, what 19 did your assignments include? 20 A. Essentially, it involved providing 21 accounting and other industry expertise to the 22 regulatory system. 3429 1 Q. Did you draft any of those regulations? 2 A. Yes, I did. 3 Q. Did you develop training materials to 4 teach any classes? 5 A. Yes, I did. 6 Q. And what were those classes? Do you 7 recall? 8 A. The training materials related to 9 investment portfolio policy guidelines on a 10 regulation that came out in 1989 and other 11 training materials related to the capital 12 standards that went effective in 1989. 13 Q. Now, at Peterson Consulting, what has 14 your work consisted of? 15 A. Accounting, financial and economic 16 analysis primarily involved in the financial 17 institutions industry. 18 Q. Have you done any damage analyses in 19 your position at Peterson Consulting? 20 A. Yes, I have. 21 Q. And for what institutions? For what 22 entities? 3430 1 A. There are many, many institutions that 2 I've done. Many of them were in the consulting 3 capacity where I was not disclosed. In some 4 cases, I did it as an expert. 5 Q. Now, you've been designated an expert 6 in other litigation? 7 A. Yes, I have. 8 Q. And can you tell us the litigation? 9 A. There is a summary of it in my resume 10 on the last page. 11 Q. Is that your expert report? 12 A. Yes. In my expert report on the last 13 page, there is a summary of testimony. 14 MR. GUIDO: Your Honor, I think at this 15 time, it would be appropriate for me to move the 16 introduction of Mr. Hargett's expert report as 17 Exhibit A11018, Your Honor. 18 MR. NICKENS: No objection, Your Honor. 19 THE COURT: Received. 20 MR. NICKENS: I will note for the 21 record, Mr. Hargett is not here as an accounting 22 expert. I attempted to depose him on that subject 3431 1 and it was made absolutely clear in the deposition 2 that he was not here to give any accounting 3 opinions or anything of that nature. He's here on 4 damage issues and on some other issues not 5 relating to accounting. 6 MR. GUIDO: Your Honor, we have not 7 designated him as a expert to opine about 8 accounting literature. There may be factual 9 disputes about the portfolio here, and his 10 accounting background we believe is relevant to 11 his opinion on whether or not certain portfolios 12 are of a certain nature or not or constitute a 13 risk-controlled arbitrage and there may be an 14 issue with regard to that matter. 15 MR. NICKENS: Well, Your Honor, on that 16 basis, I -- if I can get the reference here -- I 17 asked at Page 175 of his deposition about whether 18 he had any opinions as to whether this was an 19 appropriate risk-controlled arbitrage. Mr. Guido 20 objected and said -- stated "He has not given an 21 opinion about whether or not this was an 22 appropriate risk-controlled arbitrage." 3432 1 At Page 442 through 444 of his 2 deposition, I asked about whether he was being 3 brought as an accounting expert. He was not 4 permitted to answer any questions whether he had 5 an opinion, an accounting type opinion, in that 6 particular instance relating to gains trading. 7 So, I just want to be clear where we 8 are. I mean, he's identified and he has an 9 accounting background but he's not brought here to 10 you to bring accounting opinions. 11 MR. GUIDO: We are not bringing him 12 here to opine on any disputed issue of accounting 13 literature, Your Honor. He's being brought here 14 to explain what were the losses that were incurred 15 in the portfolio, how the portfolios grew over 16 time, what was in those specific portfolios, Your 17 Honor. But we are not presenting him as an expert 18 on whether FASB 80 required the use of linear 19 regression analysis or allowed it or required 20 something else. We're not bringing him here for 21 that purpose, Your Honor. 22 THE COURT: Proceed. 3433 1 Q. (BY MR. GUIDO) Now, you indicated 2 that you have testified or you've been designated 3 an expert in other litigation. Can you tell us 4 what litigation that was? 5 A. Yes. There was an arbitration 6 involving Freidkin and Fidelity Investments in 7 1996. There was actually a trial involving 8 Computer Discounters and Comp U.S.A. in 1996. 9 There is a couple of depositions listed which are 10 involving failed financial institutions for either 11 the FDIC or the RTC. And in addition to this, 12 after this report was prepared, in another matter, 13 I was designated as an expert involving a goodwill 14 case. 15 Q. Now, did you review any materials in 16 preparation of your report that were related to 17 the activities of USAT? 18 A. Yes, I did. 19 Q. Can you tell us what materials you -- 20 by categories that you looked at? 21 A. On Page 1 of my report, there is a 22 fairly high-level summary of some of the key type 3434 1 of documents: Regulatory examination and 2 correspondence between USAT and the regulators. 3 There are quarterly reports called thrift 4 financial reports that they filed with the 5 regulators, various internal correspondence that 6 primarily relates to financial type issues, their 7 filings with the SEC that are 10Ks and 10Qs on 8 both a quarterly and an annual basis. There are 9 audit work papers and their audit reports, their 10 internal -- for lack of a better word -- general 11 ledgers. They typically called them 12 performance -- I'm sorry -- proof list or 13 consolidated transaction listings, as well as 14 their monthly financial statements which were 15 called performance reports, and then a whole host 16 of internal accounting records that related to 17 various transactions such as interest rate swaps, 18 interest rate caps, et cetera. 19 MR. GUIDO: Now, I'd like to move the 20 admission of the source documents related to Joe 21 Hargett's expert report which I've had marked as 22 A11023, Your Honor. 3435 1 Q. (BY MR. GUIDO) Do you recognize 11023 2 as the list of documents that you've relied upon 3 in preparation for a portion of your expert 4 report? 5 A. Yes, I do. This was produced at the -- 6 my first deposition back in May. 7 MR. GUIDO: I'd like to also move the 8 admission of Exhibit A11023, Sub A, Your Honor, 9 which is another list of documents that were 10 relied upon by Mr. Hargett. 11 Q. (BY MR. GUIDO) Let me hand you 12 Exhibit 11023-A and ask you to identify that 13 document for the record, Mr. Hargett. 14 A. It's a second list of documents that 15 relate primarily to the maturity matching credit 16 issue which is one part of my report. It was also 17 produced back at my deposition in May. 18 Q. Is that the Exhibit D -- the documents 19 that back up Exhibit D to your report or the list 20 of documents which is -- 21 A. That's correct. 22 Q. -- the analysis of USAT's manipulation 3436 1 of the maturity matching credit? 2 A. That's correct. That's the primary 3 documents related to that. 4 THE COURT: Is there no objection to 5 receive either one of these? 6 MR. NICKENS: Your Honor, I'd like to 7 see them. If they are as purported, I don't have 8 any objection. I don't have an objection to 11023 9 which is identified as Hargett Exhibit 3 to his 10 deposition. 11 THE COURT: Received. 12 MR. NICKENS: I simply don't recall 13 11023-A, and I would like to confirm that it 14 was -- if we could identify it as -- 15 Q. (BY MR. GUIDO) Was 11023-A, was that 16 a document that was identified in your deposition, 17 Mr. Hargett? 18 A. Yes, it was. It was one of the two 19 documents that were indexes produced in, I believe 20 it was, the May 16th deposition. 21 MR. NICKENS: Do we know what 22 exhibit number it was to the deposition? 3437 1 MR. GUIDO: I don't know the 2 exhibit number. 3 A. It's one of the very earliest ones. 4 It's going to be a pretty low number, like less 5 than five. 6 MR. NICKENS: Based upon that, Your 7 Honor, I have no objection. We will try to 8 confirm that so that we can put a number on it. 9 THE COURT: All right. Received. 10 MR. GUIDO: I'd also -- well, before I 11 do that -- 12 Q. (BY MR. GUIDO) What questions were 13 you asked by the OTS to prepare responses to the 14 areas you were asked to look at? 15 A. I was asked to quantify losses related 16 to certain mortgage-backed security portfolios 17 related to USAT. I was asked to compile a 18 schedule of the turnover in those mortgage-backed 19 security portfolios for a certain period of time, 20 primarily '86 and 1987. I was asked to prepare an 21 analysis of how their regulatory capital 22 requirement was reported as of September 30th, 3438 1 1987, and consider whether or not it was 2 manipulated relating to one component of that 3 calculation that is known as the maturity matching 4 credit. And I was asked to analyze the sale and 5 repurchase of certain interest rate caps that 6 occurred in the latter half of 1987. And, 7 finally, I was asked to quantify the amount of the 8 regulatory capital deficit that existed in 9 December of 1988. 10 Q. Were you subsequently asked to develop 11 a summary of the mortgage-backed security 12 portfolios to present to the Court? 13 A. Yes, I was. 14 MR. GUIDO: At this point, Your Honor, 15 I'd like to move the admission of Exhibit A11022 16 which is the packet of materials that are -- 17 consist of 13 pages, the first nine of which are 18 the summary of the mortgage-backed security 19 portfolios over time and then Page 10 is the 20 calculation of losses or chart for the 21 calculations of losses in the USAT MBS portfolio 22 and Page 11 is the calculation of the losses in 3439 1 the United MBS portfolio, that separate 2 subsidiary. And then 12 is a summary of those 3 losses, and 13 is -- I think that this is also in 4 the 11022. It's a chart on the -- charts the 5 mortgage-backed security MBS portfolio turnover. 6 Now, there is an issue, Your Honor, 7 between the parties about one of these charts and 8 that is the growth and the composition of the USAT 9 mortgage-backed security portfolio. And there 10 will be additional testimony on that. But these 11 are the charts that reflect the portfolios as 12 reflected in the information that Mr. Hargett will 13 provide with regard to the losses in the 14 mortgage-backed security portfolios. 15 MR. NICKENS: Your Honor, I don't have 16 any objection to A11022 although -- and Mr. Guido 17 has earlier today provided me with copies. But I 18 would like to get them in the same order so that 19 our copy is -- we can be -- 20 THE COURT: A11022 is received. 21 Q. (BY MR. GUIDO) Now, going back to 22 your list of documents that -- USAT documents that 3440 1 you relied upon as source documents for your 2 report, are those the type of materials that 3 you've customarily relied upon to prepare reports 4 similar to the reports that you prepared for the 5 Court here? 6 A. Yes, they are. 7 Q. Now, the first page of Exhibit A11022 8 is basically a summary of the MBS portfolios by 9 bullet points. 10 Will you explain to the Court what is 11 included in the -- what you've denominated as the 12 USAT portfolio? 13 A. Yes. The USAT portfolio was 14 essentially the separate general ledger of USAT 15 with a couple of exceptions. My source for 16 preparing that information, as summarized in the 17 following charts, was a report that was given to 18 me that's dated in April of 1997 that it's my 19 understanding was prepared by an expert for one of 20 the respondents. And in that portfolio, again, 21 it's essentially the general ledger of USAT and 22 there's some items that are excluded. For 3441 1 example, there was a cash flow bond -- 2 mortgage-backed security cash flow bond that was 3 in the early part of 1986, and that's been 4 excluded. And then the one thing that I have 5 included is there was a separate subsidiary that 6 came into existence in the latter half of 1985 7 that was called USAT Mortgage Finance, 8 Incorporated. It was a very short-lived 9 subsidiary. It essentially started in the last 10 half of 1985, acquired five or $600 million of 11 mortgage-backed securities, also acquired related 12 hedging instruments -- primarily interest rate 13 swaps -- and then within a month, those 14 mortgage-backed securities, the majority of them 15 were sold and the swaps were either effectively 16 terminated through a mirroring agreement or were 17 transferred over to the USAT portfolio. 18 Q. Now -- but in terms of the material you 19 used, you say that you used a report that was 20 prepared by the respondents -- some expert for the 21 respondents. 22 Do you know how that report has been 3442 1 denominated, as whose report? 2 A. It's been represented to me that it's 3 the Coopers and Lybrand report. 4 Q. And did you take that report, and did 5 you compare those figures with anything that you 6 had worked from? 7 A. Yes, I did. I compared it essentially 8 to the information that's in my report here as 9 Exhibit A11018 where there are compilations of the 10 general ledger data, and their report also 11 indicates that it came from that same type data. 12 So, in general, I believe that the data is 13 materially the same. 14 Q. Okay. So, you attempted to reconcile 15 that -- you've concluded that the material is 16 essentially the same? 17 A. It's materially the same. 18 Q. Now, you say that the analysis of this 19 USAT portfolio that you did includes the results 20 of a subsidiary. Is that the subsidiary that's 21 mentioned on Page 1 of 1022? 22 A. Yes, it is. Again that name is USAT 3443 1 Finance Mortgage, Inc.; and it did not exist very 2 long, maybe in the latter half of 1985. 3 Q. Now, where in this packet of materials 4 can we find the summary of the data that you 5 reconciled between the expert's report and the 6 report that you had prepared? 7 A. Related to the overall caption USAT, 8 that's going to be on Page 4. 9 Q. And is the heading of that "MBS 10 Portfolio and Related Interest Rate Swaps 11 December 1984 through December 1988"? 12 A. That's correct. 13 Q. Now, will you take -- now, that -- what 14 is it that's in the Column A: MBS risk-controlled 15 arbitrage USAT only? 16 A. That's the label that appears on the 17 report that's been represented to be the Coopers 18 and Lybrand report and it essentially, again, is 19 the USAT general ledger with a couple of 20 exceptions. And again, materially, I think that 21 those numbers are consistent with what I used. 22 Q. Okay. Now, the second column, the B 3444 1 column says "USAT mortgage finance." 2 Is that the subsidiary that you 3 referred to on Page 1 of the report? 4 A. Yes, it is. That information is not, 5 to the best of my knowledge, in that particular 6 report; but it's well-documented throughout the 7 source documents, including the source documents 8 that are in my binders among other places. 9 Q. Now -- and then Column 3 for the months 10 of November '85 through March of '86, you have 11 entries for USAT Mortgage Finance and then you 12 have a combined column next to that. 13 What does that combined column consist 14 of? 15 A. It essentially is the combination of 16 Column A and Column B so that you could see what a 17 combined balance of both USAT and this particular 18 subsidiary would look like for that short period 19 of time. 20 Q. Now, going to the far right column, it 21 says "related interest rate swaps." What does 22 that refer to? 3445 1 A. That's the interest rate swaps that 2 were in existence during this time period 3 regardless of whether they were initially related 4 to USAT or this other entity known as USAT 5 Mortgage Finance, Inc. And then again, in the 6 latter half of December, some of those interest 7 rate swaps were transferred from USAT Mortgage 8 Finance, Inc. over to USAT. And this column only 9 represents the interest rate swaps. There was 10 other -- a couple of other items, a cap and a 11 collar, that's not depicted in that column. 12 Q. Okay. Now, look at Page 2 of the 13 Exhibit 1022. That shows a blue line going up. 14 Is that the Column A from the first column that 15 you referred to as mortgage MBS risk-controlled 16 arbitrage? 17 A. Yes, it is. That's essentially the 18 Column A which is on Page 4. And again, that's 19 the USAT general ledger. 20 Q. And is the column -- or the green line, 21 is that the information from Column B from Page 4? 22 A. No. It's actually Column C. It's the 3446 1 combined number. It's taking the combination of 2 what the portfolio would look like if you added in 3 that extra layer from USAT Mortgage Finance, Inc. 4 And again, basically, what happened was in 5 November of 1985, they acquired five to 6 $600 million of mortgage-backed securities and a 7 month later, they sold everything but 150. And 8 then from the information, the 150 was transferred 9 in -- over into the USAT portfolio in '86. 10 Q. Then there is this red line. Does that 11 reflect the size of the notional amount of the 12 swaps over that time period? 13 A. I believe you've moved on to Page 3; is 14 that correct? 15 Q. I'm sorry. Yes. On to Page 3. Excuse 16 me. Yes. 17 A. Page 3 reflects the notional amount of 18 the interest rate swaps during this same time 19 period. And again, that does not include a cap 20 and a collar that was put on mainly related to 21 USAT Mortgage Finance. This is swaps only. 22 Q. Okay. Now, the -- going back to 3447 1 Page 4, in the Column A, those are the monthly 2 balances of the risk-controlled arbitrage as 3 reflected in the general ledger of USAT; is that 4 correct? 5 A. That's correct. That's how the data 6 was compiled in the Coopers and Lybrand report. 7 And as I say, that information is, in my opinion, 8 materially accurate and consistent with what I've 9 done. 10 Q. Then in the far right column on Page 4 11 which is the related interest rate swaps, those 12 are the notional amounts that the general ledgers 13 showed were related interest rate swaps over that 14 time period; is that correct? 15 A. That's correct. 16 Q. Now, let's move on to Page 5 which I 17 think is -- or Page 6, excuse me, which is I think 18 the data underlying the United MBS portfolio; is 19 that correct? 20 A. That's correct. 21 Q. Now, can you tell us what that consists 22 of? 3448 1 A. This is a whole separate subsidiary of 2 USAT called United Mortgage -- United MBS or UMBS 3 for short, and that entity essentially came into 4 existence in the fourth quarter of 1986. And this 5 is, again, essentially their general ledger data 6 as compiled from their records. And this is the 7 information as presented in the Coopers report and 8 it generally consists of what I have analyzed. 9 Q. So, when you say "theirs," you mean 10 United MBS' general ledger? 11 A. That's correct. 12 Q. So, this is what was shown on United 13 MBS' general ledger and this is information that 14 you believe is materially accurate? 15 A. That's correct. 16 Q. And is this material -- the material 17 that is reflected in the Coopers and Lybrand 18 report that was prepared for the respondents? 19 A. That's my understanding, that's 20 correct. 21 Q. Now, look at February of 1987. Can you 22 tell us how many mortgage-backed securities were 3449 1 outstanding at United MBS in February of 1987? 2 A. Yes. In basically five months, the 3 portfolio has grown to over $906 million. 4 Q. Are there any caps in place at that 5 point in time? 6 A. At that point in time, no. 7 Q. Now, look at -- are these month-end 8 figures? Is that what we're looking at? 9 A. That's correct. 10 Q. Okay. Now, March 30 of '87, what was 11 the mortgage-backed security portfolio at that 12 time? 13 A. At that point, it's increased to 14 1.27 billion. 15 Q. And what was the related interest rate 16 cap portfolio at that time? 17 A. 360 million. 18 Q. Now, look at April 1987. What was the 19 mortgage-backed security portfolio size at that 20 time? 21 A. It's up to 1.67 billion. 22 Q. And what were the related interest rate 3450 1 caps at that time? 2 A. 910 million. 3 Q. Now, look at September of 1987, jumping 4 forward. What was the mortgage-backed security 5 portfolio size at that time? 6 A. It's up to 1.71 billion. 7 Q. And what were the related interest rate 8 caps? 9 A. 1.21 billion. 10 Q. And look at October and November of 11 1987. What was the approximate size of the 12 portfolio for those two months? 13 A. About 1.7 billion on the MBS side, and 14 the cap balance is down to 600 million. 15 Q. Now, do you know why that cap balance 16 went down? 17 A. Yes, I do. 18 Q. Do you know -- 19 A. Yes, I do. Essentially, there were 20 about $610 million of caps that were sold at the 21 end of October and that's depicted by that 22 decrease between September and October. And then 3451 1 two months later, there was about 580 million of 2 caps that were acquired near the end of December 3 and that's when the line is basically going back 4 up to essentially about where it was before. 5 Q. Now look at Page 5, I think, the page 6 prior to that. Is that the graphic depiction of 7 the data that we just talked about on Page 6? 8 A. That's correct. 9 Q. And this little dip here where you 10 have -- it looks like a mustache to me. And in 11 the box, it says "Sale, $610 million of caps in 12 October '87 and subsequent purchase of 13 $580 million of caps in December of 1987." 14 Is that the sale and the repurchase of 15 the caps that you just testified to? 16 A. That's correct. 17 Q. Now, look at the next-to-the-last page, 18 Page 7. Can you tell us what Page 7 depicts? 19 A. We've just talked about two different 20 portfolios as defined -- one being USAT and the 21 other being United MBS. And this chart basically 22 combines those two balances and it does not depict 3452 1 that little run-up related to United Mortgage 2 Finance for that one month. This is kind of more 3 of a snapshot of a time from 1984 to 1988. So, 4 it's essentially the USAT portfolio plus the UMBS 5 portfolio combined. 6 Q. Now, look at Page 8. How does that 7 differ from Page 7? 8 A. It does not differ as far as the data 9 that's being plotted. There is a couple dates 10 that have been added so you can see exactly when a 11 few things are happening. 12 Q. Well, take the date July 1986 that you 13 have there. What does that refer to? 14 A. That refers to an analysis that was 15 performed by Smith Breeden in July of 1986 16 relating to the interest rate risk of USAT. 17 Q. And the -- the date 9-23-86, what does 18 that refer to? 19 A. That relates to an analysis that was 20 sent to USAT by Merrill-Lynch where Merrill-Lynch 21 had apparently been requested to consider various 22 ways to either liquidate the swaps and/or lengthen 3453 1 them or other options. 2 Q. In other words, it was a memorandum 3 from Merrill-Lynch giving advice on the various 4 alternatives that were available to USAT with 5 regard to its mortgage-backed security portfolio? 6 A. Some of the alternatives, that's 7 correct. 8 Q. And then what is the significance of 9 the date of November 24th, 1986? 10 A. That's the document that is an internal 11 document that essentially summarizes where that 12 portfolio stands on a cumulative to date basis, 13 including how much gains have been recognized on 14 the MBS side as well as how much losses it would 15 take or would be incurred if the swap side was 16 liquidated at that time. 17 Q. And you mean, by "an internal 18 document," an internal document internal to USAT? 19 A. That's correct. It's a memo to 20 Mr. Gross, Williams, and Crow from Bruce F. 21 Williams to -- Jerry Williams is who the addressee 22 is and Bruce Williams is who it's from and it's 3454 1 entitled "Review of MBS Swap Arbitrage Activities 2 dated November 24th, 1986." 3 Q. What tab number is it in here? 4 A. It's in my original binders. It's 5 Tab 236. 6 Q. And what is the 9-23-86? Can you 7 identify that in your -- 8 A. I don't believe I can. That one is in 9 the source documents that I have, but I don't know 10 if that one's in this list. I don't see it right 11 offhand. 12 Q. What about the July 1986, the Smith 13 Breeden reference? Do you have that? 14 A. There is a memo related to it, at 15 least, in Tab 235. 16 Q. Now -- so, these are the -- this is the 17 data and the graphic depiction of the size of the 18 USAT and UMBS portfolios for the time period from 19 December 1984 through December 1988; is that 20 correct? 21 A. That's correct. And again, for this 22 chart, the United Mortgage Finance piece has been 3455 1 left out. 2 Q. Now, you said that you did a damage 3 calculation for the losses in the MBS portfolios. 4 Where in the report can we find reference to those 5 calculations? 6 A. In my report, the calculation is 7 essentially summarized on Page 8. 8 Q. That's Schedule A1? 9 A. That's correct. 10 Q. And that is the calculation of the 11 losses on the USAT and USAT Mortgage Finance 12 portfolios; is that correct? 13 A. That's correct. 14 Q. Does this include any of the damages 15 that you calculated for the United MBS portfolio? 16 A. No, it does not. 17 Q. Now, let's walk through that so that 18 you can explain to the Court how you did those 19 calculations. It says "gain/losses on MBSs." Do 20 you see that? 21 A. Yes. 22 Q. How -- 3456 1 A. One point of clarification. The 2 schedule on Page 8 of my report, some of this 3 information has been summarized to a higher level 4 to get back to Page 10 to the colored charts. 5 Q. Page 10 or Page 11? Page 10? 6 A. Page 10 of the -- if you look at the 7 very bottom, both of them come to 137 million. 8 This one's just summarized at a higher level. 9 Q. Why don't we walk through Page 8 and 10 then we will summarize it when we look at Page 10 11 of the colored charts. 12 MR. NICKENS: Your Honor, we have one 13 set of these charts. Could we take just a minute 14 and make a copy at least so that my colleagues 15 could have a copy even though it may not be in 16 color? 17 THE COURT: All right. We'll be off 18 the record for a moment. 19 MR. NICKENS: Also, there was a page 20 that I was missing. 21 MR. GUIDO: Why don't we make a copy of 22 that? 3457 1 (A break was taken.) 2 3 THE COURT: All right. We'll be back 4 on the record. 5 Q. (BY MR. GUIDO) Now, with regard to 6 the summary of losses on Page 8, can you explain 7 to us what the gains/losses on MBS refers to in 8 that calculation? 9 A. Yes. There's two numbers there. The 10 first one is 112 million that's essentially the 11 loss on the final disposition of the 12 mortgage-backed security portfolio, and that 13 occurred basically in the first quarter of 1989 14 right after the institution was placed into 15 receivership. But in addition to that, while this 16 portfolio was held going back between '85, '86, 17 '87, '88, there were gains and losses recognized 18 while the portfolio was being held and that's what 19 the 53 million represents. And then there is a 20 separate schedule that breaks that down by year. 21 Q. And the schedule is schedule -- 22 Schedules B and C that are in this section of the 3458 1 report? 2 A. That's correct. 3 Q. B says "losses on USAT's MBS 4 portfolios" and C says -- it says "MBS losses in 5 first quarter of 1989" and then C says "MBS 6 gains/losses recognized from January 1, 1985, to 7 December 31, 1988"? 8 A. That's correct. And that's where it 9 breaks it down by year. 10 Q. Now -- then, the next says "net 11 interest received on MBS." What does that refer 12 to? 13 A. Well, the mortgage-backed securities 14 obviously have a rate of interest attached to 15 them; and they are funded with various means of 16 financing. And this essentially represents that 17 spread between what you earn on the 18 mortgage-backed securities and what you pay on the 19 funds necessary to finance them. 20 Q. Now, is that the interest earned and 21 interest paid essentially that's reflected in the 22 general ledger of the institution? 3459 1 A. On the -- using the information 2 available, it's been estimated -- on the interest 3 income side, that information is readily available 4 and on the expense side, first of all, the primary 5 method of financing was reverse repurchase 6 agreements. And then for the balance where the 7 reverse repurchase agreements was less than the 8 MBS balance, I did a calculation estimating 9 another cost of funds related to their branch 10 deposits. So, essentially, what I was trying to 11 do is make sure that for every dollar of asset you 12 invested, you had a dollar of funding source 13 associated with it. 14 Q. Now -- then, the next says "net 15 disbursements related to USAT's interest rate swap 16 agreements." Do you see that entry? 17 A. Yes, I do. 18 Q. And what does that refer to? 19 A. There's two entries there. After the 20 swaps are transacted, primarily back in the 1985 21 time frame, based on the nature of that agreement, 22 as interest rates moved, interest rate payments 3460 1 were exchanged between USAT and the counter-party. 2 And pretty much throughout the period, they were a 3 net drain to USAT's financial resources. In other 4 words, on a net basis, USAT's paying money to the 5 counter-party related to the swap agreements. And 6 during that four-year period, that totaled 7 $99 million. 8 The next item is termination fees paid. 9 The swaps that were -- had not matured in the 10 fourth quarter of 1988 shortly before receivership 11 were terminated with a large payment made to the 12 counter-party. Essentially, you're basically 13 buying yourself out of the contract and you're 14 making a one-time payment as opposed to making 15 payments into the future. That occurred in both 16 October of '88 and December of '88, and the 17 combined number is 44 million. 18 Q. Okay. Then it refers to "net 19 disbursements related to interest rate collar and 20 interest rate caps." What does that refer to? 21 A. There was one cap and one collar that 22 essentially was put on that I mentioned earlier 3461 1 back in the fourth quarter of 1985, and that 2 particular item has been captured here. It was 3 related to some combination of USAT and United 4 Mortgage Finance. I've left them here related to 5 USAT. 6 Q. And what was the total result of the 7 losses in USAT's MBS portfolio that you have 8 determined there? 9 A. As I've calculated, that total equals 10 $135 million. 11 Q. And then there is an entry for "USAT 12 Mortgage Finance." What does that refer to? 13 A. Essentially, that's the activity I 14 mentioned back in the fourth quarter of 1985 where 15 five or $600 million of mortgage-backed securities 16 were acquired, as well as related swaps. Some of 17 the swaps were immediately mirrored, which is 18 effectively terminating them. The rest of them 19 were transferred. This tries to isolate those 20 transactions that relate to United Mortgage 21 Finance during 1985. 22 Q. And then you have a total of 3462 1 $137 million? 2 A. That's correct. 3 Q. Now, what question were you asked that 4 led you to do these calculations in this way? 5 A. I was asked to essentially quantify the 6 losses incurred or the gains incurred related to 7 the MBS portfolio of USAT. 8 Q. Does this chart capture all of the cash 9 paid out and cash received with regard to the MBS 10 portfolios at USAT? 11 A. That's what this does, yes. 12 Q. And does the graph or the chart on 13 Page 10 of your Exhibit 11022 summarize the set of 14 disbursements and set of receipts with the net 15 figure at the end? 16 A. Yes, it does. 17 Q. And that figure you calculated to be 18 $137 million? 19 A. That's correct. 20 Q. Now, did you do a similar calculation 21 for USAT's UMBS subsidiary? 22 A. Yes, I did. 3463 1 Q. Will you tell us how you did that? 2 A. That essentially begins on Page 42 of 3 my report, and it's also summarized on Page 11 of 4 Exhibit A11022, Page 11. Since UMBS was a 5 separately maintained subsidiary, it had a 6 separately maintained general ledger. It's a 7 little bit easier to track because it's a 8 self-contained entity with its own accounting 9 records. 10 So, even though conceptually you're 11 quantifying the same issue, how much money was 12 lost related to the MBSs, it's done a little bit 13 differently. Essentially, what is listed here as 14 the first number is how much cash did USAT have 15 invested in UMBS at December 31st, 1988, which is 16 basically at the time of receivership. And as 17 indicated there, there was $172 million that was 18 invested at that point in time. 19 That was basically an intercompany 20 transfer of money. There were no financing costs 21 associated with that reflected on the books of 22 UMBS. So, I've calculated what the cost of 3464 1 providing that money was to UMBS to USAT during 2 the time period that it was provided, and that's 3 essentially the financing on that investment which 4 is $32 million. 5 So, essentially, the total cumulative 6 investment that USAT had was $205 million. Then I 7 looked at the records of when UMBS was liquidated 8 in the first half of 1989 and essentially, upon 9 liquidation, USAT received back about 10 $107 million. 11 So, if you take the difference there, 12 that leads you to a subtotal of about $98 million 13 of losses at that point. I added in one other 14 calculation, and that is the interest rate caps 15 that were in question that the information leads 16 you to conclude relate to UMBS; that those caps, 17 the income and profit or loss associated with 18 them, was recorded in the general ledger of USAT. 19 So, to show the true picture of UMBS, I 20 identified the gain or loss associated with those 21 caps. And in this case, it was a gain. And 22 that's what's reflected there as the 15 million. 3465 1 So, giving them credit, if you will, for that 2 gain, the net losses come down to 82 million. 3 Q. And is that the loss figure that's 4 depicted on the chart on Page 11 of your 5 Exhibit A11022? 6 A. That's correct. 7 Q. Now, did you do anything additional to 8 the calculations to ascertain the losses to the -- 9 caused by the losses in the USAT MBS portfolio? 10 A. Yes. I looked at the losses that have 11 been quantified basically as of December '88 and 12 performed an interest calculation to bring that 13 number forward to a day close to the present time. 14 Q. Where do you find that reflected in 15 your report for the USAT mortgage-backed security 16 portfolio? 17 A. That's on Page 7 of my report for USAT. 18 Q. And what -- can you explain to us what 19 that chart shows? 20 A. Essentially, it's taking the 21 $137 million of losses related to USAT and adding 22 on simple interest -- I'm sorry -- adding on 3466 1 interest at a treasury rate, a six-month treasury 2 bill rate from basically the first of January 1989 3 through November 30th, 1996. And by adding on 4 interest, that number would increase to -- the 5 interest related to it is $69 million. 6 Q. And what would the total losses be if 7 you added in those interest rate expenses? 8 A. If you add in the interest as 9 calculated, the loss would become 206 million. 10 Q. Why did you pick the six-month treasury 11 bill rate for your calculations? 12 A. That rate was a rate that I typically 13 use on damage calculations to represent a 14 conservatively low rate of interest, and it was 15 also at the direction of counsel. 16 Q. Is that rate similar to the rate that 17 is paid by the resolution fund for money that it 18 has to finance? 19 A. I believe it to be lower than that 20 rate. 21 Q. Now, did you also calculate the 22 interest rate for the losses on the United MBS 3467 1 portfolio? 2 A. Yes, I did. 3 Q. And where is that reflected in your 4 report? 5 A. That's reflected on Page 41. 6 Q. Now, did you -- what interest rate did 7 you use in doing that calculation? 8 A. The same rate. Essentially, the 9 six-month treasury bill rate. 10 Q. And did -- what did that show you? 11 A. If you calculate interest on the 12 $82 million of UMBS losses through November 30th, 13 1996, the interest is $41 million. 14 Q. And what does that make the loss figure 15 become? 16 A. 123 million related to UMBS. 17 Q. And what is the combined losses 18 including the interest rate for both portfolios? 19 A. 329 million. 20 Q. Now, you were also asked to do a 21 turnover analysis, were you not? 22 A. That's correct. 3468 1 Q. And that is reflected where in your 2 report? 3 A. It's essentially on Page 57. 4 Q. What is the source of that information 5 or the source for that information? 6 A. The source is essentially the 10Ks and 7 the 10Qs that were filed by UFG. 8 Q. And what do those 10Ks and 10Qs report 9 that you were able to use to make the calculations 10 that are on Page 57 of your report? 11 A. It includes their financial statements 12 which are audited, and part of the audited 13 financial statements has information on purchases 14 and sales during the period. And simply rolling 15 forward the portfolio, those are the turnover 16 percentages that are apparent. 17 Q. Now, take March 31 in the first -- for 18 1986. Can you explain what it is that you did to 19 come up with the figure 214 percent as an 20 annualized securities turnover ratio? 21 A. Essentially, the first thing you need 22 to do is to calculate an estimate for the average 3469 1 balance during the period. To do that, you would 2 take the beginning balance and the ending period 3 balance and average those two numbers together. 4 Then that becomes your base and the question is: 5 How much is that base turning over? And if you 6 take the sales number and divide it into that 7 number, that will get you a number which is a 8 percentage that reflects the turnover rate. But 9 in this case, you need to multiply it times four 10 so that you can reflect it on an annualized basis. 11 Q. Now -- so, what do you do? You took 12 the 1.202 million beginning balance and what did 13 you -- 14 A. And added 1964. 15 Q. Okay. 16 A. And you average those two numbers 17 together. 18 Q. All right. 19 A. And you then take -- and the average is 20 approximately 1.58 billion. 21 Q. Okay. 22 A. And then you take the sales, which is 3470 1 845 million, and you divide the sales of 845 into 2 the 1.58 billion and then you multiply that number 3 times four. 4 Q. And that's how you come up with the 5 annualized turnover ratio. And you did that for 6 each of these time periods? 7 A. That's correct. It's also summarized 8 on an annual basis. On an annual basis, you 9 obviously don't multiply by four. 10 Q. And is that depicted on Exhibit A11022? 11 A. Yes. It's Page 13. 12 Q. Now, you have certain dates identified 13 in that -- on that chart as indicating something. 14 There is one that's 331. It says "Unrealized gain 15 in MBS portfolio of $3 million." 16 What does that refer to? 17 A. As reflected in their 10Q, at that 18 point in time, the MBS portfolio as a whole had an 19 unrealized gain of about $3 million. 20 Q. Did that include the swaps? Do you 21 know? 22 A. No. 3471 1 Q. Then at 6-30, what did that show? 2 A. By 6-30, because of changes in interest 3 rates, the unrealized loss -- it had become an 4 unrealized loss and the unrealized loss was 5 $166 million. 6 Q. And you have this sort of circle there 7 between the two days. What does that refer to? 8 A. Again, as I just indicated, during that 9 time period, interest rates were increasing fairly 10 significantly; and that's what caused the gain to 11 swing to a substantial unrealized loss. 12 Q. Now, you also did a -- were asked to do 13 a calculation of the book value of the institution 14 at a certain point in time, were you not? 15 A. Yes, its book value as well as its 16 regulatory capital and was there any deficit 17 between the two. 18 Q. Where do we find that? 19 A. That's on Page 5 and 6 of my report. 20 Q. Now, what information did you use to 21 make those calculations? 22 A. Essentially, the performance report of 3472 1 USAT that was prepared as of November 30th, 1988, 2 and the general ledger as of December 30th, 1988, 3 as well as an audited balance sheet prepared by 4 Arthur Andersen as of December 31st, 1988. 5 Q. Now, in what -- and where in your 6 report is your calculation reflecting that shown? 7 A. The actual calculation is summarized on 8 Page 6. There is an explanation explaining how 9 you get to the numbers. But basically, as of 10 December 30th, 1988, the amount of the regulatory 11 capital deficit is between 496 million and 12 522 million. And again, regulatory capital 13 deficit means the difference between how much your 14 capital requirement was and how much capital you 15 have. 16 Q. So, this figure net deficit and capital 17 under generally-accepted accounting principles is 18 a negative 344 million. You see that figure? 19 A. Yes. That's as of November 30th as 20 reflected in their records. 21 Q. Okay. Now, that figure is in what 22 records? 3473 1 A. That is in their performance report as 2 of November 30th, 1988. 3 Q. Okay. Then it says "adjustments to 4 convert GAAP to regulatory accounting principles." 5 What does that figure refer to? 6 A. Essentially in the accounting world, 7 some things count differently under GAAP than they 8 do for regulatory capital purposes. The primary 9 thing that that item relates to is goodwill 10 amortization as well as the general valuation 11 allowances. 12 Q. So, you gave them credit for the 13 $93 million? 14 A. I didn't give them credit. That's how 15 the rules -- that's how the rules work and that's 16 as reflected in their own performance report. 17 Q. You gave them credit because the rules 18 require it? 19 A. Again, I'm just merely summarizing 20 what's in their own document here. So, I'm just 21 lifting numbers out of their own report. 22 Q. Okay. Now -- and that also came from 3474 1 the performance report? 2 A. That's correct. 3 Q. Then existing regulatory capital, is 4 that the difference of the 344 and the 93? 5 A. That's correct. So, on a regulatory 6 basis, their capital position is negative 7 251 million. 8 Q. And what -- how did you calculate the 9 next entry, the regulatory capital requirement? 10 A. Again, that's the number that's 11 depicted in their own performance report as of 12 November 30th, which is 215 million. So, they 13 need 215 million in capital but they have negative 14 251 million. 15 Q. And how did you calculate the next 16 figure, the regulatory capital deficit as of 17 November 30, 1988? 18 A. Again, that's in their own report. And 19 that's the number that's depicted as being the 20 regulatory capital deficit at November 30th, 1988. 21 It's 466 million. What I then did was to take 22 that information and to roll it forward one month 3475 1 based on their own general ledger and the balance 2 sheet prepared by Arthur Andersen -- 3 Q. Okay. 4 A. -- to get a number as of December 30th. 5 Q. And where is that reflected in your 6 report? 7 A. It's essentially explained in the next 8 couple of bullets, and then the calculation itself 9 appears in the first complete paragraph at the top 10 of Page 6 when it says "Based on the above, the 11 amount of the regulatory capital deficit as of 12 December 30th, 1988, using USAT's own data was 13 approximately 496 to 522 million." 14 The reason that there is a range is 15 that there was a large amount of loan loss 16 reserves booked during that time period. And when 17 loan loss reserves are booked, that reduces 18 capital; but for regulatory purposes, they may be 19 added back to capital. And there is no 20 information as to whether or not they were 21 considered general reserves or not. So, depending 22 on which way you handle them, the range was 3476 1 between 496 and 522. 2 Q. And then did you also bring that figure 3 forward applying an interest rate factor? 4 A. Yes. Applying essentially the same 5 interest methodology I've previously described, 6 with interest, those numbers would be between 7 749 million and 788 million. 8 Q. Now, did the figures that you used 9 reflect the unrealized losses in the USAT 10 portfolios, investment portfolios and borrowing 11 portfolios? 12 A. They did not. Among other things, the 13 losses on the mortgage-backed securities that were 14 unrealized at the time are not reflected in those 15 numbers. When they terminated the swaps, they 16 booked the 44-million-dollar payment as an asset 17 as opposed to expensing it. So, that's not 18 reflected. And then the corporate bond portfolio 19 or investment securities in general also have an 20 unrealized loss that's not reflected in those 21 numbers. 22 Q. And did you attempt to ascertain what 3477 1 the total cost estimate for resolution of USAT was 2 to the resolution fund? 3 A. Yes. I obtained a report as of 4 June 30th, 1996, prepared by the FDIC and the cost 5 of resolution as calculated as of that date 6 related to the USAT entity was 1.59 billion. 7 Q. Now, were you also asked to analyze the 8 sale and the reacquisition of the interest rate 9 caps that occurred in October and December of 10 1987? 11 A. Yes, I was. 12 Q. And where is that reflected in your 13 report? 14 A. Between Pages 86 and 92, and then it's 15 summarized on Page 5. 16 Q. Okay. Now, can you tell us what it is 17 that you found when you analyzed the sale and the 18 repurchase of those caps? 19 A. Well, as depicted in Exhibit A11022, by 20 the time you get to that point in time, the 21 mortgage-backed securities portfolio is 22 significantly underwater as depicted, among other 3478 1 things, on Page 13 of that chart. So, at that 2 time, there is not an ability to recognize gains 3 by selling mortgage-backed securities. And there 4 is documents that indicate that management is 5 trying to book gains to keep losses within a 6 controlled range. 7 MR. NICKENS: Your Honor, I object to 8 the witness testifying about documents that we 9 don't have in front of us which he's 10 characterizing, and I believe erroneously -- 11 THE WITNESS: The document I'm 12 referring to is in my report on Page 89. 13 MR. NICKENS: I would like to have the 14 documents before us. I mean, he's here to give us 15 some kind of estimate of loss and not to tell us 16 what the document say. 17 THE WITNESS: Can I just suggest I read 18 the paragraph in my report? 19 MR. NICKENS: I'd like to have the 20 document reference in front of us so that we can 21 have it. It's clear that Mr. Hargett is an 22 advocate for the OTS, and I'd like to have those 3479 1 things in front of us. 2 THE COURT: Where is that document? 3 MR. GUIDO: Your Honor, I think he's 4 reading from his report which counsel for 5 respondents -- 6 THE COURT: He's citing a Document 89, 7 and I'm not sure where that document is. 8 THE WITNESS: On Page 89, I'm referring 9 to a memo that says -- an October 1st, 1987, memo 10 from Mike Crow to Jenard Gross which discusses -- 11 and that's what I was referring to right there. 12 It's in my binders. I'm not certain which one, 13 but it was produced in the deposition. If we 14 wanted to find the binders, we could do that. 15 MR. NICKENS: I would like to have the 16 document in front of us so that we could see what 17 the entire discussion is rather than having 18 Mr. Hargett merely summarize it for the benefit of 19 the OTS. 20 THE COURT: All right. We'll take a 21 recess and see if we can find it. 22 3480 1 (A break was taken at 3:27 p.m.) 2 3 THE COURT: Be seated, please. We'll 4 be back on the record. 5 Prior to the recess, we were looking 6 for a document. Perhaps you have located it. 7 MR. NICKENS: Your Honor, we have 8 located the document. It is on our exhibit list 9 as Exhibit B1783, and we offer B1783. 10 MR. GUIDO: It's also on our list as 11 A10765, Your Honor. 12 THE COURT: Well, we don't need to 13 receive it -- 14 MR. GUIDO: We don't need two numbers 15 so we'll use the first number that was given. 16 THE COURT: Exhibit B1783 is received. 17 Q. (BY MR. GUIDO) Mr. Guido, you may 18 continue. 19 (3:47 p.m.) 20 Q. (BY MR. GUIDO) Now, Mr. Hargett, you 21 were just beginning to make a statement with 22 regard to that document that I've just handed you. 3481 1 Can you continue from where you were? 2 A. Sure. Essentially, by the time you get 3 to the end of October, there has been a recent 4 gain recognized. And in that memo, I quoted in my 5 report what management said about the recognition 6 of that gain and it said, quote, "We needed the 7 earnings in the third quarter to keep our loss 8 within the 15- to 25-million-dollar range." 9 Q. Where is that referred to in 10 Exhibit B1783? 11 A. It's the third paragraph, the last 12 sentence. 13 MR. NICKENS: Your Honor, that's a -- 14 as we can see, a partial quote of the sentence. 15 MR. GUIDO: I was going to move the 16 witness back, Your Honor. 17 MR. NICKENS: It starts in the middle 18 of the sentence. 19 Q. (BY MR. GUIDO) I'd like to start, if 20 we may, with what it was that was being referred 21 to. The subject matter of the memo is accounting 22 for hedges, is it not, Mister -- 3482 1 A. That's correct. And it's discussing a 2 gain related to some futures transactions. And 3 after it discusses that gain, the final sentence 4 says "There was no reason to quarrel with this 5 conclusion due to expediencies. We needed the 6 earnings in the third quarter anyway to keep our 7 loss within the 15- to 25-million-dollar range." 8 Q. Well, let's back up again, Mr. Hargett. 9 What is the transaction that is being described in 10 this memo that that quote relates to? 11 A. In the second paragraph, it says "Bond 12 futures which we sold approximately 45 days ago," 13 and that's what it's referring to. It's 45 days 14 ago from the date of the memo, which is October 1, 15 '87. 16 Q. But it also says they were repurchased, 17 does it not? It's referring to a transaction 18 where bond futures were sold and then repurchased? 19 A. Yes, it does say that in the first 20 sentence of the second paragraph. 21 Q. So, that's what is being referred to in 22 the second paragraph? 3483 1 A. That's correct. 2 Q. And what does the second paragraph say 3 in relationship to that transaction? 4 A. Do you want me just to read the third 5 paragraph or -- 6 Q. How was that transaction accounted for? 7 A. It says "From a technical accounting 8 perspective, the gains that were recognized as a 9 result of the futures transaction should be 10 recognized because our actions indicate that the 11 sale of futures was never a hedge in the first 12 place." 13 Q. And then what does it say with regard 14 to similar transactions in the future? 15 A. The fourth paragraph starts off "Should 16 we enter into similar transactions in the future 17 with the intent of selling bond futures as the 18 rate -- as -- and as rates reach what we perceive 19 to be a high level, closing the position within a 20 relatively short time" -- I'm sorry. Let me start 21 over. 22 "Should we enter into similar 3484 1 transactions in the future with the intent of 2 selling bond futures and as rates reach what we 3 perceive to be a high level, closing the position 4 within a relatively short period of time, I don't 5 believe there was any argument that we would -- 6 that could be used to state that this was a 7 transaction -- that this transaction is a hedge." 8 Q. And the last paragraph of the 9 memorandum, the author states his opinion about 10 whether or not such transactions should be engaged 11 in in the future, does it not? 12 A. Yes, it does. And what is his view of 13 such transactions? It says "My opinion is that we 14 should not engage in these types of activities. I 15 believe they are fundamentally speculative in 16 nature and, with our meager capital base, is 17 imprudent. In addition, I believe this is an 18 extremely complex area which we as an organization 19 do not and will not truly understand. There are 20 so many factors involved that it is very difficult 21 to grasp and the proper judge -- and properly 22 judge their long-term effects. As a team, our 3485 1 track record in this type of endeavor has been 2 dismal (Salomon Brothers locked-in spread 3 portfolio, CMOs, CMO residuals, the overall market 4 value of our mortgage-backed security portfolio, 5 et cetera.)" 6 Q. Now, when did they sell the caps that 7 you refer to in this report? 8 A. October 30th, 1987. So, basically, 9 29 days later. 10 Q. And what -- how did they account for 11 that transaction? 12 A. Those particular caps resulted in a 13 gain that was recorded, and the gain was about 14 $8 million. 15 Q. An 8-million-dollar gain was recorded? 16 A. That's correct. 17 Q. Now, what was the economics of the 18 transaction -- strike that. 19 Were caps subsequently repurchased? 20 A. Yes. There were caps subsequently 21 repurchased in December of '87, basically a couple 22 months later. 3486 1 Q. Now, what was the notional amount of 2 the caps that were sold on October 30 of '87? 3 A. 610 million. 4 Q. And what was the notional amount of the 5 caps that were acquired on December 1987? 6 A. 580 million. 7 Q. And what was the difference in the 8 weighted average of the ceiling for those caps? 9 A. The ones that were sold had a weighted 10 average ceiling of 735, and what that means is if 11 interest rates exceeded 735, the cap would be in 12 the money and USAT would begin to receive money 13 under that cap agreement. For the ones that were 14 acquired in December, the cap rate on average was 15 7.5. So, USAT would begin to receive money once 16 interest rates exceeded 7.5. 17 Q. Okay. Now, with regard to the caps 18 that were sold, were there any premiums associated 19 with those? 20 A. Originally, a 12-million-dollar premium 21 had been paid relating to those caps. 22 Q. And for the caps that were acquired in 3487 1 December of 1987, were there any premiums 2 associated with those? 3 A. Yeah. In the aggregate, it was 4 $16 million. 5 Q. In your report on Page 88, you have a 6 figure of $4 million under those two figures. Why 7 is that? 8 A. It's just showing the difference 9 between what was paid for the caps that were 10 originally acquired and then sold in October and 11 then what was paid for the ones in December. 12 Q. Now, how much was realized on the sale 13 of the caps on October 30? 14 A. Approximately $17 million. 15 Q. And 8 of that was a profit? 16 A. Right. Because the 12 million that's 17 been initially paid has been amortized down to a 18 balance of approximately 9, and then when you 19 receive 17, that's a gain of approximately 8. 20 Q. Now, there was booked a profit of 21 $8 million on this transaction. Right? 22 A. Yeah. An 8-million-dollar gain was 3488 1 recognized in the financial statements. 2 Q. Now, does the -- do the records of USAT 3 indicate what purpose they stated at the time 4 there was for this transaction of selling the caps 5 and repurchasing the caps? 6 A. Yes. It's in my report on Page 88. 7 Again, there is another memo that I'm quoting 8 here. It's the final bullet, and this is 9 basically about three weeks before the actual sale 10 takes place. And it says that "It's recommended 11 the sale of 400 million in caps to redistribute 12 front-end loaded negative gap in mortgage 13 investments," end quote. 14 Q. What does that -- what does the 15 negative gap refer to to you? 16 A. A calculation of an institution's gap, 17 which is essentially how many assets are repricing 18 at certain periods of time compared to how many 19 liabilities are repricing at a certain period of 20 time, it has connotation, among other things, in 21 the context of the maturity matching credit which 22 is a component of your calculation of regulatory 3489 1 capital. 2 Q. So, for those of us who are not as 3 familiar with the regulations, why does the gap 4 figure which is, I gather, the match or mismatch 5 calculation between the instruments, the assets, 6 and liabilities of an institution -- why does that 7 have an effect on the maturity matching credit, or 8 how does that affect the maturity matching credit? 9 A. At the time, your basic capital 10 requirement was 6 percent of liabilities. And 11 then you received a credit of up to 2 percent 12 depending on what your gap was; in other words, 13 how well your assets and liabilities were matched. 14 So, in that example, if you receive the 15 full credit, you could lower your 6 percent 16 requirement down to 4 percent. In determining 17 whether or not you got the 2 percent requirement, 18 there were two calculations. There was a one-year 19 gap. There was a three-year gap. And depending 20 on what your number was, you could get up to a 21 1 percent credit for each one of those 22 calculations. So, one important test was the 3490 1 one-year gap; and another important test was the 2 three-year gap. 3 Q. Okay. And do you know what the 4 reference to "front-loaded negative gap" refers 5 to? 6 A. If you look at the caps that were sold, 7 the weighted average maturity of those caps was 8 2.3 years. But more importantly, all of them had 9 a maturity between one year and three years. So, 10 what that means is those caps were not helping for 11 the three-year gap calculation. They were only 12 helping for the one-year gap calculation. 13 So, if you redistributed them and 14 obtained caps that were longer to maturity than 15 three years, it would then help your three-year 16 gap calculation. That's how I'm interpreting this 17 column because right now, every one of them, 18 again, is not helping for one half of that credit. 19 Q. But they are helping for the other 20 half? 21 A. They are helping for the one-year 22 credit. 3491 1 Q. And how, by selling them, does that 2 help the three-year gap? 3 A. It would only help if you sold them and 4 then repurchased new caps which would have a 5 maturity longer than three years. 6 Q. Now, they repurchased caps in December, 7 did they not? 8 A. That's correct. 9 Q. And what was the weighted average 10 maturity of those repurchases? 11 A. Essentially, it's 2.3 years, as well. 12 But again, all the caps involved have a maturity 13 of between one and three years. So, essentially, 14 it didn't change their maturity matching credit in 15 any context once they were reacquired. 16 Q. Okay. 17 A. They still benefited the one-year 18 calculation, and all of them still did not help at 19 all the three-year calculation. 20 Q. It did, however, provide them with a 21 recorded book income of $8 million, did it not? 22 A. That's correct. 3492 1 Q. Now, what was the economics of the 2 transaction? They bought and they sold something. 3 How did they fare in that transaction? 4 A. Based on my understanding, the purpose 5 of that transaction to sell it and repurchase it, 6 I don't see the economic significance of it. The 7 primary focus of my report has been to show that 8 there is a gain booked, a paper profit, if you 9 will, booked during that time period. 10 Q. They -- in the transaction, they booked 11 an 8-million-dollar gain. Right? 12 A. That's correct. 13 Q. And they earned how much money? 14 $17 million? 15 A. They -- initially upon the sale, they 16 received 17 million. 17 Q. Okay. And of that 17 million, how much 18 had been amortized? 19 A. They had originally paid 12 for those 20 caps, and it had been amortized down to about 9. 21 So, about 3 million has been amortized away. 22 THE COURT: Could you explain how the 3493 1 amortizing cap -- 2 THE WITNESS: Essentially, the cap is 3 viewed as a hedge. For example, for the 4 mortgage-backed securities -- and if the cap 5 becomes in the money, you're going to receive 6 money for it being in the money. 7 THE COURT: So that it already 8 received -- 9 THE WITNESS: Well, you may receive -- 10 it's an option. It depends on what interest rates 11 do. But you pay up front the right to receive 12 that money in the future if, in fact, interest 13 rates increase. So, when you pay for that right, 14 you pay money. 15 In this case, they paid $12 million; 16 and what you do is for that 12 million you pay, 17 you amortize it or expense it, if you will, over 18 the life of the contract because there is no value 19 to it except for the fact you have a right to 20 receive payments if interest rates go up. 21 THE COURT: So, they hadn't received 22 payments. They had amortized the cost of it. Is 3494 1 that what you're saying? 2 THE WITNESS: They may or may not have 3 received payments; but if the payments happen, 4 that just goes straight into income. It doesn't 5 get adjusted to this particular asset. 6 Q. (BY MR. GUIDO) So, they amortized 7 $3 million? 8 A. Right. 9 Q. So, their cost basis is 8? 10 A. Essentially their cost basis is down to 11 9. It started at 12 less 3. It's down to 9. 12 Q. And they booked an 8-million-dollar 13 profit? 14 A. Because they sold that asset on the 15 book value of 9 for 17. 16 Q. And they had to go out and buy new caps 17 in December 1987 to replace the caps? 18 A. Had they not, their maturity matching 19 credit would have been -- would have been 20 different in comparison to what they had right 21 before the October 30th, 1987, number. 22 Q. But they went out, and they bought 3495 1 580 million in notional value of caps? 2 A. That's correct. And they paid 3 16 million for those. 4 Q. So that the economics of the 5 transaction reflected a gain or a loss? 6 A. I haven't been asked -- 7 MR. NICKENS: Your Honor, the witness 8 has already testified that he has not analyzed the 9 economics of the transaction; and Mr. Guido is 10 just trying to lead him into an answer when he's 11 already said that he has not looked at that issue. 12 MR. GUIDO: Well, he did indicate what 13 they were selling for and what they were bought 14 for; and I'm just trying to find out -- and what 15 they were reacquired for, and I'm just trying to 16 find out what the number is. 17 THE COURT: Let's have the question. I 18 think we've been all over this thing. What's your 19 question now? 20 MR. GUIDO: My question is: What was 21 the difference between the amount realized on the 22 sale and the amount paid for the reacquisition of 3496 1 the caps, Your Honor. 2 THE COURT: Can you tell us? 3 THE WITNESS: The ones they sold, they 4 received $17 million for. When they bought the 5 other ones back, they paid 16 million for them but 6 they acquired less caps and they were less in the 7 money, if you will. In other words, for the ones 8 that were reacquired, they didn't start receiving 9 interest until the rate got to 750. But on the 10 ones they gave up or sold, they would have 11 continued to receive interest when rates moved 12 above 735. So, the ones that were reacquired were 13 not as attractive as the ones that were sold. 14 Q. (BY MR. GUIDO) And what conclusion do 15 you reach from your analysis of the transaction? 16 A. I don't detect any economic benefit 17 from this transaction and, again, it appears to be 18 a gain recognition at a time when their own 19 documents indicate that they need earnings to keep 20 their losses within an acceptable range. 21 Q. Now, you also were asked to look at a 22 transaction or a series of transactions that 3497 1 related to the maturity matching credit? 2 A. That's correct. 3 Q. And what were you asked to do? 4 A. There's a memo that describes some 5 transactions related to their maturity matching 6 credit. And again, I've already described that 7 this is the credit that you get that will lower 8 your capital requirement. And I was asked to 9 essentially see if what was being described there, 10 in fact, did occur. And the memo describes an 11 improper transfer of instruments. 12 MR. NICKENS: I object to that, Your 13 Honor. He's not here to tell us what's proper or 14 improper. By what standard? This is a 15 highly-disputed issue, as he knows, as to whether 16 there was any transfer at all of these securities. 17 But for him to characterize it as improper, by 18 what standard? Is he telling you the law? I 19 object to it. 20 THE COURT: Well, we got his opinion. 21 Let's move on. Denied. 22 Q. (BY MR. GUIDO) Now, when you reviewed 3498 1 the materials at USAT to ascertain what activity 2 had occurred with regard to the maturity matching 3 credit, did you review the minutes and internal 4 memoranda of the institution? 5 A. Yes, I did. 6 Q. And are those memoranda summarized on 7 Page 62 through 63? 8 A. I believe it's 61 through 63. 9 Q. 61 through 63. And are those memoranda 10 that are quoted there memoranda that were made 11 available to opposing counsel for your deposition? 12 A. Yes, they were. 13 Q. What do those memoranda show? 14 MR. NICKENS: I wouldn't object to him 15 asking what his recollection is, but for him to 16 purport to tell us what the memoranda show is not 17 proper, particularly when we don't have the 18 documents here. It's getting late in the day and 19 I don't want to slow things down, but it's just 20 not proper for him to purport to say what the 21 documents say, particularly when we already know 22 the one example that he's given he misquoted. He 3499 1 left out a word, and he left out an entire clause. 2 MR. GUIDO: Your Honor, I had 3 discussion with counsel about the documents. I 4 gave him a list of all of the documents and I was 5 going to put all of the documents in the record as 6 exhibits. Counsel said to me, over the phone, 7 "Are you really going to do all of that?" 8 And so, I said, "No. I will rely upon 9 the report; and if any questions come up, we will 10 produce the documents." 11 It now appears that it is a problem, 12 and it seems to me that maybe what we should do is 13 adjourn for the day. I will bring the documents. 14 I will go through the documents, introduce the 15 documents into the record to demonstrate that the 16 facts that are contained in this report which I 17 thought counsel had plenty of time to verify are 18 accurate. 19 MR. NICKENS: Well, I will have a 20 chance to cross-examine. But, Your Honor, with 21 regard to this discussion, Mr. Guido gave us cuts 22 that he was saying that he was going to introduce 3500 1 into the record of some 15 volumes of these 2 documents; and we said, "You want us to make ten 3 copies of that?" And that resulted in this 4 discussion. It didn't have anything to do with a 5 specific document such as this. 6 THE COURT: It might be an overkill. 7 Maybe we can just concentrate on the document in 8 issue and have that here. Where is that document? 9 MR. GUIDO: These documents, Your 10 Honor -- 11 THE WITNESS: They are in that box 12 right over there. 13 THE COURT: Can we get the one we're 14 talking about now? We'll be off the record. 15 16 (A break was taken.) 17 18 THE COURT: Back on the record. 19 Q. (BY MR. GUIDO) Now, one of the 20 documents was a strategic planning committee 21 agenda document dated March 2nd, 1987, was it not? 22 A. Yes, it is. 3501 1 Q. And what does that refer to in terms of 2 the agenda for that meeting? 3 A. The agenda included a topic of 4 maximizing the maturity matching credit; and, with 5 respect to that issue, it had a couple of items 6 indicated including transferring adjustable rate 7 mortgages from the subsidiary to USAT as well as 8 moving caps. 9 Q. And what did it say about moving caps 10 from MBS to USAT? 11 MR. NICKENS: May I ask what he's 12 reading from, Your Honor? 13 MR. GUIDO: It's the strategic planning 14 committee agenda dated March 2nd, 1987. 15 MR. NICKENS: I have it here, but -- 16 MR. GUIDO: He's reading the insert. 17 He's not reading from the document itself. 18 A. My quote says "United" -- moving -- 19 quote, "Move United MBS caps to USAT." 20 MR. NICKENS: And where might we find 21 that in the document? 22 THE WITNESS: It's on the final page of 3502 1 the document, and it's showing various strategies. 2 And under the last half of the page, there is an 3 item here that says "Move United MBS caps to 4 USAT." 5 MR. NICKENS: Your Honor, I have a 6 four-page document. Which page is the witness 7 referring to, if I might ask? 8 THE WITNESS: Page 4. 9 MR. NICKENS: Okay. And that is 10 entitled "United Savings of Texas Maturity 11 Matching Credit as of 3-31-87 for 9-30-87"? 12 THE WITNESS: That's correct. 13 MR. NICKENS: Okay. 14 THE WITNESS: And if you look down -- 15 about halfway down the page on the left-hand side, 16 there's three things that they are considering 17 doing. 18 MR. NICKENS: Well, the document 19 says -- we don't know -- where does it say that? 20 Well, what it says is "February gap." Right? 21 THE WITNESS: That's right. And that's 22 an actual calculation, and then there's three 3503 1 things listed. And it's calculating a revised 2 gap. And No. 2 is to move United MBS caps to 3 USAT. 4 Q. (BY MR. GUIDO) What does Item No. 1 5 say? 6 A. "Exchange United MBS ARMs for USAT 7 fixed rate MBS." 8 Q. And what does Item 3 say? 9 A. It's very difficult to read. "United 10 MBS excess" -- I can't tell -- "for your deposit." 11 Q. Now, based on that memorandum, what did 12 you conclude? 13 A. Based on this one memorandum, I didn't 14 conclude anything. 15 Q. Okay. Now -- 16 A. I would point out that the 360 of caps 17 at that time does agree to the amount of caps that 18 is in the Coopers and Lybrand database by the end 19 of March. 20 Q. What did USAT do with regard to the 21 exchange of assets between the general ledger of 22 United MBS and the general ledger of USAT? 3504 1 A. United MBS had some adjustable rate 2 mortgages; and for that gap test that we've 3 discussed where you've got a one-year category and 4 a three-year category, et cetera, you place assets 5 into those buckets depending on when they reprice. 6 So, as an example, if you have an 7 adjustable rate mortgage and it reprices in one 8 year, it will go into the one-year bucket; and, 9 therefore, that would oversimplify and result in 10 less of a gap problem. In contrast, a fixed rate 11 mortgage, after factoring in prepayments, it gets 12 scheduled into its maturity bucket. As an 13 example, if it's a 30-year maturity, it would go 14 way out into the 30-year category. And what 15 happens here is some ARMs are transferred from 16 UMBS -- some adjustable rate mortgages are 17 transferred from UMBS to USAT for some fixed rate 18 mortgages. 19 Q. And what was the amount of what was 20 transferred from UMBS to USAT in interest rate 21 caps? 22 MR. NICKENS: Well, Your Honor, he just 3505 1 asked him about ARMs; and now he's asking him a 2 question about caps. I mean, the witness just 3 testified about ARMs; and then he comes back and 4 asks a question about caps. 5 MR. GUIDO: I may be confused, Your 6 Honor; but I think that I'm trying to ascertain 7 what the transfers were that were made between the 8 two institutions. And maybe Mister -- 9 THE COURT: I thought you were talking 10 about transfer of long-term or short-term. 11 MR. GUIDO: That's correct, Your Honor. 12 THE COURT: All right. And how do the 13 caps fit into this? 14 Q. (BY MR. GUIDO) Were any caps 15 transferred between any entities? 16 A. Yes. There were two transfers. The 17 first one that we just discussed was adjustable 18 rate mortgages onto the books of USAT for fixed 19 rate mortgages. 20 Q. Okay. 21 A. That's the first transfer. 22 Q. Now, was the November transfer made? 3506 1 MR. GUIDO: Excuse me, Your Honor. 2 A. Yes, there was a second transfer 3 involving interest rate caps. 4 MR. NICKENS: Your Honor, I object. 5 He's stating that as a fact. He's an expert 6 witness. It has to be an assumption. This is 7 highly disputed and there is a lot of evidence 8 that there was no such transfer of caps because, 9 as the witness knows, they were owned from the 10 beginning by USAT. This document that he's 11 referred to refers to caps that weren't even 12 bought at the time. They were contemplating 13 buying them. 14 MR. GUIDO: Your Honor -- 15 THE COURT: Well, I think we have to 16 hear his testimony. We'll hear all sides of this. 17 MR. GUIDO: Your Honor, I think my 18 question was -- what did the general ledger show, 19 I think, is what I asked. 20 MR. NICKENS: That I have no objection 21 to. But I thought the question was: Was there a 22 transfer of caps? And this witness was giving 3507 1 opinion evidence as if it were fact when it's a 2 highly-disputed fact. 3 THE COURT: All right. 4 MR. GUIDO: It may be highly disputed, 5 Your Honor; but the -- 6 THE COURT: Well -- 7 MR. GUIDO: I'm trying to just bring 8 out the facts with this witness, and I'm sorry 9 that Mr. Nickens -- 10 MR. NICKENS: I would like to know what 11 the general ledger shows. If that's the question, 12 have the witness say what the general ledger 13 shows. Then we can get it out and see. 14 Q. (BY MR. GUIDO) Now, Mr. Hargett, did 15 the general ledger show that there was a transfer 16 of any assets between United MBS and USAT? 17 A. Yes. With respect to adjustable rate 18 mortgages that's reflected in the general 19 ledger -- and the general ledger entries that I 20 looked at are summarized on Page 68, 69, and 70 of 21 my report. 22 Q. And what do those general ledger 3508 1 entries show? 2 A. With respect to the adjustable rate 3 mortgages, it shows 335 million of adjustable rate 4 mortgages going onto the books of USAT from UMBS 5 and it shows 268 million of fixed rate mortgages 6 going from USAT to UMBS and the difference being 7 handled in an intercompany -- basically an 8 intercompany account and the reverse repurchase 9 agreement account. 10 Q. Okay. Now, that's one transfer. Were 11 there any other transfers? 12 A. Yes. In my opinion, there is also 13 another transfer related to the caps. My source 14 for tracing that information was the thrift 15 financial report that was filed on a quarterly 16 basis with the regulators. 17 Q. And where is that referred to in your 18 report? 19 A. It's -- 20 MR. NICKENS: Your Honor, might we find 21 out what the general ledger shows as to the caps? 22 I thought that was the question. Mr. Guido then 3509 1 went back to ARMs. 2 THE COURT: Well, why don't you ask him 3 that? I'll take Mr. Guido's question. 4 A. The thrift finance report which is 5 filed on a quarterly basis is where the interest 6 rate caps are reflected for maturity matching 7 credit purposes. The maturity matching credit 8 test has no connotation in the context of a 9 general ledger. But in the thrift financial 10 report, that's where it's calculated. And there, 11 the March 31st, 1987, thrift financial report as 12 originally reported does not include interest rate 13 caps in the data related to the maturity matching 14 credit. That's the first time it was filed. 15 There is an amendment that is filed. 16 You physically -- once you file that report, if 17 you change it, you physically have to amend it and 18 file the amendment with the regulators. There is 19 an amendment that's filed. And when that 20 amendment is filed, the caps that I've analyzed 21 which are effectively UMBS caps -- all the 22 documentation I've seen suggests that -- those 3510 1 caps are transferred into the thrift financial 2 report for USAT. 3 And the caps that are transferred -- 4 this is important to understand. Your balance 5 sheet is as of March 31st, 1987. Okay? So, 6 you're looking at a snapshot in time of what 7 assets and liabilities and hedging instruments you 8 own; and your snapshot date is March 31st, 1987. 9 Some of the caps that are transferred as of that 10 date are not acquired until April of '87. 11 So, not only is there, in my opinion, a 12 transfer going on, you're transferring caps as of 13 the date of March 31, 1987, that are not 14 contracted for as of that date. 15 Q. (BY MR. GUIDO) Now, when we went 16 through the portfolios of USAT and UMBS when we 17 went through Exhibit A11022, you testified about 18 where -- what mortgage-backed securities were held 19 and what swaps were held at the USAT level. 20 Do you recall that testimony? 21 A. Yes, I do. 22 Q. And what page is that on in 11022? 3511 1 A. For USAT? 2 Q. For USAT alone. 3 A. For USAT alone, it's essentially Page 4 3; and the date is on Page 4. 5 Q. Okay. The date is on Page 4, and 6 that's the one that I went through with you with 7 the various columns. Right? 8 A. Right. 9 Q. Okay. And that is data that you 10 reconciled from the journals of USAT to the report 11 that was prepared by Coopers and Lybrand for the 12 respondents, is it not? 13 A. For the MBS side, it is in the general 14 ledger. For the swap side, they are not recorded 15 in the general ledger. They are recorded on 16 basically subledgers because it's an "off balance 17 sheet" asset or "off balance sheet" liability. 18 Q. Did you find any caps when you went 19 through that ledger on the USAT side? 20 A. There was one cap which we've 21 previously mentioned happened in 1985 that really 22 kind of happened at the same time of United 3512 1 Finance Mortgage, Inc. 2 Q. United Mortgage Finance? 3 A. Yeah. Back in '85. In addition to 4 that 500-million-dollar bond mortgage-backed 5 security purchase in the swaps, there was also one 6 cap and one collar purchased that related to that. 7 But aside from that one, that's the only one that 8 I'm aware of. 9 Q. Now, when you went through the journal 10 entries for United MBS and you reconciled that 11 with the Coopers and Lybrand report, did you find 12 interest rate caps in any of the ledgers or 13 schedules for United MBS? 14 A. Yes. There are schedules -- again, 15 since this is an "off balance sheet" transaction, 16 it's not going to appear in the general ledger, 17 but there's "off balance sheet" transactions and 18 labels on schedules that indicate that they are 19 related to United MBS. 20 Q. Okay. And at the time -- look at 21 the -- I don't know what page. I think it's 22 Page 6 of your Exhibit 11022. 3513 1 What was the size of the UMBS interest 2 rate caps on the schedules of UMBS at the time 3 just prior to the transfer that you're referring 4 to in your testimony with regard to the maturity 5 matching credit? 6 A. As of March 30th -- March 31st, 1987, 7 there's 360 million of caps. 8 Q. All right. And what is the amount of 9 the caps that are transferred for the maturity 10 matching credit purposes? 11 A. You essentially have to analyze a cap 12 to determine if it's in the money or out of the 13 money before you can actually count it for 14 maturity matching credit purposes. So, just 15 because you have a cap, that doesn't necessarily 16 mean it's going to account for maturity matching 17 credit purposes. 18 In order to get to the number that is 19 reflected as a transfer on the thrift financial 20 report amendment, you need to analyze all caps 21 through April which, in total, equals 910 million. 22 And of those 910 million, 790 of them are in the 3514 1 money and are transferred with the amendment in 2 the thrift financial report to be reflected as a 3 USAT transaction. 4 Q. So, they are shifted from a UMBS column 5 to a USAT column on the thrift financial report? 6 MR. NICKENS: Objection, Your Honor. 7 Leading the witness, and that's not -- 8 MR. GUIDO: I'll rephrase the question. 9 THE COURT: Sustained. 10 Q. (BY MR. GUIDO) Were they shifted from 11 one column to another column on the thrift 12 financial report? 13 A. No. That's not how it works. 14 Q. Okay. How did it work? 15 A. The general ledger -- I'm sorry. The 16 thrift financial report at that time includes 17 United Savings Association of Texas. It does not 18 include UMBS. It's not in there. So, the assets 19 are not in there, the liabilities are not in 20 there, and the hedging instruments, if any, are 21 not in there. Okay? 22 So, what we're looking at is the USAT 3515 1 information exclusive of UMBS. That's what's in 2 the TFR. What's being transferred in is these 3 caps that are UMBS caps. That's all that's being 4 transferred in. The assets and the liabilities 5 are not being transferred in. 6 Q. So that the caps are reflected on the 7 thrift financial report for the first time filed 8 by USAT? 9 A. With this amendment of the March 31, 10 1987 data, that's correct. 11 Q. And what was the impact on the maturity 12 matching credit? 13 A. Well, collectively, the impact of the 14 transfer of the adjustable rate mortgages as well 15 as the caps is summarized on Page 64 of my report 16 as well as in the detailed schedules. And 17 essentially, as originally -- as originally 18 reported at September 30th, 1987, they have excess 19 capital of $63.7 million. And after you make the 20 adjustments for these items, they are failing the 21 cap requirements by about $5 million. 22 Let me clarify one thing there. In the 3516 1 thrift financial report, whatever your gap 2 situation is for six months earlier is what you 3 use to determine your current capital requirement. 4 So, these adjustments to the gap as of March 31 5 impact your September 30th, 1987, regulatory 6 capital requirement. 7 And I'd also note that at the time 8 where they were reporting that excess capital of 9 64 million, there is a couple footnotes to my 10 schedule that indicates that there's discussions 11 with the regulators about whether or not that 12 reporting is accurate. And there's a couple items 13 in dispute in Footnotes G and F that add up to -- 14 MR. NICKENS: Your Honor, I object. 15 There isn't a pending question. All he's doing is 16 making a speech for the OTS. There isn't even a 17 question. 18 THE COURT: All right. Continue with 19 your answer. 20 A. I was attempting to explain the 21 significance of the data. All I'm trying to say 22 is of the 63 million that's reported as the excess 3517 1 regulatory capital, there's two footnotes there 2 that indicate there's an ongoing discussion or 3 debate between the regulators and OTS, that that 4 number may be overstated by over 30 million. And 5 that's even before this adjustment related to 6 maturity matching credit. 7 Q. (BY MR. GUIDO) Turn to Page 77 of 8 your report, Mr. Hargett. Is that a comparison of 9 USAT's minimum required net worth calculations as 10 reported in the various TFRs that you've been 11 testifying about? 12 A. Yes, it is. 13 Q. Now, take the figure for March of 1987. 14 A. With respect to maturity matching 15 credit or everything? 16 Q. No. With regard to the first column 17 where it says "summary calculation of minimum 18 required net worth." Do you see that? 19 A. That's correct. 20 Q. Now, what is the base factor that's 21 referred to there? 22 A. That's essentially -- as I indicated, 3518 1 the regulation -- it's a complicated regulation. 2 But at the time, among other things, the 3 percentage of your liabilities had a cap 4 requirement. That's essentially where you begin. 5 There's several components to it; but that's the 6 first component, a percentage of liabilities. 7 Q. Okay. Then what is the growth factor 8 that's referred to there? 9 A. If you were growing at a rate that was 10 in excess of what was deemed to be, quote, 11 "normal," there was an additional cap requirement 12 required for that accelerated growth. 13 Q. And then there are contingency 14 components. Can you tell us what those refer to? 15 A. Since the first number is a percentage 16 of liabilities, the thought was that the risk of 17 an S&L is on the asset side, not their 18 liabilities. So, you could have two institutions 19 with $5 billion in assets and they could have 20 markedly different risks. So, certain items were 21 defined and if those certain items had -- if one 22 institution had more or less of those defined 3519 1 items of risk, that would increase your cap 2 requirement, one of which is an item called 3 scheduled items. Another one is something called 4 recourse liabilities, standby letters of credit. 5 Direct investments is another one. And then one 6 particular type of loans, new land construction 7 loans, all of those items were considered to be 8 items that were higher than normal risk. And if 9 you were engaged in those types of activities, 10 your cap requirement would be increased. 11 Q. Okay. Then there was the maturity 12 matching credit calculation? 13 A. That's correct. 14 Q. And that is calculated by ascertaining 15 what a one-year and three-year gap is? 16 A. That's right. 17 Q. And then from those additions and 18 subtractions, what do you come up with? 19 A. As reported in the TFR, the minimum 20 required net worth at the time of 3-31-87 was 21 $200 million. 22 Q. Then to calculate whether or not you 3520 1 met the capital requirements, what calculations 2 did you have to do pursuant to the thrift 3 financial report? 4 A. "Capital" is the defined term, and you 5 would essentially add up your capital as defined. 6 And that includes the earnings or losses of the 7 institution over time as well as, you know, the 8 paid-in capital and the like. And their actual 9 net worth as allowed was $279 million. 10 Q. Okay. Now -- and is that the figure 11 that you compare to the minimum required net worth 12 to determine whether or not you're over or under 13 capital in the thrift financial report? 14 A. That's correct. 15 Q. Now, when were the transactions that 16 you're referring to -- when did they take place 17 that are reflected in your report here on Page 77? 18 A. The transfer of the adjustable rate 19 mortgages occurred in March of 1987. It was 20 posted to the general ledger in early April, but 21 that's not really a problem. They were 22 transferred then. The caps that we've discussed, 3521 1 they were not in that originally reported thrift 2 financial report as of March 31, 1987. 3 Q. And when did they first appear in the 4 thrift financial report? 5 A. It was in the -- again, the way this 6 works is if you look at that maturity matching 7 credit line, you see how over time it goes from 8 63 million of credit up to 101 million in credit? 9 Q. Uh-huh. 10 A. The 101 million in credit is in the 11 September 30th, 1987, category. But for maturity 12 matching credit, you look backwards in time six 13 months to see where you stood six months ago. So, 14 that's actually -- even though it's the 15 September 30th, '87, calculation, it's based on 16 where you were from a gap analysis as of 3-31-87. 17 Q. Now -- 18 A. So, that's the first time that the caps 19 are factored into the calculation of net worth: 20 September 30th, '87. 21 Q. And do they appear at any time in any 22 other of the general ledgers or schedules thereto 3522 1 of USAT other than in the thrift financial report? 2 A. I'm sorry. Can you repeat that? 3 Q. Do they appear in any other internal 4 documents of USAT as opposed to United MBS? 5 A. From a schedule perspective that 6 summarized the transactions, I can't recall any. 7 Q. So, they didn't appear in any schedules 8 that you saw? I mean, you testified that when you 9 prepared 11022 in that schedule, you found a 10 schedule at United MBS that showed caps? 11 A. That's correct. There's several 12 schedules over time that labeled the caps as being 13 United MBS. 14 Q. And when you went through the USAT 15 schedules to prepare the page that dealt with 16 USAT, did you find any schedules that reflected 17 any caps other than those you testified to with 18 regard to United Mortgage Finance? 19 A. No. No, I did not. 20 Q. But you did find in the thrift 21 financial report the entry for caps in the 22 September 30th, 1987, thrift financial report? 3523 1 A. It's included in that calculation as if 2 those caps were USAT caps after the amendment. 3 Q. Okay. Now, what was the consequence or 4 the minimum required net worth of USAT on 5 September 30th, 1985? 6 A. 1987? 7 Q. 1987. 8 A. From the calculation of the caps as 9 well as the ARM transfer, you can see that there 10 is a "should have been" column on that page, the 11 final column. And with the way that it was 12 reported after that transfer and amendment, they 13 received 101 million of credit; but adjusting 14 those two items back out, they should have only 15 received a 32-million-dollar credit. 16 Q. Now, how did that impact upon the 17 minimum required net worth? 18 A. It's the bottom number to show the 19 before and after effect. But for that one 20 particular item, it's about a 69-million-dollar 21 difference. 22 Q. Well, I mean, what was the minimum 3524 1 required net worth that was reported on the TFR 2 filed by USAT? 3 A. $183 million. 4 Q. Okay. And what do you believe that 5 figure should have been? 6 A. With the items that I've described, it 7 should be $252 million. 8 Q. Okay. And what was the capital level 9 that was reported by USAT on September 30, 1987? 10 A. $247 million. 11 Q. Okay. And in the TFR that was filed on 12 September 30th, 1987, what was the capital in 13 relationship to the minimum required net worth 14 that was reported on that TFR? 15 A. As reported, they were passing capital 16 by approximately $64 million. 17 Q. Now, given your view of what should 18 have been done, what was the impact on the 19 relationship of actual net worth to the minimum 20 required net worth in that report? 21 A. Based on my analysis, it would have 22 shown a capital shortfall of approximately 3525 1 $5 million. And again, this ignores any items 2 that are being disputed between the regulators and 3 USAT. This is just looking at these two 4 transactions. 5 Q. This particular transaction? 6 A. Right, or these two. 7 Q. These two transactions. 8 MR. GUIDO: I have no further 9 questions, Your Honor. Tomorrow morning, I would 10 like to, first thing, introduce the memoranda that 11 pertain -- the internal memoranda that pertain to 12 the minimum net worth capital requirement and I 13 would, if need be, have this witness authenticate 14 them and tie them to his report. But I don't want 15 to serve the Court's time or take any more of the 16 Court's time in terms of getting the three sets of 17 documents put together. 18 MR. NICKENS: Your Honor, I -- I'm 19 sorry. 20 MR. GUIDO: But I would like to have 21 that in the record before the witness is 22 cross-examined. 3526 1 MR. NICKENS: Well, I expect to 2 introduce that document and the cap agreements 3 themselves which shows the owner of the caps and 4 things of that nature. So, I believe I'm going to 5 introduce the schedules. But if I fail to do so, 6 we certainly can supplement the record. Or if he 7 wants to do it in the morning first thing, I have 8 no objection to it. 9 MR. GUIDO: I would like to have the 10 witness identify the documents that resulted in 11 his conclusions that there was a transfer of these 12 caps and these ARMs to manipulate the maturity 13 matching credit, Your Honor, in the record before 14 he's cross-examined. 15 MR. NICKENS: I expect to have a lot of 16 questions on that subject, Your Honor. 17 THE COURT: All right. You may do so, 18 Mr. Guido. And we'll adjourn until tomorrow at 19 9:00 o'clock. 20 MR. GUIDO: Thank you, Your Honor. 21 (Whereupon at 4:41 p.m. 22 the proceedings were recessed.) 3527 1 STATE OF TEXAS COUNTY OF HARRIS 2 REPORTER'S CERTIFICATION 3 TO THE TRIAL PROCEEDINGS 4 I, Marcy Clark, the undersigned Certified 5 Shorthand Reporter in and for the State of Texas, 6 certify that the facts stated in the foregoing 7 pages are true and correct to the best of my ability. 8 I further certify that I am neither 9 attorney nor counsel for, related to nor employed 10 by, any of the parties to the action in which this 11 testimony was taken and, further, I am not a 12 relative or employee of any counsel employed by 13 the parties hereto, or financially interested in 14 the action. 15 SUBSCRIBED AND SWORN TO under my hand 16 and seal of office on this the 16th day of 17 October, 1997. 18 ____________________________ MARCY CLARK, CSR 19 Certified Shorthand Reporter In and for the State of Texas 20 Certification No. 4935 Expiration Date: 12-31-97 21 22 3528 1 STATE OF TEXAS COUNTY OF HARRIS 2 REPORTER'S CERTIFICATION 3 TO THE TRIAL PROCEEDINGS 4 I, Shauna Foreman, the undersigned 5 Certified Shorthand Reporter in and for the 6 State of Texas, certify that the facts stated 7 in the foregoing pages are true and correct 8 to the best of my ability. 9 I further certify that I am neither 10 attorney nor counsel for, related to nor employed 11 by, any of the parties to the action in which this 12 testimony was taken and, further, I am not a 13 relative or employee of any counsel employed by 14 the parties hereto, or financially interested in 15 the action. 16 SUBSCRIBED AND SWORN TO under my hand 17 and seal of office on this the 16th day of 18 October, 1997. 19 _____________________________ SHAUNA FOREMAN, CSR 20 Certified Shorthand Reporter In and for the State of Texas 21 Certification No. 3786 Expiration Date: 12-31-98 22