SECTION THREE

MORTGAGE-BACKED SECURITIES

I. Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios Were Designed To Produce A Leveraged, Hedged Net Interest Spread In Which The Market Value Of The Portfolio Was Protected From Interest Rate Fluctuations

M1. Mortgage-backed securities risk-controlled arbitrage (“MBS RCA”) programs, also known as structured arbitrages or structured liability transactions, are programs to finance the purchase of mortgage-backed securities. Ex. B-1509, Tab 228 (Article from FHLBB quarterly “The ABC’s of RCA’s”) p. W100880; B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-Controlled Arbitrage: An Asset Liability Management Strategy for Financial Institution”) p. 1.

M2. MBS RCA programs “involv[e] the leveraged purchase of mortgage-backed assets which are priced to yield a positive spread, on a duration adjusted basis, over the corresponding cost of funding.” Ex. A-10654, Tab 1119 (An Introduction to Risk-Controlled Arbitrage) p. OW006024. The mortgage securities in risk-controlled arbitrage programs are pledged as collateral for the short-term financing such as reverse repurchase agreements. The transactions can therefore be highly leveraged: only a small amount of cash is required, usually about 5 percent of the purchase price. Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-Controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 2.

M3. MBS RCA programs:

Involve the purchase of a mortgage-related asset, normally a mortgage-backed security (‘MBS’), funded by a short-term liability, such as a reverse repurchase agreement (‘reverse repo.’). These newly purchased assets are then used as collateral to borrow additional funds that are then invested in more MBSs, thus highly leveraging the original asset. The short-term liability is synthetically extended using interest rate swaps, futures, options, caps, or collars, etc., so that the effective maturity of the asset and the funding source are reasonably matched.

Ex. B-4287, Tab 1850 (Office of Regulatory Activities, FHLBs Regulatory Handbook, Thrift Activities) p. 450.1.

M4. Reverse repurchase agreements involving MBSs provide that the thrift sells the MBSs to the counter-party, typically an investment banking firm, which agrees to deliver MBSs with an identical interest rate and similar collateralized pool issued by the same agency or party as the securities sold by the thrift to the counter-party. The reverse repurchase transactions are treated as “financing transactions” so that no gain or loss is recognized on the transaction. Where the risks of ownership are transferred to the buyer, or the security to be repurchased is not substantially identical to the security sold, the transaction involves a sale and purchase and is not a financing transaction. Thus, when transactions involve the exchange of securities with different coupon interest rates or issued by different agencies or institutions, the reverse repurchase agreement has been essentially terminated, and the securities exchanged are not substantially identical and must be recorded as sales and purchases of securities at market prices, with profits and losses recorded in the period incurred. Bulletin #R-48, FHLBB, Office of Examinations and Supervision, to Professional Staff, (Updated - August 15, 1985).

M5. Reverse repurchase agreements are not the only vehicles used to fund a RCA. Various other instruments have been used to fund MBS RCAs. Ex. A-10654, Tab 1119 (An Introduction to Risk-Controlled Arbitrage) p. OW006024. “The arbitrage concept involves the use of any term liability to finance the purchase of a higher-yielding mortgage investment on a risk-controlled basis. Thus, it can also be applied using other types of liabilities, such as interest rate swaps, brokered certificates of deposit (CDs), or mortgage-backed bonds.” FHLB advances can also be used. Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT)

p. CN253060. See also, Tr. 11,757: 18 - 11,758: 14 (Giarla), Ex. B-1509, Tab 228 (Article from FHLBB quarterly “The ABC’s of RCA’s”) p. W100882-3; B-1475, Tab 235 (Report from First Boston by Carol Barfein and Lisa Wolfson, “Risk-Controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions) p. 2-8.

M6. The goal of a MBS RCA is to earn a target spread on the mortgage assets in excess of the associated funding costs, hedged to protect the value of the portfolio from the effects of changing levels of interest. Tr. 11,757: 18 - 11,758: 9 (Giarla); Ex. A-10654, Tab 1119 (An Introduction to Risk-Controlled Arbitrage) p. OW006025; B-1475, Tab 235, pp. 2-5.

M7. A major risk to a MBS portfolio, as with all fixed income interest rate instruments, is an increase in interest rates. When rates increase, the market value of the securities is reduced, and the spread income over the liabilities is reduced unless some instrument such as a cap, collar or swap is used to fix the liabilities’ interest rates. A hedged portfolio is typically known as a MBS RCA. Ex B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 16.

M8. Commonly used hedge vehicles include interest rate swaps, interest rate caps, options contracts, exchange traded futures contracts, options on swap contracts, and options on futures contracts. Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 8.

M9. Interest rate future contracts are contracts to make or take delivery of a financial instrument during a month specified in the contract. 12 C.F.R. § 563.17-4 (a) (1) (1985-88).

M10. Interest rate options contracts are contracts to make or take delivery of a financial instrument upon the demand of the holder of the contract any time before the expiration date of the contract. 12 C.F.R. § 563.17-5 (a) (4) (1985-88).

M11. “Interest rate swap agreements” are contracts in which one party, usually the thrift in RCA agreements, pays a fixed rate of interest to the counter-party and receives in return from the counter-party, usually the investment banking firm that sold the MBSs to the thrift, a floating rate of interest designed to offset the short term interest paid to fund the purchase of the MBSs, either a reverse repurchase agreement, short term repricing preferred stocks, or collateral mortgage obligations. Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 9.

M12. “Caps” are defined as hedging instruments which are purchased or sold by financial institutions for a premium.

The cap agreement specifies a notional principal amount and an interest rate ceiling, both of which remain fixed throughout the life of the contract. The agreement provides that the purchaser of the cap should receive payments from the seller of the cap should the applicable index [e.g., the London International Banking Offer Rate (“LIBOR”)] index rise above the interest rate ceiling. Periodic cap payments represent the difference between the LIBOR rate and the rate ceiling, multiplied by the notional principal of the agreement, prorated for the amount of time LIBOR exceeds the rate ceiling.

Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 86; See also, B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 9.

M13. Interest rate caps have option characteristics effective in hedging mortgages. They set a maximum liability rate. Cap purchasers usually pay an upfront fee determined by the strike level, maturity, index, and market conditions and are sometimes amortized over the life of the contract. Caps provide protection against interest rate rises while allowing the benefit of falling rates. If rates fall and prepayments accelerate, the cap will not be exercised, and an over-hedged position will not result. Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 9.

M14. Options on swaps (also known as callable swaps) which can be acquired at a slightly higher cost than standard swaps enable the purchaser to terminate the swap at a specified time in the future. If falling rates are predicted, and the asset pays down faster than anticipated, this is a useful way to reduce an over-hedged position. Options on swaps can also be used to initiate a swap at a future date. Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 9.

M15. A MBS RCA portfolio has another risk, however, which is an increase in prepayments caused by a decline in interest rates. The increase in prepayments will result in a lesser increase return on the MBS than an increase in losses in the hedged instruments which fix the funding cost, causing a material decline in the value of the entire portfolio. The risks to MBS RCA “(due to changes in the level of interest rates) are [and in the 1985-85 time period were] largely mitigated by following an appropriately designed hedging strategy.” Ex. A-10654, Tab 1119 (An Introduction to Risk-controlled Arbitrage) p. OW006029; B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 2.

A. Properly Managed Mortgage-Backed Securities Portfolios Were Successful Investments For Savings And Loan Associations In 1985-1987

M16. MBS RCA portfolios are highly successful if they are entered into with a good understanding of the potential risks and are properly managed. They must be managed through rebalancing the liabilities or changing the assets as market conditions demanded. If the programs are not closely monitored to protect their value, the original spread relationships become distorted over time and lead to losses at the end of the trade which dwarf any positive yields. This happened to some portfolios in 1986 that were not properly managed. Ex. B-1509, Tab 228 (Article from FHLBB Quarterly “The ABC’s of RCA’s”) p. W100884; B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions”) p. 2.

M17. The FHLBB Office of Regulatory Activities found in 1988 that it was not unreasonable for a RCA portfolio that was properly managed to earn a spread of 100 basis points on the mortgage-related asset over the cost of funding. It found that some institutions had even reported that the net arbitrage spread for earlier RCA strategies, after deducting the costs of borrowing, hedging, and all transaction costs, were as much as 150 basis points. Ex. B-4287, Tab 1850 (Office of Regulatory Activities, FHLBS Regulatory Handbook, Thrift Activities) p. 450.1.

B. The Size And Composition Of USAT’s Mortgage-Backed Securities

Risk-Controlled Arbitrage Portfolios

M18. As of December 31, 1984, USAT held $419.2 million in MBSs funded with short term liabilities, including reverse repurchase agreements and short term CDs. Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) p. CN158910.

M19. As explained below, calendar year 1985 was a transition year for UFG/USAT. In 1985, the asset mix shifted toward a more wholesale structure with particularly strong emphasis on MBSs, corporate securities, equity arbitrage and real estate. The portfolios increased dramatically between December 31, 1984 and December 31, 1985. During that time period, investments in MBSs increased from $438 million to $1,202 million, or 174%; corporate debt securities (Junk Bonds) increased from $142 to $275 million, or 94%, and equity arbitrage increased from $0 to $288 million. Ex. A-5009, Tab 556 (USAT Performance Report, 01/31/86) p. K004494.

M20. In 1985, USAT’s MBS portfolios funded with short term liabilities increased by an additional $782.9 million. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175.

M21. The outstanding balance of USAT’s arbitrage MBS portfolios as of December 31, 1985, was $1.2 billion, including $654.1 funded with reverse repurchase agreements and $548.0 million financed with preferred stock issued through finance subsidiaries, the interest rates of which were repriced in the short term. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175; A-5009, Tab 556 (USAT Performance Report, 01/31/86) p. 2; B-954, Tab 89, p. CN152337. A major portion of the growth in MBS between December 31, 1984, and December 31, 1985, occurred before May 31, 1985, and June 30, 1985, increasing from $871 million to $1,093 million between those two dates. Ex. A-5003, Tab 550 (USAT Performance Report, 07/24/85) at Schedule AA.

M22. In 1986, USAT’s MBS portfolios funded with short term liabilities increased by an additional $1.5 billion. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175. The outstanding balance of USAT’s hedged arbitrage MBS portfolios as of December 31, 1986, totaled $2.7 billion, including $1.0 billion funded with reverse repurchase agreements, $956.4 million funded with preferred stock issued through finance subsidiaries, the interest rates of which were repriced in the short term, and $720.5 with collateral mortgage obligations (“CMO’s”) issued by other finance subsidiaries. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175.

M23. In 1987, USAT’s MBS portfolios funded with short term liabilities increased by an additional $900 million. Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) pp. 11, 14. The outstanding balance of USAT’s MBS arbitrage portfolios as of December 31, 1987, totaled $3.6 billion, including $1.6 billion held in a subsidiary, UMBS, funded with reverse repurchase agreements, $775 million funded with CMO’s in finance subsidiaries, and $196 million funded with preferred stock issued through other finance subsidiaries that repriced in the short term. Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) pp. 11, 14 and 31.

M24. The MBSs held in these various portfolios were represented to be “arbitrages designed to produce a hedged net interest spread between mortgage-backed securities and various funding sources, such as securities sold under repurchase agreements, preferred stock of special purpose finance subsidiaries bearing floating dividend rates and short term CDs.” Purportedly, “[i]n an effort to manage the interest rate risk involved with these arbitrages, [UFG] entered into a number of interest rate hedging programs, primarily interest rate exchange agreements (‘swaps’), and to a lesser degree, interest rate cap and collar programs.” Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071172; See, Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) p. CN158927. As G. Williams testified, the MBS RCA portfolios included the DART’s AMP’s and Treasury portfolios. Tr. 6,334: 21 - 6,336: 7 (G. Williams).

M25. On July 12, 1985, UFG/USAT informed the FHLBB that it held MBSs of $1,084 million as of June 30, 1985, and projected growth of up to $1,584 million by December 13(sic), 1985. Ex. A-10566, Tab 176 (Letter from G. Williams to FHLBB Re: USAT Growth) p. CN052895. Approximately $489 million of the MBSs were held directly by USAT, as of June 30, 1985. Ex. A-10568, Tab 177 (Growth Plan for 07/01/85-12/31/85, 09/19/85) p. CN056090; also admitted as B-591, Tab 582 (USAT Growth Plan, 9/19/85) p. OW004669. Between November 1, 1985, and December 31, 1985, UFG/USAT created and then partially liquidated a finance subsidiary, known as United Mortgage Finance. Five hundred million dollars in MBSs were initially purchased, of which $350 million were sold before year end 1985. Ex. A-5009, Tab 556 (USAT Performance Report, 01/31/86) p. 3. As a consequence of the year end 1985 transactions, the size of MBS arbitrage portfolios held directly by USAT, as of March 22, 1986, was $794 million. Ex. A-10619, Tab 573 (Note from Crow to Roger Re: Analysis of the MBS portfolio) p. CN056138.

M26. In addition to the MBS arbitrage portfolios held directly by USAT, MBS arbitrage portfolios were held in subsidiaries of USAT. Ex. A-1106, Tab 2046 (Minutes of meeting of Board of Directors of USAT, 05/15/85); A-1219, Tab 1438 (Minutes of meeting of the Executive Committee of USAT, Business Plan—Collateralized Mortgage Obligations, 112/12/85); B-1007, Tab 1872 (Memo from Baugh to the File Re: USAT meeting of 05/05/86) p. OW157818. The size of MBS arbitrage portfolios held directly by USAT and in the subsidiaries was $996 million as of April 31, 1986. Ex. B-982, Tab 1305 (Letter from B. Williams to Andy Feigenberg w/attached exhibits summarizing USAT’s April 30, 1986, mortgage-backed and corporate securities [with additional enclosures]) at 1. As of May 1, 1986, USAT held in CMO subsidiaries collateralized mortgage obligation arbitrage portfolios of $775 million. Ex. B-963, Tab 1434 (Memo from Crow to Gross and G. Williams Re: Update summaries on CMOs 1 through 3) p. US-3015352; A-13004, Tab 1121 (Smith Breeden’s CMO Analysis of USAT) p. OW006150.

M27. The total size of the MBS arbitrage portfolios held by USAT and its subsidiaries as of April 30, 1986, and June 30, 1986, exceeded $1,900 million. Tr. 11,818: 1 - 11,818: 11 (Giarla); Ex. A-1394, Tab 531 (Investment Committee Minutes, USAT, UFG, 05/27/86) p. US-3004764; T-4222, Tab 330 (Memo from Crow to Gross and G. Williams, Re: Summary of Smith Breeden Presentation, with attached financial statements, 07/03/86); A-13005, Tab 1122 (Smith Breeden’s Analysis of MBS Interest Rate Swaps, Caps and Collars) p. OW0061500; A-10659, Tab 1123 (Smith Breeden’s USAT Valuation and Sensitivity Analysis) p. OW005986.

M28. As of November 21, 1986, the size of USAT’s MBS arbitrage portfolios was $1,127 million, excluding the MBSs held in the CMO arbitrage portfolios. Ex. B-3945, Tab 1433 (Memo from B. Williams to Gross, J. Williams and Crow Re Comparison of MBS Gains to Interest Rate Swap Mark-to-Market Values) p. US-3000504.

M29. On August 7, 1987, USAT created a service corporation subsidiary to hold MBSs in an arbitrage portfolio. As of October 30, 1986, the subsidiary, known as UMBS (“UMBS”), held $628 million in MBSs, increasing to a high of $1.7 billion as of April 30, 1987. Ex. A-11022, Tab 295.

1. The Origin Of USAT’s Mortgage-Backed Securities Risk-Controlled

Arbitrage Portfolios

M30. The origin of USAT’s MBSs RCA portfolios was a series of meetings held with investment banking firms in 1984. The investment banking firm that USAT claimed to rely on most heavily was Salomon Brothers Inc., which was the leading vendor of MBS RCA programs in 1984 and 1985. The advice provided to USAT is contained in a summary of Salomon Brothers’ presentation of October 1984, to which was attached a memoranda written by its Director of Research, Michael Waldman, that described the types of investments in MBS RCA programs recommended by Salomon Brothers and the reasons for the recommendations. Tr. 6,320: 8 - 6,321: 4 (G. Williams); Ex. B-377, Tab 242, pp. CN253070-CN253071.

M31. Phillips, who was the first manager of the MBS RCA, was instructed by Huebsch to invest in MBSs at the end of 1984. Huebsch was not employed by USAT, but by Federated at the time, and reported to Hurwitz, who was the sole owner of Federated. Tr. 5,026: 1-13; 5,097: 5-19 (Phillips).

2. The Respondents’ Mission Statement And Board Of Directors

Meeting, May 1985

M32. The nature of the investment strategy USAT adopted in response to the recommendations of Salomon Brothers in October 1984 was defined by Hurwitz at a May 16, 1985, USAT Board of Directors meeting. Ex. A-1104, Tab 130, p. US-3003093-3097.

M33. USAT made the investments in MBS as part of the “wholesale strategy,” which was the culmination of the transition of control of USAT to respondents MAXXAM, Federated and Hurwitz. The size of the MBS portfolios were determined by the need to meet the qualified thrift lender (“QTL”) test in order to maintain the thrift charter, which was a fact well known to the managers of USAT, including Hurwitz. Tr. 6329:21 - 6333: 19 (G. Williams).

3 The Qualified Lender Test And Sales To Generate Accounting Gains Without Regard For The Impact On The Financial Condition Of USAT

M34. The extent to which the purchase of MBSs was related to the intention of Hurwitz and others to use MBSs to support USAT’s purchase of junk bonds is reflected in a memorandum entitled “Strategic Planning Committee, Thrift Test,” May 28, 1987, which addressed a proposal to increase the junk bond portfolio to $700 million from $550 million. In the section entitled Conclusions, the memorandum states “Growth of High Yield Securities to $700 million assumes additional purchases of $157 million above 3/31/87 levels,” which “would have to be supported with corresponding growth of qualifying assets (Mortgage-Backed Securities).” Ex. A-5019, Tab 1338 (USAT Performance Report, 03/20/87).

M35. As Phillips admitted in his testimony, the MBS portfolios were basically unsalvageable by the Summer of 1986. Tr. 5,280: 8 - 5,281: 4; 5,285: 12 - 5,287: 22 (Phillips); Ex. A-10649, Tab 187. As a consequence of the condition of the portfolio, Phillips could no longer add value to the portfolio by rebalancing it in response to changes in interest rates. Tr. 5,280: 2 - 5,281: 4 (Phillips).

M36. On September 23, 1986, Crow wrote to the Investment Committee, on which Hurwitz sat, attaching a draft proposal prepared by Merrill Lynch on the negative impact of the hedged liabilities that funded the MBS portfolios. Merrill Lynch had listed several options for USAT’s consideration. One option was to “reverse the high coupon deals outright and therefore erase the swap liabilities of[f] the balance sheet,” recognizing the loss instead of having the negative impact on the spread income in the future. Another option was to extend the maturity of the swaps to more closely match the duration of the MBSs. Crow explained that neither option was to be adopted, because both would require the booking of a loss on the swaps, something Respondents refused to do because it would impair USAT’s regulatory net worth. Ex. T-4252, Tab 332 (Memo from Crow to Investment Committee Re: Attached Draft Proposal on Interest Rate Swaps, 09/23/86) pp. OW012021 - 022.

M37. Respondents also knew that USAT could reduce the negative spread in its MBS RCA by shrinking its balance sheet, and similarly rejected that alternative because it would restrict USAT’s non-thrift activities:

1. Shrinking thrift assets will be possible as soon as Texas approves our application for a service corporation (2 to 3 weeks). Mortgage-backed securities can be sold and repurchased in the sub subject to collateral and dollar roll constraints. Up to $750 MM could be moved over time (through 1987), assuming gains are achievable.

2. United’s limitation in shrinking is the non-thrift assets. Real estate, preferred stock, high-yield bonds, equity arbitrage, and goodwill will make up 1.62 billion at the end of the year. This includes the effects of B2, B3 and B4 above. To reduce below $1.6 billion level will be difficult or expensive. If it cannot be reduced, the minimum size for United is $4.1 billion.

Instead of shrinking the assets or restructuring the hedged liabilities, USAT decided to increase the size of the MBS portfolios. Ex. A-10683 (T-4246), Tab 335 (Memo from Hansen to Hurwitz, Gross, Munitz, G. Williams, Crow, Berner, B. Williams, and Wolfe, Re: Growth and Capital Strategy - Next 6 months, 09/08/86) pp. OW010237 - 247.

M38. In the fall of 1986, the Investment Committee instructed Orr to increase the MBS portfolios to $3 billion from its then $1.2 billion level, by the Spring of 1987. Tr. 3,805: 6 - 3,806: 17 (Orr).

M39. As Bruno and Hansen testified, Respondents managed the MBS RCA portfolios to generate accounting gains without regard to the effect on the financial condition of USAT, but merely to satisfy the regulatory minimum net worth requirements. Tr. 12,936:6-12938:19; 13,060:9-13,062:6; 13,079:4-13,082:22 (Bruno); Tr. 12,706:10-12,707:9 (Hansen).

C. USAT’s Mortgage-Backed Securities Risk-Controlled Arbitrage

Portfolios Increased The Interest Rate Risk To USAT

M40. Respondents’ investments in MBSs increased USAT's risk of loss substantially from December 31, 1984, after the first sale of branches and loans, to December 31, 1987, when USAT reported a capital failure. FOF A328 - A331.

II. Respondents Did Not Manage The Mortgage-Backed Security RCA In 1985 In Accordance With Customary Safe And Sound Practices

A. It Was Commonly Understood In 1985 That Interest Rate Changes Would Negatively Impact The Net Interest Spread And Market Value Of Mortgage-Backed Security Risk-Controlled Arbitrage Portfolios Hedged With Swaps

M41. An increase in prepayments was a commonly understood predictable risk when USAT’s MBS RCA portfolios were first created. “Most fixed rate mortgage loans are written with options that are valuable to the borrower. Most commonly, the borrower has an option to prepay all or part of the mortgage at his discretion without penalty.” Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT, 10/24/84) p. CN253060. “One risk of an arbitrage using mortgage loans as the reinvestment is that the actual prepayment experience of the loans may differ from the prepayment assumption.” Ex. A-10654, Tab 1119 (An Introduction to Risk-controlled Arbitrage) p. OW006029.

M42. USAT’s managers also knew or should have been aware that:

The duration of MBSs are significantly affected by prepayment. As a result mortgage-backed securities risk-controlled arbitrage portfolios are subject to at least two types of uncertainty. One is the uncertainty regarding prepayment while the other is interest-rate uncertainty. Both types of uncertainty are interrelated and will be incorporated into the security’s price. The uncertainty associated with prepayment is not constant across coupons. The probability of prepayment on a ‘low’ coupon security is likely to be significantly less than that of prepayment on a ‘high’ coupon. However, the greatest level of uncertainty is associated, not with the low or high coupon security, but with those securities with coupon rates that are relatively close to the prevailing market rate of interest on new mortgages. This uncertainty exists because a relatively small increase from prevailing market rates is likely to cause a significant decrease in prepayment rates for those securities that were at the market rate. The converse also holds; If rates decline from prevailing market, the rate of prepayment is likely to increase significantly. Prepayment rates for very high or low coupon securities are not likely to be significantly affected by a small change in market interest rates. A large change in market rates is likely to be necessary if prepayment rates on these securities are to change in a significant fashion.

Ex. B-4393, Tab 2027 (Prepayment Implications of Mortgage-Backed Security Prices, Research Working Paper No. 115, Office of Policy and Economic Research, Federal Home Loan Bank Board, 11/84) p. OWJ26196. See, Ex. B-505, Tab 238 (Report from Salomon Brothers by M. Waldman, “Constructive Use of Fixed Rate Mortgages - Arbitrage Opportunities for Financial Institutions”) p. 5.

1. The Prepayment Risk Of Mortgage-Backed Securities Was Known To Be Substantial In 1984 And 1985 When USAT’s Mortgage-Backed Securities Risk-Controlled Portfolios Were Created

M43. The mid-1980's was a time of great uncertainty about how prepayments would respond to changes in interest rates. Tr. 28,382: 16 - 19 (Carron); Ex. B-4393, Tab 2027 (Prepayment Implications of Mortgage-Backed Security Prices, Research Working Paper No. 115, Office of Policy and Economic Research, Federal Home Loan Bank Board, 11/84) p. OWJ26196.

M44. As Respondents’ expert conceded in cross-examination after reviewing the research prepared for the FHLBB, it was known in 1985 that prepayments were likely to increase significantly if rates declined. As he testified in response to questions from OTS’s counsel:

Q. Okay. So, whatever the numbers were in the middle of 1985, there are two things that a portfolio manager knew: One is that prepayments were affected by changes in interest rates. Right?

A. Yes.

Q. Okay. And, two, is there was uncertainty about what the magnitude of the change in prepayment rates were. Right?

A. Yes.

Q. Okay. And, three, is that the prepayment rates with the decline in interest rates could be significant for current coupon mortgage-backed securities?

A. Whatever that term means, yes.

Q. Right. Okay. Well, ‘significant’ – I assume, when you're in business to earn a profit and not lose money is that it's going to be harmful in some major way financially to the institution. Is that fair?

A. Or helpful.

Q. Or helpful, if it turns out it’s to your advantage. Okay.

Tr. 28,385: l - 28,386: 2. (Carron).

M45. As early as April 1984, it was commonly known that unanticipated changes in prepayments, particularly those related to unforeseen changes in interest rates, could result in substantial changes in wealth. Ex. T-9078, Tab 2041 (The Estimation of Mortgage Prepayment Rates, Research Working Paper No. 112, Office of Policy and Economic Research, Federal Home Loan Bank Board, 04/84) p. OWJ26253.

M46. FHLBB research available in April 1984 explained that: “Indeed, since autumn of 1982, mortgages originally issued at rates of 14 percent or higher have shown prepayment rates that approach (and in some cases exceed) 50 percent per annum!” Ex. T-9078, Tab 2041 (The Estimation of Mortgage Prepayment Rates Research Working Paper No. 112, Office of Policy and Economic Research, Federal Home Loan Bank Board, 04/84) p. OWJ26253.

M47. The April 1984 FHLBB research also explained: “A significant inverse relationship was found between the interest-rate differential and prepayment rates. The relationship tends to be most elastic whenever the current market rate for mortgages is between one hundred and three hundred basis points below the contract rate on a pool.” Ex. T-9078, Tab 2041 (The Estimation of Mortgage Prepayment Rates, Research Working Paper No. 112, Office of Policy and Economic Research, Federal Home Loan Bank Board, 04/00/84) p. OWJ26277.

M48. As the April 1984 FHLBB research demonstrated: “The relationship [between interest-rate differential and prepayment rates] shows the greatest elasticity in the neighborhood of a negative three hundred basis point differential, where prepayment rates are generally between thirty and fifty percent per annum.” Ex. T-9078, Tab 2041 (The Estimation of Mortgage Prepayment Rates, Research Working Paper No. 112, Office of Policy and Economic Research, Federal Home Loan Bank Board, 04/84) p. OWJ26272.

M49. FHLBB research in November 1984 confirmed the conclusions reached in the April 1984 FHLBB research described above. The November 1984 study concluded:

It must be recognized that MBSs are subject to at least two types of uncertainty. One is the uncertainty regarding prepayment, while the other is interest rate uncertainty. However, the greatest level of uncertainty is associated not with the low or high coupon security, but with those securities with coupon rates that are relatively close to the prevailing market rate of interest on new mortgages.

The next sentence talks about the uncertainty existing with relatively small increases from prevailing market rates, stating, "[It's] likely to cause a significant decrease in prepayment[s]”...With regard to the converse, it says, "If rates decline from prevailing market, the rate of prepayment is likely to increase significantly." Ex. B-4393, Tab 2027 (Prepayment Implications of Mortgage-Backed Security Prices, Research Working Paper No. 115, Office of Policy and Economic Research, FHLBB, 11/84) p. OWJ26196, Tr. 28,384: 17 - 20. (Carron).

M50. The rapid increase in prepayments in response to reductions in interest rates was emphasized in the Salomon Brothers presentation to USAT in October 1984, which Hurwitz attended, upon which USAT claimed to rely. The Salomon Report stated:

Refinancing activity has had a major impact on the high-coupon mortgage security sector. In response to the interest rate declines of July-October 1982, prepayment rates’ on high-coupon issues began to climb in September. Figure 1 illustrates the path of increase for GNMAs, with 17% currently prepaying at a 44% annual rate, 16% at 39%, and 15% at 27%.

The prospect for, and then the actual, refinancing-triggered prepayments stalled the price advances of these issues in the rally. Consequently, the high-coupon sector has under-performed the market by a large margin. Since June 30, 1982, while prices of GNMA 9s and 11½s rose 26.7% and 23.5%, respectively, GNMA 15s gained only 11.7% in price, and GNMA 16s only 7.3% (see Figures 2 and 3). The quoted yield spread between GNMA 11½s and GNMA 16s widened from 60 basis points on June 30, 1982, to an enormous 283 basis points at present.

Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT, Research Report: “High Coupon Mortgage Securities as Short-Term Investments”) p. CN253078.

M51. The large increase in prepayments reported in the October 1984 Salomon presentation occurred in the market at the time USAT was initiating its MBS RCA portfolios: “Between March 7 and June 18, current-coupon GNMA yields fell by almost 200 basis points, from 13.16% to 11.17%.” As Salomon Brothers explained in September 1984,

While the market has backed off from the highs reached in mid-June, mortgage interest rates are still nearly as low as at any time during the past five years (see Figure 1). As a result of the sharp decline in interest rates, investors are uncertain about the pace at which mortgages will prepay in today’s environment.

Ex. B-586, Tab 239 (Report from Salomon Brothers by M. Waldman, M. Gordon, and S. Guterman, “The Salomon Brothers Prepayment Model: Impact of the Market Rally on Mortgage Prepayment and Yields) p. 1.

M52. Based upon its experience, Salomon Brothers explained that its prepayment “model projects that a strong rise in prepayments will occur as a result of the recent rally,” which was not unexpected, since as Salomon Brothers explained: “As shown in Figure 1, this upturn parallels those that occurred in 1976-77, the third quarter of 1980 and 1983-84, following other declines in interest rates.” Ex. B-586, Tab 239, p. 1.

M53. As Respondents’ expert conceded on cross-examination, the previous experiences relied upon in the Salomon studies described above had shown a dramatic increase in prepayments with declines in interest rates, ranging as high as 30-50 percent prepayments. Tr. 28,386: 3 - 28,387: 16 (Carron).

M54. As Giarla testified, Smith Breeden, recognized experts in MBS RCAs, assumed prepayment rates for December 1985 and early 1986, based upon their preexisting prepayment model, were projected to be significant in response to the decline in interest rates that began in late 1984. Tr. 11,798: 16 - 22; 11,803: 10 - 11,804: 9; 11,915: 3-21 (Giarla). Their projections, which were comparable to what actually transpired in December 1985, and the first quarter of 1986, revealed, for example, that the prepayment rate for the 12 ½ Freddie Mac coupon was projected by Smith Breeden under its preexisting prepayment formula to be 42% per year. Although Smith Breeden adopted a new formula in August 1986 as interest rates continued to decline, and increased its estimates for the 12 ½ Freddie Mac coupon to a 50.2% constant prepayment rate, as Giarla testified, the figures from the preexisting prepayment model projected a significant increase. In Smith Breeden’s view, an increase from 12 or 13 percent to 40 percent is a significant increase in prepayment rates. Tr. 11,873: 3 - 11,875: 11 (Giarla).

2. It Was Commonly Understood That A 200 Basis Point Decline In

Interest Rates Was A Known Predictable Risk In 1985

M55. The interest rate decline of the magnitude that occurred in the 1985-86 time period before USAT rebalanced its MBS portfolio, in response to an increase in prepayments, was a foreseeable and likely event. A 200 basis point interest rate decline had occurred five times within a 60 day period in the previous five years. Ex. A-11012, Tab 244 (Expert Report Darrell Duffie). Between December 31, 1979, and December 31, 1985, 10-year Treasury Notes and Bonds interest rates declined five times more than 200 basis points within a three to six month period. Between March 31, 1980, and June 30, 1980, 10-year Treasury Notes interest rates declined from 12.35% to 10.10%, a 225 basis point drop. Between June 30, 1981, and September 30, 1981, 10-year Treasury Notes declined from 13.85% to 11.85%, a 200 basis point drop. Between June 30, 1982, and September 30, 1982, 10-year Treasury Notes declined from 14.44% to 11.73%, a 271 basis point drop. Between June 30, 1984, and December 31, 1984, 10-year Treasury Notes declined from 13.84% to 11.55%, a 229 basis point drop. Between March 31, 1985, and December 31, 1985, 10-year Treasury Notes declined from 11.65% to 9.00%, a 285 basis point drop. Ex. A-11012, Tab 244 (Expert Report Darrell Duffie).

M56. Respondents’ expert admitted that using his method of assessing the likelihood of a 200 basis point decline in interest rates over the expected twelve year life of MBSs in the mid-1980’s would “imply a volatility of about 49 percent, which he admitted would lead him to conclude that was significant probability.” Tr. 28,338: 3-10; Tr. 28,352: 6-22; Tr. 28,363: 20 - 28,365: 8. (Carron).

M57. Respondents’ expert also conceded that the volatility figure of 49 percent was significant to the riskiness of the MBS strategy adopted by USAT. As he testified:

Q. What's the relevance of the likelihood to Joe Phillips sitting there in the summer or fall of 1985, what's the relevance of the likelihood of interest rates going down 200 basis points or going up 200 basis points?

A. I think it translates fairly directly into the riskiness of the strategy. If that number were -- were 40 percent instead of 4 percent, I would have a different opinion and I think he would have had a different opinion.

Tr. 28,365: 9-18. (Carron).

M58. At the time USAT’s MBS RCAs were initiated it was commonly believed that, absent changes in interest rates, the average expected life of a current coupon recently issued MBS was 8 to 12 years. The likelihood that interest rates for a current coupon recently issued MBS would decline by 200 basis points or more over this 8 to 12 year time period was 49%, according to Respondent’s expert witness, which Carron conceded would make a 200 basis point decline a likely event during the expected average life of the MBSs purchased by USAT. Tr. 28,352: 6-22; 28,363: 20 - 28,365: 8; 28,365: 9-18 (Carron).

M59. Smith Breeden, a recognized expert in the field, found that interest rate moves as great as 400 basis points were not unreasonable expectations, and that it was “not unlikely” that there would be rate moves of that magnitude. Tr. 11,796: 4-12 (Giarla).

M60. The magnitude and rapidity of the recent history of 200 basis point downward moves in interest rates led experts in the MBSs field to warn their clients that although they used a plus or minus 100 basis point moves for their scenario analyses, these were “small moves relative to what had happened in the two years prior to May 31, 1986.” Ex. A-13003, Tab 1118 (Introduction to Hedging Interest Rate etc.) p. 5.

3. It Was Commonly Understood In 1985 That Mortgage-Backed Security Risk-Controlled Arbitrages Could Be Structured To Mitigate The Impact Of Prepayments On The Value Of The Portfolios

M61. Managers of MBS portfolios were advised by experts, at least from 1984, to manage the prepayment risk caused by declining interest rates in a number of ways. One recommendation was to purchase “discount seasoned” MBSs that were immune to an increase in prepayments of a least 200 basis point moves, or purchase “premium” MBSs, the prepayment rate for which had already increased as a short term investment. Another common recommendation was to purchase options contracts, instead of interest rate swaps, to protect against an increase in interest rates without the harmful effects of a decline in interest rates on a fixed interest rate spread that was known to occur with the use of swaps to fix interest rates. A third was to purchase put option contracts, in addition to the swaps, to protect against increases in prepayments in a declining interest rate environment. Finally, managers were advised to closely monitor interest rates and coupon rates of newly issued MBSs, and adjust the duration of the portfolio between 25 and 100 basis point downward moves in interest rates in order to protect the value of the portfolio and yield from the harmful effects of an increase in prepayments. See FOF M62 - M97.

M62. One method recommended by investment advisors at the time USAT formed its MBS RCA portfolios to protect against the prepayment risk, was the purchase of seasoned discount MBSs. In the packet of materials distributed to the participants in the Salomon Brothers October 1984 presentation on investments in MBS RCAs, which Hurwitz attended, was an article by Michael Waldman, a recognized expert in the field. He used seasoned lower-rate mortgages as examples for the investment option he discussed; loans that had originated some time ago and were priced at sizable discounts from par deliberately. The seasoning and corresponding equity buildup and established record of servicing the debt he advised, added to their credit quality and, importantly, the discount on the mortgages provided call protection, which he explained was crucial to protect the arbitrage’s profits in a falling rate environment that probably would trigger refinancing by homeowners. Ex. B-377, Tab 242, pp. CN253070-CN253071. In order to avoid being faced with two untenable choices--to repay the FHLB advances early at stiff prepayment penalties, or to reinvest the cash flow at very low rates--both of which he explained would dramatically reduce the arbitrage’s performance, Waldman recommended the purchase of discount MBSs to provide protection against the prepayment risk. Ex. B-377, Tab 242, pp. CN253070-CN253071.

M63. Waldman repeated this recommendation in an article written in May 1985, which was available to USAT at the time it formed its MBS RCA portfolios, because the low interest rate discount mortgages he advised “provides call protection. An investment in current-coupon mortgages, in contrast, carries the risk of being refinanced under declining interest rates.” Ex. B-505, Tab 238 (Report from Salomon Brothers by M. Waldman, “Constructive Use of Fixed Rate Mortgages-Arbitrage Opportunities for Financial Institutions”) p. 3. Michael Waldman explained in his May 1985 article that the 118-basis-point advantage shown in his examples was representative of what was available in the current market with the prepayment risk on these controlled by the call protection. Ex. B-505, Tab 238 (Report from Salomon Brothers by M. Waldman, “Constructive Use of Fixed Rate Mortgages-Arbitrage Opportunities for Financial Institutions”) p. 10.

M64. In his May 1985 article, Waldman also repeated this recommendation to minimize the prepayment risk by buying high coupon MBSs funded with short term liabilities. Ex. B-505, Tab 238, p. 11.

M65. Another technique recommended to USAT to minimize the prepayment risk was the purchase of high coupon MBSs funded with short term liabilities. In the Salomon Brothers October 1984 presentation, USAT was advised that:

[P]repayment rates of high-coupon mortgages have climbed, as borrowers refinance their loans at lower mortgage interest rates. The market has attempted to adjust price levels to rapid prepayment rates, limiting the upward price movement of the premium issues. This sector may now present an opportunity.. . . As fast prepayment rates, high-coupon mortgage issues become short-term investments, with values that can be gauged by the yield spread to the Treasury yield curve. The critical question in establishing value is whether prepayment rates have already reached their ultimate levels or whether they will go still higher. GNMA prepayment rates failed to increase significantly for the first time in February, raising the possibility that prepayment rates could stabilize.

Ex. B-377, Tab 242 (Salomon Brothers Plan for USAT, Research Report, “High Coupon Mortgage Securities as Short-term Investments”) p. CN253077.

M66. Smith Breeden advised USAT that another way to protect against a reduction in the market value of a MBS RCA portfolio, was to purchase put option contracts. Smith Breeden had been advising its clients, as early as 1984, to hedge the market value risk between the mortgages and the funding anticipated changes in pre-payments. Smith Breeden projected a net interest rate yield of 124 basis points on the portfolio, with a cost of 24 basis points for the hedge, against prepayments to protect the market value of the arbitrage. Tr. 11,759: 10 - 11,760: 2; 11,760: 12 - 11,762: 4; 11,764: 8 - 11,766: 13; 11,774: 4-11 (Giarla).

M67. Smith Breeden recommended in the middle of 1986 that USAT hedge the prepayment risk to its portfolio options contracts, even though interest rates had fallen in 1985 and early 1986. Tr. 11,822: 4-21; 11,835: 22 - 11,837: 6; 11,946: 17 - 11,949: 10 (Giarla).

M68. Doug Hansen advised Charles Hurwitz and others that many of the experts who attended a conference on MBSs, had recommended the purchase of options contracts, to protect the value of MBS RCA portfolios from increases in prepayment rates. The other experts agreed with Giarla that options contracts were the most effective way to protect against the risk of prepayments in a declining interest rate environment. Ex. B-3813, Tab 1204 (Memo from Hansen to Gross, Munitz, B. Williams, Crow, Berner, J. Williams, Shebsch, Phillips and Jacobsen 06/19/86) p. W101041.

M69. The view of these experts was accepted by Bruno, the last manager of the USAT and UMBS portfolios, who testified about the benefit of an option contract as a hedge against declining interest. Tr. 12,900: 19 - 12,901: 7 (Bruno).

B. It Was Commonly Understood In 1985 That Changes In The Market

Value Caused By Changes In The Interest Rate Spread Of Risk-Controlled Arbitrage Portfolios Needed To Be Closely Monitored To Protect Against An Increase In Prepayments

M70. USAT managers knew that portfolios needed to be actively managed to mitigate the impact of an increase in prepayment speeds caused by a decline in interest rates by closely monitoring interest rate changes or changes in the coupons of MBSs issued by government agencies, and rebalancing the portfolio at predetermined interest rate levels in order to mitigate the impact of increased prepayments to changes in interest rates. As Giarla explained in his testimony:

If an institution wasn't purchasing options to hedge its prepayment risk, then typically as interest rates moved in one direction or another, it may – its hedge would get out of balance. And so, the typical situation would be that if interest rates fell, it would need less hedges; and as interest rates went up, it would need more hedges to maintain balance. So, there would be a schedule set up in advance so that whoever was doing the portfolio management would know if interest rates moved 25 or 50 or so. However many basis points, they would know how to do that hedge adjustment. So, it would take the subjectivity out of it.

Tr. 11,761: 2-15 (Giarla).

M71. Smith Breeden was a major consultant to thrift institutions in the mid-1980’s, and had considerable expertise in advising clients on the management of MBS RCA portfolios. Tr. 28,477: 14-18 (Carron).

M72. The number of Smith Breeden’s clients, which included between 18 to 24 thrifts in 1985, that relied exclusively on rebalancing to protect against an interest rate decline was very limited. Unlike USAT, the typical Smith Breeden client hedged the prepayment risk with options contracts. The client would receive a report of its interest rate risk every month or within a 100 basis point move in interest rates. The typical Smith Breeden client did monthly rebalancing anyway, even if its portfolio was well-hedged with options contracts against the prepayment risk, although they “could presumably withstand a 100 basis point move in rates without having to worry very much,” but nevertheless made small adjustment in their portfolios by adjusting the hedges, not the coupons of the MBSs. Tr. 11,760: 12 - 11,762: 22; 11,948: 17 - 11,949: 10 (Giarla). When asked by counsel for the OTS to clarify the Smith Breeden experience, Giarla responded:

Q. So, you didn't have clients, when interest rates went down in late '85, early '86, selling higher coupon mortgage-backed securities and replacing them with lower coupon mortgage-backed securities typically?

A. I don't remember exactly what they did; but if they were doing that, it would have been more as an investment decision, not as a hedging position.

Tr. 11,781: 13 - 21 (Giarla).

M73. The FHLBB recognized in 1985 that the adverse effect of an increase in prepayments could be avoided if the portfolio was rebalanced prior to the impact of increased prepayments on the market value of the MBSs. The rebalancing would occur by the rolldown of
the coupons in the portfolio from higher coupons that may prepay at higher speeds for lower coupons that may not prepay as fast in response to a reduction in interest rates. Tr. 2,787: 8 - 2,789: 20; 2,904: 15 - 2,906: 22 (Smith).

M74. It was commonly understood, from at least as early as 1984, that interest rate changes had to be closely monitored, the prepayment assumptions modified as rates rose or fell, and the duration of the assets and liabilities readjusted quickly for a RCA portfolio to remain profitable. As Greg Smith cautioned at an American Bankers Association conference, the remarks of which Hansen summarized and distributed to Hurwitz’s management team:

“When you're 100 percent duration matched, you must monitor it on a daily basis and be ready to make dramatic changes.” Tr. 12,557: 9 - 12,558: 13 (Hansen); Ex. B-3813, Tab 1204 (Memo from Hansen to Gross, Munitz, J. Williams, Crow, Berner, Williams, Huebsch, Phillips and Jacobsen Re: MBS Arbitrage, 06/19/86) p. W101041. See also, Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfien and Lisa Wolfson, “Risk-Controlled Arbitrage: As Asset Liability Management Strategy for Financial Institutions,”) p. 9.

1. It Was Commonly Understood That Ten-Year Treasury Securities Responded To Changing Economic Conditions Similar To Mortgage-Backed Securities And Were Typically Monitored By Portfolio Managers To Anticipate Increases In Prepayment Speeds

M75. The most commonly used index to monitor changes in interest rates was the 10-year Treasury bill rate, because it typically had a similar duration as current coupon MBSs and was similarly situated on the yield curve trade, making it a good benchmark for interest rates of MBSs. “A typical comparison point for discount and current-coupon GNMAs is the ten-year Government.” Tr. 11,798: 1-10 (Giarla); Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT, 10/24/84) p. CN253080; A-10654, Tab 1119 (An Introduction to Risk-Controlled Arbitrage) p. 00536; A-13002, Tab 1117 (Hedging program for savings and loan association); A-13003, Tab 1118 (Introduction to Hedging Interest Rate) p. OW006047.

M76. Monitoring the changes in the market rate for mortgages insured by the Veterans Administration was another method advocated by Respondents’ expert witness to predict increases in prepayment rates, early enough to prevent a decline in value in a MBS RCA portfolio. Tr. 28,553: 14 - 28,555: 4 (Carron).

M77. The manager of USAT’s RCA testified that it was his assumption that the 10-year Treasury rate was monitored for changes in the interests rates, which he characterized as the “conventional point on the curve for mortgage-backed securities, not the Veterans Administration’s announcement of maximum rates insured as Carron claimed in his testimony.” Tr. 5,271: 17 - 5,272: 1; 5,279: 11-12 (Phillips).

2. It Was Commonly Understood In 1985 That The Market Value Of Risk-Controlled Arbitrage Portfolios Needed To Be Closely Monitored And Rebalanced Within 25 to 50 Basis Point Decline In Interest Rates To Protect Against Increases In Prepayments

M78. Smith, the co-author of FHLBB Guidance on RCAs, testified regarding a passage in one of the articles he wrote on RCAs: “[m]arket value provides a leading indicator for future changes in book income induced by changes in prepayment speeds." Ex. B-1737, Tab 230 (Article from FHLB Quarterly, 09/87) p. 7. Smith testified that traditional accounting measures to book earnings off of the RCA transaction would lag behind what was going on in the marketplace. It usually took homeowners two or three months to start the refinancing process and, another couple months to actually refinance. He testified that the time between when rates dropped 200 basis points and when prepayments show up in the payments may be five or six months. As soon as rates decline, however, market value is impacted. To wait until book income responds to a change in rates would be five or six months beyond the point where the problem really occurred. If rates are slowly trending down as opposed to a big shock, he stated it could be a very, very long time before degradation of the transaction of book income was seen. Tr. 2,795: 6 - 2,796: 14 (Smith).

M79. Smith’s reasoning that the only effective way to measure the performance of a RCA was to mark the portfolio to market, defined as the “discounted present value of the cash flows from the arbitrage,” in order to measure the effect of changes in interest rates was repeatedly emphasized by the experts who spoke at the American Bankers Association conference referred to above in Finding M74. Ex. B-3813, Tab 1204 (Memo from Hansen Re: MBS RCA) p. W 101041. In response to questions from OTS’s counsel, Hansen explained:

Q. I would like to direct your attention to two bullet points down from there. It says, ‘[t]he way to measure how you're doing is to mark the entire portfolio to market and see what the gains are. You cannot manage the portfolio by just looking at the current spreads.’ Is the reference to spreads the interest rate paid on the liability side corrected with the swaps and the amount received on the mortgage-backed securities side?

A. That's what it sounds like.

Q. It says, ‘[y]ou cannot manage a portfolio by just looking at current spreads.’ Why is that, or why was that at the time?

A. Based on my current knowledge, I would say what they are referring to -- there is – you can be in a position to -- similar to the one we talked about earlier whereby, let's say, if rates have fallen and your mortgages haven't prepaid yet but they are about to, you still can see that you're earning a decent rate; but if you marked to market, you would see that you would have trouble ahead.

Tr. 12,549: 17 - 12,550: 18; see also Tr. 12,551: 10 - 12,552: 17 (Hansen).

M80. As Giarla explained in his testimony, Smith Breeden held the view that interest yield only gives part of the picture and that the calculation of the market value provides important information necessary to the survival of a financial institution:

Well, the definition -- at least the way I think of it, the definition of interest rate risks is changes in values caused by interest rate shifts; and if an institution -- if a financial institution doesn't effectively hedge its interest rate risk, it may become insolvent as a result. I mean, that's an extreme situation. Or it may find its interest rate spread eroded if it's moving in the wrong direction.

Tr. 11,794: 8 - 22; see also Tr. 11,806: 5-15 (Giarla).

M81. The importance of marking the portfolio to market for proper management of the arbitrage is reflected in the fact that the two MBS portfolio managers that had had previous experience with MBSs and the way prepayment speeds changed in response to interest rate changes, hired by USAT in 1987 and 1988, repeatedly marked the portfolios to market to measure their performance. Bruno went so far as to distribute an article prepared by the investment banking firm Morgan Stanley to educate the Investment Committee members, including Hurwitz, on the importance of doing so. Tr. 12,980: 15 - 12,981: 18 (Bruno); Ex. A-1499, Tab 1224 (Investment Committee Minutes, 03/30/88) p. US 3 011648.

M82. Even Respondents’ expert admitted the importance of mark to market analysis, as opposed to a yield analysis, when he was forced to change his analysis of the portfolios in response to questions raised informally about the quality of his work by OTS’s counsel. As Carron conceded in his testimony, mark to market valuation is the only measure of how a portfolio is performing when confronted with testimony he had previously given before a committee of the U.S. Congress admitted in this proceeding as Ex. T-9074, Tab 2039, pp. 30-31.

Tr. 28,313: 14 - 28,316: l (Carron).

3. It Was Commonly Understood In 1985 That The Reported Prepayment Figures Published By Investment Bankers Or Issuers, Or The Prepayment Rates On Mortgage-Backed Securities Held By The Investor Provided Inadequate Notice To Mitigate The Impact Of Prepayments On The Value Of A Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios

M83. The problem with relying upon published data or actual prepayment experience on the portfolio held by the institution is that, some time must pass before the lags in the process are worked through and the full extent of activity becomes evident. This is due to several factors:

(1) It takes time for consumers to become aware of the potential savings and of the procedure for refinancing their loans. Aggressive marketing programs by lenders can expedite this process.

(2) Homeowners will take time before making the decision to refinance. They have to weigh the up front costs of refinancing against the savings in monthly payment. In many cases, consumers will want to wait until they perceive that interest rates have stopped declining. A period during which rates level off or rise can set these people into motion.

(3) It takes time to process the transaction. The period will be longer if an appraisal and/or credit application are needed. The time from application to closing for an FHA/VA refinancing is estimated at about six to eight weeks.

Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT) p. CN253082.

M84. As Smith explained in one of the FHLBB articles he wrote:

 . . . a lag exists between the realization of prepayments in book income and the market moves that create profitable prepayment opportunities for mortgage holders. . . .  A shortcoming of this analysis is that changing spread relationships in the mortgage and swap markets, as well as deposit pricing relationships, influence market value. Shifts in these spreads may create profitable opportunities to terminate the transaction at a profit. These opportunities are unlikely to be in existence by the time book income responds.

Ex. B-1737, Tab 230, p. 7.

M85. It was commonly understood in 1985 that by the time the increase in prepayments is reported or reflected in the institution’s portfolio, the market has factored in the increase, and the portfolio has lost value because the MBSs have only gained one half of the value the swaps have lost. As Respondents expert Carron wrote:

For example, in mid-1985 the Ginnie Mae 11.5 sold at about par for a promised yield of 11.5 percent. By mid-1986 yields had dropped to about 9.5 percent and the Ginnie Mae 11.5 was selling for just over 106 percent of par. Without the effects of refinancing, it would have sold for 112. The difference is the market’s estimate of the cost of refinancing. Thus, refinancings deprived holders of 11.5 percent mortgages of half of the gain from lower market interest rates.

Ex. T-9077, Tab 2044, p. 2.

M86. Carron testified that if a portfolio manager waited until prepayments show up in the MBSs remittances from the issuers, such as FNMA, the prepayments will already have been reflected in the value of the MBSs. Tr. 28,561: 3 - 28,561: 4 (Carron).

4. Portfolio Managers Who Relied Upon A Rolldown In Coupons To Protect Against An Increase In Prepayment Speeds When Interest Rates Fell Generally Took Corrective Action To Readjust The Duration’s Of The Portfolios Within A 25 To 50 Basis Point Decline In Interest Rates

M87. Smith, the co-author of the FHLBB articles on RCA portfolios described in Findings M84 above, testified that the FHLBB recommended to roll down a risk-controlled arbitrage portfolio with a 25 to 50 basis point reduction in the interest rates on 10-year U.S. Treasury securities. Tr. 2,791: 2-17; Tr. 2,787: 22 - 2,789: 20 (Smith).

M88. Respondents’ expert’s opinion introduced in this proceeding was based upon his view that “initial MBS holdings are sold and proceeds reinvested in current MBS coupon after each 50 basis point change in market yield." Ex. B-4381, Tab 2030; B-4394, Tab 2032; B-4395, Tab 2033. As Carron testified, he selected that number because it is what portfolio managers typically did in 1985. Tr. 28,401: 12 (Carron).

M89. As Carron admitted on cross examination, he “selected 50 basis points as a --as what I considered to be a reasonable number given the thinking at the time, ” that the range he considered was “10 to 50” basis points, and that he selected the 50 basis point figures because: [L]ooking at the range of yield movements that one experiences in the market and determining, on the basis of my experience, the point at which a portfolio manager would decide that he or she was in a new interest rate environment and therefore needed to rebalance. Tr. 28,431: 7 - 28,434: 4. When asked why he did not consider any greater number, Carron responded that he selected 50 basis points for, what he characterized as:

…[S]everal reasons. 50 basis points is what economists call a focal point in the mortgage market. Mortgage-Backed Securities coupons generally come in 50 basis point incraments. At the time, the Veterans Administration would make periodic announcements of changes in the rate on VA mortgages and those would come in 50 basis point increments. So, I deduced from that that certainly by the time one of those announcements had taken place, or that mortgage bankers had shifted their production to the next higher or next lower coupon, which was in a 50 basis point increment, that would have been a clear signal to a portfolio manager that it was time to rebalance.

Q. So, do you disagree with any of those

statements today?

A. No.

Tr. 28,432: 20 (Carron).

M90. Carron concluded in his report that with his assumption that had the portfolio been rolled down every 50 basis points in market yield, the market value of the portfolio would have been preserved. Tr. 28,492: 12 - 28,493: 5 (Carron).

M91. As the authors of the First Boston study explained, “[t]he timing of the execution of the hedge is an important factor to consider in designing a hedge.” Ex. B-1475, Tab 235 (Report from First Boston by Carol Garfein and Lisa Wolfson, “Risk-Controlled Arbitrage: An Asset Liability Management Strategy for Financial Institutions") p. 9.

M92. Smith Breeden advised its clients who hedged against increases in prepayment speeds with options contracts to readjust their portfolios within a 100 basis point move in interest rates. Tr. 11,782: 17 - 11,783: 10 (Giarla).

M93. Sandy Orr, USAT’s second manager of its MBS portfolio, testified that 100 basis points is the outside range of when to rebalance: “If you have moves outside of a hundred basis point range, it is likely you will be hurt either direction.” Tr. 3,780: 12-16 (S. Orr).

M94. Hansen reviewed the tape of the American Bankers Association conference, and reported to Hurwitz’s management team that the experts in that conference stressed that in a declining rate environment, portfolios had to be rebalanced at least within 75 basis points. Tr. 12,553: 4 - 12,554: 6 (Hansen); Ex. B-3813, Tab 1204, pp. W101039-041.

5. Portfolio Managers Who Relied Upon A Rolldown In Coupons To Protect Against An Increase In Prepayment Rates Reinvested The Entire Proceeds In Order To Maintain The Spread

M95. Joe Phillips admitted that for a RCA portfolio to be successfully rebalanced, it was necessary to reinvest all of the proceeds of the mortgages sold, including the profits realized on the sales, and all prepayments that had been made. Tr. 5,613: 18 - 15,617: 9; 5,268: 8 - 5,270: 12 (Phillips).

6. It Was Commonly Understood In 1985 That If A Portfolio Manager Waited Until Interest Rates Had Declined 200 Basis Points To Rebalance, The Net Interest Spread Would Disappear And The Portfolio Would Experience A Market Value Loss

M96. As Smith wrote in one of the FHLBB articles he co-authored, "If no rebalancing is completed by the time rates have moved 200 basis points, the chances are that any rebalancing would be too little too late." Smith explained that by waiting for interest rates to move 200 basis points, if rates have declined, the gain in the value of the mortgage assets would not be enough to offset the losses in the hedges. Further, the cash would have to be reinvested at a much lower rate of interest, embedding the losses into the MBSs. Tr. 2,792: 18 - 2,793: 20 (Smith); Ex. B-2055, Tab 231 (Article Savings Institutions by Jon Scott and Terry Smith Re: “Prepayment & Risk Can Throw An Arbitrage off Track”) p. F000037.

M97. Respondents’ expert testified that if no action was taken to rebalance a RCA fully hedged with swaps until the market yield had declined by the 200 basis points, the prepayment speed would increase from a 10 CPR for the current coupon to around a 18-19 CPR[1] for a 200 basis point decline, which Carron admitted: “If you're using the term as a mortgage market analyst would have used the term at the time, yes, it's significant, . . .  the spread would go from its positive number to somewhere around zero, possibly somewhat positive,” and the portfolio would experience a market value loss. Tr. 28,464: 11-15; 28,466: 9-15; 28,466: 18 - 28,467: 2 (Carron).

C. Respondents Failed To Comply With The Customary Recommended Methods To Protect Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios Against The Impact Of Increases In Prepayment Speeds

1. Respondents Did Not Set Up USAT’s Portfolios To Mitigate The Prepayment Risk In The Mortgage-Backed Securities With Discount Coupon Securities, With Premium Coupon Securities Funded With Short Term Liabilities, Or With Option Contracts As Had Been Recommended To Them

M98. USAT’s managers did not purchase premium or discount MBSs as Salomon Brothers had recommended. Instead, USAT purchased current coupon or slightly premium MBSs in order to earn a spread of 150 basis points, not the 100 basis point spread for premium or discount securities recommended. Tr. 5,134: 8-17; 5,308: 4-18 (Phillips).

M99. USAT’s managers considered the use of options contracts to mitigate the effect of increased prepayments, but chose not to purchase them because the effect would have been to reduce the yield on the portfolio from the maximum of 150 basis points sought by Hurwitz’s management to 100 basis points or less. Tr. 5,363: 3 - 5,365: 3 (Phillips); Ex. B-858, Tab 578 (Memo from Huebsch and Phillips, 03/03/86) p. CN257963; A-10578, Tab 579 (Memo from Phillips, 11/07/85) p. CN057157-58.

2. Respondents Did Not Monitor The Prepayment Risk In The Mortgage-Backed Securities Portfolios In Accordance With The Commonly Accepted Methods Recommended In 1985

M100. USAT’s managers were aware of the literature produced in 1984 and early 1985 that indicated a 200 basis point decline in interest rates would create a substantial increase in prepayments, with prepayment rates increasing from the single digits to 30 to 40 percent. Tr. 5,310: 6 - 5,314: 1 (Phillips); Ex. B-377, Tab 242 (Salomon Brothers Strategic Plan for USAT) p. CN253078; B-505, Tab 238 (Report from Salomon Brothers) p. 11.

M101. As the manager of USAT’s MBS RCA portfolio admitted in response to questions from the OTS’s counsel, the prepayment speeds recorded in his schedule prepared at the time of the rolldown were comparable to the figures that were reflected in the Salomon Brothers study and other literature available to USAT at the time. Tr. 5,597: 12 - 5,599: 6 (Phillips).

M102. USAT’s managers did not monitor the interest rate market or the Veterans Administration pronouncements to ascertain when to rebalance the portfolios. As the portfolio manager admitted, no effort was made to anticipate when an interest rate move would increase the prepayment speeds to the 20 to 30 percent levels. Tr. 5,596: 8 - 5,596: 21; 5,260: 16-22; 5,300: 3 - 5,302: 6 (Phillips).

M103. USAT’s managers made no effort to mark the portfolio to market to ascertain its performance. As Phillips testified:

Q. Did you attempt to ascertain what the market value effect would be on the

mortgage-backed securities?

A. If we did, it would have been coincidental. It was not part of any analysis we needed to conduct the management of the structure.

Q. Okay. What do you mean by that?

A. The market value at any given moment would not have entered into any decisions to --that we undertook to manage the portfolio. It was a spread structure, and the maintenance and preservation of that spread was our objective.

Q. And not to maintain the value – the market value of the portfolio?

A. That's correct.

Q. Why not?

A. Because we had created a structure that would allow the securities to run off, allow us to hold them to maturity or whatever their final payment was. We had a structure to hedge the short funding risk to carry those with. So, the risks that we had identified as the important ones and the risks from which we earned our return were appropriately hedged and identified.

Tr. 5,154: 13 - 5,155: 14 (Phillips).

M104. USAT’s managers made no effort to model prepayment expectations or project what would happen under different interest rate scenarios to the interest rate spread, much less the market value of the portfolios, in 1985 and 1986. They only used two sources of information when managing the portfolios in 1985 and 1986. The first were yield tables that admittedly did not estimate what prepayment speeds would be with a change in interest rates. See, e.g., Ex. B-450A, Tab 580 (Salomon Brothers Mortgage Research Report, March 1985) pp. CN054433-445; Tr. 5,156: 13 - 5,157: 1; 5,605: 5 - 5,608: 17 (Phillips). The second was actual prepayment statistics published by issuers and brokerage houses which were compiled by taking the actual figures that were presented each month by the agencies as to the fraction of the securities remaining outstanding and simply calculating a rate of decline. See, e.g., Tr. 5,234: 18 - 5,235: 10 (Phillips) Ex. T-9114, Tab 2091 (Mortgage Security Prepayment Rate Profile from FHLBB Research Library, prepared by Salomon Brothers Inc.). Actual prepayment statistics, do not reflect the prepayments as they occur, and are available only after the increase in prepayments has been reflected in the price of the securities.

M105. The first time the manager of USAT’s RCA learned that there was a market value loss in the portfolio was when he received a report on the Smith Breeden analysis that showed a $58 million dollar loss in July 1986, summarized in a memorandum prepared by Crow. Tr. 5,285: 12 - 5,287: 22 (Phillips); Ex. A-10649, Tab 187 (Memo from Crow to Gross, 07/03/86).

M106. USAT’s MBS RCA managers did not seek the advice of outside consultants or investment bankers on what actions to take to protect the portfolios from an increase in prepayments, although they had received information as early as June 1985 that prepayment speeds had increased and were projected by October 1985 to go even higher. Nor did they attempt to ascertain the actions they could take to protect the portfolio or what those actions would cost. Tr. 5,599: 7 - 5,603: 13 (Phillips); see, Ex. B-586, Tab 239 (Report from Salomon Brothers by M. Waldman, M. Gordon, and S. Guterman).

3. Respondents Did Not Rebalance The Portfolios Within A 25 -50 Basis Point Decline In Interest Rate In 1985 In Accordance With The Methods Generally Utilized By Portfolios Managers At The Time

M107. The MBSs that were sold as part of the rolldown that began in January 1986 had been purchased prior to June 30, 1985, and originally issued in November 1984. Tr. 5,273: 3-9; 5,469: 20 - 5,470: 16 (Phillips).

M108. The rolldown of MBSs began in January 1986. No rebalancing transactions were made in 1985. Tr. 5,218: 19 - 5,220: 3 (Phillips); Ex. A-10631, Tab 572, p. OW002922-23. See also, Ex. B-4381, Tab 2030 (Report of Andrew S. Carron); B-4407, Tab 2035 (USAT Trade Classification).

M109. Ten-year treasury securities interest rates were 13.83% on June 30, 1984, dropped to 12.449% on September 30, 1984, and to 11.50% on December 31, 1984. They dropped further to 10.15% on June 30, 1985, and to 9.00% on December 31, 1985. The interest rate on 10-year treasury securities, which was 9.01% on December 31, 1985, dropped to 8.14 % on February 28, and 7.35% on March 31, 1986. Ex. A-13003, Tab 1118, p. OW006047.

M110. Between the time USAT purchased the MBSs for its arbitrage portfolios in the spring of 1985, and January through February 1986 when it began the so called rolldown, the Veterans Administration (“VA”) announced numerous changes in insured maximum interest rates. The VA announced eight changes in the maximum interest rates for single family fixed rate loans between November 21, 1984, and March 3, 1986. On November 11, 1984, the VA announced the maximum rate had been reduced from 13.00% to 12.50%, and on March 25, 1985, it announced an increase back to the 13.00% level. It then announced six reductions in the maximum rate. The VA announced a decrease on April 19, 1985, from 13.00% to 12.50%, on May 21, 1985, from 12.50% to 12.00%, on June 5, 1985, from 12.00% to 11.50%, on November 20, 1985, from 11.50% to 11.00%, on December 13, 1985, from 11.00% to 10.50%, and on March 3, 1986 from 10.50% to 9.50%. Ex. T-9113, Tab 2090 (Veterans Administration (VA) Mortgages Announcements of Changes in Maximum Interest Rates for Single-Family Fixed Rate Loans 1984-1986) p. 1.

M111. As the manager of USAT’s RCA portfolios admitted in response to questions from the OTS’s counsel, the 10-year Treasury rates had fallen by 200 to 300 basis points between the time the MBSs had been purchased and the dates he began to roll them into lower coupons (January 1985). Tr. 5,595: 7-17; 5,273: 15 - 5,274: 17 (Phillips). When USAT purchased the MBSs for the arbitrage portfolios, interest rates on 10-year Treasury securities were approximately 11.65% percent. When USAT began the purported rolldown in January 1986, interest rates on 10-year securities had declined to 9.0%, a 265 basis point drop from where the rates had been when USAT created the MBS RCA. When USAT made the bulk of the sales in its initial rolldown in February and March 1986, interest rates on 10-year treasury securities had fallen between 8.14 and 7.35%, a 351 to 430 basis point drop from where interest rates were when USAT created the MBS RCA. Ex. A-13003, Tab 1118, p. OW006048.

M112. As the manager of USAT’s RCA portfolios admitted when he testified, a 100 basis point move in interest rates is quite significant for a MBS portfolio. Tr. 5,274: 18 - 5,275: 7 (Phillips).

M113. Joe Phillips, the portfolio manager at the time, prepared a log of the transactions that constituted the rolldown in response to his perception of increases in prepayment speeds at the time. He listed 14 transactions between January and March 1986 as sales and purchases in response to increases in prepayment speeds. Ex. A-10631, Tab 572 (UFG statistics equity, arbitrage, investments, profit contribution) p. 5226. Only two of the 14 transactions identified as the rolldown by Joe Phillips, one on February 14, 1986, and another on March 5, 1986, were sales in which the coupon repurchased was within 50 basis points of the coupon that was sold. In two of the other transactions, the coupons were 100 basis points apart. In another, the coupons were 150 basis points apart. However, in the remaining nine transactions, with a total value of $380 million, the coupons were between 200 and 300 basis points apart. Ex. B-4381, Tab 2030 (Carron Initial Report-Exhibit 13).

i. Many Of The Mortgage-Backed Securities Sold And Replaced As Part Of The Rolldown USAT Had Already Experienced A Dramatic Increase In Prepayments And A Reduction In The Increase In Value As The Available Literature Had Predicted

M114. Seven of the fourteen transactions identified by Joe Phillips as part of the rolldown to protect the value of the MBS portfolio from increases in prepayment speeds, had already experienced such increases when sold. The prepayment rates for the MBSs sold in the exchanges of January 26, February 14, February 26 (2), March 18, March 20 and March 26 had increased from the normal 6 CPR for current coupon MBSs to between 20 and 32 CPR, according to Joe Phillips list. The face value of these sales exceeded $390 million. Ex. A-10631, Tab 572 (UFG statistics equity, arbitrage, investments, profit contribution); Tr. 28,481: 2 - 28,483: 10 (Carron).

M115. Joe Phillips admitted that the prepayment rates of 30 to 40 CPR for the securities sold on his schedule of the purported rolldown, were representative of the actual prepayment speeds that he learned of in early 1986, which prompted the rolldown to lower coupon securities. Tr. 5,596: 8-21; 5,597: 12 - 5,599: 6 (Phillips); Ex. A-10631, Tab 572 (UFG statistics Re: Equity Arbitrage investment, and profit contribution, 04/30/86) at schedule SF.

M116. USAT’s performance report for the first quarter of 1986 explained:

Over the past several months, the yield on higher coupon mortgage-backed securities has deteriorated relative to that of lower coupon mortgage-backs because of increasing prepayment speed on the higher coupon securities. In order to protect unrealized gains on the mortgage-backed securities, the investments group sold the higher coupon securities and replaced them with lower coupon securities, thus reducing net interest spreads.

Ex. A-5010, Tab 557 (Performance Report, First Quarter 1986) p. US 0001727.

ii. USAT Did Not Sell All Of Its High Coupon Mortgage-Backed Securities In The Rolldown Identified By Joe Phillips

M117. Interest rates on 10-year Treasury securities dropped from the 8.14% level on January 31, 1986, to 7.35% as of February 28, 1986, and fluctuated between 7.39% and 7.51% between that date and March 31, 1987. Ex. A-11012, Tab 244 (Expert Report of Darrell Duffie) at Tables 4.2.2 and 4.3.

M118. Over $70 million in face value of MBSs with coupons of between 11.00% and 13.5%, or over 350 to 500 basis points above the then 10-year Treasury security interest rate, were held by USAT as late as May and June 1986. Ex. B-4407, Tab 2035 ( See transactions identified as “Match” numbers 1327, 1329, 1302, 1304, 1301, 1303, 2525, 2337, and 2340, Carron report) p. 3.

iii. USAT Did Not Reinvest All Of The Proceeds Generated By The Sale And Prepayments Of The Mortgage-Backed Securities As Required For A Proper Management Of A Risk-Controlled Arbitrage

M119. Joe Phillips admitted that for a RCA portfolio to be successfully rebalanced it was necessary to reinvest all of the proceeds of the mortgages sold, including the profits realized on the sales, and all prepayments that had been made. Nevertheless, despite repeated requests by Phillips, Respondents’ managers of USAT refused to permit the reinvestment of what the manager referred to in his testimony as the paydown of prepayments, which was $75 million in August 1985, and much larger after prepayment rates had increased even further in 1986. Tr. 5,613: 18 - 5,617: 9; 5,268: 8 - 5,270: 12 (Phillips).

iv. Respondents’ Managers Of USAT Took No Action To Readjust The Swaps When It Rolled Down The Mortgage-Backed Securities In Order To Provide Better Protection From An Increase In Interest Rates

M120. The initial rolldown beginning in January 1986, generated an accounting gain of $67 million on the sale of the higher coupon MBS. The managers of the MBS portfolio made no effort to ascertain whether the profits on the securities sold could be used to restructure the swaps to better match them with the lower coupon MBS rolled into to mitigate the losses. As a consequence, USAT had hedged liabilities at least 100-200 basis points above the coupons of its MBSs with little or no protection from an increase in interest rates. Tr. 5,248: 14 - 22; 5,281: 5 - 19 (Phillips).

D. USAT’s Rolldown, Which Did Not Start Until The First Quarter Of 1986, Reduced The Spread Income To Almost Zero And Created A Market Value Loss In The Portfolios

M121. In the Spring of 1986, USAT sought to ascertain the impact of the purported rolldown in the first quarter of 1986 on the spread on the $750 million in MBSs held by USAT that were funded with reverse repurchase agreements in its RCA portfolios. On March 22, 1986, Goldman Sachs sent Crow its analysis of this portion of USAT’s MBSs. It explained that the spread on the portfolio’s expected life was only 6 basis points as of that date, would turn to a negative 25 basis points with a 200 basis point parallel decline in interest rates, and a negative 38 basis point spread with a 200 basis point parallel increase in interest rates. Ex. A-10619, Tab 573 (Memofrom Roger Wittlin to Crow Re: analysis of MBS portrfolio, 03/22/86) pp. CN056138-56143.

M122. A May 2, 1986, Performance Report to USAT's Board of Directors states that:

The level of net interest income of $3.6 million was down from the previous quarter by $2.2 million and finished short of plan. Reduced spreads on mortgage-backed securities and an increase in the level of non‑performing assets both had a negative impact for the quarter. …Over the past several months, the yield on higher coupon MBSs has deteriorated relative to that of lower coupon mortgage-backs because of increasing prepayment speed on the higher coupon securities. In order to protect unrealized gains on the Mortgage-Backed Securities, the Investments Group sold the higher coupon securities and replaced them with lower coupon securities, thus reducing net interest spreads.

Ex. A-5010, Tab 557 (USAT Performance Report) p. US 0001727.

M123. A June 19, 1986, memorandum from Bruce Williams to the Investment Committee states that, as of May 31, 1986, the arbitrage portfolio consisted of $690,125,000 of MBS assets with $760,000,000 of hedges. The memo recommends adding $75 million to $100 million of MBSs to the portfolio "to balance asset and hedge . . .  positions." A MBS analysis attached to the memo indicates that, after taking into account the hedges, the portfolio of $667,241,000 of MBS had a net spread of (.56%) and lost $312,000 in April, and the portfolio of $702,699,000 of MBS had a net spread of (.11%) and lost $64,000 in May 1986. (Exhibit 5). At the June 19, 1986, Investment Committee meeting, the recommendation to add $75 to $100 million of MBSs was approved. Ex. A-11137, Tab 1293 (Memorandum from B. Williams to Investment Committee, 06/19/86).

M124. According to the opinion of the FHLBB expert on MBSs, the action that USAT took in response to the 1985 interest rate decline was too little, too late to protect either the net interest spread, or the market value of the portfolios. Tr. 2,792: 18 - 2,793: 20 (Smith); Ex. B-2055, Tab 231, p. F000037. This is a conclusion with which Respondents’ expert, Carron, agreed. Tr. 28,464: 11-15; 28,466: 9-15; 28,466: 18 - 28,467: 2 (Carron).

III. Respondents’ Managers Of USAT Created A Subsidiary United Mortgage Finance, That Was Managed To Generate An Artificial Accounting Gain, Not To Generate A Net Interest Spread As USAT Had Represented

A. United Mortgage Finance Was Created As A Finance Subsidiary Of USAT In November 1985

M125. USAT’s October 28, 1985, revision to the Liability Growth Application represented that USAT had held $1,084,000 in MBSs as of June 30, 1985, and intended to invest the increase in liabilities in additional MBS RCAs, up to $1,584,000 by December 31, 1985. Ex. A-10575, Tab 178 (Letter from G. Williams to Green Re: USAT liability Gorwth, 10/28/85) p. CN052918. At the time, USAT was actively planning the creation of a finance subsidiary with the purported intention to make additional investments in MBS RCAs outside of the liability growth limitation applicable to USAT. Ex. A-10574, Tab 570 (Memo from Crow to G. Williams Re: Financing Sub updated, 10/24/85) p. OW002854.

M126. USAT intended to treat the new subsidiary as a separate entity for proposes of the liability growth limitation. However, USAT recognized that its attempt to avoid consolidation of the subsidiary for liability growth purposes might not succeed. In fact, USAT was advised that “the definition of a reverse repurchase agreement as a security,” which was essential for the scheme, “[was] an aggressive interpretation according to our legal staff.” Ex. A-10574, Tab 570 (Memo from Crow to G. Williams Re: Financing Sub updated, 10/24/86) p. OW002855.

M127. USAT managers concluded that “[a]ssuming th[e] transaction does not work in that the new regulations would require consolidation with the parent, it would be our intent to place the MBSs and the associated reverse repurchase agreement back into USAT. . . consistent with our prevall business plan.” Ex. A-10574, Tab 570 (Memo from Crow to Williams Re: Financing Sub updated, 10/24/85) p. OW002855.

M128. On October 25, 1985, USAT’s Asset/Liability Committee decided to establish the finance subsidiary and apply to the FHLBB for permission to place up to $500 million in securities in the subsidiary, reserving until the October 28, 1985, Executive Committee meeting a decision as to the actual size of the portfolio and hedging devices to be employed. Ex. A-1619, Tab 501 (Asset Liability Committee Meeting Minutes) p. OW120949.

M129. On November 1, 1985, USAT’s Asset/Liability Committee discussed Crow’s “Short Term Tactical Planning” memorandum, that reported that USAT had the “opportunity to add up to $400 million in liability growth by 12/31/85, but this needs to be managed closely given the current unknown status of the branch sales and financing subsidiary.” Ex. A-1620, Tab 502 (Asset Liability Committee Meeting Minutes) p. OW120947.

M130. On November 7, 1985, USAT’s Executive Committee authorized the creation of United Mortgage Finance with $500 million in MBSs funded with reverse repurchase agreements that were hedged with $500 million notional amount of swaps. Ex. A-1216, Tab 1388, p. CN124566.

M131. On November 14, 1985, the USAT Board of Directors authorized the capitalization of United Mortgage Finance with $6 million, based upon the decision that the Executive Committee has determined it is in the best interest of USAT, authorized the activities recommended by the Executive Committee, and ratified all previous actions taken to create United Mortgage Finance. Ex. A-1108, Tab 131 (Minutes of USAT Board of Directors meeting) p. US-3 003107.

M132. The previous actions ratified by the Board of Directors included the purchase of the securities to settle on November 15, 1985, and negotiation of a swap agreement to be completed before November 22, 1985, “the expected date of a final regulatory ruling on the financing sub.” Ex. A-1622, Tab 504 (Asset Liability Committee Meeting Minutes) p. OW120944.

1. USAT Was Close To Failing Its Minimum Net Worth Requirements Between August 31, 1985, And December 31, 1985

M133. In the fall of 1985, it was apparent to USAT that the shift to a wholesale strategy had not produced the increase in earnings that was anticipated. On August 21, 1985, Crow informed B. Williams that, “[h]ere is an excellent opportunity for us. In early September, we need to put together a slide show (we want to spend some money and get some sexy looking slides) for Mr. Hurwitz as to why we cannot make money at United Savings.” Ex. A-10567, Tab 852 (Memo from Crow to B. Williams) p. OW010019.

M134. As of August 31, 1985, USAT computed its regulatory net worth at $184 million, $44 million above the required minimum regulatory net worth. Ex. A-10576, Tab 853 (Memo from Crow to Gross) p. CN055416.

M135. As of October 31, 1985, USAT computed its regulatory net worth at $180 million, only $22 million above the required minimum regulatory net worth. Ex. A-10585, Tab 854 (USAT Performance Report, 11/26/85) p. CN055416.

M136. B. Williams reported in a November 26, 1985, USAT memorandum that USAT’s operations were deteriorating at the end of 1985. He explained that, as reported in a October 31, 1985, USAT performance report:

Net interest income fell $854,000 below October’s plan primarily as a result of the cost-of-carry on non-accrual loans and real estate foreclosed. Non-accruals averaged $46 million ($30 million planned) while real estate foreclosed averaged $59 million ($17 million planned) for the month. The base net interest spread in October was 1.40% compared to a plan of 1.56% and produced most of the unfavorable base net interest income variance. Sales of higher yielding corporate securities and loans earlier in the year for substantial gains contributed to the margin variance.

Ex. A-10585, Tab 854 (USAT Performance Report, 11/26/85) p. CN055408.

M137. On November 30, 1985, USAT computed its regulatory net worth at $180.1 million, only $16.8 million above its regulatory minimum net worth of $163.2 million. Ex. A-5008,Tab 555 (USAT Performance Report, 12/20/85) at Schedule AE.

2. In Order To Keep A Cushion Above The Regulatory Minimum, USAT Was Instructed By Hurwitz To Show A $1.5 Million Profit Per Quarter

M138. In response to this reduction in profitability, the minutes of USAT’s Group Managers Meeting of November 4, 1985, which Berner, Crow, Gross, Huebsch, Munitz and G. Williams attended, emphasized that “[w]ith ’86 planning and end of year approaching, [USAT] need[ed] to look for ways to enhance profitability.” Ex. A-13047, Tab 1207 (Meeting of 11/04/85) p. CN715583.

M139. At the November 17, 1985, Strategic Planning Committee, it was emphasized that USAT should “get Net Worth-target internally to 4%,” in a discussion in which Hurwitz directed that USAT needed to avoid quarterly losses; try to time gains to smooth out earnings; USAT’s goal should be not to show a quarterly loss in 1986; try for $1.5 million profit per quarter. Ex. A-1590, Tab 1295 (Strategic Planning Committee Minutes) p. US-3 008032.

M140. As recorded in an internal memorandum dated November 29, 1985, Hurwitz’s directions were adopted by USAT:

Based upon our November 17, 1985 Strategic Planning Meeting, it was agreed 1986 liability growth should fall within the following constraints:

1). Maintain a minimum regulatory capital to assets ratio of 4.0%, and

2). Report a gradual stable earnings record throughout the year. This precludes recognition of an large gains to build capital. Any significant gains from sales of real estate, branches, or loan servicing, etc. would be offset by provisions for reserves.

Ex. B-665, Tab 1391 (Memo from B. Williams to Gross, G. Williams and Core Re: 1986 Liability Growth) p. OW003550.

3. Respondents’ Managers Of USAT Sold $350 Million Of United Mortgage Finance’s MBS In December Of 1985 To Generate An Accounting Gain Of $9 To $12 Million

M141. At an USAT Executive Committee meeting on December 12, 1985, attended by Hurwitz, USAT’s managers discussed the new financing subsidiary regulations. After full discussion, it was decided that Mr. Berner should keep in daily contact with Washington representatives, to determine the status of the effective date of such regulations and a decision on the company’s course of action would be made by the Executive Committee after the issue was resolved. Ex. A-1219, Tab 1438 (USAT Executive Committee Meeting) p. OW010979.

M142. The Executive Committee also discussed several alternative actions:

Sell the MBS for a gain of about $15 million. This would reduce reliance on the branch sale to report fourth quarter earnings and provide a cushion for loss reserves, [or] [s]ell or maintain the $400 million interest rate swaps. A December sale would reduce the $15 million MBS sales gain. Swap sales could be delayed until 1986 and offset by gains on sales of servicing, real estate, branches, etc., [or] not sold.…[and] used as a general hedge. . . . 

Ex. A-1220, Tab 1390 (Agenda USAT Executive Committee Meeting, 12/12/85).

4. Respondents’ Managers Of USAT Entered Into A Mirror Swap When They Sold The $350 Million Of Mortgage-Backed Securities Out Of United Mortgage Finance That Had The Effect Of Deferring Losses On The Liability Side Of The Transaction

M143. Prior to December 31, 1985, USAT sold $350 million of the $500 million in MBSs held by United Mortgage Finance and retained the swaps in USAT, and purchased $350 million of the reverse of the swaps that were originally purchased as hedges. As reported by Gross to Hurwitz and Munitz, and others, on December 17, 1985:

Based on my conversations with Ron Huebsch and Joe Phillips today, I think where we have finally wound up on this $500,000,000 sub is as follows:

They are going to end up retaining the Solomon (sic) swaps, the Morgan assets and the Drexel flex-repos to the extent of about $150,000,000. They are going to end up liquidating the remaining assets which are going to generate an income of about $11,000,000 this year. They are going to reverse the swaps and keep them intact . . . , which should end up have the net result of spreading a loss over the five to seven year period of about the same amount of money.

Ex. B-697, Tab 1310, p. CN253185.

M144. USAT entered into a swap transaction with a notional amount of $350 million in which it was a recipient of the fixed rate and a payer of the variable rate, in effect offsetting with what is referred to as a mirror swap of the swaps it purchased to hedge that portion of the United Mortgage Finance subsidiary. Ex. A-10594, Tab 571 (Memo to the File, 01/10/86) p. US-0000885.

M145. USAT, in effect, closed out $350 million of its swap positions with swaps of different fixed rate, the effect of which was to create an annual expense for the life of the swaps as the result of the transaction. Ex. A-10594, Tab 571 (Memo to the File, 01/10/86) p. US-0000885.

M146. USAT did not treat the mirror swaps as the termination of the hedges and recognize the expenses in 1985. Instead it, in effect, deferred the new expense over the life of the swaps. Ex. A-10594, Tab 571 (Memo to the File, 01/10/86) p. OW 002852.

M147. USAT earned $1.8 million in net income in the fourth quarter of 1985, approximately the targeted amount budgeted in accordance with Hurwitz’s directives at the Strategic Planning Committee meeting of November 17, 1985. Ex. A-1590, Tab 1295, p. US-3 008032-8033. In order to achieve this result, USAT recognized as non-interest income $21.2 million in gains on the sale of securities, of which $12.5 million was gains on the sales of MBSs which “were largely produced by the liquidation of $350 million of the $500 million financing subsidiary established in late November.” Ex. A-5010 (T-4166), Tab 557 (Performance Report, Fourth Quarter and Total 1985 Performance, 02/27/86) pp. US 0001113 and US 0001115.

M148. USAT exceeded its minimum regulatory net worth requirement of $173 million by only $14 million as of December 31, 1985. USAT would have failed its minimum regulatory net worth requirement by $16 million had USAT not recognized the gains on the sale of the $350 million in MBSs from the United Mortgage Finance subsidiary, while deferring the losses on the corresponding swapped liabilities. Ex. A-5009, Tab 556 (USAT Performance Report, 01/31/86) p. 4.

M149. Reflecting the previous decision of the Strategic Planning Committee to show a $1.5 million dollar quarterly profit, and to maintain a cushion over the regulatory minimum capital requirement, Gross explained to Hurwitz and Munitz that the net result of the unwinding of United Mortgage Finance (combined with other contemplated actions) would put USAT “…in the situation of having about a $2,000,000 or $2,500,000 profit in the 4^th quarter, which is about where we would like to be.” Ex. B-697, Tab 1310 (Memo from Gross to Hurwitz and Munitz, et al., 12/17/85) p. CN253185.

B. The Managers Of USAT Knew That The Gains USAT Recorded On The Sale Of The $350 Million In Mortgage Backed Securities Were Illusory And The Result Of An Accounting Anomaly That Did Not Reflect Economic Reality

M150. In January 1986, Huebsch proposed a bonus plan for the investment group at USAT. G. Williams reviewed the proposal and made the following comments:

Due to the unique attributes of United’s Investment Department, we have been asked to approve a bonus program for that group effective January 1, 1986. In that regard, I have reviewed a preliminary proposal from Ron Huebsch to Charles Hurwitz outlining his ideas for a bonus program (attached).

I believe Ron’s proposal is too complex and could develop unwarranted gains or losses for the department simply because of interest rate movements in the money market. . . .

Ex. A-10597, Tab 855 (Memo from G. Williams to Hurwitz, Munitz, Gross Re: Bonus Plan, 01/21/86) p. CN057161.

M151. In a January 24, 1986, memorandum Gross responded to G. Williams’ proposal for a bonus plan, admitting that MBS sales produced illusory profits:

Before I comment on the Investment Department Bonus Plan, the type of thing that I am especially interested in looking at, is Schedule SF, page 2. He deals with the profit contributions from the mortgaged backed securities. In trying to determine the profitability aspect, I think, . . . you need to know . . .  is again on the sale of securities whether these are real sales or just window dressing sales. Are these really honest to goodness sales that still leave us with the same yield that we had before, rather than a lower yield? We need to take a look at it. It is even going to be more important on the junk bonds. If we take a $10 million profit, but choke down 50 basis points on our spread, we have penalized our profits for the next five to ten years on our portfolio to get that profit.

Ex. A-10599,Tab 856 (Memo from Gross to G. Williams Re: Bonus Plan) p. CN052999, (emphasis added).

M152. This acknowledgment that taking current profits could curtail future profits was not an aberration at USAT. As reflected in a January 6, 1986, USAT memorandum, USAT’s senior management knew, as Gross wrote: “I would say that [Huebsch] would have had a better return on investment had we not taken profits during the year, which had the net effect of reducing his spread.” Gross also wrote that “. . . there is no question that the arbitrage situation has not worked out as well as hoped.” Ex. A-10593, Tab 1309 (Memo from Gross to G. Williams) p. CN055780.

M153. In a February 28, 1986, USAT memorandum concerning the $30 million securities gains for 1985, Gross wrote to Hurwitz and Munitz stressing the point that the sale of MBSs and recognizing the gains while deferring the losses on the swapped liabilities is not an economic profit:

Here is my question. . . On the sale of securities, where we booked a $30 million gain for the year, I realize that a lot of this was selling the mortgage-backed securities and junk bonds. In one case, taking the gain on the mortgage-backed securities ($8 or $9 million) and the offsetting loss would be spread over several years. That is not truly a gain. The taking the junk bond profits and distinguishing between a junk bond profit that is a true profit, where there was no matching Jumbo CD or only counting as a profit if, in fact, we reinvest it at no reduced yield when we repurchased a Jumbo CD.

I’ll try to cite an example. . . if we had a 15% Jumbo CD matched against a 12½% CD and sold it at a million dollar profit, if we reinvested that money in a 14%, we now only have a 1½% yield. We have really reduced our yield to the extent that we took the profit. So it really was not a profit. On the other hand, we had more money to invest, so we still came out even. It is not a profit as opposed to the one being shown. The question in my mind now is, how much of these are honest to goodness profits? How much profit merely for book purposes that we had to reinvest at lower interest rates? Then, we can really tell what we did in that category. Over how many years do we spread the loss on the swaps on that mortgage-backed security in December and what was the exact amount of it?

Ex. A-10612, Tab 861 (Memo from Gross to Crow, Hurwitz and Munitz Re: December 1985 Performance Report) p. CN053239.

M154. USAT was advised by its General Counsel, by a memorandum dated December 11, 1985, that it did not have to count the liabilities of United Mortgage Finance toward the liability growth of USAT until March 31, 1986, at the earliest, if the reverse repurchase agreements did not roll over until after January 1, 1986. The rollover would not take place until after January 1, 1986, based on the schedule adopted by the Asset/Liability Committee. Ex. B-690, Tab 585 (Memo from Pledger to Gross, G. Williams, Munitz, Crow, Berner, Wolfe, Phillips and B. Williams Re: Recent FHLBB finance subsidiary regulations) p. OW031620.

M155. The reverse repurchase agreement that financed the MBSs held by United Mortgage Finance did not rollover until February 1986, as reflected in USAT’s Asset/Liability Committee’s minutes, at which time USAT would “officially dissolve the entity and consolidate the assets, liabilities, and swaps into USAT.” Ex. A-1626, Tab 508 (Asset/Liability Committee Meeting, 02/13/86) p. OW120940.

C. Respondents’ Managers Of USAT Knew That They Had The Flexibility To Hold Or Sell The Mortgage-Backed Securities In The United Mortgage Finance Portfolio And Satisfy The Liability Growth Limitation

M156. As of November 29, 1985, the managers of USAT knew that its “1986 liability growth [could] be limited to about $737 million. . . .” Ex. B-665, Tab 1391 (Memorandum B. Williams to Gross and Crow Re: 1986 Liability Growth) p. OWO3550.

M157. The managers of USAT knew, as reflected in the Asset/Liability Committee report of December 2, 1985, “[t]he goal at year-end would be to show the largest balance possible to use as a base for future growth. . . . The growth at year-end will likely come in the form of temporary investment in treasury securities funded with reverse repos [repurchase agreements].” Ex. A-1623, Tab 505 (Asset/Liability Committee Minutes) p. OW120943.

M158. The managers of USAT also knew, as reflected in the Asset/ Liability Committee report of January 14, 1986, that liquidity “[r]emains unusually high due to the year-end sales of securities and the recent sale of equity arbitrage stocks.” Ex. A-1624, Tab 506 (Asset/Liability Committee Minutes) p. OW120942.

M159. USAT was well within its March 31, 1986, liability growth limitation from the time it decided to liquidate $350 million of United Mortgage Finance’s MBS RCA. As of November 30, 1985, USAT’s regulatory liabilities were $4.363 billion, $317 million under its regulatory limit of $4.68 billion as of December 31, 1985. Ex. A-5008, Tab 555 (USAT Performance Report, 12/20/85) at Schedule AE; A-5009, Tab 556, p. 4. USAT’s regulatory liabilities of $4.363 billion on November 30, 1985, were also $389 million under its regulatory liability limit of $4.752 billion as of March 31, 1986. Ex. A-5008, Tab 555 (USAT Performance Report, 12/20/85) at Schedule AE; A-5010 (T-4166), Tab 557 (USAT Performance Report, February 1986) p. US 0001676.

M160. USAT’s regulatory liabilities were $4,430 million as of January 31, 1986, $322 million under its regulatory limit of $4,752 million as of March 31, 1986. Ex. A-5010 (T-4166), Tab 557 (USAT Performance Report, First Quarter 1986, 02/07/86) p. US 0001729.

M161. USAT regulatory liabilities were $4,650 million as of March 31, 1986, $102 million below the regulatory minimum of that date. Ex. A-5010 (T-4166), Tab 557 (USAT Performance Report, First Quarter 1986, 02/07/86) p. US 0001729.

M162. In addition, USAT purchased over $700 million in junk bonds and corporate stock between December 1, 1985, and March 31, 1986. If less than half of that $700 million had not been purchased, USAT could have continued to hold the $350 million in MBSs and met the March 31, 1986, liability growth limit. USAT purchased $252.8 million in junk bonds and corporate stock in December 1985. Ex. B-816, Tab 617, p. CN15964. USAT purchased $177.2 million in junk bonds and corporate stock in January 1986. Ex. B-866, Tab 619, p. CN159544.

M163. USAT owned $565.8 million in junk bonds and corporate stock on November 30, 1985. Ex. B-796, Tab 616, p. CN156649. USAT purchased $98.5 million in junk bonds and corporate stock in February 1986. Ex. B-935, Tab 621, p. CN159536. USAT purchased $196.8 million in junk bonds and corporate stock in March 1986. Ex. B-956, Tab 623, p. CN159478.

M164. As Crow testified, the business purpose of creating United Mortgage Finance was to “create spread income that would be exempt from the liability growth regulations” and when “it became apparent that just wasn’t going to work” Respondents’ managers of USAT “made a business decision to collapse the sub. Tr. 16,639: 19 - 16,640: 3 (Crow).

IV. Respondents’ Managers Of USAT Began To Sell Mortgage-Backed Securities Out Of USAT’s Risk-Controlled Arbitrage In The Second Quarter Of 1986 To Realize Gains To Bolster USAT’s Net Worth

M165. $350 million of the United Mortgage Finance subsidiary MBSs were sold in late November 1985. The remaining $150 million of MBSs were integrated into USAT MBS RCA. Ex. A-5010, Tab 557 (USAT Performance Report, First Quarter 1986, 02/07/86) Ex. A-10594, Tab 541, p. US-3 01073.

M166. Joe Phillips reported in his schedule, prepared contemporaneously with the purported rolldown, that gains of $32,118,000 were realized on the 15 transactions he identified as the rolldown. Of this amount, only one third was a gain on MBSs exchanged for coupons within 50 basis points of those sold. Ex. A-10631-J, Tab 572 (Phillips list).

M167. At the time the rolldown began, as Joe Phillips testified, the managers of USAT believed the gains on the sale of the MBSs were to be recognized as income to USAT as they had been advised to do by Peat Marwick. Tr. 5,592: 3-10 (Phillips); Ex. B-819; Tab 586, pp. 1-2.

M168. Peat Marwick, USAT’s outside auditor, recorded in its work papers that “[U]nited understands the economic reason for [loss recognition on the swaps to offset the gains on the sale of the MBS], however, and has agreed to start offsetting all such gains in 1986 so that their spreads will not be distorted.” Ex. B-819, Tab 586 (UFG Memo Re: Interest rate swaps, 12/31/85) pp. 1-2.

M169. USAT reported a net income of $1.6 million for the first quarter of 1986. USAT met this target imposed by Hurwitz at the November 17, 1985, Strategic Planning Committee meeting with $25.9 million in non-interest income that “far exceeded the planned $9.4 million due to income from equity arbitrage and gains on the sale of corporate securities.” Ex. A-5010, Tab 557 (Performance Report, First Quarter 1986) pp. US 0001726 and 0001729.

M170. Consequently, in the first quarter of 1986, USAT deferred the gains from the sale of mortgage-backs “‘rolling them’ into the basis of newly purchased securities.” Ex. A-5010, Tab 557 (USAT Performance Report, Second Quarter 1986, 02/07/86) p. US0001762.

M171. As of April 30, 1986, USAT was only $10 million above its regulatory minimum net worth of $181 million. Ex. A-5010, Tab 557 (Performance Report, April 1986) p. US 0001736.

M172. On April 17, 1986, USAT’s management was requested, in response to questions raised at a recent Strategic Planning Committee meeting, to provide Hansen with their:

comments as to the relative priorities of the following issues raised at our meetings and please indicate the issues for which you will take primary responsibility. I will revise this memo and circulate it again with priorities and responsibilities assigned.

4. PROFIT TARGETS: Our goal has been to show small quarter to quarter earnings increases. If we took larger write-offs each quarter, however, we could make a quick payback by paying off debt at an initial loss. The most important thing is to show some profits each quarter, not necessarily increasing profits. Need to trade this off versus credit watch and the state, who would like to see increasing profits.

6. TIMING OF GAINS: While the branch sales and the Weingarten sales are expected to occur second quarter, we should plan for them to occur third quarter. We should see how the second quarter looks without these gains.

Ex. A-10623, Tab 863 (Memo from Hansen to Board Re: Mustang Island) pp. OW00575-526.

M173. On April 21, 1986, Crow wrote to Munitz and stated:

As you requested, the following are thoughts concerning revenue improvement. For the foreseeable future, continue to take extraordinary profits from asset sales (loan servicing, loan sales, bonds, branches, etc.) in order to provide some level of modest profitability. The bulk of the gains however should be used to bolster reserves and take losses to dispose of REO and related problem assets as quickly as possible.

Ex. T-4190, Tab 1202 (Memorandum from Crow to Munitz, Re: Revenue Enhancement) p. US 0001933.

M174. On April 22, 1986, Crow responded to Hansen’s memorandum of April 21, 1986, stating that the profit targets are a “[h]igh priority [and] [w]ill be discussed in Strategic Planning Committee.” As to the timing of gains, he said that “[w]ithout any special gains, the second quarter will be grim. Unless we let our reserves slide precipitously, we will show a loss.” Ex. A-10628, Tab 864 (Memo from Crow to Hansen Re: UFG priorities, Mustang Island follow-up) p. CN055440.

M175. On April 24, 1986, Crow emphasized the need for gains from the sale of investment securities in a memorandum to Gross and G. Williams:

In the spirit of bad news to the top - this is something I am sure you are aware of but I thought I would remind you. It appears that several of the gains that we had counted on to bolster second quarter profits may be deferred/not occur: (1) branch sale to Merabank; (2) consumer loan to Security Pacific; (3) sale of Weingarten Stock.

Should none of these transactions close (or at least get to a state where we can book an accounting profit) second quarter earnings will probably be at a loss position unless: (1) we can allow our reserves to slide substantially. This may be impossible unless scheduled items decrease; (2) Equity arbitrage has an outstanding performance for the quarter.

I am unaware of any significant opportunities to take additional bond profits (as we did in the first quarter) or any pending real estate sales which would produce a profit.

Ex. T-4192, Tab 565, p. OW029896.

M176. On May 27, 1986, in a memorandum to Hurwitz, Munitz and Gross, Crow identified sources of gains from investment securities that could produce needed gains:

A portfolio of mortgage-backed securities held for general purposes (not part of the structured arbitrage program) was recently sold producing a gain of approximately $3.5 million. Since quarterly earnings will be adequate because of the sale of Weingarten Realty stock and equity arbitrage profits, a decision needs to be made as to the disposition of this gain. In a recent meeting, we suggested that the Olney bond be called in order to improve future period operational profitability. This memo will summarize other possible uses of the gain.

Ex. A-10637, Tab 865, p. US0001941.

M177. In a June 26, 1986, memorandum to Hurwitz, Gross, and Munitz, Crow summarized USAT’s need for capital to satisfy its regulatory minimum net worth requirement and how it had been met in the first and second quarters of 1986:

Attached are two schedules that attempt to segregate earnings performance between operating and non-recurring items. While there may be a disagreement as to what is operating and non-operating, a definitive conclusion can be drawn from the schedules. That is, with the company’s present structure, operating earnings are significantly negative without an extraordinary earnings boost on a monthly basis. For the first five months of 1986, the Association has a net loss of approximately $4.5 million per month excluding extraordinary gains. This figure excludes any provision for loan losses.

Ex. T-4219, Tab 868, p. US0000422.

A. Respondents Recognized Gains On Additional Sales Of USAT’s Mortgage-Backed Securities In The Second Quarter Of 1986, Restated Its Financial Statements For The First Quarter Of 1986 To Recognize The Previously Deferred Gains, And Did So Without Recognizing The Offsetting Losses On The Hedged Liabilities

M178. USAT incurred a $26.7 million net loss in the second quarter resulting from a $39.2 million provision for loan and real estate losses. This loss was offset by an increase in net income in the first quarter of $25.2 million caused by the change in accounting treatment to the recognition of the gains on the sale of the MBSs in the purported rolldown. The performance report stated: “In June it was determined that proper accounting would be to recognize gains/losses at the time of sale, thus requiring a restatement of first quarter earnings.” Ex. A-5010, Tab 557 (Performance Report, Second Quarter 1986 Performance Report, 08/05/86) p. US0001762.

M179. As described below USAT did not recognize the market value losses on the swaps at the time. FOF M532.

B. Respondents’ Recognition Of Gains On Sales Of The Mortgage-Backed

Securities Without Recognition Of The Losses On The Hedged Liabilities Permitted USAT To Meet It’s Net Worth Requirement As Of June 30, 1986

M180. As a result of the restatement of first quarter earnings, the recognition of the gains on the MBSs in the second quarter, and other gains on sales of investment securities, USAT’s net worth was reported to be $229 million as of June 30, 1986, $46 million above the regulatory minimum. Ex. A-5010, Tab 557 (Performance Report, Second Quarter 1986 Performance Report, 08/05/86) p. US0001765.

M181. Without the recognition of the $67 million of gains on the sales of MBSs in the first half of 1986, USAT would have failed its regulatory minimum net worth requirement.

Ex. B-3861, Tab 1304 (Memo from B. Williams to Gross, J. Williams and Crow, 11/24/86) p. CN128004.

C The Effect Of Respondents’ Managers Of USAT Continuation Of The Sales And Repurchase Of Lower Coupon Mortgage-Backed Securities Through The Second Quarter Of 1986 Produced A Negative Net Interest Spread, Created A Substantial Market Value Loss, And Increased The Interest Rate Risk To The Portfolios

M182. As reflected in memoranda to Hurwitz and other USAT managers, the sales and repurchases out of the USAT MBS RCA portfolios in the first and second quarters had produced a negative spread and had created a substantial market value loss in the portfolios. Ex. T-4311, Tab 189 (Memorandum from G. Williams to Hurwitz, Gross and Munitz, Re: USAT Running Rate - Product Line P&L, 11/24/86); Ex. T-4213, Tab 331 (Memo from B. Williams to Gross, G. Williams and Crow Re: Analysis of Investment’s MBS Arbitrage Portfolio) p. 003076.

M183. USAT retained Smith Breeden, the outside consulting firm that specialized in advising savings and loan associations, in June of 1986. Ex. B-967, Tab 1127 (Letter from G. Williams to Smith, 05/02/86) p. 000024; B-4196, Tab 1128 (Fee statements from Smith Breeden Associates).

M184. Smith Breeden advised USAT that the sale and repurchase of lower coupon MBS had negatively affected the net interest spread and market value of the hedged portfolios and that continuation of the activity would increase the negative impact. Ex. T-4222, Tab 330 (Memo from Crow to Gross and G. Williams Re: Summary of Smith Breeden Presentation, with attached financial statements, 07/03/86); A-10653, Tab 1205 (Memo from Hansen to Gross Re: Smith Breeden, 07/24/86) p. OW00596.

M185. As reported in a memorandum dated June 30, 1986, Smith Breeden advised USAT that approximately $1.9 billion in book value of MBSs had a negative market value of $58 million. Smith Breeden also reported that if rates moved up 200 basis points the loss would increase an additional $58 million to $116.5 million and if rates moved down 300 basis points the loss would also increase by $35.5 million to $93.6 million. Ex. A-13005, Tab 1122 (Smith Breeden’s Analysis of MBS Interest Rate Swaps, Caps and Collars) pp. OW006150-6151.

M186. Smith Breeden also advised USAT in the June 30, 1986, memorandum that the “[c]hange in the value of the mortgage prepayment option [was] not being hedged with swaps, caps, and collars,” resulting in the above described “[p]ortfolio loses for interest rate moves in either direction.” As a result, Smith Breeden “[s]uggest[ed] hedging the prepayment option via the purchase of options contracts.” Ex. A-13005, Tab 1122 (Smith Breeden’s Analysis of MBS Interest Rate Swaps, Caps and Collars) pp. OW006157-1691. See also, Ex. T-4222, Tab 330 (Memo from Crow to Gross and G. Williams Re: Summary of Smith Breeden Presentation, with attached financial statements) p. OW011941; A-10653, Tab 1205 (Memo from Hansen to Gross Re: Smith Breeden) p. OW005961.

M187. As the minutes of USAT’s Asset/Liability Committee meeting of July 25, 1986, reveal, USAT understood the significance of the Smith Breeden analysis. As recorded in the minutes: “in general the analysis concluded that the Association is in a position where it would lose a significant amount of market value if rates were to shift either up or down,” despite the fact that the gap position was not a problem on a consolidated basis. Ex. A-1635, Tab 517 (Asset Liability Committee Meeting Minutes) p. OW120924.

M188. The results of the Smith Breeden analysis of the MBS RCA held in USAT was confirmed by another Smith Breeden analysis of the Valuation and Sensitivity of United Savings prepared on August 14, 1986, that excluded the MBSs funded through the DART and ARP subsidiaries included in the early June 30, 1986, study. Smith Breeden found in this second analysis that the MBSs had a mark-to-market gain of $61 million, while the swaps had a mark to market loss of $118 million, for a net loss of $57 million as a result of the sales and repurchases made in 1986. Ex. A-10659, Tab 1123 (Smith Breeden’s USAT Valuation and Sensitivity Analysis) p. OW005986.

M189. Smith Breeden representatives met with Hurwitz, Munitz and other senior management of USAT on September 15, 1986. Ex. A-10665-1, Tab 1125 (Memo from Hansen to Hurwitz, et al. Re: Growth and Capital Strategy) p. 000919. Smith Breeden explained the results of its analysis of USAT’s MBS RCA. It reported that the MBS had a $6.5 million unrealized mark-to-market gain, the CMO’s (Net) a mark-to-market loss of $11.3 and the swaps a mark-to-market loss of $122 million, as of July 31, 1986. Ex. A-10666, Tab 870 (USAT strategy meeting) p. CN053081.

M190. In response to questions from OTS’s counsel, Phillips admitted in his testimony that the portfolio was basically unsalvageable as of June 30, 1986, and as a consequence of the condition the portfolio was in, he could no longer add value to the portfolio by rebalancing transactions. Tr. 5,285: 12 - 5,287: 22 (Phillips); Ex. A-10649, Tab 187, p. OW005964; Tr. 5,280: 2 - 5,281: 4 (Phillips).

V. Respondents’ Managers of USAT Continued To Sell Mortgage-Backed Securities Out Of USAT’S Risk-Controlled Arbitrage In The Third And Fourth Quarters Of 1986

M191. After having sent the three above mentioned memoranda, Crow instructed USAT’s comptroller and Vice-President for Finance to “[a]t the request of several important parties, would you please begin thinking about 3^rd quarter profits? What are we going to do to ensure profitability?” Ex. A-10641, Tab 866 (Memo from Crow to Wolfe and G. Williams Re: Request for 3^rd quarter profits, 06/11/86) p. CN055488.

M192. In a June 23, 1986, USAT memorandum, Crow reported to Gross and Munitz that USAT needed non-operating gains to report profits in the third and fourth quarters. Among the options discussed was a sale of MBSs at a gain of $1.3 million, notwithstanding that “ongoing profitability would be diminished.” The memorandum also discussed a sale of junk bonds with similar results. Crow concluded that “[n]on-operating gains will be necessary to report profits for the third and fourth quarters, unless there is an extraordinary and unexpected turnaround in the level of scheduled items.” Ex. A-10645, Tab 867 (Memo from Crow to Gross, Munitz and G. Williams Re: 3^rd and 4^th quarter income planning 1986) pp. OW029899-901.

A. USAT’s Net Worth Levels In The Second And Third Quarter Of 1986 Were Precariously Close To The Regulatory Net Worth Minimum

M193. USAT’s regulatory net worth was $229 million as of June 30, 1986, $46 million above the regulatory minimum of $183.0 million. Ex. A-5010, Tab 557 (Performance Report, Second Quarter 1986, 02/07/86) p. US 0001765.

M194. USAT’s regulatory net worth was $254.1 million as of September 30, 1986, $42.3 million above the regulatory minimum of $211.9 million. Ex. A-5014, Tab 561 (Performance Report) at Schedule AE.

M195. USAT’s regulatory net worth was $248.9 million as of December 31, 1986, $19.6 million above the regulatory minimum of $229.3 million. Ex. A-5017, Tab 564 (Performance Report) at Schedule AE.

M196. As recognized in the July 14, 1986, memorandum prepared by Hansen for Gross:

Capital is going to be king over the next few years. We might consider having a long run target of building capital even above the raised regulatory minimum, to lower risk and increase ability to take advantage of opportunities. -- In the short run, our dwindling capital is our largest problem. – Implied worth of capital to United is very high due to necessity to survival we should be willing to pay a lot for capital. – High worth of capital means we should hesitate to realize losses for the next 18 months, even though long term economics may recommend doing so. Thus we should not call bonds or whatever at a loss. We should value very highly any opportunity to realize gains.

Ex. B-1102, Tab 378 (Memo from Hansen to Gross Re: Strategy for next 18 months) pp. OW000554-558.

B. USAT’S Portfolio Managers Were Instructed To Take Gains In The Third and Fourth Quarter Of 1986 In Order To Meet Hurwitz Profit

And Net Worth Targets

M197. At the September 15, 1986, Strategic Planning Committee meeting, described above, the participants, including Hurwitz, concluded that “GROWTH and CAPITAL [were] both needed in order to restore the viability of United Savings. . . . ” In conclusion, immediate strategies were discussed including those that would “[t]ake gains on portfolio to offset operating losses, [e]stablish economically offsetting positions which generate accounting income if interest rates move, [and] [i]ncrease consolidated assets through service corporations which will purchase mortgage-backed securities and hedge against interest rate risk.” Ex. A-10666, Tab 870 (USAT strategy meeting) p. CN053087.

M198. In a memorandum to the members of the Strategic Management Committee, Hurwitz and others were provided a summary of the conclusions reached at the September 22, 1986, meeting:

n Prospects for positive GAAP and RAP earnings are poor in 06/87.

n Our actual net worth will be the same as or below required net worth at the end of the third and fourth quarters unless action is taken.

n We need earnings and good net worth in the third quarter as we still will be bargaining with the examiners and looking for a capital note issue.

n There is a strong case for taking portfolio gains in the third quarter in order to shore up reserves in the capital position.

n Third quarter results need to be close to those forecast in the regulatory business plan.

Ex. T-4250, Tab 871 (Memo from Doug Hansen to Hurwitz, Gross, Munitz, G. Williams, Crow, Berner, Jim Jackson, and B. Williams, Re: Strategic Management Committee Meeting) Item 31 p. OW012018.

M199. The next day, September 23, 1986, a USAT memorandum reported that $11.4 million in gains were being taken to alleviate USAT’s earnings deficit, including approximately $1.9 million in projected gains from sales of MBSs. Ex. T-4251, Tab 567 (Memo from Crow to Gross and G. Williams Re: Needed gains for quarterly earnings) pp. US 0002075-076.

M200. An October 1, 1986, memorandum addressing the question of fourth quarter 1986 earnings, stated:

[f]ourth quarter 1986 results are projected to show a significant loss unless a miracle happens in equity arbitrage, increased values in our bond portfolios, or an unexpected sale of real estate at a profit. As you are aware, we utilized most of our asset gains in prior quarters.

Ex. T-4258, Tab 872 (Memo from Crow to Gross and G. Williams Re: Discussion Points - Fourth Quarter 1986 Earnings) p. OW011297.

M201. On November 17, 1986, Hansen summarized, in a memorandum to Hurwitz, Munitz and others, that the Strategic Planning Committee had decided to sell additional MBSs out of the RCAs to meet Hurwitz’s profit and net worth targets. Ex. T-4304, Tab 873 (Memo from Doug Hansen to Hurwitz, Munitz, Gross, G. Williams, Crow, B. Williams, and Berner Re: Strategic Planning Committee) pp. OW010029-030

C. USAT Met Its Regulatory Net Worth Requirement As Of December 31, 1986, By The Recognition Of Gains On Sales From Its Hedged Arbitrage Portfolios While Deferring The Mark-To-Market Losses On The Hedged Liabilities

M202. USAT’s regulatory net worth was $248.9 million on December 31, 1986, only $19.6 million above its minimum regulatory net worth requirement of $229.3 million. Ex. A-5017, Tab 564 (USAT Performance Report) at Schedule AE, p. 1.

M203. This $248.9 million included the $71.1 million of gains recognized by USAT on the sale of MBSs from its hedged arbitrage portfolios in 1986, while at the same time it deferred the losses of $122 million on its hedged liabilities. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175; T-4310, Tab 188 (Memorandum from B. Williams to Gross, G. Williams and Crow Re: Review of MBS/Swap Arbitrage Activities, 11/24/86) pp. OW012065-066.

M204. Without recognition of the $ 71.1 gains, USAT would have failed to meet its minimum regulatory net worth requirement by $50.5 million ($19.6 less $71.1) as of December 31, 1986.

D. The Pattern Of Gains On The Sales Of Mortgage-Backed Securities Out Of USAT’s Hedged Arbitrage Portfolios In 1986 At Or About The Time Quarterly Financial Statements Were Required To Be Filed With The FHLBB And SEC Indicate They Were Made To Meet Hurwitz’s Profit And Net Worth Quarters End Targets

M205. A total of $82.7 million of gains on the sale of USAT’s investment securities were reported for the calendar year 1986. Ex. A-5017, Tab 564 (USAT Performance Report, 12/00/86) at Schedule DJ.

M206. $71.1 million of the total gains of $82.7 million were from sales of MBSs out of USAT’s hedged arbitrage portfolios. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86, with exhibits, 12/31/86) p. CN 071175.

M207. Of the total of $82.7 million of gains made on USAT’s sales of investment securities in 1986, most were taken at the end of each quarter: $32.0 million was reported for March, $9.3 million for June, $14.5 million for September, and $23.2 for November and December of 1986, combined almost the entire amount of the gains reported for 1986. Ex. A-5017, Tab 564 (USAT Performance Report, 12/31/86) at Schelule DJ.

E. The Negative Effect Of Respondents’ Managers Of USAT Repeated Sales And Repurchases Of The Mortgage-Backed Securities In 1986 On The Spread, Market Value And Interest Rate Risk Of USAT’s Portfolios Was Substantial

M208. On November 24, 1986, an analysis was distributed to Hurwitz and other USAT management which explained:

Since the inception of the mortgage-backed security arbitrage program, the Association has recognized approximately $67 million in gains on sales through October 1986. These gains were largely attributable to the MBS-rolldown program from high coupon to current coupon securities. When combined with current unrealized gains of $12 million, the MBS arbitrage program has provided about $79 million in total gains compared to the interest rate swap mark-to-market loss of $122 million.

(chart omitted). Ex. T-4310, Tab 188 (Memo from B. Williams to Gross, G. Williams and Crow Re: Review of MBS/Swap Arbitrage Activities, 11/24/86) p. OW012064.

M209. In that same memorandum dated November 24, 1986, B. Williams wrote to Hurwitz, and other USAT management: “Based on our portfolio at October 31, 1986, the estimated net spread on the MBS arbitrage (excluding the new MBS subsidiary and AMPS) is negative .99% . . .  ” Ex. T-4310, Tab 188 (Memo from B. Williams to Gross, G. Williams and Crow Re: Review of MBS/Swap Arbitrage Activities, 11/24/86) p. OW012065.

M210. In another memorandum also dated November 24, 1986, Hurwitz, Munitz and other USAT managers were advised:

Attached is an analysis from Kurt Schwenkel to me regarding the USAT running rate. I believe this summary deserves your utmost attention. In essence, Kurt points out that the Association’s ‘base operation’ is losing at a rate of $77 million a year, up from $40 million in 1985.

… The most dramatic observation is that primarily as a result of selling the mortgage-backed securities in June, the net interest spread on the total assets classified as investments is now in a negative position (including the cost of swaps). Due to a decline in interest rates, the interest rate swaps, caps, and collars now cost us about $42 million annually.

Ex. T-4311, Tab 189 (Memo from G. Williams to Hurwitz, Gross and Munitz Re: USAT Running Rate - Product Line P&L, 11/24/86) p. OW001121.

M211. As explained in Finding M185 above, Smith Breeden’s analysis of the portfolios as of June 30, 1986, concluded that the MBSs when all hedge instruments were included contained a $58 million unrealized market value loss and would experience an additional loss of $42 thousand with a 100 basis point decline and an additional loss of $1.7 million with an increase of 100 basis points. Ex. T-4222, Tab 330 (Memo from Crow to Gross and G. Williams, 07/03/86) p. OW011940.

M212. The first sensitivity analysis prepared by Orr that appears in the December 4, 1986, Investment Committee minutes shows that the portfolios contained an unrealized market value loss of $88 million that would increase to $105 million if rates declined by 100 basis points and would increase to $116 million if rates were to increase 100 basis points. Tr. 3,860: 20 - 3,863: 13 (Orr); Ex. A-1421, Tab 352 (Investment Committee Minutes, USAT, UFG, 12/04/86) p. US-3 005137.

VI. USAT’S Portfolio Managers Were Instructed To Continue To Make Sales Of Mortgage-Backed Securities Out Of The Hedged Arbitrage Portfolios In 1987 In Order To Generate Gains To Meet Hurwitz’s Profit And Net Worth Quarters’ End Targets In The First Two Quarters Of 1987, And To Increase The Size Of The Mortgage-Backed Securities Arbitrage Portfolios In A Subsidiary That Came To Be Known As United Mortgage-Backed Security

M213. On February 20, 1987, Crow wrote that additional sales were needed out of the MBS RCAs in order to meet Hurwitz’s profit and net worth targets:

USAT will need between $18.0 and $20.0 million in equity arbitrage profits and bond gains for the months of February and March in order to break even for the quarter.

In February, we have booked approximately $7.5 million in profits from mortgage-backed securities gains and have recorded approximately $3.0 million in equity arbitrage profits (net of cost of carry). With the target for junk bond gains at $5.0 million to $7.5 million, we should fall comfortably within the range of required gains necessary to break even.

My suggestion is to stick with the $5 - $7.5 million target for junk bond gains and continue to take mortgage-backed securities gains as we can. Relook at the situation in early to mid March and revise the targets if appropriate.

Ex. A-1426, Tab 874 (Memo from Crow to Gross Re: 1^st quarter 1987 earnings) p. CN05372.

M214. Between January 1, 1987, and May 31, 1987, before interest rates rose to a point that there were no longer unrealized gains in the MBSs held in the arbitrage portfolios, USAT sold $4.21 billion in MBSs which it replaced with other MBSs for a total gain of approximately $20 million:

1. In January 1987, USAT sold $377.0 million of mortgage-backed securities for a gain of $3.6 million. Ex. A-5018, Tab 1337 (Performance Report, 01/31/87) at Schedule DH.

2. In February 1987, USAT sold $749.3 million of mortgage-backed securities for a gain of $8.98 million. Ex. A-5019, Tab 1338 (Performance Report, 02/28/87) at Schedule DH.

3. In March 1987, USAT sold $1.167 billion in mortgage-backed securities for a gain of $4.78 million. Ex. A-5020, Tab 1339 (Performance Report, 03/31/87) at Schedule DH.

4. In April 1987, USAT sold $670 million in mortgage-backed securities for a gain of $3.51 million. Ex. A-5021, Tab 1340 (Performance Report, 04/30/87) at Schedule DH, and

5. In May 1987, USAT sold $1.178 billion in mortgage-backed securities for a loss of $1.69 million. Ex. A-5022, Tab 1341 (Performance Report, 05/31/87) at Schedule DH.

A. Respondents’ Managers Satisfied USAT’s Minimum Net Worth

Requirement With the Gains On Sales Of Mortgage-Backed Securities In The First And Second Quarters Of 1987

M215. OMITTED.

M216. USAT’s unadjusted regulatory net worth was $278.8 as of March 31, 1987, $78.0 million above its regulatory minimum net worth of $200.8. Ex. A-5020, Tab 1339 (USAT Performance Report, 04/24/87) at Schedule AE.

M217. USAT’s unadjusted regulatory net worth was $275.7 as of April 30, 1987, $42.2 million above its regulatory minimum net worth of $233.5. Ex. A-5021, Tab 1340 (USAT Performance Report, 05/22/87) at Schedule AE.

M218. USAT’s unadjusted regulatory net worth was $258.9 million as of June 30, 1987, $39.2 million above its regulatory minimum net worth of $219.8 million. Ex. A-5023, Tab 1342 (USAT Performance Report, 07/24/87) at Schedule AE.

M219. USAT’s unadjusted regulatory net worth was $247 million as of September 30, 1987, $64 million above its regulatory minimum net worth of $183 million. Ex. A-5025, Tab 1344 (USAT Performance Report, 10/23/87) at Schedule AE.

M220. OMITTED.

B. The Continued Sales Of Mortgage-Backed Securities Out Of The

Portfolios In The First Two Quarters Of 1987 Further Increased The Negative Spread, Increased The Market Value Loss And Increased The Interest Rate Risk To The Portfolios

M221. As result of the sales made to generate gains subsequent to October 1986, the net interest spread on the MBS RCA held by USAT outside of the CMO’s and UMBS subsidiaries was a negative 1.8% as of May 30, 1987, almost twice the negative .99% it was as of October 31, 1986. Ex. A-1449, Tab 385 (Investment Committee Minutes, 06/25/87) p. US-3 006019.

M222. As a result of the sales made to generate gains subsequent to October 1986, the market value of the MBS RCA held by USAT outside of the CMO’s and UMBS subsidiaries was a negative $160 million as of May 27,1987, up from a negative $102.4 million as of January 21, 1987. Ex. A-1444, Tab 1316 (Investment Committee Minutes, 05/27/87).

M223. As a result of the sales made to generate gains subsequent to October 1986, the market value of the MBS RCA held by USAT outside of the CMO’s and UMBS subsidiaries would increase to a negative $201.6 million if interest rates rose by 100 basis points and decrease only to negative $118.6 million if interest rates declined by 100 basis points. Ex. A-1444, Tab 1316 (Investment Committee Minutes, 05/27/87).

M224. The extent to which USAT took advantage of the opportunity to sell MBS in order to meet Hurwitz’s profit and net worth targets is reflected in the turnover of the MBSs portfolios reported in UFG’s 10K’s. In the four quarters of 1986, USAT sold $4.78 billion and purchased $6.474 billion of MBSs, the difference reflecting the buildup in the portfolios. In the first quarter of 1987, ending on March 31, 1987, USAT sold $2.48 billion of MBSs and purchased $3.68 billion, the difference reflecting the buildup in the UMBS portfolio. In the first first quarter of 1987, prior to the increase in interest rates described above USAT sold $1.85 billion of MBSs and purchased $1.99 billion, the difference reflecting the completion of the buildup of the UMBS portfolio. In the third and fourth quarters of 1987 after interest rates had risen, as described in Finding M225, very few sales or purchases of MBSs were made. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 4, Section III, and Exhibit C.

M225. A significant interest rate increase occurred after March 31, 1987. 10-year Treasury rates were 7.51% on March 31, 1987, increased to 8.21% on April 30, 1987, and 8.49% on May 31, 1987, peaking at 9.63% on September 30, 1987. Ex. A-11012, Tab 244 (Expert Report of Darrell Duffie) at Table 4.3, p. 2.

M226. USAT had unrealized gains remaining in its MBSs outside of the CMO’s of $26.4 million as of January 21, 1987. Ex. A-1426, Tab 357 (Investment Committee Minutes USAT, UFG, 01/21/87) p. US-3 005224.

M227. As a result of the increase in interest rates in April and May of 1987, USAT had no unrealized gains to recognize by the sale of MBSs. Ex. A-1441, Tab 368 (Investment Committee Minutes USAT, UFG, 05/05/85) p. US-3 005696; A-1444, Tab 1316 (Investment Committee Minutes USAT, UFG, 05/27/87) p. US-3 005824.

M228. As a consequence, USAT dramatically decreased the amount of MBSs that it sold to generate accounting gains. In June 1987, USAT sold only $42 million in MBSs for a loss of $326,000. Ex. A-5023, Tab 1342 (USAT Performance Report, 06/30/87) at Schedule DH. In August 1987, USAT sold no MBS. Ex. A-5024, Tab 1343 (Performance Report, 08/31/87) p. 3. In September 1987, USAT sold no MBS. Ex. A-5025, Tab 1344 (USAT Performance Report, 09/30/87) at Schedule DH.

M229. Where the annualized turnover of the MBSs had been 354% as of December 31, 1986, 305% as of March 31, 1987, and 197% as of June 30, 1987, it fell to 2-3% on September 30 and December 31, 1987. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 4, Section III, and Exhibit C.

VII. RESPONDENTS’ REPRESENTATIVES ADMITTED THAT SALES WERE MADE TO GENERATE GAINS

M230. The OTS alleged in paragraph 145 of the Notice of Charges that the MBS arbitrage portfolios were not managed “to maintain a hedged net interest spread between the MBSs and their funding source, the hedged reverse repurchase agreements

. . . to minimize the risk in USAT’s large portfolios of MBSs,” but were managed “actively to speculate on changes in interest rates and traded in and out of MBSs to recognize gains without also recognizing losses on the other side of the transactions.

M231. The Respondents denied the allegations described in Finding M230 above, and Respondents’ Federated and Hurwitz asserted in their answer that “[t]ransactions in the MBS portfolios were undertaken for the approved purposes of rebalancing the portfolio, managing the asset yields, managing the degree of interest rate risk through hedge transactions, and keeping the assets and liabilities duration matched.” Answer, ¶ 145. Respondents did not state in their answer that sales and repurchases had been made in the portfolios to generate gains to bolster profits. Answer, ¶ 145.

M232. The Respondents’ assertions in their answers that the MBS portfolios were not traded to generate accounting gains, but were traded to minimize interest rate risks, was contradicted by witnesses at the hearing, after G. Williams admitted that sales of MBSs were made out of the RCAs [to generate gains] to bolster net worth. As G. Williams testified that the managers of USAT’s MBS portfolios were “always looking for profit and talking about what could be sold.  . .  to generate gains.” (G. Williams). Tr. 6,370: 16-21 (Orr).

M233. The portfolio manager in 1986 and 1987, Sandy Orr, explained in her testimony that she was aware of risk that USAT would fail its minimum net worth requirements when she was hired in October of 1986. As Orr testified: “I knew that we were in dire straits. So, it was important to realize earnings which would go directly into capital.” She testified that, as a consequence, she was authorized by the Investment Committee to make “value trades” to generate accounting gains in the MBS portfolio. Tr. 3,765: 9 - 3,769: 19 (Orr); See also, Tr. 12,523: 1 - 12,524: 6; Tr. 12,564: 15 - 12,565: 9 (Hansen); Ex. T-4190, Tab 1202 (Memo from Crow to Munitz, Re: Revenue Enhancement, 04/21/86) pp. OW010890-891.

M234. As Orr testified, the managers of USAT were consciously aware of the criteria that to recognize gains on the sales of the portfolios, the coupons, or maturities, or the issuers of the securities had to be different in order to qualify as sales and purchases. Accordingly, they adopted a policy she proposed that permitted her to trade the portfolios to generate gains in order to “enhance the profitability of the institution.” Tr. 3,763: 7-19; Tr. 3,834: 13 - 3,838: 15 (Orr); Ex. A-1412, Tab 343 (Investment Committee minutes, USAT, UFG, 10/08/86).

M235. Orr repeatedly made trades, authorized by the Investment Committee, to either increase the yield on the portfolio or to generate gains on the MBSs sold. Tr. 3,763: 7-19; 3,851: 20 - 3,852: 7; 3864: 9-15; 3,877: 18-20; 3,884: 7-14; 3,892: 15-18; 3,908: 3-8; 3,909: 3-6; 4,046: 0-7; 4,053: 15-20; 4,149: 11-15 (Orr).

M236. As Orr testified, in order for the sales to generate gains, and to maintain the yield and reduce the interest rate risk to the portfolios, the profits had to be reinvested in MBSs, which they were not. Instead, the funds were siphoned off for other purposes, primarily to offset losses in other USAT investments or fund the equity arbitrage or junk bond portfolios. Tr. 4,130: 9 - 4,131: 21; 4,151: 17-20; 4,177: 5-12 (Orr).

M237. After G. Williams’ admissions, Crow also testified in this proceeding that sales were made out of the MBS portfolio in order to generate accounting gains: “[C]ertainly we were taking gains out of our mortgage-backed securities portfolio to bolster profits.” Tr. 16,676: 1 - 16,680: 22 (Crow).

M238. As Orr testified, the managers of USAT’s MBS RCA portfolio were “extremely “actively” [active] in looking for trades that would generate gains. She stated that value trades, which included sales to generate gains to bolster profits, were sought on a daily basis in order to maintain regulatory capital levels. Tr. 4,154: 1-7 (Orr).

M239. As Hansen testified, the managers of the MBS portfolio timed gains to show a small profit each quarter. Tr. 12,515: 8-15; 12,580: 20 - 12,582: 3 (Hansen).

M240. In a memorandum written to Hurwitz and the other senior managers of USAT, Hansen summarized the results of a September 22, 1986, Strategic Planning Committee meeting:

We need earnings and good net worth in the third quarter as we still will be bargaining with the examiners and looking for a capital note issue. There is a strong case for taking portfolio gains in the third quarter in order to shore up reserves in the capital position. Third quarter results need to be close to those forecast in the regulatory business plan.

Quarter end actions will be considered next Monday. We should take all MBS and liquidity portfolio gains, monitor equity arbitrage results, alert Joe as to the possibility of taking junk bond gains, and track the profit and capital positions closely.

Hansen testified that the reason for the sales was to show the quarterly profits that had been previously established by Hurwitz as an objective for USAT. Tr. 12,515: 8-14; 12,589: 3 - 12,591: 8; 12,519: 9 - 12,520: 15; 12,580: 20 - 12,582: 3; 12,672: 13-22 (Hansen); Ex. T-4250, Tab 871 (Memo from Hansen to Hurwitz, Gross, Munitz, G. Williams, Crow, Berner, Jim Jackson and B. Williams Re: Strategic Management Committee Meeting, 09/22/86) pp. OWO12018-2019; A-10623, Tab 335.

VIII. Respondents Belatedly Attempted To Justify The Sales To Generate Gains

M241. The Respondents attempted to rationalize the sales of MBSs out of the RCA to generate gains as normal portfolio management to take advantage of temporary aberrations in the market. Tr. 2,837: 13 - 2,838: 11 (Carron).

M242. Respondents offered a report proposed by Andrew Carron, who had previously worked for an investment banking firm that had sold mortgage-backed securities to USAT and other thrifts. Tr. 27,874: 8 - 27,876: 14. Carron attempted to justify the sales of MBS as yield enhancement or convergence trades. Ex. B-4381, Tab 2030 (Carron Expert Report, 05/28/97) p. 21; B-4382, Tab 2031 (Carron Supplemental Report 01/05/99) p. 3.

M243. OMITTED.

M244. OMITTED.

A. Frequent Swaps Of Mortgage-Backed Securities In An Attempt To Capture Increments To Relative Value Was A Practice That Was Avoided By Most Portfolio Managers Because Of The Inability To Gauge The Success Of The Approach

M245. In the mid-1980’s, portfolio managers were unable to ascertain whether changes in relative prices of MBSs were due to the market recognition of different economic characteristics of mortgages with geographic differences, income level differences, different mixes of mortgage coupons between the pools or different maturities of the mortgages within the pools. Ex. B-586, Tab 239 (Report from Salomon Brothers by M. Waldman, M. Gordan, and S. Guteman); B-377, Tab 244 (Salomon Brothers October 1984 USAT Presentation, M. Waldman Article) pp. CN 253077, CN253084; B-1619, Tab 237 (Hjerpe, III, Risk - Controlled Arbitrage For Thrifts: Description and Associated Risk, 05/11/87) p. 10.

M246. When dealing with MBSs, active portfolio managers have been severely hampered by their inability to effectively measure the interest rate sensitivities. As a result, they have been unable to determine the extent to which a swap involving MBSs would alter the interest rate exposure of their portfolio and, consequently, could not meaningfully adjust these swaps to offset an undesirable impact on their net exposure to interest rates. Portfolio managers, therefore, were often reluctant to execute swaps involving MBSs, particularly those motivated by technical or fundamental considerations, fearing that such strategies may not be successful or at least not as effective as they could be if the interest rate sensitivities of these securities were better understood. Ex. T-4622, Tab 2045 (The Relative Price Volatility of Mortgage Securities, published by Morgan Stanley, Scott Pinkus, January 1986) p. 23.

M247. If the price volatilities of the securities involved in a given swap are different, as is usually the case, the extent to which their prices may appreciate or depreciate in a particular interest rate environment can differ significantly. Such a disparity in the price volatilities of the securities can have a substantial impact on the profitability of the swap under different interest rate scenarios, particularly when evaluated over a short-term horizon. Despite the yield advantage and greater cash flow income generated by the new security, the investor’s incremental total return might have been greater had he remained in the more volatile, lower yielding security. Ex. T-4622, Tab 2045 (The Relative Price Volatility of Mortgage Securities, published by Morgan Stanley, Scott Pinkus, January 1986) p. 24.

M248. As Orr testified, prepayment speeds change at different rates between different MBSs pools, and prepayment projections differed among dealers resulting in different estimates of the value of different pools of MBSs. Nevertheless, USAT traded the MBSs to enhance the value of the portfolios based upon Orr’s “best guess” from information she received from various dealers with whom USAT traded. Tr. 3,768: 20 - 3,769: 18; 3,771: 20 - 3,772: 14 (Orr).

M249. Opportunities to trade MBSs to increase yields or capture temporary aberrations in relative market prices were relatively rare in 1985-1987. Smith Breeden Associates estimated that in 1984-85, profitable swap opportunities averaged only twice a year. Ex. A-10654, Tab 1119 (An Introduction to Risk-Controlled Arbitrage) p. 00536.

B. Frequent Sales To Capture Small Incrementals Benefits Was Speculative

Activity

M250. USAT’s sales and repurchases of the MBSs to capture temporary aberrations in the market without closing the hedge at the time of the sale of the assets was speculative activity. Ex. B-1619, Tab 237 (E.A. Hjerpe, III, Risk-Controlled Arbitrage For Thrifts: Description and Associated Risks, FHLBB Office of Policy and Economic Research, 05/11/87) pp. 23 - 24.

M251. USAT’s buy-and-sell decisions based on a short-term speculative intent rather than long-term consistent profitability created a risk to the institution. Ex. B-4287, Tab 1850 (Office of Regulatory Activities, FHLBS Regulatory Handbook, Thrift Activities, September 1988) p. 450.3.

IX. Respondents Increased The Size Of The Portfolios In 1987 And Left Them Substantially Underhedged In Order To Speculate On A Decline In Interest Rates

M252. As reflected in the minutes of the Asset/Liability Committee of October 3, 1986, USAT increased the size of the MBS portfolios in a service corporation subsidiary known as UMBS, in the latter part of 1986 and early 1987:

Mortgage-Backed Securities Arbitrage Update – It was noted that a new subsidiary had been established and capitalized at $100 million to be utilized for Sandy Laurenson’s new mortgage-backed securities arbitrage activities. It was agreed that beginning next week we would work with Smith Breeden on contacting the investment bankers and getting approval for new lines of credit to support these activities.

One open issue which was to be resolved next week was whether the $100 million advance to support the arbitrages would have to be included for both direct investment and consolidated liability growth. Jim Wolfe indicated that the regulators required a consistent accounting method whereas Bob Pozen said we could consolidate for direct investment and not for liability growth.

Ex. A-1641, Tab 523 (Asset Liability Committee Meeting Minutes, 10/03/86) p. OW005934.

M253. USAT represented in correspondence with the investment bankers from whom it sought to purchase the MBSs that:

United Savings Association of Texas has established a new wholly-owned subsidiary (UMBS Corporation) for the purpose of managing a mortgage-backed security arbitrage portfolio. UMBS was approved by the Executive Committee of the Board of Directors on August 7, 1986 (Exhibit 1) and is anticipated to initially expand to a portfolio size of about $1 billion. Sandy Laurenson, Senior Vice President and Manager of MBS Trading, will be responsible for managing the trading activities for UMBS.

The subsidiary will be capitalized at 10%, through contributions and advances from USAT, which will be subordinated to other debt (such as reverse repos). The primary activities of the subsidiary will involve investments in mortgage-backed securities funded with reverse repurchase agreements. It is planned that the arbitrage portfolio will be substantially hedged utilizing a combination of futures, options, and interest rate swaps.

Ex. A-10683, Tab 185 (Letter from Crow to First Boston Re: UMBS, 10/20/86). (Emphasis

added).

M254. In the 1987 form 10K signed on March 28, 1988, by individuals appointed to the UFG Board of Directors by MCO, the UMBS portfolio is described as a hedged arbitrage portfolio:

Acquisition of Mortgage-Backed Securities. UMBS Corporation (‘UMBS’), a wholly-owned subsidiary of the Association, engages in the acquisition of mortgage-backed securities financed principally through repurchase/dollar repurchase agreements. UMBS utilizes certain hedging techniques described above under Hedging Programs to reduce the interest rate risk associated with its acquisition of mortgage-backed securities. As of December 31, 1987, UMBS had a portfolio consisting of $1.6 billion in mortgage-backed securities.

Ex. A-3023, Tab 79 (UFG for fiscal year ended 12/31/87, without exhibits, 12/31/87) p. CN158910.

M255. A memorandum entitled “UMBS Corporation, Statement Of Purpose/ Accounting Guidelines” provided to the outside auditors to obtain their agreement of the hedge accounting treatment of UMBS, represented that the “[p]urpose of [s]ubsidiary [was] [t]o create an arbitrage which produces a hedged net interest spread between mortgage-backed securities assets and various funding sources, over a two year time horizon." Ex. B-1452, Tab 898 (Memo from Jim Wolfe to Joe Parsons) p. KPMG 054951, attaching the memorandum described above admitted at Ex. A-13034, Tab 1176.

M256. Representatives of USAT met with the outside auditors to further explain how UMBS’s MBSs would be hedged against interest rate changes. At the meeting, USAT’s representatives were asked their expectation under what circumstances would the MBS be traded? The outside auditors summarized USAT’s representatives’ response as follows:

Note: I thought that it was important to establish that the MBS would not be traded, or at least that there would be minimal trading activity. If the MBS were to be traded, it would appear that the hedge positions should be considered to be speculative.

Ex. B-1455, Tab 899 (Memo from Joe Parsons to the File, 01/29/87) p. OWJ01591.

M257. The memorandum describing UMBS as a hedged arbitrage portfolio was provided to the FHLBB examiners as part of the 1987 Examination, and, along with written assurances that the UMBS portfolio was properly accounted for by the outside auditors, was relied upon by the examiners. Ex. A-14073, Tab 1502 (Report of Examination of 11/16/87, 07/28/88).

M258. The investments in UMBS were to be funded with reverse repurchase agreements similar to the initial MBS RCA portfolios. Swaps were not used to hedge against rising interest rates. Instead, future contracts and put options were to be used to hedge against rising interest rates in order to avoid the prepayment problem encountered in the initial MBS RCA. Ex. B-1455, Tab 899 (Memo from Joe Parsons to the File, 01/29/87) p. 0WJ01591.

M259. Based upon the representations summarized above in Findings M255 and M256, the outside auditors expressed their approval for the hedge accounting treatment for UMBS, which the outside auditors’ memoranda indicates was understood to be a hedged arbitrage portfolio, not a portfolio of long term MBSs funded with short term liabilities subject to interest rate risk because of a lack of hedge activity. Ex. B-1459, Tab 900 (Memo from Joe Parsons to Jim Wolfe, 01/29/87) p. US-3 008686.

M260. The FHLBB examiners, who relied upon the work of USAT’s outside auditors for assurances that USAT properly represented its MBS activities in its financial statements, recorded UMBS as a RCA as represented in “UMBS Statement of Purpose/Accounting Guidelines” described in Finding M255 above. In the November 16, 1987, Report of Examination, the examiners recorded that:

In October 1986, UMBS began to accumulate financial futures contracts to establish what it describes as a two year anticipatory hedge program. The hedge program is centered around the anticipation of a series of liabilities which would be used to fund MBSs. UMBS uses Eurodollar Futures (short positions) to extend the maturity of its reverse repurchase agreements. It has, to a lesser degree, utilized ‘put’ options (GNMMA/T-Bills) to hedge MBSs on the asset side of the balance sheet.

Ex. A-14073, Tab 1502 (Report of Examination of 11/16/87, 07/28/88).

A. Before The Buildup Of UMBS, The Mortgage-Backed Securities

Portfolios Were Reasonably Well Balanced With Regard To Interest

Rate Risk

M261. The MBSs portfolio was relatively well balanced at the beginning of December of 1986. Tr. 3860: 20 - 3863; 13 (Orr). As Hansen testified, the MBS portfolios were not “biased towards rates rising or falling. . . . [T]he situation was still fairly well matched” at that time. Tr. 12625: 10-16 (Hansen).

B. Respondents Purchased Almost One Billion Dollars Of Securities And

Knowingly Left Them Under-Hedged Until April 1987

M262. Orr was instructed by Gross in the Investment Committee meetings, attended by Hurwitz, to increase the total MBS RCA portfolios to $3 billion by March 31, 1987. Tr. 3,805: 6 - 3,807: 1 (Orr).

M263. The UMBS MBSs portfolio was $67.8 million as of October 30, 1986, and grew to $906.6 million by February 28, 1987. During that time period, no hedges were purchased to protect against interest rate changes. Ex. A-11022, Tab 295, p. 6.

M264. The UMBS MBSs portfolio grew to $1.275 billion by March 31, 1987, and only had $360 million in interest rate caps in place to protect against interest rate changes. As of April 30, 1987, it held $1.674 billion in MBSs and only $910 million in caps, and as of May 30, 1987, when the portfolio reached its maximum size, it held $1.758 billion in MBSs and only $910 million in caps. Ex. A-11022, Tab 295, p. 6.

M265. Respondents did not even hold all of the caps in the UMBS portfolios. As described below, Respondents caused caps to be transferred to USAT from UMBS to maximize the maturity matching credit. On October 30, 1987, Respondents caused USAT to sell approximately $610 million (50%) of the approximately $1.2 billion in caps held at that time. USAT recognized a profit of approximately $7.8 million on the sale. Consequently, as of October 31, 1987, UMBS held $1.8 billion in MBSs with an embedded loss of $111 million, but few, if any, caps, so that its MBSs portfolio was substantially unhedged during the critical period between the October 1987 stock market crash and December 31, 1987. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) pp. 86-90.

1. Respondents Deliberately Left The Portfolios Under-Hedged In Order To Speculate On The Direction Of Interest Rates

M266. At the January 21, 1987, meeting of the Investment Committee, Orr reported a decision to hold a significantly unhedged portfolio in order to benefit from a decrease in interest rates:

The MBS portfolio, when combined with the interest rate swaps, are favorably positioned for further rate declines. Currently, the unrealized net loss stands at $101 million ($26 million MBS gain against a $127 million swap loss). With a 100 b.p.decline in market rates, the MBS portfolio would nearly triple in value, to $72 million, while the swap would deteriorate to a loss of $161 million, for a net loss of $89 million. If rates were to rise 100 b.p., the MBS portfolio would lose over $80 million of its current value (to an unrealized loss of $55 million), far in excess of the appreciation of the swap position (to a $93 million loss), for a net loss of $148 million… This is an improvement of roughly $13 million in liquidation value over the value run at 12/31. The liquidation value improved by $7 million if rates decline 100 b.p. and $17 million if rates rise 100 b.p.

Ex. A-1426, Tab 357 (Minutes of UFG/USAT Investment Committee, 01/12/87) pp. US-3 005220, 005224.

M267. At the January 28, 1987, Investment Committee meeting Ms. Sandy Laurenson reported that the “DARTS sub is totally unhedged and the swaps in the Investment portfolio are over collateralized.” Ex. A-1427, Tab 358 (Investment Committee Minutes, USAT, UFG, 01/28/87) pp. US-3005252 and 5260.

M268. At the February 11, 1987, meeting of the Investment Committee, a plan to purchase certain hedging instruments was first discussed. Sandy Laurenson was directed to discuss the planned purchase with Crow and Gross. However, minutes of the Investment Committee subsequent to that date do not reflect any decision having been made to purchase the hedges. Ex. A-1429, Tab 360 (Investment Committee Minutes, 02/11/87) p. US-3005306.

M269. It was not until the March 11, 1987, meeting of the Investment Committee that an effort was made to begin to hedge the interest rate risk in the buildup in UMBS. Ex. A-1433A, Tab 1303 (Investment Committee Minutes, 03/11/87) p. US-3 005420.023.

M270. The minutes from the April 8, 1987, Investment Committee meeting, at which all members including Hurwitz were present, reflect that the MBS RCA portfolios, which had deliberately been left underhedged in order to speculate on the direction of interest rates, were to be hedged in the future:

Ms. Laurenson then presented an interest rate forecast from numerous economists that was ordered attached to the minutes. After a lengthy discussion it was agreed that the consensus was interest rates over the next year will be moving in an upward direction. As a result, it was agreed that the Association should begin lengthening the liability structure and using various hedges to continue to reduce the gap. . . . In order to hedge the portfolio in a rising rate environment, various strategies were discussed including the purchase of high coupon principal only securities, interest only securities, interest rate caps, and put protection. . . . [t]he Committee approved the purchase of up to $50 million high coupon principal only mortgage-backed securities to hedge the Arbitrage I portfolio, to purchase interest only ortgage-backed securities as a replacement for mortgage-backed securities in the investment portfolio, and to purchase up to $100 million of interest rate caps to hedge the preferred stock subsidiaries.

Ex. A-1437, Tab 364 (Investment Committee Minutes, 04/08/87) p. US-3005569 (emphasis added).

M271. At the April 22, 1987, meeting of the Investment Committee, it was reported that, as of March 31, 1987, the value of the total assets in the UMBS MBS portfolio was $1.035 billion. Of this amount, the fixed hedged portion was $165.1 million, the unhedged fixed-asset portion was $427.4 million plus $109.4 million in ARB II (a total of $536.8 million in fixed unhedged mortgage-backed securities), and $333 million in adjustable rate mortgages. Ex. A-1439, Tab 366 (Minutes of UFG/USAT Investment Committee, 04/22/87), pp. US-3 005630, 005640, 005645, 005646.

M272. Some financial futures and other options transactions were utilized by UMBS during this time period. However, the volume of activity does not correspond to the size of the MBS portfolio. Based upon the available documents, minimal hedging activity occurred during the three months ended March 31, 1987. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) pp. 57 - 58, Exhibit C.

2. USAT’s Management, Including Hurwitz, Knew That The Effect Of Not Fully Hedging The UMBS And USAT Mortgage-Backed Securities Hedged Arbitrage Portfolios Created A Substantial Interest Rate Risk If Rates Were To Suddenly Rise

M273. On April 22, 1987, Sandy Laurenson reported to the Investment Committee that the USAT, UMBS, and DARTS portfolios will lose value across a wide range of coupons with an increase in interest rates. Ex. A-1439, Tab 366 (Minutes of UFG/USAT Investment Committee, 04/22/87) pp. US-3 005630, US-3.

M274. As Orr testified, interest rate forecasts “are right [only] about 50 percent of the time.” Tr. 3,995: 2 - 3,996: 6 (Orr); Ex. B-1657, Tab 375 (Memo from Schwenkel to Crow, 06/11/87). As a result, USAT was betting on Orr’s best guess of how prepayment rates would move, rather than hedging against such risk. Tr. 3,772: 6-16 (Orr).

C. Interest Rates Suddenly Rose In April 1987, Instead Of Declining Or

Remaining Constant As USAT’s Management Had Anticipated, Causing A Substantial Decline In The Market Value Of The Combined USAT And UMBS Portfolios

M275. A significant interest rate increase occurred after March 31, 1987. 10-year Treasury rates which were 7.51% on March 31, 1987, increased to 8.21% on April 30, 1987, and 8.49% on May 31, 1987, peaking at 9.63% on September 30, 1987. Ex. A-11012, Tab 244 (Expert Report of Darrell Duffie) at Table 4.3.

M276. The increase in interest rates that occurred in April and May of 1987 caused a significant market value decline in the MBSs portfolios held by USAT and UMBS. The January 21, 1987, Investment Committee minutes reported that the portfolio was favorably positioned for an interest rate decline. The liquidation value of the combined USAT, DARTS, and UMBS portfolios, including the swaps, was a negative $100.6 million, which was projected to increase to a negative $147.8 million if interest rates were to increase by 100 basis points, and decline to a negative $89.0 million if rates were to decrease by 100 basis points. Ex. A-1426, Tab 357 (Minutes of UFG/USAT Investment Committee, 01/12/87) pp. US-3 005220, US-3 005224, US-3 005225.

M277. After the increase in interest rates, the losses in the liquidation value of the combined USAT, DARTS, and UMBS portfolios, as reflected in the May 27, 1987, Investment Committee minutes, increased by $138.1 million to a negative $238.7 million, which was projected to increase to a negative $305.9 million if rates were to increase by another 100 basis points, and only decline to a negative $226.7 million if interest rates were to decrease by 100 basis points. Ex. A-1444, Tab 1316 (Investment Committee Minutes USAT, 05/27/87) p. US-3005824.

M278. Thus, between January 21, 1987, when it was reported that USAT was favorably positioned for an interest rate decline, and May 27, 1987, after a significant increase in interest rates had occurred, the market value of the USAT and UMBS MBSs portfolios declined from a negative $100.6 million to a negative $238.7 million because of the decision not to hedge the portfolios against rising interest rates, but instead to position them for a reduction in interest rates. Ex. A-1444, Tab 1316 (Investment Committee Mihjutes, USAT, 09/27/87) p. US-3 005824.

M279. Between May 27, 1987, and September 30, 1987, a period of time in which interest rates rose from the initial increase of 8.49% on May 31, 1987, to 9.63% on September 30, 1987, the market value of the USAT and UMBS MBSs portfolios declined further from the negative $238.7 million to negative $304.3 million. Ex. A-1464, Tab 1334 (Investment Committee minutes, USAT, 09/30/87) p. US-3 006524.006.

X. Respondents Directly Managed UMBS And Caused USAT To Guarantee The Liabilities Of UMBS In Response To Requests By UMBS’s Creditors

A. Correspondence With The Texas Savings And Loan Commissioner

M280. In a letter dated August 7, 1986, Respondents’ managers of USAT sought approval for the creation of UMBS from the Texas Savings and Loan Commissioner. In its letter USAT stated:

United Savings Association of Texas (the ‘Association’) is seeking approval for the establishment of a new service corporation subsidiary. The service corporation subsidiary would be formed to invest in mortgage backed securities (e.g., securities issued by GNMA, FNMA and the FHLMC and backed by single family residential mortgages). . . . [T]he operations of the proposed subsidiary will be clearly distinguished from those of the Association. The subsidiary should be profitable immediately and should continue to earn the spread described above.

The letter further explained that:

The service corporation subsidiary will acquire the mortgage backed securities through reverse repurchase transactions. As a result, the subsidiary expects to earn a spread between the rate received on the mortgage backed securities and the rate paid on the reverse-repurchase transactions. . . . There are no supervisory problems which would effect the ability of the Association to properly supervise and operate such a subsidiary corporation. The Association has adequate income and reserves to support the proposed Investment. . . .

Ex. A-10658, Tab 182 (Letter from Berner to Bowman) p. CN053199.

M281. In response to a letter of August 14, 1986, from the Texas Savings and Loan Commissioner seeking further information, USAT represented:

It is not expected that such activities will create any direct, indirect or contingent liabilities of the Association. However, under repurchase transactions, broker dealers may call for increases in collateral which the subsidiary may not have the ability to satisfy. In such event, the Association would have to supply such collateral; thus creating a direct liability of the Association to fulfill the requirements of the subsidiary.

Ex. A-10664, Tab 183 (Letter from Berner to Anderson, 09/04/86) p. OW0005276.

M282. In seeking approval for the creation of UMBS USAT again wrote on September 4, 1986, to the Texas Savings & Loan Commissioner and explained:

UMBS Corporation will acquire mortgage-backed securities by engaging in reverse repurchase transactions. The Association my (sic) further hedge these acquisitions either directly or through general hedges held by the Association on a consolidated basis. It is not expected that such activities will create any direct, indirect or contingent liabilities of the Association. However, under repurchase transactions, broker dealers may call for increases in collateral which the subsidiary may not have the ability to satisfy. In such event, the Association would have to supply such collateral; thus, creating a direct liability of the Association to fulfill the requirements of the subsidiary.

Ex. A-10664, Tab 183 (Letter from Berner to Anderson, 09/04/86) p. OW005276.

B. Respondents Caused USAT To Guarantee The Liabilities Of UMBS

M283. Respondents’ managers of USAT committed to maintain UMBS's capital at 10% of its total assets. Ex. T-4443, Tab 881 (Letter from Crow to Criscito, Paine Weber, 02/23/88); A-13016, Tab 1144 (Letter from Crow to Bill Coster, Vice President, Salomon Brothers, 02/12/87); A-10741, Tab 878 (Letter from Crow to Security Pacific Clearing Co., 04/30/87) p. CN053223; A-10742, Tab 879 (Letter from Crow to Morgan Stanley, 04/30/87) p. OW003876.

M284. In addition, USAT entered into an agreement with Drexel Burnham on February 17, 1987, to induce “Drexel and its Affiliates to enter into” repurchase agreements with UMBS, that contractually obligated USAT to pay damages to Drexel if USAT failed to “cause” UMBS to “maintain its net worth at 10% or more,” which was calculated based upon the market value of the MBSs covered by the repurchase agreements. Ex.T-9002, Tab 1664 (Letter from Berner to Drexel, 02/17/87); T-9003, Tab 1665 (Agreement between UMBS and Drexel) ¶ 1.1 and 6.3.

M285. The commitment to maintain the net worth ratio made in the letters were made at the request of the creditors who conditioned their extension of credit upon USAT providing the commitment. Tr. 15,794: 1 - 15,796: 14; Tr. 15,810: 16 - 15,811: 4 (Crow).

M286. The commitment to maintain the net worth ratio was viewed as an enforceable obligation by USAT’s senior management. In a memorandum dated May 20, 1987, Crow directed B. Williams to add to his “job description ensuring that the capital-to-asset ratio of this sub remains at 10% or above. We have committed to the analysis that we will maintain at least this ratio.” Ex. A-10746, Tab 880 (Memo from Crow to B. Williams and Doolittle, 05/20/87) p. CN053224.

M287. USAT's written commitment to maintain the capital of UMBS at 10% of its total assets was an open-ended commitment to provide unlimited support for UMBS's reverse repurchase financing. In making that commitment, USAT effectively guaranteed all of the debt of UMBS, because without maintaining the value of USAT's assets, Respondents would not be able to maintain USAT's capital at 10% of USAT's total assets. Id.

M288. On April 14, 1987, Berner wrote to the Texas Saving & Loan Commissioner:

Pursuant to our telephone conversation of April 14, 1987, it is my understanding that the Texas Savings and Loan Department has no objection to United Savings Association of Texas guaranteeing the obligations of UMBS Corporation.

As we discussed, persons issuing reverse-repo and settling securities often require the guarantee of the parent corporation.

Please be advised that United will attempt to not guarantee these obligations but we wish the authority to do so if needed.

I would like confirmation of my understanding at your earliest convenience.

Ex. B-1565, Tab 1394 (Letter from Berner to L.A. Anderson, Texas S& L, 04/14/87) p. CN157786.

M289. The Texas Saving & Loan Commissioner replied, confirming that what USAT had requested was a guarantee of UMBS’s obligations:

Confirming both our telephone conversation and your letter of April 14, 1987, this Department will take no objections to the Association guaranteeing the obligations of UMBS Corporation, the Association’s wholly-owned subsidiary, if requested by securities firms as part of the settlement of securities transactions and the issuance of reverse-repo agreements.

Please contact us when we may be of further service to you or the Association.

Ex. T-4362, Tab 1395 (Letter from Anderson, Texas S&L to Berner, 04/21/87) p. OW010236.

C. USAT Subsequently Obtained Credit From The Entities To Which

They USAT Issued Commitment Letters

M290. Subsequent to the dates of the commitment letters described in Findings M283 and M284, Security Pacific Clearing Corporation, a company to which one of the commitment letters was sent, was the entity that cleared all of UMBS’s MBSs and reverse repurchase agreement transactions. Security Pacific Clearing Corporation extended credit to USAT for its obligations to pay and actual payment for securities purchased by UMBS until it had received the funds from UMBS to pay for the securities transactions cleared through Security Pacific. Tr. 12,100: 6 - 12,102: 22 (Mims).

M291. Subsequent to the dates on the commitment letters described in Findings M283 and M284, UMBS was a counterparty to reverse repurchase agreements that financed MBSs purchased from the following counterparties to the commitment letters:

Drexel Burnham Lambert $122.7 million;

Morgan Stanley $50.3 million;

Paine Webber $38.3 million;

Pru Bache $234.6 million; and

Salomon Brothers $113.3 million

Ex. A-1448, Tab 1320 (Investment Committee minutes, 06/16/87) pp. US-3 005920-US-3 005922.

D. The Respondents Viewed The Commitment Letters They Caused USAT

To Issue To UMBS’s Creditors As Enforceable Obligations

M292. Reflecting the fact that USAT viewed the obligations of UMBS to be guaranteed by USAT, Crow wrote to B. Williams regarding the transfer of UMBS’s assets to USAT as follows:

There will be a number of technical problems involved with this move, but it probably is not that big of a deal. I do not believe we can transfer the securities directly from USAT to the sub; we would have to sell the securities and buy them back at the sub level. We would also need to inform our creditors on Wall Street, but I do not believe they will have a big problem since they are already extending reverse repo credit to USAT MBS. Please get back to me with your plan of action or tell me that this is a dumb idea.

Ex. A-10731, Tab 875 (Memo from Crow to B. Williams and Schwenkel Re: Capital position of USAT) p. CN056207.

M293. As a consequence of Respondents’ managers of USAT's commitment to maintain the net worth of UMBS at 10% of total assets, USAT’s direct investment in UMBS varied significantly depending on the level of interest rates. Initially, USAT invested $100 million in UMBS. As of June 30, 1987, when UMBS held $1.78 billion MBSs, USAT's investment had increased to $180 million. USAT's investment increased to $309 million in November 1987 due to an additional infusion of capital in UMBS to maintain 10% capital commitment because of a reduction in the market value of the MBS caused by the increase in interest rates described in Finding M225, although the face value of UMBS’s investments in MBSs remained at approximately $1.78 billion. Ex. A-22028, Tab 291 (Expert Report of Joe Hargett, 01/13/97), Exhibit B, at schedule D, p. 46.

E. The Respondents’ Managers Of USAT Directly Managed The Activities Of UMBS Through Committees Of USAT

M294. Respondents’ managers of USAT, including Hurwitz, acting through the Strategic Planning Committee and the Investment Committee, directly managed the UMBS portfolio. See e.g., Ex. A-10731, Tab 875 (Memo from Crow to B. Williams and Schwenkel Re: Capital position of USAT, 03/06/87) p. CN056207; A-1426, Tab 357 (Minutes of Investment Committee Minutes, 01/12/87) pp. US-3 005220 and US-3 005224; A-1427, Tab 358 (Investment Committee Minutes, 01/28/87) pp. US-3 005252 and US-3 005260; A-1431, Tab 381 (Investment Committee Minutes, 02/18/87) pp. US-3 005339-US3005340, and US-3 005340.034.

XI. The Respondents’ Managers Of USAT Manipulated USAT’s Accounting For Securities And Hedges Held By USAT And United Mortgage-Backed Securities To Maximize The Maturity Matching Credit In Violation Of Applicable Regulations

A. The FHLBB Increased The Capital Requirements for Institutions In January

Of 1987 But Provided For A Credit To The Requirement For Minimizing Interest Rate Risk Denominated The Maturity Matching Credit

M295. Insured institutions were required to maintain a minimum regulatory capital "in an amount equal to the sum of the institution's liability component and contingency component minus its maturity matching credit." 12 C.F.R. § 563.13(b) (1987). After a transition period, the "liability component" was to be an amount equal to 6% of total liabilities. Id. § 563.13(b)(1)(i). The "contingency component" was an amount equal to "the sum of (A) [t]wo (2) percent of recourse liabilities . . . resulting from the sale of any loan; (B) [t]wenty (20) percent of the institution's scheduled items . . .; [and] (C) . . . an amount equal to a percentage of the dollar amount of aggregate direct investment made after June 30, 1986. . . ." Id. § 563.13(b)(4)(ii).

M296. The "maturity matching credit" was defined as "an amount up to 2 percent of total liabilities by which the minimum regulatory capital requirement . . . may be reduced based upon an institution's low interest rate risk exposure as reflected by the institution's 1 year and 3 year hedged gap." Id. § 563.13(b)(5). The maturity matching credit could not, however, "reduce an institution's minimum regulatory capital requirement below 3 percent of total liabilities for any period up to and including December 31, 1989." Id. § 563.13(b)(5)(ii)(C).

M297. Effective January 1, 1987, the FHLBB revised its regulations governing minimum regulatory capital requirements for savings associations (previously referred to as "regulatory net worth" requirements). 12 C.F.R. § 563.13 (1987). Essentially, the new regulations phased in an increased requirement of 6% of total liabilities (the "liability component"), plus an additional "contingency component" calculated as the sum of specified percentages of certain types of liabilities, scheduled assets, and direct investments. The regulation also permitted a reduction of the required minimum regulatory capital to not less than 3% of total liabilities during the period from December 31, 1986, through December 31, 1989, and 4% thereafter by means of a "maturity matching credit." Id. § 563.13(b)(5)(ii)(C). Savings associations were first required to compute and satisfy the new minimum regulatory capital requirements on March 31, 1987, the end of the first quarter, in which the regulation was effective. Id. § 563.13(b).

M298. The maturity matching credit was an amount that could be up to 2% of total liabilities. The maturity matching credit was calculated based upon the extent to which the maturity and/or repricing dates of an entity’s assets and liabilities were matched. Specifically, the credit was calculated by reference to the savings association's cumulative one-and three-year "hedged gaps" as of the accounting period ended six months prior to the date of calculation. A credit of up to 1% of total liabilities was allowed for meeting specified standards for the one-year cumulative hedged gap, and an additional credit of up to 1% was allowed for meeting similar standards with respect to the three-year hedged gap. Id. § 563.13(b)(5), Tr. 3,489: 9 - 3,490: 2.

M299. The first application of the maturity matching credit (on March 31, 1987) was to be based upon USAT's September 30, 1986, balance sheet and hedged gap. The Respondents began planning for the implementation of the new regulation at least as early as August 1986 (when the Executive Committee authorized the formation of UMBS). Because of its significant liability growth during the previous years and its continuing operating losses, USAT could not continue to meet the new minimum regulatory capital requirements without a substantial increase in its maturity matching credit. Accordingly, the Respondents considered transactions that would allow USAT to claim a higher maturity matching credit in subsequent quarters. (Federated and Hurwitz Answer ¶ 219).

B. Respondents’ Managers Of USAT, In Anticipation Of The Effective Date Of

The Change In The Regulations, Adopted And Implemented A Plan To Allocate Assets And Hedge Instruments Between USAT And United Mortgage-Backed Securities To Appear To Qualify For The Maturity Matching Credit

M300. The Respondents’ managers of USAT knew that USAT's maturity matching credit as of June 30, 1987, totaled $49.1 million out of a possible $99.2 million. Accordingly, the Respondents’ managers began to plan transactions that would allow USAT to claim a higher maturity matching credit in subsequent quarters. A February 1987 memorandum to the Investment Committee stated:

The matching credit calculation excludes the impact of interest rate caps and collars unless they are ‘in the money.’ Thus, USAT does not receive credit for the current $125 million position in caps/collars. Additionally, we have been notified that in the future (the exact date is unknown), CMO's will be excluded from the maturity matching calculation. This adjustment would reduce our current credit from $49 million to $22 million.

* * *

Because our near-term earnings outlook is not extremely favorable and [a] capital note issuance is unlikely, the matching credit is our most accessible source of capital. Therefore, prior to quarter-end, we may have to restructure our assets and liabilities to increase our matching credit to maintain minimum regulatory net worth.

Tr. 3,535: 16 - 3,537: 6 (Hargett). Ex. T-5120, Tab 297 (Memo from B. Williams to Investment Committee, 02/18/87) p.US0001859.

M301. Respondents’ managers of USAT knew the estimate of the maturity matching credit as of June 30, 1987, of $49 million had further been revised downward to about $40 million. The memorandum was considered so sensitive that it was marked "DESTROY AFTER READING." (Emphasis in Original.) Taking into account actual results from January 1987, the memorandum stated:

We will have only about $32 million excess net worth [at June 30, 1987] before adjusting for February through June results (i.e., net losses, increases in scheduled items and direct investments, etc.) . . .The Asset Liability Committee will develop a proposal by mid-March which will outline a number of alternatives for March 31, 1987 restructuring (which establishes the September 30, 1987 credit amount) to optimize the matching credit.

Tr. 3,539: 12 - 3,541: 1 (Hargett). Ex. T-5121, Tab 298 (Memo from B. Williams to Gross and Crow, 02/23/87) p. US0001158. (Emphasis in original).

M302. As illustrated by the March 2, 1987, Agenda for USAT's Strategic Planning Committee, Respondents’ managers of USAT, including Hurwitz, directly considered the options of how to maximize the maturity matching credit. Tr. 3,543: 9 - 3,545: 4 (Hargett). Ex. T-5122, Tab 299 (Strategic Planning Committee Agenda, 03/02/87) p. 1.

M303. As shown by a memorandum dated March 16, 1987, Respondents’ managers of USAT knew that among the "Five Most Important Things [USAT's CFO was] Working On - March 1987" was an "[a]nalysis of and reconfiguration of the Association's balance sheet to maximize the maturity matching credit and insure meeting regulatory capital." Tr. 3,546: 19 - 3,547: 4 (Hargett). Ex. T-5123, Tab 300 (Memo from Crow to Gross, 03/26/87) p. 1.

M304. In several transactions in March 1987 designed to "maximize" USAT's maturity matching credit for September 30, 1987, Respondents’ managers of USAT caused UMBS to transfer approximately $334.8 million in adjustable-rate MBS's to USAT in exchange for approximately $268.3 million in fixed-rate MBSs. Tr. 12,078: 4-12 (Mims). USAT and UMBS each became liable on the reverse repurchase agreements associated with the MBSs received in the exchange. USAT became liable, after netting, on an additional $62.2 million in reverse repurchase agreements associated with the adjustable-rate MBSs. In order to balance the transaction, USAT forgave an intercompany receivable from UMBS of approximately $4.3 million. Tr. 3,507: 17 - 3,508: 9 (Hargett). Tr. 3,513: 8 - 3,515: 10 (Hargett). Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) pp. 67-68. In other March 1987 transactions, UMBS purported to transfer $790 million in interest-rate caps from UMBS to USAT. Id. pp. 67 & 75; (Federated and Hurwitz Answer ¶ 222).

M305. Mary Mims, Assistant Treasurer at USAT beginning in April 1983, was responsible for settling transactions at USAT. She confirmed that the above described March 1987 transactions occurred. She remembered booking a transaction transferring $320 million of variable rate MBSs from UMBS to USAT and a transaction in which $710 million of interest rate caps that were on the books of UMBS were transferred to the books of USAT. Tr. 12,078: 4-12. (Mims).

M306. Respondents’ managers of USAT caused the interest rate caps to be recorded on the USAT thrift finance report (TFR) for March 30, 1987, which is filed on a quarterly basis, as belonging to USAT, when they had been originally purchased for UMBS to qualify as a service corporation. Tr. 3,509: 4-7 (Hargett).

M307. The TFRs filed for USAT did not include UMBS, because it was a service corporation. Tr. 3,514: 15-18. Respondents continued to treat these caps as belonging to UMBS in managing its interest rate risk. But for one special report, the TFR, “they [had] transferred them for USAT’s records.” Tr. 3,639: 4-5 (Hargett). Therefore, the Respondents’ managers of USAT in effect counted them inconsistently for different purposes, Tr. 3,639: 19-20. The transfer should not have been included in the USAT’s TFR. Tr. 3,639: 22 - 3,640: 1 (Hargett).

C. Respondents’ Managers Of USAT Knew The Reallocation Of Assets

And Hedges Was Of No Economic Substance And Was Merely Done To Appear To Qualify For The Maturity Matching Credit

M308. As shown by a June 17, 1987, USAT memorandum, the Respondents’ managers of USAT, including Hurwitz, knew the above described transactions were a sham:

Although we have discussed the structure of United MBS in numerous forums (Executive Committee, Investment Committee, Strategic Planning Committee, etc.), . . . it is important we have a complete understanding of the major accounting exposure we have for the subsidiary. By management approval, $320 million in variable rate [MBS's] and . . . $710 [sic] million of interest rate caps were transferred from United MBS to USAT for maturity matching credit purposes. This accounting treatment has produced the following results and exposure:

· USAT has maximized its maturity-matching credit using ‘mirrors.’ Since United MBS's assets are not included in the calculation, USAT is ‘borrowing hedges’ to take advantage of a regulatory loophole. USAT's real interest rate exposure on a consolidated basis has not been reduced.

· The investment bankers that provide reverse repo lines were given comfort that United MBS was a MBS risk-controlled arbitrage subsidiary. In fact, it is basically $1.6 billion of unhedged MBS because of the assets and hedges transferred to USAT. Thus, with a rapid increase in interest rates, we could see a negative interest spread and operating losses in United MBS. This would be difficult to explain to Wall Street.

In USAT's movement to ‘come clean,’ our options are:

· Do nothing and continue to use mirrors to disguise our GAP.

· Unwind the asset and hedge transfers between United MBS and USAT and purchase about $1.0 billion of hedges specifically for USAT. This would cost about $12 million in additional interest expense per year. If USAT did not replace the instruments transferred to United MBS, USAT would lose its maturity-matching credit and fall below minimum required regulatory net worth.

I recommend that this situation needs to be resolved by senior management at the next Executive or Strategic Planning Committee meeting.

Tr. 3,547: 15 - 3,556: 17 (Hargett). Ex. T-5125, Tab 302 (Memo from B. Williams to Gross and Crow, 06/17/87) pp. US0000839-840.

M309. Respondents’ managers of USAT, including Hurwitz, chose not to "come clean," as B. Williams suggested. Instead, Respondents’ managers of USAT "[did] nothing and continue[d] to use mirrors to disguise [USAT's] GAP." For the quarter ended September 30, 1987, USAT's Thrift Financial Report reported regulatory capital of approximately $247 million. Based upon the inclusion in USAT's financial statements of the MBSs and interest rate caps transferred from UMBS in March 1987, USAT calculated that its one- and three-year cumulative hedged gap six months prior to the close of the quarter (i.e., on March 31, 1987 -- after the sham transactions) were -8.13% and -7.93%, respectively. Since each cumulative hedged gap percentage was purportedly less than 15%, USAT claimed a maturity matching credit of 1% of total liabilities for each component, resulting in a maturity matching credit of 2%, or approximately $101 million. Using the maturity matching credit of $101 million, USAT reported its minimum regulatory capital requirement to be approximately $183 million. Thus, USAT purported to exceed the required minimum regulatory capital by approximately $63.7 million. Tr. 3,515: 13 - 3,517: 6 (Hargett). Ex. A-11018, Tab 291 (Expert Report of Joe Hargett, 10/16/97) p. 64.

M310. Without the "mirrors" provided by its "borrowed hedges," USAT's one- and three-year cumulative hedged gap percentages were -25.36% and -20.41%, respectively. Accordingly, USAT was not entitled to claim any maturity matching credit for its one-year cumulative hedged gap, because it was more than 25%. USAT was entitled to claim only a reduced maturity matching credit of 0.64%, or approximately $32.2 million, for its three-year hedged gap. Therefore, its real minimum regulatory capital requirement was approximately $252.2 million, not $183 million. Thus, with actual regulatory capital of approximately $247 million, USAT failed to satisfy the minimum regulatory capital requirement of 12 C.F.R. § 563.13 as of September 30, 1987, by approximately $5.2 million. USAT avoided having to report this deficiency because of the sham transactions. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) pp. 64 and 80.

XII. Respondents Sold Hedge Instruments When Interest Rates Rose In 1987 To

Generate Gains To Bolster Profits To Meet The Regulatory Minimum Net Worth Requirement

M311. A significant interest rate increase occurred after March 31, 1987. 10-year Treasury rates were 7.51% on March 31, 1987, increased to 8.21% on April 30, 1987, and 8.49% on May 31, 1987, peaking at 9.63% on September 30, 1987. Ex. A-11012, Tab 244 (Expert Report of Darrell Duffie) at Table 4.3.

M312. As a result of the increase in interest rates, USAT had approximately $24.5 million in unrealized gains in its hedge instruments purchased in late 1986 and early 1987 as a result of the interest rate increase in April and May of 1987. Ex. A-1444, Tab 1316 (Investment Committee Minutes, USAT, 05/27/87).

A. Respondents Sold Futures Contracts To Generate Gains To Satisfy USAT’s Regulatory Net Worth Requirement

M313. As reported to the September 30, 1987, Investment Committee meeting by Sandy Laurenson, USAT had sold futures contracts for a realized gain of $15.2 million. Ex. A-1464, Tab 1334 (Investment Committee Minutes, USAT, 09/30/87) p. US-3 006524.006.

M314. The performance report for September 30, 1987, reported that the “[n]on-interest income was $16.3 million in September, due primarily to $20.8 million of income from options and futures contracts executed in the mortgage-backed securities department.” Ex. A-5025, Tab 1344 (USAT Performance Report, 10/23/87) p. 3.

M315. As the examiners explained in a Report of Examination:

During the quarter ended September 30, 1987, the association opened and closed 3,800 Treasury Notes Futures positions. In conjunction with the offsetting of the position, it recorded a gain of approximately $17,001,875.

Ex. A-14073, Tab 1502 (Report of Examination of 11/16/87, 07/28/88) p. OW077141.

M316. As explained in a memorandum from Crow to Gross dated October 1, 1987, the sale of the futures contracts was made in order to generate gains to meet income and net worth targets:

On the subject of the bond futures which we sold approximately 45 days ago and repurchased recently, we entered the transaction and accounted for the transaction initially as a ‘hedge’. Consistent with this method, any gain or loss incurred on a periodic basis would not be recognized in the current period but would instead be deferred and ‘rolled’ into the basis of the hedged asset.

***

When we closed out the futures positions approximately 30 days after entering the futures position, this substantially tainted the argument of the futures ever being a hedge at all. From a technical accounting perspective, the gains that were recognized as a result of the futures transactions should be recognized because our actions indicate that the sale of the futures was never a hedge in the first place. There was no reason to quarrel with this conclusion due to expediency - we needed the earnings in the third quarter anyway to keep our loss within the $15-25 million range.

Ex. B-1783, Tab 296 (Memo from Crow to Gross Re: Accounting for Hedges, 10/01/87) p. CN053333.

B. In Addition To The Sales Of Futures Contracts, Caps Were Sold In

October 1987 And Repurchased In December 1987 To Generate Gains To Meet USAT’s Regulatory Minimum Net Worth Requirements

M317. After the increase in interest rates discussed in Findings M225 between March and September 30, 1987, the UMBS portfolio was only partially hedged by the acquisition of approximately $1.3 billion in interest rate caps.

The maturity of UMBSs caps ranged from two to five years and covered

notional principal amounts from $25 million to $150 million per contract.

The weighted average interest rate ceiling for these caps was 7.71% (indexed

to short-term LIBOR rates) and USAT paid approximately $26 million in

premiums to purchase the caps. Based on the average interest rate ceiling

of 7.71%, UMBS would generally begin receiving cash payments when

short-term interest rates increased above the applicable index.

Ex. A-11018, Tab 291 (Expert report of Joe Hargett). The cash payments received were to hedge the funding source by offsetting the increased financing costs from the short term funding source. (e.g., reverse repurchase agreements). Ex. A-11018, Tab 291 (Expert report of Joe Hargett) footnote 1 p. 86.

M318. OMITTED.

M319. The caps purchased in March and April of 1987 contained unrealized gains as of October 1987 because they had been acquired before the additional significant increase in interest rates occurred from 7.85% between March 31, 1987, and 9.89% September 30, 1987. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 87; A-11012, Tab 244 (Expert Report of Darrell Duffie) at Table 4.2.2.

M320. On October 30, 1987, $610 million (47%) of the $1.3 billion in caps were sold at a $7.8 million gain. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 87.

M321. As a consequence, “[g]ains on sales of securities were $5.8 million above plan in October, due to a $7.9 million gain from the sale of $610 million nominal principal of interest rate caps.” Ex. A-5026, Tab 1345 (USAT Performance Report, 11/17/87) p. 3 and Schedule DH.

M322. Without the $7.9 million gain on the sale of the caps in October 1987, USAT would not have met its regulatory minimum net worth as of November 30, 1987. USAT’s regulatory net worth was $189 million on November 30, 1987, or only $6 million above its minimum regulatory net worth requirement of $183 million. Ex. A-5027, Tab 1346 (USAT Performance Report, 12/18/87) p. 4 and Schedule AE.

M323. As a result of the $7.9 million gain on the sale of the caps in October 1987,

UMBSs net interest spread declined from 1.66% in March 31, 1987, Ex. A-5020, Tab 1339 (USAT Performance Report, 04/24/87) p. SB1, to only .83% as of November 30, 1987. Ex. A-5027, Tab 1346 (USAT Performance Report, 12/18/87), p. SB1.

M324. By December 7, 1987, less than six weeks after selling the $610 million in caps, USAT purchased $580 million of additional caps. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 87.

M325. The terms of the caps sold in October and acquired in December were not the same. The caps sold in October had a notional amount of $610 million and a weighted average ceiling of 7.35 % for which a premium of $12 million had been paid. The caps acquired in December 1987 had a lower notional amount of $580 million and a higher weighted average ceiling of 7.50% for which a premium of $16 million had been paid. Thus, UMBS paid $16 million instead of the original $12 million, for less coverage ($580 instead of $610), and less protection (because it would not receive payments until rates reached 7.50% instead of 7.35%), in return for which it took a $7.8 million gain to avoid failure of USAT’s regulatory minimum net worth requirement. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 88.

M326. Between the sale of the caps in October and the purchase of new caps in December, USAT's exposure to interest rate risk increased because the dollar amount of the MBS portfolio remained the same yet the cap portfolio had decreased by $610 million. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 90.

M327. Authorization for the sale of the caps occurred at a subcommittee meeting of the Investment Committee on October 29, 1987, in which the minutes record “[a]fter a full discussion of the revised interest rate outlook following the precipitous decline in equity prices and precipitous rise in interest rate volatility, it was determined that USAT would reduce its interest cap position. After a unanimous vote, Ms. Laurenson was given authorization to sell the [$610 million]. . . caps.” Minutes of a meeting of a Sub-Committee of the Investment Committee of USAT. Ex. A-1472, Tab 338 (Investment Sub-Committee Minutes, USAT, 10/29/87) p. US-3 006683.

M328. At a meeting of the Investment Committee on November 19, 1987, which Hurwitz attended, Ms. Laurenson reported that she might desire to reacquire the hedges if they were selling at a good price. Ex. A-1477, Tab 339 (Investment Committee Minutes, USAT, 11/19/87) p. US-3 006730.

M329. At a meeting of the Investment Committee on November 25, 1987, which Hurwitz attended, Ms. Laurenson “suggested that it would be necessary to buy back CAPS in early December to hedge the MBSs portfolio. She noted that this was due to the change in her outlook on interest rates.” As the minutes record: “[a]fter full discussion, the Committee approved the acquisition of $620 million of CAPS.” Ex. A-1478, Tab 340 (Investment Committee Minutes, USAT, 11/25/87) p. US-3 006760.

M330. At a meeting of the Investment Committee on December 4, 1987, which Hurwitz attended, Ms. Laurenson reported “she had acquired $490,000,000 of CAPS and would be acquiring an additional $30,000,000 of three-year CAPS.” As reported in the minutes “[s]he also noted that she would be creating two-year CAPS in the Euro-dollar futures markets.” Ex. A-1479, Tab 341 (Investment Committee Minutes, USAT, 12/04/87) p. US-3 006798.

C. The Result Of The Sales Of The Hedge Instruments In 1987 Including

The Sale And Repurchase Of The Caps In October And December, Further Reduced The Spread Income On The Mortgage-Backed Securities Portfolios, Further Increased The Unrealized Loss In The Hedged Arbitrage Portfolios, And Further Increased The Interest Rate Risk To The Association

M331. The sale of futures contracts and other hedged instruments, between May 27 and September 30, 1987, had a dramatic effect on the market value and interest rate sensitivity of the USAT and UMBS portfolios. As of September 30, 1987, the market value of the portfolios was a negative $304.3 million, which was projected to increase to a negative $393.6 million if rates rose 100 basis points, and was projected only to decline to a negative $239.9 million if rates declined by 100 basis points. Ex. A-1464, Tab 1334 (Investment Committee Minutes, 09/30/87) p. US-3 006524.006.

M332. The sale and repurchase of the UMBS caps and treasury options in October and December of 1987 generated a gain of $10.9 million, which significantly impacted the net interest margin in the UMBS portfolio for the year, reducing the net interest spread of 1.85% by 97 basis points to only .88%. Ex. B-1899, Tab 1813 (Memo from B. Williams to Gross Re: Response to memo on October Performance Report, 12/16/87) p. US0001709.

M333. The net interest spread on the UMBS portfolio had been 1.53% as of January 31, 1987, attributable in large part to a spread of 2.11% on the fixed hedged portion of the portfolio. Ex. A-1431, Tab 381 (Investment Committee Minutes, 02/18/87) p. US-3 005340.034.

M334. The net interest spread of 1.53% on the UMBS portfolio declined to .68% by December 31, 1987, in large part because of a decline from 2.11% of the fixed hedged portion of the portfolio to a .46% spread, over 155 basis points attributable to the losses in the interim period due to the increase in interest rates. Ex. A-1487, Tab 388 (Investment Committee Minutes, 01/20/88) p. US-3 012518.

M335. The negative spread on the MBSs portfolio held by USAT increased from a negative .99% on October 31, 1986, to a negative 1.80% on May 31, 1987, to a negative 2.90 % on August 31, 1987 (Ex. A-1464, Tab 1334 (Investment Committee, 09/30/87) p. US-3 006524.006) attributable to the gains taken out of the portfolio in 1986 and 1987.

XIII. USAT Failed Its Regulatory Minimum Net Worth Requirement on

December 31, 1987 _______________________

M336. USAT formally acknowledged that it had failed its regulatory minimum net worth requirement as of December 31, 1987, at which time its outside auditors issued an opinion that contained a qualification that it would not be able to continue as a going concern. Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) p. CN 158935; T-8033, Tab 402 (Annual Report United Financial Group, Inc. 1987).

M337. On February 16, 1988, USAT formally filed a forbearance application with the FHLBB as part of an effort to restructure USAT by merging it with other thrifts in order to qualify for supervisory goodwill and achieve capital compliance. Ex. B-2020, Tab 1406 (Request for Capital Forbearance and the Capital Plan, USAT, 02/16/88).

M338. USAT hired a new manager for its MBS RCA portfolios in early 1988 with instructions to restructure the portfolios in order to prepare for the eventual recapitalization of the thrift. Tr. 12,769: 14 - 12,770: 3 (Bruno).

M339. USAT fired Sandy Laurenson Orr in February 1988 for insubordination. In an attempt to satisfy the FHLBB’s concerns about the lack of thrift experience among USAT’s senior management, USAT hired Lawrence Connell as President and recruited a manager for its MBS RCA who had had previous experience with thrifts’ portfolios. Dominic Bruno was hired in the first quarter of 1988 after interviewing with Munitz, Crow, and B. Williams. Tr. 12,766: 22 - 12,767: 22 (Bruno).

M340. Bruno was informed at the beginning of his employment in the first quarter of 1988 that USAT planned to be recapitalized with FHLBB financial assistant, which Bruno understood to mean inclusion in what became known as the Southwest Plan. He testified that:

I had been told that the company was in pretty bad shape; but the plan was that throughout the course of the following year, the company was confident that it would be recapitalized with the help of the regulatory authorities, that this institution was well liked by the regulators. The plan was that this company would be acquiring other institutions and would become a solid and solvent institution over the next several months.

Tr. 12,769: 4 - 12,770: 3 (Bruno).

M341. Bruno was instructed to develop a plan to restructure the USAT and UMBS portfolios so that USAT could qualify for the Southwest Plan. Tr. 12,792: 3-12 (Bruno).

A. When USAT Failed Its Minimum Net Worth Requirement The Mortgage-

Backed Securities Hedged Arbitrage Portfolios Held At The USAT And UMBS Levels Were Approximately $2.7-2.8 Billion And Had Incurred Substantial Market Losses

M342. The size of the combined USAT and UMBS portfolios was between $2.7 and $2.8 billion at the beginning of 1988, when Bruno was hired to restructure the MBS RCA portfolios in anticipation of a FHLBB-assisted recapitulation. Tr. 12,803: 21 - 12,804: 1; 12,817: 16 - 12,818: 6 (Bruno); Ex. T-4463, Tab 1262 (UFG’s Asset/Liability Presentation using the Sendero A/L Model, 04/22/88) p. OW011307.

M343. As of January 6, 1988, the USAT and UMBS Portfolios had combined mark to market loss of a negative $277 million. Ex. A-1485, Tab 1211 (Investment Committee Minutes, 01/06/88).

B. When USAT Failed Its Minimum Net Worth Requirement, The

USAT Spread Was 260 Basis Points Below Its Initial Target

M344. The MBSs portfolio held by USAT had a negative spread of 1.11%, 261 basis points below the target of 1.50% set when initiated in late 1984 and early 1985. Ex. A-5030, Tab 1266 (USAT Performance Report, 03/25/88) at Schedule SC1.

C. When USAT Failed Its Minimum Net Worth Requirement, The

Mortgage-Backed Securities Hedged Arbitrage Portfolio Held At The UMBS Level Had Experienced A Substantial Reduction In Its Net Interest Rate Spread

M345. The net interest spread on the UMBS portfolio was 1.66% on May 31, 1987, when the portfolio had reached $1.73 billion. Ex. A-5022, Tab 1341 (USAT Performance Report, 06/18/87) at Schedule SB1. The net interest spread on the UMBS portfolio of $1.71 billion MBS was .64% on January 31, 1988, 102 basis points below where it was May 31, 1987. Ex. A-5029, Tab 1265 (USAT Performance Report, 02/25/88) at Schedule SB.

M346. The USAT and UMBS portfolios had no net interest yield or spread when Bruno arrived. Bruno testified that as the March 1988 Performance Report showed, UMBS had a net interest spread of a positive 1.10% and USAT MBS had a net interest spread of minus 1.01%, which he explained that the portfolio was basically at a break-even point in terms of yield when he took it over. Tr. 13,088: 5 - 13,089: 18 (Bruno); Ex. A-5031, Tab 1267 (USAT Performance Report, 03/28/88) at Schedule SC1-SC2.

M347. In a memorandum to Jenard Gross, Bruno reported that the USAT and UMBS portfolios contained a large duration gap between the MBS assets and the liabilities which funded them--because the assets had an effective maturity of approximately 5 ½ years, while the liabilities have an effective maturity of less than 2 years, subjecting the portfolios substantially to the risk of higher interest rates. He reported that the year-to-date net yield spread between assets and liabilities was only 5 basis points, which, assuming interest rates remained unchanged, the net interest spread would be approximately zero within the year. Ex. T-6082, Tab 1261 (Memo from Bruno to Gross Re: MBS: An Investment Strategy, 07/28/88) p. US-3 012838.

M348. The magnitude of the interest rate risk as a result of the large duration mismatch is reflected in the Performance Report of January 20, 1988, the figures of which were confirmed by Bruno in his testimony. The report shows a mark-to-market loss of $245,844,000 with interest rates unchanged. If interest rates declined by 100 basis points, the loss would decline to a negative $186,169,000, and if rates were to increase by 100 basis points, the loss would increase to a negative $337,056,000. Tr. 12,925: 8 - 12,931: 9; Ex. A-1487, Tab 388.

M349. The duration mismatch was of such a size and nature that Bruno concluded that it could not effectively be hedged. Bruno found that the dramatic duration mismatch between the liabilities, that were hedged with swaps and the assets they funded, were highly risky to the portfolios and difficult to hedge. As he testified:

[I]n the context of not further damaging, the fact that they had no net income spread. I mean, hedging at that point in time meant that we were putting them in a negative net income spread which seemed rather perverse.

Tr. 13,082: l5-19 (Bruno).

D. When USAT Failed Its Minimum Net Worth Requirement, The Mortgage-

Backed Securities Portfolio Consisted Of Highly Volatile Mortgage-Backed Securities And Their Derivatives That Also Contributed To The Unmanageable Interest Rate Risk

M350. After he was hired, Bruno prepared a series of memoranda in 1988 to summarize the nature of the instruments in the USAT and UMBS portfolios for Hurwitz’s management team. Tr. 12,083: l - 20 (Bruno). Ex. T-6079, Tab 246 (Memo from Bruno to Crow, 05/17/88); T-6083, Tab 1260 (Memo from Bruno to Gross, 08/29/88), T-6082, Tab 1261 (Memo from Bruno to Gross, 07/28/88).

M351. Bruno reported to Hurwitz and other USAT management that USAT had primarily recently issued 30 yr. MBSs, and highly risky, inverse floaters, low coupon IO’s, high coupon PO’s, and MBS, residuals (in particular, residuals which were based on floating rate CMO’s). He characterized these holdings “in terms of price risk and negative convexity. . .  [as] dangerous securities and contrary to Wall Street claims . . . do not lend themselves to effective hedging.” Tr. 12,826 (Bruno); Ex. T-6082, Tab 1261 (Memo from Bruno to Gross, 07/28/88) pp. US-3 012839-840.

M352. As Bruno explained: “[C]lose to 2/3^rd’s of United’s portfolio [was] in the form of new 30 yr. current coupon MBSs.” Unfortunately, new 30 yr. current coupon MBS assets were very risky since:

a) These instruments have a long duration. Their prices are very volatile with respect to interest rate changes.

b) They are very negatively convex. As interest rates fall, the average lives of these instruments tend to shorten as prepayments accelerate. Therefore, these securities do not participate fully in a market rally. On the other hand, as interest rates rise, the average lives of these instruments tend to lengthen as prepayments slow. As a consequence, these instruments tend to deteriorate very rapidly in price when interest rates rise.

Ex. T-6083, Tab 1260 (Memo from Bruno to Gross, 08/29/88) pp. US-3 012833-834.

M353. Bruno also reported to USAT’s management team that “[u]nfortunately, United also owns a number of derivative MBS securities which have high levels of negative convexity.” Ex. T-6083, Tab 1260 (Memo from Bruno to Gross, 08/29/88) pp. US-3 012833-834.

M354. As Bruno explained, “United’s MBS portfolio is distinguished by the fact that it possesses significant positions in the riskiest MBS products created by Wall Street over the past 2 years, i.e. low-coupon IO’s, high coupon PO’s (the same kinds of securities Merrill Lynch lost millions on several months ago), and residuals off of floater-type CMO’s.” Tr. 12,827: 12 - 12,828: 14 (Bruno); Ex. T-6079, Tab 246 (Memo from Bruno to Crow, 05/17/88) p. US-3 012861.

M355. As Bruno elaborated, “[c]ertain derivative MBS products: e.g. high-coupon PO’s, low-coupon IO’s, residuals (based on CMO’s having floating tranches). . . [h]ave high levels of prepayment risk perform terribly under situations of interest volatility. United has 4% of its MBS assets in such PO’s and 3.4% in residuals.” Ex. T-6083, Tab 1260 (Memo from Bruno to Gross, et. al, 08/29/88) p. US-3 012835.

M356. Bruno explained in reporting on an October 6, 1988, sale of $68.5 million of residuals on CMO’s at management’s direction, at a loss of $33.6 million that residuals constituted the most illiquid portion of UMBS portfolio, and were the most complicated type of security within the entire MBS universe. Ex. B-2450, Tab 1287 (Memo from Bruno to Investment Committee Re: Sale of Residuals, 10/06/88) p. CN467725.

M357. Bruno concluded that, as a consequence of holding these highly volatile derivatives and without unwinding the swaps, “the effective maturity of United’s MBS assets is approximately 6 years while the effective maturity of its funding sources is not quite 2 years” from which he concluded that “United’s MBS portfolio is significantly vulnerable to the risk of higher interest rates.” Ex. T-6083, Tab 1260 (Memo from Bruno to Gross, et al., 08/29/88) pp. US-3 012833-34; Tr. 12,808 and 12,823; Ex. T-6079, Tab 246 (Memo from Bruno to Crow Re: MBS portfolio objectives, direction, and strategy, 05/17/88) p. US-3 012861.

1. Bruno Recommended That The Entire Portfolio Be Restructured To

Eliminate The Duration Gap And Return The USAT And UMBS Portfolios To Profitability Which Was Rejected Because To Do So Would Have Entailed Recognition Of The Unrecognized Losses In The Portfolio

M358. Shortly after he completed his evaluation of the USAT and UMBS portfolios, Bruno recommended that they be completely restructured in order to reduce the interest rate risk and return it to profitability. Tr. 12,803: 9-12 (Bruno). Bruno recommended that USAT shorten the effective maturity of the assets, disposing of hedging instruments that no longer served a legitimate purpose, such as the swaps, even if this required USAT and UMBS to recognize losses on issues. These assets were subject to even greater future losses if USAT and UMBS continued to hold them. Tr. 12,823: 2 - 12,826: 5; 12,807: 11 - 12,808:10 (Bruno); Ex. T-6079, Tab 246 (Memo from Bruno to Crow) p. US-3 012861.

M359. Bruno recommended restructuring the portfolios, despite the Financial impact because he concluded that the losses would only become larger if not taken within a relatively short period of time. Tr. 12,822 : 7-22 (Bruno).

M360. Hurwitz’s management team rejected Bruno’s recommendations to restructure the USAT and UMBS portfolios, because they did not want to recognize the losses that were unrecognized in the portfolios. Tr. 12,804: 16 - 12,805: 8 (Bruno).

M361. Bruno testified that the lack of a positive reaction to his proposals was because accounting considerations were insensitive to the economics of the transactions dominated in the management of the USAT and UMBS portfolios. Tr. 12,831: 1 - 12,832: 1 (Bruno).

2. The Condition Of The USAT And UMBS Portfolios When USAT

Failed Its Minimum Net Worth Requirement Were Caused By The

Sales Of Securities To Generate Gains To Satisfy USAT’s Regulatory Minimum Capital Requirement, Speculation On The Direction Of Interest Rates, And The Purchase Of Some Of The Riskiest Mortgage-Backed Securities Derivatives

M362. A USAT Corporate Finance Department’s report (using the Sendero model Ms. Laurenson testified was state of the art technology) dated June 22, 1988, stated that one of the reasons for the condition of the USAT and UMBS portfolios was:

As a result of taking gains on the MBS portfolio over the past few years,

the book yield on the current portfolio is 124 basis points below what the

same securities are yielding in the market. The book yields are below market

yields for three primary reasons:

--Most of the securities that were bought when rates were high (and accordingly had higher yields) have been sold.

--Much of the current portfolio was added over the past year when the long bond was 75-125 basis points lower than today. These were added at lower yields.

--Older securities that were added when rates were lower and had unrealized losses were never sold and are still on the books.

Tr. 12,818: 16 - 12,819: 10 (Bruno); Ex. T-4463, Tab 1262 (UFG’s Asset/Liability Presentation using the Sendero A/L Model, 04/22/88) p. OW011306.

M363. When asked whether the Corporate Finance Department’s description in Finding M363 above of how the USAT and UMBS ended up in the condition, Bruno testified that it was the result of the “volatile and esoteric” kinds of derivative instruments held in the portfolio, which would have caused problems, “even aside from the gains taken.” Tr. 12,819: 10-21 (Bruno).

M364. The Corporate Finance Department’s observation that the USAT and UMBS portfolios had been managed to generate accounting gains is consistent with what Bruno had previously reported to the regulators. Bruno reported that the portfolio had been mismanaged for accounting purposes prior to his arrival. Bruno testified that he met Jonathan Scott, an official with the FHLBB at lunch with a broker with Bear Stearns in Dallas, sometime shortly after Lawrence Connell had become President of USAT in 1988. In the course of the conversation, Bruno told Scott some of his concerns about the management of the USAT MBS portfolios. As Bruno testified, he:

[W]ound up ventilating some concern about the accounting orientation and the lack of appreciation with some economic problems within [the] portfolio[s].. . .  That there was such a concern with appearances and window dressing, as the expression is used, accounting income, that there was not a concern with the economic volatility of the assets. And I wound up ventilating this and telling him how deeply I was concerned about this and that there was a ton of money here that was being abused, effectively speaking.

Tr. 12,937: 5 - 12,938: 12 (Bruno).

M365. Bruno testified that although the sale of treasury securities for a gain and reinvesting the proceeds may result in the same net income stream, this is not the case with MBSs, because prepayments limit the increase in the value of a MBS in a declining interest rate environment. Bruno explained:

Q. Now, if you had a portfolio that was a portfolio of mortgage-backed securities and interest rates dropped 200 basis points and you took the gain and that portfolio was funded with reverse repurchase agreements hedged with swaps to protect against rising interest rates, what would be the effect of that? Would you be in the same position as if you had not sold the mortgage-backed securities?

A. To answer that question, if you now add in the economic impact of prepayments, it is a damaging effect.

Tr.13,080: 14 - 13,081: 22 (Bruno).

M366. Bruno also testified that the sales that were made out of the USAT and UMBS portfolios to generate accounting income, were not consistent with a MBS portfolio purportedly managed to maintain a net interest yield or spread. Tr. 13,079: 4 - 13,080: 20 (Bruno).

M367. In its analysis of $2.7 billion in MBSs in USAT’s RCAs, excluding the residuals, the USAT Corporate Finance Department, consistent with Bruno’s views, reported:

[W]hile the MBS portfolio is somewhat diversified in terms of coupon and age of the portfolio, the bias of the portfolio toward higher coupon (i.e. premium securities causes the overall yield to increase when rates rise (.31%).

However, costs to fund the MBS under this scenario would increase 300 basis points, causing the unhedged overall spread to turn negative.

Ex. T-4463, Tab 1262 (UFG’s Asset/Liability Presentation using the Sendero A/L Model, 04/22/88) p. OW011308.

M368. In assessing the performance of the MBS hedged arbitrage portfolios over their life, the USAT Corporate Finance Department concluded, similar to Bruno, that:

The purchase of the IO/PO’s were to protect the MBS yield when rates change. They have not performed as they were intended because:

--IO’s and PO’s behave inversely to each other, causing them to largely offset each other (this is a common problem with “Micro” hedging).

--United paid too much for them. As a result, their yield is low, pulling down the average yield on the portfolio under all scenarios from 12 to 20 basis points.

--Unfortunately, these instruments are not liquid because they have a wide spread between their bid and ask prices. The IO’s and PO’s are under water by $2 and $24 million, respectively.

The Corporate Finance Department concluded, “. . . IO’s are a bear market hedge, while PO’s are a bull market hedge. They offset each other and hurt United from both a market value as well as a yield standpoint.” Tr. 12,814 (Bruno); Ex. T-4463, Tab 1262 (UFG’s Asset/Liability Presentation using the Sendero A/L Model, 04/22/88) pp. OW011307 and OW011310.

M369. The USAT Corporate Finance Department further concluded that:

Even after hedging with swaps and caps, the mortgage back portfolio spread is vulnerable to rising interest rates. The current 24 basis point spread will turn negative if rates rise.

. . . Using hindsight, the addition of swaps was a bad decision. They cost United 128 basis points under a flat rate environment, and only help when rates rise about 400-500 basis points.

Ex. T-4463, Tab 1262 (UFG’s Asset/Liability Presentation using the Sendero A/L Model, 04/22/88) pp. OW011312-313.

3. The FSLIC Was Advised The USAT Portfolios Were

Inappropriate For A Thrift

M370. The conclusions reached by Bruno and the Corporate Finance Department are supported by a memorandum to Stuart Root, Executive Director, Federal Savings and Loan Insurance Corporation, from Lewis S. Ranieri. Mr. Ranieri, the principal creator of the MBS under whose tutelage Sandy Orr purported to learn the market, described a portion of the portfolio held at the USAT level in an attachment to the Supervisory memorandum that lead to USAT’s takeover, dated December 19, 1988. In that memorandum prepared at the FHLBB’s request, Mr. Ranieri described the portfolio as follows:

USAT owns a portfolio of mortgage-backed securities with a book value of $1.243 billion. The unrealized loss in this portfolio is approximately $103 million (valued by Merrill Lynch on 12/12). It is our understanding that nearly $987 million of this portfolio is financed with very short-term wholesale and brokered liabilities.

Tr. 13,115: 11 - 13,120: 21; Ex. T-4532, Tab 1290 (Memo from L. Ranieri to Stuart Root Re: Mortgage-Backed Securities, 12/19/88) pp. OW075520-5521.

M371. Mr. Ranieri concluded, based upon his analysis, that:

This portfolio, as currently structured, is inappropriate for a thrift because of the large mismatch in interest rate sensitivity of the assets versus the financing vehicles. The large portion of overnight or short-term financing creates two potential problems: the value of the assets is significantly more volatile than the liabilities, and the net interest margin is quite sensitive to changes in short-term rates. The portfolio is doubly sensitive to a general rise in interest rates because both the value of the assets and the net interest margin decline as rates rise. A decline in rates would have the opposite effect, as both values and margins would improve. This sensitivity to rate movement demonstrates the overall mismatch.

In summary, although the MBS portfolio would improve if interest rates went down, the same increase in rates would result in an even greater loss.

As an economic matter this entire portfolio should be either liquidated or dramatically restructured. Our numbers and discussions with FSLIC have always assumed this loss would be part of the note at Texas Cost of Funds plus 50 basis points. Adding a portion of the loss to goodwill would have several negative effects.

Ex. T-4532, Tab 1290 (Memo from Ranieri to Root Re: Mortgage-Backed Securities, 12/19/88) pp. OW075520-521.

M372. When asked whether he agreed with Ranieri’s characterization of the MBS RCA portfolios and the recommendation that it be substantially restructured or liquidated, Bruno testified that:

A I do.

Q. Do you agree that his recommendation to USAT that as an economic matter, this entire portfolio should be either liquidated or entirely restructured conforms to your recommendation that you made in May, July, and August of what they should do with that portfolio?

A. Yes.

Tr. 13,115: 11 - 13,120: 8 (Bruno).

M373. When asked how he would characterize the portfolio, Bruno testified:

Q. Now, the other question I have for you is: During this period of time you looked at this portfolio when you came in, you did these analyses of this portfolio, and you concluded that it was not an attractive portfolio -- let's put it that way. Is that a fair characterization of your view?

A. That's an understatement. That's accurate.

Q. It's an understatement. How would you characterize the portfolio?

A. A disaster.

Tr. 12,934: 15 - 12,935: 5 (Bruno).

4. Accounting Considerations Overruled The Need to Generate

A Net Interest Spread In The Portfolios

M374. Hansen testified in agreement with Bruno that USAT’s strategies for the management of the MBS RCA portfolios were ill-advised. As he explained, after the accounting change in the second quarter of 1986 occurred, because accounting considerations got in the way of the management of the portfolio to generate a positive spread, the value of which was protected with hedges against the interest rate risk in the portfolios. Tr. 12,706: 10 - 12,707: 9 (Hansen).

M375. The extent to which accounting conventions, not economic considerations, dominated the management of USAT’s MBS portfolios is reflected in the manager’s reaction to the alternatives that Merrill Lynch presented in its analysis of what to do to mitigate the losses caused by the negative spread created in the middle of 1986. As Crow stated in his memorandum, the alternatives were simply not an option because of the accounting impact on the financial statements of USAT. Ex. T-4252, Tab 332 (Memo from Crow to Investment Committee, 09/23/86) p. OW012021. As Orr testified, USAT did not even consider liquidation of the MBS RCA portfolios, because in light of the approximately $50 market value loss it was not practical to do so and still meet USAT’s regulatory minimum net worth requirements. Tr. 3,792: 10 - 3,793; 13 (Orr).

XIV. OMITTED.

XV. Substantial Losses Were Imposed On The Federal Deposit Insurance Fund

In The Course Of The Liquidation Of USAT Caused By Respondents’ Mismanagement Of USAT’s Mortgage-Backed Securities Portfolios

M376. The total loss incurred by the receiver as of December 30, 1988, was $219 million ($82 million for UMBS and $137 million for USAT. FOF 378 - 379. The losses incurred on the MBSs held in RCAs at the USAT level as of December 31, 1988, after taking into consideration the gains recognized on the Respondents’ sales to bolster net worth, and all costs attributable to the hedges, was $137 million. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) Exhibit A, at Schedule A1, p. 1.

M377. The total loss incurred by the receiver as of November 30, 1996, when the cost of funds and added to the December 31, 1988 losses increased to $329 million ($129 million or UMBS and $206 million for USAT. FOF 378 - 379.

M378. The loss of $137 million incurred as of December 31, 1988, when brought up to date by adding the FDIC’s cost of funds to November 30, 1996, increased to $206 million. Ex. A-11011, Tab 295 (Expert Report of Joe Hargett) Exhibit A, Schedule B.

M379. The loss incurred by the FDIC on the MBSs held in RCAs at the UMBS level as of December 31, 1988, after taking into consideration all of the costs of operations and gains on sales totaled $82 million.

M380. The loss of $82 million incurred as of December 31, 1988, when brought up to date using the FDIC’s cost of funds to November 30, 1996, totaled $123 million. Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) Exhibit B, Schedule A.

M381. Respondents’ expert Carron was asked by Respondents’ counsel to review Hargett’s loss calculations. He did a reverse engineering of Mr. Hargett’s work at Respondent’s counsel’s request and replicated Hargett’s conclusions. Carron’s calculations, which replicated Hargett’s results, were destroyed prior to his deposition in this matter. Tr. 28,500: 2 - 28,505: 15 (Carron).

M382. The disposition of many of the assets and liabilities out of the RCA portfolios in 1988 were managed by USAT’s portfolio managers in anticipation of a recapitulation of USAT with FHLBB assistance. They included those that generated losses on the sales of residuals and interest rate swaps. Tr. 12,906: 1-4; Tr. 12,906: 19 - 12,908: 15 (Bruno); Ex. A-1531, Tab 1256 (Investment Committee Minutes, 10/05/88) p. US-3014536; T-4517, Tab 1274 (Memo from Bruno to Connell and Crow, 10/03/88) p. OW012492-493; T-4518, Tab 1275 (Memo from Bruno to Connell and Crow, 10/03/88) pp. OW012494-498; T-4521, Tab 1276 (Memo from Bruno to Investment Committee, 10/06/88) pp. OW012501-504.

M383. The liquidation schedule followed by the receiver was similar to that proposed by USAT’s portfolio manager in December of 1988. Bruno testified that the schedule that he proposed in December 1988, for what he described as an orderly disposition of the assets and liabilities out of USAT’s RCA portfolios, was essentially followed by the FHLBB receiver after comparing the schedule of sales contained in the Hargett report with what he had recommended to USAT. Tr. 12,912: 8 - 12,915: 19; 13,131: 19 - 13,132: 10 (Bruno). Ex. A-1533, Tab 1258 (Investment Committee Minutes, 12/07/88) p. OW049860; A-11018, Tab 291 (Expert report of Joe Hargett) pp. 7-40.

M384. The losses incurred in the course of the liquidation of the MBS portfolio in 1989 conform to the figures reflected in the market values calculated by Bruno and at the time of the appointment of a receiver. Bruno estimated the market value loss of the MBSs held by USAT to be $99 million and for all portfolios to be $217 million as of December 7, 1988. Ex. A-1533, Tab 1258 (Investment Committee Minutes, 12/07/88) p. OW49869. And the losses calculated by Ranieri in his memorandum to the FHLBB, attached as an exhibit to the S-Memorandum, were likewise similar to those calculated by Hargett. Tr. 12,912: 8 - 12,915: 3; 12,926: 22 - 12,927: 5; 13,124: 11 - 13,127: 18 (Bruno); Ex. T-4532, Tab 1290 (Memo from Ranieri to Root Re: Mortgage-Backed Securities, 12/19/88) pp. OW075520-521.

XVI. Respondents Rushed Into Mortgage-Backed Securities Risk-Controlled Arbitrage

Investments Without The Knowledge Experience Or The Tools Necessary To Knowledgeably Manage A Risk-Controlled Arbitrage Portfolio

A. The Respondents’ Officers Of USAT Were Not Qualified To Oversee

The Management of Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios Contrary To Representations Made To FHLBB

M385. In seeking approval from the FHLBB to increase the size of USAT’s liabilities in 1988, Respondents represented that:

During 1984, United established an Investment Department to coordinate a brokered CD program and the investment of these funds in corporate and mortgage-backed securities. The deposits generated by this program generally have maturities of from two to twelve years and are matched against high yield securities with similar maturities and duration. This approach virtually locks in a spread between United’s asset yield and funding cost, giving significant protection against interest rate fluctuations. Additionally, this department is upgrading United’s investment portfolio to increase its overall yield.

Ex. A-10566, Tab 176 (Letter from Williams to FHLBB Re: USAT Growth) p. CN052883.

M386. In justifying USAT’s transition from a traditional thrift to one that emphasized wholesale investments in MBSs, corporate debt and equity arbitrage activities, USAT stressed the quality and experience of the new management team brought in by Respondents to manage USAT:

In understanding the implementation of USAT’s corporate strategy, investment philosophy and policies, it is important to recognize the significant experience USAT’s management brings to the Association.

As we explained, since 1982, virtually the entire USAT management team has changed and been augmented through the employment of an experienced, well rounded group of top-level executives and managers. This management team brings not only savings and loan association and banking backgrounds but a broad array of corporate, securities, business administration and entrepreneurial experience to the leadership of USAT.

In order to show the quality of this management team, I am attaching a brief resume setting forth the business experience of each of the USAT management team.

Ex. A-10634, Tab 180 (Letter from Berner to Halverson) p. OW005294.

M387. UFG's 1985 Annual Report stated that, at the end of 1985, pursuant to the Wholesale Strategy, USAT had a $2.2 billion investment portfolio, the "bulk" of which was invested in MBSs ($1.4 billion) as part of a RCA program and a fixed rate corporate bond arbitrage portfolio. As discussed below, although USAT's investments in these matching programs was described in the 1985 Annual Report as the "heart of its investment strategy," ( Ex. A-3005, Tab 2341 p. OW0000367), none of the managers of USAT, other than Hurwitz and Huebsch, had any prior experience managing any kind of security investment portfolios, and none had any experience managing MBS RCA portfolios with volatile prepayments such as USAT’s. FOF M387 - M395.

M388. Gross, who was the CEO of USAT during the period when USAT's MBS RCA portfolios were established, had developed and managed apartment buildings since 1954 (Tr. 20,059: 3 - 20,061: 19 (Gross)) and had no prior experience with MBSs. Tr. 21,518: 13-18 (Gross). As Gross testified when questioned regarding the MBS portfolio: “My experience [with MBS], as I've said from day one, was very limited. And that's the reason I wrote all the memos and asked all the questions, because I tried to learn and understand it.” Tr. 21,518: 15-18.

M389. In light of Gross' limited experience with respect to securities investments, Doug Hansen, who had a background in finance (Tr. 12,480: 20 - 12,482; 19 (Hansen)), was hired by Munitz to assist Gross. Tr. 12,488: 14 - 12,490: 14 (Hansen).

M390. G. Williams, the President of USAT in 1985 and 1986 when the MBS portfolios were created, also testified that he had no experience supervising anyone managing a MBS RCA portfolio. Tr. 6,337: 3 - 6,338: 6 (G. Williams); 15,279: 8-13 (Crow).

M391. Similarly, Crow, the Chief Financial Officer of USAT and the member of the Investment Committee, who Berner considered most knowledgeable about MBSs (Tr. 15,588: 16-17; 15,583: 5 (Berner)), also testified that he had no prior experience in overseeing the management of an MBS portfolios. Tr. 15,279: 15-22. Crow added that in the 12 years he had worked with G. Williams prior to taking a position with USAT, to his knowledge, G. Williams had not had any prior experience overseeing the management of an MBS portfolio. Tr. 15,280: 1-8.

M392. Munitz, whose experience was on the "people and processing side" as opposed to the “financial and deal making side" (Tr. 25,067: 2-7), testified that MBSs were not his area of expertise. Tr. 25,477: 16-20.

M393. Berner, who was also a member of the Investment Committee (Ex. T-7587, Tab 655 pp. OW015678-682), testified that he too had no experience or knowledge regarding MBSs. According to Berner, he and Gross were the least knowledgeable persons on the USAT Investment Committee regarding MBSs. Tr. 18,589: 14-21.

M394. In fact, none of the witnesses in this proceeding could identify any manager of USAT who had any prior experience with MBS RCA at the time USAT embarked upon its program in late 1984 and early 1985. For example, Huebsch, who was responsible for setting up USAT Investment Facility (Tr. 13,420: 3 - 13,425: 1 (Huebsch)), served on the USAT Investment Committee (Ex. T-7587, Tab 655 p. OW015678-682), and managed its equity arbitrage portfolio (Tr. 13,900: 3 - 13,901: 6 (Huebsch)), testified that he did not know whether any of the members of USAT's senior management, including G. Williams, Munitz, Crow and Gross, had any experience with MBSs. Tr. 13,740: 19 - 13,741: 18.

M395. Huebsch, when asked whether any of USAT's senior management had any experience overseeing the management of the MBS hedged portfolio at the time USAT hired Joe Phillips, testified:

I don't know whether any of them had experience with mortgage-backs. They were all, you know, very astute businessmen. They had made investments, whatever. I doubt whether any of them managed a hedged portfolio of mortgage-backed securities.

Tr. 13,879: 15-20.

M396. Doug Hansen, who assisted Gross and was a regular participant at the Strategic Planning Committee meetings where USAT investment strategy was discussed, likewise was unaware whether any of the members of USAT's senior management, including Gross, G. Williams, Munitz and Crow, had any experience with MBSs. Tr. 12,702: 22 - 12,703: 22.

B. Phillips, The Orginal Manager Of The Mortgage-Backed Securities

Portfolios, Did Not Have The Experience Or Knowledge To Safely

Manage The Mortgage Backed Securities Portfolios______________

M397. Joe Phillips, who was initially hired by USAT to direct USAT's high yield bond portfolio (Tr. 5,019: 2-21 (Phillips)), had little prior experience managing an MBS RCA portfolio before assuming that responsibility at USAT. Tr. 5,018: 20 -5,019: 7; 5,184: 20 - 5,185: 9 (Phillips). Phillips’ only exposure to MBSs was at American General Insurance Company, an insurance holding company (Tr. 5,318: 20 - 5,319: 7 (Phillips)) where he served for about a year on an investment policy committee that had studied whether "mortgage-backed securities would be suitable for one or more of our [American General's] investment activities." Tr. 5,320: 3-16 (Phillips). At Southmark, where he was employed immediately prior to coming to USAT, Phillips stated that his duties involved high-yield bonds and Treasury Bonds (Tr. 5,015: 1-10) but did not involve MBSs with their unique prepayment characteristics. Tr. 5,322: 13-18. Huebsch, who recruited Phillips to work as an investment manager at USAT, testified "I doubt whether he [had ever] managed a hedged portfolio." Tr. 13,887: 18-20.

M398. The managers of USAT concluded in the Spring of 1986 that Phillips was a little bit overwhelmed managing the junk bond and the MBSs portfolios at the same time, (Tr. 12,499:21 - 12,500: 2 (Hansen)) and sought to replace him with someone who was more familiar with the technicalities of MBSs. Tr. 6,368: 21 - 6,369 :22 (Williams).

C. USAT’s Management Did Not Know What The Economic Effect Of The

Rolldown In January And February Of 1986 Would Be On USAT’s

Financial Condition_____________________________________________

M399. In a February 19, 1986, memorandum to Huebsch, Hurwitz, Phillips, G. Williams and Munitz, Gross stated that:

I was glad to learn yesterday that you completed your roll downs of your mortgage backed securities. I wonder if you can determine or if anyone else can determine where we now stand as far as annual income stream from the mortgage backed and the swaps. Also, what sort of a spread do we now have compared to what we were originally shooting for? Do we currently have on hand any accounting techniques to know what we've done to date on the ones that we rolled down and what we will do in the future on the ones that we've now acquired.

Ex. T-4171, Tab 1312 (Memo from Gross Re: Roll Down MBS).

M400. As Crow acknowledged in a March 18, 1986, memorandum in response to Gross’ questions, Respondents’ only knew where USAT stood

[I]n terms of mortgage backed securities and the related spread per the Performance

Report Schedule SF. This is on an overall total portfolio basis. This analysis

does not attempt to segregate mortgage backed securities by block or purchase

date nor measure against any original targets. We have never tracked mortgage

backed securities by block measuring original targets as to spread versus actual

results. I believe Joe Phillips has the original targets but I do not believe that Joe

keeps up with mortgage backed securities results versus those original targets. Finance/Administration was unaware that we were "rolling down" coupons in

mortgage backed securities. Therefore, we did not analyze projected resulting spreads from the newly rolled down positions. This was done by Joe Phillips since they were involved in the actual planning and execution of the roll downs. . . The memo states

that the mortgage-backed securities system will not automatically perform the functions that are desired. . . We have worked with Salomon Brothers and know they cannot

solve our problem. We are converting to the new mortgage backed securities system

and believe that it will enhance our accounting reporting capabilities.

Ex. A-10615, Tab 862 (Memo from Crow to G. Williams).

D. It Was Not Until The Middle Of 1986 That USAT Had An Independent

Outside Consultant Do A Sensitivity Analysis Of The Market Value Of The Mortgage-Backed Securities Portfolio________________________________

M401. Phillips admitted in his testimony that USAT knew that the 100 basis point move in 10-year Treasury rates, which had occurred shortly after he had purchased the MBSs for the portfolio was a significant move. Tr. 5,274: 18 - 5,275: 10 (Phillips). However, USAT did not learn that the spread in the portfolio had turned negative and that there was a market value loss in the arbitrage portfolio until USAT received the Smith Breeden analysis in July 1986, from which Phillips concluded that the portfolio was basically unsalvageable. Tr. 5,285: 12 - 5,287: 22 (Phillips); Ex. A-10649, Tab 187. pp. OW005964-966.

M402. As Orr testified, measuring the impact on market value of different interest rate scenarios by performing “sensitivity analyses” was the best way to ascertain what was happening to the portfolios and to see what was going to happen to the portfolio. The sensitivity analyses were performed by applying different assumptions about the speeds in varying rate scenarios. Although somewhat subjective, the analyses provided “probably the most useful information that you can get on a portfolio as a whole.” Tr. 4,007: 9-11 (Orr).

M403. It was not until the summer of 1986 that USAT contracted with an outside expert, independent from the investment banking firms, to provide USAT with a scenario analysis of how its various portfolios had performed and how they would be affected by changes in interest rates. Ex. B-967, Tab 1127 (Letter from G. Williams to Gregory Smith, 05/02/86) p. 000024; Ex. B-4196, Tab 1128 (Fee statements from Smith Breeden Associates to United Savings of Houston).

M404. It was not until July of 1986 that USAT received the first results of Smith Breeden’s analysis. Ex. T-4222, Tab 330 (Memo from Crow to Gross and G. Williams) p. OW011927-941.

M405. Smith Breeden was subsequently hired to provide analyses of specific trades proposed by USAT, but, according to Crow, was unable to provide timely information to the managers of the portfolios, identify whether trades would be profitable, or support the analytical assumption in their work. Ex. A-1415, Tab 346 (Investment Committee Minutes, USAT, UFG, 10/31/86) pp. US-3 010376-US-3010377.

M406. It was not until November 1986 that USAT hired a person to develop the computer models to provide Orr with the in-house models to analyze the impact of different interest rate scenarios on the market value and spread on the MBSs portfolios. Ex. A-1414, Tab 345 (Investment Committee Minutes, USAT, UFG, 10/31/86) pp. US-3 004949-950.

M407. The first USAT internal sensitivity analysis was not performed until December 4, 1986. Tr. 3,860: 20 - 3,863: 13 (Orr); Ex. A-1421, Tab 352 (Investment Committee Minutes, USAT, UFG, 12/04/86) p. US-3 005137.

M408. Even then, however, USAT did not have the capability to timely analyze the impact of trades on the interest rate sensitivity prior to execution of the trades. Tr. 3,846: 13-16; 3,859: 8-13; 3,865: 1-11; 3,868: 6-13; 3,877: 21 - 3,878: 3; 3,891: 13-19; 3,892: 19 - 3,893: 1 (Orr).

E. Respondents’ Managers Of USAT Did Not Have The Ability To Do A

Duration Analysis Or Scenario Analysis For The Entire Portfolio Until 1987

After The Damage Had Been Done To The Portfolios____________________

M409. USAT did not obtain the capability to do timely duration analysis and current market value, cash flows, income statements, balance sheet results, "what if" capabilities for various growth strategies and asset liability structures, and results under different interest rate scenarios until 1987, when it purchased access to the “Sendero Model.” Tr. 3,993: 1 - 3,994: 18 (Orr); 8,812: 17 - 8,813: 9 (B. Williams). Prior to that time, USAT did not have the capability to measure the impact of alternative interest rate scenarios on the balance sheet. Instead, with the one exception of the Smith Breeden report, USAT relied entirely upon the investment bankers from whom USAT purchased MBSs for such information. Tr. 8,813: 15 - 8,815: 2 (B. Williams).

M410. USAT did not meet with the Sendero Corporation’s representatives until February 24, 1987, to review the services that the Sendero model could provide. Ex. B-1501, Tab 374 (Memo from B. Williams to Investment Committee Re: Asset/Liability Management Model, 02/24/87) p. US-3 007411; Tr. 3,993: 5-15 (Orr). Moreover, the Sendero model was not used by USAT until “[p]robably late 1987 through 1988.” Tr. 8,491: 22 - 9,492: 10 (B. Williams).

M411. The Sendero Model was not made available to Bruno, nor was he told that it was available for his use to model the MBSs portfolios under different interest rate scenarios. Tr. 13,129: 1-16 (Bruno).

F. Respondents Knowingly Rushed To Invest In The Mortgage-

Backed Securities Portfolio In Order To Satisfy The Qualified Thrift Lender Test Without Adequate Knowledge Of The Risk Such Portfolios Entail

M412. In a memorandum from Gross to Hurwitz and Munitz, with regard to the haste with which USAT acted in making investment decisions, Gross acknowledged:

[P]art of the problem we are faced with today is the fact that we really rushed

into our existing portfolio without the advice on the shape of the CD maturity

stream against the shape of the bond stream. The end result is that we are having

a lot of bonds called away, but we are not having the CD’s rolling off because

they are longer term. Just like our swaps were not designed properly and didn’t

give any thought to the possibility of pre-payments. That’s how we got killed in the mortgage backed securities area.

Ex. T-4333, Tab 329 (Memo from Gross to Crow, Hurwitz,and Munitz, 01/22/87) p. OW012143.

M413. In a memorandum to Gross regarding USAT’s strategy for the 18 months following the date of the memorandum, July 14, 1986, Hansen concurred, reporting that:

Another interest rate margin problem is the risk-controlled arbitrage portfolio. Smith Breeden should give us some help in not have a repeat disaster, and in balancing the swaps versus our overall interest rate risk posture. I think there must be a way so we do not have to roll up and down all the time. I think risk-controlled arbitrage can be a good business. Once we understand it better, we might even consider. . . doing some more of it.

Ex. B-1102, Tab 378 (Memo from Hansen to Gross, 07/14/86) p. OW000557.

M414. In an April 27, 1987, memorandum from Gross to Hurwitz and the other members of the Strategic Planning Committee, Gross acknowledged:

It seems to me that what keeps evolving at our Investment Committee Meetings is the obvious point that we do not have any unified strategic plan or policy with regard to interest rates.

It seems to me there are so many variables that come into play and yet we make arbitrary decisions to buy or sell without having an overall comprehensive framework.

Ex. T-4366, Tab 1660 (Memo from Gross to members of the Strategic Planning Committee, 04/27/87) p. OW012296.

M415. In a May 1, 1987, memorandum to Hurwitz and other members of the Strategic Planning Committee, Crow agreed with Gross’ assessment that Hurwitz’s management team’s lack of an adequate understanding of how MBSs portfolios were to be managed in addressing the question of whether the USAT and UMBS portfolios should be expanded further in mid-1987:

. . . Among others, the following issues have to be addressed before expansion can take place:

. . . Interest rate risk of mortgage-backs is very high and, to achieve significant spreads, cannot be hedged away. Mark-to-market losses are a real possibility.

. . . An almost ‘black box’ lack of understanding of these securities. This area is very complex and is obviously not mastered by the Wall Street firms. It is naïve to think UFG is on a parity level of understanding with Wall Street.

Ex. T-4364, Tab 877 (Memo from Crow to Hurwitz, Gross, Munitz and Berner, 05/01/87) p. OW011375.

M416. In recognition of the lack of knowledge on how to properly manage the USAT and UMBS portfolios, Berner proposed, in an April 22, 1987, memorandum to Hurwitz and other members of the Strategic Planning Committee, that they give up trying to generate a net interest rate spread from the portfolios and only utilize them to satisfy the qualified thrift test:

Over the past few days as we have watched the volatile mortgage-backed securities market, the following ‘insights’ have become apparent to me and, therefore, I thought I might share them with you.

. . . We have been told on numerous occasions that we can totally hedge the mortgage-backed securities portfolio but, of course, we will lose all of the spread. One thing to consider, perhaps is hedging it and losing the spread while maintaining the assets in order to meet our ‘thriftiness’ test. If we ultimately believe that dealing in mortgage-backed securities is too volatile an exercise, we might want to consider totally hedging so that we can meet the thriftiness test without any risk or, of course, reward.

Ex. B-1580, Tab 1659 (Memo from Berner to Hurwitz, Munitz, Gross and Crow, 04/22/87) p. W100886.

XVII. Respondents Managed USAT’s Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios In Violation Of The Board Of Directors’ Policies

A. The USAT Board Of Directors 1986 Policy Required The Mortgage-Backed Securities Portfolios To Be Managed To Protect Against Interest Rate Risk, Not To Be Traded To Take Advantage Of Short Term Shifts In Interest Rates

M417. The Board of Directors of USAT and UFG created the Investment Committee in May of 1986. Ex. T-7587, Tab 655 (Minutes of USAT Board of Directors, 05/08/86); A-1112, Tab 1307 (Minutes of UFG Board of Directors, 05/08/86).

M418. The Board of Directors of USAT and UFG adopted an Investment Policy to guide the Investment Committee on May 27, 1986, which provided that “[t]he objective of this investment policy is to manage and control the company’s resources through the most effective asset mix and funding sources to provide for optimum and stable earnings within constraints of prudent risk management, a strong liquidity position, and an adequate capital base.” Ex. A-14081, Tab 1397 (UFG Investment Policy, 05/27/86); A-10636, Tab 181 (UFG Investment Policy, 05/27/86); A-14033, Tab 1470 (UFG Investment Policy-containing handwritten notes received as Ex. A-10636, Tab 181, 05/27/86).

M419. The Respondents’ managers of USAT provided the May 17, 1986, Investment Policy to the FHLBB examiners during the course of the 1986 Examination. Tr. 17,071: 18 - 17,074: 6 (Carlton). The examiners’ understanding was that the May 5, 1986, Investment Policy, was the Boards’ policies at all relevant times and did not indicate to the examiners “that USAT intended to make sales out of the mortgage-backed securities portfolio or the high-yield bond portfolio for the purpose of generating a gain to bolster profits.” Tr. 17,280: 11 - 17,282: 18 (Carlton).

B. Resolutions Adopted By The Board of Directors In 1986 And 1987 Emphasized

That The Mortgage Backed Securities Portfolios Were To Be Traded

Only To Reduce Interest Rate Risk And Were Not To Generate Gains

To Meet The Regulatory Minimum Net Worth Requirement

M420. As reflected in the USAT Board of Directors minutes for the November 13, 1986, meeting, the Board proclaimed that it “shall be the policy of United Savings Association of Texas to undertake trading activities related to the mortgage-backed securities investment portfolio trading operation from time to time in order to reduce the net interest rate exposure of the association.” Ex. B-4065, Tab 1006 (UFG Minutes Fourth Quarter, 12/31/86) p. KPMG 035582; A-1125A, Tab 1448 (Board meeting packet—resolutions, 02/18/87); A-1128A, Tab 1449 (USAT Board meeting packet—resolutions, 05/07/87).

M421. As Crow testified, the resolutions described in Finding M419 above do not authorize the Respondents’ managers of USAT to make sales out of the MBS portfolio in order to generate gains to bolster profits. Tr. 16,688: 5 - 16,690: 19 (Crow).

XVIII. Respondents’ Managers Of USAT Failed To Maintain Complete And

Accurate Books And Records Of The Mortgage-Backed Securities

Transactions Despite Repeated Directions To Do So

A. Respondents Failed to Document the Reasons For Mortgage Backed

Securities Trading Activity

M422. USAT did not keep any records that revealed how the MBS portfolios were managed until April 1986.

M423. It was not until April of 1986, that Respondents created an Investment Committee. Prior to that date no meetings were held nor minutes kept to reflect the objectives or strategy of the MBS portfolios. FOF A202 - A209.

M424. Even after the Investment Committee was created, the minutes did not describe the objectives of the MBS portfolios and how specific transactions conformed to those objectives. Tr. 12,329: 1-12 (Claiborne); 10,299: 1 - 10,300: 8 (Millinor); Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow, 01/05/87) pp. KPMG 024414-KPMG 024415.

M425. OMITTED.

M426. The Investment Committee minutes, in most instances, merely stated that the portfolio manager made a report and attached whatever material had been distributed without an explanation of the committee’s deliberations and reasons for such actions. See e.g., Ex. B-4064, Tab 1005 (Fourth Quarter Minutes, October 1986, 12/31/86); Ex. B-4065, Tab 1006 (Fourth Quarter Minutes, November 1986, 12/31/86); Ex. B-4067, Tab 1007 (Fourth Quarter Minutes, December 1986, 12/31/86); Ex. B-4093, Tab 1012 (Second Quarter Minutes, March and April 1987); Ex. B-4105, Tab 1194 (First Quarter Minutes, February 1987, 02/18/87); Ex. B-4106, Tab 1195, (First Quarter Minutes, February 1987, 02/20/87).

B. Respondents Were Repeatedly Advised To Improve USAT’s Mortgage-

Backed Securities Portfolio Records

M427. After the completion of the audit of UFG’s December 31, 1985, financial statements, Peat Marwick informed USAT on January 31, 1986, that there were deficiencies in its system of internal controls for mortgage-backed, corporate equity and debt securities investments, including:

--Formal trading room policies and procedures for authorization, approval and initiation of transactions have not been documented. Such policies and procedures should be established with appropriate control procedures to document approval of the transactions.

--Internal trade tickets prepared by the trading department are not always completed properly and approved on a timely basis.

Ex. A-7006, Tab 987 (Letter from Peat Marwick to USAT Board of Directors, 01/31/86) p. OW120498; Tr. 10,265: 13 - 12,968: 8 (Millinor).

M428. In the course of the audit of UFG’s December 31, 1986, financial statement, Peat Marwick reviewed selected minutes of the Investment Committee. Tr. 12,430: 12 - 12,433: 19 (Claiborne); 10,487: 11 - 10,488: 3 (Parsons).

M429. Peat Marwick informed USAT on January 5, 1987, that its review of the minutes revealed deficiencies in the documentation of transactions, including that the minutes of the Investment Committee did not provide descriptions of the objectives and specific strategies of purchases and sales which Peat Marwick believed was essential for the auditors’ review of the appropriateness of the accounting treatment for the junk bond and MBSs portfolios, because without such documentation, it was impossible to conclude whether trades were made for the purpose of short term gains or for other valid purposes consistent with an investment portfolio. Tr. 12,329: 1-12 (Claiborne); 10,299: 1 - 10,300: 8 (Millinor); Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow, 01/05/87) pp. KPMG 024414 - KPMG 024415.

M430. On April 16, 1987, the FHLBB also informed USAT’s Board of Directors that the institution’s books and records were not properly maintained, in accordance with applicable regulations, to provide an accurate and complete record of all business transactions. The FHLBB informed USAT’s Board that USAT’s books and records did not accurately reflect USAT’s financial condition in that they did not readily identify the composition of the portfolio of assets, thereby overstating total assets and total liabilities by $73,687,500. Ex. A-14020, Tab 1461 (Report of Examination, 04/16/87) p. OW078172.

M431. On February 5, 1988, Peat Marwick issued a qualified opinion on USAT’s financial statements for the year ended December 31, 1987, because of its conclusion that USAT could not continue as a going concern and would therefore “have to convert tangible non-cash assets, principally mortgage-backed securities, loans and investment securities, to cash at less than the reported amounts.” Ex. T-8033, Tab 402 (Annual Report United Financial Group, Inc. 1987) p. H0701.

M432. In the course of a FHLBB Examination begun in November of 1987, the examiners issued an interim report number 2 on March 10, 1988. In that interim report, the examiners again described the deficiencies in USAT books and records:

Our review disclosed that the Association’s investment securities activity, for the most part, has been conducted within the Association’s wholly owned subsidiaries. Moreover, the Association’s records, specifically for its financial futures and options transactions, are not being maintained in such a manner which will readily disclose the Association and its subsidiaries’ outstanding position(s). Although the Association maintains an array of computer-generated reports for its investment securities transactions, these reports are not maintained nor presented in such a manner (format) which will readily disclose the Association’s compliance with applicable regulations.

Ex. A-14070, Tab 1497 (Memo from Carlton to Twomey, 03/10/88) p. OW0128899.

M433. On July 28, 1988, the FHLBB delivered the final Report of Examination that commenced on November 16, 1987, to USAT’s Board of Directors. The Report explained that USAT’s managers have:

[E]mployed some aggressive actions (increased marketable securities and speculation) which has resulted in substantial non-operating income for the institution, but has also exposed USAT to considerable risk. It is this risk, coupled with USAT’s thinly capitalized posture in a volatile market which threatens its viability.

* * *

USAT’s board of directors have not adopted a formal written business plan.

* * *

During the preceding examination, dated May 27, 1986, USAT’s books and records were not prepared and maintained in accordance with Sections 563.17-1(c)(1) and 563.23-3. The examiners were unable to reconcile the required periodic Federal Home Loan Bank Board (Board) reports to USAT’s permanent books and records. Moreover, the books and records were not maintained in such a manner which would provide complete information as to the nature of many of the transactions reviewed.

* * *

The examiners were ultimately provided sufficient documentation for the association’s financial futures/options activity during the examination. However, these transaction with respect to its hedging activity, involved a series of complex circumstances. Therefore, in order to avoid misunderstanding on the part of regulators as to the specific nature of these transaction, the association should devise audit trails and summation reports that will detail its financial futures/options hedging activities in such a manner/format (‘self contained’) which will facilitate a third party review. Furthermore, management should provide periodic reports of the association’s policy for interest rate risk. These reports should be prepared in a clear and concise manner with all supported documents readily available for review upon request.

Ex. A-6022, Tab 468 (Report of Examination, 11/16/87) p. US-3 010974.

M434. On January 19, 1989, the examiners who conducted the Southwest Plan Examination submitted a series of reports on the results of their work performed prior to the placing of USAT into receivership on December 30, 1988. In Attachment 8 the examiners explained:

A review was made of the mortgage-backed securities (MBS) activities and related investment strategies engaged in by United Savings Association of Texas (USAT), its wholly-owed service corporation, United MBS Corporation (UMBS), and USAT’s three finance subsidiaries. The institution and its service corporation engaged in a high interest rate risk leveraging strategy in an attempt to generate a large net interest spread between long-term fixed-rate assets and short-term liabilities. . . . 

The institution did not maintain documentation which would indicate the impact of these investment strategies on its asset/liability structure or capital position under different interest rate scenarios. Furthermore, in many instances, they did not analyze the impact of individual transactions such as the purchase of the residual interest of a multiple class security (residual) or the interest only portion (IO) of a stripped MBS on the entire MBS portfolio. . . . 

We also noted numerous document deficiencies and lack of proper monitoring and planning by the board of directors of this investment activity. Of particular concern was a $10 million overpayment between the purchase price for principal only (PO) stripped mortgage-backed securities indicated on the broker’s confirmation and the amount recorded to the general ledger. Management had not resolved this issue prior to the completion of the examination.

. . . We reviewed the policy and procedural guidelines revised in August 1988, for the MBS portfolio and the related activities. The new guidelines appear to be adequate. However, no new activity was reviewed to determine compliance with these policies and procedures

Ex. B-2699, Tab 1863 (Examination Report of USAT by Bese, 01/19/89) pp. OW0154317-OW154318.

C. USAT Failed To Improve Its Records Despite Repeated Warnings To Do So

M435. USAT did not respond favorably to Peat Marwick’s or the FHLBB’s directions to improve the documentation of purchases and sales so that the auditors and examiners could ascertain the consistency with the objectives and strategies of the portfolio. Crow, who Respondents’ placed in charge of the accounting department, wrote in a January 12, 1987, memorandum to B. Williams and Wolfe:

[W]e can make a decent case that while it is our intent to hold securities long term, the very volatile markets which we have been experiencing have created the necessity to do some portfolio trading out.

A lot of the other stuff in the memo appears to me to really be difficult to administer and very non-productive. I think it is an absolutely untenable position for us to mark-to-market the hold portfolios.

Ex. A-10716, Tab 897 (Letter from Crow to B. Williams and Wolfe Re: Peat Marwick recommendations, 01/12/87) p. OW003634.

M436. Despite the repeated directions to provide greater detail on the objectives of USAT’s MBS portfolios, the purposes of the transactions made therein, and how the transactions fit within previously established policies in USAT’s Investment Committee minutes, Respondents’ failed to do so.

M437. As Crow conceded in his testimony, the Investment Committee minutes for the time period sales were made to generate gains do not describe the purposes of the trades, whether the trades were made to generate gains and bolster profits in order to meet USAT’s regulatory minimum net worth requirement, or whether the sale served some other purpose. Tr. 15,704: 11 - 15,705: 7; 15,709: 16 - 15,710: 9; 15,723: 13-22; 15,724: 6-15; 15,750: 8-22; 15,755: 14-18 (Crow).

M438. As Orr conceded in her testimony, the Investment Committee minutes for the time period sales were made to generate gains do not contain a sensitivity analysis of the trades from which to ascertain the purpose or the effect of the transactions. Tr. 3,846: 13-16; 3,859: 8-13; 3,865: 1-11; 3,868: 6-13; 3,877: 21 - 3,878: 3; 3,891: 13-19; 3,892: 19 - 3,893:1 (Orr).

M439. The state of USAT’s books and records was such that Respondents’ expert was unable to use the Investment Committee minutes to categorize the purpose of 370 sales and 458 purchases in the time period in which sales were made to generate gains. Instead, Respondents’ expert was required to use staff member’s hand written notes, notations on trade tickets from which he assumed there was a connection between purchases and sales, and in some instances the mere fact that transactions occurred on the same date and in similar amounts. Tr. 28101: 4 - 28102: 12 (Carron).

M440. Respondents’ expert was unable to categorize the purpose of 135 trades, with a face amount of $4.112 billion, that generated a recognized gain of $22.246 million in profits for USAT, and had to list them as “other strategy.” Ex. B-4382, Tab 2031 (Supplemental Report of Andrew S. Carron, 01/05/99) p. 3 and Exhibits 1-3; Tr. 28116: 13 - 28117: 4 (Carron).

M441. Moreover, Respondents’ expert was only able to categorize the trades as rebalancing, value trades, or capital trades, using mathematical formulas that he assumed reflected the purposes of the trades. As Carron admitted in his testimony, the trades he classified fell within more than one category, and he then selected the category to which he placed them in his final report based upon his assumption that the trades were primarily made to reduce the interest rate risk to the association, which as described in Findings M230 - M240 above was not the case. Tr. 28,513: 18 - 28,525: 14 (Carron); Ex. T-9057C, Tab 2049 (Trade Classifications Respondents did not introduce); Ex. B-4407, Tab 2035 (USAT Trade Classification Respondents did introduce).

M442. The sensitivity analysis prepared by Smith Breeden as of June 30, 1986, concluded that the hedged MBS portfolios contained a $58 million unrealized market value loss, as a result of the rolldown in the first half of 1986, which would increase to only $58.42 million if rates declined by 100 basis points. It would only increase to $59.7 million if rates were to increase by 100 basis points. Ex. T-4222, Tab 330 (Crow Summary of Smith Breeden Presentation) p. OW011940.

M443. The sensitivity analysis prepared by Orr and Mueller on December 4, 1986, after October and November purchases and sales that resulted in the portfolio being turned over 100 percent, showed that the market value loss had increased $30 million to $88 million. The loss would increase to $105 million if rates declined by 100 basis points and increase to $116 million if rates increased by 100 basis points. Tr. 3,860: 20 - 3,863: 13 (Orr); Ex. A-1421, Tab 352 (Investment Committee Minutes, 12/04/86) p. US-3 005137.

M444. The trade analysis that Respondents’ expert prepared, which assumed the trades were made in October and November 1986 to reduce the interest rate risk, was not supported by the sensitivity analyses that USAT had prepared. In fact, trade analysis results were just the opposite. The market value loss and interest rate risk increased substantially from the trades. Consequently, Respondents’ expert was unable to accurately ascertain the purposes of the trades even from the external materials he relied upon, which the auditors and examiners stressed should not have to be relied upon. All the necessary information should be included in the Investment Committee minutes, which as Respondents’ expert testimony reveals was not the case.

XIX. Respondents Repeatedly Misrepresented Their Conduct In The Management Of USAT’s Mortgage-Backed Securities Portfolios And The Consequences Of Their Conduct In USAT’s Financial Statements

A. Respondents Misrepresented That The Mortgage-Backed Securities Portfolios Were Risk-Controlled Arbitrages

1. USAT’s 1985 Liability Growth Application

M445. On July 3, 1985, USAT notified the FHLBB that it would exceed its liability growth limitation for the second quarter of 1985. USAT represented that

[T]he primary reason for the increase in liabilities was reverse repurchase agreements used to MBSs. The interest rates on the securities are fully hedged and there is no gap exposure from these investments. They have been purchased based on a clear investment plan of the Association and have a positive impact on the Association’s financial condition.

Ex.T-4101, Tab 850 (Letter from J. Pledger (USAT) to R. Bonchak (FHLB), 07/03/85) p. 006800.

M446. On July 12, 1985, USAT filed a growth plan with the FHLBB describing the investments that resulted in the growth in excess of the regulatory limit. USAT represented that

The impetus for United’s liability growth in the first two quarters of 1985 was attributed to a program in which investments in mortgage-backed and corporate securities were matched with liabilities of similar maturity and duration. Specifically, this asset/liability match program supported incremental asset growth with minimal interest rate risk and consisted of mortgage-backed securities (FNMA’s, FHLMC’s, and GNMA’s) were purchased and funded with reverse repurchase agreements. Concurrent with the transaction, interest rate swaps were initiated which effectively lengthened the maturity and duration of the liabilities and locked in a net interest spread.

Long-term corporate securities were purchased and match funded with retail broker deposits of similar maturity and duration, which also locked in a net interest spread.

Ex. A-10566, Tab 176 (Letter from G. Williams to FHLBB Re: USAT Growth, 07/12/85) pp. CN052885-886.

M447. USAT represented in its July 12, 1985, application that

The Association’s use of reverse repurchase agreements and purchase of mortgage-backed securities has increased from $60 million at the base period of November 30, 1984, to $539 million at June 30, 1985. All of these investments are fully hedged and the related interest rate GAP exposure has been reduced to the maximum amount possible.

Ex. A-10566, Tab 176 (Letter from G. Williams to FHLBB, 07/12/85) p. CN52880.

M448. USAT stressed in its July 12, 1985, application that “its growth is consistent with the principles of safety and soundness and provides a stable income with very limited interest rate risk. The decisions made in implementing these investment policies were based on the premise of reducing the Association’s interest rate exposure.” Ex. A-10566, Tab 176 (Letter from G. Williams to FHLBB, 07/12/85) pp. 011305-011306 on T-4103 copy.

M449. The FHLBB raised a number of questions about the July 12, 1985, application. In response, USAT submitted a new application and growth plan on August 23, 1985, which was returned by the FHLBB to USAT seeking further information. USAT submitted a revised liability growth application on September 19, 1985. Ex. A-10575, Tab 178 (Letter from G. Williams to Green, 10/28/85) p. CN052906.

M450. In its September 19, 1985, revision, USAT repeated its previous representations regarding its program for matching the maturities of its liabilities and investments to control interest rate risk:

The impetus for United’s liability growth during the first half of 1985 was attributable to a program in which investments in mortgage-backed and corporate securities were matched with liabilities of similar maturity and duration. Specifically, this asset/liability match program supported incremental asset growth with minimal interest rate risk and consisted of:

-Mortgage-backed securities (FNMA’s, FHLMC’s, and GNMA’s) purchased and funded with reverse repurchase agreements. Concurrent with the transaction, interest rate swaps were initiated which effectively lengthened the maturity and duration of the liabilities and locked in a net interest spread.

-Long-term corporate securities were purchased and match funded with retail broker deposits of similar maturity and duration, which also locked in a net interest spread.

Ex. B-591, Tab 582 (USAT Growth Plan, 09/19/85) p. OW004667.

M451. USAT also repeated in its September 19, 1985, revised application, its commitment to continue to control the interest rate risk of the association:

In order to reduce and control interest rate risk on the Association’s liabilities and investments, the Association has used and will continue to use interest rate swaps. Interest rate swaps are the exchange of payments between two parties to achieve some improvement in the asset-liability match of each.

The use of swaps in a proposed asset acquisition for the Association would be to pay the fixed rate and receive a floating rate, usually the three month LIBOR. The Association would purchase mortgage backed securities financed by a reverse repurchase agreement and effectively fix the reverse repo rate by paying fixed on the swap. The receipt of LIBOR would match the reverse rate paid and allow a spread (asset yield less fixed swap cost) to be extracted. The swaps would be structured to provide a duration equal to that expected of the security, thus effectively matching maturities and locking the spread. Under all rate scenarios except a ‘flight to quality’, three month LIBOR and the three month reverse repo rate may be expected to be equal on average and thus cancel out in the analysis. The spread is thus locked at all levels of short term rates.

Ex. B-591, Tab 582 (USAT Growth Plan, 09/19/85) p. OW004670..

M452. In response to the request for more specific information about the nature of its proposed growth, USAT represented in the September 19, 1985, revision that:

As the previous table indicated, United proposes to increase its liabilities by $505 million during the fourth quarter of 1985. This proposed growth, primarily in reverse repurchase agreements, would be funded through the same investment brokers as listed on page 4 under ‘Liability Sources.’ These funds would be used to purchase additional mortgage-backed securities (FNMA’s, FHLMC’s, and GNMA’s). Concurrent with the transaction, interest rate swaps would be initiated which effectively lengthen the maturity and duration of the liabilities and lock in a net interest spread. . . . The projected yields and interest rates on these additional assets/liabilities are expected to provide a spread of 1.10% and annualized net interest income of $5.5 million.

Ex. B-591, Tab 582 (USAT Growth Plan, 09/19/85) p. OW004671.

M453. In its September 19, 1985, revision USAT repeated its previous representations concerning its past practices and future intentions:

In December 1984, United began implementing a plan to add a new layer of investments to the Association existing portfolio. Under this plan, the new layer of investments are designed to provide a built-in interest rate spread with matched investment maturities and controls on interest rate fluctuations through the use of interest rate swaps and other similar devices.

Since the implementation of this policy, the Association has been able to incrementally add new investments, which have resulted in a profitable spread without interest rate risk. The Association believes that this policy provides beneficial supplement to its older portfolio of short-term savings and long-term mortgages. Each such investment has been backed with additional net worth, which has strengthened the Association and helped to stabilize its earnings prospects.

The Association proposes to continue this plan of investments in mortgage-backed securities financed by reverse repurchase agreements within the parameters set forth in this application. The Association believes that these additional investments are in the best interest of the Association, its depositors and stockholders and that the program as implemented thus fat and as proposed within the limits of this application will strengthen the Association and provide a stronger capital base for future growth and development.

Ex. B-591, Tab 582 (USAT Growth Plan, 09/19/85) p. OW004673.

M454. After the receipt of the September 19, 1985, revision, the institution's Supervisory Agent (at FHLB-Dallas) demanded, on October 22, 1985, that USAT's Board execute a Supervisory Agreement, under which the association would be obligated, inter alia, to comply with the liability growth regulation, and to provide a monthly report to the Supervisory Agent concerning USAT's liability growth.

M455. In response to the Supervisory Agent's demand that USAT execute a Supervisory Agreement, USAT filed another revised application with the FHLBB. In its October 28, 1985, revised submission, USAT repeated its earlier representations that it had established an Investment Department to coordinate an investment program in corporate and MBSs: “Under the investment program that has been established, investments in mortgage-backed and corporate securities are matched with liabilities of similar maturity and duration. This asset/liability match program virtually locks in a spread between United’s asset yield and funding cost, giving significant protection against interest rate fluctuations.” USAT also represented that it had held $1.084 billion in MBSs as of June 30, 1985, and clarified that it intended to invest the increase in additional MBS RCAs, up to $1.584 billion by December 31, 1985, upon the approval of its liability growth application. Ex. A-10575, Tab 178 (Letter from G. Williams to Green Re: USAT Liability Growth, 10/28/85) p. CN052913; Ex. A-10575, Tab 178 (Letter from G. Williams’ to Green Re: USAT Liability Growth, 10/28/85) p. CN052918.

M456. On November 1, 1985, based upon USAT’s representations, the Supervisory Agent withdrew the demand for a Supervisory Agreement on the condition that USAT's Board adopt a resolution stating that USAT's liabilities would not exceed $4.68 billion through December 31, 1985. USAT's Board adopted the required resolution. Ex. A-10577, Tab 179 (Letter from Anderson to G. Williams Re: Liability Growth Application, 11/01/85) p. CN52929.

2. UFG’s 1985 10-K Filed On March 26, 1986

M457. As explained in Finding M457, USAT held $1.2 billion in MBS RCA portfolios as of December 31, 1985.

M458. In its 1985 10-K, signed by Hurwitz, Gross, G. Williams, Crow and Munitz on March 26, 1986, UFG represented:

The Company has also invested approximately $1.2 billion in fixed-rate mortgage-backed certificates primarily funded with short-term liabilities in hedged arbitrage programs. Through the hedged arbitrage programs, the effective term of such liabilities has been extended and their interest rate sensitivity limited by interest rate exchange agreements (‘swaps’) and cap and collar rate programs. The hedged arbitrage program has been effective in providing a continuous stream of earnings with a reasonable level of risk. During periods of rapidly changing interest rates, however, the balance between assets and liabilities and the resulting spread can become impaired. For example, during periods of declining interest rates, the speed at which mortgage-backed securities prepay tends to accelerate, requiring reinvestment of the proceeds at potentially lower yields. Since these programs are typically hedged using interest rate swaps, whereby the Company is obligated to pay a fixed rate, the overall spread on the hedged program could decrease. Conversely, during periods of rapidly accelerating interest rates, the hedged arbitrage programs can become subject to collateral calls. The Company carefully monitors its hedged programs and attempts to reinvest its assets prior to rapid prepayment as well as maintaining a layer of unencumbered collateral for such contingencies. The policies set forth herein and the Company’s program to significantly improve its interest rate sensitivity has had the effect of reducing the Company’s GAP. While management believes the use of the techniques set forth herein and the reduction of the Company’s GAP will have long-term materially beneficial effects on the Company, the Company has foregone certain short-term benefits that would have accrued as interest rates have declined.

Ex. A-3021, Tab 1161 (UFG form 10-K for fiscal year ended, 12/31/85) pp. UFG-J 1996-UFG-J 1997. (emphasis Added).

3. UFG’s 1986 10-K Filed On March 17, 1987

M459. In its 1986 10-K, signed by Hurwitz, Gross, G. Williams, Crow and Munitz on March 17, 1987, UFG described the MBS RCA portfolios held by USAT, repeated previous representations, and described MBS RCA portfolios as follows:

During 1986 and 1985, the Company’s investment in mortgage-backed securities increased by $1.5 billion and $782.9 million, respectively, reflecting the implementation of the Company’s asset/liability management strategy. At December 31, 1986, mortgage-backed securities totaled $2.7 billion, including $720.5 million utilized as collateral for the CMOs, $1.0 billion funded under programs utilizing securities sold under repurchase agreements and $956.4 million utilized primarily as collateral for preferred stock of subsidiaries and other borrowings. At December 31, 1985, mortgage-backed securities of $1.2 billion included $654.1 million funded with securities sold under repurchase agreements and $548.0 million primarily used as collateral for preferred stock of a subsidiary and other borrowings.

Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN 071175.

4. UFG’s 1987 10-K Filed On March 22, 1988

M460. Similarly, in UFG’s 1987 10-K, signed by reconstituted Board of Directors selected and controlled by MCO on March 22, 1988, the USAT MBSs portfolios were also described as RCA portfolios that had $419.2 million as of December 31, 1984, to $3.6 billion as of December 31, 1987. Ex. A-3023, Tab 79 (UFG Form 10-K for fiscal year ended 12/31/87) p. CN158910.

B. Respondents Misrepresented That The Gains On The Sales Of

Mortgage Backed Securities In 1986 And 1987 Were The Consequence Of The Rebalancing Of the Portfolios In Order To Match The Duration Of The Assets To The Hedged Liabilities

M461. OMITTED.

M462. OMITTED.

M463. OMITTED.

1. Subordinated Debt Application Filed With The FHLBB On May 9, 1986

M464. On May 9, 1986, USAT applied to issue subordinated debt. In the cover letter attached to its application, USAT repeated many of the representations it made previously, particularly, that the MBS portfolios would be duration managed to generate a spread income between the cost of funds and the income earned on the investments. Ex. A-10634, Tab 180 (Letter from Berner to Halverson Re: USAT, 05/09/86) pp. OW005297-5298; Ex. B-954, Tab 89 (Application for approval to issue subordinated debt securities, 04/29/86) pp. CN152330-331 and CN152337.

M465. In its May 9, 1986, application, USAT emphasized its management’s knowledge of the impact of interest rate changes on prepayment speeds, the potential effect of increased prepayment speeds on the value of MBSs portfolios, and how the MBSs RCA portfolios had been and would be managed:

To closely manage this process, a team of professionals constantly monitors the structured arbitrage program. This monitoring results in periodic sales and purchases of mortgage-backed certificates to maintain a closer balance between the overall durations of the securities and the underlying interest rate swaps. For example, in the current environment of rapidly declining interest rates and the associated increase in the prepayment of mortgage-backed securities, higher coupon mortgage-backed securities have been sold and lower coupon mortgage-backed securities have been purchased in an attempt to obtain a reasonable income stream to provide a spread against the underlying interest rate swap.

Ex. B-954, Tab 89 (Application for approval to issue subordinated debt securities, 04/29/86) pp. CN152330-331 and CN152337.

M466. USAT emphasized in its May 9, 1986, cover letter and application that:

While utilization of these techniques has resulted in the Association not taking full advantage of the recent dramatic decline in interest rates, USAT’s management believes that USAT should not be in the interest rate speculation business. Rather management believes we should protect our interest rate spread and reduce our GAP to the fullest extent possible in all interest rate environments.

Ex. A-10634, Tab 180 (Letter from Berner to Halverson Re: USAT, 05/09/86) pp.OW005297-5298; Ex. B-954, Tab 89 (Application for approval to issue subordinated debt securities, 04/29/86) pp. CN152330-331 and CN152337.

2. 1986 Business Plan Filed With The FHLBB On August 29, 1986

M467. On August 29, 1986, USAT submitted its 1986 Business Plan to the FHLBB and repeated its earlier representations that USAT: “[had] instituted a program designed to attempt to match the duration and interest rate sensitivity of [existing long-term fixed-rate] assets and [short-term floating-rate] liabilities.” Ex. A-10663, Tab 184 (Memo from Berner to Board Re: USAT Business Plan, 08/29/86). p. OW005470.

M468. In the August 29, 1986, Business Plan, USAT represented that MBS RCA profits made on the sales of MBSs were a result of the rebalancing to protect against an increase in prepayments:

As interest rates have fallen since the latter part of 1985, prepayments on mortgage-backed securities purchased in the program have accelerated requiring the Association to dispose of certain mortgage-backed securities and to reinvest the proceeds at lower yields. Therefore, in 1986, the Association sold higher coupon mortgage-backed securities that are more likely to prepay and purchased lower coupon mortgage-backed securities. These transactions produced gains on sales of mortgaged-backed securities during the first six months of 1986 totaling $38.9 million. At June 30, 1986, the Association’s yield on its mortgage-backed securities portfolio was 9.74%.

Ex. A-10663, Tab 184 (Memo from Berner to Board Re: USAT Business Plan, 08/29/86) p. OW005471.

M469. In the August 29, 1986, Business Plan, USAT did not explain that as a result of the purported close management of USAT’s MBS RCA portfolios, the net spread between the assets and hedged liabilities had deteriorated significantly, and that the combined market value of the assets and hedged liabilities was negative.

3. UFG’s 1986 10-K Filed On March 17, 1987

M470. In its 1986 10-K, signed by Hurwitz, Gross, G. Williams, Crow and Munitz on March 17, 1987, UFG also represented that purchases and sales of MBS portfolios were made to prevent a decline in the value of the portfolios due to increased prepayment rates:

In 1986, purchases and sales of mortgage-backed securities totaled $6.5 billion and $4.8 billion, respectively. This increase activity during a period of falling interest rates reflects, in part, the Company’s shifting from higher coupon rate to lower coupon rate mortgage-backed securities in order to curtail the prepayment risk. These transactions produced gains on sales of mortgage-backed securities during 1986 totaling $71.7 million. However, as a result of such sales and repurchases, the yield on the mortgage-backed securities portfolio decreased to 9.39 percent at December 31, 1986 from 11.60 percent at December 31, 1985.

Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) p. CN071175.

M471. UFG did not explain in the 1986 10-K that many of the sales had been made to generate gains to bolster profits to satisfy the minimum regulatory capital requirements, that as a consequences of the sales and purchases, the spread between the cost of funds and income earned on the MBSs, had turned negative and the market value of the portfolio was negative. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86, with exhibits, 12/31/86) p. CN071175.

4. Respondents’ Representation To Peat Marwick In The Course Of The 1986 Audit

M472. Managers of USAT informed Peat Marwick, before commencement of the 1986 audit, that all MBSs had been sold and replaced with lower yielding securities to better match the securities of the association with its liabilities. Tr. 12,437: 1 - 12,439: 3 (Claiborne). Ex. B-1298, Tab 1171 (Audit Planning Memorandum for UFG, 10/31/86).

a. Respondents Were Notified By Peat Marwick That Their Intention Controlled The Classification Of The Mortgage Backed Securities Portfolios As Trading Or Investment Portfolios__________________

M473. In the course of the December 31, 1986, audit, Peat Marwick discovered the turnover in the MBSs [and junk bond] portfolio. On January 5,1987, Joe Parsons, the senior manager on the audit, informed Crow of the applicable standards for the classification of a portfolio as a trading or investment portfolio:

The purpose of this memorandum is to present certain information and criteria regarding investment vs. trading accounting treatment, elicit your response to certain of our concerns and to present certain recommendations regarding future documentation of your activity.

During 1986, we have noted a considerable amount of activity in the high yield (‘junk’) bond and mortgage backed securities portfolios. Such activity raises the question as to whether such portfolios should be more properly accounted for on an investment or trading basis. In addition to the our concern as raised by this activity, we have also noted that the accounting basis for similar portfolios has been under scrutiny by regulatory and GAAP accounting authorities.

. . . Substantially all GAAP accounting guidance is provided by the AICPA Audit of Banks Industry and Audit Guide (the Guide). Management’s intent appears to be the prevailing factor in determination of the appropriate accounting. Intent of investment and trading portfolios are summarized from the Guide as follows:

· If the intent (and the ability) is to hold securities on a longer term basis, with the objective being an optimum balance between credit quality, liquidity and income, the portfolio would be considered an investment account.

· If the intent is to deal in certain securities for a profit, the portfolio would be considered a trading account.

The Guide indicates that recording of a security in the trading or investment portfolios should be documented at the time of purchase, as per management’s intent.

Recording a security in the investment portfolio does not preclude it from being traded if such trading activity has a specific purpose, such as: maintenance of the optimum balance, as noted above; due to cash requirements; or, for tax planning purposes. However, the Guide notes that:

If there is substantial turnover in the investment portfolio, management’s intention and experience determine whether a trading function is occurring and the appropriate classification and valuation method to be used.

In summary, management’s intent governs the classification of a portfolio as trading or investment accounting treatment. Such intent should be determined and documented at the time of purchase. Turnover in the portfolio is possible; however, without a record of intent and strategy at the time of purchase or trading, turnover may become an indicator of management’s intent.

Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow Re: Investment vs. Trading account, 01/05/87) p. KPMG 024413.

M474. As the Peat Marwick partner in charge of the USAT account in 1986 testified, the intent of the client was an important factor is determining whether a portfolio was properly classified as an “investment” rather than a “trading” portfolio. He also that “the reasons for the turnover . . .  would be very important” in determining whether a portfolio was an investment rather than a trading portfolio. Tr. 10,300: 6-8 (Millinor).

M475. In order to complete the audit, Parsons informed Crow in the memorandum described in FOF M472 that:

[W]e [Peat Marwick] believe that in order to conclude as to the appropriateness of the accounting treatment for the junk bond and mortgage back securities portfolios, that we must understand the objective and strategy which was used at the time of purchase and trades of the securities. Without such documentation, it is impossible to conclude whether trades were made for the purpose of short term gains or for other valid purposes consistent with an investment portfolio. . . . 

In order to document the propriety of the accounting treatment for the . . . mortgage backed securities portfolios, we would recommend:

A clear statement of strategy and intent for both the investment and trading portfolios be developed. Such statement should be retrospective for activity which has occurred to date, and incorporate those concerns as would be appropriate as presented above, and prospective for future activity.

Documentation relating to purchases should be expanded such that it includes a statement as to the intent of management in regards to the security purchased and why the purchase is consistent with the Association’s strategy.

Documentation relating to sales resulting in significant gains should be expanded such that it includes a statement as to the intent and strategy supporting the sale.

A periodic review of the portfolio be performed and documented to determine that the portfolio continues to meet the pre-determined objectives as determined by management.

Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow, 01/05/87) pp. KPMG 024414- 415.

b. Respondents Misrepresented In A “Statement Of Strategies And Objectives” That The Mortgage Backed Securities Portfolios Were Not Being Traded To Generate Gains To Bolster Profits And Net Worth Adopted To Convince Peat Marwick That The Portfolios Had Been Properly Classified_________

M476. In response to the request described in Finding M474, USAT provided Peat Marwick, its outside auditors, with a “Statement of Strategies and Objectives” for the MBSs portfolio, purportedly adopted by the Investment Committee on February 18, 1987, which stated:

Investment Portfolios - The objective of these designated portfolios will be to invest in a diversified group of MBS which will generate a net interest margin over a range of interest rate environment scenarios. The securities will be funded primarily with short duration liabilities which may or may not be hedged with various financial instruments (such as interest rate caps, collars, swaps, futures, options, etc.). It is management’s intent to maximize the net interest spread while maintaining prudent interest rate risk exposure.

It is management’s intent to hold each security on a long-term basis, however, sales may be executed from time to time to:

n Maintain or enhance current yields/spreads on assets as market opportunities exist

n Adjust the portfolio for changes in yield caused by prepayment speed variations

n Manage the portfolio’s exposure to interest rate risk, prepayment speed risk, and coupon/agency concentrations risk

n Meet liquidity requirements

n Meet other appropriate requirements that may be approved by the Investment Committee consistent with generating an ongoing net interest spread.

The investment portfolio objectives will be reviewed periodically by the Investment Committee as to maintenance of the net interest margin, interest rate risk, prepayment speed assumptions, and agency/coupon exposure.

Tr. 10,502: 19 - 10,503: 3; 10,503: 5 - 10,506: 11 (Parson); Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow Re: Investment vs. Trading account, 01/05/87) p. KPMG 024421.

M477. In response to questions from the OTS’s counsel to clarify Peat Marwick’s understanding of the “Statement of Strategies and Purposes” policies adopted by Respondents’, the manager in charge of the audit of USAT’s December 31, 1986, financial statements testified as follows:

Q. Do either of those policies under investment, in your view -- the one for mortgage-backed securities and the one for high-yield bond or junk bonds -- justify regularly making sales out of the portfolio expressly for the purpose of generating gains to bolster profits and net worth?

A. Not expressly to generate gains and net worth.

Tr. 10,545: 5-13 (Parsons).

M478. USAT’s Comptroller was also asked whether sales MBSs out of USAT’s hedged portfolios for the purpose of bolstering profits and net worth was consistent with his understanding of the intended purposes of the arbitrage portfolios. Significantly, he testified as follows:

Q. Is it your understanding that the mortgage-backed security portfolios at USAT were to be hedged portfolios to protect against interest rate movements?

A. They were to be hedged to protect against -- yes.

Q. Okay. To protect against the upward movement of interest rates?

A. Depending upon which portfolio you were talking about, I think there were some that were in addition to falling rates were possibly hedged.

Q. But it's your understanding that all of the portfolios were hedged to protect against rising interest rates?

A. I hesitate to use the word ‘all’; but in general, that was the purpose.

Q. Okay. Now, given that sort of ‘in general’ understanding, if sales were made out of those portfolios solely for the purpose of bolstering profits to be reported on a quarterly financial statement, would that have been consistent with your understanding of what the purposes of the mortgage-backed security hedged portfolios were at USAT?

A. The question is ‘if.’ Right? Not --

Q. Right.

A. No, that would not be consistent. But I guess where I'm --

Q. We're not talking about --

MR. NICKENS: Your Honor, would he let the witness finish his answer?

A. I don't know of any instances where they were sold to bolster --

Q. (BY MR. GUIDO) I understand.

A. -- profits at the end of the quarter.

Tr. 8,917: 11 - 8,919: 1 (Wolfe).

M479. USAT’s Comptroller testified he was never told that the MBSs that were held in the various portfolios that were accounted for as investment portfolios were being sold periodically to generate gains to bolster profits in the financial statements of UFG or USAT. Tr. 9,090: 5-11 (Wolfe).

M480. Similarly, the Peat Marwick partner in charge of the USAT account in 1986, testified that he did not recall anyone ever telling him that gains were taken out of hedged MBSs portfolios, with the purpose to generate profits so as to bolster net worth. Tr. 10,301: 20 - 10,302: 3 (Millinor).

c. Respondents’ Representations That The USAT Portfolios Were Hedged Risk-Controlled Arbitrage And The Gains Made On The Sales Were Coincidental To Rebalancing The Portfolios To Protect Against Interest Rate Risk Were False And Misleading_____________________________________

M481. Sales to take gains to bolster profits was not consistent with USAT’s claimed objective to maintain a yield spread in USAT’s RCA portfolios. Tr. 13,079: 6 - 13,079: 20 (Bruno).

M482. Hansen testified that, representations that gains made on the sales of MBSs out of a RCAs occurred because of rebalancing to protect against interest rate risk would be a false and misleading statement, if the sales were actually done to generate gains to meet regulatory minimum net worth requirements. Tr. 12,734: 12 - 12,735: 14 (Hansen).

M483. As set forth in Findings M230 - M240, Respondents’ made sales and repurchases out of the RCA to bolster profits to meet USAT’s net worth requirements.

M484. Respondents’ representations that the portfolios were RCA, the value of which was hedged to protect against changes in interest rates and that the gains on the sales were coincidental to the rebalancing of the portfolios to protect against an increase in prepayments, were false and misleading.

C. Respondents’ Misrepresentations To Peat Marwick

That The $350 Million In Mortgage-Backed Securities Sold Out Of United Mortgage Finance In December Of 1985 Was Mandated By A Change In The Liability Growth Limitation

M485. As described in Findings M485, Respondents’ recognized accounting gains on the sale of $350 million in MBSs out of United Mortgage Finance in December 1985, but did not recognize the losses on the swaps that had been mirrored.

M486. The files of USAT contain a memorandum dated January 10, 1986, purportedly written by Joe Phillips to the file (bearing at the bottom the initials of James Wolfe, USAT’s comptroller), describing the sale of a portion of United Mortgage Finance’s MBSs and the retention of the swaps:

Subsequent to the formation of the finance subsidiary and acquisition of the securities, the regulations applicable to finance subsidiaries were amended. Such amendment disqualified USAT Mortgage Finance, Inc. as a finance subsidiary and accordingly such liability growth would have put the Association in violation of the growth regulation for the quarter ended March 31, 1986. According, $350 million in mortgage backed securities and related reverse repurchase agreements had to be ‘undone’ in order to avoid growth regulation problems. At that time, the decision was made, 1) to sell the mortgage backed securities resulting in a $12.4 million gain, and 2) retain the swaps and utilize them for ‘general’ Association interest rate hedges rather than close them out (USAT has had an existing ‘general’ swap for sever years). Subsequent to that decision a ‘mirror’ swap was put in place.

Ex. A-10594, Tab 571 (Memorandum to the File, 01/10/86) p. OW002852.

M487. Attached to the January 10, 1986, memorandum to the file, described in Finding M485, was a summary of an AICPA Emerging Issues Task Force Opinion 84-7 (“EITF 84-7”) that stated gains and losses on termination of interest rate swaps should be accounted for in the same manner as interest rate futures contracts, with the gain or loss only recognized when the hedged transaction is sold, applying the closely analogous futures transactions described in FASB Statement No 80. Ex. A10594, Tab 571 (Memo to the File, 01/10/86) p. OW002853.

1. Respondents’ Failure To Recognize The Losses On The Mirrored Swaps Violated The Applicable GAAP And Regulatory Accounting Requirements

M488. The controlling accounting provision for accounting for futures contracts as hedge instruments is a document referred to in the accounting literature as FAS 80, which was adopted by the Financial Accounting Standards Board, the authoritative body on the appropriate application of GAAP to financial transactions. Tr.15,582: 2 - 15,583: 10 (Crow).

M489. The consensus of the Emerging Issues Task Force [“EITF”] of the American Institute of Certified Public Accountants [“AICPA”], one of the authorities on the interpretation of proper accounting principles, was that swaps were analogous to futures contracts and therefore should be accounted for similarly to futures contracts pursuant to FASB 80. Tr. 9,247: 3-16; 9,248: 9 - 9,249: 22 (Wolfe).

As reported in the EITF Abstracts:

The [AICPA Emerging Issues] Task Force reached a consensus that gains and losses on terminated interest rate swaps that were accounted for as hedges should not be recognized immediately in income because the termination of an interest rate swap accounted for as a hedge is closely analogous to a terminated futures hedge described in Statement 80. Under that Statement, the gain or loss on a terminated futures hedge, to the extent it has been an effective hedge, must continue to be deferred and recognized when the offsetting gain or loss is recognized on the hedged transaction.

Ex. B-4212, Tab 1200 (EITF Abstracts, Issue No. 84-7, Termination of Interest Rate Swaps, ref. FASB Statement No. 80) See also, Ex. B-4214, Tab 1185 (EITF Abstracts, Issue No. 84-36, Interest Rate Swap Transactions, ref. FASB Statement No. 80).

M490. The FHLBB regulatory guidance followed that of the AICPA Emerging Issues Task Force, and directed interest rate swap transactions to be accounted for in accordance with the requirements for futures contracts. Ex. A-10543A, Tab 1393 (Memo from Schilling, FHLBB Re: Proper regulatory accounting for interest rate swaps, 07/02/84).

M491. The guidance provided by the FHLBB stressed that in order to ensure that arbitrage transactions made economic sense, the accounting for swaps must be accounted for in the same fashion as futures contracts, citing 12 C.F.R. § 563.17-4(g)(2) (1984). Ex. A-10543A, Tab 1393 (Memo from Schilling, FHLBB Re: Proper regulatory accounting for interest rate swaps, 07/02/84) pp. 1-3.

M492. The FHLBB regulation, 12 C.F.R. § 563.17-4(g)(2) (1984), cited in the R-59 provides:

Gains and losses on futures contracts that are matched with existing assets or liabilities carried at cost shall be deferred and included in measurement of the dollar basis of the asset or liability and amortized over the estimated remaining life of the asset or liability as an adjustment to interest income or interest expense. If the asset or liability is sold or otherwise disposed of, the unamortized gain or loss shall be recognized in income.

12 C.F.R. § 563.17-4(g)(2) (1984) (Emphasis added).

M493. Thus, R-59 emphasized that:

When a swap position has been closed as a result of the disposition (planned or otherwise of the matched asset position, the gain or loss associated with the sale of the swap position should be treated as an adjustment of the gain or loss on the disposition of the matched asset.

Ex. A-10543A, Tab 1393 (Memo from Schilling, FHLBB Re: Proper regulatory accounting for interest rate swaps, 07/02/84) pp. 1-3.

M494. Thus, the controlling accounting literature required swaps that were unmatched or “macro” hedges were to be marked-to-market, like futures contracts, in the period in which the market value changed. If designated as a “micro” hedge, the gain or loss was permitted to be deferred and accounted for as an adjustment to income or expense with gains or losses to be recognized at the time the designated assets or liabilities of the arbitrage were disposed.

M495. If a futures contract on a security is bought through one brokerage house and another futures contract on the same security is sold through another brokerage house, the transactions are offsetting and the gain or loss on the futures contract that was initially purchased is then treated as if it had been sold and any gain or loss is recognized at that time. Tr. 12,280: 22 - 12,282: 1 (Claiborne); 12 C.F.R. § 563.17-4 (a) (5) (1985-88).

M496. Peat Marwick’s view was if USAT was able to quantify the loss that it incurred on the two swap transactions, one of which mirrored the other, a futures contract would be the next closest analogous transaction and FAS 80 would apply and the loss would have to be immediately recognized, not deferred. Tr. 12,288: 7 - 12,289: 2 (Claiborne); Tr. 9247: 11-16 (Wolfe).

2. Respondents Provided A False Explanation Of The Reason For The Sale

Of The Mortgage-Backed Securities Peat Marwick In Order To Obtain Their Approval Of The Accounting Treatment Applied To The Transaction

M497. Peat Marwick was not comfortable with USAT’s accounting for the mirrored swaps, but did not object in light of Respondents’ representations, which were false, that the transaction was forced upon them because of a change in FHLBB regulations. Tr. 10,286: 2 - 10,287: 2 (Millinor).

M498. The January 10, 1986, memorandum to the file, described in Findings M485 and M486 was provided to USAT’s outside auditors when they reviewed the transaction, without the attachment summarizing EITF 84-7. Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1.

M499. In the memorandum recording his conclusions regarding the accounting for the sale of the $350 million of securities and the mirror swap, the outside auditor stressed that the MBS “were sold only because United had to unwind a single purpose subsidiary that didn’t meet with regulatory approval,” and “[b]ecause United was close to their regulatory growth limits, they didn’t have the option of simply buying more securities at the S&L level to cure the imbalance.” Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1.

M500. USAT was advised by its outside accountants that they were uncomfortable with USAT’s failure to recognize the loss on the mirror swap, but would not object to USAT’s accounting treatment of the transaction, because of USAT’s assurance that the transaction was not voluntary, but that the sale of the MBS was required by a change in regulations that offered no other alternative. Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1.

M501. The outside auditor was not provided with the Gross memorandum to Hurwitz and Munitz, described in Finding M149, which revealed that the management of USAT considered the impact of the sale of $350 million of securities and purchase of the mirror swap on the profit and net worth of USAT, but did not analyze the need to sell the securities, in light of USAT’s liability growth situation, when it decided to liquidate the MBSs in the subsidiary and mirror the swaps, recognizing the gains and deferring the losses. Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1.

M502. The outside auditor was also not provided with the agenda for the December 12, 1985, Executive Committee meeting, described in Finding M142, that revealed the only concern at the meeting was what action should USAT take in response to the regulatory decision. The decision was actually based on the impact on USAT’s profits, not the impact on USAT’s compliance with the liability growth limitation. Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1.

M503. USAT’s files contain another memorandum from Joe Phillips on the same subject as the January 10, 1986, memorandum which contains a description of the transaction, and its justification significantly different from the description of the transaction provided to USAT’s outside auditor, which he testified would have led him to reconsider the conclusions reached in his opinion. Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86) p. 1. Tr. 10,294: 1-11,296: 7 (Millinor).

M504. As described in Findings M156 - M163, Respondents were not obligated to sell the $350 million in MBSs from the United Mortgage Finance subsidiary’s portfolios, because of regulatory obligations, but sold due to short - term profit goals.

D. USAT’S Representations To USAT’s Outside Auditors And The FHLBB That The United Mortgage-Backed Securities Subsidiary Was A Hedged Arbitrage Portfolio Protected Against Adverse Changes In Interest Rates Were False And Misleading

M505. The minutes of the Asset/Liability Committee of October 3, 1987 stressed the UMBS portfolio, described in Findings M264, was to be a hedged arbitrage portfolio:

Mortgage-Backed Securities Arbitrage Update – It was noted that a new subsidiary had been established and capitalized at $100 million to be utilized for Sandy Laurenson’s new mortgage-backed securities arbitrage activities. It was agreed that beginning next week we would work with Smith Breeden on contacting the investment bankers and getting approval for new lines of credit to support these activities.

One open issue which was to be resolved next week was whether the $100 million advance to support the arbitrages would have to be included for both direct investment and consolidated liability growth. Jim Wolfe indicated that the regulators required a consistent accounting method whereas Bob Pozen said we could consolidate for direct investment and not for liability growth.

Ex. A-1641, Tab 523 (Asset Liability Committee Meeting Minutes, 10/03/86).

1. Correspondence With The Investment Bankers

M506. USAT represented in correspondence with the investment bankers from whom it sought to purchase the MBSs that:

United Savings Association of Texas has established a new wholly-owned subsidiary (United MBS Corporation) for the purpose of managing a mortgage-backed security arbitrage portfolio. United MBS was approved by the Executive Committee of the Board of Directors on August 7, 1986 (Exhibit 1) and is anticipated to initially expand to a portfolio size of about $1 billion. Sandy Laurenson, Senior Vice President and Manager of MBS Trading will be responsible for managing the trading activities for United MBS.

The subsidiary will be capitalized at 10%, through contributions and advances from USAT, which will be subordinated to other debt (such as reverse repos). The primary activities of the subsidiary will involve investments in mortgage-backed securities funded with reverse repurchase agreements. It is planned that the arbitrage portfolio will be substantially hedged utilizing a combination of futures, options, and interest rate swaps.

Ex. A-10683, Tab 185 (Letter from Crow to First Boston Re: UMBS, 10/20/86).

2. Representations Made In UFG’s December 31, 1987, 10-K Filed On March 22, 1988____________________________________________

M507. In UFG’s 1987 10-K, signed on March 22, 1988, by a reconstituted Board of Directors, selected and controlled by MCO, it was emphasized that the $3.6 billion in arbitrages reported for USAT, included additional MBSs purchased by Respondents’ managers of USAT for

United MBS Corporation (United MBS), a wholly-owned subsidiary of the Association, [which] engages in the acquisition of mortgage-backed securities financed principally through repurchase/dollar repurchase agreements. United MBS utilizes certain hedging techniques described above under ‘Hedging Programs’ to reduce the interest rate risk associated with its acquisition of mortgage-backed securities. As of December 31, 1987, United MBS had a portfolio consisting of $1.6 billion in mortgage-backed securities.

Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) pp. 11 and 14.

M508. In the 1987 UFG 10-K, it was emphasized that hedging instruments for UMBS were intended to provide the same protection against rising interest rates as the hedges purchased initially for USAT:

Since 1984, the Association has been alleviating certain of the risks created by existing long-term fixed rate assets and short-term floating-rate liabilities through, among other things, the utilization of interest rate swaps, caps and other interest rate hedging techniques. By entering into these hedging programs, the Association is able to acquire mortgage-backed securities without deteriorating its current gap position. However, the effect of adding the interest rate swaps has been to maintain the Association’s interest expense during a period of falling interest rates.

Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended 12/31/87) p. 11.

3. Representation Made To The Outside Auditors And FHLBB Examiners

M509. In a memorandum entitled “United MBS Corporation, Statement Of Purpose/ Accounting Guidelines”, provided to the outside auditors to obtain their agreement to the hedge accounting treatment of UMBS, it was represented that the “[p]urpose of [s]ubsidiary [was] [t]o create an arbitrage which produces a hedged net interest spread between mortgage-backed securities assets and various funding sources, over a two year time horizon." Ex. B-1452, Tab 898 (Memofrom Wolfe to Parsons, 01/28/87), p. KPMG 054951, attaching the memorandum described above admitted at Ex. A-13034, Tab 1176.

M510. Representatives of USAT met with the outside auditors to further explain how UMBS’s MBSs would be hedged against interest rate changes. At the meeting, USAT’s representatives were asked what is “the expectation that the MBS will be traded? Under what circumstances would the MBS be traded?” The outside auditors summarized USAT’s representatives response as follows:

Note: I thought that it was important to establish that the MBS would not be traded, or at least that there would be minimal trading activity. If the MBS were to be traded, it would appear that the hedge positions should be considered to be speculative.

Ex. B-1455, Tab 899 (Memo from Parsons to file, 01/2787) p. OWJ01592.

M511. The outside auditors of USAT recorded in a memorandum that they understood, based on representations, that the investments in UMBS were to be funded with reverse repurchase agreements, similar to the initial MBS RCA portfolios. Swaps were not to be used to hedge against rising interest rates. Instead futures contracts and put options were to be used to hedge against rising interest rates in order to avoid the prepayment problem encountered in the initial MBS RCA. Ex. B-1455, Tab 899 (Memo from Parsons to file, 01/29/87) p. 0WJ01591.

M512. Based on the representations summarized in Findings M511, the outside auditors expressed their approval for the hedge accounting treatment for UMBS, which the outside auditors’ memoranda indicated was understood to be a hedged arbitrage portfolio, not a portfolio of long-term MBSs funded with short term liabilities subject to interest rate risk because a lack of hedge activity. Ex. B-1459, Tab 900 (Memo from Parsons to Wolfe, 01/29/87) p. US-3 008686.

M513. The memorandum “UMBS Corporation, Statement of Purpose/Accounting Guidelines” describing UMBS as a hedged arbitrage portfolio, was provided to the FHLBB examiners as part of the 1987 Examination, and along with written assurances that the UMBS portfolio was properly accounted for by the outside auditors, was relied upon by the examiners. Ex. A-14073, Tab 1502 (Report of Examination, 11/16/87).

M514. The FHLBB examiners, who relied on the work of USAT’s outside auditors for assurances that USAT properly represented its MBSs activities in its financial statements, recorded UMBS as a RCA, as represented in the document “UMBS Statement of Purpose/Accounting Guidelines.” In the November 16, 1987 Report of Examination, provided to USAT’s Board of Directors on July 28, 1988, the examiners stated:

In October 1986, UMBS began to accumulate financial futures contracts to

establish what it describes as a two year anticipatory hedge program. The hedge

program is centered around the anticipation of a series of liabilities which would be

used to fund mortgage-backed securities. UMBS uses Eurodollar Futures (short

positions) to extend the maturity of its reverse repurchase agreements. It has, to a

lesser degree, utilized ‘put’ options (GNMMA/T-Bills) to hedge mortgage-backed

securities on the asset side of the balance sheet.

Ex. A-14073, Tab 1502 (Report of Examination, 11/16/87).

4. Respondents’ Representation That United Mortgage-Backed Securities Was A Hedged Risk Controlled Arbitrage Were False And Misleading__________________

M515. As described in Findings M504 - M513, UMBS was not hedged, as Respondents had represented, but was instead left under-hedged for a significant period of time, and incurred substantial losses because of the failure to do so.

M516. As a consequence, Respondents’ representations that UMBS was hedged RCA were false and misleading.

E. Respondents Improperly Accounted For The Sales And Repurchase Of Mortgage-Backed Securities In 1986 And 1987 Out Of The Mortgage-Backed Securities Portfolios, And The Swaps That Hedged The Reverse Repurchase Agreements That Funded Their Purchase

M517. The applicable FHLBB regulation required that except for sales as part of a plan adopted for purposes of meeting the liquidity requirements, “gains and losses . . . resulting from the disposition of securities shall be recognized on an insured institution’s books at the time realized.” 12 C.F.R. § 563.23-2 (1969-1989).

M518. The applicable accounting literature also required that all gains or losses on sales of securities, including MBSs, be recognized in the institution’s financial statement at the time of sale, when the gains or losses are incurred. The Peat Marwick engagement partner recorded in a workpaper prepared in the course of the audit of the USAT’s December 31, 1985, financial statements, he was informed in a consultation he had with the Peat Marwick Department of Professional Practice:

I talked to Walter Erickson and Walter Schuetze . . . and learned [that] [u]nder no circumstance would GAAP require (or even permit) the deferral of the gain on sale of securities, whether in a swap program or not.

Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/3186).

M519. Walter Ericksons was the Partner in charge of Peat Marwick’s Thrift Practice and had been a member of the AICPA committee that drafted the Savings and Loan Accounting and Audit Guide. Walter Schultze had been a member of the Financial Standards Accounting Board, the governing body for accounting standards designated by the Securities and Exchange Commission, and subsequently became the Chief Accountant at the Securities and Exchange Commission. Tr. 12,312: 15 - 12,317: 17 (Clairborne).

M520. A sale of a MBS occurs when the security sold and the security bought as a replacement have either a different coupon, different interest rate, different maturity or have been issued by a different agency, such as the FNMA or GNMA. Tr. 10,452: 17 - 10,454: 14 (Parsons).

1. Respondents Did Not Recognize The Gains On The Sales Of Securities In The First Quarter of 1986, Instead Deferring Them By Rolling Them Into The Basis Of The Lower Coupon Securities Purchased As Replacements____

M521. In the first quarter of 1986, the Respondents did not recognized the gains on the sales of the MBSs included in the rolldown purportedly intended to stem the increase in prepayments. Instead they deferred the gains and allocated them into basis of the securities purchased as replacements, thereby reducing their recorded cost basis. Tr. 5,465: 15 - 5,466: 10 (Phillips); 10,289: 22 - 10,291: 11 (Millinor); 10,470: 7 - 10,474: 11 (Parsons).

M522. The Respondents abandoned their deferral of the gains in the second quarter of 1986 when the gains were needed to bolster profits in order to meet USAT’s minimum net worth requirement as described in Findings M172 - M177.

M523. After Respondents changed the accounting for the gains and began to recognize them, instead of deferring them and rolling them into the basis of the acquired securities, they were required by Peat Marwick to restate the First Quarter’s financial statement and not simply take the gains into income in the Second Quarter of 1986, as they intended. Tr. 12,292: 4-15 (Claiborne); 10,302: 4 - 10,305: 9 (Millinor).

2. Respondents Accounted For The Investments In Mortgage-Backed Securities In The Mortgage-Backed Securities Risk-Controlled Arbitrage Portfolios As Investments Held Until Maturity, Not Trading Securities That Would Have To Be Marked To Market

M524. In public filings made by Respondents, the investment in the MBSs portfolios are described as investment portfolios that are carried at cost. Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended 12/31/86) pp. CN071189 - CN071190; Ex. A-3023, Tab79 (UFG 10-K for fiscal year ending 12/31/87) p.CN158941; Ex. A-7009, Tab 1165 (Letter from Peat Marwick to USAT Board of Directors, 12/31/86-87); Ex. A-10774, Tab 1166 (Peat Marwick Consolidated Financial Statement for fiscal year 1987 12/31/86-87).

M525. As Respondents were informed on January 5, 1986 by Peat Marwick:

. . . management’s intent is the prevailing factor in determination of the appropriate accounting of investment and trading portfolios, and without a record of intent and strategy at the time of purchase or trading, turnover may become an indicator of management’s intent.

Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow, 01/05/87) p. KPMG 024413; Ex. B-4195, Tab 1178 (AICPA Industry Audit Guide) pp. 32 and 43.

M526. The reasons for the turnover is determinative of whether the experience supports the classification as an investment portfolio. As Peat Marwick informed Respondents’ managers of USAT, “[The] objectives and strategy which was used at the time of purchase and trades of the securities” determine “whether trades were made for the purpose of short term gains or for other valid purposes consistent with an investment portfolio.” Ex. B-1410, Tab 910 (Letter from Parsons (Peat Marwick) to Crow, 01/05/87) p. KPMG 024414.

M527. As Peat Marwick’s partners on the USAT account testified, sales out of a MBS portfolio to generate gains in a short time period is evidence that the portfolio is a trading portfolio that must be marked to market, and not an investment portfolio that may be recorded at cost. Tr. 10,296: 11 - 10,300: 8 (Millinor); 10,497: 2 - 10,500: 22 (Parsons); 12,367: 10 - 12.378: 12; 12,378: 18 - 12,383: 19; 12,384: 12 - 12,389: 22; 12,453: 22 - 12,459: 5; 12,460: 8 - 12,461: 15 (Claiborne).

M528. As described in Findings M230 - M240, Respondents sold MBSs to generate gains to bolster profits in order to meet the regulatory minimum net worth requirements, and not to simply rebalance the portfolios to protect against an increase in prepayments.

M529. As a consequence, the Respondents accounting for the MBS RCA as investment portfolios results in the filing of false and misleading financial statements with the FHLBB.

3. Respondents Accounted For The Swaps Used To Hedge The Interest Rate Of The Arbitrage Portfolios As Off-Balance Sheet Instruments But Did Not Mark Them To Market As Macro Hedges Nor Account For Them In Conjunction With The Assets Or Liabilities That They Hedged____________

M530. USAT accounted for the swaps and other balance sheet instruments it used to hedge the interest rate risk in its MBS portfolios by deferring any market value changes and amortizing them over the life of the instruments. For example, in the UFG Form 10-K for fiscal year ended December 31, 1986, Respondents explained that:

The company has made use of interest rate exchange agreements (‘swaps’), interest rate futures, options, caps and collars, to effectively convert a portion of the Company’s floating rate obligation to fixed rate obligations to provide a ceiling on future funding rates. . . . 

Interest rate futures contracts and options are utilized to hedge interest rate risk. Gains and losses on these hedges are deferred and amortized as interest adjustments over the remaining lives of the hedged short-term liabilities.

Ex. A-3023, Tab 79 (UFG 10-K for fiscal year ended, 12/31/87) pp. CN158927 and CN158941; Ex. A-3022, Tab 719 (UFG Form 10-K for fiscal year ended, 12/31/86) pp. CN071189 - CN071190; See also, Ex. A-7009, Tab 1165 (Letter from Peat Marwick to USAT Board of Directors, 12/31/86-87); Ex. A-10774, Tab 1166 (Peat Marwick Consolidated Financial Statement for fiscal year 1987, 12/31/86-87).

M531. USAT accounted for the swaps as off balance sheet items and recorded the fixed interest rate USAT was obligated to pay on the fixed side of the swap as an expense item when it was paid, and recorded the variable rate that USAT received on the variable side as an income item when received. Tr. 16,227: 15 - 16,233: 9; 16,233: 22 - 16,237: 5 (Crow); Ex. B-735, Tab 1014 (Audit Working Papers for Savings and Loan, 12/31/85). “Although United matches up their securities with their swaps on a ‘macro’ basis, no specific identification exists between any single security or group of securities and any single swap agreement.” Ex. B-819, Tab 586 (PMM Workpaper Z-56, 01/31/86).

M532. USAT did not account for changes in market value in the period that they occurred for any of the swaps used to reduce USAT’s interest rate risk, nor defer and amortize any gains of losses in market value in conjunction with the period in which the liabilities or hedges were held, the two alternatives provided for in the controlling accounting literature and FHLBB guidance. Tr. 15,531: 1 - 15,532: 17 (Crow).

M533. Respondents’ management team did not apply FASB 80 when accounting for the swaps. According to Crow, USAT viewed the swap as an off balance sheet item and accounted for the swap contracts by recording the various cash flows during the period they occurred. USAT recorded the fixed rate that it was paying as an expense and recorded the receiving variable it was receiving as a credit until the swap was extinguished, at which time it would then record a gain or loss. Tr.16,228: 18 - 16,233; 16,234: 1 - 16,237: 5; 15,584: 5 - 15,586: 1 (Crow); 9,134: 18 - 9,136 : 20 (Wolfe); Ex B-735, Tab 1014 (Audit Working Papers for Savings and Loan, USAT, for the period ending December 31, 1985).

M534. As Crow testified, managers of USAT “accounted for . . . hedges on a macro basis, and they were not to be marked to market. And a gain or loss would be recognized if the interest rate swap or whatever were extinguished.” Tr. 15,528: 14-17 (Crow).

M535. As explained above in Finding M481 - M495, a swap contract is similar to a futures contract and must be accounted for in accordance with FASB 80. Since the swaps were acknowledged to be macro hedges, and not micro hedges that qualified for deferral accounting, (principles known to Respondents’ managers of USAT), the failure to mark them to market in the period in which the gains or losses occurred violated the applicable accounting literature and FHLBB regulations and guidance.

M536. The only authorized basis upon which the Respondents could have deferred the losses on the swaps, would have been if they had qualified as micro hedges under the criteria enunciated under FASB 80. Assuming that it would have been appropriate to do so, USAT’s failure to mark the swaps to market to offset the gains on the sales of MBSs still violated the applicable accounting literature and FHLBB regulations and guidance.

M537. When managers of USAT recognized the gains on the MBSs that were sold out of the RCA portfolios, they did not recognize the market value losses that existed on the swaps at the time. Tr. 15,618: 11-15 (Crow).

M538. A reverse repurchase agreement is an agreement to sell and then subsequently buy back a specific notional amount of MBSs with a specific maturity date, at a specific coupon rate, issued by a specific agency such as FNMA. Tr. 4,108: 7 - 4,109: 16 (Memo from Director, FHLBB Office of Examinations and Supervision, to Professional Staff, Examinations and Supervision, Bulletin #R-48, Updated - August 15, 1985.)

M539. As the FHLBB explained in Regulatory (“R”) Memorandum 48 issued on August 25, 1985, dollar reverse repurchase agreements may be accounted for as financing transactions when the securities that are sold and repurchased are substantially identical in coupon and issuer, but must be accounted for as sales and purchases when “the security to be repurchased is not substantially identical to the security sold,. . .  [such as] when [the] transactions involve the exchange of securities with different coupon interest rates. . . . or issued by different government agencies with profits and losses recorded in the period incurred.” (Memorandum #R-48, Director FHLBB Office of Examinations and Supervision, Updated - August 15, 1985, Re: Securities Transactions).

M540. Similarly, the Saving and Loan Audit and Accounting Guide explains that reverse repurchase agreements are contracts to sell and repurchase MBSs within a specified time at a specified prices, with the difference in price representing the interest paid to the purchaser for the use of the funds for the interim period. If the reverse repurchase agreement involves identical securities or substantially similar securities, the substance of the transaction is to borrow and lend funds and is accounted for as a financing transaction. If the MBSs are dissimilar, the transaction is not a financing transaction, but a sale and purchase of securities that must be accounted for as such. Ex. B-4187, Tab 1177 (Audit and Accounting Guide, Savings and Loan Associations 1987) pp. 116-17 and Appendix A, p. 141.

M541. As USAT’s comptroller admitted in his testimony, when the MBSs that have been financed with the reverse repurchase agreement have been sold to a third party, the reverse repurchase agreement has been extinguished. Tr. 9,252: 1 - 9,253: 18; 9,255: 21 - 9,256: 9 (Wolfe).

M542. Thus, when the MBSs were sold, and not rolled forward as part of a new reverse repurchase agreement, and then replaced with securities with different coupons, or from different issuers, or with different maturities, the hedged instrument (the reverse repurchase agreement that funded their purchase) had been extinguished. This triggers the obligation to recognize the gain or loss on the swaps, assuming they qualified for deferral accounting in the first place.

4. Respondents’ Failure To Mark Either The Mortgage-Backed Securities Or The Swaps To Market Had The Effect Of Overstating USAT’s Capital Levels In The Thrift Financial Reports And Audited Financial Statements Filed With UFG’s 10-K’s

M543. USAT was barely above its regulatory minimum net worth requirement on June 30, 1986, and all subsequent quarterly reporting dates after that date. FOF M193 - M195 and M215 - M219.

M544. As described in Findings M208 above, the mark to market losses on the swap contracts was $122 million as early as June 30, 1986.

M545. As a consequence, Respondents filed materially false and misleading financial statements that overstated USAT’s reported net worth. FOF M202 - M203; M220; and M322.

XX. Respondents Participated In The Violations Of Safety And Soundness And Regulations With USAT’s Management Of The Mortgage Backed Securities Portfolios

M546. Control of USAT effectively shifted from the Bentley and the Coles group to the MCO/Federated shareholders between December 31, 1981, and December 31, 1985 Tr. 2,051: 6-9 (Bentley).

M547. Instrumental to the MCO/Federated assumption of control of USAT, was Hurwitz’s hiring of Munitz and Heubsch who reported to Hurwitz and were employees of Federated and Maxxam. Munitz was hired directly by Hurwitz for, “the express purpose of dealing with people-type issues.” Tr. 25,167: 18-20 (Munitz). In that capacity Munitz retained search firms to assist in locating qualified candidates and participated in the recruitment and hiring of qualified investment managers. Tr. 25,280: 15 - 25,281: 9; Tr. 25,289: 4-21; Tr. 25,482: 20 - 25,482: 15 (Munitz). Among the investment managers Munitz helped recruit and hire were Laurenson, Stodard, and Bruno. Id.

M548. Hurwitz also participated in USAT’s hiring decisions of the remaining senior management of USAT (Tr. 25,168: 18 - 25,169: 10 (Munitz)). If Hurwitz opposed the hiring of a particular individual because he felt that he or she wasn’t qualified in a particular area, it was “less likely” that they would be hired. Tr. 25,169: 22 - 25,170: 6 (Munitz). Hurwitz, who had prior experience with and was particularly knowledgeable about high-yield bond and equity arbitrage investments, was acknowledged by USAT’s management team at the April 26, 1985, Strategic Planning Committee meeting as “... the only truly qualified individual to determine the quality of some of the investments.” Ex. A-10560, Tab 174, p. US 0000385. As a consequence, Hurwitz frequently interviewed potential candidates that were under consideration by USAT as investment managers. Tr. 26,100: 1-4; Tr. 26,099: 6-9; Tr. 26,101: 6-21 (Hurwitz); Tr. 25,648: 5-10 (Stodard).

M549. In additional to personally directing Huebsch to perform investment management services for USAT in 1984, Hurwitz interviewed Phillips for the position of USAT’s initial high-yield bond and mortgage-backed securities portfolios. Tr. 26,099: 6-9 (Hurwitz); Tr. 5,324: 19-22 (Phillips).

M550. Hurwitz and Huebsch interviewed Phillips for a position as portfolio manager of USAT’s junk bond portfolio in 1984. Phillips was asked to meet with G. Williams or Crow to complete the interview process. Tr. 5,018: 11 - 5,022: 1 (Phillips). Neither Hurwitz or Huebsch held a position with USAT at the time they initiated Phillips hiring. Tr. 5,022: 2-10 (Phillips). Huebsch, however, worked for Federated, Tr. 5,022: 11-15 (Phillips), and reported to Hurwitz. Tr. 5,026: 11-13 (Phillips).

M551. Hurwitz’s office was in the suite that contained the trading room, which he visited frequently each day, and was one of the persons with whom Phillips consulted regarding trading strategy prior to the formation of the Investment Committee in May 1986. Tr. 5,042: 17-5,045: 13 (Phillips).

M552. Hurwitz participated in the initial discussions to increase the MBS portfolio at USAT in early 1985. Tr. 13,734: 6-21 (Hurwitz).

M553. Huebsch first informed Phillips that USAT would be investing in MBS RCA’s in 1984, prior to Huebsch becoming an officer of USAT, when he was still employed exclusively by Federated, which Phillips understood was being done to satisfy the Qualified Thrift Lender Test, although Huebsch did not discuss the rationale for the investment with him. Tr. 5,096: 19 - 5,101: 17 (Phillips).

M554. Huebsch and Phillips decided on the initial structure for the MBS RCA in 1984, which they discussed with the members of the informal investment committee that existed at the time, prior to the time Huebsch became and officer of USAT. Tr. 5,111: 3 - 5,113: 22 (Phillips).

M555. Phillips reported to Huebsch on his activities with regard to the MBS RCA’s and Huebsch attended all meeting held with G. Williams to report on his activities. Tr. 5,145: 12-5,146: 10 (Phillips).

M556. Between some time in 1984 and the date of his testimony in this proceeding, Huebsch worked primarily for Federated, and did not become an office of USAT until February 18, 1985, but his salary was paid at all times by Federated, owned by Hurwitz to whom Phillips reported during the entire time he was employed by Federated. Hurwitz oversaw Phillips management of the MBS RCA’s. Tr. 13,407: 1 - 13,409: 1; 13,414: 18 - 13,423: 4 (Huebsch).

M557. Huebsch and Phillips reported to Munitz, who was Hurwitz’s chief assistant, on the performance of the MBS RCA’s. Tr. 13,452: 7 - 13,455: 13; (Huebsch).

M558. Hurwitz set the profit targets for the USAT in November 1985, that established the policy at USAT to make sales out of the RCA’s to generate gains to satisfy USAT’s minimum regulatory net worth requirement. Ex. A-1590, Tab 1295 (11/17/85 Strategic Planning Meeting ), pp. US-3 008032-33; Tr. 13,380: 12 - 13,381: 13 (B. Williams). In that meeting Hurwitz emphasized that USAT should “…get [its] net worth target internally to 4 percent. Don’t report losing quarter. Don’t show quarter-to-quarter decline.” Id. at US-3 008032; Tr. 13,231: 3 - 5 (B. Williams). Tr. 13,231: 6-13; Tr. 13,233: 1 - 13,234: 7 (B. Williams).

M559. Following the meeting USAT adopted the strategy advocated by Hurwitz. On November 29, 1985, B. Williams advised USAT’s senior management that based upon what was agreed to at the meeting USAT would:

1) Maintain a minimum capital to assets ratio of 4.0%.

2) Report a gradual stable earnings record throughout the year [1986].

Ex. B-665, Tab 1391, (memo from B. Williams, 11/29/85) p. OW003550.

M560. After setting the income targets in November 1985, Hurwitz participated through the Executive Committee in the sale of the $350 million in MBSs out of United Mortgage Finance after which United Mortgage Finance was collapsed to realize a gain. By the end of November 1985, USAT’s management created a new $500 million MBS RCA portfolio in USAT Mortgage Finance. Ex. A-1622, Tab 504, (Asset/Liability Committee Minutes, 11/20/85). p. OW0120944Within three weeks of creating the portfolio, USAT’s Executive Committee considered whether to “sell the MBS for a gain of about $15 million.” Ex. A-1220, Tab 1390 (Executive Committee Agenda, 12/12/85). p. OW011603. However, no action was taken by the Executive Committee on that date. Ex. A-1219, Tab 1438 (Executive Committee Minutes, 12/12/85). p. OW010978. Gross advised Hurwitz on December 17, 1985, that Huebsch and Phillips had “wound up” United Mortgage Finance by selling $350 million of MBS’s, retaining $150 million of the MBS’s at the USAT level generated an income of about $11,000,000 this year.” Ex. B-697, Tab 1310 (Gross memo, 12/17/85), p. CN253185. This permitted USAT to show a modest $1.8 million profit for the last quarter of 1985. Ex. A-5010, Tab 557, (USAT Performance Report, 02/07/86) pp. US 0001113 and US0001115; B-697, Tab 1310 (12/17/85 Gross memo). Instead of selling the swaps which hedged the liquidated MBSs and incurring a loss in 1985 (Ex. B-697, Tab 1310 (memo from Gross, 12/17/85) p. CN253185), “a ‘mirror’ swap was put in place” and the loss on the swaps was deferred. Ex. B-819, Tab 586, (memo from Phillips to file, 01/01/86) p. 6.

M561. Hurwitz also participated in the “so called” rolldown of the MBSs in early 1986 that was managed by Joe Phillips. In a memorandum dated February 19, 1986, Gross informed Hurwitz, Huebsch and Phillips that he was glad that they had “completed [the] roll down of [the] mortgaged-backed securities” and asked whether Hurwitz or any members of USAT’s management could determine “where we now stand as far as a [sic] annual income stream from the mortgage backed and swaps” and “what sort of a spread do we now have compared to what we were originally shooting for?” (Memo from Gross, 02/19/86) Ex. T-4171, Tab 1312, p. US0001026.

M562. Hurwitz’s involvement in the management of the MBS RCA’s went beyond simply setting major stragegies for the institution. For example, he received a memorandum from Phillips dated November 17, 1985, that described the various hedging instruments available to USAT and how they worked. Tr. 5,363: 13 - 5,365: 5 (Phillips). Ex. A-10578, Tab 579 (Memo from Phillips to Hurwitz et. al Re: Hedging of collateral), p. 1.

M563. As all the witnesses have testified, Hurwitz regularly attended the Investment Committee meeting at which the MBS RCA portfolios were managed. Tr. 3,776: 5-16 (Orr). As Orr testified, no actions were taken by Orr or other portfolio managers without the Investment Committee being fully informed and its approval having been obtained. Tr. 3,796: 18-22 (Orr); 3,806: 20 - 3,807: 1.

M564. When Phillips was relieved of his responsibility for the MBS RCA’s, Hurwitz was among the people who asked Munitz to undertake the recruitment that led to the hiring of Sandy Laurenson (Tr. 25,481: 20 - 25,483: 10) and Hurwitz personally interviewed Laurenson for the job of managing USAT’s MBS portfolios. Tr. 26,100: 1-11 (Hurwitz).

M565. After it became clear that the rolldown strategy might have been a failure, in June 1986, USAT sought the assistance of Smith Breeden. (Tr. 3,021: 18 - 3,022: 4 (Smith). Smith Breeden came to USAT’s attention because Hurwitz’ son had taken several courses at the University of North Carolina from Doug Breeden, one of the principals of Smith Breeden, and thought he was really bright. Tr. 3,962: 21 - 3,963: 16 (Orr). After USAT retained Smith Breeden as a consultant, Hurwitz was involved in considering Smith Breeden’s analysis of USAT’s MBS portfolio and received materials from Smith Breeden regarding the hedging of that portfolio. For example, after initially reporting to USAT on June 30, 1986, that its MBS/RCA portfolio had a mark-to-market loss of $58 million (Tr. 11,820: 9 - 20 (Giarla)), Smith Breeden provided a report (Ex. A-10666, Tab. 870 (09/15/86 Strategy Meeting Report, 09/15/86)) and made a lengthy presentation to Hurwitz and USAT’s senior management on September 15, 1986, regarding the USAT MBS portfolio. Ex. T-4246, Tab 335, (Memo from Hansen, 09/08/86) ¶ G p. 6; Tr. 11,751: 4-12 (Giarla). In addition, on October 13, 1986, Smith Breeden sent a number of materials and articles to USAT, Hurwitz, and Doug Hansen pertaining to the hedging of USAT’s mortgage backed securities. Ex. B-1258, Tab 372 (Letter from Giarla to Laurenson, 10/13/86). On October 30, 1986, Crow submitted a memorandum to members of the Investment Committee, including Hurwitz, advising them that the relationship with Smith Breeden was not working satisfactorily. The Smith Breeden consulting arrangement with USAT was thereafter terminated. Ex. A-1416, Tab 347 (Investment Committee Minutes, USAT, UFG, 10/30/86) p. US-3 005032; Tr. 4,026: 12 - 4,028: 9 (Orr).

M566. Hurwitz actively participated in the establishment of criteria of when to take gains to generate profits to bolster net worth. FOF M566 - M570.

M567. In the September 8, 1986, memorandum from Hansen to Crow, Phillips, and B. Williams, it was noted that:

In the past, trades have generally been made by looking at market values or economics rather than accounting yield. This was appropriate before the recent accounting change.

With the new accounting treatment, gains and losses on trades are recognized immediately. There is a trade-off with every transaction between one- time earnings gains or losses and changes in the recurring net interest margin. The committee recognized the need to devise a decision rule for these situations. The decision rule will hinge on the value United places on capital. The committee discussed a variety of possible “cost of capital” numbers, ranging from 9% to 20%. Input from the investment committee on this matter would be helpful.

The committee noted that when rates rise, MBS trading becomes difficult due to declines in market values. United will be forced to retain its current MBS portfolio in the event of a rapid rise in rates. The committee then raised the question of whether our current portfolio would be the ideal one to hold for the long term. The committee consulted Smith Breeden on this matter; the response was that our current portfolio would be a fairly good one to hold in the event of a down market. The only possible improvement they might suggest would be to diversify coupons by purchasing some premium securities. Further consideration of this matter was postponed, pending the Sept 15 Smith Breeden presentation.

Ex. B-1212, Tab 379 (Memo from Hansen to Crow, Phillips and B. Williams Re: MBS Trading Committee, 09/08/86), pp. US-3010603-604.

M568. As the minutes for the September 18, 1986, meeting of the Investment Committee attending by Hurwitz and Munitz indicate, Respondents’ adopted criteria for the trading of MBSs to generate gains. As recorded in the minutes of September 18, 1986:

The committee reviewed the minutes of the Mortgage-Backed Security Trading Committee for the week. All transactions were approved. The committee then discussed the implicit cost-of-capital calculation made when a trade is made which improves the Association from an economic perspective and allows a book gain, but lowers on-going book spread income. The committee then debated the optimal degree to which United should specify characteristics of particular mortgage pools when trading these securities.

Ex. A-1409 Tab 380 (Investment Committee Minutes for USAT, UFG, 09/18/86), p. US-3 004883-892).

M569. Subsequent to the September 18, 1986 meeting, sales that met the criteria established were made and reported to the Investment Committee. Ex. B-1231, Tab 380A (Memo from Hansen to Crow, Phillips, B. Williams, Investment Committee, Re: MBS Trading, 09/22/86) p. US-3 010602. Ex. A-1410, Tab 546 (Investment Committee Minutes, USAT, UFG, 09/24/86) p. US-3 004894.

M570. OMITTED.

M571. Hurwitz’s direct involvement in the decision by USAT in the third quarter of 1986 to take gains out of its investment portfolios, to shore up its net worth, is reflected in his participation in the consultation with Smith Breeden. One of the “Immediate Strategies” recommended by Smith Breeden at the September 15, 1986, presentation attended by Hurwitz was to “[t]ake gains on [the MBS] portfolio to offset operating losses.” Ex. A-10666, Tab 870 (USAT Strategy Meeting, 09/15/86) p. US 0002061. After attending the presentation, Hurwitz met with the members of the Investment Committee on September 18, 1986, and among the matters they discussed was the impact the sale of MBSs has “when a trade is made which improves the Association from an economic perspective and allows a book gain, but lowers on-going book spread income.” Ex. A-1409, Tab 380 (Investment Committee Minutes, USAT UFG, 09/18/86) p. US-3 004884. Four days later, on September 22, 1986, the Strategic Planning Committee also met to consider, among other things, USAT’s “Earnings and Growth Strategy” and “taking portfolio gains in the third quarter to shore up reserves and [USAT’s] capital position.” Ex. T-4250, Tab 871 (Memo from Hansen, 09/22/86) item 31, p. OW012018. Hansen suggested in his memorandum to Hurwitz and the other members of the Committee that “[w]e should take MBS and liquidity gains …alert Joe (Phillips) as to the possibility of taking junk bond gains, and track the profit and capital positions carefully.” Id. p. OW012019. At the conclusion of his memorandum, Hansen recommended that in the third quarter of 1986, USAT “Take $10 MM securities gains in junk, MBS, and liquidity portfolios.” Id. p. OW012020.

M572. Prior to the creation of the Investment Committee by the Board of Directors in May of 1986, all investment decisions regarding the MBS were made by a small group that included Huebsch who reported to Hurwitz. Tr. 5,043: 5-12 (Phillips).

M573. Hurwitz participated in the Investment Committee meeting on January 21, 1986, in which it was reported the portfolio was positioned for an interest rate decline, actively participated in discussion at subsequent Investment Committee meeting at which it was decided to assume the risk of adverse moves in interest rates.

M574. After interest rates turned against USAT in the Spring of 1987, and the Association’s MBS portfolio suffered a precipitous mark-to-market decline in the value, Hurwitz also participated in discussions regarding USAT’s future interest rate policy. At the Investment Committee meeting on April 22, 1987, Laurenson informed the Committee that as a result of interest rate movements the MBS portfolio had a “distinct mark-to-market decline” (Ex. A-1439, Tab 366, p. US-3 005631), and had a liquidation value along with the associated hedges of negative $197,161,000. Id. p. US-3 005655. Berner immediately wrote Hurwitz, Munitz, Gross and Crow and proposed that USAT’s “top management,” rather than Sandy Laurenson, should make a “corporate decision on where we believe interest rates will move.” Ex. B-1580, Tab 1659 (Memo from Berner, 04/22/87) p. CN031786. On April 27, 1987, Gross also proposed to Hurwitz and the members of the Strategic Planning Committee that USAT takes steps to establish a “unified strategic plan or policy with regard to interest rates.” Ex. T-4366, Tab 1660 (Memo from Gross to Members of Strategic Planning Committee, 04/27/87).

M575. During the first half of 1987 Hurwitz, as a member of the Strategic Planning Committee, also participated in the decision by USAT to transfer $320 million of variable rate MBS and $710 million of interest rate caps from UMBS to USAT in order to maximize USAT’s maturity matching credit to reduce USAT’s net worth requirement. Ex. T-5125, Tab 302 (Memo from B. Williams to Gross and Crow, 06/17/87); T-5120, Tab 297 (Memo from B. Williams, 02/18/87) p. US-0001859. As early as September 8, 1986, Hansen had proposed to Hurwitz and the other member of the Strategic Planning Committee that USAT take advantage of the maturity matching credit as part of USAT’s Growth and Capital Strategy. Ex. T-4246, Tab 335 (Memo from Hansen to Hurwitz, 09/08/86) ¶ C, pp. 2-3. The Strategic Planning Committee again considered the maturity matching issue at the March 2, 1987, meeting (Ex. T-5122, Tab 299 (Strategic Planning Committee Agenda, 03/02/87) and May 4, 1987 (Ex. A-1598, Tab 2317, p. US 0 001253) after which, “by management approval,” UMBS transferred to USAT the MBS and caps, which in B. Williams words “maximized [USAT’s] maturity matching credit using ‘mirrors’.” Ex. T-5125, Tab 302 (memo from B. Williams to Gross and Crow, 06/17/87).

M576. Hurwitz also participated in the decisions to sell the futures contracts and caps in the fall of 1987, to capture the unrealized profits to help meet USAT’s net worth obligation. See Investment Committee Minutes Ex. A-1451, Tab 1321, p. US-3 006088; A-1452, Tab 1322, p. US-3 006113-114; A-1453, Tab 1324, p. US-3 006155; A-1454, Tab 1324, pp. W100536 and 546; A-1464, Tab 1334, p. US-3 006524.006; See also, FOF M327 - M330.

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[1] CPR means the percentage of mortgages that prepay in a two month period.