Opening Remarks of Kenneth Guido, Lead Attorney for the OTS, in the OTS vs MAXXAM, Sept. 22, 1997
MR. GUIDO: May it please the Court, my name is Kenneth Guido; and I represent the Office of Thrift Supervision in this proceeding. As introduction to my opening statement, I thought it would be important to summarize the notice of charges or the claims that are set forth in the notice that was filed on December 26th, 1995. The first claims in the notice deal with respondents' failure to maintain the net worth of United Savings Association of Texas as it required as a condition MCO and Federated having required control of USAT and its holding company, United Financial Group, and the respondents causing false and misleading statements to be made regarding the put call option with regard to the acquisition of the stock of United Financial Group. Those are claims 1 through 3 of the notice. In addition, the notice alleges violations of the Control Act and its applicable regulations for the failure to register MCO and Federated as savings and loan holding companies and failure to file annual reports with the FSLIC savings and loan holding companies. That's Claim No. 4, Your Honor.
Claim No. 2, Your Honor, is that the respondents failed to comply with United Financial Group's net worth maintenance condition that was imposed as a result of a merger of United Financial Group with another savings and loan holding company.
In addition, the notice of charges alleges that the respondents caused USAT to purchase junk bonds from Drexel, Burnham, Lambert with whom respondents were acting in concert to acquire control of UFG and USAT, and it did so without the prior written consent of the Federal Home Loan Bank Board causing respondents to violate and causing USAT to violate the affiliated party regulations of 12CFR. In addition, the notice of charges alleges that respondents engaged in unsafe and unsound practices and made false and misleading statements while speculating in USAT's portfolios of mortgage-backed securities. Those are claims 6 and 7, Your Honor.
In addition, the notice of charges alleges that when the respondents could no longer use accounting gains to generate profits to shore up the capital of United Savings Association of Texas, they engaged in sham transactions to transfer caps and adjustable rate mortgages from a subsidiary, United MBS, to the parent company, USAT, in order to reduce the capital requirements for the holding company.
The notice of charges also alleges that the respondents caused USAT to guarantee a debt or the debts of a subsidiary corporation, United MBS, in violation of the applicable service corporation regulations, the liability growth regulations, and the direct investment regulations. So, those are the claims, I believe, that are claims 9 through 11 in the notice of charges, Your Honor.
The notice of charges also alleges that the respondents, in order to generate profits for USAT, engaged in unsafe and unsound lending and investment practices and violated the applicable regulations in connection with investments in Park 410, an 80 million-dollar loan, and the Norwood United Project which was a 30 million-dollar loan with a 9 million-dollar capital contribution. The allegations in there are that the respondents failed to properly underwrite the loans, relied on inadequate and fraud appraisals, approved disbursements prior to loan approval by the board of directors, and failed to comply with applicable lending regulations as a result of which USAT incurred losses in excess of $80 million. That's Claim No. 12 in the notice of charges, Your Honor.
Then, finally, at a time when USAT couldn't meet its minimum regulatory capital requirements and when it was rapidly approaching insolvency, respondents, with knowledge of both of these facts, approved retroactive increases in compensation, bonuses, severances, payments, and debt forgiveness for themselves and other USAT insiders in excess of $40 million.
They, therefore, caused the limited remaining assets of USAT/UFG to be distributed themselves, further depleting those assets and damaging their financial condition and impairing their ability to meet UFG's net worth maintenance obligation. That's claim No. 12, Your Honor.
And before I proceed, elaborate on these, Your Honor, I think it's important to put this into context by looking at the financial condition of United Financial Group over time and the financial condition of MCO over time, Your Honor.
In 1982, prior to acquisition of control of USAT and UFG, UFG had total assets of $1.8 billion, Your Honor. At the same time, MCO had assets of $484 million, Your Honor. By 1987, a year before USAT was closed, UFG had assets of $7.1 billion, Your Honor. And MCO or MAXXAM at the time -- it's not clear to me when MCO Holdings became MAXXAM -- had assets of $1.4 billion approximately which increased in 1988 to $3.63 billion.
During this time period, Your Honor from 1984 to
1988, USAT purchased junk bonds underwritten by Drexel Burnham Lambert,
a total of about $1.6 billion, I believe, Your Honor. In 1984, they bought
$49 million. 1985, the amount went up to $317 million. 1986, it went to
$772 million. 1987, it was $267 million. And 1988, it fell off because
of the decline in the 8 thrift to $115 million.
During that same time period, Drexel Burnham Lambert on net underwrote approximately $1.8 billion in junk bond issuances by MAXXAM.
I believe, in addition, there are two other telling facts. You've heard this morning a little bit about Drexel Burnham Lambert's ownership of MCO stock which, I think, is relevant to issues that will come up in this proceeding; but, also, you will hear in the testimony that during this entire time period, MCO Holdings, Federated, and the related entities other than UFG and its subsidiaries purchased no junk bonds from Drexel Burnham Lambert or anyone else, Your Honor.
Now, turning to the first and fourth claims, MCO's net-worth maintenance obligation, Your Honor, the facts will show that with the assistance of Drexel, MCO Holdings and Federated purchased 24.9 percent of the outstanding stock of United Financial Group. It initially did so through a subsidiary of Federated called -- Federated Reinsurance, I think, was the name of that company which it filed an application to acquire something in excess of 10 percent. And it sought approval of the Federal Home Loan Bank Board to do so. It did receive that approval. It was told that it would have to rebut a presumption of control if it did so. It sought to rebut that presumption. Federal Home Loan Bank Board determined that it had not rebutted that presumption and concluded that for purposes of the regulations, Federal Reinsurance was in control.
Subsequent to that point in time, MCO and Federated increased their purchases of stock so that the amount finally reached to 24.9 percent, as I indicated, was purchased with the assistance of Drexel. In addition, MCO and Federated filed an application, H(e)1 application, to obtain control of United Financial Group and, indirectly, its hundred-percent owned subsidiary, USAT. That application was approved.
As a condition to that application, Your Honor, the bank board provided that for as long as they, MCO and Federated or the applicants, directly or indirectly controlled United Savings, applicants shall contribute a pro rata share based on their UFG holdings of any additional infusions of capital in a form satisfactory to the supervisory agents that may become necessary to maintain its net worth at the level required by the corporation's net-worth regulations.
At about the same time, the evidence will show that Drexel's -- excuse me -- that MCO Holdings sought other ways to obtain stock in UFG without triggering this provision which would establish control. The evidence will show that it did so because it did not want to be bound by the net-worth maintenance condition; and, in fact, it sought repeatedly to get the bank board to change the net-worth condition.
It entered into an agreement with Drexel, in order to avoid the prescriptions in that condition, to acquire another 790,000 shares of stock of UFG in addition to the 24.9 percent that it owned. And over a long period of time in negotiations, it sought to draft what is referred to as a "put call option" in this situation.
Under that agreement which was eventually adopted, Drexel agreed to hold stock for MCO. MCO had the right to call that stock for payment of the fee which it paid at a predetermined price. If that call option were not exercised, Drexel negotiated and received the right to put that stock to MCO.
The negotiations didn't stop there however, Your Honor. Drexel demanded and received, in addition, guarantees that it would be reimbursed for any losses that it might occur; and it also received a letter of credit guaranteeing that if it put that stock to MCO, because of MCO's failure to call the stock, that it would receive its fee that it had contracted for and the full amount of that stock. The full 790,000 shares approximately, Your Honor, were not included in that put call option because it turned out that there were regulations of the National Association of Securities Dealers that didn't allow broker dealers such as Drexel to enter into such an agreement. It had a limit of 150,000 shares that could be covered in this situation.
Because of the staggered term of the put and the call here, however, Your Honor, Drexel and MCO were permitted to enter into an agreement for 300,000 of those shares.
What happened to the 490,000 shares, Your Honor, that were left? Drexel held them. It held them during a long period of time when the UFG stock prices were declining. It only sold that stock after MCO announced that it was no longer going to attempt, in the parlance of the Federal Home Loan Bank Board, to acquire control over UFG.
Your Honor, that put call agreement that was entered into with Drexel imposed the preponderate economic risk of ownership on MCO. There was no risk whatsoever to Drexel under that arrangement. Unless the third-party entity had issued the letter of credit, it defaulted on its obligation. But in all respects, the contract shifted all risks of ownership to MCO. No other party had a risk of ownership.
Now, one of the questions that will come up in this proceeding as we go is the whole question of: Why are there net-worth maintenance
conditions? Why did the agency require net-worth maintenance conditions?
You will hear testimony, Your Honor, that net-worth maintenance conditions were a bargain between individuals that purchased savings and loans and the Federal Home Loan Bank Board. You will hear testimony that in the 1979/1980 time period, traditional thrifts were in a great deal of trouble financially because of the oil crisis and the spike in interest rates that went with inflationary impacts that were related to attempts to defend the dollar during that time period.
You will hear testimony that there was a need to get new management into savings and loans to expand them into less traditional activities, Your Honor. You will hear testimony that Congress expanded the investment powers of savings and loans at this point in time in the 1979/1980 time period in order to assist them in becoming profitable again.
You will also hear, however, Your Honor, testimony
that when recruiting new management or attempting to make savings and loans
available to new management and new owners, there was no opportunity to
get infusions of capital or very little opportunities to do so because
people didn't want to risk their funds, putting it into entities that were
as severely damaged as savings and loans were at that time.
You will hear, Your Honor, testimony that the reason why net-worth conditions were demanded is because the agencies wanted something in return. They couldn't get people to risk their capital as a way of assuring that they wouldn't abuse their powers as managers of those thrifts like they can do today.
So, instead, what they did is they extracted net-worth maintenance conditions; and they did so in a number of ways, one of which was to unilaterally impose conditions in the resolution as was done here stating that if certain acts were undertaken on the other side, that the net-worth maintenance condition would be triggered.
But you will hear testimony, Your Honor, that it was viewed as a bargain, that it was something that was being extracted in exchange for giving people the right to control savings and loans, to expand their geographic lending areas, to expand their investment powers and allow them to engage in activities that traditional thrifts had not been allowed to engage in at that point in time.
Now, we believe that the statutory or the acquisition of stock meets the requirements of control, Your Honor; but we do not stop there, Your Honor. You will hear testimony, Your Honor, that at all relevant times, Mr. Hurwitz was the controlling shareholder of a business trust named Federated Development which was one of the two acquirers. He was the chairman and chief executive officer of that entity. He was also a trustee of that entity as were two of his associates, George Kozmetsky and Barry Munitz. Through Federated, Hurwitz controlled MAXXAM/MCO Holdings which was formerly known as McCullough Oil Company. He was also its chairman and chief executive officer. And he, Kozmetsky, and Munitz were all directors of MCO. They also all became directors of UFG. Hurwitz became the chairman of the board and CEO of UFG; and Munitz was also a director of USAT, positions they held as representatives of MCO and Federated.
In fact, Barry Munitz had correspondence that will
be part of the record of these proceedings that shows Barry Munitz has
an indemnification agreement with MCO because of his serving on that, on
the board of UFG at MCO's behest. The board of directors' meetings of UFG,
which had absolutely no operations other than USAT, were held simultaneously
with USAT's boards.
The evidence will show that Charles Hurwitz attended those meetings and in some of those instances will show that Charles Hurwitz was reporting to the board of USAT on activities of USAT, that he also in some instances even went so far as to second motions that were made by Mr. Munitz you will find in the course of this. The record of evidence will show that Mr. Hurwitz, Mr. Kozmetsky, and Munitz attended most of those joint board meetings.
The evidence will show that Mr. Hurwitz -- that Mr. Munitz directed the hiring of UFG and USAT senior management. The evidence will show that Mr. Hurwitz and Munitz were the only two UFG board members who were on what was referred to as the "strategic planning committee" which I will get to a little later on when I explain how they transformed this thrift from a traditional savings and loan to one that engaged in what the respondents refer to as wholesale activities. That strategic planning committee that was so instrumental in defining the direction of UFG and USAT had, as its only other members, senior employees hired by either Charles Hurwitz or Barry Munitz. In addition, Charles Hurwitz and Barry Munitz were also members of the management committees, were also senior employees that Mr. Hurwitz and Mr. Munitz had hired. In addition, Mr. Hurwitz and Mr. Munitz caused UFG and USAT to create a joint investment committee which had exactly the same members. It was composed entirely of senior management that they had selected; and Mr. Hurwitz and Mr. Munitz, to a lesser extent, actively participated in its deliberations. None of this should be a surprise because in the H(e)1 application to acquire control, MCO and Federated stated their intentions for UFG and USAT once control had been acquired. The record will show that they stated in that application MCO and Federated believed that the financial services industry is entering into a period of rapid growth, diversification, and change. MCO and Federated's investment in UFG will enable them to participate in an increasingly diversified financial services industry that, in turn, UFG and USAT will benefit from MCO's investment expertise in the financial markets.
Following that admonition, Mr. Hurwitz and Mr. Munitz, acting through various UFG and USAT committees, selected financial analysts to help devise a new investment strategy for UFG as described in the H(e)1 application. In response, the strategic planning committee adopted an investment strategy recommended by the analysts and advocated by Charles Hurwitz that dramatically changed USAT's business operations. The change, as I said, caused USAT to shift away from being a traditional thrift that originated residential loans funded with retail deposits to a wholesale strategy funded with broker deposits and, in this case, reverse repo agreements. The evidence will show they caused USAT's size to increase, as I stated at the outset, from 1 -- from a 1.8 billion-dollar institution to one with $7 billion in assets. They structured the USAT committees in a way in order to dominate USAT's policies and procedures. They devised its strategic plan. Charles Hurwitz advocated that they sell branches to generate capital to grow, which they did. He advocated that they curtail retail residential lending, which they did. He advocated they redirect its investments into high-risk junk bonds, which they did. He advocated that they direct other investments into corporate equity securities, which they did. He advocated that they purchase mortgage-backed securities funded with reverse repos, which they did.
As a consequence of the change, the evidence will
show that USAT's balance sheet was stripped of profitable assets in order
to meet regulatory capital requirements and forced the failure of regulatory
capital, the net effect of which was to increase the losses to the Federal
Insurance Funds when the institution failed.
The evidence will show, Your Honor, that the growth, the redirection of investment activity, and the stripping of the balance sheet were done by the respondents in order to survive a downturn in the Texas economy, to continue their investment activities as a diversified financial institution, have USAT emerge as a viable entity, and have respondents Hurwitz, MAXXAM, MCO, and Federated benefit financially from a hope for recovery.
The evidence, in essence, Your Honor, will show that the respondents received the benefit of control of a multi-billion-dollar institution and deliberately redirected its investments and operations which, if they had not obtained deposit insurance, would have cost substantial sums of money in the hundreds of millions of dollars assuming that they could have even gone out and raised those funds.
The facts will show, Your Honor, that, in essence, the government conferred a quantifiable substantial financial benefit, the control of USAT, on the respondents Hurwitz, MCO, and Federated -- those respondents accepted and retained the benefits of control; and, in fact, they vigorously exercised it -- and that those respondents are seeking to avoid that -- their obligation to meet the net-worth maintenance condition which was the benefit that the Federal Home Loan Bank Board thought it was obtaining when it allowed them to obtain control.
Respondents' control over USAT's investments, as the evidence will show, facilitated their receipt of financial assistance from Drexel. I indicated at the outset that Drexel had underwritten 1 -- approximately $1.8 billion in financing junk bonds for MCO or MCO-related entities. I also pointed out the evidence will show that during that time period, USAT purchased $1.6 billion in junk bonds underwritten by Drexel.
The evidence will also show, as Your Honor is aware from the earlier matters that came up today, that Drexel loaned approximately 230- to 250,000 shares of MCO directly in its own name. The evidence will also show, as I pointed out, that MCO didn't purchase any junk bonds at all during this time period. But what is also significant is that during the time period of 1982 through 1988, Drexel was also a major financier of USAT's purchase of mortgage-backed securities. In fact, at a time when USAT was running into financial trouble, Drexel stepped in, the evidence will show, and picked up the gap in the financing of USAT's mortgage-backed security portfolio, Your Honor. In essence, the relationship between Drexel, MCO, and Federated was of mutual benefit. The benefit from the MCO side will dramatically be evidenced by the statements that Mr. Munitz made in his interview with the FDIC when he was asked, "What were Mr. Hurwitz's motivations for owning USAT and continuing to keep it open?"
And he said, as reflected in the notes of the counsel for the FDIC, "Peer group pressure."
Who was going down, and who was still alive? He did not want to hurt his reputation among Pierce and Miliken. He was concerned about a net-worth maintenance risk to MAXXAM, and USAT was his ticket to ride with Drexel. The evidence will show that the OTS sought to get Mr. Munitz to testify to these matters; and his testimony was not satisfactory so that the OTS sought a subpoena enforcement or initiated a subpoena enforcement action for the notes which it had sought. And he would not voluntarily provide the notes that his lawyers had prepared, the two of them in the room with the FDIC people; and the two sets of notes were then taken and combined into a recitation of the facts. That subpoena enforcement action failed, Your Honor, the evidence will show; but the District Court observed that the FDIC's attorney's testimony appeared to provide ample proof of what Dr. Munitz said. And, therefore, in the Court's view, there wasn't substantial need to overcome the prescriptions of the attorney work product document.
In either case, Your Honor, the evidence -- we will attempt to introduce the evidence of the two FDIC attorneys of what Mr. Munitz said at that interview which we believe explains the benefits to the continued operations of USAT that Charles Hurwitz derived from his ownership.
Essentially, the evidence will show that USAT was important to Hurwitz in maintaining his relationship with Pierce including Milken; but the evidence will also show that Milken was extremely dependent upon savings and loans purchases of junk bonds in order to maintain a market for Drexel's underwriting activities.
As I stated earlier, the size of this symbiotic relationship, Your Honor, was $1.6 billion of purchases of junk bonds by USAT and the underwriting of approximately $1.8 billion of junk bonds from respondents which allowed it to increase from the size of an institution of about $500 million to well over 300 million or to well over a 3 billion-dollar institution.
Under those circumstances, Your Honor, the existence of the put call -- the full extent of the put call option from the regulators in order to avoid any risk, that there would be the imposition of a net-worth maintenance condition.
The evidence will also show that MAXXAM and Federated and Mr. Hurwitz had another reason for not having the net-worth maintenance condition triggered by the put call option and obscuring the full significance of the put call option from the regulators, and that was that they didn't want to be in a position where the federal regulators could review MCO's issuance of junk bonds.
The evidence will show that if a holding company comes within the jurisdiction of the Federal Home Loan Bank Board, it then had to get its approval for the issuance of debt. That would have had a detrimental effect, from the testimony of MCO employees, on MCO's operations; and, therefore, it was something to be avoided. Therefore, what happened was that MCO never sought the approval of the regulators for the put call option or asked whether or not it would trigger the net-worth maintenance condition despite the fact that there were opinions that had previously been issued by the general counsel's office of the Federal Home Loan Bank board that said when you have contractual rights such as an option to obtain stock in an entity and you have the preponderate economic interest in that stock because of that contractual relationship, you are deemed to hold the voting stock for purposes of the control regulations. And the opinions went on further to say that if you have any question about this, you should submit the issue to us for our opinion.
We believe that by failing to notify or to request an opinion by the actions that it took to obscure the full significance of the put call option and, particularly, the letter of credit, Your Honor, that the respondents acted in reckless disregard of the law.
Now, I'd like to move to the second claim, Your Honor, which is the claim with regard to UFG's net-worth maintenance obligation. As I stated earlier at the outset, it also had a net-worth maintenance obligation. That obligation was imposed when it granted UFG's application to acquire Houston First American Savings Association and merge it into USAT and a stipulation executed by the chairman of the UFG, Mr. Gross -- I'm sorry. I think it was Mr. Williams at the time. Excuse me, Your Honor. By failing to direct UFG to make the required contributions to the net-worth of USAT as required by the applicable regulations, the individual respondents essentially violated a written agreement entered into with the Federal Home Loan Bank Board. They violated a condition imposed in writing by the Federal Home Loan Bank Board in connection with the granting of that application and engaged in unsafe and unsound practices within the meaning of 12 USC1818. Those violations, the failure to satisfy the net-worth maintenance obligation of UFG, were a reckless disregard to the law where applicable regulations are ordered by the Federal Home Loan Bank Board. The individual respondents were aware of the resolution that imposed the condition and the stipulation executed by the chairman in October of 1983. They were aware that USAT had failed to meet its regulatory capital requirements as of December 31, '87.
As members of UFG's board of directors, they received a written demand from the Federal Home Loan Bank Board supervisory agent on May 13th, 1988, to meet that obligation. They did not respond to the request and took no steps to contribute any capital to USAT at any time before the association was placed into receivership. As a consequence of their actions, the assets of UFG were substantially depleted so that when the OTS and the Federal Home Loan Bank Board, in a bankruptcy proceeding that UFG had filed, finally was able to perfect its claim, substantial sums of monies had been dissipated.
One of the ways those funds was dissipated, Your Honor, was the payment of excess salaries, bonuses, and severance benefits that the respondents authorized to be paid to others and to themselves. I think the total amount was somewhere around the range of $4 million, two of which went to the respondents in this matter. We believe that that evidence will demonstrate that not only was respondents' failure to meet the net-worth maintenance obligation of UFG in reckless disregard of the law but it was also, Your Honor, a flagrant attempt to unjustly enrich themselves at the expense of the Federal Home Loan Bank Board and the Deposit Insurance Fund.
Now, I'd like to move on to the fifth claim, Your Honor. The fifth claim is predicated upon Drexel being -- acting in concert with MCO and Federated to obtain control over UFG and USAT. There is no dispute between the parties, Your Honor, at least as of this date, that if Drexel was acting in concert with MCO and Federated to obtain control, it was an affiliated party for the purposes of the affiliated party regulations.
We believe the evidence, as I explained earlier,
will show that Drexel acted on MCO's behalf to acquire stock that it put
into a special account to be held for MCO, that it accumulated the initial
stock that resulted in the acquisition of 24.9 percent of UFG's stock or
-- excuse me -- a sizable portion of that actual stock, that it held 490,000
shares of the 790,000 that it acquired and held in a special account for
MCO, and that it put 300,000 of that into a put call option that it held
or entered into for MCO's benefit to obtain control.
The evidence will show that USAT at Charles Hurwitz' and Ron Heubsch's direction purchased junk bonds from a number of companies including a sizable portion of that portfolio that was underwritten by Drexel. The total amount of those purchases exceeded $1.6 billion, Your Honor. As a consequence, those Drexel underwritten junk bonds contained junk bonds that lost $47 million for USAT. The respondents never sought approval for that -- those affiliated party transactions, Your Honor. And the respondents played crucial roles in the management of that portfolio. In fact, Charles Hurwitz and Ron Heubsch directed that that portfolio be cherry picked for profits periodically to bolster the capital of USAT into a forestall regulatory takeover. That portfolio was not managed as a consistent entire portfolio. That portfolio was managed as specific assets to be used and sold to bolster USAT's capital to forestall regulatory control.
The evidence will show, Your Honor, that the regulators never were presented with the opportunity to value that acquisition of junk bonds from Drexel in light of the fact that Drexel was underwriting substantial amounts of junk bonds for MCO to finance its takeover activities. We believe that the facts will demonstrate that the respondents acted in reckless disregard of the requirements of the law when they initiated that junk bond portfolio with Drexel, when they failed to obtain the requisition regulatory approval; and they did so because they did not want the regulators to review those purchases in light of Drexel's underwriting of junk bond purchases for MCO.
Now, I'd like to move on to the mortgage-backed security portfolio, Your Honor, and those claims which are in claims 6 and 7. There has been a great deal of dispute during the period of discovery about what constituted the portfolios that are at issue in this case. And I think we're coming closer to agreement, but my characterization of the facts in this regard may still be subject to some dispute.
There were essentially, what it looks like now, two portfolios, Your Honor, of mortgage-backed securities. One was the USAT portfolio or what has sometimes been referred to as the "Jones portfolio." That portfolio -- the purchases began in 1984. By 12/31/84, there was a small portfolio of approximately $98.9 million of mortgage-backed securities. It increased to about 616 million by 12/31/85. And then it was somewhere around 1.2 to 1.3 billion by November 30, 1988.
There were a number of representations that were made about that portfolio, Your Honor, as the evidence will show. The core of those representations were that it was a risk control arbitrage financed by reverse repurchase agreements that repriced every 30 to 60 days. It was hedged with swaps to extend the maturity of the 30-day and match it with the expected duration of the underlying mortgages in the mortgage-backed security portfolio. And the respondents committed, as required by the applicable regulations, to manage this portfolio in order to minimize the changes in interest rate risk. In other words, they committed themselves to minimize the risk of loss that could be occasioned by changes in interest rates. And as Your Honor knows, that is traditionally done in the savings and loan industry by trying to match the duration of assets and liabilities. The evidence will also show, however, Your Honor, that to match the duration of mortgage-backed securities and swaps is no easy task. Prepayment rates are not easily predicted or forecasted, and there is great room for error. Moreover, they increase dramatically, prepayment rates due, with a decline in interest rates requiring careful monitoring of the portfolio with someone with a great deal of sophisticated knowledge of those instruments.
We believe that the evidence will show that the respondents acted recklessly when they placed a person in charge of this original portfolio who had never had responsibility for managing such a portfolio; that, when he was hired, he was never asked any questions about mortgage-backed security portfolios or his knowledge thereof. And the evidence will show that the only knowledge that he got about the operations of mortgage security portfolios was reading promotional literature distributed by investment banking firms that were peddling mortgage-backed securities to savings and loans. The evidence will show that this manager failed to appreciate the sensitivity of repayment rates to changes in interest rates. The evidence will show that sometime in late 1985, for the next six months, interest rates declined 300 basis points. The evidence will also show, Your Honor, that this person who was responsible for managing that mortgage-backed security risk control arbitrage portfolio didn't start taking any action to protect that portfolio from the dramatic increase in prepayment rates until interest rates had dropped 2.25 percent, Your Honor, almost the full -- or more than two-thirds of the full 3 percent that they declined. The action that he took was to roll down to lower coupon mortgage-backed securities, Your Honor, which the evidence will show merely had the effect of locking in a loss in the spread in that portfolio which, as the evidence will show, one of the experts hired by USAT to help explain to them what had happened in that portfolio found that not only did he lock in a loss but no matter what way interest rates moved, Your Honor, that portfolio would have generated greater losses. That's how that portfolio was managed, Your Honor.
The evidence will show that that's in contrast to what even the respondents' expert testifies is the appropriate way to manage a portfolio when you use swaps to match the duration of the reverse repo agreements and the mortgage-backed securities. The evidence will show that even the respondents' experts state that, one, if you're going to use a roll down-down strategy to protect a mortgage-backed risk control arbitrage portfolio from changes in prepayment rates, that you must roll down every 50 point basis move which was not done. The evidence will also show, Your Honor, that when you roll down that 50 basis points, that a responsible manager of a risk control arbitrage portfolio will also reinvest all of the proceeds including the profits because there is a profit that will be made during that first 50 basis point move. The evidence will show, Your Honor, that the person managing this portfolio concluded that not all of the proceeds were reinvested as they should have been to protect that portfolio against further losses. As a consequence, we believe, Your Honor, the initial portfolio -- the evidence will show that the initial portfolio generated a negative spread, that it resulted in a portfolio that would lose money no matter what direction it would move in, and that the respondents recklessly failed to terminate that portfolio to avoid future losses when interest rates moved one direction or the other.
Now, USAT couldn't continue -- couldn't not continue to purchase mortgage-backed securities -- this is in June of 1986, Your Honor -- because by that time, they had sold most of their branches that generated retail deposits to be used to generate residential mortgage loans. So, they had no way to continue to operate as a qualified thrift under the qualified thrift lender test except by holding mortgage-backed securities if they wanted to continue to invest in junk bonds which we explained -- have explained the evidence will show is very important to MCO, Federated, and Mr. Hurwitz. They, therefore, had to purchase mortgage-backed securities to continue to meet that test and remain a thrift of the size that they were to purchase junk bonds, to engage in the equity arbitrage program that they had previously been engaged in, and, also, as I will show, to make highly risky commercial development loans in order to hopefully benefit by a turnaround in the market in Texas. So, what did they do? They created a second portfolio, and they created a portfolio which resulted in them being somewhere around -- holding somewhere around -- I think it's $3.3 billion in mortgage-backed securities at some point in time in 1988.
In this case, they did go find somebody who had more experience, Your Honor. They didn't use Joe Phillips, the previous manager. The evidence will show that they hired somebody who had managed such portfolios in the past, who had studied such portfolios and, I think, had a doctorate from MIT. They, again, repeated their representations that they were going to create risk-controlled arbitrage portfolios. They were going to be financed with reverse repo agreements. They were going to be managed in a way to minimize interest rate risk. They didn't say anything about swaps this time because they learned something from their experience with swaps, if it was only that, as the evidence will show, that they didn't know how to manage that kind of a portfolio this portfolio manager. However, Your Honor, they didn't buy any hedges to match the duration of the reverse repo with the mortgage-backed securities. In other words, they went naked, Your Honor, to use the parlance of the CFTC that I remember from my previous life.
In March of 1987, there was only $360 million of hedges that were purchased. Why did this happen, Your Honor? Well, the evidence will show that the investment committee and the manager of the portfolio were speculating on the direction of interest rates, that they projected that interest rates were either going to decline or remain steady, that they were not attempting to minimize the risk from interest rate changes and, in fact, they were attempting to maximize that risk, Your Honor.
What happened? Rates substantially increased during that time period, and that portfolio lost substantial sums of money. Even at its height, that portfolio was not managed to minimize interest rate risk. At its height, it had $1.7 billion in mortgage-backed securities and only 1.1 or $1.2 billion in hedges. It didn't minimize the risk.
The evidence will show, contrary to what the respondents would have this Court believe, that that portfolio could have been hedged against the interest rate risk that caused the loss in an economic fashion. As a consequence, that portfolio was operated exactly contrary to the representations that were made to the regulators, exactly contrary to the regulations that were applicable to the operations of such service or subsidiary corporations, and that the two portfolios combined caused a loss of $270 million to the Insurance Fund or to USAT and, indirectly, the Insurance Fund.
We believe, Your Honor, the evidence will show that those two portfolios were recklessly managed in disregard of the law and that they were continually managed in the way that they were managed in order to continue to meet the qualified thrift lender test and, also, to keep USAT afloat so that it could engage in its other activities. These activities, Your Honor, ended up creating losses to the portfolios. They did not end up generating enough income or accounting income in order to help USAT meet its capital requirements.
So, as a consequence, the respondents came up with
another scheme to keep USAT afloat. It was referred to, as the evidence
will show by internal accountants at USAT, as smoke and mirrors, I think.
I, for a while, thought or recall that the person who testified referred
to it as a sham. Well, that's the incorrect term. It's my term for what
happened with the maturity matching credit. The term -- it may be a little
more polite term -- inside USAT was that they engaged in smoke and mirrors
to meet capital requirements.
And what was the smoke and mirrors? Essentially, what they did was they manipulated the maturity matching credit in order to extend their control. And how did they do that? The evidence will show that in January of 1987, the Federal Home Loan Bank Board demanded its capital requirements. It phased in an increase of capital requirements to 6 percent capital, but it allowed a credit for what it called maturity matching credit. And that was calculated based on a reduction for assets that were duration matched to avoid the interest rate risk which is such a threat to the financial well-being of savings and loans. In direct contravention of the regulations, the respondents, to meet this maturity matching credit test and get the full benefit of it so that they could satisfy the capital requirements and keep USAT afloat for their other purposes, shifted $320 million of variable rate mortgage-backed securities and $710 million of caps from United MBS's books to USAT's books or from United MBS's general ledger, to use the technical term, to United Savings Association's general ledger. What did this have -- what effect did this have on United mortgage-backed securities which the regulations require to be duration matched which was the second of the mortgage-backed portfolio? Basically, it ended up undermining that match; and, as a consequence, it created a situation where it appeared that the interest rate risk exposure to USAT had been reduced when, in actuality, there had been no change and, in fact, regulations that specify how subsidiary corporations will be operated was violated. The evidence will show that the variable rate mortgage-backed securities and the caps were originally on the general ledger of United MBS and that they were transferred. The effect of it was to reduce the capital requirement for USAT from around $284 million to 184. It ended up creating a situation where USAT appeared to be in compliance with its capital requirements as opposed to not in compliance. The evidence will show that the respondents tried to obscure where the caps were, on whose general ledger they were, who owned them. The evidence will show that the respondents tried to say, "Well, look. There was never really any movement of these things because they were always on USAT's books" because the income from the caps is recorded on USAT's books.
Well, the evidence will show, Your Honor, that USAT was filing consolidated tax returns or financial statements for purposes of the SEC requirements; and, as a consequence, it had to take the income from the assets that were owned by United MBS and record them on its books because it had to, for that purpose, combine them on the books. But for the purpose of the maturity matching credit, those principles don't apply; and the respondents who have argued with regard to -- I think it's the guarantee issue which I'm coming to next, that you can consolidate for one purpose and not for another, should well understand that fact.
But the evidence will show that what happened here was, in the words of the person who was responsible for doing it, smoke and mirrors, Your Honor; and it was in reckless disregard of the requirements of the law.
Now, I'd like to turn to the guarantee issue, Your
Honor. Do you remember earlier, I said that at some point in time, USAT
was having trouble with the investment banking firms and getting them to
finance their mortgage-backed security purchases through reverse repo agreements?
As a consequence, a number of things happened, one of which was, the evidence
will show, that the investment banking firms sought some sort of assurances
that United MBS which had purchased $1.8 billion worth of mortgage-backed
securities from them would have the capital to meet its obligations or
its collateral calls under those agreements.
The evidence will show that in response to that concern, that USAT made a commitment to the issuers of those reverse repo agreements to maintain the capital of United MBS at 10 percent of assets that created not only the margin for the collateral for those such as are required for the purchase of futures contracts, called a margin; in addition, also have additional capital; and that there was always a deeper pocket to protect those people who were financing United MBS's purchases of those mortgage-backed securities. That commitment was made directly to those lenders; and that, we believe the evidence will show, constituted a guarantee for purposes of our regulations.
The evidence will show, in fact, that it probably even meets the requirements of the Texas cases that the respondents have been touting for so long unsuccessfully so far in this proceeding. But in either case, we believe the evidence will show that by issuing those commitments to maintain the capital of United MBS at 10 percent of value, that the respondents acted with reckless disregard of the requirements.
Now, I'd like to turn to the last two claims, Your Honor. Those are those that deal with the real estate lending and compensation issues. The evidence with regard to the real estate claims will show that at the direction of Charles Hurwitz and Jenard Gross primarily, that USAT entered into a few costly high-risk real estate loans in order to book large loan fees and did so masking losses so as to avoid having to take a set of reserves against those transactions, both of which dealt with raw land. The first was Park 410, an 80 million-dollar transaction. It was initiated by Charles Hurwitz and Jenard Gross. It violated USAT's own internal lending policies. It was never presented to the board of directors. It would have been the largest loan, I think that evidence will show, that USAT had ever issued. There was no due diligence done on that property.
Now, it may be that the respondents believed that due diligence wasn't necessary because the evidence will show that in another transaction, Mr. Hurwitz has testified in his deposition that he didn't need a due diligence. All he needed to do was go out there and look at the property because that was better than a due diligence, Your Honor.
There was no appraisal of the property prior to the commitment of the loan. And when it came in, the appraisal didn't comply with R41B, the applicable regulation on what needs to be in an appraisal. In addition, there was inadequate capital. We believe that the underwriting for that loan was in reckless disregard of the law, Your Honor, as the evidence will show.
The Norwood loan, Your Honor, was done in a similar fashion. The evidence will show that there was an inadequate appraisal. There were inadequate evaluations of borrowers' financials, that USAT's own internal policies were violated when there was no guarantee, full guarantee required where its practice was to require full guarantees, and that there were improper disbursements.
We believe, Your Honor, in that case, also, the evidence demonstrated that they acted -- respondents acted in reckless disregard of the law. There's not much I can say at this point in time because I think you've now heard about the compensation issue two times already, Your Honor.
And all I can say at this point in time is that if reckless disregard of the law has any meaning under this statute, it clearly covers these compensation practices that occurred here. What essentially happened here is that the respondents were on notice that the thrift failed to meet its regulatory capital requirements, was likely to be taken over, and had a net-worth -- and UFG had a net-worth maintenance obligation and they ended up compensating themselves with extravagant bonuses, excessive salaries after they knew those facts. That is not only a clear reckless disregard of the law, but it clearly is unjust enrichment in violation of the net-worth maintenance obligation.
Now, respondents in their lengthy prehearing submission attempt somehow to say, "Well, look. You know, the regulators knew all of this. They knew about the wholesale strategy. They knew about the option agreement. They knew about the MBS trading. They knew or they had views about the Austin market."
Well, Your Honor, the evidence will show that all of that is mere smoke and mirrors.
With regard to the put call option, yes, Your Honor, there is evidence that the regulators knew something about an option. But the evidence will show that many of the people who viewed that option agreement -- in fact, you can take a look at the enormous prehearing submissions and see the quotes -- that a number of people just thought it was a call option, Your Honor. They didn't know there was a put to it as well which transferred all of the economic risk of ownership to MCO. Nowhere will you find, Your Honor, that the regulators knew anything about the letter of credit nor that the stock had been put into an escrow account to guarantee that the transaction would occur.
I don't believe, Your Honor, that partial knowledge -- in light of the fact that the respondents knew that they could have gone to, I think, what was referred to as CASDI at that point in time and may still be referred to as CASDI at the OTS, corporate and securities division, I think, and get an opinion from them like everyone else had been doing and, in fact, exactly how the respondents had done when they converted one of those preferred stock -- convertible preferred stocks to another convertible preferred stock to avoid triggering the regulations that would have counted that stock as stock owned by MCO and, thereby, in itself, triggered the net-worth maintenance condition.
They knew they could have done something, and they
didn't do it and that they tried to avoid the issue coming up. And, in
fact, I think at one point in time in their prehearing submission, they
make the statement, "Well, something was submitted to the Texas Savings
and Loan commissioner." And they described the Texas Savings and Loan commissioner
as the primary regulator, Your Honor. Well, the Texas Savings and Loan
commissioner, as the evidence will show, was never the primary regulator
for purposes of federal regulations; and that is just another example of
the smoke and mirrors that's been presented in this proceeding so far.
Another example, Your Honor, that will be demonstrated by the evidence,
you'll find in a prehearing submission that how could anyone complain about
-- I can't remember whether it was Park 410 or Norwood -- being underwritten
in a market that everybody knew was a declining market because even the
regulators viewed it positively, that market as positively -- quoting something
from Ginger Baugh who was a supervisory analyst with the Federal Home Loan
Bank Board in Dallas where they say in their submission -- boldly assert
that she says the Austin market was a growth market.
Well, Your Honor, the quote that they took is totally distorted. The evidence will show that that quote came from a memorandum that Ginger Baugh wrote to her superior telling -- summarizing what was in a filing that was made by the respondents in this case. Those are not her views. Those are her summaries of someone else's views, passing it on to the person who had the responsibility to make a decision.
And lastly, Your Honor, you heard a great deal; and you'll hear a great deal in argument -- I don't know whether you'll ever see any testimony to that effect -- about how this thrift went down because of the decline in the Texas economy. The Texas economy may have contributed to the losses here; but what we are complaining about here, Your Honor, is failure to meet a net-worth maintenance obligation that the respondents, MCO and Federated, agreed to. We're talking about reckless operations of what is called the wholesale strategy, Your Honor, which the evidence will show even the respondents agree as reflected in a memorandum written by respondent Mr. Crow that the losses to this thrift and the cost to the federal taxpayer caused by the reckless operations of the respondents while they were unjustly enriching themselves was the direct result of actions that were taken by the respondents in reckless disregard of the law in managing all of the wholesale strategy portfolios which they claim to be so proficient at managing.
Thank you, Your Honor.
to Munitz testimony, Oct. 6, 1998
OTS vs MAXXAM Trial Testimonies
Kenneth Guido's Opening Remarks
Barry Munitz Testimony
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