VII. RESPONDENTS ENGAGED IN UNSAFE AND UNSOUND PRACTICES AND MADE FALSE AND MISLEADING STATEMENTS WHILE SPECULATING WITH USAT¹S MBS PORTFOLIOS A. APPLICABLE STATUTES AND REGULATIONS 136. At all relevant times, insured associations, directors, officers, employees, agents, and other persons participating in the conduct of the affairs of such associations were prohibited from engaging in any unsafe and unsound practice in conducting the business of an insured associationor violating any law, rule, or regulation, or any condition imposed by the FHLBB in writing in the connection with the granting of any application or other request @y the insured association, or any written agreement entered into with the FHLBB. Former 12 U.S.C.A. § 1464(d)(2)(A) (1989). 137. At all relevant times, insured institutions were required to maintain safe and sound management and pursue financial policies that were safe and consistent with economical home financing and the purposes of insurance of accounts. 12 C.F.R. § 563.17(a) (1983-89). 138. At all relevant times on and after July 3, 1984, insured institutions were obligated to devise, adopt, implement, and monitor policies and procedures to manage the interest rate risk exposure created by the mismatch of the effective maturities of their assets and liabilities. 12 C.F.R. §§ 563.17-6, 571.3 (1985-88). 139. At all relevant times, insured institutions were authorized to enter into exchanges of interest payment obligations with another party (³interest rate swaps²) only for either ³of two purposes: to fix an interest rate on a deposit base which [was] used to fund fixed rate loans (a Œmatched swap¹) or to hedge against rising interest rates.² Institutions were permitted to enter such transactions: (1) to transform variable-rate obligations into fixed-rate obligations; (2) to match the effective maturities of assets and liabilities; or (3) to hedge a specific asset or liability position. FHLBB Regulatory Bulletin No. 59 at 1 (July 2, 1984) (³Bull. R-591²). B. RESPONDENTS CAUSED USAT TO PURCHASE MBS¹S FOR THREE USAT PORTFOLIOS 140. After the initial restructuring described above, USAT made substantial purchases of MBS's at Respondents' direction in what the Respondents represented were risk-controlled arbitrage programs. USAT's acquisition of MBS's were funded with reverse repurchase agreements that repriced in a short term (30 to 60 days), the duration of which was to be extended to match the anticipated life of the MBS's through the purchase of swaps. 141. The initial USAT portfolio2 was held by USAT directly. By December 31, 1985, USAT held approximately $500 million in MBS's in this portfolio. USAT purchased swaps to match the duration of the short-term reverse repurchase agreements with the expected life of the MBS (estimated to be approximately 5 years). The yield on the MBS's was initially about 12.6% and the fixed payments USAT was obligated to make under its interest rate swaps were approximately 11.3%, for a projected net profit of approximately 1.3%. 142. A second USAT MBS portfolio was held in USAT Mortgage Finance Incorporated (³USAT Mortgage²), formed in November of 1985 as a subsidiary of USAT. USAT Mortgage acquired an additional $500 million of MBS's at Respondents¹ direction in November 1985, funded with reverse repurchase agreements and hedged with interest-rate swaps. 143. On August 7, 1986, Respondents organized another USAT subsidiary, United MBS Corporation (³United MBS²), initially capitalized with a $100 million investment by USAT, to purchase a third portfolio of MBS'S, which consisted of $500 million of MBS's financed with reverse repurchase agreements. The United MBS portfolio eventually increased to $1.8 billion in MBS's as of June 30, 1987. 144. As described below, the Respondents represented to the FHLBB that these three MBS portfolios would be risk-controlled arbitrage programs that would generate a safe return on the spread between the interest paid on the reverse repurchase agreements and the interest earned on the MBS's. C. USAT ŒS INVESTMENTS IN THE PURPORTED MBS STRUCTURED ARBITRAGE PORTFOLIOS WERE UTILIZED TO SPECULATE ON THE DIRECTION OF INTEREST RATES AND TO GENERATE ILLUSORY ACCOUNTING PROFITS AS OPPOSED TO REAL ECONOMIC PROFITS 145. Respondents did not manage the three portfolios to maintain a hedged net interest spread between the MBS's and their funding source, the hedged reverse repurchase agreements. Instead of managing the portfolios to minimize the risk in USAT's large portfolios of MBS's, Respondents caused USAT to trade the portfolios actively to speculate on changes in interest rates and traded in and out of MBS's to recognize gains without also recognizing losses on the other side of the transaction. USAT's program was reckless from the outset and became progressively more unsafe and unsound because of increasingly risky strategies adopted by Respondents, including outright speculation in interest rate fluctuations and the generation of illusory accounting profits as opposed to real economic profits. 146. Between November 1, 1985 and January 21, 1986, ten-year Treasury rates fell from 10.00% to approximately 7.33%. Respondents responded to the decline in interest rates by selling a large amount of the MBS's in the USAT Mortgage portfolio, while retaining the offsetting swaps, which had fallen in value by an amount greater than the MBS's value had risen, because of the increase in mortgage prepayment speeds. 147. The first sale of MBS's, from the USAT Mortgage portfolio, resulted in a $9.3 million reported profit in 1985, without which USAT would have incurred a loss for the year. The $9.3 million gain was offset by a larger unrealized, locked-in loss of $13.8 million in the value of the swaps with their funding cost of 11.3%. The resulting net loss of $4.5 million, would, if recognized, have put USAT below its required regulatory net worth. 148. USAT sold additional MBS's in January through April of 1986 as interest rates continued to decline, replacing the MBS's sold with lower-coupon MBS's, the net effect of which was that the replacement MBS's yielded less than the locked-in funding costs on the swaps. Eventually, the net interest spread became negative, even after taking into consideration the gains from the MBS sales. Nevertheless, USAT continued to recognize the gains on sales of MBS's, even though they were more than offset by unrecognized losses on the swaps. This activity, which was referred to by the Respondents as USAT's ³roll-down strategy,² made no economic sense even to the portfolio managers, and was done to create a false impression of USAT's compliance with regulatory net worth requirements. 1. RESPONDENTS' SPECULATION IN MORTGAGE BACKED SECURITIES WAS DONE IN ORDER TO APPEAR TO MEET USAT NET WORTH REOUIREMENT 149. Respondents' trading in USAT¹s MBS portfolios in 1986 and 1987,which generated accounting profits on the sales of MBS's while USAT failed to recognize the losses on the swaps used to fund their purchase, was intended to create an appearance that USAT met its minimum regulatory net worth requirement. 150. Respondents knew that absent extraordinary transactions, USAT could not ³make money.² Moreover, the Respondents knew as early as March 1985 that USAT's performance would be closely monitored by the FHLB-Dallas and regulatory action would be taken if the association's ³earnings and net worth position [began] to deteriorate.² 151. In addition, Respondents knew that they could not offset USAT's operating losses merely with profits from the spread between the cost-of-funds and the return on the MBS risk-controlled arbitrage portfolios. They knew that USAT could not survive without substantial extraordinary income from the sales of assets, including MBS's. The Respondents, in response, relied on USAT's gains trading of MBS¹s to generate accounting profits in 1986 and 1987. For example, the annualized turnover in USAT's MBS portfolio during the four quarters of 1986 and first quarter of 1987 was as follows: Quarter Ended MBS Portfolio Annualized Turnover Rate Balance (in 000's) March 31, 1986 $1,964,090 214% June 30, 1986 1,935,571 250% September 30, 1986 1,939,638 138% December 31, 1986 2,697,419 354% March 31, 1987 3,817,396 305% 152. Numerous internal memoranda reflect that the rapid pace with which Respondents bought and sold MBS's to generate accounting profits that made no economic sense, but created the impression of compliance with net worth requirements. USAT reported $10 million in profits from sales of junk bonds, MBS's and other portfolios in March 1986, and almost immediately thereafter began to search for additional sales opportunities. An April 24, 1986 USAT memorandum on the subject of second quarter gains necessary to offset related losses reported: ³I 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.² Nevertheless, a June 11, 1986 USAT memorandum directed: ³[A]t the request of several important parties would you please begin thinking about 3rd quarter profits? What are we going to do to ensure profitability?² 153. A June 23, 1986 USAT memorandum reported that USAT needed non-operating gains to report profits in the third and fourth quarters. Among the options discussed was a sale of MBS's at a gain of $1.3 million, notwithstanding that ³ongoing profitability would be diminished.² The memorandum also discussed a sale of junk bonds with similar results. A July 14, 1986 USAT memorandum that discussed ³restructuring for survival/enhanced earnings,² observed that USAT was losing $4.5 million per month excluding extraordinary gains and that USAT ³[could] not operate without extraordinary gains.² The memorandum further stated that USAT ³[did] not have a major amount of Œspecial gain¹ opportunities left.² In addition, the memorandum acknowledged that certain ³problems² that had been ³defer[red]² were ³likely to become problems in the future² and noted that USAT expected an increase in real estate owned of up to $150 million by reason of increased foreclosures. 154. A memorandum dated September 15, 1986 prepared by Smith Breeden Associates (³Smith Breeden²) for a USAT Strategic Planning Committee meeting on which Respondents Hurwitz and Munitz sat suggested that USAT ³take gains on portfolio to offset operating losses² and ³establish economically offsetting positions which generate accounting income if interest rates move.² A September 22, 1986 memorandum to USAT's Strategic Management Committee recommended that USAT should take ³portfolio gains in the third quarter in order to shore up reserves and the capital position.² It also recommended that USAT should ³build up unrealized gains as insurance for the future² as discussed in a Smith Breeden proposal to arbitrage zero-coupon MBS's. 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 MBS's. 155. At the October 1, 1986 meeting of the Investment Committee, upon which Respondents Hurwitz and Munitz sat, one portfolio manager recommended ³the sale of [an additional] portion of the liquidity and mortgage backed securities portfolios to recognize profits which were recently created by the market rally.² The minutes of the meeting reflect that ³after discussions, the asset sales were approved....² 156. On November 12, 1986, the Investment Committee instructed the USAT MBS portfolio manager to: ³[U]se opportunities to take profits and swap to higher yielding securities. Use opportunities to shorten swap maturities, take fee income, and reduce swap yield by writing puts on 5-10 year Treasuries.² 157. An attachment to the minutes for the November 19, 1986 Investment Committee meeting reported that in compliance with these directions, USAT ³[had taken] profits of $3.5 million in USAT portfolio² in the previous week. An attachment to the minutes for the November 25, 1986 meeting of the Investment Committee stated that the next week's plan was to ³continue to take profits primarily in the investment portfolio.² Under the heading, ³P & L Highlights,² the attachment stated: Unrealized gains of close to $14 million exist in the USAT Investments Portfolio. Taking gains today, however, would result in a lowered yield on the remaining portfolio. The decision has to be made whether or not this income is more valuable now, in a lump sum, or would benefit the company more as part of a larger, ongoing interest income stream. USAT chose to take the major portion of these gains as a lump sum: [UFG] posted a $16.5 million loss in November, which resulted in a year-to-date deficit of $22.9 million. November's performance reflected a $20.4 million loss on equity arbitrage and the continued high cost-of-carry on non-performing assets, offset by $8.9 million of gains on sales of investment securities. * * * Net interest income of negative $.8 million in November was relatively unchanged from October. . . . 158. USAT reported accounting gains of $79 million from its 1986 MBS sales. These gains were illusory, however, because the embedded market losses on the swaps on the other side of the transactions exceeded $122 million (a minimum loss based on the assumption that there would be no change in interest rates). The Respondents knew, moreover, that if interest rates were to change in either direction, the embedded loss of $122 million would increase because of a mismatch in the durations of the assets and liabilities in the portfolio.3 159. Respondents' management of the United MBS portfolio posed an even greater risk to USAT. In addition to the generation of illusory accounting profits, Respondents actively managed the United MBS portfolio to speculate on the direction of interest rates with increasingly risky derivatives of MBS's, which were not adequately hedged against interest rate risks, contrary to their representations to the FHLBB. 160. Interest rates fluctuated between 8 percent and 8-1/2 percent between January 5 and March 17, 1987. United MBS purchased additional MBS's in March of 1987. As of March 31, 1987, United MBS held approximately $1.6 billion in MBS's and had purchased interest-rate caps (³caps²)4 with a notional amount of $480 million, which only partially hedged the portfolio. MBS yields rose from 8.43% on March 25 to 10% on April 28, 1987. In the meantime, the United MBS portfolio had increased to $1.7 billion as of April 30, 1987. Only after interest rates had already increased substantially (to 9.57% on April 8, 1987), did United MBS increase the notional amount of caps to more than $480 million to hedge its MBS portfolio against rises in interest rates. By this time, however, United MBS had already lost $111 million on the MBS portfolio. The United MBS portfolio increased to nearly $1.8 billion in MBS¹s as of June 30, 1987, but United MBS or USAT still held only approximately $1.2 billion in caps that were purchased to hedge United MBS¹s portfolio. These figures remained relatively constant until September of 1987. 161. Even United MBS's approximately $1.2 billion in out-of-the-money interest-rate caps did not hedge against all losses. USAT had paid a premium of $26.3 million for the $1.2 billion in caps. The maturity dates on the caps ranged from two to five years from the contract dates, a period less than the anticipated duration of the MBS portfolio. Thus, when interest rates moved up, the caps: (a) did not protect against the first .8% interest rate move; (b) did not fully protect against losses because their duration was substantially less than the projected lives of the MBS portfolio; and (c) provided no protection at all for $500 million of MBS's held by United MBS. 162. Respondents did not even hold all of the $1.2 billion in caps in the United MBS portfolios. As described below, Respondent caused approximately $710 million in caps to be transferred to USAT from United MBS 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. USAT recognized a profit of approximately $7.8 million on the sale. Consequently, as of October 31, 1987, United MBS held $1.8 billion in MBS's with an embedded loss of $111 million, but no caps, so that its MBS portfolio was totally unhedged. 163. United MBS purchased $580 million of caps as of December 7, 1987, less than six weeks after selling the $610 million. The caps sold in October and acquired in December had the same maturity dates, but in December, United MBS paid a higher premium for a smaller notional amount and accepted a higher rate ceiling as well. The net effect of the sale of caps in October 1987 and the purchase of a lower notional amount of caps with a higher ceiling in December 1987 was less protection to United MBS from changes in interest rates at a net cost of $4 million. The similarities and differences are highlighted below: (Dollars in Millions) Notional Weighted Average Premiums Principal Ceiling Paid(Rec) Caps acquired - December 1987 $580 7.50% $16 Caps sold - October 1987 (610) (7.35%) (12) Difference ($30) 0.15% $4 164. Increasing interest rates during 1987 had put many of the cap agreements ³in the money.² As a consequence, the premiums required to purchase caps with rate ceilings similar to those sold had increased significantly by December 1987. The gain USAT had realized on the $610 million in caps sold in October 1987 was more than offset by the higher premiums USAT paid to replace $580 million of those caps six weeks later. Additionally, because the caps acquired in December 1987 had a weighted average interest rate ceiling 15 basis points higher than those caps sold in October 1987, they generated less interest income over the term of the caps. 165.Consequently, as of December 31, 1987, United MBS held $1.8 billion in MBS's with an imbedded loss of $111 million and only $580 million in caps (hedging only one-third of the United MBS portfolio). Moreover, those caps provided little protection against interest rate fluctuations. D. RESPONDENTS' SPECULATION IN THE THREE PORTFOLIOS INCREASED THE RISK OF LOSS TO USAT AND EVENTUALLY CAUSED USAT TO LOSE IN EXCESS OF $275 MILLION 166. The possibility of loss from changes in interest rates is one of the major risks that financial institutions face, because of the difficulty in matching the duration of assets and liabilities. This is particularly true of MBS portfolios, particularly those the size of USAT's, where prepayment speeds can change dramatically in response to changes in interest rates. 167. On November 30, 1984, USAT held $60 million in MBS's. On December 31, 1984, USAT reported holding $419 million in MBS's. Its holdings increased to $1.202 billion on December 31, 1985, to $2.697 billion on December 31, 1986, and to a peak of $3.587 billion on December 31, 1987. 168. Instead of trying to reduce the interest rate risk in USAT's large portfolio, as described above, Respondents speculated on the direction of interest rates, recognized gains on one side of its portfolios without recognizing the losses on the other side, increasing the risk of loss to USAT, and misrepresented to the FHLBB that USAT was not in violation of its minimum net worth requirements. 169. Respondents, activities increased USAT's risk of loss from 11% of its book equity on December 31, 1984 to 226% of its book equity on December 31, 1987. On December 31, 1984, after the first sale of branches and loans, USAT risked losing approximately $23 million if interest rates rose one percentage point (approximately 11% of its book value of approximately $208 million). On December 31, 1985, after the purchase of the first MBS's, USAT risked losing approximately $50 million if interest rates rose one percentage point (approximately 26.8% of USAT's book value of approximately $186 million). On June 30, 1986, after the first sales from USAT's MBS portfolio had been made and before the formation of United MBS, USAT risked losing approximately $68 million if interest rates rose one percentage point (approximately 28% of USAT's book value of $242 million). On December 31, 1986, after the formation of United MBS, USAT risked losing approximately $82 million if interest rates rose one percentage point (approximately 33% of USAT's book value of approximately $248 million). On December 31, 1987, approximately a year after the formation of United MBS, USAT risked losing approximately $143 million if interest rates rose one percentage point (approximately 226 percent of USAT's book value of approximately $63 million). 170. As a consequence of the increased risks USAT faced from Respondents' speculation in MBS's, the Respondents' creation of artificial accounting profits, and Respondents' failure to conform to FHLBB requirements that MBS portfolios be prudently managed to reduce interest rate risks, USAT incurred net losses of more than $90 million on the USAT and United Mortgage Finance portfolios and more than $185 million on USAT's investment in United MBS. E. RESPONDENTS KNEW OF THE UNQUANTIFIED RISK IN THE MBS PORTFOLIO, KNEW THAT THEY LACKED THE KNOWLEDGE TO SUPERVISE THE PORTFOLIO MANAGERS, AND KNEW THAT THE REPORTED PROFITS WERE ILLUSORY AND WERE REPORTED IN ORDER TO CREATE THE APPEARANCE OF COMPLIANCE WITH USAT'S NET WORTH REOUIREMENTS 171. The Respondents, actions to cause USAT to purchase the MBS's described above was the outgrowth of meetings the Respondents attended in early 1985 with Salomon Brothers and other investment banking firms engaged in selling MBS structured arbitrage portfolios to savings and loan associations. Respondents were told about the benefits and risks of MBS arbitrage programs. They were told about the impact of changes in the rates at which individuals prepay their mortgage loans as interest rates change, i.e., that when rates declined the value of the MBS's would increase, but not as fast as comparable Treasury rates because of the likelihood of borrowers prepaying their mortgage loans. The exercise of this prepayment right, which was well known in the industry as the ³prepayment option,² could cause the return on the MBS's to fall below the interest paid for the funds used to purchase the MBS's. 172. As early as January 1986, the Respondents knew that their MBS strategy would have a negative impact on USAT's long-term ability to yield sufficient returns on its MBS investments. Respondents knew that if USAT continued to recognize extraordinary income from the sale of MBS's and other assets without taking into account the accumulating losses on the swap side, the projected future income stream of USAT would be seriously decreased. Although Respondents knew that their understanding of how MBS's responded to changes in interest ratio was inadequate, Respondents continued to pursue their speculative strategies. 173. A January 24, 1986 USAT memorandum stated: [T]he second thing that 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, reather [sic] than a lower yield? We need to take a look at it . . . .I[f] we take a $10 million profit, but choke down 50 basis points on our spread, we have penalized our profits for thenext five to ten years on our portfolio to take that profit.² According to the minutes of a January 27, 1986 meeting of USAT's Audit Committee, Respondent Gross directed USAT's Controller to prepare a sheet showing the actual spread the company earned on all MBS's in 1985. He complained that he had not been receiving actual numbers and the company was making decisions based upon numbers which might not be factual. 174. Moreover, a USAT internal memorandum dated February 6, 1986 demonstrated the Respondents' awareness that the impact of the rolldown on the MBS's paired with the existing swap agreements was likely to be negative: If you have to then replace 12 1/2 [coupon MBS] with 11 1/2 [coupon MBS] and, still have to match it up with the same swaps that you originally had on, it appears to me that you have worsened your position. Further, the memorandum stated: You may take some profits in these pools, in other words, you may sell some of the mortgage-backed securities at a profit because of market factors, which is great. But, afterwards you may be getting a stream of income, which is less than what you anticipated. If that is the case, you really are not making that profit. 175. Later in February 1986, a USAT memorandum from Respondent Gross questioned: 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. 176. In a February 28, 1986 USAT memorandum concerning the $30 million securities gains for 1985, Respondent Gross stated: [I]n 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. * * * [If we reinvest proceeds at a lower rate,] [w]e have really reduced our yield to the extent that we took the profit. So it really was not a profit. * * * 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? 177. In a March 18, 1986 memorandum, Crow responded to the concerns set forth in Gross¹ February 19 memorandum. Crow stated: We do know where we stand in 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 ³rolling down² coupons in mortgage backed securities. Therefore, we did not analyze projected resulting spreads from the newly rolled down positions. The mortgage backed securities system will not automatically perform the functions that are desired. The memorandum reported: ³We are converting to the new mortgage backed securities system and believe that it will enhance our accounting reporting capabilities.² In the interim, USAT employees attempted to prepare schedules manually to track MBS spread results by block. 178. In May of 1986, the Respondents again sought to quantify the negative impact that they knew the sales of MBS's were having on USAT's financial health. On May 2, 1986, Gerald Williams wrote to Gregory Smith of Smith Breeden proposing to retain Smith Breeden to provide various services. The letter stated that USAT's ³primary interests in the short run² included: (1) An overall review of our mortgage backed securities structured arbitrage programs and CMO positions to determine areas of opportunity for improvement or preservation for profits. (2) Implementation of your asset-liability modeling tool for the entire institution and your recommendations as to appropriate courses of action. 179. The results of the Smith Breeden analysis performed in the summer of 1986 were as follows: Mike Giarla from Smith Breeden has produced a preliminary look at the interest rate sensitivity of United . . . we lose if rates move in any direction. * * * Thus United is not net long or net short interest rates. There is no gap: it has been closed. The institution is reasonably well balanced interest-rate-wise, as we lose approximately the same amount in either direction. This would explain why United's results have not improved with the drop in rates since late 1985. We were probably in the same position then as we are now -- any rate change hurts us. * * * The magnitudes are large . . . . A rate change of minus 200 basis points causes United to lose $50 MM in market value. A rate change of plus 200 basis points causes United to lose $21 MM. These losses will be reflected in income over time. Memorandum from Hansen to Gross dated July 24, 1986. 180. At its September 3, 1986 meeting, USAT's Investment Committee ³decided that the Committee would review the possibility of buying out some of its swaps and/or extending them. [Respondent] Crow was directed to discuss this issue with certain investment bankers.² 181. Thereafter, USAT retained Merrill Lynch to study USAT's swaps. Merrill Lynch advised USAT on ³options available to ameliorate high coupon liabilities.² One of the alternatives put forward by Merrill Lynch was to ³reverse the [underlying] high coupon deals outright and therefore erase the swap liabilities [from] the balance sheet.² One of the benefits of this alternative was that it would eliminate USAT's ³negative carry of approximately 500 basis points.² The cost of reversing the transactions, however, would have been ³a substantial series of up front payments made by [USAT] to its counterparties . . . taken currently against income.² 182. Despite the high cost of its interest rate swaps, USAT did not reverse the transactions. Instead, Respondents caused USAT to continue to incur a negative carry of approximately 500 basis points to retain the swaps and the associated transactions on its books. Respondents¹ reason for retaining the swaps was to avoid recognition of the losses embedded in its swap positions. Recognition of the losses would have revealed the illusory nature of the accounting profits that USAT had reported and would have revealed USAT's violation of the minimum regulatory net worth requirement. F. SIXTH CLAIM FOR RELIEF: RESPONDENTS' SPECULATION WITH THE THREE USAT MBS PORTFOLIOS WAS UNSAFE AND UNSOUND) (All Respondents) 183. OTS repeats and incorporates the allegations set forth in paragraphs 1 to 182 above. 184. Respondents caused USAT to engage in trading and speculation in MBS'S, interest-rate swaps, and interest-rate caps. Respondents caused USAT to engage in interest-rate swaps for reasons other than the reduction of interest-rate risk. Respondents failed to devise, adopt, implement, and monitor policies and procedures to manage the interest-rate risk created by the mismatch of the effective maturities of USAT's assets and liabilities. Respondents caused USAT to account for its MBS portfolio as being held for investment. Respondents caused USAT to account for its holdings of interest-rate swaps and interest-rate caps as hedging instruments. 185. Respondents¹ speculation in MBS¹s, interest-rate swaps, and interest-rate caps constituted unsafe and unsound management of USAT and the pursuit of unsafe financial policies that were inconsistent with economical home financing and the purposes of insurance of accounts, constituted a breach of their fiduciary obligations, and violated 12 C.F.R. § 563.17 (a) (1983-1988). 186. Respondents¹ use of interest-rate swaps for reasons other than the reduction of interest-rate risk violated Reg. Bull. No. 59 (July 2, 1984). 12 C.F.R. § 563.17 (a) (1983-1988). 187. Respondents¹ failure to devise, adopt, implement, and monitor policies and procedures to manage the interest rate risk exposure created by the mismatch of the effective maturities of USAT¹s assets and liabilities violated of 12 C.F. R. §§ 563.17-6 and 571.3 (1985-88). Footnotes: 2 This portfolio became known as ³Joe's Portfolio², for Joe Phillips, the person responsible for the management of USAT's MBS portfolio from January 1, 1985 to September 30, 1986. 3Respondents continued to trade USAT's MBS portfolios to generate additional illusory accounting, not real economic, profits in 1987. USAT's gains trading continued in 1987. An attachment to the minutes of the January 5, 1987 Investment Committee meeting show pending MBS transactions as of January 2, 1987, including sale of $562,057,000 of FHLMC 9% and 9.5%, FNMA 9%, and FHLMC 8.5% MBS's, and the purchase of $599,830,000 of FHLMC and FNMA 8.5-9.5% MBS's. Further, an attachment to the minutes of the January 14, 1987 Investment Committee meeting reported that USAT was continuing to ³swap the investment portfolio to increase yield.² 4 ³Caps² are hedging instruments 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 will receive periodic payments from the seller of the cap should the applicable index (in this case, the London Inter-Bank Offered Rate (³LIBOR²)) rise above the interest rate ceiling.