VIII. RESPONDENTS MISREPRESENTED THAT THE THREE USAT MBS PORTFOLIOS WERE HEDGED, RISK-CONTROLLED ARBITRAGE PORTFOLIOS AND THAT THEY WERE NOT TRADING PORTFOLIOS TO SPECULATE ON CHANGES IN INTEREST RATES A. APPLICABLE STATUTES AND REGULATIONS 188. At all relevant times, all persons were prohibited from making any false, fictitious, or fraudulent statements with regard to any matter within the jurisdiction of any department or agency of the United States. 18 U.S.C. § 1001. 189. At all relevant times on and after January 2, 1986, insured institutions and their directors, officers, agents, employees, affiliated persons, and other persons participating in the conduct of the affairs of such institutions, and persons filing or seeking approval of any application were prohibited from knowingly: (a) making any written or oral statement to the FHLBB or its agents, representatives, or employees that was false or misleading with respect to any material fact or omitted to state a material fact concerning and matter within the FHLBB's jurisdiction; or (b) making any such statement or omission to any person auditing or otherwise preparing or reviewing an insured institution's financial statements. 12 C.F.R. § 563.18(b) (1986-89). 190. At all relevant times, under GAAP, marketable equity securities, including those held by savings associations, were to be reported on the balance sheet of the association at the lower of their cost or their market value on the balance sheet date. The excess of cost over market value was to be accounted for as a valuation allowance. S&L Audit Guide at 20; SAV-AAG ¶ 3.18; "Accounting for Certain Marketable Securities," Statement of Financial Accounting Standards (³SFAS²) No. 12 ¶ 8 (Financial Accounting Standards Board (³FASB²) 1975) (clarifying application of ARB No. 43, Ch. 3A, ¶ 9 to equity securities). "Changes in the valuation allowance for a marketable equity securities portfolio included in current assets shall be included in the determination of net income for the period in which they occur." SFAS No. 12 ¶ 11; see SAV-AAG ¶ 3.18. 191. At all relevant times, similarly, under GAAP, ³[debt] [s]ecurities should be recorded at cost, including expenses incident to acquisition," ³[p]remiums and discounts should be amortized against investment income," and "[a] parenthetical disclosure of market values should be made in the financial statements or the notes." S&L Audit Guide at 20; see SAV-AAG ¶ 3.28. [N]o allowance for a decline [in market value] ordinarily is necessary if management, intends to and has the ability to hold the securities to maturity. . . . However, if it is probable that the amortized cost will not be realized at maturity (permanent impairment) the estimated loss should be recognized by charging current operations and reducing the carrying amount of the investment. In determining whether there is a permanent impairment, an association should consider various factors, including management's intentions, its ability to hold until maturity, supervisory directives, regulatory requirements, and other circumstances. A reduction in the carrying amount of the investment because of permanent impairment should be considered to establish a new cost basis. Market recoveries in subsequent periods, if any, should not be recognized until realized upon sale or disposition. S&L Audit Guide at 21 (emphasis added); see SAV-AAG ¶ 3.28. The analogous AICPA Audit Guide, Banks (1983) (³Bank Audit Guide²) set forth similar accounting standards for banks¹ accounting for investments in securities. Id. at 29-43. Likewise, "Accounting for Certain Mortgage Banking Activities," SFAS No. 65 (FASB 1982) set forth specific accounting standards applicable to mortgage-backed securities (³MBS's²): "A . . . mortgage-backed security shall not be classified as a long-term investment unless the mortgage banking enterprise has both the ability and the intent to hold . . . the security for the foreseeable future or until maturity.² Id. ¶ 6. 192. At all relevant times, filings required by the Securities and Exchange Act of 1934, 15 U. S. C. § 78a et. seq. , with respect to securities issued by insured institutions were to be filed with the FHLBB. 12 C.F.R. § 563d.1 (1983-89). On and after July 11, 1983, financial statements included in such filings were required to comply with generally accepted accounting principles and with applicable regulations of the FHLBB and the Securities and Exchange Commission, 12 C.F.R. § 563c.l(a)(3), (b) (1984-89). B. RESPONDENTS MISREPRESENTED TO THE FHLBB THAT USAT'S MBS PORTFOLIOS WERE FULLY-HEDGED, RISK-CONTROLLED ARBITRAGE PROGRAMS THAT HAD REDUCED, AND WOULD CONTINUE TO REDUCE, USAT'S INTEREST-RATE RISK 193. Respondents knew that speculation in the MBS portfolios constituted an unsafe and unsound practice in violation of regulatory proscriptions. Consequently, Respondents knowingly misrepresented their intentions and activities to the FHLBB and their outside auditors. 194. In a July 12, 1985 letter and growth plan to the FHLB-Dallas, explaining the reasons for its 1985 liability growth in excess of the regulation limit, Respondents explained that the excess growth was covered in part by its issuance of reverse repurchase agreements and its purchases of MBS's that were ³fully hedged, and the related interest rate GAP exposure . . . reduced to the maximum amount possible.² 195. Respondents further assured the FHLB-Dallas in that growth plan that: [T]his asset/liability match program supported incremental asset growth with minimal interest rate risk and consisted of: -Mortgaged-backed securities (FNMA's, FHLMC's, 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 rate 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. Respondents represented to the FHLB-Dallas that USAT would continue these purported risk-controlled practices for the remainder of 1985 and the first half of 1986 "by, in effect, leveraging its excess net worth with safe diversified investments that provide a positive impact on the Association's financial condition." 196. Upon learning of USAT's excessive liability growth, 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. 197. In an October 28, 1985 response to the Supervisory Agent's demand that USAT execute the Supervisory Agreement, Respondents represented to the FHLB-Dallas that: Shortly before the end of June 1985, [USAT] realized that it ha[d] incurred a significant amount of liability growth. This growth was strictly related to the wholesale purchase of mortgage backed securities funded by reverse repurchase agreement[s] and "swapped" to avoid any interest rate exposure. If anything, this is the kind of growth the Federal Home Loan Bank should be happy to see. USAT submitted a revised Liability Growth Application with the October 28, 1985 letter, which stated that USAT desired to add MBS's on a hedged basis in order to leverage the incremental capital generated by its branch sales while avoiding interest-rate risk. This activity was purportedly designed to provide a steady stream of earnings. The Respondents¹ application stated that the asset/liability match program "virtually lock[ed] in a 72 spread between United's asset yield and funding cost." The Business Plan attached as Exhibit B to USAT's revised liability growth application represented that one of USAT's objectives was to reduce: United's exposure to the volatility of interest rates through a more closely matched asset/liability structure and to increase the Association's interest-earning asset base to offset the impact of the long term, fixed rate mortgage portfolio. 198. On November 1, 1985, based upon projections of liability growth supplied by USAT in its October 28, 1985 revised Liability Growth Application, 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, representing annual growth of 26.5%. USAT's Board adopted the required resolution. Upon receipt of the required resolution by the Supervisory Agent, USAT's Liability Growth Application was deemed withdrawn. 199. Respondents took no action to correct their false statements subsequent to January 1, 1986. Instead, Respondents made additional representations that its MBS investments would be hedged so as to guarantee a steady income in the spread between the return on the MBS and USAT's cost of funds. In a May 9, 1986 letter from USAT's General Counsel, Respondent Berner, Respondents represented to the FHLBB: In order to assure itself that it would no longer be subject to the mismatch of assets and liabilities, (generally called a "GAP") USAT has instituted a program of utilizing GNMA, FNMA and FHLMC securities to match its assets and liabilities in a sophisticated government securities matched investment program. * * * These matching techniques eventually result in long-term assets and liabilities being duration-matched with a built-in spread such that the Association has significantly reduced the risk of interest rate fluctuations. * * * 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 that we should protect our interest rate spread and reduce our GAP to the fullest extent possible in all interest rate environments. 200. On August 29, 1986, Respondents delivered a copy of USAT's 1986 Business Plan to the FHLB-Dallas. In it Respondents represented in that plan 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. * * * [Since 1984,] the overall interest rate sensitivity of the Association's liabilities has been decreased as a result of: (i) its 1984 year-end sale of 20 branches in which $647.9 million of predominantly short-term deposits were exchanged for longer-term mortgaged-backed notes; (ii) its emphasis (through liability pricing) on the acquisition of long-term certificates of deposit; and (iii) its utilization of interest rate swaps and other interest rate hedging techniques. In 1985, the Association significantly increased its investment in long-term mortgage-backed securities funded by short-term repurchase agreements. In order to prevent a worsening in the Association's GAP position, the Association has entered into interest rate exchange agreements ("swaps") as well as interest rate cap and collar agreements. The result of the strategies described above has been to more closely match the interest rate sensitivity of the Association's assets and liabilities. At June 30, 1986 the Association had reduced its estimated one-year GAP to $1.07 billion (or 19.3% of total assets) from $1.64 billion (or 47.0% of total assets) at December 31, 1983. 201. In a February 18, 1987, Respondents again represented in a statement to the FHLBB that: UFG and its subsidiaries objective . . . 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 [was] management's intention to maximize the net interest spread while maintaining prudent interest rate risk exposure. C. RESPONDENTS MISREPRESENTED THAT USAT'S PRACTICE OF RECOGNIZING PROFITS AND DEFERRING LOSSES IN THE MBS PORTFOLIOS WAS NOT TRADING WHICH REQUIRED THE PORTFOLIOS TO BE MARKED TO MARKET 202. In order to prevent the FHLBB from discovering that USAT's MBS portfolio were not managed, hedged risk-controlled arbitrage portfolios, Respondents also misrepresented their activities to USAT's outside auditors. 203. Respondents falsely informed USAT's auditors that the sale of the USAT Mortgage MBS portfolio in 1985 was necessary because of a change in FHLBB regulations that would have required USAT to include the amount of USAT Mortgage's liabilities in calculating its total liabilities, which would have put USAT over the amount permitted by the FHLBB's growth regulations for the quarter ended March 31, 1986. The auditors concluded that "[USAT]'s use of a 'mirror' wasn't anything that seemed to fit comfortably within recognized GAAP." Because of the claimed unanticipated change in FHLBB regulations, USAT's auditors concluded, however, that no specific rule prohibited USAT's treatment of the transactions. Although the auditors agreed with USAT's accounting treatment of the gains and loss on the December 1985 sales, the auditors directed Respondents to offset "all such gains in 1986 so that their [sic] spreads [would] not be distorted." 204. In early 1986, Respondents complied with USAT's auditors¹ direction to match 1986 gains from USAT's sale of MBS's with the offsetting losses in its swap positions by reducing the basis of newly acquired MBS's by the amount of the gains. In the middle of 1986, USAT's auditors learned that Respondents were replacing USAT's MBS's with securities with a different coupon, or issued by a different agency, and, as a consequence, required Respondents to recognize the gains, not defer them as an adjustment to the basis of the newly acquired MBS¹s. 205. USAT's auditors also learned in the middle of 1986 that Respondents had caused USAT to make a substantial number of trades in the MBS portfolio. They directed Respondents to clarify USAT's investment policies or mark its portfolio to market as a trading account. For example, on November 6, 1986, Respondents were advised by USAT's auditors that Respondents "needed to put 'on the record' USAT's policy as it relate[d] to junk bonds to avoid mark-to-market treatment." 206. On January 5, 1987, USAT's auditors again expressed concern to Respondents that the level and nature of the trading in USAT's MBS and junk portfolios might require mark-to-market treatment. The auditors noted the GAAP guidance that "if the intent is to deal in certain securities for profit, the portfolio would be considered a trading account" and would be required to be marked-to-market. USAT's auditors recommended that Respondents document USAT's overall objectives and strategy as well as portfolio requirements and Respondents¹ intent with respect to each trade. 207. On January 29, 1987, USAT's auditors again advised Respondents that gains trading in the MBS portfolio should result in mark-to-market accounting and further advised "that if it [became] apparent that a hedge [was] being managed in order to maximize profits, the program should subsequently be considered to be a speculative position. 208. Respondents ignored this advice. Instead, Respondents devised misleading, after-the-fact policies and rationales to support USAT's activities. A January 12, 1987 USAT memorandum shows that Respondents caused USAT's auditors to be given a false and misleading rationale for the speculative trading that was done with USAT's MBS portfolios: I believe we can make a decent case [to the auditors] 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. 209. Respondents provided USAT's auditors with an Investment Policy that misrepresented to USAT's auditors that it was USAT's intent "to maximize the net interest spread while maintaining prudent interest rate risk exposure," "to hold each security on a long-term basis," and that "sales may be executed from time to time" to inter alia: Maintain or enhance current yields/spreads on assets; Adjust the portfolio for changes in yields caused by prepayment speed variations; Manage the portfolios¹ interest rate risk prepayment speed risk and coupon/agency concentrations risk. The Respondents did not, however, inform USAT's auditors that all trades out of the MBS portfolios were made to generate an illusory profit to bolster USAT's net worth. 210. As a consequence, USAT's auditors did not require the portfolio to be marked-to-market, and, as described above, Respondents' sales of MBS's were not for the limited purposes Respondents described to USAT's auditors, but were traded actively to create illusory accounting gains offset by unrecognized losses on the swaps in order to create the false appearance that USAT satisfied its net worth requirements. As a result of USAT's auditors¹ lack of knowledge, the FHLBB did not learn that the USAT MBS portfolios were not managed to maintain prudent interest rate risk, but were instead managed to generate illusory accounting profits and speculate on fluctuations in interest rates. D. SEVENTH CLAIM FOR RELIEF: RESPONDENTS' MISREPRESENTATIONS THAT USAT'S MBS PORTFOLIO WAS A RISK-CONTROLLED ARBITRAGE AND NOT A TRADING PORTFOLIO THAT SPECULATED ON THE CHANGES IN INTEREST RATES VIOLATED PROHIBITIONS AGAINST MAKING FALSE AND MISLEADING STATEMENTS (All Respondents) 211. OTS repeats and incorporates the allegations set forth in paragraphs 1 to 210 above. 212. Respondents' representations that USAT's reverse repurchase agreements were fully hedged by corresponding interest-rate swaps, interest-rate caps, and interest-rate collars were false and misleading in violation of 12 C.F.R. § 563.18(b) (1986-88). 213. Respondents' representations to its outside auditors that USAT's MBS portfolios were hedged arbitrage portfolios and not traded to increase USAT's reported net worth were false and misleading in violation of 12 C.F.R. § 563.18(b) (1986-1988).