IX. RESPONDENTS CAUSED USAT TO ENTER INTO SHAM TRANSACTIONS TO FALSELY INFLATE ITS MATURITY MATCHING CREDIT IN ORDER TO MEET ITS NET WORTH REQUIREMENTS A. APPLICABLE STATUTES AND REGULATIONS 214. At all relevant times, insured institutions were required to maintain a minimum regulatory capital "in an amount equal to the sum of the institution's liability component and contingency component minus its maturity matching credit." 12 C.F.R. ¤ 563.13(b) (1987). After a transition period, the "liability component" was to be an amount equal to 6% of total liabilities. Id. ¤ 563.13(b)(1)(i). The "contingency component" was an amount equal to "the sum of (A) [t]wo (2) percent of recourse liabilities . . . resulting from the sale of any loan; (B) [tlwenty (20) percent of the institution's scheduled items. . .; [and] (C) . . . an amount equal to a percentage of the dollar amount of aggregate direct investment made after June 30, 1986 . . . . Ò Id. ¤ 563.13(b)(4)(ii). The "maturity matching credit" was defined as Òan amount up to 2 percent of total liabilities by which the minimum regulatory capital requirement may be reduced based upon an institution's low interest rate risk exposure as reflected by the institution's 1 year and 3 year hedged gap.Ó Id. ¤ 563.13(b)(5). The maturity matching credit could not, however, Òreduce an institution's minimum regulatory capital requirement below 3 percent of total liabilities for any period up to and including December 31, 1989.Ó Id. ¤ 563.13(b) (5) (ii) (C). 215. At all relevant times, the FHLBB could disregard any transaction entered into primarily to reduce or evade the minimum regulatory capital requirement. 12 C.F.R. ¤ 563.13(f) (1987-88). B. RELEVANT FACTS 1. REVISIONS OF MINIMUM REGULATORY CAPITAL REQUIREMENTS 216. Effective January 1, 1987, the FHLBB revised its regulations governing minimum regulatory capital requirements for savings associations (previously referred to as "regulatory net worth" requirements). 12 C.F.R. ¤ 563.13 (1987). Essentially, the new regulations phased in an increased requirement of 6% of total liabilities (the "liability component") plus an additional "contingency component" calculated as the sum of specified percentages of certain types of liabilities, scheduled assets, and direct investments. The regulation also permitted a reduction of the required minimum regulatory capital to not less than 3% of total liabilities during the period from December 31, 1986 through December 31, 1989 and 4% thereafter by means of a "maturity matching credit.Ó Id. ¤ 563.13(b)(5)(ii)(C). Savings associations were first required to compute and satisfy the new minimum regulatory capital requirements on March 31, 1987, the end of the first quarter in which the regulation was effective. Id. ¤ 563.13 (b) . 217. The maturity matching credit was an amount that could be up to 2% of total liabilities. The maturity matching credit was calculated based upon the extent assets and liabilities were duration-matched. Specifically, the credit was calculated by reference to the savings association's duration-matching position (cumulative one- and three-year "hedged gaps") as of the accounting period ended six months prior to the date of calculation. A credit of up to 1% of total liabilities was allowed for meeting specified standards for the one-year cumulative hedged gap, and an additional credit of up to 1% was allowed for meeting similar standards with respect to the three-year hedged gap. Id. ¤ 563.13 (b) (5) 2. RESPONDENTS CAUSED USAT TO ENGAGE IN SHAM TRANSACTIONS IN ORDER TO MAXIMIZE USAT'S MATURITY MATCHING CREDIT 218. The first application of the maturity matching credit (on March 31, 1987) was to be based upon USAT's September 30, 1986 balance sheet and hedged gap. The Respondents began planning for the implementation of the new regulation at least as early as August 1986 (when the Executive Committee authorized the formation of United MBS). Because of its significant liability growth during the previous years and its continuing operating losses, USAT could not continue to meet the new minimum regulatory capital requirements without a substantial increase in its maturity matching credit. Accordingly, the Respondents considered transactions that would allow USAT to claim a higher maturity matching credit in subsequent quarters. 219. As shown by a February 1987, memorandum, the Respondents knew that USAT's maturity matching credit at June 30, 1987 totaled $49.1 million out of a possible $99.2 million. It noted that: The matching credit calculation excludes the impact of interest rate caps and collars unless they are "in the money". Thus, USAT does not receive credit for the current $125 million position in caps/collars. Additionally, we have been notified that in the future (the exact date is unknown), CMOÕs will be excluded from the maturity matching calculation. This adjustment would reduce our current credit from $49 million to $22 million. * * * Because our near-term earnings outlook is not extremely favorable and [a] capital note issuance is unlikely, the matching credit is our most accessible source of capital. Therefore, prior to quarter-end, we may have to restructure our assets and liabilities to increase our matching credit to maintain minimum regulatory net worth. 220. As shown by a February 23, 1987 memorandum, Respondents knew the estimate of the maturity matching credit at June 30, 1987 had been revised downward to $40 million. The memorandum was considered so sensitive that it was marked "DESTROY AFTER READING". (Emphasis in original.) Taking into account actual results from January 1987, the memorandum stated: "[W]e will have only about $32 million excess net worth [at June 30, 1987] before adjusting for February through June results (i.e., net losses, increases in scheduled items and direct investments, etc.)." (Emphasis in original.) The memorandum further stated that: "The Asset Liability Committee will develop a proposal by mid-March which will outline a number of alternatives for March 31, 1987 restructuring (which establishes the September 30, 1987 credit amount) to optimize the matching credit." 221. As shown by the March 2, 1987 Agenda for USAT's Strategic Planning Committee, among the five topics listed for the committee's consideration that day was: 5) MAXIMIZING MATURITY MATCHING CREDIT -STRATEGIC OBJECTIVE FOR QUARTERLY TARGET & FUTURE ASSET GROWTH -ALTERNATIVES AND COST TO MAXIMIZE BENEFIT As shown by a memorandum dated March 26, 1987, Respondents knew that among the "Five Most Important Things [USAT's CFO was] Working On - March 1987Ó was Ò[a]nalysis of and reconfiguration of the Association's balance sheet to maximize the maturity matching credit and insure meeting regulatory capital.Ó 222. In several transactions in March 1987 designed to "maximize" USAT's maturity matching credit for September 30, 1987, Respondents caused United MBS to transfer approximately $334.8 million in adjustable-rate MBS's to USAT in exchange for approximately $268.3 million in fixed-rate MBS's. USAT and United MBS each became liable on the reverse repurchase agreements associated with the MBS's received in the exchange. USAT became liable, after netting, on an additional $62.2 million in reverse repurchase agreements associated with the adjustable-rate MBS's. In order to balance the transaction, USAT forgave an intercompany receivable from United MBS of approximately $4.3 million. In other March 1987 transactions, United MBS purported to transfer $790 million in interest-rate caps from United MBS to USAT. 5 223. As shown by a June 17, 1987 USAT memorandum, the above described transactions were a sham: Although we have discussed the structure of United MBS in numerous forums (Executive Committee, Investment Committee, Strategic Planning Committee, etc.), . . . it is important we have a complete understanding of the major accounting exposure we have for the subsidiary. By management approval, $320 million in variable rate [MBS's] and . . . $710 [sic] million of interest rate caps were transferred from United MBS to USAT for maturity matching credit purposes. This accounting treatment has produced the following results and exposure: ¥USAT has maximized its maturity-matching credit using "mirrors". Since United MBS's assets are not included in the calculation, USAT is "borrowing hedges" to take advantage of a regulatory loophole. USAT's real interest rate exposure on a consolidated basis has not been reduced. ¥The investment bankers that provide reverse repo lines were given comfort that United MBS was a MBS risk-controlled arbitrage subsidiary. In fact, it is basically $1.6 billion of unhedged MBS because of the assets and hedges transferred to USAT. Thus, with a rapid increase in interest rates, we could see a negative interest spread and operating losses in United MBS. This would be difficult to explain to Wall Street. In USAT's movement to "come clean", our options are: ¥Do nothing and continue to use mirrors to disguise our GAP. ¥Unwind the asset and hedge transfers between United MBS and USAT and purchase about $1.0 billion of hedges specifically for USAT. This would cost about $12 million in additional interest expense per year. If USAT did not replace the instruments transferred to United MBS, USAT would lose its maturity-matching credit and fall below minimum required regulatory net worth. I recommend that this situation needs to be resolved by senior management at the next Executive or Strategic Planning Committee meeting. 224. Respondents chose not to "come clean." Instead, Respondents "[Did] nothing and continue[d] to use mirrors to disguise [USAT's] GAP." For the quarter ended September 30, 1987, USAT's Thrift Financial Report, filed with the FHLBB, reported regulatory capital of approximately $247 million. Based upon the inclusion in USAT's financial statements of the MBS's and interest rate caps transferred in March 1987, USAT calculated that its one- and three-year cumulative hedged gap six months prior to the close of the quarter (i.e., on March 31, 1987 -- after the sham transactions) were -8.13% and -7.93%, respectively. Since each cumulative hedged gap percentage was purportedly less than 15%, USAT claimed a maturity matching credit of 1% of total liabilities for each component, resulting in a maturity matching credit of 2%, or approximately $101 million. Using the maturity matching credit of $101 million, USAT reported its minimum regulatory capital requirement to be approximately $183 million. Thus, USAT purported to exceed the required minimum regulatory capital by approximately $63.7 million. 225. In fact, without the "mirrors" provided by its "borrowed hedges, "USAT's one- and three-year cumulative hedged gap percentages were -25.36% and -20.41%, respectively. Accordingly, USAT was not entitled to claim any maturity matching credit for its one-year cumulative hedged gap, because it was more than 25%. USAT was entitled to claim only a reduced maturity matching credit of 0.64%, or approximately $32.2 million, for its three-year hedged gap. Its real minimum regulatory capital requirement was approximately $252.2 million, not $183 million. Thus, with an actual regulatory capital of approximately $247 million, USAT failed to satisfy the minimum regulatory capital requirement of 12 C.F.R. ¤ 563.13 as of September 30, 1987 by approximately $5.2 million. USAT avoided having to report this deficiency because of the sham transactions. C. EIGHTH CLAIM FOR RELIEF: VIOLATIONS OF MINIMUM REGULATORY CAPITAL REQUIREMENTS (All Respondents) 226. OTS repeats and incorporates the allegations set forth in paragraphs 1 to 225 above. 227. Respondents caused USAT and United MBS to engage in sham exchanges of MBS's and transfers of interest rate caps. The purpose of the sham exchanges was to manipulate USAT's one-and three-year hedged gap in order to claim the largest possible maturity matching credit and thereby evade the minimum regulatory capital requirement. Accordingly, the exchanges are transactions that are to be disregarded. 12 C.F.R. ¤ 563.13(f) (1987-88). 228. Respondents, as a consequence, failed to maintain USAT's required minimum regulatory net worth as of September 30, 1987, in violation of 12 C.F.R. ¤ 563.13(b) (1987). __________________________ 5 In fact, however, approximately $430 million of the interest-rate caps were not actually consummated with the issuing brokers until April 1987.