SECTION SIX, Part V Supervision after the 1987 Examination

SECTION SIX

EXAMINATION AND SUPERVISION OF USAT

I. The Supervision Of USAT Prior To 1986 Examination And The Representations Made By USAT In Its Various Applications

A. The Supervision Of USAT Prior To The 1986 Examination

1. Neil Twomey Becomes The Supervisory Agent For USAT At The End Of 1985

S1. During the majority of the time that USAT was engaged in the Wholesale Strategy, the FSLIC Supervisory Agent assigned to USAT by the FHLB-D was Neil Twomey. Tr. 23,228: 7-13; Tr. 23,236: 3-11 (Twomey). Twomey became the Supervisory Agent for USAT on December 2, 1985, when he began working for the FHLB-D, and USAT remained under his supervision until USAT was placed in receivership at the end of 1988. Id.

S2. When Twomey first became responsible for the supervision of USAT his case load consisted of 90 institutions of all sizes. Tr. 23,230: 2-9; Tr. 23,234: 21 - 23,234: 5 (Twomey). By August 1987 he had become part of the “large troubled thrifts group” and his case load had declined to approximately 40 institutions. Tr. 23,235: 10 - 23,236: 2 (Twomey). In the middle of 1988, his case load changed again and he became responsible for the supervision of 25 large thrifts. Id.

S3. Twomey had the assistance of between 4 and 6 analysts, who were responsible for reviewing the examination reports and correspondence received from the institutions under Twomey’s supervision. Tr. 23,233: 7 - 23,234: 4 (Twomey). Ginger Baugh was the Supervisory Analyst assigned to USAT until August 1988 at which time she was replaced by Mark Dunn. Tr. 23,250: 13 - 23,251: 2 (Twomey).

S4. There were three levels of supervision above Twomey. At the end of 1985 his immediate supervisor was James Halverson who reported to Lou Roy, the head of Regulatory Supervision. Mr. Roy in turn reported to Roy Green, the President and Principal Supervisory Agent (“PSA”) of the FHLB-D. Tr. 23,236: 18 - 23,237: 4; Tr. 23,237: 16-20 (Twomey). By May 1986 Joe Selby had replaced Mr. Roy as the head of Regulatory Affairs Supervisory Regulation (Tr. 23,238: 11 - 23,239: 10 (Twomey)) and the following year Halverson was replaced as Twomey’s immediate supervisor by Danny Thomas. Tr. 23,237: 5-10 (Twomey). In August 1987 George Barclay replaced Mr. Green as the President and PSA of the FHLB-D. Tr. 23,238: 3-10 (Twomey).

S5. In 1985 examinations of institutions were run by the District Director, who was an employee of the FHLB-D and had responsibility for all examination functions. Tr. 23,230: 10 - 22,230: 10 (Twomey). The supervisory staff did not participate in the conduct of the examinations other than to comment on the scope of the examination and to request additional testing be done in areas of interest to supervision. Tr. 23,231: 12 - 23,232: 18 (Twomey).

2. The Condition Of USAT When Twomey Became The Supervisory Agent

a. USAT’s Net Worth

S6. When Twomey joined the FHLB-D as a Supervisory Agent he requested that the Supervisory Analysts working with him prepare a summary of each of the 90 institutions under his supervision. Tr. 23,502: 4-20 (Twomey). The Summary Report of USAT that Ginger Baugh prepared stated that, as of December 1985, USAT had assets of $4,755,945,000, which included Goodwill of $252,575,000, and a net worth of $186,629,000 or 3.9% of its total assets. Ex. A-11055, Tab 1869, (12/12/85 USAT Summary Report).

b. USAT Had Not Been Examined Since 1983

S7. The summary for USAT prepared by Ginger Baugh, dated December 12, 1985, indicated that the last time USAT had been examined was as of July 25, 1983, prior to the initiation of the Wholesale Strategy by USAT’s management. Id.; Ex. A-11055, Tab 1869, (12/12/85 USAT Summary Report). Twomey explained the reason USAT had not been examined more recently as follows:

From 1982 through 1985, the overall number of examiners nationwide declined from over a thousand down to 700. And at the same time, in Texas, Florida, and California, the examinations were becoming much more complex because the number of institutions were growing and the number of large institutions were increasing and the number of complex transactions they were investing in was increasing.

So, instead of examiners going in and looking at an institution in two or three weeks and leaving, they were now staying two and three months. We had less people, we had longer exams, and it was creating a shortage. The time between one exam and another was increasingly dramatically.

Tr. 23,241: 9 - 23,242: 2 (Twomey).

S8. In Texas, the number and size of institutions was growing so rapidly and the FHLB-D had such a shortage of examiners, it became necessary in 1986, to bring in examiners from the Boston, New York and Chicago Districts to augment the examination staffs. Tr. 23,242: 3-17 (Twomey). At the same time, the FHLB-D engaged a number of Certified Public Accountant (“CPA”) firms to conduct examinations at various institutions. Tr. 23,242: 9-11 (Twomey). Between 1985 and 1988 the FHLB-D dramatically increased its examination staff, however it was not until 1988 that the District had commensurate examination staffing to deal with the problems that existed. Tr. 23,242: 18 - 23,243: 5 (Twomey).

B. MCO’s Attempts To Modify The Net Worth Maintenance Provision In FHLBB Resolution N0. 84-712 Approving The MCO/FDC Holding Company Application And The Representation Regarding MCO/FDC’s Ownership Of UFG

1. MCO’S Attempts To Modify The Net Worth Maintenance Condition

S9. After Twomey became the Supervisory Agent of USAT he periodically received requests from Munitz, as President of FDC, to extend the time in which MCO and FDC could complete their acquisition of an additional 10% of the outstanding shares of UFG as authorized by FHLBB Resolution No. 87-712 (Dec. 6, 1984) (the “FHLBB Resolution”). Ex. B-1046; Tab 1622, (06/17/86 Munitz letter); B-1212, Tab 1628, (09/17/86 Munitz letter); B-1354, Tab 1630, (12/12/86 Munitz letter); B-1523, Tab 1632, (03/14/87 Munitz letter); B-1668, Tab 1634, (06/19/87 Munitz letter); B-1754, Tab 1636 (09/17/1987 Munitz letter); Tr. 23,533: 17 - 23,535: 15 (Twomey).

i. The Net Worth Maintenance Condition Imposed By

FHLBB Resolution No. 84-712

S10. As discussed previously at FOF A62 - A64, the FHLBB Resolution, which permitted MCO and FDC to acquire control of UFG within 120 days after the date of the resolution, imposed a net worth maintenance requirement on MCO and FDC. Ex. T-1059, Tab 15, (FHLBB Resolution No. 84-712) p. OW009468; Tr. 23,532: 19 - 23,533: 16 (Twomey). The net worth maintenance condition had two parts. The first part, the “pro rata” obligation, dealt with the obligation of MCO and FDC to maintain the net worth of the Association in the event they acquired control of USAT but their ownership of UFG shares did not exceed 50% of the outstanding shares of UFG. It read as follows:

For so long as [MCO and FDC] directly or indirectly control [USAT], Applicants shall contribute a pro rata share based on their UFG holdings, of any additional infusion of capital, in a form satisfactory to the Supervisory Agent, that may be necessary for the Insured Institution to maintain its net worth at the level required by [FSLIC’s] Net Worth Regulation.

Id.

S11. The second part of the net worth obligation required that MCO and FDC “contribute 100 percent of any additional capital that may be required to maintain the net worth of the Insured Institution” in the event that MCO and FDC directly or indirectly acquired over 50% of the outstanding voting shares of UFG. Id.

ii. MCO’s Initial Requests For Extensions Of The

Period In Which It Might Acquire Control Of UFG

And USAT

S12. MCO and FDC initially sought two extensions of the 120 day period in which they were permitted to acquire control of USAT without any mention of MCO’s opposition to the net worth maintenance obligation. MCO and FDC explained that they needed “additional time to formulate properly their prospective business and operational plans.” Ex. T-1065, Tab 1621 (02/28/85 Munitz letter); T-1068, Tab 1622, (06/06/85
Munitz letter). However, on August 30, 1985, when a further extension was sought, Munitz expressed reservations about MCO and FDC being required to give an “unlimited guarantee -- both by amount and by time” (Ex. T-1079, Tab 1623 (08/10/85 Munitz letter) and thereafter sought the advice of William Eckland, MCO’s Regulatory Counsel “regarding possible strategies for attempting to obtain relief from entering into the Federal Home Loan Bank Board’s standard net worth maintenance undertaking.” Ex. CT-1067, Tab 100 (10/25/85 Eckland letter).

iii. MCO’s Proposals To Limit Its Liability Under The Net

Worth Condition Imposed By Resolution No. 84-712

S13. On December 3, 1985, Eckland wrote a letter to Julie Williams, the Associate General Counsel for the FHLBB, and requested another extension of time under the resolution. Eckland explained that MCO and FDC were “reluctant to enter into the net worth maintenance agreement contained in the Order” (Ex. T-1109, Tab 67 (12/03/84 Eckland letter) p. OMX 21933) and proposed that in order “[t]o alleviate the above concerns, [MCO and FDC] requests that the net worth maintenance provision in the Order be modified to place a limit on the aggregate amount of capital that [MCO and FDC] would be obligated to infuse in order to maintain United’s minimum regulatory net worth requirement.” Id. The draft language submitted by Eckland proposed to leave the both the “pro rata” and 50% ownership provisions unchanged, but added a proviso capping the aggregate amount of capital MCO and FDC would have to infuse under either part of the net worth maintenance obligation. Ex. T-1113, Tab 68 (01/29/86 Eckland letter) pp. OMX 21917 and 21927.

S14. On January 31, 1986, Eckland again wrote Ms. Williams seeking a further extension until March 31, 1986, and suggesting yet another modification of the net worth maintenance provision in the FHLBB Resolution which eliminated the “pro rata” obligation completely. Ex. T-1113, Tab 68 (01/29/86 Eckland letter) p. OMX 21912. Eckland wrote that under the proposal MCO and FDC:

“would not be obligated to infuse capital to maintain the net worth of [USAT] unless and until [MCO and FDC] acquires control of greater than 50 percent of UFG’s outstanding voting stock. . . . In exchange for obtaining a waiver of the net worth maintenance commitment when its ownership interest in UFG does not exceed 50 percent, [MCO and FDC] agree to raise $40 million of capital for [USAT] …”

Id.

S15. As discussed in greater detail at FOF S34, Hurwitz contacted Drexel to assist USAT with the issuance of a $50 million subordinated debt offering. Ex. T-9020, Tab 1948, (01/22/86 Crow Memo). MCO proposed to acquire $10 million of USAT subordinated notes on the condition that the FHLBB agree to waive the “pro rata” net worth maintenance requirement. Ex. T-1118, Tab 1643 (03/20/86 Berner memo); Ex. B-954, Tab 89 (04/29/86 Subordinated Debt application) p. CN152393.

S16. The discussions regarding the modification of the net worth maintenance obligation were carried out between the FHLBB - Washington and MCO and FDC. Tr. 23,532: 9-18; 25,534: 15 - 25,535: 6 (Twomey). Twomey played no role in considering the proposed modification; he merely facilitated the discussions by “routinely” sending letters to FDC granting the requested extensions. Tr. 23,534: 13 - 23,535: 15 (Twomey).

iv. The FHLBB Did Not Modify The Net Worth Condition

S17. The FHLBB never changed its position regarding the net worth condition contained in FHLBB Resolution 84-712, and no action was ever taken by the FHLBB to modify the condition as MCO and FDC proposed. After three years, MCO and FDC advised the FHLBB on December 21, 1987 that they had decided not to seek any further extensions and the approval for MCO and FDC to acquire control of UFG lapsed on December 22, 1987. Ex. T-1140, Tab 102 (12/21/87 Eckland letter); T-1139, Tab 1638 (11/17/87 Munitz letter).

2. MCO’S Failure To Disclose The Stock Option Agreement

i. The Stock Option Agreement With Drexel

S18. As previously discussed at FOF A71 - A73, even before the FHLBB issued Resolution No 84-712, MCO began exploring with Drexel various “scenarios” for acquiring an additional interest in shares of UFG without purchasing such shares outright. Once Resolution No 84-712 was issued, MCO and Drexel began active negotiations of a Put/Call Option Agreement for MCO’s future acquisition of up to 790,000 shares of UFG from Drexel. FOF A80 - A87. As discussed previously at FOF A93 - A95, on December 24, 1985, MCO paid Drexel a $683,147 premium to obtain a stock option agreement to acquire 300,000 shares of UFG in July 1988. Under the terms of the agreement, in the event the MCO option was not exercised DBL was given a option to put the shares to MCO for $2,577,000 ($8.56 per share), which amount was secured by an irrevocable letter of credit. Ex. T-1805, Tab 26 (12/17/85 MCO Minutes) p. OW009576-80.

S19. After entering the Stock Option Agreement, Munitz wrote to the Commissioner for the TXS&L on January 25, 1986, and described the essential terms of the Stock Option Agreement. Ex. A-10155, Tab 34. As discussed previously at FOF A98 - A99, no exception was taken by the TXS&L to the transaction. Ex. B-832, Tab 87 (02/10/86 TXS&L letter).

S20. MCO also filed a Schedule 13D amendment on April 30, 1986, which described the transaction with Drexel and attached a copy of the Stock Option Agreement. Ex. A-2074, Tab 37 pp. OFD 2622 and 2633-52. After UFG learned of the existence of the Put/Call Stock Option Agreement, Berner determined that the information regarding the Stock Option Agreement was “relevant disclosure” regarding MCO and FDC’s ownership of UFG shares, and included a brief description of the Stock Option Agreement in UFG’s 1986 Proxy Statement. Ex. A-3013, Tab 88 (03/31/86 UFG Proxy) p. 3; Tr. 19,183: 21 - 18,184: 17; Tr. 19,185: 16 - 22 (Berner).

ii. MCO’s Continuing Correspondence With The FHLB

S21. As discussed above, after MCO entered into the Put/Call Stock Option Agreement with Drexel, MCO continued to have ongoing discussions and exchange correspondence with the FHLBB and the FHLB-D for two more years regarding the modification of the net worth maintenance condition imposed by Resolution No. 84-712. Ex. T-1140, Tab 102 (12/21/87 Eckland letter). Although MCO determined that the Stock Option Agreement was sufficiently relevant to MCO and FDC’s ownership of UFG to report the agreement to both the TXS&L and on the Schedule 13D, MCO and FDC never advised the FHLBB or the FHLB-D of the existence of the Stock Option Agreement in any of their correspondence with the regulators regarding the requested waiver of the net worth maintenance obligation.

S22. In MCO’s last letter to the regulators on November 17, 1987 urging the regulators to grant MCO a waiver of the condition in Resolution No. 84-712, Munitz not only failed to disclose the fact that MCO had acquired an additional interest in UFG through the execution of the Stock Option Agreement, but affirmatively represented to Darrel Dochow, Executive Director, Office of Regulatory Policy, Oversight and Supervision for the FHLBB that “[MCO and FDC] has not taken action to acquire control of UFG.” Ex. T-1139, Tab 1638.

C. USAT’s Liability Growth Violation In 1985

S23. The FHLB-D Summary Report on USAT prepared for Twomey when he became the Supervisory Agent for USAT, indicated that USAT had been the object of supervisory intervention by the FHLB-D to address a liability growth violation which occurred in the latter half of 1985. Ex. A-11055, Tab 1869.

S24. In about 1985, the FHLBB attempted to place limitations on the rate at which thrifts could grow and to limit the extent to which a thrift could invest in certain types of investments by passing a liability growth regulation and a direct investment regulation. Tr. 23,504: 4 - 23,506: 7 (Twomey). Twomey explained the reason for these new regulations as follows:

Well, during the early Eighties, a number of parties were now acquiring thrifts. For example, there was a small thrift in northern Texas that was relatively only 30 or 40 million in size; and very shortly afterwards, it was over a billion dollars. What was happening with these institutions, new owners were coming in and using broker deposits -- they were growing the institution; and at the same time, they were borrowing money basically with broker deposits. They were making numerous investments. And it was the view of the Federal Home Loan Bank Board that this may be unsafe and unsound because if you were growing probably 300 percent a year or greater, how could you properly underwrite those new investments, the new assets that you were putting on the books. And it looked like they could possibly put FSLIC at harm by growing too fast, not making safe and sound decisions. So, at the time, the finance -- the Federal Home Loan Bank Board adopted regulations limiting growth unless you filed a business plan and got the approval of the Principal Supervisory Agent. You had to be limited in growth to 25 percent a year, no more, and had to put no more than 10 percent of your assets in direct investments.

Tr. 23,506: 19 - 23,508: 1 (Twomey).

S25. As discussed previously at FOF A344 and A349, by July 1985, as a result of the implementation of the Wholesale Strategy, USAT had experienced significant asset and liability growth in its MBS (from zero to $489 million) and high-yield bond (from $91 million to $288 Million) portfolios and had exceeded the new liability growth limits imposed by the FHLBB’s new regulation. Ex. A-10566, Tab 176 (07/12/85 G. Williams letter) p. CN052886.

S26. On July 17, 1985, G. Williams submitted a proposed Growth Plan for USAT to the FHLB-D and requested that the Principal Supervisory Agent approve the excessive growth, which USAT had experienced during the first half of 1985. Ex. A-10566, Tab 176 (07/12/85 G. Williams letter). Under the Growth Plan, United’s projected liabilities by December 31, 1985 would have been within the range of permissible growth. Ex. A-10566, Tab 177 (09/19/85 USAT Growth Plan).

S27. Initially, the FHLB-D declined to give retroactive approval to the violation and submitted a proposed Supervisory Agreement to United on October 24, 1985. Ex. A-10577, Tab 178 (11/01/85 FHLB-D letter). However on November 1, 1985 the Supervisory Agreement was withdrawn and the “Association was required to sign a board of directors resolution stating that its total liabilities as of December 31, 1985 would not exceed 125 percent of total liabilities reported at December 31, 1984.” Id. Ex. A-11055, Tab 1869 (12/12/85 Summary Report). The matter was resolved before Twomey assumed responsibility for the supervision of USAT. Tr. 23,514: 10-22 (Twomey).

D. USAT Application To Exceed The Direct Investment Limitations

S28. After Twomey became the Supervisory Agent of USAT the first supervisory issue that arose with respect to USAT was its pending application to increase its direct investment limitation, which USAT had submitted on August 20, 1985. Ex. A-11057, Tab 1870A. In the application USAT proposed to increase direct investments from 10% to 18% of its assets, which would have had the effect of increasing USAT’s direct investment limit from $440 million to $792 million or 450 percent of the June 30, 1985 regulatory net worth of USAT. Id. p. OW089982. According to the application, the increase was needed “to improve management’s flexibility within the framework of the corporate strategy as set forth below.” Id. The application then described the new “Corporate Strategy” that USAT had initiated, including USAT’s establishment in 1984 of an “Investment Department to coordinate a brokered CD program and the investment of these funds in corporate and mortgage-backed securities” a program which “virtually locks in a spread between United’s yield and funding costs, giving significant protection against interest rate fluctuations.” Id. p. OW089984.

S29. On November 6, 1985, USAT submitted an amendment to the application in which USAT explained that it planned to increase its equity securities and real estate investments. In Exhibit A to the amendment USAT proposed by December 31, 1987 to increase its investments in equity securities from $110 million to $338.6 million and to increase its direct investments in real estate from $94.6 million to $341.3 million. Ex. B-642, Tab 1871, p. OW152420.

S30. In an internal memorandum, Supervisory Agent Twomey and Supervisory Analyst Baugh expressed concerns over USAT’s “condition and operations” and recommended to PSA Roy Green that USAT’s application to increase the direct investment limit to 18% be denied. Ex. A-11153, Tab 1870, p. OW120757. In particular Twomey and Baugh commented upon USAT’s “increased level of scheduled items…the recent trend of operating losses, and the unresolved issue of the net worth maintenance agreement…” and observed that “…the proposed level of direct investments at 18 percent of total assets is likely to increase the financial exposure of the Corporation.” Id. p. OW120757. They concluded that the PSA should “withhold final consideration of the proposed activities until the net worth maintenance agreement [with MCO] is in place.” Id. p. OW120758. The recommendation was approved by PSA Green, and on January 8, 1986, he advised USAT that the application would be held in “abeyance until the finalized net worth maintenance agreement is in place.” Ex. A-12149, Tab 1539.

S31. On February 18, 1986, USAT modified its application to exceed the threshold limits on direct investments and sought a 2% increase to 12%. Ex. A-11154, Tab 1913, (05/25/86 Twomey memo) p. OW158129. On May 25, 1986, Twomey recommended that the request be tentatively approved, and that final approval be subject to the results of the examination that was about to commence on May 27, 1986. Id. p. OW158130.

S32. As more fully discussed at FOF S123 - S129, problems arose during the 1986 examination of USAT, and on May 11, 1987, PSA Green denied the direct investment application. Ex. A-14063, Tab 1493. Green’s letter stated as follows:

During and since the examination, we continue to have concerns regarding the condition of United. These concerns included numerous incidences of improperly maintained books and records, routinely amended financial reports to FHLB Dallas, a history of net operating losses, an increasing involvement in high risk investments, and increased scheduled items. As a result the request to exceed the direct investment limitation is hereby denied.

Id.

E. USAT’s Application For Approval To Issue Subordinated Debt

S33. After receiving PSA Green’s January 8, 1986 letter holding the direct investment application in abeyance until a finalized net worth maintenance agreement was in place, MCO began to take immediate steps to attempt to resolve the net worth maintenance issue by proposing to “agree to raise an additional $40 million of capital for United within eighteen months” through the issuance of subordinated debt. Ex. T-1113, Tab 68 (01/31/86 Eckland letter to Julie Williams) p. OMX 21914.

1. USAT Obtained The Assistance Of Drexel To Issue Subordinated

Debt.

S34. Hurwitz personally contacted Drexel and arranged for a representative of Drexel “to come to Houston and review with [USAT] the feasibility of a capital note issue.” Ex. T-9020, Tab 1948 (01/22/86 Crow memo). On March 20, 1986, Berner discussed with FHLB-D representatives a proposal whereby the FHLB-D would agree to a waiver of the net worth maintenance obligation if MCO infused $10 million into USAT as part of a $50 million “capital note public offering.” Ex. T-1118, Tab 1643 (03/20/86 Berner memo) p. OMX 22209. Berner “told the Regulators that [USAT] would have an application for the Subordinated Note Transaction on their desk by April 15, 1986 together with a draft of the offering circular.” Id. p. OMX 22210.

S35. On April 29, 1986, USAT filed an “Application For Approval To Issue Subordinated Debt Securities” with the FHLB-D which sought approval to issue $50 million in sub debt. Ex. B-954, Tab 89. The Application described MCO’s interest in the subordinated debt offering as follows:

It is anticipated that MCO will acquire $10,000,000 of the Notes on the same terms and conditions as other purchasers provided that certain waivers are obtained from the FHLBB....Federated and MCO are currently discussing....waiver of a condition requiring Federated and MCO to guarantee that they will cause the Association to satisfy its regulatory net worth requirements. In the event that such waiver is not obtained and Federated’s and MCO’s application is not approved prior to or contemporaneously with the FHLBB approval of the Association’s application to issue the Notes, MCO has indicated it will not acquire any of the Notes offered hereby. In such event, it is anticipated that this offering would be terminated.

Id. p. CN152393.

S36. As discussed previously at FOF A379 - A387, before USAT filed the application, the USAT Board never considered or approved the issuance of $50 million in subordinated debt or in any way authorized management to take action to secure the approval of the regulators for such a debt issue.

2. The Response Of The Regulators To USAT’s Subordinated Debt

Application

S37. The application was not acted upon immediately by the FHLBB. The FHLB-D, which was commencing its first examination of USAT in over two years on May 27, 1986, requested that USAT take no action with respect to the issuance of the notes until such time as the FHLB-D had an opportunity to review the examiner’s preliminary findings. Ex. B-1000, Tab 1644 (05/27/86 Berner letter). On May 27, 1986, Berner wrote a letter to Twomey in which he stated “USAT is acceptable to delaying the public offering of the Notes until such time as you have received the preliminary indication of the condition of the Association and such indication is acceptable to you.” Id.; Tr. 19,234: 12 - 19,235: 10 (Berner).

S38. On June 23, 1986, USAT requested that the amount of the proposed sub debt offering be increased to $75 million. Ex. A-12158, Tab 1755. In a letter to USAT on July 1, 1986, Twomey advised USAT that the FHLB-D had no objection to the requested increase “[h]owever, in light of the volume of activity proposed by United during recent months, the Association should prepare a comprehensive formal Business Plan for the Supervisory Agent’s review and approval.” Ex. B-1084, Tab 1645. Pursuant to this request, Berner sent Twomey a copy of USAT’s 1986 Business Plan on August 29, 1986. Ex. Twomey 21, Tab 91. As discussed previously at FOF A388 - A390, there is no evidence in the minutes of the USAT Board that the 1986 Business Plan was ever presented to, reviewed, or approved by the USAT Board before to its submission to the FHLB-D.

S39. Once the 1986 Examination commenced a problem arose with respect to Couch Mortgage, Tr. 19,235: 11-10; Tr. 19,243: 15 - 19,245: 6 (Berner).[1] On October 31, 1986, the “Dallas Bank reversed its original recommendation for United’s $50-75 million subordinated debt application to a recommendation for denial, based on Couch loans and the examiner’s findings” (Ex. A-11084, Tab 1878, p. OW157751) and “[i]n late November or early December, [USAT] was informally informed by the staff of the Federal Home Loan Bank in Washington that the capital note application would be sent back to Dallas because Washington was concerned about disclosure relating to the Couch situation.” Ex. B-1439, Tab 1646 (01/15/87 Berner letter).

S40. On January 28, 1987, Berner formally advised Joe Selby that [“. . .United Savings Association of Texas hereby requests the withdrawal of our application and the return to us, under separate cover of the application. United Savings will update the application in order to more fully deal with the Couch Mortgage Company loans and will resubmit the application with updated offering materials.”] Ex. B-1451, Tab 1647.

S41. Both the subordinated debt application and the 1986 Business Plan submitted in support of the application contained partial descriptions of the Put/Call Stock Option Agreement entered into between MCO and DBL. As discussed in great detail in FOFs S185 - S189, neither document disclosed MCO’s letter of credit to secure its obligation under the option or MCO’s obligation to indemnify DBL for any losses it might sustain under the agreement. See Ex. B-954 (04/29/86 Subordinated Debt Application) p. CN152394-93; A-10663, Tab 184, (1986 USAT Business Plan) p. OW150628.

F. USAT MBS/RCA Portfolios

1. Representations To The Regulators In The USAT Applications

Regarding The MBS/RCA

S42. All of the various applications described the structured arbitrage activities of USAT and consistently represented to the regulators that the strategy was to generate “spread” income by locking in a spread and to reduce interest rate risk by matching assets and liabilities. Ex. B-642, Tab 1871 (11/06/85 Amended Direct Investment Application) p. OW152418; A-10568, Tab 177, (09/19/85 USAT Growth Plan) p. CN056089; B-954, Tab 89 (04/29/86 Subordinated Debt Application) pp. CN152324-25 and CN152330-31; A-10663, Tab 184 (08/28/86 USAT Business Plan) p. OW150614.

S43. The Subordinated Debt Application and the 1986 Business Plan explained that the MBS portfolios were constantly monitored and purchases and sales of MBS made out of the portfolios as part of USAT’s “Structured Arbitrage Program.” Ex. B-642, Tab 1871, pp. CN152330-31 and CN152337. The Subordinated Debt Application described these activities in the MBS portfolio as follows:

To closely manage this process, a team of professionals constantly monitors the structured arbitrage program. This monitoring results in periodic sales and purchases of mortgage-backed securities to maintain a closer balance between the overall durations of the securities and the underlying interest rate swaps.

Id. p. CN152331. The application goes on to explain USAT’s monitoring process as follows:

In order to alleviate the effects of prepayments, the Association has sold higher yield mortgage-backed securities and purchased lower yield mortgage-backed securities, thus reducing the net interest spread.

Id. p. CN152337.

S44. The 1986 Business Plan described the process of selling MBS to manage USAT’s Structured Arbitrage Program as follow:

As interest rates have fallen since the latter part of 1985, prepayments on mortgage-backed securities purchased in the program have accelerated requiring the Association to dispose of certain mortgaged-backed [sic] securities and to reinvest the proceeds at lower yields. Therefore, in 1986, the Association sold higher coupon mortgage-backed securities that are more likely to prepay and purchased lower coupon mortgage-backed securities. These transactions produced gains on sales of mortgage-backed securities during the first six months of 1986 totaling $38.9 million.

Ex. A-10664, Tab 183 p. OW005471.

2. The Regulators Understanding Of The MBS/RCA Gains

i. The Regulators Had Little Previous Experience With MBS

RCA Investments

S45. On May 5, 1986, representatives of USAT, including Gross and USAT’s auditors, met at the FHLB-D with Ginger Baugh and Jim Halverson. Ex. B-1007, Tab 1872 (05/29/86 Baugh memo). The purpose of the meeting was to discuss USAT’s pending applications, including its applications to increase its direct investment limitations and to issue subordinated debt, and which Baugh stated were “directly and indirectly related to United’s increase in securities activities.” Id. p. OW157817. At the conclusion of the meeting Gross wrote a memorandum to Hurwitz and the other managers of USAT expressing disappointment over the regulators lack of understanding of USAT’s activities. Ex. T-9025, Tab 1936 (05/06/86). Gross’ memorandum states:

I think the tenor of the conversation was that [Ginger Baugh and Jim Halverson] didn’t begin to understand what in the world our business is or what we do, so it was a very propitious meeting….She didn’t know what a mortgage back security was or what a repo and a swap were, so I can understand why they are very apprehensive about what we are doing.

Id. p. CN249761, emphasis added. Gross concluded the memorandum by suggesting:

Charles [Hurwitz] and I and possibly Dave Kirkpatrick should go back up and sit down with Roy Green [the PSA at the FHLB-D] and talk to him and see if we can’t get [the pending applications] off dead center.

Id. p. CN249761.

S46. It was hardly surprising that the FHLB-D supervisory staff was unfamiliar with the types of arbitrage investment activities USAT had initiated as part of its Wholesale Strategy. According to Twomey, of the 25 large institutions he was supervising in 1988, USAT was the only one that was engaged in either MBS risk-controlled arbitrage (Tr. 23,636 :12 - 23,637: 12), high-yield bond arbitrage (Tr. 23,510: 13 - 23,511: 19; 23,637: 13-22) or equity arbitrage activities. Tr. 23,638: 1-6.

S47. According to Examiner Carlton, the FHLB-D examination staff was understaffed, inexperienced, and unprepared to respond to the rapid growth in the size and activities of thrift institutions that occurred after the passage of the Garn-St. Germain legislation in 1982. Tr. 16,844: 6 - 16,845: 9; Tr. 16,846: 16 - 16,847 :14. As the Respondents’ own expert, William Wallace, testified, at the time thrifts were given expanded powers under Garn-St. Germain, the supervisory powers of the regulators were not expanded to “assure that institutions handled their new powers wisely.” Tr. 25,711: 20 - 25,713: 3 (Wallace). In 1986 and 1987, the FHLB-D did not have any specialists to examine security investment activities (Tr. 16,825: 1-8 (Carlton)); as thrifts began to invest in securities investments it was necessary to train examiners in these new areas. Tr. 16,848: 12 - 16,849: 9 (Carlton).

ii. The Regulators Expressed Concern About USAT’S Non-

Operating Gains From Various Sources Including Securities Sales

S48. Throughout the entire period Twomey served as the Supervisory Agent of USAT the Institution’s non-operating gains were the subject of constant supervisory concern to Twomey because without them USAT would have had negative income. Tr. 24,750: 1 - 24,751: 17 (Twomey).

S49. Supervisory Agent Twomey began to express concern about USAT’s reliance upon non-operating income from gains on sales of branches and direct investments as soon as he took over the supervision of USAT. In the January 8, 1986 memorandum from Twomey to PSA Green recommending that USAT’s application to increase direct investments not be approved, Twomey noted that USAT had sustained operating losses in 1984 and 1985 and that the only “[a]ctivities resulting in net profits during 1984 and 1985 have been non-operating items, particularly branch sales and sales of direct investments.” Ex. A-11153, Tab 1870 (01/09/86 Twomey memo) p. OW120753. Twomey’s memo reported that between 1980 and 1984 “sales of direct investment, primarily real estate, represented approximately $37.4 million in operating income.” Id. p. OW120754.

S50. According to USAT’s subordinated debt application, the trend of reliance upon non-operating income by USAT continued in 1985. For example, USAT reported that the sale of USAT’s branches had generated gains of $81.5 million and $7.2 million in 1984 and 1985, respectively. Ex. B-954, Tab 89, p. CN153336. USAT also reported non-operating gains in 1985 of $ 27 million from the sale of loans and loan servicing as well as “gains on investment securities of $24.8 million.” Id. The application did not identify which of USAT’s investment portfolio’s had generated the gains. Id.

S51. In a letter to USAT dated May 12, 1986, regarding the subordinated debt application, Twomey cautioned USAT that such non-operating gains should not be relied upon to offset operating expenses. Ex. B-978, Tab 1754 (05/12/86 Twomey letter). The letter states:

While we are aware of the substantial income gained from the sales of branches and from sales of investment securities during the past two years, it was never intended that the Association rely on these outside sources to meet operating expenses.

Id. pp. CN208030-31.

S52. On May 21, 1986, a representative of USAT met with Twomey and Baugh for the purpose of USAT explaining its investments in corporate debt and equity securities. Baugh’s notes of the meeting state:

SA Twomey stated his concern with the net operating losses in the Association. He discussed the fact that United has been depending on gains from securities transactions and branch sales to show net profit.

Ex. B-4001, Tab 887 (06/02/86 Baugh memo) p. OW153023.

S53. On May 23, 1986, Twomey again expressed his concern regarding USAT reliance upon non-operating securities gains in a memorandum to PSA Green:

For the year ended December 31, 1985, United earned a net profit of $10.96 million. However, the Association incurred a net operating loss (before extraordinary items and taxes) of $12.5 million. Net income was bolstered by securities activities which netted $27.2 million of non-operating gains.

Ex. A-11154, Tab 1913, p. 5.

S54. The trend continued throughout 1986 and in UFG’s 1986 10-K it was reported under the heading “Equity and Corporate Debt Securities” that “[t]he Company reported a $94.5 million and a $37.9 million gain on sales of investment securities for the years ended December 31, 1986 and 1985, respectively.” Ex. A-3033, Tab 719, p. CN071154. The UFG 10-K did not identify whether the gains had been generated by sales from USAT’s equity arbitrage portfolio, its high-yield bond portfolio or its MBS portfolios. Id.

iii. USAT’s TFR’s Did Not Disclose The Source Of The Non-

Operating Income Derived From Securities Transactions

S55. As a FSLIC-insured institution, USAT was required to file a Thrift Financial Report (“TFR”) on a monthly and quarterly basis which “would be a statement of condition, statements regarding P&L, and other miscellaneous information regarding the state of their assets.” Tr. 23,589: 14 - 25, 590: 6; Tr. 23,811: 1-11 (Twomey). Twomey testified that, as the Supervisory Agent, he relied upon the TFR’s as the “primary source [of information] regarding the financial status of [USAT]” (Tr. 23,810: 17 - 23,811: 11) and reviewed the TFR’s monthly (Tr. 23,811: 10-11) to “monitor operations” and “judge trends, shifts in asset composition of the institution, their growth, their investments.” Id.; Tr. 23,590: 1-14.

S56. When Twomey raised the issue of USAT’s reliance upon non-operating income generated by “gains from securities transactions” (Ex. B-4001, Tab 887 (06/02/86 Baugh memo) p. OW153023), he based his observations primarily on the information that USAT had submitted to the FHLB-D in its TFR’s. Tr. 23,587: 22 - 23,588: 21 (Twomey).

S57. The TFR required that a thrift report separately in Section D both its “Operating” and “Non-operating Income.” Ex. T-8177, Tab 1873 (Sample TFR) p. 3. Twomey explained that under the category “Non-operating Income” a thrift would list its aggregate gains from the sale of all “investment securities.” Id., Tr. 23,590: 10 - 25,591: 11. For purposes of the TFR the term “investment securities” was defined on page D-7 of the TFR instructions (Ex. T-8178, Tab 1874) and included any gains from sales of US Government and Agency Securities (id., Line A370, p. A-11), Common and Preferred Stock (id., Line A382, p. A-12), and Other Investments as defined in the instructions, including “junk bonds.” Id., Line A384, p. A-12; Tr. 23,592: 20 - 23,595: 9 (Twomey).

S58. Twomey testified that by reviewing the operating and non-operating income reported in a TFR he could get some idea of how well an institution was doing on an operating basis, which was the “key ratio in our analysis of the institution.” Tr. 23,595: 10 - 19. If a thrift had operating losses and was relying upon non-operating income from investment securities or other sources, which were “not a repeatable item,” to generate positive net income, that raised a supervisory concern. Tr. 23,595: 10 - 23,596: 16; Tr. 24,750: 1 - 24,751: 17 (Twomey). The TFR, however, did not identify which category of securities had been sold to generate the non-operating gains from investment securities or the reason such sales were made. Consequently, Twomey did not know whether non-operating gains from investment securities that USAT reported in its TFR were generated by the sale of treasury bonds, common stock, high-yield bonds or some other asset defined as investment securities in the TFR. Tr. 23,597: 7 - 23,598: 2; Tr. 24,883: 1 - 24,884: 22; Tr. 24,885: 15 - 24,886: 8 (Twomey).

iv. The Regulators Understood That USAT’s/MBS RCA Portfolio From Time To Time Generated Gains As Part Of The Regular Rebalancing Of The Portfolio

a. The USAT/MBS Portfolio Was Created To

Generate Spread Income

S59. Twomey testified that he understood that USATs strategy with respect to its MBS portfolios was to create a RCA such as that described under Section 450 of the FHLBB’s Regulatory Handbook. Ex. B-4287, Tab 1850, p. 450.1; Tr. 23,716: 5 - 23,718: 3 (Twomey). Twomey described the strategy as follows:

USAT had entered into basically what was a risk-controlled arbitrage regarding their mortgage-backed securities. Basically, they were purchasing mortgage-backed securities; at the same time, [sic] with, which is short-term money borrowed. And what they basically did was setting up a spread where the yield of the mortgage-backed securities was higher than the cost of the repo money that they were borrowing. And they would manage that portfolio to try to maintain that spread.

Tr. 23,492: 12-21.

S60. Twomey testified that, as USAT repeatedly represented in its various submissions to the FHLB-D in 1985 and 1986, including its 1985 Business Plan (A-10566, Tab 176, p. CN052891) and its Application to exceed the direct investment limits (Ex. B-642, Tab 1871, p. OW152418), it was his understanding that the purpose of USAT’s strategy was to generate “spread” income. Tr. 23,492: 17-22; Tr. 23,717: 17 - 23,718: 3. He defined the “spread” as the difference between the “yield on the mortgage-backed securities” and the “cost of the repo money they were borrowing.” Tr. 23,492: 17-22; Tr. 23,492: 16-22.

S61. Twomey understood that from time to time there would be sales of MBSs to manage the portfolio, but it was never his understanding that USAT’s management was trading MBSs in its RCA portfolio for the purposes of generating gains to bolster profits and increase USAT’s capital. Tr. 23,497: 11-17 (Twomey).

S62. The FHLBB Handbook on RCA cited “Trading” as one of the risks associated with implementation of an MBS RCA portfolio and states “[t]he risk would occur if an RCA institution makes buy-and-sell decisions based on a short-term speculative intent rather than long-term consistent profitability.” Ex. B-4287, Tab 1850, p. 450.3. According to Twomey he never understood that the MBSs held in USAT’s RCA portfolios were sold for the purpose of generating short-term gains (Tr. 24,897: 13 - 23,898: 5), and he neither authorized nor encouraged USAT to trade the MBSs in their RCA portfolios. Tr. 23,721: 8-16. In Twomey’s view engaging in buy and sell decisions based upon short-term speculative intent would have been inconsistent with the principles of safety and soundness. Tr. 23,721: 17 - 23,722: 1.

b. Twomey Expected That USAT Would Have Non-Operating Gains From The Sale Of MBS As Part Of The Normal Rebalancing Of The RCA Portfolios

S63. Twomey testified that as part of the management of an MBS RCA portfolio it was appropriate to sell MBSs to rebalance the portfolio (Tr. 23,493: 3-10; Tr. 24,892: 20 - 24,893: 15; Tr. 24,896: 13-20; Tr. 24, 897: 8-21) and it was not unanticipated that such rebalancing would generate gains. Tr. 24,435: 3-15; Tr. 24,892: 20 - 24,893: 15; Tr. 24,896: 13-20; Tr. 24, 897: 8-21. Twomey explained that if interest rates declined, as they did in 1986 (Tr. 24886: 17 - 24,887: 7), and higher yielding MBSs began to pre-pay (Tr. 24,892: 6-12; Tr. 24,894: 1-20), as part of the rebalancing, the portfolio manager would sell off the higher yielding MBSs (Tr. 24,886: 17-22) and buy market rate MBS. Tr. 24,892: 8-12. Twomey viewed these kinds of sales as an appropriate means of managing the portfolio to deal with accelerated prepayments (Tr. 24,892: 13-15) and considered the gains from such sales part of the normal maintenance of USAT’s MBSs portfolios. Tr. 24,897: 13-21; Tr.24,895: 1-16.

S64. When Twomey reported to PSA Green on May 23, 1986, that USAT’s “[n]et income was bolstered by securities transactions which netted $27.2 million of non-operating gains” it was not a matter of great concern. Ex. A-11154, Tab 1913, p. OW158133); Tr. 24,883: 1 - 24,884: 22 (Twomey). Twomey testified that this income figure for investment securities would have been obtained from USAT’s TFR (Tr. 24,884: 5-22) and was consistent with the gains one would expect from a properly maintained and balanced MBS RCA portfolio. Tr. 24,886: 1 - 24,887 : 4.

S65. This was confirmed in USAT’s 1986 Business Plan and UFG’s 1986 Annual Report, which reported that in 1985 and 1986, as interest rates fell, USAT generated substantial gains when it rebalanced its MBS RCA portfolio by disposing of higher coupon MBSs and reinvesting the proceeds in lower coupon MBSs. Ex. A-10663, Tab 184 (08/29/86 Business Plan) p. 0W150614; B-2095, Tab 1884 (UFG Annual Report) p. OW075840. UFG’s 1986 Annual Report described the rebalancing as follows:

In 1986, purchases and sales of mortgage-backed securities totaled $6.5 billion and $4.8 billion, respectively. This increased activity during a period of falling interest rates reflects, in part the Company’s shifting from higher coupon rate to lower coupon rate mortgage-backed securities in order to curtail prepayment risk. These transactions produced gains on sales of mortgage-backed securities during 1986 totaling $71.7 million.

Ex. B-2095, Tab 1884, p. OW075840, emphasis added.

S66. A Restructuring Proposal submitted by USAT to the FHLB-D on May 29, 1987, also reported that during the interest rate decline in 1986 an 1987 “USAT was able to generate substantial gains on the sales of corporate and mortgage-backed securities.” Ex. A-1223, Tab 888, p. 0W151907. Although Twomey did not recall receiving the proposal (Tr. 24,430: 9-21), the gains on sales of securities reported in the proposal were consistent with the non-operating income on investment transactions that was reported in USAT’s TFR. Tr. 24,433: 15 - 24, 435: 1. Twomey explained that in a declining interest rate environment he would expect such gains from a managed portfolio (Tr. 24,435: 3 - 24,436: 3):

I viewed the sales coming out of their risk-controlled arbitrage portfolios as their normal maintenance of those portfolios.

Tr. 24,897: 18-21 (Twomey).

S67. Twomey was not aware that USAT was selling MBSs out of the portfolios to generate gains to meet regulatory capital requirements. Tr. 24,897: 13-5; Tr. 23,497: 10-17; Tr. 24,886: 12 - 24,887: 7.

G. USAT’s Junk Bond Portfolio

1. FHLB-D Expresses Concerns About USAT’s Investments In Junk

Bonds

i. The Initial Concerns Raised In May 1986 By The

FHLB-D Regarding USAT’s High-Yield Bond

Investments

S68. In approximately May 1986, the FHLB-D became concerned about USAT’s “increase in securities transactions,” particularly with respect to “Private Placement Bonds from Ivan Boesky.” Ex. B-1007, Tab 1872 (05/29/86 Baugh memo) p. OW157817. On May 5, 1996, FHLB-D representatives Baugh and Halverson met with representatives of USAT and UFG at the offices of the FHLB-D to discuss their concerns. Id. The notes of the meeting of USAT’s auditor, James Milnor, who attended the meeting, list under concerns the following issues: “no exam for 2 yrs,” “earnings history,” “junk bonds,” and “hedging.” Ex. B-970, Tab 999.

S69. At the meeting USAT explained its “Operating Strategy” to the regulators (Ex. B-1007, Tab 1872 (05/29/86 Baugh memo) p. OW157817) and USAT’s “Security Transactions” including its high-yield bond arbitrage activities (id. p. OW157818). Baugh’s notes indicate that the regulators learned that “a substantial amount, or the majority, of [USAT’s] securities transactions are and have been of subinvestment quality and involving arbitraging” (id. p. OW157818). According to Baugh’s notes, “SA Halvorsen [sic] requested that [management] provide a written description of their bond purchases and arbitrage activities, and other securities transactions common to United.” Id. Following the meeting Neil Twomey (who did not participate in the discussion with USAT’s management) followed up on Halverson’s request in a letter to Arthur Berner on May 12, 1986, which stated: “In our meeting on May 5, 1986, we relayed the [FHLB-D] position regards to sub-investment quality securities. The Association should detail its investment securities activities, including the extent of such activities in sub-investment quality securities.” Ex. B-978, Tab 1754, p. CN208031.

S70. Gross, who attended the May 5 meeting, reported in a memo to Hurwitz and other members of USAT’s management that “[t]he tenor of the meeting is that they didn’t begin to understand what in the world our business is or what we do.” Ex. T-9025, Tab 1936 (05/05/86 Gross memo) p. CN249761. Gross proposed that he and Hurwitz meet with PSA Green “to see if we can’t get everything off dead center.” Id. p. CN249762.

ii. USAT’s Responses To The Regulators Request For Information On USAT’s Investments In Sub-Investment Grade Bonds

S71. On May 9, 1986 Berner sent a letter to Halverson with the requested “amplification and elaboration….regarding USAT’s operations.” Ex. T-4197, Tab 720, p. OW152651. On the second page of his letter Berner gave an explanation of USAT’s “Corporate Bond Strategy and USAT’s investment in “…so-called ‘junk’ (high-yield) corporate debt instruments.” Id. Berner wrote:

The Association has implemented its program of investing in corporate bonds in order to maintain an interest rate spread between the high-yield corporate bonds and duration matched long-term certificates of deposit.

Id. p. OW152652. Berner described how corporate bond investment decisions were made by USAT and stated that the investment team makes recommendations to the Investment Committee which “thoroughly discusses and examines each potential investment.” Id. However, as discussed previously at A 203 - A 206, Berner did not disclose to the regulators that the USAT Investment Committee and the procedures it adhered to were only approved by the USAT Board on May 8, 1986 (Ex. T-7587, Tab 655 (05/08/86 USAT Minutes) pp. US-3003144-46) one day prior to writing his letter to Halverson, and that most of USAT’s high-yield bond investments were made prior to the creation of the Investment Committee. Ex. B-935, Tab 621 (04/15/86 Phillips letter to TXS&L) p. CN159535.