11733 1 UNITED STATES OF AMERICA Before the 2 OFFICE OF THRIFT SUPERVISION DEPARTMENT OF THE TREASURY 3 In the Matter of: ) 4 ) UNITED SAVINGS ASSOCIATION OF ) 5 TEXAS, Houston, Texas, and ) ) 6 UNITED FINANCIAL GROUP, INC., ) Houston, Texas, a Savings ) 7 and Loan Holding Company ) ) OTS Order 8 MAXXAM, INC., Houston, Texas, ) No. AP 95-40 a Diversified Savings and ) Date: 9 Loan Holding Company ) Dec. 26, 1995 ) 10 FEDERATED DEVELOPMENT CO., ) a New York Business Trust, ) 11 ) CHARLES E. HURWITZ, ) 12 Institution-Affiliated Party ) and Present and Former Director ) 13 of United Savings Association ) of Texas, United Financial Group,) 14 and/or MAXXAM, Inc.; and ) ) 15 BARRY A. MUNITZ, JENARD M. GROSS,) ARTHUR S. BERNER, RONALD HUEBSCH,) 16 and MICHAEL CROW, Present and ) Former Directors and/or Officers ) 17 of United Savings Association of ) Texas, United Financial Group, ) 18 and/or MAXXAM, Inc., ) ) 19 Respondents. ) 20 21 TRIAL PROCEEDINGS FOR JUNE 16, 1998 22 11734 1 A-P-P-E-A-R-A-N-C-E-S 2 ON BEHALF OF THE AGENCY: 3 KENNETH J. GUIDO, Esquire (Not present) Special Enforcement Counsel 4 PAUL LEIMAN, Esquire SCOTT SCHWARTZ, Esquire 5 BRUCE RINALDI, Esquire RICHARD STEARNS, Esquire (Not present) 6 and BRYAN VEIS, Esquire (Not Present) of: Office of Thrift Supervision 7 Department of the Treasury 1700 G Street, N.W. 8 Washington, D.C. 20552 (202) 906-7395 9 ON BEHALF OF RESPONDENT MAXXAM, INC.: 10 FRANK J. EISENHART, Esquire 11 of: Dechert, Price & Rhoads 1500 K Street, N.W. 12 Washington, D.C. 20005-1208 (202) 626-3306 16 13 DALE A. HEAD (in-house) 14 Managing Counsel MAXXAM, Inc. 15 5847 San Felipe, Suite 2600 Houston, Texas 77057 16 (713) 267-3668 17 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO. AND CHARLES HURWITZ: 18 RICHARD P. KEETON, Esquire 19 KATHLEEN KOPP, Esquire of: Mayor, Day, Caldwell & Keeton 20 1900 NationsBank Center, 700 Louisiana Houston, Texas 77002 21 (713) 225-7013 22 11735 1 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO., CHARLES HURWITZ, AND MAXXAM, INC.: 2 JACKS C. NICKENS, Esquire 3 of: Clements, O'Neill, Pierce & Nickens 1000 Louisiana Street, Suite 1800 4 Houston, Texas 77002 (713) 654-7608 5 ON BEHALF OF JENARD M. GROSS: 6 PAUL BLANKENSTEIN, Esquire 7 MARK A. PERRY, Esquire of: Gibson, Dunn & Crutcher 8 1050 Connecticut Avenue, N.W. Washington, D.C. 20036-5303 9 (202) 955-8500 10 ON BEHALF OF BERNER, CROW, MUNITZ AND HUEBSCH: 11 JOHN K. VILLA, Esquire MARY CLARK, Esquire 12 PAUL DUEFFERT, Esquire of: Williams & Connolly 13 725 Twelfth Street, N.W. Washington, D.C. 20005 14 (202) 434-5000 15 OTS COURT: 16 HONORABLE ARTHUR L. SHIPE Administrative Law Judge 17 Office of Financial Institutions Adjudication 1700 G Street, N.W., 6th Floor 18 Washington, D.C. 20552 Jerry Langdon, Judge Shipe's Clerk 19 REPORTED BY: 20 Ms. Marcy Clark, CSR 21 Ms. Shauna Foreman, CSR 22 11736 1 2 INDEX OF PROCEEDINGS 3 Page 4 MICHAEL GIARLA 5 Examination by Mr. Guido................11740 6 Examination by Mr. Nickens..............11876 7 Further Examination by Mr. Guido........11939 8 . 9 . 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . 11737 1 P-R-O-C-E-E-D-I-N-G-S 2 (10:05 a.m.) 3 THE COURT: Good morning. 4 Be seated, please. The hearing will 5 come to order. There is scheduled for continued 6 hearing at this time and place the proceeding 7 styled MAXXAM, Inc. and others which was 8 instituted by OTS Order No. AP 95-40. Are there 9 any appearances that have not previously been 10 entered? I gather not. 11 Are there preliminary matters? 12 MR. GUIDO: Your Honor, there is one 13 matter, and that pertains to the Bruce Williams 14 materials that you directed the respondents to 15 provide to the OTS prior to the adjournment of the 16 last recess. We still haven't received those. I 17 would like to have those because it would 18 facilitate us preparing -- 19 THE COURT: Who are you holding 20 responsible for that? 21 MR. GUIDO: I think that's the Williams 22 and Connolly law firm that's responsible for that, 11738 1 Your Honor. 2 THE COURT: Ms. Clark? 3 MS. CLARK: Yes. Good morning, Your 4 Honor. The Court requested that we provide the 5 Bruce Williams documents to Mr. Guido prior to the 6 resumption of Mr. William's testimony and I agreed 7 to do that and I will do that. I notified 8 Mr. Guido by letter last week, I believe it was, 9 that I will do that; and that will be done. 10 THE COURT: When is Mr. Williams 11 scheduled to return? 12 MR. GUIDO: As early as Monday 13 afternoon or Tuesday of next week, Your Honor. 14 MS. CLARK: As I advised Mr. Guido, I 15 have not made a decision about what documents I 16 will use with him and as soon as I do, I will 17 provide them and I've given him my best estimate 18 as to when that will be. 19 THE COURT: Can you do it before that? 20 MS. CLARK: If I can, I certainly will, 21 Your Honor. 22 MR. GUIDO: Your Honor, I raised this 11739 1 because when I came into the courtroom today on 2 the elevator, one of the paralegals came up with a 3 box. Seems to me the documents are prepared, Your 4 Honor; and we are entitled to the documents. 5 THE COURT: I don't see why we need to 6 wait until Saturday if he's going to be here on 7 Monday. 8 MS. CLARK: If I gave Mr. Guido the 9 documents they will not be the documents when the 10 testimony is resumed. I have not made that 11 selection, Your Honor; and as soon as I do, I 12 will. It does not contain the documents that I 13 will be using with Mr. Williams. 14 THE COURT: So, somebody designated a 15 box like that to confuse Mr. Guido. 16 MS. CLARK: I suspect that's probably 17 what happened, Your Honor. 18 THE COURT: Well, I would ask that you 19 do it as soon as possible. 20 MS. CLARK: I do intend to do that. 21 Thank you. 22 THE COURT: Are there other matters? 11740 1 MR. GUIDO: No, Your Honor. 2 THE COURT: Do you have a witness? 3 MR. GUIDO: Michael Giarla we would 4 like to call as a witness, Your Honor. 5 MR. RINALDI: Given the fact that 6 summer is coming on and it's fairly close to the 7 courtroom and there are a lot of people, does the 8 Court have any views regarding removal of coats? 9 THE COURT: No, but you may remove your 10 jacket if you get too warm. Would you take the 11 oath, please? 12 13 MICHAEL GIARLA, 14 15 called as a witness and having been first duly 16 sworn, testified as follows: 17 18 EXAMINATION 19 20 THE COURT: Be seated, please. 21 Q. (BY MR. GUIDO) Would you state your 22 full name for the record, please. 11741 1 A. Michael Joseph Giarla. 2 Q. What is your business address? 3 A. 100 Europa Drive, Suite 200, 4 Chapel Hill, North Carolina. 5 Q. Where are you employed? 6 A. Smith Breeden Associates. 7 Q. What is your position? 8 A. President. 9 Q. President. Is that the chief executive 10 officer of Smith Breeden Associates? 11 A. No. I'm president and chief operating 12 officer. 13 Q. Is there a chief executive officer? 14 A. Yes. 15 Q. Who is that? 16 A. Douglas T. Breeden. 17 Q. Now, would you spell your last name? 18 THE WITNESS: G-I-A-R-L-A. 19 THE COURT: Thank you. 20 Q. (BY MR. GUIDO) Where did you attend 21 college? 22 A. Harvard University. 11742 1 Q. What did you major in? 2 A. Statistics. 3 Q. What degree did you receive? 4 A. Bachelor of arts. 5 Q. Did you do any post-graduate work? 6 A. I have an MBA from Stanford Business 7 School, 1985. 8 Q. Any other degrees? 9 A. No. 10 Q. And where were you employed after you 11 received your MBA from Stanford? 12 A. Smith Breeden. 13 Q. Have you been employed anywhere else 14 other than Smith Breeden? 15 A. No. 16 Q. What was your first position with Smith 17 Breeden? 18 A. Associate was my first title. 19 Q. Okay. And when were you first employed 20 with Smith Breeden? 21 A. July 29th of 1985. 22 Q. When was Smith Breeden -- is it 11743 1 Smith Breeden & Associates? 2 A. Right. 3 Q. When was it first founded? 4 A. June of '82. 5 Q. By whom? 6 A. Douglas T. Breeden and Greg L. Smith. 7 Q. And can you tell us a little bit about 8 Mr. Breeden's background? 9 A. He has a Ph.D. in Finance from Stanford 10 and taught in business schools at, if I can 11 remember the list, University of Chicago, 12 Stanford, MIT -- there may be another one in 13 there -- since 1985 at business schools. His 14 expertise is in options pricing and mortgage 15 securities, investments area. 16 Q. What about Mr. Smith's background? 17 A. Greg Smith was a -- Smith Breeden was 18 more of a marketing person. He had a variety of 19 sales positions with various Wall Street firms and 20 lived in the Kansas City area. And he and Doug 21 hooked up -- they met doing some consulting at the 22 Chicago Board of Trade independently. And one 11744 1 thing led to another, and they started 2 Smith Breeden in 1982. 3 Q. So, Smith is the marketing person? 4 A. Smith was the marketing person, and 5 Doug was the research and quantitative person of 6 the team. 7 Q. In the mid-Eighties, how many employees 8 did Smith Breeden have? 9 A. Well, when I joined in '85, there were 10 probably 10 or 12 people; and then we grew pretty 11 rapidly from there. So, I would say by 1987, we 12 probably had 25, 25 to 30 employees. 13 Q. And how many employees today? 14 A. About 75. 15 Q. Now, in the mid-Eighties, who were your 16 clients? You don't need to name them 17 individually, but by category. 18 A. They were predominantly savings and 19 loans. 20 Q. And how many savings and loan clients 21 were there in the mid-Eighties? 22 A. I'm just guessing. Probably 18 to 24, 11745 1 somewhere in that range. 2 Q. Now, what's the client base today? 3 A. We still have financial institution 4 clients that we do consulting work with, but most 5 of our base is discretionary money management 6 business. So, we work with large corporate 7 pension funds and manage mutual funds, as well. 8 Q. Now, when was Smith Breeden first 9 contacted by USAT requesting Smith Breeden's 10 assistance? 11 A. I'm not really sure because I wasn't 12 involved in the initial contact. I presume 13 Greg Smith was the one who was in touch with 14 United. 15 Q. When did you first have contact with 16 United Savings? 17 A. I believe it was June -- June or July 18 of 1986. 19 Q. And was Doug Breeden or Mr. Smith 20 contacted shortly before that, to your knowledge? 21 A. Presumably. I'm just not sure. 22 Q. But it wasn't as early in the middle of 11746 1 1985? 2 A. I doubt it. I don't think so. 3 Q. What were you initially retained to do 4 for USAT: Smith Breeden? 5 A. We were hired to do a project where we 6 would analyze essentially the institution's 7 balance sheet, looking at interest rate risks, 8 market values, the risk of market value changes 9 due to interest rate changes, and kind of make 10 some recommendations about how to -- how to hedge 11 interest rate risk, if there was any, and make 12 recommendations about any recommendations about 13 investments that we could. 14 So, that was the general scope of it. 15 Q. Were you subsequently retained to do 16 something else for USAT? 17 A. Well, after -- yes. After the -- 18 Q. What was that? 19 A. After the project ended, which I think 20 was mid-September of '86, USAT or United -- I'm 21 not sure which entity -- hired Smith Breeden on an 22 ongoing basis as an investment advisor. And the 11747 1 typical services we would perform under that 2 agreement would be investment advice, help 3 selecting mortgage investments or analyzing 4 mortgage transactions, and also doing interest 5 rate risk analysis. 6 Q. Now -- and how long did that 7 relationship last? 8 A. It was approximately a month. 9 Q. Okay. And why did it end? 10 A. Well, I'm not totally sure because it 11 wasn't really my decision; but it just seemed to 12 kind of fizzle out. I know after we started 13 this -- after the project ended and when we 14 started this ongoing relationship, some new 15 personnel appeared at United. Sandy Laurenson, I 16 think, was hired as a portfolio manager. So, I 17 reviewed it as she was hired to perform some of 18 the services that we were providing. 19 So, there was some overlap there. But, 20 the relationship just kind of fizzled out. 21 Q. Who was the principal contact person 22 with USAT at Smith Breeden Associates during that 11748 1 month period of time you were hired as investment 2 advisor? 3 A. I think Sandy became the principal 4 contact person after she was hired. 5 Q. Who was the principal contact person 6 with Smith Breeden? 7 A. It would have been myself and Mike 8 Schumacher. 9 Q. Who was Mike Schumaker? 10 A. Mike was another associate who worked 11 with me during this period on the project. 12 Q. Now, prior to Sandy Laurenson joining 13 USAT, who were your principal contacts when you 14 were doing the investment advisory function? 15 A. During our project or the -- 16 Q. The one-month period of time when you 17 were an investment advisor? 18 A. That's -- Sandy was the main contact 19 person. 20 Q. Now, prior to that when you were hired 21 to do the sensitivity analysis of the various 22 portfolios at USAT, who was your principal 11749 1 contact? 2 A. The people I remember dealing the most 3 with at United were Mike Crow and Bruce Williams 4 and Doug Hansen. 5 Q. Now, when you say "deal with," were 6 they the ones that provided you with access to the 7 information that you needed to do the analysis 8 that you did for them? 9 A. Yes. 10 Q. Were they the people that provided you 11 with the questions that they wanted you to respond 12 to in doing an analysis of the materials? 13 A. Yes. 14 Q. Were they the individuals that provided 15 you with information about what USAT's business 16 objectives were? 17 A. To the extent we knew what they were, I 18 would say yes. 19 Q. Now, did you deal with anyone else at 20 USAT besides those three people? 21 A. I'm sure we came into contact with lots 22 of others there, but I don't -- I mean, those were 11750 1 the main ones. I mean, we met other people at 2 meetings; but those three were the main three 3 people that I remember dealing with. 4 Q. Did you deal with Charles Hurwitz? 5 A. I think I met him once at one meeting. 6 Q. Was that the September 15th, 1986 7 meeting? 8 A. Yes. 9 Q. Is that a meeting at which you 10 presented your recommendations to USAT of what 11 they should be doing going forward? 12 A. Yes. 13 Q. Now, did you, in the course of doing 14 any work for USAT, provide them with any 15 literature that had been prepared by Smith Breeden 16 regarding risk-controlled arbitrages or 17 mortgage-backed securities portfolios? 18 A. Yes. 19 Q. Would you take a look at the binder 20 I've handed you? 21 22 (Whereupon the witness complied.) 11751 1 MR. GUIDO: Your Honor, in an effort to 2 speed up the process, I put together binders of 3 documents that are likely to be introduced. 4 THE COURT: Thank you. 5 Q. (BY MR. GUIDO) I would like to direct 6 your attention to the document that we've had 7 marked as A13002, which is a hedging program for 8 blank savings and loan association, Mark Giarla, 9 Smith Breeden Associates, October 1985. It has 10 from your deposition Exhibit No. 443-3 on it. 11 Is that one of the pieces of literature 12 that you provided to USAT in the course of your 13 representation of them? 14 A. Yes. 15 Q. I would like to direct your attention 16 to the document I've had marked as 17 Exhibit A 13003, which is an introduction to 18 hedging interest rate risk futures swaps and 19 options by Douglas T. Breeden and Michael J. 20 Giarla dated May 30, 1986. And it says "draft" on 21 it, "Comments welcome." It's Exhibit 443-2 from 22 your deposition. 11752 1 Is that one of the pieces of literature 2 that you provided to USAT? 3 A. Yes. 4 Q. Then I would like to direct your 5 attention to the document -- I think it's two or 6 three documents in the packet. And it's 7 Exhibit A 10654. And it says, "Introduction to 8 risk-controlled arbitrage - Michael J. Giarla, 9 August 18, 1986." And it's Exhibit 442 from your 10 deposition. 11 Do you see that document? 12 A. Yes. 13 Q. Are those materials or literature that 14 you provided to USAT in the course of your 15 representation of USAT? 16 A. Yes. 17 MR. GUIDO: I would like to move the 18 admission, Your Honor, of Exhibit A13002, 13003, 19 and A10654. 20 MR. NICKENS: No objection, Your Honor, 21 although I would think it would be appropriate at 22 this time to find from the witness when these 11753 1 matters were sent to USAT since -- 2 THE COURT: We will get to that. 3 Received. 4 MR. GUIDO: Now, I would like, also, 5 Your Honor -- 6 7 Q. (BY MR. GUIDO) Now, let's go through 8 the three documents. 9 When did you, if you can recall, 10 provide Exhibit A13002 to USAT? 11 A. I'm really not sure, although I -- 12 where it says "No. 4" here on the upper left-hand 13 corner, it reminds me that -- I believe it was 14 part of a -- several documents that I sent in a 15 letter to Sandy Laurenson, I guess, probably in 16 September or October of 1986. 17 Q. Will you turn back to Exhibit B1257, 18 which is -- it's probably the fourth or fifth 19 document from the end. It's a letter from you to 20 Sandy Laurenson dated October 13th, and then it 21 has -- 22 A. Right. Okay. So -- right. So, I 11754 1 believe I -- I believe I provided that first 2 exhibit in conjunction with this letter. 3 Q. Okay. So that if you look in that 4 letter, it would be the Document No. 4 on that 5 letter? 6 A. Right. 7 MR. GUIDO: Your Honor, I would like to 8 move the admission of Exhibit B1257, the 9 October 13th, 1986 letter from Michael Giarla to 10 Sandy Laurenson. 11 MR. NICKENS: No objection, Your Honor. 12 THE COURT: Received. 13 Q. (BY MR. GUIDO) And then if you look at 14 Exhibit Number -- in that letter, it says 15 "Document No. 2." Is the reference to Document 16 No. 2 the document that I have had marked as 17 Exhibit A13003? 18 A. Yes. 19 Q. And then the document that's marked 20 A10654, was that provided as part of the packet of 21 materials that accompanied the October 13th, 1986 22 letter? 11755 1 A. That, I'm not sure about. 2 Q. There is no mention of that, is there? 3 A. It's not clear from the letter. I'm 4 not sure. 5 Q. But did you provide it shortly after 6 its preparation in August of 1986? 7 A. I believe so. 8 Q. Or in any case, you provided it before 9 the end of October or the beginning of November 10 when the relationship terminated between 11 Smith Breeden and USAT? 12 A. Right, I believe so. 13 Q. Now, why did you provide this 14 literature to USAT? 15 A. I don't recall being specifically asked 16 for it; but we would typically give documents like 17 this to our clients because they provided good 18 introductory materials about interest rate risk 19 and hedging and also presented Smith Breeden's 20 philosophy on managing interest rate risks and 21 investments and how we looked at mortgage 22 securities. 11756 1 Q. Now, I would like to start with 2 Exhibit A13003 and ask you some questions about 3 that. I have the wrong number. I want you to 4 take a look at the August 1986 memorandum, which 5 is A10654. In terms of -- let me ask you a few 6 general questions before we get into this. 7 In terms of Smith Breeden's general 8 approach, is it fairly consistent as reflected in 9 these three documents that I've just introduced 10 into the record? 11 A. Yes. 12 Q. Now, this document says -- if you turn 13 to the first page which is Bates stamped 523 -- 14 sets out the purpose of the -- of the paper. 15 Do you see that. It says, "To 16 introduce the recipient to a financial strategy 17 known as risk-controlled arbitrage." 18 Do you see that? 19 A. Yes. 20 Q. Now, what do you mean by the term 21 "risk-controlled arbitrage"? 22 A. Well, risk-controlled arbitrage is a 11757 1 term that was used in the mortgage industry at 2 that time. And typically what it means, or at 3 least the way we use it here -- it means basically 4 the investment in mortgage securities funded by a 5 variety of funding sources designed to earn a 6 spread between -- spread of income between the 7 mortgage securities and the funding cost and the 8 risk is interest rate risk and prepayment rate 9 that can't be fully arbitraged away with the 10 funding. So, the risk is controlled with various 11 hedge instruments. 12 Q. Is that because the funding is 13 typically short-term funding and the 14 mortgage-backed securities are typically longer 15 term instruments? 16 A. That's true. Also, the funding sources 17 tend not to have any option characteristics. 18 Q. And typically, a risk-controlled 19 arbitrage has an effort to match the duration of 20 the liabilities with the expected life of the 21 mortgage-backed securities? 22 A. Well, I would say trying to match the 11758 1 effective duration or the price sensitivities of 2 the mortgages with the funding sources in the 3 hedges. 4 Q. And typically, that is done with 5 extending the duration of the liabilities through 6 the use of swaps? 7 A. Swaps or futures. 8 Q. Or futures? 9 A. Right. 10 Q. Now -- and was the risk-controlled 11 arbitrage an arbitrage that typically contained 12 hedges or methods of managing the portfolio in 13 terms of controlling the pre-payments risks that 14 were involved in risk-controlled -- 15 A. When you say "typically," do you mean 16 how Smith Breeden would do it or how -- 17 Q. Well, Smith Breeden or Smith Breeden's 18 clients at the time. 19 A. Well, when Smith Breeden discussed 20 risk-controlled arbitrage, we would, I think, 21 almost always or always discuss the need to hedge 22 prepayment risks. And we would typically 11759 1 recommend options, the use of options to hedge 2 that risk. 3 Q. They were other ways of doing it. 4 Other people did other things in risk-controlled 5 arbitrage to manage the prepayment risk. I 6 remember Franklin -- I litigated the Franklin 7 case, and I remember that there was discussion 8 there about different methods of controlling the 9 prepayment risk. 10 Do you remember what those others were 11 that other clients at Smith Breeden used? 12 A. Well, another way to manage that risk 13 is to rebalance the portfolio on a periodic basis. 14 Q. Is that called dynamic something? 15 A. Dynamic rebalancing, I guess, is 16 another term. 17 Q. It was the term of art at the time? 18 A. Apparently. 19 Q. What did that entail? 20 A. Well, what it would entail is 21 ultimately having a schedule of points -- well, 22 let me back up and try to explain it concisely. 11760 1 The -- we don't have any diagrams; so, 2 I'll try to describe it with words. If an 3 institution wasn't purchasing options to hedge its 4 prepayment risk, then typically as interest rates 5 moved in one direction or another, it may -- its 6 hedge would get out of balance. And so, the 7 typical situation would be that if interest rates 8 fell, it would need less hedges; and as interest 9 rates went up, it would need more hedges to 10 maintain balance. So, there would be a schedule 11 set up in advance so that whoever was doing the 12 portfolio management would know if interest rates 13 moved 25 or 50 or so. However many basis points, 14 they would know how to do that hedge adjustment. 15 So, it would take the subjectivity out of it. 16 Q. So that there were predetermined point 17 moves in interest rates where the portfolio of 18 hedges would either be expanded or contracted to 19 keep the interest -- the prepayment risk under 20 control? 21 A. Right. Interest rate risk, right. 22 Q. And it was a rebalancing of the hedge 11761 1 instruments -- either the futures or the swap 2 instruments -- that people were doing? 3 A. That was typically how we would 4 structure it, right. 5 Q. Now, was there a third way that people 6 were doing -- controlling prepayment risks by 7 selecting different coupons over other coupons 8 when they established the risk-controlled 9 arbitrage at the outset? 10 A. You could rebalance your portfolio 11 either by changing the asset characteristics or 12 the liability characteristics. So, I'm sure that 13 there were people -- there were portfolio managers 14 who would -- let's say when rates fell, then to 15 keep in balance, you would need to probably lower 16 the coupon rate on the mortgages; and if rates 17 went up, you would want to increase the coupon 18 rate to keep the balance. 19 Q. Did any of the Smith Breeden clients 20 attempt to control prepayment risk by shifting the 21 coupons of the mortgage-backed securities? 22 A. Not typically -- not to my knowledge. 11762 1 Q. Did any of the Smith Breeden clients 2 attempt to ameliorate the prepayment risk 3 beforehand by purchasing deep discount 4 mortgage-backed securities at the outset? 5 A. I wouldn't -- well, if they purchased 6 deep discount mortgages, it would have been 7 because they were good investments on a 8 risk-adjusted basis. So, the reason to purchase 9 them wouldn't have been just for managing 10 prepayment risk, per se. 11 Q. But did clients purchase deep discount 12 mortgage-backed securities that had the effect of 13 ameliorating the prepayment risk? 14 A. I'm sure some of our clients did buy 15 deep discount securities, but I'm not sure that 16 the reason was to ameliorate prepayment risk. 17 Q. Are you familiar with a man named 18 Michael Waldman at Salomon Brothers? 19 A. Yes. 20 Q. Have you read his literature? 21 A. It's been a long time, but I have read 22 it. 11763 1 Q. In the mid-Eighties, he put out a 2 number of papers, Salomon Brothers research 3 papers, on mortgage-backed securities? 4 A. Right. 5 Q. Do you recall what he was advocating in 6 the mid-Eighties? 7 A. Not -- no. 8 Q. Okay. Now, this risk-controlled 9 arbitrage that we've talked about, was that also 10 known as a structured arbitrage? 11 A. I don't recall. It may have been. 12 Q. Now, take a look at -- what was the -- 13 I guess it's on Page 525 in the next-to-the-last 14 paragraph. 15 What were the goals of risk-controlled 16 arbitrage from Smith Breeden's perspective when 17 you wrote this paper? 18 A. The goal was to build a portfolio of 19 assets that are in a spread over the associated 20 funding sources and hedges and earn a spread over 21 a wide range of interest rate scenarios. 22 Q. Here it says it's a target spread of 11764 1 100 basis points after the hedge. 2 Do you see that? 3 A. Yes. 4 Q. Was that the typical target that 5 Smith Breeden was recommending to its clients at 6 the time? 7 A. Yes. That was the long-run average, 8 what we thought was achievable in the mortgage 9 market. 10 Q. Now, how -- and I guess maybe you 11 answered the question. What did you recommend 12 that the client focus upon, your clients focus 13 upon, in selecting which mortgage-backed 14 securities to purchase as part of the 15 risk-controlled arbitrage? 16 A. Well, we would conduct analysis for our 17 clients. I think I mentioned earlier we would do 18 what I call risk-adjusted analysis. So, we would 19 try to quantify all the risks that are, you know, 20 relevant to a particular investment and 21 essentially penalize -- quantify each risk and 22 then penalize the yield on the investment by 11765 1 however much we quantified each risk. 2 So, you come down to an option-adjusted 3 spread or risk-adjusted spread for each potential 4 investment which takes into account essentially 5 the cost of hedging, the funding cost, and the 6 cost of hedging. 7 And then we would recommend the 8 investments with the widest option-adjusted 9 spreads. 10 Q. Now, did that include the cost of the 11 option contracts you recommended the client buy to 12 manage the prepayment risk? 13 A. Yes. 14 Q. And that -- you believed at the time 15 that could result in the earning spread of 16 100 basis points? 17 A. Right. 18 Q. In fact, I think that the -- you have 19 an example on one of these papers that sets that 20 out. 21 Do you know which paper that is? 22 A. It's the -- it's Page 11 on the same 11766 1 exhibit we've been talking about. 2 Q. Okay. 3 A. I think that's it's. 4 Q. Let's turn to that. I think maybe this 5 will explain what it is that you're describing in 6 terms of a risk-controlled arbitrage. 7 The -- it has a column there that says 8 "price paid" and "weighted maturity." What does 9 the "price paid" refer to? 10 A. That's the price in dollars per $100 11 face amount of Freddie Mac 9 mortgage-backed 12 securities. 13 Q. And what does "weighted maturity" refer 14 to? 15 A. This is a mortgage security; so, it's a 16 pool of underlying mortgage loans. And the 17 average term, till those loans mature, until they 18 get totally paid off, is 22.2 years. 19 Q. So, that's the contractual term? 20 A. Right. 21 Q. It doesn't take into consideration any 22 pre-payments? 11767 1 A. Right. 2 Q. Then it says "current yield monthly," 3 "current yield semi-annual." 4 Do you see those two? 5 A. Yes. 6 Q. Why do they differ? 7 A. It's just a -- it's an arithmetic -- 8 totalogy, I guess. 9 Q. But they are both analyzed figures. 10 Right? 11 A. Well, the mortgage is paid -- mortgage 12 coupons are paid monthly. So, like, if you 13 receive a 905 monthly rate, that's compared to a 14 922 semi-annual rate. So, we try to put 15 everything in a semi-annual basis so you can 16 compare it with treasury securities that have two 17 payments a year. It's just a convention. 18 Q. Okay. And then it says, "Hedged 19 one-year funds - cost: 7.16." Does that refer 20 to, for example, the reverse repos that are hedged 21 with the swaps? 22 A. Right. It could be that or it could be 11768 1 one-year deposits or representative of one year 2 funding. 3 Q. So the -- the funding source here is 4 essentially a one-year finance -- 5 A. Right. 6 Q. -- which then gave you a net figure; 7 and that is funds out, funds in. And you end up 8 with this 2.6 percent? 9 A. 2.06. 10 Q. Then it has this Entry No. 2: 11 "Principal payments and percentage of cost." Can 12 you explain to us what that calculation refers to? 13 A. There's two pieces to it. The first 14 one is this would be kind of on average during the 15 first year -- well, during the first year, I 16 guess. The regularly scheduled mortgage payments 17 that the borrowers would make contain both 18 principal and interest. 19 So, in those payments would be 20 approximately -- the principal payment would 21 represent 15 percent of the loan balances, the 22 beginning loan balances; and then -- so, that's 11769 1 the scheduled part. Then a certain number of 2 people will prepay their mortgages during the 3 year. 4 So, we were estimating that 10.8 5 percent would prepay. So, the total principal 6 repaid would be 12.3 percent of the initial 7 principal balance during the year. 8 Q. Is that what's referred to as a 9 constant repayment rate? 10 A. I believe so. 11 Q. Okay. And so, then you end up with a 12 profit, .06. Does that get added into the net 13 current yield? 14 A. Yes. 15 Q. So, you have a spread, I guess, at this 16 point in time between whatever the costs are 17 excluding any of your hedging costs and the return 18 that you get on the mortgage-backed securities on 19 this typical example? 20 A. Right. 21 Q. Then Item 3, it says "hedged capital 22 costs." Can you tell us what that refers to? 11770 1 A. Well, the mortgage has more interest 2 rate risk. So, it has a longer effective duration 3 or greater effective duration than the one-year 4 funding that's shown in the example. 5 At this point in time, the yield curve, 6 basically the curve of interest rates versus yield 7 or versus maturity was upward sloping. So, longer 8 term treasury securities had higher coupon rates 9 than short term. What that implies is if you were 10 to hedge the interest rate risk of the mortgage, 11 you would have to fund it with longer term -- 12 longer than one-year funding sources which means 13 that you would pay a higher rate on the matched 14 funding than you would on the one-year funding. 15 So, what No. 3 does, it comes up with an estimate 16 of how much more the coupon rate would be on a 17 matched liability than the one-year. So, the 18 estimate is 89 basis points. So, we're saying -- 19 per year. 20 So, if you moved up further in the 21 yield curve to pick an appropriate matched 22 funding, it would be 89 basis points more than the 11771 1 one year. 2 Q. So, that 89 basis points get added to 3 the -- 4 A. Right. 5 Q. That would take care of the increase in 6 interest rate risk that you refer to as a parallel 7 shift outward in the yield curve? 8 A. Right. 9 Q. So, that's what that was designed to 10 do. Then it says, "Capital gain due to one year 11 less maturity." 12 What does that refer to? 13 A. I think it just means that at the end 14 of the year, the mortgage will have one year less 15 to -- it will be slightly shorter in duration; 16 and, therefore, if you're analyzing it, it will be 17 on a slightly lower point on the yield curve. And 18 there should be a slight change in price as a 19 result because now the cash flows are being 20 discounted at slightly lower discount rates. So, 21 that was a fairly small adjustment. So, you would 22 expect a very slight price increase; and, so, it 11772 1 was, like, one basis point. Just a minor 2 adjustment. 3 Q. Then the next entry says "reserve for 4 options." 5 Do you see that: No. 5? 6 A. Uh-huh. (Witness nods head 7 affirmatively.) 8 Q. .24 percent, what does that refer to? 9 A. That would be our estimate of the cost 10 of buying options typically out of the money puts 11 and call options to hedge the changing durations 12 or the prepayment risk. 13 Q. Okay. So that that's the cost per year 14 to hedge the prepayment risk in your model? 15 A. Right. 16 Q. That is essentially hedging the 17 correctness or incorrectness of your prepayment 18 figure of 123 percent? 19 A. Well, it's hedging the anticipated 20 changes in pre-payments as rates move. 21 Q. Okay. So, it provides you with 22 protection from changes from the prepayment rates 11773 1 that you have under that Section 2 which totaled 2 123 percent. 3 Is that a fair statement? 4 A. The way I would say it is if we're 5 estimated 123 percent prepayment rate, if rates 6 don't change and if rates go down, we would 7 estimate a higher rate of prepayment and if rates 8 went up, a lower rate of prepayment. And the 9 options would -- would hedge the market value risk 10 between the mortgages and the funding for those 11 anticipated changes in pre-payments. 12 Q. Now, Page 526, Bates stamp 526, 13 Paragraphs 3 and 4, you talk about the difference 14 between liability and asset hedges. 15 Can you explain to us what the 16 difference between a liability hedge and an asset 17 hedge is? 18 A. It's really, I think, more of an 19 accounting issue than anything else. You could 20 look at it -- if you have a portfolio of mortgages 21 and the main funding source is short term and the 22 mortgages are longer duration, then you can -- and 11774 1 you're hedging that portfolio, you could either 2 look at it as if your hedge is either short in the 3 assets effective duration to equal the liabilities 4 or lengthen the liabilities to equal the 5 mortgages. 6 The issue is from an accounting 7 standpoint: How do you want to look at it? Do 8 you want to attach the hedges to the assets or to 9 the liabilities? 10 Q. So, it's basically taking the 11 difference between assets on one hand and 12 liabilities on the other and trying to get them to 13 proximate each other in terms of duration? 14 A. Right. Right. 15 Q. And that an accountant -- for 16 accounting purposes, the client could designate it 17 either as an asset hedge or a liability hedge? 18 A. Right, I think so. 19 Q. What's the advantage of designating it 20 a liability hedge from the client's perspective? 21 A. I think there's more flexibility 22 because from a portfolio management standpoint, I 11775 1 think it's easier to deal with since the 2 liabilities will typically stay there and not 3 change dramatically where you might find 4 opportunities to buy or sell assets out of your 5 portfolio. 6 So, there typically would be more 7 transactions done on the asset side, and it's 8 easier to administer if you treat things as a 9 liability hedge. 10 Q. Were there more choices in terms of 11 mortgage-backed security pools at different 12 durations than there were liabilities at different 13 durations? 14 A. Yes. There's more opportunity to add 15 incremental value on the asset side than, I think, 16 on the liability side. 17 Q. What was the accounting -- 18 MR. NICKENS: Your Honor, I have two 19 objections. One is Mr. Giarla has not been 20 designated as an expert witness. He is here as a 21 fact witness. He has not provided us with a 22 report. We have not had an opportunity to depose 11776 1 him. Although there is a certain amount of 2 background information to the advice he may have 3 given to USAT, we seem to be essentially given a 4 lecture on risk-controlled arbitrage that we have 5 not been told to expect from this witness. 6 Secondly, this is not an accountant; 7 and I would object to this particular question 8 on -- being received as an expert opinion on 9 accounting issues. 10 There has not been any person 11 designated to give expert accounting by the OTS, 12 expert accounting opinions concerning the 13 treatment of this. I don't have an objection to 14 his testifying as to his understanding as a 15 portfolio manager, but I wouldn't want it received 16 as an expert opinion on accounting. 17 MR. GUIDO: Your Honor, I'm sorry. I 18 could have phrased the question a little more 19 artfully. I was really asking him his 20 understanding of what the accounting advantage 21 was. It's in his literature. In fact, it's at 22 the top of Page 527 in response to the question; 11777 1 and I am basically having him elaborate on what it 2 is he explained to USAT are the typical advantages 3 of designating a hedge as a liability hedge as 4 opposed to an asset hedge in his understanding. 5 I am not attempting to qualify this 6 witness as an accounting expert. I'm only 7 attempting to draw him out on his understanding 8 and what it is he provided to this client. 9 THE COURT: Do you understand the 10 question as Mr. Guido has rephrased it? 11 THE WITNESS: Yes. 12 THE COURT: All right. 13 Q. (BY MR. GUIDO) What was your 14 understanding of the accounting advantage as to 15 designating a hedge as a liability hedge? 16 A. My understanding of the advantages, 17 that if -- if you would -- if you designated an 18 asset hedge and if you were to sell the assets, I 19 believe you would probably have to treat the -- 20 treat the hedge as if you had closed it out or 21 market-to-market whereas if you treat the hedge as 22 a liability hedge and you sell the asset and buy 11778 1 another asset in its place, presumably you 2 wouldn't have to take the gain or loss on the 3 hedge into income. So, it's -- it just provides 4 more flexibility. 5 THE COURT: What provides more 6 flexibility? 7 THE WITNESS: Liability hedge provides 8 more flexibility. 9 Q. (BY MR. GUIDO) In other words, it 10 gives the client the option of generating 11 accounting gains without having to generate losses 12 on the hedge side by rebalancing its portfolio? 13 A. Well, I mean, that's in certain 14 circumstances. It would just give the portfolio 15 manager -- I mean, they could take either gains or 16 losses on the assets depending on the situation. 17 It just allows them to defer the gain or loss on 18 the hedges and to treat that independently of the 19 particular, you know, purchase or sale on the 20 asset side. 21 Q. Now, when your clients in the 22 mid-Eighties were engaged in dynamic rebalancing 11779 1 or rebalancing by selling mortgage-backed 2 securities of one coupon and buying them of 3 another one to adjust the duration of the 4 mortgage-backed security portfolio or keep it in 5 line with the liabilities, when interest rates 6 went down, what would they do? What did they 7 typically do? 8 A. The clients that didn't have options, 9 they were -- 10 Q. Those without options? 11 A. What they would typically do when rates 12 went down would be they would take off -- well, 13 the hedges -- we haven't talked about what hedges 14 are. 15 A typical hedge position would be a 16 short position in the futures contract or a 17 pay-fix swap and purchase of, let's say, call 18 options to protect the rates going down. You 19 would want to buy back some of your futures or 20 take off some of the interest rate swaps. That 21 would be a typical adjustment that would get done. 22 Q. Did any of your clients not do the 11780 1 adjustment at the hedge level but do it at the 2 mortgage-backed securities level? 3 A. Well, I guess the answer is probably 4 "yes" and "no" in the sense that our clients would 5 do transactions continuously; and some of those 6 purchases or sales of mortgage securities would -- 7 you know, might have helped balance their 8 position. But typically, they would separate the 9 investment from the hedging decision. 10 So, I would say, typically, the 11 adjustment would be on the hedge side, not the 12 asset side. 13 Q. So, you didn't have clients, when 14 interest rates went down in late '85, early '86, 15 selling higher coupon mortgage-backed securities 16 and replacing them with lower coupon 17 mortgage-backed securities typically? 18 A. I don't remember exactly what they did; 19 but if they were doing that, it would have been 20 more as an investment decision, not as a hedging 21 position. 22 Q. Did you have any clients, when interest 11781 1 rates went up, selling lower coupon 2 mortgage-backed securities and selling -- 3 A. Again, I don't recall what our clients 4 did specifically; but we would -- our clients 5 would typically and we would be recommending 6 typically that the adjustments be made on the 7 hedge side rather than the asset side. 8 Q. You never recommended a client do the 9 adjustments by selling higher coupon 10 mortgage-backed securities and buying lower coupon 11 mortgage-backed securities? 12 A. Right. That would be driven by some 13 risk-adjustment analysis or investment analysis, 14 not just the hedging issue. 15 Q. Now, look at Page 530. The last -- the 16 last two paragraphs. 17 Was Smith Breeden advocating the 18 purchase of options as a way of protecting against 19 the prepayment risk as opposed to rebalancing the 20 portfolio periodically in the mid-Eighties? 21 A. Yes. 22 Q. Okay. And why was that? 11782 1 A. From a -- from our standpoint as an 2 investment advisor, we felt like we didn't have 3 any particular expertise at figuring out which way 4 rates were going. 5 So, our view, as kind of the safest 6 position for our clients to be in, would be to buy 7 options to protect -- to kind of fully protect the 8 institution against interest rate risk to the 9 extent it could be measured. So, it was just the 10 least risky position you could take. 11 Q. Why was rebalancing more risky than 12 just purchasing the options contract to protect 13 against the change in prepayment rates? 14 A. Well, there's -- there's pros and cons 15 to both. But the possible pitfalls of the 16 rebalancing strategy are that since there's a 17 human involved, you could have, you know, somebody 18 who doesn't execute when they are supposed to; or 19 you could have a situation where the market moves 20 overnight beyond the point at which you would 21 ordinarily rebalancing. Those are a couple of 22 risks. 11783 1 You could have -- interest rates could 2 be more volatile ex-post than what was kind of 3 implied by the options prices; so, it might cost 4 more to do the dynamic rebalancing. 5 Q. What do you mean the market might move 6 overnight beyond where you would ordinarily 7 readjust the hedge? 8 A. Well, if you go back to our discussion 9 earlier about having specific points where you 10 would rebalance your hedge if rates moved by 11 specific increments that you had set up in add 12 advance -- let's say you had a 50 basis point 13 increment -- 50 basis point move down in rates is 14 where you would adjust your hedge. You could have 15 some kind of event in the marketplace where, you 16 know, before you kind of came into work that day 17 or before you even kind of realized it, rates 18 might have fallen 75 basis points. So, rates 19 would have moved beyond the point where you wanted 20 to do the adjustment. So, there's kind of like a 21 gap in the market. 22 That -- an event like that is 11784 1 infrequent; but during the stock market crash, you 2 could have a pretty major move in interest rates 3 during the day that might be hard to -- might 4 cause some problems in executing the rebalancing 5 strategy. 6 Q. What were the typical points which your 7 clients were rebalancing their hedges in the 8 mid-Eighties? 9 MR. NICKENS: Your Honor, we continue 10 to receive expert testimony without relationship 11 to USAT. Mr. Guido well knows that this witness 12 has testified that he knows nothing about the 13 rolldown that occurred at USAT. So, now, he's 14 trying to bring this man, I know, who knows 15 nothing about the facts and is developing what is 16 expert testimony without having identified him as 17 an expert, giving us a report, let us 18 cross examine him, and prepare a deposition. I 19 object. 20 MR. GUIDO: The witness, Your Honor, 21 just testified that he did provide this material 22 that explained how rebalancing can be used by the 11785 1 portfolio. I'm just trying to understand how he 2 was using that term "rebalancing the portfolio," 3 and I think it's rather important to know how 4 frequently one does that and at what points one 5 does that. I'm just trying to clarify for the 6 record. I'm trying to find out what kind of 7 advice he was giving to his clients in the 8 mid-Eighties. We are going to get into three 9 papers where he specifically gave advice to the 10 client on what to do with these portfolios, and I 11 believe that I am entitled to ask him his 12 foundational questions so that I can use that 13 information to shed light on the advice he did 14 give to the client. 15 MR. NICKENS: Your Honor, what is the 16 relevancy of what other clients were doing if he 17 did not communicate that to USAT? And that's my 18 objection. This man is here as a fact witness to 19 provide consulting services to USAT. He has 20 testified in his deposition that he knows nothing 21 about the rolldown that they conducted in the 22 first quarter of 1985. 11786 1 What this opens the door to is -- of 2 course, I have to then question him as an expert 3 witness here on the stand without having a 4 deposition, which is going to greatly extend his 5 testimony and -- beyond what he's been identified 6 as what he's supposed to be here for. 7 MR. GUIDO: Your Honor, this isn't like 8 I went and found a third party and put him on the 9 stand. This is somebody who gave advice to these 10 people, Your Honor. And all I'm asking is 11 questions that go to the weight of the advice he 12 gave that client. 13 THE COURT: It didn't seem to me your 14 questions were directed to advice he gave. I 15 gather the purpose of this witness is to show that 16 he gave advice to USAT and it wasn't followed. 17 Is that the gist of his testimony? 18 MR. GUIDO: Yes, Your Honor. He did 19 advise them that they could do -- they could 20 rebalance the portfolio or the hedges or they 21 could purchase option contracts. His preference, 22 he testified, was that they buy option contracts 11787 1 to protect against the prepayment risk, Your 2 Honor. Now I'm trying to get from the witness 3 what he means by the term "rebalancing"; and I 4 think the best way to get that is through what his 5 clients were typically doing at that time when 6 they were rebalancing their portfolios. 7 MR. NICKENS: No. 1, Your Honor, I've 8 heard no testimony as to whether or not he advised 9 USAT about rebalancing beyond these documents; and 10 certainly what he was telling other clients unless 11 he related that to USAT is irrelevant to factual 12 testimony here. He has testified in his 13 deposition that he has no knowledge about USAT's 14 rolldown. 15 MR. GUIDO: Your Honor, I think 16 Mr. Nickens isn't paying much attention to the 17 documents we've just introduced. If you look at 18 the second paragraph of the October 13th letter 19 which is Exhibit B1257 which has been admitted 20 into evidence, it says in the last sentence, "We 21 should discuss the issue of buying the options 22 versus rebalancing the futures position 11788 1 periodically." 2 That is exactly what I am addressing, 3 Your Honor, is the question of whether or not they 4 should be buying options versus rebalancing the 5 portfolio. 6 MR. NICKENS: Then, Your Honor, the 7 question should be: Did you discuss it? Do you 8 recall it here 12 years later, and what did you 9 tell them? Not a -- not this kind of testimony 10 about what may have been said to someone else. 11 I suspect that the answer is that this 12 witness does not recall having any such discussion 13 with them and that Mr. Guido may be aware of that 14 and is trying to get to it in a different way. 15 That's my objection. 16 THE COURT: Well, I think we should get 17 to the point as to what he told -- 18 MR. GUIDO: Your Honor, that's what 19 I've been trying to do. 20 THE COURT: It doesn't seem to me your 21 question was phrased exactly like that. I think 22 Mr. Nickens is correct. I would like to focus on 11789 1 what was communicated to USAT. 2 Q. (BY MR. GUIDO) Mr. Giarla, would you 3 take a look at the October 13th letter. It's 4 Exhibit B1257. It says, "We should discuss the 5 issue of buying the options versus rebalancing the 6 futures position periodically." 7 Do you see that? 8 A. Yes. 9 MR. NICKENS: Your Honor, may I ask 10 exactly where we are? 11 MR. GUIDO: October 13th letter, the 12 second full paragraph, the second-to-the-last 13 sentence. 14 MR. NICKENS: Thank you. 15 Q. (BY MR. GUIDO) What did you refer to 16 when you were referring to rebalancing the futures 17 position periodically? 18 A. As I read this, it refers -- we had 19 made either recommendations to buy Fannie Mae 9s 20 and 9 and a halfs and hedged them with futures 21 contracts. And I guess we also showed a hedge 22 position that included options on T bond futures. 11790 1 So, the -- it may have -- I don't 2 remember the exact discussions at the time. It 3 may have been that we had discussions about 4 rebalancing the futures versus buying the options. 5 Q. Did you have discussions with them? 6 A. I just don't remember what discussions 7 took place. 8 Q. You don't recall? 9 A. No. 10 Q. Now, what is the advantage, again, of 11 the purchase of the options contract as opposed to 12 rebalancing the portfolio? You advocated 13 throughout these papers and this recommendation to 14 Sandy Laurenson that they purchase options 15 contracts and not rebalance the hedge? 16 A. Right. 17 Q. I think you also earlier testified that 18 there were a number of reasons for that, correct? 19 A. Right. 20 Q. And was -- and you testified that one 21 of the reasons was that the rebalancing may come 22 too late in terms of an interest rate increase. 11791 1 Do you recall that? 2 A. Yes. 3 Q. Did you explain to Sandy Laurenson why 4 you preferred the purchase of options contracts 5 over the rebalancing as a method of readjusting 6 the hedge for changes in prepayment rates? 7 A. You know, I don't recall, you know, 8 specifically what took place in the discussions. 9 Q. But you do recall telling her that you 10 preferred the purchase of options as opposed to 11 rebalancing the hedge? 12 MR. NICKENS: Your Honor, the witness 13 has testified he didn't recall. The question has 14 been asked now, "Do you recall?" when he said he 15 didn't recall. 16 MR. GUIDO: Your Honor, I may have 17 stated the second question incorrectly; but as I 18 recall -- 19 THE COURT: All right. Restate the 20 present question. 21 Q. (BY MR. GUIDO) You did tell Sandy 22 Laurenson and you did tell the people at USAT in 11792 1 your various presentations to them that 2 Smith Breeden's preference was that the clients 3 purchase option contracts to protect against the 4 change in prepayment rates as opposed to 5 rebalancing the hedge position? 6 A. I believe so. I mean, it's certainly 7 in the letter here. And typically in our analysis 8 to our clients, we would always recommend an 9 options hedge as the first cut or as our preferred 10 hedge. 11 Q. Okay. Now, let's go to -- back to 12 Exhibit No. A10654. 13 THE COURT: We'll take a short recess. 14 15 (Short break.) 16 17 THE COURT: Be seated, please. We'll 18 be back on the record. 19 Mr. Guido, you may continue. 20 MR. GUIDO: Thank you, Your Honor. 21 Q. (BY MR. GUIDO) I would like to turn 22 now to Exhibit 13003, Mr. Giarla, what is an 11793 1 introduction to hedging interest rate risks. And 2 on the first paragraph of that, it talks about 3 what the function of a hedge is. It says that -- 4 MR. NICKENS: Your Honor, may I ask 5 what page we're at? 6 MR. GUIDO: 1695. It's the first 7 paragraph of the introduction. 8 Q. (BY MR. GUIDO) It says, "Protect the 9 market value of assets and liabilities to changes 10 in interest rates." 11 Do you see that? 12 A. Yes. 13 Q. Why is it important to do so? 14 A. Well, the definition -- at least the 15 way I think of it, the definition of interest rate 16 risks is changes in values caused by interest rate 17 shifts; and if an institution -- if a financial 18 institution doesn't effectively hedge its interest 19 rate risk, it may become insolvent as a result. I 20 mean, that's an extreme situation. Or it may find 21 its interest rate spread eroded if it's moving in 22 the wrong direction. 11794 1 Q. How do you measure the performance of 2 the risk-controlled arbitrage if the premise of 3 the hedge is to protect market value? 4 A. Well, what we would typically do is 5 look at the market values of the assets, the 6 liabilities, average the hedges as a portfolio 7 along with any, you know, income stream that's 8 been earned on it; kind of look at the changes 9 every month, let's say. You could take whatever 10 period of time you want; but typically, look at it 11 on a month-to-month basis over a period of time 12 and see wherever it's been effective or not. 13 Q. Now, on Page 13 of that document which 14 is Bates stamp 1706, in the third paragraph, it 15 says, "In order to more easily demonstrate the 16 fact that First Savings is exposed to changes in 17 interest rates, it is useful to calculate the 18 market values of the firm and its component parts 19 under different interest rate scenarios. Each 20 liability for parallel shifts in the treasury 21 yield curve of between minus 4 percent and plus 22 4 percent (in increments of 100 basis points)." 11795 1 Does that mean you go out 400 basis 2 points one way and 400 basis points the other? 3 A. Yes. 4 Q. Why did you pick 400 basis points? 5 A. Well, I'm not sure why 400 versus 500; 6 but we wanted our clients to realize that 7 400 basis point moves were not unreasonable and -- 8 certainly, if interest rates had moved that much 9 over a period of a year or two. So, that, also, 10 some securities have option characteristics that 11 you might, if you don't look, you know, go beyond 12 100 basis points. 13 So, for a couple of reasons, we would 14 look, you know, for large moves in rates. One, so 15 you could pick up all the different 16 characteristics of assets and liabilities; and the 17 other, that it is -- it is not unlikely that you 18 can get rate moves of that magnitude. 19 Q. Now, you then on Page -- turning back 20 to the beginning, Page 1696, you have a Schedule 1 21 which is a coupon treasury yield for 1984 through 22 '86. 11796 1 Do you see that? 2 THE COURT: Where are we again, 3 Mr. Guido? 4 MR. GUIDO: Same exhibit, Bates 5 stamp 1696, which is Page 3 of the exhibit. 6 Schedule 1 called "coupon treasury yield curves, 7 1984 through '86." 8 Q. (BY MR. GUIDO) Where did Smith Breeden 9 obtain that information? 10 A. Would have been from some market quote 11 service like Telerate or something like that. 12 Q. Now, on the first paragraph -- the 13 second paragraph on Page 1695 when you're 14 discussing recent changes in interest rates, 15 you're always using the 10-year treasury. 16 Do you see that in that paragraph? 17 A. Right. 18 Q. Why do you use the 10-year treasury? 19 A. I'm not sure that there's any 20 particular reason. It seemed like -- what we talk 21 about is short-term and long-term rates, and we 22 just picked that one as kind of the 11797 1 representative -- 2 Q. Is the performance of the 10-year 3 treasury correlated to the performance of 4 mortgage-backed security coupons? 5 A. I would say 7 to 10 year treasuries are 6 similar. 7 Q. Is that why the 10 years were picked 8 for this example? 9 A. I'm not sure why. It's just a 10 benchmark treasury. 11 Q. Now, the next page, 1697, Schedule 2 12 which is Page 4, it says Smith Breeden assumed 13 annualized long-term prepayment rates. 14 Do you see that? 15 A. Yes. 16 Q. Now, at that -- it says Smith Breeden 17 assumed annualized long-term prepayment rates. 18 Were they Smith Breeden's projections 19 of what the prepayment rates would be, given the 20 current interest rates at the time? 21 A. Yes. At each month end, those were the 22 assumptions we were using going forward. 11798 1 Q. And why did Smith Breeden use 2 assumptions as opposed to actual performance for 3 those months? 4 A. Well, the actual performance for a 5 specific month reflects the interest rate 6 environment from two or three months earlier. So, 7 using the current month doesn't take into account 8 all the relevant information. 9 Q. Is it a two- or three-month delay 10 because of the delay in getting the results from 11 Fannie Mae and Freddie Mac to the client? 12 A. It's more of the time when the interest 13 rates fall from when the borrower makes the 14 decision to refinance and the loan is actually 15 refinanced to when a buyer of a mortgage security 16 sees it. It could typically take two or three 17 months. 18 When you get a prepayment today, it 19 reflects what borrowers were doing several months 20 earlier, the decisions they made several months 21 earlier. 22 Q. It takes that long for the decision to 11799 1 flow through the system? 2 A. Right. Right. 3 Q. And how did you develop -- what kind of 4 model did you use? I mean, we don't want to get 5 into great detail about the model that 6 Smith Breeden uses, but typically how do you 7 calculate the assumed prepayment rates given the 8 interest rate environment? 9 MR. NICKENS: Your Honor, could we have 10 a time period for this question? Is he talking 11 about 1985? 1986? 1990? 12 MR. GUIDO: Let's start with 1985, and 13 then we'll go to 1986. 14 Q. (BY MR. GUIDO) How did you do it? 15 A. Well, I wasn't the person creating 16 prepayment models; so, I guess we should establish 17 that. 18 Q. Somebody in Smith Breeden was, weren't 19 they? 20 A. Doug Breeden was the main person at 21 this point in time. The main factors that we 22 would take into account would be -- first of all, 11800 1 we had some historical data that we could look at. 2 The main factors are the difference 3 between the coupon rate on a particular mortgage 4 and what the refinancing rate is; and we could 5 take into account the general economic conditions 6 for the country or possibly for the region if 7 there's a specific mortgage security whose loans 8 are in a specific part of the country and it has 9 either, you know, fast or fast-growing economic or 10 slow economic. That would make a difference on 11 prepayment assumptions. And the age of the 12 mortgages, whether they are seasoned or not -- 13 seasoned is a factor. And there's a footnote to 14 that effect on the bottom of the page. And, also, 15 there's a seasonality effect that mortgages tend 16 to prepay more quickly in the summer and slower in 17 the winter. 18 So, those were some of the main 19 factors. 20 Q. Is one of the factors the relationship 21 between the compound rate and current interest 22 rate? 11801 1 A. Right. 2 Q. And did -- and that is -- is that a 3 significant factor? 4 A. That is the most important factor. 5 Q. And how did -- what did Smith Breeden 6 look to to come up with these figures here in 7 terms of that factor? Did it look at the 8 relationship of pre-payments in the past, the 9 changes in the interest rates? 10 A. You would look at that, and you would 11 have to make assumptions about borrower behavior 12 outside the data set. 13 For extreme moves in rates, you might 14 not have data that covers those experiences. So, 15 you would have to make reasonable guesses as to 16 what would happen. 17 Q. Let me direct your attention to a 18 couple sort of examples. February 28th, 1985, the 19 12 percent pre-paying at 10 and the 13s Fannie Mae 20 and Freddie Macs at 13. 21 Do you see that? 22 A. Yes. 11802 1 Q. And that was based on the interest rate 2 using 10 years of 11.9 percent. 3 A. Okay. 4 Q. Okay. And then when you drop down to 5 December 31, '85, you have, for the 12s, 6 20 percent prepayment rate, and for the 13s, a 7 40 percent prepayment rate. And that's with 8 interest rates 10 years at 9.01. Right? 9 A. Right. 10 Q. So that that is what Smith Breeden 11 anticipated the pre-payments would become given 12 that interest rate at that point in time based on 13 historic experience? 14 A. Right, plus our historic experience and 15 whatever other judgment we would have. 16 Q. Okay. Were those prepayment 17 assumptions consistent with what the actual 18 results were in December of 1985? 19 A. Well, I think, in general, they were. 20 I don't, you know, have the specific data on it. 21 I do have a recollection that our estimates were 22 probably a little on the low side, and probably 11803 1 most people in the industry were on the low side 2 during that period of time. 3 Q. But were they significantly out of line 4 with what your projections were? 5 A. I don't -- I mean, I don't recall. I 6 know we would revise our prepayment model, and we 7 revised it upwards during the period. We 8 certainly -- I think we had the directions and the 9 magnitudes right. 10 Q. Now, when you talk about measuring -- 11 when you talked about the 400 basis point move 12 either way, you talked about market value. That 13 that's what you look to: Liquidation value. 14 What was it that you looked to to 15 ascertain what that value was? How did you 16 determine what the value of the mortgage-backed 17 security was or the value of a cap was or the 18 value of the reverse repos was? 19 THE COURT: A lot of questions there, 20 Mr. Guido. 21 Q. (BY MR. GUIDO) Let me take the first 22 one. 11804 1 How did you determine what the market 2 value would be with shifts in interest rates? 3 What did you look to? 4 A. Well, the way we would typically do it 5 is your -- you know what the market price is 6 today. You can observe a market price of a 7 mortgage today; and for estimating its value up 8 and down, you know, let's say for the plus 100 9 basis point scenario, what you would -- what we 10 would do is we would have, I guess, to think about 11 it -- most simply, I guess, you would project the 12 cash flows out, assuming interest rates were 13 100 basis points higher, and then discount those 14 cash flows at a risk-adjusted rate that's 15 consistent with the interest rate environment. 16 So, you use a higher discount rate to come up with 17 a market price. 18 We would assume that the 19 option-adjusted spread on the mortgage would stay 20 constant through the -- for each of those 21 scenarios. 22 Q. Now, why didn't you just use the yield? 11805 1 Why did you have to do an analysis of the market 2 value? Why didn't you just use that year's yield 3 on the mortgage-backed securities to measure their 4 effectiveness? 5 A. Well, the yield doesn't really tell you 6 much about market values. So, I guess -- we 7 mentioned it earlier. Our view of hedging is 8 trying to insulate a portfolio or institution from 9 market value changes. So, you can have, you know, 10 two securities with the same yields that have very 11 different interest rate risk. The yield really 12 doesn't give you enough information. 13 Q. So, would you say it only gives you a 14 part of the picture? 15 A. Right. 16 Q. Okay. Now, I would like to turn to the 17 document that I have marked as Exhibit A13004, 18 which is the CMO analysis for United Savings; and 19 it's Exhibit 443-1 from your deposition and dated 20 June 30, 1986, from Mike Giarla - Smith Breeden & 21 Associates. 22 I would like to also direct your 11806 1 attention to Exhibit A13005, which is the analysis 2 of the MBS interest rate swaps, caps, and collars 3 also prepared by Mike Giarla June 30, 1986. 4 And then the third is A10659, which is 5 the USAT valuation and sensitivity analysis dated 6 August 14th, 1986. 7 Do you see those three? 8 A. Yes. 9 Q. Are those the three studies, 10 sensitivity analyses, that you prepared for USAT 11 which you testified to earlier? 12 A. Yes. 13 MR. GUIDO: I would like to move the 14 admission of Exhibit A13004, A13005, and A10659, 15 Your Honor. 16 MR. NICKENS: No objection, Your Honor. 17 THE COURT: Received. 18 Q. (BY MR. GUIDO) Let's start with the 19 CMO analysis: 13004. Who provided you with the 20 data that you used for that -- that analysis? 21 A. Some subset of the folks at United. 22 I'm not sure who exactly gave it to us. 11807 1 Q. This doesn't reflect that there are any 2 swaps, caps, and collars -- that is, hedging 3 instruments -- does it? 4 A. It doesn't mention anything in this 5 particular document, but -- I don't believe -- 6 Q. Now, it mentions a strip mortgage. 7 A. Right. I see strip mortgages in here. 8 Q. Okay. Do you recall what you were 9 asked to do in preparing this report? 10 A. I can tell you what the report does. I 11 don't remember exactly what we were asked to do. 12 I can infer it from the report. 13 Q. Let's take Page 1658. It says, 14 "Analysis of interest rate sensitivity of CMOs." 15 Do you see that? 16 A. Yes. 17 Q. Is that one of the things that you were 18 asked to do? 19 A. Yes. 20 Q. Were you also asked to analyze the 21 interest rate sensitivity of those CMOs that are 22 mentioned there: The CMO Series 1, CMO Series 2, 11808 1 CMO Series 3 in light of the purchase of the 2 Goldman account proposed strip mortgage-backed 3 securities? 4 A. I believe we were asked to or Goldman 5 may have recommended some specific hedge for one 6 of the CMOs. We looked at our analysis of how 7 that CMO would look matched with their 8 recommendation. 9 Q. Now, what were the CMOs that were in 10 Series 1, 2, and 3? Do you recall? 11 A. I don't recall the collateral but I 12 believe they were fixed-rate mortgage securities 13 collateralizing the trust and I believe that there 14 were bonds issued that were probably fixed-rate 15 bonds. Again, I don't recall specifically. So, 16 these, I believe, were CMO residuals. 17 Q. Now, let's go and look at the -- 18 Page 23, which are the discussions. Look at the 19 Bullet Point No. 2. It says -- 20 THE COURT: Excuse me. I didn't get 21 your reference. 22 MR. GUIDO: I'm sorry. It's Bates 11809 1 stamp 16 -- I think -- 72, Your Honor. It's 2 Page 23 of the document. 3 MR. NICKENS: Your Honor, it's the last 4 page of the document. 5 MR. GUIDO: The very last page. 6 Q. (BY MR. GUIDO) Do you see that it 7 says, "Market for CMO residuals is now more 8 efficient - spreads to treasury have narrowed"? 9 A. Yes. 10 Q. Do you see that? 11 A. Yes. 12 Q. What is that referring to? Is that a 13 recommendation to sell more CMO residuals to 14 increase the CMOs, or is it to dispose of the 15 portfolio in its entirety? 16 A. It refers to possibly selling these 17 residuals, but it's not -- I wouldn't say it's a 18 recommendation to sell it. It's just saying the 19 market prices of residuals in general are higher 20 than they used to be, all other things being 21 equal; so, they might be an opportunity. So, you 22 might want to look into the market values. It may 11810 1 be an opportunity. 2 Q. So, suggesting to the client that this 3 may be a time to sell? 4 A. It's something to be investigated, but 5 we hadn't made that determination at that point. 6 Q. The third bullet point says, "Works 7 only if complemented by the purchase of 'out of 8 the money' puts to protect against large increases 9 in the level of market interest rates." 10 Do you see that? 11 A. Yes. 12 Q. Can you show us where on these charts 13 that conclusion is supported by the data? 14 A. Okay. Well, the easiest one is on 15 Page 19 if you just flip back four pages, I guess. 16 There's a graph. The numbers are located 17 somewhere else in the document, but the graph is 18 probably the best thing. CMO2 is -- the change in 19 market value of CMO2 we estimate is reflected by 20 the line connected by the boxes, the squares with 21 the lines connecting them. The strip mortgages 22 are shown with the little pluses with the lines 11811 1 attached, and then the net is just adding together 2 those two other lines. All of these reflect 3 changes in market values from base. 4 So, if you look at the net lines, which 5 is the little diamonds, starting from zero and 6 going to the left is interest rate decreases. And 7 it looks like the changes of the combined CMO plus 8 the strip mortgages is pretty small. Then if you 9 go to the right, you have interest rate increases. 10 Looks like there's a small change for interest 11 rates going up 1 percent. 12 Then as you get larger moves in that, 13 the combination of those two starts to lose the 14 further and further you go higher in terms of 15 interest rate moves. So, that's -- 16 Q. That's without the options? 17 A. Right. Right. 18 Q. Now, does Page 20, the chart at the 19 bottom, reflect what would happen if the options 20 would have been purchased? 21 A. Right. So, if you look at Page 20, the 22 upper left graph is the same as what's shown on 11812 1 19. The upper right graph shows market value 2 changes on an options portfolio that's identified 3 in the little box there: 20015, puts on T bond 4 futures. Then the bottom graph shows the net 5 position if you add those options in, which is a 6 fairly flat curve. 7 Q. Now, Item No. 4 or Bullet Point No. 4 8 says, "Stripped MBSs may not be the most efficient 9 way to hedge." 10 And then Item No. 5 says, "Major 11 disadvantage of the stripped MBS is the small size 12 of the market. Much more illiquid than other 13 hedging vehicles." 14 Do you see that? 15 A. Yes. 16 Q. Were you recommending that they use 17 options as opposed to the strip MBSs as a hedging 18 vehicle? 19 A. I think we were more comfortable 20 with -- these comments reflect a couple of things. 21 One is we were more comfortable with options than 22 the strips. The other is that the strip mortgages 11813 1 have a certain investment component to them. So, 2 this relates back to some earlier things we talked 3 about. We would make hedging -- we like to 4 separate the investment decision from the hedging 5 decision. So, to the extent you wanted to use 6 strip mortgages as a hedge, we wanted to analyze 7 whether or not they were the cheapest hedge. 8 Q. Okay. Did you make clear to the people 9 at USAT that you want -- that your approach was to 10 separate the hedging decisions from the investment 11 decisions? 12 A. I don't remember having that 13 discussion. It may have been in some of the 14 literature that we described to you. 15 Q. For someone that is knowledgeable of 16 this market, would they infer that from this 17 literature? 18 A. I'm not sure. I would have to go back 19 and look at it. That was our general philosophy. 20 Q. Now, look at the first bullet point. 21 "Until analyzing the interest rate sensitivity of 22 the entire firm (macro sensitivity), I would 11814 1 advise against 'micro-hedging' particular subsets 2 of the firm." 3 Do you see that? 4 A. Yes. 5 Q. Why is that? 6 A. Well, if the -- the goal -- okay. 7 Well, until you know what the entire picture looks 8 like, introducing something else to the 9 institution may actually increase its interest 10 rate risk. For example, if the whole institution 11 was well-hedged but you just looked at one piece 12 of it that wasn't and tried to hedge that in 13 isolation, then you would probably be increasing 14 the overall risk of the company. 15 So, we would warn people that until we 16 had a good picture of the entire institution, we 17 wouldn't recommend doing any micro hedges of 18 specific pieces of it. 19 Q. Okay. Now, in terms of what you 20 found -- forget the recommendations. 21 Go back to Page 6 of the memo. This is 22 the three CMO series. Is this what is typically 11815 1 referred to as a sensitivity analysis? 2 A. Yes. 3 Q. And that shows the -- a change from a 4 base value going to the right with an increase in 5 interest rates and going to the left with a 6 decrease; is that correct? 7 A. Yes. 8 Q. And it shows that there are increasing 9 losses as you go -- have a decrease in interest 10 rates and an increase in gains if you have 11 increasing interest rates; is that right? 12 A. Yes. 13 Q. And is this what you had referred to as 14 doing a market value analysis of doing 15 mortgage-backed securities going out -- this case 16 is 500 basis points each way? 17 A. Yes. 18 Q. Now, I would like to turn to the next 19 document that you did, which is June 30th also. 20 It's Exhibit A13005; and it's the analysis of the 21 mortgage-backed securities, interest rate swaps, 22 caps, and collars. 11816 1 Do you see that? 2 A. Yes. 3 Q. Who provided you with the information 4 that you used to prepare that report? 5 A. Well, the market data. So, like, the 6 interest rate swap spreads which is on Page 1 and 7 treasury yield curves, those are just provided by 8 market makers basically; and then United's 9 specific data was provided by people at the 10 institution. 11 Q. Now, go to Page 4. That says, 12 "Analysis of current value of mortgage pool swaps, 13 caps, and collars." 14 Do you see that? 15 A. Yes. 16 Q. It says "book value." 17 Do you see that figure? 18 A. Right. 19 Q. It says $1.9 billion. Is that face 20 value, or is it cost? 21 A. That, I am not sure. I would assume 22 it's cost, but I'm not positive. 11817 1 Q. So, they asked you to analyze 2 $1.9 billion worth of mortgage-backed securities? 3 A. Right. 4 Q. And then under -- then it says "swaps, 5 caps, and collars." 6 Do you see that? 7 A. Yes. 8 Q. They asked you to evaluate the swaps, 9 caps, and collars in relationship to those 10 mortgage pools; is that correct? 11 A. Yes. 12 Q. Did they tell you why they wanted you 13 to do that? 14 A. I don't recall. 15 Q. I would like to direct your attention 16 to Exhibit A10649, which is the micro memorandum 17 to Jenard Gross dated July 3rd, 1986. And it's 18 entitled, "Summary of Smith Breeden presentation." 19 It was Exhibit 437 from your deposition. 20 MR. GUIDO: And it's Tab 187 in the 21 admitted documents, Your Honor. 22 Q. (BY MR. GUIDO) And it says at the 11818 1 beginning, "We met with Mike Giarla of 2 Smith Breeden Associates on June 30, 1986. Mike 3 stated that we are moving along well with all of 4 the data input and cleansing necessary for the 5 overall asset liability model. He anticipates we 6 will have the first output from the asset 7 liability model at the end of July. Smith Breeden 8 has analyzed two specific areas of United's 9 business - our present CMOs and our structured 10 arbitrage program." 11 Do you see that? 12 A. Yes. 13 Q. Does that help explain why you were 14 asked to look at -- refresh your memory of why you 15 were asked to look at the mortgage pools in 16 relationship to the swaps, caps, and collars? 17 A. Again, from this, I'm assuming that it 18 means they were related to each other; but, again, 19 I don't recall specifically the conversations we 20 had back then. 21 Q. When you prepared the study, did you 22 assume they were related to each other? 11819 1 A. That I -- again, I don't know for sure. 2 The way we've done it would kind of lead me to 3 believe that they thought they were related in 4 some way. 5 Q. Now, looking at the analysis of that 6 portfolio on Page 4, which is 1677, sensitivity 7 analysis there, what does that show? 8 A. I'm sorry. Page 4? 9 Q. Yeah, Page 4, the analysis of current 10 value of mortgage pool swaps, caps, and collars. 11 A. Well, I guess it shows several things. 12 One is the gain over book on the mortgage pools is 13 28 million. The loss on swaps, caps, and collars 14 is about 86 million from book. 15 So, the -- this portfolio of mortgage 16 swaps and caps and collars as a whole has a loss 17 of 58 million relative to book, and then the net 18 market value change in the portfolio as rates move 19 is that it's gained slightly as rates go down for 20 100 basis point moves. 21 And then beyond that, it -- it loses 22 for, you know, larger rate moves down; and it also 11820 1 loses in market value as rates go up from base. 2 So, it's fairly well-matched -- fairly 3 well-hedged for short moves and rates but not for 4 larger moves. 5 Q. Now, look at Page 11, which is the 6 discussion. It says the mortgage-backed -- under 7 Bullet No. 2, it says, "The mortgage-backed 8 securities are not quite duration matched with 9 current swaps, caps, and collars - net 10 underhedged." 11 Is that consistent with what you just 12 testified to? 13 A. Yes. 14 Q. What do you mean by "net underhedged"? 15 A. Without any hedges, the mortgages would 16 gain as rates went down and lose as rates went up. 17 "Net underhedged" would still mean they would 18 still gain slightly. I think that was consistent 19 with that exhibit. 20 Q. Then look at Bullet Point No. 4. 21 MR. NICKENS: Your Honor, I apologize; 22 but I've lost the page reference. 11821 1 MR. GUIDO: I think it's the last page 2 of this exhibit, as well. This is the 3 mortgage-backed security analysis. 4 MR. NICKENS: Okay. Thank you. 5 Q. (BY MR. GUIDO) "Change in the value of 6 mortgage prepayment option is not being hedged 7 with swaps, caps, and collars. Portfolio loses 8 for interest rate moves in either direction 9 (except for 1 percent decline in rate levels)." 10 Do you see that? 11 A. Yes. 12 Q. "Suggests hedging the prepayment option 13 via the purchase of options contracts." 14 Do you recall making that 15 recommendation? 16 A. I don't recall exactly at that time 17 making it, but I'm sure we did. 18 Q. Why are you sure that you did? 19 A. It's written here, and it's consistent 20 with what we would have recommended given the risk 21 that was in that portfolio. 22 Q. Now, you again at the top say, "Until 11822 1 analyzing the interest rate sensitivity of the 2 entire firm, I would advise against micro-hedging 3 particular subsets of the firm." 4 Do you see that? 5 A. Yes. 6 Q. Then it goes on and says, "One runs the 7 risks of increasing the overall interest rate risk 8 of the firm by hedging the subset of the company." 9 Is that consistent with what you 10 previously testified to? 11 A. Yes. 12 Q. "Similarly, securities swaps which 13 change the interest rate sensitivity of the firm 14 must also be advised against until the interest 15 rate sensitivity of the entire firm is known." 16 What does that refer to: Securities 17 swaps? 18 A. It refers to, for example, selling a -- 19 one particular mortgage-backed security and buying 20 another one to replace it. 21 Q. Now, as of the date that you did this 22 report -- June 30th, 1986 -- had USAT done a 11823 1 sensitivity analysis of the entire firm of USAT? 2 A. I don't recall. We hadn't done it. We 3 hadn't finished doing it. 4 Q. Prior to that point in time, had one 5 been done? 6 A. I don't know. 7 Q. When you provided -- you did do a 8 valuation of the sensitivity analysis of the 9 entire firm, didn't you? 10 A. Yes. 11 Q. Did they provide you with any work that 12 had been done prior to that? 13 A. I don't remember. 14 Q. Now -- now, let's take a look at the 15 USAT valuation and sensitivity analysis which is 16 Exhibit A10659. Now, this says as of June 30, 17 1986, the date of the report -- excuse me. 18 The date of the report is August 14th, 19 1986. Look at the Bates stamped Page 000040. 20 A. Yes. 21 Q. It says that it -- it's done as of 22 June 30, 1986 -- interest rates -- as of June 30, 11824 1 1986. 2 Do you see that? 3 A. Yes. 4 Q. The earlier study that you had done, 5 the earlier two studies, what were the effective 6 dates of the interest rates that were used for 7 those studies? 8 A. For the interest rate swaps, caps, 9 collars, and mortgage pools, it was May 30th, 10 1986. The CMO analysis was, looks like, 11 June 25th, 1986. 12 Q. So, for the exhibit that we've marked 13 A13004 is June 25th, 1986; and for A13005, the 14 mortgage-backed securities analysis, that was 15 May 30th? 16 A. Right. 17 Q. And this August 14th one was done 18 for -- as of June 30th? 19 A. Yes. 20 Q. Now, can you tell us what 00040 shows 21 with regard to the portfolio at USAT at that -- 22 for the entire firm of USAT at that point in time? 11825 1 A. Okay. Relative to -- let's see. These 2 are expressed as gains or losses relative to book 3 value, I believe. So, the bottom -- if you look 4 at the very bottom line under the column that's 5 labeled "base," the number is negative 6 189.7 million. So, that's the combined -- our 7 estimate of the value of the combined portfolio of 8 assets and liabilities. And I have one footnote 9 that I -- there's a loss relative to book of 10 189.7 million. Our analysis of liabilities, like 11 deposits, doesn't take into account any franchise 12 value. 13 THE COURT: Mr. Guido, I'm not sure 14 where we are. 15 MR. GUIDO: I'm sorry. It's Exhibit 16 A10659, Your Honor; and it's entitled, "United 17 Savings Valuation and Sensitivity Analysis, 18 August 14, 1986." 19 THE COURT: Where does it say 20 August 14th? Okay. 21 MR. GUIDO: Then if you look at the 22 Bates stamp 00040, it's in the middle of the page 11826 1 at the bottom. 2 THE COURT: Thank you. 3 MR. GUIDO: That says that the 4 effective date yield curve rates are as of 5 June 30th, 1986. So, even though the report is 6 dated August 14th, the valuation date is June 30, 7 1986. 8 THE COURT: Thank you. 9 A. So -- 10 Q. (BY MR. GUIDO) Mr. Giarla, you said at 11 the base rate, the net loss was 189,707,000 based 12 on those interest rates at that date? 13 A. Right. 14 Q. And of that was -- if you look at the 15 line above that under swaps, caps, and collars was 16 the loss 117,821,000? 17 A. Yes. 18 Q. And then the net loss for assets and 19 liabilities was 71,886,000? 20 A. Right, yes. 21 Q. So, that is one of the conclusions that 22 you reached in that study? 11827 1 A. Right. 2 Q. Okay. Now, what does it show happens 3 with changes in interest rates? 4 A. The liquidation value decreases as 5 rates fall. You see the negative numbers get 6 larger in absolute value. 7 Q. As rates fall, they lose more money? 8 A. They lose more, right. And as rates 9 rise, they gain -- for a 100 basis point move, the 10 loss gets less, goes from 189.7 to 174.8; so, they 11 gain slightly. For larger moves up, the 12 liquidation value falls beyond there. 13 Q. Now, what did you recommend that they 14 do in response to what you discovered in doing 15 your sensitivity analysis? 16 A. Well, in this particular report, we 17 showed two different things, I guess. One was we 18 demonstrated how the -- how, by using options, 19 they could better hedge against that prepayment 20 risk for large moves in interest rates in either 21 direction. So, that's shown starting, I think, on 22 Page 11. 11828 1 Q. Which is Bates stamp 00049? 2 A. Right. So, we showed, I think, two 3 different examples of options portfolios and 4 examples of ways to provide protection against the 5 large moves in rates; and we showed kind of 6 annualized costs of that, of each of those. 7 So, the one on Page 11, Bates stamped 8 000049, provides more protection than the one on 9 the subsequent page; and, therefore, it costs 10 more. That was one thing. 11 Then the other -- 12 Q. Let's just stop right there. On 13 Page 11, you recommended if they wanted full 14 protection, that they could get that protection 15 with the annualized cost of options of 16 $16.3 million. Right? 17 A. Right. 18 Q. Then on Page 12, you said they could 19 capital maximum loss of $9 million and an annual 20 cost of $10 million. 21 Do you see that? 22 A. Right. 11829 1 Q. Why did you provide them with two 2 recommendations? 3 A. I think just from our experience in 4 showing institutions different ways to hedge, it's 5 always -- especially with options, the one 6 question that often comes up is, well, how, you 7 know -- how much protection do you want? How many 8 options do you want to buy? How totally do you 9 want to protect? I guess the way to think about 10 it is the insurance analogy, which is what 11 deductible do you want to have? Do you want a 12 zero deductible or do you want 250,000 or 13 10 million? 14 You can think of Page 11 as having a 15 lower deductible than the one on Page 12; and, 16 therefore, it costs less. I don't recall the 17 discussions at that point; but it was common to 18 get into discussions with our clients about, you 19 know, comparing different levels of option 20 protection versus the cost of each of those. 21 Q. Now, did you make any other 22 recommendations? 11830 1 A. Looks like we took a look at the 2 mortgage-backed securities in their portfolio and 3 we looked to see, if it was our portfolio, if we 4 were managing the portfolio, what securities would 5 we sell and which securities would we replace 6 those with in order to earn a higher risk-adjusted 7 return, you know, based on our own models. 8 So, on Page 13 of the report, we said 9 given the marketplace as it stands on that 10 particular day, we thought they could sell -- it 11 would be wise to sell the securities on the left 12 and buy the securities on the right or, actually, 13 I guess, buy Fannie Mae 12 and a halfs and we 14 would replace everything on the page with 15 Fannie Mae 12 and a halfs; and we showed an 16 estimate in increase of income on a hedge basis as 17 a result of that swap again using our analysis of 18 our models. 19 Q. Now, why were you recommending that 20 they purchase Fannie Mae 12 and a halfs and 21 replace what they had in their portfolio? 22 A. I guess -- do you mean how did we come 11831 1 up with the -- 2 Q. How did you come up with the idea -- or 3 how did you determine that they would be better 4 off if they purchased Fannie May 12 and a halfs 5 and sold the Fannie Maes that they had and the 6 Ginnie Maes they had and the Freddie Macs that 7 they had? 8 A. It's based on Smith Breeden's 9 option-adjusted spread analysis. We look at -- 10 this is what we would do for all our clients 11 typically is look at the securities that they 12 currently owned, look at -- once you take the 13 current price and yield and make the adjustments 14 for all the different risks as I talked about 15 earlier and come down to a risk-adjusted spread, 16 we would look at all the securities they would own 17 and compare them to what else was available in the 18 marketplace. And if what they owned had a lower 19 risk-adjusted return than what they could obtain 20 somewhere else in the marketplace, we would 21 recommend that they sell something else and buy 22 something that was more profitable. 11832 1 I'm sure we did that analysis here on 2 their portfolio and made a recommendation. And at 3 the time, it must have seemed to us that 4 Fannie Mae 12 and a halfs were pretty attractive 5 mortgaged securities to own relative to other 6 mortgage-backed securities. 7 Q. Now, what else did you recommend? Did 8 you recommend that they put options on when they 9 bought the 12 and a halfs replacing those that 10 they sold? 11 A. Well, it looks like -- if you go to 12 Page 16 -- Page 16 takes our initial analysis, 13 subtracts out, I believe -- well, okay. I jumped 14 ahead. 15 If you look at Pages 14 and 15, they 16 take the first analysis from this document and 17 then we subtract out the mortgage securities that 18 we recommended that they sell and then we added in 19 Fannie Mae 12 and a halfs. So then we have a new 20 net effect of rate changes. 21 The bottom of Page 15 would show what 22 the institution would look like if they took our 11833 1 recommendation to sell everything shown on Page 13 2 and buy Fannie Mae 12 and a halfs. 3 On Page 16 and 17, we say if you did 4 that, then these are some hedge adjustments that 5 you might want to make to reasonably balance 6 your -- the interest rate risk of the institution. 7 Again, we showed a couple of possibilities, 8 although the one on Page 17 looks a little strange 9 to me. 10 Q. Okay. So, then you -- 11 A. I'm not sure what that one is. 12 Q. Pardon? 13 A. I'm not quite sure what the one on 14 Page 17 is since it costs more but is not as well 15 matched as the one on Page 16. 16 Q. And did you make any other 17 recommendations to them? 18 A. Then on Page 18, we discussed 19 growing -- we discussed purchasing mortgage 20 securities through a service corporation on a 21 hedge basis and generating incremental earnings 22 for the institution. 11834 1 Q. Now, what was the service corporation 2 investment you were recommending? 3 A. Well, as I read this, it says 4 160 million could be added -- in equity could be 5 added to the service corporation, I guess, based 6 on their size at that point. 7 Q. Okay. And did you then value the 8 effect that that -- that adding those 9 mortgage-backed securities in the service 10 corporation would have on the interest rate 11 sensitivity of USAT? 12 A. Right. That's shown on, I believe, the 13 next page, on the page Bates stamped 57. 14 Q. Now, where does that -- does that 15 include -- the Bates stamped 57, does that 16 include, also, the swap to the 12 and a half 17 Fannie Maes that you were recommending or is that 18 separate from that or can you tell? 19 A. It would take me a little while to 20 figure it out. I'm not sure -- I'm not sure 21 whether it does or not. 22 Q. So, as of August 14th, after you had 11835 1 done the entire sensitivity analysis of the firm, 2 you were recommending, one, that USAT purchase 3 options to protect itself against the prepayment 4 risk? 5 A. Right. 6 Q. Two, that it sell some of its portfolio 7 and replace that portfolio with Fannie Mae 12 and 8 a halfs. Right? 9 A. Right. 10 Q. And hedge those with options contracts. 11 Right? 12 A. Well, we -- we would be hedging 13 whatever the residual risk that was left. I mean, 14 some of the hedges they had in place would be 15 hedging those mortgages; but then we -- we also 16 recommended, you know, options to rebalance -- top 17 kind of refine the hedge. 18 Q. Okay. And then you were recommending 19 that they purchase $1.6 billion in mortgage-backed 20 securities in the service corporation. Right? 21 A. Right. 22 Q. And what was the hedge that you were 11836 1 recommending or the hedges that were to be put on 2 in the service corporation? 3 A. I'm not sure that it -- let's see what 4 it says here. I'm not sure that it says here, but 5 it would have presumably been interest rate swaps 6 and futures and options, I would think. 7 MR. GUIDO: Your Honor, I'm finished 8 with this segment of my questioning; and it's 9 12:30. This might be a good time to break. 10 THE COURT: How much longer do you 11 have? 12 MR. GUIDO: I have maybe, at most, an 13 half an hour, Your Honor, maybe 15 minutes; but 14 I -- I mean, it just takes time for me to get the 15 final questions together. 16 THE COURT: Mr. Nickens, you're going 17 to cross examine? 18 MR. NICKENS: I mean, Your Honor, this 19 witness has a 4:30 flight. He has indicated that 20 it would be -- if we don't meet that schedule or 21 don't finish by that time, that it would be more 22 important -- it would be more convenient for him 11837 1 to come back at a later time rather than stay over 2 tonight because of his business that he has 3 tomorrow. I will do everything I can, assuming we 4 meet Mr. Guido's schedule to finish; but I can't 5 guarantee that we're going to be there. 6 MR. GUIDO: One of the questions -- I 7 had a conversation with the witness coming in this 8 morning, and there may be -- I don't know if 9 there's a possibility of a flight an hour or two 10 later today so that we can finish this and avoid 11 having him come back, but I am pretty much 12 finished. 13 Your Honor, I think we can get this 14 witness in and out today. I don't know how he 15 feels about later flights. 16 THE COURT: Where are you flying to? 17 THE WITNESS: I have to be in 18 Chapel Hill, North Carolina -- 19 THE COURT: There's only one flight? 20 THE WITNESS: There's a 4:30 that gets 21 me in at 10:30. We could try for a 6:30, and that 22 one gets in at midnight. I don't know whether 11838 1 that's available. 2 MR. GUIDO: Is it your preference to 3 see if that's available? 4 THE COURT: Well, it's certainly 5 preferable if we could finish this witness today. 6 And I'm thinking if we come back at 2:00 and you 7 have a half an hour, that's 2:30; and then 8 Mr. Nickens has a half an hour. That seems a 9 little tight. 10 We'll adjourn until 2:00. 11 12 (Lunch break.) 13 14 THE COURT: Be seated, please. 15 We'll be back on the record. 16 Mr. Guido, you may continue with your examination. 17 MR. GUIDO: Thank you, Your Honor. 18 Q. (BY MR. GUIDO) Mr. Guido, I would like 19 to direct your attention to the October 13th 20 letter, again, from you to Ms. Laurenson. That's 21 Exhibit B1257. 22 Do you have that? 11839 1 A. Yes. 2 Q. It has the copies going to Mr. Charles 3 Hurwitz, Mr. Michael Crow, and Mr. Doug Hansen. 4 Why did they receive copies of that 5 letter? Do you know? 6 A. I don't recall. 7 Q. You indicated that you had met 8 Mr. Hurwitz at some meeting? 9 A. Right. I believe I only met him once 10 at the September 15th meeting. 11 Q. The strategy meeting? 12 A. Right. 13 Q. Now, let's turn to Exhibit A10665, the 14 growth and capital strategy - next six months memo 15 dated September 8th, 1986, from Doug Hansen to 16 Charles Hurwitz, Jenard Gross, Barry Munitz, Jerry 17 Williams, Mike Crow, Art Berner, Bruce Williams, 18 and Jim Wolfe. 19 Does that have your handwriting on the 20 document? 21 A. Yes. 22 Q. And is that -- the Bates stamp 11840 1 Nos. 000914 through 000919 Bates stamps that were 2 put on that document by Smith Breeden Associates? 3 A. Yes. 4 Q. Is this a document that was produced to 5 the OTS in response to a subpoena that was served 6 on Smith Breeden & Associates? 7 A. Yes. 8 Q. Is that a document that was provided to 9 you by people at USAT for the September 13th 10 strategy meeting -- 11 A. I believe so. 12 Q. -- which is A10666? 13 A. I believe so. 14 Q. Is A10666 a -- it says, "United Savings 15 Association strategy meeting - September 15th, 16 1986." Is that a document that was generated by 17 Smith Breeden Associates? 18 A. Yes. 19 Q. And did you rely upon any of the 20 information in A10665 to prepare Exhibit A10666? 21 A. I imagine some of the issues from the 22 September 6th or whatever -- September 8th letter 11841 1 were addressed in my -- in the September 15th 2 strategy meeting document. 3 MR. GUIDO: I would like to move the 4 admission of Exhibit A106657 and S10666, Your 5 Honor. 10666 may be in the record under another 6 number. 7 MR. NICKENS: A10666 is at Tab 870. 8 MR. GUIDO: A10665 has not been 9 introduced, Your Honor. We move the admission of 10 A10665. 11 MR. NICKENS: Your Honor, I have no 12 objection to A10665; but the Bates numbers that 13 Mr. Guido read out are different than our copy, 14 which is an issue we would like to get 15 straightened out. 16 THE COURT: It appears that the 17 document, 10666 or 10655, does not have the 18 handwriting on it. 19 MR. GUIDO: The one that's in the 20 record does not have the handwriting. 21 MR. NICKENS: That's correct, Your 22 Honor. What happened, I think, is that this copy 11842 1 has been taken from a different file. Mr. Giarla 2 produced some documents to the OTS that had this 3 document in it; and it's just that somehow or 4 another, the copies have been mixed up. 5 MR. GUIDO: Why don't we mark this 6 10665.1, Your Honor? 7 THE COURT: Well, it's in the record as 8 T4246; so, I think the logic is -- 9 MR. GUIDO: Just leave it at 10665? It 10 is the same document, Your Honor. This happens to 11 be Mr. Giarla's rendition -- 12 THE COURT: Maybe one should be T4246A 13 or some related to the document that is in. Does 14 that create a problem? 15 MR. GUIDO: Your Honor, this document 16 I'm going to use for a purpose other than what the 17 other document was used for because it has some 18 notes in it that tie into the strategy meeting of 19 September 15th. 20 THE COURT: All right. Well -- so, you 21 want to put it in -- you want to put them both in? 22 MR. GUIDO: Yes, Your Honor. 11843 1 THE COURT: Okay. 2 MR. GUIDO: And the other copy is -- 3 MR. NICKENS: Could we get a copy? If 4 there's handwriting that is significant -- I've 5 seen the document. I don't have an objection to 6 it, but I don't have a copy of it. 7 MR. GUIDO: Here you go. 8 THE COURT: And the other one, 10666, 9 also has been received earlier. 10 MR. GUIDO: I think that that is the -- 11 this is the same copy of what's been admitted, 12 Your Honor. Tab 870. 13 THE COURT: All right. 10665 is 14 received. 10666 is already in evidence. 15 Q. (BY MR. GUIDO) Now, I would like to 16 direct your -- 17 MR. NICKENS: Your Honor, I'm sorry. 18 As I understand it, Mr. Guido is offering a 19 document that is identical to A10665 but that it 20 has handwriting on it that he's going to discuss 21 with the witness and that we are going to identify 22 as A10665-1. 11844 1 MR. GUIDO: I thought -- 2 THE COURT: That document is in as 3 Exhibit T4246. It's already been received. 4 MR. NICKENS: The one with the 5 handwriting -- 6 THE COURT: Without the handwriting. 7 10665 has the handwriting. Is that clear? 8 MR. NICKENS: No, Your Honor. I'm 9 sorry. My copy of 10665 -- 10 THE COURT: Well, the copy that 11 Mr. Guido gave out this morning has handwriting on 12 it. 13 MR. NICKENS: I think that what 14 happened is that he determined that this was the 15 same as 10665, put that number on the one with the 16 handwriting even though it -- I mean, it is a 17 little different because of the handwriting. 18 MR. GUIDO: Your Honor, I think -- can 19 I make a statement? I think the document was in 20 as -- 21 THE COURT: Let's be off the record for 22 a minute. 11845 1 (Discussion held off the record.) 2 3 THE COURT: Back on the record. 4 MR. GUIDO: I offer the document that 5 has the handwriting on it which is Exhibit 444 6 with Bates stamp 914 through 919, the 7 September 1986 memo from Doug Hansen to Charles 8 Hurwitz and others regarding growth and capital 9 strategy - next six months as A10665-1. I also 10 offer the same document that does not have the 11 handwriting on it, nor does it have the 12 Smith Breeden Bates stamp numbers on it, as 13 A10665; and that document has Bates stamp US463 14 through 469, Your Honor. 15 THE COURT: All right. Received. 16 Q. (BY MR. GUIDO) Now, I would like to 17 direct your attention to A10665-1, which -- 18 MR. GUIDO: Have these been admitted? 19 THE COURT: Yes. 20 Q. (BY MR. GUIDO) Page 918, the Bates 21 stamp Page 918 where it says, 22 "Smith Breeden/senior management meeting will be 11846 1 held on Monday, September 15th, from 3:00 p.m. to 2 9:00 p.m. Attending: Hurwitz, Gross, Munitz, 3 B. Williams, Berner, Crow, B. Williams again, 4 Wolfe, Heubsch, Phillips, Hansen, Smith, Breeden, 5 Giarla, Schumacher. The agenda: UFB current 6 position and interest rate risk, recommendations 7 on strategy for UFB and for the risk-controlled 8 arbitrage portfolio, hedging, Smith Breeden 9 philosophy, CMOs. Prior to the September 15th 10 meeting, B. Williams, Wolfe, and Hansen will go to 11 Chapel Hill, North Carolina, to help develop the 12 recommendations and the presentation." 13 Did you attend a meeting in Chapel Hill 14 with Bruce Williams, Mr. Wolfe, and Mr. Hansen to 15 help develop the recommendations for the 16 September 15th presentation? 17 A. I don't recall whether we had a meeting 18 or not. 19 Q. Do you recall whether or not there was 20 a meeting ever scheduled? 21 A. I don't. 22 Q. Do you recall whether or not there were 11847 1 any events that may have precluded a meeting? 2 A. As I look through some other documents 3 here, there is some reference to having a client 4 seminar. It may be that -- which would have taken 5 place around the same time. 6 So, it may be that that preempted a 7 meeting with these folks. 8 Q. You don't recall? 9 A. I don't recall either way. 10 Q. Now, looking at the handwriting on the 11 document, that is your handwriting? 12 A. Yes. 13 Q. And do you recall whether those were 14 notes that you took discussing this memorandum 15 with someone, or were they just your review of the 16 memorandum in preparation for the September 15th 17 meeting? 18 A. It looks like I wrote these notes as I 19 was reading it by myself. 20 Q. Now, was the memorandum provided to you 21 for purposes of preparing for the September 15th 22 meeting? 11848 1 A. I presume so, but I don't recall 2 exactly when it was given to us or what the 3 circumstances were. 4 Q. Now, let's turn to the meeting itself, 5 which is at Tab 870. It's A10666. It says, 6 "United Savings Association strategy meeting - 7 September 15th." 8 Who attended that meeting from the USAT 9 side? 10 A. Well, I'm not sure that I can recall 11 everyone. I know that Mr. Hurwitz was there. 12 That's when I remember meeting him. I'm pretty 13 sure Mike Crow was there. You know, I don't 14 recall the other people. I assume Doug Hansen and 15 Bruce Williams were there, but I can't be sure. 16 There may have been other people. 17 Q. Now, at that meeting, did you present 18 the report that you had prepared on June 30th on 19 the CMOs? 20 A. That, I don't recall. 21 Q. Did you present the results of the 22 study that you had done on the MBS portfolios? 11849 1 A. Again, I don't recall explicitly 2 presenting those at that meeting. 3 Q. Look at the back at 10665-1 again where 4 it says "the agenda" on the page Bates stamped 5 918. It says, "Recommendations on strategy from 6 UFG for the risk-controlled arbitrage portfolio 7 hedging Smith Breeden philosophy CMOs." 8 Do you see that? 9 A. Right. 10 Q. Do you recall whether the meeting was 11 basically a meeting where Smith Breeden made a 12 presentation? 13 A. I know we -- I'm sure we made a 14 presentation. I'm sure this 10666 was part, if 15 not all, of that. 16 Q. Okay. Now, was there a discussion with 17 the representatives of USAT about the 18 recommendations at that meeting on September 15th, 19 1986? 20 A. I believe so. 21 Q. Okay. Do you recall who participated 22 in it? 11850 1 A. Other than the Smith Breeden people, I 2 don't remember who from United. 3 Q. Did Charles Hurwitz? 4 A. I don't remember. 5 Q. Did Michael Crow? 6 A. Again, I don't remember any 7 conversations really from that meeting. 8 Q. All right. Now, in this document, you 9 reached some conclusions that are on Bates stamp 10 US2061, Page 8 of the document. 11 Do you see those conclusions? 12 A. Yes. 13 Q. Were those conclusions that you drew 14 from the growth and capital strategy memo that is 15 A10665-1? 16 A. Well, the memo may have been an input 17 or certainly had some information in it; but I 18 think the conclusions were, you know, mainly 19 Smith Breeden. Again, I don't remember when we or 20 when I received this other memo or how it was used 21 in the context of the September 15th meeting. 22 Q. Then you made some recommendations on 11851 1 Page 9 of 10666? 2 A. Right. 3 Q. A10666. Bates stamp 2062. Do you see 4 those recommendations? 5 A. Yes. 6 Q. And the first is immediate strategies. 7 It says, "Take gains on portfolio to offset 8 operating losses." 9 Do you see that? 10 A. Yes. 11 Q. Then if you look down to the fifth 12 bullet point, it says, "Swaps in existing 13 portfolio." 14 Do you see that? 15 A. Yes. 16 Q. What were you referring to when you 17 were referring to swaps in existing portfolio? 18 Was that your recommendation, that they sell 19 mortgage-backed securities that are in their 20 portfolio and buy those 12 and a half Fannie Maes? 21 A. I don't know if it refers to that 22 specific recommendation, but it would be a similar 11852 1 recommendation. 2 Q. So that when you use the term "swaps," 3 what you're talking about is you buy some 4 mortgage-backed securities to replace some that 5 you sell? 6 A. Right. 7 Q. And then what are you referring to when 8 you say "take gains on portfolio to offset 9 operating losses"? Is that a swap transaction, as 10 well? 11 A. No. It would be -- well, it may be in 12 conjunction with a swap; but it would be to 13 generate accounting income if they had, you know, 14 gains on the asset side. 15 Q. You were recommending that they sell 16 assets to generate gains if they were in -- if 17 they had any unrealized gains in any assets? 18 A. Right. The context of it is, 19 basically, the institution needs at that point to 20 preserve its capital and maybe add additional 21 capital so that it could continue to pursue 22 economically profitable activities. So, one way 11853 1 to preserve their capital would be to recognize 2 gains where they had them to offset operating 3 losses. 4 Q. So, you're recommending that they 5 make -- they sell any profitable assets that they 6 have in their portfolio? 7 A. Well, I think -- I'm not saying they 8 should sell all or any; but that was one strategy, 9 would be to take some gains, yeah. 10 Q. Then the next -- look at the second 11 bullet point. Strategically offsetting positions 12 which generate accounting income if interest rates 13 move? 14 A. Right. 15 Q. Look at Page 11, Bates stamp 2064, and 16 Page 12, Bates stamp 2065, and Page 13, Bates 17 stamp 2066. 18 Is that the sort of transaction that 19 you were referring to? 20 A. Yes. 21 Q. Now, is that basically a transaction 22 where you're recommending to the client that they 11854 1 buy both sides of the transaction and then when 2 interest rates move in either direction, they take 3 the gain on the side that has a gain? 4 A. That's one possibility would be to take 5 it -- to take the gain. They don't have to, but 6 it's there to create flexibility. So, for 7 example, there are many instances in the past 8 where we had seen clients, when interest rates 9 rose, who wouldn't take advantage of profitable 10 opportunities to sell assets because they had 11 losses on them. So, this type of situation 12 creates an environment where you can find 13 something on the balance sheet that has gains when 14 rates go up. 15 So, you can, for example, sell some 16 assets that has losses on them and take the gains 17 on the accounting side and reinvest the assets. 18 So, it allows the client to do some things that it 19 wouldn't or it might not have been able to do 20 otherwise. 21 Q. Is it fair to characterize this as a 22 transaction where they could take gains on one 11855 1 side of the transaction and -- the asset or 2 liability side -- and defer the losses on the 3 other side? 4 A. I think they could. 5 Q. Is that basically what this is 6 describing, this transaction? 7 A. Yeah, that's one effect of it. 8 Q. Then the third is increase consolidated 9 assets through service corporations which will 10 purchase mortgage-backed securities and hedge 11 against interest rate risks. Is that essentially 12 the proposal that you made in the August 14th 13 memorandum about investing in service 14 corporations -- 15 A. Yes. 16 Q. -- which was Exhibit A10659? 17 A. Yes. 18 Q. And then look at the sixth bullet 19 point: "Strategically set pre-payment rates in 20 order to maximize accretion of discount and 21 minimize amortization of premium on mortgage 22 related securities." 11856 1 What does that refer to? 2 A. Well, to the -- well, mortgage 3 securities aren't all bought at the same price. 4 They could either be bought at par, which is $100 5 per hundred face amount or you could buy them at a 6 premium which is more than 100 or less than 100, 7 which is a discount. And in order to deal with 8 the accounting for that premium or discount, the 9 institution would use some prepayment assumptions. 10 And, for example, if you had a premium mortgage, 11 the faster the prepayment rate, the faster you 12 would write off the premium. 13 So, to the extent that the institution 14 had some leeway in selecting the prepayment 15 assumptions that it used, the lower the prepayment 16 rate you used on discounts -- or the higher the 17 prepayment rate on premiums, the more favorable 18 the accounting would be. 19 Q. How would they be able to do that? I 20 thought prepayment rates were just prepayment 21 rates. 22 A. Again, I'm not an accountant. At least 11857 1 there is some interim period -- maybe it's the 2 interim year where the institution has some leeway 3 in selecting what prepayment assumptions it uses. 4 I assume their auditors look at it and make sure 5 it's reasonable. I don't believe every month they 6 use the actual prepayment experience. 7 Q. Now, I would like to direct your 8 attention back to Exhibit A13003. I would like to 9 direct your attention -- that's your introduction 10 to hedging interest rate risks with futures, 11 swaps, and options paper. I would like to direct 12 your attention to the page Bates stamped -- I'm 13 sorry. That's the wrong document. I'm sorry. I 14 misspoke. 15 I want to direct your attention to 16 Exhibit A10654, which is your paper on 17 introduction to risk-controlled arbitrage and 18 particularly Bates stamp 526, which is Page 3 of 19 the memo. That paragraph says, "For the duration 20 of the arbitrage, the investor should be 21 constantly looking for profitable swap 22 opportunities." 11858 1 Now, by "swap opportunities," did you 2 mean something similar to your recommendation that 3 they sell various mortgage-backed securities and 4 purchase the Fannie Mae 12 and a halfs? 5 A. Yes. 6 Q. "By buying those securities that appear 7 undervalued relative to all other potential 8 investments and then selling these when the market 9 dictates (when the duration adjusted spreads to 10 treasury on the securities held are no longer 11 attractive relative to alternative mortgage-backed 12 securities)." 13 Do you see that? 14 A. Yes. 15 Q. What does that refer to? 16 A. Well, the nomenclature's consistent. 17 The duration adjusted spread is the same thing, 18 what I talked about as being the risk-adjusted 19 spread earlier. That's a measure of the profit or 20 the risk-adjusted profit that we would calculate 21 on a particular security if they bought it and 22 hedged it. 11859 1 So, what we're saying is you always 2 want to hold the securities whose option-adjusted 3 spreads are the widest. What this says and what 4 this means is you would buy things with a wide 5 spread and you would sell them if that spread 6 subsequently tightened relative to other things in 7 the marketplace. 8 Q. So, what you're recommending here is 9 that they buy mortgage-backed securities that have 10 a higher spread to treasuries than other 11 mortgage-backed securities? 12 A. A higher hedged spread. 13 Q. To treasuries? 14 A. Right. Right. 15 Q. And how often does that occur per year? 16 A. Well, I would say on average, we would 17 find probably twice a year some major 18 opportunities to shift the characteristics of the 19 portfolio. I mean, that's just kind of an 20 estimate over a long period of time; but there may 21 be small opportunities that you could find every 22 month. I would say probably twice a year is kind 11860 1 of our average. 2 THE COURT: Excuse me. I'm not sure I 3 understood. How do treasuries fit into this? 4 You're talking about mortgage-backed securities 5 being hedged with what? 6 THE WITNESS: Typically, it would be a 7 combination of short-term borrowings -- either 8 deposits or short-term collateralized borrowings 9 where you would use the securities as 10 collateral -- short position in either treasury 11 futures or interest rate swaps where you pay fixed 12 and receive floating. 13 THE COURT: When you say "treasuries," 14 you mean options on treasuries? 15 THE WITNESS: Treasury notes and 16 treasury bonds. Interest rate swaps are priced at 17 a spread over treasuries. The way that people 18 look at mortgage securities is to benchmark them 19 relative to the treasury curve. So, if you have a 20 mortgage security with a similar duration to, 21 like, a seven-year treasury, you basically compare 22 the rates on that to each other. 11861 1 Q. (BY MR. GUIDO) The spread to treasury 2 is the difference between the treasury interest 3 rate for that duration and the mortgage-backed 4 security of the same duration; is that right? 5 A. Right. 6 Q. So, if you have a 10-year treasury at 7 9 percent and you have a spread to treasury of 8 170 points, that would be a mortgage-backed 9 security interest rate of 10.7 percent? 10 A. Yes. 11 Q. And that 10.7 percent was calculated 12 using your methodology of ascertaining what the 13 prepayment rates are and, therefore, developing 14 your duration value of that security; is that 15 correct? 16 A. Right. And in our -- in here where it 17 says "duration adjusted spreads," that also would 18 include the options cost that we talked about. 19 Q. You first have to duration adjust the 20 value of the mortgage-backed securities to its 21 expected life? 22 A. Right. You come up with an estimate of 11862 1 how the -- how sensitive the mortgage price was to 2 interest rate moves and find a treasury security 3 that has a similar price sensitivity. 4 Q. It's a differential between the two? 5 A. Right. 6 Q. And then to do one of these swap 7 opportunities utilizing that methodology is that 8 you want to buy the security that has the 9 option-adjusted spread greater than those that 10 you're selling? 11 A. Yes. 12 THE COURT: Okay. 13 Q. (BY MR. GUIDO) Now, does the 14 transaction, the swap transaction, involve 15 transaction costs? 16 A. Yes. 17 Q. And are those -- were those transaction 18 costs in 1985 greater than they are today? 19 A. Maybe slightly but not much greater. 20 Q. Were those transaction costs costs that 21 one had to take into consideration when 22 determining whether or not to do the swap 11863 1 transaction? 2 A. Well, we would certainly take them into 3 account. 4 Q. Now, did you have a rule of thumb of 5 how many basis points there had to be in the 6 differential before you could justify the 7 transaction? 8 A. No, because we would -- for example, in 9 calculating the option-adjusted spread, if you 10 were -- when it came down to doing a swap, you 11 would use -- for example, if you were selling the 12 mortgage, you would use the sale price in the 13 calculations. If you were buying, you would use 14 the purchase price. That would take into account 15 the bid/ask spread. There's no brokerage fee on a 16 mortgage spread. 17 Q. When you did these transactions or the 18 transactions that you were advising being done 19 here, did you advise against just simply using the 20 yield on the mortgage-backed securities as a 21 criteria for determining whether or not a swap was 22 justifiable or not? 11864 1 A. If it was just an unhedged yield, not 2 looking at the options, risk, or interest rate 3 risk, then, yes, we would advise against it. 4 Q. Did you advise against it? 5 A. Generally -- 6 MR. NICKENS: Did he advise USAT 7 against it? 8 Q. (BY MR. GUIDO) Did you advise USAT? 9 A. I don't know specifically other than 10 what's in the literature that we went over. 11 Q. So, the only advice that you gave is in 12 this literature that we're seeing today? 13 A. Plus whatever we discussed, but I don't 14 remember the specific conversation. 15 Q. Now, I would like to show you a packet 16 of -- one of the client letters that you provided, 17 and I've had those marked as A13006. And I would 18 like to direct your attention to the first -- 19 first of all, I guess I should read into the 20 record what these are. 21 MR. GUIDO: These are letters to all 22 clients at various dates. The first one is 11865 1 March 5th, 1986. The second is March 14th, 1986. 2 The third is March 21st, 1986. The fourth is 3 March 31, 1986. The fifth is April 11, 1986. The 4 sixth is April 18th, 1986. The seventh is 5 April 25th, 1986. The eighth is May 2nd, 1986. 6 The ninth is June 26, 1986. The tenth is 7 July 11th, 1986. The 13th is August 5th, 1986. 8 The 14th is August 29. The 15th is September 22. 9 The 16th is October 10. The 17th is November 3rd. 10 The 18th is December 16th. The 19th is 11 February 3rd, 1987. The 20th is March 3rd. 12 THE REPORTER: Slow down, please. 13 Q. (BY MR. GUIDO) February 3, 1987. 14 March 3, 1987. April 8th, 1987. May 6th, 1987. 15 June 22, 1987. July 28, 1987. October 5, 1987. 16 October 20, 1987. December 30, 1987. 17 I would like to move the admission of 18 those documents plus the cover letter to me from 19 Michael Giarla dated May 30, 1988, Your Honor. 20 MR. NICKENS: Your Honor, my only 21 objection is that there is no showing that these 22 records went to USAT. I think they could be 11866 1 received -- and some of them both precede and come 2 after the USAT relationship. I think they can be 3 received in the record, and I don't have any 4 objection for what they are worth otherwise. But 5 until they are shown to be -- to have been given 6 or the information transmitted to USAT, then I 7 would have that objection. 8 THE COURT: All right. Received. I 9 think we should see what this witness knows about 10 who received these documents. 11 Q. (BY MR. GUIDO) Now, this packet of 12 materials are a packet of materials that I 13 requested from you, are they not? 14 A. Yes. 15 Q. And they are a packet of materials that 16 I requested from you in light of the fact that I 17 noticed that attached to the Sandy Laurenson 18 Exhibit B1257 was the October 10th, 1986 market 19 update letter? 20 A. Right. 21 Q. Now, these documents reflect your views 22 of the market during the time periods covered by 11867 1 these letters, do they not? 2 A. Yes. 3 Q. And during the period of time that you 4 were retained by USAT, did you provide these 5 letters to USAT? 6 A. I believe we provided them for the -- 7 not during the project but during the 8 subsequent -- I don't know how to describe it, but 9 when we shifted from being hired to do this 10 project to where we were kind of in an ongoing 11 investment advisory relationship with USAT. 12 That's typically when they would have been 13 provided with these market update letters. I 14 don't know if we provided them before that or not. 15 Q. Do you know whether or not you provided 16 them with all of those that are in this packet? 17 A. I certainly doubt it. I certainly 18 wouldn't have provided anything after the 19 relationship ended, and I doubt they would have 20 received it prior to the relationship being 21 consummated. 22 Q. Now, I would like to direct your 11868 1 attention to the document dated March 5th, 1986, 2 the second paragraph. Let's do the first 3 paragraph. It says, "Over the last few days, 4 significant compression of prices has occurred in 5 the premium coupon sector, defined as 10 and a 6 half to 15 percent coupons. This price 7 compression has been precipitated by the heavy 8 selling of these coupons based on the market's 9 perception that grossly higher prepayments will 10 occur on these coupons. At the writing of this 11 report, the market is indicating an acceleration 12 in pre-payments of 1.5 to 4 times January's level 13 of constant annual prepayment, depending on the 14 particular coupon. As pointed out in earlier 15 letters, our analysis indicates the market's 16 projection of prepayment rates is overstated, and 17 this overstatement has become more exaggerated 18 over the past few weeks." 19 Do you see that? 20 A. Yes. 21 Q. Did you recommend during the period of 22 time that you were retained by USAT that mortgage 11869 1 premium mortgage-backed securities be purchased to 2 be included in client's portfolios? 3 A. Yes. 4 Q. Did that include the purchase of 12 and 5 a half Fannie Maes? 6 A. I believe so, yes. 7 Q. Now, I would like to direct your 8 attention to the April 11th, 1986 memorandum to 9 all clients. It says -- the last paragraph on the 10 first page. "Fannie Mae prepayment data for March 11 was released this week. Prepayments were sharply 12 higher in March than in February but were not as 13 dramatic as those recorded on Freddie Mac 14 securities for the same period. Coupons below 15 10 percent demonstrated a 15 percent increase on 16 average while those coupons above 10 percent 17 demonstrated prepayment increases of 50 percent. 18 11 percent to 12.25 percent coupons showed the 19 largest increase of 40 to 200 percent. These 20 prepayment increases were slightly lower than our 21 expectations." 22 Do you see that? 11870 1 A. Yes. 2 Q. Is that correct? 3 A. I assume so. I mean, there's not 4 enough information. I have no reason to doubt it. 5 Q. The accuracy of that conclusion? 6 A. Right. 7 Q. Then I would like to direct your 8 attention to the August 5th, 1986 newsletter. It 9 says in the first sentence, "Smith Breeden has 10 changed its method for calculating pre-payments. 11 The old method assumed that the percentage of 12 mortgages pre-paying each month would simply be 13 the stated annual prepayment rate divided by 12." 14 Then it goes on to describe the 15 disadvantage. In the third paragraph down -- this 16 is what I want to direct your attention to. "In 17 addition to changing the actual method of 18 calculating prepayment pay-downs, Smith Breeden 19 has changed its assumptions regarding pre-payments 20 in general"? 21 A. Yes. 22 Q. "Exhibit B gives a good idea as to the 11871 1 net effect of the change in prepayment assumptions 2 by using the old prepayment formula to calculate 3 effective prepayment rates under both the new and 4 the old prepayment assumptions." 5 Do you see that? 6 A. Yes. 7 Q. Let's turn to Exhibit B which you 8 describe. "Exhibit B gives a good idea as to the 9 net effect of the change in prepayment assumptions 10 by using the old prepayment formula to calculate 11 effective prepayment rates under both the new and 12 the old prepayment assumptions. As the tables 13 show, the new prepayment assumptions lead to much 14 higher prepayment rates on high coupon Fannie Maes 15 and Freddie Macs than do the old assumptions." 16 Let's turn to Exhibit B. Look at -- 17 maybe you'll have to tell us how to read this 18 chart. 19 A. All right. I think the relevant 20 columns are the fourth, fifth, sixth, and seventh. 21 Comparing apples to apples is to look at the 22 right-most two sets of two columns each. The 11872 1 middle set is the old prepayment rate assumptions, 2 and the right hand is the new prepayment. 3 Q. Let's take the coupon Freddie Mac 12 4 and a half. Under the old assumptions, what does 5 that show? 6 A. 12 and a half Freddie Mac? So, the old 7 would be 42 percent. 8 Q. So, the prepayment rate would be 9 42 percent per year? 10 A. Actually, that's the old prepayment 11 formula -- 12 Q. Right. 13 A. -- which I guess wasn't a constant 14 prepayment rate, I think. 15 Q. Okay. But it was a -- 16 A. It was a prepayment rate. 17 Q. So, the percentage of those mortgages 18 that would pay off in one year. Right? 19 A. No. If you divide 42 by 12, it gives 20 you the percentage of prepaid in a particular 21 month. I think that's the -- when we changed to 22 the, quote, "new formula," now the new formula 11873 1 quotes in terms of how many will prepay in the 2 next year. I think that's the distinction. 3 Q. Then changing the assumptions, what 4 does it show the prepayment rate being for 12 and 5 a half? 6 A. 50.2 percent. 7 Q. Okay. And that was the change? 8 A. Yes. 9 Q. What was it that led you to change the 10 assumptions in August of 1986? 11 A. I think it was just that we had more 12 data; and as interest rates continued to decline, 13 we felt like our prepayment assumptions were a 14 little -- were on the low side for those premium 15 mortgages. So, we increased our estimates. 16 Q. Now, earlier today when I asked you 17 about the prepayment assumptions for December of 18 1985 -- do you recall that? I asked you whether 19 or not those were in conformity with actual 20 experience. 21 Do you recall your testimony then? 22 A. I don't remember exactly what I said, 11874 1 but I remember discussing it. 2 Q. Do you recall whether or not they 3 were -- your assumptions were consistent with the 4 actual experience? 5 A. I think I said that we were a little -- 6 maybe I shouldn't use "a little," but we were low. 7 I think most people were during that time. 8 Q. Now, is a change of prepayment rates 9 from 12 or 13 to 40 a significant increase in 10 prepayment rates? 11 A. Yes, I think so. 12 Q. And is a change from 10 or 13 to 52 or 13 50.2 a significant increase in prepayment rates? 14 A. Say that again. 15 Q. From 10 or 13 to -- 16 A. Sure, it's substantial. 17 Q. So, they are both significant? 18 A. Yes. 19 Q. Would you consider both of them to be 20 very significant? 21 A. I think it just depends on the -- on 22 the asset that's being affected by it. 11875 1 Q. Assume that they are 30-year 2 mortgage-backed securities with anticipated lives 3 of seven to ten years -- 4 A. Right. Well, if -- 5 Q. -- 12 and a half percent coupons, 6 bought current unseasoned? 7 A. Well, certainly, the increase from 13 8 to 50 or whatever is certainly going to have a 9 much more major effect than 42 to 50. Again, you 10 would have to look at the actual specifics of it 11 to identify, you know, exactly how much of a 12 difference it would make. 13 Q. But it would make some difference? 14 A. Yeah, it certainly would. 15 Q. But a change from 10 to 40 or 13 to 40 16 would be very significant, as well. Right? 17 A. Yes. 18 Q. Have you had any contact with USAT 19 personnel since you left? 20 A. I don't think so. 21 MR. GUIDO: I have no further 22 questions, Your Honor. 11876 1 THE COURT: Do you want to take a 2 recess before you begin, or are you ready to 3 begin? 4 MR. NICKENS: Your Honor, I need to 5 move. If we're going to take our afternoon 6 recess, we might as well do it now; and I'll get 7 set up. 8 9 (Short break.) 10 11 THE COURT: Be seated, please. We'll 12 be back on the back. I believe the 13 direct-examination of the witness is complete. 14 Mr. Nickens, you are going to cross? 15 16 EXAMINATION 17 18 Q. (BY MR. NICKENS) Mr. Giarla, I'm going 19 to ask you a few questions about your testimony. 20 I'll start with the judge's question about asking 21 you about the treasuries and the pricing of 22 mortgage-backed securities. 11877 1 Mortgage backs are, in fact, priced in 2 relationship to treasuries, are they not? 3 A. Yes. 4 Q. Would you explain to the judge how that 5 occurs? 6 A. Well, I guess, the first reason is that 7 the mortgage-backed securities that we're dealing 8 with in this particular case are issued by an 9 agency or quasi-governmental agency so they have 10 credit risk that's slightly worse than the 11 treasury bonds or treasury notes. So, the 12 treasury securities are the closest thing in terms 13 of credit risk to the mortgage securities. So, 14 that's the first aspect of it. 15 Then just -- that's the way the fixed 16 income markets work in general is to benchmark 17 things -- benchmark their pricing relative to 18 treasuries. 19 Q. If you're going to compare to 20 mortgage-backed securities, you compare them to a 21 comparable treasury return; is that correct? 22 A. Yes. 11878 1 Q. That's what "benchmark" means? 2 A. Right. 3 Q. Now, how do you go about doing that? 4 How do you go about determining what the price is, 5 or what you would be willing to pay for a given 6 mortgage-backed security? 7 A. Well, the price -- typically, it would 8 be for a -- for a generic mortgage security, 9 there's a price that you can observe in the 10 marketplace. That's the given part. 11 The analysis part is to take that price 12 and say given my prepayment assumptions and given 13 where interest rates are, given the prepayment 14 risk that I think is embedded in here, what 15 risk-adjusted spread is left over if I were to buy 16 the security at the market price. And then you 17 would then kind of use your -- if you have some 18 hurdle rate or you compare it to some other 19 investment that you own. 20 Q. In the course of doing that, do you 21 calculate a yield? 22 A. Yes, you start with a yield. 11879 1 Q. And you calculate the yield using a 2 prepayment assumption? 3 A. Yes. 4 Q. And what is the source of that 5 prepayment assumption? 6 A. It would be the analyst's prepayment 7 model or a prepayment model. In our case, it 8 would be a prepayment model that we had designed. 9 Q. And back in 1985, the process was 10 similar? 11 A. Oh, you mean to where it is today? 12 Q. You would calculate a yield -- 13 A. Right. 14 Q. -- for the two securities? 15 A. Right. 16 Q. And in each instance, you would use a 17 prepayment assumption? 18 A. Right. 19 Q. And in 1985, it was one that was 20 internal to Smith Breeden -- 21 A. Yes. 22 Q. -- and had been developed by 11880 1 Mr. Breeden, if I understood your testimony? 2 A. Yes. 3 Q. Now -- and in these swap situations, 4 you're comparing one security to another as it's 5 related to a comparable treasury, correct? 6 A. Right. 7 Q. And you know historically there is a 8 typical relationship between the given treasury 9 and a mortgage-backed security. Right? 10 A. Right. 11 Q. And so you observe it, and let's 12 just -- to get along here, let's say it's 13 100 basis points and you observe in the 14 marketplace that that relationship has changed and 15 it is now selling at 80 basis points, correct? 16 A. Right. 17 Q. Now, is that the sort of thing that 18 a -- you would expect a portfolio manager to 19 watch? 20 A. Yes. 21 Q. And what would a portfolio manager be 22 advised to do if he observed this 20 basis point 11881 1 difference from the historic relationship in a 2 given instance? 3 A. Well, one reasonable possibility would 4 be a recommendation to sell the security. 5 Q. So, because the market was offering you 6 more than you thought that that relationship 7 should be -- 8 A. Right. I mean, if you -- I think the 9 example that was posed was kind of long-run 10 spreads at 100 basis points. And now, this is at 11 80. So, it's kind of less than a historical 12 average. So, as long as you believed 100 was a 13 good assumption going forward, it would be 14 reasonable to recommend that you sell that 15 security. 16 Q. Because you believe that over time, 17 it's going to return to the historical 18 relationship of 100? 19 A. Right. 20 Q. For some reason at that particular 21 point in the marketplace, there is a trading 22 opportunity. Right? 11882 1 A. Right. 2 Q. And it goes the other way, also, 3 correct? 4 A. Yes. 5 Q. And you would expect portfolio managers 6 to take advantage of those relationships that they 7 observe in the market when they are able to? 8 A. Yes. 9 Q. And that wouldn't -- would that affect 10 the risk-controlled arbitrage in any material way? 11 A. Well, it depends on what the portfolio 12 manager did to rebalance his hedge or whether he 13 or she rebalanced. 14 Q. Let me ask you to assume that you could 15 conduct such a trade without any effect on 16 durations. You can't do that. Right? 17 A. You could find comparable risk mortgage 18 securities to swap into probably. 19 Q. If you had made such an observation, 20 one would be well-advised to make the trade? 21 A. Correct. 22 Q. Now -- and it does occur -- let's -- 11883 1 you indicate in your document that you have made 2 observations that these opportunities occur about 3 twice a year? 4 A. Yes. 5 Q. But you also indicated that they occur 6 on a daily or monthly basis? 7 A. Right, on a smaller scale. 8 Q. In other words, with a given security, 9 you could make such an observation and make a 10 trade on that security, right, on a daily basis? 11 A. Yeah, possibly. Sure. 12 Q. And when you were referring to twice a 13 year, you were referring to market conditions such 14 that there was a broader range of opportunities. 15 Right? 16 A. Right. Major -- major opportunities. 17 Q. And that might persist over a wider 18 range of securities -- 19 A. Yes. 20 Q. -- and be present for a longer period 21 of time? 22 A. It could. 11884 1 Q. And, again, an observant, knowledgeable 2 portfolio manager should take advantage of those 3 opportunities? 4 A. Yes, if they saw them. 5 Q. And has anyone ever indicated to you 6 that there was something wrong with taking 7 advantage of those opportunities for a portfolio 8 manager of a risk-controlled arbitrage? 9 A. I don't know. Somebody may have. 10 Q. Anybody ever made it aware to you that 11 there was something wrong with that? 12 A. No, not that I am aware of. 13 Q. Now, Mr. Guido ended by asking you 14 about an exhibit which is a part of A13006 15 relating to your weekly update for August 5th, 16 1986. 17 Do you have that in front of you? 18 A. The August -- 19 Q. Yes, sir. It's the one relating to the 20 change and prepayment rates. 21 A. Okay. I have it. 22 Q. Now, earlier, you indicated that your 11885 1 analysis of these swaps starts with an assumption 2 about prepayment rates, correct? 3 A. Yes. 4 Q. You can't get away from that, can you? 5 A. No. 6 Q. You can't make the analysis if you 7 can't make an assumption about pre-payments? 8 A. That's correct. 9 Q. And in this particular case, what you 10 were changing -- you were changing your 11 assumptions about pre-payments, correct? 12 A. Yes. 13 Q. Now, that's different from changing 14 pre-payments? 15 A. Yes. 16 Q. I mean, if the market moves -- 17 A. Right. 18 Q. -- you expect pre-payments to move, 19 correct? 20 A. Yes. 21 Q. But that's not what this is talking 22 about. This is talking about -- you have changed 11886 1 your assumptions about what is going to happen in 2 relationship to a market move? 3 A. Right. It's a question of how much 4 will they move. You know they will move. The 5 question is how much. 6 Q. In terms of changing the assumptions, 7 this was a significant change? 8 A. Yes, I think so. 9 Q. Significant enough that you reported it 10 to your clients? 11 A. Right. 12 Q. You had been advising your clients for 13 some period of time to buy premium coupon 14 securities. Right? 15 A. Yes. 16 Q. In fact, you had just made a 17 recommendation to USAT about possibly purchasing 18 nearly $900 million of 12 and a half percent 19 mortgaged securities. Right? 20 A. Right. 21 Q. Now, what was the effect of your change 22 of your assumptions on the value of those 12 and a 11887 1 halfs? 2 A. Reading these, they were not the 3 recommended security anymore. So, this would have 4 changed our opinion so that we would -- I think 5 this is recommending -- let's see -- Fannie Mae 6 15s and season -- well, there's a list; but the 12 7 and a halfs aren't on the list. 8 Q. Now, the effects of increasing your 9 prepayment assumptions -- in this case, from 12 10 and a halfs Freddie Macs to 42 in round numbers -- 11 would be to reduce the value of those 12 and a 12 halfs. Right? 13 A. Right. 14 Q. Because you would receive that 12 and a 15 half percent premium for a shorter period of time? 16 A. Right. 17 Q. Now, when was it that you had made the 18 recommendation for the 12 and a half percent 19 purchase? 20 A. I'd have to go back and look. Sorry. 21 Q. Was it only a few months before? 22 A. (Witness reviews the documents.) 11888 1 There's too many documents; so, it takes me a 2 while to find them. 3 MR. GUIDO: I think it's the August 4 document on the USAT sensitivity. 5 Q. (BY MR. NICKENS) Is it Exhibit A10659, 6 the August 14th analysis? 7 A. Uh-huh. Uh-huh. Right. 8 Q. So, it wasn't this portion of your 9 advice that USAT didn't follow, was it? 10 A. I'm sorry? 11 Q. Well, you had changed your analysis 12 about 12 and a halfs and whether they would have 13 been recommended at about the same time this paper 14 went out, hadn't you? 15 A. Right. So, a month later, we wouldn't 16 have been making the same recommendation. 17 Q. And so, USAT would have had virtually 18 no opportunity to analyze your recommendation and 19 to make it before you changed it? 20 A. Right, presumably. 21 Q. Now, you do expect your clients to 22 analyze your recommendations, don't you? 11889 1 A. Yes. 2 Q. And USAT was sort of a stickler about 3 that, weren't they? 4 A. Well, I presume so. I don't -- I don't 5 know if I would call them sticklers or what. 6 Q. They asked a lot of questions, didn't 7 they? 8 A. They asked questions like most clients. 9 Q. Were they -- in terms of your 10 experience, did they ask more questions than the 11 usual client? 12 A. I'm not sure how to -- I would say they 13 were probably average in terms of asking 14 questions. 15 Q. There's certainly nothing wrong with 16 asking questions? 17 A. Not at all. 18 Q. And -- now, you indicated -- at this 19 point in time, you had been -- well, let's step 20 back. 21 When the relationship with USAT began 22 in May or June of 1986, you had been with the firm 11890 1 less than a year? 2 A. Right. 3 Q. And you had come immediately out of 4 business school? 5 A. Right. 6 Q. So, this was -- you were just getting 7 your career started? 8 A. Right. 9 Q. Now, how did you find USAT's -- the 10 people that you worked with as far as their 11 analytics and approach to business? 12 A. That's a hard question to answer. I 13 don't know that I -- I'm not sure quite how to 14 answer that. 15 Q. Were they analytic people? 16 A. Yeah, I think so. I think so. I think 17 they were. 18 Q. And did they appear to understand the 19 advice that you were giving them? 20 A. As far as I could tell, I think so. 21 Q. Now, you indicated that one of the 22 other -- first of all, did you have any other 11891 1 Texas S&L clients? Did Smith Breeden have any 2 other Texas S&L clients? 3 A. At least one: San Antonio Savings. 4 Q. What happened to San Antonio Savings? 5 A. They perished in the real estate 6 problems of that year, same time period. 7 Q. And another one of your clients was 8 Franklin Savings? 9 A. Yes. 10 Q. And they are the ones that used this 11 dynamic rebalancing? 12 A. Yes. 13 Q. And did the Government come -- appear 14 to come a time when the Government questioned that 15 activity? 16 A. I'm not sure but possibly. 17 Q. Well, the management of Franklin 18 Savings was replaced at the behest of the 19 Government? 20 A. I know the institution was taken over 21 at some point. It was -- it was a couple years 22 after Smith Breeden's involvement. 11892 1 Q. I'm just trying to get the facts -- 2 A. Some of them, I just don't know. 3 Q. Let me ask you: With regard to their 4 activities, they were rebalancing assets in 5 response to interest rate movements, correct? 6 A. That, I don't remember. I mean, also, 7 to clarify that, that particular client at certain 8 times used options and other times did the dynamic 9 rebalancing. I just don't remember the time frame 10 and haven't reviewed any of the documents. 11 MR. GUIDO: Would you clarify which 12 client you're talking about? 13 MR. NICKENS: I'm talking about 14 Franklin Savings. 15 Q. (BY MR. NICKENS) Is that what you were 16 talking about? 17 A. Right. 18 Q. You indicated at one time they were 19 doing rebalancing an another time they were 20 choosing options? 21 A. Correct. 22 Q. Now, let's get -- let's see if we can 11893 1 get the record straight on this. 2 You do not know what Joe Phillips did 3 in his rolldown in the first quarter of 1985, do 4 you? 5 A. No. 6 Q. You have not studied any of the prior 7 transactions; that is, prior to the time that 8 Smith Breeden came on in May of 1985? 9 A. That's correct. 10 Q. And those questions about a rolldown, 11 will you agree with me -- excuse me -- 1986. I 12 apologize. 13 You will agree with me that those 14 questions about when to initiate a rolldown are 15 questions of judgment? 16 A. Yes. 17 Q. One that in order to evaluate 18 whether -- 19 MR. GUIDO: Your Honor, I object to the 20 line of questions. Mr. Nickens objected to me 21 because he said I was trying to qualify this 22 witness as an expert. 11894 1 If he wants to do this, I think I 2 should be able to ask the witness what is a 3 typical point in time in which you do a rolldown, 4 which Mr. Nickens is trying to avoid having me 5 ask. 6 For him to start now talking about it 7 being a question of judgment assumes to me that 8 he's now gone beyond asking this witness fact 9 questions. He's objected to the witness being an 10 expert; and now he's trying to have his cake and 11 eat it, too, Your Honor. 12 If he's entitled to ask these 13 questions, I am entitled to ask the question of 14 when is the appropriate time to commence a 15 rolldown when you have a reduction in interest 16 rates. To start asking this witness about 17 judgment assumes, seems to me, to be going far 18 beyond what he objected to me doing on direct, 19 Your Honor. And I object to the question on that 20 grounds. 21 Otherwise, I think I'm entitled to ask 22 my question which is: When is the appropriate 11895 1 time to commence a rolldown when you have a moving 2 interest rate? 3 THE COURT: The appropriate thing is 4 save your question, and we'll ask it on redirect. 5 MR. GUIDO: Thank you, Your Honor. 6 Q. (BY MR. NICKENS) The question, if I 7 might, Mr. Giarla: Will you agree with me that 8 when to roll down is a question of judgment? 9 A. Yes. 10 Q. And to make an evaluation of whether 11 that was an appropriate judgment, you would have 12 to go back and study the situation that that 13 particular person was put into. Right? 14 A. Yes. 15 Q. And are you familiar with the whipsaw 16 effect? 17 A. Yes. 18 Q. Could you tell the Court what that is? 19 A. Hopefully, it's the same whipsaw 20 effect. 21 Q. I'll stop you if we're not 22 communicating. 11896 1 A. I think of it in terms of this 2 rebalancing issue. I'm trying to -- the issue of 3 rebalancing versus buying the options. So, if you 4 undertake this strategy to rebalance your hedge -- 5 dynamically rebalancing I think I said earlier is 6 what happens. As rates go down, you need less 7 hedges. So, you end up buying back, let's say -- 8 if you had a futures position, you would have to 9 buy back futures when rates go down. When prices 10 are high -- as rates go up and prices are high, 11 you want to sell. You're always buying high and 12 selling low to rebalance. The more volatile the 13 rates are, the more you incur a transaction cost. 14 You get whipsawed by the interest rate. 15 It's that kind of anticipated cost 16 that's similar to the cost of buying options to 17 begin with. That's the same whipsaw you're 18 referring to. 19 Q. Let me ask you to look at a document 20 that has been labeled B823 and is at Tab 234, and 21 it should be in front of you. I think this is the 22 already-admitted copy. 11897 1 Mr. Giarla, I'm not going to ask you to 2 read this entire article which is an article about 3 Franklin Savings which we have dated in 1986 and 4 is already in evidence. I would ask you to look 5 at the third page and, in particular, the second 6 paragraph under "leaner pickings" that starts out 7 "most practitioners." 8 A. Uh-huh. 9 Q. Do you see that paragraph? 10 A. Yes. 11 Q. "Most practitioners feel it's 12 sufficient to re-evaluate their arbitrages either 13 monthly or with every 100 basis point change in 14 rates, whichever comes first. One particularly 15 rigorous Drexel customer that rebalanced daily 16 found its initial spread of 125 basis points 17 gradually whittled down to about 35 basis points 18 by early December." 19 Was that consistent or inconsistent 20 with your experience at the time? 21 A. Well, I haven't viewed that many 22 institutions who were doing dynamic rebalancing 11898 1 since most of our clients bought options. So, I 2 presume it's representative of what actually 3 happened. 4 Q. Then let me ask you to look at the next 5 column, just the -- across from the "leaner 6 pickings," there's a paragraph that starts, "Most 7 thrifts that pursue risk-controlled arbitrage also 8 actively trade pass-throughs - buying those they 9 think are undervalued and selling ones they think 10 are too dear - to add incremental returns. They 11 view this as another means of obtaining insurance 12 against prepayment risk. They constantly sift 13 through the peculiarities of different 14 pass-through issues and track the pattern of 15 supply and demand in the market much the same way 16 active managers of fixed-income portfolios do to 17 boost returns." 18 Is that what we were talking about 19 earlier about trading swaps? 20 A. I'm not sure about the -- the part of 21 about prepayment risk does not make total sense to 22 me in the context of that paragraph. 11899 1 Q. But this is what we were talking about? 2 A. Yes. 3 Q. And it was a recommended activity? 4 A. Yes. 5 Q. Now, I want to talk about your 6 presentation that was made, if we might, in 7 September of 1986. As you do that, I would like 8 to refer you back to a copy of the presentation 9 which is Exhibit A10666. 10 A. Okay. 11 Q. Do you have that in front of you? 12 A. Yes, I do. 13 Q. I would ask you to turn over to the 14 fourth page, which is a chart entitled, "UFG 15 overall interest rate sensitivity." 16 Now, was this the product of your work 17 of looking at the institution as a whole to make 18 recommendations to USAT? 19 A. Yes. 20 Q. So, when it says "UFG," we're talking 21 about United savings as a whole? 22 A. Yes. 11900 1 Q. Now, the -- you show there a curve that 2 is fairly flat from minus 2 to a little past 3 plus 1, correct? 4 A. Right. 5 Q. And then it goes down a little bit from 6 that point to plus 2 and then down more and down 7 more on the other side, too? 8 A. Right. 9 Q. Now, in comparing the shape -- that was 10 the situation that you found United Savings in 11 when you were doing your analysis in July and 12 August of 1986, correct? 13 A. Yes. 14 Q. And how did that compare to other 15 institutions that you were familiar with in terms 16 of the shape of that curve? 17 A. Well, in terms of institutions that I 18 had looked at or that we looked at or that I had 19 seen I was looking at for the first time, before 20 we were involved with them and they were hedging 21 with our recommendations, this was the most 22 well-balanced of all the ones I had seen of, you 11901 1 know, 1 to 2 percent rate. 2 Q. That would generally be thought in 3 terms of Smith Breeden as a result of good 4 management and not poor management? 5 A. I would just say it's the result of 6 having a portfolio that was reasonably well-hedged 7 for that -- the interest rates. 8 Q. But that was regarded as being a 9 desirable goal. Right? 10 A. Yes. 11 Q. This wasn't something that was bad? 12 A. Right. 13 Q. And when you said that if interest 14 rates moved up or down, your situation worsened, 15 that wasn't a critique, was it? 16 A. No. I mean, that was just pointing out 17 the facts; and those were -- that was not atypical 18 of institutions with mortgage securities. 19 Q. Particularly an institution with 20 mortgage securities that has hedged them. Right? 21 A. Right. Well, that hedged them with 22 duration-matched hedges but maybe not the options. 11902 1 Q. Okay. But the point we're trying to 2 get at is that this wasn't a criticism, that you 3 have achieved some terrible result in which 4 whatever happens to interest rates, your situation 5 is going to worsen? 6 A. That's correct. 7 Q. That was, according to the view that 8 you were espousing at the time, exactly where you 9 wanted to be. Right? 10 A. Correct. 11 Q. You didn't want to be negative? 12 A. Right. It's where we would have 13 recommended they be except for the options and 14 hedges. Right. 15 Q. Okay. And you were asked about this by 16 the OTS, were you not? 17 A. I believe so. 18 Q. And you told them at that time that 19 that was typical of a hedged-situation person 20 owning mortgage backs. Right? 21 A. Right. 22 Q. And that was before the Notice of 11903 1 Charges was written in this case? 2 A. I don't know when it was written. 3 Q. You've never seen the Notice of 4 Charges? 5 A. I don't believe so. 6 Q. So, you have no idea what use has been 7 made of that claim that things worsened regardless 8 of what happened to interest rates? 9 A. No. No. 10 Q. Now, going forward -- let me ask you to 11 just turn the page. 12 The small chart at the top shows 13 historical liquidation values. Right? 14 A. Right. 15 Q. And they are negative? 16 A. Yes. 17 Q. But they have improved over where they 18 were in March and September of '84? 19 A. Right. 20 Q. And what about the interest rate 21 sensitivity which is the chart just below it? 22 A. Uh-huh. 11904 1 Q. In terms of the direction that the 2 institution is going in, is that a good or a bad 3 chart? 4 A. It's a good chart. The trend is good. 5 I know that they had significantly more interest 6 rate risk in the earlier periods, and it's 7 decreased over time. 8 Q. They are not to the goal, but they are 9 making progress. Would that be a fair description 10 of this chart? 11 A. Yes. 12 Q. Now, let me ask you to go over to 13 Page 6. Tell the Court what Page 6 represents. 14 A. It was our estimate of the net income 15 over the next -- at least on the top, the graph, 16 the bar graph would be our estimate of net income 17 for the institution for the next three years 18 assuming that they didn't grow and assuming there 19 were no interest rate changes so that there would 20 be a loss of about 60 million the first year, 21 50 the second year, and 43 or 44 the next year. 22 Then the table on the bottom shows how 11905 1 those net incomes would be protected to change as 2 interest rates moved, and you can see there's four 3 other different scenarios shown there. 4 Q. And Mr. Giarla, you were informing them 5 that according to your analysis, if they did 6 nothing, that over the next three years, they were 7 going to lose about $160 million; and that's if 8 interest rates didn't change at all? 9 A. Right. 10 Q. Does that mean that they were -- had an 11 impossible situation? 12 A. No, not necessarily. 13 Q. And you make a recommendation as to 14 what they could do to address this problem? 15 A. At least in part, yes. 16 Q. Would you agree that it was a problem 17 to be looking at these kinds of prospects if you 18 did nothing? 19 A. Yes. 20 Q. And your recommendation -- well, let's 21 turn to the next page. The cumulative liquidation 22 value -- well, tell us what that is. 11906 1 A. The liquidation value on the left 2 should tie in with an earlier exhibit. So, that 3 was just the snapshot of their assets and 4 liabilities values on that day, not giving any 5 value to the franchise value or any deposit 6 premium or branch premium. So, that's kind of a 7 lower bound on the value presumably. There we 8 assume the numbers on all the real estate 9 projects. We didn't assess those. They just gave 10 us the numbers for that. 11 And then I believe what this shows is 12 that if they don't grow, let's say, in two years, 13 their liquidation value -- well, I'm not -- it 14 says there's going concern values. And I think 15 that's a little different from the liquidation 16 value in that it's essentially a discounted cash 17 flow analysis. The institution stays the same 18 size, what's the present value of the earning 19 stream going out as far as we can project it. And 20 we get minus 357 million which is in the same 21 order of magnitude as the liquidation value. The 22 25 percent growth scenario -- I believe the 11907 1 situation grew 25 percent annualized in terms of 2 assets. I don't know the exact assumptions on 3 what the growth was, whether it was all mortgages 4 or part mortgages and part other activities. We 5 projected the earnings out and discounted those 6 back and got a minus 138. 7 The last bar is assuming a 50 percent 8 annualized growth rate which gets you above zero 9 to 67 million using that discounted cash flow 10 methodology. 11 Q. You were telling USAT that the solution 12 to their problem was to grow out of it? 13 A. If they could be profitable or grow 14 based on the earnings assumptions embedded in 15 here, then -- then they could make up that 16 negative liquidation value. 17 Q. And what were you recommending as the 18 means or form of growth? 19 A. Well, the bulk of it was 20 mortgage-backed securities purchases on a hedge 21 basis. 22 Q. Why were you making that 11908 1 recommendation? 2 A. Of course, that was our expertise; so, 3 that was what we were comfortable recommending. 4 And it's also an activity that was essentially 5 indigenous, I guess, to USAT since they were in 6 the mortgage business. 7 Q. They would have to grow according to 8 certain regulations to -- with 60 percent assets 9 that qualified for the so-called thriftness test, 10 correct? 11 A. Right. I don't remember the exact 12 percentage, but there was a test. 13 Q. And were you recommending that they go 14 out and make a bunch more loans? 15 A. That would certainly be a reasonable 16 activity, but I'm sure they couldn't generate 17 loans to that scale at that point in time. 18 Q. And did that have anything to do with 19 the economy in Texas? 20 A. Probably, yeah. 21 Q. And were there any other qualifying 22 assets other than loans or mortgage-backed 11909 1 securities that you were aware of? 2 A. I'm sure there were. I just don't -- 3 searching my memory banks, I can't recall. 4 Q. Now, compare for the Court, if you 5 will, your evaluation of the difference between -- 6 in terms of risk of holding whole loans as opposed 7 to mortgage-backed securities. 8 A. Whole loans have more credit -- 9 typically have more credit risk and are less 10 liquid than the mortgage securities. 11 Q. And in that sense, which would you 12 prefer? 13 A. All other things being equal, you would 14 prefer the securities. I mean, presumably, you 15 would demand a higher rate on the whole loans to 16 make you want to own those versus the mortgage 17 securities. 18 Q. Because they are riskier? 19 A. Because of those additional risks. 20 Q. And that's the traditional relationship 21 between risk. Right? 22 A. Yes. 11910 1 Q. Turning to the next page, we see your 2 conclusions. Those are your conclusions. Right? 3 A. Yes. 4 Q. This wasn't something that USAT told 5 you should be your conclusions? 6 A. No. These are Smith Breeden's 7 conclusions. 8 Q. And they were that growth and capital 9 are both needed in order to restore the viability 10 of United Savings, correct? 11 A. Yes. 12 Q. And how was that -- that was to be 13 achieved at least partly through the acquisition 14 of mortgage-backed securities? 15 A. Yes. 16 Q. In what amount? 17 A. Let's see. On the next page, it looks 18 like -- if you look at the middle of the page, it 19 says, "Advance to service corporation 20 100 million." That would -- if that were done, 21 that would support a billion dollars of mortgage 22 assets, mortgage securities. Then it says, 11911 1 "Margin equity arbitrage and use as advance to 2 service corp." That would support half a billion. 3 So, that's 1 and a half billion of incremental 4 mortgage securities. 5 Q. So, you were recommending to USAT that 6 they grow by $1 and a half million in order to get 7 out of the situation where they had negative 8 earnings? 9 A. Then actually -- on the next page, 10 Page 10, if they raised additional capital with 11 capital notes or something, other ways, there was 12 another 600 million according to this exhibit. 13 So, that brings it to over 2 billion. 14 Q. So, the recommendations on this page 15 are Smith Breeden's recommendations, correct? 16 A. Correct. 17 Q. Part of your recommendations were to 18 take advantage of a situation involving some of 19 the accounting rules by which you could set up 20 offsetting economic positions and realize gains on 21 one side realizing that you had losses on the 22 other? 11912 1 A. Yes. 2 Q. Now, in making that recommendation, did 3 you think you were recommending something that was 4 improper? 5 A. No. 6 Q. Was it something that you recommended 7 as being a reasonable response to the difficulties 8 that USAT faced? 9 A. Yes, and that would allow them to -- 10 the flexibility to do these other things that 11 added economic value and economic earnings. 12 Q. Now, just to see how this works, if we 13 can turn over to Page 12, you have identified 14 there by the boxes the specific reactions to a 15 particular interest rate scenario. Right? 16 A. Right. 17 Q. And if interest rates went down 18 300 basis points, the agency zeros would increase 19 in value by 142 point something million? 20 A. Right. 21 Q. That's a gain that you could take, as 22 you stood it, at that point in time? 11913 1 A. Right. 2 Q. Even though you recognized -- where 3 would be the loss under that scenario? 4 A. Well, the -- the institution would be 5 still 39 million better off, if you look at the 6 far right, in economic value; so, there's no loss. 7 Actually, the institution is better off 8 economically. 9 Q. But not to the extent of $142 million. 10 Right? 11 A. Right. There's a 140-million-dollar 12 loss on the swaps plus brokered zeros; so, that 13 offsets everything but the 38.7 million. 14 Q. If your interest rates went up 300 15 basis points, you were estimating a gain in the 16 swaps plus zeros of approximately $81 million? 17 A. Right. 18 Q. Okay. Now, I want to ask you some 19 questions, Mr. Giarla, if I might, about some of 20 the documents that Mr. Guido questioned you about. 21 Specifically, if you could look at 22 A13003, which is your introduction to hedging 11914 1 interest rate risks dated May 31, '86. 2 A. Yes. 3 Q. I just have a couple of questions about 4 Page 4. Is this a chart of the assumptions that 5 you were assuming at the time for interest rates? 6 A. I believe so. 7 Q. In other words, this is not historical 8 prepayment rates? 9 A. Yes, that's correct. 10 Q. These are your assumptions you were 11 using during that time frame? 12 A. Right. 13 Q. And by that time frame -- in other 14 words, even though this chart was made obviously 15 after May of '86, if we go up there in December of 16 '84, that was the assumption you were using in 17 December of '84? 18 A. Yes. 19 Q. These are the assumptions that you 20 changed in August of '86? 21 A. Yes. 22 Q. You changed your methodology for 11915 1 generating these? 2 A. Right. 3 Q. You changed your methodology by which 4 you had gotten these assumptions? 5 A. Right. 6 Q. Now, how were your assumptions in 7 relationship to other Wall Street -- well, Wall 8 Street firm assumptions in the period of time in, 9 let's say, the first part of 1985? 10 A. I think the -- I think we -- and this 11 may sound self-serving. But to the extent I can 12 be objective, I think our analysis and prepayment 13 models were better than what most people on 14 Wall Street were using and particularly in our 15 estimation of interest rate risk and pre-payments 16 for higher coupon mortgages. 17 Q. And your estimates were higher than 18 most of those estimates, correct? 19 A. As I recall, they were. 20 Q. And they still turned out to be 21 considerable too low for what happened? 22 A. They were lower than actuality, yes. 11916 1 Q. But they were higher than what most 2 people had been predicting? 3 A. I think so. 4 Q. Tell the Court what happened to the 5 mortgage-backed securities market and, in 6 particular, risk-controlled arbitrages in the 7 first quarter of 1985. 8 MR. NICKENS: Excuse me. I apologize, 9 Your Honor. 10 Q. (BY MR. NICKENS) It's 1986. 11 A. The thing I remember most about 1986 12 was that it was -- the early part of 1986 was a 13 period when Wall Street firms recorded some fairly 14 large losses on their positions in high coupon 15 mortgages where they had had high coupon mortgages 16 inventory or whatever portfolios and had 17 essentially overhedged. So, they had 18 overestimated the interest rate sensitivity of 19 those securities. 20 So, they might have assumed that the 21 high coupon mortgages had an effective duration of 22 two and a half or three where maybe we were 11917 1 assuming one and a half or something like that. 2 Q. The brokerage houses tried to hedge 3 their positions. Right? 4 A. Right. 5 Q. They are in the business of buying and 6 selling securities. So, when they hold them in 7 inventory, they try to hedge them? 8 A. Right. Some firms also had their own 9 proprietary hedging operations. 10 Q. And those are professional traders 11 whose everyday base is managing those portfolios. 12 Right? 13 A. Right. 14 Q. And whose -- all of their -- 15 presumably, most of their business activity was 16 devoted toward trying to understand 17 mortgage-backed securities and predict their 18 values? 19 A. Right. 20 Q. And what happened? 21 A. They lost considerable amounts of money 22 as interest rates fell. 11918 1 Q. Because they were overhedged? 2 A. Because they overestimated the interest 3 rate sensitivity of the high coupon mortgages. 4 Q. Mr. Giarla, let me ask you to look at 5 Exhibit 10654, which is your paper dated August of 6 1986, an introduction to risk-controlled 7 arbitrage. 8 Did you prepare this document for 9 distribution to your clients? 10 A. Yes. 11 Q. And is there any question that you 12 regarded risk-controlled arbitrage as a reasonable 13 activity for thrift institutions? 14 A. Yes, I did. 15 Q. Now, if you could look over at Page 11, 16 which is Table 1. Mr. Guido asked you about this. 17 This is an example that you provided for your 18 clients of what they might be able to do with a 19 hedged risk-controlled arbitrage. Right? 20 A. Right. 21 Q. And you started out with a -- let me 22 put it this way. If you take the positive parts 11919 1 of that, your spread is about 2.13 or 213 basis 2 points? 3 A. Right. 4 Q. And that would include -- that was over 5 the cost of funds, correct? 6 A. Right. 7 Q. And the cost of funds was a one-year 8 cost of funds? 9 A. Right. 10 Q. So, it was already adjusted for a 11 longer period of time than you would get with a 12 repo, for example? 13 A. That's correct. 14 Q. And you've got reserved for options 15 minus .24. Your suggestion was you ought to spend 16 .24 of your basis spread on options? 17 A. For this particular security, right. 18 Q. And another 89 for your caps and other 19 hedges? 20 A. Well, actually, the cap means capital 21 loss, which -- 3 refers to extending out the yield 22 curve, matching the liability to a 11920 1 duration-matched one. 2 Q. The .24, does it have any relationship 3 to what one would have, losses of spread, based 4 upon rebalancing if you choose that way of 5 approaching the risk-controlled arbitrage? 6 A. Yeah. I would think that, on average, 7 the rebalancing strategy would give you a similar 8 loss. I mean, there's a lot of different 9 outcomes. The average overall outcomes you would 10 expect to be similar to the .24 basis. 11 Q. You prefer the options, but another 12 approach was the rebalancing? 13 A. Right. 14 Q. Now, nowhere in here do you hedge 15 against errors in your prepayment assumptions, do 16 you? 17 A. Right. 18 Q. I mean, that's not hedged. If you've 19 made a mistake about your prepayment assumptions, 20 you're going to have a problem; and it's not 21 hedged anywhere in your example? 22 A. That's correct. That's a risk. 11921 1 Q. So, the very risk that caught people up 2 in the first quarter of 1986 wouldn't have been 3 hedged in the example? 4 A. Right. To the extent that our 5 prepayment estimates are wrong, there's risk. It 6 could go either way. You could make more or make 7 less than what you're -- 8 Q. Now, let me ask you to -- let's go back 9 to what your assignment was at USAT. 10 I would like to show you a document 11 that might help in that regard, if I can find it. 12 I believe it's Exhibit B967. That's a new one. 13 Mr. Farley is going to help us. 14 Do you have B967 in front of you? 15 A. Yes. 16 Q. Do you see it as a letter from Jerry 17 Williams to Greg Smith dated May 2nd, 1986? 18 A. Yes. 19 MR. NICKENS: Your Honor, we offer 20 B967. 21 MR. GUIDO: No objection, Your Honor. 22 THE COURT: Received. 11922 1 Q. (BY MR. NICKENS) Now, is there a 2 description there of what USAT was asking you to 3 do at that point in time? 4 A. Yes. 5 Q. Would you read to the Court what it 6 was? 7 A. "Label 1: An overall review of our 8 mortgage-backed security structured arbitrage 9 programs and CMO positions to determine areas of 10 opportunity for improvement or preservation of 11 profits; and 2, implementation of your asset 12 liability modeling tool for the entire institution 13 and your recommendations as to appropriate courses 14 of action." 15 Q. And is that what you then endeavored to 16 do up until the time that the relationship changed 17 after you had finished this first part? 18 A. Yes. 19 Q. And do you recall what you charged for 20 your efforts in that regard? 21 A. I don't remember. 22 Q. Okay. Let me show you a document that 11923 1 was labeled as B4196. Could you tell the Court 2 what that is? 3 A. These are invoices from Smith Breeden 4 to United, looks like. 5 MR. NICKENS: Your Honor, we offer 6 B4196. I will say that I pulled these four pages 7 from a much longer document: A10810. 8 MR. GUIDO: No objection, Your Honor. 9 THE COURT: Received. 10 Q. (BY MR. NICKENS) Now, does that refresh 11 your recollection, Mr. Giarla, as to what was 12 charged for this first part of the assignment? 13 A. The first two pages which total 100,000 14 would have been our fees for the project that we 15 performed. 16 Q. Now, let me ask you to look at the 17 results of that part of the project. And, first, 18 let's look at the CMO analysis, which is Exhibit 19 A13004 that Mr. Guido asked you about. 20 Do you have that in front of you? 21 A. Yes. 22 Q. First of all, let's talk for a minutes 11924 1 about what the CMO was or is. In this particular 2 case, USAT was issuing a CMO, correct? 3 A. Yes. 4 Q. And they had some kind of a shelf 5 registration with the SEC for doing that? 6 A. I believe so. 7 Q. Explain for the Court and the record 8 what -- how the CMO structure worked and what it 9 was. 10 A. Okay. I believe the typical structure 11 would be that mortgage-backed securities with 12 fixed rates of interest -- again, I don't recall 13 what theirs were -- were put into a trust, and 14 then the cash flows -- and bonds were issued. The 15 trust issued bonds which investors would buy, and 16 the cash flows from the underlying collateral in 17 the trust would be split up among the bonds that 18 were issued. And then whatever cash flows were 19 left over was retained by United in this case 20 which was called the residual. I think in those 21 CMOs, the bonds that were issued were probably 22 fixed rate bonds and usually two or three. It was 11925 1 a fairly simple structure at that point compared 2 to eventually how CMOs were issued. The residual 3 cash flows were basically essentially like a 4 stream of interest income that varied depending on 5 how interest rates moved and how pre-payments came 6 out on the underlying mortgages. 7 Q. Let me, if I may, Mr. Giarla, step 8 back. They would buy mortgage-backed securities. 9 In this case, I think the amount was about 10 $750 million at this point in time. They would 11 take those cash flows and repackage them and sell 12 them to the marketplace in a package that was more 13 favorable for certain buyers than the mortgage 14 backs. Right? 15 A. Right. 16 Q. And in doing that, they were able to 17 realize a profit from buying the mortgage backs 18 and reselling cash flows pursuant to the CMO bond. 19 Do I have that right? 20 A. Right. In theory, you should issue -- 21 if the cost of the collateral was less than the 22 value of -- I'm sorry -- yeah, was less than the 11926 1 value of what you sold the bonds for, plus what 2 you kept for yourself. 3 Q. Why were prepayment assumptions 4 important to this CMO activity? 5 A. Yes. 6 Q. And why? 7 A. Because prepayment -- well, the value 8 of the residual is -- or at least your estimate of 9 the value of it is dependent upon the prepayment 10 assumption. 11 Q. Was USAT asking you to examine their 12 prepayment assumptions? 13 A. Well, I'm not sure if we analyzed their 14 prepayment assumptions; but we provided our 15 estimates of what we thought prepayment rates 16 would be. 17 Q. Did they ask you the question of 18 whether they should hedge the mortgage-backed 19 securities that they had as a part of the CMO 20 program? 21 A. Again, I don't remember specifically, 22 you know, looking at it that way. I know we 11927 1 certainly were asked to give recommendations about 2 hedging for the whole institution. 3 Q. If you look at Page 1656 of 4 Exhibit 13004 -- 5 A. Okay. 6 Q. -- do you see any evidence there on 7 your analysis of CMO values versus interest rates 8 of any hedges? 9 A. No. 10 Q. And then later in the document, you're 11 evaluating a proposal that apparently had been 12 made by Goldman Sachs for a hedge related to 13 stripped mortgage-backed securities? 14 A. Yes. 15 Q. You weren't particularly favorable 16 toward that recommendation? 17 A. Right. 18 Q. Now, if, in fact, USAT had bought 19 $750 million of unhedged mortgage-backed 20 securities for this program, was that included in 21 the sensitivity analysis that you did later of all 22 of their mortgage-backed securities? 11928 1 A. I'm not sure that I understand the 2 question. If they had purchased -- 3 Q. Let me ask you to look at the document 4 that is at 13005, which is your analysis of the 5 mortgage-backed securities, along with various 6 hedging instruments. And you've got a book value 7 of a billion nine in the mortgage pools. 8 I'm asking you whether that included 9 approximately $750 million from the CMO. 10 A. Okay. That includes everything, I 11 believe. Well, let's see. 12 No, I think that's inclusive of the 13 CMOs themselves. I mean, this would be -- the 14 CMOs were one entity in and of themselves; and 15 this was, I think, all the other mortgage 16 securities. 17 Q. When you made your proposal for the 18 12 and a halfs, what was the amount that you 19 suggested be sold? 20 A. I'll find it again. 21 MR. GUIDO: You mean the face amount? 22 MR. NICKENS: Well, the invested 11929 1 amount. 2 MR. GUIDO: You asked him to look at 3 A10659, the valuation and sensitivity analysis. 4 A. Looks like about 832 million face 5 amount of mortgages. 6 Q. (BY MR. NICKENS) And is it obvious that 7 those numbers are not directly comparable to the 8 billion nine because one is book value and one is 9 face amount. Right? 10 A. Right. 11 Q. But it's obvious that there's some 12 large piece that's not being addressed by your 13 sell option, correct? 14 A. Yes. 15 Q. Now, let me ask you to assume -- and 16 we'll see if we can establish it one way or 17 another later in the record, Mr. Giarla -- that 18 this amount includes the CMO amounts which we know 19 to have been unhedged. 20 A. Okay. 21 Q. If that turns out to be correct, how 22 would that affect your analysis of their hedge 11930 1 position if you took out the CMOs? Let me put it 2 another way. 3 If that turns out to be correct that 4 the billion nine that you were analyzing included 5 750 million of unhedged MBS that they were asking 6 your advice what they should do about it, wouldn't 7 that impact your sensitivity analysis as reflected 8 on Page 11 of Exhibit A13005? 9 A. Sure. I mean, whether -- all right. 10 The question is whether the CMOs were included in 11 this analysis or not. 12 Q. I understand that. 13 A. If they weren't, then certainly the 14 numbers would be different. 15 Q. And in particular, your conclusion that 16 the mortgage-backed securities -- again on 17 Page 11 -- the mortgage-backed securities are not 18 quite duration-matched with current caps, swaps, 19 and collars net underhedged might have to be 20 re-evaluated. 21 A. Right. Right. 22 Q. You were doing what they asked you to 11931 1 do. They said, "Look at the institution as a 2 whole, but if we have a big chunk of mortgage 3 backs that we know to be unhedged" -- 4 MR. GUIDO: Objection. That is a 5 mischaracterization of the testimony. I think the 6 Michael Crow letter says you must analyze the 7 structured arbitrage portfolio. 8 Q. (BY MR. NICKENS) Given the instructions 9 that you had, however you remember them, 10 Mr. Giarla, you would want to know whether or not 11 the CMOs were included in here or not, wouldn't 12 you? 13 A. I guess I don't understand the 14 question. My understanding of these two reports 15 is the CMOs were analyzed separately from the 16 mortgage-backed securities. That's what I believe 17 is -- so, I believe this August 14th one doesn't 18 include the CMO analysis in it. 19 Q. So, you believe that USAT at this point 20 in time actually owned well over $2 billion in 21 mortgage-backed securities? 22 MR. GUIDO: It doesn't say that. It 11932 1 says $.9 billion. 2 MR. NICKENS: Your Honor, I don't want 3 to respond to Mr. Guido because I don't want to 4 get into that; but I don't think he should be 5 asking me questions while I'm trying to 6 interrogate the witness. Let me rephrase the 7 question. 8 THE COURT: If you have an objection, 9 state it as an objection, Mr. Guido. 10 MR. GUIDO: Thank you, Your Honor. 11 A. We're looking at the same exhibit. If 12 you look at 10659 -- is that the one we've been 13 looking at? 14 Q. (BY MR. NICKENS) Yes. 15 A. The CMOs are shown -- if you look at 16 Bates stamp Page 40, CMOs are shown as a separate 17 line item, the fifth one under the "asset" column. 18 Q. Yes, sir. 19 A. So, we just kind of treat them as a 20 separate entity to themselves. 21 Q. What is the amount of mortgage backs 22 that you show in that same analysis? 11933 1 A. Looks like a billion one of mortgage 2 back securities. 3 Q. So, what that suggests to you is 4 whether or not that billion nine, whether it 5 includes the CMOs or not? 6 A. Yeah, that's a good question. Let me 7 go back to that page and look at it. Which one 8 had the billion nine on it? 9 Q. It's the analysis of mortgage-backed 10 securities, interest rate swaps, caps, and 11 collars, Exhibit A13005 at Page 4. 12 A. Okay. So, it may have included -- it's 13 possible that it included the mortgages underlying 14 the CMOs. 15 Q. And if it did, it certainly would 16 affect the conclusion about -- to the extent they 17 were hedged? 18 A. Yes. 19 Q. Now, let me ask you to look at 20 Document B967 which is in front of you. It's -- 21 it should be here. 22 Do you find over there attached to it a 11934 1 document entitled, "Preliminary interest rate 2 sensitivity analysis"? 3 A. Yes. 4 Q. And that was dated what? 5 A. July 24th, 1986. 6 Q. And just for the record, what was that? 7 A. It looks like our -- kind of a 8 preliminary analysis of the balance sheet. As we 9 get more data, as the summer wore on, it was an 10 update of our analysis. It was an update of the 11 balance sheet of United. 12 Q. Now, did there come a time when you 13 were consulting with USAT with regard to various 14 trading opportunities available among their 15 mortgage-backed securities? 16 A. Yes. 17 Q. And let me ask you to look at some 18 documents in that regard. If you would look at 19 Exhibit B1212 which is found at Tab 379. 20 Do you have B1212 in front of you? 21 A. I do. 22 Q. Mr. Giarla, I would like to draw your 11935 1 attention to the third paragraph that begins, "The 2 committee approved the execution of the second 3 leg" -- and I guess first -- the fourth paragraph 4 says, "Mike Crow had had a prior conversation with 5 Smith Breeden on this trade. They did not oppose 6 it." 7 Then I would ask you to read the third 8 paragraph describing the trade. 9 A. (Witness reviews the document.) Okay. 10 Q. Have you had a chance to read that 11 paragraph? 12 A. Yes, uh-huh. 13 Q. Is that what you would describe as a 14 value trade? 15 A. Yes. 16 Q. And is that similar to the swap 17 discussion that we had at the beginning of my 18 examination? 19 A. Yes. 20 Q. And do you see anything wrong with the 21 proposed trade as it is described in B1212? 22 A. No. 11936 1 Q. Now, similarly, let me ask you to look 2 at Exhibit B1231, which is in the record at 3 Tab 380. 4 MR. GUIDO: What's the tab? 5 MR. NICKENS: 380. 6 MR. GUIDO: And the other one was Tab, 7 what, 381? 8 MR. NICKENS: I lost it. I'll get it 9 for you. 379. 10 Q. (BY MR. NICKENS) Mr. Giarla, have you 11 had a chance to look at this September 22nd, 1986 12 memo from Doug Hansen about mortgage-backed 13 securities trading committee? 14 A. Yes. 15 Q. And it indicates that their trade was 16 made or was asked to be approved and executed and 17 that Smith Breeden was consulted on the trade? 18 A. Right. 19 Q. In examining the trade, how would you 20 characterize it? 21 A. It's a swap from Freddie Mac 9 and a 22 halfs to Freddie Mac 8 and a halfs. 11937 1 Q. And it realized a 700,000-dollar 2 book -- accounting gain? 3 A. Apparently, right. 4 Q. Now, there's a sentence, "The implied 5 capitalization rate is 21 percent." 6 Do you recall ever having any 7 conversations with USAT about trying to develop a 8 decision rule for when a trade should take place 9 in relationship to its impact on their capital? 10 A. Not -- no, I don't. 11 Q. Was the consideration of the impact on 12 capital something that you thought was a 13 reasonable or unreasonable consideration in terms 14 of when you decided to make a trade? 15 A. Well, it's certainly something that 16 institutions considered or should consider if it 17 has a significant effect. 18 Q. And, in fact, the proposal that you 19 made in September was specifically one designed to 20 help them preserve capital so that they would have 21 the ability to add assets and grow out of the 22 problem? 11938 1 A. Right. 2 Q. Now, let me ask you to look at a 3 document that has been labeled as Exhibit B1263 4 and has not yet been admitted into the record. 5 Mr. Giarla, I just want to identify 6 this document, hopefully get it admitted. Can you 7 tell the Court what it is? 8 A. It says, "Smith Breeden Associates 9 hedge accounting system presentation to USAT - 10 October 16th, 1986, from Mike Schumacher at 11 Smith Breeden." And basically, this is a document 12 that is kind of a teaching tool or explanatory 13 tool that talks about interest rate risk and also 14 talks about liability hedging and methodology 15 where you could -- if you used futures to hedge 16 liabilities, how you might assign gains or losses 17 on futures to particular future periods. 18 Q. And was this part of a presentation 19 that was made to USAT? 20 A. I think so, yeah. 21 MR. NICKENS: Your Honor, we offer -- 22 we offer Exhibit B1263. 11939 1 MR. GUIDO: No objection, Your Honor. 2 THE COURT: Received. 3 Q. (BY MR. NICKENS) Did it ever come to 4 your attention that USAT's accountants had a 5 problem with the structure that you were 6 proposing? 7 A. Not that I know of. 8 Q. That's not something that came to your 9 attention? 10 A. I don't recall that coming up. 11 MR. NICKENS: Your Honor, if I might be 12 given a minute, I may be finished. 13 THE COURT: All right. 14 MR. NICKENS: Your Honor, that's all I 15 have at this time. 16 THE COURT: Do you have any redirect? 17 MR. GUIDO: Yes, Your Honor. 18 19 FURTHER EXAMINATION 20 21 Q. (BY MR. GUIDO) You were asked a number 22 of questions by Mr. Nickens about the swaps, and 11940 1 your paper said that they occurred one to two 2 times a year on the average was your experience. 3 Why did you, in your paper, say that 4 they occurred one to two times a year and then, on 5 cross-examination, indicate that you thought that 6 they -- that there might be swap opportunities 7 that could occur on a monthly, weekly, maybe daily 8 basis? 9 A. Well, I guess to clarify, typically we 10 find on average a couple of opportunities a year 11 to make major adjustments to the portfolios, major 12 opportunities. But on a -- and, of course, you 13 don't know exactly when that will occur. So, it 14 could occur at any point in time. You need to be 15 monitoring the markets all the time. 16 Then if you have a large portfolio of 17 securities, there may be some opportunities that 18 come up on any given day to take advantage of some 19 small opportunity. 20 Q. Now, does the risk increase in terms of 21 the accuracy of your assumptions about 22 pre-payments when the spread opportunity or the 11941 1 swap profit opportunity is smaller than those one 2 to two times a year? 3 A. No, it's really a function of what the 4 securities are that you're looking at and how 5 sensitive they are to the prepayment assumption. 6 Q. You were talking about Wall Street 7 making a mistake about prepayment assumptions and 8 resulting in losses in the first part of 1986. 9 They were incorrect about prepayment assumptions, 10 were they not? 11 A. Right. That was on a particular sector 12 of the market. 13 Q. Now, the prices of mortgage-backed 14 securities are a reflection of prepayment speeds, 15 are they not? 16 A. Yes. 17 Q. And the market could be right, or it 18 could be wrong. Right? 19 A. Right. 20 Q. And the trader could be right or could 21 be wrong, could they not? 22 A. Yes. 11942 1 Q. The more they do the trading, the more 2 likely it is that they could make an error? 3 A. I think your question is -- well, let 4 me make sure I understand it. 5 The more transactions you do, the 6 greater the chance that you will make an error 7 relative to somebody who trades less. 8 Q. Right. 9 A. From a numbers game, yes, I suppose 10 that's possible. 11 Q. And that the narrower the difference in 12 the profit opportunities by making the swap, the 13 greater the possibility of an error? 14 A. Yeah. All other things being equal, 15 that's probably true. 16 Q. Now, you indicated that you changed the 17 assumptions, the August 5th, 1986 newsletter. 18 Mr. Nickens asked you whether or not that resulted 19 in you changing your recommendation about 20 purchases of Fannie Mae 12 and a halfs. 21 Do you recall that? 22 A. Yes. 11943 1 Q. Now, I would like you to take a look at 2 your newsletter of August 14th; first of all, the 3 exact language of your letter of August 5th. 4 In the last paragraph of the newsletter 5 dated August 5th, 1986, in Exhibit A13006, I would 6 like to direct your attention to that. 7 A. All right. 8 Q. Okay. It says, "Not surprisingly, the 9 change in prepayment assumptions combined with the 10 new method of calculating prepayment rates has 11 caused Smith Breeden to modify its opinion of 12 which mortgage pools look like the best buys. We 13 have been recommending Fannie Mae 12s and 15s. 14 However, the increase in estimated prepayment 15 rates has caused us to lower our opinion of the 16 value of premiums." 17 Do you see that? 18 A. Yes. 19 Q. It says, "Additionally, Smith Breeden 20 feels that the cost of hedging unseasoned pools is 21 prohibitively high. So, we advise against buying 22 new pools. Consequently, we are now recommending 11944 1 Fannie May 15s and seasoned 8 and a halfs to 9 and 2 a halfs together with Freddie Mac 13s, 14 and a 3 halfs through 15s, and seasoned 9 through 9 and a 4 halfs." 5 And it goes on and talks about Ginnie 6 Maes. It doesn't say that you withdrew your 7 recommendation to purchase 12 and a halfs, does 8 it? Just indicated what you thought were the best 9 buys? 10 A. Right. They just presumably moved down 11 on the list relative to some of the other ones. 12 Q. Now take a look at the August 14th -- 13 excuse me? 14 A. 29th. 15 Q. August 29th newsletter. Look at the 16 last paragraph on the first page there. And I 17 direct your attention to, again, the sentence that 18 says, "Unfortunately, prices jumped," the line 19 that starts there, look at the sentence right 20 after that that says, "The best pools remain the 21 seasoned Fannie Mae and Freddie Mac premiums, with 22 spreads in excess of 100 basis points available on 11945 1 Fannie Maes with coupons of 12 or greater and on 2 Freddie Macs from 12 and a half and up"? 3 A. Yeah, right. 4 Q. That doesn't indicate that you changed 5 your opinion on Fannie Mae 12 and a halfs, does 6 it? 7 A. Just apparently for a brief time in 8 between this -- in between these two letters. 9 Q. But in neither case did your 10 assumptions result in a conclusion that the 11 Fannie Mae 12 and a halfs were not good buys? 12 A. That's correct. 13 Q. Now, Mr. Nickens asked you some 14 questions about rebalancing and asked you to look 15 at Exhibit B823, which was a newspaper article. 16 A. Institutional investment article. 17 Q. Right. And he directed your attention 18 to the paragraph that says, "Most practitioners 19 feel it's sufficient to re-evaluate their 20 arbitrages either monthly or with every 100 basis 21 point change in rates, whichever comes first." 22 And you said, "Well, I presume that's 11946 1 correct." 2 You didn't know. Why did you presume? 3 Because it was in print in a newspaper article? 4 A. Right. Right. 5 Q. You don't know anything other than what 6 was in the article, do you? 7 A. Like I said, a number of our clients 8 that did rebalancing was very limited. I think I 9 said that earlier. 10 Q. Did any of your clients wait monthly? 11 A. The ones that -- well -- 12 Q. I mean, there are two ways to do it. 13 MR. NICKENS: Your Honor, I would like 14 to hear the answer. 15 MR. GUIDO: Let me rephrase the 16 question. 17 THE COURT: Let's hear the answer to 18 the last question. 19 A. Do any of our clients rebalance 20 monthly? 21 Q. (BY MR. GUIDO) Yes. 22 A. The answer is yes, but there's more to 11947 1 the answer. 2 Q. Okay. What's the more? 3 A. Each of our clients has their interest 4 rate risk by different amounts and by different 5 numbers of options, and so -- and, also, we did 6 monthly reports. So, the typical client could 7 receive a report of their interest rate risk every 8 month; and even if they were hedged, there might 9 be small things that would happen to the portfolio 10 that would make it go out of balance a little bit. 11 The typical client of ours did monthly rebalancing 12 anyway, even if they were well-hedged. 13 Q. So, the client who hedged their 14 prepayment risk with options might rebalance on a 15 monthly basis? 16 A. Right. 17 Q. Now, those clients who hedged the 18 prepayment risk with options, would they also wait 19 the hundred basis points before they re-evaluated 20 their position? 21 A. I think before a hundred basis -- I'm 22 trying to remember; but at some point, we would 11948 1 redo our analysis. And I don't recall how far 2 rates would have moved for us to redo it. 3 If they were hedging with options, they 4 could presumably withstand a 100 basis point move 5 in rates without having to worry very much. 6 Q. This paragraph could be referring to a 7 client that had options to protect itself against 8 changes in prepayment rates and not one that 9 simply relied upon rebalancing of its swaps or 10 futures contracts to protect -- 11 A. It could. I don't know. 12 Q. Now, with regard to the clients that 13 you had that didn't use options to protect 14 themselves against the prepayment rates, how often 15 did they rebalance their portfolio? 16 A. Well, the only one I can remember -- 17 there may have been others -- the only one was the 18 Franklin case. The analysis I remember seeing at 19 the time, they had a schedule where they would 20 rebalance in 25 basis point increments, I think. 21 Q. Now, Mr. Nickens asked you whether or 22 not the OTS took objection to what Ernie Fleischer 11949 1 had done and took action against the thrift for 2 his management of that thrift. 3 Do you recall that question? 4 A. I wasn't sure if that was the exact 5 question, but I remember a question like that. 6 Q. And that the OTS placed Franklin in 7 receivership or conservatorship. Right? 8 A. Yes. 9 Q. Did OTS bring any enforcement action 10 against them for mismanagement of that thrift? 11 A. I don't know. 12 Q. So, the record would show that? 13 A. Yes. 14 Q. You've never heard of an enforcement 15 action brought personally against Ernie Fleischer 16 as was brought against Charles Hurwitz for his 17 management? 18 A. I don't know. Sorry. 19 Q. Now, you were asked a question about 20 the values, the historic values that are in 21 your -- in your chart on the September 15th report 22 which is A10666, historic liquidation values. 11950 1 Now, did these values take into 2 consideration the value of goodwill? 3 A. They would have -- goodwill would have 4 been written off. 5 Q. Would have been excluded from this 6 calculation? 7 A. Right. 8 Q. So, now -- it's very hard for me to 9 tell on the copy that I have, the dates; but is 10 the last date -- is that July of 1986? 11 A. That's what it looks like, yeah. 12 Q. And can you take a look -- I can't 13 tell -- but you start at -- is it -- the first bar 14 is March of 1984? 15 A. Yes, I think so. 16 Q. And the second bar, the deepest bar 17 graph is -- would that be June of '84? 18 A. Yes. 19 Q. And then the next would be September of 20 '84? 21 A. Right. 22 Q. And then the one after that would be 11951 1 December of 1984. Would that be fair? 2 A. Right. 3 Q. What does that show in terms of the 4 loss? 5 A. Looks like the loss went from minus 540 6 to minus 300. 7 Q. Do you know what it is that caused that 8 to happen? 9 A. No. 10 Q. Did it have anything to do with the 11 sale of the branches by USAT during that time 12 period? 13 A. It could have. I don't know. 14 Q. What was the increase in the loss from 15 December of 1984 to July of 1986 as shown by your 16 analysis? 17 A. Looks like approximately 130 million. 18 Q. Now, let's take a look at the interest 19 rate sensitivity chart. How does that chart 20 compare with the analysis that was done on -- on 21 the entire USAT entity which was done in August of 22 1986 which is Exhibit A10659? They seem to be the 11952 1 same dates. 2 A. Uh-huh. The -- there's only one data 3 point on -- if you look at Exhibit 10666, Bates 4 stamp 2057, which is the three graphs, the middle 5 graph is what we're looking at. The very -- the 6 right-most bar which looks like minus 4 or 7 5 million, that should tie in with the -- that 8 should be the average gain or loss for a 1 percent 9 rate move for the institution shown in 10659. So, 10 if you look at Bates stamped Page 00041 -- 11 Q. 00041? 12 A. Right. The net effect of rate changes; 13 is that right? Actually, I might have gone to the 14 wrong exhibit. Maybe the -- whatever our 15 latest -- I'm sorry. 16 Maybe the September 15th one is the one 17 I need. I'm sorry. 18 Q. We're on the September 15th one. 19 A. Then that's -- okay. Do you want me to 20 compare it with that exhibit? Basically -- 21 Q. If you look at the loss, if you look at 22 Exhibit A10659 and you look at the change, the 11953 1 1 percent change, you find the answer on Bates 2 stamp 41, don't you, at the bottom, which is 3 $21 million? 4 A. Right. 5 Q. Now, but on this chart, on A10666, it 6 shows 4 to 5 million? 7 A. We're graphing the average of the plus 8 1 and minus 1, gains and losses. 9 Q. So, this chart is an average of the 10 plus 1 and the minus 1? 11 A. Right. 12 Q. So, this here averages an increase up 13 and an increase down. This UFG interest rate 14 sensitivity chart on 2057 on Exhibit No. 10666 is 15 not an adverse interest rate move? 16 A. Right. It's an average. 17 Q. Of a positive and a negative? 18 A. Right. 19 Q. It also says that it's dealing with 20 UFG's interest rate sensitivity, not USAT? 21 A. I'm not sure why that is. 22 Q. UFG did have subsidiaries other than 11954 1 USAT, did it not? 2 A. Yeah. I don't remember the structure 3 of how the subsidiaries worked. 4 Q. But that could also explain the 5 difference, could it not? 6 A. It's possible. 7 Q. Now, you also looked at UFG's projected 8 net income with Mr. Nickens that was in that 9 September 15th analysis. And then you looked at 10 it and it showed on Page 4, which is the Bates 11 stamp 2059 -- and you indicated that that 12 indicated to you that it was advantageous to grow 13 the institution out of its deficit. 14 Do you recall that testimony? 15 A. Yes. Yes. 16 Q. Did you ever take into consideration 17 whether or not the institution would have been 18 better off just closing? 19 A. No. 20 Q. Why not? 21 A. Well, that wasn't -- I guess it wasn't 22 our decision to make. 11955 1 Q. The client didn't ask you to make it, 2 did it? 3 A. Right. 4 Q. Now, on your accounting profit example 5 that you did, you said that it was designed to 6 take advantage of the accounting rules to generate 7 capital or accounting capacity or book capital. 8 Why was it that you said that that was 9 a good thing? 10 A. Because it would allow the institution 11 to take advantage of -- of economically profitable 12 activities and that it might not have been able to 13 do otherwise. 14 Q. It buys time. Is that what you're 15 saying? 16 A. That's one possibility. Other 17 possibilities are, for example, when interest 18 rates increase and you find profitable swap 19 opportunities in your portfolio, oftentimes we 20 would see institutions being unwilling to sell 21 assets because they would have to recognize an 22 accounting loss. So, if they had a gain somewhere 11956 1 else in the portfolio that they could recognize, 2 it would allow them to undertake those profitable 3 swap opportunities. 4 Q. Have you ever heard of the phrase 5 "intent-driven accounting principles" -- 6 A. No. 7 Q. -- or "outcome-oriented accounting" -- 8 A. No. 9 Q. Now, you were asked how did your 10 assumptions differ from the Wall Street 11 assumptions; and you indicated that you thought 12 yours were better. 13 In what time frame were you talking 14 about? 15 A. The particular period I think we were 16 focusing on was early '86. 17 Q. When in '86? March? April? 18 A. I think first, second quarter. It was 19 the period where interest rates fell and there 20 were significant losses recognized by firms 21 hedging their premiums. 22 Q. Was it the first or second quarter? 11957 1 A. I thought it was the first, but it may 2 have been the second. 3 Q. It could have been the second? 4 A. It's possible. 5 Q. What was -- what was the error that 6 Wall Street made in terms of its assumption about 7 pre-payments? They assumed it was going to be 8 greater or less than you did? 9 A. I think the ultimate assumption was 10 that high coupon fixed-rate mortgages would gain 11 in value more than they did as rates fell. So, it 12 may have been a prepayment assumption. It 13 probably was related to prepayment assumptions. 14 However, they came up with their estimates of 15 interest rate risk and determining how to hedge 16 it. They had more hedges than they needed; so, 17 they ended up losing more on the hedges than they 18 needed. 19 Q. Why would they overhedge if they 20 underestimated pre-payments? 21 A. They would have -- yeah, because 22 they -- 11958 1 Q. I think that's what you just said. 2 A. Right. If you underestimate 3 pre-payments, you have the security that you think 4 is going to increase in value more than it 5 actually does when the rates go down. So, you 6 would put on more hedges. You need more hedges to 7 hedge against. 8 Q. Let me ask you -- we've talked about 9 two kinds of hedges here. One is the swap type 10 hedge which protects against upward movements in 11 interest rates, and then the other is you put on 12 options contracts to protect against the downward 13 movements. Right? 14 A. Well, a swap hedge protects you against 15 rates going either direction. It's designed to 16 reduce the volatility of the market value of the 17 combined portfolio. The options benefit you for 18 larger moves in rates that a swap wouldn't take 19 into account. 20 So, the problem Wall Street firms had 21 during that period is that they, I think, assumed 22 that high coupon mortgages were more interest rate 11959 1 risky, that their prices would change on average 2 more than they actually did. So, they put on more 3 hedges, futures or swaps, than they actually 4 needed, as it turned out. 5 Q. So, was their estimate of prepayments 6 higher or greater than yours? 7 A. Their estimate was less than ours. 8 Q. You think that was the first quarter or 9 second quarter of 1986? 10 A. Right, I think so. 11 Q. In terms of the time period, the last 12 quarter of 1985, were there any differences in the 13 assumptions between Smith Breeden and Wall Street 14 about prepayment assumptions? 15 A. I imagine it would be similar. The 16 reason the first quarter comes to mind is that's 17 when I think there was a lot of public information 18 and articles and newspapers about it. 19 Q. Now, you were asked some questions 20 about two trades: Exhibits B1212 and Exhibit 21 B1231. I would like to -- let's start with B1231, 22 the sale and the purchase of those two entities. 11960 1 It says Smith Breeden was consulted on the trade. 2 Do you see that? 3 A. Yes. 4 Q. But it doesn't say what Smith Breeden's 5 views were at the time? 6 A. That's correct. 7 Q. Do you recall what your views were? 8 A. No, I don't. 9 Q. Were there trades that were brought to 10 your attention by USAT that you recommended they 11 not make? 12 A. Well, as I look at this, I guess the -- 13 you know, we saw that one proposed hedge with 14 the -- that Goldman had proposed that we said we 15 didn't recommend. I'm not sure that they were 16 planning on doing it, but we recommended that. 17 At the time we worked with Sandy, there 18 may have been some potential transactions that we 19 analyzed and didn't recommend. 20 Q. Do you recall whether or not you 21 recommended that they make the trade or not make 22 the trade in Exhibit B1231? 11961 1 A. I don't recall. 2 Q. Now, when you would look at trades 3 where you were swapping one security for another, 4 what was it that you looked to to ascertain 5 whether or not the trade should be made? 6 A. The bottom line is the option-adjusted 7 spread. 8 Q. Okay. And he had spread income, 9 option-adjusted spread income. Right? 10 A. Right. 11 Q. This says the spread income is a 12 negative of 150 in the first year, does it not? 13 A. Right. 14 Q. That doesn't conform to your general 15 criteria of recommending a trade, does it? 16 A. I'm not sure how they are measuring 17 that; but if, by "spread income," they mean 18 option-adjusted spread, then it doesn't conform. 19 Q. If it doesn't include option-adjusted 20 spread income, just pure spread income, you have 21 also advised clients not to do that, have you not? 22 A. You wouldn't base your decision just on 11962 1 spread income. Right. 2 Q. That could only mean one or the other. 3 Right? Either spread income or option-adjusted 4 sped income. Right? It can't have any other 5 meaning, can it? 6 A. Those are the two I would think of. 7 Q. Let's take a look at Exhibit B1212, 8 which is the Doug Hansen memo regarding another 9 trade. It says, "The committee approved the 10 execution of the second leg of a two-part trade 11 that was in process. Joe Phillips had sold 12 $80 million of Freddie Mac 9s and purchased 13 Fannie Mae 9s at the same price. Fannie Mae 9s 14 typically trade 8/32 dearer than Freddie Mac 9s. 15 The initial trade allowed United to purchase the 16 Fannie Maes cheaply. One month later, Joe 17 Phillips proposed reversing the trade, as 18 Fannie Mae 9s were now selling 10/32 dearer than 19 Freddie Mac 9s. The completion of the trade will 20 yield United a gain of 250,000 and leave us with 21 the Freddie Mac 9s we originally owned." 22 Do you see that? 11963 1 A. Yes. 2 Q. Does this indicate anything about the 3 option-adjusted spread income? 4 A. It doesn't specifically mention it, but 5 you can make an inference. 6 Q. How do you make an inference? 7 A. Well, I guess the first thing that it 8 says is that why do Fannie Mae 9s typically trade 9 8/32 dearer than Freddie Mac 9s. That has to do 10 with the payment delay. They come in a month 11 later. So, that's why Fannie Mae 9s typically 12 have a higher price because you get the cash flow 13 a month sooner. If you make that assumption, that 14 they have similar characteristics, if the 15 relationship is, instead of 8/32, 10/32, then that 16 would imply the Fannie Mae 9s would have a 17 slightly worse option-adjusted spread. 18 Q. Could one of the reasons for the 19 difference and changes have been changes in 20 pre-payments during that time period? 21 A. It's possible. There are a variety of 22 reasons. 11964 1 Q. This doesn't indicate anything about 2 the prepayment characteristics of these pools, 3 does it? 4 A. No, it doesn't. 5 Q. Is there a term that's used to describe 6 the prepayment characteristics of specific pools? 7 Do you think of WACs or WAMs or similar terms? 8 A. When you say "prepayment 9 characteristics," you mean what determines the -- 10 Q. There are differences between 11 prepayment characteristics of different pools, is 12 there not? 13 A. You could have Fannie Mae 9s with 14 different weighted average maturities, if that's 15 what you're getting at. They don't have to be -- 16 the Fannie Mae and Freddie Mac 9s don't have to 17 have the same characteristics. 18 Q. This phrase leaves us with the 19 Freddie Mac 9s that we originally owned may or may 20 not be true depending on the particular pools that 21 are involved. Right? 22 A. Right. But I think here they are 11965 1 talking about reversing the trade that probably 2 hasn't settled yet. 3 Q. But you don't know that? 4 A. That's my assumption, given the wording 5 of it. 6 Q. This says Mike Crow, at a prior 7 conversation with Smith Breeden on this trade, did 8 not oppose it? 9 A. Right. 10 Q. Do you recall what Smith Breeden's 11 views were? 12 A. No, I don't. 13 Q. Possibly Smith Breeden could have been 14 silent on it? 15 A. Yes. 16 MR. NICKENS: Your Honor, it's 5:00 17 o'clock; and just about anything is possible. 18 These questions about "is it possible" really 19 don't add much to the record. I object. 20 THE COURT: How much more do you have? 21 MR. GUIDO: I only have a couple of 22 questions, Your Honor. 11966 1 Q. (BY MR. GUIDO) Now, Mr. Nickens asked 2 you about implied capitalization rate. 3 Can you tell us what implied 4 capitalization refers to? 5 A. I'm not really sure what it means. 6 Again, I could venture a guess. It somehow 7 relates to the trade-off between the 700,000 of 8 accounting gains and the foregone income, but I -- 9 Q. If you're losing money and you own a 10 thrift and you're losing money and your capital is 11 negligible and you run a risk of being placed into 12 conservatorship, to the owners, is the money worth 13 more as capital gain or as an income stream? 14 A. I'm not sure. Seems like it's all -- 15 it should be all the same, I would imagine, unless 16 there's -- yeah. I don't know that there's a 17 difference. 18 Q. If you have an income stream of an 19 institution that you're about to lose, is the 20 capital gain worth more to you than the income 21 extreme that you're not going to be able to 22 realize? 11967 1 A. Well, I guess it seems to me the income 2 stream is related to the -- should be related to 3 the -- kind of an overall capital gain or loss in 4 the institution. 5 Q. If you have an institution and unless 6 it generates capital quickly, is the implied 7 capitalization rate greater for that institution 8 than one that is not about to be taken over? 9 A. Yeah, I'm not sure what the implied 10 capitalization rate is. But I think your question 11 is whether, if you thought the institution -- 12 let's say you thought the institution would be 13 taken over in a year, you know. 14 Would you rather have income sooner 15 than later? I guess the answer's sooner than 16 would be better. 17 MR. GUIDO: No further questions, Your 18 Honor. 19 MR. NICKENS: I don't have anything 20 further, Your Honor. 21 THE COURT: All right. Thank you, 22 Mr. Giarla. We'll adjourn until 9:00 tomorrow 11968 1 morning. 2 3 (Whereupon at 5:03 p.m. 4 the proceedings were recessed.) 5 . 6 . 7 . 8 . 9 . 10 . 11 . 12 . 13 . 14 . 15 . 16 . 17 . 18 . 19 . 20 . 21 . 22 . 11969 1 STATE OF TEXAS COUNTY OF HARRIS 2 REPORTER'S CERTIFICATION 3 TO THE TRIAL PROCEEDINGS 4 I, Marcy Clark, the undersigned Certified 5 Shorthand Reporter in and for the State of Texas, 6 certify that the facts stated in the foregoing 7 pages are true and correct to the best of my ability. 8 I further certify that I am neither 9 attorney nor counsel for, related to nor employed 10 by, any of the parties to the action in which this 11 testimony was taken and, further, I am not a 12 relative or employee of any counsel employed by 13 the parties hereto, or financially interested in 14 the action. 15 SUBSCRIBED AND SWORN TO under my hand 16 and seal of office on this the 16th day of June, 17 1998. 18 ____________________________ MARCY CLARK, CSR 19 Certified Shorthand Reporter In and for the State of Texas 20 Certification No. 4935 Expiration Date: 12-31-99 21 . 22 . 11970 1 STATE OF TEXAS COUNTY OF HARRIS 2 REPORTER'S CERTIFICATION 3 TO THE TRIAL PROCEEDINGS 4 I, Shauna Foreman, the undersigned 5 Certified Shorthand Reporter in and for the 6 State of Texas, certify that the facts stated 7 in the foregoing pages are true and correct 8 to the best of my ability. 9 I further certify that I am neither 10 attorney nor counsel for, related to nor employed 11 by, any of the parties to the action in which this 12 testimony was taken and, further, I am not a 13 relative or employee of any counsel employed by 14 the parties hereto, or financially interested in 15 the action. 16 SUBSCRIBED AND SWORN TO under my hand 17 and seal of office on this the 16th day of June, 18 1998. 19 _____________________________ SHAUNA FOREMAN, CSR 20 Certified Shorthand Reporter In and for the State of Texas 21 Certification No. 3786 Expiration Date: 12-31-98 22