5141 1 UNITED STATES OF AMERICA Before the 2 OFFICE OF THRIFT SUPERVISION DEPARTMENT OF THE TREASURY 3 In the Matter of: ) 4 ) UNITED SAVING 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 10-27-97 22 5142 1 A-P-P-E-A-R-A-N-C-E-S 2 ON BEHALF OF THE AGENCY: 3 KENNETH J. GUIDO, Esquire Special Enforcement Counsel 4 BRUCE RINALDI, Esquire RICHARD STEARNS, Esquire 5 and BRYAN VEIS, Esquire (Not present) of: Office of Thrift Supervision 6 Department of the Treasury 1700 G Street, N.W. 7 Washington, D.C. 20552 (202) 906-7395 8 ON BEHALF OF RESPONDENT MAXXAM, INC.: 9 FRANK J. EISENHART, Esquire 10 CATHERINE BOTTICELLI, Esquire of: Dechert, Price & Rhoads 11 1500 K Street, N.W. Washington, D.C. 20005-1208 12 (202) 626-3306 13 DALE A. HEAD (in-house) Managing Counsel 14 MAXXAM, Inc. 5847 San Felipe, Suite 2600 15 Houston, Texas 77057 (713) 267-3668 16 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO. AND 17 CHARLES HURWITZ: 18 RICHARD P. KEETON, Esquire of: Mayor, Day, Caldwell & Keeton 19 1900 NationsBank Center, 700 Louisiana Houston, Texas 77002 20 (713) 225-7013 21 22 5143 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 5144 1 2 EXAMINATION INDEX 3 Page 4 JOSEPH PHILLIPS 5 Examination (Cont'd) by Mr. Guido........5145 6 Cross-Examination by Mr. Nickens.........5316 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 5145 1 P-R-O-C-E-E-D-I-N-G-S 2 (10:35 a.m.) 3 4 THE COURT: Be seated, please. The 5 hearing will come to order. Unless there are 6 preliminary matters, we will continue with the 7 examination of Mr. Phillips. 8 MR. GUIDO: Thank you, Your Honor. 9 10 EXAMINATION 11 12 Q. (BY MR. GUIDO) Mr. Phillips, when you 13 reported to Jerry Williams on your activities 14 prior to the creation of the investment committee, 15 did anyone accompany you when you met with 16 Mr. Williams? 17 A. Very often, it would be Ron Huebsch. 18 Q. Why did Mr. Huebsch attend with you 19 when you were reporting to Mr. Williams? 20 A. We consulted on many subjects, and we 21 executed most transactions -- virtually all 22 transactions in the trading room at the MCO 5146 1 building. And Mr. Huebsch had market inputs and 2 helpful comments on how certain transactions 3 should be undertaken. 4 Q. Now, when you met with Mr. Williams 5 with Mr. Huebsch, was that to report on what you 6 had been doing? This is prior to the investment 7 committee's creation. 8 A. It could either be to report or to 9 suggest certain strategies to complete things we 10 had already suggested and already started. 11 Q. Now, you indicated that your background 12 had been in managing high-yield corporate bond 13 portfolios. 14 Can you tell us what the risks were with 15 those portfolios? 16 A. The primary risk in high-yield 17 corporate bonds is credit risk, and it is also the 18 primary source of return from holding corporate 19 bonds, high-yield corporate bonds. 20 Q. Are high-yield corporate bonds as 21 volatile to changes in interest rates as 22 mortgage-backed securities? 5147 1 A. No, they are not. 2 Q. Did you have any experts available as 3 consultants to you in the 1984, 1985 time frame 4 when you put on the mortgage-backed security 5 risk-controlled arbitrage portfolio for USAT? 6 A. Yes, we did. 7 Q. Who were they? 8 A. They were individuals from specialized 9 departments of investment banking firms, 10 specialized departments that could discuss 11 interest rate swaps and other devices, as well as 12 people from the mortgage-backed securities trading 13 area. 14 Q. Did you eventually consult with Smith 15 Breeden to obtain advice from them regarding the 16 management of the risk-controlled arbitrage MBS 17 portfolio? 18 A. I did not personally, but the 19 association did retain Smith Breeden for that. 20 Q. When was that? 21 A. I believe it was in 1986. 22 Q. Was it sometime in June of 1986? 5148 1 A. I don't recall the date. 2 Q. Was it in the early part of the year 3 when you were selling mortgage-backed securities 4 of one coupon and purchasing mortgage-backed 5 securities of another coupon? 6 A. It could have been during that same 7 period. 8 Q. Did they advise you on what to do 9 during that period? 10 A. No, they did not. 11 Q. Now, in the 1985 time period, had you 12 retained a consultant such as Smith Breeden to 13 advise you on the management of the 14 risk-controlled arbitrage mortgage-backed security 15 portfolio at USAT? 16 A. No. 17 Q. Now, you indicated that you consulted 18 with representatives of the investment banking 19 firms? 20 A. Yes. 21 Q. Who were those individuals? 22 A. I don't recall the names of the 5149 1 individuals who were the specialists. Our 2 salesmen referred them to us and, in many cases, 3 they visited our offices and made presentations or 4 simply discussed how their products did work. 5 Q. Was one of those people Michael Waldman 6 from Salomon Brothers? 7 A. No, I don't think so. 8 Q. Was one of those people Scott Pinkus 9 from Morgan Stanley? 10 A. I met with Scott Pinkus, but I don't 11 recall whether it was in our offices or whether it 12 was in New York. But I had met him and visited 13 with him once or twice. 14 Q. And who is Mr. Pinkus? 15 A. Mr. Pinkus was a mortgage-backed 16 securities research analyst. I believe he was at 17 Morgan Stanley when I first met him. 18 Q. Okay. Do you know who Michael Waldman 19 was? 20 A. Michael Waldman also did research and 21 wrote on mortgage-backed securities, and he was 22 with Salomon Brothers. 5150 1 Q. Did you have access to their literature 2 in 1985? 3 A. Yes. 4 Q. And did you produce some of that 5 literature to the OTS in response to a subpoena 6 served upon you in the investigative phase of this 7 proceeding? 8 A. Yes, I did. 9 Q. Now, were they employed by the 10 investment banking firms that were selling 11 mortgage-backed securities to USAT? 12 A. Yes, they were. 13 Q. Now, did you have any -- in 1985 and 14 late '84, did you have a computer capability to 15 analyze the interest rate sensitivity of the 16 risk-controlled arbitrage mortgage-backed security 17 portfolio based on changes in interest rates? 18 A. We had the beginnings of systems that 19 are more available today. We had the Bloomberg 20 system and for a while, we had a proprietary 21 system that was provided by Drexel. 22 Q. And what information was input into 5151 1 that system to ascertain what the effect would be 2 of changes in interest rates on the 3 risk-controlled arbitrage portfolio? 4 A. The kind of inputs that systems like 5 that would accept would include a range of 6 interest rate curve shifts to be modeled, the 7 characteristics of the security or the portfolio 8 being modeled, and assumptions regarding the 9 response of prepayment to those shifts in interest 10 rates. 11 Q. Did it accept different prepayment 12 rates for different interest rate scenarios? 13 A. I believe that such systems would. 14 Q. Do you recall when you had access to 15 that system? 16 A. I believe it was 1985. 17 Q. Do you recall when in '85? 18 A. No, I don't. 19 Q. Who was responsible for maintaining 20 that system at USAT? 21 A. It was a modeling system on which to 22 simulate certain market results. It was not a 5152 1 system of transactions or anything that really 2 needed to be maintained. It was a system by which 3 you could make these assumptions and produce these 4 results. 5 You could also calculate certain numbers 6 that were needed for closing mortgage-backed 7 securities transactions: The accrued interest and 8 the amount of face value that was to be delivered 9 and things of that nature. But it was not a 10 system of transactions that needed actual 11 maintenance. So, I would use this; but there was 12 no maintenance to it. 13 Q. Was it a system that gave you a 14 conclusion with regard to what would happen if 15 interest rates moved 100 basis points either way? 16 A. It was a system that would give you -- 17 yes. What would happen -- however, it might not 18 at that time have made a clear link between 19 interest rate shifts and the effect on prepayment. 20 I believe the prepayment would have had to be 21 something you would have put in yourself. 22 Q. So that the system did not 5153 1 automatically include changes in prepayments based 2 on changes in interest rates? 3 A. I believe that it did not. 4 Q. Did the system provide you with a 5 calculation of what the yield was on the 6 portfolio? 7 A. Yes. Subject to all those inputs that 8 we mentioned earlier, it would give you a yield. 9 Q. Okay. Would it give you the yield on 10 the mortgage-backed securities? 11 A. Yes, it would. 12 Q. Would it give you the net yield on the 13 difference between what was earned on the 14 mortgage-backed securities or anticipated to be 15 earned on the mortgage-backed securities and what 16 was paid on the swaps? 17 A. This system was not a system to manage 18 the risk-controlled arbitrage. It was a system 19 solely for the analysis of mortgage-backed 20 securities. 21 Q. It was only a system that determined 22 what the yield might be on the mortgage-backed 5154 1 security standing alone? 2 A. That's correct. 3 Q. And it only calculated yield? 4 A. Well, a system like this might also 5 calculate price given yield. 6 Q. Now, what were you most interested in 7 looking at in 1985 in evaluating the performance 8 of the mortgage-backed securities? 9 A. We would have been interested in the 10 yield that we had earned and the yield that we 11 could expect subject to what might happen with 12 prepayments. 13 Q. Did you attempt to ascertain what the 14 market value effect would be on the 15 mortgage-backed securities? 16 A. If we did, it would have been 17 coincidental. It was not part of any analysis we 18 needed to conduct the management of the structure. 19 Q. Okay. What do you mean by that? 20 A. The market value at any given moment 21 would not have entered into any decisions to -- 22 that we undertook to manage the portfolio. It was 5155 1 a spread structure, and the maintenance and 2 preservation of that spread was our objective. 3 Q. And not to maintain the value -- the 4 market value of the portfolio? 5 A. That's correct. 6 Q. Why not? 7 A. Because we had created a structure that 8 would allow the securities to run off, allow us to 9 hold them to maturity or whatever their final 10 payment was. We had a structure to hedge the 11 short funding risk to carry those with. So, the 12 risks that we had identified as the important ones 13 and the risks from which we earned our return were 14 appropriately hedged and identified. 15 Q. Doesn't the prepayment risk refer to 16 the option of the borrower to prepay the 17 mortgages? 18 A. Yes, it does. 19 Q. So, how could you be so certain that 20 you could maintain the portfolio until your 21 expected life had expired if the purchaser had an 22 option to prepay? 5156 1 A. If the purchaser exercised his option 2 to prepay, the durations that we had calculated 3 for use in creating the match would change and we 4 would undertake to rebalance the portfolio to 5 bring that back in line. 6 Q. And you used the yield figures to 7 determine when to rebalance? 8 A. No. We would have used the durations. 9 Q. You would have used the durations? 10 A. That's correct. 11 Q. And that -- and how did you ascertain 12 the duration at any given point in time? 13 A. Well, we had the basis books that I 14 referred to before in which we could look up the 15 coupon of the issue, the approximate remaining 16 time to maturity, and the price or the yield, and 17 suggest a prepayment speed and get a duration from 18 these books. 19 Q. Did these books tell what you the 20 prepayment speeds would do based on how far the 21 coupon that you held was away from the par or the 22 current market? 5157 1 A. No, they did not. 2 Q. Who was the first vendor that you 3 purchased a risk-controlled arbitrage from? 4 A. I believe that it was from 5 Merrill-Lynch. 6 Q. And who was the salesman from 7 Merrill-Lynch again? 8 A. The salesman was Joe Schuler. 9 Q. Why did you purchase from 10 Merrill-Lynch? 11 A. I believe that at that time, they were 12 the first to line up all the pieces that it took 13 to put a transaction like this together. It 14 essentially took two or three different 15 departments of these firms to execute, almost 16 simultaneously, the transactions required to do 17 this. 18 Q. Who were the largest firms in terms of 19 business in marketing mortgage-backed securities 20 and risk-controlled arbitrages at the time? 21 A. Salomon Brothers was quite large. I 22 believe that Morgan Stanley, First Boston were 5158 1 also quite large. 2 Q. Now, didn't they also have the 3 capability of providing you with all three pieces 4 of risk-controlled arbitrage, the reverse repo, 5 the swaps, or caps or collars, and the 6 mortgage-backs themselves? 7 A. Yes. Any of them could. 8 Q. So, why did you pick Merrill-Lynch? 9 A. Well, they were among the first to show 10 us a complete package, brought experts down from 11 New York to discuss how the interest rate swaps 12 would work, and really just the first ones ready 13 to go. 14 Q. Now, had any of the other firms that 15 you just mentioned made presentations to you with 16 regard to what they were proposing prior to 17 purchasing the risk-controlled arbitrage from 18 Merrill-Lynch? 19 A. I don't recall that formal 20 presentations had taken place before this. All of 21 the salesmen in the mortgage-backed securities 22 business had presented structures like this at one 5159 1 point or another very early. 2 Q. Now, can you describe for us what the 3 basic structure was of the risk-controlled 4 arbitrage that you purchased from Merrill-Lynch? 5 A. The basic structure involved the 6 purchase of mortgage-backed securities financed 7 with a reverse repurchase agreement, which was a 8 short-term borrowing which could be quite short. 9 It could be from overnight to a couple of months. 10 And the spread created by the difference between 11 those two yields, the yield and the cost of the 12 short borrowing, would be reduced by the use of an 13 interest rate swap. And the interest rate swap 14 would have required the association to be a fixed 15 rate payer, and the fixed rate would essentially 16 offset the floating rate received, which 17 essentially created a longer term financing than 18 the reverse repo would have by itself. And we 19 used the face amounts, I believe, that were 20 equivalent. And we matched the duration of the 21 swap to the duration of the mortgage-backed 22 securities. 5160 1 Q. Your expected duration? 2 A. Yes, given the prepayment assumption. 3 Q. Now, what is this -- I've noticed in 4 some of the papers that we're going to go through 5 today, there is a thing called a CPR. 6 Can you tell us what a CPR is? 7 A. It is one of several prepayment 8 measurements. I believe that CPR was one of the 9 more common ones at that time, and it meant 10 constant prepayment rate. 11 Q. Okay. Now -- and is that how you 12 calculated the duration of the mortgage-backed 13 securities to match the duration of the swaps to 14 them? 15 A. We would use the CPR in the calculation 16 of duration, yes. 17 Q. Now, in terms of the mortgage-backed 18 securities that you purchased, were those 19 essentially purchased at par or a slight premium 20 to par? 21 A. Yes, they were. 22 Q. So, they were essentially at whatever 5161 1 the current market value was or close thereto? 2 A. They were near the current market rate 3 or slightly higher than the current market rate. 4 Q. And then in some cases, you paid a 5 premium for those? 6 A. Yes. 7 Q. Now, if you were pricing the security, 8 would 100 be par? Is that the way you would 9 define par? 10 A. Yes. 11 Q. Okay. And 101 would be a premium? 12 A. That's correct. 13 Q. 99 would be a discount? 14 A. Yes. 15 Q. Now, with regard to the swaps, when you 16 were paying the fixed rate on one end, the long 17 end, and receiving the variable rate, what would 18 happen if interest rates went down? 19 A. If interest rates went down, the rate 20 paid on the interest rate swap, of course, would 21 remain constant. It was a fixed rate for a term. 22 The rate on the reverse repurchase agreement might 5162 1 change depending on which end of the yield curve 2 did go down. If it went down, it would also fall. 3 The interest rate received on the interest rate 4 swap, also a variable rate, might also go down. 5 And the market price of the mortgage-backed 6 security would rise depending on how high the 7 coupon was and what the expected behavior of 8 prepayments might be after this market -- after 9 this market move. 10 Q. Put the mortgage-backed securities 11 aside. Would you end up paying more on the swap 12 if interest rates went down? 13 A. No, you would not. 14 Q. Why not? 15 A. Because we were the fixed payer of the 16 swap. And so, we paid a fixed rate for a term 17 certain just as if it was a borrowing. 18 Q. And you received a variable rate in 19 return. Right? 20 A. That's correct. 21 Q. And those two payments would net 22 themselves out to determine who it was and how 5163 1 much they had to pay the other party? 2 A. Yes, that's correct. 3 Q. So, if the rates went down -- if you 4 were a fixed rate and rates went down, the net 5 payment to whoever was the counter-party would 6 increase, would it not? Just looking at the swap. 7 A. Well, I'm not sure. I guess that's 8 correct, looking at the swap. If the floating 9 rate that we paid -- I'm sorry -- the floating 10 rate we received went down, the net amount would 11 be larger, that's correct. 12 Q. Now, I'd like you -- I'd like to move 13 to another subject. And this goes to sort of 14 later in 1986. 15 Will you take a look at Exhibit A1406 16 which is the investment committee minutes of 17 August 28th, 1986? And I direct your attention to 18 the third page of the document which is Bates 19 stamped US34861. 20 Do you see that page? 21 A. Yes. 22 Q. And look at the third paragraph from 5164 1 the bottom. It says "Mr. Crow proposed that until 2 our new mortgage-backed securities position was 3 filled that we consider moving ahead with 4 approving mortgage-backed security value trades 5 that will improve the overall portfolio position 6 and yield. In the future, he proposed that 7 mortgage-backed securities trading be accomplished 8 through a committee consisting of Mr. Crow, 9 Mr. Phillips, Mr. Bruce Williams, and Mr. Doug 10 Hansen. Mortgage-backed security trades would be 11 executed by a majority vote of the members of the 12 committee and the concurrence of Smith Breeden 13 Associates. Smith Breeden would be consulted on 14 each trade involving mortgage-backed securities 15 and the economics and reason for each trade would 16 be reported to the investment committee. The 17 committee approved these procedures for future 18 trading in mortgage-backed securities and they 19 were to be presented for final approval to 20 Mr. Jenard Gross before implementation." 21 Do you see that? 22 A. Yes. 5165 1 Q. Was such a policy adopted by the 2 investment committee? 3 A. Yes. A subcommittee of this group was 4 formed. 5 Q. And was Smith Breeden retained to be 6 consulted on trades involving mortgage-backed 7 securities and the economics and reason for each 8 trade? 9 A. We already had a business relationship 10 with Smith Breeden and I know that on at least one 11 occasion that I recall, we contacted them 12 regarding a proposed trade. 13 Q. Now, what is the reference to value 14 trades? 15 A. A value trade would have been one that 16 would have helped the portfolio in some small, 17 incremental way but would not be of the sort of 18 transaction that would constitute a significant 19 rebalancing of restructuring. 20 Q. Can you give us an example of such a 21 trade? 22 A. Very often, there would be intermarket 5166 1 opportunities to trade out of a similar security 2 issued by one agency into that of another to -- 3 because there might be some anomaly. These 4 securities might trade at a certain relationship 5 to each other, and that relationship might be out 6 of line. And we could execute that transaction, 7 in effect, buying a security cheaper than it might 8 ordinarily be available and sometime later have 9 the opportunity to reverse that and perhaps 10 improve the portfolio with that gain. 11 Q. What was the major factor that affected 12 the price of a mortgage-backed security at that 13 time? 14 A. Expected prepayment speeds would be the 15 most important factor. 16 Q. And did you attempt to ascertain 17 whether or not it was expected prepayment speeds 18 that was affecting the price of the 19 mortgage-backed security that you were trading 20 into or out of? 21 A. Yes. But quite often, they would be 22 similar coupons and over reasonable periods of 5167 1 time, similar coupons might be expected to have 2 similar prepayment behavior. My recollection is 3 that the most frequent sort of value trade was 4 that between -- between different agencies such as 5 Freddie Mac or Fannie Mae and having relationships 6 that were, given by their different 7 characteristics, somewhat out of line and the 8 opportunity to trade with that. 9 Q. Now, when you say that the 10 characteristics of the prepayments were similar, 11 did you attempt to calculate that or did you 12 assume that to be the case? 13 A. We wouldn't have examined the 14 individual pools that were being suggested. We 15 wouldn't even know what they were until 16 settlement. But we understood the differences in 17 their characteristics might include the delay of 18 the first payment from time of ownership that 19 would cause some difference in price that was a 20 reasonably permanent difference. And we 21 understood that certain agencies at that time 22 had -- all the loans were assumable and that those 5168 1 had different prepayment characteristics. But in 2 these cases, we didn't find these to be the most 3 important characteristics because we thought the 4 securities were reasonably similar. 5 Q. I'd like you to now explain to us other 6 examples of value trades. You said the most 7 common was going from one issuer -- Fannie Mae to 8 Freddie Mac or Freddie Mac to Fannie Mae. 9 Were there other types of value trades? 10 A. I think I would include the opportunity 11 to do a dollar roll as a sort of value trade, 12 although not a trade on the security but a trade 13 against the short-term borrowing rate. We could 14 always -- I should say quite often improve the 15 performance of the portfolio by improving the 16 short-term rate that we were financing at by using 17 a dollar roll. 18 Q. Can you explain to the Court what you 19 mean by "using a dollar roll to enhance the 20 yield"? 21 A. A dollar roll was a kind of transaction 22 that was proposed by a bond dealer who, quite 5169 1 often, come settlement date did not have the 2 securities to deliver. In that case, we'd be 3 willing to purchase securities from others to 4 effect his delivery at a somewhat higher price 5 than the market would dictate. And there would be 6 a time at which that transaction would be reversed 7 and at an advantageous price. And the net effect 8 to the person executing it would be to have paid a 9 short-term rate once all these flows were netted 10 out. And that short-term rate effectively paid 11 would quite often be lower than the reverse repo 12 rates. 13 Q. So, was that transaction a transaction 14 that you expected to benefit off the price that 15 was paid for the security as opposed to the price 16 that you would receive when you took it back? 17 A. Well, with the dollar roll, the net 18 effect was to compare to the financing rate that 19 was paid carrying mortgage-backed securities. The 20 price that was paid and the price that was 21 received, when unwound, was calculated precisely 22 to generate this rate. It was known at the outset 5170 1 and, when the coupon flows were included and the 2 prices were paid and the time period calculated, 3 the net result was a financing raid, not a gain or 4 a loss. And I believe that subject to observing 5 the accounting rules in effect, the transaction 6 would have been counted as a financing and not a 7 sale and repurchase. 8 Q. Now, with regard to that transaction, 9 did you assume that there wouldn't be any change 10 in the market value of the mortgage-backed 11 securities that were subject to the dollar roll? 12 A. There was no such assumption, but the 13 forward price that we would pay to unwind the 14 transaction was fixed in advance. 15 Q. So that if the mortgage-backs changed 16 in price, it would have an effect on the 17 profitability of the transaction? Market value 18 changed. 19 A. No, because the purpose of the 20 transaction had nothing to do with the market 21 value but only to do with the financing rate that 22 was synthesized out of these flows. So, the 5171 1 market value would not have mattered. 2 Q. And it didn't matter to you because of 3 the same reasons. You said your focus was on 4 yield and not market value; is that correct? 5 A. That's correct. 6 Q. Now, look at Exhibit A1409 which are 7 the minutes of the investment committee of 8 United Financial Group and United Savings 9 Association of Texas dated September 18th, 1986. 10 Do you have Exhibit 1409 before you? 11 A. Yes. 12 Q. Okay. Look the first paragraph. It 13 says "A meeting of the investment committee was 14 held on September 18th, 1986. Present were 15 Mr. Hurwitz, Mr. Gross, Mr. B. Williams, 16 Mr. Phillips, Mr. Jacobson, and Mr. Hansen." 17 Do you see that? 18 A. Yes. 19 Q. Now, it says it's the investment 20 committee of United Final Group. Was Mr. Gross a 21 member of -- 22 MR. NICKENS: Your Honor, I object. It 5172 1 says "The minutes of the investment committee of 2 United Financial Group and United Savings 3 Association of Texas." It's both. 4 MR. GUIDO: I'm sorry, Your Honor. I'm 5 sorry. I misspoke. 6 THE COURT: All right. We can hear the 7 record. Let's proceed. 8 Q. (BY MR. GUIDO) It says "A meeting of 9 the investment committee was held on 10 September 18th, 1986. Present were Mr. Hurwitz, 11 Mr. Gross" -- I think I said B. Williams, but I 12 think that that's a G. Williams -- "Mr. Phillips, 13 Mr. Jacobson, and Mr. Hansen. Mr. Hansen acted as 14 secretary." 15 Was Mr. Hurwitz a member of the 16 United Financial Group investment committee? 17 A. I don't know about the United Financial 18 Group committee. I don't think I was a member of 19 it, didn't conduct any business for it. I don't 20 believe that Mr. Hurwitz was a member of any of 21 these committees. 22 Q. But you wouldn't dispute the corporate 5173 1 records if they indicated that he was a member of 2 the United Financial Group investment committee, 3 would you? 4 A. I would not. 5 Q. Now, when you made reports to 6 committees, investment committees, did you make a 7 report to one committee or two committees or more 8 than one? 9 A. I made a report to one meeting. 10 Q. Okay. And it was described to you as 11 the investment committee? 12 A. Yes. 13 Q. Now, at this meeting, turn to Page 2. 14 And see the fourth paragraph from the bottom on 15 Page 2 which is Bates stamped 3 -- US34884? 16 A. Yes. 17 Q. It says "The committee reviewed the 18 minutes of the mortgage-backed security trading 19 committee for the week. All transactions were 20 approved. The committee then discussed the 21 implicit cost of capital calculation made when a 22 trade is made which improves the association from 5174 1 an economic perspective and allows a book gain but 2 lowers ongoing book spread income. The committee 3 then debated the optimal degree to which United 4 should specify characteristics of particular 5 mortgage pools when trading these securities." 6 Do you see that? 7 A. Yes. 8 Q. Okay. Now, what is the reference to 9 "book gain" in that paragraph? 10 A. A book gain would have been the gain 11 realized with the difference between the price at 12 which a security was sold and the book value at 13 which it was held. 14 Q. Okay. And then it says "The committee 15 then debated the optimal degree to which United 16 should specify characteristics of particular 17 mortgage pools when trading these securities." 18 Do you know what that refers to? 19 A. Well, I don't remember seeing these 20 minutes for quite a long time, if ever. But it 21 would have included such characteristics as their 22 coupons, prepayments, expected prepayment speeds, 5175 1 and, of course, the agencies issuing them. 2 Q. Now, the -- turn to the next page of 3 that packet of materials. 4 Do you see that? 5 A. Yes. 6 Q. Now, the rest of the report, it deals 7 with equity arbitrage; is that correct? 8 A. This packet of minutes includes 9 attachments for securities transactions, 10 recommendations. They appear to be regarding 11 high-yield bonds. 12 Q. Now, turn to Exhibit A1410. Do you 13 have A1410 in front of you? 14 A. Yes. 15 Q. That's the minutes of September 24th of 16 the investment committee of United Financial Group 17 and United Savings Association of Texas. 18 Do you see that? 19 A. Yes. 20 Q. Now, look at the fourth paragraph down. 21 It says "Mr. Phillips then reported on the 22 mortgage-backed securities portfolio. He stated 5176 1 that the association had sold some mortgage-backed 2 securities and had profited to the extent of 3 approximately $1.4 million." 4 Do you see that? 5 A. Yes. 6 Q. Now, what do you mean -- what does the 7 term "profited" in that context mean? 8 A. This would have referred to the book 9 gain that you asked me about earlier. 10 Q. Okay. Now, turn to Exhibit A1411, 11 which are the minutes of the investment committee 12 of United Financial Group and United Savings 13 Association of Texas of October 1, 1986. 14 A. I don't believe I have 1411. 15 Q. Why don't you just read along with me? 16 It says in the fourth paragraph, "Mr. Phillips 17 recommended the sale of a portion of the liquidity 18 and mortgage-backed securities portfolios to 19 recognize profits which were recently created by 20 the market rally." 21 Do you see that sentence? 22 A. Yes. 5177 1 Q. Then it says a few sentences down, 2 "After discussions, the asset sales were approved 3 and it was agreed the asset liability committee 4 would develop a recommendation for restructuring 5 the liquidity portfolio." 6 Can you tell us what the reference to 7 "liquidity portfolio" is there? 8 A. The liquidity portfolio was that amount 9 of funds that were held with a minimum credit 10 rating and a maximum band of maturities. 11 Basically if they were to be held in corporate 12 securities, I believe they had to be of single A 13 credit quality and no more than, I believe, three 14 years. 15 Q. Okay. What sort of securities were in 16 that liquidity portfolio? 17 A. They were short-term, high-grade 18 corporate bonds. 19 Q. Now -- and it makes reference to the 20 mortgage-backed securities portfolio. Is that 21 making reference to the investment portfolio of 22 mortgage-backed securities that you managed? 5178 1 A. Yes. 2 Q. And was that a risk-controlled 3 arbitrage as you understood it? 4 A. Yes. It probably was. 5 Q. Okay. Now, I'd like for you to take a 6 look at the performance report of December 1986, 7 which is A5017, and direct your attention to the 8 Chart DI of that. I'm sorry. DJ. Excuse me. 9 That has the heading "Gain on Sale of Investment 10 Securities." 11 Do you see that? 12 A. Yes. 13 Q. And it has -- see the column that says 14 "current month"? The chart that says "current 15 month"? 16 A. Yes, I do. 17 Q. Then it has listed Fannie Mae, 18 172,499,000 with a gain of 3,555,000. 19 Do you see that? 20 A. Yes. 21 Q. Then it has Freddie Mac 613,755 for a 22 gain of $12,543,000? 5179 1 A. I believe all these numbers are in 2 thousands. 3 Q. Pardon? 4 A. I believe all these numbers in 5 thousands. 6 Q. These are all in thousands? Okay. 7 Excuse me. So, that means that it's 613,755,000? 8 A. Yes. 9 Q. And it's 12,543,000 terms of profit for 10 the Freddie Macs? 11 A. That's correct. 12 Q. And then for the Ginnie Maes, it is 13 48 million and a profit of 150,000. 14 Do you see that? 15 A. Yes. 16 Q. Now, are those the transactions that 17 you just referred to or we just referred to in 18 terms of the value trades to enhance yield or to 19 generate book profits? 20 MR. NICKENS: Your Honor, I don't know 21 what -- this is the -- we're talking about the 22 current month? 5180 1 MR. GUIDO: It says current month. 2 A. I wasn't there at this time; so, I 3 couldn't be sure. 4 Q. (BY MR. GUIDO) Okay. Now, during the 5 time you were there, there were sales out of the 6 mortgage-backed security portfolio that you 7 managed that generated book gains, was there not? 8 A. Yes, that's correct. 9 Q. Do you have any idea what the magnitude 10 was? 11 A. No, I don't. 12 Q. Was it somewhere at least as high as 13 $67 million? 14 A. It could have been that high, yes. 15 Q. And it could have been higher, could it 16 not? 17 A. Yes. 18 Q. Now, do you recall on Friday when I 19 showed you the bottom part of this chart? I asked 20 you whether the figures for March, June, 21 September, and December reflected an increase in 22 the sales from the investment securities of USAT 5181 1 to generate book profits just prior to the filing 2 of the required financial statements at quarter's 3 end. 4 A. It shows higher gains were taken, yes. 5 Q. And did that figure, that increased 6 figure, reflect what you recall was the emphasis 7 on selling securities for a gain at quarter's end 8 in order to generate book gains? 9 MR. NICKENS: Your Honor, we have 10 already covered this and the witness testified 11 that he did not recall these quarterly matters. 12 So, now he's going back and purporting to review 13 testimony that the witness said that he did not 14 recall as if it were a fact and he had testified 15 to it. 16 MR. GUIDO: I think the witness 17 testified, Your Honor, that when I showed him this 18 material, it refreshed his recollection. And I am 19 about to show him another document that will 20 reflect this, as well, which he's also seen. The 21 questions I asked him before were with regard to 22 junk bonds. I'm now asking the questions with 5182 1 regard to mortgage-backed securities; so, it is 2 not duplication of what I had done. 3 MR. NICKENS: My objection, Your Honor, 4 is that he now says that he was summarizing 5 testimony about junk bonds to apply to 6 mortgage-backed securities. My objection is to 7 the erroneous summarization of the prior testimony 8 and giving it to the witness as if that is what he 9 had said before and asking that as a basis for his 10 answer to this question. 11 THE COURT: Well, my question was: 12 Were you referring to a document in the last 13 series of questions? 14 MR. GUIDO: Yes, Your Honor. I was 15 referring to the figures that are shown in Exhibit 16 -- I have to find the beginning of the document -- 17 5017, A5017, Your Honor. And it's the DJ chart. 18 It's toward the end. It's about two thirds of the 19 way in the packet and it's headed 20 "United Financial Group, Inc., Gain on Sale of 21 Investment Securities, December 31, 1986, in 22 Thousands." 5183 1 MR. NICKENS: And the witness testified 2 he wasn't there so he couldn't possibly remember 3 them. 4 THE COURT: Well, that was his 5 testimony. So, what's your question, Mr. Guido? 6 Q. (BY MR. GUIDO) Do you recall being 7 asked to make sales out of the mortgage-backed 8 security portfolio in order to generate gains at 9 quarter's end in order to have those gains 10 reflected in the financial statements? 11 A. I do not. 12 Q. Now, do you recall receiving 13 instructions to make sales out of the 14 mortgage-backed security portfolio in order to 15 generate gains? 16 A. No. 17 Q. You do not? Did you make sales out of 18 the mortgage-backed security portfolio in order to 19 generate book gains? 20 A. No, not in order to generate gains. 21 Q. Now, you just testified with regard to 22 one of these trades where you made a 5184 1 recommendation to "make sales out of the 2 mortgage-backed security portfolio to recognize 3 profits which were recently created by the market 4 rally." That's Exhibit A1411, and it's the 5 investment committee minutes of October 1st. 6 Do you recall that? 7 A. Yes. 8 Q. Now, isn't that a recommendation to 9 make sales out of the mortgage-backed security 10 portfolio to recognize profits which were created 11 by a market rally? 12 MR. NICKENS: Your Honor, I object to 13 the form of the question in this regard: The 14 document says "mortgage-backed securities 15 portfolios," plural. Mr. Guido has consistently 16 ignored that and asked the witness about 17 portfolio, singular. 18 THE COURT: All right. Well, let's 19 clarify that. 20 Q. (BY MR. GUIDO) Mr. Phillips, did you 21 have responsibility for managing the 22 mortgage-backed security portfolios at USAT? 5185 1 A. I had responsibility for managing those 2 that were -- that I accumulated and ran versus the 3 structure we discussed, yes. 4 Q. Those that you ran pursuant to the 5 structure that we just discussed? 6 A. Yes. 7 Q. And that is what's known as a 8 risk-controlled arbitrage, is it not? 9 A. Yes. 10 Q. Is your reference here to anything 11 other than the risk-controlled arbitrage on these 12 minutes of October 1st, 1986? 13 MR. NICKENS: Your Honor, it's not his 14 reference. These are the minutes of the 15 investment committee. It would be appropriate to 16 ask him what portfolios he thinks may be 17 referenced here. But then to say that it is his 18 puts it -- casts it in a different light and I 19 think an erroneous light. 20 Q. (BY MR. GUIDO) Mr. Phillips, did you 21 ever make any recommendations to do something that 22 to the portfolio that you were not responsible 5186 1 for? 2 A. No, I did not. 3 Q. Now, will you look at Exhibit A1411 4 again? It's the October 1st minutes. 5 A. I believe that's the one you brought to 6 me. 7 Q. Okay. It says "Mr. Phillips 8 recommended the sale of a portion of the liquidity 9 and mortgage-backed securities portfolios to 10 recognize profits which were recently created by 11 the market rally." 12 Do you see that? 13 A. Yes, I do. 14 Q. Is that a recommendation to make a sale 15 out of the mortgage-backed security portfolio to 16 generate book profits? 17 A. It is characterized in those minutes as 18 a recommendation for sale to generate profits. 19 However, I believe that any such sale would have 20 also contemplated some reinvestment in securities 21 to keep that structure intact. 22 Q. The risk-controlled arbitrage structure 5187 1 intact? 2 A. Yes. 3 Q. Now, did you ever conclude at any time 4 that the risk-controlled arbitrage portfolio that 5 you had set up had been damaged beyond repair? 6 A. We did conclude at some point that 7 continuing to rebalance it would not yield us any 8 more benefit and that it was not something that we 9 would undertake to do in a large way anymore. 10 Q. And was that prior to the point in time 11 where you adopted the policy to engage in value 12 trades? 13 A. It could have been about the same time. 14 Q. Okay. Now, was the decision that was 15 made to engage in value trades made, in part, 16 because the investment committee and you had 17 concluded that the risk-controlled arbitrage 18 portfolio could not be salvaged by rebalancing? 19 A. I do recall that at some point, we knew 20 that continued rebalancing would not provide any 21 further benefit and that the value trades, when 22 taken incrementally, would provide small benefits 5188 1 in trades that would not have significant 2 restructuring or rebalancing effects. 3 Q. Were the value trades undertaken to 4 ameliorate the damage that had been caused by the 5 failure of the risk-controlled arbitrage 6 portfolio? 7 A. We realized, of course, that the size 8 of these trades would be relatively small and 9 their benefit would be relatively small. So, 10 while there would be net benefits, we did not 11 expect that, when taken together, these would 12 offset the effects on the spread in the 13 risk-controlled arbitrage which had diminished. 14 Q. But were the value trades an attempt to 15 ameliorate some of the damaging effects of the 16 failure of the risk-controlled arbitrage? 17 A. I don't recall that we considered it 18 that way. We considered that we had a portfolio 19 of securities that exposed us to market 20 opportunities and that in the ordinary course of 21 active management, we might undertake some of 22 these transactions that would be of benefit. 5189 1 Q. Now, I'd like you to take a look at 2 Exhibit A5014 which are the -- which is the 3 performance report of September 1986. I direct 4 your attention to the page that says "DJ." 5 Do you see that page? 6 A. Yes. 7 Q. Now, that page has the current month's 8 gains on sales of investment securities. Do you 9 see that? 10 A. Yes. 11 Q. And it shows Ginnie Maes, $21 million 12 in amount for a gain of $1,675,000. 13 Do you see that? 14 A. Yes. 15 Q. And it has Fannie Maes in the amount of 16 264,100,000 for a gain of 3,033,000. 17 Do you see that? 18 A. Yes. 19 Q. Then it has Freddie Macs, $110 million 20 in amount for a gain of 2,848,000. 21 Do you see that? 22 A. Yes. 5190 1 Q. And look at the year-to-date figures. 2 Do you see the month of September has 14 million 3 504? 4 Do you see that? 5 A. Yes. 6 Q. What were the reasons for those sales 7 that are reflected in that performance report? 8 A. I don't know at this time. This much 9 later, it looks as if it was a quarter end. Looks 10 as if some securities were sold to realize gains. 11 Q. Okay. Now, I'd like to direct your 12 attention to a document that I showed you with 13 regard to the high-yield bonds and that's T4251. 14 It's dated September 23rd, 1986. It's a memo from 15 Mike Crow to Jenard Gross and Jerry Williams. And 16 it says "The attached schedule presents our best 17 estimate of gains that will be needed for 18 quarterly earnings. We are proceeding with taking 19 these gains" is what that document says. 20 Do you have that document in front of 21 you? 22 A. Yes. 5191 1 Q. And it says "We are proceeding with 2 taking these gains." 3 Do you see that on the first page? 4 A. Yes. 5 Q. Then it has "gains to alleviate 6 deficit" on the second page. 7 Do you see that? 8 A. Yes. 9 Q. And it says "mortgage-backed 10 securities, 1.9." 11 Do you see that? 12 A. Yes. 13 Q. Now, were you ever given a target 14 figure to achieve in terms of gains on sales from 15 the mortgage-backed security portfolio at the time 16 you were at USAT? 17 MR. NICKENS: Your Honor, the witness 18 has testified that he was never given any such 19 instructions. 20 THE COURT: Well, let's hear the answer 21 from the witness. 22 A. I don't recall any target for gains of 5192 1 mortgage backs. Only for corporate bonds. 2 Q. (BY MR. GUIDO) Okay. But you do 3 recall being told or authorized to engage in value 4 trades to either generate gains or to increase the 5 yield in the mortgage-backed security portfolio? 6 MR. NICKENS: Your Honor, he's 7 expressly testified that it was to increase yield 8 and now -- and he said that it was not to realize 9 gains. And now Mr. Guido has expressed a question 10 that says "or" which should elicit a yes answer 11 but create a false impression in the record. And 12 I suggest that's quite deliberate. 13 MR. GUIDO: Your Honor, there is 14 nothing inappropriate about the question. It is a 15 question. 16 THE COURT: Restate the question. 17 MR. GUIDO: And I do think that 18 Mr. Nickens should refrain from trying to affect 19 this witness' testimony. I'm asking him the 20 questions after showing him documents that show 21 that the institution thought it was engaged in 22 sales of mortgage-backed securities to generate 5193 1 profits at quarter's end. 2 MR. NICKENS: Your Honor, that's -- 3 MR. GUIDO: I just want this witness, 4 after having refreshed his memory, to answer my 5 question. 6 MR. NICKENS: I object to the question. 7 I object to questioning the witness that misstates 8 his testimony, then tries to put in an "or" to get 9 something different in the record. I do object to 10 that. I do not agree with Mr. Guido's 11 characterization of the record or this witness' 12 testimony as to mortgage-backed securities. He 13 couldn't have been plainer when asked a direct 14 question about whether he was ever asked to 15 realize gains out of those portfolios. And he 16 said "no." 17 MR. GUIDO: I think his response was he 18 never was given a specific target, Your Honor. 19 THE COURT: All right. I think you'd 20 better restate your question. 21 Q. (BY MR. GUIDO) Does this document 22 refresh your recollection of whether or not you 5194 1 were ever authorized to make sales out of the 2 mortgage-backed securities portfolio in order to 3 generate reported gains? 4 A. No, it does not. 5 Q. It does not? So that this document, as 6 far as you know, doesn't reflect your 7 understanding of what you were doing with regard 8 to the mortgage-backed security portfolio at the 9 time? 10 MR. NICKENS: Object to the form of the 11 question, Your Honor. 12 THE COURT: You may answer. Is there 13 some discrepancy between the document and your 14 recollection? 15 THE WITNESS: Yes. This document does 16 not reflect my understanding of the management of 17 the portfolio. 18 MR. NICKENS: Your Honor, may I? 19 What's happened here is that there was a 20 restatement of earnings required by the 21 accountants as a result -- 22 MR. GUIDO: Your Honor, I object to 5195 1 Mr. Nickens trying to coach this witness on future 2 questions. 3 MR. NICKENS: I am not trying to coach 4 this witness on anything. We've gotten his plain 5 testimony, and I don't think that we should allow 6 Mr. Guido to -- when he knows the answer to these 7 things. He is trying to create, deliberately, a 8 false impression. He knows that this was a 9 restatement of the earnings that occurred as a 10 result of the accountants required and not a bunch 11 of sales for gains. 12 THE COURT: Well, I think you'll have 13 to bring that out in some other matter. Let's 14 have questioning by Mr. Guido. 15 MR. GUIDO: Thank you, Your Honor. 16 Your Honor, I would like to have 17 marked -- it was part of my packet of documents 18 that were part of the September 24th minutes which 19 were A1410. It was not in the packet that the 20 witness had, and I presume it wasn't in the packet 21 that you had. It's Bates stamped US310802, Bates 22 stamp. I'd like to have that marked as 1410A. It 5196 1 is a memorandum dated September 22nd from Doug 2 Hansen to Mike Crow, Joe Phillips, Bruce Williams, 3 investment committee regarding mortgage-backed 4 security trading committee. 5 MR. NICKENS: Your Honor, we weren't 6 provided with a copy of this; but if you give me a 7 moment, I think I can find it in another set. 8 MR. GUIDO: I have copies here for you, 9 Mr. Nickens. 10 THE COURT: Is that in under another 11 exhibit number? 12 MR. GUIDO: No, it's not. It was 13 attached to my set of T1410, as I recall. But it 14 has not been admitted and it was not part of the 15 Exhibit 1410. It may have been part of some other 16 exhibit. 17 THE COURT: It appears to be in as 18 B1231. 19 MR. NICKENS: Yes, Your Honor. It's at 20 Tab 342. And I think that's T4250. 21 MR. GUIDO: I have no idea. I don't 22 recall seeing the document before. 5197 1 MR. NICKENS: This is the same 2 document. Right? 3 MR. GUIDO: Yes, it is. 4 MR. NICKENS: It's at Tab 342 and, if I 5 read this correctly, at T4250. 6 THE COURT: Well, the document is 7 already in. Let's refer to it by its number and 8 forget about T -- the T1410A. 9 MR. BLANKENSTEIN: It's not the same 10 document, Your Honor. 11 MR. NICKENS: B1231 -- 12 MR. GUIDO: I don't think it's been 13 admitted. 14 MR. NICKENS: Yes, it has. 15 MR. LANGDON: It's in evidence. 16 THE COURT: I show it as having been 17 received on 10-21. 18 MR. NICKENS: Okay, Your Honor. There 19 is -- the data Mr. Guido is now referencing is 20 different than Exhibit 342 or Tab 342. And I 21 believe the reason is that it's a similar memo 22 from Mr. Hansen of the same date but -- and we had 5198 1 misidentified it, apparently, because of that 2 confusion. 3 THE COURT: Well, it seems to have the 4 same Bates stamp down there. 5 MR. NICKENS: The Bates stamp on -- 6 Your Honor, on Exhibit T4250 is US2070 and this is 7 US3010602. 8 THE COURT: Let's be off the record for 9 a minute. 10 11 (Discussion off the record.) 12 13 THE COURT: As discussed off the 14 record, it appears that the exhibit that has been 15 offered as T1410A is already in the record as 16 Exhibit B1231. And we'll refer to it by the 17 latter number. 18 Q. (BY MR. GUIDO) Now, have you had an 19 opportunity to review B1231, Mr. Phillips? 20 A. Yes. 21 Q. Now, it says "The committee met several 22 times during the week of September 15th to approve 5199 1 and execute a trade from Freddie Mac 9 and a 2 half's to Freddie Mac 8 and a half's. Crow and 3 Williams were absent. Smith Breeden was consulted 4 on the trade." 5 Do you see that? 6 A. Yes. 7 Q. Do you recall that trade? 8 A. No. 9 Q. Then it says "The gain booked is 10 $700,000. The loss in spread income is 150,000 in 11 the first year." 12 Do you see that? 13 A. Yes. 14 Q. Now, is that a trade that increased the 15 yield on the mortgage-backed security? 16 A. No, it is not. 17 Q. Okay. Is that a trade that increased 18 the book gain? 19 A. It is a trade that created a book gain, 20 yes. 21 Q. Now, this is by -- this is minutes of 22 the mortgage-backed security trading committee, is 5200 1 it not? 2 A. Yes. 3 Q. And you sat on that committee. Right? 4 A. Yes. 5 Q. And that's the committee that was 6 established by the minutes of July 23, 1986, which 7 is Exhibit A1402, is it not? 8 A. Yes. 9 Q. My question for you is: Were sales 10 made of mortgage-backed securities out of the 11 risk-controlled arbitrage to generate book gains? 12 A. No. 13 Q. Does your recollection of that fact 14 conform to the description of this trade that's 15 recorded on B1231? 16 A. This transaction does certainly 17 generate a book gain. It also -- I see from 18 what's presented here, it also has a lower 19 prepayment rate. And at the time, that might have 20 been being an important part of the consideration, 21 as well. 22 Q. Is there any mention of prepayment 5201 1 rates in that memorandum? 2 A. No. 3 Q. Other than it just reflects it? 4 A. That's correct. 5 Q. It just records that a gain was booked 6 of 700,000 and there was a loss of spread income 7 of 150, doesn't it? 8 A. That's correct. 9 Q. Do you know why that trade was engaged 10 in? 11 A. No, I do not. 12 Q. Now, I'd like you to look at a document 13 that I've had marked as A10574 which is an 14 October 24th, 1985, memorandum from Mike Crow to 15 Gerald Williams regarding financing sub update. 16 MR. GUIDO: And I'd like to move the 17 admission of A10574, Your Honor. 18 MR. NICKENS: No objection, Your Honor. 19 THE COURT: Received. 20 Q. (BY MR. GUIDO) Do you recall when we 21 discussed the growth of the USAT mortgage-backed 22 security risk-controlled arbitrage portfolio, 5202 1 Mr. Phillips, that you testified about the 2 creation of an entity called United Mortgage 3 Finance? 4 A. Yes, I do. 5 Q. And that that was sometime in November 6 of 1985? 7 A. Yes. 8 Q. And how large did that portfolio 9 become? 10 A. I believe it was over $500 million. 11 Q. Exhibit A10574, is that a memorandum 12 regarding the creation of that subsidiary 13 corporation? 14 A. Yes, it is. 15 Q. Okay. And does that memorandum conform 16 to your understanding of the status of the 17 regulatory questions regarding the creation of 18 that finance subsidiary? 19 A. I don't recall the details that are in 20 here. I don't believe that this subject matter 21 area would have involved me. 22 Q. Do you recall participating in any 5203 1 discussions regarding the creation of that 2 subsidiary? 3 A. I recall participating in the 4 discussions for investing the assets of that 5 subsidiary. 6 Q. And do you recall discussions about 7 what type of mortgage-backed security portfolio 8 would be held by that subsidiary? 9 A. No. 10 Q. Was the original purpose of the 11 transaction to provide an income stream through a 12 hedged arbitrage portfolio? 13 A. Yes. It was -- the goal was to have a 14 similar structure as that we had in the 15 association itself. 16 Q. Now, that entity was subsequently 17 dissolved, was it not? 18 A. Yes. 19 Q. And was that because the assumptions 20 about the regulatory response turned out to be 21 incorrect? 22 A. Yes. 5204 1 Q. Now, I'd like to have you look at what 2 we have marked as Exhibit A10594, which is a memo 3 from you to the files dated January 10th, 1986, 4 and the subject being MBS sale. 5 MR. NICKENS: No objection. 6 MR. GUIDO: We move the admission of 7 the document, Your Honor. 8 THE COURT: You said no objection, 9 Mr. Nickens? 10 MR. NICKENS: No objection, Your Honor. 11 THE COURT: Received. 12 Q. (BY MR. GUIDO) Does the first 13 paragraph describe the structure of the portfolio 14 when United -- excuse me -- USAT Mortgage Finance 15 that was created in '85 and disbanded at the end 16 of '85? 17 A. Yes. 18 Q. And does the second paragraph, the 19 first two sentences, which say "Subsequent to the 20 formation of the finance subsidiary, an 21 acquisition of the securities, the regulations 22 applicable to finance subsidiaries were amended. 5205 1 Such amendment disqualified USAT Mortgage Finance 2 as a finance subsidiary and, accordingly, such 3 liability growth would have put the association in 4 violation of the growth regulation for the quarter 5 ended March 31, 1986." 6 Do you see that? 7 A. Yes. 8 Q. Where did you get that information? 9 A. It was told to me at the time that we 10 would have to collapse this structure by someone 11 who had conveyed this to me. I don't know who. 12 Q. You don't recall who? 13 A. It would be some senior officer of 14 United Savings. 15 Q. Now -- then, it says "Accordingly, 16 350 million in mortgage-backed securities and 17 related reverse repo agreements had to be undone 18 in order to avoid the growth regulation problems." 19 Do you see that? 20 A. Yes. 21 Q. Now, when you were told of the need to 22 collapse or to dissolve United Mortgage Finance, 5206 1 were you asked to look at alternatives for the use 2 of that portfolio in order to avoid violating the 3 growth regulations? 4 A. I don't recall that I was asked because 5 it would have -- the subject area would have been 6 outside my scope, dealing with the exact 7 conditions and how they might fit with the 8 regulation. I wouldn't have been involved with 9 that. 10 Q. But you had to get rid of $350 million 11 worth of securities, correct? 12 A. Yes. 13 Q. Now, you also managed another portfolio 14 called a high-yield bond portfolio. 15 Do you recall that? 16 A. Yes. 17 Q. Do you recall what the size of that 18 portfolio was at the time? 19 A. I believe that it got up to 20 $600 million. 21 Q. Did anyone ask you to explore the sale 22 of the -- some of the high-yield bond portfolio so 5207 1 that USAT could absorb this $350 million in 2 mortgage-backed securities? 3 A. I don't recall any such request. 4 Q. Was your testimony you don't recall or 5 it didn't happen? 6 MR. NICKENS: Your Honor, if he doesn't 7 recall, he doesn't know whether it happened. 8 MR. GUIDO: Well, I'm not -- it's not 9 clear to me what his response is, Mr. Nickens. 10 I'm trying to clarify it. 11 THE COURT: All right. Can you answer 12 the question? Denied. 13 THE WITNESS: I don't recall any such 14 request, Your Honor. 15 Q. (BY MR. GUIDO) Now, the next sentence 16 says "At that time, the decision was made, one, to 17 sell the mortgage-backed securities resulting in a 18 12.4 million-dollar gain, and, two, retain the 19 swaps and utilize them for general association 20 interest rate hedges rather than close them out 21 (USAT has had an existing general swap for several 22 years.)" 5208 1 Do you see that? 2 A. Yes. 3 Q. Now, who made that decision that you're 4 referring to there? 5 A. I believe this decision was made 6 collectively among senior officers of United 7 Savings. 8 Q. Do you recall who they were? 9 A. No, but these would be the sort of 10 decision I would expect to come from Mr. Crow, 11 Mr. Williams. 12 Q. What about Mr. Gross and Mr. Hurwitz? 13 A. I'm not sure this level of detail would 14 have been something that they would have become 15 engaged in. 16 Q. It then says "Subsequent to that 17 decision, a mirror swap was put in place." 18 Do you see that? 19 A. Yes. 20 Q. Whose idea was that? 21 A. I don't recall whose idea it was. 22 Q. Does this mean that the original 5209 1 decision to use them for general interest rate 2 protection had been discarded and a decision was 3 made to put on mirror swaps? 4 A. Yes. 5 Q. And you indicate that there was a 6 12.4-million-dollar gain on the mortgage-backed 7 securities. 8 Do you see that? 9 A. Yes. 10 Q. What was the loss on the swap side? 11 A. I don't know. 12 Q. Was it a comparable amount? 13 A. It's very likely there would have been 14 a loss of some amount because it essentially had 15 the offsetting effect. It was the opposite side 16 of the market. Whether it was the same amount, I 17 don't know because the market price response of 18 these two kinds of securities are not the same. 19 Q. All right. So -- and that's because of 20 the prepayment factor on the mortgage-backed 21 security side. Right? 22 A. Well, they each had different sorts of 5210 1 convexity profiles. And so, they would perform 2 differently when the markets moved. 3 Q. All right. But the loss was either 4 comparable or greater on the swap side, was it 5 not? 6 A. I don't know if it was or not. But it 7 would be a loss. 8 Q. Okay. And it would be comparable. 9 Would that be fair? 10 A. Yes. 11 Q. Now, the last paragraph says "In view 12 of the transactions which occurred relative to 13 USAT Mortgage Securities, it is United's position 14 that the transactions have been properly reflected 15 in its financial statements in accordance with 16 existing accounting literature." 17 Do you see that? 18 A. Yes. 19 Q. Now, how were they -- how were those 20 transactions accounted for in USAT's financial 21 statements? 22 A. Well, I know them to be accounted for 5211 1 only by what's given in the previous paragraphs. 2 A gain recognized the swap offset. 3 Q. Now, the gain of $12.4 million was 4 recognized. Right? 5 A. Yes. 6 Q. And because of the mirror swap on the 7 swap side, the losses on the swap were deferred, 8 were they not? 9 A. They were spread out over time, yes. 10 Q. Now, are you an accountant? 11 A. I am not. 12 Q. It says "In view of the transactions 13 which occurred relative to USAT Mortgage 14 Securities, it is United's position that the 15 transactions have been properly reflected in its 16 financial statements in accordance with accounting 17 literature." 18 Why are you making an accounting 19 conclusion in this memo to the file? 20 A. I had to have been advised of this. 21 Q. Okay. Were you told to write this 22 memorandum to the file? 5212 1 A. I don't know. 2 Q. You don't know? Did you ever discuss 3 this memorandum with anyone before you prepared 4 it? 5 A. I don't recall. It looks very 6 straightforward until that last paragraph. It 7 looks like something I would write in the ordinary 8 course. 9 Q. Did you ever in any other instance 10 reach conclusions on your own about the proper 11 accounting for a transaction? 12 A. No. 13 Q. Did somebody tell you to put that 14 paragraph in this memorandum? 15 A. If I put this here, I had to have been 16 advised that this was correct because I don't rule 17 on accounting. 18 Q. Why did you write this memorandum to 19 the file? 20 A. I don't recall now why I wrote it, but 21 it seemed that these transactions needed to be 22 memorialized. It was a very significant set of 5213 1 activities that were undertaken when this was 2 done, and it seemed it should be memorialized. I 3 don't know if I -- at this point, if I was told at 4 that time to write it for the file or not. 5 Q. Why was this a very significant 6 transaction that needed to be memorialized? 7 A. It was a large transaction that 8 substantial portions of were reversed very shortly 9 after being done, and it seemed that there should 10 be a record of what happened. 11 Q. Why was that? Why should there be a 12 record of it? I mean, don't the financial 13 statements just show -- the general ledger just 14 show transactions? Why did you need to write a 15 memo to the file? 16 MR. NICKENS: Your Honor, there is 17 about three or four questions there and I'm 18 wondering which one he wants answered. 19 THE COURT: Let's take one at a time. 20 Q. (BY MR. GUIDO) Would the general 21 ledger reflect the transactions? 22 A. Yes. 5214 1 Q. Why was there a need to go beyond the 2 general ledger and write this memo to the file? 3 A. I believe even now that this 4 transaction was quite significant and different 5 from what we were doing. I don't recall whether I 6 was asked to write this for the file; but I still 7 believe that in trying to remember what happened, 8 this is helpful. 9 Q. Did it have a significant impact on the 10 financial statements of USAT? 11 A. I don't know. 12 Q. Do you recall whether there were any 13 questions raised at that time about whether or not 14 USAT would meet its regulatory capital 15 requirements? 16 A. No, I don't. 17 MR. GUIDO: Your Honor, it's five after 18 12:00. This might be a good to him to take a 19 break. 20 THE COURT: All right. We'll recess 21 until 1:30. 22 5215 1 (Luncheon recess taken at 12:06 p.m.) 2 3 THE COURT: Be seated, please. We'll 4 be back on the record. 5 Mr. Guido, you may continue. 6 MR. GUIDO: Thank you, Your Honor. 7 (1:34 p.m.) 8 Q. (BY MR. GUIDO) Mr. Phillips, will you 9 take a look at the document that is marked as 10 A11022 which is the draft and look at Page 4 of 11 that document, please? That is the chart of the 12 portfolio at the time. We've been talking about 13 United Mortgage Finance, and I have a few more 14 questions about that portfolio. 15 Look at the figure under MBS 16 risk-controlled arbitrage, Column A, as of 17 November 1984. Do you see the figure 653,973 in 18 that column? 19 A. I'm sorry. Where? 20 Q. Look under Column A for November 1985. 21 Was that the approximate size of the 22 risk-controlled arbitrage at the time 5216 1 A. I believe that it was. 2 Q. Okay. Then look at the Column B. It 3 says "USAT Mortgage Finance, $500 million." 4 Do you see that? 5 A. Yes. 6 Q. Okay. Was that the approximate size of 7 the original USAT Mortgage Finance portfolio? 8 A. Yes. 9 Q. Okay. And combined was about 1.153 10 billion? 11 A. Yes. 12 Q. Now, working down to March of 1986 I 13 think you testified that -- well, excuse me. 14 Let's back up to December of 1985. These are 15 month end figures. That shows 150,000 in USAT 16 Mortgage Finance. 17 Is 150,000 the remainder that was left 18 after you disposed of the $350 million in 19 mortgage-backed securities you testified about 20 before lunch? 21 A. Yes. This would be 150 million. 22 Q. 150 million. Excuse me. 5217 1 A. Yes. 2 Q. So that the combined size of the 3 portfolio was about $766 million? 4 A. Yes. 5 Q. Now, when you go down to -- through 6 March, the size of the 150 million that was left 7 after the sale of 350 decreases to zero. 8 Can you tell us why that happened 9 A. No, I cannot. 10 Q. Do you recall whether or not those were 11 disposed of, the 150 million were disposed of over 12 time? 13 A. It's my recollection that we had 14 collapsed a subsidiary and the assets were sold. 15 Q. Okay. The reason I ask that question, 16 if you look at April of '86, the difference 17 between March of '86 and April of '86 in Column A, 18 it shows the portfolio going from 687 million up 19 to 879 million. 20 Do you know why that was? 21 A. No, I don't. 22 Q. Now, looking at the Column A from 5218 1 April '86 through -- you left, I think, in October 2 of '86? 3 A. November. 4 Q. November. Looking at the size of the 5 portfolio, is that the approximate size of the 6 risk-controlled arbitrage portfolio during that 7 time period? 8 A. Up until November. 9 Q. November '86. 10 A. I don't really recall with any 11 precision the exact amount. I know that we had 12 accumulated securities up to 650 million or so, 13 and I don't remember how it might have grown. 14 Q. Okay. We'll get to the growth issue 15 when we talk about some other transactions. But 16 all you recall is the initial 650-million-dollar 17 acquisition? 18 A. Yes. 19 Q. Now, did you sell mortgage-backed 20 securities out of the risk-controlled arbitrage 21 portfolio in 1985? 22 A. I don't recall that we did in 1985. 5219 1 Q. Did you at any time in 1986, other than 2 the value trades that we've talked about this 3 morning? 4 A. Yes. We undertook a number of 5 rebalancing transactions during 1986. 6 Q. And do you recall the time period of 7 those transactions? 8 A. They took place from very early in the 9 year until some point, I believe, in the summer. 10 Q. Pardon? In the summer? 11 A. Yes. 12 Q. Did you prepare any schedule of those 13 trades? 14 A. Yes. I prepared a spreadsheet with 15 which to attract the dollar flows among these 16 blocks of securities. 17 Q. Would you take a look at what I have 18 had marked as Exhibit A10631 and particularly look 19 the first two pages of that which have imaging 20 Nos. OW02922 through OW02923. 21 Are those two pages the schedule that 22 you prepared of the mortgage-backed securities 5220 1 that you -- transactions that you've described as 2 rebalancing transactions? 3 A. Yes, they are. 4 Q. When did you prepare this document? 5 A. I believe that this document was 6 created over a period of time. As different 7 transactions were undertaken, they were added to 8 it. I don't know exactly when I started it. 9 Q. In what format was it created? What 10 form was it when you were, overtime, creating the 11 document? 12 A. This was prepared on a computer 13 spreadsheet. The second page is actually the 14 first page of it. 15 Q. So that -- 16 A. And the first page is the continuation. 17 Q. So, the way the document goes is you 18 would take the third page, put it face up, and 19 then you would paste on Page 2 to it -- 20 A. That's correct. 21 Q. -- in reverse order? Now, you -- did 22 you, in addition to generating this document in a 5221 1 computer, also sort of paste it up anywhere so 2 that you could trace the transactions? 3 A. Yes. This -- this form was not 4 necessarily the original document. I believe that 5 the columns were cut from hard copy documents and 6 pasted on to a sheet. I didn't format it in this 7 way. This is the way I assembled it. 8 Q. What do you mean, this is the way you 9 assembled it? 10 A. That is, I believe that subsequent 11 transactions may have been cut in this form and 12 pasted on here. I can't tell by looking at it 13 now, but I don't believe that when I was doing 14 this, my computer would print this all out in 15 these columns this way. 16 Q. So that, in other words, you initially 17 just printed out the transactions. Then you 18 pasted them together to show how they fit 19 together? 20 A. Yes. 21 Q. And you did that -- did anyone refer to 22 that in any way when you did it? 5222 1 A. Well, I was using it as a tool, and I 2 remember that Ron Huebsch may have referred to it 3 as something like paper dolls because it was all 4 cut out and repasted. 5 Q. Now, what was the purpose of preparing 6 this document? 7 A. The purpose was to see which bonds and 8 which coupons were sold and to see how the 9 proceeds were deployed into newer bonds at lower 10 coupons. 11 Q. So, was the purpose to see which 12 transactions fit together as part of the 13 rebalancing, the so-called rebalancing? 14 A. Yes. 15 Q. And this is a document that you created 16 contemporaneously with doing the so-called 17 rebalancing? 18 A. Yes. 19 Q. Now, look at OW02924 through OW02927. 20 Can you tell us what those documents are? 21 A. They are schedules that show 22 contribution from various investment activities. 5223 1 Q. Is that the format that was used with 2 the performance reports that I showed you that you 3 testified about earlier today? 4 A. Yes, they are. 5 Q. Is this a portion of the April 30, 1986 6 performance report? 7 A. By the annotations and by the form, it 8 looks like it is. 9 Q. Now, the last two pages, let's turn to 10 those. The second-to-the-last page is OW02928. 11 Can you tell us what that page is? 12 A. It's a listing of mortgage-backed 13 securities with the amount purchased, the amount 14 currently held, the amount paid down, and the 15 yield when it was purchased. 16 Q. Okay. Now, is that making reference to 17 the securities that were sold that are referred to 18 on Bates stamps OW02922 and 2923? 19 A. In some cases, they are the same coupon 20 and agency. So, they may well be the same ones. 21 Q. Do you recall seeing this document 22 before? 5224 1 A. Yes. I may have prepared this 2 document. 3 Q. And did you prepare this document at or 4 about the time that you prepared the spreadsheet 5 Bates stamps 2921 through 2922? 6 A. I don't remember. 7 Q. Now, the last page is OW02929. Can you 8 tell us what that is? 9 A. This is a handwritten schedule that 10 shows some listing of securities and interest rate 11 swaps. It looks as if it -- it looks as if it 12 shows the yield on the securities at the top 13 summarized. 14 Q. Is that in your handwriting? 15 A. Yes, it is. 16 Q. Did you prepare that at or about the 17 time that you prepared the schedule, which is 18 Bates stamp OW02921 and 2922? 19 A. I believe I would have made this 20 somewhat earlier because it seems that to have 21 made it so much later when this other schedule was 22 created would have not been necessary. This looks 5225 1 like a very early calculation for me. 2 Q. For that schedule. Now, look at the 3 very last page, OW02930. Can you tell us what 4 that is? 5 A. It's a listing of interest rate swaps, 6 and it appears to be -- since it shows a loss, it 7 appears that it is a list of swaps that was put up 8 to offset some existing interest rate swaps, to 9 mirror them. 10 Q. So, this looks like what it would cost 11 to generate mirror swaps to offset other swaps? 12 A. Yes. 13 Q. When was this document prepared? 14 A. I believe that judging by the titles 15 here, Morgan/FHLB swaps, this would have been done 16 at the time that the finance subsidiary was being 17 unwound. 18 Q. Now, does this pertain to the finance 19 subsidiary or does it pertain to the purported 20 rebalancing that's reflected in 2922 through 2923? 21 A. This should pertain to the finance 22 subsidiary because that's where the offsetting 5226 1 swaps were confused. 2 MR. GUIDO: Now, I'd like to move the 3 admission of the packet of documents that I have 4 marked as Exhibit A10631, Your Honor. 5 MR. NICKENS: No objection, Your Honor. 6 THE COURT: Received. 7 Q. (BY MR. GUIDO) Now, let's go to the 8 schedule, 2922 and 2923, and start with 2923 which 9 has the description of the various entries on 10 there so that we can clarify the record of what's 11 on this document. It says in the far left-hand 12 corner at the top, "MBS Swap Analysis." 13 Do you see that? 14 A. Yes. 15 Q. What does that refer to? 16 A. It refers to the sale of one security 17 and the purchase of another. 18 Q. So that that's how the term "swap" is 19 being used? 20 A. Yes. 21 Q. Not in the sense of an interest rate 22 swap? 5227 1 A. That's correct. 2 Q. Now, the first says "SETL DT," and then 3 it goes across and there is -- looks like dates. 4 What does that refer to? 5 A. These would refer to settlement dates 6 of various transactions. 7 Q. And what does a settlement date refer 8 to? 9 A. It would be the point in time at which 10 securities would be delivered and funds exchanged 11 for them. 12 Q. Does that differ from what's called a 13 trade date? 14 A. Yes. 15 Q. Now, why did you use settlement date 16 and not trade date here? 17 A. I don't remember why at this time. 18 Q. Is settlement date the date that the 19 transaction -- the financial terms of the 20 transaction are finalized? 21 A. No. That would be the trade date. 22 Q. Now, it says "Held bond (dealer)." 5228 1 What does that refer to? 2 A. The held bond in this schedule would be 3 the bond that was originally held and was to be 4 sold. 5 Q. So, that's the dealer from which the 6 original bond was purchased? 7 A. Well, the dealer refers to the -- yes, 8 to the dealer from which it was purchased. 9 Q. Now, let's take -- see the column 10 12-85? It says "GS." What does that refer to? 11 A. Goldman Sachs. 12 Q. Then the next one, 2-18, says "FOB." 13 What does that refer to? 14 A. First Boston Corporation. 15 Q. Then the next one says "FOB." Then the 16 next one says "collar." What does that refer to? 17 Is there an institution named collar? 18 A. There was an interest rate collar as a 19 hedging device in place. These securities, 20 Freddie Mac 13s, were hedged by that collar or, I 21 should say, the attendant risks were hedged by 22 that collar. 5229 1 Q. Was that a PaineWebber transaction? 2 A. It very likely was. I believe the 3 original collar transactions were with 4 PaineWebber. 5 Q. Okay. And then the next one, 3-26, 6 says "MS." What does that refer to? 7 A. Morgan Stanley. 8 Q. Then the third says "collar," as well. 9 Is that also a PaineWebber transaction? 10 A. Very possibly. 11 Q. Then there is one at 3-18. It says 12 "PW." Do you know what that refers to? 13 A. That's PaineWebber. 14 Q. And then 3-21, it says "DBL." Who does 15 that refer to? 16 A. That's Drexel. 17 Q. And 3-26, it says "MS" again. Is that 18 Morgan Stanley again? 19 A. Yes. 20 Q. And then 2-26 says "GS." Is that 21 Goldman Sachs again? 22 A. Yes, it is. 5230 1 Q. And the next, "DBL" means Drexel 2 Burnham? 3 A. Yes. 4 Q. And what's "SMB" mean in the next one? 5 A. Smith Barney. 6 Q. Ask what's "SB" again? 7 A. Salomon Brothers. 8 Q. So, any time "DBL" is used, it means 9 Drexel Burnham? 10 A. Yes. 11 Q. And any time "GS" is used, it means 12 Goldman Sachs? 13 A. Yes. 14 Q. Now, let's go back down to the 15 descriptions of the issuances. It says "issuer." 16 Does that refer to the federal agency 17 that issued the mortgage-backed securities? 18 A. Yes. 19 Q. Ginnie Mae, GNMA is Ginnie Mae. FHLMC 20 means Freddie Mac? 21 A. Yes. 22 Q. FNMA means Fannie Mae? 5231 1 A. Yes. 2 Q. Now, then the next is "coupon." Is 3 that the interest rate on the face value of the 4 instrument, the mortgage-backed security that was 5 purchased? 6 A. Yes, it is. 7 Q. And then it says "current face." What 8 does that mean? 9 A. "Current face" would be the amount of 10 face value that was currently held. 11 Q. And would that differ from the face 12 value when the mortgage-backed security was 13 purchased? 14 A. Yes. 15 Q. And why is that? 16 A. From payments of principal, whether 17 scheduled or early. 18 Q. Okay. So, in other words, prepayments 19 or payments of principal would reduce the face 20 value of the mortgage-backed securities originally 21 purchased to some lower figure? 22 A. That's correct. 5232 1 Q. Now -- do you know what the magnitude 2 of the pay-down was on these mortgage-backed 3 securities that were part of this purported roll 4 down? 5 A. They got quite high. I don't know 6 exactly what they were at every point that we held 7 them, but they -- 8 Q. They were quite substantial? 9 A. They increased, yes. 10 Q. So that -- take the current face of 11 $50 million on this Ginnie Mae in the first 12 column. The original face could have been as high 13 as 75 million? 14 A. I don't know what the original face 15 was. I believe we showed the current CPR on here 16 of 5.16. It would suggest that the original face 17 was not that much more. 18 Q. Because it was held for less than a 19 year? Is that -- 20 A. Well, it hadn't -- it was held for a 21 short time and this rate was not that high. 22 Q. Now, the next says "purchase price." 5233 1 It says 95.84 using 12-85 as an example. 2 Is that the discount premium factor that 3 you and I discussed? 4 A. Yes. That's the purchase price as a 5 percent of par. 6 Q. Okay. And then it says "market value." 7 Do you see that? It says 102, which is a premium 8 to par. 9 Do you know what that refers to? 10 A. That would be the price at which we 11 sold it. 12 Q. Okay. So that that -- so, market value 13 is the price at which you sold that security? 14 A. Yes. 15 Q. And then "current CPR, 5.16," what is 16 that again? 17 A. That is -- 18 Q. CPR. 19 A. An annual rate of prepayment that this 20 security was experiencing. 21 Q. Called a constant prepayment rate? 22 A. Yes. 5234 1 Q. So, that's whatever the prepayment rate 2 was for that security? 3 A. Yes. 4 Q. Now, where did you get that 5 information? 6 A. This would have come from published 7 tables. 8 Q. Tables that were published to show what 9 the prepayment rate was with that particular 10 security? 11 A. Probably for that particular category 12 and coupon. 13 Q. Now, was that different than the tables 14 that you testified about earlier? 15 A. Those tables were used to calculate 16 yield and duration. They were not tables that 17 showed the actual prepayment speed of anything. 18 Q. Okay. So, what you looked at were 19 tables that would show or purported to show what 20 the actual prepayment speed was for this 21 particular security at this particular time? 22 A. Yes. 5235 1 Q. Now, who published those? 2 A. They were widely available from a 3 variety of securities dealers to publish 4 mortgage-backed securities newsletters. 5 Q. Do you know how they were compiled? 6 A. They would be compiled by taking the 7 principal factors which were presented each month 8 by the agencies as to the fraction of the 9 securities remaining outstanding and simply 10 calculating a rate of decline. 11 Q. Do you know how -- let's take Ginnie 12 Maes, for example. Do you know how Ginnie Mae 13 gathered that data? 14 A. Well, whoever administered the 15 securities and processed all the loans under them 16 had to compile these numbers. 17 Q. Now, did that data originate with 18 Ginnie Mae or did they get that data from mortgage 19 bankers who were servicing the pools of 20 mortgage-backed securities that were underlying 21 the mortgage-backed securities issued by Ginnie 22 Mae? 5236 1 A. These pools could have been 2 administered by trustees and outside parties that 3 would have had to report this, I suppose. 4 Q. Do you know what the delay time was 5 between the reporting of the information and the 6 date at which the information was gathered by 7 those outside entities? 8 A. No, I don't. 9 Q. Do you know what the time delay was 10 between the time that Ginnie Mae got that 11 information and the time that it was published? 12 A. No, I don't. 13 Q. Now, take Freddie Mac. Do you know how 14 Freddie Mac gathered the information that was used 15 to calculate the prepayment rates? 16 A. I do not. 17 Q. Were -- did Freddie Mac have outside 18 people servicing the mortgage-backed securities 19 that underlied the pools of mortgage-backed 20 securities that it held as underlying the 21 mortgage-backed securities at issue? 22 A. I'm not familiar with the 5237 1 administration of the securities themselves. I 2 just know that the factors were available at 3 the -- within the first week of every month. And 4 those would be the raw material for making the 5 computations. 6 Q. But you don't know the delay time 7 between when the material was first collected by 8 the person servicing the mortgage to when it 9 became public? 10 A. That's correct. I do not. 11 Q. And is that the same for Fannie Mae? 12 A. Yes. 13 Q. Could that be a significant delay if it 14 was as much as 45 days? 15 A. That would depend on the market, 16 whether prepayment rates had moved in some 17 unexpected way. 18 Q. Well, take the market in December of 19 1985 through March of 1985. Could that -- if 20 there had been a delay of 45 days, could it have 21 been significant? 22 MR. KEETON: You misspoke. 5238 1 MR. GUIDO: Pardon? 2 MR. KEETON: You said December '85 to 3 March of '85. 4 MR. GUIDO: December of '85 to March of 5 '86. Excuse me. 6 A. If one relied on those as critical 7 decision variables, you could make a mistake with 8 that. 9 Q. (BY MR. GUIDO) And if the delay had 10 been 75 days, could the -- could that have been a 11 significant delay in that time period? 12 A. Yes. If you relied on them in that 13 fashion, yes. 14 Q. Now, you relied on these figures in 15 preparing this table, did you not? 16 A. I posted these figures as what the CPRs 17 were when we sold them, what we thought them to 18 be. 19 Q. Now -- 20 A. I'm not sure how it played in our 21 decision at that point. 22 Q. Okay. Now, there is then the entry 5239 1 "BEY." Do you see that entry? 2 A. Yes. 3 Q. What does that refer to? 4 A. That stands for bond equivalent yield 5 which was to convert a security with monthly 6 payments to that equivalent of a semi-annual 7 payment security as a reference point. 8 Q. Why did you do that? 9 A. It was routinely done so that it could 10 be compared to semi-annual securities such as 11 treasury bonds and corporate bonds. 12 Q. And why did you want to compare it to 13 treasury bonds and corporate bonds? 14 A. Because those were fairly universal 15 standards. To quote the yield on a 16 mortgage-backed security, one needed to refer that 17 it was a monthly payment instrument and, 18 therefore, the actual yield was -- received would 19 be somewhat higher than a semi-annual security. 20 And so, we made the adjustment to make them 21 equivalent. 22 Q. Were you comparing Ginnie Maes to 5240 1 Ginnie Maes? Why did you need to convert both of 2 them to a bond equivalent yield to compare the 3 two? 4 A. It was merely convention. 5 Q. Okay. Did you use the figures at all? 6 A. We would refer to these figures as the 7 yields. 8 Q. So, when you talked about an increase 9 or decrease in yield, you used these figures on 10 this report? 11 A. Yes. 12 Q. So that that's the purpose that -- 13 A. Yes. 14 Q. Now, when you did your yield 15 enhancement trades in 1986, did you use the bond 16 equivalent yield when you made those calculations 17 or did you use the actual yield on the 18 mortgage-backed securities? 19 A. I believe we would have used bond 20 equivalent. 21 Q. Now, the next says "realized gain." Do 22 you see that entry? 5241 1 A. Yes. 2 Q. And that runs all the way across the 3 page. What does that refer to? 4 A. This would refer to the gain on the 5 sale of the held bond. 6 Q. So, that -- 7 A. The difference between the book value 8 and the sale price. 9 Q. So, it's whatever the purchase price is 10 reflected by book value was subtracted from 11 whatever the sales proceeds were? 12 A. Yes. 13 Q. Now, then you go down to the purchase 14 bond. Do you see that category? 15 A. Yes. 16 Q. And it's issuer again, coupon which 17 you've testified about, purchase price, CPR, as 18 well. And then it has this thing called "sales 19 proceeds." 20 Can you tell us what that meant 21 A. I believe the sale proceeds were the 22 sale -- the proceeds from the sale of security 5242 1 that's directly above it in the column. 2 Q. Now, then there's -- it says "face 3 purchase" and that was, I guess, whatever the 4 dollar amount was paid for the mortgage-backed 5 securities that were purchased? 6 A. I believe this was the amount of face 7 value that could be purchased with those proceeds. 8 Q. Okay. Or that was purchased with those 9 proceeds? 10 A. Yes. 11 Q. Then it says "adjusted purchase price, 12 94.904." What does that refer to? 13 A. Well, that appears to be a reduction in 14 the basis of the purchased bond by the amount of 15 the gain. 16 Q. So, in other words, that would be a 17 corrected purchase price as a percentage of par if 18 one factored in the gain on the sale of the 19 security which was substituted by the repurchase? 20 A. That's right. And this would have been 21 strictly an analytical adjustment. This was not 22 an accounting treatment. 5243 1 Q. Okay. Now, what is your understanding 2 of the column -- drop down to where it says "gain 3 (rolled/not rolled) on unrolled gain." 4 What does that refer to 5 A. I need a moment to reacquaint myself 6 with it. It looks as if this represents the 7 differences essentially due to rounding between 8 what was sold and what was bought where we 9 purchased round lots of at least a million bonds 10 and there was some excess proceeds from the sale 11 that didn't get reinvested. 12 Q. Now, look at -- now, let's go backup to 13 the estimated annual income column. Do you see 14 that? And income pick up entry. Do you see 15 those? 16 A. Yes. 17 Q. The estimated annual income appears for 18 both the mortgage-backed security that was sold, 19 the top group, and those that were purchased, the 20 bottom group; is that right? 21 A. Yes. 22 Q. And that's the annual income that you 5244 1 expected on the return on those mortgage-backed 2 securities? 3 A. Yes. 4 Q. Okay. And was that going out one year, 5 two years, or what? 6 A. It would have been essentially the 7 first year. 8 Q. Okay. Then it has "income pick up." 9 Do you see that? 10 A. Yes. 11 Q. And the first one is under -- there 12 isn't anything with regard to estimated annual 13 pick up for the transaction at 12-85; but for the 14 12-18, it shows 17. Is that $17,000? Is that 15 what that refers to? 16 A. Yes, it is. 17 Q. Okay. And the next one is 410 under 18 2-26. Is that 410,000? 19 A. Yes. 20 Q. And on through. Now, going to the 21 entry on 3-26, do you see that one? That one 22 shows an 11,505,000 estimated annual income and 5245 1 then an income pick up of 11 million 505. 2 Is that figure 11505 as a pick up an 3 error? 4 A. Yes, it must be. 5 Q. Because -- and the reason why it's an 6 error is that if you look at the securities sold 7 at the top, it doesn't have an estimated annual 8 income for that security? 9 A. That's right. And so, a subtraction 10 was performed and there was nothing to subtract. 11 Q. And the reason there was no figure up 12 above is that there was an error in entry into the 13 computer? 14 A. Yes. 15 Q. Then there are these three 16 transactions: 2-26, 3-20, and then it says 17 3-4-5 -- "3, 4, 5, reg." Do you see that? 18 A. Yes. 19 Q. Now, are those just straight purchases 20 and not swapping one mortgage back for another? 21 A. Well, it appears from this that no sole 22 security is paired with it. That's all I can be 5246 1 sure of. 2 Q. Now, what doe "3, 4, 5 reg" refer to? 3 A. I don't remember. 4 Q. Now -- and then when you move over to 5 the next column, you get the -- you get a negative 6 $53,000 in income under "Dunn." 7 Do you see that, "Dunn SB"? 8 A. Yes. 9 Q. Do you recall what the "Dunn" referred 10 to? 11 A. No, I don't. 12 Q. And then a 14-million-dollar pick up in 13 the DBL. 14 A. Yes. 15 Q. Now, on these transactions, there are 16 some circles around some of the transactions. 17 Do you see those on the sheet of paper? 18 A. Yes. 19 Q. Okay. What do those refer to? Take 20 the one under 3-26. It says Freddie Mac 10, 21 98.9375. Take that. 22 What does that circle and the arrow and 5247 1 the other circle under 3-26 refer to? 2 A. It directs your attention to the fact 3 that this bond moved up to the top of the schedule 4 as a held bond. It was later sold, with the 5 proceeds buying the Freddie Mac 9 and a half's. 6 Q. So that that's sort of a second-level 7 transaction? 8 A. Yes. 9 Q. And then take the Freddie Mac 9 and a 10 half that was purchased on 3-26 to replace this 11 one replacement. There's a circle around that and 12 then there is an arrow to the other page or the 13 other side of the ledger. 14 What does that refer to? 15 A. It would indicate that this position 16 was sold. 17 Q. And -- 18 A. And paired with two other transactions. 19 Q. Okay. And when you say that this 20 position was sold, does that refer to the two 21 transactions, the two sales that are referred to 22 on 3-28 on Bates stamp 2922? 5248 1 A. Yes. 2 Q. Okay. Is there a figure on 3 Exhibit A10631 on either Page 2922 or 2923 that 4 would identify the total realized profits from 5 these sales? 6 A. There is a totals column, but I have 7 not examined it to see what it means. 8 Q. I think the -- you run the realized 9 gain line over. You end up on the last entry 10 under the Freddie Mac 9 and a half, the last one, 11 as a realized gain of 5,753,000. 12 Do you see that figure? 13 A. Yes. 14 Q. Is the figure 67,832 the total realized 15 gain which is the total of all of the items 16 across? 17 A. By the way this is set up, this 18 should -- this should add to that column, yes. 19 Q. But the schedule shows that there was a 20 67-million-dollar realized gain on these 21 transactions? 22 A. Yes. 5249 1 Q. Now, take a look at the transaction at 2 12-85. That's a 50-million-dollar face value. 3 Do you see that? 4 A. Yes. 5 Q. And it's selling a 12.25 coupon and 6 purchasing a 12 percent coupon. 7 Do you see that? 8 A. Yes. 9 Q. And the CPR for the one sold is 5.16 10 and the one purchased is 5. Do you see that? 11 A. Yes. 12 Q. Okay. Why was that transaction entered 13 into? 14 A. All of these transactions represents a 15 move to lower coupons and, it was hoped, lower 16 prepayment speeds. 17 Q. Well, the figures that you have on 18 prepayment speeds don't show any significant 19 difference between the two, do they? 20 A. They are quite close on this one. 21 Q. Okay. Let's take the transaction 2-18. 22 That shows a coupon 11 for 10 and a CPR of 11 for 5250 1 10. I'm sorry. It shows an 11 for 10 in coupons 2 and an 11 for 11 in CPR. 3 Do you see that? 4 A. Yes. 5 Q. What was the reason for that 6 transaction? 7 A. We would have expected that a 8 10 percent coupon would have had -- would have let 9 us expect a lower CPR in the future. 10 Q. So that these CPR figures that you have 11 here have nothing to do with your expectations 12 about the future? 13 A. I believe these are historic. 14 Q. Did you do any simulations prior to 15 engaging in these transactions to ascertain how 16 rapidly prepayments increased with a percentage 17 change in interest rates or a 100 basis point 18 change? 19 A. We did not model prepayment speeds, per 20 se, against interest rates. 21 Q. Were you doing this intuitively? 22 A. I think many of the -- many of the 5251 1 tools that are used in this business now were not 2 as widely available then. I don't think we had a 3 lot of hard research to show that link. It was 4 quite intuitive. 5 Q. So, you had nothing available to you to 6 show you what prepayment speeds were likely to be 7 as your mortgage-backed security became more of a 8 premium security? 9 A. Well, there was quite a lot of 10 contemporaneous research being developed at that 11 time. 12 Q. What did people look to -- 13 MR. NICKENS: Your Honor, I don't 14 believe the witness had completed his answer. 15 MR. GUIDO: I'm sorry. 16 A. It may have differed in approach and 17 style. The result was, of course, a positive 18 relationship between interest rates and prepayment 19 speeds. The exact link was not at all certain 20 and, I suggest, probably is still not entirely 21 certain. 22 Q. (BY MR. GUIDO) Well, let's move to 5252 1 the next transaction that I'd like to direct your 2 attention to and that is the 3-21 transaction with 3 DBL. March 21st. That shows a Freddie Mac 11 4 coupon being exchanged for a Fannie Mae 10 and a 5 current CPR of 11 being exchanged for a current 6 CPR of 10. 7 Do you see that? 8 A. Yes. 9 Q. Is the difference between an 11 and a 10 10CPR significant? 11 A. No. I would say it's not significant. 12 Q. Now, look at the collar transactions. 13 Take the first one. You see that? 14 A. Yes. 15 Q. It says "Freddie Mac 13 for Freddie Mac 16 13. Current CPR of 30 in exchange for a current 17 CPR of 30." 18 What was the purpose of that transaction 19 A. I can't see any apparent purpose from 20 this. 21 Q. Now, look at the income pick up. Do 22 you remember you testified about yield 5253 1 enhancement? It's zero, isn't it? 2 A. Yes. 3 Q. And the securities are identical, 4 aren't they? 5 A. Yes, they are. 6 Q. Is the only difference the difference 7 in the sales proceeds, the amount realized when it 8 was sold, and the face amount that was purchased? 9 A. Yes. 10 Q. And what does that show? That the face 11 amount goes from 114278 to 115505. Right? 12 A. I'm sorry. Can you tell me which 13 column? 14 Q. Look at "sales proceeds and face 15 purchase." 16 MR. NICKENS: I think you've got the 17 wrong column, Mr. Guido. 18 A. I am in the collar column. 19 Q. (BY MR. GUIDO) I'm sorry. It's the 20 purchase price 47326, and 47326 was the current 21 face. Do you see that? I'm sorry. 22 A. That's correct. 5254 1 Q. So that the number is identical? 2 A. Yes. 3 Q. Look at the figure that says "estimate 4 realized gain." Do you see that? $2,514,000? 5 A. Yes. 6 Q. Was the only economic impact of this 7 transaction that there was a realized gain? 8 A. The bond equivalent yield is higher on 9 this column. It went from 1271 to 13. 10 Q. So, there was a pickup in the yield -- 11 of the bond equivalent yield? 12 A. Apparently not enough to extend into 13 dollars for this bottom calculation. 14 Q. So, it was insignificant? 15 A. It was nearly 30 basis points. I would 16 say it was significant. 17 Q. And what would 30 basis points have 18 turned out to be? 19 A. Well, 30 basis points on $47 million. 20 Q. Now, was that the reason for the 21 transaction? 22 A. I really don't recall the exact reason. 5255 1 Q. Okay. Now, take the other column, the 2 12 for the 12 and the Ginnie Maes with a CPR of 13 3 for a CPR of 13. The BEY, bond equivalent yield, 4 are they the same or different? 5 A. It is the same in this case. 6 Q. And what is the realized gain? 7 A. $6.3 million. 8 Q. Was this transaction entered into for 9 any purpose other than to generate a gain? 10 A. It's clear that a gain came out of it. 11 I can't be sure it was entered into for that 12 purpose. 13 Q. From this, can we tell whether or not 14 there was any other reason other than to realize a 15 gain? 16 A. We cannot. 17 Q. What was the reason for those trades? 18 A. At this point, more than 10 years 19 later, I can't be sure. 20 Q. Now, what is the purpose of 21 rebalancing? 22 A. Generally, it would be to realign the 5256 1 match of durations between the assets and 2 liabilities. In the case of the mortgage-backed 3 security portfolio, we had the additional 4 dimension of bringing prepayment speeds of the 5 held portfolio under control. 6 Q. Is one of the purposes of rebalancing 7 to head off the loss in a risk-controlled 8 arbitrage before it occurs? 9 A. Yes. 10 MR. NICKENS: Your Honor -- I don't 11 understand the question, but apparently the 12 witness did. 13 THE COURT: Next question. 14 A. Can I continue? If the loss was 15 expected to be from increasing prepayments, that 16 would be correct. 17 Q. (BY MR. GUIDO) So that the purpose of 18 rebalancing is to rebalance the portfolio before 19 the fact, not after the fact? 20 MR. NICKENS: What fact, Your Honor? I 21 mean. 22 Q. (BY MR. GUIDO) Before the fact that 5257 1 prepayment speeds increased. 2 A. Well, one would have to make the 3 judgment that prepayment speeds had, indeed, 4 increased and would continue. 5 Q. Had increased or were likely to 6 increase? 7 A. Well, it could be either. 8 Q. Well, if you were trying to maximize 9 profits or minimize losses, isn't your objective 10 to anticipate what the risks are and to protect 11 yourself from those risks before you experience 12 the harm caused by those risks? 13 A. Yes, to the extent that you can 14 anticipate and identify these changes when they 15 are actually occurring. 16 Q. Okay. And in this case, what it is 17 that you need to identify was the extent to which 18 prepayment rates would increase in response to a 19 decline in interest rates? 20 A. Yes. We had to assess our expectation 21 of continued prepayment speeds. 22 Q. What did you use -- what figures did 5258 1 you look to to ascertain what the likelihood of an 2 increase in prepayment speeds was? 3 A. What figures? We had -- yeah. 4 Q. What figures did you look to? 5 A. We had contemporaneous research on the 6 subject. We had historical prepayment speeds 7 prepared and distributed periodically by virtually 8 everyone in the business. 9 Q. You mean contemporaneous actual 10 prepayment speeds that I asked you a question 11 about the delay in the reporting of? 12 A. That's correct. 13 Q. And that's what you relied upon? 14 A. That and the general market trends as 15 were quoted. We -- we did -- because of the size 16 of the transactions we undertook, we dealt in what 17 they called generic coupons. We did not identify 18 particular pools of securities to purchase because 19 we couldn't have moved in the size required to do 20 these transactions. So, we relied on our belief 21 of what, for example, all Freddie Mac 11s prepaid 22 at as opposed to individual loans. 5259 1 Q. So, you essentially used actual 2 prepayment speeds to predict the prepayment speeds 3 at that date? 4 A. Actual prepayment speeds and our market 5 outlook of what interest rates might do. 6 Q. Okay. So, you also made -- besides 7 looking at actual prepayment speeds on Date 1, to 8 figure out what was going to figure out what was 9 going to happen on Date 2, you used those actual 10 prepayment speeds and your estimate of what you 11 thought interest rates were going to do out into 12 the future? 13 A. That's correct. 14 Q. Did you use anything else? 15 A. We may have relied on suggestions from 16 others as to what these prepayment speeds would do 17 when rates changed. It was a widely discussed and 18 researched topic. 19 Q. Well, let's take some of these 20 transactions that are on here. And let's start 21 with the -- let's take the first transaction on 22 2-26. The FOB, First Boston transaction. 5260 1 That shows a current CPR of 20. 2 Do you see that? 3 A. Yes. 4 Q. Now, was that significantly higher than 5 the CPR when that was purchased? 6 A. I don't know what it was when we 7 purchased it, but I'm sure it wasn't as high as 8 20. 9 Q. Look at the purchase price. It was 10 98.68. Right? 11 A. Yes. 12 Q. And the market value was 105 at this 13 point in time. Obviously, interest rates had 14 moved, had they not? 15 A. That's correct. 16 Q. And when interest rates move, the CPR 17 changes, doesn't it? 18 A. Yes. 19 Q. So, had you done any analysis to 20 determine when that mortgage-backed security 21 portfolio pool might reach a CPR of 20? 22 A. No, we had not. 5261 1 Q. Take the Morgan Stanley transaction of 2 3-26. That shows a current CPR of 32. Do you see 3 that? 4 A. Yes. 5 Q. And it shows -- it also increased in 6 market value over purchase price. Do you see 7 that? 8 A. Yes. 9 Q. Okay. Is it fair to assume that the 10 CPR when that was purchased was less than the 11 32 percent? 12 A. Yes, it is. 13 Q. Was anything done to determine when 14 that CPR for that pool might reach 32 percent? 15 A. No. We did not model CPRs, prepayment 16 speeds. 17 Q. Now, when you engaged in this swap of 18 securities in this purported rebalancing, what did 19 you purchase to replace the mortgage-backed 20 security that you had sold? What coupon? 21 A. In every case, we purchased a lower 22 coupon. 5262 1 Q. Okay. And was that lower coupon 2 essentially at about par or at whatever the 3 current rate was at that time? 4 A. Quite close to par. 5 Q. Okay. Did you attempt to ascertain 6 whether you would get greater protection by 7 leap-frogging the par and going into a discount 8 coupon, let's say, 100 or 200 basis points below 9 the market at that time? 10 A. I remember that we chose not to 11 leapfrog because it would cost too much in loss 12 coupon. We would have not been able to replace 13 every dollar of coupon income with the additional 14 face amount available by going lower. 15 Q. Now, if you had purchased the lower 16 coupon, the one you looked at in terms of 17 repurchasing, did you look at it in terms of 18 purchasing additional insurance against increase 19 in prepayment rates? 20 A. Our objective there was to begin 21 bringing the coupons lower without losing all of 22 the coupon income that we were getting from the 5263 1 pool as it evolved. We were quite sure that 2 jumping too many coupon increments at a time would 3 cost us too much in cash flow. 4 Q. Did you ever attempt to do the 5 mathematics to ascertain whether that was the 6 case? If you're buying them at a discount, you 7 can buy more of them, can't you? 8 A. Yes. However, the yield calculations 9 differ somewhat from the actual cash coupons 10 received. And I recall evaluating that one aspect 11 of it, the cash coupons received, for the 12 additional amount of face value that could be 13 purchased. And there was an unacceptable 14 trade-off by jumping too far. 15 Q. What was that trade-off in dollar 16 figures? 17 A. I don't know. 18 Q. What was it in terms of percentage 19 figures? 20 A. We did it -- I feel that we must have 21 done it in terms of dollars because you couldn't 22 evaluate it in percentages. 5264 1 Q. Did you do it in terms of yield? 2 A. I don't think so because that would not 3 have been the criteria. We were concerned with 4 the amount of face value we would have from the 5 proceeds and how much would come off of those. 6 The yield was a bit smoother to project than the 7 coupons. We had to have enough money to offset 8 against the swaps and everything else. 9 Q. But I mean, you could calculate the 10 yield by taking whatever your revenue stream was 11 on your mortgage backs and your revenue of payout 12 on the swap side and figure out what the field 13 yield is, couldn't you? 14 A. That's correct. 15 Q. Did you do that? 16 A. Yes. 17 Q. And did you ascertain what the cost 18 would be to leapfrog the current coupons and move 19 into a discount security to buy additional 20 protection against acceleration in prepayments? 21 A. I don't recall that we made every -- 22 the calculation of every such transactions. I 5265 1 believe that at the time, we went in small 2 increments as to preserve the cash flow. 3 Q. My question is: Did you do the 4 mathematics to determine whether or not that was a 5 more appropriate approach as opposed to using 6 discounted coupons as part of the purported 7 rebalancing? 8 A. Well, the use of the discounted coupon 9 is another bet on direction, and I don't believe 10 that we undertook to evaluate that. 11 Q. So, you didn't evaluate it, did you? 12 A. No. 13 Q. Had you ever looked at the difference 14 between purchasing current coupon mortgage-backs 15 and discount mortgage-backs in terms of what the 16 yield would be in a risk-controlled arbitrage like 17 you set up? 18 A. I believe that the yield in the 19 discount securities was lower. 20 Q. Do you recall how great it was? 21 A. For certain discounts that were low 22 enough coupons, it could be substantially lower, 5266 1 maybe 30 basis points or more. 2 Q. So, we're talking somewhere around 30 3 to 40 basis points here when we're talking about 4 moving from current coupon to discount coupon 5 securities? 6 A. It could be higher for particularly 7 slow paying discount bonds. 8 Q. How do you know this? 9 A. We were marketed a program that was 10 dedicated to discount bonds that was sold by 11 Bear Sterns in conjunction with a prepayment 12 tracking system they had. And I know that they 13 tried to identify slow-paying, discount pools in 14 hopes that people would pay more for them. 15 Q. The -- was that a proposal that 16 Bear Sterns made to you as part of the various 17 proposals that were made to you in 1984 and early 18 1985? 19 A. No. 20 Q. No? How do you know about that? 21 A. We were contacted by a salesman from 22 Bear Sterns and by salesmen of other firms in 5267 1 Houston that clear through Bear Sterns with the 2 same resources and materials to track prepayments. 3 And I was familiar with their program from that. 4 Q. Now, when did you become familiar with 5 that? 6 A. I don't know. 7 Q. Was that sometime in 1984, '85, or is 8 that subsequent to that? 9 A. I would think it would have been in 10 1985. 11 Q. Now, in doing a rebalancing that you 12 testified about, what is it that you need to do to 13 make the rebalancing successful, if possible? 14 A. You would want to realign the durations 15 to try to get the match and the interest rate 16 sensitivity back in line, and you would want to 17 have -- used an outlook for prepayment speed in 18 assessing the duration of the mortgage-backed 19 security in doing that and that would be the 20 primary goal. And if that included going to lower 21 coupons with lower prepayment speeds in a rising 22 market, that's what you would do. 5268 1 Q. Now, what did you -- what was the view 2 that you held at the time about what you would do 3 with the proceeds from the sales of the 4 mortgage-backed securities that had been sold to 5 be replaced by new mortgage-backed securities? 6 A. We would deploy those proceeds into the 7 purchases. 8 Q. Now, to make the rebalancing 9 successful, was it necessary to reinvest not only 10 the proceeds from the sale but the profits from 11 the sale of the mortgage-backed security that was 12 sold? 13 A. It should be the entire proceeds. 14 Q. Okay. 15 A. Which would include the profit. 16 Q. Include the profit. And the principal 17 returned on sale. What about the prepayments? 18 A. The prepayments should be replaced, 19 also. 20 Q. Okay. Did you reinvest all of the 21 proceeds, including the prepayments, the 22 principal, and the gain on the sale in the course 5269 1 of the rebalancing? 2 A. It appears that from -- from this that 3 the current face is the amount shown in the 4 analysis. So, I would suppose from that it would 5 be the amount remaining after prepayments. 6 Q. So, you didn't invest the prepayments? 7 A. To the extent that current face did not 8 reflect those -- and I'm not altogether sure that 9 they did or did not in every case reflect those -- 10 that's correct. 11 Q. Did you seek authority from the 12 investment committee to reinvest the prepayments 13 to preserve the integrity of the risk-controlled 14 arbitrage? 15 A. We did ask for an incremental 16 investment. That could have been the cumulative 17 result of such prepayments not being previously 18 invested. 19 Q. Did you explain that to the investment 20 committee? 21 A. Yes. 22 Q. And did you explain to the investment 5270 1 committee that it was necessary to maintain the 2 integrity of the risk-controlled arbitrage to do 3 so? 4 A. I believe that we did. 5 Q. And what was the investment committee's 6 response? 7 A. It would have been in the summer, and 8 the committee preferred to defer that until 9 Ms. Laurenson had either been hired or come to 10 work there. 11 Q. Okay. So, they didn't do it? 12 A. That's correct. 13 Q. Now, had you rolled down -- take, for 14 example, the 3-18 PaineWebber transaction that's 15 on Bates stamp 2923 on Exhibit A10631. 16 Had you rolled or rebalanced that 17 transaction prior to an acceleration in 18 prepayments 19 A. Is this the column headed 3-18? 20 Q. Yes. 21 A. We were showing a CPR of 25. So, at 22 that point, prepayments would have already 5271 1 commenced. 2 Q. Going across these transactions, which 3 ones of these transactions would you say the 4 prepayments had already accelerated when you made 5 the transactions? 6 A. Generally speaking, it would be those 7 with relatively high CPR numbers. 8 Q. And what is a relatively high CPR 9 number? 10 or above? 20 or above? 10 A. Well, in some cases -- in some cases, 11 even 20 or 25 would be high. 12 Q. Now, let's take some of those 13 transactions. Will you take a look at Exhibit 14 A11012 which is the chart of the interest rates 15 that I gave you which was from Dr. Duffie's expert 16 report. 17 Now, when you were looking at interest 18 rates to monitor how to respond to potential 19 increases in interest rates, what point in the 20 yield curve were you looking at 21 A. Typically, we would look at the 22 ten-year column. 5272 1 Q. Let's take the ten-year column. 2 MR. NICKENS: On which chart? 3 MR. GUIDO: On the chart Table 4.2.1, 4 SBA treasury yield curves. 5 MR. NICKENS: Your Honor, for the 6 record, this is the third page of Exhibit A11012, 7 which I believe has been identified as being Smith 8 Breeden estimates of treasury yield curves. 9 MR. GUIDO: It's actually not Page 3. 10 This is just selected pages from Dr. Duffie's 11 report. It's Table 4.2.1 on his report. 12 MR. NICKENS: But it's Page 3 of the 13 exhibit. 14 MR. GUIDO: It's not Page 3 of the 15 exhibit. It's Page 3 of this compilation of the 16 exhibit. 17 THE COURT: All right. Table 4.2.1. 18 MR. GUIDO: SBA treasury yield curves. 19 Q. (BY MR. GUIDO) Now, take the 20 transaction of 2-26, the First Boston/Freddie Mac 21 transaction where the prepayment speeds are 20. 22 Do you recall when these mortgage-backed 5273 1 securities were purchased? 2 A. No, I don't. 3 Q. Okay. They were before June 30th of 4 1985, were they not? 5 A. It's very likely they were. 6 Q. And they were purchased basically 7 between April and June of that year of '85. 8 Right? 9 A. That's correct. 10 Q. Let's take June 30th, 1985. What does 11 that show happened to interest rates between 12 June 30, 1985, in the ten-year portion of the 13 yield curve, and February 28th, 1986? 14 A. They fell. 15 Q. And they fell by how many basis points? 16 A. From 10 and a half down to 735, 320. 17 Q. 327 basis points? 18 MR. NICKENS: Your Honor, I must be 19 looking at the wrong column. May I ask -- 20 MR. GUIDO: The ten-year column. 21 MR. NICKENS: On Exhibit 421? But I 22 thought they were measuring from June of '84 5274 1 through February of '85. 2 MR. GUIDO: I said June of '85 through 3 February of '86. Excuse me. The date of this 4 transaction is 2-26-86. I picked the next closest 5 day, which was February 28th, 1986, which shows 6 7.35 to June 30th of '85 as of when this 7 transaction is reported. 8 MR. NICKENS: I was just looking at the 9 wrong part of the chart, Your Honor. Excuse me. 10 And this is from the settlement date of this 11 transaction, correct? 12 MR. GUIDO: That's correct. 13 Q. (BY MR. GUIDO) That shows an 14 approximately 317 basis point drop, does it not? 15 A. Yes. 16 Q. What were you looking at while interest 17 rates were dropping 317 basis points? 18 A. We were looking at current markets and 19 what we thought it was. We couldn't look back, 20 obviously, and see that they had moved that much. 21 I mean, we couldn't look back the way you can now 22 and see how much they had moved. 5275 1 Q. Well, look at the movement between June 2 of '85 and October of '85. That's about 100 basis 3 points, wasn't it? 4 A. Yes. 5 Q. Is 100 basis points a fairly 6 significant move? 7 A. Yes, it is. 8 Q. What were you monitoring at that point 9 in time? 10 A. I don't understand the question. 11 Q. What were you looking to to determine 12 when it is that you should rebalance when you saw 13 interest rates drop that 100 basis points between 14 June and October of '85? 15 A. We did want to see whether there would 16 be an impact on our own holdings at that time and 17 whether all prepayment speeds would accelerate 18 with this move. 19 Q. And what did the figures tell you? 20 A. Well, ultimately, we did determine that 21 prepayment speeds had increased. 22 Q. When did you determine that? 5276 1 A. I'm not sure exactly when. 2 Q. Before or after the fact? 3 MR. NICKENS: Again, Your Honor, I 4 would ask what fact? 5 Q. (BY MR. GUIDO) Before or after the 32 6 or 30 or 20 CPR figure showed up in the results 7 that you were seeing. 8 A. Well, it's certainly possible that a 9 higher CPR than our purchase CPR could have been 10 experienced before we made the transaction. It's 11 not at all clear whether we were sure that would 12 persist because it was important to know whether 13 this was a real change or just noise in the 14 market. 15 Q. Well -- what do you mean, "noise in the 16 market"? Just volatility? 17 A. Yes. 18 Q. Well, look at the rates from, let's 19 say, 5-31-84 through June 30, '85. What does that 20 show you in terms of progression of interest 21 rates? 22 A. They had fallen. 5277 1 Q. And fallen in sort of a lop step 2 fashion, doesn't it? 3 MR. NICKENS: Your Honor, I don't know 4 what that means. The interest rates go down a 5 little each month. 6 Q. (BY MR. GUIDO) So, they go down a 7 little each month? 8 A. Yes. 9 Q. They don't show anything other than a 10 downward trend, do they? 11 A. That's correct. 12 MR. NICKENS: Your Honor, that's not 13 quite correct. There is a movement up on December 14 of '84 to January of '85. 15 THE COURT: We'll take a short recess. 16 17 (A short break was taken 18 at 2:52 p.m.) 19 20 THE COURT: Be seated, please. We'll 21 be back on the record. 22 Mr. Guido, you may continue. 5278 1 MR. GUIDO: Thank you, Your Honor. 2 (3:18 p.m.) 3 Q. (BY MR. GUIDO) Now, looking at 4 Exhibit A10631 and look at the interest rate chart 5 that I showed you from 10-22. It shows that 6 interest rates on February 28th, '86, were 7.35 in 7 the ten-year range; 3-31-86, they were 8 7.35 percent; and April 30th, they were 9 7.34 percent. 10 Do you see that? 11 A. Yes. 12 Q. Okay. Now, for all of the transactions 13 that are dated February 26th and later dates on 14 your schedule, which is A10631, your chart, were 15 those interest rates 317 basis points or more 16 below what they had been on June 30, 1985? 17 MR. NICKENS: Your Honor, are we 18 comparing treasury rates with treasury rates? Are 19 we comparing treasury rates with mortgage rates? 20 MR. GUIDO: I'm not comparing anything. 21 I'm comparing two treasury rates together. 22 There's a 317-point decline I think the witness 5279 1 has agreed to. 2 Q. (BY MR. GUIDO) And as of -- take the 3 Morgan Stanley 3-26 transaction. Those ten-year 4 treasury rates had declined 317 basis points, had 5 they not? 6 A. Since that point you asked me about, I 7 believe that's correct. 8 Q. And you indicated that you were using 9 ten years because that's where you were on the 10 yield curve? 11 A. Ten years was a conventional point on 12 the curve for mortgage-backed securities. 13 Q. Now, the 3-18 transaction for 14 PaineWebber, do you see that? Ginnie Mae 13 in 15 there? Were they also down 317 basis points? 16 A. Yields were down during this period 17 that you have asked me about. 18 Q. As reflected on this chart? 19 A. Yes, that's correct. 20 Q. And for all of the transactions dated 21 2-26 or later, they were down to at least 317 22 basis points on the ten-year treasuries? 5280 1 A. Yes. 2 Q. Now, when did you learn that the 3 risk-controlled arbitrage had turned negative and 4 was basically unsalvagable? 5 MR. NICKENS: Your Honor, there are two 6 questions there. And I believe it will be useful 7 to get both answers. 8 Q. (BY MR. GUIDO) When did you learn the 9 risk-controlled arbitrage had a negative spread? 10 A. I believe that we learned that in the 11 summer of '86, and it could have been May or June. 12 Q. That you learned that the spread had 13 turned negative? 14 A. Yes. 15 Q. And when did you learn that it had a 16 substantial negative market value? 17 A. I'm not sure I learned that it had a 18 substantial negative market value. 19 Q. When did you learn or conclude that it 20 was unsalvagable? 21 A. By "unsalvagable," if you mean that we 22 could no longer add benefit to it by these 5281 1 transactions -- 2 Q. By rebalancing. 3 A. I believe that we would have concluded 4 that in the summer. 5 Q. Now, did -- when you did these 6 calculations on these transactions that we've 7 talked about in Exhibit A10631, did you make any 8 effort to ascertain whether or not you could buy 9 yourself out of the losses with the 10 67-million-dollar realized gains that you 11 testified about? 12 A. I did not, no. 13 Q. Did anyone, to your knowledge? 14 A. I don't know. 15 Q. Did you ever attempt to ascertain at 16 that point in time what it would have cost to 17 purchase mirror swaps to mitigate any further 18 losses on the swap side? 19 A. I don't believe I did. 20 Q. I want to hand you a document that 21 we've marked as Exhibit A10619, which is a 22 memorandum from Roger Wittlin from Goldman Sachs 5282 1 to Mike Crow dated March 22nd, 1986. 2 Have you ever seen that document before? 3 A. Yes, I have. 4 Q. When did you see that document? 5 A. You showed it to me a couple of nights 6 ago. 7 Q. Okay. Have you ever seen it before? 8 A. No. 9 Q. And did you -- is your testimony that 10 you never saw it on or about March 22nd, 1986? 11 A. Yes, it is. 12 Q. Now, can you tell us what this is? 13 A. This seems to be an analysis of the 14 profitability of a risk-controlled arbitrage 15 taking into account mortgage-backed securities, a 16 variety of hedge instruments, and short-term 17 rates. 18 Q. Is this an analysis of USAT's 19 portfolio? 20 A. Yes, it is. 21 Q. Now, did anyone ever discuss this study 22 with you? 5283 1 A. No. 2 Q. What does it show with regard to the 3 status of the risk-controlled arbitrage portfolio 4 if the interest rates remain stable? 5 MR. NICKENS: Your Honor, if we're 6 going to discuss the document, I would like it to 7 be offered as a part of the record. The witness 8 has said he's never seen it before his preparation 9 for his testimony but, nevertheless, I'm not going 10 to object to the document. 11 MR. GUIDO: I move Exhibit A10619, Your 12 Honor. 13 THE COURT: Received. 14 Q. (BY MR. GUIDO) You have seen similar 15 documents, have you not, Mr. Phillips? 16 A. I have seen analyses of risk-controlled 17 arbitrage before. I have not seen this study. 18 Q. This particular study? 19 A. Yes. 20 Q. Okay. But this format is not 21 dissimilar to you? 22 A. This is a reasonable way to capture all 5284 1 the effects on one page. 2 Q. Now, take a look at the page that is 3 Bates stamped CN056139. 4 Do you see that? 5 A. Yes. 6 Q. Okay. Now, is that an analysis of the 7 status of the USAT risk-controlled arbitrage 8 portfolio with no change in interest rates? 9 A. By the way it's annotated at the top, 10 "change in short rates" and "change in mortgage 11 rates zero," it seems to represent that. 12 Q. Now, is this an analysis of the 13 portfolio as it existed when you were managing it, 14 or does it indicate that it is an analysis of the 15 portfolio utilizing different instruments to 16 protect that portfolio from further losses? 17 A. I can't be sure by looking at it, but 18 it -- I had assumed in discussing it that it was 19 an analysis of the United Savings portfolio. 20 Q. Well, looking at it now, is that a 21 correct assumption? 22 A. Well, the securities are not listed on 5285 1 here and the swaps are not listed. It's only cash 2 flows and accounting flows. I can't see exactly 3 if these are the same securities. I have assumed 4 that they are. 5 Q. Okay. Well -- but you can't be sure 6 that this is -- 7 A. I was not familiar with the study; so, 8 I can't -- 9 Q. And no one ever showed you this study? 10 A. No. 11 Q. Now, let's take a look at 12 Exhibit 10649. This is the Mike Crow memo to 13 Jenard Gross and Jerry Williams dated July 3rd, 14 1986. 15 MR. GUIDO: This has previously been 16 admitted, Your Honor, into evidence. 17 Q. (BY MR. GUIDO) Now, have you seen 18 this document before? 19 A. I believe that I have. 20 Q. Okay. And had you seen this at the 21 time it was -- on or about the time it was 22 prepared in July 1986? 5286 1 A. Yes. 2 Q. Okay. Is this the first time that you 3 saw any figures that indicated that the market 4 value of the risk-controlled arbitrage portfolio 5 that you managed had a negative value? 6 MR. NICKENS: Your Honor, could we get 7 a page reference? 8 MR. GUIDO: It's US372606 was the first 9 page of the document. I haven't asked him about 10 any other pages. 11 MR. NICKENS: I thought he was asking 12 him something in the document that indicated to 13 him that there was a negative market value, and I 14 just was asking for the reference so that we could 15 all see it. 16 MR. GUIDO: I didn't make any reference 17 to anything, Mr. Nickens. My question was: Is 18 this the document that the witness had seen that 19 indicated to him that the value of the 20 mortgage-backed securities portfolio was negative, 21 Your Honor. That's my first question. 22 A. I don't see that fact in here. 5287 1 Q. (BY MR. GUIDO) All right. Let me 2 direct your attention then to Bates stamp US37273. 3 Do you see that? 4 A. Yes. 5 Q. Does that show a negative figure for 6 the value of the mortgage-backed security 7 portfolio hedged with swaps, caps, and collars? 8 A. Yes, it does. 9 Q. Does it show a negative figure of 10 $58,036,000 with no change in interest rates? 11 A. I'm not sure where you're directing me. 12 Q. Well, look -- it says "base value." 13 See the circle in the middle of the page? 14 A. Yes, I do. 15 Q. It says "negative value $58,034,000," 16 does it not? 17 A. Yes, it does. 18 Q. Is this the first time that you learned 19 what the market value of the risk-controlled 20 arbitrage portfolio was that you had managed at 21 USAT? 22 A. Yes, I believe it is. 5288 1 Q. Now, it makes a recommendation at the 2 last page. 3 Do you see the mortgage-backed 4 securities discussion page? 5 A. Yes. 6 Q. And see the second-to-the-last entry 7 says "Change in the value of the prepayment option 8 is not being hedged with swaps, caps, and collars. 9 Portfolio loses for interest rate moves in either 10 direction (except for 1 percent decline in rate 11 levels)." 12 Do you see that? 13 A. Yes. 14 Q. And then -- well, before I ask -- go 15 on, did you discuss that observation with anyone 16 from Smith Breeden? 17 A. I don't recall discussing anything with 18 anyone from Smith Breeden. 19 Q. Did you attend any presentations by 20 Smith Breeden? 21 A. Yes. 22 Q. Did you ask any questions of anyone in 5289 1 those presentations? 2 A. I don't recall asking a question. They 3 presented a very complete presentation of what 4 they had done. 5 Q. Now, then, the last entry says 6 "Suggests hedging the prepayment option via the 7 purchase of options contract." 8 Do you see that entry? 9 A. Yes. 10 Q. Do you know what that refers to? 11 A. That would refer to attempting to add 12 convexity back to the portfolio so that it would, 13 in effect, not go down in market value when rates 14 fell. In fact, not fall in a rising market. 15 Q. Okay. Was that done? Do you know? 16 A. Not to my knowledge. 17 Q. Do you know why? 18 A. No. 19 Q. Did anyone ask you your views of 20 whether or not it should be done? 21 A. I don't recall anybody asking me. 22 Q. Now, you -- prior to this time, you had 5290 1 never seen any market value analyses of the 2 risk-controlled arbitrage portfolio that you were 3 in charge of managing for USAT; is that correct? 4 A. That's correct. 5 Q. Okay. And why didn't you try and 6 ascertain what the market value was and the market 7 value effect of changes in interest rates? 8 A. Well, the market value of individual 9 securities was not unknown to us. We did know 10 what market value securities were. And from time 11 to time, we may have evaluated what such an effect 12 would be to do swaps. For example, when we did 13 the mirror swaps in the financing sub, we did not 14 manage this portfolio for any kind of market gain 15 or total return. It was a spread portfolio. And 16 so, we didn't use market value in any of our 17 decision points. 18 Q. You used the yield? 19 A. Yield and duration, yes. 20 Q. I'm going to show you a document that 21 I've marked as T4622, which is a publication of 22 Morgan Stanley, the fixed income division, 5291 1 mortgage securities research and analysis. It's 2 by Scott M. Pinkus and Maria Chandoha, 3 C-H-A-N-D-O-H-A, dated January 1986. 4 Now, you testified earlier that you had 5 consulted with Mr. Pinkus with regard to 6 mortgage-backed securities portfolios. 7 Do you recall that testimony? 8 A. Yes, I do. 9 Q. Do you recall what it is that you 10 consulted with him about? 11 A. He had developed an expertise in this 12 topic of prepayment speeds and it was the most -- 13 probably the most important research topic in 14 mortgage-backed securities. And we consulted with 15 him on that. 16 Q. So, you consulted with him with regard 17 to prepayment speed issues? 18 A. Yes. 19 Q. Now, did you view him as expert on this 20 topic? 21 A. Yes. 22 Q. And did you view him as an expert on 5292 1 the way one should manage a risk-controlled 2 arbitrage portfolio? 3 A. No. 4 Q. Why not? 5 A. His expertise was research, and what he 6 studied was prepayment behavior and interest 7 rates. 8 Q. Now, this is one of the documents, is 9 it not, that you produced to the OTS in response 10 to the subpoena served upon you in the 11 investigative phase of this proceeding? 12 A. I believe that it is. 13 Q. I want you to turn now to Page 2 of 14 that document. It says "The increased 15 participation in the mortgage securities market of 16 non-traditional mortgage investors, such as money 17 managers and pension funds, has led to a greater 18 emphasis in the market on short-term performance. 19 These investors tend to be less interested in the 20 anticipated yield to maturity of a security than 21 in the total return they can expect to earn over a 22 three- or six-month horizon. While the actual 5293 1 cash flows received from a mortgage security and 2 the rates at which they can be reinvested over a 3 given horizon will have an impact on the total 4 return that is earned on the mortgage investments, 5 changes in the market value of the security can 6 have an overwhelming influence on the total return 7 over a relatively short-term horizon." 8 Do you see that paragraph? 9 A. Yes. 10 Q. What is it that you understand 11 Mr. Pinkus is saying about the importance of 12 market value to the performance of a 13 risk-controlled arbitrage? 14 A. I don't understand him to be talking 15 about risk-controlled arbitrage here but, rather, 16 total return of the sort of mutual fund or other 17 total return an investor might undertake. 18 Q. So, you don't understand this to be a 19 comment on whether or not one should use yield 20 analysis or one should look to market value to 21 determine the performance of a risk-controlled 22 arbitrage? 5294 1 A. That's correct. I do not. 2 Q. Now, if you use yield analysis to 3 ascertain the -- how a portfolio is doing, what 4 time period is covered by that yield analysis? 5 A. Well, it's a yield to the expected life 6 of the security given a prepayment speed. It may, 7 of course, be extinguished before maturity because 8 it prepays ahead of the contract schedule. It 9 would be a rate that takes that into account. 10 Q. When you use yield analysis to 11 ascertain the value, how far out into the future 12 do you go? 13 A. The yield is run to that point in time 14 at which the bond disappears. I can't tell you 15 whether it's 30 years or some point less than that 16 because each one would prepay in a different way. 17 We would have a prepayment assumption. I can't 18 tell you the exact date that it would extinguish, 19 but that's the date at which -- to which the yield 20 runs. 21 Q. When did you your yield analysis, when 22 you looked at the mortgage-backed securities to 5295 1 see what its yield was, were you looking at the 2 current yield at that time? 3 A. No. Any yields maturity with respect 4 to mortgage-backed securities has to be done to 5 the maturity whenever it is, and whenever it is is 6 a function of the prepayment speed assumed. 7 Q. Okay. So, you were looking at the 8 yield figure factored out, taking all cash flows? 9 A. Yes. 10 Q. All right. Now, you also testified 11 earlier that you engaged in what you refer to as 12 value trading. 13 Do you recall that? 14 A. Yes. 15 Q. And what was that again? 16 A. Those would be relatively smaller 17 transactions which had incremental benefits to the 18 portfolio but were not of the magnitude to really 19 restructure it or to rebalance it. 20 Q. I'd like to direct your attention to 21 Paragraph 3 on Page 23. I'm sorry. It's 22 Paragraph 3 on Page 2. 5296 1 THE COURT: Would you state that again, 2 please? 3 MR. GUIDO: Pardon? 4 THE COURT: Restate the citation. 5 MR. GUIDO: We're looking at T4622. 6 THE COURT: Page? 7 MR. GUIDO: And it's Page 23, Your 8 Honor, and Paragraph 3. 9 Q. (BY MR. GUIDO) It says "When dealing 10 with mortgage securities, active portfolio 11 managers have been severely hampered by their 12 inability to effectively measure the interest rate 13 sensitivity of these securities. As a result, 14 they have been unable to determine the extent to 15 which a swap involving mortgage securities would 16 alter the interest rate exposure of their 17 portfolio and, consequently, could not 18 meaningfully adjust these swaps to offset any 19 undesirable impact on their net exposure to 20 interest rates. Portfolio managers, therefore, 21 are often reluctant to execute swaps involving 22 mortgage securities, particularly those motivated 5297 1 by technical or fundamental considerations, 2 fearing that such strategies may not be successful 3 or at least not as effective as they could be if 4 the interest rate sensitivities of the securities 5 were better understood." 6 Do you see that paragraph? 7 A. Yes, I do. 8 Q. Now, you were engaged in swapping of 9 one security for another for marginal increases in 10 yields, were you not? 11 A. Yes. 12 Q. Does this indicate that that runs a 13 risk of not being successful because of the lack 14 of understanding of the volatility of interest 15 rates? 16 A. Any of these strategies could fail if 17 prepayment speeds were incorrectly assumed. 18 Q. Now, look at Page 24, Paragraph 3, the 19 last sentence. It says "Since almost all swaps 20 involving mortgage securities that are executed on 21 a proceeds basis result in an incremental change 22 in a portfolio's interest rate exposure, the 5298 1 success or profitability of these swaps is 2 particularly sensitive to future interest rates." 3 Do you see that sentence? 4 A. Yes. 5 Q. Do you agree with that sentence? 6 A. I certainly agree with the second part. 7 I assume, subject to the first part being 8 corrected, I would agree with all of it. I can't 9 speak for every kind of security swap that takes 10 place. We certainly expected that ours would 11 change, our interest rate exposure. So, this does 12 describe the kind of swap we did. 13 Q. I mean, you did indicate that 14 Mr. Pinkus, in your view, was an expert on 15 prepayment rates and their effect as a result of 16 interest rate changes, did you not? 17 A. Yes. 18 Q. Okay. Now, what was it that led you 19 not to purportedly rebalance the USAT 20 risk-controlled arbitrage portfolio until interest 21 rates in the ten-year benchmark had declined 317 22 basis points? 5299 1 MR. NICKENS: Your Honor, I object to 2 the form of the question. There's -- that's not 3 the evidence. We're talking about trade dates or 4 settlement dates for these transactions, which is 5 not the time when the decision would have been 6 made. 7 Q. (BY MR. GUIDO) Mr. Phillips, you used 8 trade date in your chart, did you not? 9 MR. NICKENS: He used settlement date, 10 Your Honor. 11 Q. (BY MR. GUIDO) Settlement date. 12 Excuse me. 13 A. I used settlement date. 14 Q. Why did you use settlement date? 15 A. Well, those were the points at which 16 time everything could be measured as to the 17 dollars that did expect to flow. In some cases, 18 the chart indicates that some securities were 19 sold, others purchased, and those sold all on the 20 same settlement date, which indicates in a period 21 of four weeks or so, all those transactions could 22 have taken place before anything ever settled. 5300 1 So, there could have been several transactions in 2 those dates. 3 Q. Now, with regard to your understanding 4 about interest rates and prepayment risks, what 5 was your assumption about the prepayment rates 6 between June of 1985 and December of 1985? 7 A. At the outset when the portfolio was 8 essentially originally accumulated, we -- we 9 expected stability in those rates. 10 Q. What was your expectations about the 11 prepayment rate for a mortgage-backed security 12 that was at 200 basis points over the current 13 market? 14 A. I'm sorry. At 200 basis points over -- 15 Q. -- the current market. So, in other 16 words, for a 12 percent mortgage in a 10 percent 17 interest rate market. 18 A. Generally speaking, one would expect 19 that they would increase. 20 Q. What was the magnitude of the increase 21 that you expected at the time? 22 A. I don't recall. 5301 1 Q. Okay. Did you have any literature 2 available to you that indicated that? 3 A. We had some research that focused on 4 the degree -- the direction of correlation, the 5 sign of correlation. We all expected, of course, 6 that increased -- lower interest rates would lead 7 to increased prepayments. The actual relationship 8 is still a matter of debate but was just beginning 9 to be researched very carefully. 10 Q. Well, what did people look to in the 11 latter half of 1985 to project out increase in 12 prepayments based on changes in interest rates? 13 A. I don't know. 14 Q. Did you know then? 15 A. No. 16 Q. Did you have available to you any 17 literature that provided you with estimates of 18 prepayment speeds in relationship to specific 19 interest rates? 20 A. No. I don't believe that we did. Most 21 of the literature discussed recent historical 22 rates. 5302 1 Q. So, at the time, you didn't have any 2 reference points to ascertain what particular 3 interest rate levels would create what level of 4 prepayment speeds on the mortgage-backed 5 securities that you had in your portfolio? 6 A. That's correct. 7 Q. Now, you testified that you bought 8 at-the-money or slight premium coupon 9 mortgage-backed securities when you entered into 10 the risk-controlled arbitrage portfolio? 11 A. Securities right at par or slightly 12 above par, yes. 13 Q. Did you ever discuss with any of the 14 analytical people at any of the investment banking 15 firms that you had been dealing with whether there 16 was a less risky coupon to purchase for the 17 risk-controlled arbitrage portfolio? 18 A. I'm not sure what you mean by "less 19 risky." Every -- 20 Q. Less risky in terms of the prepayment 21 option. 22 MR. NICKENS: Your Honor, I don't 5303 1 believe the witness had completed his answer and 2 he was cut off by Mr. Guido. 3 MR. GUIDO: Excuse me. I thought that 4 was a question. 5 Q. (BY MR. GUIDO) Excuse me, 6 Mr. Phillips. 7 A. Well, we had a prepayment speed 8 assumption on every security on every coupon. For 9 premium bonds, of course, a higher prepayment 10 speed would have been an unfavorable outcome. And 11 whether a different coupon was less risky in that 12 regard would have been closely tied to one's 13 outlook on interest rates. 14 Q. I'd like to show you Exhibit B377, 15 which is an October 24th Salomon Brothers 16 presentation to United Savings of Texas. 17 MR. GUIDO: It has already been 18 admitted into the record, Your Honor. 19 Q. (BY MR. GUIDO) I direct your 20 attention to Bates stamp CN253047. And I direct 21 your attention to the second or the first full 22 paragraph on that page. 5304 1 MR. EISENHART: Your Honor, may we have 2 some identification of the page from which counsel 3 is reading? He apparently is using a different 4 copy of the document than we have, and we don't 5 have the Bates stamp numbers. 6 MR. GUIDO: UFG 1/14. 7 MR. EISENHART: Thank you, Your Honor. 8 MR. NICKENS: It's Page 8. 9 MR. GUIDO: Page 8. 10 Q. (BY MR. GUIDO) Look at the middle of 11 the paragraph. See the paragraph that starts "the 12 second arbitrage spread"? 13 A. Which paragraph is that? 14 Q. The first full paragraph at the top of 15 the page. It starts "the second arbitrage 16 spread." 17 Do you see that? 18 A. Yes. 19 Q. Okay. Seven lines down, the sentence 20 appears "Perhaps even more important, the discount 21 on the mortgages provides call protection. If 22 rates decline or prepayments increase, there is a 5305 1 yield advantage associated with the early payoff." 2 Do you see that? 3 A. Yes, I do. 4 Q. It's talking about discount mortgages 5 providing protection against prepayment rates, is 6 it not? 7 A. Yes. 8 Q. Then look at what is attached to that 9 document, which is an article entitled 10 "Risk-controlled Arbitrage for Thrift 11 Institutions" by Michael Waldman dated 12 October 1983. And the first page of it is 13 CN253057. 14 Do you know who Michael Waldman is? 15 A. Yes. He was in mortgage-backed 16 security research at Salomon Brothers. 17 Q. And did he also, like Mr. Pinkus, do 18 research in prepayment rates and the effect of 19 interest rate changes on prepayment rates? 20 A. I believe that he did. 21 Q. Would you consider him to be an expert 22 on that subject? 5306 1 A. Yes. 2 Q. Okay. Now, look at Page CN253070. 3 Do you see that? 4 A. Yes. 5 Q. Now, that says -- see "call protection" 6 down there at the bottom? "For both of the 7 investment options discussed -- single-family home 8 mortgages and commercial mortgages -- we used 9 seasoned, lower-rate mortgages as examples. In 10 other words, the loans were originated some time 11 ago and are priced at sizable discounts from par. 12 The choice of this type of loan was made 13 deliberately. The seasoning and corresponding 14 equity buildup and established record of servicing 15 the debt adds to their credit quality. Perhaps 16 even more important, the discount on the mortgages 17 provides call protection. Call protection is 18 crucial in protecting the arbitrage profit." 19 Do you see that sentence? 20 A. Yes, I do. 21 MR. NICKENS: Your Honor, I would, 22 under the rule of optional completeness, offer the 5307 1 following paragraph on the next page where it says 2 "Consider an arbitrage where Federal Home Loan 3 Bank advances finance the purchase of 13 and a 4 half percent current coupon single-family 5 mortgages. Suppose interest rates declined -- 6 say, 400 basis points -- setting off rapid 7 refinancing of the mortgages (a 250 basis point 8 rate decline probably would trigger some 9 refinancing by the homeowners)." 10 That would conclude my offer there, 11 Your Honor. 12 Q. (BY MR. GUIDO) Now, look at CN253047. 13 I'm sorry. It says in the next-to-the-last 14 paragraph -- 15 MR. NICKENS: Your Honor, I -- 16 MR. GUIDO: Page 8 again. 17 Q. (BY MR. GUIDO) And I may be repeating 18 myself, but I have a question for you. The last 19 sentence on the next-to-the-last paragraph says 20 "Currently a thrift should be able to realize 105 21 basis point spread on a LIBOR-based interest rate 22 swap arbitrage into discount single-family 5308 1 mortgages." 2 Do you see that? 3 A. Yes. 4 Q. Okay. Now, you purchased a swap 5 portfolio which you estimated having 150 basis 6 point spread; is that right? 7 A. Yes. 8 Q. Did you attempt to evaluate what the 9 rate of return would be on a portfolio with 10 discounted mortgage-backed securities? 11 A. I believe that we priced potential 12 transactions of lower coupon issues. 13 Q. And do you recall whether or not you 14 encountered a basis point spread similar to what 15 is being suggested in this Salomon Brothers 16 presentation? 17 A. Yes. I believe this is about -- about 18 what we encountered. 19 Q. What you encountered. And you chose 20 the higher spread, did you not? 21 A. That's correct. 22 Q. And you chose the higher spread at a 5309 1 time when someone was advising that you could, for 2 a lower spread, have less risk. Is that the case? 3 A. Well, less risk of prepayment but not 4 less risk of underperforming if this outlook was 5 wrong. I mean, this is a market call, too. 6 Q. So -- I'm just trying to get when the 7 decision was made. 8 So, you did have alternatives that you 9 were aware of at the time that you purchased the 10 original mortgage-backed security portfolio of 11 having someone make a presentation to you that 12 showed what the rate of return would have been 13 utilizing discount coupon mortgage-backed 14 securities? 15 A. I don't recall that we had a 16 presentation, but we could as easily price and 17 estimate yields from discounts and make these 18 comparisons ourselves. 19 Q. Now -- 20 MR. NICKENS: Your Honor, I would for 21 the record point out that Exhibit B337 is, in 22 fact, a presentation to United Savings. 5310 1 MR. GUIDO: It's 377. I mean, I 2 described it as a presentation to United Savings 3 Association. It's B377. 4 MR. NICKENS: I apologize. I wrote 5 that down wrong, Your Honor. 6 Q. (BY MR. GUIDO) Now, look at the 7 prepayment history information on Bates stamp 8 353078. 9 Do you see that? That is in the paper 10 that was attached to it by Michael Waldman to the 11 presentation. That shows prepayment history, does 12 it not? The Figure 1, prepayment rates of high 13 coupon Ginnie Maes? 14 A. Yes, it does. 15 Q. And what does it show prepayments going 16 to if you had a decline in interest rates from 15 17 to 13 percent or 200 basis points? 18 A. For 15, 16, and 17 percent 19 securities -- 20 Q. Yes. Use the 15 percent security. 21 What does it show? 22 A. It rose to something slightly under 5311 1 30 percent. 2 Q. Okay. And what about for 16, the 3 premiums? What does it show? 4 A. Approaching 40 percent. 5 Q. Okay. Is that any different -- 6 MR. NICKENS: Your Honor, I object to 7 that. This document is 13 and a half percent 8 current coupon. All of these are premium 9 mortgages. And, in fact, it is entitled "High 10 Coupon Mortgage Securities as Short-term 11 Investments." 12 So, the suggestion in the question that 13 15 percent was current is simply wrong. 14 MR. GUIDO: Well -- 15 Q. (BY MR. GUIDO) What do you understand 16 the current interest rate to be in a 15 -- for 17 that 15 percent mortgage at the time that it was 18 placed? 19 A. I'd have to read the assumption in this 20 paper, which I have not done. 21 Q. Well -- 22 A. This seems to be the behavior of three 5312 1 different securities. 2 Q. That's right. And I'm just asking the 3 behavior of one security to start with. In the 4 15 percent security, what does that show that 5 15 percent security doing with a decline of 6 interest rates from 15 to 13 percent? 7 A. It rises. 8 Q. And it rises from about 3 to 4 percent 9 to about 28 percent? 10 A. Yes. 11 Q. Okay. Now, that was information that 12 was available to you on October 24th, 1984? 13 A. Yes. 14 Q. Now, I'd like you to take a look at 15 Exhibit B505. That is the 1985 rendition of the 16 Michael Waldman memorandum that was part of the 17 offering to you in October of 1985, is it not? 18 A. I haven't found it yet. 19 Q. Here. I have a copy for you. Now, 20 look at Page 11 of Exhibit B505. Now, take a look 21 at -- what was -- for the Ginnie Mae 15, what was 22 the prepayment rate for that when mortgage rates 5313 1 were approximately 15 percent? 2 A. I'm not sure where you're reading this. 3 Q. Okay. Let's go -- what does it show as 4 the variation in prepayment rates for Ginnie Mae 5 15? 6 A. It shows that they rose. 7 Q. And they went from somewhere around 4 8 to somewhere around 37? 9 A. Yes. 10 Q. And during a period of time when 11 interest rates declined. Right? 12 A. Yes. 13 Q. When you look at interest rates when 14 they are at 14, what does it show the prepayment 15 rate to be on that Ginnie Mae 15? 16 A. Something quite low. 17 Q. Okay. And what does it show when it 18 goes to 12? 19 A. By the time it reached 12, it was 20 approximately 7 percent. 21 Q. Okay. And then it went to almost 40. 22 Right? 5314 1 A. Yes. 2 MR. NICKENS: Your Honor, again under 3 the rule of optional completeness, at that same 4 page of the document, the conclusion is stated, 5 "In addition to their shortened average lives, 6 high coupon Ginnie Maes have shown relatively 7 stable price behavior since this refinancing 8 period began. Figure 17 shows the price movements 9 of Ginnie Mae 15s and 16s compared with 11 and a 10 half's and 9s. For example, since Ginnie Mae 15s 11 first rose above par in late 1982, they have 12 traded in a range of 102 to 109. This trading 13 range has persisted for more than two years. Over 14 the same period, the price of Ginnie Mae 9s have 15 swung up and down by 18 points as market yields 16 declined and rose. Thus, high coupon mortgages 17 have a short-term character which leads to a 18 different method for describing their value." 19 Q. (BY MR. GUIDO) What's the percentage 20 difference between 102 and 109, Mr. Phillips? 21 A. 7 percentage points. 22 Q. Okay. What was the haircut that USAT 5315 1 had to post for mortgage-backed security purchases 2 through reverse repos? 3 A. I don't remember the exact amount, but 4 it was a relatively low percentage, I believe. 5 Q. Was it 5 percent? 6 A. It could have been 5 percent or less. 7 Q. So that this range was greater than the 8 collateral cushion that USAT had posted with the 9 reverse repo dealers? 10 A. I believe you said the range was 7 11 percentage points? 12 Q. Yes. 102 to 109. 13 A. And I believe the haircut was up to 14 5 percent, depending on how long the repo would 15 be. 16 Q. Yeah. So that that fluctuation was 17 greater than the haircut that the reverse repos 18 had required as a cushion for price variations? 19 A. Yes. 20 MR. GUIDO: No further questions, Your 21 Honor. 22 THE COURT: Mr. Nickens, do you have 5316 1 some cross? 2 MR. NICKENS: Yes, Your Honor, I do. 3 4 CROSS-EXAMINATION 5 6 (4:12 p.m.) 7 Q. (BY MR. NICKENS) Mr. Phillips, you 8 have met freely with both sides in this case? 9 A. Yes, I have. 10 Q. You've met with -- you've been 11 interviewed on several occasions by the OTS? 12 A. I was interviewed by some attorneys in 13 my office in Jersey City, and then I gave a 14 deposition to the OTS. 15 Q. And you met with the OTS several times 16 while you've been here in Houston, correct? 17 A. Yes. 18 Q. You freely answered every question 19 that's been put to you? 20 A. Yes. 21 Q. And you were interviewed by the FDIC? 22 A. Yes, I was. 5317 1 Q. Now, I'd like to -- and have you failed 2 or refused to answer any question that's been put 3 to you during all this time? 4 A. No. 5 Q. You've tried to the best of your 6 ability here -- 10, 11, 12 years later -- to 7 recall these events and answer the questions that 8 have been put to you? 9 A. Yes. 10 Q. I'd like to go back into a little bit 11 of your educational background. 12 Are you aware of the fact that part of 13 the OTS' case is that you were incompetent to 14 handle risk-controlled arbitrage using 15 mortgage-backed securities? 16 A. Yes, I am. 17 Q. What is your response to that? 18 A. I think that's incorrect. 19 Q. Now, with regard to your educational 20 background, you told us that you had graduated 21 with two degrees from Texas A&M University? 22 A. Yes. 5318 1 Q. And you are a chartered financial 2 analyst? 3 A. Yes, I am. 4 Q. Now, explain to the Court what it takes 5 to acquire that distinction. 6 A. The chartered financial analyst program 7 is a professional securities analysis designation 8 that is administered by a central body that 9 requires three annual examinations in six or seven 10 subject matter areas. 11 Q. Is it comparable or not comparable to 12 the designation of certified public accountant? 13 A. It is -- it is not entirely comparable 14 because it is not a licensing procedure. It is a 15 professional designation that is quite rigorous 16 but is not recognized legally in the same respect. 17 Q. And when did you acquire your 18 designation as a CFA? 19 A. 1980. 20 Q. Now, you went to work at American 21 General Insurance Company; is that correct? 22 A. Yes. 5319 1 Q. Could you tell the Court something 2 about American General? 3 A. At that time, it was an insurance 4 holding company that owned a variety of insurance 5 companies: Life insurance, property casualty 6 companies, as well as a very large annuity 7 company. 8 Q. How large a company is American 9 General? What is its stature in the State of 10 Texas, for example? 11 A. Well, it is a very large company, 12 considerably larger now than it was then. I 13 believe that the character of the company has 14 changed in that it doesn't do as many lines of 15 business as it did at that time. 16 Q. And then after -- how long were you at 17 American General? 18 A. I was there eight years. 19 Q. And what was the nature of your 20 responsibilities? 21 A. I began assisting a vice president with 22 a portfolio of privately-placed securities, 5320 1 primarily debt securities of reasonably low-credit 2 quality. 3 Q. And did you have any exposure while you 4 were at American General to mortgage-backed 5 securities? 6 A. Yes, I did, in the last -- in the last 7 year or so that I was there. 8 Q. And would you explain to the Court what 9 the nature of that exposure was? 10 A. I was a member of an investment policy 11 committee and among our duties were developing 12 policy. In particular, a new head of our 13 department had come in and was interested in 14 understanding if the mortgage-backed securities 15 would be suitable for one or more of our 16 investment activities. 17 Q. And what was the nature of the studies 18 that you did at American General concerning the 19 use of mortgage-backed securities? 20 A. The individual that came and took our 21 department over had an academic background and had 22 done work in asset liability matching. He was 5321 1 aware that we had a fast-growing product in the 2 annuity area. And it was a very competitive 3 product that would need to offer the highest 4 possible yield to the customer. And in order to 5 do that, we had to be sure that we had the 6 appropriate securities to provide that and we 7 could do that without -- without the risk of 8 losing that money and finding ourselves 9 mismatched, in effect. 10 Q. Now, after eight years at American 11 General, you and Mr. Sullivan left to go to 12 Southmark? 13 A. That's correct. 14 Q. And tell the Court what the nature of 15 Southmark's business was. 16 A. Well, Southmark Corporation was a real 17 estate company that had financial activities in a 18 variety of real estate areas but also owned a 19 savings and loan association and was interested in 20 developing an investment program for that. 21 Q. Now, what savings and loan institution 22 did Southmark own? 5322 1 A. San Jacinto Savings. 2 Q. And how large an institution was that? 3 A. I don't recall. 4 Q. Do you know where it ranked in -- among 5 large Texas S&Ls? 6 A. No, I don't. 7 Q. Okay. And did you have -- I know you 8 were there for a short time. But did you have any 9 activities concerning that institution while you 10 were at Southmark? 11 A. Yes. 12 Q. What did you do? 13 A. I joined with Mr. Sullivan to invest 14 some of its assets, as well as assets of other 15 Southmark subsidiaries. 16 Q. Did any of that involve mortgage-backed 17 securities? 18 A. No, they did not. 19 Q. And the focus of that activity was on 20 high-yield or junk bonds? 21 A. And US treasury bonds. 22 Q. Now, what do you do for a living today, 5323 1 Mr. Phillips? 2 A. I'm the director of corporate bond 3 research at Freeman Securities. 4 Q. Ask tell the Court what the nature of 5 your business is today. 6 A. Freeman securities is a bond dealer in 7 Jersey City, New Jersey, focusing primarily on 8 high-yield corporate bonds and mortgage-backed 9 securities. I support the high-yield bond 10 activity in writing research reports and 11 presenting them to clients to assist clients in 12 making investment decisions. 13 Q. And what are the nature of those 14 clients? 15 A. They are all institutional -- financial 16 institutions. Primarily mutual funds, but also 17 insurance companies and accounts managed by 18 private managers. 19 Q. How would you rank their 20 sophistication? 21 A. I'm sorry. The customers'? 22 Q. Yes. 5324 1 A. Quite high. 2 Q. And you're providing services to these 3 sophisticated institutional investors? 4 A. That's correct. 5 Q. Now, how long have you been in this 6 business, Mr. Phillips? I'm talking about the 7 financial advice business. 8 A. Well, if you mean for the account of my 9 own employer or -- I've been doing this kind of 10 work in corporate bonds primarily for 21 years. 11 Q. Other than whatever has been said in 12 this case, has anyone ever accused you of 13 incompetence in doing your job? 14 A. No. 15 Q. Now, with regard to your hiring at 16 United Savings, which I believe you testified was 17 in September of 1984? 18 A. Yes. 19 Q. And you testified about having some 20 meetings to discuss your hiring with Mr. Huebsch 21 and Mr. Hurwitz. Right? 22 A. Yes. 5325 1 Q. And was -- what did you bring to that 2 meeting? 3 A. I had been developing this matching 4 idea for high-yield bonds primarily when we were 5 at Southmark and, of course, we never got to 6 implement that. I still believed that that would 7 be successful as a strategy, and I proposed to 8 Mr. Sullivan that that's what we should present to 9 the United Savings people. 10 Q. And did you make that presentation? 11 A. Yes, we did. 12 Q. Both to Mr. Huebsch and to Mr. Hurwitz 13 and to others? 14 A. Yes. 15 Q. Who were the others? 16 A. In the second -- or, I should say, for 17 me, a third meeting, those others would have 18 included Gerald Williams and Mike Crow. There 19 could have been others present that I don't 20 recall. 21 Q. And what was your perception of the 22 sophistication of its -- the financial 5326 1 sophistication of Mr. Williams and Mr. Crow? 2 A. I believe they grasped the significance 3 of the duration matching very quickly. However, I 4 believe they were concerned about managing credit 5 risk with what I was proposing because they -- one 6 of them characterized high-yield bonds to me as 7 something like unsecured commercial loans, which 8 they would have had experience with. 9 Q. Now, what was the reaction of 10 Mr. Huebsch and Mr. Hurwitz to the program that 11 you described? 12 A. I believe they also accepted the 13 premise that this would be a good way to manage 14 high-yield bonds in a savings and loan 15 association. I had already been told that they 16 had owned some. And I believe it was very shortly 17 after that I learned that there were variable rate 18 securities which suggested they, too, had some 19 feeling for the sensitivity of the repricing 20 liabilities. 21 Q. Now, was it your concept the one that 22 was eventually implemented at United Savings with 5327 1 regard to high-yield bonds? 2 A. Yes. 3 Q. And this was something you brought to 4 the institution when you were hired? 5 A. Yes. 6 Q. Now, you indicated that Mr. Huebsch had 7 been employed at Federated; is that correct? 8 A. Yes. 9 Q. I want to show you two documents, 10 Mr. Phillips: B3817 and B3816. While I'm passing 11 that out, if you could just tell the Court what 12 B3817 is. 13 A. It is a press release that announced 14 that I had joined United Savings. 15 Q. And what was the date? 16 A. September 1984. September 11th. 17 MR. NICKENS: We offer B3817, Your 18 Honor. 19 MR. GUIDO: No objection, Your Honor. 20 THE COURT: Received. 21 Q. (BY MR. NICKENS) And the second page 22 indicates the publications on which this 5328 1 announcement was to be placed? 2 A. Yes. 3 Q. The major banking publications of the 4 United States? 5 A. Yes. 6 Q. And tell us what B3816 is. 7 A. It's an article about our investment 8 activities. 9 MR. NICKENS: Your Honor, we offer 10 B3816. 11 MR. GUIDO: No objection, Your Honor. 12 THE COURT: Received. 13 Q. (BY MR. NICKENS) Now, let me ask you 14 to look down at -- I mean, this is in February of 15 1986, is it not, Mr. Phillips? 16 A. Yes. 17 Q. And it's reporting a spectacular year 18 that you had had in 1985, correct? 19 A. I'm still reading it. 20 Q. Well, I'm focusing on the headline, if 21 you will. "Superior results make 1985 a truly 22 vintage year." Right? 5329 1 A. I see that. 2 Q. Now, I'd like to -- if you could look 3 down to the bottom of the first column, it 4 describes Mr. Huebsch. It says "Ron, whose last 5 name is pronounced Huebsch like Huebsch with an H 6 on the end, joined United on July 1st, 1984, to 7 set up the investment department. He switched 8 over from Federated Development Company where he 9 managed the investment operations for more than 15 10 years. Ron, a Harvard graduate, has specialized 11 in common stocks and debt securities throughout 12 his career in New York as well as Houston." And 13 then it goes on to talk about you. 14 Now, this publication indicates that 15 Mr. Huebsch went to United in July of 1984. Do 16 you see that? 17 A. Yes. 18 Q. Now, you indicated that it was your 19 recollection, many years later, that he joined 20 USAT after you did? 21 A. Yes, that's correct. 22 Q. Okay. Now, which one is correct; or do 5330 1 you know? 2 A. I don't know, but I believe that he 3 became an actual officer of United Savings 4 sometime later. 5 Q. Has it been suggested to you in these 6 various meetings you've had of late that 7 Mr. Huebsch came in 1985? 8 A. I recall -- that would be a reasonable 9 time to -- for that to have happened. I really 10 don't remember anybody suggesting a point in time 11 to me. 12 Q. But if this document is correct, then 13 it would have been before you got there that he 14 joined United to set up the investment department? 15 A. Yes. 16 Q. And when you joined, the investment 17 department was in the process of being set up? 18 A. Yes. 19 Q. I'd like for you to look at the third 20 paragraph of Exhibit B3816. "The heart of its 21 investment strategy is matching securities of 22 various durations with deposits of similar 5331 1 maturities to lock in a spread between the cost of 2 funds and their return over specified term. This 3 provides control over interest rate risk, a major 4 hazard during recent years to financial 5 institutions that were funding long-term mortgages 6 against short-term deposits." 7 Now, I realize, Mr. Phillips, this is 8 not your publication. But does that sort of 9 accurately describe the risk-controlled arbitrage 10 using MBS, as well as your high-yield bond 11 program? 12 A. Yes. 13 Q. And then it goes on and we've covered 14 your qualifications. And it talks about Lauren 15 Jordan on the second page. 16 Do you see that? 17 A. Yes. 18 Q. Tell us your -- tell the judge your 19 impression of Ms. Jordan. 20 A. Ms. Jordan had been a trader before she 21 joined United Savings and had worked for a large 22 savings and loan association, I believe, that was 5332 1 not headquartered in Houston. 2 Q. And it indicates that her educational 3 background was that she had a master's in business 4 administration from the University of Wisconsin? 5 A. Yes, I recall that. 6 Q. Did you find her to be a competent or 7 incompetent person? 8 A. I found her to be a competent person. 9 Q. Then also as a part of your group was 10 Mr. Carlson? 11 A. Yes. 12 Q. And what were his responsibilities? 13 A. Mr. Carlson worked on the equity 14 arbitrage activities. 15 Q. And it indicates that as an educational 16 background that he had a master's in business 17 administration from Rice University and a law 18 degree from the University of Houston; is that 19 correct? 20 A. Yes. 21 Q. Did you find him to be a high-quality 22 person? 5333 1 A. Yes, I did. 2 Q. Who else worked in your department? 3 They identified one other person here as a trading 4 assistant, Mister -- or Brinder Jacobs? 5 A. Yes. 6 Q. Now, this -- well, let's, before we 7 leave the document, go over to the second column 8 on the second page. "The department has been so 9 successful in investing that during 1986 it plans 10 to start advising other financial institutions on 11 how to manage their investment dollars.... for a 12 fee, of course. A subsidiary of United Savings 13 has been set up to provide these investment 14 advisory services to small savings and loans." 15 Was that done? Was that -- was that 16 subsidiary set up? 17 A. I believe that it was and that we were 18 appropriately registered as an advisor. 19 Q. Anyone ever suggest to you that the 20 group was incompetent to manage risk-controlled 21 arbitrage during that period? 22 A. No. 5334 1 Q. Now, Mr. Guido spent some time talking 2 to you about the physical layout with regard to 3 the trading room; is that right? 4 A. Yes. 5 Q. And you indicated that it was a room 6 with five or six offices? 7 A. Well, the room itself was a single room 8 at the end of a hallway of offices that were in 9 Mr. Hurwitz' suite. 10 Q. Now -- and you indicated that you saw 11 Mr. Hurwitz there on a regular basis? 12 A. Yes. 13 Q. Now, I want to make sure we have this 14 straight. Now, this was where he officed. Right? 15 A. Yes. 16 Q. So, you're telling us that you saw 17 Mr. Hurwitz in his office on a regular basis? 18 A. Yes. 19 Q. Do you draw any significance for that, 20 that he went to work on a regular basis? 21 A. No. 22 Q. Now, Mr. Guido asked you about a 5335 1 conversation that Mr. Hurwitz related to you 2 concerning high-yield bonds with Mr. Milken. 3 Do you recall that testimony? 4 A. Yes, I do. 5 Q. What was the result of that 6 conversation? Did you or did you not buy the 7 security that was at issue? 8 A. We did not. 9 Q. Did Mr. Hurwitz pressure you to buy it? 10 A. No. 11 Q. Did he relate to you what Mister -- 12 what he had said to Mr. Milken when he received 13 this call? 14 A. Yes, he did. 15 Q. What did he say to you? 16 A. He said words to the effect, "I don't 17 tell these guys what to do." 18 Q. And have you discussed that 19 conversation with the attorneys for both the FDIC 20 and the OTS? 21 A. I believe that I've discussed the 22 incident that Mr. Milken called and exerted this 5336 1 pressure. I'm not sure if I told everyone that's 2 asked me all these details, but I have related the 3 incident. 4 Q. Did Mr. Hurwitz ever pressure you to 5 buy anything? 6 A. He did not. 7 Q. Who made the decisions concerning what 8 securities to buy, whether we're talking about 9 high-yield bonds or mortgage-backed securities? 10 A. With high-yield bonds, it would have 11 been primarily me. With respect to 12 mortgage-backed securities, Ron Huebsch would have 13 weighed in with his opinion of market direction 14 and the things that would have affected the 15 performance of mortgage backs. 16 Q. What was your impression of 17 Mr. Huebsch? 18 A. He had a great deal of market 19 experience and was quite good at feeling direction 20 and flow from watching screens and listening to 21 chatter on the phone about what was happening. He 22 had a good sense of -- I guess we call a flow. 5337 1 Q. Was he helpful or unhelpful as far as 2 the investment activities of United Savings, to 3 your observation? 4 A. Helpful. 5 Q. Now, United Savings had an investment 6 committee? 7 A. Yes. 8 Q. And did it meet regularly? 9 A. Yes. I believe that it did. 10 Q. Now, when that committee -- when did 11 that committee first begin meeting to your 12 recollection? 13 A. I have had my recollection refreshed by 14 having documents shown me that it began in early 15 1986, I believe. 16 Q. Well, is that when the committee first 17 began to meet or when they first began to keep 18 regular minutes? 19 A. I'm not sure. 20 Q. Let me show you a document that has 21 been marked as A1388 and is at Tab 525. 22 Do you have A1388 in front of you? 5338 1 A. Yes, I do. 2 Q. And when you said that you had your 3 memory refreshed, was it with this document or 4 other documents? 5 A. I believe that I was shown a document 6 that chartered the committee. 7 Q. And was it dated? 8 A. Yes. And I believe it was earlier in 9 1986 than this. 10 Q. Well, let's just look at 1388, 11 Mr. Phillips, if we might. It says "A meeting of 12 the investment committee" -- the first paragraph, 13 and it's entitled "The investment committee 14 meeting of United Savings Association of Texas." 15 "A meeting of the investment committee of United 16 Savings Association of Texas was held at the 17 executive offices of the company on April 24th, 18 1986." 19 You see that? 20 A. Yes. 21 Q. "And all members of the investment 22 committee, with the exception of Mr. Bruce 5339 1 Williams, were present. Mr. Jenard Gross acted as 2 chairman of the meeting and Mr. Arthur S. Berner 3 noted the minutes. Mr. Gross stated that it was 4 appropriate for the investment committee to begin 5 formalizing its actions. He noted that the 6 investment committee had been carrying out its 7 functions without formal minutes having been 8 taken, but he thought it was appropriate at this 9 time to begin such formal minutes." 10 Do you see that? 11 A. Yes. 12 Q. And does that indicate to you that this 13 investment committee was functioning prior to 14 April 24th, 1986? 15 A. Yes. 16 Q. Now, I realize this is a long time ago, 17 but what was the sort of reporting structure with 18 regard to investments at United Savings when you 19 were there in the period 1985 to '86? 20 MR. GUIDO: Before or after of the 21 investment committee? 22 MR. NICKENS: Well, that's what I'm 5340 1 trying to determine, Your Honor. We have this 2 documentation. It's been suggested to the witness 3 that this was the first of the meetings of the 4 investment committee. I think the documentation 5 indicates that it went back for some time before, 6 and I don't know what he might say in that regard. 7 A. Could you repeat the question? 8 Q. (BY MR. NICKENS) I'm trying, 9 Mr. Phillips -- I've forgotten my question so -- 10 I'm trying to find out from you what your 11 recollection is concerning the reporting 12 relationship and particularly the role of the 13 investment committee in 1985 and '86. 14 A. It's my recollection that the activity 15 of the senior management group as a committee was 16 less formal. But I did consult with Gerald 17 Williams and Ron Huebsch on high-yield bond 18 transactions. And regarding mortgage-backed 19 securities, I believe that our reporting and 20 notice procedure was broader. Michael Crow would 21 have been included, people like that. 22 Q. And that was for the time period in 5341 1 1985, as well as 1986? 2 A. Yes. And when this group began 3 functioning as a committee, I can't be sure; but I 4 believe Mr. Gross would have been involved if 5 there was a formal, sit-down group. 6 Q. Okay. 7 MR. NICKENS: Your Honor, I'm going to 8 move on to another subject. I don't know what 9 your wishes are. We're around the time that we 10 traditionally take our break. 11 THE COURT: All right. We'll adjourn 12 until 9:00 o'clock. 13 14 (Whereupon at 4:42 p.m. 15 the proceedings were recessed.) 16 17 18 19 20 21 22 5342 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 27th day of 17 October, 1997. 18 ____________________________ MARCY CLARK, CSR 19 Certified Shorthand Reporter In and for the State of Texas 20 Certification No. 4935 Expiration Date: 12-31-97 21 22 5343 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 27th day of 18 October, 1997. 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