5344 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 10-28-97 22 5345 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 (Not present) 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 BOTTICELLO, Esquire of: Dechert, Price & Rhoads 11 1500 K Street, N.W. Washington, D.C. 20005-1208 12 (202) 626-3306 16 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 5346 1 ON BEHALF OF RESPONDENT FEDERATED DEVELOPMENT CO., 2 CHARLES HURWITZ, AND MAXXAM, INC.: 3 JACKS C. NICKENS, Esquire of: Clements, O'Neill, Pierce & Nickens 4 1000 Louisiana Street, Suite 1800 Houston, Texas 77002 5 (713) 654-7608 6 ON BEHALF OF JENARD M. GROSS: 7 PAUL BLANKENSTEIN, Esquire MARK A. PERRY, Esquire 8 of: Gibson, Dunn & Crutcher 1050 Connecticut Avenue, N.W. 9 Washington, D.C. 20036-5303 (202) 955-8500 10 ON BEHALF OF BERNER, CROW, MUNITZ AND HUEBSCH: 11 JOHN K. VILLA, Esquire 12 MARY CLARK, Esquire PAUL DUEFFERT, Esquire 13 of: Williams & Connolly 725 Twelfth Street, N.W. 14 Washington, D.C. 20005 (202) 434-5000 15 OTS COURT: 16 HONORABLE ARTHUR L. SHIPE 17 Administrative Law Judge Office of Financial Institutions Adjudication 18 1700 G Street, N.W., 6th Floor Washington, D.C. 20552 19 Jerry Langdon, Judge Shipe's Clerk 20 REPORTED BY: 21 Ms. Marcy Clark, CSR Ms. Shauna Foreman, CSR 22 5347 1 2 EXAMINATION INDEX 3 Page 4 JOSEPH PHILLIPS 5 Cross-Examination (Cont'd) by Mr. Nickens..5348 6 Cross-Examination by Mr. Eisenhart.........5495 7 Redirect-Examination by Mr. Guido..........5576 8 Cross-Examination by Mr. Keeton............5628 9 10 11 12 13 14 15 16 17 18 19 20 21 22 5348 1 P-R-O-C-E-E-D-I-N-G-S 2 (9:00 a.m.) 3 THE COURT: Be seated, please. The 4 hearing will come to order. 5 Mr. Nickens, you may continue with your 6 cross-examination. 7 MR. NICKENS: Thank you, Your Honor. 8 9 CROSS-EXAMINATION 10 11 12 Q. (BY MR. NICKENS) Mr. Phillips, 13 yesterday I was asking you some questions about 14 the investment committee and I'd like to turn to a 15 subject that we had discussed a little bit before, 16 and that relates to the sophistication of the 17 operation at United Savings. 18 How would you compare the people and 19 equipment and tools that you had available at 20 United Savings to what was available at your prior 21 employers? 22 A. We actually had considerably more 5349 1 information, resources at United Savings than I 2 did or any of us did when we were at American 3 General. 4 Q. And let me ask you to look back at a 5 document that has been introduced as Tab 173, and 6 I put it in front of you. 7 MR. NICKENS: It is also, Your Honor, 8 Exhibit T4061. 9 Q. (BY MR. NICKENS) Do you have that, 10 Mr. Phillips? 11 A. Yes, I do. 12 Q. And this has been previously identified 13 as a memo from Mr. Huebsch to Mr. Williams in the 14 latter part of March 1989. And it describes a 15 setup for an investment department. 16 MR. GUIDO: You mean 1984? 17 MR. NICKENS: 1984. I think it is 18 March 29th, 1984. 19 Q. (BY MR. NICKENS) Do you see that? 20 A. Yes, I do. 21 Q. Now, obviously -- how does this 22 description of the investment department that 5350 1 Mr. Huebsch laid out in March of 1984 compare with 2 the one that was actually done at USAT? 3 A. What was actually done was quite like 4 this plan laid out here. 5 Q. And if you look over on Page 2, the 6 overall asset management. Do you see that 7 paragraph, that first paragraph? 8 A. Yes. 9 MR. GUIDO: What page? 10 MR. NICKENS: Page 2 of Exhibit T4061. 11 Q. (BY MR. NICKENS) And Mr. Huebsch 12 describes the need to get a handle on the 13 valuation of the loan portfolio, both mortgage and 14 consumer. And then he says "While we can supply 15 the raw data, there are a number of valuation 16 programs available on the street. These programs 17 not only incorporate fairly sophisticated 18 valuation techniques like duration but also allow 19 for changing the existing interest rate scenario 20 and then reexamining the portfolio under different 21 scenarios." 22 Do you see that? 5351 1 A. Yes. 2 Q. And did USAT obtain the facility to do 3 both duration analysis and scenario analysis? 4 A. Yes, we did. 5 Q. And what is scenario analysis described 6 as today on, for example, the Bloomberg system? 7 A. Today, such an analysis would provide 8 the simulation of results under different market 9 conditions. In particular, shifts in the yield 10 curve and twists and non-parallel movement where 11 short rates and long rates do not move together 12 necessarily but allows the simulation of many more 13 outcomes than previously models might have 14 allowed. 15 Q. And today, we'd call that a stress 16 test? 17 A. Yes. 18 Q. And how did the comparable scenario 19 testing -- how did it compare with what we have 20 available today in the stress test? 21 A. Well, the technology was less advanced 22 at that time. Most of them provided for flat -- 5352 1 simulations of flat yield curve shifting parallel 2 and the effects of twists in the curve, for 3 example, were not provided for. And extrapolation 4 and linkage between interest rate moves and 5 prepayment speeds, for example, was less developed 6 and not a part of all of these packages. 7 Q. Did United Savings have, to your 8 knowledge, the best available technology of the 9 time? 10 A. I believe that we did. We were among 11 the first subscribers to the Bloomberg system and 12 its analytics. And we had, for a short time, a 13 proprietary product that Drexel had provided to 14 us. And we, of course, had our own modeling 15 capability on electronic spreadsheets, as well. 16 Q. Were you computerized? 17 A. Yes, we had personal computers. 18 Q. Now, if you turn over to the page -- 19 the last page of Exhibit -- excuse me -- the 20 next-to-the-last page, there is a chart there in 21 Exhibit T4061. 22 How does that chart compare to what was 5353 1 the arrangement that you came to know at United 2 Savings? 3 A. The system worked quite a bit like this 4 model. 5 Q. Now, what was -- you had a committee at 6 United Savings called the asset/liability 7 committee? 8 A. Yes. 9 Q. Or the ALCO committee? 10 A. Yes. 11 Q. Describe for the Court what the ALCO 12 committee was and what its role was. 13 A. The function of this committee was to 14 address and deal with issues related to the 15 matching of assets and liabilities 16 association-wide, I believe, although most of my 17 business with the committee had to do with 18 portfolios I managed and the matching of them. 19 Q. Now, how did the ALCO committee fit 20 into this organizational chart? 21 A. Well, as initially conceived, there 22 really was no investment program that did not 5354 1 include some sort of matching activity. And so, 2 while Ron Huebsch didn't anticipate it in this, 3 per se, I believe it was always implicit and, 4 indeed, when I came aboard with the program that I 5 pitched upon arriving, it was always implicit that 6 we would have matching and, thus, asset/liability 7 management would always be part of what we did. 8 Q. How did this matching -- what was the 9 purpose of the matching with regard to interest 10 rate exposure? 11 A. The purpose was to limit the risk that 12 was created by short funding, in effect. 13 Financing assets with short-term liabilities, 14 financing assets with longer durations and longer 15 maturities that, if short rates changed, of 16 course, such a spread could be reduced or 17 eliminated. And so, having assets and liabilities 18 repriced at essentially the same points in time 19 eliminated or significantly reduced such risk. We 20 didn't match with maturities because it was not 21 necessarily practical, but the calculation of 22 duration and using that as a matching technique 5355 1 worked mathematically and was a very useful tool. 2 Q. Now, how does that compare with the 3 activities of the traditional thrift of funding 4 long-term loans with deposits? 5 A. Well, the traditional style of the 6 thrift would have this inherent mismatch and left 7 it vulnerable to a number of risks, not least of 8 all disintermediation which would occur when rates 9 rose higher than thrifts could pay and money 10 exited the thrifts. It left them in a real 11 liquidity problem. And, of course, as short rates 12 rose in the ordinary course and deposit rates 13 rose, their overall spread would be significantly 14 diminished so there was a bit of volatility 15 inherent in the traditional thrift model from 16 interest rate risk. 17 Q. Now, again, with the point of what 18 happened with regard to the trading department or, 19 excuse me, the investment department, let me ask 20 you to look at a document that has been marked as 21 Exhibit B391. 22 Do you have Exhibit 391 in front of 5356 1 you? Mr. Phillips, Exhibit B391 appears to be a 2 memo from Mr. Paulin to Mr. Munitz, Mr. Hurwitz, 3 Mr. Williams, and Mr. Huebsch with regard to 4 United trading desk dated November 30th, 1984. 5 A. I didn't understand from whom you said 6 the memo came. 7 Q. I said from Mr. Paulin. 8 A. From? 9 Q. Yes. 10 MR. NICKENS: Your Honor, we would 11 offer B39. 12 MR. GUIDO: No objection, Your Honor. 13 THE COURT: Received. 14 Q. (BY MR. NICKENS) Now, you see here 15 Mr. Paulin describes the setting up of the United 16 trading desk? 17 A. Yes. 18 Q. And it involved hiring a full-time 19 trader? 20 A. Yes. 21 Q. And if you could focus -- and it was 22 indicated that they were -- that you were going to 5357 1 try to be operational by January 2nd, 1985. 2 Did you -- did United achieve that 3 objective? 4 A. Yes, I believe that it did. 5 Q. And with regard to the electronic 6 market information, it indicates that they were 7 going to acquire a Telerate terminal. 8 Do you see that? 9 A. Yes. 10 Q. The Reuters News Wire, both the hard 11 wire Domestic Service and the Foreign Exchange 12 Service. 13 Do you see that? 14 A. Yes. 15 Q. And he's suggesting here that "Maybe we 16 could also try in 1984 the new satellite 17 receiver." 18 Was that new or old technology? 19 A. I believe that was all new technology. 20 Q. Then he goes on to say that the trading 21 desk access to Federated's Dow Jones and Quotron 22 Service could be provided on a shared-cost basis. 5358 1 Was that done? 2 A. Yes. 3 Q. And then over on the second page in 4 Paragraph 5, you get to mundane things like a time 5 clock device which you need at a trading desk, 6 correct? 7 A. Yes. 8 Q. And he indicates that he has discussed 9 with Mike Crow and David Barrett -- now, these 10 were employees of United? 11 A. Yes, they were. 12 Q. -- as to how this would work with 13 regard to the treasury operations at United. 14 Do you see that? 15 A. Yes. 16 Q. Now, what did treasury do with regard 17 to its interface with the investment department? 18 A. Once treasury -- once trading tickets 19 were prepared, they went to the treasury 20 department to be processed and to settle the 21 transactions. The completed trading ticket was 22 the only real product of the trading department. 5359 1 It did not handle securities or cash or effect 2 wire transfers or do any sort of accounting. And 3 so, the treasury picked up the -- all the 4 remaining duties in the transaction after the 5 ticket was written. 6 Q. And did that include the accounting? 7 A. Yes. 8 Q. And who was the head of the treasury 9 department while you were there? 10 A. The treasurer was David Barrett when I 11 arrived, and it was later Bruce Williams. 12 Q. Now, with regard to this -- your 13 capabilities on your scenario analysis and 14 durations, I would ask that you look at 15 Exhibit B410 which is a memo from Mr. Crow to 16 Bruce Williams dated December 20th, 1984, showing 17 a copy to you and to Mr. Jim Wolfe. 18 MR. NICKENS: And, Your Honor, we offer 19 B410. 20 MR. GUIDO: No objection. 21 Q. (BY MR. NICKENS) Mr. Phillips, who 22 was Mr. Wolfe? 5360 1 A. Mr. Wolfe was involved in accounting 2 for the association. I don't know his exact 3 position. 4 THE COURT: Mr. Nickens, have you 5 handed a copy of that or is it in? 6 MR. NICKENS: No. I offered it. I 7 failed to give you your copy. I'm sorry. 8 THE COURT: Received. 9 Q. (BY MR. NICKENS) I'm sorry, 10 Mr. Phillips. I was asking you who Mr. Wolfe was. 11 A. He was a manager in the accounting 12 area. I'm not sure exactly what his position was. 13 Q. And Exhibit B410 indicates that "GRW 14 has requested that we add to the monthly 15 performance report a schedule summarizing the new 16 United in terms of spreads, rates, and duration." 17 Do you see that? 18 A. Yes. 19 Q. Now, who was GRW? 20 A. Gerald Williams. 21 Q. And it further indicates that "Joe 22 Phillips recently prepared such a schedule and it 5361 1 was my understanding at the staff meeting that you 2 had received such a report for inclusion in the 3 monthly performance report. Please establish a 4 consistent procedure to include this report 5 monthly." 6 Do you see that? 7 A. Yes. 8 Q. And this -- does this indicate that you 9 had the capability to prepare spreads, rates, and 10 duration for the investments that you were 11 supervising in the investment department? 12 A. Yes. 13 Q. And did you do so on a regular and 14 periodic basis? 15 A. I remember doing so at the outset for 16 this purpose. Later, I prepared a regular 17 matching report that was circulated among 18 management. I don't believe that that report, in 19 that form, actually was included in the 20 performance report; but it was a widely-circulated 21 internal report that I prepared. 22 Q. Who prepared the performance reports? 5362 1 A. I believe that it was members of the 2 accounting and treasury areas. 3 Q. And you might supply some information, 4 but you yourself and your department did not 5 participate in the preparation of that report? 6 A. That's correct. We did not. 7 Q. Now, get to the bottom line here. Did 8 you feel like you had everything you needed to do 9 your job while you were at United? 10 A. Yes. We had quite good communications 11 with the dealer firms. We had appropriate direct 12 lines. We had information services. We had a 13 small, reasonably focused group, no beginners in 14 the group, and I felt that, at the time, we had 15 the state-of-the-art, certainly more than I had 16 ever been able to use before. 17 Q. And does that apply both to your 18 high-yield bond portfolio and the mortgage-backed 19 securities? 20 A. Yes. 21 Q. Now, did you understand the use of the 22 hedging devices such as swaps, caps, collars, 5363 1 things of that nature? 2 A. Yes, I did. 3 Q. Let me ask you to look at Exhibit B858. 4 I'm going to hand you B858, Mr. Phillips. 5 Mr. Phillips, this B858 is a memo from Mr. Huebsch 6 and yourself dated March 3rd, 1986, addressed to 7 the executive committee of United Financial Group. 8 And the subject was mortgage-backed securities 9 uses of caps, collars and swaps to hedge. 10 Did you prepare this memorandum? 11 A. Yes. I believe that I did. 12 MR. NICKENS: Your Honor, we offer 13 B858. 14 MR. GUIDO: No objection, Your Honor. 15 THE COURT: Received. 16 Q. (BY MR. NICKENS) Now, what was the 17 purpose or intention of the preparation of B858? 18 A. This memorandum presented different 19 alternatives to hedging various risks and how they 20 each worked. 21 Q. And this was to provide this 22 information to upper management? 5364 1 A. Yes. 2 Q. Is this information that you were aware 3 of at the time that you made the decisions about 4 setting up the mortgage-backed securities 5 portfolio? 6 A. Yes. 7 Q. Let me ask you to take a look at an 8 Exhibit A10578. A10578 is a memo from you to 9 distribution -- which is Mr. Williams, Mr. Gross, 10 Mr. Hurwitz, Mr. Crow, and Mr. Huebsch -- dated 11 November 7th, 1985, and entitled "Interest Rate 12 Swaps, Hedging of Swap Collateral." 13 Do you see that? 14 A. Yes. 15 MR. NICKENS: Your Honor, we offer 16 A10568. 17 MR. GUIDO: No objection, Your Honor. 18 THE COURT: Received. 19 Q. (BY MR. NICKENS) Now, what was the 20 purpose of this memorandum, Mr. Phillips? 21 A. This memorandum discusses the hedging 22 of mortgage-backed securities that were not 5365 1 acquired for the risk-controlled arbitrage but, 2 instead, to be provided as collateral on interest 3 rate swaps. 4 Q. Describe for the Court the problem that 5 you were addressing here with this memorandum. 6 A. In the interest rate swaps that we 7 entered, it was a convention that the fixed payer, 8 which United Savings was, had to collateralize its 9 obligation, and the conventional collateral is 10 government securities and other high-quality 11 securities. And in this case, we were using 12 mortgage-backed securities as such collateral. In 13 holding those, it was determined, also, that those 14 securities which were held as collateral for the 15 obligations also needed to be hedged. 16 Q. Prior to the use of mortgage-backed 17 securities to collateralize these obligations, 18 what kinds of instruments had you used? 19 A. We had used high-yield bonds. 20 Q. And this -- by having to move to 21 mortgage-backed securities, you introduced a new 22 problem. Right? 5366 1 A. Yes. 2 Q. And you were addressing that problem 3 and the need to hedge those instruments? 4 A. That's correct. 5 Q. Now, did you have the understanding of 6 these kinds of hedging instruments that you 7 describe in Exhibit 10578 at the time that you set 8 up the mortgage-backed securities risk-controlled 9 arbitrage? 10 A. Yes. 11 Q. And this memorandum indicates that you 12 were providing various calculations to indicate 13 how the hedging instruments would work. 14 Did you have that ability at the time 15 you set up the mortgage-backed securities 16 portfolio risk-controlled arbitrage? 17 A. Yes. 18 Q. Now, how did collars work as opposed to 19 swaps and caps? 20 A. Caps and collars were both option 21 strategies. And a cap itself was a single option 22 position, a single long-option position which was 5367 1 relatively costly to acquire because it required 2 the purchase of long options. 3 A collar could be put together more 4 cheaply. It had the relative disadvantage of 5 hedging away certain upside results, but it was 6 very effective within a band of interest rate 7 movement. 8 Q. Now, at the time you set up the 9 mortgage-backed securities risk-controlled 10 arbitrage, Mr. Phillips, did you consider the 11 various hedging instruments available in the 12 marketplace? 13 A. Yes. 14 Q. And what did you choose? 15 A. We chose primarily interest rate swaps. 16 Q. And why did you choose swaps -- well, 17 let me ask: Did you consider the use of various 18 futures? 19 A. Yes, we did. 20 Q. And -- but you chose swaps? 21 A. Yes. 22 Q. Explain to the Court why you chose 5368 1 swaps at that point in time over these other 2 hedging devices. 3 A. The interest rate futures markets were 4 not sufficiently deep in the forward months of 5 contract expiration. They were reasonably 6 effective in the expirations that were coming in 7 the next few months where you could put together a 8 strategy that would very likely protect you. And 9 I'm talking about contracts on short-term rates 10 because we were not looking to hedge asset values 11 with long-term contracts. 12 After a few months, the ability to 13 protect yourself was significantly diminished 14 because there wasn't enough liquidity or depth in 15 those markets to create a structure that would go 16 on for a long period of time. Indeed, you 17 couldn't even be sure that you could roll it over 18 effectively when the hedge began wearing off. 19 And so, with interest rate swaps, we 20 had the ability to put together something that 21 would hold up for a longer period of time. 22 Q. And was that a reason, business 5369 1 decision that you and the others made at the time? 2 A. Yes. 3 Q. You just didn't choose swaps because 4 some salesman came in and said, "I'd like to sell 5 you a few swaps"? 6 A. No. We did not. The same salesman 7 would have sold us any of those structures. 8 Q. Now, you had contact, regular contact, 9 with salespeople from investment bankers. Right? 10 A. Yes. 11 Q. Did you -- I mean, and they made 12 presentations? 13 A. Yes. 14 Q. Did you evaluate those presentations, 15 or did you just accept them for whatever they 16 said? 17 A. We evaluated them because many of them 18 were not identical. Many of them had different 19 terms and conditions and prices and costs. So, it 20 was not altogether straightforward. They needed 21 to be differentiated and distinguished so we could 22 tell which was the best. 5370 1 Q. Now, in addition to these salespeople, 2 did you have access to the financial analysts at 3 these and various investment bankers? 4 A. Yes, we did. 5 Q. And did you make use of that resource? 6 A. Yes. 7 Q. Did you feel that it was advantageous 8 or disadvantageous to contact several investment 9 bankers to get information from them? 10 A. It would have been advantageous because 11 at the bottom line, each was going to compete with 12 the cost of putting together something for us. 13 Q. And did you maintain contacts with a 14 number of those banks? 15 A. Yes, we did. 16 Q. Now, Drexel has become an issue in this 17 matter, Mr. Phillips. So, would you explain to 18 the Court how it is that Drexel got into the 19 mortgage-backed securities business, if you know. 20 A. It's my recollection that Drexel 21 started its business in mortgage-backed securities 22 from capital created elsewhere in the firm from 5371 1 the profits of the high-yield bond business and 2 others. And they assembled in a very short time a 3 first-rate group from all over Wall Street and 4 became a very serious competitor in only a couple 5 of years. 6 Q. When you say "assembled group," they 7 went out and hired away people from other banks? 8 A. Yes. 9 Q. And did you do business exclusively 10 with Drexel? 11 A. We did not. 12 Q. Were you ever instructed that you had 13 to do business with Drexel? 14 A. No. 15 Q. Were you ever directed to make a trade 16 with Drexel? 17 A. No. 18 Q. Were you ever directed to make a 19 purchase or sale at what you thought was a 20 non-market rate with Drexel? 21 A. I was not. 22 Q. With anybody else, were you ever 5372 1 instructed to make a trade that you thought was 2 not at the market price? 3 A. No, I was not. 4 Q. And what did you do to determine that 5 you were getting the market price? 6 A. We had a trader in our trading room who 7 tracked market levels, bids, and offers for 8 holdings that we had plus a wide variety of 9 securities that were coming to market or trading 10 in the secondary market. 11 Q. Now, did you maintain a business 12 relationship with Salomon Brothers? 13 A. Yes. 14 Q. And who was your salesperson there? 15 A. Our primary salesperson was Phillip 16 Swatzell. 17 Q. And did you maintain relationships with 18 First Boston? 19 A. Yes. 20 Q. And do you recall who your salesperson 21 was there? 22 A. Charles Ingram. 5373 1 Q. And do you recall Lisa Wolfson? 2 A. Yes. 3 Q. Did you have contacts with Ms. Wolfson? 4 A. I attended a presentation that she led 5 at United Savings' offices. 6 Q. You mean she came down from New York to 7 United Savings to make a presentation? 8 A. Yes. 9 Q. What was the nature of that 10 presentation? 11 A. It was a presentation of a matched 12 investment program in mortgage-backed securities 13 quite like the risk-controlled arbitrage that 14 later became a conventional term. 15 Q. Was this presentation made before or 16 after United set up its risk-controlled arbitrage 17 in mortgage-backed securities? 18 A. It was before. 19 Q. So, you had this information available 20 to you from Ms. Wolfson and others when you made 21 the decisions that you had to make? 22 A. Yes. 5374 1 Q. Did you simply follow her advice, or 2 did you evaluate the information that she gave 3 you? 4 A. At this point, I'm not sure exactly 5 what her advice was. But -- 6 Q. You mean "at this point" some 12, 13 7 years later? 8 A. Yes. But I remember in broad terms 9 that she outlined a broad structure quite like 10 others suggested and perhaps like we undertook. I 11 can't be sure if she suggested certain details 12 like using interest rate swaps or other hedge 13 devices; but it was, in general, of the same form 14 that we ended up using and we compared it to those 15 presented by others. 16 Q. And did you have business relationships 17 with Morgan Stanley? 18 A. Yes. 19 Q. And who was your salesperson on that 20 account? 21 A. Originally, Brian Anderson. 22 Q. And Mr. Guido asked you yesterday about 5375 1 Mr. Pinkus? 2 A. Yes. 3 Q. You had contact with him, as well? 4 A. Yes, I did. 5 Q. And he was an expert on prepayments? 6 A. Yes. He was an expert in 7 mortgage-backed security research in general, but 8 prepayments in particular. 9 Q. And you had a business relationship 10 with Merrill-Lynch? 11 A. Yes. 12 Q. Who was your salesperson there? 13 A. Joe Schuler. 14 Q. We mentioned Drexel. Did you know 15 Mr. Ken Sullivan at Drexel? 16 A. I did not. 17 Q. Did you have a business relationship 18 with PaineWebber? 19 A. Yes. 20 Q. And do you recall who your sales 21 representative was on that account? 22 A. My salesman there was Jim Tart. 5376 1 Q. Now, how did you maintain these 2 relationships? We talked about the fact they 3 existed, but what did you do to maintain those 4 relationships or what did they do? 5 A. Well, they called me on the phone, 6 presented bids and offers on securities that we 7 owned or might be interested in. In the ordinary 8 course, they might give us market levels. If 9 their research people had come up with a strategy 10 or method for doing what we were doing either in 11 bonds or in mortgage-backed securities, they would 12 present those. 13 Q. Now, did you have the ability to 14 comparison shop those proposals? 15 A. Yes, I did. 16 Q. And did you do so? 17 A. Yes. 18 Q. Now, was there any major market-maker 19 in mortgage-backed securities with which United 20 Savings did not have an account? 21 A. We didn't undertake to follow the 22 Bear Sterns program. We may not have had an 5377 1 account with Bear Sterns. They had a somewhat 2 different approach to trading mortgage-backed 3 securities, and it did not fit with what we did. 4 Q. And why was that? 5 A. It was very pool specific. It tracked 6 prepayment speeds by pool. It extrapolated what 7 they thought prepayment might be and tried to 8 identify value based on prepayment. Whether or 9 not it was effective was unclear and it could only 10 be done in relatively small transactions, far too 11 many to fit our program. 12 Q. Let me see if we understand it. They 13 were marketing a tool by which you could look at 14 specific pools to obtain some slight advantage 15 over the difference in prepayments that might 16 occur there? 17 A. Yes. 18 Q. And that was based upon an analysis of 19 geography and demographic data? 20 A. It was -- it was segmented 21 geographically, but it was based on historical 22 prepayments of the pools. And it was an attempt 5378 1 to find some path for the future based on what had 2 happened. 3 Q. And the reason you couldn't use that 4 analysis is that you were buying in such amounts 5 that it didn't allow you to use those 6 distinctions? 7 A. Yes, yes. We also were unsure that it 8 was effective. 9 Q. Now, let me ask you some questions, if 10 I might, about prepayment modeling back in this 11 period. Mr. Guido asked you a number of questions 12 about whether or not you used prepayment models in 13 1984 and 1985. 14 Do you recall that? 15 A. Yes. 16 Q. And you indicated that you did not 17 model the relationships at that point in time 18 between prepayments and interest rate moves? 19 A. That's correct. 20 Q. Now, to your knowledge, did anyone else 21 do that in that time frame? 22 A. I don't recall seeing serious academic 5379 1 work that could be tested and defended in the area 2 of prepayment speed with respect to interest rate 3 movement. I recall seeing a lot of historical 4 relationships that did not purport to be models. 5 Q. Now -- and so, what did you use for 6 obtaining these estimates of prepayments? 7 A. We, of course, had the historical 8 information; but we used primarily our judgment as 9 to, first of all, what rates would do and then, 10 secondly, how prepayments might respond. 11 Q. Now, you mentioned something, I believe 12 yesterday, about some kind of yield books or bond 13 books? 14 A. Yes. 15 Q. What were those? 16 A. Those were simply for calculating 17 yields and durations. They required you to plug 18 in a prepayment speed in order to get yields and 19 durations. 20 Q. Well, what did you use? I mean, were 21 there conventions that you used with regard to 22 mortgage-backed securities in terms of prepayments 5380 1 back in 1984 and '85? 2 A. I'm sorry. Conventions? I'm not 3 sure -- 4 Q. I mean rules of thumb, conventions, you 5 know, things that you might be able to look at to 6 make an estimate of your prepayments. 7 A. There was historical experience from 8 various coupons on how they performed when rates 9 moved, but they didn't necessarily tell us what 10 would happen next. It was much more important to 11 have a handle on what interest rates were going to 12 do. And so, our expectation is what built up our 13 prepayment expectation. 14 Q. Of course, you knew that if interest 15 rates went down, that it was likely that 16 prepayments would increase? 17 A. Yes. If they went down sufficiently 18 and persisted at lower rates. 19 Q. So, this was not a principle that you 20 were not aware of? 21 A. That's correct. 22 Q. Now, has the perception in the 5381 1 marketplace with regard to the volatility of the 2 relationship between interest rates and 3 prepayments changed since 1984 and '85? 4 A. Well, the relationships are better 5 understood. There's considerably more data at 6 this time. The mortgage-backed security products 7 were not as widely used as they are now. The 8 markets were not as developed and the applications 9 for the products not nearly as broad as they are 10 now. So, the relationships are considerably 11 better understood now. 12 Q. Let me show you a document and see if 13 we can illustrate the status of the information 14 available to people back in 1984 and 1985. And 15 I've handed you a document that is entitled 16 "Determining the Yield of a Mortgage Security" by 17 Michael Waldman and Mark Gordon, CFA, March 1985, 18 on the cover of Salomon Brothers, Inc. Mortgage 19 Research. 20 And if you look over to the last page 21 of the document, do you see there that it is -- 22 this publication was addressed to you at United 5382 1 Savings? Well, I think you may have -- just a 2 second. You appear to have a series of documents 3 labeled Exhibit 450. Let me show you my copy, and 4 let's just identify for the record that number. 5 Could you just indicate by the Bates 6 No. CNO54445 to whom the publication appears to be 7 addressed? 8 A. It is addressed to me. 9 MR. GUIDO: I'm sorry. What number? 10 11 (Discussion off the record.) 12 13 MR. NICKENS: Your Honor, we would 14 offer B450. 15 MR. GUIDO: Your Honor, I have no idea 16 what B450 is. It's a jumble of what's being 17 offered by 450. 18 Are you offering the portion that was 19 sent to Mr. Phillips? 20 MR. NICKENS: Well, Your Honor, this -- 21 this appears to be a compilation of a Salomon 22 Brothers' publication. My intention is only to 5383 1 question the witness about the first few pages. 2 But rather than trying to sort it all out at this 3 time, I go ahead and offer the whole thing. 4 MR. GUIDO: I object, Your Honor. I 5 have no idea how any of this fits together or 6 whether or not the document is what Mr. Phillips 7 received. If we can put it together the way it 8 belongs, I have no objection. 9 THE COURT: I don't see Bates numbers 10 on -- 11 MR. GUIDO: I don't have Bates numbers 12 on mine either, Your Honor. 13 MR. NICKENS: Your Honor, what's 14 happened here is this was copied directly out of 15 the exhibits that Mr. Phillips provided to the OTS 16 at the time of his deposition. And some of those 17 were numbered or at least I believe them to be. 18 But I will ask that if we could take a short 19 break, that additional copies be made of the 20 document that I have here so that there will be no 21 question as to the source of this information. 22 But it'll take us a few minutes to do so. 5384 1 THE COURT: All right. We'll be off 2 the record for a few minutes. 3 4 (A short break was taken 5 at 9:47 a.m.) 6 7 THE COURT: We'll be back on the 8 record. 9 (9:52 a.m.) 10 Q. (BY MR. NICKENS) Mr. Phillips, I have 11 handed you a document and I would ask that you 12 just mark that as B450A that bears the Bates 13 No. 9901411 through 9901433. 14 And do you see on that last page the 15 address to you? 16 A. Yes, I do. 17 Q. And with regard to the documents that 18 you produced to the OTS in response to their 19 subpoena, did you Bates number them? 20 A. I didn't number anything. 21 Q. Do you know if they were Bates 22 numbered? 5385 1 A. I'm not sure what that is, a Bates 2 number. 3 Q. Okay. Fair enough. We live in our own 4 little world here at times. We forget that the 5 rest of the world doesn't have this. Okay. 6 In any event, does B450A appear to be a 7 document that you received? 8 A. Yes. 9 MR. NICKENS: Your Honor, we offer 10 450A. 11 MR. GUIDO: No objection, Your Honor. 12 THE COURT: Received. 13 Q. (BY MR. NICKENS) Now, let's see if we 14 can illustrate -- this is by Mr. Waldman and 15 Mr. Gordon in March of 1985. Right? 16 A. Yes. 17 Q. This is the very time frame where 18 you're setting up the risk-controlled arbitrage, 19 correct? 20 A. I think at this time, we were 21 continuing to accumulate and build it. 22 Q. And Mr. Waldman describes in here the 5386 1 development of prepayment modeling to some degree. 2 And let me ask you to help us point out a few 3 things for the judge. If you turn over to the 4 fourth page, which is 54436, do you see in the 5 upper left-hand column, there is a paragraph that 6 starts out "the earliest model"? 7 A. Yes. 8 Q. And it reads "The earliest model for 9 incorporating prepayments used the prepaid life 10 concept. This approach represents all the 11 prepayments on a mortgage pool by one balloon 12 prepayment at a typical or average point in time. 13 A 12-year prepaid life assumption became 14 established as a market convention for quoting 15 yields on 30-year mortgages. Figure" -- 16 MR. GUIDO: What page are you on? 17 MR. NICKENS: I'm on Page CN054436. It 18 is the fourth page of the exhibit. 19 MR. GUIDO: What paragraph? 20 MR. NICKENS: The first paragraph on 21 the left side of the -- left side column. 22 MR. GUIDO: That starts "However, 5387 1 projecting pass-through yields"? 2 MR. NICKENS: No. It starts out as I 3 read, "the earliest model." 4 MR. GUIDO: I've got it. 5 Q. (BY MR. NICKENS) Okay. Rather than 6 reread it, Mr. Phillips, it ends "Figure 2 depicts 7 the mortgage cash flow under a 12-year prepaid 8 life assumption." 9 Do you recall the time frame where the 10 12-year convention was used? 11 A. Yes. 12 Q. And how did that work? 13 A. It was a rather crude assumption as to 14 how yields would be computed. It was -- it used 15 an average life concept assuming that loans really 16 were not outstanding for 30 years. However, it 17 assumed that a loan prepaid by its contractual 18 terms until the 12th year and then it was paid in 19 full. And I believe that the use of this method 20 was a compromise because the technology was not 21 fully developed to do it any better than this. 22 Q. And what did that translate into in 5388 1 terms of CPRs? 2 A. Well, it had no real use of CPR during 3 the 12 years. Obviously, a CPR could be computed 4 across the stream of cash flows; but I think that 5 you basically ignore CPR. 6 Q. Okay. Then let me ask you to look at 7 the bottom -- the right side of the page toward 8 the bottom where it says "FHA experience" where 9 Mr. Waldman writes "A commonly-used approach for 10 calculating cash flow yields that was developed in 11 the 1970s bases prepayments schedules on FHA 12 experience. Mortgage pool payments are modeled as 13 a percentage of the year by year termination 14 patterns of FHA insured mortgages as observed by 15 the Department of Housing and Urban Development." 16 Was this one of the government agencies 17 that published prepayments? 18 A. I believe that it was, yes. 19 Q. Now, let me ask you to look over to 20 Page -- two pages over to Page CNO54438. And do 21 you see there on the right side, there is 22 something called yield tables? 5389 1 A. Yes. 2 Q. And it says "Salomon Brothers, Inc. in 3 conjunction with Financial Publishing Company, 4 recently published a three-volume set of mortgage 5 security yield books. The tables in the book 6 provide the quoted yield as well as the cash flow 7 yield for various constant prepayment rates. A 8 sample page is shown below." 9 Now -- and then it goes down at the 10 bottom to say "The books also show the 11 weighted-average life and durations corresponding 12 to each prepayment rate. The weighted-average 13 life is the weighted average time at which 14 principal is repaid and corresponds to the 15 standard measure of average life for sinking fund 16 bonds. The duration, the average time to receipt 17 of cash flows weighted by the present value of 18 those cash flows, measures" -- and then it -- we 19 lose the -- well, I can't tell what's next. 20 Was this the yield table type of 21 information that you said you used at that time? 22 A. This is a page from one of those books. 5390 1 Q. And Salomon Brothers is announcing the 2 yield table in March of 1985 as the latest 3 development in the -- in the modeling of 4 prepayments? 5 A. Yes. 6 Q. Now, let us look at the next 7 development which -- and I'm going to ask you to 8 look at Exhibit B586. 9 MR. NICKENS: It is already in 10 evidence, Your Honor, at Tab 239. 11 MR. GUIDO: What exhibit number.? 12 MR. NICKENS: B586. 13 MR. GUIDO: Is that the September 1985 14 Waldman publication? 15 MR. NICKENS: I believe it is. It is 16 not in the tab. We have a copy for the witness. 17 Q. (BY MR. NICKENS) Let me show you, 18 Mr. Phillips, B586, which is the September 4th, 19 1985, Salomon Brothers publication of the Salomon 20 Brothers prepayment model, "Impact of the Market 21 Rally on Mortgage Payments and Yields." 22 And let me -- now, this is after you 5391 1 have set up the mortgage-backed securities 2 risk-controlled arbitrage, correct? 3 A. Yes. 4 Q. And it is just before you're looking at 5 doing a similar one for United Mortgage Finance? 6 A. Yes. 7 Q. And let me ask you to look at the 8 second paragraph. Well, first of all, the first 9 paragraph announces that in mid-year, between 10 March 7th and June 18th, there was a very 11 significant drop in Ginnie Mae yields in 1985; is 12 that right? 13 A. Yes. 14 Q. And those yields dropped nearly 200 15 basis points at the very time that you were 16 setting up the risk-controlled arbitrage; is that 17 correct? 18 A. That's correct. 19 Q. And then it says "While the market has 20 backed off from the highs reached in mid-June, 21 mortgage interest rates are still nearly as low as 22 at any time during the past five years. As a 5392 1 result of the sharp decline in interest rates, 2 investors are uncertain about the pays at which 3 mortgages will prepay in today's environment." 4 Do you see that? 5 A. Yes. 6 Q. And does that accord with your 7 recollection, whatever you may have left from that 8 long ago? 9 A. Yes. 10 Q. And what would be the impact of this 11 information that interest rates had fallen 200 12 basis points, as indicated here, and there is 13 uncertainty as to what prepayments -- what was 14 going to happen with prepayments? 15 A. It would suggest the uncertainty could 16 be the result of not knowing how much further 17 rates might fall or whether they might fall at 18 all. 19 Q. Now, when you're doing this on a 20 day-to-day basis, I guess, of course, you know 21 what's going to happen to interest rates the next 22 day? 5393 1 A. No. That's not correct. 2 Q. So, you have to make a decision without 3 knowing what's going to happen the next day? 4 A. Yes. 5 Q. And if interest rates have fallen, of 6 course you know they are going to continue to 7 fall? 8 A. That's not necessarily true. 9 Q. Well, what do you do to deal with this 10 uncertainty? 11 A. Well, you would develop an outlook 12 based on a number of things. In particular, 13 expectation of how the economy would perform and 14 what central bank responses would be and money 15 supply and all those sorts of inputs. And with 16 that outlook, basically compute your prepayment 17 speed and other kinds of tools you would need to 18 manage securities. 19 Q. Now, when we look at these historical 20 curves, we get a nice, smooth curve as to yields 21 and to prepayment rates. 22 You can do that, can't you? 5394 1 A. Yes. 2 Q. Now, is that how it happens in the real 3 world? 4 A. No, it is not. 5 Q. And explain to the Court why the 6 reality is different and how that affects the 7 portfolio manager who has to make these decisions. 8 A. Well, the fact that an interest rate 9 structure may have changed from one period to the 10 next certainly doesn't imply that it will continue 11 on that path or that it might take any particular 12 change next. 13 In addition, the response of 14 prepayments is a function of several things, 15 including interest rates; but, also, the ease in 16 doing so and uncertainty as to -- for the 17 homeowner as to whether he should wait to do it at 18 lower rates. There are many uncertainties that a 19 number of market participants are weighing in 20 trying to decide direction. 21 Q. How does that affect a decision about 22 whether to rebalance a mortgage-backed securities 5395 1 portfolio? 2 A. We needed to have the conviction that 3 rates would either continue to fall or that they 4 would persist in some way to make the rebalancing 5 effective. In the absence of that, trading to 6 rebalance when it wasn't needed could have a 7 whipsaw effect and result in, in this case, 8 underperformance if we were wrong. 9 Q. Now, you were shown a number of charts 10 dealing with treasury rates, 10-year treasury 11 rates we focused on. 12 Do you recall that? 13 A. Yes. 14 Q. Now, at the time, were you also looking 15 at interest rate -- at mortgage rates? 16 A. Yes. 17 Q. Now, there is a historic relationship 18 between treasury rates and mortgage rates, is 19 there not? 20 A. Yes. 21 Q. But it does vary over time? 22 A. Yes, it does. 5396 1 Q. And if you were making a decision about 2 rebalancing and you had available to you both 3 mortgage rates and treasury rates, which one would 4 you focus on? 5 A. With respect to rebalancing, I'm not 6 sure if I understand the question. 7 MR. GUIDO: Is your question regarding 8 what he did then or what his fees are today? 9 MR. NICKENS: My question focuses, Your 10 Honor, to the events at the time, what was 11 available at the time. 12 Q. (BY MR. NICKENS) Let me ask you this. 13 You were looking at both mortgage rates and 14 treasury rates? 15 A. That is correct. 16 Q. And the mortgage rates would be the 17 most direct predictor of prepayments, would they 18 not? 19 A. Yes, they would. 20 Q. I mean, it would be highly unusual but 21 you could have a situation where the treasury 22 rates went down and the mortgage rates didn't go 5397 1 down as far? 2 A. Yes, that could happen. 3 Q. Now, returning to Exhibit 586 if we 4 might, Mr. Phillips, in the second paragraph, it 5 says "It has recently been common practice for 6 market participants to evaluate yields and yield 7 spreads based upon the past 12 months' prepayment 8 experience. This procedure assumes that past 9 year's experience -- the past year's experience 10 provides a good estimate of future prepayments, a 11 reasonable approach when housing market activity 12 is relatively stable." 13 Does that accord with your recollection 14 of what the market was like in September of '85? 15 A. Yes, it does. 16 Q. And -- 17 MR. GUIDO: For purposes of completion, 18 Your Honor, to apply Mr. Nickens' rule to this, I 19 believe -- 20 MR. NICKENS: I believe it's a federal 21 rule, Your Honor, but -- 22 MR. GUIDO: Well, I think 5398 1 Mr. Nickens -- 2 MR. NICKENS: I'll adopt it, but it's 3 not mine. 4 THE COURT: All right. Read it. 5 MR. GUIDO: The next sentence says 6 "With the repeat fall in rates, however, this 7 assumption is no longer valid." 8 Q. (BY MR. NICKENS) And what's happening 9 here is that Salomon Brothers, in September of 10 1985, is announcing their first attempt to model 11 prepayments. 12 Is that what this is about? 13 A. Yes. 14 Q. And that was just following, six months 15 earlier, their announcement of yield tables as the 16 latest development in following prepayments? 17 A. That's correct. 18 Q. And if we look over at Page 5 of 19 Exhibit B586, "Salomon Brothers, who is touting 20 this new development of the prepayment modeling 21 itself, indicates that there are still kinks to be 22 worked out, particularly as to high coupon 5399 1 issues." 2 Do you see that? 3 A. Would it be under the paragraph "high 4 coupon issues"? 5 Q. Yes, it is. And it says about 6 mid-paragraph, "First, the prepayment estimates 7 for the high coupon category carry the greatest 8 margin of error. Second, these securities have a 9 special defensive quality because the shifts in 10 prepayment rates that occur with changing interest 11 rates dampen their price movements." 12 And he goes on to say "As a 13 consequence, the price volatility of the high 14 coupon issues is less than that indicated by their 15 projected average lives or durations." 16 Do you see that? 17 A. Yes, I do. 18 Q. Now -- and if you turn over to the next 19 page, there is a chart there showing the Ginnie 20 Mae yield spreads off treasuries. 21 MR. GUIDO: Is this Page 6? 22 MR. NICKENS: This is Page 6, the next 5400 1 page after Page 5. 2 Q. (BY MR. NICKENS) Do you see that? 3 A. Yes, I do. 4 Q. And it shows how variable those spreads 5 can be off treasury rates. Right? 6 A. Yes, it does. 7 Q. And in any event, this modeling was 8 based upon historical information? 9 A. Yes, it was. 10 Q. Now, did you use the Salomon Brothers 11 prepayment model? 12 A. We considered some of the findings in 13 this paper, along with other research, in our 14 ordinary management of the structure. 15 Q. And let me ask you to look at Tab 531. 16 MR. NICKENS: Your Honor, it is 17 Exhibit A1394. 18 THE COURT: Did you offer B586? 19 MR. NICKENS: Your Honor, I believe it 20 is already in evidence. 21 THE COURT: Okay. 22 MR. NICKENS: Although it is not there 5401 1 at that tab. If the records indicate differently, 2 I will certainly offer it. 3 MR. GUIDO: No objection, Your Honor. 4 THE COURT: I understand B586 is in the 5 record. 6 Q. (BY MR. NICKENS) Mr. Phillips, A1394 7 are the minutes of the investment committee of 8 United Financial Group of May 28th, 1986. And I 9 just want to draw your attention to the third 10 paragraph where it says "Mr. Bruce Williams 11 presented a mortgage-backed securities prepayment 12 assumption memorandum which had been recommended 13 by the asset/liability committee. After full 14 discussion of these assumptions, the investment 15 committee unanimously approved the utilization of 16 such assumptions. It was noted that the 17 asset/liability committee would be presenting to 18 the investment committee on a monthly basis 19 information to review the prepayment assumptions 20 and their impact and their changes to the 21 association. The chairman ordered Mr. Williams' 22 memo dated May 27th, 1986, to be attached to the 5402 1 minutes." 2 And then if you go over there and look, 3 you'll find that the memorandum is attached. This 4 is at Page US3004762. 5 Do you see that? 6 A. Yes. 7 Q. And this indicates that you were going 8 to -- you had recommended the use -- or 9 Mr. Williams had recommended the use of Morgan 10 Stanley's CPR figures, correct? 11 A. Yes, it does. 12 Q. Now, Mr. Phillips, at any point in time 13 that you were employed at United Savings, did you 14 ignore the movement of interest rates and its 15 effect on prepayments? 16 A. No, we did not. 17 Q. What did you do to try to do your level 18 best to estimate those prepayments and their 19 effects on your structures? 20 A. We consumed a great deal of 21 contemporaneous research on the topic of the sort 22 we've been discussing today and previously. 5403 1 Q. And was it a concern at the highest 2 levels of management on a day-to-day basis? 3 A. Yes, it was. 4 Q. Now, an issue has been raised in the 5 case about option adjusted spread models. 6 Were those available to you in 1985 or 7 '86? 8 A. I believe that the theories had been 9 developed. I don't believe the technology had 10 been delivered for option adjusted spread 11 calculations in every case. Certainly not for 12 mortgage-backed securities. 13 Q. Okay. And let me ask you to look at 14 Exhibit B3815 with regard to this particular 15 issue. Mr. Phillips, Exhibit 3815 is, on its 16 face, the Salomon Brothers publication of its 17 Mortgage Research Department entitled "Evaluating 18 the Option Features of Mortgage Securities: The 19 Salomon Brothers Mortgage Pricing Model" by 20 Michael Waldman, Mark Gordon, September 1986. And 21 it bears those numbers, the Bates Nos. 9901237 22 through 990-1254, indicating that it was among the 5404 1 papers that you produced to the Office of Thrift 2 Supervision. 3 MR. NICKENS: Your Honor, we offer 4 Exhibit B3815. 5 MR. GUIDO: No objection, Your Honor. 6 THE COURT: Received. 7 Q. (BY MR. NICKENS) Now, can you briefly 8 take a look at this B3815, Mr. Phillips, and tell 9 the Court whether this constitutes the 10 announcement by Salomon Brothers of its 11 development of an option adjusted spread model for 12 mortgage-backed securities? 13 A. Yes, it does. 14 Q. And how soon after this publication did 15 you leave United Savings? 16 A. Approximately two months. 17 Q. How often did the investment bankers 18 announce this sort of new things that they would 19 like to get its customers to adopt? 20 A. Well, from time to time, as they may 21 develop ideas like this. I don't think there was 22 a regular frequency. 5405 1 Q. And was there a process of evaluating 2 those developments? What I'm trying to get at, 3 Mr. Phillips, is if this thing came out, would you 4 immediately decide, "Boy, we need to run over and 5 get us an option adjusted spread model" or would 6 you evaluate the use of that and its application 7 to your employer? 8 A. Well, I believe that I read the piece 9 when it came out. I don't know that it was 10 available to us with respect to our own portfolio 11 in a time frame that we could have looked at it 12 very critically to see if we could use it. It 13 certainly was an attempt to address issues 14 regarding mortgage-backed securities. I don't 15 think that we would have necessarily had time to 16 get involved with it. 17 Q. Okay. And let's -- if we look over at 18 the conclusion, which is at Page CN054533, 19 Mr. Waldman is indicating that this is a powerful 20 new approach for analyzing mortgage securities. 21 That's the first sentence, correct? 22 A. Yes. 5406 1 Q. And then -- but his final word of 2 caution is "Future directions clearly involve 3 further applications of the model and the 4 development of more sophisticated models." 5 Do you see that? 6 A. Yes, I do. 7 Q. And that is what, in fact, happened, 8 isn't it? 9 A. I believe that's correct. 10 MR. NICKENS: Your Honor, I'm going to 11 move to another subject if this is an appropriate 12 time. 13 THE COURT: All right. We'll take a 14 short recess. 15 16 (A short break was taken 17 at 10:19 a.m.) 18 19 THE COURT: We're back on the record, 20 Mr. Nickens. 21 MR. NICKENS: Thank you, Your Honor. 22 (10:44 a.m.) 5407 1 Q. (BY MR. NICKENS) Mr. Phillips, I'd 2 like to turn to the subject of the structure of 3 the original mortgage-backed securities 4 risk-controlled arbitrage and see if we can shed 5 some light on that issue. And in that regard, I 6 would like, if you could, to consider Exhibit B591 7 which is the United Savings Association of Texas 8 growth plan, July 1, 1985, through December 31, 9 1985, dated September 19th, 1985. 10 MR. NICKENS: Your Honor, we offer 11 B591. 12 MR. GUIDO: No objection, Your Honor. 13 I think it is already in the record in Gerald 14 Williams' testimony. I don't know the number, but 15 I think it's already in. 16 THE COURT: Well, we'll receive it 17 under this number. 18 Q. (BY MR. NICKENS) I'd like for you to 19 turn over to the third page of B591, Mr. Phillips, 20 which is actually Page No. 2 at the bottom. And 21 we see there the program for matching maturities 22 and controlling interest rate risk where 5408 1 Mr. Williams writes "The impetus for United's 2 liability growth during the first half of 1985 was 3 attributable to a program of which investments in 4 mortgage-backed and corporate securities were 5 matched with liabilities of similar maturity and 6 duration. And specifically, this asset/liability 7 match program supported incremental asset and 8 growth with minimal interest rate risk and 9 consisted of mortgage-backed securities, Fannie 10 Mae, Freddie Macs, and Ginnie Maes purchased and 11 funded with reverse repurchase agreements. 12 concurrent with the transaction, interest rate 13 swaps were initiated which effectively lengthened 14 their maturity and duration of the liabilities and 15 locked in a net interest spread." 16 And then he goes on, "And then 17 long-term corporate securities were purchased with 18 match funded -- and match funded with retail 19 broker deposits of similar maturity and duration 20 which also locked in a net interest spread." 21 Now, did this describe the programs of 22 which you were managing? 5409 1 A. Yes, it does. 2 Q. Now, if we look at the next page, which 3 is the fourth page of the document, it's 4 Page No. 3, US3007331, you see there at the top it 5 describes the growth of the mortgage-backed 6 securities portfolio of the risk-controlled 7 arbitrage. 8 Do you see it? 9 A. Yes, I do. 10 Q. And it indicates that as of 12-31-84, 11 it was zero? 12 A. Yes. 13 Q. And then as of 3-31-85, it was 127. 14 And then as of 6-30-1985 at 489. 15 Do you see that? 16 A. Yes. 17 Q. And -- now, this was the 18 risk-controlled arbitrage as opposed to any other 19 MBS that the institution may have owned? 20 A. Yes. 21 Q. And this was specifically the arbitrage 22 that you were in charge of managing? 5410 1 A. That's correct. 2 Q. And do you also see that along with the 3 growth in the balances of mortgage-backed 4 securities -- well, let me -- that you have a 5 growth in the reverse repos from zero to 116 to 6 465? 7 A. Yes. 8 Q. Now, once you had the structure in 9 place, did you grow it, to your recollection? 10 A. I believe that in both cases, corporate 11 securities and mortgage-backed securities, the 12 portfolios became larger than -- as stated here, 13 yes. 14 Q. The -- and then you indicate -- looking 15 at the yield rates, and you're indicating that 16 from 3-31-85 to 6-30-85, your net interest spread 17 on both portfolios -- right -- had decreased from 18 285 basis points to 176 basis points. 19 Is that what that's telling us? 20 A. Yes, it is. 21 Q. Now -- and if we turn to the next page, 22 Page 4 of the document, US3007332, you indicate 5411 1 that you have a duration match in the 2 mortgage-backed securities of 5.1 with 5.0, 3 correct? 4 A. Yes. 5 Q. And that's almost -- I mean, that's a 6 very close match in terms of these durations, is 7 it not? 8 A. Yes, it is. 9 Q. Now, explain -- and then the next page, 10 you've got a discussion of control of interest 11 rate risk. This is on Page 5. And I believe the 12 judge has heard that already. 13 But explain -- you indicated yesterday 14 that you were hedging the liabilities as opposed 15 to market values? 16 A. That's correct. 17 Q. Explain to the Court why that was. And 18 I know you've addressed some of this before, but 19 if you would, to review it with us. 20 A. At the outset, the risk-controlled 21 arbitrage or I should say the mortgage-backed 22 securities investment program targeted the spread 5412 1 between yields on those securities and financing 2 costs as opposed to a total return approach that 3 encompassed the market value of the securities. 4 And the reason was that we didn't want really 5 another dimension of uncertainty introduced. We 6 had the short funding risk to deal with. We had 7 prepayments to deal with. To require the movement 8 of market value to be incorporated in our return 9 under this objective would have been another risk 10 that, if hedged, would have taken basically all 11 the return out of the securities. One, it would 12 be like adding another leg to the stool which 13 wasn't needed. We had a balanced approach. We 14 had identified a source of return from the 15 portfolio. We had identified attendant risk that 16 we could deal with. To deal with the market value 17 would have required an entirely different kind of 18 hedge and that hedge, to be effective, would have 19 taken all the return out of the portfolio. 20 Q. Now, let's look at this. You had -- in 21 the ideal world which never happens but ideally, 22 the life of your liabilities would match that of 5413 1 the life of your assets, correct? 2 A. That's correct. 3 Q. And that's the reason that you sort of 4 serialized the swaps so that they would mature or 5 expire as you knew you were going to get 6 prepayments on the mortgage-backed securities? 7 A. That's correct. 8 Q. And the notion -- and one of the nice 9 things about mortgage-backed securities with all 10 the problems that we've seen is that they prepay 11 at par. Right? 12 A. That's correct. 13 Q. And so, even though you may have 14 interim differences in market value, if you can 15 get them to the point where they prepay, they 16 prepay at par? 17 A. That's correct. 18 Q. Now, how does that fit into the idea of 19 a cash flow model as opposed to a market value 20 model? 21 A. Well, it provides the certainty that 22 principal payments are received at par and you 5414 1 know how much that is. You may not know exactly 2 in what proportion they will be received, but 3 you're not dependent on market levels to achieve 4 the returns that you're modeling. 5 Q. So, the idea was to hold them either 6 until the market was favorable or until the time 7 when you terminated the entire arbitrage? 8 A. That's correct. 9 Q. And that was this notion about a 10 locked-in spread? 11 A. Yes, subject to the weaknesses of that 12 term, "locked in." 13 Q. It never was intended to convey that 14 "There is nothing bad that can happen to us. 15 We're going to make this X amount of money no 16 matter what"? 17 A. That's correct. 18 Q. Now, if you can look over to the next 19 page of Exhibit B591, you see there Mr. Williams 20 is reporting on a fourth quarter proposed 21 incremental investments and he's looking at 22 mortgage-backed securities in the volume of 5415 1 $500 million funded with reverse repos of 2 475 million. 3 Do you see that? 4 A. Yes. 5 Q. And you were looking at an interest 6 rate spread based upon the yield curve at that 7 very time of 110 basis points? 8 A. That's correct. 9 Q. And was that the United Mortgage 10 Finance structure? 11 A. The 500 million corresponds with what I 12 believe the United Mortgage Finance was. 13 Q. And that was in the fourth quarter of 14 1985? 15 A. Yes. 16 Q. Now, let me ask you to look at Tab 178. 17 MR. NICKENS: It is, Your Honor, 18 A10575. 19 Q. (BY MR. NICKENS) And this is a letter 20 from Mr. Williams to Mr. Roy Green of the Federal 21 Home Loan Bank of Dallas dated October 28th, 1985, 22 and is already in evidence. And I would ask that 5416 1 you turn over to Page CN52910. 2 Do you see there in Paragraph 3 a 3 description of a planned program for regular 4 investment and/or sale of corporate securities? 5 A. Yes, I do. 6 Q. And that is a description of your match 7 funding corporate securities portfolio along with 8 the mortgage-backed securities portfolio, is it 9 not? Or is this the match funding -- this is the 10 corporate securities. Right? 11 A. Yes. Paragraph 3 refers to corporate 12 securities. 13 Q. And you indicate in the paragraph under 14 Paragraph 3 under the corporate securities that 15 "There are to be -- periodic sales of these 16 securities are coincidental and occur either to 17 realize profits while maintaining or increasing 18 the spread or to avoid unexpected losses due to 19 changes in credit considerations. Accordingly, 20 there is no regular program to sell these 21 securities." 22 Do you see that? 5417 1 A. No. Can you refer me to a paragraph? 2 Q. I'm sorry. I started right here. 3 Middle of the paragraph under the numbered 4 Paragraph 3 where it's referring to sales of the 5 corporate securities. 6 A. Yes, I see that. 7 Q. Now, did that accurately describe the 8 objectives and program in the majority backed 9 securities? 10 A. No. I believe this is corporate 11 securities. 12 Q. I'm sorry. I apologize. I am talking 13 about the corporate securities. 14 A. Yes, it does. 15 Q. Okay. And Mr. Guido asked you whether 16 you had ever informed the regulators of sales in 17 that program. 18 Do you recall that? 19 A. Yes. 20 Q. And do you see here where it is 21 indicated by Mr. Williams that sales are 22 contemplated? 5418 1 A. Yes, I do. 2 Q. Now, let me ask you to turn to the next 3 page. Is that a scenario analysis that you 4 provided for the Federal Home Loan Bank on your 5 mortgage-backed securities? 6 MR. GUIDO: Which page? 7 MR. NICKENS: It's Page CN052911. 8 A. I don't know that I provided this. 9 Q. (BY MR. NICKENS) Okay. It is a 10 scenario analysis? 11 A. Yes, it is. 12 Q. And indicating rates going up and down 13 and the effect on the portfolio of those 14 movements? 15 A. Yes, it is. 16 Q. And in particular, it is indicating the 17 differences between swaps, caps, and collars and 18 how they react as hedging instruments in that 19 scenario. Right? 20 A. Yes. 21 Q. Now, I want to ask you to look at a 22 document that we have labeled B500. B500 is a 5419 1 chart labeled "USAT Mortgage Arbitrage" and 2 indicating at the top "Transfers from RC 1700-Joe 3 Phillips." 4 MR. NICKENS: Your Honor, we would 5 offer B500. 6 MR. GUIDO: No objection, Your Honor. 7 THE COURT: Received. 8 Q. (BY MR. NICKENS) Now, Mr. Phillips, 9 what is -- do you recall what an RC number is? 10 A. No, I don't. 11 Q. Does the term "responsibility center" 12 ring a bell? 13 A. Yes. 14 Q. And that was a way -- that was an 15 accounting of the various portfolios. Did you use 16 it? 17 A. I did not use it myself, no. 18 Q. But you were aware of its use by the 19 accountants? 20 A. Yes. 21 Q. Now, this summarizes the 22 risk-controlled arbitrage, the original one, does 5420 1 it not? 2 MR. GUIDO: What do you mean by "the 3 original one?" 4 MR. NICKENS: I'm talking about the one 5 that was put into place as distinguished from 6 United Mortgage Finance. 7 A. Yes, I believe that it does. 8 Q. (BY MR. NICKENS) And let's look at 9 the amounts. If you look the first one, under the 10 reverse repos, you've got Freddie Mac 13s and 11 Ginnie Mae 12s in an approximate amount just under 12 a hundred million dollars. Right? 13 A. That's correct. 14 Q. And then in the Series 2 or the 15 RC 7412, you've got Fannie Mae pass-through 16 certificate of 13 percent. Again, a bit under a 17 hundred million dollars? 18 A. Yes. 19 Q. Okay. Now, if we put the pieces 20 together, these six items, what approximate amount 21 do we get? 22 A. It looks to be approximately 5421 1 500 million or a little less. 2 Q. Okay. And in -- as allocated among 3 these various responsibility centers? 4 A. Yes. 5 Q. For accounting purposes? 6 A. Yes. 7 Q. And you believe this to be -- and we 8 don't have a date, but do you believe this to be 9 an accounting of the risk-controlled arbitrage 10 that you set up in the first and second quarters 11 of 1985? 12 A. Yes, I believe it represents that. 13 Q. And the securities described there are 14 the ones that you purchased from various sources? 15 A. Yes. 16 Q. Now, yesterday, you indicated that you 17 thought that you had purchased this from 18 Merrill-Lynch. And I note that we've got a number 19 of sources here: PaineWebber, Salomon Brothers, 20 Drexel. 21 Does that refresh your recollection 22 perhaps as to where those may have been purchased? 5422 1 And let me say, you know, as opposed to the 2 reverse repos, I don't know the answer to this 3 question. 4 A. I think it very likely that the 5 original securities were purchased from the same 6 dealer who arranged the interest rate swaps. So, 7 this -- that's the way I would remember it. So, 8 yes, this would refresh my memory. 9 Q. Okay. And let's address that point. 10 Typically, you would make arrangements with the 11 same dealer to get your reverse repos and your 12 swaps and the MBS, correct? 13 A. That's correct. 14 Q. Now, did you study the issue of 15 risk-controlled arbitrage before you made a 16 recommendation to go into it for USAT? 17 A. Yes, I did. 18 Q. Were you comfortable with your level of 19 understanding of that arbitrage principles? 20 A. Yes. 21 Q. And you thought it was a good idea? 22 A. Yes. 5423 1 Q. Let me ask you to -- tell the Court 2 some of the advantages that you saw for 3 risk-controlled arbitrage as applied to United 4 Savings. 5 A. Well, many of the approaches that were 6 discussed at that time had to do with growth, but 7 growth in a reasonably matched way so that the 8 risks inherent in the old savings and loan model 9 wouldn't be carried forth and that the growth 10 could be done in such a way as that a spread could 11 be extracted and the association could be built up 12 around and over the old model. And so, all the 13 discussions of additional investments were with 14 respect to some sort of matched approach. In 15 corporate securities, it was the long-funded CDs 16 to fund those. But with mortgage-backed 17 securities, with their complexity, it was deemed 18 that the basic approach should be, again, to find 19 a spread between the financing cost and the yield 20 and to willingly give up some of that spread in 21 order to make the short rate less volatile. And 22 so, we thought that it offered a number of 5424 1 advantages over what was done before and certainly 2 over any total return approaches which required 3 mark-to-market and other treatments that would not 4 have decreased volatility. 5 Q. And in order to get this protection 6 with the swaps against rising rates, you had to 7 give up the advantage that might otherwise accrue 8 from falling rates? 9 A. Yes, in some cases. In particular, 10 with interest rate swaps, if short-term rates had 11 fallen, we would not get that advantage because we 12 had created for ourselves a longer term and 13 somewhat higher fixed rate. 14 Q. Now, let me ask you to look at a 15 document that we have marked as Exhibit B237, 16 which is a research working paper by Mr. Edward 17 Hjerpe of the Office of Policy and Economic 18 Research of the Federal Home Loan Bank Board on 19 May 11th, 1987. And in particular, if you could 20 turn over to the third page and the introductory 21 paragraph, I'm going to read from that 22 introductory paragraph, Mr. Phillips, and ask you 5425 1 whether you agree or disagree with Mr. Hjerpe's 2 observations. 3 MR. NICKENS: I'm sorry. Your Honor, 4 the exhibit number is B1619. I have a tendency, 5 in order to help myself, to read out the tab 6 number to find it and not the exhibit number. 7 Q. (BY MR. NICKENS) In the middle of 8 that first introductory area paragraph, Mr. Hjerpe 9 reports "Many of these institutions are key 10 players in the thrift industry." And here's where 11 I'd like you to -- "RCA can yield a high return on 12 equity, can be tailored to allow differing levels 13 of interest rate risk, can increase capital 14 through retained earnings, and can achieve rapid 15 growth in the balance sheet of an institution with 16 little associated marginal cost." 17 And then he goes on to say "This 18 strategy, however, is not risk free." And he goes 19 on to discuss that. 20 Would you agree with those general 21 observations? 22 A. Yes, I would. 5426 1 Q. Of course, these are observations after 2 the falling interest rate environment of 1986 that 3 affected USAT's risk-controlled arbitrage. Right? 4 A. That's correct. 5 Q. Now, what is the role of leverage with 6 risk-controlled arbitrage? 7 A. Well, it's -- it's critical in deriving 8 the spread; that is, if the securities were not 9 purchased with borrowed money, there would be no 10 spread. And so, the leverage is a critical part 11 of making the spread. 12 Q. And let's see if we can illustrate that 13 for the Court. If you are buying at a 10 percent 14 haircut, let's say, so that you've put up $100,000 15 to buy a million dollars of the security -- 16 A. Yes. 17 Q. -- and your spread is 100 basis points, 18 that would be, what? $10,000 on a million 19 dollars? 20 A. Yes. 21 Q. And that 10,000-dollar return would not 22 be a very good return if you had invested a 5427 1 million dollars? 2 A. That's correct. 3 Q. But if you have invested $100,000 and 4 used leverage, that's a pretty decent return, is 5 it not? 6 A. That's correct. 7 Q. Now -- and that is the basic idea of 8 risk-controlled arbitrage? 9 A. Well, it's the basic idea of financial 10 leverage in any context, to magnify the return on 11 equity. 12 Q. Now, how do you go about deciding how 13 much leverage that you can use in your arbitrage? 14 A. Well, in our case, we used the standard 15 haircuts that were required by the reverse 16 repurchase market. And that, of course, may have 17 been tied into the consideration of liability 18 growth elsewhere that would not have been directly 19 part of my decisions. But the ability to borrow 20 on mortgage-backed securities was somewhat 21 dictated by reverse repo markets. 22 Q. So, you've got the market discipline 5428 1 plus whatever the regulations are -- 2 A. Yes. 3 Q. -- tend to determine the amount of 4 leverage? 5 A. Yes. 6 Q. And then you've got to make a decision 7 about what your risk tolerance is with regard to 8 the leverage? 9 A. That's correct. 10 Q. And if you could look over to Page 13 11 of Mr. Hjerpe's article, reading from the first 12 sentence in that carry-over paragraph, it says 13 "That goal is to lock in a rate of return on the 14 assets over the cost of funding for the life of 15 the asset regardless of changes in the interest 16 rate environment." 17 Do you see that sentence? 18 A. Yes, I do. 19 Q. Now, is that what you have described to 20 the Court as your spread analysis as opposed to a 21 market value analysis? Or perhaps you could 22 indicate how those two things relate, if they do. 5429 1 A. Well, he describes it as a return on 2 assets in this case. The objective would be the 3 same by analyzing through spread, and it's in 4 general agreement with what we were undertaking. 5 Q. Now, let me ask you to look over to 6 Page 30, which is the conclusion of Mr. Hjerpe's 7 article. Again, this is 1987 and this conclusion 8 says "Though RCA is a complex series of financial 9 transactions, it does not include any transactions 10 that are new to the thrift industry. The 11 packaging of all the transactions into a 12 highly-leveraged growth strategy is the only new 13 component. At present, it appears that a 14 reasonable spread can be attained by proper 15 implementation of such a strategy. However, these 16 opportunities have diminished and will probably 17 continue to diminish in the future to a point 18 where the cost meet or exceed the return. The 19 concept of an RCA strategy can, in fact, be quite 20 appropriate for a thrift. It includes active 21 participation in the mortgage markets, putting 22 long-term assets on the books of an institution, 5430 1 and attempting to fund these assets with 2 lower-cost liabilities. This is the typical 3 mission of a thrift. In addition, RCA is a 4 relatively low-cost and rapid method for inflating 5 the balance sheet of an organization. The 6 strategy can help problem institutions generate 7 income with little cost that may help to offset 8 negative earnings on other assets and, in turn, 9 improve overall return on assets and equity for 10 these institutions. The same concerns that are 11 relevant for any other thrift activities are also 12 of concern here -- namely, interest rate risk, 13 liquidity risk, and the associated problems of 14 implementation." 15 Now, were those thoughts consistent 16 with the thoughts that went into your decision to 17 implement a risk-controlled arbitrage at United 18 Savings? 19 A. Yes. 20 Q. Now, before you went into this 21 investment, you got presentations from various 22 investment bankers among other analysis, correct? 5431 1 A. Yes. 2 Q. And we have looked at some length at 3 Exhibit B377, which is at Tab 172. And I believe 4 Mr. Guido showed you this yesterday. 5 MR. GUIDO: What's the exhibit number? 6 MR. NICKENS: B377. 7 Q. (BY MR. NICKENS) That was a little 8 presentation booklet that -- or not a little 9 presentation booklet that Salomon Brothers gave 10 you on or about October 24th, 1984? 11 A. Yes. 12 Q. And this was done before you decided -- 13 or before you implemented the strategy, correct? 14 A. Yes. 15 Q. And did you consider the information 16 provided by Salomon Brothers and others? 17 A. Yes, we did. 18 Q. Let me -- just a few quick points here, 19 if we might, Mr. Phillips. If you would look over 20 to the -- I'm trying to find the conclusion. It's 21 at Page 253069. 22 Do you have that page, Mr. Phillips? 5432 1 A. Yes, I do. 2 Q. And this is part of the article -- the 3 1983 article by Mr. Waldman and Mr. Lupo dealing 4 with risk-controlled arbitrage for thrift 5 institutions published in October 1983. And I'd 6 like to focus, if we might, on the first full 7 paragraph there above "other investment options, 8 commercial mortgages." 9 Mr. Waldman indicates "As this analysis 10 indicates, the profits on the arbitrage stand up 11 to a surprising degree under an assortment of 12 tests relating to the market price of the 13 mortgages, the general level of interest rates, 14 and the timing of interest rate fluctuations. In 15 other words, the duration match provides a 16 significant degree of protection against interest 17 rate movements." 18 Now, was that consistent or 19 inconsistent with your thinking at the time that 20 you implemented the risk-controlled arbitrage 21 using mortgage-backed securities? 22 A. That is consistent. 5433 1 Q. And how was it that this structure was 2 able to hold up to various changes to interest 3 rate and other changes in the environment? 4 MR. GUIDO: Which structure? 5 Q. (BY MR. NICKENS) The structure of 6 risk-controlled arbitrage using mortgage-backed 7 securities that you implemented in the first two 8 quarters of 1985. 9 A. It performed because the structure was 10 immune from fluctuations in short-term rates, the 11 rates at which the securities were financed. 12 Q. And as to long-term rates, it provided 13 significant protection? 14 A. As to -- long-term rates were not 15 really a factor because we were just focusing on 16 the spread. 17 Q. Then let me ask you with regard to this 18 prepayment issue to look over at CN253082. It's a 19 little further on in the article or another 20 article. And do you see that? It's called 21 "build-up period" at the top? 22 A. Yes. 5434 1 Q. And then if we go down six paragraphs, 2 there is one that begins "The question in making 3 prepayments." 4 A. I see that. 5 Q. "The question in making prepayment rate 6 assumptions involves trying to estimate the 7 ultimate stabilized levels for these issues as 8 well as the band of coupons that eventually will 9 show some activity. Rules of thumb for the rate 10 savings necessary for making refinancing 11 worthwhile vary between 2 and a half to 3 and a 12 half percent. This implies that the edge of 13 refinancing band for Ginnie Maes should be 14 somewhere between Ginnie Mae 14s and 15s, which is 15 consistent with the experience so far." 16 Now, you know, I asked you earlier 17 about rules of thumb. He indicates the rule of 18 thumb of 250 to 350 basis points to make 19 refinancing worthwhile. 20 Was that the thinking at the time? 21 A. Yes, I believe that it was. 22 Q. And how did that -- it turns out that 5435 1 our experience since then has changed that, has it 2 not? 3 A. Yes. 4 Q. And how has it changed? 5 A. I believe that prepayment of mortgages 6 is somewhat more responsive to rate changes 7 because mortgage markets themselves are more 8 liquid and actually, I believe, easier to process 9 and actually get done. 10 Q. And how would that change affect the 11 perception of risk-controlled arbitrage using 12 mortgage-backed securities? 13 A. Well, to undertake that today, you 14 would have, very likely, closer points to consider 15 in rate moves to consider a rebalancing of the 16 portfolio. 17 Q. That is, you would be looking at 18 smaller movements than you would have thought have 19 been necessary back in 1984? 20 A. Yes. 21 Q. I want to ask you a few questions about 22 United Mortgage Finance. Mr. Guido asked you 5436 1 yesterday about a memo from you -- it's 2 Exhibit B785 -- to the file dated January 10th, 3 1986. 4 Do you recall that? 5 A. Yes, I do. 6 Q. Now -- and let me ask you to look at 7 B892, which is a similar memo dated March 25, 8 1986. 9 MR. NICKENS: Is B892 in evidence? 10 Your Honor, we would offer B892. 11 MR. GUIDO: No objection, Your Honor. 12 THE COURT: Exhibit B892 is received. 13 Q. (BY MR. NICKENS) Now, you expressed 14 yesterday some indication that you're not an 15 accountant and you don't know how that would have 16 come about; is that right? 17 A. That's correct. 18 Q. And do you notice the initials down at 19 the bottom of the page of the document? 20 A. Yes, I do. 21 Q. What are those initials? 22 A. JLW. 5437 1 Q. Are those your initials? 2 A. They are not. 3 Q. Are they the initials of Mr. Jim Wolfe? 4 A. I don't know what the L is, but it 5 could be. 6 Q. And he was an accountant? 7 A. Yes. 8 Q. And would that indicate some 9 collaborative effort on your -- the parts of both 10 of you to produce this memo? 11 A. Yes. I could not have drawn a 12 conclusion in the last paragraph. 13 Q. And you indicated yesterday that you 14 thought that it was just useful to have a 15 memorandum of what had occurred. Right? 16 A. Yes, I did. 17 Q. Let me ask you to -- I've put in front 18 of you Exhibit B690, which is a memorandum from 19 Mr. Jim Pledger to distribution dated 20 December 11th, 1985, entitled "Recent Federal Home 21 Loan Bank Financed Subsidiary Regulations." 22 MR. NICKENS: Your Honor, we would 5438 1 offer B690. 2 MR. GUIDO: No objection, Your Honor. 3 THE COURT: Received. 4 Q. (BY MR. NICKENS) Mr. Phillips, I 5 don't want to go through all this with you. But 6 Mr. Pledger was the lawyer -- counsel for United 7 Savings? 8 A. Yes. 9 Q. And he was responsible for regulatory 10 affairs? 11 A. Yes. 12 Q. And without going through this word by 13 word, he is here describing the regulations and 14 how they might apply to the formation of a new 15 subsidiary? 16 A. Yes. 17 Q. And what was it that happened that 18 disqualified United Mortgage Finance and required 19 that it be collapsed? 20 A. I believe the revere repurchase 21 agreements would have not been treated as off the 22 balance sheet, in effect, and, thus, would have 5439 1 caused a violation in the growth regulation at the 2 time of liabilities. 3 Q. There was a grandfathering provision 4 that allowed those reverse repos, if entered into 5 before the date of the regs, to be excluded from 6 the liability growth limitations. 7 Do you recall that? 8 A. I believe we were operating under some 9 assumption that our treatment might be an 10 exemption. 11 Q. But when they re -- reverse repos are 12 short-term borrowings. Right? 13 A. That's correct. 14 Q. And what became clear is that although 15 grandfathered for the first time, as soon as they 16 rolled over, you were going to have to include 17 them in your liability growth limitation -- 18 A. I believe that was the case, yes. 19 Q. -- or calculations? And so, that 20 change made it necessary for you to collapse the 21 structure? 22 A. Yes. 5440 1 Q. Now, was that expected or unexpected? 2 A. I believe the change in the 3 interpretation or that interpretation was 4 unexpected. We, I don't think, would have entered 5 into the transactions in the first place. 6 Q. Now, was this issue looked at from an 7 accounting point of view by the outside auditors? 8 A. I believe so, yes. 9 Q. Let me ask you to look at B819. 10 MR. NICKENS: And, Your Honor, I'll 11 explain to the Court, B819 is from the accounting 12 work -- the handwritten portions are from the 13 accounting work papers of Peat Marwick dealing 14 with this issue. They are very difficult to read 15 and, as a result, we had typed a version of this 16 that is at the top. But this is our work product 17 to assist both ourselves and the Court and 18 everybody else in being able to review this. And 19 we would expect that they -- that everybody would 20 have a chance to compare them. But it seemed to 21 make it a lot easier. And so, with that 22 understanding, we would offer B819. 5441 1 MR. GUIDO: Your Honor, we have no 2 objection as long as we have an opportunity to 3 review it and express an objection to the 4 accuracy. 5 THE COURT: All right. Received. 6 Q. (BY MR. NICKENS) And my only question 7 at this point with regard to B819, Mr. Phillips, 8 is: Is this an indication of the review by the 9 accountants of the accounting treatment for the 10 collapse of United Mortgage Finance? 11 A. Yes, it is. 12 Q. Mr. Phillips, I want to turn now just 13 for a moment to the question of the 14 asset/liability/liability committee and its 15 minutes. Mr. Guido put most of those minutes in. 16 I would like to offer, in addition to those, B516, 17 which is Mr. Crow's memo to you and Mr. Huebsch 18 and Mr. Bruce Williams dated May 31, 1985. 19 MR. NICKENS: We would offer B516. 20 MR. GUIDO: No objection, Your Honor. 21 THE COURT: Received. 22 Q. (BY MR. NICKENS) You see there that 5442 1 this is an indication of the organizational -- or 2 an invitation to attend an organizational meeting 3 of the asset and liability committee? 4 A. Yes, I do. 5 Q. Now, I'm going to ask you to look at 6 A1608 through 1641. 7 MR. GUIDO: What Bates are those? 8 MR. NICKENS: Your Honor, these were 9 introduced by Mr. Guido and they follow the asset 10 and liability committee minutes from June 12th, 11 1985, through October 6th, 1986. 12 MR. GUIDO: The first -- Your Honor, I 13 think that the packet of materials that were 14 introduced had the asset/liability/liability 15 committee meeting of January 10th, 1985. The 16 memorandum refers to an asset/liability/liability 17 policy committee. 18 MR. NICKENS: Your Honor, I'm just -- 19 MR. GUIDO: Are you going to use all 20 the asset and liability committee minutes, 21 Mr. Nickens? 22 MR. NICKENS: Your Honor, my intention 5443 1 is to get the witness to look at these with regard 2 to their interest rate forecasts which are done on 3 an every other week or a monthly basis with regard 4 to the issue as to what they were forecasting as 5 to interest rates at the time as recorded in the 6 ALCO minutes. And -- 7 THE COURT: What's the problem? The 8 exhibits are in the record. 9 MR. NICKENS: Yes, sir. There may be a 10 few that -- I think the problem is getting them 11 together here. But were they done as -- 12 MR. GUIDO: I think I have an extra 13 set. 14 Q. (BY MR. NICKENS) I'm going to put in 15 front of you these -- 16 MR. NICKENS: I have been asked to 17 point out, Your Honor, that there is what appears 18 to be a typographical error with regard to A1607 19 in that typically, the first date in the memo is 20 the date of the memo and then the subject is the 21 date of the meeting. And in this particular case, 22 it appears that the January 10th, 1986 meeting was 5444 1 erroneously reported as January 10th, 1985. 2 MR. GUIDO: Your Honor, we have no 3 objection to correcting the document because it 4 doesn't conform to the record as we understand it. 5 The committee was formed in late May or early 6 June, and this appears to be talking about 1986 7 interest rates. 8 Q. (BY MR. NICKENS) And if we can return 9 to 1608 or let's go to 1609. Let me ask you to 10 just turn over to 1611. Okay. You see Item No. 1 11 on Exhibit A1611 on the interest rate outlook? 12 A. Yes, I do. 13 Q. Now, is this something that the asset 14 and liability committee kept track of on a regular 15 basis? 16 A. Yes. 17 Q. And how did you go about determining 18 what your interest rate outlook was? 19 A. I believe that everyone on the 20 committee made some inputs as to the 21 interpretation of economic news and events. Ron 22 Huebsch, I believe, very often had viewpoints that 5445 1 he had developed from observing the market and was 2 very often contributed to this. 3 Q. And in July of 1995 (sic), in A1611, 4 Mr. Huebsch -- it was recorded Mr. Huebsch was -- 5 "thinks that we have seen the bottom of the 6 current interest rate cycle, primarily reflecting 7 the recent weakness of the US dollar in the 8 currency markets"? 9 A. Yes. 10 Q. And how would that kind of evaluation 11 of the interest rate outlook affect your 12 management of a risk-controlled arbitrage? 13 A. It would suggest that if rates were not 14 falling further, that with respect to a 15 risk-controlled arbitrage, prepayments would 16 likely not increase. 17 Q. Let me ask you to look at August 16th, 18 1985, which is at A1614. 19 What was the interest rate outlook 20 reported in August of '85? 21 A. It was suggested that very short-term 22 rates would be between 7 and three-eighths and 7 5446 1 and one-half percent. 2 Q. And it was described as being -- 3 remaining relatively stable? 4 A. Yes. 5 Q. And then if you look over to September 6 which is at 16 -- A1616, what were you looking at 7 in September of 1985? 8 A. We expected at that time that rates 9 would lie in a 100 basis point range of movement. 10 Q. And that was both for the short rates 11 and the long rates? 12 A. That's correct. 13 Q. Now, explain to the Court how that -- 14 the difference between -- well, how would the 15 shape of the yield curve affect your analysis of 16 whether to rebalance? 17 A. If long rates were expected to fall, 18 the attendant expectation of prepayment rate 19 acceleration would require us to consider 20 rebalancing at that point if we expected that 21 rates would fall precipitously. 22 Q. And typically, the yield curve on 5447 1 treasuries is an upward sloping curve? 2 A. Typically, it is. 3 Q. Meaning simply that one must -- if 4 you're going to invest long-term, you have to pay 5 a higher coupon to get the investor to go that 6 longer term. Right? 7 A. That's correct. 8 Q. And -- but the degree or slope of that 9 curve varies from time to time? 10 A. Yes, it does. 11 Q. And what is a flattening of the yield 12 curve? What does it describe? 13 A. It describes when short-term rates and 14 long-term rates are quite close and there is very 15 little additional yield available by extending 16 maturities. 17 Q. Now, you also had to make a decision 18 about how to set your CD rates, correct? 19 A. Yes. 20 Q. And how did your interest rate outlook 21 affect that decision? 22 A. If the yield curve was flat, it was 5448 1 entirely possible that people would be unwilling 2 to extend and that we would have to take that into 3 consideration that it would be harder to raise 4 longer-term money in such an environment and in 5 weighing it against our opportunities, we'd have 6 to be aware of that. 7 Q. And when we're talking about -- this is 8 the rate that the institution has to pay in order 9 to attract depositors? 10 A. That's correct. 11 Q. And that's a competitive market? 12 A. Yes. 13 Q. Now, let me ask you to look over to 14 Exhibit 1617 with regard to your interest rate 15 outlook at the end of 1985. And tell the Court 16 what your best thinking was concerning interest 17 rates as of that time on September 27th, 1985. 18 A. We expected stable rates and a 19 positively-sloped yield curve. 20 Q. For the remainder of the year? 21 A. Yes. 22 Q. Okay. And did that change in the end 5449 1 of October, which is 1618, or did it stay the 2 same? 3 MR. GUIDO: What's the date of 1618? 4 MR. NICKENS: It is dated October 22nd, 5 1985, Your Honor, and indicates the meeting 6 occurred on October 18th, 1985. 7 A. It reads that rates would remain flat 8 to gently upward projected rates. I take by 9 that -- and it says across the yield curve. I 10 take by that it means a positively-sloped yield 11 curve. 12 Q. (BY MR. NICKENS) And how would that 13 projection affect a decision to rebalance or not? 14 A. The decision to rebalance would, of 15 course, include the expectation of prepayment 16 rates changing. And a positive slope would 17 suggest that risk-controlled arbitrage 18 opportunities would continue to be available and 19 effective. I'd have to think about your question 20 a moment regarding the question about rebalancing. 21 In a flat rate environment, 22 essentially, the -- a flat curve environment, the 5450 1 risk-controlled arbitrage structure is not usually 2 effective. It's not available because there is 3 not enough spread left once everything is hedged 4 because you don't start with enough. If the yield 5 curve flattened, I suspect many aspects of the 6 risk-controlled arbitrage would come under 7 pressure because it required a positive slope to 8 work. 9 Q. Now, if you're projecting stable or 10 gently rising rates, is that an argument for or 11 against rebalancing? 12 A. That would be an argument against 13 rebalancing. 14 Q. And let's look at what you were 15 projecting at the end of October, which is at 16 A1619. Tell the Court what has been recorded as 17 being your interest rate projection as of the end 18 of October 1985. 19 A. At the end of October, we expected that 20 rates would remain essentially unchanged for two 21 to four months and then might shift downward over 22 time. 5451 1 Q. It indicated with a possibility of a 2 slight downward shift in yield curve? 3 A. Yes. 4 Q. So, you were recognizing that, whereas 5 you had been predicting stable or slightly rising 6 rates, you were now looking at slightly declining 7 rates? 8 A. Yes. 9 Q. Now, let's go over to November at 10 Exhibit 1620. What is reported there on your 11 interest rate outlook? 12 A. In November, it's characterized as a 13 somewhat bullish window meaning rates might be 14 expected to fall over the next four to five 15 months. 16 Q. And then the second paragraph there 17 says "It was agreed we should wait two months or 18 so before attempting to extend USAT's liability 19 maturities. This current window was considered an 20 opportunity to also begin a program of purchasing 21 caps or collars to hedge the association's 22 long-term gap. These subjects will be more 5452 1 specifically addressed in the next few weeks." 2 Now, what is the significance of that 3 consideration with regard to a rebalancing issue, 4 if it applies? 5 A. Well, it would alert us that the 6 likelihood or the possibility of prepayments 7 experienced changing should be considered in the 8 future. 9 Q. And let's look at the next report, 10 which is A1621. You're indicating there a 11 continued bullish outlook over the next four to 12 five months. The committee will continue to 13 address alternatives to reducing the association's 14 gap position during this window of 15 declining/stable interest rates. 16 Do you see that? 17 A. Yes, I do. 18 Q. And -- now, yesterday, we looked at the 19 roll-down transactions. And the first one of 20 those occurred in December or the settlement date 21 was indicated to be in December, correct? 22 A. Yes. 5453 1 Q. And how long, typically, is there 2 between a trade date and a settlement date for 3 mortgage-backed securities? 4 A. I believe it could be up to four weeks. 5 Q. Typically a month? 6 A. Yes. 7 Q. So, if you made a decision in November 8 to sell a security, you wouldn't show a settlement 9 date until sometime in mid-December? 10 A. That's correct. 11 Q. And your first rebalancing transaction 12 had a settlement date in December? 13 A. Yes. 14 Q. Indicating that that decision was 15 probably made sometime in November? 16 A. It could have been made, yes. 17 Q. Now, that particular transaction, if I 18 recall, involved a Ginnie Mae security. 19 Do you remember that? 20 A. I can't recall for sure now. 21 Q. Well, explain to the Court the 22 difference between the prepayment characteristics 5454 1 of Ginnie Mae securities as opposed to Freddie Mac 2 or Fannie Mae securities. 3 A. The Ginnie Mae mortgage-backed security 4 included loans which I believe were VA and FHA 5 loans. At that time, they were assumable loans 6 and, for that reason, were slightly less prone to 7 prepayment. 8 Q. Then let's see if we can go through 9 here. We're looking at November 20th, 10 Exhibit 1622. You were reporting that "Over the 11 next few months, a bullish interest rate scenario 12 was expected. The yield curve has flattened such 13 that the jump in treasury rates from one to two 14 years was now only about 70 basis points which was 15 down from over 100 basis points a few months ago. 16 It was agreed that we should begin pushing for 17 longer term deposits at this time. Additionally, 18 rate competition in longer term deposit maturities 19 has been reduced." 20 Now, were you guys over there just 21 ignoring interest rates? 22 A. No, we were not. 5455 1 Q. And let me ask you to look at the next 2 exhibit, which is 1623. Now, what's the date of 3 that meeting? 4 A. December 2nd, 1985. 5 Q. And -- well, the -- is that the meeting 6 or is that the date of the memo? 7 A. That's the date of the memorandum, and 8 it references a date of -- a meeting of 9 November 22nd, 1985. 10 Q. Now -- and what does it say about your 11 interest rate outlook at the end of 1985? 12 A. It says "We will not see much more rate 13 decline in the long end of the yield curve. 14 However, there may be room for more reductions in 15 the short end. It was anticipated a cut in the 16 discount rate could occur if the economy continues 17 its gently-growing pattern." 18 Q. Now, how would a determination that you 19 didn't expect to see more rate decline of the long 20 end of the curve affect a decision to rebalance? 21 A. It would suggest while some prepayment 22 experience above that expected might have 5456 1 occurred, there was probably no need to leapfrog 2 various coupons in rolling these coupons down. 3 Q. Okay. Let me ask you to look over at 4 what you were projecting on February -- at the end 5 of January, which is Exhibit 1625. 6 Now, Mr. Phillips, did you just make 7 these things up? I mean, did you put down 8 something that was convenient or did you seriously 9 consider them? 10 A. These outlooks were derived from the 11 participants in these meetings that had various 12 inputs. And Mr. Huebsch was key to that because 13 of his contact with the markets, but everyone had 14 an opinion as to how to interpret economic events 15 and develop these outlooks. 16 Q. Now, could you get by without just -- 17 without having any outlook? 18 A. No, you could not. 19 Q. You had decisions to make that required 20 you to make these evaluations. Right? 21 A. Yes. Every position -- long, short -- 22 was, in effect -- was based on some outlook. 5457 1 Q. Now, let me ask you to look at 2 Exhibit A1625 and what your interest rate outlook 3 was at the end of January. That's No. 1. Why 4 don't you just read it for the Court? 5 A. "Interest rate outlook in the near-term 6 rates in a three to six-month maturity range 7 should fall below 8 percent. However, no 8 reduction in the discount rate is expected. The 9 economy is getting stronger, and we have likely 10 seen the end of the fall in long-term rates." 11 Q. So, your best judgment was at the end 12 of January that you had bottomed out with regard 13 to the long-term rates? 14 A. That's correct. 15 Q. How does that affect a rebalancing 16 decision? 17 A. Well, our expectations about long-term 18 rates would be those that affect prepayment 19 expectations, as well. If we felt that they would 20 not fall further, we would be unlikely to expect 21 higher prepayments. 22 Q. Now, despite the exercise of your best 5458 1 judgment, you were flat wrong, weren't you? 2 A. Yes. 3 Q. And you made decisions based upon an 4 error in judgment as to what would happen to 5 interest rates? 6 A. Yes. 7 Q. Let me ask you to look at No. 4 on this 8 item on Exhibit A1625 where it states "It was 9 agreed investments would buy $100 million 10 mortgage-backed securities to match against the 11 100-million-dollar five-year collar which USAT 12 owns as a result of the partial dissolution of the 13 finance subsidiary in December 1985. The collar 14 has a floor of 7.75 percent and a ceiling of 15 11.5 percent." 16 Now, explain to the Court what that was 17 about. 18 A. This collar would have been a hedge 19 instrument that was residual to the collapse of 20 that financing subsidiary. And it's apparent from 21 this memorandum that there were no securities 22 explicitly matched against them. And the collar 5459 1 really did not perform any function for us without 2 something matched against it. 3 Q. Let me ask you to look over at what 4 your interest rate outlook was in February. And 5 it's at Exhibit A1626. Read to the Court what 6 your interest rate outlook was at that time. 7 A. "The treasury curve remains relatively 8 flat, with only a 160 basis point spread between 9 the 30-day and 30-year treasury yields. The 10 likelihood of the Fed coming in to reduce 11 short-term rates was thought to be minimal." 12 Q. Turn over to the next one at 1627, 13 Mr. Phillips, and read to the Court what your 14 outlook was on February -- the end of 15 February 1986. 16 A. "The yield curve remains relatively 17 flat. Rates could decline a little more with most 18 of the movement expected in the short end of the 19 yield curve." 20 Q. Now, at this point in time, you were 21 engaged in the roll-down, were you not? 22 A. Yes. 5460 1 Q. Now, if you -- what was that based upon 2 if you had an interest rate outlook of relatively 3 flat with little declines? 4 A. Well, the coupons we held had 5 experienced the prepayments above those expected, 6 and a roll-down to the next or more moderate 7 coupon was assumed to be sufficient. 8 Q. Let me ask you to look over at your 9 meeting of March 21 which is at A1629. And at the 10 end of the first paragraph, you indicated that 11 "The long end of the yield curve was expected to 12 remain relatively stable with not much potential 13 for any further decline." 14 Was that your outlook at the time? 15 A. Yes. 16 Q. Was that the outlook throughout the 17 first quarter of 1986? 18 A. I believe that in reviewing these 19 memoranda through this date by week or 20 periodically, that would be the case. It would 21 show that we did have that outlook. 22 Q. You were of the opinion throughout this 5461 1 period that you had reached the bottom of these 2 declines? 3 A. Yes. 4 Q. Now, let me ask you to look over to 5 your meeting of June 6th, which is Exhibit 1632. 6 Now, it indicates here that you were beginning to 7 see prepayments or expected to see prepayments; is 8 that correct? 9 A. We certainly expected that rates would 10 begin to fall and at least with respect to this 11 instrument described here which I believe was 12 backed by collateral, not unlike mortgage-backed 13 securities, prepayments were expected to advance. 14 Q. And by this point in time, you had 15 completed the roll-down? 16 A. I believe that we had completed the 17 roll-down at about this time. 18 Q. And look down at Item No. 4 on 19 Exhibit 1632. You were discussing putting 20 together a proposal to add up to 300 million in 21 mortgage-backed securities to the existing 22 portfolio? 5462 1 A. Yes. 2 Q. And what happened to that proposal? 3 A. I don't recall that it was undertaken. 4 Q. Now, let me ask you to look over at 5 Exhibit 1633, which is your meeting -- reporting 6 on your meeting of June 20th, 1986. And Item 7 No. 3 says "Goldman Sachs has presented a proposal 8 for hedging our current CMOs and First Boston is 9 expected to complete a presentation Monday, 10 June 23rd, on a program they have developed." 11 Now, yesterday, you were shown a 12 proposal from Goldman Sachs. Is that this 13 proposal or some different proposal? 14 A. I believe that what we looked at 15 yesterday was an analysis of profitability on the 16 risk-controlled arbitrage and this seems to be 17 addressing CMOs, not the same thing. 18 MR. NICKENS: Your Honor, it's noon. 19 I'm going to try to expedite and curtail somewhat 20 my questions so we can get Mr. Phillips off the 21 stand. Mr. Eisenhart has some questions with 22 regard to high-yield bonds and we want to make 5463 1 sure we leave some time for redirect so that they 2 can get out of here. But I believe I'll be able 3 to meet that goal. 4 THE COURT: All right. When? 5 MR. NICKENS: Well, by being able, over 6 the lunch hour, to go through this and to get to 7 some questions that I feel have to be answered and 8 maybe put in some documents, I think that I will 9 take maybe 30 or 45 more minutes and then 10 Mr. Eisenhart will have his examination. And we 11 believe we still will have time to allow Mr. Guido 12 for his redirect. 13 THE COURT: All right. We'll adjourn 14 until -- 15 MR. RINALDI: Your Honor, just for 16 purposes of scheduling, it is agreed among all 17 counsel that we should not try to schedule an 18 additional witness this afternoon? 19 MR. NICKENS: No. We will take the 20 entire afternoon. I feel certain of that, Your 21 Honor. 22 THE COURT: All right. 5464 1 (Luncheon recess taken at 12:01 p.m.) 2 3 THE COURT: Be seated, please. We'll 4 be back on the record. Mr. Nickens. 5 MR. NICKENS: Thank you, Your Honor. 6 (1:35 p.m.) 7 Q. (BY MR. NICKENS) Mr. Phillips, I'd 8 like to ask you some questions about the 9 roll-down. What was the reason for the roll-down? 10 A. The primary reason was to move the 11 portfolio holdings into mortgage-backed securities 12 with lower coupons that were expected to prepay at 13 a slower rate than those we had currently held. 14 Q. Was there any question that that was 15 the correct response to duration drift that you 16 get from decreasing rates? 17 A. I believe that is the correct response. 18 Q. And what about the timing of the 19 response? What were the factors that dictated the 20 timing of it? 21 A. We began the transactions at a point in 22 which, in our judgment, the prepayments on the 5465 1 held securities had begun to occur at above 2 average -- at an above expected rate. 3 Q. And did you do that as soon as you 4 recognized the issue? 5 A. Yes, but the recognition is not 6 instantaneous. It would be after evaluating 7 market movement, the effects on the securities we 8 held, and the outlook for prepayment within that 9 coupon category. It was something that would 10 develop over a period of time. 11 Q. Was any part of the motivation for the 12 roll-down associated with the recognition of 13 accounting gains? 14 A. It was not. 15 Q. And, indeed, what was the accounting 16 policy that USAT had at the time concerning the 17 substitution of the one MBS for the other? 18 A. Very early on, gains that were realized 19 from the sale of mortgage-backed securities were 20 rolled into the basis of the security purchased so 21 that it would reflect a lower cost on the security 22 purchased. And so, I believe no gain was actually 5466 1 recorded. 2 Q. Now, let's see if we can illustrate 3 that for the Court. If you have a security that 4 has appreciated in value because of declining 5 rates to, let's say, 105 and you sell that 6 security and you buy another security at par, 100, 7 then you take that 5 gain and you reduce your 8 basis or cost of the first security to 95, 9 assuming that the par amounts are the same and -- 10 A. And assuming 5 was the gain, yes. 11 Q. Okay. So, what is the effect of that 12 treatment on book yield? 13 A. The effect was that book yield would be 14 recorded higher because the cost of the security 15 was lower. 16 Q. So, for the same amount of income, you 17 got a lower cost basis and it will reflect a 18 larger percentage yield? 19 A. That's correct. 20 Q. And in that way of looking at it, is 21 there any gain at all from the sale of the first 22 security? 5467 1 A. No, there is not. 2 Q. Now, you were asked some questions 3 about an exhibit which is A10631 at Tab 572. 4 Do you recall this was your recordation 5 of the roll-down? 6 A. Yes. 7 Q. Mr. Guido asked you about it yesterday 8 at length? 9 A. Yes. 10 Q. Now, looking at the page that is at 11 OW2923, with that first transaction, can you 12 illustrate for the Court how the reduction in 13 basis is recorded? 14 A. In the left column, there is a heading 15 "realized gain." And in the next column, the one 16 we're discussing, that amount is 3 million 124. 17 That amount would be subtracted from the purchase 18 price of the security purchased which -- the 19 dollar price of which was 101. The extended 20 price, I think, is not shown. But the 3 million 21 124 would be subtracted from the cost to result in 22 the adjusted purchase price shown here of 94.904. 5468 1 Q. And the effect of that would be to 2 increase book yield and to recognize no gain? 3 A. That's correct. 4 Q. Now, Mr. Guido asked you yesterday 5 whether the purpose of any of these transactions 6 was to realize gain as opposed to recognize gain. 7 Was the purpose to realize gain? 8 A. No, it was not. 9 Q. And there -- taking recognition as 10 being an accounting concept, there was no 11 accounting gains under the policies then in 12 effect? 13 A. That's correct. 14 Q. So, it's not possible that there could 15 have been a book recognition purpose to these 16 transactions as long as that policy was in effect? 17 A. That's correct. 18 Q. And do you know the circumstances under 19 which that policy was changed? 20 A. It was my understanding that the public 21 accounting firm that audited United at some point 22 decided that was an inappropriate treatment and 5469 1 suggested it be changed. 2 Q. Now, with regard to these 3 calculations -- first of all, you performed these 4 calculations? 5 A. Yes. 6 Q. And using a computer or some program to 7 keep track of these things? 8 A. I entered this material on a computer 9 and set up the calculations myself. 10 Q. Now, as to the dealers, you called out 11 the dealers yesterday and I don't believe 12 Merrill-Lynch was among that group. 13 Does that indicate that, in fact, these 14 securities were bought from dealers other than 15 Merrill-Lynch? 16 A. Yes, it does. 17 Q. And let me ask you to look over at 18 Page 2928. 19 THE COURT: What exhibit is this? 20 MR. NICKENS: Your Honor, it's Exhibit 21 A10631. 22 MR. GUIDO: What page? 5470 1 MR. NICKENS: The page that I've asked 2 the witness to go to is OW002928. 3 Q. (BY MR. NICKENS) Now, you were asked 4 about this yesterday, Mr. Phillips. And I'd like 5 to go over it in a little more detail with you. 6 On the -- this is a chart that you 7 prepared? 8 A. Yes. 9 Q. And it is to describe the portfolio as 10 it was on August 31, 1985? 11 A. Yes. 12 Q. And the portfolio we're talking about 13 is the risk-controlled arbitrage using 14 mortgage-backed securities that was put into 15 effect in the first two quarters of 1985? 16 A. Yes. 17 Q. And the securities that you owned as of 18 8-31-1985 are described in the left-hand column? 19 A. That's correct. 20 Q. And they were Fannie Mae 12 and a 21 half's and 13s, Freddie Mac 12s and 13s, and 22 Ginnie Mae GPMs affectionately known as GPMs. 5471 1 Right? 2 A. Yes. 3 Q. At 12 and a quarter and Ginnie Mae 13s? 4 A. That's correct. 5 Q. And the total original purchase was 6 what? 7 A. I haven't added these up, but I believe 8 it was quite close to $500 million. 9 Q. And that the current face as of this 10 date was, like, 470 million? 11 A. Yes. 12 Q. Now, looking at the average price, 13 would that have been the purchase price for the 14 securities? 15 A. I believe that it was. I have no 16 reason to think we put market prices on here as of 17 this date. I believe these were purchase prices. 18 Q. And if that is the case, we look at 19 when you bought the Fannie Mae 12 and a half's, 20 they were at a slight premium? 21 A. Yes. 22 Q. And the same with the 13s, at a 5472 1 premium? 2 A. Yes. 3 Q. But the Freddie Mac 12s and 13s were 4 both bought either at a discount or at a very 5 slight -- or just about at par? 6 A. Yes. 7 Q. And your Ginnie Maes 12 and a quarters 8 were bought at a substantial discount? 9 A. Yes. 10 Q. And the Ginnie Mae 13s at a premium? 11 A. That's correct. 12 Q. So, your portfolio was a combination 13 of -- from a coupon point of view -- of premium 14 discount or slight discount and par coupons? 15 A. That's correct. 16 Q. Now, let's return, if we might, to 17 Page 2923, which is the chart. Can you tell from 18 this chart whether you were reinvesting the 19 proceeds? 20 A. Yes. 21 Q. And what do you conclude? 22 A. I conclude that substantially all the 5473 1 proceeds were reinvested. 2 Q. And in addition to that, there was 3 something close to $200 million of additional 4 mortgage-backed securities bought in February and 5 March? 6 A. Yes, that's correct. 7 Q. And what was the purpose of those 8 purchases, if you recall? 9 A. I don't recall the exact purpose. 10 Q. Then -- and looking at the CPRs, why 11 did you put that on the chart? 12 A. It's for information only. It does not 13 enter into any calculations on the chart. It was 14 just to remind us of where they were when the 15 transactions were done. 16 Q. And it indicates that you were slowing 17 the CPRs through this process of the roll-down? 18 A. That's correct. 19 Q. And that's what you intended to do; is 20 that right? 21 A. Yes. 22 Q. What is the effect of slowing the CPRs 5474 1 on the durations? 2 A. Durations would lengthen, generally 3 speaking. 4 Q. And the effect of increased 5 prepayments -- that is, more than expected -- 6 would have been to shorten durations? 7 A. That's correct. 8 Q. And -- so, is it fair to say that this 9 is a process of maintaining a match of durations? 10 A. Yes, a match against those of the 11 interest rate swaps. 12 Q. Now, Mr. Guido asked you something 13 about leapfrogging and described that as being -- 14 going from a premium situation into a deep 15 discount situation. 16 Do you recall that? 17 A. Yes, I do. 18 Q. Is that a good idea or a bad idea? 19 A. In one respect, it was a bad idea 20 because we had -- we would give up cash coupons 21 received disproportionately to the amount of 22 additional face value we could purchase of lower 5475 1 coupon bonds. And we could have lept too far to 2 the point where we were not able to generate 3 enough cash to use against our liabilities. 4 The second reason is that that, too, 5 would be a market call, a bet on outlooks and 6 expectations, that could have been as easily wrong 7 as what we did. 8 Q. Well, did you -- when you say "wrong," 9 have you looked at what would have happened had 10 you not rolled down? 11 A. No. 12 Q. But if prepayments had continued on the 13 same basis, you would have received -- you would 14 have never had any of these gains that you sold 15 the securities for, would you? 16 A. That's correct. 17 Q. You would have received your money back 18 at par and then you would have had to have 19 reinvested at whatever the current rates were? 20 A. Yes. 21 Q. So -- but you haven't made that 22 technical comparison about the effect of not 5476 1 rolling down? 2 A. No, I have not. 3 Q. So -- I mean, I'm not -- you said 4 something about a mistake. 5 Do you know whether this was a mistake? 6 A. Oh, no. I meant that we were wrong 7 about the direction of rates in our outlook. A 8 bet to roll down into 8 percent coupons or 9 something quite low was as likely to be wrong as 10 our position that rates were reasonably stable and 11 that small incremental moves would be sufficient. 12 Q. Let me ask you to look at a document 13 that has been marked as Exhibit B3713. Looking at 14 B3713, can you identify this as a listing of the 15 activity in the mortgage-backed securities from 16 December 1985 through June of '86? 17 A. Yes. 18 MR. NICKENS: Your Honor, we offer 19 Exhibit B3713. 20 MR. GUIDO: No objection, Your Honor. 21 THE COURT: Received. 22 Q. (BY MR. NICKENS) Now, Mr. Phillips, 5477 1 can you identify the initials at the bottom of the 2 page as the characteristic signature of Vivian 3 Carlton, one of the examiners in the case? 4 A. No, I cannot. 5 Q. If we look at the note, it says that 6 "This WP" -- work paper -- "is included to show 7 the activity of the mortgage-backed securities 8 trading from December '85 through June of '86." 9 Do you see that? 10 A. Yes. 11 Q. Now -- and if you can look to the 12 second page -- well, first of all, I apologize. 13 The first trade is indicated 12-18-85. And we can 14 see the date on this one. Right? 15 A. Yes. 16 Q. And you indicated earlier that that's 17 the settlement date, which meant that the decision 18 would have had to have been made sometime in 19 the -- probably in the early part of November and 20 then effectuate the trade? 21 A. Yes. Very likely in the previous four 22 weeks. 5478 1 Q. And similarly with all these other 2 dates that we go down the page here? 3 A. Yes. 4 Q. And the first transaction was to roll 5 down from a 12 and a quarter to a 12? 6 A. Yes. I see that. 7 Q. And if we go back to our chart, you've 8 got a very slight improvement in the CPRs from 9 that trade? 10 A. That's correct. 11 Q. And what is the significance of the 12 fact that we're dealing with Ginnie Mae product 13 here? 14 A. These are backed by, I believe, 15 generally assumable loans somewhat less likely to 16 prepay. 17 Q. And then the second transaction listed 18 here is one on January 17th and then another on 19 January 15th, correct? 20 A. Yes. 21 Q. And again, are of a roll-down variety 22 from 12 and a half Fannie Maes to 11 percent 5479 1 Freddie Macs in the first instance and then 12 and 2 a half Fannie Maes to 10 percent Fannie Maes in 3 the second instance. 4 A. Yes. 5 Q. Okay. Now, are these trades listed on 6 your chart, Exhibit A10631? And I'll refer you 7 over to the far right side of the -- 8 A. They are the two columns on the far 9 right side of the schedule. 10 Q. And so, in January -- in December -- 11 well, actually, in November, you began a 12 roll-down. You continued that in December -- 13 MR. GUIDO: The document doesn't say 14 November. I object to the characterization of the 15 document. 16 MR. NICKENS: Well, let me go through 17 that again, Your Honor. 18 Q. (BY MR. NICKENS) You would have had 19 to have made the decision on this first roll-down 20 transaction in November. Right? 21 A. Yes, I believe that would be correct. 22 Q. So, the decisions reflected here were 5480 1 to continue into -- began in November? 2 A. Yes. 3 Q. And then continued in December and 4 January? 5 A. That's correct. 6 Q. And, in fact, most of these February 7 transactions would have all been done in January? 8 MR. GUIDO: Objection. It's pure 9 speculation. If the witness knows or, if you have 10 a document, Mr. Nickens, I think you should 11 produce it. 12 THE COURT: I'll sustain the objection. 13 Q. (BY MR. NICKENS) What is the normal 14 settlement date from the trade date in the 15 mortgage-backed securities market? 16 A. Mortgage-backed securities of various 17 coupons at that time settled on various days of, I 18 believe, the third week of each month. And so 19 that a trade, when executed, would specify for 20 what month and most often, it was the next month. 21 So, it could be, I suppose, up to six weeks of a 22 lag between the trade date and the settlement 5481 1 date. 2 Q. And what would be the shortest period 3 of time? 4 A. Well, I don't know when there was a 5 cutoff for trades to settle on the normal week. I 6 can't be sure that the shorter settlements were 7 not possible. 8 Q. But on average, you take it to be the 9 four-week period you've described for us? 10 A. Well, it could be as much as six weeks 11 if you're in the previous month; but, yes. 12 Q. And, therefore, looking at these 13 settlement dates in February which ranged from 14 February 14th to February 27th, if that four-week 15 or seven-week period applies, then it would have 16 been in January? 17 A. That's correct. 18 Q. Now, let me ask you to go to the second 19 page of Exhibit 3713. Do you see over in the 20 right-hand column, there is a comment column? 21 A. Yes, I do. 22 Q. And there is an indication there on the 5482 1 3-19 trade of a pair-off? 2 A. Yes. 3 Q. Explain to the Court what a pair-off 4 is. 5 A. This would reflect a security or series 6 of transactions which were executed but offset 7 each other prior to settlement and, therefore, did 8 not settle. 9 Q. Now, on this page beginning with the 10 March 1986, do you see a number after the buy/sell 11 number there? 12 A. Yes. 13 Q. And in the first column, that's 7413? 14 A. Yes. 15 MR. GUIDO: Are these the pair-offs 16 again? 17 MR. NICKENS: No, Your Honor. 18 Q. (BY MR. NICKENS) Can you tell us what 19 that 7413 designates? 20 A. I believe it's an accounting category, 21 a group of some sort. 22 Q. The RC number we discussed earlier? 5483 1 A. It seems to be the same sort of 2 numbers, yes. 3 Q. And if you turn to the next page, do 4 you see actually a column, "RC"? 5 A. Yes, I do. 6 Q. Now, let me ask you to look at 7 Exhibit A11022 which is at Tab 295. And I'm going 8 to ask you to look over at Page -- the fourth page 9 of the document which is the one entitled "MBS 10 Portfolio and Related Interest Rate Swaps." 11 This is the page that lists the various 12 amounts in USAT Mortgage Finance, MBS 13 risk-controlled arbitrage. 14 Do you see that? 15 A. Yes, I do. 16 Q. Mr. Guido asked you about it. Now, if 17 we look down at June of '85, the total there is 18 769 million. 19 Do you see that? 20 A. Yes. 21 Q. Now, based upon the documents that we 22 have just examined which indicate that the total 5484 1 for your risk-controlled arbitrage was about 2 $500 million, would you conclude that there is 3 $269 million of MBS from some other source in this 4 number? 5 A. Yes, I would. 6 Q. And when you added the 150 million from 7 United Mortgage Finance after the collapse, that 8 would bring it to about 650 million, correct? 9 A. That's correct. 10 Q. And that's the number that had stuck in 11 your memory as to the amount of the arbitrage? 12 A. Yes, it is. 13 Q. Now, also, you were asked some 14 questions yesterday about some trades in the 15 performance reports of September of '86. 16 Do you recall that? 17 A. Yes, I do. 18 Q. And if you look at this chart, it 19 indicates that from August, September, and 20 October, there are minor changes in the totals. 21 Do you see that? 22 A. Of what year, please? 5485 1 Q. 1986. 2 A. Yes. 3 Q. It goes from 9-18 to 9-21 to 9-01. 4 A. Yes, I see that. 5 Q. Now, if there had been substantial 6 sales during those months, the securities would 7 either have to -- well, would either be incorrect 8 or the securities would have had to have been 9 replaced; is that correct? 10 A. Yes. 11 Q. Now, let me ask you to look over at 12 Tab -- excuse me -- A1402, which is at Tab 539, 13 and are the investment committee minutes of 14 United Financial Group and United Savings dated 15 July 23rd, 1986. And I'm going to ask you, 16 Mr. Phillips -- this document is already in the 17 record -- to look over at the second page. 18 And it says that "Mr. Phillips" -- this 19 is the second paragraph. "Mr. Phillips then 20 discussed the company's mortgage-backed security 21 program. He presented a list of the 22 mortgage-backed securities trades for July 1986 5486 1 and discussed this in detail. After full 2 discussion, it was determined that Mr. Phillips 3 should present a similar list at the second 4 meeting of each month and discuss these 5 transactions in detail. It was also determined 6 that Mr. Crow should request a representative of 7 either Drexel Burnham or Smith Breeden to make a 8 presentation to the company, preferably on a 9 Saturday, discussing mortgage-backed securities 10 tactics and strategies." 11 Do you see that? 12 A. Yes, I do. 13 Q. And then if you would turn over one 14 page, you see a chart that is -- actually, the 15 next two pages constitute the chart, do they not? 16 A. Yes. 17 Q. And did you prepare any part of those 18 two pages? 19 A. The second page, which is the 20 right-hand side of the chart, is in my 21 handwriting, yes. 22 Q. And do you know who did the left-hand 5487 1 side? 2 A. No, I don't. 3 Q. Now, the very first one indicates, 4 again, a pair-off. And you have written the 5 rationale on the second page. And could you read 6 that for us? 7 A. I think -- I believe it says "Salesman 8 could not deliver 9 and a half's. Sold at a 9 profit. More advantageous than dollar roll." 10 Q. And then the impact? 11 A. "Profit of $196,000 reinvested in 12 Freddie Mac 9s." 13 Q. Okay. Now, is that a dealer fail? 14 A. Yes. 15 Q. Explain to the Court what a dealer fail 16 is. 17 A. Well, from time to time, a securities 18 dealer may transact in a security and, when 19 settlement date arrives, is unable to deliver that 20 security and is obligated to do so by market 21 convention and standards. And since he's unable, 22 he needs to essentially extinguish his obligation 5488 1 by delivering it by borrowing it from someone else 2 or buying it back at an advantageous price from 3 the person that he sold it to. 4 Q. And in this particular instance, you 5 indicate that the price was more advantageous than 6 a dollar roll? 7 A. Yes. 8 Q. Now, from an accounting point of view, 9 do you know how that gets reflected on your books 10 and records? You bought a security, and then the 11 dealer is unable to deliver. You've got to 12 substitute security. 13 Do you know how that is recorded on 14 your books and records from an accounting point of 15 view? 16 A. I believe that the security that was 17 unable to be delivered was sold back and a 18 substitute security was purchased, and that's what 19 the books would reflect. 20 Q. So, you'd have a purchase and a sale on 21 the delivery date a month later and a new purchase 22 and then that would be the security that you would 5489 1 own? 2 A. That's correct. 3 Q. Even though, in fact, no real sale had 4 taken place? 5 A. Yes. 6 Q. Now, if we look at this chart, we go 7 down, the second one listed on the rationale side 8 says "coupon roll-down from Ginnie Mae 12s 9 necessary to stem prepayments." 10 That's in your handwriting? 11 A. Yes, it is. 12 Q. And then what have you written on the 13 impact? 14 A. Profit of some amount that I -- I can't 15 read. "Assets retained versus swaps." 16 Q. And the trade itself involved moving 17 from a Ginnie Mae 12 to a Ginnie Mae 9? 18 A. I see -- oh, yes, it does, yes. 19 Q. The sell and the buy are -- the sell is 20 below the buy. Right? 21 A. That's correct. 22 Q. Now, the next one indicates it was a 5490 1 dollar roll? 2 A. Yes. 3 Q. And what was the impact of that dollar 4 roll? 5 A. That dollar roll created a lower cost 6 of funds estimated at -- I believe it says 7 1.86 percent. 8 Q. Okay. And then the impact, it says 9 "That amounts to $126,000 over, what, 28 days? 10 A. Yes. 11 Q. Now, were such transactions good or bad 12 for the institution? 13 A. That was a beneficial transaction that 14 we would have ordinarily undertaken. It was 15 advantageous, yes. 16 Q. Did it have any impact on the arbitrage 17 features -- that is, the duration matching and 18 other factors of the arbitrage? 19 A. No, it does not directly because it is 20 not treated as a sale and a purchase if the rest 21 of the accounting rules governing dollar rolls are 22 followed. It is also true that the same face 5491 1 amount that is tendered in the dollar roll is 2 received back for -- so, for some period of time, 3 you would experience no prepayments on the roll 4 securities, which is another advantage. 5 Q. Then, if we come down further on your 6 list, you -- well, you say -- about midway, it 7 says "Paid on 2/32nds for swap Freddie Mac to 8 Fannie Mae. Dealer unable to deliver." And I 9 can't read that next word. Can you? "Unable to 10 deliver Freddie Mac." 11 A. Freddie Mac. 12 Q. And what was the effect of that dealer 13 fail? 14 A. We paid up 2/32nd of a percentage point 15 to buy Fannie Maes, which I believe was a narrower 16 differential. So, it was an advantageous 17 purchase. And it resulted in six basis points of 18 incremental yield or approximately $30,000 19 annually. 20 Q. So, that six basis points difference 21 produced $30,000 additional income or that was the 22 projection? 5492 1 A. Yes, that's correct. 2 Q. Then we come down and you've got 3 another coupon roll down, Ginnie Mae 12 to Freddie 4 Mac 9 and a half's, necessary to stem prepayments. 5 Do you see that? 6 A. This would not be the next one. 7 Q. No. I'm sorry. It's down here. 8 A. Yes, I see that. 9 Q. And then down below that one, you've 10 got another dealer unable to deliver, sold back at 11 a profit, which produced nearly $200,000 of 12 profit? 13 A. Yes. 14 Q. Again, that would have shown up on your 15 accounting records as a purchase and a sale and 16 then another purchase? 17 A. Certainly a purchase and a sale. I see 18 that in the next column, it was reinvested in -- I 19 believe it says 7s. I can't be sure. 20 Q. Or 9s perhaps? 21 A. 9s, yes. 22 Q. And if someone were looking at this and 5493 1 didn't know the purpose of these transactions and 2 they were just measuring turnover, they would get 3 some measure of turnover that you were turning 4 over your portfolio when, in fact, it didn't have 5 anything to do with that? 6 A. That's correct. I think without these 7 explanations, this -- the left side of this 8 schedule would be less meaningful. 9 Q. Now, we come down to -- after that one 10 to -- it says "Swap Freddie Mac to Fannie Mae. 11 Pay up to 1.5/32nds versus typical 10/32nds." And 12 then it indicates "yield pickup at six basis 13 points or $15,000 annually." 14 Do you see that? 15 A. Yes, I do. 16 Q. And let's go back and look over at the 17 next page about what we're -- what this is. They 18 are hard to line up, but can you find the one that 19 it relates to? 20 A. I see several Freddie Mac to Fannie Mae 21 swaps here. It could be one of several of these. 22 Same coupon, I believe. 5494 1 Q. And was that good or bad for the 2 institution? 3 A. They were small effects, but they were 4 incrementally beneficial. 5 Q. And did it have any material impact on 6 the arbitrage itself? 7 A. No. 8 Q. I'm talking about the structure of the 9 arbitrage. 10 A. No, it did not. 11 Q. Now, the next-to-the-last one, you've 12 got, once again, "Dealer could not deliver. 13 Synthetic dollar roll, cancelling trade, buying 14 later at lower price." 15 And that had the effect of making, 16 what, about $315,000 for the institution? 17 A. Yes. 18 Q. Now, Mr. Phillips, did -- in managing 19 the risk-controlled arbitrage using 20 mortgage-backed securities, did you use your best 21 judgment in making those decisions? 22 A. Yes, I did. 5495 1 Q. Did you ever do anything to harm -- 2 that you thought was intended to harm the 3 institution? 4 A. I did not. 5 Q. Did you ever do anything or were you 6 ever instructed to do anything to benefit someone 7 other than the institution? 8 A. No. 9 MR. NICKENS: I pass the witness, Your 10 Honor. 11 THE COURT: Mr. Eisenhart, do you have 12 some questions? 13 MR. EISENHART: I do. Thank you, Your 14 Honor. 15 16 CROSS-EXAMINATION 17 18 (2:14 p.m.) 19 Q. (BY MR. EISENHART) Good afternoon, 20 Mr. Phillips. 21 A. Good afternoon. 22 Q. We have met before, have we not? 5496 1 A. Indeed. 2 Q. I want to take just a few minutes with 3 you this afternoon and talk to you a little bit 4 about the high-yield bond portion of the case. I 5 will try my best to keep this brief and try my 6 best not to repeat any of the areas that you've 7 covered with Mr. Nickens. 8 I want to take you back for just a 9 moment to the time you were hired at USAT. And 10 you said, I believe, that you and Mr. Sullivan had 11 worked together at Southmark. Things didn't work 12 out there. So, you went to interview together 13 with USAT; is that right? 14 A. That's correct. 15 Q. Now, as I understand your explanation, 16 you had developed this notion of a high-yield bond 17 portfolio funded by long-term certificates of 18 deposit; is that correct? 19 A. I had developed the idea of a 20 high-yield bond portfolio that would be immunized 21 in some fashion against interest rate moves, yes. 22 I wasn't sure that exactly how it would be done, 5497 1 but I had come up with that approach. And I 2 wasn't sure that any thrifts were doing it. 3 Q. And was it your idea or your concept 4 that this would be funded with some type of 5 long-term liability? 6 A. Some long-term liability or some hedge 7 to create a long-term liability, in effect. 8 Q. And had you explained this concept that 9 you had to Mr. Sullivan when you were beginning to 10 look for another job? 11 A. Yes. 12 Q. And was it for that reason that he 13 wanted you to come along to this meeting at United 14 Savings? 15 A. Yes. 16 Q. And was it your understanding that one 17 of the things you wanted to do at that meeting was 18 to present this concept that you had as an idea 19 that might be implemented there? 20 A. Yes, I did. 21 Q. And I gather that meeting was 22 successful, at least from your standpoint, because 5498 1 they invited you to come back and have further 2 conversations? 3 A. Yes, that's correct. 4 Q. Now, initially, as I recall, you met 5 with Mr. Hurwitz and Mr. Huebsch; but when you 6 came back for further conversations, it was at 7 Mr. Williams' request? 8 A. Yes. 9 Q. And I think you said you then met with 10 Mr. Williams and with Mr. Crow and maybe with some 11 others, but at least with those two? 12 A. Yes. 13 Q. Was it your understanding after you 14 interviewed with Mr. Hurwitz and Mr. Huebsch that 15 you were hired? 16 A. No, it was not. 17 Q. So, you didn't view this second 18 interview that you were going to have with 19 Mr. Williams and Mr. Crow as just a formality? 20 A. No, I didn't. 21 Q. That was part of the interview process, 22 as far as you were concerned? 5499 1 A. Yes. 2 Q. Now, you had had experience with 3 high-yield bonds both at American General 4 Corporation and at Southmark; is that correct? 5 A. That's correct. 6 Q. Just for the record, what's your 7 working definition of a high-yield bond? What are 8 we talking about? 9 A. It would be a bond with a credit rating 10 by a major rating agency below what is considered 11 investment grade. For Moody's, that would be a 12 security rated below BAA. And for Standard & 13 Poors, it would be a security rated below triple 14 B. 15 Q. Now, as I understand it, compared to 16 high-grade corporate bonds, there is perceived 17 with these bonds to be some credit risk typically; 18 is that correct? 19 A. Yes. 20 Q. And the high yield that they pay, that 21 is the higher yield comparable to high-grade 22 corporate bond or treasuries as designed to 5500 1 compensate you for taking that credit risk, is it 2 not? 3 A. Yes. 4 Q. Now, you had had experience both at 5 American General and at Southmark in managing 6 portfolios of high-yield bonds; is that correct? 7 A. That's correct. 8 Q. There has been some talk throughout 9 your testimony of the concepts of trading and the 10 concepts of active management of a high-yield bond 11 portfolio. 12 Are these terms that have meaning to 13 you? 14 A. Yes, they are. 15 Q. In your view, is there a difference 16 between a portfolio that's a trading portfolio and 17 a portfolio that is actively managed? 18 A. Yes. 19 Q. Could you explain to the judge what the 20 difference between those two is? 21 A. A trading portfolio would be one in 22 which the securities were acquired with the 5501 1 intention to resell them at a higher price for a 2 trading profit. And the market value of the 3 security or the change in the market value would 4 represent a risk to that strategy that would 5 require either an acceptance of that risk or some 6 sort of hedge to manage it. An actively managed 7 portfolio is an investment portfolio held for 8 investment that, in the case of treasury bonds or 9 high grade bonds, would require some interest rate 10 outlook in order to set up the positions. In the 11 case of high-yield bonds, it really requires an 12 analysis of the underlying credits of the 13 securities and your outlook regarding those 14 credits. And so, in order to be paid for taking 15 credit risk and accepting credit risk, it would 16 require a very careful assessment of that risk. 17 Q. Now, were the high-yield bond 18 portfolios that you had been involved in managing 19 at American General and Southmark, were those 20 trading portfolios or portfolios that were 21 actively managed? 22 A. They were actively managed. 5502 1 Q. And was it this concept of an actively 2 managed portfolio that you were proposing to USAT, 3 as well? 4 A. Yes, it was. 5 Q. Now, you've said that a trading 6 portfolio and an actively managed portfolio have 7 somewhat different objectives in terms of what 8 you're looking for out of the portfolio; is that 9 right? 10 A. That's correct. 11 Q. With the trading portfolio, as I 12 understand it, you would be looking mostly at the 13 market price and the profits you might earn buying 14 and selling the stock based on market price? 15 A. Buying and selling the bonds, yes. 16 Q. Bonds. Excuse me. Whereas with the 17 actively managed portfolio, you're really more 18 concerned with the spread and the earnings over a 19 period of time. Is that -- 20 A. Yes. 21 Q. Now, besides the different objectives 22 in these two types of portfolios, would they 5503 1 typically be structured in some different fashion? 2 A. Yes, they would. 3 Q. What would be the differences in 4 structure that you would expect to see? 5 A. A trading portfolio wouldn't be matched 6 against anything, at least not in the fashion that 7 we matched our portfolio. The risks of -- in a 8 trading portfolio are somewhat different. The 9 risks that the market value that you settled at 10 would be less than you bought it at. And so, in 11 order to hedge that kind of portfolio, you would 12 use a different structure and that might mean 13 financial futures against long rates or something 14 that more closely approximated the risk of market 15 value movement. 16 Q. Versus in an actively managed portfolio 17 your funding is, what, more tied to the duration 18 of your expected assets? 19 A. In our actively managed portfolio which 20 was matched, we would carefully assess credit risk 21 and -- because we intended to hold the 22 securities -- and as a corollary or in addition to 5504 1 that fact, we were matching this against 2 longer-term liabilities. And so, that's the 3 primary and, I suppose, very important difference. 4 Q. Now, you said that you intended to hold 5 these securities and, yet, we've seen in some of 6 the documents and in responses -- in response to 7 questioning by Mr. Guido that, on occasion, there 8 were securities sold out of this portfolio for 9 gains, have we not? 10 A. That's correct, yes. 11 Q. Is that inconsistent, in your view, 12 with the concept of an actively managed portfolio? 13 A. No, it is not. 14 Q. In fact, when you managed your 15 portfolio at American General and at Southmark, 16 were bonds occasionally sold out of those 17 portfolios for gains? 18 A. Yes, they were. 19 Q. Is there anything unusual about that? 20 A. No. 21 Q. And is that consistent with the notion 22 of an actively managed portfolio? 5505 1 A. Yes, it is. 2 Q. Now, how did you go about selecting the 3 securities for your high-yield bond portfolio at 4 USAT? 5 A. Upon being presented a security either 6 through a new issue or a secondary offering, we 7 would take a look at this -- at the financial 8 statements of the issuer and determine or 9 otherwise assess the credit risk and evaluate 10 whether the yield being offered was sufficient for 11 that risk. 12 Q. How did you come upon the portfolios 13 that you took -- strike that. 14 How did you come upon the securities, 15 the individual bonds, that you would take under 16 consideration? Where would you find out about 17 them? 18 A. They would be offered to us by 19 securities dealers. 20 Q. Now, these would be the salesmen that 21 would call on you? 22 A. Yes. 5506 1 Q. And when you would perform your 2 analysis, you would look, you said, first at the 3 credit risk? 4 A. Yes. 5 Q. In analyzing the credit risk, how would 6 you go about doing that? 7 A. We would analyze the financial 8 statements and publications that might comment on 9 the industries that these companies were in and 10 any other news about the companies or their 11 industries to evaluate where we thought the credit 12 position was headed. 13 Q. Now, after you did your evaluation of 14 the credit risk, would you then be in a position 15 to make a recommendation with respect to whether 16 that bond should be purchased or not? 17 A. Well, we would then compare our 18 findings with the yields that were offered for 19 those securities; and at that time, we could make 20 a recommendation. 21 Q. And would the purpose of that 22 comparison -- that is, comparing the bond to the 5507 1 yield -- be to see whether the yield was 2 sufficient to compensate you for the credit risk 3 that you had found? 4 A. Yes. 5 Q. And assuming that, in your judgment, 6 the yield was sufficient to compensate you for 7 that credit risk, you would then be in a position 8 to make a recommendation? 9 A. Yes. 10 Q. To whom would you make your 11 recommendation? 12 A. Very early, in conjunction with Ron 13 Huebsch, I would make recommendations to senior 14 management of United Savings, which would include 15 Gerald Williams and very probably Michael Crow. 16 Q. Mr. Phillips, I'd like to have you take 17 a look a moment -- for a moment at a document 18 which has been marked B403. 19 Now, this is a memorandum dated 20 December 10th, 1984, from you to a distribution 21 list. And as I read the memo, the distribution 22 list consists of Mr. Bentley, Mr. Williams, and 5508 1 Mr. Crow; is that correct? 2 A. Yes, it is. 3 Q. Are you the author of this document? 4 A. Yes. 5 MR. EISENHART: Your Honor, I move 6 B403. 7 MR. GUIDO: No objection, Your Honor. 8 THE COURT: Received. 9 Q. (BY MR. EISENHART) Now, in B403, are 10 you recommending or at least informing them of 11 your interest in certain securities? 12 A. Yes. 13 Q. And there are four securities listed 14 there; is that correct? 15 A. Yes. 16 Q. Are these high-yield bonds? 17 A. Yes, they are. 18 Q. And would this be the typical way in 19 that time period that you would have presented 20 your recommendation with respect to a high-yield 21 bond? 22 A. Yes, it is. 5509 1 Q. Now, I noticed that the people that you 2 presented it to are Mr. Bentley, Mr. Williams, and 3 Mr. Crow. 4 Would they be the typical list of 5 people to whom you would make your recommendation 6 in that time period? 7 A. Yes. 8 Q. Was there any requirement that you 9 include either Mr. Hurwitz or Mr. Huebsch on that 10 list? 11 A. No. 12 Q. And, in fact, at any time when you 13 worked at United Savings Association of Texas, did 14 you feel that you had to clear any of your 15 high-yield bond purchases with Mr. Hurwitz? 16 A. I did not. 17 Q. Did you do so on any regular basis? 18 A. No. 19 Q. Did Mr. Hurwitz ever steer you toward 20 or away from any high-yield bonds? 21 A. Not before the fact. He complained 22 about a bond we actually did hold, or two. 5510 1 Q. And I think Mr. Guido had asked you 2 about those on Friday, did he not? 3 A. Yes. 4 Q. You said he was critical of something 5 called the Minstar bond; is that right? 6 A. Yes. 7 Q. And he was also critical of an Atlantic 8 City casino issue? 9 A. Yes. 10 Q. In those instances, did his criticisms 11 turn out to be well-founded? 12 A. I'm sure in the case of the Atlantic 13 City bond, it was. I don't really remember 14 exactly what happened at Minstar. 15 Q. I think you said -- and I may be 16 paraphrasing here -- but in the case of the 17 Minstar issue, he didn't like the way the company 18 was structured or the way they did business? 19 A. That's correct. 20 Q. I think you said it was a blind pool or 21 something like that? 22 A. Could be characterized as such, yes. 5511 1 Q. But you don't remember how that one 2 came out? 3 A. No. 4 Q. Are those the only two examples you can 5 think of where he ever had any after-the-fact 6 comment on one of your bond issues? 7 A. I believe that there was one other 8 holding that he was critical of, a Texas Air 9 issue. I don't remember that we sold it. 10 Q. So, I take it from that that while 11 Mr. Hurwitz was free to give you his views on a 12 bond, you didn't feel necessarily that you were 13 bound to take action based on his criticism? 14 A. Not necessarily bound, yes. 15 Q. You would take his advice as coming 16 from a knowledgeable person? 17 A. Yes. 18 Q. Mr. Guido had asked you -- I think he 19 made rather a big issue about it on Friday, as 20 well -- about the instance in which the Drexel 21 salesman was upset with you because you wouldn't 22 buy a bond and said Mike Milken was upset and he 5512 1 was going to call Mr. Hurwitz. 2 Do you remember that? 3 A. Yes. 4 Q. I think you testified earlier today -- 5 although Mr. Guido didn't ask you the question on 6 Friday -- that, in fact, when Mr. Hurwitz called 7 you back to say that Milken had called him, his 8 advice to you was "I told Milken that that's his 9 call to make, that I don't make that call"? 10 A. Yes, or words to that effect, yes. 11 Q. And did you buy that bond? 12 A. We did not. 13 Q. Now, what input did Ron Huebsch have in 14 your decisions with respect to particular bonds in 15 the high-yield bond portfolio? 16 A. His primary strength was assessing 17 markets; and although I don't believe he had a 18 background in corporate credit, he had a very good 19 sense for market direction and could be helpful in 20 developing a strategy to acquire a security. 21 Q. And would it be fair to say that you 22 used him as a resource in making your decisions 5513 1 about these bonds? 2 A. Yes. 3 Q. Would it be fair to say you used him as 4 a sounding board to sometimes test the strength of 5 your own views? 6 A. Yes. 7 Q. Did he ever order you to buy particular 8 bonds? 9 A. He did not. 10 Q. Did he ever order you to deal with 11 particular bond dealers, such as Drexel? 12 A. No. 13 Q. You mentioned that salesmen would call 14 on you from time to time. I gather you would also 15 get prospectuses on these bond issues? 16 A. Yes. 17 Q. And you mentioned that you also 18 sometimes attended road shows; is that correct? 19 A. That's correct. 20 Q. Now, after the investment committee was 21 set up, were you required to clear all your 22 purchases of high-yield bonds through the 5514 1 investment committee? 2 A. Yes. 3 Q. And would you do that prospectively? 4 That is, would you present them periodically with 5 lists of investments that you wanted to make? 6 A. Yes, I believe that it was in advance. 7 Q. Was there usually a discussion of these 8 recommendations at the committee? 9 A. Yes, there were. 10 Q. Were your recommendations always 11 followed? 12 A. I believe that they were not. 13 Q. So, there would be sometimes you would 14 make a recommendation and the committee would turn 15 you down? 16 A. Yes. 17 Q. To the extent your recommendations were 18 either accepted or rejected by the committee, were 19 those -- were those reflected in the minutes of 20 the committee? 21 A. I believe they were. 22 Q. So, we could go to those minutes and we 5515 1 could see the recommendations you made and whether 2 the committee accepted them or rejected them? 3 A. Yes. 4 Q. Did the investment committee ever steer 5 you toward any particular bonds or any particular 6 bond dealers? 7 A. They did not. 8 Q. Now, in structuring and managing your 9 portfolio, Mr. Phillips, was diversification one 10 of the things that you took into account? 11 A. Yes, it was. 12 Q. And what do you mean by 13 "diversification"? 14 A. It most often is used to describe the 15 distribution among various industry groups of 16 security holdings. 17 Q. The idea being that you want to avoid 18 undue concentration in a particular industry 19 group? 20 A. Yes. 21 Q. And was that something you paid 22 attention to from time to time? 5516 1 A. Yes, it was. 2 Q. And did you consider that the USAT 3 high-yield bond portfolio, during the period that 4 you managed it, was a diversified portfolio? 5 A. Yes. 6 Q. You've been involved or you had been 7 involved in -- with high-yield bonds for a number 8 of years before you came to USAT; is that correct? 9 A. Yes. 10 Q. Did you consider them an unduly risky 11 investment? 12 A. No, I did not. 13 Q. I'd like to have you take a look for a 14 moment at an exhibit called B1256. Now, I will 15 represent to you, Mr. Phillips, that Exhibit B1256 16 is something called a final interim report. And 17 basically, these are -- it is a document that was 18 prepared by an examiner who was looking at USAT in 19 the fall of 1986. 20 Have you ever seen this document 21 before? 22 A. No, I don't believe I have. 5517 1 MR. EISENHART: Your Honor, I would 2 agree, I think, that this witness is not the 3 proper witness to sponsor the document. However, 4 I would be glad to offer it at this time as a 5 document that does come from the examination work 6 papers and was produced for us by the OTS from the 7 examiner's files. And I'm told that they have 8 stipulated that this is part of the examination 9 files. 10 MR. GUIDO: I haven't stipulated 11 anything. Maybe one of my colleagues has. If 12 Mary can clarify that for us. 13 MS. CLARK: Yes, Your Honor. 14 MR. GUIDO: As long as the record shows 15 what you believe to be the case, I don't mind 16 agreeing to the stipulation. 17 MS. CLARK: Your Honor, Mr. Veis has 18 reviewed the documents that we have identified as 19 from the examination work papers and stipulated 20 that that is the source and, in this case, it is 21 from the examination as of May 1986. 22 MR. EISENHART: Well, I would offer 5518 1 Exhibit B1256. 2 MR. GUIDO: Based on that 3 representation, Your Honor, I have no objection. 4 THE COURT: Received. 5 Q. (BY MR. EISENHART) Mr. Phillips, I'd 6 like you to turn, if you would, to Page 11 of the 7 document. And you'll see the numbers written in 8 the lower right-hand corner. Now, on Page 11, the 9 examiner, who I think the record will show -- 10 MR. GUIDO: Is that Bates stamp 11 OW121463? 12 MR. EISENHART: Yes, it is. 13 MR. GUIDO: Would you please use the 14 Bates stamp numbers when they are available? 15 Q. (BY MR. EISENHART) On that page, 16 Mr. Phillips, the examiner, who I believe the 17 record will show was one Vivian Carlton whose name 18 appears on the first page of the document, makes 19 the following statement. "United Savings 20 Association of Texas, USAT, is engaging in 21 practices relating to its investment portfolio 22 which are highly risky and could lead to losses." 5519 1 She says "As of June 30, 1986, USAT has 2 468,271,626 or 10 percent of its assets in 3 non-liquidity securities holding portfolio." 4 Then she says "Junk bonds are 5 securities that offer double-digit interest rate 6 yields but which are risky and either lowly rated 7 or unrated by Standard & Poors and Moody's." 8 Would you agree that -- with 9 Ms. Carlton's observation that the USAT high-yield 10 bond portfolio was highly risky? 11 A. I would not agree. 12 Q. Now, she's making this observation, 13 according to the front page of Exhibit B1256, on 14 October 10th, 1986. That was just before you left 15 the institution, was it not? 16 A. Yes. 17 Q. I'd like to have you take a look at 18 another document, which is -- this is a document 19 which has been marked B3819. And it is a 20 memorandum and a report both dated October 21st, 21 1986, from Robert Sahadi, director of the Office 22 of Policy and Economic Research of the Federal 5520 1 Home Loan Bank Board, to bank board chairman Edwin 2 Gray, bank board member Donald Hovde, and senior 3 executive staff of the bank board. 4 Have you ever seen this document 5 before, Mr. Phillips? 6 A. Yes, I have. 7 Q. And is that recently in connection with 8 this case? 9 A. Yes. 10 Q. Did you have any awareness of this 11 document prior to that time? 12 A. No. 13 MR. EISENHART: Your Honor, I would 14 like to offer B3819 as a document from the Federal 15 Home Loan Bank Board. 16 MR. GUIDO: Objection, Your Honor. 17 There is no Bates stamp on this document to reveal 18 that it came from the bank board or for us to 19 authenticate the document. 20 MR. EISENHART: Well, Your Honor, I can 21 speak to that. This is a document that we had 22 sought throughout discovery in this case. We have 5521 1 a specific document request that we served on OTS 2 in this case asking for any evaluations by the 3 bank board of high-yield bonds. We were aware of 4 the existence of this document because there is a 5 reference to it in a newspaper article in another 6 document that's been produced and, as a matter of 7 fact, is already in evidence in this case. It's 8 the investment committee minutes of USAT dated 9 November 19th, 1986. There is attached to that -- 10 to those minutes a copy of a newspaper article 11 referring to this document. We have asked for it 12 by category, and we have made a specific request 13 on OTS to produce this document. They have never 14 been able to do so, they say. They have never 15 produced it. They say they have never been able 16 to locate it. 17 We located a copy of the document 18 approximately two weeks ago and, at that time, I 19 wrote a letter to Mr. Stearns. My letter is dated 20 October 20th, 1997, just slightly more than a week 21 ago, producing a copy of the document and another 22 document on the same subject matter that we had 5522 1 also found telling him that we had found these, 2 calling on him again to have OTS produce the 3 documents as they had been requested to do on many 4 occasions, and putting him on notice that in the 5 event OTS was unable to produce a copy from its 6 files that it would agree was authentic, that we 7 were going to produce the copy -- we were going to 8 use at trial the copy that we had found and that 9 we would view OTS' failure to produce this 10 document as a waiver of any objection based on 11 authenticity. 12 I've not had any response to the 13 letter. I don't think that there could be any 14 serious question about the authenticity of this 15 document. It is produced. It is obviously on 16 bank board letterhead produced by people that we 17 know were employed in these positions at the time 18 and is rather clearly, I believe, the document 19 that's referred to in the article that is already 20 in evidence. 21 MR. GUIDO: Your Honor, I have no basis 22 for ascertaining the authenticity of the document. 5523 1 As far as I understand, a search has been made for 2 this document that Mr. Eisenhart has claimed is a 3 Federal Home Loan Bank Board document for a number 4 of months, even a number of years. I myself have 5 sought to find the document and have never been 6 able to find the document. 7 I do not believe that Mr. Stearns' 8 failure to respond to the letter is -- constitutes 9 a waiver. It just means that Mr. Eisenhart has an 10 obligation to authenticate the document. It's my 11 understanding that his claim is that the document 12 was found in the files of his law firm. It seems 13 to me he can put somebody on to authenticate the 14 document from the files of his law firm. And if 15 there is somebody who knows that the document came 16 from the Federal Home Loan Bank Board, he can put 17 them on and testify to that effect. 18 But we have not been able to find the 19 document, Your Honor. There is no doubt that it 20 is referred to in a newspaper article, but I have 21 never agreed to the truthfulness of any of the 22 facts that are asserted in any newspaper articles 5524 1 as I have agreed to the introduction of documents 2 in this proceeding. If there is a way of 3 authenticating the document, I'm perfectly happy 4 to do it. But I have never been able to find the 5 document, nor have I been able to authenticate the 6 document. If Mr. Stearns has had other 7 communication with people, I'm perfectly happy to 8 agree to it. 9 MR. EISENHART: Mr. Stearns has never 10 responded to my letter, Your Honor. The document 11 was found in a binder of materials that were 12 obviously produced for -- by the Federal Savings 13 and Loan Advisory Council for a meeting in 1986. 14 This document and another document that 15 OTS has never produced on the same subject were 16 both part of that binder of materials. The binder 17 was in our library in an uncatalogued file. 18 Somebody stumbled across it by accident. We have 19 no idea of particularly where we got it from. It 20 obviously came from someone in or about that 21 period of time 11 years ago, but I don't think 22 that there can be any serious doubt to anyone who 5525 1 looks at the newspaper article that this is the -- 2 this is the study that's quoted in that. 3 We -- we have repeatedly sought the 4 discovery of this document in this case and we 5 have actually asked for depositions of OTS 6 officials to try to uncover the whereabouts of 7 this document and, quite frankly, a lot of other 8 documents that we had expected to be in the files 9 of the Federal Home Loan Bank Board in Washington 10 that they have never been able to produce. And 11 we've been turned down on that discovery. 12 THE COURT: I'll receive the document. 13 MR. EISENHART: Thank you, Your Honor. 14 Q. (BY MR. EISENHART) Mr. Phillips, 15 Exhibit B3819 is dated October 21st, 1986, is it 16 not? 17 A. Yes. 18 Q. And that's, by my calculation, just 19 about the same time -- I think there is about 11 20 days' difference from Ms. Carlton's comments in 21 the exam report; is that correct? 22 A. That's correct. 5526 1 Q. I'd like to direct your attention to 2 some of the statements in this study by Mr. Sahadi 3 and his memo to the chairman of the bank board and 4 ask whether these agree with your experience with 5 high-yield bonds. 6 The first page of the memorandum, he 7 says "The best statistical evidence says that 8 non-takeover junk bonds, when broadly diversified 9 and actively managed, significantly outperform 10 comparable portfolios of treasury issues even 11 after taking defaults into consideration." 12 Is that consistent with your 13 experience? 14 A. Yes. 15 Q. He goes on to say, "It is not 16 appropriate to single out junk bond holdings, per 17 se, because of their perceived risk because 18 consumer loans and credit card receivables, both 19 of which have non-negligible default rates, are 20 not singled out because of their riskiness." 21 Would you agree with that observation? 22 A. Yes, I would. 5527 1 Q. In the report itself, on Page 2, he 2 makes the following statement. And here, he is 3 quoting from an earlier report by Eric Hemel of 4 the bank board to Chairman Gray. He says "The 5 paper pointed out that high-yield bonds carry more 6 risk than investment-grade corporate bonds, but 7 they still have some advantages over unsecured 8 commercial loans originated by thrifts and over 9 participation interests thrift institutions 10 purchase in commercial loans originated by others. 11 There is a certain tradeoff between risks and 12 returns in investing in junk bonds. The empirical 13 evidence generally supports the hypothesis that 14 the return on high-yield bonds more than offset 15 the additional risks." 16 Is that consistent with your 17 experience? 18 A. Yes, it is. 19 Q. He goes on quoting the same paper to 20 say that "The paper pointed out that although junk 21 bonds have higher default and loss ratios than 22 bonds rated investment grade, the loss ratios on 5528 1 high-yield bonds seem to correspond fairly closely 2 with the loss ratios on regular commercial loans 3 issued by money center banks. That is not to say 4 that investment in junk bonds is low risk, but it 5 does indicate that precluding the holding of junk 6 bonds on the grounds of safety and soundness could 7 be deemed arbitrary in the absence of data to 8 substantiate the assertion of excessive risk." 9 Would you agree with that observation? 10 A. I don't have any experience with 11 commercial loans at money center banks, but the 12 part of his statement regarding rejection of the 13 junk bonds on the grounds of safety and soundness, 14 I believe, is arbitrary when you don't compare it 15 to other sorts of investment opportunities. 16 Q. On Page 9 of the report, he says "The 17 most recent study on junk bonds appeared in The 18 Wall Street Journal on September 29th, 1986. Of 19 the 86 billion in junk bonds issued since 20 January 1, 1980, 2.9 billion have defaulted. That 21 does not mean that there are 2.9 billion in losses 22 because junk bonds still trade at positive prices 5529 1 after default. This 3.4 percent default rate is 2 much less than the interest rate premium these 3 bonds enjoy over gilt-edge issues. Somewhat 4 surprisingly, Drexel Burnham has underwritten over 5 half the junk bonds over this period and the 6 default rate on these issues is only 1.9 percent." 7 He's really making two points there, 8 and let me take them one at a time. The first is 9 his observation that the 3.4 percent default rate 10 is much less than the interest rate premium these 11 bonds enjoy over gilt-edge issues. 12 Would that be consistent with your 13 experience? 14 A. Yes. 15 Q. He then says that, "Somewhat 16 surprisingly, Drexel Burnham, which has 17 underwritten over half the junk bonds over this 18 period, has a default rate on their bonds of only 19 1.9 percent compared to the 3.4 percent overall." 20 Would that be consistent with your 21 experience? 22 A. I don't recall the default rate of 5530 1 Drexel underwritten issues. 2 Q. Okay. Well, if he's right -- let me 3 back up for a second and ask you just a little bit 4 about Drexel. 5 In this period of time that we're 6 talking about when you managed the USAT portfolio, 7 '84 through '86, Drexel Burnham Lambert was a 8 major force in the high-yield bond market; is that 9 correct? 10 A. Yes. 11 Q. They had, as this paper suggests, well 12 over half of the new issues? 13 A. Yes. 14 Q. As a practical matter, would it have 15 been possible to manage a high-yield bond 16 portfolio of any size, any significant size, in 17 that period of time without dealing with Drexel? 18 A. I believe it would not. Their 19 contribution to the liquidity of the market was 20 critical in managing portfolios. 21 Q. And they had many high-quality issues, 22 did they not? 5531 1 A. They had many high-yield issues? 2 Q. Yes. 3 A. What do you mean? 4 Q. And of the high-yield issues, many of 5 theirs were a high quality, were they not? 6 A. Some were, yes. 7 Q. In fact, if the study that's quoted in 8 this report was right and that the default rate on 9 the Drexel bonds was only 1.9 percent compared to 10 a 3.4 percent overall default rate, if you had 11 constructed a portfolio without any Drexel bonds, 12 you would have an excessive risk of default in 13 that portfolio, would you not? 14 A. On average, you would have -- if you 15 purchased almost everything, I suppose, on 16 average, you would have a slightly higher 17 statistical default rate if you had not purchased 18 Drexel securities. 19 Q. You would certainly not have done 20 yourself any favors by deliberately excluding 21 Drexel from your portfolio, would you? 22 A. That's correct. 5532 1 Q. Turn to Page 11 of Mr. Sahadi's report. 2 At the bottom of that page, he says "Memorandum 3 R63" -- which is apparently entitled Commercial 4 Loan Investments, Federal Home Loan Bank Board 5 Guidelines for Safe and Sound Administrative 6 Practices dated July 18th, 1985 -- "provides 7 general guidelines for implementing a safe and 8 sound investment policy for commercial loans and 9 establishes criteria and procedures for making the 10 specific loans. Since junk bonds can be 11 considered commercial loans, this memo would apply 12 to them, although no specific mention of 13 high-yield corporate debt securities appears in 14 the memo. An investment in commercial loans or 15 junk bonds by management of an association must 16 include an evaluation of credit risk factors, the 17 potential profitability of the function under 18 general money market and competitive lending 19 market conditions, and the compatibility of the 20 function with the overall strategic goals." 21 Does that fairly describe the way you 22 evaluated potential high-yield bond purchases? 5533 1 A. Yes, it does. 2 Q. So, accepting his comparison to 3 commercial loan practices as accurate, then the 4 way you underwrote prospective high-yield bond 5 purchases was essentially the way an institution 6 would underwrite a commercial loan? 7 A. Yes. 8 Q. Turn to Page 13 of Mr. Sahadi's report. 9 At this point in the report, he is discussing the 10 advantages and disadvantages for the board of 11 various courses of action. And under Option 2, 12 which says "Limit junk bond holdings to a percent 13 of assets dependent upon an institution's level of 14 capital," he says "One of the disadvantages is 15 that investment in high-yield bonds would help to 16 improve the earnings of institutions with a low 17 capital level." 18 Do you agree with that? 19 A. Yes. 20 Q. And, in fact, that was precisely one of 21 the reasons why USAT was interested in 22 implementing a high-yield bond portfolio, wasn't 5534 1 it? 2 A. I'm not aware of that particular 3 reason. I really thought this was all my idea. 4 Q. You didn't realize that there were 5 great minds on parallel tracks? 6 A. No, I didn't. 7 Q. And finally, he goes on to make one 8 last observation -- one last observation and 9 conclusion. His one last observation appears at 10 the top of Page 14, at least the last one that 11 I'll refer you to. He says "Limiting an 12 investment that has no sufficient data to support 13 the proposition that it poses excessive economic 14 risks and threatens the safety and soundness of 15 insured institutions may raise policy implications 16 and potential legal difficulties." 17 Would you agree with that? 18 A. My experience in legal difficulties and 19 policy implications is not -- doesn't give me a 20 great deal of insight there, but I believe that 21 arbitrarily limiting it would be the incorrect 22 thing to do. 5535 1 Q. And would you agree with me that his 2 view of this seems to be markedly different than 3 the view expressed by Ms. Carlton in the 4 examination report where she describes it as 5 excessively risky? 6 A. Yes. 7 Q. And finally, would you turn to Page 16 8 of Mr. Sahadi's report? At the bottom of that 9 page, he makes his recommendation. He says, 10 "Therefore, we recommend that the suggested course 11 that the board should consider is not to outlaw or 12 prohibit investments in high-yield bonds but, 13 rather, to provide a framework for prudent and 14 sound investing." 15 Do you see what I refer to? 16 A. Yes. 17 Q. And to your knowledge, was that the 18 course of action that the bank board followed in 19 the 1986 time period? 20 A. I don't know the course of action they 21 followed. 22 Q. Well, they allowed institutions to 5536 1 consider -- continue to own high-yield bonds, did 2 they not? 3 A. Yes, they did. 4 Q. I want to go back for a moment and talk 5 a little bit more about your dealings with Drexel 6 Burnham Lambert. We've talked about their 7 prominence in the high-yield bond field. 8 Had you dealt with Drexel when you were 9 at your previous employers, American General and 10 Southmark? 11 A. Yes, I had. 12 Q. When you went to USAT, was there a 13 Drexel salesman assigned to the USAT account? 14 A. I believe that Ron Huebsch spoke to a 15 salesman from Drexel who was not the same person I 16 had dealt with. 17 Q. And who was the person that you had 18 dealt with from Drexel? 19 A. I had dealt with David Bergman. 20 Q. And when you say you had dealt with 21 him, this had been at your prior employers? 22 A. Yes. 5537 1 Q. Now, after you arrived at USAT, did you 2 continue to deal with Mr. Bergman? 3 A. Yes, I did. 4 Q. How did you manage to do that if there 5 was somebody else already calling on the USAT 6 account? 7 A. Well, someone else had already actually 8 been calling on Ron Huebsch in whatever capacity 9 he operated, whether for the behalf of USAT or 10 others. He had no objection to me continuing the 11 relationship I already had. 12 Q. So, the person from Drexel that you 13 dealt with when you were at USAT was somebody that 14 you selected, then, based on your prior dealings 15 with him? 16 A. Yes. 17 Q. This was not somebody that you were 18 ordered to deal with by anyone else? 19 A. That's correct. 20 Q. And was Mr. Bergman the person you 21 dealt with throughout the two years you were at 22 USAT? 5538 1 A. Yes. 2 Q. Now, you dealt with a number of other 3 brokers in the high-yield bond field, did you not? 4 A. Yes. 5 Q. And I think you had described earlier 6 who those different people were? 7 A. Yes. 8 Q. Did anybody ever push you to deal with 9 Drexel exclusively? 10 A. No. 11 Q. Did anybody ever push you to buy more 12 bonds from Drexel than you might otherwise buy 13 given their market share? 14 A. No, they did not. 15 Q. Were you aware that Drexel had any kind 16 of an investment banking relationship with MCO or 17 Federated? 18 A. Yes. 19 Q. Did that play any part in your dealings 20 with them as manager of the high-yield bond 21 portfolio? 22 A. No. 5539 1 Q. Did anybody ever attempt to link those 2 two together, to your knowledge? 3 A. Not to my knowledge, no. 4 Q. Would you say that your dealings with 5 Drexel were driven by market forces? 6 A. Yes. 7 Q. Did you ever make any efforts to hide 8 or conceal from the USAT regulators the fact that 9 you were dealing with Drexel? 10 A. No. 11 Q. I'd like you to take -- before we do 12 that, would you take a look at, once again, at 13 B1256? This is Ms. Carlton's interim examination 14 report. And I'll ask you to refer to 15 Page OW121465 which is also numbered Page 13. 16 On that page, Ms. Carlton makes the 17 following observation. She says "Per examination 18 and discussion with Joe Phillips, vice president 19 of investments, it was noted that many of the 20 issues referring to the high-yield bond portfolio 21 were underwritten/brokered through Drexel Burnham 22 Lambert, Incorporated, which is a 6 percent 5540 1 stockholder of United Financial Group, Inc., the 2 holding company. This has the appearance of a 3 conflict of interest." 4 Do you remember having such a 5 discussion with Ms. Carlton? 6 A. No. 7 Q. Were you aware in or about October 1986 8 that Drexel was a 6 percent stockholder of 9 United Financial Group, Inc.? 10 A. I remember finding out some years later 11 that Drexel was a holder. I'm sure I did not know 12 at that time. 13 Q. You don't remember any -- Ms. Carlton 14 or any other examiner ever coming to you and 15 saying that there was some conflict of interest in 16 dealing with Drexel because Drexel had stock in 17 UFG? 18 A. I do not. 19 Q. Do you think you would have remembered 20 that if someone had ever made such a statement to 21 you? 22 A. Yes. 5541 1 Q. Would you take a look at Exhibit B1045. 2 Going to pass that document over, Mr. Phillips. 3 MR. EISENHART: Your Honor, I'm passing 4 on to a new area. This might be a good moment to 5 take a short break. 6 THE COURT: We'll recess. 7 8 (A short break was taken 9 at 3:04 p.m.) 10 11 THE COURT: Be seated, please. We'll 12 be back on the record. Mr. Eisenhart, you may 13 continue with your cross-examination. 14 MR. EISENHART: Thank you, Your Honor. 15 (3:26 p.m.) 16 Q. (BY MR. EISENHART) Mr. Phillips, I 17 would like to talk to you for a moment about your 18 dealings with the regulators on the high-yield 19 bond portfolio and maybe, as a starter, we ought 20 to turn to Exhibit B405. It should be -- it's 21 been admitted already at Tab 165. It should be in 22 one of those folders right in front of you. 5542 1 Do you have it? 2 A. Yes, I do. 3 Q. Now, this is a memo from you to a list 4 of people detailing a visit with the Texas Savings 5 and Loan Department; is that correct? 6 A. Yes. 7 Q. Now, when you first began to manage the 8 high-yield bond portfolio at USAT, did you have a 9 practice of seeking approval from the Texas 10 Savings and Loan Department before you would make 11 a purchase or sale for that portfolio? 12 A. Yes, I believe we did. I think 13 Mr. Bentley helped us with the pre-clearance in 14 the early stages. 15 Q. But it was a pre-clearance procedure, 16 which is to say you got things approved in 17 advance; is that correct? 18 A. Yes. 19 Q. And you say you think that Mr. Bentley 20 assisted you in that? 21 A. Yes. 22 Q. Did he have -- he knew the people in 5543 1 Austin and had some rapport that he was able to do 2 that? 3 A. Yes. 4 Q. Now, after you had a few months 5 experience with this preapproval process, did you 6 find that it was somewhat cumbersome or difficult 7 to work that way? 8 A. Yes, it was. 9 Q. And did you have a conversation with 10 Mr. Bentley about that? 11 A. I don't recall discussing it directly 12 with him. I remember that it was a difficult 13 procedure and that at some point, it was 14 suggested -- I don't know by whom -- that we go to 15 Austin and visit Mr. Anderson. 16 Q. So, you and Mr. Bentley went from 17 Houston up to Austin to visit with Mr. Anderson? 18 A. Yes. 19 Q. Do you recall that trip? 20 A. I certainly do. 21 Q. Why is that trip so vivid in your 22 recollection? 5544 1 A. We flew in an aircraft piloted by 2 Mr. Bentley. 3 Q. Was this a comfortable trip? 4 A. It was not. 5 Q. When you got to Austin -- and you did 6 get to Austin, thankfully -- you met with 7 Mr. Anderson? 8 A. That's correct. 9 Q. And did you explain to him the 10 difficulties that you were having with 11 preapproval? 12 A. Yes, I did. 13 Q. And did you work out some sort of a 14 procedure with him? 15 A. Yes. 16 Q. What was the procedure that you worked 17 out? 18 A. We were to notify him monthly in 19 writing of securities holdings and to show changes 20 in the holdings, I believe, transactions, 21 purchases, and sales since the last report. 22 Q. So, you would send the Texas S&L people 5545 1 then each month a list of the holdings in the 2 portfolio as well as what had been added to it or 3 sold out of it in the prior month? 4 A. That's correct. 5 Q. And that was a procedure that was 6 agreeable to the people of the Texas S&L 7 Commission? 8 A. Yes. 9 Q. I'd like to mark -- Mr. Phillips, I'd 10 like to show you a document which has been marked 11 as Exhibit B406. This is a letter from you to 12 Mr. Anderson dated December 14th, 1984. 13 Did you send such a letter? 14 A. Yes. 15 MR. EISENHART: I offer B406, Your 16 Honor. 17 MR. GUIDO: No objection, Your Honor. 18 THE COURT: Received. 19 Q. (BY MR. EISENHART) Now, was this the 20 letter you wrote to Mr. Anderson confirming the 21 arrangement reached at this meeting? 22 A. Yes, it is. 5546 1 Q. And you say to him in this letter, "As 2 agreed, we will promptly report to you at the end 3 of each month our holdings and changes in the 4 holdings of non-liquidity securities"; is that 5 correct? 6 A. Yes. 7 Q. By "non-liquidity securities," you're 8 referring to the high-yield bond portfolio? 9 A. Yes, I am. 10 Q. And in the course of your discussion 11 with Mr. Anderson, was it clear -- did you make it 12 clear that there would be sales out of this 13 portfolio from time to time? 14 A. Yes. 15 Q. That's one of the things that's 16 referred to by "changes in the portfolio," is it 17 not? 18 A. Yes, it is. 19 MR. EISENHART: Your Honor, I would 20 like to offer at this time in the record a package 21 of documents. These consist of letters to and 22 from the Texas Savings and Loan Department on 5547 1 generally a monthly basis, although there may be 2 some occasions where there is no letter in a 3 particular month and then the prior month -- the 4 next letter will cover two months. But they were 5 generally sent monthly. These cover the period 6 January 17th, 1985, which is shortly after this 7 meeting took place, through October 28th, 1986, 8 following which Mr. Phillips left the association. 9 And these are a collection of the monthly reports 10 that he submitted each month to the Texas S&L 11 Department, as well as the letters from the Texas 12 S&L Department back to Mr. Phillips approving the 13 monthly report. 14 I don't propose to go into these with 15 him in any detail, but I would like them as part 16 of the record. I have attached on here a list 17 showing each of the documents, together with the 18 date of the document. And on the list, those that 19 are already in evidence -- and there are several 20 that have already been put in -- are highlighted 21 and it's noted that they are already in. 22 With Your Honor's permission, I would 5548 1 simply propose to read a list of these into the 2 record now. I provided this list to Mr. Guido 3 earlier so he can -- he would have it and he can 4 say whether they have objection to any of them, if 5 that's acceptable. 6 MR. GUIDO: Your Honor, we have no 7 objection to not even reading them into the record 8 but just listing the exhibit numbers and we will 9 stipulate that they are part of the record. 10 THE COURT: Are they consecutively 11 numbered? 12 MR. EISENHART: Not entirely. No, they 13 are not, Your Honor, in looking at the list. 14 THE COURT: I think we better make a 15 record of what numbers we're receiving. 16 MR. EISENHART: Fine. I will simply 17 read the list into the record. The following 18 documents are offered: Exhibits B429, 431, 435, 19 444, 453, 463, 467, 504, 507, 515, 521, 530, 544, 20 560, 570, 577, 587, 594, 607, 632, 656, 667, 674, 21 688, 796, 816, 817, 866, 906, 935, 946, 956, 972, 22 3829, 1031, 1090, 1093, 1167, 1229, 1242, and 5549 1 1293. 2 And for the sake of completeness, I 3 would note that the following, which are part of 4 this package, have already been received into 5 evidence. And those would be: B1075 which is 6 admitted at Tab 257, B1148 which is admitted at 7 Tab 258, B1219 which is admitted at Tab 259, B1236 8 which is admitted at Tab 260, and B1265 which is 9 admitted at Tab 261. 10 THE COURT: All right. The 11 documents -- exhibit numbers that you have just 12 read, other than those already admitted, are 13 hereby received. 14 MR. EISENHART: Thank you, Your Honor. 15 Q. (BY MR. EISENHART) Now, Mr. Phillips, 16 could I ask you just to take a look quickly at 17 that package? As I say, I don't intend for us to 18 go into any detail. But do those appear generally 19 to be the letters that you would routinely send to 20 the Texas S&L Department each month and then the 21 letters you would receive in response from them 22 each month? 5550 1 A. Yes, they are. 2 Q. Now, I'd like to refer you a moment to 3 a document which -- I'd like to ask you to take a 4 look at a document which has been marked as 5 Exhibit B1023. This is a memorandum to the file 6 from Ginger Baugh of the Federal Home Loan Bank of 7 Dallas dated June 2nd, 1986. And the memorandum 8 records a meeting which took place on May 21, 9 1986. And it would appear under the topic "issues 10 discussed" as though you were one of the persons 11 who was present at that meeting. 12 Do you see that reference? 13 A. Yes, I do. 14 MR. EISENHART: Your Honor, I would 15 move B1023. 16 MR. GUIDO: No objection, Your Honor. 17 THE COURT: Received. 18 Q. (BY MR. EISENHART) Do you have any 19 recollection, Mr. Phillips, recognizing that it's 20 11 years later, of meeting with people from the 21 Federal Home Loan Bank of Dallas in or around 22 May 1986 to talk about the high-yield bond 5551 1 portfolio? 2 A. I remember going to the Home Loan Bank 3 of Dallas. I don't know if this meeting took 4 place there or at our association. 5 Q. Under "purpose," the following 6 statement appears. It says "Following the 7 association's most recent meeting at the bank, 8 Mr. Berner from United invited Supervisory Agent 9 Halvorson, Twomey, and analyst Baugh to Houston to 10 observe the securities operation. As time was not 11 available for such a trip, the association 12 requested this meeting to explain to Supervisory 13 Agent Twomey, in particular, United's investment 14 in corporate debt and equity securities." 15 Not clear from that whether this took 16 place at the bank or not, but it's your 17 recollection that you attended at least one 18 meeting at the Dallas bank? 19 A. Yes, I did. 20 Q. And at that meeting, did you describe 21 the high-yield bond portfolio that you were 22 managing? 5552 1 A. Yes. 2 Q. It notes here under "issues discussed" 3 that apparently you did provide some information 4 on this occasion about the high-yield bond 5 portfolio. 6 Do you see that? 7 A. Yes. 8 Q. It goes on to note a discussion on the 9 following page where it says -- apparently, there 10 was some discussion about how the income from 11 securities transactions should be regarded. And 12 it says "According to Mr. Crow, income from 13 securities transactions should not be considered 14 extraordinary as United has made them a part of 15 its ordinary operations." 16 Do you see that? 17 A. Yes. 18 Q. Do you recall at the meeting you 19 attended at the Dallas bank any discussion of 20 whether income from securities was now a regular 21 part of USAT's operations? 22 A. No, I don't. 5553 1 Q. Would you have considered in or around 2 June of 1986 that, in fact, it was a regular part 3 of USAT's operations? 4 A. Yes, I would. 5 Q. Now, I'll ask you to take a look at a 6 document which is already in evidence. This is 7 B1042. And it's in evidence at Tab 232 and should 8 be in a folder right there in front of you. 9 Now, the meeting that we just referred 10 to with Mr. Twomey, et al, at the Dallas bank took 11 place in late May and Exhibit B1042 refers to a 12 meeting which took place several weeks later on 13 June 10th, 1986. 14 Do you see that? 15 A. Yes. 16 Q. And I believe you saw this document 17 earlier. It records a visit by a Dr. Terry Smith 18 and Dr. Jonathan Scott who were investment experts 19 at the Federal Home Loan Bank of Dallas who were 20 sent down to talk to you about your operations. 21 Do you recall that? 22 A. I did see this. I did see this 5554 1 earlier, yes. 2 Q. Okay. And I don't remember. Did you 3 have a recollection of this meeting? 4 A. I did not. 5 Q. Okay. In looking at the text of the 6 document -- and I think that there was some 7 discussion of this on Friday -- in about the 8 middle of the second paragraph, it says "While the 9 portfolio does require certain adjustments to keep 10 the durations matched, the management of the bond 11 portfolio does not involve bond swapping to pick 12 up yields or premature selling to capture capital 13 gains currently unrealized." 14 Do you see what I just read? 15 A. Yes. 16 Q. And you had a rather extended 17 discussion about that particular sentence with 18 Mr. Guido on Friday, did you not? 19 A. Yes. 20 Q. Now, one of the things that he talked 21 to you about was how you would view Dr. Scott's 22 use of the term "premature selling to capture 5555 1 capital gains." 2 Do you remember that? 3 A. Yes. 4 Q. And he asked you in particular how you 5 would define the word "premature" as used in that 6 context. And if I remember, you said that that 7 would refer to the selling of a bond prior to 8 maturity; is that correct? 9 A. Yes, I did. 10 Q. That, in fact, would be a very literal 11 definition of what "premature" would mean in that 12 context, i.e., prematurity? 13 A. That's correct. 14 Q. Would you agree with me, though, that 15 if you defined premature selling as the selling of 16 a bond prior to maturity, that would really 17 encompass any selling of a bond, would it not? 18 A. Yes. 19 Q. So that if, in fact, Dr. Scott meant to 20 use the word "premature" in the context in which 21 you have talked about it, he would be saying that 22 there would never be any selling of bonds; isn't 5556 1 that correct? 2 A. That's right. 3 Q. Can you imagine that you would have met 4 with him in June of 1986 and given him the 5 impression that there would never be any selling 6 of bonds in this portfolio? 7 A. No. 8 Q. I mean, that would be totally untrue, 9 would it not? 10 A. It would be untrue. 11 Q. And would there have been any reason 12 for you to say such a thing? 13 A. No. 14 Q. Would you agree with me that whatever 15 Dr. Scott meant by his term "premature selling to 16 capture capital gains," it could not have been the 17 meaning that we've talked about in this courtroom? 18 A. Yes, I agree. "Premature" is not a 19 word that's used in money management. 20 Q. So, if we were going to have a real 21 understanding of what that sentence means, we 22 would have to have Dr. Scott come into the 5557 1 courtroom and tell us what he meant by it? 2 A. Yes. 3 Q. Did you ever get any feedback from this 4 meeting with Dr. Scott and Dr. Smith? 5 A. I don't recall the meeting, nor any 6 feedback. 7 Q. Okay. They concluded this memo by 8 saying in summary, "Terry Smith and I" -- or 9 Dr. Scott concludes by saying "In summary, Terry 10 Smith and I are of the opinion that United Savings 11 is responsibly managing its 12 less-than-investment-grade debt portfolio. And 13 they say they were very impressed with 14 Mr. Phillips and feels he understands the risks 15 attendant in managing such a portfolio and is 16 capable of managing them." 17 Do you recall such a view ever being 18 conveyed back to you following the meeting? 19 A. No. 20 Q. I'd like you to take a look for a 21 second at a document that I think may have been 22 put into evidence earlier today. It's 5558 1 Exhibit B625. It's a letter from Mr. Williams of 2 USAT to Mr. Roy Green, president of the Federal 3 Home Loan Bank of Dallas. Rather than have you 4 search, I'll just hand you another copy of it. 5 MR. GUIDO: I think it's in as A51075. 6 MR. EISENHART: Fine. I will accept 7 that. 8 MR. GUIDO: It's the October 28th, '85 9 letter. 10 MR. EISENHART: Yes. What was the 11 number again. 12 MR. GUIDO: It's Tab 178. I think it's 13 A51075. 14 MR. EISENHART: Fine. We will call it 15 by that, Mr. Phillips. 16 Your Honor, I have another copy right 17 here, if you'd like. 18 Q. (BY MR. EISENHART) I'll ask you to 19 turn to a document that bears the bar code Bates 20 stamp No. OWO004627. 21 MR. GUIDO: Your document has a 22 different Bates stamp number than mine. 5559 1 MR. EISENHART: It has the number in 2 the lower right-hand corner 006748. 3 Q. (BY MR. EISENHART) Do you have the 4 page, Mr. Phillips? 5 A. Yes, I do. 6 Q. It states there -- and this is 7 Mr. Williams writing to Mr. Green in October 1985. 8 So -- well before the meetings that we just talked 9 about. He describes your portfolio. He says "The 10 match funded corporate securities portfolio listed 11 in Exhibit A as of June 30, 1985, is deemed to be 12 an optimal size. Therefore, no additional 13 investments are planned. The objective of the 14 match funded corporate securities portfolio is to 15 maintain a duration match spread." 16 He says "Periodic sales of these 17 securities are coincidental and occur either to 18 realize profits while maintaining or increasing 19 the spread or to avoid unexpected losses due to 20 changes in credit considerations. Accordingly, 21 there is no regular program to sell these 22 securities." 5560 1 Is that consistent with the operation 2 of the portfolio? 3 A. Yes. 4 Q. And those were, in fact, the reasons 5 for sales that you described earlier in your 6 testimony, were they not? 7 A. Yes. 8 Q. I'd like to direct your attention to 9 Exhibit B591. This was also put in evidence this 10 morning, but I have some extra copies of it right 11 here if that will make it easier. This was the 12 United Savings Association growth plan dated 13 September 19th, 1985. And I would like you to 14 turn to Page 4, which I think is actually the 15 fifth page of the exhibit? 16 MR. GUIDO: Is that OW04670? 17 MR. EISENHART: It is. 18 Q. (BY MR. EISENHART) The last paragraph 19 on that page -- this is now September 1985. It 20 says "In addition to the net interest margin 21 benefit provided by the corporate securities 22 portfolio, from time to time, opportunities exist 5561 1 for gains on sales of selected securities." 2 See what I referred to? 3 A. Yes. 4 Q. And this was a communication sent to 5 the federal regulators in September 1985; is that 6 correct? 7 A. Yes. 8 Q. Was there any effort made, to your 9 knowledge, Mr. Phillips, to hide from the federal 10 regulators the fact that securities were sold out 11 of this portfolio from time to time? 12 A. No, there was not. 13 Q. And, in fact, since they had already 14 been informed of that on at least several 15 occasions, any intention to do that or any effort 16 to do that would have been futile, would it not? 17 A. Yes. 18 Q. I'd like to talk to you for a moment 19 about a couple of issues that came up in the 20 context of your testimony on Friday concerning the 21 high-yield bonds. Mr. Guido went into -- at some 22 length with you the physical location of the 5562 1 trading room when you first moved to the trading 2 room at MCO and he asked you, in particular, how 3 often Mr. Hurwitz would come into that trading 4 room. 5 Do you remember that? 6 A. Yes. 7 Q. On the instances when Mr. Hurwitz did 8 come into the trading room, how often would he 9 actually talk to you in the context of the 10 high-yield bond portfolio? 11 A. I didn't work in the trading room 12 myself. I visited it, also. I had a separate 13 office. And so, if we came into contact in the 14 trading room, it would be because we both happened 15 to be there at the same time and he might ask me 16 about the market and I would be perhaps as likely 17 to ask the trader what was going on in the market. 18 Q. Well, let me ask you -- let me put it 19 to you this way. On the occasions when you 20 observed him in and around the trading room, how 21 would you compare his level of interest in, say, 22 the equities market or the equities trading as 5563 1 compared to the high-yield bond market and the 2 high-yield bond trading? 3 A. His interest in the equity areas was 4 much stronger. 5 Q. Now, Mr. Guido asked you whether MCO 6 and Federated purchased high-yield bonds. Do you 7 know whether they did or not? 8 A. I believe that they did not. 9 Q. Do you know why they didn't? 10 A. Not explicitly; but observing what 11 these companies did, there was no appropriate 12 investment strategy for companies like that to use 13 any kind of fixed income securities. 14 Q. This was not an investment in which you 15 would have expected them to have a high degree of 16 interest? 17 A. That's correct. 18 Q. Going back to the trading room for a 19 second. As I understand it, all of the trading 20 operations at USAT were eventually consolidated at 21 that room; is that correct? 22 A. Yes. 5564 1 Q. And that would have included the 2 equities trading, the high-yield bond portfolio, 3 and the mortgage-backed securities portfolio? 4 A. Yes. 5 Q. And, in fact, sometime shortly after 6 that, did not the bank move its executive 7 headquarters to that building? 8 A. Yes, it did. 9 Q. And would it have been your impression 10 that the trading room was consolidated and set up 11 there in anticipation of that move? 12 A. No, I would not have drawn that 13 conclusion. 14 Q. Okay. Finally, Mr. Phillips, I would 15 like to talk to you -- I think I asked you 16 earlier, Mr. Phillips, about the fact that selling 17 high-yield bonds out of a portfolio to take 18 capital gains was not unusual. And I think you 19 said it was not; is that correct? 20 A. Yes. 21 Q. And I believe you said that, in fact, 22 you had -- in the portfolios you had managed 5565 1 before coming to USAT, there were such sales? 2 A. Yes. 3 Q. Was it unusual for those kinds of sales 4 to take place at the end of the year? 5 A. It was not unusual. 6 Q. Going back, for example, to when you 7 managed the high-yield bond portfolio at the 8 insurance company, American General, would it have 9 been your experience there that securities were 10 often sold out of the portfolio at the end of the 11 year? 12 A. I did not manage the high-yield bond 13 portfolio at American General, but we, in a 14 variety of portfolios, realized gains at the end 15 of the year. 16 Q. And this was a normal part of an 17 actively managed portfolio in your view? 18 A. Yes. 19 Q. When you were at American General, how 20 extensive would this end-of-the-year trading 21 become? 22 A. It was quite extensive. We were 5566 1 preparing for it. We had asked people not to take 2 vacations in December. We had to await, in 3 effect, target amounts to be realized. And that 4 input came from elsewhere, but it was a fairly 5 well-organized activity. 6 Q. And that was not, in your view, 7 inconsistent with the notion of an actively 8 managed portfolio? 9 A. Yes, not inconsistent. 10 Q. Finally, Mr. Phillips -- and I know you 11 have longed to hear that word -- I would like to 12 ask you about several statements that were made by 13 Mr. Guido as part of his opening statement to the 14 Court in this case. And I've handed you and I've 15 handed the Court and I've handed counsel a copy of 16 the opening statement, although I don't propose to 17 offer it as an exhibit. I'm handing it simply so 18 that as I refer you to specific words, you can 19 follow and make sure that I'm saying them 20 correctly. And I will say that on your copy and 21 on the copies I've handed to the Court, I have 22 highlighted the sections that I actually propose 5567 1 to read. 2 I'll ask you if you turn first to 3 Page 89. And you will see there a statement that 4 reads as follows: "The evidence will show that 5 USAT, at Charles Hurwitz' and Ron Huebsch's 6 direction, purchased junk bonds from a number of 7 companies, including a sizable portion of that 8 portfolio that was underwritten by Drexel." And 9 this, you should know, is a statement that 10 Mr. Guido made to the Court at the start of the 11 case. 12 Now, do you recall that Mr. Hurwitz or 13 Mr. Huebsch ever directed you to purchase a 14 high-yield bond just because it was underwritten 15 by Drexel? 16 A. I do not. 17 Q. Did they mandate that any specific 18 portion of your portfolio come from Drexel? 19 A. No. 20 Q. And you've already said that it would 21 have been virtually impossible to run a high-yield 22 bond portfolio of any size in the '84 to '86 time 5568 1 frame without doing business with Drexel; is that 2 correct? 3 A. Yes. 4 Q. He goes on to state "The respondents 5 never sought approval for that -- for those 6 affiliated party transactions," meaning the 7 transactions with Drexel. And he's referring here 8 to an allegation they made in this case that 9 transactions with Drexel required approval because 10 Drexel had a stock ownership in UFG. 11 Did you ever have any reason to believe 12 that Drexel was an affiliate of USAT or that you 13 needed to get approval from the federal regulators 14 to buy Drexel underwritten high-yield bonds? 15 A. I did not. 16 Q. Did any regulator ever suggest to you 17 that they were an affiliate and that you needed to 18 get approval? 19 A. No. 20 Q. Given your reporting arrangements with 21 the Texas regulators and the Federal Home Loan 22 Bank of Dallas, would you have had the slightest 5569 1 hesitation about asking for approval of those 2 transactions if anybody had ever suggested to you 3 that approval was necessary? 4 A. I would not. 5 Q. And, in fact, you were reporting to the 6 Federal Home Loan -- or to the Texas regulators 7 and later to the Federal Home Loan Bank of Dallas 8 every month exactly what you were buying for the 9 portfolio, were you not? 10 A. That's correct. 11 Q. Were Drexel underwritten issues, in 12 your view, any riskier than issues underwritten by 13 others? 14 A. No. 15 Q. Did USAT pay any higher prices for 16 Drexel underwritten issues than other purchasers 17 of those issues? 18 A. No. 19 Q. Do you have any reason to believe that 20 the terms on which USAT acquired Drexel 21 underwritten securities were any less favorable to 22 USAT than the terms on which those securities were 5570 1 offered to others? 2 A. I do not. 3 Q. Now, were there occasions on which you 4 bought for the portfolio Drexel underwritten 5 securities in the secondary market in which they 6 were acquired from brokers other than Drexel? 7 A. Yes. 8 Q. And if you were to acquire a Drexel 9 underwritten security in the secondary market from 10 another broker, say, just for example, from 11 Merrill-Lynch, would the acquisition of that 12 security by USAT advantage Drexel in any way? 13 A. No. 14 Q. Mr. Guido made another statement. This 15 is at Page 89. I think it spills over on to 16 Page 90. "The respondents," meaning the 17 respondents in this case, "played crucial roles in 18 the management of that portfolio," referring to 19 the high-yield bond portfolio. "In fact, Charles 20 Hurwitz and Ron Huebsch directed that the 21 portfolio be cherry-picked for profits 22 periodically to bolster the capital of USAT and to 5571 1 forestall regulatory takeover." 2 Would you say that Mr. Hurwitz or 3 Mr. Huebsch played crucial roles in the management 4 of the high-yield bond portfolio at USAT? 5 A. No, I would not. 6 Q. Did either of them ever direct you to 7 cherry-pick the high-yield bond portfolio for 8 profits? 9 A. No. 10 Q. He says on Page 90, "That portfolio," 11 meaning the high-yield bond portfolio, "was not 12 managed as a consistent entire portfolio. That 13 portfolio was managed as specific assets to be 14 used and sold to bolster USAT's capital to 15 forestall regulatory control." 16 Was that true during any of the time 17 that you were in charge of the portfolio? 18 A. That was not true during that period. 19 Q. Did you manage this portfolio as a 20 series or collection of individual asset 21 purchases? 22 A. No. 5572 1 Q. You managed it as a portfolio, did you 2 not? 3 A. Yes, I did. 4 Q. In the same way you had managed 5 portfolios at American General and at Southmark? 6 A. Yes. 7 Q. He goes on to say on Page 90, "The 8 evidence will show, Your Honor, that the 9 regulators never were presented with the 10 opportunity to value that acquisition of junk 11 bonds from Drexel in light of the fact that Drexel 12 was underwriting a substantial amount of junk 13 bonds for MCO to finance its takeover activities." 14 Now, you advised the regulators -- 15 first the state regulators and then later both 16 federal and state -- on a monthly basis of all 17 your high-yield bond transactions, did you not? 18 A. Yes. 19 Q. And we saw from the documents that 20 those same regulators were aware that some of 21 those bonds came from Drexel. Isn't that the 22 case? 5573 1 A. I believe in some cases, the 2 underwriter or dealer firm could have been shown, 3 yes. 4 Q. Well, we saw, in fact, a document in 5 which Ms. Carlton, the federal examiner, said that 6 she thought there might be some conflict of 7 interest because Drexel owned stock in UFG? 8 A. Yes. 9 Q. So, nobody was hiding from the 10 regulators the fact that you were buying bonds 11 from Drexel? 12 A. That's correct. 13 Q. They clearly knew that. Would you 14 conclude that Drexel's relationship with MCO was 15 any secret? 16 A. No, I would not. 17 Q. You knew about it, didn't you? 18 A. Yes. 19 Q. And you were not an MCO employee? 20 A. That's correct. 21 Q. And once again, did that relationship 22 affect in any way what high-yield bonds you bought 5574 1 or how you managed the high-yield bond portfolio? 2 A. It did not. 3 Q. Finally, Mr. Guido says, again at 4 Page 90, "We believe the facts will demonstrate 5 that the respondents acted in reckless disregard 6 of the requirements of the law when they initiated 7 that junk bond portfolio with Drexel when they 8 failed to obtain the requisite regulatory 9 approval, and they did so because they did not 10 want the regulators to review those purchases in 11 light of Drexel's underwriting of junk bond 12 purchases for MCO." 13 Do you have the slightest reason to 14 believe that any of that's true, Mr. Phillips? 15 A. No, I don't. 16 Q. Did you consider that the high-yield 17 bond portfolio you put together was one that was 18 initiated with Drexel? 19 A. No. 20 Q. Did Drexel dominate that portfolio or 21 in any way influence its management? 22 A. No, it did not. 5575 1 Q. Did anybody ever tell you to favor 2 Drexel for any reason in the management of the 3 portfolio? 4 A. No. 5 Q. Did anyone ever tell you to favor 6 Drexel for any reason in the composition of the 7 portfolio? 8 A. No. 9 Q. Did you ever buy a security for that 10 portfolio based on anything other than the merits 11 of the security? 12 A. I did not. 13 Q. Did anyone ever tell you to hide, 14 conceal, or lie about the presence of Drexel 15 underwritten issues in the portfolio for fear that 16 the regulators might look at them in light of 17 Drexel's investment management activities with 18 MCO? 19 A. No. 20 Q. Finally, Mr. Phillips, one last 21 question. During the two years you managed the 22 high-yield bond portfolio at USAT -- that is from 5576 1 September '84 through the end of October 1986 -- 2 was that portfolio profitable? 3 A. Yes, I believe that it was. 4 MR. EISENHART: Thank you very much, 5 Mr. Phillips. That's all I have. 6 THE COURT: Do any of the other 7 respondents have any cross for Mr. Phillips? 8 MR. BLANKENSTEIN: No questions, Your 9 Honor. 10 MR. KEETON: None, Your Honor. 11 MS. CLARK: No, Your Honor. 12 THE COURT: Thank you. Mr. Guido, 13 redirect? 14 MR. GUIDO: Thank you, Your Honor. 15 16 REDIRECT-EXAMINATION 17 18 (4:06 p.m.) 19 Q. (BY MR. GUIDO) I'd like to direct 20 your attention to Exhibit B391, which was the 21 first document that you looked at today when 22 Mr. Nickens was questioning you. 5577 1 THE COURT: Could we just revert back 2 to Exhibit B625? Are we saying that is in 3 evidence? 4 MR. GUIDO: I think it was in 5 previously as A -- 6 MS. BOTTICELLI: -- 10575. 7 MR. GUIDO: 10574? 10575, Your Honor. 8 It was previously admitted. 9 THE COURT: Thank you. 10 MS. BOTTICELLI: What is the Tab 11 number? 12 MR. KEETON: 178. 13 THE COURT: Excuse me. 14 Q. (BY MR. GUIDO) B391 is the Paulin 15 memo, the United trading desk memo. I can show 16 you my copy. I just have one short question. It 17 says under "staff" under the United desk, "United 18 is in the process of hiring a full-time trader to 19 work under Ron's direction." 20 Do you see that? 21 A. Yes. 22 Q. Who does that refer to? 5578 1 A. The trader referred to would be Lauren 2 Jordan. 3 Q. Okay. And she's the woman that you 4 testified handled the trading of high-yield 5 securities in the secondary market? 6 A. Yes, she did. 7 Q. Now, Exhibit B410 is a memorandum that 8 you referred to as a document that set out the 9 types of analyses that you did in the analysis of 10 the mortgage-backed security portfolio. It says 11 that you did a schedule summarizing the terms of 12 spreads, rates, and duration. 13 Do you see that? 14 A. Yes, I do. 15 Q. Now, was that an analysis that referred 16 to the yield that you would expect under different 17 prepayments that you had assumed to exist with 18 regard to mortgage-backed security portfolios? 19 A. I believe at this date -- at this date, 20 I believe we would have begun investing in 21 mortgage-backed securities. I don't see that this 22 memorandum calls for those prepayment speeds to be 5579 1 included in such a report. 2 Q. Okay. So that there is no analysis 3 that was done as of December 20th of 1984 of 4 yields based on different assumptions about 5 prepayment rates? 6 A. Well, none that was documented in this 7 fashion. 8 Q. Now, what were the typical prepayment 9 rates in December of 1984 for a current coupon or 10 par coupon mortgage-backed security? 11 A. I don't recall. 12 Q. What were they for those that were 200 13 basis points out? 14 A. If you mean 200 basis points higher -- 15 Q. Yes. 16 A. -- than current coupon, I believe from 17 information you've shown me that such securities 18 had experienced higher prepayment rates, at least 19 in the past. 20 Q. And what was the magnitude? Do you 21 recall? 22 A. For the period of time that the 5580 1 graphs -- 2 Q. We're talking about 1984. 3 A. No, I don't recall. 4 Q. Now, you testified that at the outset, 5 that when you were approached with various 6 alternatives, that you ended up purchasing the 7 first mortgage-backed securities from 8 Merrill-Lynch. 9 Do you recall that testimony? 10 A. Yes. 11 Q. Do you still stand behind that 12 testimony today? 13 A. I've been shown material that suggests 14 that was incorrect. 15 Q. And what material was that? 16 A. The spreadsheet that basically tracks 17 the roll-down of coupons. 18 Q. Well, were there high coupon 19 mortgage-backed securities that were held after 20 March of 1986? 21 A. I don't recall. I'd have to look at 22 the schedule. 5581 1 Q. You don't recall. You'd have to look 2 at that. 3 Did the roll-down include the roll-down 4 of all mortgage-backed securities that had been 5 purchased prior to June of 1985? 6 A. I don't know. 7 Q. You don't know? But you wouldn't 8 dispute the documents if they showed that there 9 were documents or there were mortgage-backed 10 securities that were purchased prior to June of 11 1985 and were not rolled down as reflected in that 12 schedule? 13 A. I would not. 14 Q. And is it likely that there were such, 15 in your recollection? 16 A. I think it unlikely, but possible. 17 Q. Let me show you -- well, let me show 18 you a portion of Exhibit A1127, which is the 19 Coopers and Lybrand study. And let me show you a 20 transaction. It shows that as late as April, 21 there was a settlement transaction of -- I'm 22 sorry. It was as late as -- as late as June 13th, 5582 1 1986, there was a sale of a Ginnie Mae 13 and a 2 half mortgage-backed security. 3 Did you purchase any mortgage-backed 4 securities in the course of the roll-down that had 5 coupons as high as 13 and a and a half? 6 A. I believe that we did not. 7 Q. Anything that was as high as 13 and a 8 half had to have been purchased prior to June of 9 1985. Right? 10 A. Certainly before the period of the 11 roll-down. 12 Q. Now, you testified that with regard to 13 the transactions that were referred to as the 14 collateral, I think, for the swaps or the collars. 15 Do you recall Exhibit A10578 which was dated 16 November 7th, 1985? 17 A. Yes. 18 Q. Okay. And you recall testifying that 19 that is a recommendation to purchase collars to 20 hedge the collateral for the swaps in that 21 situation? Do you recall that testimony? 22 A. Yes. It was to hedge collateral for 5583 1 some interest rate swaps, yes. 2 Q. Now -- and the collateral being 3 mortgage-backed securities? 4 A. Yes. 5 Q. Okay. And that the reason you needed 6 to use collars to hedge the risk in that situation 7 is that you were switching from high-yield bonds 8 as collateral to mortgage-backed securities as 9 collateral. Wasn't that your testimony? 10 A. The reason we needed to do some hedge, 11 yes. I believe we chose collars as some optimal 12 choice in this group. 13 Q. And you said that the use of 14 mortgage-backed securities created a problem that 15 the junk bonds didn't create. 16 Do you recall that testimony? 17 A. Yes. 18 Q. What was that problem? 19 A. The duration mismatch. 20 Q. The prepayments? The duration mismatch 21 caused by the prepayments? Isn't that it? 22 A. Well, had we used high-yield bonds as 5584 1 we had before, we had those matched. And pledging 2 them, since they were not already securing any 3 other obligation, was easy to do. They were free 4 and clear. And using mortgage-backed securities, 5 we had a much longer-term security with different 6 characteristics that required some sort of hedge 7 to keep it in line. 8 Q. And it was a collar that was used. 9 Right? 10 A. Yes. 11 Q. And the collar was like having a cap 12 for the -- if interest rates go up, it protects 13 you against changes in the upward side, and you 14 have a floor which protects you from increased 15 prepayments when interest rates go down. 16 Isn't that the function of the collar? 17 A. It certainly protected you from -- from 18 the effect of falling rates in terms of receiving 19 certain benefits of falling rates. It offset the 20 benefit that might have been received from falling 21 short-term rates. 22 Q. But it also protected you against 5585 1 increase in prepayment speeds, didn't it? 2 A. Somewhat. 3 Q. I mean, isn't that the function of a 4 collar with mortgage-backed securities? 5 A. I believe that this collar was -- had 6 the effect of paying out and offsetting a series 7 of cash flows to offset the effect of rising rates 8 and would have required the payment of cash flows 9 in terms of falling rates below the floor. I 10 don't believe it was tied to market value of the 11 securities. 12 Q. I understand that. 13 A. Or the effect of losing securities to 14 prepayments. 15 Q. Okay. Now, you also had -- used 16 collars when you purchased the mortgage-backed 17 securities from PaineWebber prior to June of '85. 18 Do you remember those purchases? 19 A. Yes, I do. 20 Q. And what was the purpose of the collar 21 there? 22 A. The purpose of the collar there was, as 5586 1 I just described, to function in somewhat the same 2 way that the interest rate swap did except that 3 rather than create a fixed rate, it allowed a band 4 of rate fluctuations beyond which you would be 5 protected from further movement. 6 Q. Okay. Including whatever the effect 7 was of prepayments when interest rates went down 8 below a certain amount? 9 A. I believe the collar was fixed against 10 short-term rates and not against any loss of 11 principal value. 12 Q. I didn't ask you how technically it was 13 done. I asked you what the purpose was. 14 A. I don't believe it was that purpose. 15 Q. So, it was not designed to protect 16 against acceleration of prepayment rates? 17 A. It was not. It was designed to effect 18 a similar hedge as we had against short funding 19 risk and hedged with swaps. 20 Q. Now, take a look at Exhibit A10631. 21 Have you had a chance to review those trades where 22 you've sold one of those PaineWebber 5587 1 mortgage-backed securities and repurchased the 2 identical security? 3 A. No. 4 Q. You haven't had an opportunity to 5 review it? 6 A. I believe it's been brought to my 7 attention. I have not considered -- 8 Q. When was it brought to your attention? 9 A. I believe in your examination 10 yesterday. 11 Q. Have you had a chance to think about it 12 since then? 13 A. No. 14 Q. Do you have any explanation for the 15 transaction? 16 A. No, I don't recall the purpose of the 17 transaction. 18 Q. The transaction generated a gain, did 19 it not? 20 A. Yes, it did. 21 Q. Now, Mr. Nickens asked you some 22 questions about accounting issues, about your 5588 1 understanding about how those transactions would 2 be accounted for. 3 Do you recall that? 4 A. Yes, I do. 5 Q. And do you recall that you testified it 6 was your understanding that they couldn't be 7 accounted for by recognizing the gain, that they 8 had to be included -- or the gain had to be 9 included into the basis for the acquired security 10 in order to properly account for them under 11 directions from Peat Marwick? 12 MR. NICKENS: Your Honor, I object to 13 the form of that question. I believe the 14 testimony was that the company had accounted for 15 them by rolling it into the basis and that 16 Peat Marwick required them to not account for them 17 in that way. So, it's -- if I understood the 18 question, it's the direct opposite of what 19 Mr. Guido posed. 20 THE COURT: Well, that was my 21 recollection, but let's hear it from the witness. 22 A. It was my recollection that the method 5589 1 of accounting that treated gains as rolled into 2 the basis of the acquired security was an election 3 by the association and that it was later 4 overturned. I believe that I did it, on this 5 document, as an analytical tool to tracking the 6 effective differences and this, of course, was not 7 a report of accountability. 8 Q. (BY MR. GUIDO) In fact, it indicates 9 that it could be treated either way. You tucked 10 it into the basis and you also showed what a 11 realized gain would be, didn't you? 12 A. That's correct. 13 Q. Take a look at Exhibit B819 with regard 14 to understanding what the accountants were telling 15 you at the time. 16 A. I'm not sure which one that is. Oh, 17 it's in the folder. 18 Q. This is a memorandum Mr. Nickens claims 19 that was in the work papers of Peat Marwick and 20 has had the memorandum typed up to where you can 21 read it. 22 A. I haven't located it yet. 5590 1 Q. Why don't you take a look at my copy? 2 We can just read along together. Look at the -- I 3 mean, the memorandum is a summary of the creation 4 in the collapse of United Mortgage Finance. 5 Do you see that? 6 A. Yes, I do. 7 Q. Okay. And then it says "After learning 8 of these transactions" -- your mirror swap and 9 others. It says "After learning of these 10 transactions, I felt that some accounting 11 questions existed as to the proper treatment for 12 GAAP. I talked to Walter Erickson and Walter 13 Schuetze about this topic and learned the 14 following: One, under no circumstance would GAAP 15 require (or even permit) the deferral of the gain 16 on sale of securities, whether in a swap program 17 or not." 18 Okay? Do you see that sentence? 19 A. Yes, I do. 20 Q. Do you understand that to mean the gain 21 had to be recognized according to those two 22 accountants? 5591 1 A. Yes, I do. 2 Q. Now -- 3 MR. NICKENS: Your Honor, this is an 4 entirely different transaction. We're talking 5 about United Mortgage Finance where they did not 6 substitute the securities. This is an entirely 7 different transaction, as I'm sure Mr. Guido is 8 aware. 9 MR. GUIDO: Well, it says "swap program 10 or not," Mr. Nickens. It is talking about the 11 accounting, and it does go on to talk about how to 12 account for swaps later on. 13 MR. NICKENS: But, Your Honor, the 14 question was -- the question was directed to the 15 gain and we've been talking about gains relating 16 to an entirely different matter. And this relates 17 to United Mortgage Finance where the gain was 18 realized at the end of the year. The securities 19 were not replaced, and that's what he's analyzing. 20 MR. GUIDO: Your Honor, I think the 21 phrase says "whether swap or not." It doesn't 22 talk about a gain in isolation. 5592 1 THE COURT: All right. What's your 2 question? 3 MR. GUIDO: My question is: Is it his 4 understanding that the reading of this was that 5 the position of Walter Erickson and Walter 6 Schuetze as described here, his understanding of 7 what that is, says the gains had to be recognized 8 when one security was swapped for another in a 9 risk-controlled arbitrage program? 10 A. Yes, that is my understanding. 11 Q. (BY MR. GUIDO) Now, I'd like to 12 direct your attention to the last sentence in 13 this. The last paragraph says "Given the facts 14 and circumstances" -- this is referring to the 15 United Mortgage Finance transaction -- "it does 16 not appear to me that we have any firm rules that 17 would require any 1985 loss recognition to offset 18 United's 1985 gain." 19 Remember your memorandum that you 20 testified to, the memorandum to the file where you 21 said that you were not going to offset the losses 22 on the swap side against the gains on the sale of 5593 1 the $350 million of mortgage-backed securities 2 when you dissolved United Mortgage Finance? 3 A. I remember the memorandum that 4 described the dissolution of that entity, yes. 5 Q. And you recall the description of the 6 accounting for it in that memorandum? 7 A. Yes, I do. 8 Q. And then it says "United understands 9 the economic reasoning for doing so, however, and 10 has agreed to start offsetting all such gains in 11 1986 so that their spreads will not be distorted." 12 Do you see that sentence? 13 A. Yes, I do. 14 Q. Okay. Were you aware that there were 15 two different views within Peat Marwick at the 16 time about how to properly account for the gains 17 that would be realized in a swap of one 18 mortgage-backed security for another? 19 A. I don't recall being aware of it. 20 Q. Okay. 21 A. I also am not sure what that last 22 sentence precisely means. 5594 1 Q. Okay. Now, do you know how the 2 transactions that are described as occurring at 3 the beginning of 1986 were accounted for by USAT? 4 A. I have come to believe they were -- 5 that the gains were deferred primarily from 6 discussions we've had here. 7 Q. So, basically, discussions with either 8 me or Mr. Nickens or -- 9 A. Yes. 10 Q. -- my asking you questions on the 11 stand or Mr. Nickens asking you questions on the 12 stand? 13 A. That's correct. 14 Q. Do you have any independent knowledge 15 of how they were accounted for? 16 A. No, I don't. 17 Q. Okay. Do you have any independent 18 knowledge of whether or not those gains were 19 subsequently recognized in a modification of a 20 financial statement by USAT independent of your 21 discussions with Mr. Nickens or me or our 22 questions in this proceeding? 5595 1 A. No, I don't. 2 Q. Who would be the person we should ask 3 those questions of? 4 A. Persons performing accountings that 5 would prepare statements and transactions, I 6 suppose, would know that. 7 Q. Now, when you did these transactions, 8 were you aware of how far down interest rates had 9 fallen? 10 A. Yes, I was. 11 Q. And what was your perception of how far 12 they had fallen? 13 A. They had fallen by a couple of 14 percentage points by that time. 15 Q. Okay. By at least a couple of 16 percentage points? 17 A. Yes. 18 Q. Now, you indicate you used the 19 settlement date on those transactions. Was that 20 settlement date the date that you used to 21 determine the constant prepayment rate? 22 A. I don't recall exactly when I did make 5596 1 those determinations. Some of these entries, I 2 believe, were made coincident with the 3 transactions. Others could have been put in 4 later. 5 Q. Okay. 6 A. But I believe they were accurate 7 estimations of CPRs when I put them in. 8 Q. Now, when you put the CPRs in, were 9 those CPRs that you learned about that prompted 10 you to make those -- 11 A. Yes. 12 Q. -- initiate those transactions? 13 A. I don't recall whether these were the 14 exact CPRs that we used at the time. I think I 15 have them here as -- to remind us of what we were 16 looking at at the time. I can't be sure these 17 were the exact CPRs I used. 18 Q. Okay. But were they -- are these 19 approximately close to the ones that you used to 20 determine that you needed to make the trades? 21 A. I believe they are representative. 22 Q. Now, a couple of those instances has a 5597 1 CPR going to 30. Do you see that? 2 A. Yes. 3 Q. Now, in those transactions, what was 4 the price of the bond doing up to that point in 5 time? 6 A. Well, in that -- I'm looking at a 7 column on which the CPR went to 30 and the price 8 of the bond increased. 9 Q. It increased significantly, did it not? 10 A. Yes, over the price that we paid for 11 it. 12 Q. Now, were those CPRs with the 200 or 13 300 basis point rise in interest rates comparable 14 to what historic patterns had been in nineteen -- 15 late 1984 and 1985? 16 MR. NICKENS: Your Honor, this is 1984 17 and 1985. It couldn't be historic. 18 MR. GUIDO: This is 1986. We're 19 looking at 1986. 20 MR. NICKENS: I apologize, Your Honor. 21 A. I believe that these prepayment rates 22 here correspond with some that you showed me from 5598 1 high coupon mortgage-backed securities that had 2 prepaid early in previous periods. I'm not sure 3 about the 1984, '85 period you described. 4 Q. (BY MR. GUIDO) But given your 5 understanding of prepayment rates in the 1984, 6 1985 time frame, based on the material that was 7 available to you at the time, are those prepayment 8 rates comparable to what prepayments rates had 9 been when there had been a 200 or 300 basis point 10 drop in interest rates? 11 A. Yes, they are. 12 Q. So, in 1986, you weren't surprised at 13 the magnitude of the change, were you, in 14 prepayment rates? You were surprised by the 15 decline in the interest rates and how sudden it 16 had been? 17 MR. NICKENS: Your Honor, he's asking 18 two questions. I object. 19 THE COURT: Let's take one at a time. 20 Q. (BY MR. GUIDO) One at a time. 21 A. We were not surprised by the fact that 22 prepayment rates moved up very quickly when 5599 1 interest rates fell dramatically. 2 Q. Okay. And -- but what you were 3 surprised about is the direction interest rates 4 had moved? 5 A. They did continue to fall, and we 6 expected a fairly steady outlook. 7 Q. Look at Exhibit B586, if you could. 8 That's the September 4th, 1985, Waldman piece. 9 Did you find it? 10 A. Which one was it? 11 Q. It's the September 4th, Michael Waldman 12 piece. It's Exhibit B586. Why don't we use my 13 copy and we can read it. Look at the fourth 14 paragraph down. It says "The model projects that 15 a strong rise in prepayments will occur as a 16 result of the recent rally." It's making 17 reference to the rally between March 7th and 18 June 18th in the mortgage-backed securities 19 portfolios. 20 Were you aware that that was likely to 21 occur in September of 1985? 22 A. We were aware that such conditions 5600 1 could lead to prepayments. 2 Q. Okay. And did you consult with any of 3 the investment banking firms of how you should 4 reposition the portfolio in September of 1985 to 5 protect yourself from that expected increase in 6 prepayment speeds? 7 A. I don't believe that we consulted with 8 anyone quite that early. As to the method, I 9 think we did discuss it with some and they agreed 10 that it was reasonable. 11 Q. They agreed what was reasonable? 12 A. That our approach to acquiring lower 13 coupon securities was a reasonable response. 14 Q. I'm talking about September. You 15 hadn't done anything in September, had you? 16 A. We had not. 17 Q. Okay. I'm talking about September of 18 1985. Salomon Brothers puts out this publication 19 and it says "The model projects a strong rise in 20 prepayments will occur as a result of the recent 21 rally." And I asked you whether or not you were 22 aware that prepayment speed changes of the 5601 1 magnitude that occurred as reflected in your 2 rebalancing, so-called rebalancing memorandum, you 3 were aware of. Now, I'm just trying to find out 4 whether or not in September of 1985 or October 5 that you consulted with any investment bankers 6 about what steps to take in anticipation of a 7 rapid increase in prepayment speeds? 8 A. No, I don't believe we did. 9 Q. Now, this says in the last paragraph, 10 "Discount issues provide value even if the rise in 11 prepayments falls short of that projected by the 12 model," and it is these projected increases in 13 prepayment speeds. This is those discounted 14 mortgage-backed securities again. Okay? 15 Did you make any effort in the fall of 16 1985, any time after September 4th, to ascertain 17 whether or not discount mortgage-backed securities 18 would provide you protection against an increase 19 in prepayment rates? 20 A. We didn't need to determine anything. 21 I believe that that sort of information is 22 implicit in the characteristics of discount 5602 1 mortgage-backed securities. We would have known 2 that. 3 Q. Okay. So, you would have known it. 4 Did you attempt to price what that protection 5 would be? 6 A. I do not recall doing anything like 7 that. 8 Q. Now, you testified yesterday that the 9 reason that you didn't look to discount 10 mortgage-backed securities as protection from 11 prepayment speeds, despite the fact that Salomon 12 Brothers had, in its presentations to you and in 13 its publications, had described that as a way of 14 providing cushion against prepayment -- increases 15 in prepayment speeds, that it would have ended up 16 being harmful to the portfolio if interest rates 17 went up. 18 Do you recall that? 19 A. I recall more clearly that it would be 20 very costly to do so. I don't recall precisely 21 that I mentioned that it would be harmful if rates 22 went up. 5603 1 Q. When -- but you just testified that you 2 never priced discount mortgage-backed securities 3 in the fall of 1985. 4 How can you say that it was costly? 5 A. Well, we later determined it was costly 6 when we pursued the roll-down. With respect to 7 your question of September, we had made no such 8 determination. 9 Q. Okay. But when -- you started the 10 roll-down after prepayments had already kicked in, 11 the accelerated prepayments had already kicked in. 12 You found out it was too expensive? 13 A. That's correct. 14 Q. Because the market had already factored 15 in the prepayment speed increases, hadn't they? 16 A. Yes. 17 Q. Now, you never priced them in the fall 18 of 1985? 19 A. I believe we did not. 20 Q. Do you recall in response to one of the 21 questions from Mr. Nickens that you said for you 22 to do so would have been speculating that interest 5604 1 rates were not going to go up? 2 A. I don't know that I used the word 3 "speculating," but it would be to take a market 4 position based on an outlook that could have been 5 as easily wrong as right. 6 Q. Now, Mr. Nickens read into the record 7 earlier today the minutes of the asset/liability 8 committee. 9 Do you recall those minutes? 10 A. Yes, I do. 11 Q. And from June of 1985 to December of 12 1985, did the asset/liability committee ever 13 predict anything other than stable or declining 14 interest rates? 15 A. I believe that the outlook that was 16 predicted in those minutes was stable with a 17 couple of small exceptions. I think primarily 18 stable to down. 19 Q. Right. So that taking your estimate of 20 which direction the market was moving, would the 21 purchase of discounted mortgage-backed securities 22 in the fall of 1984 have increased or mitigated 5605 1 the risks to the USAT mortgage-backed security 2 portfolio you were managing? 3 A. It would have mitigated those risks had 4 we known the outcome. 5 Q. Now, you talked about using the yield 6 books. And particularly, you talked about using 7 the yield books in reference to Exhibit 450A, 8 which is the Salomon Brothers memorandum entitled 9 "Determining the Yield of a Mortgage Security" in 10 March of 1985. 11 Do you have that document before you? 12 A. Yes, I do. 13 Q. Now, turn to the page -- I think it's 14 Page 7, which is the yield tables, which I think 15 your copy is not legible. So, I'll provide with 16 you a copy of the page that is legible. 17 You testified that this is one of those 18 yield tables that you utilized when you were 19 managing the USAT portfolio to determine what the 20 yields were at any given point in time. 21 Is there any way you can use this table 22 to ascertain what the prepayment speed would be 5606 1 for a mortgage-backed security that was 200 basis 2 points above par or the market? 3 A. No, I don't believe there is. 4 Q. Okay. And this is what you testified 5 to yesterday that you had available to you to 6 measure the impact of prepayment speeds? 7 A. Yes. 8 Q. Now, how did you use this if it didn't 9 tell you what prepayment speeds would be if there 10 was an increase or a decrease of 200 basis points 11 in interest rates? 12 A. A prepayment speed was chosen in 13 determining a yield and duration in this table. 14 Q. So, you would just plug the figure in 15 somewhere? 16 A. That's correct. 17 Q. Okay. And then you would use the table 18 and it would calculate the yield based on that 19 prepayment speed? 20 A. Yes. 21 Q. So, it's basically sort of a 22 multiplier, an equation that evaluated cash flows 5607 1 over time? 2 A. Well, the calculations underlying this 3 would be very detailed and complex, which is the 4 reason you'd want to use a book like this. 5 Q. And that's why you have the -- 6 A. That's right. 7 Q. -- mathematics in that paper? 8 A. That's correct. 9 Q. But this table is essentially the 10 results of those mathematics. Right? 11 A. Yes, it is. 12 Q. But this table doesn't tell you what 13 prepayment speeds will be if there is a decline of 14 200 basis points in interest rates? 15 A. It does not. 16 Q. And that what you would do is you would 17 take whatever the prepayment speed was you were 18 assuming and you would plug it into that table and 19 you'd come out with a yield figure. Right? 20 A. Yes. 21 Q. Now, that yield figure did not include 22 what the market value impact was on the 5608 1 mortgage-backed security in relationship to the 2 swap that it was hedged by. Right? 3 A. That's correct. 4 Q. So that it only gave you part of the 5 picture. It didn't give you the entire picture? 6 A. That's correct, yes. 7 Q. Now, when did you ever acquire the 8 entire picture? 9 A. Well, the other side of the transaction 10 was relatively fixed. It did not change with 11 market movement, only primarily with the passage 12 of time. It was much more like a calculated 13 duration on a corporate bond or something like 14 that. There was no prepayment to affect it. You 15 could calculate it at market yields, at points in 16 time, and get a duration without a table like 17 this. 18 Q. All right. Now, let's take a look 19 at -- I think it's Exhibit 500, which is the 20 schedule of transfers between the so-called 21 Account 1700 to some other accounts. Would you 22 take a look at that? It's Exhibit B500. It's the 5609 1 one-page document called USAT Mortgage Finance. 2 A. Can you show me what it looks like? 3 Q. Why don't you use my copy? Here it is. 4 Now, Mr. Nickens asked you some questions about 5 this and asked you whether or not that was the 6 totality of the risk-controlled arbitrage 7 portfolios that you managed for USAT. And I think 8 it comes up to 450 to $500 million total, and it 9 reflects transfers from RC 1700, Joe Phillips 10 account. 11 Were there mortgage-backed securities 12 that you managed for USAT subsequent to June of 13 1985 that were above the figures that are 14 represented on this piece of paper? 15 A. There were other securities held in 16 different strategies. I don't think that I was 17 involved in the management of them. 18 Q. So, is it your testimony that you only 19 managed $450 million of the USAT mortgage-backed 20 security portfolio? 21 A. I managed these assets plus those that 22 came out of the collapse of the financing sub. 5610 1 Q. Now, you testified that your 2 understanding is prior to the creation of USAT 3 Mortgage Finance, that your recollection was that 4 there were about 600 to $650 million worth of 5 mortgage-backed securities in the portfolios that 6 you managed. 7 A. I thought that was after the collapse. 8 I thought it was 500 plus 150 later. 9 Q. Okay. So, you're thinking that that 10 was the total amount? 11 A. Yes. 12 Q. Now, were there other people that 13 managed risk-controlled arbitrage portfolios at 14 USAT? 15 A. No. 16 Q. No? So, you're the only person that 17 managed risk-controlled arbitrage portfolios at 18 USAT? 19 A. During my tenure, yes. 20 Q. Now, did you manage any mortgage-backed 21 securities that were not in a risk-controlled 22 arbitrage portfolio? 5611 1 A. There were other securities. I believe 2 they were not actively managed. They were 3 collateral for a floating rate preferred stock, 4 for example. 5 Q. Is that like a CMO and -- 6 A. There was a CMO. 7 Q. And there was a DART, or is that the 8 preferred -- 9 A. That is the preferred stock. 10 Q. So, there was a DART and there were 11 some CMOs and those were in some subsidiaries and 12 you didn't manage those? 13 A. I believe we may have participated in 14 evaluating some, but we did not manage them after 15 they were purchased. 16 Q. Now -- but all of the mortgage-backed 17 securities that were held by USAT, taking those, 18 USAT directly, who managed those besides you? 19 A. There were also some securities that 20 were not part of the risk-controlled arbitrage 21 which I believe were held when I arrived, and I 22 did not actively manage those. 5612 1 Q. Who did? 2 A. I don't know. They were accounted for 3 in treasury. 4 Q. They were accounted for in treasury, 5 but you don't know who managed them? 6 A. No. 7 Q. Do you know whether or not those were 8 hedged portfolios? 9 A. I do not. 10 Q. Who would we ask if we wanted to find 11 out how those were managed? 12 A. I believe the manager of the treasury 13 department would have known. 14 Q. Bruce Williams? 15 A. Yes. 16 Q. So, if we wanted to know how those were 17 managed, he'd be the person to ask? 18 A. I believe so. 19 Q. Okay. And when did you first learn 20 that the risk-controlled arbitrage portfolio that 21 you managed had become -- had reached such a loss 22 that it was essentially unsalvagable? 5613 1 MR. NICKENS: Your Honor, this -- 2 Q. (BY MR. GUIDO) -- as a 3 risk-controlled arbitrage? 4 MR. NICKENS: This exact question was 5 asked on direct, and it goes beyond the scope of 6 anything we covered on cross. This precise 7 question was asked. 8 THE COURT: Sounds familiar. 9 MR. GUIDO: Pardon, Your Honor? 10 THE COURT: I said it sounds familiar. 11 Did you ask that before? 12 MR. GUIDO: I'll withdraw the question, 13 Your Honor, and go to the -- it was a predicate 14 for another question, and I'll just go to the next 15 question. 16 THE COURT: All right. Let's have the 17 next question. 18 Q. (BY MR. GUIDO) You testified today 19 about Exhibit A10631, Bates stamped OW002928. 20 Do you recall testifying about that 21 document? 22 A. Yes. 5614 1 Q. It has in there a reference to a column 2 called "pay-down." 3 Do you see that? 4 A. Yes, I do. 5 Q. What does that refer to? 6 A. It would be the amount of principal on 7 the underlying loans that was paid down and thus 8 passed through to the holder. 9 Q. Now, yesterday, you testified that you 10 requested that those pay-downs be reinvested in 11 mortgage-backed securities. 12 Do you recall that? 13 A. Yes. 14 Q. And that you were turned down? 15 A. I believe that I testified I was turned 16 down regarding realized gains on the sale of 17 securities. 18 Q. And not the pay-down? 19 A. I believe that the schedule we referred 20 to earlier shows that we -- that we invested the 21 face amount held. 22 Q. Yeah. The face amount held, but not 5615 1 the original face amount I think was your 2 testimony, was it not? 3 A. That's correct. 4 Q. Okay. So, the difference between the 5 face amount held and the original face amount is 6 that pay-down figure, is it not? 7 A. Yes, it is. 8 Q. Okay. So that the figure that you were 9 asking to be reinvested is that figure on that 10 piece of paper, isn't it? 11 A. It would have been a different figure 12 at the point in time we had made such a request, 13 but it's the same kind of number, yes. 14 Q. Okay. How large is that figure? 15 A. This number totals $75 million. 16 Q. Okay. And what is 10 percent of that 17 figure per year? 18 A. 10 percent per year would be $750,000. 19 Q. 75 million? Did you say that? 20 A. I said 75 million. It would be 21 $7 and a half million. 22 Q. $7 and a half million a year. So, 5616 1 there was an income stream, if you use that figure 2 and you assume 10 percent being earned on the 3 mortgage-backed security, that there was a 4 7.5-million-dollar shortfall that was not being 5 matched against the cost of the swaps? 6 A. Certainly not until any further 7 securities were purchased. That would be -- that 8 would be the appropriate analysis for it. I can't 9 be sure exactly what the numbers would be, but 10 that would be -- 11 Q. But your recommendation was to the 12 investment committee, given the existence of all 13 of the swaps and all of the other transactions 14 that had taken place, that there was leakage, I 15 think, was the term that you used that you needed 16 to reinvest. And my question is: Is it that 17 $75 million or what that figure eventually became? 18 A. It would be a figure comparable to 19 this. Probably higher at a later point in time. 20 Q. Because this is what? August of '85. 21 Right? 22 A. Yes. 5617 1 Q. So, by March of '86, it would be quite 2 a bit higher? 3 A. Yes. 4 Q. It could be as high as $150 million? 5 MR. NICKENS: Your Honor, it could be 6 $300 million. It's pure speculation about how 7 high it could be here at five minutes till 5:00 8 after this witness has been on the stand X number 9 of days. 10 THE COURT: Sustained. 11 Q. (BY MR. GUIDO) Now, I'd like to -- do 12 you know what the purpose of the purchases that 13 are on the Schedule 171 on the second page, those 14 three purchases there? 15 A. No, I don't recall the purpose of these 16 three purchases. 17 Q. Were those before your request to the 18 investment committee to make the purchases to 19 alleviate the leakage that you had been concerned 20 about? 21 A. I believe they are before the request. 22 Q. Now, I'd like to turn to the junk 5618 1 bond -- your junk bond testimony quickly, if I 2 may. 3 You testified that you were requested 4 to make sales out of the high-yield bond portfolio 5 at year's end to generate gains for purposes of 6 the financial statements. 7 Do you recall that testimony? 8 A. Yes, I do. 9 Q. Did you ever tell any regulator that 10 you had received that request? 11 A. Yes, I did. 12 Q. Who? 13 A. I don't recall who it was, but I was 14 shown correspondence by an examiner that said I 15 had done so. 16 Q. And who showed you that correspondence? 17 A. I was shown that in meetings in the 18 past few days, and I don't know who showed it to 19 me. 20 Q. Was it me? 21 A. It could have been. 22 Q. But you don't recall who showed you 5619 1 such a document? 2 A. No, I don't. 3 Q. But other than that document, do you 4 have any recollection that you told a regulator 5 that you were instructed to make sales out of the 6 junk bond portfolio to generate gains for 7 accounting purposes at year end? 8 A. I don't remember making any such 9 statement. 10 Q. Do you recall making any such statement 11 to any accountants from Peat Marwick? 12 A. I don't remember meeting with any 13 accountants. 14 Q. Okay. Do you recall making any such 15 statements to the Texas Savings and Loan 16 Commission? 17 A. No. 18 Q. Do you recall making any such 19 statements to Terry Smith? 20 A. No. 21 Q. Now, did you make sales out of the 22 high-yield bond portfolio to generate gains at 5620 1 quarter's end to bolster income for the financial 2 statements? 3 A. Yes, I did. 4 Q. Did anyone ever ask you whether or not 5 you had done so from either the Texas Savings and 6 Loan Commission, the Peat Marwick accounting firm, 7 or the Federal Home Loan Bank Board regulatory 8 people? 9 A. I am sure the Texas regulator did not, 10 nor the accounting firm. I don't recall whether 11 anyone from the Home Loan Bank did. 12 Q. Okay. Did you know the basis for the 13 initial decision to invest in junk bonds at USAT? 14 A. No. 15 Q. Were you privy to any discussions where 16 that initial decision had been made? 17 A. No. The decision had been made before 18 I arrived. They owned securities already. 19 Q. Now, did you have discussions with the 20 regulators regarding the high-yield bond 21 portfolio? 22 A. Yes. 5621 1 Q. And one of them was Terry Smith, was it 2 not? 3 A. Yes. 4 Q. And one of them was Ginger Baugh, was 5 it not? 6 A. Yes. 7 Q. And one of them was Neil Twomey, was it 8 not? 9 A. Yes. 10 Q. Did you ever tell any of them that 11 Drexel had underwritten junk bonds for MCO or its 12 affiliates? 13 A. I don't remember telling them that. 14 Q. Do you ever recall them mentioning that 15 fact to you? 16 A. No. 17 Q. You indicated that Drexel was a 18 significant participant in the high-yield bond 19 market. 20 Do you recall that testimony? 21 A. Yes, I do. 22 Q. Can you describe what it is that you 5622 1 meant by "a significant participant in the 2 high-yield bond market"? 3 A. As an investment banker, they brought 4 quite a lot of issues to market. They made 5 markets in almost every high-yield bond issue, not 6 exclusively their own. And they provided a great 7 deal of liquidity to the market. 8 Q. What do you mean that they made the 9 market? 10 A. They stood ready to buy and sell 11 securities as a matter of course. 12 Q. Were there times when Drexel was the 13 only place you could go to get a quote for the 14 market price of a security in the high-yield area? 15 A. From time to time, there may have been 16 such times, yes. 17 Q. What would you do in that situation? 18 A. Well, one would hope you would not have 19 to sell without knowing every available bid in the 20 market. 21 Q. How often did that occur? 22 A. I don't recall that it occurred very 5623 1 often. 2 Q. But it occurred? 3 A. I think it was possible that from time 4 to time it did occur, yes. 5 Q. Why did Drexel have that role? Why did 6 that happen? 7 A. They got into the market quite early. 8 They had made these markets. They had created 9 applications for high-yield bonds. They were 10 quite active in the investment banking side of it. 11 They just had a very large role. 12 Q. Were they the dominant investment 13 banking firm on the sales side of mortgage-backed 14 securities? 15 A. They became a prominent -- I don't 16 think dominant -- player in mortgage-backed 17 securities. 18 Q. They were a prominent player in the 19 sale of mortgage-backed securities? 20 A. Yes, they did. 21 Q. Were they a predominant player in the 22 underwriting of mortgage-backed securities? 5624 1 MR. EISENHART: Your Honor, I don't 2 know if counsel is misspeaking himself. His last 3 couple of questions he's talked about 4 mortgage-backed securities. 5 Q. (BY MR. GUIDO) I'm sorry. High-yield 6 bonds, junk bonds. 7 MR. GUIDO: Excuse me, Your Honor. 8 A. I have answered those questions in 9 respect to mortgage-backed securities. 10 Q. (BY MR. GUIDO) Okay. Excuse me. 11 Let's go back to junk bonds. With regard to 12 high-yield bonds, were they the dominant sales 13 source for mortgage -- I mean junk bonds? 14 A. Yes, they were. 15 Q. Were they the dominant source of 16 underwriting for junk bonds? 17 A. Early on, they were, yes. 18 Q. And what do you mean by "early on"? 19 A. They were in quite early, since 1977 20 perhaps, and it was some years later before anyone 21 else really got big enough to challenge them in 22 this line of business. 5625 1 Q. Well, when you were managing the 2 portfolio for USAT in 1985, were they the dominant 3 force on the sales side of high-yield bonds? 4 A. Yes, they were. 5 Q. Were they the dominant investment 6 banking firm on the underwriting side at that 7 time? 8 A. Yes. 9 Q. And did they have a significant role to 10 play in the pricing of mortgage-backed securities? 11 A. Do you mean high-yield -- 12 THE COURT: Which are we talking about? 13 Q. (BY MR. GUIDO) High-yield securities? 14 A. Yes, they did. 15 Q. And did that include initial offerings 16 of high-yield securities? 17 A. Yes. 18 Q. And did that include the secondary 19 market of high-yield securities? 20 A. Yes, it did. 21 Q. Okay. And were you, as a consequence, 22 dependent upon Drexel for the profitability of the 5626 1 high-yield bond portfolio that you managed for 2 USAT? 3 A. No. I don't believe those all 4 followed. 5 Q. Why not? 6 A. Because others did make markets. The 7 markets perhaps were not as liquid and deep as one 8 might hope and certainly not as much as today. 9 But I never viewed that we had a dependence on 10 Drexel for profitability. 11 Q. But what Drexel did in that market 12 could impact upon the profitability of the 13 portfolio you managed? 14 MR. EISENHART: Your Honor, the witness 15 answered the question directly. He's now asking 16 him to speculate. 17 THE COURT: All right. Sustained. 18 Q. (BY MR. GUIDO) Given the market 19 position that Drexel had, did it have the market 20 power to affect the performance of the portfolio 21 that you managed in junk bonds for USAT? 22 A. It could only if it manipulated the 5627 1 market. 2 MR. GUIDO: No further questions, Your 3 Honor. 4 MR. NICKENS: Your Honor, contrary to 5 my nature but considering all of the 6 circumstances, I find no compelling reasons to 7 keep Mr. Phillips here any longer. So, I will not 8 have any questions. 9 MR. EISENHART: I have no further 10 questions, Your Honor. 11 MR. KEETON: I just want to hear the 12 last answer. I couldn't hear it. Would the court 13 reporter read it back? 14 15 (The reporter read back the 16 answer as requested.) 17 18 MR. KEETON: I do have one question. 19 20 21 22 5628 1 2 CROSS-EXAMINATION 3 4 5 Q. (BY MR. KEETON) Did you ever see any 6 instance where you felt that Drexel had, quote, 7 "manipulated the market," Mr. Phillips? 8 A. No, I did not. 9 MR. KEETON: Thank you. 10 THE COURT: Thank you, Mr. Phillips. 11 You may step down. We'll adjourn until 12 9:00 o'clock tomorrow. 13 14 (Whereupon at 5:04 p.m. 15 the proceedings were recessed.) 16 17 18 19 20 21 22 5629 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 28th 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 5630 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 28th 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