SECTION SIX

EXAMINATION AND SUPERVISION OF USAT

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

A. The Supervision Of USAT Prior To The 1986 Examination

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

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

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

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

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

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

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

a. USAT’s Net Worth

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

b. USAT Had Not Been Examined Since 1983

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

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

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

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

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

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

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

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

i. The Net Worth Maintenance Condition Imposed By

FHLBB Resolution No. 84-712

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

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

Id.

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

ii. MCO’s Initial Requests For Extensions Of The

Period In Which It Might Acquire Control Of UFG

And USAT

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

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

Worth Condition Imposed By Resolution No. 84-712

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

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

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

Id.

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

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

iv. The FHLBB Did Not Modify The Net Worth Condition

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

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

i. The Stock Option Agreement With Drexel

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

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

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

ii. MCO’s Continuing Correspondence With The FHLB

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

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

C. USAT’s Liability Growth Violation In 1985

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

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

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

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

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

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

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

D. USAT Application To Exceed The Direct Investment Limitations

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

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

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

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

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

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

Id.

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

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

1. USAT Obtained The Assistance Of Drexel To Issue Subordinated

Debt.

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

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

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

Id. p. CN152393.

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

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

Application

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

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

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

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

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

F. USAT MBS/RCA Portfolios

1. Representations To The Regulators In The USAT Applications

Regarding The MBS/RCA

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

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

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

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

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

Id. p. CN152337.

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

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

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

2. The Regulators Understanding Of The MBS/RCA Gains

i. The Regulators Had Little Previous Experience With MBS

RCA Investments

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

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

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

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

Id. p. CN249761.

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

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

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

Operating Gains From Various Sources Including Securities Sales

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

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

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

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

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

Id. pp. CN208030-31.

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

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

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

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

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

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

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

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

Operating Income Derived From Securities Transactions

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

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

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

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

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

a. The USAT/MBS Portfolio Was Created To

Generate Spread Income

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

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

Tr. 23,492: 12-21.

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

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

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

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

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

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

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

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

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

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

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

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

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

G. USAT’s Junk Bond Portfolio

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

Bonds

i. The Initial Concerns Raised In May 1986 By The

FHLB-D Regarding USAT’s High-Yield Bond

Investments

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

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

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

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

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

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

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

S72. At USAT’s request, the regulators and representative of USAT met a second time on May 21, 1986, so that USAT could “explain to SA Twomey, in particular, United’s investments in corporate debt and equity securities.” Ex. B-4001, Tab 887 (06/02/86 Baugh memo) p. OW153022. Ginger Baugh reported in a memo to the file, on the meeting that Mr. Phillips discussed USAT’s “strategy in acquiring securities investment,” but Baugh concluded that “[v]ery little new information was provided.” Id.

S73. Twomey expressed concern about the risks associated with high-yield bonds in a rising interest rate environment (Ex. B-4001, Tab 887 (06/02/86 Baugh memo) p. OW153022) and “stated his concern with the net operating losses in the Association. He discussed the fact that United has been depending on gains from securities transactions and branch sales to show net profit.” Id. p. OW153023. In response, Crow advised Twomey that “income from securities transactions should not be considered extraordinary, as United has made them a part of its ordinary operations.” Id. Twomey continued to be concerned about USAT’s junk bond investment and at the conclusion of the meeting Baugh noted the following:

Future Action: SA Twomey requested that United provide the Bank with a description of the Corporate debt securities purchased, including the names of the issues, what each is rated by S&P or Moody’s, the representative yield, etc. He also requested information on how United is structuring itself in a rising interest rate scenario.

Id.

2. USAT Management’s Representations To The Regulators

Regarding Gains In The Junk Bond Arbitrage Portfolio

S74. Following the meeting with USAT on May 21, 1986, Twomey continued to be concerned about whether USAT was properly engaging in investments in high-yield bonds. Tr. 23,600: 19 - 23,601: 4; Tr. 23,602: 13 - 23,603: 8 (Twomey). On June 6, 1986, Twomey sent a memorandum to Jonathan Scott, the Chief Financial Officer for the FHLB-D (Tr. 23,601: 11-12) and requested that he conduct an informal examination or review of the practices of USAT with respect to the purchases of high-yield bonds. Ex. B-1034, Tab 1522; Tr. 23,603: 9 - 23,604: 8. The memorandum stated:

…we have been informed that United routinely invests in non-investment grade securities. As of March 31, 1986, 77.6 percent of its corporate bond portfolio are considered non-investment grade securities.

In order that we may assess the risks inherent in the portfolio, we would appreciate your examination of United’s investment at your earliest convenience.

Ex. B-1034, Tab 1522.

S75. On June 10, 1986, Mr. Scott along with Terry Smith, an Assistant Vice President of Financial Management at the FHLB-D (Tr. 2761: 12-13 (Smith)), met with Crow, B. Williams, Phillips and Berner and discussed USAT’s corporate bond portfolio. Following the meeting Scott wrote a memorandum to Twomey on USAT’s high-yield bond portfolio. Ex. B-1042, Tab 232 (06/12/86 Scott memo). Mr. Scott described USAT’s investment strategy to generate spread income in his memorandum to Twomey dated June 12, 1986 as follows:

In September of 1984, United conceived the strategy of purchasing less than investment-grade corporate debentures (B and BB rated bonds) financed with term deposits issued through brokers. The idea behind the strategy was to have a dedicated portfolio of bonds duration matched to achieve a 200 basis point spread.

Id. p. OW158333 (emphasis added). Scott was informed by USAT’s management that:

While the portfolio does require certain adjustments to keep the durations matched, the management of the bond portfolio does not involve bond swapping to pickup yields or premature selling to capture capital gains currently realized.

Id. p. OW158334 (emphasis added). Scott concluded the memorandum by stating that: “In summary, Terry Smith and I are of the opinion that United Savings is responsibly managing its less than investment grade debt portfolio.” Id.

S76. Terry Smith, who assisted with the review of the junk bond portfolio, testified that USAT’s management told him that the junk bond portfolio was not a trading portfolio, which he stated was consistent with the statement in Scott’s memorandum that USAT’s “bond portfolio does not involve bond swapping to pick up yield or premature selling to capture capital gains currently unrealized.” Tr. 2,820: 13 - 2821: 2. During the review of USAT high-yield bond activity, Smith and Scott never reviewed the actual junk bond trades that USAT was making to ascertain whether it was in fact being managed as an investment portfolio as USAT’s, management told them. Tr. 2,824: 6-11 (Smith).

3. The Regulators Understanding Of The Junk Bond Portfolio

And The Reasons For The Gains On Sales Of Bonds

i. Based Upon Scott’s Review Of USAT’s Junk Bond

Portfolio, Twomey Understood That It Was An

Investment Portfolio Created To Generate Spread

Income

S77. Twomey testified that “given the assurances from Mr. Scott and Mr. Smith…I had a high degree of confidence that this portfolio was being managed properly and professionally.” Tr. 23,609: 6-10. It was Twomey’s understanding that the purpose of the portfolio was to fund the purchases of the junk bonds with duration-matched CDs and to achieve a spread which would generate income for USAT (Tr. 23,494: 13 - 23,495: 11; 23,512: 15-21), just as Scott had described in his June 12, 1986 memorandum to Twomey. Ex. B-1042, Tab 232, p. OW158333.

S78. According to Twomey, the junk bond portfolio was designed to be an investment portfolio, not a trading portfolio (Tr. 23,607: 20; Tr. 24,900: 4-13), and it was not the intent of USAT to sell bonds out of the portfolio to generate gains to bolster USAT’s profits and capital. Tr. 23,497: 18 - 23,498: 2 (Twomey). When Scott reported to Twomey that USAT did not engage in “bond swapping, pickup yields, or premature selling to capture capital gains currently unrealized,” (Ex. B-1042, Tab 232, p. OW158333), he understood that to mean that USAT was not “cherry picking” or “sweeping the portfolio for profits.” Tr. 23,607: 16 - 23,608: 13 (Twomey). Sweeping for profits, he explained, may occur when interest rates change and the value of bonds increases over historic cost. In that situation “…you might sweep the account by picking the ones with the most profits and selling them so you could realize a gain which would then impact your bottom line.” Tr. 23,606: 11 - 23,608: 4 - 23,608: 4. However, based upon what he was told by Scott, it was Twomey’s understanding that this was not a practice in which USAT engaged. Tr. 23,608: 5-10; 25,047: 20 - 25,048: 9.

ii. Twomey Expected That USAT Would Have Non-

Operating Gains From The Sale Of High-Yield Bonds

As A Consequence Of Called Bonds And Rebalancing

To Adjust For Credit Risk

S79. Notwithstanding the fact that the high-yield bond portfolio was an investment portfolio for the purpose of generating spread income, Twomey testified that he understood that there would from time to time be sales of bonds from the portfolio. Tr. 23,575: 20 - 23,576: 3; Tr. 24,887: 8-17; Tr. 24,899: 7-15. The fact that the sales resulted in gains to USAT and increased the non-operating income reported on USAT’s TFR’s was not a problem for Twomey. Tr. 24,434: 20 - 24,435: 15.

S80. Twomey explained that, as was the case with the MBS portfolios, he understood that the purpose of junk bond sales that resulted in USAT gains was to maintain the junk bond arbitrage portfolio. Tr. 24,899: 4 -15. The needs of the portfolio “necessitated the various sales to rebalance the portfolio and maintain the risk-controlled arbitrage.” Id. Twomey testified as follows regarding the purpose of the junk bond sales that resulted in gains to the Association:

Q. [BY MR. RINALDI] And what would be the purpose for executing those bonds -- I mean selling those bonds, as you understood it?

A. Well, two primarily. Some bonds could be called. The second thing would be if there was -- since these are unsecured business loans, if the company underlying the bond was to suddenly have a downturn and its credit worthiness to decline, they may make a decision to sell that corporate debt before it further deteriorates.

Tr. 23,576: 4-13. Twomey further explained:

Q. [BY MR. RINALDI] Now, in addition, if those gains had been as a result of sales of high-yield bonds, what was your understanding in July of 1986 as to why USAT would have been selling high-yield bonds?

A. Again, as part of their arbitrage on the high-yield bond portfolio, they still performed credit analysis on those bonds. And if a bond would have a drop-off in its credit, the institution, USAT, could sell it; or in some cases, there might be redemptions.

Q. And was that consistent with a -- an investment portfolio of a high-yield bond arbitrage?

A. Yes.

Tr. 24,887: 8-21.

S81. Twomey never understood that USAT’s management was trading junk bonds out of its investment portfolio in order to generate gains to enhance USAT’s capital:

Q. [BY MR. RINALDI] Did USAT ever tell you that those profits were the results of sales that had been executed out of the junk bond portfolio for the purposes of generating gains to bolster profits to meet USAT's capital requirements?

A. No, they didn't.

Q. Did USAT ever tell you that such gains had resulted from premature selling of the bonds to capture capital gains to bolster profits?

A. No, they did not.

Tr. 23,577: 11-20. Based upon what USAT’s management told Scott, Twomey testified he did not know that USAT’s management was selling junk bonds for the purpose of generating gains:

Q. Did you understand by that that they had told Mr. Scott that they were not selling high-yield bonds in order to capture gains to –

A. Yes.

Tr. 25,048: 6-9 (Twomey).

iii. The Representations Made To The Regulators

By USAT’s Management Regarding The Junk

Bond Portfolio Were False

S82. Joe Phillips, the Investment Manager of the USAT Junk Bond Portfolio between 1984 and 1986, was shown a copy of the June 12, 1986 memorandum to Twomey regarding Scott’s review of USAT’s management of the Junk Bond Portfolio. Tr. 5075: 15 - 5017: 17 (Phillips). Phillips testified that management’s representations to Scott that “the management of the bond portfolio does not involve bond swapping to pick up yields or premature selling to capture capital gains currently unrealized” was false and did not accurately describe how USAT managed the junk bond portfolio. Phillips gave the following testimony:

Q. [BY MR. GUIDO] Was the management of the bond portfolio intended to involve bond swapping to pick up yields or premature selling to capture capital gains currently unrealized?

A. The management style that we used would contemplate some trading of securities that might be -- that might include bond swapping or some sale which I would not characterize as premature.

Q. I mean, it says -- did the concept behind the portfolio at the outset entail bond swapping in order to pick up yields?

A. Yes, I would say that it did.

Q. Did it involve selling to capture gains currently unrealized? Talking about the initial concept.

A. In my initial concept, we did suggest that this portfolio would be actively managed and that these techniques are part of that set of things you do.

Q. I mean, they are things that were done. Right?

MR. EISENHART: Your Honor, to the extent Mr. Guido is intending to refer to the memo, he has left out a fairly important word, which is the memo talks about "premature selling."

Q. (BY MR. GUIDO) Did the initial contemplation of the portfolio entail premature selling to capture capital gains?

A. I would say, yes, it did.

Q. It did?

A. (Witness nods head affirmatively.)

Q. Now –

THE COURT: What do you mean by "premature"?

THE WITNESS: "Premature" is not a word I would use in this -- in discussing a bond. If he means somehow earlier -- earlier than maturity, he may characterize it as premature. It's not a word we use.

THE COURT: So, "premature" means before the bond –

THE WITNESS: Before it matures, if that's what he means.

Q. (BY MR. GUIDO) Now -- so, what you're saying is this memo doesn't accurately reflect what the portfolio was intended to be?

A. With respect to that sentence, I would say it's not accurate.

Q. It clearly doesn't conform to what happened, does it?

A. That's correct. It does not.

Tr. 5,077: 5 - 5,081: 2 (Phillips), emphasis added.

S83. As discussed previously in Section Three at J34, as early as 1984, USAT had begun to trade junk bonds. For example, between February 15, 1985 and December 1987, USAT made over 70 purchases and sales of Phillips Pete Co. SB 14.75% maturing March 15, 2000. See J35 - J46 above.

II. The 1986 Examination Of USAT

S84. The 1986 examination of USAT commenced on May 27, 1986. Ex. T-8142; Tab 1450, p. 2; A-14096, Tab 1451. (The date that an examination begins is known as the “as of date.” Tr. 16,681: 2-10.) The manner and comprehensiveness with which the 1986 examination was conducted were the subject of much dispute during the hearing in this case. The OTS contends, and the Court agrees, that this examination and the subsequent 1987 examination are as significant for the areas they did not review as for the findings and conclusions of the examiners as to the matters that they did review.

A. Vivian Carlton, The Examiner-in-Charge

S85. The Examiner-in-Charge (“EIC”) of the 1986 examination was Vivian E. Carlton. Tr. 16,884: 11-13; Ex. A-14096, Tab 1451. Ms. Carlton had been an FHLBB examiner since 1981. Tr. 16,811: 3-8. Ms. Carlton holds a Bachelor of Science degree in accounting, with a minor in management, from Alabama State University. Tr. 16,809: 14 - 16,810: 1. Prior to beginning her career as a thrift examiner, Ms. Carlton had worked as an accountant for the U.S. Forest Service in 1975 and 1976, Tr. 16,810: 5-12, and as an auditor for the Department of Energy from 1976 through 1980. Tr. 16,810: 13 - 16,811: 2.

S86. Because of her prior experience as a government accountant and auditor, Ms. Carlton became an intermediate level examiner immediately. Tr. 16,811: 9-18. Ms. Carlton rose rapidly in the FHLBB examination staff. She began to act as EIC of examinations of savings associations in 1982, after only six months of employment with the FHLBB and with only 12 to 15 prior examinations. Tr. 16,812: 4-15. In addition, Ms. Carlton was appointed conservator of Investor Savings, an approximately $40 million asset institution in Houston, Texas in 1983 and 1984, where she was in charge of oversight and management of the institution until it was placed in receivership and liquidated. Tr. 16,812: 16 - 16,814: 14.

S87. In 1984 and 1985, Ms. Carlton participated in the FHLBB’s management development program. During her participation in the program, Ms. Carlton was detailed to the FHLBB’s Atlanta regional office as an analyst to assist supervisory agents for approximately six months. Following her Atlanta detail, Ms. Carlton was assigned to work for the head of the FHLBB staff in Washington, DC. Tr. 16,815: 1 - 16,816: 9.

S88. Upon completion of the management development program, Ms. Carlton returned to Texas and began to concentrate her work in the examination of large thrifts. Tr. 16,816: 10-20. In addition to her examinations of USAT, she also participated in the examinations of San Jacinto Savings and University Savings, both of which were large Texas thrifts. Tr. 16,816: 16-20. Prior to beginning the examination of USAT, Ms. Carlton had participated in over thirty examinations. Tr. 16,895: 22 - 16,896: 4.

S89. Ms. Carlton is not a specialist in any examination area. Tr. 16,824: 20-22. Although the Dallas region of the OTS does have specialist examiners today, the FHLB-D did not have specialist examiners in 1986 and 1987. Tr. 16,825: 1-8. Indeed, as will be discussed below at S317, it was not until 1988 that examiners with special expertise were brought in from outside regions to review such areas as securities trading.

S90. Ms. Carlton has participated in placing three savings associations in receivership. Tr. 16,816: 21 - 16,817: 7. In addition, in 1989 and again in 1991, Ms. Carlton acted as a resident examiner at two separate institutions to monitor compliance by institutional acquirers in connection with the so-called “Southwest Plan.” Tr. 16,817: 12 - 16,818: 22. The resident examiner attended all significant meetings at the institution and also acted as EIC for examinations of the institution. Tr. 16,16,819: 6-17. It was very unusual for an examiner to be assigned as a resident examiner for more than one institution. Tr. 16,819: 1-5.

S91. In 1991, Ms. Carlton became a field manager. Tr. 16,820: 19 - 16,821: 1. She currently has a caseload of approximately 18 institutions. She oversees the examinations of those institutions, provides input into the consideration of any pending applications by those institutions, monitoring the activities of the institutions, and recommending supervisory actions. Tr. 16,821:17 - 16,822: 18.

S92. Ms. Carlton is a certified Thrift Regulator. Tr. 16,817: 8-11. In addition, Ms. Carlton is a certified Fraud Examiner. Tr. 16,819: 21. Certification as a Fraud Examiner is granted based upon experience and training by a public-private consortium consisting of representatives of law enforcement (the Federal Bureau of Investigation and the Department of Justice), the banking industry, and the accounting profession. Tr. 16,820: 11-18.

B. Overview of Examination Procedures and Examiners’ Responsibilities

S93. Prior to the commencement of an examination, an institution receives a letter enclosing a “Pre-Examination Response Kit,” or “PERK” package. The PERK package consists of various schedules and questionnaires to be filled out by the institution prior to the arrival of the examination team. In addition, the PERK letter requests that certain other information be available upon the arrival of the examination team. Tr. 16,825: 12 - 16,827: 6; see, e.g., Ex. A-14014, Tab 1455. The information supplied is then distributed among the assistant examiners by the examiner-in-charge in order for them to conduct their assigned segments of the examination. Tr. 16,827: 7-14.

S94. The conduct of the examination is governed initially by a “scope memorandum,” in which the field manager instructs the examiner-in-charge as to which areas are to be reviewed and the procedures to be followed. Tr. 16,827: 14 - 16,828: 1. In some cases, the scope memorandum may contain special audit or review requests, for example, if “something has been identified as a critical area of review between examinations.” Tr. 16,828: 7-9 (Carlton). In addition, the scope of the examination may be modified based upon the initial findings of the examination team. Tr. 16,828: 1-5. The scope memorandum also generally reflects areas that were left unresolved in prior examinations, although, Ms. Carlton testified, it is unusual to have unresolved issues carry over from one examination to the next. Tr. 16,828: 10-22.

S95. Ms. Carlton described the examiners’ responsibility as follows:

The examiner’s responsibility is to go into an institution, review the basic operating areas of that institution, determine the financial condition of the institution, identify risks that may be inherent within the portfolio that could cause any adverse conditions to the institution or to the capital or the viability of that institution.

Tr. 16,829: 5-12. Examiners determine whether the institution is operated in accordance with its own policies and procedures as well as federal and state regulations. Tr. 16,829: 13-17. In order to conduct their review, examiners follow standard examination procedures which are set out in what are today denominated “programs.” Tr. 16,830: 8 - 16,831: 1.

S96. After reviewing the information provided by the institution pursuant to the PERK letter, the examiners obtain further information as necessary by making specific requests to the institution. Tr. 16,831: 19-22. Where there is a simultaneous state examination, the state and federal teams will share information and work product, although the federal examination teams may well conduct additional work because of differing state and federal standards. Tr. 16,831: 5-19.

S97. The examination process is intended to be a cooperative, rather than an adversary, one. Tr. 16,832: 15-21. Generally, examiners have access to any individual in an institution for purposes of obtaining information necessary for the completion of the examination. Tr. 16,833: 21 - 16,834: 1. There are regular meetings with management as well at which the examiners discuss the status of the examination findings and seek additional information to resolve any questions or problem areas. Tr. 16,834: 2-16. More serious issues are raised more formally in an “exception report,” a document that lists violations or raises issues as to which there is incomplete information and seeks explanations or additional information. Tr. 16,833: 2-14. Management is encouraged to disclose significant problems during the examination, Tr. 16,834: 17 - 16,835: 13, and is required to respond in writing to the exceptions reported by the examiners. Tr. 16,836: 1-9.

S98. Ms. Carlton specifically testified that an examiner does not, and cannot, approve or disapprove of transactions undertaken by an institution. Tr. 16,841: 19 - 16,842: 4. That is the function of the management and the board of directors of the institution. Tr. 16,842: 5-7. Supervisory personnel might be called upon to approve or disapprove of transactions, but only in the limited circumstance that there is a pre-existing supervisory agreement or if proposed transaction is one for which the regulations require that the institution submit an application for approval. Tr. 16,842: 8 - 16,843: 3. Examiners attend meetings of boards of directors, but only for the purpose of observing the decision-making process. Their opinions and observations concerning the institution’s decision-making process are expressed, if at all, only in reports of examination. The only comments that examiners make in such meetings relate to the status of the examination. Tr. 16,843: 4 - 16,844: 5.

S99. The examiners’ ultimate product is a final report of examination. However, during the course of long examinations (over 60 days) or where the examiners find significant violations, the examiners prepare interim reports. Tr. 16,836: 16 - 16,838: 4. An issue reported in an interim report is not required to be repeated in the final report of examination, regardless of whether or not the issue has been resolved prior to the close of the examination. Tr. 16,837: 5-19.

S100. One of the features of a final report of examination is a rating of the institution on a numerical scale of one to five, one being the best rating and five the worst. Each institution receives an overall or “composite” rating that is based upon ratings in a number of areas. Tr. 16,837: 20 - 16,839: 5. In the 1980’s, the ratings were known as “MACRO” ratings, an acronym representing ratings of the following subject areas: Management; Asset Quality; Capital Adequacy; Risk Management; and Operations. Tr. 16,838: 5-9. The current rating format uses the acronym “CAMELS,” which represents ratings of the following subject areas: Capital Adequacy; Asset Quality; Management; Earnings; Liquidity; and Sensitivity.

S101. The EIC makes an initial rating recommendation, but the ultimate decision on an institution’s rating is made by supervisory personnel. Tr. 16,839: 19 - 16,841: 4. A rating of three or worse will generally entail some sort of supervisory action. Tr. 16,841: 5-18.

C. Conduct Of The USAT Examination

S102. Ms. Carlton explained (as did Mr. Twomey) that in the early 1980’s, the FHLBB examination staff was understrength and under-experienced. Tr. 16,844: 8-15. The thrift industry had grown and changed markedly, and the FHLBB had been unable to recruit a sufficient number of new examiners to examine thrifts that were growing in both size and complexity or to train its examiners to review the new lines of business that had opened up for the thrift industry, such as major commercial lending, real estate development lending, and securities investments. Tr. 16,844: 16 - 16,849: 8.

S103. The May 27, 1986 examination was the first examination of USAT since 1983. USAT had received a composite rating of two in the 1983 examination. Because of its good rating, and because the regulators were unaware of significant problems at USAT, the FHLBB had deferred the next examination of USAT until 1986 in order to first examine more severely impaired institutions that posed a threat to the FSLIC deposit insurance funds. Tr. 16,882: 21 - 16,883: 11.

S104. As noted above, Ms. Carlton was notified on May 15, 1986, that she was to conduct an examination of USAT. Ex. A-14096, Tab 1451. To staff the examination, she was initially assigned a single assistant examiner and seven Coopers & Lybrand auditors. Id. In addition to deferring examinations, another means the FHLB-D used to ration its limited staff of experienced examiners was to hire junior accountants/auditors from private accounting firms to supplement the examination team and to work under the direction of the EIC and other examiners. Tr. 16,885: 6-13. The fact that the examination team was to be composed primarily of auditors, most of them inexperienced auditors, at that, indicated that the FHLB-D expected few problems at USAT. Tr. 16,886: 3 - 16,889: 14; Ex. A-14010, Tab 1452.

S105. Ms. Carlton testified that, if there were no critical issues to address, it would normally require a staff of eight to ten examiners working for four to five weeks to conduct an examination of an institution the size of USAT ($4.5 billion in assets). Tr. 16,891: 3-16; Tr. 16,885: 14-21. In the event, the examination took considerably longer than expected, with a total of 5,366 hours expended, equivalent to more than 13 weeks for ten examiners. Tr. 16,890: 11 - 16,892: 5; Ex. A-14011, Tab 1453. Of the 5,366 hours expended in the examination, 2,805 were spent in reviewing loan underwriting, and 1,476 were spent in financial analysis, an area that included the review of the trial balance, reconciliation of the general ledgers and the reports that were submitted to the regulators, and reconciliation of internal financial reports that were tied to federal or state reports. Tr. 16,893: 18 - 16,895: 16. Those two areas alone took approximately three-fourths of the time spent in the entire examination. Tr. 16,895: 17-21. Ms. Carlton also testified that USAT had a larger variety of non-traditional investments than any of the 30-plus institutions she had previously examined. Tr. 16,896: 8 - 16,897: 14.

D. Lack Of Cooperation By The Institution

S106. From the very beginning of the examination, USAT fell short in meeting its obligation to provide complete and timely information to the examination team. The PERK letter notified the institution that the examination would commence on May 27, 1986 and requested that certain information be provided prior to that date. Ex. A-14014, Tab 1455. Nevertheless, some very fundamental and important information requested in the PERK letter was not provided until July; Ms. Carlton testified, and Exhibit A14014, Tab 1455, confirms that USAT did not provide trial balance worksheets and operating worksheets until July 1986, more than a month late. Tr. 16,900: 7 - 16,901: 3. The examination team discovered within a few weeks that USAT’s books were in serious disarray. The flow of information to the examiners slowed down, and they found they were unable to reconcile loan ledgers and subledgers. Tr. 16,903: 8 - 18.

S107. Ms. Carlton testified that management of USAT provided only a minimal degree of cooperation to the examiners, and ultimately instructed USAT staff not to communicate with the examiners. The examiners were told that there would be no more informal communication with the staff and that all requests for information must be submitted to management in writing. Tr. 16,911: 2 - 16,913: 5. USAT management did not discuss its new and unusual policy with the examiners before implementing it. Tr. 16,913: 7-12. During the remainder of the 1986 examination and during the 1987 examination, management designated liaison personnel who purportedly were to respond to the examiners’ requests. Tr. 16,913: 13-21. Ms. Carlton testified that during the 1986 examination it was frequently necessary to request information more than once, and that the liaison personnel were responsive to subsequent requests only some of the time. Tr. 16,914: 12 - 16,915: 2.

E. Interim Reports

S108. Ms. Carlton testified that she was required to include in her interim reports significant activity that would adversely affect the financial viability of the institution, unsafe and unsound practices, or regulatory violations that would jeopardize the net worth or financial condition of an institution. Tr. 16,915: 16 - 16,916: 2. Because of the length of the May 27, 1986 USAT examination, Ms. Carlton submitted three interim reports dated July 17, August 19, and October 10, 1986, Ex. A-14016, Tab 1457; Ex. A-14017, Tab 1459; Ex.A-14019, Tab 1460A, in addition to her final report of examination, Ex. A-14020, Tab 1461.[2]^/

1. The July 17, 1986 Interim Report

S109. Ms. Carlton’s first interim report noted three areas of concern. First, USAT had failed to meet its net worth requirement for the quarter ended March 31, 1986. Second, there were significant deficiencies in USAT’s books and records. Third, USAT had become involved in the junk bond market.

i. Net Worth Deficiency

S110. USAT’s failure to meet its net worth requirement was due to the examiners’ classification of some $168 million in loans as scheduled items. The bulk of the scheduled items ($140,253,697) were loans purchased from Couch Mortgage Company.[3]^/ In addition, though, there were four loans totaling $25,479,118, Tab 1457that had been modified while contractually delinquent and $2,498,249 in loans to facilitate that had been unreported. In addition, the examiners believed that upon completion of additional reviews already in progress, there would be further assets that would require reserves, which would further decrease USAT’s net worth. Ex. A-14016, Tab 1457, p. 1. Ms. Carlton described briefly the numerous and significant consequences that might ensue from failure to meet the net worth requirement, including the possibility of the imposition of a supervisory agreement or other supervisory mechanism that would or could restrict: liability growth; direct investments; loans to one borrower; investments in service corporations and finance subsidiaries; use of brokered deposits; issuance of subordinated debt; use of repurchase agreements to finance securities purchases; forward commitments; and payments of dividends, salaries, and bonuses. Tr. 16,917: 20 - 16,924: 14. In addition, Ms. Carlton testified that an institution that had failed to comply with the net worth requirement could be required to divest itself of junk bonds. Tr. 16,929: 17 - 16,930: 1. Any such restrictions would have impacted USAT’s operations.

ii. Books and Records

S111. Ms. Carlton found extensive problems with USAT’s books and records, particularly with respect to records of real estate owned and the classification of loans. Ex. A-14016, Tab 1457, pp. 1-2. Files relating to more than $4 million in Real Estate Owned could not be found, and, therefore, USAT could not demonstrate that it held legal title to those properties. Id. p. 1. The examiners were unable to reconcile USAT’s Thrift Financial Report to USAT’s books and records because of inadequate documentation in the institution. USAT had no GAAP to RAP reconciliation. There were numerous misclassifications of loans. USAT, itself, was unable to balance it books which were out of balance by more than $1 million. Id. p. 2. Both Ms. Carlton and Rex Cool, the examiner in charge of the concurrent State of Texas examination described USAT’s books and records as the worst they had ever seen. Tr. 10,175: 18 - 10,176: 8 (Cool); Tr. 17,071: 4-17 (Carlton); Tr. 18,011: 2 - 18012: 21 (Carlton). Indeed, Ms. Carlton testified that USAT was the only institution she had ever examined in which the books and records were such that her examination team could “make a statement that we could not reconcile each quarter's work from the previous examination to [the] current examination.” Tr. 18,012: 16-18.

S112. During the hearing, the Respondents sought to minimize the importance of the condition of USAT’s books and records and the problems identified by Ms. Carlton and to attribute it to the the difficulties of the merger of two computer systems. Disturbingly, however, there is evidence in the record that indicates that these problems were of long standing and that the Respondents were well aware of them and their importance. On October 25, 1984, fully a year-and-one-half before the commencement of the 1986 examination, Gerald Williams had written a memorandum to the Executive Committee of UFG addressing a number of issues relating to USAT’s strategy and performance:

The back office situation within USAT is in much worse shape than any of us realized. Everyone understood the impact of introducing a new computer system but this has not turned out to be our most pressing concern. The big problem is the company’s inefficiency and the total disarray of our loan files and missing documents that are fundamental to the business. It is taking an extraordinary amount of time by second and third-level managers to “clean house” that will continue into 1985. Notwithstanding the fact that USAT must get its house in order, the sheer effort diverts management’s time away from more productive matters. Additionally, the overall recomputerization project is taking longer due to the complexities of merging the two existing systems. The positive aspect of this is that we are doing some long-neglected “due diligence” on the company.

Ex. A-10546, Tab 171.

iii. Investment Securities

S113. Finally, the July 17, 1986 interim report discussed briefly concerns with investment securities, particularly junk bonds. At the time, based upon a cursory review of the portfolio, Tr. 16929: 3-9, there were two primary concerns. First, USAT held $10 million par of Hudson Funding Corporation bonds, of which it had been able to divest itself. Hudson Funding was associated with Ivan Boesky, whose business dealings had been questioned at the time. Second, the examiners questioned the adequacy of USAT’s reserves for losses on securities. Ex. A-14016, Tab 1457, p.2.

2. The August 19, 1986, Interim Report

S114. In early to mid-September 1986, see Tr. 16,939: 6 - 16,940: 2, Ms. Carlton submitted a second interim report dated August 19, 1986. Ex. A-14017, Tab 1459. In her second report, Ms. Carlton noted additional areas of concern and expanded upon the areas described in her first report. In the area of Risk Management (the “R” in “MACRO”), Ms. Carlton noted a significant documentation deficiency: Neither the numerous individuals involved in the trading of financial instruments nor USAT as an institution maintained “documentation to support the thought and decision making processes involving the given hedging and investment activity.” Id. p. 1. Ms. Carlton explained that “the individuals who were responsible for the area … could not explain the hedging activity and the investment activity for that area and how it reflected back to the business plan and overall strategy in which they had invested [in] those instruments.” Tr. 16,943: 8 - 16,943: 3.

S115. In addition, the report noted that USAT had restated its income for the first and second quarters of 1986, increasing income from the sale of mortgage-backed securities by some $36 million. Ex. A-14017, Tab 1459; see Tr. 16,936: 2 - 16,938: 11. This had been reported to Ms. Carlton’s field manager previously in a special report dated September 4, 1986. Ex. A-14018, Tab 1458. Ms. Carlton noted in both the special report and the interim report, and confirmed in her testimony that the examiners had learned of the restatement of income from the Houston Chronicle newspaper, not from management of USAT. Tr. 16,937: 11-17

S116. Third, the August 19, 1986 interim report noted that USAT had been notified that it should establish a reserve for some $10 million in preferred stock in Independent American Savings and Loan Association (received in conjunction with the sale of branches). Ms. Carlton reported that the responsible officer of USAT had “stated that USAT would not reserve the $10,000,000 unless instructed by Dallas.” Ex. A-14017, Tab 1459, p. 2. Ms. Carlton explained that this meant that USAT was aware the preferred stock had no value, and yet it refused to take any action to create a reserve for the worthless asset unless required to do so by FHLB-D.

S117. Fourth, the second interim report expanded upon the previously reported books and records deficiencies. Ex. A-14017, Tab 1459, pp. 3-4. In addition to the continuing loan classification issues reported in July 1986, the report noted four items that would require the amendment of USAT’s financial reports to the FHLB-D. It noted that the March 31 and June 30, 1986 Quarterly Financial Reports and the March, April, May, and June monthly financial reports had been amended,[4] but only on account of only two of those items, the restatement of income discussed above and a reclassification of interest rate swap expense. The other two items not yet reflected in the financial reports would have reduced USAT’s net worth by over $4 million. One of them indicated that assets would decrease by $598,116 and the other would reclassify some $3,568,510 in accrued non-earning loans from Accrued Interest Receivable to Specific Reserve and Valuation Allowance. Id. p. 3. (As Ms. Carlton explained in her testimony, creation of a specific reserve removes the asset as a component of net worth. Tr. 17,209: 1-10.) Ms. Carlton described the components of USAT’s financial statements as “a moving target” that could not be reconciled. Tr. 16,946: 17 - 16,947: 7. Ms. Carlton concluded by that point that there could be no thorough analysis of all financial reports subsequent to the previous exam “due to the lack of support and the magnitude of reporting errors on the March 31, 1986 Quarterly Report.” Ex. A-14017, Tab 1459, p.3. Ms. Carlton testified that she concluded that USAT lacked internal controls and that the financial information it provided was unreliable.

S118. The fifth area of concern (relating to Management, the “M” in “MACRO”) was that there was no directors and officers bond coverage. Sixth, under Asset Quality (the “A” in “MACRO”), Ms. Carlton discussed two areas of concern. The first was the review of “major/commercial loans,” in which she noted numerous documentation exceptions. The second area of concern was the Couch loans. In addition to many problems with the documentation and underwriting of the loans themselves, Ms. Carlton noted that all of the loans “were 87days delinquent on June 27, 1986 at which time USAT granted a $2,324,164 loan for the purpose of paying the delinquent interest.” Ex. A-14017, Tab 1459, p. 4. Management claimed that it was necessary to make the loan to keep Couch out of bankruptcy, “because it would take years for USAT to recover $140,000,000 if Couch filed for bankruptcy.” Id. p. 5. She noted that although management agreed about the risks of the Couch situation, they did not agree that the loans should be scheduled. Id.

3. The October 10, 1986 Interim Report

S119. Ms. Carlton’s third and final interim report was dated October 10, 1986. Ex,. A-14019, Tab 1460A. It addressed ten separate areas of concern and reported that the field work of the examination was complete. The first area Ms. Carlton addressed was USAT’s lack of compliance with the minimum net worth requirement. She noted that USAT had been below its required minimum net worth since December 31, 1985. As of June 30, 1985, the deficiency was $10,491,956. Moreover, that calculation did not take into account specific reserves of $9,207,015 that had been requested by the examiners, but that had not been established. In addition, she noted that USAT’s own calculations contained significant errors such as incorrectly reducing its liabilities by $260 million and failing to include all of its subsidiaries in the calculation of its direct investments. The primary cause of the deficiency was the large amount of scheduled items, aggregating some 10.6% of total assets. Id. p.2.

S120. Under Scheduled Items, the report noted that USAT had understated its scheduled items by more than $308 million due to failure to properly report a number of asset categories, including some $139 million in Couch loans. Id. p.3. This alone led to a $60 million understatement by USAT of its required minimum net worth. Tr. 16,959: 18 - 16,960: 13. In a separate discussion of the Couch loans, the report noted that USAT had filed a lawsuit against Couch in connection with the servicing of those loans and stated that approximately $50 million of the loan portfolio was subject to conflicting lien claims by other institutions. It noted that the loss due to the Couch loans could not be determined. Id. p. 4.

S121. The report also noted that USAT transacted a great deal of business through subsidiaries. It recommended that the subsidiaries be closely monitored in view of USAT’s net worth deficiencies and the risks attendant to some of the business of USAT’s service corporations. Id. pp. 5-7. Under the title, “Secondary Market Activity, the report noted that 22% of USAT’s assets were invested in MBS, reiterated the description of the restatement of income, and criticized the time at which securities purchases were booked. Id. p. 8. The report also noted that USAT had made an error in reporting its interest rate swaps. Id. p. 10.

S122. Under “High Yield Investments (Junk Bonds), the report noted that USAT’s non-liquidity securities portfolio constituted 10% of assets and that a large proportion of that portfolio consisted of junk bonds. The report noted high concentrations in certain issues and described three instances in which USAT had violated its own procedures in the past by holding more than 5% of a given security issue. Id. pp. 11, 13.[5]^/ The report described USAT’s equity arbitrage activities under “Other Areas Of Concern.” It noted the risk of loss involved in equity arbitrage, but stated that no instance had been found where USAT had lost money in the equity arbitrage portfolio. Id. pp. 14, 12. Finally, the report described USAT’s holdings of Weingarten Realty, Inc. and expressed concern at the role of Charles Hurwitz’ role in that he “appear[ed] to control certain activities of the association.” Id. p. 15.

F. The Final Report Of Examination

S123. Field work for the Final Report of Examination of United Saving Association of Texas as of May 27, 1986, was completed on October 3, 1986, and the report was transmitted to supervision on January 14, 1987. Tr. 17,991: 8-14; Ex. A-12105, Tab 1611, p. OW123334. A copy of the report was sent to USAT on March 9, 1987, without comment at management’s request. On April 16, 1987, a second copy was sent to USAT, this time accompanied by supervisory comments and directives in a cover letter. The report itself largely repeated the concerns expressed in the three interim reports, supplemented with more detailed discussion and support. The cover letter reflected both the supervisory review of the final report and supervisory consideration of USAT management’s responses to the criticisms and recommendations reflected in the report and the examiners’ exceptions. See Ex. A-14020, Tab 1461.

1. Rating and Major Exceptions

S124. The examination report summary identified four major problem areas, all of which had been addressed in interim reports: USAT’s net worth deficiency, increased scheduled items and classified assets (including the Couch Mortgage Company loans), improperly maintained books and records, and reliance on nonoperating items for profitable operation. Ex. A-14020, Tab 1761, OW078149.

S125. Ms. Carlton initially recommended a composite rating of “4,” but her field manager disagreed and assigned a rating of “3.” Tr. 16,866: 17 - 16,867: 3; Tr. 17,992: 14 - 17,995: 3. The final composite rating assigned to USAT by its supervisory agent, Neil Twomey, however, was a “4,” with “4” ratings assigned to the Management, Asset Quality, and Risk Management components as well. Id. p. OW078144. Ms. Carlton explained that a “4” means that an institution exhibits a combination of unsafe and unsound practices that require immediate supervisory action, because the potential for loss is imminent, and the viability of the institution may be in jeopardy, because of the potential for insolvency. Tr. 16,985: 3 - 16,386: 9.

S126. The examination cover letter expanded on the report summary and identified “several matters of supervisory concern, including capital adequacy, asset quality, books and records, internal controls, and investment practices. The cover letter directed USAT to establish a reserve of $3,068,438 for assets classified as loss items and to increase USAT’s reserves for uncollectible interest by $851,437. The letter also noted that as a consequence of the additional required reserves, USAT, which had already failed to meet its net worth requirement as of June 30, 1986 by $10.5 million, actually had a net worth deficiency of $14.4 million, or 6.3% of net worth. Ex. A-14020, Tab 1461, p. OW078142.

S127. In addition, the cover letter acknowledged that USAT management had protested the examiners’ calculation of the net worth requirement. The cover letter indicated that management would be required to provide additional information with respect to $296.9 million in assets the examiners had classified, but which USAT maintained should not have been classified. Prominently included among those assets were $140 million in Couch Mortgage Company loans. Id. OW078142-43. Also included among those assets were the $21 million loan to Stephen M. Block, Trustee (classified substandard) and the $30 million Norwood loan (subject to special comment), which are discussed above at R240 - R307 in connection with the Norwood/United Park JV transaction. See id. pp. OW078157, OW0078166-67, OW078171-72.

S128. The cover letter also noted that USAT had once again revised its June 30, 1986 report to reflect additional net worth of $13.2 million – coincidentally, just enough to cover the net worth deficiency as calculated by the examiners. The letter expressed skepticism of this adjustment and stated: “This office is very concerned that United’s true condition has not yet been revealed. Exacerbating our concern is the questionable state of United’s books, records, and systems as noted in the Report…” Id. p. OW078143.

S129. Additionally, the cover letter stated:

The matter of United’s investment portfolio has been discussed at length in recent months, and Management has repeatedly attempted to assure this office that the investments being made were prudent. However, in view of the market conditions as stated and projected by market sources we are not convinced that United’s investments have a tolerable amount of risk.

Id. p. OW078143.

2. Areas Not Covered

S130. Ms. Carlton testified at some length concerning the fact that the examination team did not complete all of the designated examination procedures in the examination of USAT. She explained that after the examination team had completed most of the review of asset quality and of USAT’s books and records, and the team could not reconcile the books and records and could not reach a conclusion as to losses in the Couch portfolio, FHLB-D management asked the team to cease the examination and finalize the report in order to forward the report to Washington. She was told that in view of the problems her team had identified, a new examination would commence within a short time. Accordingly, the examination team completed a summary of activities in the subsidiaries and closed the examination. Tr. 16,975: 3 - 16,976: 8.

S131. Ms. Carlton identified several areas that were not reviewed in the examination because the examination was truncated at the request of supervision.. She testified that the examination team did not perform a complete review of USAT’s securities transactions. Tr. 17,074: 5-8. The examination team did not perform a complete review of interest rate risk management, either, because the examination team had been told to leave the institution. Tr. 17,089: 12 - 17,090: 7. Likewise, there was only a limited analysis of interest rate swaps, “because we had been asked to leave the institution.” Tr. 17.091: 7-16. Similarly, Ms. Carlton testified, the examination team did not analyze the relationships of MBS, reverse repurchase agreements, and interest rate swaps, even though there was an examination program to do so, again “because we had been asked to leave.” Tr. 17,093: 15 - 17,094: 18. The examination team simply filed the documentation it had received, and closed out the examination as they had been told to do. E.g., Tr. 17,094: 22 - 17,096: 5 (swap documentation). The examination team did not complete the examination program relating to high-yield bonds for the same reason. Tr. 17,099: 20 - 17,100: 5; Tr. 15,157:18 - 17,158: 10 (discussing Ex A-14063, Tab 1493, p. OW128998). Equity arbitrage was yet another area in which the examination team did not complete the examination objectives, again for the same reason. Tr. 17,108: 17 - 17,109: 6.

S132. Ms. Carlton also testified that the examination team had been given no information concerning certain specific matters that came to light subsequently. She stated that she had not been told that USAT’s interest rate swaps were $12 million underwater. Tr. 17,091: 17 - 17,092: 7. Additionally, she stated that the investment goals expressed in the Investment Committee Minutes compiled by the examination team did not indicate that USAT intended to make sales out of the high-yield bond portfolio for the purposes of generating a gain to bolster profits. Tr. 17,122: 5 - 17,123: 9; Ex. A-14055A, Tab 1487.

III. Supervision After The 1986 Examination

A. The Continuing Supervisory Concern Of The FHLB-D Regarding USAT’s Involvement With DBL And Its Investments In Junk Bonds After The Commencement Of The 1986 Examination

1. The Continuing Inquiries By The FHLB-D Regarding USAT’s High-Yield Bond Portfolio

S133. After the commencement of the 1986 examination, the FHLB-D continued to be concerned about USAT’s high-yield bond portfolio and in the latter part of 1986 Ginger Baugh requested that USAT provide the FHLB-D with a description of “the current status and outlook of the Association’s high-yield bond portfolio.” Ex. A-12164, Tab 1875 (12/18/86 Berner Letter).

S134. In response to the request, Berner sent Supervisory Agent Twomey a letter on December 18, 1986, in which he described the manner in which USAT was managing the portfolio. Ex. A-12164, Tab 1875. Berner advised Twomey that the portfolio had generated $12.8 million in spread income and “realized market gains in excess of $42 million,” and that USAT expected to increase its high-yield bonds in 1987 to generate “spread” income. Id. p. OW160838. The letter in part stated:

Thus, at a time when the Texas economy offers few areas of profitability, United’s high-yield bond portfolio has been extremely successful. Ironically, at this time, linked to the unsettled market, the spread between the interest rate offered on those high-yield bonds with strong credits and interest rates which can be received through other investments is at an historical high. The current spread between the portfolio yield and United’s fixed rate cost of funds is 3.46%.

* * * * *

Thus, United believes that it is in the best interest of its depositors, stockholders, the FSLIC and the FHLBB to take advantage of the spreads offered in the high-yield bond market by investing in good credit high-yield bond offerings identified though extremely careful research, and monitored by a team of experienced, talented managers.

In view of the spreads available at this time on strong corporate credits, by year-end United expects its high-yield bond portfolio to be approximately $475 million and, depending upon the market response to such bonds, United expects to increase such investments in 1987 by $200-300 million of strong corporate credits.

Id. p. OW160838, emphasis added.

S135. Twomey testified that after receiving Berner’s letter it was still his impression that

the USAT high-yield bond portfolio was a “matched duration” investment portfolio which had been entered into by United for the purposes of earning spread income. Tr. 23,614: 15-19.

2. The FHLB-D Expresses Concern About The Departure Of Joe Phillips And The Liquidity Of High-Yield Bonds

S136. In the latter part of 1986 Joe Phillips left USAT. Tr. 5,218: 1-3 (Phillips). Phillips had been highly regarded by Jonathan Scott and was the primary reason the FHLB-D felt “reasonably comfortable” with USAT’s junk bond operations. Ex. A-11073, Tab 1877 (03/25/87 Summary for RRC) p. OW152879; Tr. 23,615: 22 - 23,616: 21 (Twomey). On January 28, 1987, Twomey wrote USAT and expressed concern about Phillips departure and urged USAT to consider reducing the investment risks of USAT’s high-yield bond portfolio. Ex. B-1453, Tab 253. Twomey also cautioned USAT about the possible illiquidity of the portfolio:

It is our understanding that Drexel Burnham is considered the primary vehicle nationally for high-yield bond investments. Considering the company’s involvement with the Ivan Boesky case, it is reasonable to assume that Drexel will directly or indirectly experience repercussions from the case. If, as a result of those repercussions, Drexel withdraws from the high-yield bond market, the liquidity of such bonds would be severely hampered. Therefore, it is imperative to consider United’s position under these and other negative conditions.

Id. p. CN208066. Twomey concluded the letter as follows:

United is urged to carefully review its strategy with regard to investments to consider reducing the investment risks, even at the expense of lower yields.

Id.

S137. Twomey testified that when he wrote the January 28, 1987 letter, he was concerned about the marketability of USAT bonds if something happened to DBL and was therefore urging them to consider reducing the size of the high-yield bond portfolio. Tr. 23,617: 18 - 23,618: 6.

3. USAT Continued To Represent That The High-Yield Bond Portfolio Was An Investment Portfolio, Duration Matched To Generate Spread Income

S138. Berner responded to Twomey’s concerns regarding DBL and the marketability of USAT’s bonds by letter dated February 11, 1987. Ex. A-12169, Tab 1876. Once again Berner reiterated that the USAT high-yield bond portfolio was “duration matched” with “long-term retail brokered CD’s” for the purpose of generating a “spread” income. Id. p. OW151990. Berner advised Twomey that “United does not believe that the possible involvement of Drexel Burnham Lambert in the Ivan Boesky matter will have any significant long or short-term effect on the high-yield bond market.” Id. p. OW151992. Berner continued:

United has no current or proposed arrangement with Drexel or any other brokers with regard to the purchase and sale of high-yield bonds. In fact, for the most part, United’s high-yield bond portfolio is designed to be an investment and not a trading portfolio so that long-term holdings are the expectation upon acquisition.

Id. p. OW151992.

S139. In response to Twomey’s concerns regarding the liquidity of USAT’s high-yield bond portfolio, Berner stated:

Charles Hurwitz would appreciate meeting with you to discuss his insights into the liquidity and high-yield bonds, at your convenience.

Id.

S140. Twomey testified that after receiving Berner’s letter he continued to believe that the USAT junk bond portfolio was not a trading portfolio and that long-term holdings were the expectation. Tr. 23,625: 8-21.

S141. Berner’s representations that the high-yield bond portfolio was an investment portfolio rather than a trading portfolio and that long term holdings were the expectation upon acquisition were false. In fact, as discussed in Section three, above at J34 - J48 USAT frequently bought and sold the same high-yield bonds within a very short period of time.

4. Berner Offers To Have Hurwitz Discuss The Liquidity Of The High-Yield Bond Portfolio

S142. As discussed previously at FOFs A 312 - A 318, Charles Hurwitz, who initially directed Huebsch to set up the high-yield bond portfolio (Tr. 13,423: 5 - 13,424: 10 (Huebsch)), was the only member of USAT’s senior management who had any experience with high-yield bonds. Tr. 13,504: 1-7 (Huebsch); Tr. 25,906: 9 - 25,907: 9 (Hurwitz). After assuring the FHLB-D that there was no “decrease in [high-yield bond] liquidity as a result of the Boesky situation” Berner suggested:

In this connection, as we discussed, Charles Hurwitz would appreciate meeting with you to discuss his insights into the liquidity of high-yield bond.

Id. p. OW151992.

S143. Although Twomey did not recall whether he spoke with Hurwitz on this occasion regarding the USAT high-yield bond portfolio, he stated that during the period he supervised USAT he had talked with Hurwitz on several occasions (Tr. 23,624: 11-21) and he understood that “Mr. Hurwitz definitely had a great deal of knowledge in the area of junk bonds.” Tr. 23,624: 22 - 23,625: 7.

B. Supervisory Action Was Taken By The FHLB-D When It Obtained The Final Results Of The 1986 Examination

1. The Supervisory Agent Recommended That USAT Be Directed To Sign A Supervisory Agreement

S144. By March 1987, Examiner Carlton had submitted several Interim Reports for the 1986 Examination to FHLB-D supervision (Ex. A-14016, Tab 1457 (07/17/86 Interim Report); A-14017, Tab 1459 (09/16/86 Interim Report) and Twomey was aware of the preliminary conclusions reached by the Examiners in the 1986 Examination. Tr 23,638: 14 - 23,640: 3 (Twomey).

S145. After receiving information regarding the results of the 1986 Examination, Twomey submitted a summary to the Regulatory Review Committee (“RRC”), on March 25, 1987, recommending a proposed supervisory course of action to be taken with respect to USAT. Ex. A-11073, Tab 1877 (RRC Summary); Tr. 23,639: 14 - 23,640: 3 (Twomey). In the RRC summary Twomey noted, among other things, that “the Association failed to meet its minimum net worth requirement” (id. p. OW152879) due to an increase in scheduled items associated with the Couch Mortgage loans. Id. p. OW152878-79. The summary also commented on USAT’s junk bonds and noted that USAT “held $10 million in Boesky bonds…examiners stated that the Association had been unable to sell…” Id. The summary stated:

2. Areas of Concern: Low tangible net worth, continuous net operating losses, increasing scheduled items, potential losses due to Couch loans, potential losses due to “junk” bond trading, and substantial interest rate risk suggest that United may become a problem institution, if it is not already. However, of more concern is the possibility that United may be covering up the problem in its books and records.

Id.

S146. When questioned about the concerns he expressed in the RRC summary regarding potential junk bond losses Twomey testified:

Q. Was it your understanding at this point in time that USAT was engaging in trading of junk bonds in order to generate gains to increase their capital?

A. No.

Q. Then what are you referring to when it says "potential losses due to junk bond trading"?

A. Again, junk bonds reviewed by the regulatory -- by me as being more risky than normal, traditional thrift assets such as loans on a single-family home. And again, with [USAT’s] decreasing net worth and our discussions with [management] over [USAT’s] net worth position, we were concerned that if they continued to make large investments in junk bonds with a shrinking net worth, we were concerned that if suddenly the market turned against them on their junk bond investments, they wouldn't have the reserves necessary to cushion the institution.

Tr. 23,643: 16 - 12.

S147. Twomey concluded the March 25, 1987 RRC summary with the following recommendation:

3. Recommendation and Action Plan: We recommend that an unaffiliated auditing firm be sent to United to thoroughly audit their books and records.

We also recommend that United be directed to sign a Supervisory Agreement addressing net worth deficiencies and violations of 563.17-1 & 17-2 (appraisals) and 563.23-3 and T18-5 (books and records.)

Ex. A-11073, Tab 1877, p. OW152880. Twomey also attached an outline for a proposed USAT supervisory agreement which listed violations and unsafe and unsound practices and “Specific Corrective Actions.” Id. p. OW152881. Among other things it proposed restricting USAT’s junk bond investment activities by “[l]imit[ing] Investments to high-grade bonds and securities.” Id.

2. In Lieu Of A Supervisory Agreement The FHLB-D Required That USAT Obtain Third-Party Reviews Of Its Books And Records And Of Its Investment Portfolio

i. The Closing 1986 Examination Letter

S148. Twomey’s continuing concerns regarding USAT’s investment activities and the risks associated with them were reflected in the closing examination letter sent to the USAT Board by Senior Supervisory Agent Daniel Thomas on April 16, 1987, which, stated, in part:

The matter of United’s investment portfolio has been discussed at length during recent months, and Management has repeatedly attempted to assure this office that the investments being made were prudent. However, in view of the market conditions as stated and projected by market sources, we are not convinced that United’s investments have a tolerable amount of risk.

Ex. T-8014, Tab 395 p. UFG-H 0232, emphasis added..

S149. Additionally, the Senior Supervisory Agent expressed grave concerns about the accuracy of USAT’s books and records in the closing letter sent to the USAT Board. The letter noted that USAT had filed numerous amendments to its TFRs and stated:

The directorate is advised that frequent and/or routine amendments are, at best, viewed unfavorably and, at worst, gives the impression of adjusting the line items to reflect a predetermined position. As members of the board, you have the responsibility to determining the true condition of the Association. This office is very concerned that United’s true condition has not yet been revealed. Exacerbating our concern is the questionable state of United’s books, records, and systems, as noted in the Report on 24 and 25.

Ex. T-8014, Tab 395, p. UFG-H 0232.

ii. USAT Opposed Entering Into A Supervisory Agreement

S150. When Twomey suggested that USAT be required to enter into a Supervisory Agreement it was opposed by USAT. Tr. 23,263: 21-23,265: 17. Twomey explained:

At various times, they [USAT] communicated to me that because of a large portion of their liabilities, their borrowed money, was repo money coming from Wall Street, they were very sensitive to the fact that UFG was a publicly reporting company and that if they had to make a disclosure they were under some type of supervisory restrictions, it would adversely affect their ability to raise money on Wall Street.

Tr. 23,264: 2-10.

S151. The head of the Regulatory Review Committee and the head of FHLB-D regulatory affairs, Joe Selby, was concerned that the FHLB-D did not have an accurate picture of USAT’s condition because during the 1986 Examination Examiner Carlton had not been able to determine USAT’s “true financial position.” Tr. 23,645: 7-19; Tr. 23,263: 4-11 (Twomey). Under these circumstances, Selby did not want to impose a supervisory agreement upon USAT until he knew the true condition of USAT. Id. Selby decided that it would be more constructive to engage outside auditors to go in and review the books, the records, and the systems of USAT so that the regulators could get an accurate report of USAT’s condition. Tr. 23,263: 3-20; Tr. 23,645: 12-19 (Twomey).

iii. Grant Thorton Is Selected To Perform A Third Party Review Of USAT’s Books And Records

S152. USAT’s Board agreed to the third party books and records review proposed by the FHLB-D (Tr. 23,236: 16-21 (Twomey)) and on August 28, 1987, Grant Thornton was retained by USAT to conduct the review. Ex. A-11084, Tab 1878 (10/01/87 Significant Case Report) p. OW157751. On October 16, 1987, Grant Thornton completed its review and it was determined that the books and records were “substantially improved” from the 1986 Examination. Ex. A-12199, Tab 1879 (06/01/88 Significant Case Report) p. 0W150767.

3. Prudential Bache Reviewed USAT’s Junk Bond Investment Procedures But Did Not Review The Portfolio Activity To Determine Whether It Was Consistent With USAT’s Declared Intentions

S153. In addition to the books and records review, USAT was also directed by the FHLB-D to obtain a third-party review of its activities with respect to its investment activities. Tr. 23,654: 15-23,655: 3 (Twomey).

i. The Requested Scope Of The Review

S154. On August 7, 1987, representatives of the FHLB-D met with officers of USAT to discuss, among other things, the third party review of USAT’s investment portfolios. Ginger Baugh’s notes of the meeting indicate that Neil Twomey advised USAT that:

[t]he scope would include high-yield bonds, equity arbitrage, mortgage backed securities, policy and procedures to see if they support the activities and to see if United follows established policy and procedures, review personnel to see if they have expertise to handle the job.

Ex. A-11078, Tab 1760, p. OW157685. Twomey testified that “[w]e wanted somebody, an outside party principally from Wall Street, to be able to go in there and look at their mortgage-backed securities, look at their junk bonds, and the trades coming out of both of them.” Tr. 23,655: 9-14

S155. Following the meeting, Twomey sent a letter to Berner on September 9, 1987, outlining the scope of the review directed by the FHLB-D. Ex. B-1742, Tab 282. By this time, the scope of the review had been cut back so that it only included the high-yield bond portfolio. Id. The letter stated as follows:

“It is our understanding that you will continue the search for an appropriate reviewer and request our concurrence for your proposed choice. The scope of the review, at a minimum, should include an analysis of the following:

1. United’s written investment objectives and policies.

2. Experience, education, and skills of the individuals responsible for the management of the investment portfolio, including their expertise in strategy formulation, analytical research, execution, and trading. This should include both the personnel requirements for these individuals as well as the actual experience of United’s portfolio management.

3. Composition of the high-yield investment portfolio, including assets, industry and/or size concentrations, prices paid as compared with market clearing prices and market conditions, and with consideration for the yields and prices of securities with similar risks. This should include an analysis of the changes in the overall composition of the portfolio over time with respect to risk, maturity, or any other salient measures.

4. Trading activities with respect to the high-yield investment portfolio, including the timing of dealer quotes, the reinvestment of proceeds into similar/dissimilar investments of more/less risk, and the decision-making processes involved in selling securities.

5. Monitoring and oversight functions of the portfolio.

Ex. B-1742, Tab 282 (Twomey scope letter) p. UFG 08408, emphasis added.

Twomey testified as follows regarding the intended scope:

We also wanted them to look at their portfolios, the composition, how they were mixed, any trading activities, you know, any buy-sell of each of those portfolios out of a reasonable period of time. And look at the reports that those portfolio managers submit to senior management to see if they provide enough information for monitoring and oversight of the portfolios.

Tr. 23,666: 5-13.

ii. Prudential Bache Was Selected To Review USAT’s High-Yield Bond Portfolio

S156. Ginger Baugh’s August 10, 1987 memorandum to the file concerning the August 7, 1987 meeting between the regulators and USAT management indicates that initially it was contemplated that either Merrill Lynch or Morgan Stanley would be retained by USAT to conduct the high-yield bond review. Ex. A-11078, Tab 1760, p. OW157685; A-11079, Tab 1680 (08/10/87 Berner memo) p. OW005758.

S157. Berner informed Twomey that USAT’s management “discussed the undertaking with representatives of Merrill Lynch Capital Markets and found the proposed fee unacceptable.” Ex. B-1742, Tab 282 (09/09/87 Berner letter) p. UFG 08408. According to Twomey, USAT refused to pay the $100,000 fee proposed by Merrill Lynch for a full scope review. Tr. 23,332: 5-19; Ex: A-11084, Tab 1878 (10/01/87 SSC Report) p. OW157751-2. Instead, USAT selected Prudential Bache, who were also acceptable to the FHLB-D, to conduct a review of just the high-yield bond portfolio for a fee of $30,000. Ex: A-11084, Tab 1878 (10/01/87 SSC Report) p. OW157751-2; Tr. 23,663: 2-28 (Twomey).

S158. On November 24, 1987, Prudential Bache completed its review of the USAT junk bond portfolio and submitted its report to the FHLB-D. Ex. A-14092, Tab 1509 (Prudential Report). The report addressed the following points regarding USAT’s high-yield bond portfolio: (1) the Association’s written objectives, policies and procedures; (2) the backgrounds and experience of the persons managing the portfolio; (3) the diversification of the portfolio among industries; (4) the diversification of purchases and sales among broker/dealers; and (5) the Association’s monitoring and continuing credit review. Id. p. OW180635. Prudential-Bache’s review consisted of meeting with “four individuals employed full-time in connection with the management of the Association’s portfolio of Securities” and “reading various documents provided to us by the Association with regard to the management and composition of its portfolio of Securities. Id. p. OW180636. The Prudential Bache report concluded that USAT’s activities in all of the areas it reviewed “were generally comparable to and consistent with those of most of our other institutional clients investing in Securities.” Id. p. OW180637-38.

4. The Trading Activities In The USAT High-Yield Bond Portfolio Were Never Reviewed By The FHLB-D Or Prudential Bache

S159. As discussed previously, when Jonathan Scott and Terry Smith reviewed USAT’s high-yield bond portfolio on June 12, 1986, they only reviewed the policies and procedures regarding the management of the USAT high-yield bond portfolio and did not examine any individual trades. Tr. 23,327: 1-10 (Twomey). According to Smith, they did not get into any detail about the exact composition of the portfolio (Tr. 3,337: 17-2) or attempt to ascertain whether the junk bond portfolio was being managed as a trading or an investment portfolio. Tr. 2,824: 6-11; Tr. 2,824: 6-11.

S160. After the FHLB-D expressed concern about USAT’s high-yield bonds in May 1986, USAT sent the FHLB-D a summary each month of its high-yield bond and equity transactions. Ex. B-1075, Tab 257 (06/30/86 Phillips letter); Tr. 23,671: 4 - 23,672: 13; Tr. 23,675: 2-16 (Twomey). The reports were retained by the FHLB-D for informational purposes to respond to potential inquires from Congress or the FHLBB in Washington, D.C. Tr. 23,673: 15 - 23,674: 9 (Twomey). However, no analysis was done of USAT’s high-yield bond and equity arbitrage activities based upon the reports. Tr. 23,673: 15-20 (Twomey).

S161. Likewise, when Prudential Bache conducted its review of the USAT’s high-yield bond portfolio it did not review any of USAT’s “[t]rading activities with respect to the high-yield investment portfolio” (Tr. 23,667: 13 - 23,668: 5; Tr. 23,669: 14 - 23,670: 10 (Twomey)) as Twomey requested in his September 9, 1987 letter to Berner outlining the expected scope of the review. Ex. B-1742, Tab 282; A-14092, Tab 1509.

C. After The Examiners Advised USAT Of Its Net Worth Failure Following The 1986 Examination, USAT “Fiercely Contested” The Net Worth Deficiency And Refused To Recognize Write Downs Requested By The Regulators

S162. The April 16, 1987 letter sent by Daniel Thomas to the USAT Board regarding the 1986 Examination stated that Examiner Carlton determined that USAT had failed to meet its net worth requirement as of June 30, 1986 by $10.5 million, or 4.6% of net worth. Ex. T-8014, Tab 395 p. UFG-H 0231; Tr. 24,458: 8-24,460: 22 (Twomey).

S163. By October 1, 1987, based upon USAT’s size and operating results, FHLB-D supervision considered United to be a “significant problem case or a potential problem case.” Tr. 23,659: 22 - 23,661: 2 (Twomey). As a result a Significant Supervisory Cases Report was prepared by the FHLB-D with respect to USAT and submitted to Washington. Tr. 23,659: 22 - 23,661: 2 (Twomey); Ex. A-11084, 1878, (SSC Report). The Significant Supervisory Cases Report and the “S” Memorandum dated December 20, 1988, which was prepared in order to place USAT in receivership, both state that USAT “fiercely contested” the Examiner’s determination that USAT had failed its net worth requirement as of June 30, 1986. Ex. A-11084, Tab 1878, p. OW157751; T-8142, Tab 1450, p. 4. According to Supervisory Agent Twomey, “United refused to book the reserves that would then have impaired their capital, causing them to fail regulatory capital which would then automatically cause [the FHLB-D] to put them under regulatory restrictions.” Tr. 23,266: 20 - 26,267: 2.

1. USAT’s Fear Of Wall Street’s Reaction To A Net Worth Failure

S164. On May 1, 1987, Berner sent a response to the 1986 Examination Report to Senior Supervisory Agent Daniel Thomas, Ex. A-12175, Tab 1540. USAT disputed the net worth calculation of the Examiner and asserted that based upon USAT’s recalculation the “Association exceeded the minimum net worth requirement on June 30, 1986.” Id. p. OW154469-72. In particular USAT challenged Examiner Carlton’s classification of $140 million in Couch Mortgage loans as scheduled items. Id. p. OW154473.

S165. For the next three months USAT continued to dispute Carlton’s findings. However, the July 30, 1987 entry in the Significant Supervisory Cases Report dated October 1, 1987, states that after “receiving numerous financial report and attending several meetings with United’s accountants, the Supervisory Agent [Twomey] continues to believe that United did fail its capital requirement as of June 30, 1986. Ex. A-11084, Tab 1878, p. OW157751.

S166. On August 7, 1987, representatives of the FHLB-D, including Baugh and Twomey, again met with representatives of USAT and discussed, among other things, USAT’s failure to meet its capital requirement as noted in the 1986 Examination report. Ex. A-11079, Tab 1680 (08/10/87 Berner memo) and A-11078, Tab 1760 (08/10/87 Baugh memo). Baugh’s notes of the meeting state the following: “Net Worth Requirement as of March 31 and June 30, 1986 - The issue continues to be whether valuation reserves and loss provisions at those date were general or specific.” Ex. A-11078, Tab 1760, p. 1. Twomey explained that if the reserves were general they would not subtract from USAT’s net worth, but if they were specific reserves they would have reduced USAT’s net worth by the amount of the specific reserves. Tr. 23,649: 2-15.

S167. The memorandum states that USAT advised the FHLBB that “the determination [on valuation reserves and losses] needs to be made at the latest by August 13, 1987 for the next required SEC filing.” The memorandum continues; “United states that the reason for the emphasis on this subject is Wall Street’s discomfort with capital deficiencies.” Id. Twomey explained that:

…if their net worth declined by a discernible amount, they were concerned that because of all the repos they had outstanding, you know, funding their mortgage-backed security risk-controlled arbitrage, that perhaps Wall Street, who were giving them money would [not] have rolled them again and start calling the money back.

Tr. 23,650: 8-18 (Twomey).

S168. USAT’s concern over Wall’s Street’s potential reaction to a reported net worth failure was so great that USAT’s management requested that Twomey provide a letter assuring their reverse repurchase lenders that “there was no immediate regulatory action contemplated against the institution” by the FHLB-D. Tr. 23,651: 5-12 (Twomey); Ex. A-11079, Tab 1680 (08/10/87 Berner memo) p. OW0057587; A-11078, Tab 1760, (08/10/87 Baugh memo) p. OW157684. Twomey was reluctant to give the proposed “comfort letter” without first discussing it with the legal department and senior officers of the FHLB-D. Tr. 23,651: 13 - 23,652: 2 (Twomey). In lieu of a letter, Twomey offered to give “regulatory feedback” and advise USAT’s Wall Street lenders that the FHLB-D was “not taking any immediate action against [USAT].” Twomey testified that he considered taking such an action to avoid a “potential liquidity crisis” at USAT and having to immediately put USAT through some type of receivership. Tr. 2,653: 7 - 23,654: 7. [6]

2. The Dispute Over Whether USAT Had Failed Its Net Worth Requirement Continued Until USAT Filed Its Forbearance Application In February 1988

S169. The issue of whether USAT had failed its minimum net worth requirement continued to be disputed by USAT throughout 1987. Tr. 23,266: 20 - 23,267: 22 (Twomey). UFG’s Consolidated Statement of Operations dated October 31, 1987, contained a calculation of USAT’s regulatory net worth as of that date and a discussion of the ongoing dispute between USAT and the FHLB-D regarding the requested write down which USAT was still resisting. Ex. T-8024, Tab 398, p. UFG-H0271. On that date, UFG calculated USAT’s excess net worth to be $12,997,000. Id. However, footnote 2 stated that:

…there were $94.7 million of disputed assets that have not been included in scheduled items by the Association. Should the Regulator’s position prevail, the Association’s capital requirement would increase by an additional $18.9 million.

Footnote 3 additionally stated:

Included in net worth is $13.2 million of general reserves as determined by the Regulators, which they now believe might be specific reserves. Actual net worth would decrease by this amount, retroactive to June 30, 1986, if the Regulators’ revised position does not change.

Ex. T-8024, Tab 398, p. UFG-H0271. The regulators and USAT’s management agreed if either of the write downs requested by the Regulators, which USAT disputed, had been agreed to by USAT the Association would have failed its minimum net worth requirement. Tr. 4,601: 1 - 4,602: 5 (Dermody); Tr. 14,808: 10 - 14,811: 18 (Crow); Tr. 20,912: 22 - 20,913: 22 (Gross).

S170. The issue of whether USAT had failed its minimum net worth requirement was not finally resolved until February 16, 1988, when USAT conceded that it was capital deficient and filed a forbearance application with the FHLB-D requesting that the institution not be subject to supervisory or enforcement action to enforce the minimum capital requirements of the FHLBB or to terminate FSLIC insurance. Ex. T-8033, Tab 402 (1987 UFG Annual Report) p. H 0682; Ex. B-2020, Tab 1406 (Forbearance Application).

D. MCO And FDC Exchange Over 700,000 Shares Of UFG Series C Preferred Stock For Series D Preferred Stock To Avoid Exceeding Ownership Of 25% Of Outstanding UFG Common Shares

S171. Pursuant to the terms of the UFG Series C Preferred Stock, which was issued in a rights offering by UFG in May 1984, a holder of the preferred stock was entitled to elect to convert each share of such stock into two shares of voting common stock of UFG after June 15, 1987. Ex. T-113, Tab 75 (03/04/87 Berner letter to Julie Williams). As discussed at A48 - A61, FDC and MCO acquired 47,702 shares and 688,824 shares, respectively, of the Series C stock, equal to 6.3% and 91.2%, respectively, of the outstanding Series C Preferred stock of UFG, which were convertible into a total of 1,473,052 shares of UFG common stock. Id. p. 2. If the MCO and FDC Series C Preferred shares had been converted to common shares of UFG on or after June 15, 1987, MCO and FDC would have owned approximately 35% of the then outstanding UFG Common Stock. Id.

S172. Berner testified that in the early part of 1987 Federated and MCO became concerned that if the preferred stock “…could be converted, it was capable of being converted, that would be considered ownership of the common stock” (Tr. 19,248: 15-18; Tr. 19,247: 15 - 19,248: 5), and MCO and FDC would hold over 25% of the outstanding shares of UFG common stock and would be “deemed” to have acquired control of UFG. Ex. T-1131, Tab 75 (03/04/87 Berner letter to Julie Williams) p. OW007389-92.

S173. When MCO and FDC became aware of the potential problem, Berner was asked by Munitz or Howard Bressler or outside counsel for MCO and FDC, to contact the FHLBB and determine how the C Preferred shares would be treated once they were subject to conversion. Tr. 19,247: 19 - 19,250: 4 (Berner). After contacting the FHLBB Berner advised Hurwitz and Munitz on February 18, 1987, that he had been “orally informed” by staff of the FHLBB on a “no name” basis that “the staff position is that Preferred Stock which is not immediately convertible to the underlying common is not considered to be a holding of the underlying common and, therefore, would not be counted in determining ‘control’.” Ex. B-1493, Tab 1648 (02/18/87 Memorandum Berner to Hurwitz and Munitz).

S174. After learning that once the C Preferred shares became immediately convertible such shares would be treated the same as holding common stock of UFG, MCO and FDC “…requested that the preferred stock be exchanged [by UFG] for a new series of preferred stock that would not be convertible for another year.” Tr. 19,253: 16 - 19,254: 16. (Berner).

S175. On March 4, 1987, Berner submitted a letter to Julie Williams, Director of Corporate and Securities Division for the FHLBB, requesting formal confirmation from the FHLBB that it would take “no action for violations of the Change in Savings and Loan Control Act” if UFG were to exchange its C Preferred Stock for an equal number of Series D Preferred stock with a conversion date of July 1, 1988. Ex. T-1131, Tab 75, p. OW008904; Tr. 19,254: 17 - 19,255: 20 (Berner).

S176. At the time Berner submitted his letter seeking a “no action” letter in connection with the exchange of Series C for Series D preferred shares, he was aware, and had been aware since early 1986 (when the subordinated debt application had been discussed and filed), that the FHLBB had included a net worth maintenance condition in its approval of FDC and MCO’s application to acquire more than 25% of the shares of UFG and that the net worth maintenance condition was of great concern to MCO and FDC and the subject of continuing discussions with the FHLBB. Tr. 19,202: 22 - 19,205: 3; Tr. 19,222: 15 - 19,226: 13. His letter specifically noted that upon conversion MCO and FDC would own 34.99% of the common stock of UFG, Ex. T-1131, Tab 75, p. OW008905. Thus, Berner was aware that MCO and FDC would be subject to the net worth maintenance obligation imposed by the condition in the resolution approving the application upon conversion.

S177. Moreover, Berner was also aware that USAT was in dire financial straits: USAT had unsuccessfully sought to raise up to $75 million in additional capital through the subordinated debt offering in 1986. Tr. 19,237: 2-15. Serious questions had arisen in the 1986 examination as to USAT’s net worth compliance, particularly in connection with the Couch Mortgage situation, Tr. 19,242: 6 - 19,246: 2, and were known to UFG and USAT management, including Berner in September 1986. Ex. A-14060, Tab 1492. On March 9, 1987, just five days after Berner’s letter to Julie Williams, FHLBB-D had sent a copy of the Final Report of Examination from the 1986 examination to USAT without comment. Ex. A-14060, Tab 146, p. OW078142. The Report of Examination stated expressly that USAT’s net worth was below the required amount. Id. p. OW078152. FHLBB-D sent another copy of the Final Report of Examination to USAT, with comments, on April 16, 1987. Id. p. OW078142.

S178. All of the events set forth above occurred before Ms. Williams’ response to Berner’s letter and the exchange of the Series C Preferred Shares for Series D Preferred Shares described below. Thus, even though Berner, the Senior Vice President and General Counsel of UFG, was well aware of both the need for capital and the obligation to provide it, at the behest of MCO and FDC, he facilitated a transaction that was detrimental to the interests of both UFG and USAT in that it effectively deprived a capital-starved institution of an immediate source of additional capital, while enabling USAT and MCO to evade their obligation to infuse capital pursuant to the net worth obligation.

S179. In the letter, Berner described to Ms. Williams the extent of MCO and FDC’s ownership of common shares of UFG as follows:

Federated Development Company (“Federated”) and MCO Holdings, Inc. (“MCO”) hold 9.8% and 13.5%, respectively, of the issued and outstanding shares of the voting common stock of UFGI….Federated and MCO acquired 47,702 shares and 688,824 shares respectively, of Series C Stock equal to 6.3% and 91.2%, respectively of the outstanding Series C Stock.

Ex. T-1131, Tab 75, p. OW008905. It is noteworthy that Berner’s letter to Julie Williams revealed none of the information set forth above at FOFs A48 - A61 concerning the origin of the convertibility feature in Series C stock, FDC and MCO’s role in underwriting the offering, or Hurwitz’ and Munitz’ participation as members of the Board of Directors and of the Executive Committee in setting the terms of the original transaction. Rather, Berner’s letter described the Series C preferred stock as if it had been purchased in an arm’s-length transaction – merely noting the legal characteristics of Series C preferred stock, the level of FDC and MCO’s current holdings of UFG common stock and preferred stock, and the fact that if the Series C stock were converted to common stock, FDC and MCO would hold 34.99% of the voting common stock of UFG, Ex. T-1131, Tab 75. Id. p. OW08904-06.

S180. Additionally, although Berner testified that he had disclosed the put/call option in UFG’s various Proxy statements because it was a “material fact that should be disclosed” which was “relevant” to MCO and FDC’s ownership of UFG (Ex. A-3014, Tab 92; Tr. 19,183: 12 - 19,185: 22), the letter to Ms. Williams does not contain any reference to the put/call agreement between MCO’s and DBL whereby MCO acquired an option to acquire an additional 300,000 shares or 3.6% of the outstanding common shares of UFG. Tr. 19,259: 4 - 19,260: 21; Tr. 19,268: 13 - 19,269: 18 (Berner). Berner testified that he believed Ms. Williams was aware of the existence of the put/call option because it was mentioned in the USAT application to issue subordinated debt and in the Form 13-D filed by MCO with the Securities and Exchange Commission. Id.

S181. On April 8, 1987, Ms. Williams requested that Berner “[p]lease provide information as to when Federated and MCO acquired their respective 9.8 and 13.5 percent interests in the Common Stock [of UFG].” Ex. B-1561, Tab 1649. In response, Berner advised Ms. Williams that “Federated and MCO acquired their respective interests in the common stock in 1982,” but again did not disclose the existence of MCO’s interest in the put/call option. Ex. B-1566, Tab 1650 (04/14/87 Berner letter).

S182. On May 6, 1987, Ms. Williams sent a letter to Berner advising him that, “[b]ased on the information contained in your March 4, 1987 letter…this Division concurs with your view that the proposed exchange of the Series C Stock for the Series D Stock without the prior approval of the Federal Savings and Loan Insurance Corporation (“Corporation”) would be permissible. …” Ex. T-1134, Tab 1651, p. OMX 01333. Ms. Williams’ letter then recites her understanding that, in addition to the C Preferred Shares, MCO and FDC, “…own an aggregate of 23.3 percent of the outstanding shares of Common Stock [of UFG].” Id. The letter did not indicate that Ms. Williams was aware of the put/call option or that she took the shares DBL optioned to MCO into consideration in preparing her no action response. Id.; Tr. 19,269: 14 - 19,270: 1 (Berner). Following the receipt of Ms. Williams letter, MCO and FDC exchanged the Series C Stock for the Series D. Stock. Ex. A-3015, Tab 94 (1988 UFG Proxy Statement) p. UFG O3780; Tr. 19,270: 2-5 (Berner).

S183. On February 29, 1988, USAT advised Ms. Williams that UFG proposed to exchange the Series D Stock for a new Series E Convertible Preferred Stock which would not be subject to conversion until July 1, 1989. Ex. T-1141, Tab 1653. Based upon the representation by Berner that the “facts and circumstances surrounding the proposed exchange are essentially identical to those set forth in my March 4, 1987 letter,” Ms. Williams approved the exchange of the Series D shares for Series E shares. Ex. B-2146, Tab 1652.

S184. Once again there was no discussion of the put/call option in Berner’s correspondence to Ms. Williams. Ex. T-1141, Tab 1653 (02/29/88 Berner letter); Tr. 19,272: 8-11 (Berner). UFG thereafter converted the D Series Stock to the E Series Stock. Ex. A-3016, Tab 93 (1989 UFG Proxy Statement) p. UFG O3803.

E. The Regulators Reviewed DBL’s Ownership Of UFG Stock But Were Unaware Of All The Facts Relating To The Put/Call Stock Option Agreement Between DBL And MCO

1. USAT Did Not Disclose Either MCO’s Irrevocable Letter Of Credit Guaranteeing Its Performance Under The Stock Option Agreement Or MCO’s Indemnification Agreement

S185. In its application to the FLSIC for approval to issue subordinated debt, which was filed on April 29, 1986 with the FHLB-D, USAT included a section on the “Stock Ownership of UFG,” USAT’s parent holding company. Ex. B-954, Tab 89, p. CN152394-93. The Table listing the principal stockholders of UFG indicates that Drexel Burnham Lambert Group, Inc. owned 488,931 shares of UFG, or 6.0% of the outstanding common stock of the corporation. Id. p. 85. In footnote 6 it further stated as follows:

In December 1985, DBL granted to MCO a call option on 3000,000 of the shares of UFG's Common Stock which DBL holds (the "Call"). The Call is exercisable during a one month period commencing July 1, 1988. In the event that MCO does not exercise the Call, it is required to grant to DBL a put option in respect of such shares, exercisable during a one month period commencing August 1, 1988.

Ex. B-954, Tab 89 (Sub Debt Application) p. CN152394-93.

S186. A similar description of UFG’s stockholders was also included in the 1986 Business plan submitted to the FHLB-D on August 29, 1986. Ex. Twomey 21, Tab 91, p. OW150626-28. The Business Plan also contains a footnote with the identical description of the put/call option agreement between DBL and MCO that appeared in the subordinated debt application. Id.

S187. Neither the subordinated debt application nor the 1986 Business Plan fully described the put/call agreement between DBL and MCO in that they failed to mention: (1) that MCO’s performance under the DBL put option was secured by an irrevocable letter of credit, and (2) that MCO agreed to indemnify DBL against all loss associated with the transaction. Ex. T-1085, Tab 26 (Stock Option Agreement) p. OW009577 and OW009587.

2. The FHLB-D Was Not Aware Of Either The Letter Of Credit Or The Indemnification Agreement In The Stock Option Agreement

S188. In a draft memorandum to S.G. Hass from H. Joe Selby, dated 07/24/86, on the subject of USAT’s subordinated debt application, there is a discussion of MCO and FDC’s ownership of shares of UFG. The memorandum notes that FDC and MCO “own 9.8 percent and 13.5 percent, respectively of UFG” as well as “an aggregate 97.5 percent of UFG’s C Convertible preferred Stock.” Ex. A-11011, Tab 256, p. 2. The Memorandum then describes the put-call option as follows:

MCO also has a call option to acquire 300,000 shares of UFG’s common stock from an unaffiliated third party on July 1, 1988.”

Id.

S189. There is no mention in the FHLB-D memo of either MCO’s irrevocable letter of credit to guarantee its performance under the stock option agreement or its indemnification obligation, which shielded DBL from all losses associated with the transaction. Id.

3. The Supervisory Agent Continued To Be Concerned About DBL’s Ownership Interest In UFG

S190. Twomey continued to be concerned about USAT’s involvement with DBL and in the latter part of 1987, asked Analyst Baugh to review DBL’s ownership of UFG shares to determine whether DBL was an affiliate of USAT. Tr. 23,679: 15-20 (Twomey). Twomey testified: “I was, you know, now aware that Drexel owned shares in the holding company [UFG]. And because of ongoing questions concerning Drexel, I wanted a detailed breakout of their ownership and, at the same time, I requested a breakout [from Analyst Baugh] of the detailed ownership of UFG by other known parties.” Id.

i. Baugh’s Memo To Twomey On DBL’s Ownership Of UFG Shares Discussed The Put/Call Option, But Did Not Mention MCO’s Letter Of Credit Or The Indemnity Agreement

S191. In response to the request, Baugh provided Twomey with a memorandum dated September 5, 1987, that described MCO, FDC and DBL’s ownership interest in UFG. Ex. B-1739, Tab 1523. The memorandum indicated that MCO and FDC respectively owned 13.49% and 9.8% of the outstanding shares of UFG. Id. The memorandum also described the MCO and FDC’s ownership of the convertible preferred stock of UFG, which was convertible into shares of common stock and concluded that “[t]ogether, MCO and Federated Owned 23.3% of the common stock of UFG and 97.5% of the convertible preferred stock of UFG at 6-1-86.” Id.

S192. Baugh’s September 5, 1987 memorandum also stated that DBL owned 6.0 % of the outstanding shares of UFG, and contained the following description of the put/call option between DBL and MCO:

MCO Holdings, Inc. (“MCO”) also has a call option for 300,000 (3.67%) of the 488,931 shares of UFG held by Drexel Burnham to be exercised 7-1-88 to 7-31-88. If not exercised, then Drexel will place a put option on those shares to MCO for the period 8-1-88 to 8-30-88.

Ex. B-1739, Tab 1523.

S193. In her deposition Baugh testified that she “assumed” that the information contained in the handwritten notes (Ex. A-12180, Tab 1928 (Baugh notes)) from which she prepared her memorandum to Twomey regarding the put/call option came from the December 31, 1985 MCO 10-K. Tr. 24,989: 7-15. In fact, the December 31, 1985 MCO 10-K (Ex. A-2084, Tab 85 (12/31/85 MCO 10-K) p. DE002809) contains the same information regarding the put/call option that appeared in Baugh’s handwritten notes (Ex. A-12180, Tab 1928).

S194. Twomey testified that it did not concern him that DBL owned 6% of the common stock of UFG. He stated that he was concerned that if their ownership exceeded 10% “Drexel would be deemed an affiliated party, and all the transactions with United would come under review of the PSA.” Tr. 23,680: 10-12.

S195. Neither Baugh’s memorandum, her handwritten notes, nor the description of the put/call option that appeared in the December 31, 1985, MCO 10-K mentioned either the MCO’s obligation to indemnify DBL against any losses under the put/call agreement or the fact that MCO secured its obligation to perform with an irrevocable letter of credit. Ex. B-1739, Tab 1523 (09/05/87 Baugh memo).

ii. The Supervisory Agent Did Not Know About The Letter Of Credit Or The Indemnity Agreement

S196. Twomey testified regarding his knowledge of the put/call option between MCO and DBL. Tr. 23,681:4 - 23,688: 1. Twomey stated that he was unaware at any time in 1986, 1987, and 1988 that, in the event that MCO exercised the call but did not make full payment to DBL for the shares or that DBL exercised the put but did not receive full payment for the shares, DBL could draw upon a letter of credit obtained by MCO in the amount of the shares' purchase price. Tr. 23,683: 10-22; Tr. 23,685: 1-10. In addition he was unaware that MCO, as part of the option arrangement, had agreed to indemnify DBL against any loss associated with the transaction as reflected in Paragraph 8 of the Option Agreement. Tr. 23,683: 17-23; Tr. 23.687: 3-10 (Twomey). The only information Twomey ever received regarding the put/call option is what was communicated to him by Baugh in her September 5. 1987 memorandum. Ex. B-1739, Tab 1523; Tr. 24,982: 4-9 (Twomey).

S197. Twomey testified that he was not particularly concerned about the put/call option, but that if he had thought that the 300,000 shares that had been optioned to MCO might be attributable to MCO for purposes of determining whether they owned over 25 percent of the outstanding shares of UFG, he would have referred the matter to Julie Williams. Tr. 23, 681: 17 - 23,682: 21. Twomey stated that “Ms. Williams at that time was an attorney with the Federal Home Loan Bank Board in Washington, D.C. And she was, I believe, in charge of the security division which would review these types of questions.” Tr. 23,682: 17-21.

S198. Ms. Williams was the individual who had previously approved UFG’s request to convert its C Preferred Stock, (which was convertible to common stock in June 1987) to D Preferred Stock, (which was not convertible until June 1988). As discussed above at S180, although the March 4, 1987 request submitted by Berner to Ms. Williams purported to describe the nature of MCO and FDC’s ownership of UFG, it did not disclose any aspect of the MCO put/call option to Ms. Williams. Ex. T-1131, Tab 75 (03/04/87 Berner letter) p. OW008905; B-1566, Tab 1650; T-1134, Tab 1651, p. MX004214 - 15; Tr. 19,259: 4 - 19,260: 21; Tr. 19,268: 13 - 19,269: 18 (Berner).

S199. Twomey testified that if he had known about the letter of credit or the indemnity provision in the option, he would have had a different view as to whether MCO controlled the 300,000 optioned shares. Tr. 23,684: 22 - 23,687: 20. According to Twomey, the letter of credit and the indemnity requirement changed the nature of the option:

[b]ecause this is an economic transaction. This transaction is done. They have done -- this transaction has already occurred. Therefore, as far as I'd be concerned, MAXXAM controls those additional 300,000 shares.

Tr. 23,686: 4-8. He continued:

“[i]f I had known this, it would have changed my opinion, and I still would have referred it to our Washington office to get their written opinion.

Tr. 23,685: 20 - 23,686: 1.

F. USAT Continued To Represent To The Regulators That Its Arbitrage Portfolios Were Profitable And Low Risk

S200. The April 16, 1987 letter to the USAT Board of Directors transmitting the 1986 Examination Report stated: “The matter of United’s investment portfolio has been discussed at length during recent months, and Management has repeatedly attempted to assure this office that the investments being made were prudent. However, in view of the market conditions as stated and projected by market sources, we are not convinced that United’s investments have a tolerable level of risk.” Ex. T-8014, Tab 395.

1. USAT‘S Representations To The FHLB-D After The 1986 Examination Was Completed Regarding Its Investment Portfolios

S201. Following the submission of the 1986 Examination to the Board USAT’s management continued to assure the FHLB-D that its investment portfolios represented “a safe business risk” and a “profitable activity.” Berner’s letter to the FHLB-D responding to the 1986 Examination Report stated the following regarding USAT’s investment portfolios: “[t]he Association believes that this program of investment not only provides a safe business risk but also a degree of profitability which is difficult to achieve elsewhere. . . .In view of the significant management expertise in this area and the review policies, we disagree with the FHLB’s characterization of this profitable activity.” Ex. A-12175, Tab 1540 (05/01/87 Berner letter) p. OW154484-85.

S202. The following month USAT again wrote to the FHLB-D touting the success of its investment portfolios and offering to make its investment staff and expertise available to smaller institutions to handle financial investments. Berner’s letter to Twomey dated June 16, 1987 states in part:

United Savings Association of Texas has been able to implement a program of successful investments in mortgage-backed securities, high-yield bonds and equity arbitrage through the expertise it has maintained by hiring and retaining a highly qualified staff of experienced investment managers.

Ex. A-14065, Tab 1494, emphasis added.

2. Contrary To Berner’s Representations To The FHLB-D, USAT’s MBS/RCA Were Not Successful

S203. The Minutes of the Investment Committee of UFG and USAT dated June 11, 1987, which were taken by Berner, indicate that at the time these representations were made by Berner in his June 16, 1987 letter to the regulators regarding the success of USAT’s MBS investments, the Association’s MBS portfolio was experiencing enormous mark-to-market losses. Berner wrote in the June 11, 1987 minutes that “Sandy Laurenson reported on the mortgage-backed securities portfolio. Her report was ordered attached to the minutes of the meeting. . . . The Committee reviewed in detail the report and status of the portfolio.” The sensitivity summary, which is included in Laurenson’s report and attached to the minutes shows that, if interest rates remained unchanged, the MBS and the associated hedges had losses totaling $245,417,000. Ex. A-1447, Tab 1319 p. US-3 005864. This was an increased decline in the market value of the MBS portfolio of over $140 million since the January 21, 1987 Investment Committee meeting at which Laurenson reported “the unrealized net loss [in the USAT MBS portfolio] stands at a net of $101 million ($26 million MBS gain against a $127 million swap loss).” Ex. A-1426, Tab 357 p. US-3 005224.

S204. In addition to having these unrealized losses, the May 1987 Performance Report which is attached to the June 25, 1987 investment Committee minutes, showed that the MBS portfolios also had a net interest spread of minus 1.80%. Ex. A-1449, Tab 385, p. US-3 006019.

S205. Twomey testified that at the time he received Berner’s June 16, 1987 letter it was his understanding that the USAT MBS risk controlled arbitrage program was a “successful” and “profitable” program that had offset the losses suffered by USAT as a result of the decline in the Texas economy. Tr. 24,865: 21 - 24,868: 7. Twomey testified that he continued to believe that USAT’s MBS program was a success until December 1988 when he received the Southwest Plan Examination from Examiner Brenda Bese which reported that USAT’s MBS program had unrealized losses in June 1987 of over $200 million. Tr. 23, 385: 8 - 23,386: 12; Tr. 24,869: 6-21.

IV. The 1987 Examination Of USAT

S206. The 1987 examination of USAT commenced on November 16, 1987. Ex. A-14073, Tab 1502. Once again, Vivian Carlton was assigned as EIC. Ex. A-14058, Tab 1488. In her testimony, Ms. Carlton described a meeting prior to the 1987 examination between USAT management and certain regulators in which the third-party reviews were discussed. Ms. Carlton was called into the meeting. Management of USAT were informed at that meeting that Ms. Carlton would be the EIC of the next examination. As Ms. Carlton described the meeting:

They were told, in essence, that the findings of the ’86 exam were substantiated and that as we commenced the 1987, that the role I would be playing as being the examiner in charge was to make sure that those corrections had been corrected and that conditions were improved and – either improved or corrected during the 1987 examination.

Tr. 17,128: 7-14. As with the 1986, examination, the manner and comprehensiveness with which the 1987 examination was conducted were the subject of much dispute during the hearing in this case.

A. Scope And Conduct Of The USAT Examination

S207. In addition to a generic scope memorandum, Ex. A-14058, Tab 1488, Ms. Carlton also received a special scope memorandum. Ex. A-14059, Tab 1489. The special scope memorandum set forth three specific outstanding issues brought forward from the 1986 examination, as well as raising three additional concerns. Tr. 17,130: 10-15. The description of the new and outstanding issues to be reviewed indicates that FHLB-D, specifically Supervisory Agent Neil Twomey, had serious reservations about the candor, integrity, and competence of USAT management as of November 1987, if not earlier,[7]^/ as well as suspicions as to Hurwitz’ role at the institution. First, Ms. Carlton was directed to complete the review of the general and specific loan reserves. The special scope memorandum noted that “[t]he subject of United’s reserves has not yet been resolved. Therefore, it has not yet been determined whether the amount of general loan loss reserves which has been included in United’s calculation of its minimum net worth requirement is accurate.”[8]^/ Ex. A-14059, Tab 1489. Second, Ms. Carlton was to review the Couch Mortgage situation.

It appears that United continues to exclude some or all of the Couch Mortgage Company loans which were scheduled by examiners at the previous examination. Please determine what portion, if any, of these loans were accurately reported by United since the 1986 examination and whether United has inappropriately removed any portion of these loans from regulatory reporting without PSA approval. In addition, please analyze the loans from a current posture to determine the proper accounting for the loans currently.

Id. Third, the special scope memorandum noted that “[s]everal of the loans [(including the Stephen Block, Trustee loan)]classified or otherwise criticized at the 1986 examination are still being disputed by United’s management,” and instructed Ms. Carlton to review those loans.[9]^/ Id.

S208. Ms. Carlton was also instructed to conduct an overall review of investment securities, with the possibility that additional work might be required after receipt of the Prudential Bache report. Id. In addition, the special scope memorandum directed Ms. Carlton to “update the analysis of stock ownership and/or control of United.” It noted: “We are specifically interested in control held by Mr. Charles Hurwitz both directly and indirectly.” Id. In addition, Ms. Carlton was to review transactions with affiliates. The memorandum stated: “We are interested in any loans or other transactions between United, its holding company, or its subsidiaries with any company owned or controlled by Charles Hurwitz.” Id.

B. Interim Reports

1. The January 15, 1988 Interim Report

S209. In her first interim examination report, dated January 15, 1988, Ms. Carlton found that “[a] review of USAT’s FHLBB quarterly report at September 30, 1987 disclosed sufficient regulatory capital to meet its minimum requirements.” Ex. A-14069, Tab 1496, OW128892. She explained in her testimony, though, that the minimum net worth calculation was based upon USAT’s books and did not reflect the adjustments for specific loss reserves and Couch Mortgage that had been directed to be made after the 1986 examination. Tr. 17,162: 18 - 17,164: 15. As of November 30, 1987, USAT had failed to meet its net worth requirement by $7,353,000 due to an increase in scheduled items and classified assets, including $26,846,000 in Couch loans and $37,470,000 in other classified loans. In addition, she noted, USAT had not established specific reserves for appraised losses on REO (a 100% deduction from assets, see Tr. 17,198: 2-21; Tr. 17,209: 1 - 10), which would further adversely impact USAT’s capital position. Ex. A-14069, Tab 1496, OW128892.

S210. Ms. Carlton noted that asset quality continued to deteriorate and criticized assets had grown substantially. She specifically mentioned problems involving REO, scheduled loans, and Couch Mortgage. Ex. A-14069, Tab 1496, OW128893-94.

S211. In her financial analysis, she noted that USAT had been marginally profitable in the third quarter of 1987, but only “by generating significant amounts of non-operating income – gains on sales of mortgage-backed securities, gains on sales of investments secuities [sic], gains on sales of futures contracts and loan sales.” Ex A-14069, Tab 1496, OW128895. She noted that continued reliance on non-recurring income from securities transactions placed additional risk on the association. Id. To illustrate that point, she noted that USAT had experienced a $50 million loss in October 1987. In addition, she noted that there was a $55 million unrealized loss in the junk bond portfolio as of November 30, 1987, and that the junk bond portfolio at that date had a book value of $677 million. Id. OW128896.

S212. She reported that DBL owned 9.7% of the stock of UFG, up from a reported 3.97 in the previous examination. Id. OW128897. She noted, as well, that USAT’s books and records had improved in that the examiners could now reconcile USAT’s financial reports with its books and records. Id. OW128898. Her report concluded: “USAT’s financial condition continues to deteriorate and from preliminary review is not meeting its minimum regulatory capital requirements. Id.

2. The March 10, 1988 Interim Report

S213. Ms. Carlton followed up her first interim report with a second two months later, on March 10, 1988. Ex. A-14070, Tab 1497 (03/10/88 Iterim Report). By that time, financial results were available for the fourth quarter of 1987. They showed a loss of $183,757,000 in that quarter alone. In addition they showed a loss of $11,941,000 in the third quarter, id. OW128899, for a net loss for the year of $185.7 million. Id. OW128900. By this time, USAT’s regulatory capital had fallen to $63 million, a deficiency of more than $110 million. Between the first and second interim reports, the examiners had classified an additional $120 million in loans. Id.

S214. Ms. Carlton reported that the review of the association’s investment securities was incomplete as of March 10, 1988. She did report, however, that USAT’s records of futures and options transactions were not being properly maintained to disclose the positions of USAT and its subsidiaries in accordance with the regulations and USAT’s own policies. See Tr. 17,179: 10 - 17,180: 16; Ex. A-14062, Tab 1490, OW128884, ¶ F. The lack of such records unduly burdened and delayed the examination, because the examination team had to wait for the association to generate records it should already have been maintaining. Ex. A-14070, Tab 1497, OW128901; Tr. 17,177: 1 - 17,178: 13; Tr. 17,181: 6-18.

S215. Another aspect of the securities review noted by Ms. Carlton was the sale of CMO residuals to DBL. The report noted that according to the information available to the examiners, DBL still owned 9.7% of the shares of UFG. Ex. A-14070, Tab 1497, OW128901. In her testimony, Ms. Carlton indicated that at the time the comment was written, she also knew that DBL had sold high-yield bonds to USAT or one of its subsidiaries. However, she testified that she did not know at that point whether DBL underwrote securities for Hurwitz-affiliated entity and she had never been told that either DBL or Michael Milken owned stock in MCO. Indeed, while she had heard of Michael Milken, she was unaware of his affiliation with DBL. Tr. 17,183: 1 - 17,185: 13.

S216. Ms. Carlton also reported on the examination of USAT’s subsidiaries. She noted:

Profitability in the subsidiaries was attributable to investment in the securities market. This type of investment produced positive results until the volatile nature of this activity surfaced as a result of the October 1987 stock market crash. USAT is still experiencing the adverse effect of the “October crash” as is evidenced by the fourth quarter 1987, $32,000,000 net loss experienced by the service corporations.

Ex. A-14070, Tab 1497, OW128907. One subsidiary, United MBS Corporation was the principal vehicle for mortgage-backed securities investments. Ms. Carlton stated:

United MBS is a 100 percent owned subsidiary of USAT, incorporated on August 11, 1986 for the purpose of entering into mortgage-backed financing activities. USAT’s total investment in UMBS is approximately 250 million dollars at September 30, 1987 and 270 million dollars at December 31, 1987. Mortgage-backed securities make up 96 percent of UMBS’s $1.6 billion portfolio at December 31, 1987, while reverse repo and dollar roll obligations make up 91percent of UMBS’s total liabilities of approximately 1.5 billion.

UMBS generates income by entering into reverse repo and dollar roll contracts collateralized by their FNMA, GNMA, and FHLMC mortgage-backed securities. The “spread” income, the difference between the proceeds received and the repurchase value on these MBS security contracts is predetermined and it appears no speculation is involved. UMBS is operating profitably at December 31, 1987 with a year-to-date net income of $37,479,000.

Ex. A-14070, Tab 1497, OW128908. Ms. Carlton testified that she had been unable to determine, based upon the available documentation, the purpose of the sales that had generated the $37 million gain, that is, whether the gains were the result of sales to rebalance the portfolio, or to enhance the spread, or to improve asset quality, or to bolster quarterly and year-end profits. She could only see that the sales had occurred and that there were gains. Tr. 17,192: 7 - 17,193: 6. During an exhaustive review of the workpapers relating to investment securities, Ms. Carlton testified with respect to each workpaper, whether prepared by the examiners or provided to them by USAT, that nothing in the documentation available to the examiners provided any indication of “gains trading,” sales for the purpose of bolstering quarter-end or year-end profits, speculation (with the exception of certain financial futures and options transactions, see Tr. 17,248: 21 - 17,251: 21; Ex. A-14073, Tab 1502, OW077138, OW077141-42), or any other improper securities activity. Tr. 17,278: 4 - 17,316: 8. Indeed, her communications with USAT’s auditors, Peat Marwick, which had been undertaken precisely because of the examiners’ inability to determine from the documentation supplied by USAT whether USAT’s securities activities were properly accounted for, left her with the understanding that USAT was not trading its securities portfolio, but rather holding it for investment. Tr. 17,315: 16 - 17,316: 8; Ex. A-14070, Tab 1497, OW128901.

S217. In addition, Ms. Carlton noted that $49,199,365 of the Park 410 loan (discussed at R50 - R111) had been classified substandard. Ex. A-14070, Tab 1497, OW128902-04.

S218. Ms. Carlton reported that the examination was nearly complete and that virtually all exceptions had been given to management. In closing her report, she stated:

The reconciliation of the Association’s books and records to required FHLBB reports continues to be a slow process. Several major items, including regulatory capital requirement computation, investment securities and hedging activity are currently in dispute.

Ex. A-14070, Tab 1497, OW128909.

C. The Final Report Of Examination

S219. Ms. Carlton concluded her examination of USAT on May 20, 1988. USAT received a composite rating of “4,” with the following MACRO component ratings:

Management 3

Asset Quality 4

Capital Adequacy 5

Risk Management 3

Operating Results 4

Ex. A-14073, Tab 1502,OW077256; Tr. 17,273: 11 - 17,276: 20. The narrative portion of the final report, like the final report for the 1986 examination, largely repeats the findings of the interim reports, sometimes with a more detailed analysis.

S220. The Final Report of Examination as of November 16, 1987 was transmitted to the board of directors of USAT by letter dated July 28, 1988. Ex. A-14073, Tab 1502. The completion of the report had been delayed until July 5, 1988 because the examiners had been requested to prepare comprehensive management comments for the report. Ex. T-8142, Tab 1450, p. OW075443. The examination team had expended a total of 5,457 hours in the examination. Ex, A-14073, Tab 1502, OW077255. Of that time, over 1,000 hours had been spent in each of the areas of loan underwriting and financial analysis, and over 1,600 hours were spent in report preparation. By contrast, only 499 hours had been spent in the examination of USAT’s four active subsidiaries. Id. see id. p. OW077147.

S221. The examiners’ major exceptions are summarized in the report p. OW077124-25. There had been high turnover of directors and management since the previous examination. As previously described, USAT had failed to meet its minimum regulatory capital requirement by $114 million as of December 31, 1987. USAT’s specific reserves were $59 million short of what was required, and appraised losses totaled more than $43 million. USAT had underreported its criticized assets by $217 million on September 30, 1987. USAT’s GAP position had deteriorated markedly so that it had a cumulative negative net GAP position through 2007 (twenty years), whereas in the 1986 examination the cumulative negative net GAP had only run through approximately 1989 to 1991 (three to five years). See Ex. A-14020, Tab 1461, OW078174; Tr. 17,041: 13 - 17,045: 6; Tr. 17,246: 15 - 17,248: 12. In addition, USAT had a net loss of $40 million on interest rate swaps, caps, and collars, and had speculative transactions in financial futures and options. The report noted the substantial ($554 million) investments in service corporations that had posted a loss of $32 million in the last quarter of 1987. Finally, USAT had lost over $185 million in the year ended December 31, 1987, and without a change in the operating trend or an infusion of capital, it was projected to deplete its regulatory capital by the first quarter of 1989.

V. Supervision After The 1987 Examination

A. USAT Net Worth Failure

1. USAT’s Management Became Aware Of USAT’s Potential Net Worth Failure In The Latter Part Of 1987

S222. By the end of October 1987, it had become evident even to USAT’s management that USAT was about to fail its minimum net worth requirement. In a memorandum to Hurwitz and the management of USAT, dated October 29, 1987, Berner wrote:

Based on current estimates, it appears as if United will fail to meet its minimum regulatory net worth at October 31, 1987.

Ex. T-8022, Tab 396 p. UFG 04074. Berner explained that “if we fail to meet our last calculated regulatory capital requirement, we will be in violation of the regulations.” and USAT would be subject to possible “corrective actions” which might include, among other things, requiring USAT to increase its regulatory capital, requiring USAT to limit its operational expenditure, and requiring USAT to cease or limit investments. Id. Berner concluded the memo by suggesting:

[i]n order for United to meet its minimum regulatory requirement as of October 31, 1987 we might want to consider some of the following;

(1) Infusing capital from UFGI to USAT;

(2) Selling an asset (there may be some portfolio assets in the mortgage-backed securities portfolio or some other portfolio);

(3) Infusing Capital from some other source (e.g. MCO, Federated).

Id. p. UFG 04076, emphasis added.

S223. In the October 31, 1987, UFG Consolidated Statement of Operations, it was calculated that USAT had excess net worth of $12,997,000. Ex. T-8024, Tab 398 p. UFG-H 0271. However, in order to obtain this figure, $94.7 million in disputed assets were not included as scheduled items and USAT included in its net worth $13.2 million in general reserves which the regulators believed should not have been included in net worth. Id. The regulators and management agreed that if USAT had made the adjustment requested by the regulators, USAT would have failed its net worth requirement on October 31, 1987. Tr. 4,601: 1 - 4,602: 5 (Dermody); Tr. 14,808: 10 - 14,811: 18 (Crow); Tr. 20,912: 22 - 20,913: 22 (Gross).

S224. A month later on November 30, 1987, Gross drafted a set of notes regarding USAT’s future strategy. Ex. T-8030, Tab 1797; Tr. 20,905: 16 - 20,907: 21 (Gross). The second page of the notes under the heading “A New Strategy” states:

B. Where Are We?

1. Leveraged to hilt

2. Below regulatory net worth

Ex. T-8030, Tab 1797 p. US-3 007580, emphasis added.

S225. On December 4, 1987, Munitz sent a memorandum to Hurwitz and the members of USAT’s senior management on the subject of the “Strategic Planning Agenda – Sunday, December 6, at 2:00 p.m.” Ex. B-1879, Tab 1803. Under the subject of General Background Munitz also noted:

Where is United now – the challenges: (leveraged, below net worth, jumbo CD, marked below water, attaching non earning portfolio, against regulatory tide?, reserve question and Couch)

Ex. B-1879, Tab 1803 p. OW045505, emphasis added.

2. UFG Reported USAT’s Net Worth Failure In Its 1987 Annual Report

S226. By the end of 1987, UFG reported in its Annual Report that UFG had sustained losses of $117 million in 1987, and by year-end stockholder equity in the company had declined to negative $41 million. Ex. T-8033, Tab 402 p. H 0658. UFG also reported that “management agrees that as of December 31, 1987 the Association [USAT] was below its required minimum regulatory capital.” Id. p. H 0681.

3. Examiner Carlton Meets With The USAT Board And Informs Them Of Their Net Worth Deficiency

S227. On March 30, 1988, at a Special Meeting of the USAT Board, Examiner Carlton presented a high level summary of her finding regarding the 1987 Examination to the members of the USAT Board. Ex. T-8049, Tab 405. All of the members of the USAT Board were present. Id. Attached to the minutes of the meeting is the agenda which Ms. Carlton presented to the Boards. Id. p. OW054325.

S228. Attachments I and II to the Agenda are the net worth calculations of Ms. Carlton and of USAT’s management as of September 30, 1987 and December 31, 1987. Id. p. OW054326-27. On September 30, 1987, although USAT calculated that it had excess net worth of $63.7 million, the examiners concluded that, in fact, USAT had a net worth deficit of negative $14.4 million. Id. p. OW054326. By December 30, 1987, USAT concluded that it was $53.6 million capital deficient, while the Examiners reported that, in fact, USAT had a regulatory capital deficit of $112.5 million. Id. p. OW054327.

4. USAT’s Financial Condition Continues To Deteriorate And By June 30, 1988 USAT Was Insolvent

S229. Following the Special Meeting of the Board of Directors of USAT the condition of the Association continued to deteriorate further. In the Second Quarter 1988 Performance Report, dated August 23, 1988, management reported to the Board of UFG a second quarter loss of $31.7 million and year-to-date loss of $53.1 million. Ex. T-8095, Tab 406A p. UFG-J 2610. The reports explained that the results for the second quarter were improved because they “reflect a $31.1 million gain on the extinguishment of the PennCorp debt.” Id.

S230. The Performance Report stated that USAT, which did not include the PennCorp gain in its operations, recorded “a $62.5 million regulatory loss for the second quarter.” Id. p. UFG-J 2613. According to the report:

USAT reported regulatory capital of $ 86.0 million as of June 30, 1988, which was $163.1 million below the minimum regulatory capital requirement. As a result of the examination report and a transfer of certain general reserves to specific reserves, USAT’s regulatory capital as of July 31, 1988 was negative $8.6 million.

Id.

S231. Five months later on December 20, 1988, the “S” Memorandum prepared by the FHLB-D recommending that USAT be placed in receivership (Ex. T-8142, Tab 1450 p. 1), reported that, in fact, “[a]s of June 30, 1988, United reported insolvency on a RAP basis due primarily to the establishment of $40.3 million in specific reserves for losses identified in the asset portfolio.” Id. p. 5.

5. By October 1988 USAT’s Net Worth Approached Negative $300 Million

S232. On October 4, 1988, the Board of USAT held a Special Meeting to review “the current status of the Association’s participation in the Southwest Plan and the potential recapitalization and restructuring of the Association…” Ex. T-8108, Tab 443 p. UFG-D 2424. Crow reported to the USAT Board that USAT had a negative net worth of $115 million through August 31, 1988, and projected further significant losses in September and in the fourth quarter of the year. Id. p. UFG-D 2425. The minutes of the Special Meeting reflect that Gross, the President and CEO of USAT “noted that the Association’s negative net worth position would exceed $400 million without dealing with the current goodwill on the Association’s books in excess of $150 million.” Id. p. UFG-D 2426.

S233. As of October 31, 1988 United reported negative regulatory capital of $272,791,000. Ex. T-8142, Tab 1450 (“S” Memo) p. 1.

6. USAT Had A $500 Million Regulatory Capital Deficit When It Was Placed In Receivership

S234. Joe Hargett, an expert called by the OTS, testified that by December 30, 1988, when USAT was placed in receivership, USAT’s “Regulatory Capital Deficit” was between $496 and $522 million. Ex. A-11018, Tab 291 (Hargett Report) p. 6; Tr. 3,472: 7-15 (Hargett).

S235. Hargett testified that: “regulatory capital deficit means the difference between how much your capital requirement was and how much capital you have.” Tr. 3,472: 12-15. In the case of USAT, according to its own records, the Association had, as of November 30, 1988, a regulatory capital requirement of $215 million and a capital position of negative $251 million, or a total regulatory capital deficit ($215 million + $251 million = $466 million) of $466 million. Tr. 3,474: 3-21 (Hargett). Hargett then adjusted the November 30, 1988, deficit for certain changes that occurred to the institution in December 1988, which are described in his report, to obtain USAT regulatory capital deficit for December 30, 1988. Tr. 3,474: 21 - 3,475: 13 (Hargett). Hargett explained that the December 30, 1988 total regulatory capital deficit was expressed as a range because there was uncertainty whether certain loan loss reserves should be treated as general or specific reserves. If they were general reserves they would have been counted toward USAT’s capital and the “regulatory capital deficit would have been $496 million. If the reserves were specific they would not have been counted toward capital and the deficit would have been $522 million. Tr. 3,475: 13 - 4,376: 1 (Hargett). The deficit calculation was based on USAT’s own data and did not include the underlined losses in the MBS portfolio, losses on high-yield bonds, or other losses that were not recognized until after the appointment of a receiver on December 30, 1988. As of June 30, 1996, the current estimate of the total cost to the FSLIC Resolution Fund for the resolution of USAT was $1.59 billion. Tr. 3,476: 22 - 3,477: 63; Ex. A-11018, Tab 291 (Expert Report of Joe Hargett) p. 6.

S236. Hargett calculated that with interest through November 1996 USAT’s total regulatory capital deficit was between $749 million and $788 million. Ex. A-11018, Tab 291 (Hargett Report) p. 6.

B. The Resignations By Members Of The USAT And UFG Boards And The Appointment Of New Board Members By Hurwitz And MCO

S237. As the financial condition of USAT and UFG deteriorated in 1987 a number of the members of both Boards resigned.

1. The Resignations From The UFG Board

S238. In September 1987 the Board members of UFG consisted of nine members: Mr. Sterling, Mr. Silverman, Mr. Borman, Mr. Whatley, Mr. Keltner, Mr. Kozmetsky, Hurwitz, Gross and Munitz. Ex. T-8054, Tab 403 (03/31/88 Berner memo) p. OW035556; T-8003, Tab 399 (List of UFG/USAT Directors) p. UFG2004771. By March 1988 six of these directors, Messrs. Keltner, Borman, Silverman, Sterling, Hurwitz and Kozmetsky, had resigned. Id. Only Gross, Munitz and Whatley continued to sit on the Board of UFG after March 1988. Id.

S239. On February 10, 1988, the day before Hurwitz resigned his positions at UFG, Crow, Berner, and Paul Schwartz, an employee of MAXXAM, joined the UFG Board. Ex. A-1139, Tab 2112 (02/10/88 UFG Minutes). According to Berner he was asked to join both the UFG and USAT Boards by either Hurwitz or Gross. Tr. 18,527: 9 - 18,528: 15. Crow testified that he was asked to serve on the UFG Board by Munitz. Tr. 14,740: 4 - 14,741: 4. Both Crow and Berner testified that they had entered into employment contracts with UFG that required that they serve as directors if requested. Tr. 18,527: 9 - 18,528: 15 (Berner); Tr. 14,740: 4 - 14,741: 4 (Crow). Schwartz, who was the Senior Vice-President for Corporate Development of MAXXAM, did not recall who asked him to serve on the UFG and USAT Boards, but said it could have been either Munitz or Hurwitz. Tr. 1,262:16 - 1,264:10 (Schwartz).

S240. After March 1988, the Board of UFG consisted of Munitz, Gross, Crow, Berner, Schwartz and Whatley. Whatley was the only member of the Board who was not recruited to the Board by either Hurwitz or Munitz or affiliated with MAXXAM, the controlling shareholder of UFG. Ex. T-8003, Tab 399 (List of UFG/USAT Directors) p. UFG2004771.

2. The Resignations From The USAT Board

S241. A similar exodus of Directors also occurred on the USAT Board at or about the time USAT failed its net worth requirement. In the case of USAT, of the seven directors on the Board in September 1987 (Messrs. Gross, Munitz, Sterling, Silverman, Kozmetsky, Whatley, and Keltner), four directors resigned after October 1987 (Messrs. Kozmetsky, Keltner, Sterling and Silverman). Ex. T-8003, Tab 399 (List of UFG/USAT Directors) p. UFG2004770.

S242. On February 11, 1988, Berner and Schwartz also joined the USAT Board. Ex. T-8039, Tab 412 (02/11/88 USAT Minutes) p. OW054273. After March 1988, USAT’s Board consisted of Gross, Berner, Whatley, Schwartz and Munitz. Ex. T-8003, Tab 399 (List of UFG/USAT Directors) p. UFG2004770. As in the case of UFG, after March 1988, with the exception of Whatley, all of USAT’s Directors were persons who were recruited and hired by Hurwitz or affiliated with MAXXAM, a company he controlled.

C. USAT’S Application For Capital Forbearance

S243. On February 11, 1988, at the same Board meeting at which Berner and Schwartz became Directors of USAT, the Board unanimously approved the filing of a Forbearance Application with the FHLB-D. Ex. T-8039, Tab 412 (02/11/88 USAT Minutes) p. OW054298. USAT submitted its application for capital forbearance to the FHLB-D on February 16, 1988. Ex. B-2020, Tab 1406. The application also “requested forbearance from the application of the brokered deposits limitation (Section 563.4), loans-to-one borrower limitation (Section 563.9-3), and investment in finance subsidiaries (Section 563.13-2(e)(3)). Id., Ex. A-11093, Tab 1909 (03/09/88 RRC Summary) p. OW123065.

S244. On March 9, 1988, Twomey and Baugh submitted a Summary to the Regulatory Review Committee regarding the USAT capital forbearance application. The memorandum reviewed the applicable criteria for receiving a capital forbearance and concluded with the recommendation that “United’s application for capital forbearance be approved.” Id.

1. The Application Was Not “Deemed” Complete Because Of The

Pending Examination

S245. The recommendation of Twomey and Baugh, however, was not approved by the RRC and on March 16, 1988, Twomey wrote a letter on behalf of the PSA advising USAT that because “the results of the examination [commenced in November 1987] might impact the institution’s regulatory capital,” pursuant to FHLBB Rule No 87-1297, dated December 22, 1987, the “subject request will not be deemed complete until the examination is complete.” Ex. B-2081, Tab 1915.

S246. On March 22, 1988, Berner met with Twomey and told him that “United was distressed the Dallas Bank had not granted [USAT’s] Forbearance Application.” Ex. B-2091, Tab 1655. Berner’s memorandum dated March 23, 1988, to Hurwitz, Munitz and Gross regarding the meeting states:

Neil said…it was the Dallas Bank’s opinion that the Forbearance Application could not be approved until after the examination. He said there were concerns over the quality of assets, conflicts of interest and other items arising from the examination.

Id. Twomey refused to say whether, in fact, the Forbearance Application would be approved at any time. Id.

2. UFG Was Directed To Comply With Its Net Worth Maintenance Obligation And Infuse Capital Into USAT

S247. After the FHLB-D determined that the Forbearance Application was not deemed complete, Twomey advised UFG on May 13, 1988, that USAT had failed to meet its minimum regulatory capital requirement as of December 31, 1988. Ex. T-8070, Tab 71. In the letter, Twomey reminded UFG that in order to obtain the approval of the FHLBB for the merger of Houston First American Savings into USAT, UFG had agreed in 1982 to maintain the net worth of USAT at the level required by applicable regulations and directed UFG “to advise the Supervisory Agent of the steps which will be taken to infuse capital into United.” Id.; Tr. 23,474: 6 - 23,475: 4 (Twomey).

S248. When UFG did not respond to Twomey’s May 13, 1988 letter in writing and did not infuse any capital into USAT (Tr. 23,476: 9-14; Tr. 23,481: 9-12 (Twomey), Twomey made two subsequent requests to UFG, on December 8, 1988 and December 28, 1988, demanding that it comply with its net worth obligation and infuse whatever available capital it had into USAT. Ex. T-2021, Tab 73; T-8149, Tab 407; Tr. 23,476: 15 - 23,481: 8 (Twomey). Although UFG had recorded a net gain of $181.5 million on December 31, 1984, resulting from the sale of USAT branches, (Ex. B-476, Tab 142 (1984 UFG annual report) p. CN151653, and Twomey believed UFG still had between $10 and $20 million in assets in December 1988, it did not infuse any capital into USAT as directed by the Supervisory Agent. Tr. 23,477: 2 - 23,479: 3: Tr. 23,481: 9-12 (Twomey). UFG actually had more than $25,000,000 in assets as of December 31, 1988. Ex. A-3024, Tab 81, p. 04263.

3. The 1987 Examination Is Completed

S249. After the 1987 Examination was completed, Twomey advised FHLB-D Assistant Director David Bradley that USAT’s capital position on June 30, 1988, was $35.1 million below USAT’s projections in the Capital Plan included in the Forbearance Application (Ex. B-2020, Tab 1406 (Forbearance Application) p. OW091246) and Twomey recommended that “the application be withdrawn and returned to the institution for appropriate revision.” Ex. T-8093, Tab 1866 (07/27/88 Twomey memo). Consistent with Twomey’s recommendation the FHLB-D withdrew the application and returned it to USAT on July 9, 1988. Ex. B-2341, Tab 1919.

D. USAT Increased The Salaries Of Senior Management And Granted Large Prepaid Bonuses At A Time When USAT Had Failed Its Net Worth Requirements And Was Approaching Or Had Become Insolvent

S250. After USAT failed its net worth requirement and applied to the FHLB-D for Capital Forbearance in February 1988, the senior managers of USAT and UFG, who controlled the Boards of USAT and UFG, approved substantial increases in their own compensation. In addition to approving large salary increases for themselves, senior management also approved bonuses and employment contracts that provided for substantial severance benefits in the event they were terminated.

S251. These compensation practices, which supervisory agent Twomey and OTS expert Allen Dermody testified were unsafe and unsound practices (Ex. Towmey letter); Tr. 4,573: 7 - 4,576: 11 (Dermody); Tr. 23,429: 10-15; Tr. 23,488: 6 - 23,440: 19 (Twomey)), were part of the allegations in the thirteenth claim for relief in the Notice of Charges pertaining to settled respondents Munitz, Berner, Gross and Crow. They are discussed briefly here for two reasons: first, USAT’s management lied to the regulators regarding the existence of USAT’s employment agreements and as discussed in greater detail later, when Supervisory Agent

Twomey learned of the true facts, he recommended that USAT’s present management be terminated.

S252. Second, as discussed at FOFs S329 - S335 and S344 - S346, when MAXXAM/Hurwitz bid to recapitalize USAT with the FSLIC’s assistance, MAXXAM proposed to retain USAT’s management. In part, because of the FHLB-D concern over management’s past actions with respect to their own compensation, the FHLB-D recommended that old management be removed and objected to the MAXXAM bid which contemplated retaining the existing managers.

1. USAT Gave Senior Management Salary Increases In April 1988

S253. On March 30, 1988, the same day Examiner Carlton discussed USAT’s net worth failure with the members of USAT’s Board (Ex.T-8049, Tab 405 (03/30/88 Special USAT Board Minutes)), the Compensation Committee of USAT and USAT reviewed a “proposal” made by Mr. Berner to resolve a “problem” regarding the “current status of Employment Contracts.” Ex. T-8050, Tab 418 (03/30/88 Compensation Minutes). The meeting was attended by James Whatley, the only member of the USAT’s Compensation Committee (Ex: A-3015, Tab 94 (1988 UFG Proxy) p. 7; Tr. 18,774: 15 - 18,775: 7 (Berner)), as well as Munitz, Gross, and Berner. Ex. T-8050, Tab 418 (03/30/88 Compensation Minutes). The minutes of the Compensation Committee only stated that Berner

…presented a proposal which was discussed with and approved by the Committee. The Committee requested that Dr. Munitz retain a compensation specialist to pass on the fairness of the proposal. Mr. Whatley noted, however, that the Company should proceed as quickly as possible on the proposal without waiting for the report of the compensation specialist.

Id. The minutes did not identify the problem with the employment contract or explain what the proposal was that the Committee approved. Id.

S254. A memorandum prepared by Berner on March 31, 1988 marked “Privileged and Confidential Attorney Work Product” explained the proposal which was presented by Senior Management at the March 30, 1988 meeting to Whatley as the sole member of the Compensation Committee acting without a quorum. Ex. T-8053, Tab 421; Tr. 18,774: 15 - 18,775: 7 (Berner). Among other things, Munitz, Gross and Berner (Tr. 18,795: 1-9 (Berner)) proposed that Whatley approve an increase in the current salaries of USAT’s management, retroactive to January 1, 1988, “equal to the 1987 salary plus bonus received in 1988 for 1987 work.” Ex. T-8053, Tab 421 (03/31/88 Berner memo); Tr. 18,818: 11-18 (Berner).

S255. According to Whatley, as a member of the Compensation Committee, he was not authorized to approve salary increases proposed by Munitz, Gross and Berner without the approval of the full Board of Directors. Ex: A-3015, Tab 94 (1988 UFG Proxy) p. 7; Tr. 4,200: 19 - 4,201: 22; Tr. 4,203: 8 - 4,204: 2; Tr. 4,261: 11 - 4,262: 21 (Whatley). Consequently, Whatley did not approve the proposed salary increases at the March 31, 1988 meeting of the Compensation Committee, but simply recommended that such increases be approved by the Board of USAT. Tr. 4,378: 21 - 4,379: 11 (Whatley).

S256. On April 5, 1988, the salary increases were authorized without Board approval by Gross and put into effect by USAT. Ex. T-8055, Tab 422 (04/04/88 Salary Adjustments); Tr. 18,846: 7-15. The effect of the increases was to raise the base salaries of USAT’s management by approximately 60% (id.; Tr. 4,649: 19 - 4,650: 6 (Dermody))at a time when USAT was failing its minimum capital requirement. Tr. 18,851: 6-13 (Berner). Under the new salary structure, the four highest compensated persons were Gross, Munitz and Berner, the architects of the plan, and Crow. Tr. 18,847: 19 - 18,848: 20 (Berner). The salary increases were not considered or approved until the May 10, 1988 USAT Board meeting, over a month after it the new salary structure was implemented. Ex. T-8068, Tab 460 (05/10/88 USAT Minutes); T-8068A, Tab 461 (Berner Affidavit) at ¶ 12; Tr. 4,392: 18 - 4,393: 2 (Whatley); Tr. 4,966: 12 - 4,967: 6 (Dermody).

S257. Supervisory agent Twomey was not informed of the salary increases by USAT and testified he did not learn of them until November 1988, when they were discovered in the course of the Southwest Examination. Ex. T-8115, Tab 1923 (11/04/88 Gutherie Memo) p. OW028501; B-2699, Tab 1863 (Southwest Examination Report) p. OW154215; Tr. 24,788: 10 - 24,784: 13; Tr. 24,785:5 - 24,786: 15 (Twomey).

2. USAT Gave Senior Management Prepaid Bonuses In April 1988

S258. At the March 30, 1988, meeting of the Compensation Committee, Berner also proposed that Whatley approve a special 1988 bonus equal to the bonuses that were paid in 1987. Ex. T-8053, Tab 421 (03/31/88 Berner memo) at ¶ 5. Berner’s memorandum to Whatley, Gross and Munitz explained that “[t]his special bonus would be paid 25% currently and 75% on January 1, 1989 and will be placed in trust with an independent Trustee.” Id. at ¶ 5.

S259. As was the case with the salary increases, Whatley testified that he did not approve the special bonus (Tr. 4,382: 11 - 4,383: 1), because as a member of the Compensation Committee he only had the authority to make recommendations regarding bonuses, which then had to be approved by the Board. Tr. 4,202: 10-16; Tr. 4,261: 11 - 4,262: 21 (Whatley).

S260. Following the Compensation Committee meeting, Gross also authorized the implementation of the special bonuses on April 5, 1988 (Ex. T-8055, Tab 422 (Pro Rata Bonuses) p. UFG-D 1982), and by April 26, 1988, a trust was created by Berner to administer the portion of the special bonus that was to be paid on January 1, 1989. Ex. T-8062, Tab 427 (1988 Executive Bonus Plan); Tr. 18,852: 20 - 18,853: 3; Tr. 18,855: 14 - 18,856: 7(Berner). Pursuant to the special bonus, $291,365 was paid immediately (Ex. Ex. T-8055, Tab 422 (Pro Rata Bonuses) p. UFG-D 1983) and $879,345 was placed in an irrevocable trust to pay the deferred portion of the bonuses at a time when USAT was failing its net worth requirement. Ex. T-8062, Tab 427 (1988 Executive Bonus Plan) p. UFG-A 0718; Tr. 18,854: 22 - 18,855: 8 (Berner).

S261. The special bonus was considered and approved by the USAT Board on May 10, 1988, over a month after the special bonuses were implemented. Ex. T-8068, Tab 460 (05/10/88 USAT Minutes); T-8068A, Tab 461 (Berner Affidavit) at ¶ 12; Tr. 4,392: 18 - 4,393: 2 (Whatley); Tr. 4,966: 12 - 4,967: 6 (Dermody).

3. USAT Entered Into Employment Agreements With Senior Management That Guaranteed Millions In Severance Benefits At A Time When USAT Is Insolvent

S262. Between September 1987 and July 1988, USAT and UFG entered into two sets of employment contracts with senior management which substantially increased the compensation and conferred substantial severance benefits upon USAT’s managers at a point in time when the Association was failing and its parent was approaching insolvency.

i. The UFG Employment Agreements In September 1987

S263. On September 9, 1987, UFG entered into employment contracts with six members of the senior management of USAT and UFG, including Berner and Crow. Ex. A-1133, Tab 1402 (09/09/88 UFG Minutes) p. OW035549. Among other things, the contracts provided for a base salary through the end of 1988 at the level the executives were then being paid (Ex. A-11032, Tab 483 (09/09/87 Berner Contract) p. OW128393; B-1743, Tab 1365 (09/09/87 Crow Contract) p. CN127893-94; Tr. 18,628: 9-17; Tr. 18,629: 14-20 (Berner)) as well as an automatic bonus at the end of the year. Ex. A-11032, Tab 483 (09/09/87 Berner Contract) p. OW128393; Tr. 18,631: 12 - 18,633: 2 (Berner). The contracts also provided for two years severance pay. Id. p. CN128399; Tr. 19,593: 17 - 19,594: 2 (Berner). Although the contracts were entered into between UFG and senior management, the base salaries and the bonuses under the contracts were paid by USAT. Tr. 18,629: 14 - 18,631: 2; Tr. 18,632: 19 - 18,633: 21 (Berner).

ii. The Initial USAT Employment Agreements In

February 1988

S264. By February 1988 the financial condition of UFG had deteriorated to the point that senior executives were concerned about UFG’s “viability” (Ex. T-8054, Tab 403 (03/31/88 Berner Memo) p. OW035557) and it was proposed “that a ‘back up’ Employment Agreement be entered into among the executive officers and USAT.” Id. The proposal was approved by the USAT Board on February 11, 1988, and USAT entered into employment agreements with six members of senior management, including Crow and Berner. Ex. A-1141, Tab 99 (02/11/88 USAT Minutes) p. US-3 002787; T-8043, Tab 413 (02/11/88 Berner Contract); T-8042, Tab 416 (02/11/88 Crow Contract).

S265. The salaries under the USAT employment agreements were set at the same levels as under the September 1987 UFG employment agreements. Id. Pursuant to paragraph 9(d)(ii) of the employment agreements, a USAT executive was entitled to two years severance pay in the event of a termination. Ex. T-8043, Tab 413 (02/11/88 Berner Contract) p. W 401377-78. However, the contract contained no provision, such as a letter of credit or a trust arrangement, to guarantee the payments in the event USAT was placed in receivership and an executive was terminated. Id. The term of the employment agreements was through the end of 1988. Id. p. W 401370.

iii. The July 1988 USAT Employment Agreements

S266. Two months after the February 1988 USAT employment agreements were approved, Berner, Munitz and Gross proposed that USAT “provide for amended Employment Contracts…for those with contracts now plus new contracts for Jenard Gross and Barry Munitz.” Ex. T-8053, Tab 421 (03/31/88 Berner memo) at ¶ 6. Whatley, as the sole member of the Compensation Committee, concurred with the proposal of senior management and on June 28, 1988, at a Special Meeting of the Board of Directors of USAT recommended that USAT enter into a new set of employment contracts with nine members of USAT’s senior management including Berner, Crow, Gross & Munitz. Ex. T-8078, Tab 434 (06/28/88 USAT Minutes). In addition to approving amended contracts for Berner and Crow, the Board also approved new employment contracts for Gross and Munitz, who had not previously entered into any employment agreements with USAT. Id.

S267. The new contracts incorporated a number of significant changes. Among other things, the new employment agreements adopted the higher salary levels that USAT implemented in April 1988 which added the 1987 bonuses to the 1987 base salaries. Tr. 4,673: 4-8 (Dermody). For example, Berner’s base salary under the new agreement increased from $170,736 (Ex. T-8043, Tab 413 (02/11/88 Berner Contract) p. W401371) to $284,736 (Ex. T-8085, Tab 438 (01/07/88 Berner Contract) p. 3. Also, the terms of the new agreements were extended three years to December 31, 1991. Id. p. 1; Tr. 4,672: 14 - 4,673: 4 (Dermody). The new contracts also required that USAT secure the severance benefits under paragraph 9 of the contracts by delivering letters of credit to the senior managers in the amount of two years annual salary. Ex. T-8085, Tab 438 (01/07/88 Berner Contract) p. 18-22; Tr. 4,673 10-17 (Dermody).

S268. The members of the USAT Board who voted to approve the contracts were Berner, Gross, Munitz and Whatley. Tr. 18,912: 12-18 (Berner). Each of the three Board members who had contracts approved by the board at the meeting (Berner, Munitz and Gross) abstained from voting when their own contract was under consideration but voted on the other contracts. Ex. T-8078, Tab 434 (06/28/88 USAT Minutes) p. OW035553; Tr. 18,912: 19 - 18,913: 6 (Berner).

S269. At the Special June 28, 1988 USAT Board meeting the Board also approved the hiring of Lawrence Connell as President and CEO of USAT and authorized an employment agreement between Mr. Connell and USAT. Ex. T-8078, Tab 434 (06/28/88 USAT Minutes) p. OW035554. As discussed in greater detail later, Mr. Connell was hired to bolster USAT’s management and overcome the regulators concerns about the lack banking experience among USAT’s senior management. Ex. A-11160, Tab 1861 (05/27/88 Twomey memo) p. OW075487 and 90; B-2224, Tab 1695 (06/03/88 Berner memo) p. OW028586.

S270. At the June 28, 1988, meeting of the UFG Board the Board authorized USAT to enter into nearly identical employment agreement between UFG and the same nine members of USAT’s senior management Ex. T-8079, Tab 435 (06/28/88 UFG Minutes); T-8082, Tab 436 (Berner UFG contract).

4. USAT Ignored The Advise Of Legal Counsel And Its Employment Consultant

S271. Prior to recommending that Whatley and the USAT Board approve new employment contracts with senior management, Berner had received a memorandum from Thomas M. Leahey of the law firm of Kirkpatrick & Lockhart dated March 25, 1988, on the subject of Employment Contracts. Ex. T-8048, Tab 417. Among other things, Leahey advised Berner that in the case of FSLIC v. Bass, 576 F. Supp. 848 (N.D. Ill. 1983) the court held that employment contracts adopted by a failing savings and loan four months before it was placed in receivership which provided for severance payments for officers were invalid and constituted an “unsafe and unsound practice.” Id. p. UFG-K 1615. Berner testified that, although he understood it might be considered and unsafe and unsound practice for USAT to enter into the new contracts at a point in time when it was failing its net worth he went ahead and entered into new contracts anyway without advising the FHLB-D or seeking their views. Tr. 18,769: 9-21; 18,772: 1-17 (Berner).

S272. Similarly, Hewitt and Associates, a consulting firm retained by USAT/UFG to assist with the July 1, 1988 employment agreements, admonished Berner that before entering into the employment agreements they should be reviewed by the legal department. On June 7, 1988 Hewitt advised Berner that before USAT secured severance benefits with a letter of credit or a trust as USAT intended UFG should “check with outside counsel to make sure any funded arrangements do not violate federal or state banking laws regarding ‘unsafe and unsound practices.’” Ex. T-8074, Tab 432 (Hewitt Funding Report) p. H 0182. Berner testified that while he generally discussed the concept of safety and soundness with Regulatory Counsel Leahey (Tr. 18,994: 11 - 18,995: 11), he did not seek or obtain any legal opinion from Leahey as to whether it would be considered an unsafe and unsound practice to enter into the contracts. Tr. 18,995: 12-18.

5. Berner Failed To Disclose The Existence Of The USAT Employment Contracts

S273. In May 1988, as part of the process of selecting institutions to participate in the Southwest Plan, which is discussed in detail at FOF S287, Supervisory Agent Twomey sent letters to associations which he supervised requesting information about the employment agreements such institutions had entered into with their executives. Tr. 23,419: 2 - 23,420: 11 (Twomey). In a letter to Gross dated May 13, 1988, Twomey made the following request to USAT:

In order to complete our records, please submit a copy of all employment contracts between officer or employees and the Association or any of its subsidiaries.

Ex. T-8069, Tab 429, emphasis added.

Berner responded to Twomey’s inquiry on May 18, 1988, as follows:

United Savings Association of Texas has just received your letter dated May 13, 1988, concerning employment contracts between the Association or any of its subsidiaries or officers or employees thereof.

Please be advised that the Association has not entered into employment agreements with such officers or employees. As you are aware, United Financial Group, Inc., the holding company, has entered into certain employment agreements which have been provided to Vivian Carlton in connection with our examination.

Ex. T-8071, Tab 430, emphasis added.

S274. Berner’s response was clearly false. As discussed above, three months earlier, on February 11, 1988, USAT had entered into employment contracts with six members of USAT’s management, including Berner (Ex. A-1141, Tab 99 (02/11/88 USAT Minutes) p. US-3 002787; T-8043, Tab 413 (02/11/88 Berner Contract); T-8042, Tab 416 (02/11/88 Crow Contract)) which Berner himself had drafted. Tr. 18,719: 21 - 18,720: 8 (Berner).

S275. Twomey was clearly misled by Berner’s letter. On May 23, 1988, Twomey wrote a letter to the Board of Directors of UFG which stated:

On May 13, 1988, the Supervisory Agent of the Federal Home Loan Bank Board of Dallas requested that United Savings Association of Texas provide us copies of each of the employment contracts between the Association or any of its subsidiaries and officers or other employees. We were subsequently advised by Mr. Arthur S. Berner that no such contacts exist. However, he indicated that employment agreements do exist between United Financial Group, Inc. and its officers and /or employees. Therefore, please provide us with copies of each such contract between United Financial Group, Inc. and /or any of its subsidiaries and the officers and other employees of these entities. These should be submitted to this office no latter than June 6, 1988.

Ex. B-2211, Tab 1376, emphasis added.

S276. Although two of the members of the UFG Board of Directors (Crow and Berner) had employment contracts with USAT and five of the six members of the UFG Board (Gross, Munitz, Berner, Schwartz and Whatley), were on the USAT Board at the time the USAT contracts were approved UFG did not correct the false information that no contracts existed between USAT and any of its employees that Berner had communicated to Twomey. Instead, Berner responding on behalf of the UFG Board, on June 1, 1988, sent copies of the six UFG employment agreement entered into on September 9, 1987 to the regulators. Ex. T-8072, Tab 431; Tr. 19,018: 18 - 19,019: 17 (Berner). Again, Berner failed to either disclose the existence of the February

11, 1988 USAT employment agreements or to provide the regulators with copies of the agreements. Id.; Tr. 19,020: 10 - 19,021: 6 (Berner).

S277. Berner’s only explanation for not disclosing the February 11, 1988 USAT employment agreements was that, although the contracts had been executed, he did not believe they were “effective.” Id.

6. USAT Funds The Severance Benefits At A Time When It Is Insolvent

S278. Pursuant to Paragraph 9(i) of the July 1, 1988 USAT employment agreements entered with senior management, “USAT’s obligation with respect to severance benefits under the Employment Contract [were] to be secured by an unconditional irrevocable letter of credit…or with cash deposited with a trustee by USAT in a trust account maintained for [senior management’s] benefit…” Ex. T-8106, Tab 441 (10/03/88 Gross letter); Ex. T-8085, Tab 438 (01/07/88 Berner UAST Contract) p. 18-22.

S279. USAT determined that it would not be feasible to obtain a letter of credit or to establish a trust account as required under the employment agreements (Ex. T-8106, Tab 441 (10/03/88 Gross letter)) and on October 3, 1988 Gross advised Munitz:

In lieu [of a letter of credit or trust] USAT has deposited an aggregate amount of $6,612,980.00 with First City National Bank …with respect to USAT’s obligation to pay severance benefits under all executive employment agreements to which it is a party.

Id.

S280. The $6.6 million escrow was established on September 28, 1988 (Ex. T-8104, Tab 440 (Escrow Agreement)) and approved by the Board of USAT six days later on October 4, 1988 (Ex. T-8108, Tab 443 (USAT Minutes) p. UFG-D 2429) at a time when the net worth of the Association was at least negative $200 million. Id. p. UFG-D 2425.

7. Twomey Did Not Learn About The Existence Of The USAT

Employment Agreements Until October 1988

S281. As discussed later in S309 - S312, except for the contract entered into with Larry Connell, Twomey remained unaware of the existence of the remaining July 1, 1988 USAT Employment Agreements entered into with other members of USAT’s senior management until they were brought to his attention in October 1988 by Brenda Bese, the Examiner conducting the Southwest Examination, (Tr. 23,328: 11-19 (Twomey)), October 1988. Tr. 23,346: 4-16 (Twomey). In Southwest Examination Interim Report No 2, dated October 17, 1988, Ms. Bese advised Twomey that USAT entered into employment contracts with eight senior executives of USAT on July 1, 1988. Ex. B-2699, Tab 1863 (Southwest Examination) p. OW154209. The Interim Report also disclosed to Twomey, for the first time, that USAT’s senior management had received substantial pay increases under the new employment agreements (Id.; Tr. 23,351: 10-16 (Twomey)) and that the agreements provided for substantial severance benefits, which had been secured by the deposit of $6.6 million of USAT assets in an escrow account. Ex. B-2699, Tab 1863 (Southwest Examination) p. OW1542010; Tr. 23,352: 2 - 23,253: 13 (Twomey). As discussed later, upon learning of these facts, Twomey sent a letter to USAT on October 27, 1988 instructing USAT’s management not to make any payments under the contracts other than the base monthly salary payments

E. The Southwest Plan

S282. In order to deal with failing depository institutions in Texas, such as USAT, the FHLBB devised something that came to be known as the “Southwest Plan.” Twomey explained that:

In late 1987, the Federal Home Loan Bank Board and the Federal Home Loan Bank of Dallas had organized what they called the Texas plan, which was the -- there was so many insolvent S&Ls in the Texas area that we were going to, with FSLIC assistance, merge them together and then recapitalize them with outside buyers infusing capital and with FSLIC guarantees to cover the new buyers from losses. And later on, it became what's called the Southwest Plan. They changed the name. In May of 1988, the first two institutions to go through receiverships involving -- a number of institutions went through receivership. But two acquirers came in. Coastal and Southwest Savings in Dallas -- Coastal Bank here in Houston -- were the first two acquirers.

Tr. 23,246: 6-22; Tr. 23,278: 15 - 23,279: 8 (Twomey).

S283. Examiners were brought to Texas from all over the country to review institutions that were going to be acquired or were being considered as acquirers to determine their overall safety and soundness and the competence of their management to participate in the Southwest Plan. Tr. 23,247: 7-19 (Twomey). These examinations were referred to as Southwest Plan Examinations by the FHLB-D. Id.; Ex. T-8142, Tab 1450 (“S” Memo) p. 5.

1. USAT’s Efforts To Be Considered As An Acquirer In The Southwest Plan

S284. Beginning in the latter part of 1987, USAT expressed an interest in potentially participating in the so-called Southwest Plan. Ex. B-1855, Tab 1682 (11/18/87 Berner Memo). On November 18, 1987, Twomey met with Berner and described to Berner the process by which institutions would be selected to participate in the Southwest Plan. Tr. 23,284: 7-22 (Twomey). In a memorandum Berner sent to Hurwitz and the senior management of USAT he described his meeting with Twomey. Ex. B-1855, Tab 1682 (11/18/87 Berner Memo). Berner wrote that the process of matching institutions to participate in the Southwest Plan was being conducted by Bud Gravette in “secret.” Id. p. OW045476. Twomey testified he was not involved in the process (Tr. 23,278: 18 - 23,279: 8; 23,23,282: 13 - 23,283: 19 (Twomey)) and had no idea which institutions would be selected to participate. Tr. 23,284: 7-18.

S285. Berner reported that during his November 18, 1987 conversation, Twomey assured him that USAT was “too big to fail” (Ex. B-1855, Tab 1682 (11/18/87 Berner Memo) p. OW045477). Twomey testified that by this, he meant that if USAT had a “liquidity crisis” he “was prepared to recommend to FSLIC that we would move in and the bank would use FSLIC-guaranteed money to infuse capital – infuse cash into the institution.” Tr. 23,285: 7 - 23,286: 6 (Twomey). According to Berner’s memorandum, Twomey also told him that:

…it would have made his life a whole lot easier if Charles Hurwitz had never heard of redwood trees but that, basically, the Dallas Bank considered Charles to be a “smart business person” and that it was important to have smart business people running Texas thrifts at this time.

Ex. B-1855, Tab 1682 (11/18/87 Berner Memo) p. OW045477.

S286. The following month, on December 24, 1987, Twomey again spoke with Berner regarding USAT’s potential participation in the Southwest Plan to consolidate thrifts, and informed Berner that USAT would not be one of the acquiring thrifts. Ex. B-1910, Tab 1859 (Berner memo) p. W 105435; Tr. 23,291: 12-20 (Twomey). The memorandum Berner sent to Hurwitz and USAT’s senior management regarding the meeting stated: “…although United was considered one of the ‘good guys’ we do not seem to be in the ball park.” Id. Twomey advised Berner that “if [USAT] wanted to be considered [as an acquirer], we had to get Gravette’s ear very quickly and suggested a meeting as soon as possible.” Id.; Tr. 23,292: 6-16 (Twomey).

2. Management Was The Main Concern In Selecting Participants For The Southwest Plan

S287. By the end of March 1988, United was not being considered for participation in the Southwest Plan (Tr. 23,293: 11-16 (Twomey)) and Berner again spoke to Twomey about the Southwest Plan. Berner described the March 22, 1988 meeting in a memorandum to Hurwitz, Munitz and Gross dated March 23, 1988. Ex. B-2091, Tab 1688. At the meeting, Berner informed Twomey that USAT was “upset” about the fact that USAT did not seem to be a “player” in the Southwest Plan. Id. p. W 104569. According to Berner’s March 23, 1988 memorandum, Twomey told Berner that:

…United was not considered to be one of the front runners in the initial wave of the Southwest Plan. [Twomey] said that Bud Gravette had made that clear in a meeting that he had with [Gross] and [Berner].

Id. p. OW104569.

S288. Twomey explained to Berner that the main item of concern regarding an institution’s participation in the Southwest Plan was “ ‘management’ and that S&L’s were being brought in to rate their management.” Ex. B-2091, Tab 1688 (03/23/88 Berner memo) p. W 104570. Twomey testified that Mr. Gravette was requesting information about how various thrifts conducted their business and whether thrifts had the management capability to operate a larger surviving institution if they were merged with other institutions. Tr. 23,294: 18 - 23,295: 21 (Twomey).

S289. At the conclusion of the discussion at the March 22, 1988 meeting Twomey and Berner discussed the role Charles Hurwitz played at United. Berner’s notes state:

Neil also said that the Dallas Bank was concerned about the “numerous” requests they were receiving from governmental agencies about the activities of Charles Hurwitz. He said that he had recently been contacted by the General Accounting Office and “another” agency about Hurwitz’s activity. He said that there was a concern that Hurwitz was using United Savings as a vehicle for “dumping Drexel Junk Bonds”.

I told him that this was ludicrous and, in fact, the only areas where United had made profits over the last three years was in the high-yield bond and equities securities business.

Twomey asked what Hurwitz’s current role in United was. He stated that although he knew that Hurwitz was off the Board, he had often seen institutions where “control” was in non-board members. I told Neil that while Charles certainly had a say in overall policy direction, in fact, the day to day operations were totally out of his hand and even on policy decisions there was a free exchange of ideas between all senior management. While I would not deny to Neil that if Charles wanted something done it would probably be done, I stressed that, in fact, Charles was out doing other deals and was not imposing his will upon United or United’s management.

Ex. B-2091, Tab 1688 (03/23/88 Berner memo) p. W 104571, emphasis added.

3. FHLB-D’s Evaluation Of USAT’S Management In May 1986

S290. On May 24,1988 Twomey and Baugh received a request from the FSLIC or Mr. Gravette (Tr. 23,303: 3-13 (Twomey)) for information regarding USAT’s general financial condition and its management “for the purpose of determining the strength and weaknesses of potential acquirors [sic] in the ‘Southwest Plan’.” Ex. A-11160, Tab 1861 (05/27/88 Twomey memo) p. OW075487. On May 27, 1988, Twomey and Baugh updated the information which they had previously provided on this subject on May 5, 1988. Id. Twomey’s memorandum contained the following evaluation of USAT’s management:

Generally, management is considered motivated and skillful in their respective area. However, none of the 11 senior level managers have strong S&L or banking backgrounds, and only 4 have any banking and 2 any S&L experience.

Id. p. OW075487. Twomey concluded the memorandum as follows:

United’s holding company is publicity held and is very much in the public eye. We believe that if United is not allowed to participate in the acquisition of other institutions in the Southwest Plan, its exclusion would be perceived negatively. United is already considered a borderline institution by Wall Street, on which United is largely dependent for earnings as well as liquidity through repo lines. In addition, the press has begun to portray United negatively. Therefore, with some bolstering of senior management, and depending on the results of the final examination report, we would recommend that United be allowed to participate as an acquirer in the Southwest Plan.

Id. p. OW075490, emphasis added.

4. USAT Hires Larry Connell To Bolster Management

S291. For some time, the Regulators had been stressing to USAT that USAT needed a senior thrift or financial executive to strengthen their overall senior management team. Tr. 23,304: 17 - 23,305: 11. In fact, on March 9, 1988, Twomey reported to the RRC that USAT only “marginally” met the requirement that a thrift be “currently well managed” in order to qualify for capital forbearance. Ex. A-11093, Tab 1909 (03/09/88 RRC Report) p. OW153064. Twomey stated in his memo:

….senior level management has little or no savings and loan experience nor operations experience in a financial institution. In the 1986 examination report, Examiners noted that senior management seemed to lack a clear understanding of the operations of the overall institution, and the same comments have been made verbally during the current examination. Because of this lack of cohesiveness, management was rated “4” based on the May 26, 1986 examination.

Id., emphasis added.

S292. On June 3, 1988, Berner met with Twomey and, among other things, discussed USAT’s efforts to hire a senior executive officer with savings and loan experience. Ex. B-2224, Tab 1695 (06/03/88 Berner memo) p. OW028585. PSA Barclay was very interested in USAT’s efforts to hire a new senior executive and Twomey kept Barclay informed on the current status of the search. Id.; Tr. 23,306: 3-11 (Twomey).

S293. Berner’s memorandum to Hurwitz, Munitz and Gross on the June 3, 1988 meeting with Twomey states that Twomey advised him that “for the first time, the people in Washington and Dallas were talking about United’s role in the Southwest Plan.” Ex. B-2224, Tab 1695 (06/03/88 Berner memo) p. OW028586. Twomey cautioned, however, that “it was extremely important that [USAT] find the senior executive since that would be the initial step in participating in the Southwest Plan.” Id.

S294. On June 30, 1988, Berner wrote a memorandum to Hurwitz, Gross and Munitz informing them that he had advised Twomey the previous day that USAT was in the process of finalizing a contract with Larry Connell. Ex. B-8081, Tab 1377. Larry Connell was a thrift executive who had experience managing two previous failed thrifts and had served as the head regulator of the national credit unions. Tr. 23,316: 14-22 (Twomey). Larry Connell was ultimately hired as the President and CEO of USAT and appointed to the USAT Board and the USAT Executive Committee. Ex. T-8078, Tab 434 (06/28/88 USAT Minutes) p. OW035554; A-1153, Tab 2115 (08/15/88 USAT Minutes); Tr. 23,317: 2-4 (Twomey).

S295. Berner’s memorandum regarding his June 29, 1988 conversation with Twomey states “[Twomey] flatly stated that after we had hired Connell [USAT] would have ‘satisfied all the requirements that the Federal Home Loan bank Board of Dallas had concerning United’ and that United would have no impediments to participating in the southwest Plan.” Ex. B-8081, Tab 1377. Twomey testified that, with the hiring of Connell, USAT had met the basic criteria set by the FHLB-D, but that it was up to Tom Lykos as to how USAT would fit into the Southwest Plan and there was no guarantee that USAT would participate at all. Tr. 23,317: 14 - 23,318: 12.

5. Hurwitz Submits A Bid For USAT

i. USAT, With The Assistance of Hurwitz, Submitted an Initial Bid In September To Participate In The Southwest Plan

S296. After hiring Connell, USAT’s management began to formulate a proposal for USAT’s participation in the Southwest Plan which it discussed with the FHLB-D on September 10, 1988. Ex. B-2399, Tab 2371 (09/10/88 Berner Memo); A-1156, Tab 1413 (09/08/88 USAT Minutes) p. US-3 002844-45. Under USAT’s initial proposal, USAT contemplated that “$50 million of equity could be raised from the current shareholders [MCO] on an expedited basis” and the rest of the necessary capital would be raised through the issuance of subordinated debt with the assistance of Merrill Lynch. Id. On September 21, 1988, MCO advised USAT that “in order to facilitate [USAT’s] reorganization and recapitalization, MCO or an affiliate of MCO is willing to provide $50 million in common stock equity for the acquisition of no less that 80% of the common stock of New United.” Ex. B-2405, Tab 2372.

ii. USAT’s Initial Proposal Failed When Hurwitz Backed

Out

S297. After receiving the USAT proposal to reorganize and recapitalize USAT with the assistance of MCO, Mike Patriarca, the Agency Directory for the FHLB-SF began active negotiations with USAT and MCO to put together a deal to reorganize USAT as part of the Southwest Plan. Tr. 23,776: 5 - 23,776: 19 (Twomey). In a memorandum dated October 3, 1988, Patriarca advised Thomas Lykos, the Deputy Director for the Southwest Plan, who was responsible for making recommendations regarding Southwest Plan assistance packages, that the negotiations with USAT and MCO failed when MCO “was unable to fulfill a commitment to make $50 million available on September 30, 1988” and withdrew its support for the proposal. Ex. B-2442, Tab 2373 p. OW0158184; T-8108, Tab 443 (10/04/88 USAT minutes) p. UFG-D 2427. The memorandum stated:

Last week we tried to close a deal with United (#4430). Although we came close, negotiations broke down when the equiy capital investor [MCO] backed out at the eleventh hour on 9/27/88.

Id.

S298. At the time Hurwitz was involved in a large transaction to purchase Kaiser Aluminum. Ex. B-2156, Tab 1892 (04/29/880 Danny Wall Questions); Tr. 20,146: 21 - 20,147: 18 (Berner); Tr. 25,981: 2-4 (Hurwitz). Berner explained that MCO was unable to close the transaction for the recapitalization of USAT because MCO was preoccupied with closing the deal to acquire Kaiser Aluminum. Tr. 20,146: 21 - 20,147: 18 (Berner).

S299. After Hurwitz withdrew from the negotiations, Berner wrote in a memorandum on October 24, 1988, that “it is clear Mr. Connell felt he had been left holding the bag as a result of Mr. Hurwitz not providing capital he had committed to during the week of September 30.” Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13662.

iii. Hurwitz Expressed A Renewed Interest In October

1988 In Assisting With The Recapitalization Of USAT

S300. After closing the purchase of 100% of Kaiser Aluminum, Hurwitz again became interested in USAT and MAXXAM began to “focus [its] attention on [a] joint effort with United’s current management to restructure and recapitalize United Savings of Texas.” Ex. B-2491, Tab 1961 (10/31/88 Hurwitz letter).

S301. In a letter dated October 17, 1988, Hurwitz and MAXXAM Group Inc. (formerly MCO) advised Thomas Lykos that MAXXAM now wished to participate in the reorganization of USAT and forwarded to Lykos a Private Placement Memorandum in which MAXXAM proposed to raise a total of $250 million in capital for the recapitalization of USAT. Ex. B-2466, Tab 1958. Under the new proposal MAXXAM proposed to raise “$30 million of common equity, of which 24.9% [$7.47 million] will be provided by MAXXAM and the balance by the Investors,” borrow $25 million from banks, and raise an additional $200 million through the issuance of capital debentures. Id. p. UFG 12472. Under the proposal the FSLIC was to have a “substantial role” (id. p. UFG 12475) by providing “notes and guarantees on a substantial portion of [USAT’s] $4.8 billion of assets”(id. p. UFG 12471) over a ten year period. Id. p. UFG 12475. Although the proposal stated that MAXXAM intended to “redirect” USAT away from its Wholesale Strategy to a “more retail oriented strategy” (id. p. UFG 12480), it was anticipated that “New United [would] also continue with bond investing and arbitrage activity.” Id. p. 12472.

iv. Hurwitz’s Commitment To Retain USAT’S Existing

Management

S302. After receiving the MAXXAM’s October 17, 1988 proposal, Gross sent a letter to MAXXAM on October 24, 1988 seeking clarification on a number of “issues relating to the various constituencies.” Ex. B-2476, Tab 1959, p. UFG 06225. Among other things, Gross asked about MAXXAM’s “thinking on management and employee continuity.:” Id. p. UFG 06226. Hurwitz, in a letter to Gross dated October 25, 198,8 reiterated MAXXAM’s commitment to retain USAT’s existing management, who, as discussed in part FOFs A136 and A150 - A156, had been hired by Munitz and Hurwitz. Ex. B-2481, Tab 1960, p. UFG2015985; B-2466, Tab 1958, p. 12486-88 and 12503. Hurwitz stated:

One of the basic reasons why we are interested in playing the role of equity investor in the proposed acquisition and restructuring is that we have strong confidence in the current management, Therefore, our plan would be to retain and support the current group, including honoring of existing contacts and related fiscal obligations.

Id. p. UFG2015985, emphasis added.

6. The Hyperion/Ranieri Bid

i. Ranieri Submitted A Bid To Acquire USAT After

Hurwitz Backed Out Of The Initial Recapitalization

Negotiation

S303. After the initial deal with Hurwitz to reorganize USAT fell through on September 27, 1988, Patriarca advised Larry Connell that the FSLIC was still interested in working with USAT to develop a recapitalization proposal. Ex. B-2442, Tab 2373 (10/04/88 Patriarca Memo) p. OW158184. On October 3, 1988, Patriarca and Connell discussed with Mr. Lou Ranieri the possible participation by Ranieri in the recapitalization of USAT. Id. Mr. Ranieri was the head of an investor group known as Hyperion Partners L.P./Ranieri Wilson & Co. Inc. (“Hyperion”). A-14201, Tab 2375 (12/30/88 Recommendation Memo) p. OW076502. Connell had a prior relationship with Ranieri and, according to Berner, felt more comfortable working with the Ranieri group after he had been left “holding the bag” as a result of Hurwitz withdrawing from the initial deal. Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13662.

S304. Ranieri advised Patriarca that he could easily raise substantial capital and requested an opportunity to acquire United as well as other packages of thrifts under the Southwest Plan. Ex. B-2442, Tab 2373 (10/04/88 Patriarca Memo) p. OW158184. By October 18, 1988, Ranieri had prepared and submitted a bid directly to the FSLIC to acquire USAT under the Southwest Plan. Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13662. Berner described the Ranieri proposal as “intending to create a more traditional S&L as opposed to the Hurwitz ‘merchant banking’ concept.” Id.; Tr. 20,427: 11-21 (Berner).

ii. USAT, Which Attempted To Control The Bidding

Process, Supported The Maxxam Bid

S305. Initially, USAT intended to submit a “generic” bid for potential investors to respond to without the bidders going to the FSLIC. Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13661. In this way, Berner hoped that the USAT Board, (which, as discussed at FOF S242, had been appointed by Hurwitz) would be able to “maintain control over the bid process.” Id. Accordingly, on October 14, 1988, Berner submitted USAT’s generic bid (id. p. UFG 13662) to the FSLIC. Thereafter, on October 17, 1988, MAXXAM, in consultation with USAT, submitted its recapitalization proposal supporting the USAT bid. Ex. B-2466, Tab 1958 (MAXXAM proposal); B-2481, Tab 1960 (10/25/88 MAXXAM letter) p. UFG2015984; Tr. 20,412: 16-22 (Berner). The MAXXAM proposal consisted of a 30 page Private Placement Memorandum which MAXXAM prepared that week with the assistance of Berner. Ex. B-2466, Tab 1958 (MAXXAM proposal) UFG 12465-500; Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13661; Tr. 20,421: 9-17 (Berner).

S306. In contrast, the Ranieri bid was submitted directly to the FSLIC and considered by the FSLIC to be separate from the USAT generic bid. Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13664. In view of the Ranieri bid, USAT’s management became concerned that it “might have lost control of the bidding process.” Id. After two subsequent meetings of the USAT Board on October 21 and October 31 (Ex. A-1160, Tab 2118; A-1161, Tab 21190), at which the MAXXAM and Ranieri bids were discussed, USAT’s management , which had previously told Patriarca that it was “taking a neutral position” on the bids (Ex. B-2478, Tab 1787 (10/24/88 Berner Memo) p. UFG 13664), came out in favor of the MAXXAM bid. Ex. A-1161, Tab 21190 (10/31/88 USAT Minutes) p. US-3 002880. On October 31, 1988, USAT’s Board advised Thomas Lykos that although it did not receive the requisite information necessary “to fully evaluate Hyperion’s proposal” the USAT Board had concluded that the MAXXAM bid was “superior on all accounts to the bid provided by Hyperion.” Ex. B-2490, Tab 2359.

VI. The Southwest Plan Examination

S307. On September 7, 1988, an examination team primarily from the Seattle Bank commenced an examination of USAT to determine if United was acceptable as an acquirer under the Southwest Plan. Ex. T-8142, Tab 1450 (“S” Memo) p. 5. An examination team was brought in from outside Texas in order to make an independent evaluation of the institution and its management and how they were coping with the economic situation in Texas. Ex. B-2377, Tab 1775 (08/23/88 Berner Memo); Tr. 23,325: 2-16 (Twomey). A successful examination report was a pre-condition to USAT’s participation as an acquirer in the Southwest Plan. Id.

S308. Before the examination could be written up and presented to USAT, USAT was placed in receivership. Tr. 23,329: 6-18 (Twomey). As a consequence the interim examinations, which had been prepared by Ms. Bese and her staff, were made available to the successor institution (Bank United) so that the new managers would be aware of the problems that the examination had revealed. Ex. B-2699, Tab 1863 (01/19/89 Southwest Examination) p. OW154230; Tr. 23,339: 16 - 23,340: 5; Tr. 23,329: 19 - 23,330: 1; Tr. 23,387: 18 - 23,388: 15 (Twomey).

A. FHLB-D Criticizes USAT’S Employment Contracts

S309. A major area of concern in the Southwest Examination were the USAT Employment Contracts and the escrow of $6.6 million in USAT assets to fund severance benefits at a time when USAT was insolvent. Of the five interim reports prepared by Bese, four (Interim Reports Nos. 2, 3, 4 and 5) discussed the compensation practices USAT’s management engaged in after USAT failed its regulatory net worth requirement. Ex. B-2699, Tab 1863 (01/19/89 Southwest Examination) p. OW154209-219.

1. FHLB-D Learns Of Employment Contract In Southwest Examination

S310. Interim Examination Report No. 1, identified as one of the main focuses of the examination, whether “management’s capabilities are sufficient to undertake the expansion as a candidate for the Southwest Plan.” Id. p. OW154207. Accordingly, among the first things the examiners requested from USAT’s management during the examination was “a list of all employees (holding company, association and service corporations) that have employment, consulting or other types of agreements.” Ex. T-8176, Tab 1867 (information request log) item 5 pp. OW127277 and OW127285; Tr. 23,439: 17 - 23,440: 6; Tr. 23,441: 17 - 23,442: 10 (Twomey). The information regarding the contracts was requested on September 13, 1988 and the requested list was provided to Ms. Bese on September 21, 1988. Id.; Tr. 23,442: 6-10; Tr. 23,444: 7-10 (Twomey).

2. The Examiners Criticizes USAT’s Employment Agreements And The Funding Of Severance Benefits

i. Interim Report No. 2

S311. After USAT disclosed the existence of the July 1, 1988 USAT employment agreements in the response to Ms. Bese’s request, Examiner Bese submitted Interim Report No. 2 on October 17, 1988. Ex. B-2699, Tab 1863, p. OW154209. The report described the July 1, 1988 contractual arrangements between USAT and its senior managers and recommended various revisions of the agreements. Id. p. OW154209-12. Among other things, Bese questioned whether “an association in United’s financial condition should be placing $6.6 million in assets in an escrow for ten members of management.” Id. p. OW154211. Bese also noted that “the eight highest paid United executives are awarded compensation that is significantly higher than compensation levels identified in [a U.S. League 1988 Savings and Loan compensation] survey.” Id. p. OW154212. Overall, Bese assigned USAT a Tentative Macro Rating of “3” for management. Id. p. OW154214.

ii. Interim Report No. 3

S312. In Interim Report No 3, Bese noted that ‘the salaries for senior-executives and mid-management were increased as of July 1, 1988” and that an Executive Bonus Plan had been initiated in 1988 to act as a “golden handcuff.” Id. p. OW154215. The report noted that the reasonableness of USAT’s salary increase was being reviewed and concluded the report by downgrading the Tentative Macro Rating for USAT management to a “4.” Id. p. OW154216.

3. The Supervisory Agent Declared The Employment Contracts Unsafe And Unsound And USAT Agreed To Remove From Escrow The $6.6 Million Set Aside To Fund Management’s Severance Benefits

S313. After receiving Interim Report No. 2 and learning for the first time of the existence of the July 1, 1988 Employment Agreements (Tr. 23,328: 11-19 (Twomey)), the substantial pay increases (Tr. 23,351: 10-16 (Twomey)), and that the agreements provided for substantial severance benefits, which had been secured by the deposit of $6.6 million of USAT assets in an escrow account (Tr. 23,352: 2 - 23,253: 13 (Twomey)), Supervisory Agent Twomey took immediate action to mitigate the effects of the employment agreements.

i. Twomey Advised The Board That The Contracts Were

Unsafe And Unsound

S314. On October 27, 1988, Twomey sent a letter to the USAT Board of Directors advising them that, after reviewing USAT’s employment agreements with its senior management, the FHLB-D had concluded that :

Each and every contract reviewed was found to be in violation of Section 563.39 of the Insurance Regulations, 12 C.F.R. § 563.39 (1988) (“Section 563.39”) in significant respects. Further, because these contacts provided for excessive compensation and severance payments, their execution at a time when United was approaching, or had actually reported insolvency, represented an unsafe and unsound practice by the Board of Directors and senior management of United.

Ex. T-8111, Tab 444, emphasis added. Twomey then directed the Board not to extend the contracts beyond December 31, 1988 and to:

Make no payments, and allow no payments to be made directly or indirectly, pursuant to any employment contract, bonus, agreement, retirement, pension or profit sharing plan, severance agreement, employee benefit plan or other similar agreement, or fund or escrow account related to such agreements, except for base monthly salary payments to employees pursuant to contracts upon which United is itself legally obligated…

Id.

ii. USAT Agreed To Remove The Severance Benefits From

The Escrow And To Return Them To The Association

S315. After sending the October 27, 1988 letter, Twomey met with Berner and Connell on November 3, 1988 (Ex. T-8120, Tab 449 (11/07/88 Berner letter) and again with the full Board of USAT on November 7, 1988 and expressed the concerns of the FHLB-D regarding the USAT employment agreements, the Executive Bonus Plan and the severance escrow. Ex. A-1163, Tab 447 (11/07/88 USAT Minutes) pp. US-3 002885-86. Contrary to the views of the FHLB-D, the USAT Board stated that “in their opinion the employment agreements were fair and reasonable and complied with all material regulations.” Id. p. US-3 002885. However, after discussing the escrowed severance payments and the Executive Bonus Plan with representatives of the FHLB-D, Berner advised Twomey that the Board agreed that:

All monies previously put into escrow for payment [of] senior executives Employee Bonus Plan and as security for such executives’ severance benefits are in the process of being, and will be, removed from escrow and returned to the Association.

Id.; Ex. T-8120, Tab 449 (11/07/88 Berner letter). However, the Board did not alter the base compensation under the agreements or reduce the amount of promised severance benefits under the employment agreements. Id.

S316. Twomey continued to question the reasonableness of the USAT employment agreements and, on November 21, 1988, again advised the Berner that, among other things, the “level of compensation paid to senior management generally appears to be excessive” and that “severance payments of two times annual salary may be considered excessive in light of the Institution’s financial condition.” Ex. T-8127, Tab 451 p. CN140638.

4. Southwest Examination Is Very Critical Of USAT’s Current Management

S317. On December 19, 1988, Examiner Bese submitted her last interim examination report to Twomey, Interim Report No. 5. Ex. B-2699, Tab 1863, p. OW154220-29. The first item dealt with in the report was her evaluation of USAT’s Management. Bese’s report contained the following assessment of USAT’s existing management team:

United Saving’s Board of Directors and management have not consistently operated the association in a manner to protect the interests of the stockholders or FSLIC fund. Weaknesses were noted in employment contracts and bonus programs, which were developed by management and approved by the Board of Directors as outlined in the previous Interim Reports. In addition, poor loan underwriting, inadequate investment decisions, and exceptions in accounts between the holding company and United Savings were noted.

Jenard Gross, Michael Crow, and Arthur Berner were the key management personnel involved in making major decisions for all association functions. These individuals were involved in all major committees: Executive, Investment, Asset Classification, and Senior Loan. Their decisions have had a significant negative impact on the viability of the association.

Jenard Gross has already resigned from his position with United Savings. Serious consideration should be given as to whether Michael Crow and Arthur Berner should continue at United Savings.

Id. p. OW154220, emphasis added. Bese again assigned a Tentative Macro Rating of “4” to management. Id. p. OW154229.

B. Examination Findings Concerning USAT’s Mortgage-Backed Securities Investments

S318. In 1988, for the first time, there was an examiner available to review USAT’s MBS investment program who had the background and training to do so. See Tr. 22,376: 6 - 22,378: 4. Mr. Leonard Lapidus, an examiner from the Chicago district of the Federal Home Loan Bank Board, conducted a review of USAT’s MBS investment program for the years 1985 through 1988[10]^/ over a three-to-four week period between Thanksgiving and Christmas 1988. Tr. 22, 376: 21 - 22,377: 3; 22,536: 17 - 22,537: 4. Mr. Lapidus became an examiner in May of 1981 and specialized in the examination of “capital markets” matters (i.e., MBS’s treasury and agency securities, junk bonds, and hedging instruments such as options, interest rate swaps, and other derivative securities) for the FHLB-Chicago. Tr. 22,361: 11 - 22,364: 17. In his testimony, he described a number of relevant courses he had taken. Tr. 22,365: 4 - 22,367: 11.

S319. In his testimony, Mr. Lapidus described the manner in which he conducted his review of USAT’s MBS investment program. Tr. 22,378: 17 - 22,388: 14. In addition, he identified and explained his workpapers, which were introduced in evidence in their entirety. Tr. 22,388: 15 - 22,451: 5; Ex. A-14101, Tab 1842; Ex. A-14102, Tab 1843; Ex. A-14103, Tab 1844; Ex. A-14104, Tab 1845; Ex. A-14105, Tab 1846. Finally, Mr. Lapidus identified and explained the section of the final report of examination that he had drafted. Tr. 22,451: 18 - 22,506: 2; Ex. A-14106, Tab 1847.

S320. Mr. Lapidus submitted his section of the final report of examination on or about January 20, 1989. Tr. 22,453: 9 - 22,454: 14. Prior to submitting his report in written form, Mr. Lapidus and Ms. Bese reported orally to FHLB-D in mid-December 1988, prior to USAT’s being placed in receivership. Mr. Lapidus testified that his oral report was substantially the same as his written report. Tr. 22,506: 5 - 22,507: 10.

S321. Mr. Lapidus concluded that USAT had engaged in “a high interest rate risk leveraging strategy in an attempt to generate a large net interest spread between long-term fixed rate assets and short term liabilities.” Ex. A-14106, Tab 1847, p. OW154317. The interest rate risk had been only “partially hedged.” Id. Further, Mr. Lapidus concluded that “[t]he institution also engaged in a forms [sic] of gains trading.”[11] Id. He explained:

When interest rates declined, the institution sold higher coupon rate MBS and replaced them with lower coupon rate MBS. However, when interest rates increased, the risk of these lower coupon rate MBS was not adequately hedged. As of September 30, 1988, the unrealized loss on the MBS net of hedging gains and losses was $213.7 million. In addition, the net spread between the MBS and reverse repurchase agreements which included the dollar rolls was 35 basis points.

Id.[12] In addition, Mr. Lapidus noted inadequate documentation of investment decisions, analysis, and monitoring. There were also numerous documentation deficiencies with respect to the transactions themselves. Id.; see Tr. 22,508: 20 - 22,522: 22.

VII. USAT Is Placed In Receivership

A. USAT Entered A Consent Agreement In November 1988

S322. By September 15, 1988, the financial condition of USAT had deteriorated to the point that Twomey recommended to PSA Barclay that USAT be required to sign Consent Merger Agreement. Ex. 2404, Tab 1805 (9/15/88 Supervisory Status Memo) p. OW158451. Twomey prepared a draft of a Consent Agreement and submitted it to USAT. Ex. T-8107, Tab 442 (10/3/88 Leahey letter) p. A03171. On October 4, 1988, prior to approving the creation of the $6.6 million escrow account to fund severance benefits (Ex. T-8108, Tab 443 (USAT Minutes) p. UFG-D 2429); the USAT Board reviewed in detail the proposed Consent Agreement prepared by the FHLB-D. Id. p. UFG-D 2427. The Board initially objected to the Consent Agreement because it “precluded additional equity arbitrage and high-yield bond investments” and instructed Berner to attempt to negotiate with the Dallas Bank to eliminate this restriction on USAT’s future activities. Id. Ex. B-2459, Tab 1661 (10/12/88 Berner letter) p. CN140650. On November 7, 1988, however, the Board concluded that in view of USAT’s insolvency “there was no leeway in this matter” and executed the Consent Agreement. Ex. T-8117, Tab 447 (11/7/88 USAT Minutes) p. OW035338; T-8142, Tab 450 (“S” Memo) p. 6; T-8119, Tab 448 (Consent Agreement).

1. The Terms Of The Consent Agreement

S323. Under the Consent Agreement, the Board of USAT consented to the appointment of a conservator or receiver and agreed to approve any merger, consolidation or transfer of the associations assets and liabilities. Ex. T-8119, Tab 448 (Consent Agreement), ¶¶ 1-4, pp. OW150933-34; Tr. 23,248: 4-19 (Twomey). The principal clauses in the Consent Agreement included: the orderly reduction of dollar rolls, repurchase agreements, junk bonds, equity arbitrage securities and interest rate swaps; and strict adherence to loan underwriting and investment policies which had to receive prior approval from the Supervisory Agent. Ex. T-8142, Tab 1450 (“S” Memo) p. 6; T-8119, Tab 448 (Consent Agreement). The Agreement also prevented USAT from entering into or revising any employment agreements with senior management. Id., ¶¶ 22(q), (s) and (t), p. OW15094.

2. The Orderly Liquidation Of USAT’s Arbitrage Portfolios

S324. Pursuant to Paragraphs 18 (a)(i)and (iii)of the consent Agreement, USAT had 60 days in which to present a plan for the “orderly reduction of dollar-rolls and repurchase agreement obligations as well as “interest rate swaps” that were part of USAT’s MBS RCA program. Ex. T-8119, Tab 448 (Consent Agreement) p. OW150937. The Consent Agreement also called for USAT to submit a plan for “the liquidation of its high yield corporate securities and its equity arbitrage securities.” Id., ¶ 18(a)(ii).

S325. In compliance with the terms of the Consent Agreement, Dominic Bruno submitted to Crow on December 8, 1988, a plan for the orderly liquidation of certain of USAT’s assets and liabilities, including MBS, ARMS, Residuals, Swaps, Caps, Collars, Reverse Repos and Dollar Rolls, over a period of one week to three months. Ex. T-6084, Tab 1291. Bruno advised Crow of the plan of liquidation intended to liquidate these assets and liabilities “in a manner which is efficient and which does not have an adverse market impact.” Id. p. US 0000330.

S326. On December 14, 1988, Stodart advised Crow that he was formulating a similar plan of liquidation for USAT high-yield securities portfolio. Ex. B-2607, Tab 1942.

S327. On December 21, 1988, Berner presented a plan of liquidation to Twomey for the Equity Arbitrage Portfolio, which contemplated the complete liquidation of the portfolio by September 30, 1989. Ex. B-2629, Tab 1786.

B. The “S” Memo

S328. After the Consent Agreement was executed, on November 16, 1988, Twomey recommended that USAT be transferred to the FSLIC for resolution. The FHLB-D concluded that in light of USAT’s insolvency, it could not cure its own problems and that the only way it was going to be resolved was though FSLIC assistance. Ex. A-11165, Tab 1858; Tr. 23,244: 6 - 23,245: 20 (Twomey).

S329. On December 20, 1988, the FHLB-D submitted an “S” Memorandum Recommendation for the Appointment of Receiver and Federal Savings and Loan Insurance Corporation-Assisted Resolution for USAT (the “S” Memo). Ex. T-8142, Tab 1450. The “S” Memo described the supervisory history of USAT beginning with the 1986 Examination, the situation that USAT currently was in and recommended that the institution be placed in receivership. Id.

C. Based Upon The Examination Results Twomey Recommended That The FSLIC Not Retain Existing Management

S330. After submitting its initial Management Assessment Reports on USAT’s management to the FSLIC on May 5, 1988 and May 27, 1988. Ex. B-2182, Tab 1921; A-11160, Tab 1861, FHLB-D Supervision continued to review the actions of USAT’s management to determine their strengths and weaknesses as a potential acquirer under the Southwest Plan. On December 15, 1988, Twomey prepared a management assessment update for submission to the FSLIC. Ex. T-8145, Tab 1865, pp. OW028474-77. As discussed below, the update, which was very unfavorable to USAT’s management, accompanied a memorandum from Twomey to the FSLIC dated December 21, 1988, in which Twomey recommended that Berner, Crow and Munitz be dismissed as officers of USAT. Id. p. OW028473.

1. The FHLB-D’s Continuing Assessment Of USAT’S

Management

S331. After receiving copies of the July 1, 1988 USAT employment contracts from USAT during the Southwest Examination, Twomey submitted the contracts to the legal department of the FHLB-D for review to determine whether the agreements were in compliance with the 12 C.F.R. § 563.39 (1988), a regulation governing employment agreements. Ex. T-8115, Tab 1923 (11/4/88 Guthrie Memo) p. OW028501; Tr. 24,780: 18 - 24,781: 9 (Twomey). On November 4, 1988, the FHLB-D legal department concluded that :

As indicated below, we believe a finding that the contracts discussed below are excessive in several respects would be legally supportable. All of the following employment contracts that include United as a party are in violation of Section 563.39. Many of those violations are substantial.

Id.

S332. In addition, Twomey asked Ms. Guthrie to review Berner’s performance as General Counsel of USAT. Ex. T-8145, Tab 1865, pp. OW028478-80; Tr. 23,407: 13 - 23,408: 5 (Twomey). On December 12, 1988, Guthrie delivered a memorandum to Twomey which questioned the excessiveness of Berner’s compensation (id. p. OW028478), criticized his failure to comply with applicable regulations in drafting the USAT employment agreements (id.), and raised serious conflict of interest questions. Id. pp. OW028478-80). The memorandum concluded by questioning whether Berner should continue to serve as a director of USAT and UFG and give legal advice, when the interests of the two entities were clearly adverse. Id.

S333. In addition, in late November, Twomey conducted an informal survey of the compensation levels of executive management at two dozen other insured institutions in Texas with greater than $1 billion is assets. Id. p. OW028477. Twomey determined that, in most instances, the compensation of USAT’s executive management was significantly higher than their peers, and in some instances more than double the amounts paid to individuals performing similar functions at similar sized institutions. Id., Tr. 23,462: 21 - 23,465: 4 (Twomey)

2. Twomey’s Recommendation To The FSLIC

S334. After reviewing the interim examination reports submitted by Examiner Bese and taking into consideration his personal observations and experiences with USAT (Tr. 23,417: 2-17), Twomey updated his May 27, 1988, assessment of USAT’s suitability as an acquirer under the Southwest Plan on December 15, 1988. Ex. T-8145, Tab 1865, pp. OW028474-77. Twomey’s December 15, 1988 memorandum discussed the weaknesses which the Examiners had noted in their Interim Examination Reports, attached Ms. Guthrie’s evaluation of Berner’s performance, and summarized Twomey’s conclusions regarding the excessive nature of USAT’s compensation for executive managers. Id. The update was submitted to FSLIC as an attachment to a December 21, 1988 memorandum entitled “Termination Recommendation.” Id p. OW028473.

S335. The Termination Recommendation recommended that Berner, Crow, and Bruce Williams be dismissed at the time of the FSLIC receivership of USAT because “under the leadership of these individuals, United has engaged in unsafe and unsound practices which have led to the deterioration of United’s financial condition.” Id. It also recommended a termination of the employment contract between USAT and Munitz. Id.

S336. On December 30, 1988, when USAT was placed in receivership, the employment contracts were canceled by the FSLIC and Crow, Berner and Williams were all terminated as employees of USAT. Ex. A-3016, Tab 96 (3/31/89 UFG Proxy) p. 9.

D. The FSLIC Selects The Hyperion Bid

1. The FSLIC Selection Procedures

S337. The negotiations with bidders for the acquisition of USAT were conducted on behalf of the FSLIC by Mike Patriarca. Tr. 23,780: 4-6; Tr. 25,016: 7-14 (Twomey). Mr. Patriarca reported to Tom Lykos FSLIC’s Deputy Executive Director for the Southwest Plan. Ex. B-2442, Tab 2373 (10/3/88 Patriarca Memo). Mr. Lykos in turn reported to Stuart Root, the Executive Director of FSLIC, who was responsible for making recommendations on prospective bidders to the FHLBB. Ex. A-14201, Tab 2375 (12/30/88 Recommendation Memo); Tr. 23,311: 14-18 (Twomey). The FHLBB, which at the time was composed of Mr. Wall, the Chairman, Mr. White and Mr. Martin (Ex. B-2669, Tab 1888 (12/30/88 FHLBB Transcript) p. 40), was responsible for selecting the a bidder to take over USAT. Id. p. 38; Tr. 23,777: 22 - 23,778 (Twomey).

S338. The FHLB-D did not participate in the actual negotiations with the potential bidders. Twomey explained that if Patriarca made a request for information or required some action be taken, he would ask Twomey for assistance. Tr. 23,780: 4 - 23,781: 16 (Twomey). As discussed previously, Twomey provided the FSLIC with the results of the Southwest Examination and an evaluation of USAT’s suitability to become an acquirer (Ex. B-2635, Tab 474 (12/21/88 Twomey Memo). The FHLB-D also certified potential bidders for participation in the Southwest Plan (Tr. 23,961: 22 - 23, 962: 10 (Twomey)), but normally did not become involved in negotiations with the bidders. Tr. 23,780: 17-22 (Twomey).

S339. In the case of USAT, the first time Twomey interfaced with the potential buyer, the Ranieri Group, was during the first two weeks of December 1988. Tr. 23,780: 22 - 23,781: 16; Tr. 25,016: 12-14 (Twomey). After learning that “Ranieri was the one [the FSLIC] were primarily negotiating with” (Tr. 25,016: 7-11 (Twomey)), Twomey contacted representatives of the Ranieri Group to work out the terms of an operating agreement. Tr. 23,780: 22 - 23,781: 16 (Twomey).

2. FSLIC Recommendation Memorandum To The FHLBB

S340. On December 30, 1988, Stuart Root submitted a memorandum to the FHLBB recommending that the FSLIC be appointed as receiver for USAT and that USAT be reorganized and transferred to the Ranieri Group, Hyperion Partners L.P. (the “Ranieri Group” or “Hyperion”). Ex. A-14201, Tab 2375. The memorandum described how, after conducting an “extensive analysis of the potential acquirers,” MAXXAM and Hyperion (id. p. OW076501), each member of the FHLBB had determined on December 9, 1988, that the “Hyperion proposal presented the FSLIC with the most advantageous and superior alternative” and authorized the Southwest Plan staff to enter into final negotiations with Hyperion. Id. p. OW076502.

S341. Among the reasons cited by Root for recommending the Hyperion bid was the quality of the capital offered by the Hyperion bid. Hyperion proposed to infuse $200 million into USAT, $90 million of which, or 45%, was equity capital (GAAP capital). Id. pp. OW076502-03. The remaining capital was to be raised through the issuance of subordinated debt (RAP capital). Id. In contrast, “[t]he MAXXAM Group also offered to infuse $200 million in capital, however, 100% of this capital was in the form of RAP capital.” Id.

S342. The memorandum also indicated that the Hyperion bid had four pools of covered assets which were phased out after 1, 5, and 7 years. Id. In contrast the MAXXAM bid required the FSLIC to guarantee covered assets for a period of 10 years. Id. p. OW076503; Ex. B-2669, Tab 1888 (12/30/88 FHLBB Transcript) pp. 11-12.

S343. According to the memorandum, the FSLIC also concluded that the Hyperion bid had “a greater likelihood of consolidation and contraction in a geographic area that is relatively saturated with thrifts and other depository institutions.” Ex. A-14201, Tab 2375 p. OW076503.

S344. Initially the FSLIC reported that the Hyperion bid also would result in “a lower cost of resolution (id. p. OW076503), however, on the day the FHLBB met it was determined that in fact the Hyperion bid was $100 million more expensive than the MAXXAM bid. Ex. B-2668, Tab 1788 (12/30/88 Solomon Memo) p. 117485.

3. The FHLB-D Refused To Recommend MAXXAM As An

Acquirer

S345. When MAXXAM initially was negotiating with Mike Patriarca in September 1988, at the time the Southwest Examination of USAT commenced, the FHLB-D had certified MAXXAM as an eligible bidder. Tr. 23,961:22 - 23,962: 10 (Twomey). After the completion of the Southwest Examination, the FHLB-D had a different view of MAXXAM’s eligibility as a bidder. On December 29, 1988, when the FHLB-D sent to Tom Lykos its recommendation regarding the eligibility of potential bidders to acquire USAT (Ex. B-4344, Tab 1929 (FHLB-D letter); A-14200, Tab 2374 (FHLB-D letter)), PSA Barclay advised Lykos:

The Dallas Bank is unable to recommend MAXXAM at this time because the availability of the proposed cash infusion is questionable. Furthermore, MAXXAM’s proposed management includes senior executives, currently having positions at United, that are unacceptable to Supervision.

Ex. B-4344, Tab 1929. Attached to the letter was a Proposal Evaluation which criticized MAXXAM’s reliance on the sale of subordinated debentures to outside investors to raise $200 million in capital to infuse into the institution. Id. p. OW077040. The evaluation also was critical of the fact that MAXXAM proposed to retain the current management of USAT, including Berner Crow and Bruce Williams, who the Supervisory Agent had recommended be dismissed. Id.

S346. Supervisory Agent Twomey, in an interview on December 19, 1990, when questioned why he would not recommend MAXXAM as an acquirer, stated that:

…his primary concern was with the management team that Hurwitz had installed at United (e.g., Jared [sic] Gross). They were running a $6-1/2 billion institution and were constantly making strategic errors such as going into the market at the wrong time and were “constantly blowing themselves up.” Furthermore, United’s management had arranged for trust accounts outside United that were multimillion dollar golden parachutes. Furthermore, the salary of certain management had increased three or four times and, in one case, nine times. He stated that United’s management was poor on the whole, and to put it mildly, United had not fared well under this management team.

Ex. B4326, Tab 1889 p. 8.

S347. The FHLB-D also sent a letter to Lykos on the Ranieri/Hyperion bid. PSA Barclay did not recommend that the Ranieri bid be accepted; however, he reported that the Hyperion partners were eligible to be an acquirer and that, if selected by the FHLBB, the FHLB-D was “committed to carefully monitor and prudently regulate the resulting entity.” Ex. A-14200, Tab 2374.

S348. Stuart Root did not receive George Barclay’s letters until the day of the FHLBB meeting to consider the MAXXAM and Hyperion bids, so Barclay’s views were not reflected in the Stuart Root memorandum recommending that the FHLBB approve Hyperion as the acquirer of USAT. Ex. B-2669,Tab 1888 (12/30/88 FHLBB Transcript) pp. 1-2 and 19-20.

4. The FHLBB Approved The Hyperion Bid Despite The Fact

That It Was More Expensive

S349. On December 30, 1988, after deliberating nearly two hours[13], the FHLBB approved the acquisition of USAT by the Hyperion Group. Id. pp. 38-40. The final resolution, which was approved by Board members Wall and White (Martin voluntarily withdrew from the deliberation) (id. p. 40), stated, among other things:

2. The Bank Board determined on the basis of the record, including oral presentations, that terms of the Maxxam bid were not acceptable and that Maxxam was not qualified and capable of acquiring the assets and certain liabilities of the association.

* * * *

4. The Bank Board, as operating head of the Corporation determined that the Hyperion offer is acceptable and that Hyperion is a qualified and capable acquiror.

5. The Bank Board, as operating head of the Corporation determined that authorization of the Hyperion acquisition would lessen the risk of the Corporation.

Id. p. 38-39.

Among the factors discussed at the FHLBB meeting relating to the bid selection were the following:

· Equity Capital: The Hyperion proposal included $90 million in equity capital and $110 million in subordinated debt (RAP capital), while the MAXXAM bid offered only $200 million in RAP capital and no equity. Id. p. 2. The Board also considered the “quantity and the nature of capital” and questioned the lack of equity capital in the MAXXAM bid. The Board noted that they would be appropriately criticized if they accepted a bid that did not provide for GAAP capital. Id. p. 17 and 36.

· Unacceptability of Existing Management: The MAXXAM bid proposed to use former management which was unacceptable to FHLB-D. Id. pp. 2, 4 and 21-22. Supervision was critical of former management for “cherry picking” the MBS arbitrage portfolios (id. pp. 29-30) and management’s excessive compensation and severance arrangements. Id. pp.30-32.

· The FSLIC guarantee: The Hyperion bid required a shorter period of FSLIC support which would result in a quicker liquidation and a potentially less costly resolution. Id. pp. 11-12.

· Tax Consequences: The Hyperion proposal was not “a tax driven transaction as opposed to the MAXXAM proposal.” Id. p. 6. The MAXXAM proposal contemplated a much greater tax savings to the acquirer, which it was to share with the FSLIC, and was considered more tax motivated. Id. p. 7.

· Ability to Shrink: Ranieri was considered to have “demonstrated ability” to shrink the liabilities side of the balance sheet. Id. p. 8; Ex. A-14201, Tab 2375 (FSLIC Memorandum) p. OW076503.

· Cause of Problem: The FSLIC and the FHLB-D questioned whether it would be “proper procedure for a 25 percent participant on the ownership side that caused this problem to come out with 100 percent ownership of a viable institution brought about by FSLIC assistance.” Id. pp. 19 and 4; Ex. B-2668, Tab 1788 (12/30/88 Solomon Memo) p. 117486.

· Acceptability of MAXXAM as a bidder: In light of the fact that MAXXAM proposed using former management who were unacceptable to FHLB-D the Board discussed whether MAXXAM was even eligible as a bidder. Id. pp. 17-21, 24-25, and 34-35.

S350. The Board also considered the “costing” of the bids which were “less than 3-½ percent apart.” Id. p. 16. Despite the fact that the MAXXAM bid was less costly than the Hyperion bid (id. p. 34), Board members Wall and White both stated that they found the terms of the MAXXAM bid to be “unacceptable” (id. p. 36) and approved the Hyperion bid. Id. pp. 39-40.

E. MAXXAM Challenged The Actions Of The FHLBB In Approving

The More Costly Hyperion Bid

S351. On December 7, 1995, less than three weeks before the present Notice of Charges was filed by the OTS, the same counsel who represent MAXXAM in this proceeding, filed a Petition for Review against the OTS seeking to set aside the December 30, 1988 order of the FHLBB, FHLBB/FLSIC Resolution No. 88-1535P, which approved the Hyperion bid and awarded USAT to the Ranieri Group. Ex. T-9010, Tab 1809 (Petition for Review). The MAXXAM petition, among other things, argued that the conduct of the FSLIC in awarding USAT to the Ranieri Group was arbitrary and capricious; an abuse of discretion; not in accordance with law, applicable regulation and the constitution; and unwarranted by the facts. Id. pp. 9-10.

S352. On December 10, 1996, the Fifth Circuit Court of Appeals ruled against MAXXAM. Ex. T-9013, Tab 1812 (12/10/96 5^th Cir. Order). The court stated that MAXXAM could not convince the court that the timing of MAXXAM’s action “was not too much of a coincidence to be a coincidence.” Id. p. 2. The court specifically held:

Our careful consideration of the record in this case…convinces us beyond peradventure that the reversal and relief sought by MAXXAM in this appeal are unavailable and that the FHLBB committed no reversible error in denying MAXXAM’s petition for review. The order appealed from is therefore, affirmed in all respects.

AFFIRMED.

Id.

Respectfully submitted,

____________________

Richard C. Stearns

Bruce F. Rinaldi

Kenneth J. Guido, Jr.

Bryan T. Veis

Paul Leiman

Scott E. Schwartz

Enforcement Division

Office of Chief Counsel

Office of Thrift Supervision

1700 G Street, N.W.

Washington, D.C. 20520

Tel: (202) 906-7966

Fax: (202) 906-7005

October 4, 1999.

---

[1] See discussion of Couch Mortgage below at S 110, S 127.

[2] In the course of examining Ms. Carlton concerning both the 1986 and 1987 examinations, OTS also introduced into evidence the workpapers substantiating the conclusions Ms. Carlton reached. With very few exceptions, however, it would be redundant to discuss the workpapers in these findings, because the reports stand on their own, and the workpapers in evidence did in fact support the conclusions that Ms. Carlton reached in her interim and final reports.

[3] The very mention of Couch Mortgage Company during the trial was contentious, as the OTS had made no claims with respect to these loans. The OTS’s evidence with respect to Couch Mortgage related to its effect on the conduct and duration of the examination, and the court heard only a limited amount of evidence with respect to the substance of the Couch Mortgage situation. There is a synopsis of the origin of the problem and the ongoing dispute between the regulators and USAT’s management in the “S” Memo, Ex. T-8142, Tab 1450, pp. 7-8. The thrust of OTS’s argument during the hearing was that the magnitude of the scheduled Couch Mortgage Company loans was the reason for the examiners’ inability to complete the examination with respect to other areas of the examination. See Tr. 16,869: 15 - 16,874: 12.

[4] See also Ex. A-14085, Tab 1460 (workpaper summarizing amendments USAT’s monthly and quarterly reports.

[5] Based upon the subject matters of the pages of the report, it is clear that the page numbered “12” is out of order, and should be placed after page 14. It is obviously a continuation of the discussion of equity arbitrage begun on page14, not a continuation of the discussion of junk bonds begun on page 11. Equally clearly, the page numbered 13 is a continuation of the discussion of junk bonds begun on page 11.

[6] During this period of time that USAT was expressing concern about Wall Street pulling its reverse repurchase agreement because of a reported net worth failure, DBL was providing USAT with over $788 millions in financing through reverse repurchase agreements and dollar rolls. At the end of 1987 DBL was providing $474 million in reverse repurchase agreements and $315 million in dollar rolls to the association. Ex. A-3023, Tab 79 (UFG 12/31/87 10-K) p. CN158947.

[7] See Ex. A-14063, Tab 1493, OW128997-98 p. OW128998 (Memorandum from Neil Twomey to Roy Green, April 23, 1987) (“In short, it appears that United may be misstating financial statements and circumventing regulations to avoid supervisory actions.”). Ms. Carlton described conversations with Mr. Twomey in which they discussed the possibility that USAT might be deliberately misstating financial statements. They felt that it was anomalous and inconsistent that a management team that purported to be competent and experienced enough to handle complex investment securities was unable to deal with basic accounting issues and maintain proper books and records. Based upon that they concluded that it appeared that management was attempting to circumvent the regulations and prolong the examination process to avoid recognizing USAT’s net worth deficiency. Tr. 17,154: 15 - 17,156: 16.

[8] Ms. Carlton explained that the failure of USAT to classify its assets properly and to make the required adjustments to its reserves meant that any calculations based on the unadjusted figures would not accurately reflect the true condition of the institution. Tr. 17,131: 13 - 17,132: 13.

[9] Ms. Carlton testified that it was unusual for such a dispute to last until the next examination. Tr. 17,132: 14 - 17,133: 6.

[10]^/ Futures and options transactions were reviewed only for the period January through September 1988. Ex. A-14106, Tab 1847 p. OW154324. The more limited review of futures and options transactions was on the instructions of either the examiner-in-charge or FHLB-D. Tr. 22,502: 16 - 20.

[11] See the discussion of “gains trading” above at J24 - J56; see also, Tr. 22,753: 12 - 22,755: 13 (discussing Ex. B-4193, Tab 1180; noting that USAT’s experience tracked the description of gains trading); Tr. 22,759: 21 - 22,762: 16 (discussing Ex. B-4287, pp. 450.7-450.8 discussion of “Accounting Gains and Losses Versus the Economics of the Transaction;” noting similarity of USAT’s transactions and accounting to examples of improper activities).

[12] In addition to his own analysis, Mr. Lapidus also received corroborative information on the subject of gains trading from Mr. Dominic Bruno, the MBS portfolio manager at USAT in 1988. Mr. Bruno informed Mr. Lapidus that prior to his arrival, USAT had sold off MBS’s for a profit and bought lower coupon MBS’s to generate accounting profits in order to meet capital requirements and continue to operate the institution Tr. 22,440: 5 - 22,441: 16. When asked whether Mr. Bruno had indicated whether there had been a conscious decision by management to make such sales to shore up capital, Mr. Lapidus stated: “As far as I know, it was their intent to do so. It was not something they did, I mean, by accident. Their goal was to generate income.” Tr. 22,442: 14 - 22,443: 13.

[13] The meeting began at 4:09 p.m. and lasted until 7:08 p.m. Id. pp. 1 and 40. The Board was at recess from 5:00 p.m. to 6:09 p.m. and 6:45p.m. to 6:58 p.m. Id. pp. 23 and 37.