Free Proposed Findings of Fact and Conclusions of Law - District Court of Federal Claims - federal

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No. 93-531C (Senior Judge Loren Smith) ______________________________________________________________________________ IN THE UNITED STATES COURT OF FEDERAL CLAIMS _____________________________________________________________________________
AMBASE CORPORATION AND CARTERET BANCORP, INC. Plaintiffs, and FEDERAL DEPOSIT INSURANCE CORPORATION, Plaintiff-Intervenor, v. UNITED STATES OF AMERICA

______________________________________________________________________________ DEFENDANT'S PROPOSED FINDINGS OF FACT ______________________________________________________________________________ MICHAEL F. HERTZ Deputy Assistant Attorney General JEANNE E. DAVIDSON Director KENNETH M. DINTZER Deputy Director OF COUNSEL: ELIZABETH M. HOSFORD Senior Trial Counsel VINCENT D. PHILLIPS DELISA SANCHEZ AMANDA L. TANTUM Trial Attorneys

DAVID A. LEVITT Trial Attorney Commercial Litigation Branch Civil Division Department of Justice 1100 L Street, N.W. Washington, D.C. 20005 Tel: (202) 307-0309 Fax: (202) 514-7969

Date: September 12, 2008

Attorneys for Defendant

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TABLE OF CONTENTS Page TABLE OF AUTHORITIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi DEFENDANT'S PROPOSED FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 I. II. BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 CARTERET'S NEW BUSINESS STRATEGY. . . . . . . . . . . . . . . . . . . . . . . . . . . 2 A. B. C. D. Carteret's 1981 Expansion And 1982 Supervisory Acquisitions.. . . . . . . . 2 Carteret's 1986 Supervisory Acquisitions. . . . . . . . . . . . . . . . . . . . . . . . . . 5 Carteret's Attempts To Raise Capital Through Stock Offerings. . . . . . . . . 6 Carteret's Capital Raisings Suggest The Market Understood Its Weak Position . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Carteret's Commercial and Corporate Lending Strategy . . . . . . . . . . . . . . 7 1. When Carteret Decided To Establish A Commercial and Real Estate Lending Division In 1983, It Had No Experience In These Types Of Lending . . . . . . . . . . . . . . . . . 10 Carteret Placed Approximately $1 Billion In Commercial And Real Estate Loans On Its Books Between 1983 And 1986 But Did Not Conduct Proper Underwriting Or Effective Monitoring. . . . . . . . . . . . . . . . . . . . . 11 Carteret's Strategy Of High Risk Lending Also Extended To Mortgage Lending. . . . . . . . . . . . . . . . . . . . . . . . . . 18 Carteret Failed To Properly Classify Problem Assets Or Establish Adequate Loan Loss Reserves . . . . . . . . . . . . . . . . . 19 Carteret Was Not Overreserved As Of September 1992 . . . . . . . 24

E.

2.

3.

4.

5.

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III.

BY 1989, CARTERET HAD BECOME EFFECTIVELY INSOLVENT . . . . . . 29 A. Due To Its Poor Core Operating Earnings, Carteret Relied Upon Asset Sales .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 FDIC Recommended Termination Of Deposit Insurance .. . . . . . . . . . . . 34 Carteret Experienced A Large Deposit Decline Between 1983 And 1989.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

B. C.

IV.

CARTERET'S CONDITION FROM 1990 THROUGH 1992. . . . . . . . . . . . . . . 36 A. B. The Regulators' Findings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 The Actions Of Supervisory Officials. . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

V. VI.

CARTERET'S SALE OF ASSETS FROM 1990 THROUGH 1992. . . . . . . . . . 40 AMBASE'S ACQUISITION OF CARTERET WAS FOR SELF-SERVING PURPOSES AND DID NOT BENEFIT CARTERET. . . . . . . . . . . . . . . . . . . . . 43 A. B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Ambase Interfered With Carteret's Business And Wasted Carteret's Capital By Entering Into Unsound Employment Contracts And Engaging In Unsound Business Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Ambase Was Unable To Assist Carteret As Required By The CMA .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

C.

VII.

CARTERET'S REAL ESTATE LOSSES PRECLUDED IT FROM RAISING CAPITAL TO CURE ITS INSOLVENCY. . . . . . . . . . . . . . . . . . . . . 55 A. By 1991, Carteret Was Unable To Access The Public Capital Markets Due To Its Loan Losses, The Poor Quality Of Its Portfolio, And Its Own Auditor's Concerns About Its Viability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Problems Faced By Other Thrifts Demonstrate That Carteret Would Have Been Unable To Raise The Needed Amount Of Capital.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

B.

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C.

Carteret's Experience Demonstrated That It Could Not Raise Private Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Regulators Did Not Pressure Potential Investors To Act Prematurely And Did Not Warn Them That Carteret Could Not Be Successful. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Plaintiffs' Repeated References To Carteret's Excellent Performance Ignore Regulators' And Investors' Conclusions . . . . . . . . . 71

D.

E.

VIII.

PROFESSOR CALOMIRIS'S ESTIMATION OF CARTERET'S VALUE AT THE TIME OF THE BREACH IS UNSUPPORTED. . . . . . . . . . . 72 A. The $266 Million Purchase Price For Carteret Is Not A Good Starting Point For A Calculation Of Market Value. . . . . . . . . . . . . 72 Carteret's Market Value Would Have Declined Sharply Between It's Purchase By Ambase And The Breach And Cannot Be Determined Through Professor Calomiris's Comparison With 46 Other Thrifts .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

B.

IX.

PROFESSOR CALOMIRIS'S CLAIMS FOR LOST PROFITS ARE UNSUPPORTED.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 A. B. The Gordon Growth Model Is Inapplicable . . . . . . . . . . . . . . . . . . . . . . . 78 Even If The Gordon Growth Model Were Applicable, Professor Calomiris Has Misapplied The Model.. . . . . . . . . . . . . . . . . . . 80 1. The Estimate Of Carteret's Market Value At The Time Of Breach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 The Model Improperly Excludes The 1990 and 1991 Losses And Non-Core Income From The Calculation of Carteret's Average Earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . 81 The Discount Rate Is Inapplicable to Carteret. . . . . . . . . . . . . . . . 83

2.

3. C.

Professor Calomiris's Terminal Value Measure Of Damages Is Not Actually An Ex-Ante Model And Is Fatally Flawed . . . . . . . . . . . 84 Professor Calomiris Erroneously Calculates Carteret's Market Value In 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 -iii-

D.

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X.

CARTERET'S CONDITION WOULD HAVE BEEN NO BETTER IN THE NON-BREACH WORLD THAN IT WAS IN THE REAL WORLD. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 THE DAMAGES CLAIMED COULD NOT HAVE BEEN ANTICIPATED. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 WOUNDED BANK DAMAGES ARE NOT SUPPORTED. . . . . . . . . . . . . . . . 89 A. Claims By Former Executives Related To Severance Agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Costs Related To The Sale Of Florida Branches. . . . . . . . . . . . . . . . . . . . 91 Costs Incurred In Seeking Out Additional Capital. . . . . . . . . . . . . . . . . . 90 Legal Expenses Related To OTS Regulatory Actions And Investigations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

XI.

XII.

B. C. D.

XIII.

THE RECEIVERSHIP DEFICIT WAS PROPERLY CALCULATED. . . . . . . . 93 A. B. Thrift Resolutions By The RTC Were Reasonable And Fair. . . . . . . . . . 93 Professor Calomiris's Assertions Related To Interest Costs Levied By The Government Are Unsupported. . . . . . . . . . . . . . . . . . . . . 93 1. Professor Calomiris's Claims That No Interest Rate Or A Lower Interest Rate Should Have Been Charged Are Unfounded.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Professor Calomiris's Claim That The RTC/FDIC Intentionally Chose A High Interest Rate Is Unsupported.. . . . . . 97 The RTC/FDIC's Pro Rata Payment Of The Three Loans Was Appropriate. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 The Escrow Interest Calculation Is Consistent With The Virtually Risk-Free Nature Of Funds Held In Escrow.. . . . . . . . 100

2.

3.

4.

C.

The Length Of Time Required To Resolve Carteret Did Not Reduce The Premium Realized From The Sale Of The Branches.. . . . . 101

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1.

Carteret Was Not A Relatively Healthy Failed Thrift. . . . . . . . . 101 a. Carteret Relied Upon Funding Support And Subsidies From The FHLB And The RTC. . . . . . . . . . . 101 Professor Calomiris's Choice Of Financial Measures Of Health Are Unsupported.. . . . . . . . . . . . . . 102

b.

2.

3.

Professor Calomiris's Claim That The "Delay" Resulted In A Loss To The Receivership Is Disproved By Actual Marketplace Deposit Premium Data Showing A Gain To The Receivership. . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Professor Calomiris Incorrectly Assumes That A Whole Bank Resolution Results In Higher Deposit Premiums Than A Branch Sale Resolution.. . . . . . . . . . . . . . . . . . . . . . . . . 107

D.

The Minority Preference Program Did Not Reduce The Proceeds Recovered In The Resolution Of Carteret. . . . . . . . . . . . . . . . . . . . . . . . 108 Carteret's Federal Tax Liability Was Properly Calculated. . . . . . . . . . . 110 1. The Post Insolvency Interest Was Not A Deductible Expense In 1995.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 Federal Financial Assistance Was Reflected Properly On The Receivership's Tax Returns. . . . . . . . . . . . . . . . . . . . . . . . . 111 Carteret's 1992 Tax Loss Is Uncertain And Unavailable As A Deductible Expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

E.

2.

3.

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TABLE OF AUTHORITIES Page(s) CASES

Ambase Corp. v. United States, 58 Fed. Cl. 32 (2003). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 STATUTES, RULES, AND REGULATIONS Financial Institutions Reform, Recovery and Enforcement Act, Pub. L. 101-73, 103 Stat. 183 (1989) .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS AMBASE CORPORATION AND CARTERET BANCORP, INC., Plaintiffs, and FEDERAL DEPOSIT INSURANCE CORPORATION, Plaintiff-Intervenor, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )

No. 93-531C Senior Judge Loren Smith

DEFENDANT'S PROPOSED FINDINGS OF FACT

I.

Background 1. Prior to 1982, Carteret Savings Bank, FA ("Carteret"), a savings association

chartered by the Federal Home Loan Bank Board ("FHLBB"), had historically engaged in traditional mortgage lending and deposit taking activities. DX 7171 at WOP298 0700. Its geographic focus was on central and northern New Jersey. DX 7171 at WOP298 0700. 2. In 1981, Carteret had approximately $1.9 billion in liabilities, a net worth ratio

under 2.1 percent, PX 2433 at OAM006 0027, and had suffered a net loss of $9.2 million. DX 8000A at Exh. 3, Table 1, p. 2. In 1982, Carteret suffered a net loss of $23.3 million. DX 8000A, Table 1, p. 2.

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II.

Carteret's New Business Strategy 3. In 1982, focusing on the need to raise capital and regain profitability, Carteret

abandoned the traditional model of the thrift industry and embarked upon a highly risky business strategy. PX 6501 at WOR682 0670-671 (O'Brien Aff.); DX 8000A at ¶ 26 and n.21; DX 5038A at ¶ 13. In Carteret's Annual Report for 1982, Robert O'Brien, Carteret's Chairman and Chief Executive Officer ("CEO"), explained that Carteret had enlarged its office network, expanded its asset base and introduced new products in response to "new economic realities." PX 1 at AMB029912. Mr. O'Brien observed that new legislation allowed thrift institutions to compete on a more equal basis with commercial banks, and new investment powers allowed thrifts to diversify from their traditional "low-yield fixed rate asset [mortgage] portfolios and . . . costly fluctuating deposits." Id. at AMB029912-13. He stated that Carteret's goal was to remain "at the forefront of the rapidly changing financial services industry." Id. 4. Carteret's new strategy was to expand geographically by (1) acquiring the

branches and assets of troubled savings and loan institutions (S&Ls), and (2) diversifying into new lending areas, such as commercial real estate and corporate loans. DX 8000A at ¶ 26. 5. Carteret pursued the branches and assets of troubled thrifts without addressing its

critical state of undercapitalization. DX 8000A at ¶ 27. It exacerbated its severely undercapitalized position by acquiring assets of failing S&Ls. Tr. 2909:8-15, 2910:10-13 (R. Smith); DX 8000A at ¶ 26; PX 2433 at OAM006 0026-27. A. 6. Carteret's 1981 Expansion And 1982 Supervisory Acquisitions In the twenty-one months between January 1981 and September 1982, Carteret

acquired six state-chartered thrifts with assets of approximately $227 million. PX 2433 at 2

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OAM006 0026; PX 1 at AMB029922. Pursuant to an assistance agreement with the Federal Savings and Loan Insurance Corporation ("FSLIC") dated July 30, 1982, Carteret acquired River Edge Savings and Loan Association of River Edge, New Jersey ("River Edge"). The Government provided Carteret $4.6 million in cash assistance in connection with the River Edge acquisition. PX 1601 at CAM5240840. 7. In March 1982, Carteret switched from a state to a Federal charter to take

advantage of the relaxed Federal banking environment and expand its markets. PX 2433 at OAM006 0026. 8. On September 30, 1982, Carteret acquired Barton Savings & Loan Association of

Newark, New Jersey ("Barton") and First Federal Savings and Loan Association of Delray Beach, Florida ("Delray"). PX 2433. With respect to the Barton merger, the FSLIC reimbursed Carteret for one-half the negative net worth of Barton ­ approximately $1 million ­ as of the date of the acquisition, PX 1 at AMB029922, and Carteret received an immediate cash contribution of $10.7 million. PX 2433 at OAM006 0020. Carteret neither asked for nor received cash assistance in connection with the Delray acquisition. PX 6501 at WOR6820672; PX 1 at AMB029922. 9. The Barton and River Edge assistance agreements provided Carteret with capital

contributions totaling $15.3 million. PX 1 at AMB029922. 10. Carteret booked approximately $168 million in goodwill from the Delray

acquisition, and approximately $46 million in goodwill from the Barton acquisition. Ambase Corp. v. United States, 58 Fed. Cl. 32, 26 (2003) ("Ambase I"). The goodwill resulting from the Delray and Barton acquisitions constitutes approximately 90 percent of the goodwill at issue in 3

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this case. PX 6501 at WOR6820672. 11. At the time it acquired Barton and Delray, the ratio of Carteret's net worth ($36

million) to total assets ($2.3 billion) was only 1 percent, far less than the five percent generally viewed as the minimum for a healthy thrift under generally accepted accounting principles (GAAP). Tr. 3028:18-21 (R. Smith). 12. Carteret's primary motive in acquiring Delray was to gain a market presence in

Florida, which it believed would complement its primary New Jersey market because many people from New Jersey owned second homes in, or retired to, Florida. PX 6501 at WOR 6820671. Carteret took on $212 million in net liabilities in acquiring Barton and Delray. As a result, Carteret's balance sheet absorbed substantial risk, and Carteret reported tangible net worth of negative $212.3 million following the acquisitions. DX 8000A, Exh. 3; DX 9501. 13. Regulators were aware of Carteret's highly leveraged condition at the time of the

acquisitions, but were "reasonably confident that Carteret's management possess[ed] the necessary expertise to deal with any problems which might confront it as the result of the proposed mergers." PX 2433 at OAM006 0027. This view, however, was based upon Carteret's operating plan and historical business model, and did not anticipate that Carteret would seek out high-risk commercial and corporate lending to fill its capital shortfall. PX 2433 at OAM006 0028. Carteret had not engaged in high-risk lending prior to the acquisitions and did not indicate that this would be its strategy. Id. 14. At the beginning of 1983, following the Barton and Delray acquisitions, Carteret

owned 29 new branch offices and its assets had increased by 87.8 percent. PX 1 at AMB029922.

4

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B. 15.

Carteret's 1986 Supervisory Acquisitions In June 1986, as part of a strategy to expand into Maryland, Virginia, and the

District of Columbia, Carteret acquired First Federal Savings and Loan Association of Montgomery County, in Blacksburg, Virginia ("First Federal"), Mountain Security Savings Bank of Wytheville, Virginia ("Mountain Security"), and Admiral-Builders Savings and Loan Association, of Parkville, Maryland. DX 8022 at FAM002 1782, 1784; PX 5 at AMB013889. As a state chartered thrift insured by the Maryland Deposit Insurance Fund, Admiral is not at issue in this case. Ambase I, 58 Fed. Cl. at 35, n.1. 16. At the time of the First Federal and Mountain Security transactions, FHLBB

policy entitled a thrift that acquired a troubled out-of-state thrift to branching rights in the state of the insolvent thrift, as well as two contiguous states. PX 2490 at WOQ288 0327. Carteret acquired Mountain Security and First Federal to expand its branch network to Virginia, Maryland and the District of Columbia. In connection with the acquisitions, Carteret requested, and FHLBB approved, branching rights in Virginia, Maryland and the District of Columbia. PX 2490 at WOQ288 0327-0328. 17. FSLIC was Mountain Security's receiver and, in that capacity, entered into an

acquisition agreement with Carteret. PX 2490 at WOQ288 0322. Carteret and First Federal agreed to merge, and the agreement was approved by the FHLBB. PX 2490 at WOQ288 03190320. As a result of the acquisitions of First Federal and Mountain Security, Carteret booked approximately $22 million in goodwill. PX 6501 at WOR682 0678. Approximately $20.3 million of the goodwill was generated by the Mountain Security acquisition, and the remainder was attributable to the First Federal acquisition. PX 6501 at WOR682 0678. 5

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18.

First Federal and Mountain Security had negative net worth and Admiral had a net

worth of only 0.5 percent of assets. PX 2490 at WOQ288 0317. Thus, these acquisitions increased the leverage on Carteret's balance sheet, and further contributed to its undercapitalized condition, adding approximately $22 million of goodwill and hundreds of millions of dollars of below-market mortgages. Tr. 657:8-13 (Calomiris). 19. Carteret's branches in Maryland, Virginia and Washington, D.C. were never

profitable, DX 8054 at WOQ699 0503 and, as reflected in the 1991 Business Plan presented to the Office of Thrift Supervision ("OTS"), were sold in 1990 in order to "allow . . . operations to be scaled back to strategically important markets." DX 7171 at WOP298 0703. Carteret's management wanted to reduce its "expensive retail funding network" by replacing expensive retail deposits with marginally less expensive wholesale funds. PX 2110 at WOQ698 1437; Tr. 1482:6-1483:7 (Day). 20. Carteret's management acknowledged that selling the branches, which were

outside Carteret's "primary marketing area," DX 7171 at WOP298 0703, enhanced profitability. Tr. 1467:8-14 (Day); PX 2207 at CAM381 1344; DX 7340 at WOQ678 1963. C. 21. Carteret's Attempts To Raise Capital Through Stock Offerings Carteret converted to stockholder ownership in August 1983 and raised $58.4

million through the sale of 6.82 million shares of common stock. PX 2 at AMB029930, AMB029932; PX 3 at AMBNP006935. Its stock was traded over-the-counter on the NASDAQ system. PX 2 at AMB029930. 22. Carteret raised a total of approximately $120 million through issuances of

common and preferred stock between 1983 and 1986. PX 3 at AMBNP006935; PX 4 at 6

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AMB030093; PX 5 at AMB013892; Tr. 2919:19-2920:3 (R. Smith). In addition to the conversion offering, Carteret raised approximately $11.0 million in a February 1985 common stock offering, $21.2 million in an August 1985 preferred stock offering, PX 4 at AMB030093, and $28.7 million in an April 1986 common stock offering. PX 5 at AMB013892. These capital raisings were insufficient to fill the gap created by the $212 million in negative tangible net worth resulting from the acquisitions of Barton and Delray. Tr. 2920:4-12 (R. Smith). D. Carteret's Capital Raisings Suggest The Market Understood Its Weak Position Following its IPO, in which it raised $58.6 million, Carteret's stock traded at a

23.

price to earnings ("P/E") ratio of 1.78 to 2.17, whereas the average stock of Standard & Poor (S&P) 500 companies traded at a P/E ratio of 13.4. Carteret's price to book ("P/B") ratio ranged from .56 to .64, whereas the average stock of S&P companies traded at a P/B ratio of 1.4. DX 9502. The market's pricing of Carteret's stock relative to average stocks in the S&P 500 index indicated that the market did not accord the goodwill substantial value and believed Carteret's strategy of growth faced a troubled future. Tr. 2918:15-2919:18 (R. Smith). Although an investor might hope to achieve substantial earnings on Carteret's stock if the business strategy worked, "the price/earnings ratio discount[ed] the probability of all that happening." Tr. 2919:910 (R. Smith). E. 24. Carteret's Commercial and Corporate Lending Strategy In addition to expanding its branch network through acquisitions of struggling

thrifts, Carteret sought to diversify into "significant new products" and "investment opportunities" like corporate and commercial real estate loans. PX 1 at AMB029912. Although diversifying into these higher yielding products had the potential to improve Carteret's interest 7

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rate risk and profitability, such new products also exposed Carteret to higher credit risk. DX 8000A at 11, n.20; Tr. 2921:13-20 (R. Smith). 25. In April 1983, Carteret formed an Income Property Division and began

commercial real estate lending. Carteret's Corporate Banking Division became operational after September 30, 1983, and, by October 31, 1983, had extended lines of credit and other loan commitments totaling $100 million. PX 2 at AMB029940. By the time OTS issued its October 26, 1984 report of examination, the Income Property Division had originated $500 million in commercial loans, primarily on projects located in New Jersey and Florida, and the Corporate Banking Division had $193.5 million in commercial loans outstanding. DX 8043 at WOR961 1188. 26. Carteret's expansion into commercial real estate and corporate lending was

aggressive and not accompanied by the "needed credit administration capability in these new areas." DX 8000A at ¶ 32. Carteret failed to recruit competent staff to handle its commercial and corporate asset portfolios. PX 5331 at KH 033535-36, 033538; Tr. 1469:24-1470:16 (Day). For example, loan officers often misrepresented the quality of the prospective borrowers and the viability of the project to the thrift's credit review committee. PX 2106 at WOQ6750026. The internal loan review ("ILR") process did not employ objective criteria; instead, "the majority of the review function [was] vested in the loan officer." PX 2109 at KH 054207. 27. Carteret's Board of Directors failed to establish policies to guide the corporate and

commercial lending divisions. PX 2106 at WOQ6750028-0029 (1989 OTS Report of Examination or "ROE"). After a thorough review of corporate lending policies in 1989, OTS concluded that Carteret lacked adequate policies concerning commercial lending objectives, 8

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acceptable products and collateral, underwriting criteria for each type of loan, monitoring procedures, diversification, acceptable industry type, geographical location, credit mix, and acceptable financial statements. Id. at WOQ6750029. 28. Lacking policy guidance, the lending function became extremely haphazard.

Thus, OTS examiners reviewing delinquent consumer and mortgage loans originated for at least $500,000 found the loan files to be "in a state of disorder[,]" which "could delay and/or jeopardize Carteret's ability to commence legal action against a borrower if deemed necessary." PX 2111 at C-AM-A-0320839. Further, appraisals were inadequate. Tr. 1471:11-12 (Day). With regard to construction/development loans, bank personnel failed to request the inclusion of a market or economic feasibility study in the appraisal reports. PX 2106 at WOQ6750032. Such studies were of vital importance given Carteret's "significant on-going construction projects in economically distressed or overbuilt regions of the country." PX 2106 at WOQ6750032. Further, OTS noticed instances in which the loan officer allowed the borrower to supply the appraisal instead of obtaining the appraisal himself. Id. Thus, Carteret's "underwriting proposals were overly optimistic[.]" Tr. 1470:7-8 (Day). 29. As a result of a due diligence conducted on behalf of Ambase in 1988, KPMG

Peat Marwick concluded that "the commercial lending and commercial real estate portfolios represent a relatively high degree of prospective risk" and identified the primary factors to be "[a] credit process which has not been fully developed in the planning and monitoring segments[;] [t]he high concentrations . . . in categories generally considered to be of high risk . . . [and the fact that] specific individual credits [were] in the process of liquidation." PX 4804 at AM00089630. Peat Marwick advised that "increased investments in people and processes will 9

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be required." Id. Indeed, as late as 1990, regulators concluded that Carteret's Executive Vice President for Commercial Real Estate Lending lacked an effective staff and employed an approach to evaluating problem credits that was "not realistic in this day and time." PX 2110 at WOQ698 1507. 30. By June 30, 1989, 23.6 percent of Carteret's balance sheet consisted of

commercial real estate loans. This contrasted sharply with the rest of the industry. A study profiling the distribution of assets within the portfolios of healthy and insolvent thrifts found that, on average, healthy thrifts invested only 6.9 percent of their balance sheets in commercial real estate loans, and insolvent thrifts only invested 13 percent of their balance sheets in commercial real estate loans. DX 5038A at ¶ 135 and Exh. 19; DX 8098 at WOQ625 1633-37. Thus, in 1989, "Carteret itself looked at its own position . . . as part of its strategic planning exercise, and it realized that it was looking pretty risky compared to what might be called a solvent thrift. In fact, it looked pretty close - more close to an insolvent thrift than a solvent thrift." Tr. 3414:4-9 (Saunders). Carteret's 1990 Strategic Plan, created in 1989, recognized that the investment Carteret had made in commercial real estate loans was almost twice the investments even insolvent thrifts had made in commercial real estate loans. DX 8098 at WOQ626 1633-37. As a result, in 1989, when management absorbed the magnitude of the "potential losses in Carteret's commercial loans" in a deteriorating economy, Carteret decided to withdraw from commercial real estate lending "as rapidly as possible." DX 7171 at WOP298 0701.

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1.

When Carteret Decided To Establish A Commercial and Real Estate Lending Division In 1983, It Had No Experience In These Types Of Lending

31.

Carteret hired executives who had been involved in corporate and commercial

banking for other financial institutions when it created its Income Property and Corporate Banking Divisions, but it had no infrastructure to support corporate and commercial lending. DX 8043 at WOP300 2119; DX 8000A at ¶ 32. During the 1984 examination, the FHLLB observed that Carteret had grown from $2.1 billion to $5.4 billion in assets from 1982 to September 1984, but that "net operating results . . . were marginal." Id. at WOP300 2118-2119. The reason for the "marginal" performance was the high cost of funds as well as "[h]igh operating costs resulting from expansion and entry into new lending and service corporation areas." Id. at WOP300 2118. Thus, from the inception of commercial and corporate lending, these sectors did not appear to contribute profits to the thrift. 32. Robert J. Mueller, who was installed as Chairman of the Credit Committee and

established the Corporate Banking Division, was the subject of an OTS enforcement action in 1990 in connection with unsafe and unsound practices relating to retirement pay. In March 1992, Mr. Mueller consented to the entry of a Cease and Desist Order requiring the payment of $310,000 in restitution to Carteret. DX 804 at WOP300 2119; DX 9122 at WOR081 0285. On January 24, 1991, Carteret terminated the employment of Charles J. McCabe, Executive VicePresident For Commercial Assets, because Mr. McCabe was responsible for the improper classification of commercial assets and the corresponding understatement of valuation allowances. PX 2111 at C-AM-A-0320831. 33. In June 1991, Carteret hired J. Wayne Moor, a former executive of Amerifirst 11

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Savings Bank in Miami, Florida to replace Mr. McCabe as Executive Vice-President For Commercial Assets. Mr. Moor had extensive experience in evaluating problem loan portfolios. Carteret tasked Mr. Moor with performing a realistic evaluation of Cartert's loan portfolio. DX 7000A at 20; PX 803 at CAM402 0341; Tr. 1498:18-1499:4 (Day); JX 1 at Tr. 14:25-16:3 (Moor); Tr. 1498:13-17 (Day). Mr. Moor and an experienced appraiser visited many of Carteret's larger borrowers. They reviewed detailed reports, prepared at Mr. Moor's direction, on credits accounting for 93.1 percent of the total commercial asset portfolio. DX 7000A at 23; Tr. 1499:8-11 (Day). 34. Mr. Moor concluded that the commercial lending portfolio "was a smoldering pile

of dung." DX 9129 at Tr. 114:5-7. He also concluded the lending "was done on a shotgun basis." Id. at Tr. 65:12-13. "That means you have a salesman asking you for the loan . . . .There wasn't a lot of work done on the projections, obviously, because they all had the same projections, things were going to get better, better, better and the property was going to be worth more, more, more, more. And that was true in almost every situation, and almost every situation the opposite happened." Id. at Tr. 65:14-23. Mr. Moor also concluded that the internal classification system was "a joke," and that "the hole [which had to be filled with reserves] was at least $150 million." Id. at Tr. 89:24; 112:22-24. 2. Carteret Placed Approximately $1 Billion In Commercial And Real Estate Loans On Its Books Between 1983 And 1986 But Did Not Conduct Proper Underwriting Or Effective Monitoring

35.

Carteret's corporate and commercial real estate lending increased from zero to

approximately $500 million over an eighteen month period beginning in April 1983. DX 5038A at ¶ 21. Carteret "restructured its balance sheet from a traditional thrift lender into a diversified 12

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financial services institution . . . [with significant investments in] commercial, consumer, and commercial real estate loan portfolios, as well as increased its service corporation and investment activity." PX 2104 at AMB019342. As OTS noted in its 1989 examination, "[T]he board approved underwriting policies for . . . all lending activity (exclusive of residential loans) are vague and general in terminology. As such, these policies are inadequate and cannot be construed as providing useful guidance for management to prudently underwrite or oversee this activity." PX 2106 at WOQ6750028. 36. Loan underwriting is the process of identifying the risk of an investment and then

setting an appropriate return to compensate for taking the risk. Tr. 2354:17-25 (O'Rourke). 37. To properly engage in underwriting, a loan officer analyzes the proposed loan,

prepares financial statements, and, in the case of real estate development loans, examines appraisal reports provided by the borrower. Tr. 1470:19-25 (Day). For larger loans, the bank should also have completed a marketability analysis to support the appraiser's rationale in arriving at the project's estimated valuation. Tr. 1470:25-1471:1 (Day); PX 2106 at WOQ675 0032. Considering this information, the loan officer determines whether the bank should make the loan or reject it by evaluating whether the loan will earn the bank money at low risk. Tr. 1471:1-8 (Day). 38. Carteret, however, failed miserably in the underwriting function for the new

commercial lending strategy. In 1988, the OTS noted recurrent deficiencies in appraisals, including "[u]nsupported assumptions that have a significant effect on the final market value" and "[p]oor comparables that did not share important characteristics with the subject of the appraisal." PX 2104 at AMB019345. In fact, OTS examiners reviewed three appraisals that 13

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were dated after the loan closings. Id. 39. For example, in the 1990 and 1991 examinations, the Federal Deposit Insurance

Corporation ("FDIC"), Carteret's secondary regulator (following the enactment of the Financial Institutions Reform, Recovery and Enforcement Act, Pub. L. 101-73, 103 Stat. 183 (1989) ("FIRREA")), and OTS analyzed a $51.8 million loan Carteret made in November 1988 to Swedeland Development Group for a large golf course and residential development in Northwest New Jersey. Tr. 1472:7-17 (Day); PX 2109 at KH054313. The developer contributed very little capital and had no experience in a project of that size. Tr. 1472:17-20 (Day). The project almost immediately experienced cost overruns, and, with the downturn in the economy, the developer could not sell the product and had no resources to complete the development effectively. Tr. 1472:20-25 (Day); PX 2109 at KH054315, KH054318. The 1990 OTS ROE noted that, out of a planned 140 units, only ten had been sold, and many of these were sold to insiders. PX 2109 at KH054314, KH054316. Carteret had failed to recognize these risks during its underwriting process. PX 2109 at KH054318. 40. OTS examiners concluded that "[i]nitial projections were obviously flawed and

overall administration of the project is considered to have been lax." PX 2109 at KH054315. Although Carteret's Credit Committee approved this loan, its approval stipulated that the borrowings were to be partially secured by a $5 million letter of credit facility. PX 2109 at KH054313. This letter of credit, however, was never issued. PX 2109 at KH054313. In addition, Carteret did not place this loan on its internal watch list or adversely classify it, even though the project was running eight to twelve months behind scheduled sales and the development was "obviously in trouble." PX 2109 at KH054209, KH054315. 14

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41.

In addition, in May 1989, Carteret made a $16.7 million residential development

loan for construction of Moore Estates, an upscale condominium and townhouse development in Convent Station, near Morristown, New Jersey. Tr. 1473:1-3 (Day); PX 2109 at KH054308. Carteret accepted the developer's theory that wealthy "empty nesters" would purchase smaller, yet upscale, homes to remain near family, but never did a marketability study to verify the theory. Tr. 1473:1-9 (Day). When Carteret did initiate a study in September 1990, it concluded that there was no market for that type of development. Tr. 1473:10-13 (Day). The study described the overall building concept as "totally flawed." PX 2109 at KH054309. 42. The 1990 OTS ROE noted that the revolving line of credit for the Convent Station

development was based on the maximum balance occurring when 44 units were to be under construction. PX 2109 at KH054308. As of June 30, 1990, only 12 units were under construction, and only $1,074 remained available under the line of credit. PX 2109 at KH054308. There had been no closings, and only three sales contracts. PX 2109 at KH054308. OTS examiners conducted a site inspection and found "that the project was effectively abandoned by the borrower in a partial stage of completion and in a condition which is very unappealing and likely to raise concerns from the community." PX 2109 at KH054209. Despite these problems, the development's close proximity to Carteret's headquarters, and the borrower's acknowledgment that he could not complete the project without significant additional funding, Carteret did not adversely list this project in its March 31, 1990 Classified Asset Report. PX 2109 at KH054209, KH054309. The OTS examiners determined that a Doubtful classification was warranted. PX 2109 at KH054309. 43. Another example of Carteret's underwriting deficiencies was its loan relationship 15

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with Paul V. Profeta, which reached nearly $60 million in loans as of June 30, 1990. PX 2109 at KH054211. Regulators found numerous instances where Mr. Profeta had dictated loan terms to Carteret's management. Tr. 2355:8-12 (O'Rourke). Carteret provided Mr. Profeta with one $30 million loan secured by a 21-story office building. PX 2106 at WOQ675 0142. Carteret accepted an appraisal from Mr. Profeta dated approximately three months after the loan was granted. The decision to grant the loan without an appraisal was as improper as the decision to let the borrower obtain and submit the appraisal. Carteret should have obtained it independently. Tr. 2356:3-5 (O'Rourke); PX 2106 at WOQ675 0158. Carteret also accepted financial information from Mr. Profeta without auditing it or scrutinizing it and accepted uncertified rent rolls for Mr. Profeta's office building at face value. Tr. 2355:3-2356:9 (O'Rourke); PX 2106 at WOQ675 0142, WOQ675 0147, WOQ675 0152. Mr. Profeta admitted that companies such as Xerox and AT&T, which he claimed were tenants, were either not tenants at the date the loan was originated or received major rent concessions. PX 2106 at WOQ675 0143. 44. Regulators concluded that Carteret's poor underwriting of commercial loans

"began as early as 1986 and continued until lending activity was terminated in 1989." PX 5331 at KH 033535. As our expert on financial institutions and capital markets, Professor Roy Smith, stated, Carteret "made a lot of bad loans in a hurry without the skill to be able to evaluate the credit risk that those loans entailed. And they didn't monitor them very well to be able to address them before they got even worse." Tr. 2921:13-17 (R. Smith); DX 7063 at WOP814 0024 (the decline in asset quality noted in the 1989 OTS ROE was attributable in part to the lack of adequate underwriting). "These were bad loans or weak loans that were time bombs, in a sense, and which were ignited by the economic conditions prevailing in 1990 and `91." Tr. 2924:2316

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2925:1 (R. Smith). 45. Regulators, along with Carteret's own accountants and other consultants,

emphasized Carteret's inability to manage its credit exposures through adequate underwriting or other credit controls. Tr. 2921:6-10 (R. Smith). Therefore, OTS's 1989 ROE stated that Carteret's "loan underwriting policies (except for residential lending) are considered inadequate" and required that management "act to redefine its goals and objectives, as well as establish prudent lending guidelines for the bank's loan officers." DX 7063 at WOP814 0024. The FDIC noted that Carteret did not have any quantitative or qualitative guidelines for assessing credit risk and did not have defined goals for issuing credits. DX 8054 at WOQ699 0514. 46. In addition to criticizing Carteret's inability to underwrite commercial loans,

regulators concluded that Carteret's internal loan review (ILR) function was inadequate and inept. Tr. 2357:6-13 (O'Rourke). Carteret's weak or nonexistent loan review function meant that there was no check to identify emerging problems, giving management a false sense of confidence that the portfolio was performing well because there was no independent review of existing risks or risk factors that were turning negative. Without a very robust internal independent process for identifying problems, those problems intensified and got out of control. Tr. 2357:19-2358:8 (O'Rourke). 47. The OTS examiners "determined that problem loans are not being identified in a

timely manner and the institution's internal loan classifications do not accurately reflect the risk of nonrepayment." PX 2106 at WOQ675 0033. Examiners considered Carteret's practice of having the loan officer critique his or her own loans without adequate analysis on the part of the loan review staff to be the primary weakness in the ILR program. The loan review staff also 17

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seemed to be more concerned with defending loans than with providing an independent review. PX 2110 at WOQ698 1438; Tr. 1479:2-1480:21 (Day). During the 1989 examination, OTS encountered a "breakdown in the loan approval process . . ." PX 2106 at WOQ6750029. 48. For example, during a 1990 site inspection of the Swedeland housing

development and golf course, OTS examiners learned that the project was running eight to twelve months behind scheduled sales and that the golf course would not be ready for use on schedule. PX 2109 at KH054209. Given that the developer was to repay most of Carteret's loan through completed unit sales, the OTS examiners noted that these were significant concerns. Id. The ILR, however, had not monitored the project's progress and had not categorized the loan as subject to criticism or placed it on a watch list. Id. OTS examiners, on the other hand, adversely classified it and noted that the ILR's failure to identify this large and clearly troubled credit in a timely manner called into question the effectiveness of the entire ILR function. PX 2109 at KH054209, KH054318. 3. Carteret's Strategy Of High Risk Lending Also Extended To Mortgage Lending

49.

In September 1987, Carteret's Board revised its loan policy to authorize one-to-

four family "no documentation" or "limited documentation" loans. PX 2111 at C-AM-A0320839. This new policy enabled Carteret to make loans without verifying a borrower's income and employment during the underwriting process. Thus, loans were extended without determining the borrowers' ability to repay them. Tr. 478:5-9 (Bianco); PX 2106 at WOQ675 0050-51. 50. From January to July 1989 alone, Carteret made $413 million in "no doc"

mortgage loans. PX 2106 at WOQ675 0050-51; Tr. 478:5-16 (Bianco). Our expert on financial 18

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institutions and damages, Professor Anthony Saunders, noted that these "limited documentation" mortgages are what today are referred to as sub-prime mortgages, which could not be securitized. Tr. 3577:4-3579:5 (Saunders). 51. In a targeted review of five "limited documentation" loans, OTS's 1991

examination revealed that "[g]enerally, the files were found to be in a state of disorder." PX 2111 at C-AM-A-0320839. The borrowers, who owed over $3.3 million, were delinquent in their payments by as much as 27 months. Id. The examiners found that the state of disarray of the loan files "could delay and/or jeopardize Carteret's ability to commence legal action against a borrower if deemed necessary." Id. 4. Carteret Failed To Properly Classify Problem Assets Or Establish Adequate Loan Loss Reserves

52.

Examiners determine which loans are likely to have problems and, as a result,

adversely impact earnings and capital. Tr. 1435:15-20 (Day). Examiners select certain credits for review, then request the credit files on these loans from the bank. Tr. 1435:21-1435:25 (Day). Examiners then review the files, discuss the loan with bank management, and come to a conclusion about whether the loan has weaknesses that warrant an adverse classification. Tr. 1435:25-1436:4 (Day). Examiners have to be able to defend their recommended classifications, so they do not classify assets until they have performed a thorough evaluation. Tr. 1497:181498:8 (Day). 53. Most of the OTS and FDIC examiners' time was spent on asset review. Tr.

2346:12-20 (O'Rourke) ("50 to 70 percent of our time [is spent] on asset quality"); Tr. 1426:1619 (Day) ("probably the greatest amount of manpower is expended in evaluating the quality [of] assets"). FDIC relied upon OTS's review of loans in many cases, but on several examinations 19

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OTS and FDIC worked as a team, splitting up the loan reviews and discussing their results. Tr. 1570:16 - 1572:14 (Day). The 1990 examination "was a joint effort of FDIC and Office of Thrift Supervision (OTS) personnel" "which centered primarily on commercial real estate loans and corporate lending activity . . ." PX 2110 at WOQ6981434. OTS acted as Carteret's primary supervisor, and the FDIC was the insurer. Tr. 1431:12-20 (Day). Mr. Day, one of the FDIC examiners, spent a great deal of time working with OTS personnel in loan evaluations, often on a daily basis, and believed that OTS personnel did a careful job in evaluating loans and making reserve recommendations. Tr. 1431:21-25, 1500:15-1501:12 (Day). 54. Adversely classified assets are divided into three categories: substandard, doubtful

and loss. Tr. 1436:5-8 (Day). Substandard assets are not supported by the borrower's collateral, net worth, or ability to pay. Tr. 1436:12-14 (Day). They have significant operating defects that could jeopardize orderly liquidation, or, if the situation remains unresolved, could result in loss. Tr. 1436:14-17 (Day). They are characterized by the distinct possibility that the insured institution will sustain some losses if the deficiencies are not corrected. DX 7000A at § 3.1.2. "Doubtful" is a more severe level of classification for loans that will result in a significant loss that cannot yet be quantified to an exact point. Tr. 1436:18-23 (Day). Doubtful assets have weaknesses that make collection or liquidation in full highly questionable and improbable. DX 7000A at § 3.1.2. Assets classified as "loss" are non-bookable assets that should be charged off the bank's books. Tr. 1437:1-3 (Day). 55. The amount of a thrift's capital plays no role in determining whether an asset

should be classified. Tr. 1437:24-1438:8 (Day); Tr. 2360:15-23 (O'Rourke). Further, the amount of capital that a thrift has plays no role in an analysis of the thrift's reserves. Instead, the 20

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examiner looks at the individual assets and determines the fair value, net realizable value, or market value irrespective of the institution's capital levels. Tr. 3179:10-18 (Kennedy). 56. Thrifts are required to establish adequate valuation allowances in accordance with

GAAP. DX 7000A at § 3.1.4. Under GAAP, a loss should be recognized when it is probable and can be reasonably estimated. Id. Valuation allowances are increased through charges to income (e.g., loan loss provisions) and recoveries. Valuation allowances are decreased by charge-offs. DX 7000A at § 3.1.1. The establishment of reserves reduces income and capital on a dollar-for-dollar basis. Tr. 3145:17-22, 3156:24-3157:5 (Kennedy). A valuation allowance is considered adequate if it is sufficient to cover both losses on specifically identified assets and losses inherent in the remaining asset portfolio. DX 7000A at § 3.1.1. 57. A high level of adverse classifications requires a high level of reserves to

compensate for the risk in that portfolio. Tr. 1437:17-20 (Day). OTS and FDIC followed established methodologies for determining the appropriate level of reserves. Tr. 1437:20-23 (Day). The risk factors considered by the examiner in establishing reserves involve the adequacy of the ILR, the quality of management, changes in the asset portfolio involving a transition from lower to higher risk assets, historical losses, peer group comparisons, and current economic conditions. Tr. 1915:18-1916:20 (S. Smith); DX 5048. Peer group comparisons and historical losses are only marginally relevant because peer groups involve different geographic regions and different asset configurations. Tr. 1917:25-1918:7 (S. Smith). 58. To set loan loss reserves, the standard procedure is to provide a 20 percent reserve

for a substandard asset, 50 percent for a doubtful asset, and total charge-off for items classified loss. Tr. 1438:9-1439:5 (Day). To determine the adequacy of a thrift's reserves, FDIC 21

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examiners total up the indicated percentages of reserves and compare them to the thrift's actual reserves. Tr. 1441:19-1442:4 (Day). Adequacy of reserves cannot be determined by comparing them to the reserves of another thrift, because thrifts have differing investment philosophies, histories, and managements. Tr. 1442:9-17 (Day). In Carteret's case, a comparable thrift would have had to have had a high percentage of commercial real estate loans in the northeast and Florida, and a high concentration of commercial business loans. Tr. 2373:7-20 (O'Rourke). 59. Judgments related to reserves must be made in a disciplined manner based on a

detailed analysis of the loan portfolio. Tr. 3186:12-3187:6 (Kennedy). Examiners should come up with similar recommendations as to overall reserve levels. Tr. 1569:4-23 (Day) 60. Carteret did not properly classify assets. DX 9129 at Tr. 112:24 (Moor). The

responsibility for classifying an asset rests upon management. DX 7000A at § 3.1.2. Under the regulations issued both prior to and after the enactment of FIRREA, examiners also have the authority to identify and classify assets. Id. The effectiveness and thoroughness of a thrift's asset classification policy and practice play an integral role in ensuring that its reserves are adequate because an asset's classification affects the need for and appropriate amount of the reserve. DX 7000A at § 3.1.3. Internal loan review should be an independent audit-type process that ensures that management classifies assets properly. Tr. 2363:2-7 (O'Rourke). 61. From December 1987 to June 30, 1989, Carteret was required to increase its level

of classified assets by approximately $400 million. Tr. 1904:4-10 (S. Smith). The result was that, as of 1989, Carteret's classified assets equaled 5.6 percent of its total assets, which was well above its peer group's average of 3.3 percent. DX 7000A at § 3.2.1. The 1989 discrepancy between Carteret's internally classified loans ($150 million) and the regulators' adverse 22

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classifications ($397.721 million) indicated that Carteret's internal loan review system was "woefully inadequate" and failed to recognize problem loans. Tr. 1442:18-1443:9 (Day). 62. The enactment of FIRREA and Carteret's downsizing had no impact on the

condition of Carteret's problem assets. Tr. 2356:24-2357:5 (O'Rourke). 63. Regulators concluded that Carteret did not take adequate provisions for loan

losses, particularly because it was basing its reserves on historical losses even though its asset composition had evolved from primarily residential to significant commercial lending. Tr. 1445:1-1446:1 (Day). Basing reserves on historical losses was inappropriate for a bank that had evolved from making one-to-four-family residence loans to making multi-million dollar, acquisition development loans. Tr. 1445:1-1446:1 (Day). Management's failure to provide for adequate reserves resulted in an overstatement of earnings performance. PX 2110 at WOQ698 1434; Tr. 1445:1-1446:1, 1474:12-25 (Day). Indeed, regulators considered Carteret's reported earnings from as early as 1986 to be "misleading." PX 2110 at WOQ698 1438; Tr. 1480:221481:20 (Day). 64. Loan loss reserves established by management almost doubled between 1987 and

1988, rising from $8.4 million to $14.1 million. Tr. 2942:23-2943:13 (R. Smith); DX 9506. The reserves doubled again in 1989, rising to $27.5 million. Tr. 2943:4-11 (R. Smith); DX 7000A at § 3.2.1. In 1989, OTS concluded that Carteret still needed to increase its reserves by $77.2 million. DX 7000A at § 3.2.1; Tr. 1915:7-9 (S. Smith); Tr. 3412:5-9 (Saunders). Although this was later reduced to $54.3 million, Tr. 1921:16-1922:15 (S. Smith), Carteret failed to book either amount in 1989. DX 7000A at § 3.2.1. 65. Even if Carteret had booked the additional $77.2 million in reserves required by 23

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OTS, the reserves would have been insufficient to cover the substandard and doubtful loss classifications. DX 8054 at WOQ699 0501. 66. Carteret's insufficient reserve position was based in large part on management's

contention that classifications only had to relate to the portion of the asset "at risk" rather than the entire asset. Tr. 1904:10-1905:1 (S. Smith). This was not regulatory practice and was not approved by the regulators. Id. 67. Mr. Moor described Carteret's system of identifying adversely classified assets as

"a joke." DX 9129 at Tr. 112:24 (Moor). He emphasized that his August 1991 "review was done in an organized fashion by experienced real estate people who [were] very aware of the accounting and regulatory rules that apply to the assets reviewed. The same things cannot be said about the existing reserve position." DX 44 (August 8, 1991 Moor Memo). Mr. Moor's review resulted in the addition of $120 million to reserves, which resulted in a total reserve for the second quarter of 1991 of $150 million. FDIC examiners considered even this level of reserves to be only marginally adequate. Tr. 1496:18-1497:17 (Day). 68. Because the loan losses resulted from poor underwriting and the economic

downturn, these losses could have been and should have been recognized prior to FIRREA. The losses "were not just something that happened in the last minute," but instead were due to "bad loans or weak loans that were time bombs, in a sense, and which were ignited by the economic conditions prevailing in 1990 and `91." Tr. 2924:21-2925:2 (R. Smith). 5. 69. Carteret Was Not Overreserved As Of September 1992

Professor Calomiris asserted that, in a world without the breach, Carteret would

have taken $50 million less in reserves than the $150 million that Carteret recorded in the real 24

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world in mid-1991. PX 2702A at Table 16; PX 2704A at Table 2; PX 9053a. Professor Calomiris, however, thought it "quite possible" that Carteret's reserves in 1989 should have been higher and acknowledged that he had not analyzed the required reserves to determine whether $77.2 million, the amount OTS initially ordered added to reserves, was in fact the correct figure. Tr. 1178:18-1179:4 (Calomiris). 70. David A. Kennedy, a Certified Public Accountant ("CPA") and real estate

valuation expert, demonstrated that Carteret's reserves were not overstated by $50 million as of September 1992, as asserted by Professor Calomiris and Mr. Bianco. Tr. 262:5-264:17 (Bianco); DX 7000A at 26-27; PX 9053. Their views are "at odds with contemporaneous statements by management[,]" given Chief Financial Officer Donald Kramer's statement in July 1992 that Carteret was adequately reserved after the $150 million write-down. DX 7000A at 26-27; PX 2993 at C-AM-A-0243012. Also, Mr. Kennedy noted that "such an approach [i.e., reducing reserves by $50 million] would not have been acceptable to Carteret's auditors and would have been inappropriate under accounting principles and SEC reporting requirements." DX 7000A at 26. Mr. Kennedy noted that, if Carteret took reserves that were higher than needed in order to gain the confidence of new investors, then the financial statements would have been misstated under GAAP and Securities and Exchange Commission ("SEC") rules and regulations. Tr. 3188:10-3189:5 (Kennedy). 71. Mr. Moor, who was appointed by Mr. Bianco to review the commercial loan

portfolio and recommend reserves in June 1991, conducted an extensive evaluation analysis which included site visits, discussions with individual borrowers, brokers and appraisers, and an evaluation of rent rolls and other relevant records. Tr. 3170:3-3171:6 (Kennedy); Tr. 3364:7-13 25

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(Kennedy). Mr. Moor recommended the addition of $150 million in reserves. Tr. 3164:10-21 (Kennedy). 72. Carteret's Board of Directors determined that Mr. Moor's estimate was an

accurate reflection of Carteret's asset portfolio and accepted Mr. Moor's recommendation. Tr. 3195:25-3198:4 (Kennedy); DX 7227 at WOQ695 1029-30. The Board of Directors adopted a resolution noting that "the association's independent accountants have reviewed the level of valuation allowances at the most recent quarter-end and have indicated that the association's reserves were adequate at such date." Tr. 3195:8-12 (Kennedy); DX 7227 at WOQ695 1030. Mr. Kennedy opined that reserves could not be deemed adequate while at the same time being overstated because this would create a material misstatement. Tr. 3197:13-3198:4 (Kennedy). 73. Mr. Kennedy conducted an independent evaluation of Mr. Moor's reserve analysis

and concluded that Mr. Moor employed a systematic and detailed analysis, and that he fully documented the rationale supporting the reserves. Tr. 3221:14-3222:1 (Kennedy). Tr. 3209:193210:11, 3234:6-24 (Kennedy). Further, Mr. Kennedy concluded that Carteret would have been required to take the same level of reserves in the absence of the breach because the asset quality dictated the required reserves. Tr. 3235:12-3237:3 (Kennedy). 74. Price Waterhouse, Carteret's outside auditor at the time Mr. Moor recommended

the addition to reserves, approved Mr. Moor's recommendation to the Board of Directors. Price Waterhouse concluded that Carteret's financial statements, which presented the reserves in accordance with GAAP, were free of material misstatements. Tr. 3205:22 to 3206:1 (Kennedy). OTS compared the examiners' reserve analysis with Mr. Moor's and concluded that each confirmed the other. DX 427 at CAM152 1296; Tr. 2388:7-12 (O'Rourke). OTS Examiner 26

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O'Rourke, who was stationed at Carteret at the time as a resident examiner, testified that Mr. Moor's recommendation as to reserve levels was based upon a fundamentally sound approach and was reasonable in light of the massive problems with the corporate and commercial real estate loan portfolios. Tr. 2393:6-17 (O'Rourke). 75. Even if Carteret were realizing 105 to 110 percent of the reserved amount on

some of its classified assets, that does not indicate Carteret was over-reserved. Some assets resolve for more than their reserved value, others less. Tr. 2395:10-21 (O'Rourke). The proceeds of individual asset sales are irrelevant to the determination of reserves, which depends upon a broad measure of the value of the entire portfolio rather than a focus upon individual asset dispositions. Id. 76. The Resolution Trust Corporation ("RTC") did not receive liquidation value in its

sale of Carteret's assets. As noted in the due diligence report prepared by Lyons, Zomback & Ostrowski ("LZO") for Kohlberg & Co., a potential Carteret investor, "[n]o attempt was made by either Carteret or LZO to measure these assets on a liquidation basis, which measurement would have additional valuation shortfalls from those determined by LZO." DX 95 at WOP338 1384; Tr. 3232:1-3233:3 (Kennedy). Further, OTS Examiner O'Rourke saw no evidence of a "fire sale" of Carteret's classified assets. Tr. 2397:19-24 (O'Rourke). Moreover, if the assets had been valued on a liquidation basis, the financial statements would have violated GAAP. As Mr. Kennedy observed, "[a] liquidation basis is not an appropriate basis for establishing reserves for an ongoing entity. And if you establish the reserves based on liquidation basis, your financial statements will be misstated." Tr. 3233:21-25 (Kennedy). Mr. Vigna acknowledged that Carteret's assets were carried "at close to market values." PX 2805 at WOP334 1036; Tr. 27

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3238:1-3241:16 (Kennedy). 77. Carteret would have suffered immediate economic costs if it had held the non-

performing and real estate owned ("REO") assets in the "but-for" world for a longer period than it held them in the real world. Between 1989 and 1991, Carteret suffered lost interest income of at least $62 million on non performing loans and negative cash flow of $6.3 million on foreclosed real estate because these assets were on Carteret's books. DX 9614; Tr. 3262:163263:11 (Kennedy). In addition, Carteret suffered out-of-pocket costs of $4.1 million between July 1, 1991, and September 30, 1992, for upkeep on the foreclosed property. DX 9614. 78. It is impossible to conclude that particular assets or areas would, if held, increase

in value even if there is a general trend of increasing asset prices. Tr. 3266:16-3267:15 (Kennedy). Professor Calomiris has provided no analysis showing that Carteret's assets would have increased in value by a sufficient amount to offset the $73 million in cost that would be associated with holding those assets. Tr. 3267:5-10 (Kennedy). There are clear examples of Carteret assets which would not have increased in value even if market conditions improved. For example, Interstate Plaza II was an office building that had never been occupied and cost $150,000 per year to maintain. Further, appraisers determined that the highest and best use of the land was not as an office building. Tr. 3265:6-19 (Kennedy); DX 9615. Thus, it would have made no sense to hold this asset. Tr. 3265: 6-8 (Kennedy). Similarly, Hightstown Hotel, which had been closed, was in a depressed area, was physically degenerating, and was costly to maintain. Tr. 3265:20-3266:9 (Kennedy); DX 9615. If Carteret had not disposed of these assets, it would have incurred substantial holding and monitoring costs. Thus, these assets were not economically viable even if general market conditions improved. Id. 28

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III.

By 1989, Carteret Had Become Effectively Insolvent 79. At the completion of the 1989 examination, Mr. Day recommended a composite

rating of "5" for Carteret, which indicated an "extremely high immediate or near term probability of failure." DX 8054 at WOQ699 0508. Carteret's pre-FIRREA insolvency had its origins in the firm's historical performance. A. Due To Its Poor Core Operating Earnings, Carteret Relied Upon Asset Sales Between 1983 and 1986, Carteret reported net earnings of $113 million. DX

80.

8000A, Exh. 3, Table 1. The quality of the earnings, however, was extremely low. As regulators noted, core operating earnings are "the essential elements of a viable .