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Exhibit A
Case 1:93-cv-00531-LAS
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Roy C. smith New York, NY
October 16, 2007
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UNITED STATES COURT OF FEDERAL CLAIMS AMBASE CORPORATION and CARTERET BANCORP, INC.,
plaintiffs,
Case No. 93-531
and FEDERAL DEPOSIT INSURANCE CORPORATION, PlaintiffIntervenor,
VB.
THE UNITED STATES OF AMERICA, Defendant.
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Tuesday, October 16, 2007 New York, New York Time: 12:55 p.m. Day 1, Volume 1 Pages 1-193 Day 1, Volume 1 of the deposition of PROFESSOR ROY C. SMITH, taken by Plaintiffs,
pursuant to Notice, held at the offices of Navigant consulting, 666 Third Avenue, New York, New York, on
Tuesday, October 16, 2007 at 12:55 p.m. before
Josephine H. Fassett, a Certified Shorthand Reporter
and Notary Public of the State of New York.
Alderson Court Reporting 1-800-FOR-DEPO
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Roy C. Smith New York, NY
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October 16, 2007
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1 (Expert Report of Professor Roy C. 2 Smith marked as Exhibit Saunders 1, as of 3 this date.) 4 PROFESSOR ROY C. SMITH, 5 the witness, having been duly sworn by a 6 Notary Public, was examined and testified 7 under Oath as follows: 8 EXAMINATION BY 9 MR. THOMPSON: 10 Q Good afternoon. Please state your
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,
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APPEARANCES:
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COOPER & KIRK, PLLC
Appearing for Plaintiffs
1~23 New Hampshire Avenue, N.W. Washington, D.C. 20036 BY: DAVID H. THOMPSON, ESQ
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FEDERAL DEPOSIT INSURANCE CORPORATION Appearing for Plaintiff-Intervenor 550 17th Street, N, W, Room 6030
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Washington. D.C. 20429 10 BY: GARY A KUIPER, ESQ.
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name.
Roy Smith. Mr. Smith, or Professor Smith, I'm David Thompson with the firm of Cooper & Kirk. I represent Ambase Corporation. With me today are the Chainnan of Ambase, Richard Bianco, and John Ferrara also with Ambase. MR. THOMPSON: And would counsel, or Mr. Kuiper, would counsel like to identitY themselves for the record? MS. GRONER: Sure. I'm Arlene Pianko Groner and I'm representing the United States and I'm also counsel for Professor Smith who's our expert in this case. MR. KUIPER: And I'm Gary Kuiper with A
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UNITED 5TATES DE?ARTMENT OF JUSTICE
Appearing for Defendant
1100 L Street, N.W. Room 7024 W
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ALSO
PRESENT,
RICHARD A. BIANCO, Ambase Chainnan
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JOHN P. FERRARA, Ambase
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RlCHARD BIANCO, Son
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Q
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INDEX WITNESS PROFESSOR ROY C. SMITH By Mr. Thompson
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the FDIC. MR. THOMPSON: Off the record for a
moment.
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EXHIBITS SMITH DESCRIPTION PAGE No.1 Expert Report of Professor Roy C. Smith 4 No.2 Errata to Smith Declaration dated October IS, 2007 52
(Whereupon, off the record.) (Whereupon, resumed.) BY MR. THOMPSON: Professor) have you ever been deposed Q before? A No. Q Okay. And have you ever been retained as an expert witness in a case before? A No. Q Well, let's go over some ground rules then. We can take a break any time you like, my only request is that if there's a question pending, that you'd go ahead and answer that question. Let's try (0 talk one at a time since we have a court reporter here trying to create an accurate record. If I cut you off at any point during this deposition, just let me know that you weren't fmished with your answer. It's certainly my intention to get your full and complete testimony
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Roy C. Smith New York, NY
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8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 market conditions, do you mean macroeconomic 23 conditions, is that one of the factors? I mean the conditions ofthe market to 24 A 25 detennine whether a buyer wishes to buy the thing
and not truncated. And, if I ask you a question and you answer it, I'm going to assume you understood the question. So, with that, why don't we just jump in and let me ask you: Does the market value of any finn represent the discounted prediction of the finn's future after-tax cash flows? It can reflect that. A Q Does it nonnally reflect that? It might. A Q In what circumstances -In other words, there are other A factors that might influence it. Q What would influence a finn's value other than the predicted future after-tax cash flows? Market conditions. A Q Anything else? A That's a large one, but -Q Well, let me ask you: When you say
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A Because it's considered to be a
risk-free investment.
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Q And that's because it's backed by the United States Government? Yes. A Q Is that a reasonable assumption in
your opinion that investors can rely on -A It's a reasonable assumption as long as we're staying within the United States. Q Okay. And sorry about that, I think you accurately anticipated what my question was, but
because we have a court reporter here, just as I'm
going to try to let you finish your answers, if you'll try to let me finish my questions, but let me just get that on the record so that it's all accurate. But is it reasonable for investors to rely upon a guarantee of the United States Government? Yes. A Q Okay. Now you attended the Naval Academy; is that right? Yes. A Q Graduated 1960? 2S A Yes.
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you're trying to sell and that could be, you know, reflecting many different elements. Q Would that be factored into the
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discount rate?
If you could figure out what it was, A if it changed instantly, you might be able to do so, but people don't always agree on what discount rates are, but there will be a buyer or there won't be at the price you wish to sell and those will be affected by the things.
Q
Do investors look at after-tax cash
12 flows as opposed to pre-tax cash flows? 13 I would suppose they usually do. A 14 Q Why is that? IS Because cash flow isn't cash flow if A 16 it has to take part of it and give it to the 17 Government. 18 Q When selecting a discount rate for a 19 government security. what's the appropriate discount 20 rate? 21 That's the maturity ofthe security. A 22 Q Well, would you add a risk premium? For a government security generally 23 A 24 not. 25 Q Why not?
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Q And then you served our country for four years? Yes. A Q And went to Harvard Business School? Yes. A Q And then you went to Goldman? A Yes. And was Goldman a trading finn at that Q point? It did some trading. A Q What else did Goldman do in 19 -It was principally an investment A banking finn with some trading activities. Q When you say investment banking finn, what do you mean by that? It did underwritings, it did mergers, A it did other corporate finance transactions. Q How many employees were there at Goldman approximately when you started? I don't know, I'd have to guess, I A would say probably 400. Q What position did you have when you fIrst started at Goldman in 1966? I was an associate. A Q And what were your areas of
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opposed to mismanagement and bad underwriting standards? I couldn't allocate a certain A percentage -Q Okay. -~ to you. The economic conditions A were worsening in that period, as everyone knows, but there were plenty of S&L's that didn't suffer the same degree as they did. Q But there were a lot of other financial institutions that were experiencing heavy losses in '90 and '91, correct? That's correct. A Q And Citibank had big losses, didn't it, at that time? A It did. Q And it was technically insolvent, wasn't it? A Technically it wasn't but it was functionally insolvent if you regard the regulators presence in their life as being very substantial in order to hold them up, but -- anyway, that's how it came out. Q And did some sort of Arab sheik make an investment in Citibank in the year '91?
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'82? No. Why not? A It's perfectly acceptable to have an aggressive strategy, that of course means it's a risky strategy, but then it's up to you to execute it correctly, and you could have an aggressive strategy for the purpose of making money but aggressive strategies are riskier than others and may fail. Q So on a prospective basis sitting in 1982 what Carteret did was not irrational? Not per se. One would have to know A more about what their plans for executing their strategy were at the time when they announced it in '82, that's infonmation I don't have. Q Now in the mid 1980s the stock market had a favorable view of Canere!; is that right? A I don't know what you mean by favorable. Q Well, the market capitalization was increasing? Yes, from a very low level. It went A public at a price-to-earnings ratio of about two, which most people would not think to be a very A
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A way.
Yes, in '91. He's still there, by the
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And he's made out pretty well, right? Hehas. Q All right. Now in '90 and '91 the Inc was selling hundreds of billions of dollars of commercial real estate; is that right? That is my understanding but I don't A have infonnation available to me at the moment to say. Q Okay. Did the RTC's sale of assets in '90 and '91 exert downward pressure on the commercial real estate market? It's possible. A Q Isn't it likely just from supply and demand? The commercial real estate market is a A very large market and it does include many things that weren't in the portfolios of the RTC, so to some degree large parts of it were not affected, other parts were, so when you blend them, you get some effect. Q Okay. But do you believe that Carteret's strategy of rapidly expanding its asset base was ill-advised in the early eighties, '81,
Q
A
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favorable rating but it was at least a rating, and it improved from that somewhat during those years you mentioned but it wasn't as high as some that would be considered outstanding companies. Q But the stock market capitalization doubled in the first couple of years? I think we have a table on this, but I A get what you're saying. It did increase. MS. GRONER: Could you just identify for the record the table you're looking at? THE WITNESS: I'm looking at Exhibit 3. I can't find the part I'm looking for. BY MR. THOMPSON: Q I don't think it has the stock market capitalization, I may have missed it, but. Well, it has the stock price, that's A probably a proxy for the question. This is page 3 of3, Table I, Exhibit 3. It has some stock prices here. Q Okay. So that's a proxy for the market cap A in this case. Q Right. So it starts off in '83 trading nine to eleven and then by --
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A And then it goes down to six and three-eighths to 10 and five-eighths and then it goes to -- then it goes back. Then it goes up to six and five-eighths to 18 and one-eighth and so on, then back, then down to -- so it has increased, the stock market has increased. Q Okay. And Carteret was repeatedly able to access the capital markets in the 1980s; is that right? A It was. Q Okay. Now you conclude Paragraph 9, turning to page 4, by saying, quote, these losses depleted Carteret's regulatory capital and substantially reduced the market value ofthe company. Are the losses you're referring to there the 1990 and '91 losses? A Yes. Q Why would an investor have cared about those losses? Well, how about because it depleted A the regulatory capita] and it substantiaJly reduced the market value. That's one reason they would
care.
Q And what would you expect the stock of a company that announced such losses to do, would it
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Carteret and its parent Ambase. Is it true that losses at a bank are only a problem if the bank doesn't have sufficient capital to absorb them? If a bank doesn't have sufficient A capital to absorb losses, it may become bankrupt, it may become insolvent. If it does have sufficient capital, it may escape insolvency but that doesn't mean it doesn't have problems caused by the bank loss -- by the loan losses. Loan losses are not greatly desirable. Q But in order to understand the seriousness of loan loss, of any particular loan loss it's measured against the capital of the bank; is that right? A It's an indicator of the ability to tolerate the pain before you die. Q Nicely put. Now, what mistaken and misguided management decisions by Carteret are you referring to in this sentence? Well, those are enumerated in the rest A ofthe paragraph. Q Okay. So that's -- let me ask you
just so the record's clear on this.
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go up or down or stay the same? A It's difficult to say, it depends on what, to what extent that information had already been in the market and had been able to be priced by that. Q And do you have an opinion as to whether Carteret's stock price in 1989 and the end of] 989 had taken into account the magnitude of those future losses? A I would suspect not. Q Okay. A They appear to have been a surprise to Carteret. Q And was it-Therefore, they wouldn't have been A announced. Q So it would have been a surprise to
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investors too?
Yes. Okay. Now, let's look at Paragraph 10 and the first sentence, and it says, quote, I find that Carteret's loan losses and Carteret's failure to build sufficient capital to cushion against such losses were the direct result of mistaken and misguided strategic and management decisions made by A
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Can you point to any strategic decision that was made during Mr. Bianco's tenure at Carteret with which you disagree? A No. Q Okay. Now, in the middle of the paragraph in point I you say Carteret decided to, quote, engage in rapid expansion of its asset base by acquiring large amounts of assets and liabilities from failing S&L's without commensurately increasing its capital. Please explain what you are referring to here. The acquisitions of Delray and the A other failing S&L assets which was done with consent and in some cases cooperation of the thrift regulators, done on a basis without Carteret having put up any additional capital really at all, though the FDIC or FSLIC put up 16 million, I believe, and there was some additional borrowings from the Federal Home Loan Bank Board, the addition of these risky assets were not accompanied by a comparable amount of underpinning capital. Q Underpinning tangible capital? A Tangible capital. Q Were the capital markets accessible to Carteret in 1982?
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A
The footnotes of the financial
statements usually have some infonnation about it or
as in any -- in terms ofthe disclosure item in any offering of securities and something the companies report on. Q And so when they report the mismatch do they tell you, can you then figure out how much money they're going to make or lose if interest rates move a hundred basis points this way or that? I believe you can. A Q Is that something you typically do
when you invest in a bank's stocks?
I do not. Okay. I do not make that calculation. A Q Okay. How do you -- to what extent do you then try to figure out -- figure in interest rate risk when you're making an investment in a bank stock? I try to make an assessment to the A extent that I can of what degree of exposure they have to serious capital losses because of interest rate mismatching. I may get that information casually or I may get it through the disclosures that they already have but I don't make independent A
Q
the accounting custom of recording the value of loans that they're holding for investment at their historical cost, which is to say, the par, whereas in reality a variety of factors can change that, interest rate changes could make the value of those things go down or up and any change in the perception of credit exposure relative to what it was at the time when the loan was originally priced could also change it. These things are not going to be known by outside observers or readers of financial statements, they're often not known by even the auditors until they do sample test performances to find them out and, therefore, it's difficult to know what the credit risk is, you really have to rely on the management to tell you this in the form of how much they have set aside for
reserves or writeoffs on an annual basis and the
record will tell us that frequently these are not aggressively taken. Q All right. How frequently what are not aggressively taken? Loan losses and writeoffs. A Q Managements are loathe to -They would prefer not to take them to A the full extent that they might.
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efforts to perform my own due diligence on it, however, I don't buy failing S&L assets. Q And just so the record is clear. Have you analyzed Carteret's interest rate risk profile at any point from 1981 through 1992? A I only looked at the information that I saw in the financial statements and the Report of
Examinations.
Okay. A Which were reasonably quiet on these issues during this period because it was not thought to be a particularly serious exposure. Q Okay. Do you consider yourself an
Q
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Q Okay. And they often don't take them to the full extent they should? They often don't, and maybe they A should, but usually it's when ·they get into subsequent trouble that you discover there was this difference in reporting, but that could be explained
as management judgment at the time, it's just
difficult to know. Q And is there some discretion afforded management as to how much of a loan loss they have to take here or there? A Yes, and their auditors have to
consent to it or they wonlt issue a clean opinion.
expert in interest rate risk?
Not as you would define an expert. Q Okay. Now as for credit risk, it's perfectly acceptable for a thrift to have some credit risk; isn't that right? Of course. A A
Q And as an investor how do you measure credit risk?
With great difficulty. It's very hard A to know what a bank is worth from the outside because all of the information is on the inside about the credit exposures. Banks and S&L's have
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Q Okay. And the auditors are to some degree A flexible within limits as to what should and shouldu't be taken. Q Okay. There's usually a discussion. A Q All right. Is it, do you think it's fair to say in your experience a 10 percent range of reasonableness or 20 percent range of flexibility? A I would hope it would be better than, smaller than 10 percent would be the range. Q You'd hope?
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these loans and so many of them failed they must have been doing something wrong. Q I understand. A Whether it was poor credit standards, poor execution of existing standards that went poor or whatever, there are many things that go into how they do it but they did it in a way that had terrible results. Understood, your point, but -- and Q you've also made the point that Carteret waited too long to go to the capital markets. Are there any other instances of mismanagement at Carteret that you can identifY? I've chosen to identifY these in A Paragraph 10. Q Anything that's not in Paragraph 10? A No, ifthere were more, I probably would have added it. Q Now, were Carteret's loans different than other, the loans that other S&L's were making at the time? Well, I'm not aware of any other S&L A with the same track record on their loan portfolio, there may have been some but I'm not aware of it, but it was an unusualIy poor record, so they had --
time felt that they had a burden, and it was considerable, because there were so many loans, so many S&L's in trouble and they had to do the best they could to prevent an industry colIapse and to minimize the taxpayer burden of insuring the whole industry colIapse and they were certainly frightened that the whole industry might in effect have a run on the bank causing difficulties that would be extremely serious for the country. They fult this burden. I think they felt that they should follow a strategy that would do its best to protect or to move along or to delay any worsening of circumstances that might protect, for example, 85 percent ofthe industry even if it meant that some part of the industry would be given one drink, one free drink too many and therefore be endangered by it So I think there's a certainly rational basis for why the regulators did what they did, but in doing it they may have engaged in particular policy making on the. spot which obscured fmancial transparency and engaged in a kind of calculation of regulatory capital in particular that would be unrealistic. Q Was the Government advantaged by
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it probably has to stand out as an example of loan management that was, that was on the lower end of the whole industry. We have data on this, you may realize, we'll come to later. AlI right. Okay. Do you think the Q regulators should have approved Carteret's acquisition of Barton and Delray in 1982? A WelI, I find that question somewhat outside the scope of my assignment here. Q WelI, you talk about the number of instances about lagging regulators and inefficient regulators and so you1re not ~A Yes. You know, you made statements about Q the regulators so -WelI, there was -- that's factualIy A demonstrated. You asked me in particular whether [ thought they should or should not have approved this thing. Q Right. If you don't have an opinion, it's okay, but you make a number of statements about the regulators in the S&L industry and so, you know, 1 want to know whether those general statements had any application for this case. A I believe that the regulators at the
delaying the day of reckoning? They thought so, I believe, because A they thought ifit all happened in an accelerated fonn that would make the fear ofthe industry such that it could have had a stampeding effect, I think they thought that. Q And with the benefit of hindsight, and I know they didn't have that advantage but you do, do you think they were right? A 1 think you could make the case that they were right. 1 have looked at this over the years and I've felt that way but there are others who don't. Q Okay. Why did the other S&L's present a burden to the FSLIC in 1982? MS. GRONER: Excuse me. Ambiguous. Who do you mean by the other S&L's? BY MR. THOMPSON: Q I thought you had said, Professor, that there were other S&L's that were presenting a burden? A Yes, at that time the S&L industry had a number of S&L's suffering from mainly asset liability mismatches which was threatening their capital, including Delray.
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6 7 8 9 1a II 12 13 14 15 a severe crisis in its savings and loan industry 16 conunencing in 1979 and continuing through the 1980s. 17 Please explain, how did this crisis come about? 18 A It was predominantly a crisis in the
but on the other hand maybe they missed it. Q Do you have an opinion on that with respect to Carteret as to whether you are in a better position to evaluate management as opposed to the OTS officials? A I do not. Q Okay. And what about with respect to the FDIC, do you have any opinion on who's in a better position to judge the institution, yoursel f -A I do not. I do not. Q Okay. All right. Now, turning to Paragraph 13 of your report on page 5, the first sentence says, quote, The United States experienced
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A Free market. Q . - free market? Okay. And when -A Another example of an awkward regulatory constraint on an industry. Q That had, ultimately had a very negative effect? A If you're going to regulate, you ought to regulate both the same way so they don't get into these mismatch situations, but in this case the spike in interest rates was accompanied by refinancing of the loans at higher interest rates that became higher than the yields they were receiving on the mortgage portfolio they owned, and because they were leveraged more than 10 times to one, sometimes 20 times to one, the rate at which capital was eroded was very rapid. Q And when you say, you know, you should regulate both the same way, is this similar to what happened in the California energy market? AYes, it is actually. I was going to think about it but I decided it was probably an unnecessary contribution by me anyway so why should I lead you to another thing that -Q So the regulators should have had a more sensible regime in place for the S&L's in the
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late seventies; is that fair to say? A Plenty of people have said so. Q Okay. Now you say in the second sentence of Paragraph 15 that, quote, This crisis ultimately cost taxpayers approximately $250 billion and was the most significant financial catastrophe since the collapse of9,000 banking and thrift organizations in 1931 to '34. Closed quote. The $250 billion number, where does that come from? loA Where did it come from? It's an 11 estimate that I and some others have used to try to 12 determine the actual cost to the Government of both 13 insuring the deposits and then receiving the 14 recovery subsequently. There are estimates of the 15 net cost that range from somewhere between 16 150 million and 300 million or so. 17 Q Billion? 18 A Billion. 19 Q Yeah. 20 A And I don't know what it really was 21 but frankly I'm not sure anyone else does either 22 because it's hard to know what all those recoveries 23 were and when they were received and how they got 24 accounted for, but that's our guess. 25 Q And just help me out. Why is it hard
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the S&L industry, it existed since colonial days and it was very distributed throughout the United States and had a lot of political support and this practice was tolerated up until the time when it became problematic. Q Well, and wasn't there a period of time where the Government regulated what the rates were on the deposits? A Yes. Q And so in that regard would there have been any interest rate risk back when the deposits were regulated? A Ironically, had they been restricted by these regulations, then nobody would have deposited their money there because they would have gone elsewhere to get their deposits at higher rates and as a result they wouldn't have made these loans. Or loans would have to be refinanced in some other way at the time. Q Now, did the Government also restrict the rates the S&L's could charge on the loans they made, was that also regulated? A I'm not aware ofthat. Q Okay. So the deposits were at one point regulated but the loans were --
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to know what was received? Because the receipts from loans and A real estate that was recovered by the FDIC and the OTS took years to work out of and involved interest charges and, you know, all kinds of things, so. 1 haven1t seen a clean accounting on it, and I'm not sure there is one, but some academics have studied it and they have made this range of estimates. And have you written on this, I mean Q this $250 billion number, is that -I haven't written about the number per A se, f've included it in things I've had to say about it, I didn't think it made too much difference if it was 200 or 250 million so I didn't bother to make a further investigation. Q Okay. When you did the calculation were you trying to basically bring it to present value and add on interest? No, this was meant to be the cost at A the time it was incurred. Okay. Q Most ofthose estimates were made at A the time rather than now looking backwards and then putting it in term at any time. Q Okay.
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we've talked about, and how it affected 90 percent of the S&L's by 1981 were losing money, and then in the last sentence you say, quote, The problem was exacerbated by accelerated deregulation of the thrift industry which permitted thrifts to diversify into non-home mortgages and other assets and by lagging ineffective regulators efforts by the FHLBB and the FSLlC which allowed thrifts to attempt to grow out of their problems without adding sufficiently to equity capital and accelerated deregulation. What are you talking about? A Starting with the 1992 Act -Q '82 [ think you meant? A '82, yes, sorry. Did I say '92? Q I think you did. '82 Garn-St Germain I think it was A called. Q Yes. Yes. A And then there were, of course, a little bit of piecemeal deregulation as they went along at the regulator, regulator level itself, for example, deciding on policies relating to goodwill. Q Right. But the idea was to let the S&L's A escape the problems they were in by attempting to
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But when we compare it to the A thirties, we take the 1930s number and adjust it for the present, for the money value in about 1990 which would make it more comfortable. Okay. And how much did that cost? Q A It came out the same as I recall. Q Okay. And the $250 billion, is that the total 198 J through, you know, 1995 number? A It's supposed to be. Okay. I note you cite a number of Q times to Mr. White's book. Have you found that generally to be reliable? I have. A Q Okay. And is it reasonable to assume -A Professor White is a distinguished professor of economics at the Stem School where I teach and he was a member of the Federal Home Loan Bank Board at the time that this was going on. His book on it has been regarded as a very authoritative
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compete in other businesses that they had never been in, Q And wasn't the idea also to try to get the healthy thrifts in to help the sicker thrifts? A To the extent there were healthy thrifts. I mean you're talking about, many of these thrifts weren't very much healthier than the ones they were rescuing, but yes, there was some effort to consolidate the thrifts on a basis in which the surviving enterprise would be less likely to fail than the one that was being rescued, which may not be a great improvement in the overall survivability factor, but that's what they were trying to do. Q And ifthe healthy thrift had positive tangible capital that it was bringing to the table then that would be a benefit to the insurance fund that now there's an additional buffer between it and the losses, right? A It could be, as long as it didn't deplete that capital by investing it in a vast amount of losses that were out there somewhere else. Q But even if those losses were huge and ultimately doomed the whole project, at least the Government would be better off for having had that tangible capital that the healthy thrift brought to
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the table; is that true? A Yes, but the healthy thrift might not enjoy the process if that took place. Right. Fair enough. Q Serve your country by dying for us, A not necessarily a strategy everybody likes to follow. Q Right. And the new types of lending
there? Well, yeah, I just was going to fix it Q but I didn't want to -You can say, I suppose you could say A it either way. If you prefer to say regulatory efforts, that would be alright with me, it means the same thing. Yes. Right. Okay. What are you Q talking about with respect to the Federal Home Loan Bank there, how was it lagging and ineffective? Well, it was my understanding at the A time, and partly based on my discussions with Professor White, that the regulatory population was quite small and it had been subject to some efforts by the Reagan Administration to, you know, cut back on government and budget restrictions and that the regular -- the inspections that were required to be made were often made late and that the reports of inspections took longer than they might have otherwise done until there was a general recognition that the thing was falling behind schedule and, therefore, when you're regulating something that gets in trouble and the time it takes to regulate them is widening, you're losing control of that part. Page 101
and assets that were pennitted, this was commercial
real estate lending? Those are the ones which we have A discussed, yes. Q Okay. And that was all part ofthe 1982 legislation? A Yes. Q And the regulators understood that commercial real estate lending was riskier, right? A They did. They did. But, you know, there were many things. Some S&L's engaged in a great deal of investment in junk bonds, for example, they're among Michael Milken's greatest clients were several junk bond -- or several S&L's. And there were some who took their right privilege to invest
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famous one in Arizona called The Venetian that failed. So in some ways it forced the S&L's to be yield chasers and to accept a greater amount of risk
in order to get a higher amount of interest income
so as to offset their other problems. Q They were yield chasers because they had these huge problems and -A They needed yield. Q Right. The only way -The only way they could get yield in a A sense was they were let out of the box and go get yield, okay, so we're going to get it from whomever we can and we like the ones with the most amount of yield and some of us were not able to tell the difference in the risk. Q And the reason they were in this profile was because they had huge negative tangible net worth and to get out ofthat situation they needed yield; is that right? 1 think so, yes. A Okay. Now when you say that there Q were lagging and ineffective regulatory-regulator -- is there maybe a typo, should that be regulatory efforts? A Is that the question, is there a typo
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And your basis for making those Q statements is Professor White's -Well, yes, but it was-A Q Okay. -- as far as my lmderstanding was A
concerned, it was pretty widely accepted, it was
generally known. Q Well, what about the FSLlC, same story? I don't know for sure -A Q Okay. -- whether it fits exactly in there or A not, but it was -- I don't know. Q Okay. Was the regulation of Carteret in 1982 in any way flawed through ineffective efforts? A I didn't detect any sign ofthat when I was looking at it. Q Okay. Did FIRREA fix the regulatory problems that you identifY in Paragraph 14? A I believe that FIRREA was an effort to tighten the regulatory standards because there was some concern about the extent of which the Govemment was having to pay for deposits, so they're insured by the Government, and that many
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repriced. Q And does that delay in disposal tend to depress the price? A It might. Q With respect to -A It depends. The delay actually might take the pressure off the market. If you try to accelerate the disposal and sell everything at once at any price anybody would pay, the prices would be perhaps lower, the sales at the lower price. So if you delay it a bit, you might be trying to keep some of the supply off the market so as to avoid having to take as big losses as you might otherwise have to do. Q And was that a conscious decision of the regulators the strategy that you were just articulating? A J don't know but J believe it was something they certainly had the ability to choose and consider as they went along. Q Okay. J mean, other than the nahrral fact that, okay, you can't sell these assets overnight, what's your basis for saying things were running late? A Well, I think that J was referring
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could have done. Q So you don't think supervisory goodwill was real capital? A I don't. Q Okay. Now, in terms of delaying tactics employed by well-connected S&L owners. A There's some anecdotal evidence of prominent politically connected S&L owners who were able to intervene with the Government to delay regulatory actions or postpone them or one way or another. Q Mr. Keating? A That's right. Well, his is among others but he wasn't the only one. Q Okay. But Carteret wasn't involved in that? A No. Q All right. Now, let's see. The regulators-A This paragraph, by the way, refers to the industry not to Carteret. Q Okay. And regulators were inefficient, what did you have in mind when you wrote that? A I think efficient regulators would
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principally to the fact that in order to force a disposal you had to have the information that enabled you to decide to do so, and if that
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5 reports or other reasons, then it would simply take 6 longer to know when to do it. 7 Q Now you say tlaccounting infonnation 8 was inaccurate because of specialtrealrnents allowed 9 by regulators," what are you referring to there? 10 A Well, J would be happy to use 11 supervisory goodwill as an example.
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Q When you say it was inaccurate, I mean, it was fully disclosed. A Well, that's true, it was disclosed, someone could look through it and make his own judgment. Q Right, so I don't understand how that would be inaccurate. A Was that a question? Q Is it? J mean, you think that the use of supervisory goodwill was inaccurate? A It gave, it gave a coloration to the financial statement that capital was present when it wasn't, real capital was not there, and that contributed to an inaccurate reading of it by some,
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have detected some of these problems sooner and been able to act on them quicker than they did do. We have evidence that many regulators detected them but as they passed the information up the chain of command to where the, you know, the authority to conduct actions occurred, they didn't result in actions being taken, they were either delayed or postponed or forgotten about it or whatever, and as a result the overall process of administering regulation to this industry became affected by it in such a way you could call it inefficient. Q Okay. Anything else you had in mind when you wrote that? A No more than that, J was making general statements about what I think are generally understood characteristics of the industry at the time which J derived from sources that J have looked at. Q Okay. Now you state that 55 percent of all S&L assets had been taken over by the RTC. Approximately how much in the way of assets are we talking about here, hundreds of billions? A Yeah. Q And was-A J don't know more precisely than that
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at the moment.
wasn't ready or did I have an opporttmity to engage
Q
Well, was it, were a lot of these
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in private equity investments of the sort that were
assets commercial real estate assets?
I assume that some were, I would A imagine the majority were not. Q What do you think the majority were? Mortgage-related loans. A Okay. But Carteret certainly wasn't Q alone in having commercial loans that went bankrupt? No, after 1982 many people followed A the perfectly permitted regulatory pathway to become engaged in commercial loan. 13 Q Right. Now you state where I wanted 14 to skip ahead to Footnote 18 for a moment and 15 explore a few thematic points that you've invested 16 extensively in financial service industry securities 17 and is that on behalf of yourself and your family? Yes, that's what this footnote refers 18 A 19 to. 20 Q Okay. Have you ever been engaged to 21 provide investment advice to anyone else? 22 A No. 23 Q Okay. And what's the largest 24 percentage of a financial institution you've ever 25 owned, I mean, have you ever owned more than 5
going on at that time, so the opporttmity never presented itself. Q Well, I mean, there were some publicly-traded thrifts at the time? 7 There were, but they didn't interest A 8 me at the time. The thing that would have 9 interested me, if anything, would have been the 10 opportunity to come into a private equity 11 arrangement that would do the sort of things that 12 Mr. Perelman and others have done that were very
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successful investments, but I didn't have an option
to do that, nobody invited me to join them so I -Q Right. A -- wasn't there myself in that industry, so it didn't happen. Q Okay. A But I could have. I mean, I have invested in banks before that are in private equity
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situations, so that these opportunities come from time to time.
Q
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When you say you've done it before, Not before that period, I've done
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percent?
No. No. Q Did you purchase stocks in any S&L's or banks in the period 1989 through 1992? A No. Q Okay. Why not? A I wondered if you'd ask me that A
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before now but not then. Q Right. Okay. So when did you first make an investment in a bank stock or thrift stock? Or let me rephrase that. When did you first make an equity
investment --
8 question. 9 Well, first of all, it was an industry 10 I didn't know sufficiently well to want to bother 11 with having to educate myself about it. 12 Secondly, I mean, it was a troubled 13 industry and in order to invest in a troubled 14 industry you'd have to know more about it than I did 15 and I wasn't willing or had the time to take to put 16 into learning about it, nor was I motivated because 17 I thought it was such a great investment opportunity 18 for me. So that's the answer to that. But I didn't 19 get access to my own capital until I left Goldman 20 Sachs, I had only small amounts of capital before 21 that, and so in 1988 I began to have access to my 22 partnership capital as it was returned to me. I 23 began to invest that in a portfolio of public and 24 private investments of various types. By then, 25 there wasn't much of an S&L industry left and I
In banks? A 8 Q -- in a bank or a thrift? Probably in 1991 and 1992 I bought a 9 A 10 substantial portfolio of bank stocks including 11 Citigroup and some others, Bank of America, and 12 those, you know, those rose in value considerably 13 from that time on. 14 Q Yeah, those were good investments, 15 right? 16 A And the reason I did it was that I had 17 just finished writing a book about the American 18 banking industry and how it had returned to some 19 assemblance of health after having gone through the 20 gates of hell in the prior years, the ones you 21 mentioned before with respect to Citigroup and 22 others who were in a, you know, on the ropes for 23 some years but recovered, and so as a result of my 24 research in this industry I deci ded that investing 25 in those banks would be an interesting thing to do,
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so I made the investment. Q And you did that in '91 and '92? Around that time. A Okay. Any other thri fts or banks? Q Not thrifts. A Q Okay. Well, I was invited onto a board of a A thrift with the intention that I would be given some stock when the company demutualized and became a public company, I considered it but I declined the opportunity. Q Okay. What thrill was that? It was Montclair Savings Bank in A Montclair, New Jersey. Q Why did you decline? I wasn't convinced that the S&L crisis A was over, I didn!! want to be exposed to any personal liability as a director, I just got my capital out of Goldman Sachs and I didn't want to give it back to some litigant. Q J won't take that personally. But was that a period oftime where the regulators really were going after directors, Neal Bush and Silverado? A Yes. At that time in general terms
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What was the geographic location? A It was a Florida S&L, thrift. I mean it was a thrift-like bank, I think it was actually a bank but it was indistinguishable from a thrift. Q Was it a startup? It had been a startup. A Q And was it a good investment? A Yes. Okay. And why did you -- how did you Q evaluate the opportunity to invest in that? I was approached by a good friend who A worked at Keefe Bruyette, which is one of the leading experts on bank reorganizations and recapitalizations, and I decided that ifhe was going to invest in it, then I could do too. I didn't perform any special due diligence, though I did carefully read the materials given to, me and then there was a, there was an incident when the bank lost some money on a loan matter which J investigated subsequently. I wasn't entirely a passive investor. Q Okay. So you tried to get to the bottom of why did this loan go bad and are there going to be more? A Yes. And I talked to the CEO about
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'89 or thereabouts, yes, there were those things going on. Q Yeah, and so it was a difficult environment? A Well, it was not considered a place for wise adults to go, so I didn't Q Okay. And with respect to the banks were there any other banks that you bought in '9J or '92? A Well -- '91, '92? Q Yeah. I think I just bought a series of A several banks, it was a portfolio of banks, and then I sat on it for a long number of years and then sold it down later, but I also have invested in private banks, startup banks. Q Okay. A You're going to ask me who was that bank and frankly I've forgotten, I bought it from a private equity into a private equity deal. It carne, it was -- it did its job, it got sold and I've forgotten about it. Q And what were the years approximately of when you were in that private equity bank deal? A Probably about five years ago.
things of this kind and I got a better understanding of it. Basically I thought they made a mistake, and they did. Q Okay. Now, when you were thinking about whether to do this investment, were there
certain ratios that you were looking at in tenns of
valuations? I mean, do you look at multiple to book that you were being able to buy in at? That was one of the multiples that one A looks at. Q And did you look at price-earnings
ratio?
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assets? A
Yes. And what other ratios, return on
Return on assets, yes. Anything else that was important to your decision? A Well, I like to look at performance indicators other than return on capital numbers such as the net interest income minus loan losses divided by assets or something like that to indicate it.
Q
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losses? A
I'm sorry. net interest income minus
Minus loan losses or charge-offs then
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divided by the asset, so what's the, what's the
revenue return on assets and compare that to some others.
Q And what's the difference between a loan loss and a charge-off? Maybe none. A Q Okay. I've never understood that. There's a lot of vocabulary in this A stuff that is not necessary but there may be a technical distinction but it basically means that
we're setting aside some of our income to cover our
estimate as to how much of the losses of -- how much the loan portfolio losses will be increased by. Q Okay. So now when you bought Bank of America and Citicorp? A Citicorp then, yeah. Q And do you remember any of the other banks that were in that portfolio? A I think Bank One was in there and
written off as much as it needed to be, so they would be able to come back to being strong and competitive banks again, which they were. There was also a very substantial
amount of management turnover and change in
toughening up that took place in those banks during that time. Almost every bank had totally new management which were devoted to bottom-line management in trying to demonstrate that they could, you know, make a high level of return on assets, which I believe was a principal benchmark retum, I'm going to go from something weI) below I percent to something close to two. Now that meant we had a different management approach and they were showing signs of being less interested in diversifying into too many other businesses than they had done before which suggested a focus on the main basics of the business which I thought was healthy. So they had learned a lesson from their mistakes and it seemed to be they had adjusted to that by management changes and other necessary steps. Q Okay. Now, you talked about the net
maybe onc more.
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But you can't recall right now? Not right now. If you do remember -It was ]5 years ago. Yeah. Okay. And these were good
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income minus loan loss over assets is one ratio, did
you also look at market to book? A Yes.
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investments) were they not?
Yes, I held them till the end of the A decade and they were a very good investment by that
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And why did you think they were good investments in '91 and '92? Because the best I could tell the pig A passed through the python. The loan loss problems which had held them back were being absorbed and digested and excreted and, therefore, the rest of the snake was com ing back to be, coming back into business again, and I thought that the prices of these places had been or had been knocked down sufficiently to not take all that into account, so I was making a judgment that the worst had been behind them and that they were going to come out of it better. I did some analysis of ratios and such but I was largely working on the kinds of analyses that I just described, the net income, the net interest income minus loss charge-offs divided by assets seeing the trends in that and what was evident to me was that the commercial lending business of these banks was very strong and healthy, credit cards and all those things, and that the quantity of exposure in wholesale lending was very small and pretty much
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And price-earnings ratios? Yes. Q And ROA? A Yes. Q Any other ratios that you would have looked at? Those are prominent ones most people A use when looking at banking values, there may be others if you want to drill down deeper you can look at. Q Okay. But those were the ones you looked at? I was particularly interested in A those. Q Yeah. Along with the one I just mentioned. A Q Yes, sir, right. Now you mentioned trends, so why were you looking at trends? A Why was I looking at trends? Yeah. Q A Well, trends are an indicator of the future, of what the future is likely to be, and a trend, of course, would be the ability to, you know,
Q
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before but also it was a trend in interest rates, a trend in the market for banking products and in industrial expansion. Remember, these were good years after the '91 recession, the industry improved. Q And then the industry started improving in 192? A I would guess somewhere around there. And there was a modest recession in '9], it was over by that, in that year and it took a little while for the rest of it to get going but, you know, the American technology and economic growth was very strong in those years and the banks were coming back to being main players in it, so that was the trend, the change from what they were to something they Were going to be in the future. Q Okay. Any other investments in banks that you've made through the years? A Well, that plus the Alliance Mezzanine Capital which is a private equity limited partnership which effectively operates as if it were a bank, it is an SBIC. Okay. Q I'm an investor in that company too. A Right. When you look at market to Q
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Q Okay. A Banks of course are changing as they become more involved with deregulated investment banking activities which mean a larger portion of their asset base must be mark to market than was the case before, so they are evolving into a different sort of species than what they were, but at the time of the Carteret matter almost all book values of banks were based on historical accounting. And there was no other way to do it because they didn't tell you what the, if you didn't think the reserves were adequate, you had to guess. Right. And so when you made your Q investment in Citicorp and Bank of America you were relying on the historical book values signed off on by the auditors; is that right? A Yeah. But as I recall, the market to book value was below one at that time reflecting the fact that the stock market had looked through what the historical accounting for book value was and it discounted it by some amount which it assumed to be the mark to market writedown. Q So the stock market was basically saying we think you haven't written off as much of your loans as you should have?
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book ratios, are you looking at the book value on a fair market basis or on a historical basis? A Well, there's some difficulty in looking at it in the future because you don't know what the future of value is. You can make estimates of earnings for the next several months, you could make an estimate for what, say, you know, 2008 will be and you could do your market to book by adjusting book value but you won't always get that right because there are many other things that adjust book value, so mostly book value is used in the current context rather than the forward-looking context Q And, I'm sorry, I might not have been clear, but I meant, you know, wben you talk about a market to book of let's say two, the book of the denominator, is that done on a historical basis or is tbere an attempt to mark that book to market as of the time you're doing the investment? A Oh, I'm sorry, you meant historical accounting as opposed to -Q Fair market value -A -- the clock? Q Fair market value accounting, yes. A It's generally done in banks by historical accounting.
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A Yeah, of course the stock market was just making an approximation and that's generally where it went to. Q Okay. But it was trading below book for a A time. Okay. When you make an investment in Q a bank do you try to think about franchise value too? A Yes. There are other intangibles besides goodwill. Q Okay. And what is franchise value? A I think a definition of it would be the value, the going-concern value of an enterprise taking into account the quality of its brands, its customer base, and the probability that it will continue to serve this market efficiently and well in the future. Q And in the banking industry a bank's relationship with its customers can be valuable; is that right? A Yes, it can be valuable, it doesn't necessarily have to be a great premium, I mean you may have a poor relationship with your customers. Right. Do you have an opinion whether Q
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branches that were sold in 1990, do you have an opinion as to whether those branch sales had any impact on Carteret 1s net income in '91 or '92? No. A Q Okay. Now, as deposits run off, does that generally decrease franchise value? 7 A Well, not necessarily, it might. 8 Certainly if you're having a run on the bank and 9 deposits are running off, people are worried about 10 you and therefore your franchise value would 11 disappear, but if you're simply adjusting for some
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But in tenns ofjust buying a Q particular branch do you think there would be a control premium with respect to a single branch? Not in theory there would be but it's A hard to say that one would make a big deal out of it. Q Right. A And particularly when branches are often sold for mutual accommodation reasons. You know, you may be required by a regulator to sell a branch or somebody may want a branch in your neighborhood that would be willing to pay you more for it than you think it's worth, those kinds of factors get in there, it's difficult to generalize and say that all branch premiums are a result of franchise premiums, though they might be. Q Okay. Do you have an opinion as to whether the branch premiums that were realized by the sale of Carteret's branches were related to franchise value? I don't have an opinion though I would A accept that it might be so. Q Okay. Do you have an opinion as to whether Carteret sold branches in 1990 because of the breaching provisions ofFIRREA?
reason or another, you have too many branches in
Morristown and not enough in Jersey City, you might switch and that could have no effect on it. Q Okay. Now when you were evaluating banks to invest in did you look at the dividends they pay? Yes. A Why do you do that? Q Money they're giving me. A Q What does the -A Part of the return that you get for investing in it. What would it tell you about a bank if Q it cut its dividend?
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I don't have a -- I haven't thought A that one out, I don't know that I could tell from studying it. What I do know is that they needed to shore up the capital base and they had to, to the extent that they could shrink assets and turn it into cash to improve the ability of the service to endure the loan offers they were taking would be the first priority. Is it reasonable to assume that the Q asset shrinkage that Carteret went through in '90, '91, '92 that's teflected in your Exhibit 3 was attributable to the need to raise additional capital? A That would certainly be a principal Okay. If not the only reason, it could have A been the only reason, but it was also clear that the bank was generally under-capitalized regardless of whether you count goodwill or not. Q With respect to the assets that were disposed of in '90, '91, '92 do you know whether there was a positive spread income on those assets? A I don't recall. Q Okay. Now with respect to the
A It would probably tell me that the bank had a good reason to cut it, principally that it needed to conserve the capital. Would it be cause for concern? Q Yes, generally. A Okay. And if a bank increases its Q dividend on a regular basis -A Excuse me, may I add to my last
I~
I!
answer? Q By all means.
A It would be cause for concern but it might also be a cause for concern if they didn't cut it. If I knew they were in difficulty and they were paying a dividend, I would consider that possibly to be irresponsible. Q Okay. So we have to have the correct A dividend policy, that's what we're looking for. Q Sort of like GM had a big dividend a few years ago? A Well, this happens periodically in big companies and they reduce dividends because they are going through some sort of transition and need to have to retain the capital. This was true for the American big banks that went into the trouble during
reason. Q
35 (Pages 134 to 137)
Alderson Court Reporting 1-800-FOR-DEPO
47e53.10-7c474318-b5ce-12d94.7e6f74
Case 1:93-cv-00531-LAS
Document 267-2
Filed 02/21/2008
Page 18 of 50
Roy C. Smith New York, NY
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B
October 16, 2007
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9 10 11 12 13 14 15 16 17 18 19 20 21 22 gains or losses on assets? 23 It depends what they're from. For the A 24 most part banks must now account for, I think all 25 companies must now account for so-called
the same time we're talking about. Q And if a bank increases its dividend on a regular basis is that a good thing? A Same answer, it's got to be the right dividend policy, not one that seems to be inappropriate. [fthere are many investment opportunities and they're instead paying out dividends instead oftaking those opportunities, you might want to wonder whether the management has, you know, a business plan that is consistent with what you think it should be. Q Okay. What's more important to you as an investor, a cash dividend or a stock dividend? A Well, a cash dividend is real money and a stock dividend, which is paid to everybody, it's just a form of dilution. Q Is a stock dividend just like a stock split? Yes. A Q Now as an investor in a bank what relevance do you or weight do you give to one-time
enterprise is made up by this source of income which comes from a different source than the main business
of the bank. Q Well -A If my business is lending, it ought to be where [get most of my income from. Q So in terms of -- [mean, Goldman Sachs they book a lot of profits from sales, right? Goldman Sachs i
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