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IN THE UNITED STATES COURT OF FEDERAL CLAIMS No. 92-550C (Judge Williams) ______________________________________________________________________________ NORTHEAST SAVINGS, F.A., Plaintiff, v. THE UNITED STATES, Defendant. ______________________________________________________________________________ DEFENDANT'S SUPPLEMENTAL BRIEF ______________________________________________________________________________

MICHAEL F. HERTZ Deputy Assistant Attorney General JEANNE E. DAVIDSON Acting Director KENNETH M. DINTZER Assistant Director Of Counsel: SCOTT AUSTIN Senior Trial Counsel MELINDA HART ELIZABETH HOSFORD SAMEER YERAWADEKAR Trial Attorneys TAREK SAWI Senior Trial Counsel Commercial Litigation Branch Civil Division Department of Justice Attn: Classification Unit, 8th Floor 1100 L Street, N.W. Washington, D.C. 20530 Telephone: (202) 616-0323 Facsimile: (202) 307-0972 Attorneys for Defendant

December 3, 2007

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TABLE OF CONTENTS Page TABLE OF AUTHORITIES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -iiDEFENDANT'S SUPPLEMENTAL BRIEF. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 I. Causation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 A. B. C. D. CalFed Is The Binding Precedent For Lost Profits Cases .. . . . . . . . . . . . . . . . . . . 2 This Case Is Conceptually Indistinguishable From CalFed . . . . . . . . . . . . . . . . . 3 Northeast Cannot Meet Any Causation Standard . . . . . . . . . . . . . . . . . . . . . . . . . . 4 The "Substantial Factor" Standard Requires a Showing that the Loss Would Not Have Occurred "But For" the Breach. . . . . . . . . . . . . . . . . . . . . . 6

II.

Northeast's Profitability Projections. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

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TABLE OF AUTHORITIES

Page(s) CASES Abbott Laboratories v. Brennan, 952 F.2d 1346 (Fed. Cir. 1992).. . . . . . . . . . . . . . . . . . . . . . . . 6 Bluebonnet Sav. Bank, F.S.B. v. United States, 339 F.3d 1341 (Fed. Cir. 2003). . . . . . . . . . . . . 8 California Federal Bank v. United States, 54 Fed. Cl. 704 (2002), aff'd, 395 F.3d 1263 (Fed. Cir. 2005).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim Citizens Federal Savings Bank v. United States, 474 F.3d 1314 (Fed. Cir. 2007). . . . . . . . . . . . 1 Columbia First Bank v. United States, 60 Fed. Cl. 97 (2004). . . . . . . . . . . . . . . . . . . . . . . . . . 6, 7 Fifth Third Bank v. United States, 402 F.3d 1221 (Fed. Cir. 2005). . . . . . . . . . . . . . . . . . . . . . . 5 Glendale Federal Bank, F.S.B., v. United States, 378 F.3d 1308 (Fed. Cir. 2004). . . . . . . . . . . 5 Hansen Bancorp. Inc. v. United States, 367 F.3d 1297 (Fed. Cir. 2004).. . . . . . . . . . . . . . . . . . . 8 J.D. Hedin Construction Co. v. United States, 456 F.2d 1315 (Ct. Cl. 1972). . . . . . . . . . . . 6, 7, 8 Krauss v. Greenbarg, 137 F.2d 569 (3d Cir. 1943). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6, 7 Krofft Entertainment, Inc. v. CBS Songs, 653 F. Supp. 1530 (S.D.N.Y. 1987). . . . . . . . . . . . . . 7 LaSalle Tallman Bank, F.S.B. v. United States, 317 F.3d 1363 (Fed. Cir. 2003). . . . . . . . . . . . . 8 Menne v. Celotex Corp., 861 F.2d 1453 (10th Cir. 1988).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Old Stone Corp. v. United States, 450 F.3d 1360 (Fed. Cir. 2006). . . . . . . . . . . . . . . . . . . . . . 5, 8 Point Productions A.G. v. Sony Music Entertainment, Inc., 215 F. Supp. 2d 336 (S.D.N.Y. 2002). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Shyface v. Secy of Health and Human Services, 165 F.3d 1344 (Fed. Cir. 1999). . . . . . . . . . . . 6

MISCELLANEOUS Corbin on Contracts §§ 992 at 6-7, and § 997 at 21 (1964) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

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C. McCormack, Handbook on the Law of Damages § 73 at 261 (1935).. . . . . . . . . . . . . . . . . . . 7 Prosser and Keeton et al., Prosser and Keeton On The Law Of Torts, 266-68 (5th ed. 1984). 6, 7

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS NORTHEAST SAVINGS, F.A., Plaintiff, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) )

No. 92-550C (Judge Williams)

Defendant's Supplemental Brief On October 24, 2007, this Court directed the parties to file supplemental briefing regarding the appropriate standard for causation "based upon the facts of this particular case." The Court also directed supplemental briefing identifying "those portions of the record which document profitability projections for Northeast from the time of the merger negotiations until the breach." Defendant respectfully submits the following brief in response to the Court's order. I. Causation The proper causation standard requires Northeast to prove that its damages "`inevitably and naturally, not possibly or probably' flow from the defendant's breach." California Federal Bank v. United States, 395 F.3d 1263, 1267 (Fed. Cir. 2005). We respectfully disagree with the suggestion, in Citizens Federal Savings Bank v. United States, 474 F.3d 1314, 1318 (Fed. Cir. 2007), that the causation standard may vary from case to case. Nonetheless, we first demonstrate below that this suggestion, even if correct, cannot apply to lost profits cases. Then we demonstrate that this case is conceptually indistinguishable from CalFed. Thus, it would be error to apply a "less exacting" causation standard than the standard applied in Calfed. Third, we show that Northeast's claim fails under either causation standard. Finally, we demonstrate

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that properly applied, the "substantial factor" standard is not less exacting than the "but for" standard. To the contrary "but for"causation is a prerequisite to a finding of causation pursuant to the "substantial factor" test. A. CalFed Is The Binding Precedent For Lost Profits Cases

Citizens Federal did not address a claim for lost profits damages. CalFed did. The appellate court in CalFed explained that the very nature of lost profits theories requires the trial court to award only those claimed profits that plaintiffs prove would have been earned but for the breach. 395 F.3d at 1267-68. This is necessary to ensure "that the nonbreaching party will not be awarded more than it would have received if the contract had been performed." Id. at 1268. It would defy logic to award Northeast "profits" that it would not have earned even if the contract had been performed. Such "profits" cannot possibly be termed "lost." They would be a pure "windfall." Consequently, the Federal Circuit explicitly held that such profits cannot be awarded. "The inability to prove by a preponderance of the evidence that profits would have been made but for the breach will therefore preclude recovery on a lost profits theory." Id. (emphasis added). The Federal Circuit's prohibition of lost profits awards in cases where plaintiffs fail to meet the "but for" standard is so clear and unequivocal, that nothing short of overruling Calfed can allow a different standard. Citizens Federal, obviously cannot overrule CalFed. Moreover, because Citizens Federal did not involve a lost profits theory, anything the majority of the Citizens Federal panel state or suggest on the subject of lost profits claims is simply dicta, and cannot be construed to overrule the Court's unequivocal holding in CalFed.

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B.

This Case Is Conceptually Indistinguishable From CalFed

Even if Citizens Federal permits the court to choose among causation standards, a position with which we disagree, and even if this ability to choose applied to lost profits cases, the only appropriate standard here is the standard applied in Calfed. In CalFed, the Federal Circuit considered the proposed "less exacting standard . . . that the breach need only be a `substantial factor' contributing to the loss," CalFed, 395 F.3d at 1267, and held that the trial court "correctly rejected the `substantial factor' test." Id. at 1268. Thus, even if the standard can vary based on the facts of a particular case, under the facts of CalFed it would have been error to apply a "less exacting standard." Id. As we show below this case is conceptually indistinguishable from CalFed. Thus, even if the standard may vary based upon the facts, the Court should apply the CalFed standard in this case. Northeast's claim is virtually identical to the lost profits model rejected in CalFed, where the expert "used a funding proxy in his model that repriced frequently because he knows that interest rates declined during the early 1990's. In reality, the bank thought interest rates were going to rise during that period, and would not have taken such a gamble." California Federal Bank v. United States, 54 Fed. Cl. 704, 708 (2002)), aff'd, 395 F.3d 1263 (Fed. Cir. 2005). Like CalFed, Northeast believed that rates would rise and would never have built a portfolio that admittedly loses money in a rising interest rate environment. Gov br. 10-17. Dr. Baxter, Northeast's sole expert witness, admitted that, even if Northeast had all of the goodwill, and even if it had leveraged the goodwill to obtain precisely the assets and the liabilities in his model, his model would have generated losses - not profits - absent a decline in rates. Tr. 942-45 (Baxter). Thus, if Dr. Baxter's model is utilized in its entirety and we change one and only one variable ­ assume that interest rates do not decline ­ the model admittedly 3

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would generate losses not profits. Tr. 942-45 (Baxter); see also DX 5037; Tr. 2634-36 (Thakor). In short, Northeast's model generates all of its alleged profits by placing a bet that interest rates would decline. Tr. 1778-79, 1869 (Fischel); Tr. 2634-36 (Thakor). This is because the liabilities in the model re-price much faster than the assets. Tr. 2167-72 (Bankhead). Thus, in a falling rates environment the spread, or difference, between the cost of the liabilities and the yield on the assets increases. DX 4001; Tr. 2152-54 (Bankhead); DX 5037; Tr. 2634-36 (Thakor). In the real world, Northeast believed that rates would increase, and its real world portfolio, designed consistently with Northeast's real world forecasts, was "well positioned for an increase in interest rates." PX 573 at 0433. Unfortunately, as Northeast observed in its business plans, "interest rates fell to their lowest levels in 30 years during 1993 and adversely impacted the company's business and profitability in several ways." DX 203 at 1365. Because the facts of this case are conceptually indistinguishable from CalFed ,Gov. Reply br. 3-6, the Court should adopt CalFed's but-for causation standard. C. Northeast Cannot Meet Any Causation Standard

The CalFed trial court held that plaintiff's claim would fail under any causation standard. CalFed, 54 Fed. Cl. at 713 n.18. As the Federal Circuit observed, "[t]he Court of claims stated that it would reach the same result regardless of which of the two standards was applied." 395 F.3d at 1267. Nor can it be otherwise. As the bank believed interest rates would rise, there is simply no possibility that it would continue to fund its investments with liabilities that will reprice very quickly and thus would become ever more costly as rates go up and result in losses based upon the bank's own forecasts. 54 Fed Cl. at 708.

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In Dr. Baxter's model, Northeast would have had to acquire on a daily basis liabilities that re-priced very quickly at a time when Northeast expected rates to rise. The liabilities in the model on average re-price within 18 to 41 days. PX 10 at 3805. The model also would have Northeast invest those funds in assets that did not re-price quickly and, thus, would not benefit from - and indeed would be devalued by - the anticipated rising rates. That is, the cost of the liabilities based upon Northeast's expectations would continually increase, while the yield from the assets, funded by those liabilities, would not. Thus, the model requires the no-breach bank to make a multitude of decisions every day that would have been counter to its own perceived best interest. Gov. Reply br. 32-37; Tr. 2587-93 (Thakor). Given Northeast's real world interest rate expectations, there is simply no possibility that Northeast would have pursued the strategy in Dr. Baxter's model. Indeed, as Dr. Baxter himself admitted, "you certainly wouldn't take risk on the other side of what you believed would happen." Tr. 983 (emphasis added). As no rational bank would invest in a portfolio that would admittedly lose money based upon the bank's actual forecasts, neither the "substantial factor" nor the "but for" test would save Dr. Baxter's model. Indeed, it was in the context of an identical model from the very same Dr. Baxter, that the Federal Circuit first advised that "given the speculative nature of such a damages claim, . . . experience suggests that it is largely waste of time and effort to attempt to prove such damages" in a Winstar-related case. Glendale Fed. Bank, F.S.B., v. United States, 378 F.3d 1308, 1313 (Fed. Cir. 2004). Gov. br. 1-2; Gov. Reply br. 2-6. The Federal Circuit felt compelled to repeat the same guidance when it examined an identical model in CalFed, 395 F.3d at 1270-71; accord Old Stone Corp. v. United States, 450 F.3d 1360, 1377 (Fed. Cir. 2006); Fifth Third Bank v. United States, 402 F.3d 1221, 1237 (Fed. Cir. 2005).

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D.

The "Substantial Factor" Standard Requires A Showing That The Loss Would Not Have Occurred "But For" the breach

The traditional causation standard in breach of contract cases in the Federal Circuit requires the plaintiff to prove that the claimed damage "was attributable solely to, and was therefore directly caused by, the [breach]." J.D. Hedin Constr. Co. v. United States, 456 F.2d 1315, 1330 (Ct. Cl. 1972). The "substantial factor" test, by contrast, originated in tort law to analyze concurrent-cause cases. See Keeton et al., Prosser and Keeton On The Law Of Torts, 266-68 (5th ed. 1984). Even in tort cases, however, the substantial factor test has not "replaced the need for each liable defendant to be a but-for and substantial contributor to the indivisible injury." Menne v. Celotex Corp., 861 F.2d 1453, 1461 (10th Cir. 1988). Moreover, the courts have made clear that, when the claimed damages could have resulted from multiple factors, the plaintiff "must establish that the breach alone would have been sufficient" to cause the claimed damage and that it would not have occurred "but for" the breach. Point Productions A.G. v. Sony Music Entertainment, Inc., 215 F. Supp. 2d 336, 341 (S.D.N.Y. 2002). The Federal Circuit requires application of both tests, even in the tort context. Shyface v. Secy of Health and Human Servs., 165 F.3d 1344, 1352 (Fed. Cir. 1999). Thus, the "substantial factor" test may only be applied in place of a "but for" test if doing so would "generally yield identical results." Abbott Labs. v. Brennan, 952 F.2d 1346, 1352-53 (Fed. Cir. 1992); Columbia First Bank v. United States, 60 Fed. Cl. 97, 105 (2004) (under the substantial factor test, plaintiff required to show that the breach "directly and primarily" caused the alleged loss); Krauss v. Greenbarg, 137 F.2d 569, 572 (3d Cir. 1943) (defining substantial factor to mean the "predominating" factor).

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Indeed, in Abbott the Federal Circuit observed that the "substantial factor" test is more rigorous than the "but for" test and further explained that "no case has been found where the defendant's act could be called a substantial factor when the event would have occurred without it . . ." Id. (citing Prosser & Keeton, The Law of Torts, 268).1 Consequently, precedent makes clear that the substantial causal factor test is no less demanding than the "but for" standard for determining causation as, even under the substantial factor test, courts require a plaintiff to show that the breach was the primary or predominant cause of the loss. Columbia First, 60 Fed. Cl. at 105 (under the substantial factor test, plaintiff required to show that the breach "directly and primarily" caused the alleged loss); Krauss, 137 F.2d at 572 (3d Cir. 1943) (defining substantial factor to mean the "predominating" factor). For this reason, there is no distinction between the substantial causal factor test and the longstanding causation principles applicable in this Court. For example, in J.D. Hedin Constr. Co. v. United States, 197 Ct. Cl. 782, 456 F.2d 1315 (1972), the court barred a claim for borrowing costs where the plaintiff's financial trouble resulted from both the breach and other

A concurrent causation issue was addressed in Krofft Entertainment, Inc. v. CBS Songs, 653 F. Supp. 1530 (S.D.N.Y. 1987). There, Krofft claimed that CBS breached a licensing agreement which caused Krofft to be unable to obtain financing to produce a Broadway play. CBS maintained that there could be no causation if it established that, even if it had not breached the license agreement, Krofft would still have been unable to obtain financing. The district court agreed. In addressing the law of causation, the district court cited C. McCormack, Handbook on the Law of Damages § 73 at 261 (1935), for the proposition that in a breach of contract case a breaching party's act or omission ordinarily can only be considered a "substantial factor" in causing the damage "where the damage would not have occurred `but for' the alleged wrongful act or omission . . . ." Id. at 1534. Similarly, the court cited 5A Corbin on Contracts §§ 992 at 67, and 997 at 21 (1964) for the proposition that "[i]t must be shown that but for the breach" the damages would not have been incurred. Id. "Corbin concludes that a plaintiff cannot charge the other party with losses and disappointments that would have occurred in the absence of any breach by the other party, since such losses were `not caused by the other party's breach of duty.' Id. 7

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factors, because "the proof is not sufficient to show that plaintiff's financial stringency leading to the borrowing of these funds was attributable solely to, and was therefore directly caused by, the improper termination." 197 Ct. Cl. at 782, 456 F.2d at 1330. Finally, under no circumstances should an award of damages place a plaintiff in a better position than performance would have done. Such an award would be an "unfair windfall." Old Stone, 450 F.3d at 1378. This Circuit has repeatedly reinforced the core causation principle that "the non-breaching party should not be placed in a better position through the award of damages than if there had been no breach." Hansen Bancorp. Inc. v. United States, 367 F.3d 1297, 1315 (Fed. Cir. 2004) (quoting Bluebonnet Sav. Bank, F.S.B. v. United States, 339 F.3d 1341, 1345 (Fed. Cir. 2003)). "Courts should avoid bestowing an `unfair windfall' on the plaintiff by compensating him or her above and beyond the losses suffered under the breached agreement." Id. (citing LaSalle Tallman Bank, F.S.B. v. United States, 317 F.3d 1363, 1371 (Fed. Cir. 2003)). If Northeast would have suffered the same "loss" absent the breach or if it would not have earned the alleged lost profits absent the breach, then any award would by definition constitute an impermissible "unfair windfall." II. Northeast's Profitability Projections Neither Northeast nor the Government ever contended that Northeast's profitability projections were an accurate or even a useful indicator of its actual or "but for" performance. Indeed, they were not. The projections state the underlying assumptions and forecasts upon which the projections are based. Northeast's assumptions and forecasts about the economic environment and future interest rates were consistently wrong. A look at Northeast's projections, however, is useful in demonstrating that Dr. Baxter's model is demonstrably wrong.

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By his own admission, Dr. Baxter's portfolio contains zero credit risk (the risk that borrowers will default on their loans) and thus suffers zero credit losses. "There are no credit losses [in Dr. Baxter's model]." Tr. 952 (Baxter). Similarly, Dr. Baxter admitted that his portfolio would consistently benefit from declining rates, because the liabilities are of much shorter duration than the assets they fund. Gov. Reply br. 1-2; 32-38. Nonetheless, not one of Northeast's plans and projections are based upon taking zero credit risk, because Northeast viewed credit risk as a means of increasing profitability. Gov. Reply br. 28-32. Further, not one of Northeast's plans or projections are based upon consistently funding longer term assets with short term liabilities in anticipation of continually falling rates. To the contrary, Northeast for much of the relevant time period expected rates to rise, and structured its portfolio accordingly. That is, it extended the duration of its liabilities to insulate them from the expected rise in rates, and it shortened the duration of its assets in the hope that their yield would increase with the expected rise in rates. Consequently Northeast's real portfolio, constructed based upon its real world expectations, suffered from the actual decline in rates. Gov. Reply br. 32-38. The recession and the decline in rates harmed Northeast. Dr. Baxter's hypothetical portfolio however, benefits from the decline in rates and is completely insulated from the recession. Dr. Baxter admitted, that Northeast did not expect rates to decline, and, in fact, the rate decline, that generates all of his alleged profits actually harmed the real Northeast. Tr. 92425; 954; 962; 988 (Baxter); DX 203 at 1364. Dr. Baxter further admitted that the recession, which "dramatically impacted" Northeast and caused it to suffer "exceptionally high levels of foreclosures and charge-offs," had no effect "at all" upon his incremental portfolio. Tr. 948, 962 (Baxter); DX 203 at 1364. Indeed Dr. Baxter testified as follows:

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Q. Now, we can tell here sir, that the things that happen in the real world that were very bad for the real bank were either extremely helpful or didn't affect your incremental bank at all, like the recession in the credit losses and the drop in interest rates. Correct, sir? A. That's generally the case. Tr. 962 (Baxter) Given these admitted facts, it is clear that Dr. Baxter's model bears no relation at all to Northeast's pre-breach or post-breach projections. In short Dr. Baxter's model, prepared with the benefit of hindsight, avoids all credit risk, escapes the recession without even one cent of credit losses, and bets heavily and successfully on falling rates. Northeast's real world portfolio, like that of all of its peers, was harmed by the recession. We now review and identify every projection in the record per the Court's instructions. 1. PX 66 (Kaplan Smith Special Study dated August 19, 1988). This is a projection by Northeast's financial advisors. That projection has no relevance, in part because it projects a growth rate that would result in Northeast failing its pre-FIRREA capital requirements. PX 66 at 4013. It is also inconsistent with Mr. Rutland's strategy. Gov. Br. 21-22. Finally, during most of the period, they project a return on assets (ROA) of less than 30 basis points. Dr. Baxter's model generates 81 basis points. Gov. Br. 4. Northeast's actual ROA was 2.7 basis point, a mere fraction of these estimates. Northeast's core earnings were negative. Gov. Br. 2-6. Northeast's peers also had negative earnings. Gov. Br. 7. 2. PX 67 (Kaplan Smith Special Study dated September 16, 1988). This study contained 7 options. Options 1-3 did not include profitability projections. PX 67 at 3111-13. Option 4 projected losses. Option 5 projected failing the pre-FIRREA capital requirements.

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Options 6 and 7 were premised upon the sale of branches, and the regulators refused to permit that sale. Gov Br. 21-22. 3. PX 146 (1989 Business Plan). This plan only made a projection for 1989. Moreover, a "key element" of the business plan was Northeast's strategy to "build a commercial lending capability." PX 146 at 0145. In contrast, Dr. Baxter's portfolio includes zero commercial loans and he admits that such lending would have resulted in losses because of its high credit risk and the recessionary environment. Gov. Reply br. 38-39. Moreover, the plan projected that interest rates would remain flat throughout 1989. Id. at 0169. However, interest rates actually increased significantly during the first quarter of 1989. DX 4004. In fact the "substantial change . . . in the level of interest rates" was one of the reasons cited by Northeast for revising the plan. PX 151 at 3430, 3432. 4. PX 148A (Three year Strategic Projections dated May 10, 1988). This plan has the same projections as DX 179 ("Revised 1989 Business Plan with 1990 and 1991 projections" dated May 15, 1989). These projections demonstrate the fallacy of Northeast's argument that shrinkage causes harm. The plans projected shrinkage from $7.9 billion in assets in March 1989 to $4.9 billion in December 1991. DX 179 at 3496, 3515. At the same time the plans projected that the profits would increase. Northeast's actual performance also shows the fallacy of assuming that reduced asset size leads to less profits. Northeast reported a net loss of $12.9 million in 1989 when its assets were $7.9 billion, and it reported net income of $13 million in 1994 when its assets were $3.3 billion. DX 285 Ex. 1. Again, a "key element" of the plan was to "build a commercial lending capability." Id. at 4078. In contrast, Dr. Baxter's portfolio includes zero commercial loans and he admits that such lending would have resulted in losses because of the high credit risk and the recessionary environment. Gov. Reply br. 38-39. 11

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The plan also projected a decline in rates in 1990, but both short term and long term rates increased throughout most of 1990. DX 4004. Moreover, Northeast's assessment of interest rates changed in 1991 when Northeast began to anticipate that rates would increase. PX 581 at 9025. Finally, Northeast projected very little credit losses. DX 179 at 3504, 3514. Its actual experience, however, showed significant credit losses. During the same period that the real world Northeast reported over $117.4 million in loan loss provisions and foreclosure expenses, Dr. Baxter's hypothetical portfolio did not suffer one cent of such losses. DX 3002; Tr.1787-88. (Fischel). 5. PX 151 (Three year outlook dated July 21, 1989). This plan has the same projections as PX 154 (July 31, 1989 Response letter to the December 1988 report of examination enclosing "revised 1989 Business Plan and 1990 outlook"). The plan projects significant shrinkage and an increase in profitability as the bank shrinks. PX 151 at 3434, 3441. As with all of its plans Northeast continues to underestimate the recession and its impact on its loan losses. For example it projected loan losses of $3.9 million for calender 1990 and 1991. PX 151 3442,3443. Its actual losses for fiscal 1991 and 1992 were $8.9 million and $10.2 million respectively. PX 12 at 0735. Subsequent to March of 1991, we can see from Northeast's documents that it expected interest rates to rise, and it wanted to protect itself from this expected rise. DX 3023; Tr.1875-81 (Fischel); DX 4007; Tr. 2172-83 (Bankhead); PX 581 at 189025. It did so by creating an asset sensitive portfolio, in which the assets re-priced faster than the liabilities. Tr. 2189-95 (Bankhead). In a 10-K filed for the fiscal year ending March 31, 1992, Northeast reported that, as a result of its overall strategy of originating adjustable rate mortgages ("ARMs") for its portfolio and selling fixed rate assets, the bank was asset sensitive (meaning that it had a positive 12

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gap). PX 23 at 7965. Consequently, Northeast's "interest earning assets can be expected to respond more quickly to changes in interest rates than its interest bearing liabilities, resulting in an increase in net interest income when rates increase and a decrease when rates decrease." PX 23 at 7965. Northeast continued to expect that rates would rise, and acted accordingly during the relevant time. PX 24 at 1832; PX 25 at 1563; Tr. 478-85 (Walters). This, is precisely the opposite of Dr. Baxter's portfolio which assumes that Northeast would have structured its portfolio to anticipate a decrease in interest rates. The remaining projections in the record are PX 332 (March 17, 1989 Financial Management Committee Meeting); PX 333 (April 21, 1989 Financial Management Committee Meeting); PX 211 (July 6, 1989 Response letter to the December 1988 ROE) and DX 181 ("Revised 1989 Business Plan"). Again, in each projection, Northeast predicts an increase in profitability as it shrinks. In contrast, Dr. Baxter's model assumes that shrinkage equals lost profits. In each projection Northeast, underestimates the effects of the recession. In actuality, as Northeast itself later reported, the recession, "dramatically impacted" Northeast and caused it to suffer "exceptionally high levels of foreclosures and charge-offs." Tr. 948, 962 (Baxter); DX 203 at 1364. Thus, while Northeast's projections cannot serve as a predictor of performance, they do show that Northeast's expectations, forecasts, and strategies were precisely the opposite of Dr. Baxter's model. Not surprisingly Northeast had consistently negative core earnings from the mid 1970s until it ceased to exist in 1994, Gov. br. 2-6, while Dr. Baxter's model generates $112 million in core earnings during a five-year period. Gov. Reply br. 9-13. We note that the Court directed plaintiffs to file any attachments to PX 1065, if such

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attachments were part of the record. We do not believe that the attachments were ever part of the record, thus the assumptions and underlying analysis upon which the projections in PX 1065 are based are not available.

Respectfully submitted,

MICHAEL F. HERTZ Deputy Assistant Attorney General /s/ Jeanne E. Davidson JEANNE E. DAVIDSON Director /s/ Kenneth M. Dintzer KENNETH M. DINTZER Assistant Director

OF COUNSEL: SCOTT AUSTIN Senior Trial Counsel MELINDA HART ELIZABETH HOSFORD SAMEER YERAWADEKAR Trial Attorneys

/s/ Tarek Sawi TAREK SAWI Senior Trial Counsel Commercial Litigation Branch Civil Division Department of Justice Attn: Classification Unit, 8th Floor 1100 L Street, N.W. Washington, D.C. 20530 Telephone: (202) 616-0323 Facsimile: (202) 307-0972 Attorneys for Defendant

December 3, 2007

14

Case 1:92-cv-00550-MCW

Document 181

Filed 12/03/2007

Page 19 of 19

CERTIFICATE OF FILING I hereby certify that on December 3, 2007, a copy of the foregoing "DEFENDANT'S SUPPLEMENTAL BRIEF," was filed electronically. I understand that notice of this filing will be sent to all parties by operation of the Court's electronic filing system. Parties may access this filing through the Court's system.

s/ Tarek Sawi