Free Motion to Strike - District Court of Federal Claims - federal

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EXHIBIT B EXPERT REPORT OF DANIEL R. FISCHEL PX 245

MOTION OF PLAINTIFF TO STRIKE TESTIMONY OF DANIEL R. FISCHEL

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REPORT OFDANlEL R FISCHEL I. QUALlFICAnONS
1. 1, Daniel R. Fischel, am Director, Chnimun d President or

Lexecon Inc, a consullmg 1 mne 1 I p s c

.

.

vPriety of legal and regulatory issuer. 1 a also the Ln md B m a Frcunan Rofe~sor r m o

Law and Burinerr at The University o f Chicago Law School. 1 haw sewed previously as

Dean o f l h e University o f Chicago Law School Dimor o f the Law and Economics
Rognm at The Univen~ty Chicago Law School, and as Profasa of La* and of Business at The Univnriry ofChicago G d u a t e School of&lsincs.

2.

Both my research and my teaching have conecmed the economies

corporalc law and financial markets. Ihave published approximately fifty articles in

b

leading legal and efonomicsjoumls and am coauUlor. with Judge Fnnk Eawerbmok of the Scvcnrh Circuil Couri of Appeals, ofthe book Ths Economic Stmture o f C o m t e

LE (Haward University Press). Couns ofall levels, including the Supreme Coun ofthe
I Irtitcd States, havc cited my ariicks 8s authoriet~ve.&.=&~Ccntral

Bank v. Fint

lntcrnace Bank, 114 S. Ct. 1439 0994); Basic lnc. v. Levinson, 485 11 S. 224,246 n. 24 (1988); and Edear v. MITE Cm.. 457 U.S 624.643 ( 1 982). M y curriculum vitae, which contains a list o f my publications, isattached herno 8s Exhibit A.

3.

1 havc served as a consultant or adviser on economic issues to.

atllurag others ~ h c United Stales Securities and Exchange Commission. The National Association ofSccurilies Dealcn. the New Yo& Stock Exchange. the Chicago B w r d of Ivade. the Uni~ed Slates Dcpanmcnt of Labor. the United States Dcpanmcnt of Justice:

EXHIBIT
- .

.

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the Federal Deposit lnsunncc Corpontion, the Resolution TNSI Coqmation, m d thc

F e h l T n k Cornminim.
4. 1 a a member of lhc Amcriun Economics Association md the m

Center for the Study of the Economy and the Slate a( The Univcnity of Chiigo, and formcr Chairman of lhc American Association of Law Schoob' W i o n on Law and
Economics. 1 have t c s t i f i as an expal whncss in multipk pmccdmgs m fcdcral and

state courts across the country, as &ailed in Exhibit A.

n.

INTRODUCTION AND SUMMARY OF CONCLUSIONS
5. Norlhcasl Savings. FA. (YNolrhcasl"w "the Associalion") was

formed in March 1982 when The k h c m n a d y Savings Bank acquired HvtrMd (Connecticut) Federal Savings & Loan Association i n s supmisoy mcgcr. Complainll
3. Northeast recorded approximalcly SI08,951,000 of supervisory goodwill as a rcsuh of

*c aquisilion oiHanCord.

u 139. ,

In October 1982, Northas1 acquired Freedom

Fcdwl Savings k Loan of Worcester, Massachusnts ('Fncdom Federal'? and Fim Fcdcnl Saving & Loan Association ofBonon, Msssachuretts ('First Federal"') in supnviswy tranwclions.

M, 13.

Northeast recorded $163,330,000 of supervisory

goodwill as a msuh oflhe acquisition ofFrccdom Fedml and 517,738.000as a result of the acquisilion of First Federal.

u.,1 6 7 . Nonheast also issued S5O million of Income
Id.,

Capital Cenificslcs ("ICCs") lo the Federal Savings and Loan Insurance Corpwation ("FSLIC") in connection with the acquisitions of Frecdm Federal and First Fcdenl.

n49.57

70.

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6.

In 1983, Nonhean n n v m c d from muhsl to stock form; it sold

over fin million sham ofunnmw, sta'k to dcpositw, ocbcr m a,

and the gcncnl

plmlii a the time of thc canvas-m. C o m p l s i 173. In 1985, Notlhcaa r a i d rn
m m s
-rs-0 e v o

rrock lo the g m l public. 1P I n March 1987. Nmheat and chc FSLlC agreed to a
tnnsaaion i n whim Noflhwt exchanged of 1 2 million shares of cumulative p r c f e d sock (the "FSLlC Rcferrcd St&") and cash for the ICCI &Id by thc FSWC.

M, 74 n

& 75. 7hc FSLlC Preferred Slock was recorded on Norlhcad's bodu as capital in the

7.

7hc Financial InstitutionsReform, Raovuy and Enforcement A d

of 1989 ("FIRREA") was enecled on Augun 9,1989 to rrsolve the thrif! industry crisis.

C

Among Mhcr things, FIRREA changed the regulalay capital requimncnts and mriMed

the caent to which supervisory goodwill and other typn of intangible capital eould bc

used tor regulatory opilal purposes! Plainliffs claim that these pmvisions o f FlRREA
and ihe implcmenling regulations breached thcir urntract with the United States.

8.

O lanuary 8. 1990. N o r l b s ~ a apiral plan with the On.as n filed

rcquind by FIRREA and OTS inkrim capital requirements (~he"Capital Plan"). Complaint 193. The principal clcmems orthe Capital Plan wtre (1) a reorganization into
a holding company struclurc; (2) a mduction in Nonheau's tMal assets; (3) the

conversion oCSSOO million in residential mongagc loans lo mwcgage-backedsecurities;

and (4) the cnhanccmcnl o f core capital lhrough relaincd earnings. &.' By ils lencr
I The rclcvanl provisions o f FlRREA and i s implementing regulations are described i n .

Complsinl fl 77-91. 2. 'Ihc reorganizationprocccdcd as follows: a newly-formed holding company, Nonhcasl Fcdcral Corp. CNFC'' w 'the Company") issued i t s stock to the owners of Nonheast in cxchangc for thcir Nonheas~ common stock. and issued its cumulative

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dated M u c h 9,1990, as amended by its kncr dated March 22,1990, OTS conditionally approved No&rd's Capilal Plan. l , g

194.

NmheaS -fully

impkmated i*i

Capi~al Plan and u m c into compliance with the tkn current capiul ~ u i m m c n i in July s 1990.

In tg 9s-w.
9.

In hi repwS PlaintiRs expert,

D .Ncvins D. Buter, has r

purported to u k u h l e "thes o w and amounts ofdamages suffered by Northust as a

result ofthe breach o f wnrraa." Expert Rcporl of Dr. Nevbrr D Burtcr, A u g W 19. .
2003 ("Baxtw Repwt"), 1 3 .

Dr.Baxta uses '(t]wo altcmalive methods

...l o cahk

cxpcctancy damages."

u.. 15. 'Ihc h

t method purportedly nmsura "the a d d i t k d

pfi that Northeast would have earned had it had L e benefn o f its bargain whh che

Government and retained ils promised regulatory upilal."

u.A d i n g to Dr.Baxtcr,

chc principal components o f l h c x dunages arc: (I) los( p f i from chc shrink i n thc
earning assets that he claims was a direct conscqucncc o f ihe alkged breach ofwnlmct, which he estimates to bc $1 12.352 m i l l i i (2) the cou ofraising additional capital i n connecrion with the acquisition o f certain branches md deposits frwn failed credit unions
in Rhode Island. which he cstimalcs lo be S 15.609 million (adjwed for taxes), and (3)

incidental or wounded bank damages o f $1 1647 millin.

u. Dr.Baxlcr claims that thc
value o f "the

damages under this melhod Iota1 $129.607 million.
10.

u, W5 & 66.
u.,

%K

C O ~ ~ method purpwtedly measures the

regulatory crpilal that war lost by Northtosl as a dim! consequence o f lhc breach"
16. According to Dr. Baxtcr. damagcs under !his method total S75.833 million. or

S 122.906 million adjwted for ~axes.

u.

p t f e m d slock in cachange for the Noahcast curnulalive prefmcd held by the FDIC as successor to the FSLIC. Nonheasc Federal then contribuled the Nonhcast cumulative preferred stock to Northean, which resul~ed common equity a! the in Nolthrssl level, includabk in core and tangibk capital under OTS regulations. Compbinl 98-99.

n

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11.

1 have been asked by II DcpPrtmenI o f lustkc lo analyze (hcsc IC (he mstnials

claims. -Lcxaon's pofcsthl staffbu w i s e d me. Exhibil B idatif-

tba m have reviewed. As a rcsuk o f l h i m i e w and analysis, 1 have rrsfhcd ihc

.

D.Baxkr's r

calculatiarr of "lw profib"damages att based ona h speculative and implsuribk assumplion%

a of

If Northeast had wanled to hold additional whoksak arscu,or bcr on doclining i n t a r s mt*r (vhiih i lhe c n u o f Dr. Baxter's '1051 profits" s damages calculation). I cwld have done so.

D.Baxtcr's calculalion o f (he pui-pared value o f lhc b s l rcgulatoly r capilal is incorrect.
1elaborate upon and explain the bases for lhcsc conclusions in h e maindcr of this report.

111.

DR. BAXTER'S LO= PROFITS DAMAGES MODEL IS BASED ON A SERJES OF SPECULATlVE AND IMPLAUSIBLE
~

ASSUMPTIONS
12. N m During the period horn Sepccmbcr 30. I989 l o March 31, 1995,

t repolred curnulalive pretax, pm-amonization, prc-accretion income o f no more

than $16.5 million? I n fact, however, Northug was unpmfilable a,an operaling basis,
bccwsc its rcpwted income included sppmximafely $45 million i n gains from the uk o f

assets. Ncvenhclcss, Dr. B m m claims that i n the absence of the alleged breach.
Norrheast would have earned an additional $1 12.352 million i n pre-tax profils during (his period. In ordcr l o lurn lhc unprofitable "actual bank" into lhc profilablc -'but-for bank"

3. The $16.5 million figure may ovmlale Nonheasl's cumulative pretax, preamoflization, pre-accmlion income bcesux i t includes whelcvcr acerelion income Nonheasl recognized during the 1994 and the firs( quancrof 1995. (We wcrc unablc lo d c t n i n e the amount o f accretion income Nonheart recognized during this period because accrrtion income was no1 sepmlely wportd on the Thrifi Financial Repons during this pcriod.)

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(ir., Noctbcut absent the alkgcd breach),

D .BWcr had to make a series of.ssumptions r

a b m what would havc occumd in Ihc hypothetical, m b r e a c h rznuio. I n pertienlar,

Dr. Ihxtcr rrsumCS:
i. Thc but-for bank would havc had tots1assets ofS6.9 b i l l i thrwehout r k p~riod rr~m scptmba 3 0 . 1 ~ 9 ~ c c c m k 31,1993, ud (ha,rcdu~ed (o r ilr total SSCIS by about5600 millioo. Repon 394.)

n

ii.

The assumed "fivegone" clsxls would have ben, whoksak uscts.
42-43.)

U..fl

ii The assumed foregone assets would have b e m fmancul by Jhwc-tm i.
wholesale liabilities. @jv142.) iv.

Thc ~UI-fa would have been able to use all ofits supmiwry goodwill bank as rcgulrtory capid, but all other thrih would have had to operate undcr FIRREA's capital r c q u k c n t s without any forbearances. (Baxter Dcp. Tr.. 38322 - 3893).
Measuring lost p m f i with a whoksak spread is conwrvativc. (Baxlcr RepoR 144.) Thc but-fa bank would havc WM the samc amount ofconsumer loans at the samc time that the actual bank wld iu consumer loans. @ 147.) J ,

v. vi.

vii.

Thc but-for bank w w M have suspended dividend p a y m u on iuoutslanding prefcmd and common stock n the samc time thw the actual bank dd i. Exhibil6; Baxta Dcp. Tr. 434%-18)

m..,

viii.

Thc but-for bank would have securitized thc same luans at the samc times that the actual bank securitized its loans. (Baxter Repon. Exhibit6; Bsxler Dcp. Tr. 432:20434:7)

ix.

The but-fw bank would have acquired cmain Rhodc Island credit union branches in May 1992 on esxnti.lly the same l m n s ihat wtual bank d d bu~ i, the but-Tw bank would not have sold $35.2 million o f p f e m d stock as pad ofthe transactions. (Baxtn Report, 1 58.)
The but-rw bank would not have incurred the coas ofthe financial advisory services associated with II shareholder rights ofl'ering that Nonheasc setually IC considered. bul did n a complctc, in the s u m m of 1993. 160.)

x.

a..

xi.

The but-for bank would have been wellcapitalized at year-end 1992 and

remained M a1 all tima.

m., 161.)

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xii.

Shawmut National Corporation would have acquired the but-for h n k at qpmxirnsldy the same time thrl it acquired thc m r l buJr 134.)

u, .

No one could know to r rworublc degree o f ccNinty wlmt (hc but-for h k m ihave k
done in all oflhcsc

For (hi mason a l q D.B.xxtm's lDSt profits r

model is speculative. I n the rcminder of this section. I dePuibe many ocher reasons ;why

Dr. Baxter's b l profie damagu model is spceulalive and implausibk, and why his ksl s
profib dsmrya alculstions are inanroct.

A.

asuna~tiw mardime
13. As n o t 4 above, Dr. BPxter's lost profs damsges model assumes
-

1 . II h - f o r bank would have hsd tolal assets o f 56.9 billion throughout the period h1IC
f -

September 3 4 1989 to December 31,1993 (and lhm would have reduced ie tolsl This assumpion is implausible for at IenM two B.

c

asxls by about t600million).'

0

Fim, it is inconsistent with Nor(hear('s prc-bmch business plan. I n iurevised 1989 Business Plan, dated May 15. 1989 (which assumed "regulatory forbearance o f supervisory goodwill'?, Norlhusl projectedthat it would rcducc its size fmm $8.0 billion

in total assets as o f June 30, 1989 l o S6.8 billion in total asses by December 31, 1989 and
S4.7 billion in total asscts byDecember 31. 1990. &Northeast Savings, F.A.. Revixd

I989 Business Plan with 1990 and 1991 projeaions, May 15,1989 ("theMay 1989 Revised Business Plan"), a15 8 15.' Dr. Banter assumes that the but-for bank would

4. Dr. Baxtcrrlsa provides %parate calculations o f t k ponions orthe purpor(cd lost

profits associated with thc approximately S I billion reduction i n size that occurred i n wlcndar year 1991, and the k t profils associated with the divencd assets fmm what he refen to as ?he 1989-90shrink' and "thc.1991 shrink." See B u t n Repac, 52. 53 & ~xhibils 10-12. Since these calculations arc h d on the same Ion profits dmages model, the points discussed in ihc 1 ~ xalso apply to these calculations. 1 5. In its original I989 business plan. Nonhcaw had projected that it would have approximately S8.l billion in total asscts throughout 1989. N o n h e a Savings. F.A.. 1989 Business Plan. Deccmkr 1988, at 17. Norihcsst revised the business

n

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have hd far more asscIs.

Exhibit C (comparing Dr. Butcr's size projectionswith

chc projections o f the May 1989 Revised Business Plan).

1. 4

SeconQ D .Banter's size assumpion ignores dK unplanned r

lanuary 8.1990 The Cs&l

Plan (whiih took h e phnsc-out of supavisory goodwill

into account) projected Bat Nonhcast would inause its Mtsl assets from $5.1 billion as ofMarch 31,1990 m $5.7 billion as o f December 31,1993. SpS, Nodhest Savings FA, Capital Plan. January 8.1990. Scctionll, at 7-1 1. However, due to various factors, including severe ruxsiom in Nonhesst's market mas, and the adoption o f lhe Fedcnl Deposit Insurance Cocpontia, Act o f 1991 ("FDICIA"), whieh contained higher capital standards for thrifts. Nonhem instad reduced its total a u a s to $3.9 billion during chis

paiod.

I t is 'mplwsibk

to assume that the but-for bank wculd havc maintained its s-bx

during this period (as Dr. Barter assumes) when the actual bank reduced its s i z for reasons other than the alkged breach. Exhibit D illustrates this inconsistency by comparing the actual changzs inNorthfast's total assas with the assumed changes in the total s W s o f D .Baxtu's but-for bank during this pcriod.b r

plan in May 1989 "in light o f the new capital requirmmts contained within" FIRRW. May 1989 Revised Business Plan. at 1. In July 1989. Nwtheast further rcviscd its business plan; this revision projected that total arscts would drclimc more rapidly (il projected S5.6 billion i n total assets at Dcccmkr 31. 1989), but not as much overall (it projected 55.2 billion in total assns as o f Dceemkr 31. 1990). 6. Nonhcan also reduced its total assets by approximately $600 million in 1994. Dr. Baxler assumes that the but-for bank also wcvU havc reduced its total asses by this amount bcclusc i h c 1994 reduction in size i s not a conwqumcc orlhc breach.'. Barter Repon, 140. This rationak also i s inconsistent with Dr. Baxar's assumption that the but-lor Bank would have maintained its size during the period from March 31, 1990loDee~nkr31,1993.

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15.

The behavior o f ocher UlriRs also doa not suppMI L.B u l a ' s k

m u m p i o n that thc b u t - h bank w w l d have maintained i size han September 30. U 19W through Dcamba 31,1993. Many other large lhrih ha^ wac fully capital I1to nvcl the regulatory capital m)ui-tS) also r e d 4 their total a. s% s during this period.

&FXhibit E.

B .

p a c u r n ~ t i w b w t #becommi(iol: orlhe m u w d brtlonc a 16.

As noted above, D .Baxtcr a l w assumes Iha~ additional r the

'*foregone? assets that he assumes Nolrhcuc would have had wwld have been whoksak

I n his model, the bm-for bank's whokwle arras incruse horn $4.52 billion as o f
Seprembcr 30,1989 lo U.16 billion as o f March 31, 1995, and the but-for bank's retail arras decrease from $2.06 billion as of Scpernber 30,1989

co $0.79 b i l l i i as of March

31, 1995. B u t e r Report, Exhibit 4. The assumption that all o f the assumed foregone
wouM have been wholaale assets is fundamentally incomistent with both

Nonheasl's busincss p h and its actual behavior.
17.

To begin with. on October 14,1988. Northcasl publicly announced

that its chairman and chief executive oacer. George P Rutland ("Rutland") (who had .

joined the bank as its new chairman and c h i i f execu~ivc offier in ;uly 1988) had
direelion for the company. formulated a new ~Wtegic

& Exhibit F. The key elements

of the new c o r p o ~ e slntcgy included rebuilding the company's I a n origination network (which wwld include a newly formed commercial loan business and a consumer loan business), originating rather than purchasing loans, and substituting originated assets for assets prchascd in wholesale markets.

Id.

As pan o r ~ h c corporate straegy. new

Nonheaw expanded its residential mongage lending oprstions lo scwc markets in

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s w k C a l i f m i % LMlg Islmd, New Jcncy and w h Conmcticuf end formed a st w r m
commercial lending p u p to make commercial rnongagc loans. &Northeast Savings,

FA, 1989Business Plan, Dcccmkr 1988 (the''0rigid
P

1989 h ) & 4-6. "a I ,
p

..
new purrhaws" ormwlgagc-backed securities ('MBS").

ad

Sq Origins1 1989

pba, M 12 & 13. And even though lhis plan pojcctcd no ovenll change in size, thc plan
projded that Nwthusl w w l d during 1'989.
iU whoksak assets a d in-

its retail aa*s

Id.,at. 18. .
18.
The May 1989 Revised Business Plan also w l k d for% loan

pathrces" and "no new purchswf' o f MBS. May 1989 Revised Business Plan, a 14 &
15. This plan projccled lhal Noriheast would
iljholdings of whoksale lsws

substant~lly, (fm $6.18 billion as ofMarch 31, 1989 to $1.26 billion as ofDcconbcr

b

31. 1991)and icsEs ia retail a w l s wb~antinlly (fmn $1.38 billion l o $3.34 billion rt thesame time). But, Dr. Bsxlcr's model assumes the cxaa opposite. Exhibit G.

Similarly. NorthCdR'S Capital Plan projcclcd that chc Association's retail assels would incruse substantially and that its wholcsak asscts w w l d decrease subslantially during the period from Much 3 1,1990 to Dccembcr 3 I 1993; whereas D .Baxter's model , r assumes that the but-for bank's relail and wholesale asset levels w w l d barety change during hi period. 19. Erhibil H.

D. Bar~er's r calculalions also assume tha~ none orthe assumed

facgom asscls would have been rnail assets. Bul, Nonheasl c l i m i ~ l c d consumer its and commncial knding opcralions, and reduced its msidcnlial lending operalions only
haw it was capiul constrained. I n panicular:

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.

Aflcr completing x v e n l bsmrctionr in early 1989. the Company decided no( to punuc m m a e i a l real cdale knding activities unlil the capiul requirements ~CCMK cieam. @ NmihcaS Savings, F A " 10-K f w the fiscal year mdcd M d 31,1989. at 16, .ndNorrhan Savings, FA., Bard Minutu, May 19, 1989.81 3.)

The company mv1StO 111 capital requirement by reducing its lending and invcslmnl sdiviiies that would require higher capital kvek." Therefore, WIG revised FY 1990plsn callled) for a rodudion in commercial and consumer knding" 4 "the sak ofthc Associslion's home cquily mdil l in ihc t plu(a of 1989." (tblk& i m Savings, FA, 1989 Businus Pbn Rcslatcd fa the F i i l Year Ending Murh 31.1990wirhaFiralYur1991 Oul10d(.OdokrIl. 1989.9.1-2,)

Y .

.

She Company sold appoxirnslcly $251 million in uw loans during the r m second half o f f-11990, and 513 million i n comumn h s during f i l
1991. (?4onhca.d Savings Monthly Financial Highligh~s the months Occobcr for 1989 thmugh March 1990, Northurr Saving?., FA., 10-K for the fiscal year ended Mlreh 31,1990. at 10 & N o r t h s t Federal Cwp, 10-K for the fiscal year cndodMarch 31. 1991.a17.)

&

The Company decided no( looriginale any new cornmcrcial loans during fiscal 1991 m future y u r r dw primarily to the stringent risk-b8.d capital requirema& (Northeast Savings, FA., 10-K for ihc fiscal year cndcd March 31, 1990, a 8.) 1 'The Company eliminated ils consumer loan origination unit in August 1990. ( N o r i m Federal Cwp., 10-K Tor the liscal year ended March 31, 1991, a 43.) t The Company "needed lo slow its midential mortgage origination volume in the sceond quarter [of fiscal yur 19901 d w to the anticipakd new capital regulations under FIRRU!' (Northeast Federal Corp, 10-0 for the fiscrl qvsncr cnded September 30, 1919. a! II).

.

She Company reduced ia residential mongage loan originations during r i l 1992 and 1991 primarily d w l o the capital constraints imposed by FIRREA wd the redudion in the asset sire of the Association (Nonheas~ Federal Corp.. IO-K for the fiscal ycar ended March 31. 1992, a1 63).'

7. Northeast's singlc-famijy residential loan originations decreased from approximalely 51,015 million in fiscal ycar 1990 l o 5768 million in fiscal ycar 1991 and S442 million in fiscal year 1992. (Northeast Savings. F.A.. IO-K for the fiscal year ended March 31, 1990, al7, Northcast Federal Cop., IO-K for the fiscal ycar ended March 31. 1991. at 5 B Nonhcast Federal Corp, 10-K for the fiscal ycar cnded March 1992,

at 5.)

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The bubfcr bank would have had moft regulatory capital. M m , k is likely that the
forcpne rcs& if my,would have includedm a i l apdr
20. I n fact, Dr. k l a wn&

ihrc 'he but-fa bank wwld have hd

144. D . Banter provides no suppac for t i m i o n an4 in nny event, Norrheast's r hs
dilbanking was not profitahk. Due to severe recessions in New Engbnd and
California, Northad had substantial increases in non-performing m c t s and e d i t lossa during the relevant period.

& & NOTthcast F h l Corp., 10-K for the fiscal year
Exhibit I Exhim J. I n fact. because and

ended December 3 1. 1993. at 18. Also.

Nonhcast's Califomia knding open~ions mn so unsuccessful, N o d m s i completely

I

shut down is California loan origination network in Febrwry 1994.

WOT916 0674 As

and -NorrheaS Federal Cap. IOQ lor the liscal quarter ended March 31, 1994, M 6.
nottd above, Nwtheast's curnula1ive income fmm operations during the period from

Scpembcr 30. 1989 lo March 31, 1995 was negative, even h g h N o r i h u n held both retail and wholcwlc asses. I f D .Baxter's assertion thal the whoksak assets were r profitable invertrnents i s t ~ ethcn this implies th.1 Nmhcaw's retail assets were , unprofilable. Therefore. Northensf presumably would have beat kss profitable, not more, if it had originated more (and riskiir) retail assets during this period.
C.

Assumulions reeardint the urofitabilitv otthe a a r m c d lorcronc assets
21.

D. r Baxlcr assumes that the spread thc but-lor bank would have

earned on the assumed foregone owes in each period would have been lhc same as the dificrence between (a) the weighted average inrerest rate that Northean received on ia

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actus1 wholesak m, @)theaverage intmst rate that Nonhcad p i d on ils actual and whoksalc liabiliiin (which Dr. Baas recognizes wtrr principally shortlam M L B advances and mpunhase rgrwmnts) in each paiod. Baxlw Rcpon, ( 4. Bsxler implicilb assumes that the Pnumcd foregone s~4erm whoksale liabilities.' Thex .ssumptionr are implausible for i c v m l masons.
22.

T w Dr. h.

Fi, NOrltKIS( was nol using whoksak liabiliticsto Iinpncc iu
the amounts o f wholade W Norheart held always g m t l y
K. Mwrover, there is

1

w h o l s k -1s;

exceeded (hc amounts ofwholesak liabilities it held. &Exhibit

no reason l o assume chat N o r i b was using the rchtivcly small amounts o f whdesak liabilities it held exclusively to liname any o f ils w h o b k sswcs per se. Presumably, ils financing decisions took into accoun~ entire arvt porlfoliw. its

23.

S d ,using shon-term FHLB advances and repurchass to

finance the foregone assets D .Baxkr assumes would have cntaikd substantial intrrcst r rate risk. Exhibit L compares the spread between the weighted average interen rate that Northeast actually earned on wholesale asms and the average i n k m t rate that Nonhcan anually paid on ie wholesale liabilities wilh the 3-month Treasury rate. The exhibit shows that the spread increased subslantially in the early 1990s when inlered rates fell, but then contracted sharply in 1994 and 1995 when interest rates increased. I n other

8.

Dr.Baxter also implicitly assumes that Ulm m u l d have been no credit losses on the assumed f~egone wholcsak assets, because he makes no provision for any such losses in his calculations. &g Baxter Repon. Exhibit 6. While MBS arc credit enhanced, this assumption is implausible with respect to purchased loans, which compilscd over 30 pcrccnl of Nonhcsst's whoksale assets as orJune 30, 1989. % Baxtcr Rcpon, Exhibit 4. (Dr. Baxter's report docs not explicitly specify what rnction orlhc assumed foregone assets would be purchased loans. However. his calculstions orthe but-for bank's risk-based capital requirrmmts imply that all o f the wumcd foregone assets are purchased loans.) Northeast's had suhstamial credit

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wads, the hypocheIial profits fiom Dr. Blulu's model src ihc producl ofa h i i s i g h I
driven bd on blling intnrsc rates, no( (hc loss o f a pmfitabk investment opportunity.

24.

The assumption that Northas! would have bn on declining
reasons.

r tm, N
&

m had a slated pliio f

limitingS; cxpmure t interest m e changes. I o

N h h t s w Fedcnl Corp, 10-K far F & m l Corp.,

~ h fiscal ycnr ended Much 31,1991. at 46-51, &Northud c

IOK fw t k

liily e a ended March 31.1992, at 65-67. Sceond, N o b t recognized that it m
able to comply with its interest ratc risk policy by reducing k relianceon shorl-lcmr wfiolcsak liabilities because by s doing, i t had r c d d rhe scnsilivity o f its net intuesl o income to changes in i n l m s l rates.

14. Finally, as a rcsull o f the implementation o f its
during most o f the

svalegy, Northeast's short-tenn aaet liability gaps were

relevant period, meaning that the Associ.tion's nd interest income was expccled to incwasc when intmsl riles rose and dccnax when inlcrtsl nlcs fell. & Northessl Savinki, FA, IOK for the fiscal year ended March 31,1990, at 40-42, Northeast Federal

C r . 10-K for the liscal ycar ended March 31, 1991, at 46-51, N011hea.d Federal Corp., op,
I O K for the fiscal year endcd March 31.1992, a1 65-68,

.ndNortheast Federal Corp,

a I O K f the hsul year ended December 3 1,1993, at 78-82. Dr. Baxta's assumption
about financing is implausibk because it assumes that the but-fw bank's interes rate risk psilion w w l d have been exactly the opposite ofthe position the actual bank had. Mwcovcr, for Dr. Baxter's lost profits calculations to be comct, he would have to establish not only that the assumed foregone assets would have ktn financed by the s M - t c n n wholesale liabilities that he assumed, but also that the but-for bank w w l d not

losses on its loans.

& fl20 &.

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have used hedges to reduce w eliminate the interest n t e risk that this financing policy w w l d have created.

D .

fiarum~tiom about SccuiWh.tioa 25.
m-b31,1992, During the Iiseal years aaeo and the y u r s ended March 31,1992, I991 and 1990,thc

Association securitized residential mortgage loans totaling 5376.6 m i l l i $2.6 million, $14.5 million, $365.6 million and $402.5 million, rrspedively. NorhuMF c h l Corp.,

10-Kfor the fiseal year ended December 31.1993,

at 14. Om oiUK reasons Nathcas(

dd ro is because it "needed to enhamx its risk-based capital ralios." i

u? Norlhcaff atso

recognized that securitizationreduced credit risk because none o f h e mortgage-backed snuritier c r d had rccoursc provisions.

u. Dr. Baxter implicitly aswmcs (hst UK

(t-

but-for bank would have securitized the same amounts o f loans at ,he same time, because hc makes no allowanw b r the additional credil losses that the but-for bank would have had otherwise. 'ibis is speculative because lhe but-for bank would havc had more regulatory capital an$, therefore, would no1havc had lhc same need to securitize loans i n order to enhance iU risk-based capital ratios.

E.

Assumptions about the DEPCO t n n a d i o a r

26.

On May 8,1992, NFC and Northeast compkted a series o f

conjoined ~ransactions,which had been negotiated with the State o f Rhodc Island, the Rhodc IslandDepositors Economic ProlectionCorporation ("DEPCO"), and the rcccivm (?he Receivers") for four Rhodc Island credit unions (the "Credit Unions'), and were
9. Northcssl.~ Capital Plan "callled] for the xcuritizalion of $500 million in residential

mortgage loans lo rnongage-backed securities in cakndar year 1990 to reduce the risk-based capital requirement.- & Nonhcasl Savings, F.A., Capital Plan, January

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subject to the requisilc approvals ofthe Ofice of Thrifi Supewisi and the Federal Deposit Insurance Corporation. & NorUlessl F a k n l Corp, I0-Qfor the quarterly
period cn&d m b c r 31.1991, at 6-7, Northcasl Fcdaal C p 10-KT r the fiscal a, o

yar ended M r h 31.1992, at 2 and Nonhasl Federal ac .

ye-

ended Decnnbcr 31.19$3, a 134. Pursuant l ihe bsnssctiom (i) Nwthrast w u i d t o approximately 5315 millwn o f c w u of the Credit U n i i from thc Racivcn, (ii)

Nathasc issued 5315.0 millwn of insured deposii accounts in the Associstion to
depositors in the Credit Unions (iii) NFC issued and sold to DEPCO 351,700shares of a .~ .. .. -. .
new clas o f p r r f d stock, the 5850 Cumulative kfcrrcd Stock, S a i El ({he "New

~ e i m e ~tock"), WII as wanants to purchase 800,000 d as

ofthe ~&-n,mpsny's

common sock Tor 535.1 7 million, and contribuld the proceeds to ihe Association. and
(iv) NFC issued and mid $28.95 million of FA Sinking Fund Unartilicated Debentures,

b

due 2012 ("5% Debentures") to the Receivers, who,in turn, distributed hdebencum to certain depositors in h e Credit Unions in wnsidmtion of a portion of their dcposk claims against the meivnships for the Credit Unions. and (v) NFC rc&rchaocd its adjustable rate pefmcd stock, with a face amount orapproximqtcly SbO.1 million, plus accumulatd dividends from the FSLIC Resolution Fund ("FRF") for $28.0 million in
cash (the proceeds of the debenture sale) and

5 . million in 9% Debentures. 70

M. NFC

had the right to pay the l i s t five years of dividends on the New Prrfcncd Stcck by the issuance of additional Ncw Preferred Stock (a payment in kind). 27.
jcj.

As noted previously, Dr. Banter assumes that in the non-breach

xcnario. these tnuuaclions would have laken place on "esmtialty ~ h vlmc terms," but c

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the p r e f d stock md wanants would not have been sold l DEPCO, b e c a w Northeast o

-M

not have needed capilal. This assumption b spcculstivc for Wu
28.

-

First, Dr. Baler's claim lhat the but-for h k would nol have

ncded capital bDotshps hum the re* of h lrnplausrbk i s -

: :

-

the but-for bank would no( have ban ss profitabk 8s Dr. Baxla assumes fx lhc mascm i d i ~ u s c above. lhcn thnc is no btsis for his assumption lhat the but-for bawk Would not d

have mdcd &I. 29.

Dr. Bantu's assumption i s also speculative banuR he docs not

csablish that Slate of Rhodc Island, DEPCO,and the Receivers would have agreed to the other lnnsactionr U all, let a
h on the same terms, ifNonhtsst

Financial had rrw

a g m d to issue the New & f d Stock and (hc warrants to DEF'CO. nK original proposal made to Nonheasi included the issuance ofUquityof Northast Savings, probably some form of pftferrcd stock, to the extent of IWh of liabilities assumed." Nmheast Savings, FA, Special B a r d Mecling, Scptemkr 25,1991, a 2 (PNEOI7 !

2289). 30.

Dr. Buter also analyzes incomaly k rm cost of raising capital

to Nwthcasl. To begin wiL, Norlheasl did not i s u e the Prcfurcd Wock w the warrants; NFC d d TkrcfOrc, whatever costs were incwed, NFC incuned them, not Nan-. i. 31. Moreover. Dr. Baxter does not conlend that the transaction was

unfair to NFC. 1'0lhc contmry, he asxrls that the warrants were included in the transaction because #heslalcd dividend rate of8.5 percent on the prekmd sock was "well below market." k x t n Repon. 959. But, ifthe tranvlelien was fairly-priced. then the n a present value ofthe fulurc paymenlsthat DEPCOexpecled to receive from NFC

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on the pfmcd Sock ud wanants was equal to the p h DEPCO paid for the prcfemd
stock

- $352 million. Dr. Bsxtera1.m docs rnattribute any trwanions coar to the
Y.Umkr lhese cicumslmcw I h a t f o w (he

capital raising porlion of lhc t m n s d h .
llCI

32

Dr. Bnxm pwporls 10 c a h h e the ncl cosl o f the prefarcd slock

by comparing the dividcndr paid on the preferredso& (payments based on tbc 85%
slrtcd racc) with the amount th.1NoNha.d would have pbd if it could have raised S35.17
m i l l i s its swage cost o f funds. B D I t u Rcporl, Exhibit 14. O the text o f h rrporl, ( n i

he refas to this a the "cosl o f funds swings gnrrslcd by ihc ush received. Barn
Report, 158.) 7his is wrong for hvo reasom. F i r q there is no reason to believe that
N o f i h w could have raised $352 million in long-tam Funding at its avenge cost o f

*

finds. To the contrary. D .I j a t w ' r positim is tha the 8 J K s u t t d rate on the preferred r
stock was 'well bclow markn.""
Second, the dividends that NFC paid wcm payments in

kind, nbt paymcnls in a b Dr. Baxhzr provides no basis Tor his implicit assumption lhac r. the payments in kind wnc as valuabk as thc p a p m t s in d, this assumption is and i m s i s t c n t with his contention that the dividend rate on the prcfened mock was "well below marka."

10. This is teatbwk finance. k & Bmlcy, Richard A. & Myers, Stcwarl C . Primioks o f C o m l e FiMnq(Sevcah Edition, 2003). at W 4 7 (stating that "it's d i f i u l t to find financing schemes with lnct prrxnt valucs] signiriantly different from zero" b e a u x ofcompcIitio, i n h n c i a l markets). 1I.Dr. Baxtcr'r own data show that the rates Nonhcau paid for rhon-term whoksale funds exceeded Nonhcaa's average cost o f funds. Compare L e wholcssle funds rate shown in Baxter Repon, Exhihit 7 the average cosl o f funds s h o w i n Exhibit 14. Ofcounc. Ihc r a l n for long-term, unsecured financing would be substantially higher.

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33.

As for the wanants,

D.BMcr cqvata the nec cod ofthe wanants r

with the value of the wrmnts. B a x b Rtporf Exhibit 14. Bul chi i g ~ b n the funds cb.c s

N C w i v e d *W F

it hued UDCwaIrMh. To rcitaa(S if the ~ u r i l i r mrc fagy s
valw o f lhc

tim& th.1 it received. In the a h o f uansaaioos costs, the net c a o f the issuance
w.l

mo.

F .

w
premiumi 34.

s
In the summer o f 1993, Northeast filed s regirtmionstatement f r o

the sak of additional common stock through a rights offering to existing sharcholdm. Howcvcr, the Company d e c i i not to pmceed with thc bansaction. According to Dr. Baxter, Noriharst incurredS313 thousand i n oul-01-pal;ct c m s for financial advisay vrviccs and f l i n g rces. Baxter Repon. 160. Dr. Baxta ascrts that "but for the breach, Nonhcast w w l d not havc medcd additional capital, and would nm have incuned these expenses" (which he includes as pan of the purported 7rounded bank damages").

u.

This conclusion i s spcculativc bccaux the actual bank did not need additional capital (it
remained in capilal compliance cvcn though i t d M proceed with the otTning). but i d

considered raising il anyway. Dr. Baxbr's conclusion is also speculative because i~
bootstraps fmm the resl of his implausible lo9 pmlits damages model. If but-for the

bank would not have k e n as profitable as Dr. Baxter assumes for thc reawns discusxd previously. thcn there i s no basis for his assumplion that 1hc but-for bank would not havc needed additional capital (w at least considcrcd raising additional capital).
35.

Dr. Baxter also asserts that the but-for bank w w l d have become

"well capitalized at ycar-cod 1992 and rcmaincd so at a l l times" and. ~hercim, -Id

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have qualified fa lower deposit inananec pmniums, vvingNorlhu,rt $1334 million. B a l e r Repml,

n61-62.

'This,too, i speculative because it kmwaps from the rcsl o f s

Dr. Bma's implausible lost polib dunylcs makl.
1v ;

P T H E A S T PROM HOLDING ADDITIONAL WHOLESALE ASSETS OR BETIWC O N

DECLINING JNTEREX RATES
36. FlRREA did not prevent Northeast 6wn holding additional wholesale d s . One way Nonhcan a l w could have h n c d the acquisition o f additional wholesale assets was by originating and holding f e w m a i l asMs. During the

period from June 30, 1989 to March 3 1 1995, Nonhaul originated over $4 billion in ,
retail assets. M i b i t h. i 37. Mormver. if additional whokssk as-

wm ihwght to k

desirable investmmts. NFC f w l d have raised funds by issuingsecurities and contributing !he funds raised 1 Nonheast in order to i 0 suficicnt Tor it l o hold thc additional -8. its regulatory capital by an amount Since NFC war a publii compny,
i t could

have raised mo&y by issuing common stock via 8 righls ofking. Altmalively. NFC

could have n i w d money by issuing prcfemd stock or debt securities" Many thrifts and
thrift holding wmpanics raised capital i n thcsc and olhcr ways aRcr the enactment of FIRREA.

& Exhibit N. The exhibit shows 617 issues of sawiticr by 482 t h r i b and

thrift holding companies during the period f m October 1. 1989 to March 31. 1995.

12. Academic studies have generally found that capital raising by r i ~ n c i ainstilulions l has relatively m a l l effects on existing stock prices. SCt C o m n l B Tehranian, 'An examination o f voluntary versus involuntary sccurily issuances by commercial banks," J. Financial E c a 35 (1994) 99, at 110; Hwvilz, L a & Robertson. "Valuation cffccls of new securities issuance by bank holding cornpanin: nnu cvidencc" Thc Financial Rcvicyl26 (1991) 91. at 91 & 101; Comctt. Mchnn & Tchnnian, "Arc Financial Markc~s Overly Optimislic about ihc Prorpcc~s f Firms o Issuances by That Isuc Equity? Evidencc from Voluntary Versus lnvolunlary Equi~y Banks." I Fiiancp 53 (1998) 2139. .

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38.

Furthmncfc, NFC could havc raised monq by bmolumg

wholesak funds .nd used thc pmeccds to plrchse whokrslc ruc(s at the holding

company kvel. N o thrifl is q u i d l o invest in whoksde aseba bwrcnv w h o k a k
--

fund% Therefore, ifNFC had wanted to IJSC wholssk liabilitia to i n v m in whokslk assets,

L could havc done so without raising capital at Northeest.
39.
Presumably NFC and Nonhesst d not lake lhcsc dcpr because i d

they did not believe tha making addiional invcsmcne i n w h d a s k wdr would have
been desirable. This is not surprising because t h m is no rason to expect that a sbategy orusing whoksalc liabilities l o purchase wholcssk assas would be pfilablc. the msrlms for wholesale assets and whokrsk liabilities ur competitivg these

Because

and IiabilPicsarc fairly priced. (Dr. Baxtn m c d m this stating that 'luholcsak 8 M s

-

b

and liabilities arc always available at market prices...."

Baxtn Rcporl, ') 44.) This

intuition presumably explains why Norlhcast adopted its antcgy orexiting wholesale markets in 1988.
40.

Moreover, if Northeast had wanted to k t on declining i n t n a t

ratn, a Dr. Baxtn's but-for bank docs, it could have done so by lengthening the maturity of b asseu, shorvening the maturity o f its liabilities, or enkring into intewtrate swap transactions that lengthenedL c effective maturity of its asscts (or shonmd the

effective maturily o f its liabilities). The failure ofNonhtast lo take thew steps impba
that it did not believe that bening on declining interest mtes was desirabk. isnot

surprising bceaux thew is no reason to cxpct that belling on declining interest rates would be prolitable, on avenge (since interest rates can go up as well as down).

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v.

DR. BAXTER'S CALCULATION OF TEE PURPORTED VALUE OF THE LOST REGULATORY CAPITAL I INCORRECF S
41.

D.B u t c r pulpow to calculate thc valucofthc wpcnisaY r
a

goodwill that N d e W lod b to replace the supervisory goodwill by raising real capital o Dannba 31,1989. Baxter n

Report, 167. This appmach is conceplually flawed btcause N o t l k s l d not raise i d
u p i d l o m p k e the supervisory goodwill it losl

- and did no( i n c u che cosIs o f w doing

- pnsumably because Na(heast did not bclicve that thc valveoft& regulatory capital
thsl it would havc oblaimd was worth whatcm w a s i t would have incumd. In ahn wads, even if D .Buter had corrcflly measured wha thc con ofraising replacanent r capital would have been (and he has noS for the reasons discussed below), this cost would have been greater than, n d equal to the valueof the s u p m i s g . goodwill that

c .

Northart los. 42.

Dr. Baxtcr's calculwion is also flawed on its own terms. Dr.

Baxter purports to consider the costs o f r hypothetical issuance of a prcfemd stock with a face value oT5202.325 million (Nonheast's supervisory goodwill balance at Dewrnber 31.1989) and which promised l o pay investon a 7.90 pncent dividend (i.~.. the risk-fkc yield) on the face value. Baxtcr Repon. Exhibit 19 & Notes 3 & 8 to Exhibit 19. Becaux this p r e f c d nockwould have been risky, it would have sold for a price below par; Dr. Buter ~1kul8les the preferred stock would havc sold for $131.039 million that
@ d an assumed 16 ptrcenl discount rate). a on

Id., Exhibit 19 & Notes 6 & 9 to Exhibit

19. D .Baxtn cstirnates rhat the transactions costs o f issuing this prcfemd slack would r

have totaled S4.547 million. Id., Exhibit 19 &Note 12 to Exhibit 19. Dr. Baxtcr further assumes that ihe proceeds from the hypothetical issuance w w l d k invested in long-term

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government bonds yielding 7.90 pmrm.

g , 3. D.Baxtnlhcn obsaves that if . Note r

N a m bad brm abk t invest $202.325 million in such govcmmcn4bonds, the o
intnest i t would have rmived in u c h period would hare b a n sul5dknt to p y the promiseddividendson the hypothdial prcfemd stock hue.

u.,M

e 5 to Exhibit 19.

He cGms lhat the value ofchc supervisory goodwill equals thc ditTmna bchvcu, (hc 5202.325 million ncccnary to make this hypothetical invevmcnt and the S131.019 million thrc Northeast wouM bsve rcccivod horn isruing the prckmd s& t, plus

m ~ c t i o n costs ofS4547 million, an amount which totals $75.833 m i l l i . s 19 & Note 12 to Exhibit 19. 43.

u, Exhibit

h Baxter's analysis of t h c x hypothcliul tnnsnctians is i m t . .

As hc d w a i k s it, N o r t h fmt would have issued preferred stock to investors worth

&

S131.019 million at the time ofissuancc in exchange fwS131.019 million in cash. This would have k e n a fair exchange, and would have entaikd no net Eosl to Northcut, o than the assumed lnnsaclions EosU 0154.547 million. Northeast chcn would have used the $131.019 million lo purchax govanmcnl bonds wonh S131.019 million. This t w
would have been a kir exchange thM would have entailed n no costs to Northeast. The o
K(

h

cost of these two transactions. themfore, would havebeen 54.547 million.

D. r

Baxtn's assertion that the diffirrncc between the face value o f the preferred stock and the markn value ofthe preferred stock measures LC cow o f the transactions is wrong. net 44. 1 is true lhal had Nonheasl engaged in these transactions, the 1

subsqumc interest payments on the government bonds would have been insumcicnt to pay the dividends on the peferred sloek ifthev had been made. However. the reason the prefcmd sock would have been a risky security at issuance is because then would have

been unccnainly as lo whether the promised dividend payments would have been ma&

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subsequently. I n situations in which ihe dividends oa the pnfemd stock would have

been mined, Norhe& would have retainedihe intcred rcuipts it meired from iu
invcstmmt in g w m ~ c nbonds. t

D .Bnxtu's carh flow analysis is fl.wcd kcauP he r

ignores UKSC siluationr. However. the passibiliy chst thcse situations would occur is pcciscly the ww why t h e w o f the p r e f d stock w w l d have b&a the same as chc value of govnnmcnt bonds even though them ofthe promised dividend payments

on ihc prcfemd nock would havc nrcndsd tbc amount o f the p w a i f f d i n t a c d
p y v n t s on the govanment bonds.

45.

The omission ofprcfemd dividend payments i s not juu a

thcorclical possibility. I n February 1990. the Association actually d suspend the i d q w d y a s h dividend on its wwanding prcfcned stock because i t klievcd "it was both

clt

necessary and nppmpr*te to caucwc lhc upi!al ofthe Anakrion." S ~ S~ k , , Northeast Federal Cap.. 10-K for the fiscal year mdcd D e m b u 31.1993.sl56. ~ a & v e r . h Baxter aswmcs that lhc but-for bank &would . have suspended dividend

payments even lhough i t w w l d havc had at least as much regulatory capital as the actual bank would have had ifit had raked rcplacemmt capital. This is compktely i n c w i n c n t with Ik. Banlcr's calculation orthe wst ofreplacement cspilal, whiih, as explained above, assumes (hat the all oflhc dividend payments on the hypolhdiat preferred stoek omering would have bccn made.

-

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