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

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UNITED STATES COURT OF FEDERAL CLAIMS
NORTHEAST SAVINGS, Plaintiff vs. THE UNITED STATES, Defendant ) ) Case No. ) 92-550C ) )

Pages: Place: Date:

1760 through 2102 Washington, D.C. November 2, 2006

HERITAGE REPORTING CORPORATION
Official Reporters 1220 L Street, N.W., Suite 600 Washington, D.C. 20005-4018 (202) 628-4888 [email protected]

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS

NORTHEAST SAVINGS, Plaintiff vs. THE UNITED STATES, Defendant

) ) Case No. ) 92-550C ) )

Courtroom 5 National Courts Building 717 Madison Place Washington, D.C.

Thursday, November 2, 2006

VOLUME 8

The parties met, pursuant to the notice of the Judge, at 8:30 a.m.

BEFORE:

THE HONORABLE MARY ELLEN COSTER WILLIAMS

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APPEARANCES: ON BEHALF OF THE PLAINTIFFS: MICHAEL W. KIRK, ESQ. CHARLES J. COOPER, ESQ. VINCENT J. COLATRIANO, ESQ. DAVID LEHN, ESQ. Cooper & Kirk 555 Eleventh Street, N.W., Suite 750 Washington, D.C. 20004 (202) 220-9656

ON BEHALF OF THE DEFENDANTS: TAREK SAWI, ESQ. JEFFREY INFELISE, ESQ. ELIZABETH HOSFORD, ESQ. SCOTT AUSTIN, ESQ. SAMEER P. YERAWADEKAR, ESQ. MELINDA HART, ESQ. U.S. Department of Justice 1100 L Street, N.W. Washington, DC 8th floor

20036

(Index appears at end of transcript)

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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Honor.

P R O C E E D I N G S THE COURT: MR. SAWI: THE COURT: MR. SAWI: -

On the record. Good morning, Your Honor. Good morning, Mr. Sawi. I have the privilege of calling

Professor Fischel to the stand, Your Honor. THE COURT: forward. Whereupon-DANIEL R. FISCHEL a witness, called for examination, having been first duly sworn, was examined and testified as follows: THE COURT: Thank you, Professor. Please Very well. Please come

be seated and make yourself comfortable. THE WITNESS: Thank you. Thank you, Your

THE COURT: MR. SAWI:

You're welcome. Your Honor, I am happy to report

we only have one binder and a small one at that, and if I may approach, I will hand one to the witness and hand two to the clerk. THE COURT: Certainly. Actually, before we start,

THE WITNESS:

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could I just get a little water? THE COURT: Take your time, yes. It's empty up here. Let me give

THE WITNESS: THE COURT:

Oh, what happened?

you some of this one. THE WITNESS: THE COURT: Thank you, Your Honor.

You're welcome. I'm all set, Your Honor.

THE WITNESS:

DIRECT EXAMINATION BY MR. SAWI: Q. Good morning, Professor Fischel. A. Good morning. Q. Let me start, sir, by asking you a few questions about your credentials. Let's go to the very first tab of the binder, tab 1, and this is DX-287A. a copy of your current resume? A. Yes, at least as of a month ago. Q. Okay. What is it that you do? Sir, is this

A. I am president of a firm by the name of Lexecon, which is an economics consulting firm based in Chicago. I have also had a parallel

academic career at the University of Chicago and at Northwestern University, both in Chicago, primarily at the University of Chicago, but also

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at Northwestern. Q. Okay. Tell me a little bit about your

current position at Northwestern University. A. Currently, I have a joint appointment at Northwestern University as a professor of law and business in both the law school and the business school, the Kellogg School of Management. Q. Okay. And what is your current position at

the University of Chicago? A. At the University of Chicago, I'm the Lee and Brenna Professor of Law and Business at the University of Chicago Law School, Emeritus. Q. Okay. Have you had other positions at the

University of Chicago? A. Yes. For many years I was the -- actually

the same academic title that I just stated but not emeritus. I was an active faculty member there I served as dean of the I also had a

for a number of years.

law school for a number of years.

joint appointment at the University of Chicago Graduate School of Business. And also, for many

years, I served as director of the Law and Economics Program at the University. Q. What is the Law and Economics Program and what is your role in it as a director?

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A. The program is, as the title sounds, it's a program based in the law school but really a university-wide program that is dedicated to the study of the interrelationship between law and economics, the effects of particular legal rules, regulatory regimes, alternative systems for controlling undesirable conduct or encouraging beneficial conduct. Q. What courses have you taught at Northwestern University and the University of Chicago? A. I've taught a number of courses, but I have focused in the area of business associations and corporate finance and the regulation of financial markets. Q. Do any of your courses deal with the subject matter of this case? A. Yes. One of the -- well, first of all,

I've taught courses in the regulation of financial institutions directly. In my corporate finance

class, at least in recent years when I taught the course, I actually had class materials on the Winstar decision and the subsequent damage cases filed subsequent to the Supreme Court decision in Winstar, because the basic issue of the

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relationship between the existence of profits or claimed lost profits resulting from the passage of FIRREA, which decreased the ability of financial institutions to borrow, really raises a fundamental question which has been widely studied and written about by many academics, including myself, on the relationship between leverage, the ability to borrow, and whether or not that makes you or a firm more successful or less successful, and that's the basic issue in many of these Winstar cases as well. Q. Sir, have you taught courses in the business school as well as the law school? A. I have. As I stated, I've had joint

appointments at both the Northwestern Law School -- Northwestern Business School and the University of Chicago Graduate School of Business, and particularly at the University of Chicago, when I had a joint appointment, I taught a course in the business school, and even when I teach courses in the law school, I typically get a fair number of business students enrolled in those courses. Q. Okay. Can you briefly describe your

educational background?

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A. Yes.

I went to Cornell University where I

graduated with a Bachelor's Degree in 1972, a major in American history, a minor in economics. Then I went on to graduate school in history, actually, at Brown University, where I got a Master's Degree in 1974. And then I went to the

University of Chicago Law School, where I received a law degree in 1977, studied law and economics with a number of professors on the University of Chicago faculty. Then I clerked for several years, first on the Court of Appeals in the Seventh Circuit, and then I had the privilege of clerking on the United States Supreme Court with the late Justice Potter Stewart. Then I practiced law for less than a

year, and then I began my academic career, first at Northwestern, then at the University of Chicago. Q. Let me go to your publications. published any books or articles? A. Yes, I've published two books, one entitled The Economic Structure of Corporate Law, co-authored with my long-time co-author Frank Easterbrook, now Judge Easterbrook, that was published by Harvard University Press, and I also Have you

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published a book called Payback:

The Conspiracy

to Destroy Michael Milken and his Financial Revolution. I have also published approximately 50 articles in leading legal and economics journals on various subjects related to my areas of expertise. Q. Okay. Besides your book with Judge

Easterbrook, have you done any other work with him? A. Yes. As I stated, we've had a long history We've probably -- I don't know

of collaboration.

what the exact number is, but co-authored at least ten articles together in addition to the book. Q. Okay. Have any of your books and articles

ever been cited by courts? A. Yes, hundreds of times, from the United States Supreme Court on multiple occasions on down to courts really at all levels. Q. Okay. Do any of your books or articles

discuss regulation of the savings and loan industry? A. Yes. I wrote an article on the regulation My book on -- my book

of financial institutions.

Payback has extensive discussion of the savings

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and loan crisis, the causes of the savings and loan crisis in the 1980s, and the federal response to it. I have also written about both the Winstar decision in the Supreme Court as well as the use of economic evidence in analyzing damage claims pursuant to the Winstar decision in the Supreme Court, and I've also written about related subjects, again, the relation -- particularly the relationship between lost profits claims and alleged claims of inability to borrow money, what the relationship is between lost profits and the ability to borrow money. Q. Okay. publications. We've talked about your Have you given lectures or speeches

in your area of expertise? A. Yes. I've lectured and spoken widely to

various groups, to conferences of federal judges, to conferences of business executives, legal groups. I've lectured at many of the major

universities in the country on various subjects, again, related to the subjects that I've written about and taught about. Q. Okay. Now I want to switch to your

previous testimony and consulting experience.

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Let's go to page 7 of your resume, if we can put that up on the screen. Sir, have you ever testified as an expert before? A. Yes, many times. Q. Approximately how many times? A. I think if you include all forms of testimony under oath, I think approximately 200 times. Q. Let's put your experience in Winstar cases aside for a moment. Have you ever testified in

other -- other than in Winstar cases on issues such as lost profits? A. Yes, many times. Q. Okay. Have you testified as an expert in

lost profits cases arising from FIRREA or the Winstar decision? A. Yes, I think in previous trials, I've testified in the Glendale case, the CalFed case, the Bank United case and the Suess case, as the Government's expert on lost profits in all those cases. I also testified in at least one other case that I remember that didn't result in -- it actually settled right before I testified at

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trial, the Statesman case, I believe, and worked on any one of a number of others. Q. Okay. In the four cases you testified on

lost profits claims, Glendale, CalFed, Suess and Bank United, were plaintiffs awarded lost profits in any of those cases? A. To the best of my knowledge, no. Q. Can you talk a little bit about your involvement in other cases concerning damages claims other than those arising from FIRREA? A. Well, virtually all the cases that I've testified in involve damage claims in one form or another, whether retained by either the plaintiffs or the defendants, and I've testified in a wide variety of different types of cases ranging from virtually all of the major corporate scandals involving firms like Enron and WorldCom and all the others to many just major commercial disputes between companies. I've also testified in many breach of contract type cases where there's claims of damages or lost profits, and the basic methodology in those cases is similar even though the subject matter differs obviously depending on the facts and circumstances of a particular case.

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Q. Okay.

Can you briefly describe your work,

your consulting work, with respect to the subject of valuation? Does valuation -- is valuation

involved in your analysis of the cases that you've testified in? A. Yes, again, valuation is another subject that appears in virtually every case. I have

spent my career, first of all, teaching principles of valuation, writing about principles of valuation as an author, and also consulting, applying basic principles of valuation, both as a consultant and an expert witness, to various problems that arise in litigation. MR. SAWI: Your Honor, I move to qualify

Professor Fischel in the same areas that he was qualified to testify in in Glendale, CalFed, Suess and Bank United trials. These areas are

valuation, financial institutions, financial markets, the regulation of financial markets, and the economic analysis of lost profits and other damages claims. MR. KIRK: Could I just request you read

them a little more slowly? MR. SAWI: MR. KIRK: Sure. Thanks.

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MR. SAWI:

Valuation, financial

institutions, financial markets, the regulation of financial markets, and the economic analysis of lost profits and other damage claims. THE COURT: MR. KIRK: Voir dire? Yes, Your Honor, very briefly.

VOIR DIRE EXAMINATION BY MR. KIRK: Q. Good morning, Professor. A. Good morning, sir. Q. You have never served as an executive for a thrift or any other financial institution, correct? A. That's correct. Q. You've never been on the board of directors of a thrift or any other financial institution? A. Correct. Q. You've never been employed by a thrift or a financial institution as an employee. right? A. Correct. Q. You've never served as a consultant except in the context of civil litigation for a thrift or any other financial institution. Is that true? Is that

A. Not completely true, but -- I mean,

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basically correct, but I have had consulting projects that have involved financial institutions outside of the context of litigation. Q. Have they been directly for a financial institution? A. I would say they're directly for institutions who wanted to become financial institutions. Q. I see. You've never offered any business Is that true?

consulting advice to a thrift. A. That's correct.

Q. You do not hold yourself out as an expert on the management of thrift operations? A. No, I do not. Q. Nor are you an expert on the regulatory capital rules that are applicable to -specifically to thrifts? A. Correct. Q. You're not an expert on mortgage banking? A. No, I'm not. Q. You're not an expert on how thrifts manage credit risk? A. Correct. Q. You're not an expert on the management of interest rate risk?

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A. Correct. Q. You're not an expert on the way that thrift managers typically measure interest rate risk? A. Correct. Q. You're not an expert on the ways that thrift regulators measure or regulate interest rate risk? A. Correct. Q. You're not an expert on the securitization of mortgages. Is that right?

A. Correct. MR. KIRK: Thank you, Your Honor. I have

nothing further, and we have no objection to the qualifications of Professor Fischel in the areas mentioned by Mr. Sawi. THE COURT: Professor Fischel. THE WITNESS: THE COURT: Thank you, Your Honor. Thank you. Congratulations,

You are again admitted as an

expert in the Court of Federal Claims in the areas of valuation, financial institutions, financial markets, regulation of financial markets, and economic analysis of lost profits and other damage claims. THE WITNESS: Thank you very much, Your

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Honor. THE COURT: MR. SAWI: You're welcome. Your Honor, may I beg the We have a couple of

Court's indulgence again?

blow-ups that we would like to put here if that's possible. THE COURT: MR. SAWI: THE COURT: Certainly. Thank you. I would invite, Mr. Kirk, if

you would like to position yourself so that you can see it clearly. MR. KIRK: Okay. I think Mr. Sawi told me

they'd also be on the screen, but -MR. SAWI: the screen. MR. KIRK: MR. SAWI: -- but if need be -They are the ones that you had a They will definitely also be on

long, long time ago. MR. KIRK: THE COURT: Thank you. Very well.

DIRECT EXAMINATION (cont.) BY MR. SAWI: Q. Professor Fischel, have you formed any opinions in this case? A. I have.

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Q. Can you briefly summarize your opinions? A. Yes. case. I have formed two opinions in the

My first opinion is that the breach, the

elimination or, more accurately, the phase-out of supervisory goodwill embodied in FIRREA actually benefited Northeast, did not harm Northeast. the contrary, they were benefited by it. The On

whole purpose of FIRREA was to cause thrifts to put up more of their own money, to engage in less risky activities than they had before FIRREA, which had triggered the savings and loan crisis in the 1980s. Northeast, in the early 1980s, was faced with a very hostile and adverse business climate, severe recessionary conditions in both the northeast and California. The breach, by causing

Northeast to be less risky and better capitalized, actually enabled Northeast to avoid losses and possible failure which might have resulted had it continued the same business policies that it had been engaging in prior to FIRREA. Q. Just a quick clarification, sir. mean to interrupt. I don't

You said in the early 1980s.

Is that what you meant? A. I'm sorry, I meant the early 1990s. Excuse

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me, I misspoke. Q. Yes, sir. A. Thank you. And my second opinion, I would say my principal opinion, is that the damage analysis of Dr. Baxter is fundamentally flawed, and let me just explain what I mean by that, although I hope to have the opportunity to explain it more fully in testimony. Dr. Baxter's damage analysis is based on basically three separate pillars, all of which in my opinion are wholly implausible. The first

thing to -- the first pillar that -- the first and most important thing I think to recognize is that every set, every single set of Dr. Baxter's lost profits damage calculations are based on a massive bet on interest rates, having nothing to do with successful operation of the bank. It's not just a massive bet on interest rates, but it's the identical bet as the RCA program that the regulators criticized and the bank itself stated was an impermissible activity, but my criticism even goes beyond that, because it's not just a massive bet with respect to an activity that the bank said it wouldn't engage in,

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but it's a bet on interest rates in the exact opposite direction that the bank itself believed interest rates were going to move. So, Dr. Baxter has all of its profits coming from a decline in interest rates in a risk-controlled arbitrage program at a time when the bank itself was projecting that interest rates would rise. So, the combination of the extreme

bet on an impermissible activity, where the bet is in the opposite direction of what the bank actually believed in terms of how interest rates were going to behave, makes the first pillar of Dr. Baxter's analysis, as I said, completely implausible. The second pillar, equally implausible, is that Northeast in the real world was losing money. Its competitors were also losing money, but Dr. Baxter has a calculation of lost profits where he assumes that his billions of dollars in forgone assets would have had zero credit losses, not one dollar of credit losses, at a time when both Northeast and its peer banks in the real world were all losing money, and that, as I said, is also implausible. And the third pillar, as I said,

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implausible as well, is that Dr. Baxter has his but-for bank much bigger than the actual bank in order to generate his lost profit calculations, but he assigns virtually no expenses to the cost of running a much bigger bank. He has general and

administrative expenses close to zero even though the -- his assumed but-for bank is much larger than the actual bank, and that's also fundamentally inconsistent with Northeast's behavior in the real world as well as the behavior of peer thrifts. Now, in order to create these three pillars, Dr. Baxter makes a series of assumptions about what assets the bank would have held in the nonbreach world, how they would have been financed, how large the nonbreached bank would have been, how profitable it would have been, and in my opinion, those assumptions are, first, wholly speculative, because nobody could possibly know those details to a reasonable degree of certainty, not Dr. Baxter, not me, not anyone, but even more fundamentally than the fact that the assumptions are speculative, to the extent there's economic evidence with respect to each of the issues that Dr. Baxter examines, it is almost

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uniformly in the opposite direction of the assumptions that he makes on all of those issues, and for those reasons, I think Dr. Baxter's damage analysis, as I stated at the outset, is fundamentally flawed. Q. Thank you, sir. Before asking you about your opinions, I'd like to ask you a few background questions. Have

you analyzed Northeast's profitability during the pre-FIRREA period? A. I have. Q. Can I get you to look at tab 2 of your binder, and this is DX-3000. Can you please

explain this exhibit to the Court, sir? A. Yeah, this is a document that really is taken directly from a Northeast document. are not calculations of mine. These

I think it's

important in analyzing any lost profits claim to compare the claim with real world benchmarks, because the closer the lost profits claim matches real world benchmarks, the more plausible it is, and the -- conversely, the less of a relationship there is between the lost profits claimed and real world benchmarks, the less plausible it is. So, I started by looking at the

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relationship between the claim and Northeast's performance in a variety of ways and then the performance of Northeast peers. So, in any event,

this is a document taken directly from Northeast which shows with respect to core earnings for the fiscal years from 1985 through fiscal year 1989, right before the passage of FIRREA, Northeast had cumulative core earnings of negative $39 million -- in other words, $39 million of losses -- which is simply the sum of all of the bars reflected on the page. Q. Okay. Why did you look at core earnings? First of

A. Well, for a number of reasons.

all, core earnings reflect the profitability of the operations of the bank, and therefore, they're a natural thing to look at. Secondly, Dr. Baxter's lost profit damage calculations are core earnings, and therefore, it's a apples-to-apples comparison. And third, Northeast itself stated that core earnings were what was important in understanding what determines the value of the bank. Q. On that point, let me take you to tab 3 of your binder, and this is PX-211, and this is a

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document the Court has seen many times.

It's

Northeast's response to the exam report that was commenced December '88, and it's dated July 6th, 1989, and I'll take you to the page Bates stamped at the bottom 2362, the last paragraph, and it carries over to the next page. Is what Northeast says here relevant to your opinion and to the point you just made previously? A. Yes, and, you know, because I know this document's been examined at length, I just want to point out one sentence on I guess page 2. Q. Okay. A. If it's possible to highlight the second full sentence, I don't know what's on the -- yeah, that -- the next sentence, "A review of the minutes" sentence. Q. Okay. Right, absolutely.

A. Okay, I hope everybody can see that, but the statement is made, "A review of the minutes of the period in question indicates a pervasive understanding that core earnings, rather than gains on sale, support a stock price." Gains on sale, as well as unrealized losses, are what's not picked up in core earnings,

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and so the statement is that what is important for determining value, for determining the level of the stock price of an institution, the value of that investor's place on it, is core earnings, which is one of the reasons, as I indicated, that in my analysis of Northeast's profitability, I focused on core earnings. Q. Okay. While the Court has seen this

document many times before, I don't think anybody talked about this particular passage. stock price significant? Why is

What's -- so what?

A. Well, because stock price is what determines value in the marketplace. So, when

investors look at financial data, they look at everything about Northeast's performance and decide how much the institution is worth. They

can look at all kinds of things, but the statement is made, I believe correctly, that what's most important is how the business is doing, and in an institution where how the business is doing is measured by the term "core earnings," that is what is significant. The problem with looking at other measures, such as a measure that includes gains on sale, is then you also have to realize -- then you also

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have to take into account the losses that have been incurred on assets that have not yet been sold, and frequently the unrealized losses, as I believe was the case for Northeast prior to FIRREA, would equal -- would either equal or exceed the amounts recognized in gains on sale, and core earnings, in effect, takes that into account by ignoring both gains on sale and unrealized losses on assets that are underwater but are not yet sold and just focusing on how the business is doing -- and the statement is made that's what investors do as well -- in determining what the level of Northeast's stock price should be. Q. Okay. Now, in his opening statement,

Mr. Kirk said that, "The Government's core earnings argument is ultimately a red herring," and then he went on to say, "because it focuses on Northeast's noninterest income and expenses, whereas the primary impact of the breach was to reduce the net interest income by reducing interest-earning assets," and that's on trial transcript page 89, lines 6 through 12. Do you agree with that, sir? A. No, I believe it's incorrect. Just based

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on the definition of core earnings that Northeast itself gave in its annual report, I believe core earnings includes all elements of value other than gains on sale and unrealized losses and other extraordinary items. Q. All right. Have you also analyzed

Northeast's profitability during the post-FIRREA period? You have shown us --

A. I have. Q. All right, go ahead. A. I have, excuse me. Q. Let's go to tab 4, and this is DX-3001. Can you explain this exhibit to the Court, please? A. Yes, this is another, you know, what I'll call real world benchmark of -- to analyze the relationship or to test the plausibility of Dr. Baxter's lost profits damage model to compare the model with what Northeast was doing in the real world after FIRREA, and I think the graph is self-explanatory. In some years, Northeast had positive core earnings, other years it had negative core earnings, but cumulatively, in the period after FIRREA, until the time of the Shawmut acquisition, the core earnings, the cumulative core earnings,

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were negative $22.3 million, $22.3 million worth of losses. Q. Okay. Have you also analyzed Northeast's

credit losses during the post-FIRREA period? A. Yes. As I said, Dr. Baxter has an analysis

where he assumes zero credit losses, not one cent of credit losses, and again, to test the plausibility of that assumption, I thought it was useful to look at, again, another real world benchmark, how Northeast did in the real world, and you can see that -Q. Let's go to tab 5, which is -A. Oh, I'm sorry, excuse me. Q. -- DX-3002. We're there now, sir. A. I apologize. And you can see that the portfolio of Northeast in the real world, in contrast with the assumptions that Dr. Baxter made in his lost profits damage calculation, in the real world, Northeast had significant loan loss provisions and REO operations expense, REO operations expense being defined as the costs incurred to manage and sell foreclosed assets, that the cumulative total was over $100 million of losses in REO expenses, Go ahead.

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$117.4 million. Q. Okay. Northeast. All right, we have talked about

Have you analyzed the profitability of

retail thrifts in the northeast during the post-FIRREA period? A. I have, and let me just explain this for a second. Q. Okay. A. One of the issues, obviously, with a post-FIRREA comparison of Northeast to Dr. Baxter's damage model is -- a perfectly legitimate question that could be raised is to the extent that the breach that Northeast is complaining about is influencing its performance in the period after FIRREA, it's not a completely fair comparison to compare Northeast's actual performance to lost profit damage calculations models. So, that's one of the reasons I also

looked at the pre-FIRREA period that I talked about before. But I also looked at how other thrifts in the same economic environment performed, most of which were not in any way affected by the breach, because they didn't have supervisory goodwill that was eliminated by or phased out by FIRREA, and so

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in order to get a sample of thrifts, I didn't make any independent determination. What I did was I

looked at the list of peer thrifts that were compiled by Kaplan Smith, Northeast's consultants, in the report that Kaplan Smith compiled. If you look at that report, there is a list of New England thrifts that Kaplan Smith identified as peer thrifts, comparable thrifts, in order to compare Northeast against, and I looked at their performance between 1990 and 1994. Q. Let's go to tab 6. A. And that is the -- the list of thrifts in tab 6, and there are 11 thrifts, excuse me, on this list. One of the thrifts, Old Stone, we see

a footnote or a note 2 next to it, and that's because it's a plaintiff in Winstar related litigation. So, we'll forget for the moment Old

Stone and look at the other nine -- excuse me, the other ten thrifts that are listed as peers, as comparable thrifts, not by me, but by Northeast's consultant, Kaplan Smith. And so of those ten other thrifts, those ten other peers or comparable thrifts, nine of the ten lost large amounts of money in the post-FIRREA period precisely because of the severe

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recessionary conditions that Northeast and these other thrifts were faced with. If you look at the

cumulative total on the bottom of all of the thrifts, there were losses of $743 million, minus -- if we take out Old Stone, about 100 million, a little over 100 million, it's still cumulative losses of 630 million of the thrifts that Northeast's consultant identified as comparable. That to me is a particularly important real world benchmark to compare Dr. Baxter's lost profits damage model again, because if you have Northeast losing money and then you have nine out of the ten thrifts that its own consultant identified as peers or comparable losing even larger amounts of money, that creates, as I said, a real world benchmark to analyze the plausibility of a lost profits damage model and begins to make you suspect that there's something wrong with the model in order to produce a result that's so different from Northeast's performance before FIRREA, Northeast's performance after FIRREA, and the performance of nine out of the ten thrifts that were not influenced by the breaching provision of FIRREA but were identified as

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comparable or peers by Northeast's own consultant. Q. Thanks. All right, sir, we're done with the background data, and we are now about to launch into your first opinion. questions about it. Can you provide a brief summary of the reasons you believe that Northeast benefited from the breach? A. Yes. I think it's useful that the blow-up I'd like to ask you some

is on the easel, so I can go through all four of them, but presumably the breach led Northeast to take certain steps that, with the benefit of hindsight, allowed Northeast to be less vulnerable to the severe recessionary conditions in the northeast and California than it would have been had it not taken the steps that it did in response or at least partially in response to the breaching provisions in FIRREA. MR. SAWI: And just for the record, Your

Honor, this exhibit that we are about to talk about is DX-3004. The prior exhibit about New

England retail thrift peer groups of Northeast was DX-3003. BY MR. SAWI:

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Q. All right, sir, let me take you again to DX-3004, we have the blow-up here, and let's start with the first point, "Northeast reduced residential mortgage loan originations." What is the relationship, if any, between the breach and Northeast's reduction of residential loan originations? A. Again, it's a fairly simple relationship. As a result of the breach, Northeast had less capital. Because it had less capital, it had to

hold fewer assets, all else equal, and one of the ways that it decided to deal as a matter of business strategy with its requirement that it hold less assets was that it reduced its residential mortgage or loan originations, which it stated clearly in its public disclosures. Q. Let's go to tab 8, and this is DX-3005, which contains some excerpts from Northeast's public filings concerning loan originations. this relevant to your testimony, sir? A. Yes. Q. Can you please explain? A. Yeah, and again, because these are just illustrative quotes, maybe if you could highlight the last sentence in the first quote. Is

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As I said, a clear relationship, because when you have less capital, you hold fewer assets, all else equal, and the statement is made just clarifying or confirming that relationship, that -- the statement is made, "The reduction in residential mortgage loan originations is primarily attributable to the capital constraints imposed by FIRREA and the reduction in the asset size of the Company." And the second quote, a couple years later, basically the exact same thing, so no need to read it separately, but it says the same thing. Q. Okay. Have you prepared an exhibit

illustrating Northeast's reduction in residential loan originations? A. I have. Q. Let's go to tab 9, DX-3006. us through this exhibit, sir? A. Yes. The dotted red line at the top is the Can you walk

level of planned originations of single-family residential loans in both the original business plan, the December 1988 plan, and the revised 1989 business plan in May of 1989, and they both project originations of a billion dollars of single-family residential loans for each of the

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years in the post-FIRREA period. And then if you look at the bars, which combine adjustable-rate mortgages and fixed-rate mortgages, adjustable rate being the blue and fixed rate being the green, the -- Northeast hits the billion dollar target in March of 1990, but subsequent to that, the new originations fall short, far short, of the billion dollar -original billion dollar target, going down to it looks like a little bit over 400 million in the March -- fiscal year ending March of 1992, and then going back up again but not to the billion dollar level. Q. Okay. How did Northeast benefit from

reducing residential loan originations? A. Because any time you're doing less lending in a severe recessionary climate, you're avoiding losses, and so, again, with the benefit of hindsight, now that we know that it was very difficult for any thrift, for Northeast or for any of its competitors or peers, to make money in this climate because of the severe recession, to the extent that Northeast was less exposed to the recession because it made fewer loans, it benefited, and to the extent that the reason that

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it made fewer loans was because of the new capital rules of FIRREA, particularly the phase-out of the ability to count supervisory goodwill as capital, that was a benefit, because if it hadn't reduced its originations, it would have made more loans and it would have had more losses. Q. Okay. Did Northeast itself discuss the

relationship between the recession and its credit losses in its public filings? A. It did. Q. Have you prepared an exhibit summarizing these discussions? A. I have. Q. Let's go to tab 10, DX-3007, and it's a two-page exhibit. sir? A. Yeah, this is -- you know, again, these are just quotes, so I don't want to, you know, read them all, but the basic idea in all the quotes is that Northeast had large losses in its single-family residential real estate loans in the post-FIRREA period, and the reason that it did was the economic downturn in New England and California. The first quote talks about New England, Can you walk us through that,

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the second quote talks about New England and California, both referring to the existence of unanticipated losses, charge-offs, because of severe recessionary conditions, severe recessionary downturns in New England and California. The third quote on page 2 is probably the most detailed, but they're all to the same effect, that there's a significant amount of losses because there's a severe recession, as you would expect. So again, to the extent that the breach

caused Northeast to make fewer loans, as it itself stated, the losses that it did suffer would have been even greater, presumably, if it had made the amount -- the billion dollar amount of projected new mortgage loan originations that it had originally contemplated in the original 19 -December 1988 business plan and the revised plans if it didn't have to cut back because of the new capital rules. Q. All right. Let's go back to the blow-up,

and point 2 on it is, "Northeast securitized residential loans/removed recourse provisions." Can you explain what that means, sir? A. Yes. In response to the new risk-based

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capital requirements in FIRREA, and particularly the inability to count supervisory goodwill as capital in order to meet the new risk-based capital requirements as a result of the breaching provision of FIRREA, Northeast had to become a less risky bank because it had less capital than it otherwise would have had if it still had the ability to count supervisory goodwill as capital to satisfy the risk-based capital requirements, and it took a variety of steps in order to become a less risky bank. One of those steps was to securitize assets, and, relatedly, to remove recourse provisions. Q. Okay. What is the relationship, if any,

between the breach and Northeast's residential loan securitization or recourse removal? I think

you have already described that, but is there anything you want to add to that? A. I think I have described it. The basic

idea is when you have less capital because you can no longer count supervisory goodwill as capital, all else equal, you have to become less risky, and by securitizing loans, which transfers the credit risk of the loans from the bank to the issuing

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agencies of the securities, whatever issuing federal agency was issuing the securities, or by removing recourse provisions, which is the ability, in the event of a default, to come after the bank, the -- Northeast was able to reduce the risk-weighting of its assets, which was a way to deal with the fact that it had less capital that it could use to meet the new risk-based capital requirements. Q. Okay. Let's go to tab 11, which is DX-208.

It's the Northeast Savings capital plan, and the date on it is January 8, 1990. Let me direct your

attention, sir, to the page -- Section 1, page 6. Is that relevant to your testimony, sir? A. Yes. This is a discussion of what I've

been describing, how Northeast adopted certain steps to comply with the new capital rules, including the securitization of loans. So, if you

could highlight -- let's see, the first sentence of the second full paragraph, why don't we start there. The first two sentences, I guess, where

Northeast is talking about capital strategies in the alternative that Northeast is undertaking in order to comply with core capital and risk-based capital requirements, and the statement is made,

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"The base strategy involves two steps," and it talks about two steps, and then if we could go to the "In addition" sentence, the two steps are forming a holding company and reducing asset size, which are important, but not the point that I'm talking about now, and the statement is made, "In addition to these two steps, the base strategy" -in calendar year 1992, excuse me -- "the base strategy calls for the securitization of $500 million in residential mortgage loans to mortgage-backed securities in calendar year 1990 to reduce the risk-based capital requirement." And then further discussion of the possibility of additional loan securitizations in subsequent years. Q. Okay. Let me take you to tab 12, which is

PX-241, and this is an affidavit from Mr. George Rutland dated April 1, 1991. Is this relevant to your testimony? A. Yes. This really is a clear discussion of

the relationship between the breaching provision of FIRREA and the decision by Northeast to securitize assets and to eliminate recourse provisions, and if I could just point to several parts of this document.

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Q. Sure, sure.

Please do.

A. If we want to start with paragraph 5, and I'll try and do this quickly even though there are a number of different places -Q. Take your time. A. -- in the document, I don't want to be too tedious with this, but if we could start with paragraph 5. Q. All right, sir, we're there. A. And first the -- if we could just highlight the first sentence, the statement is made, "Solely because of the restrictions imposed by FIRREA and the OTS regulations on the inclusion of capital of supervisory goodwill and FSLIC's cumulative preferred stock -- restrictions that violated the contractual promises made by FSLIC and FHLBB to Northeast," so the introduction to what I'm about to describe is -- the statement is made by Mr. Rutland that a series of steps were undertaken solely, for the only reason, of the violation of the contractual promise, the -- what the Supreme Court determined to be a breach. And then if we could go to paragraph 6, again, the -- just the first sentence, if we could highlight that, "Over the last 15 months, while

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waiting for the Court to rule on the merits of its claim," namely, whether or not its contract was breached, "Northeast has gone to immeasurable lengths to come into compliance with the new capital requirements." And then paragraph 7, again, the first sentence, "Since December of last year, Northeast has taken a number of important steps regarding the new capital requirements." And with that

introduction, now we can, I think, turn to paragraph 18. Q. Okay. A. Again, really the whole paragraph is directly relevant, because this is a discussion of one of the steps that Northeast took solely as a result of what was later determined to be the Government's breach, and there's a discussion of how Northeast has "developed and implemented a system to routinely securitize $100 million of mortgage loans per quarter into high-quality mortgage-backed securities. Such securitization

reduces the amount of capital that must be maintained against the mortgage loans, thus reducing Northeast's risk-based capital requirement," because they no longer have the

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ability to use supervisory goodwill to count as capital. And then in paragraph 19, there is a discussion of the related decision, the -- "In addition, Northeast has been able to improve its risk-based capital position through other means such as removing the recourse provisions on $338 million of sold assets, at an annual cost of $400,000." And then just finally, really making the same point, if we could look briefly at paragraph 23, and maybe just the last sentence -- it's duplicative, but just the last sentence, because it's a good summary, beginning with "Northeast's reorganization." Mr. Rutland states that, "Northeast's reorganization into a holding company structure, coupled with the overall reduced asset size of Northeast," and this is the relevant part for what I'm discussing now, "and the reduction in risk-weighted assets through the securitization of loans, enabled it to comply with the OTS interim capital requirements within the time frame specified by FIRREA." So, the affidavit really confirms the

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statements in the capital plan that as a result of the new risk-based capital requirement and the inability to count supervisory goodwill as capital to satisfy the new risk-based capital requirement, Northeast had to undertake a series of steps to reduce the risk-weighting of its assets to become a less risky bank, and two of those steps were securitizing loans, which transfers the credit risk of the loans to a federal agency, and removing recourse provisions, which has the same effect of eliminating the possibility of having to make good on defaults; instead, that risk again being transferred to a federal agency. Q. Have you prepared an exhibit illustrating the amounts of loans Northeast securitized and the amount of recourse that it removed? A. I have. Q. Okay. DX-3008. Can we go to tab 13, and this is

Can you please explain this exhibit,

Professor? A. Yes. This is just a depiction of the

amount of securitizations and recourse removal in the period from October 1989 through December 1994, again, with two bars, the blue bar being securitizations and the green bars -- the green

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part of the bars being recourse removal, and you can see that over that slightly more than five-year period, Northeast, if you combine securitizations and recourse removal, reduced the riskiness of it looks like about $1,364,000,000 worth of assets, again making Northeast a less risky bank by taking those steps, by transferring the credit risk on that amount of assets from itself to federal agencies. Q. Now, sir, I want you to assume that Dr. Baxter agrees with you that securitization of loans at that time period, '89 and '90, and recourse removal and generally reduction in risk is actually economically beneficial given what we know now about the recession. With that assumption, how would that -- how is that relevant to analyzing his lost profits model? A. Well, it would be -- if he agreed with that proposition, it would be fundamentally inconsistent with his lost profits damage model, because these were steps, as Mr. Rutland stated, which were taken solely because of the breach. In

the absence of the breach, therefore, presumably, they would not have been taken. There would have

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been -- instead of the credit losses on these assets being shifted to a federal agency, they then would have been incurred by Northeast, but Dr. Baxter's model in the nonbreach world has zero dollars, not one cent, for loan losses, and therefore, if Dr. Baxter agreed with what I said, that would be a fundamental inconsistency with his lost profits damage model. MR. KIRK: Your Honor, I have an objection,

and I would move to strike the witness' response. During his deposition, I specifically asked Dr. -Professor Fischel, "Do you have an opinion --" and I'm on page 162 of the deposition -- "Do you have an opinion as to whether Northeast would have done anything differently with respect to securitization if the risk-based capital requirements had been implemented but supervisory goodwill had not been phased out? "ANSWER: Well, in addition to caveat

number one," which I'll explain in a moment, it was a convention that Professor Fischel used in his deposition, "I would just repeat again that there would have been some incentive to securitize, but it would have been a weaker incentive, a weaker incentive than what, in fact,

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in the real world -- what, in fact, existed in the real world. "QUESTION: But do you have an opinion, one

way or the other, whether with that weaker incentive they still would have done it? "ANSWER: one." And actually, before I explain what that is, would Your Honor like copies of these? THE COURT: "done it" means. MR. KIRK: THE COURT: I'm sorry? I'm not clear on what the Yes, and I want to know what No, because of caveat number

phrase they still would have "done it" that you just read means. MR. KIRK: Let me provide the text of the

deposition, and then I will respond to that question. Your Honor, may I approach? THE COURT: MR. KIRK: Please. Professor? Thank you, sir.

THE WITNESS: MR. KIRK: THE COURT: MR. KIRK:

Your Honor? Thank you, Mr. Kirk. I believe that the way the

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binder is set up, it includes both Professor Fischel's report, and then after the report, Your Honor, the deposition appears -- oh, I'm sorry, it's the other way around. The deposition is

first, and I believe the relevant passage is on the first day of the deposition, so it would be the first tab, and again, it's page 162. exchange I read is lines 1 through 15. And, Your Honor, to answer the Court's question, the "done it" plainly refers to the immediately preceding question, which was -- the "it" is, "Would they have done anything differently with respect to securitization if the risk-based capital requirements had been implemented but supervisory goodwill had not been phased out?" In other words, do you have an opinion as to whether or not their securitization would have been any different in the no-breach world, and the witness said he had no opinion. Now, let me explain what caveat number one is. Throughout his deposition, Professor Fischel The

in his answers was repeatedly of the view that questions concerning what might have happened in the no-breach world were not knowable based on,

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you know, the difficulty of understanding what would have happened in a world that did not exist. If the Court turns to page 19 of the deposition, Professor Fischel himself describes what is meant subsequently by "caveat number one" throughout his deposition. The only additional point I'd make to page 19, there it's described as a standing caveat. things turned out, there were, I think, two or three subsequent ones. as caveat number one. And I would just add that the caveat only reinforces the point. He -- he's saying that So, this one became known As

because he doesn't know what the world would look like in a world that didn't exist, he has no opinion on the question that he, in his -- in the answer I'm seeking to have stricken, he's now offered an opinion on. MR. SAWI: THE COURT: Your Honor, may I respond? You may, but you may not, yet. I'd like to.

THE WITNESS: THE COURT:

I know. But I understand the rules of

THE WITNESS:

the Court, Your Honor. MR. SAWI: Your Honor, the deposition and

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the expert report clearly link the securitization to an increased incentive to Northeast to meet the risk-based capital requirements as a result of the elimination of the phase-out of goodwill. The

question was asking him, if you grandfathered the goodwill, would they still have had an incentive, and the answer was it would have been a weaker incentive, and Professor Fischel stated in his deposition, as he stated today, that no one could know with a reasonable degree of certainty what would have happened in a world that didn't exist. That was true that -- that was his testimony throughout the deposition, and it was his testimony at the very beginning of today. So,

we don't think that there is anything inconsistent in this testimony with anything Professor Fischel said, and certainly plaintiffs should be welcome to cross examine him and use the deposition if they think that there is any inconsistencies during cross. THE COURT: The motion to strike is not The motion to strike

based on an inconsistency.

is based upon this witness offering an opinion now when he said he didn't have one before. MR. SAWI: Your Honor, I don't --

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THE COURT: MR. KIRK:

Right? Yes, Your Honor, that's exactly

MR. SAWI:

I don't believe the witness is

offering an opinion to a reasonable degree of certainty about -- based on his own expertise. He's simply referring to what plain -- what plaintiff said in an affidavit as the sole reason for the securitization, and that's the only connection he's making with that, but I -THE COURT: So, it's not his opinion. It's

going back to what he's inferring from the Rutland affidavit. MR. SAWI: it's -THE COURT: So we are not going to take it From the economic evidence, but

as an expert opinion? MR. SAWI: Only to the extent that he is

giving -- making an inference from the record to support the testimony that he's just given, and I'd be happy to follow up with the witness and clarify -- and clarify this -THE COURT: I'm sure you would, okay. Let

me hear from Mr. Kirk. MR. KIRK: Your Honor, I didn't object to

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the witness' interpretation of the Rutland affidavit. Arguably, it wasn't proper expert

testimony, but I feel cross examination is the cure there. It was only when, in the answer that I'm seeking to have stricken, he took it a step further and said that -- and I don't have the exact answer before me -- but the substance of it was, absent the breach, they would not have done the securitization, that's why Dr. Baxter's model is wrong. He's, therefore, offering precisely the

opinion that I asked do you have an opinion on. THE COURT: Very well. What the Court is

going to do at this point is I am going to deny the motion to strike without prejudice. I am

going to let you renew it again if you see fit after the close of all the testimony when the Court can better assess the deposition along with today's trial testimony. MR. KIRK: MR. SAWI: THE COURT: Very well, Your Honor. Okay. You may proceed, and you may

proceed to the extent you deem appropriate given the Court's ruling. MR. SAWI: Thank you, Your Honor.

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BY MR. SAWI: Q. Professor Fischel, do you know what would have happened to Northeast to a reasonable degree of certainty if the phase-out of goodwill had not happened? Could you draw us a lost profits model

for what Northeast would have looked like in the no-breach world? A. As -- you know, I -- again, just to repeat, I think what was just quoted from my deposition and as I stated at the outset of my deposition, I think it's impossible to know in the degree of detail that Dr. Baxter has posited what would have occurred in the nonbreach world. What I said on this issue in my deposition, what I intended certainly to say in my testimony, that in the real world, Northwest -- Northeast securitized assets and removed recourse in order to comply with a new risk-based capital requirement where they no longer had the ability to count supervisory goodwill as capital. That

was the stated reason that they did it and is an economic logic as to why they did it. If they still had -- in a but-for world where they still had the ability to count supervisory goodwill as capital, they would have

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had a much weaker incentive to take steps to reduce their riskiness, exactly as I stated in the deposition, because they would have been better able to comply with the new regulations and the new risk-based capital requirement, because they would have had the ability to count supervisory goodwill as capital, which they did not have in the real world because of the breach. Exactly what they would have done in the real world had they still had the -- excuse me, exactly what they would have done in the but-for world -- it's important to keep that distinction -- if they still had the ability to count supervisory goodwill as capital had there been no breach, there is no way to know. What I think you can say to a reasonable degree of certainty, which is what I said in the deposition, is they would have had a much weaker incentive to reduce their risk-weighting because they could have complied with the new regulations and rule even if they did not reduce their risk-weighting. That was really the point.

So, to the extent that there were losses avoided in the real world because they had to take certain steps to reduce their riskiness, such as

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securitizing assets and removing -- recourse removal, that enabled them to avoid losses that they would have incurred