Free Memorandum of Contentions of Fact and Law - District Court of Federal Claims - federal

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS No. 92-550C (Judge Williams) ______________________________________________________________________________ NORTHEAST SAVINGS, F.A., Plaintiff, v. THE UNITED STATES, Defendant. ______________________________________________________________________________ DEFENDANT'S MEMORANDUM OF CONTENTIONS OF FACT AND LAW ______________________________________________________________________________ STUART E. SCHIFFER Deputy Assistant Attorney General DAVID M. COHEN Director JEANNE E. DAVIDSON Deputy Director WILLIAM F. RYAN Assistant Director Of Counsel: SCOTT AUSTIN MELINDA HART ELIZABETH HOSFORD JEFFREY INFELISE SAMEER YERAWADEKAR Trial Attorneys Department of Justice TAREK SAWI Trial Attorney Commercial Litigation Branch Civil Division Department of Justice Attn: Classification Unit, 8th Floor 1100 L Street, N.W. Washington, D.C. 20530 Tele: (202) 616-0320 Fax: (202) 305-7643 Attorneys for Defendant

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TABLE OF CONTENTS EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 I. II. Northeast's Model Is Inconsistent With Its Track Record . . . . . . . . . . . . . . . . . . . . . . . . 2 The Model Takes More Interest Rate Risk Than Plaintiff Wanted to Take . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The Model Assumes That Plaintiff Would Bet On Falling Interest Rates At A Time When Plaintiff Expected Rates To Rise . . . . . . . . . . . . . . . . . 4 The Model Eliminates Credit Risk Contrary To Northeast's Strategy At The Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 The Model Is Based Upon A Multitude Of Other Speculative And Implausible Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

III.

IV.

V.

CONTENTIONS OF FACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I. BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 A. The Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1. 2. The Schenectady/Hartford Merger . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Northeast's Acquisition Of Freedom Federal And First Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

B.

Northeast's Post-Acquisition, Pre-FIRREA Operations . . . . . . . . . . . . . . . . . . . 10 1. 2. 1982-1988 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1988-89: Change In Strategic Direction . . . . . . . . . . . . . . . . . . . . . . . . . 12

C. D. II.

FIRREA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Northeast's Post-FIRREA Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

NORTHEAST'S LOST PROFITS MODEL IS CONTRADICTED BY ITS REAL WORLD TRACK RECORD, STRATEGIES, AND EXPECTATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

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A.

Northeast's Core Earnings Were Consistently Negative While Its Damages Model Shows $112 Million In Core Earnings . . . . . . . . . . . . . . . . 20 Northeast Wanted To Limit Its Exposure To Interest Rate Risk While Its Model Makes A Huge Bet Upon Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Northeast's Model Assumes That Northeast Would Bet On Falling Interest Rates At A Time When It Expected Rates To Rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Dr. Baxter's Model Assumes Away Prepayment Risk . . . . . . . . . . . . . . . . . . . 31 The Model Eliminates Credit Risk Contrary To Northeast's Strategy At The Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Northeast Erroneously Assumes That Larger Asset Size Translates Into Greater Profits And That The Breach Was The Reason For All Of Its Complained-Of Shrinkage . . . . . . . . . . . . . . . . . . . . 34

B.

C.

D. E.

F.

III.

NORTHEAST'S LOST PROFITS CLAIM DOES NOT MEET ANY OF THE APPLICABLE LEGAL REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . 35 A. B. C. Foreseeability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Causation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Reasonable Certainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

IV.

NORTHEAST IS NOT ENTITLED TO RECOVER AS DAMAGES ANY COSTS ASSOCIATED WITH ITS ACQUISITION OF RHODE ISLAND CREDIT UNIONS IN 1992 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 A. Any Costs Associated With Northeast's Issue Of Preferred Stock When It Acquired Rhode Island Credit Unions In 1992 Are Not Recoverable Because They Are The Result Of Remote Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Northeast Is Not Entitled To Recover Hypothetical Costs Associated With The Acquisition Of The Rhode Island Credit Unions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

B.

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C.

Northeast Is Not Entitled To Recover Costs Incurred By Its Holding Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Northeast's Claim For The Costs Associated With The Acquisition Of The Rhode Island Credit Unions Is Based Upon Speculative Assumptions Not Supported By The Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Even Were The Court To Award Northeast Its Claimed Cost-OfReplacement Damages, It Is Not Entitled To A Tax "Gross-Up" . . . . . . . . . . . 47

D.

E.

V.

NORTHEAST'S ALLEGED "WOUNDED BANK DAMAGES" ARE PREMISED UPON ITS FLAWED LOST PROFITS MODEL AND ARE FACTUALLY AND LEGALLY INFIRM . . . . . . . . . . . . . . . . . . . . . . . . . 47 NORTHEAST HAS GROSSLY OVERSTATED THE AMOUNT OF CONTRACTUAL GOODWILL TO WHICH IT WAS ENTITLED ABSENT THE BREACH . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 A. Northeast's Actual Accounting Of Its Goodwill And Contract Provisions Governing That Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 GAAP Controls Pursuant To Plain Language Of The Contract Documents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 As Northeast Told The Public, GAAP Required The Write-Down Of Its Goodwill For Reasons Unrelated To The Breach . . . . . . . . . . . . . . . . . . . 60

VI.

B.

C.

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

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TABLE OF AUTHORITIES CASES

American Federal Bank, FSB v. United States, 68 Fed. Cl. 346 (2005) ............................................................................................................... 41 Bluebonnet Sav. Bank F.S.B. v. United States, 266 F.3d 1348 (Fed. Cir. 2001) .................................................................................................. 36 California Fed. Bank, FSB v. United States, 395 F.3d 1263 (Fed. Cir.) ............................................................................................... 35, 38, 39 California Fed. Bank v. United States, 54 Fed. Cl. 704 (2002), aff'd, 395 F.3d 1263 (Fed. Cir. 2005) .................................................................................. passim Coast Fed. Bank, FSB v. United States, 48 Fed. Cl. 402 (2000), aff'd, 323 F.3d 1035 (Fed. Cir. 2003) ......................................................................................... 57 Coast Federal Bank v. United States, 323 F.3d 1035 (Fed. Cir. 2003) ........................................................................................... passim Corbetta Constr. Co. v. United States, 461 F.2d 1330 (Ct. Cl. 1972) ..................................................................................................... 54 DPJ Co. Ltd. v. FDIC, 30 F.3d 247 (1st Cir. 1994) ........................................................................................................ 41 Diesel Systems, LTD. v. Yip Shing Diesel Eng'g Co., 861 F. Supp. 179 (E.D.N.Y. 1994) ............................................................................................ 45 Eleven Line, Inc. v. North Texas State Soccer Association, Inc., 213 F.3d 198 (5th Cir. 2000) ....................................................................................................... 3 Energy Capital Corp. v. United States, 302 F.3d 1314 (Fed. Cir. 2002) .................................................................................................. 40 Erickson Air Crane Co. of Wash, Inc. v. United States, 731 F.2d 810 (Fed. Cir. 1984) .................................................................................................... 45 Fifth Third Bank v. United States, 402 F.3d 1221 (Fed. Cir. 2005) ........................................................................................... 35, 43 iv

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First Hartford Corp. Pension Plan & Trust v. United States, 194 F.3d 1279 (Fed. Cir. 1999) .................................................................................................. 45 Glendale Fed. Bank, F.S.B., v. United States, 378 F.3d 1308 (Fed. Cir. 2004) .................................................................................................. 35 Glendale v. United States, 239 F.3d 1374 (Fed. Cir. 2001) ............................................................................................... 8, 34 Glendale Federal Bank v. United States, 43 Fed. Cl. 390 (1999), aff'd in part, vacated in part, 239 F.3d 1374 (Fed. Cir. 2001) ............................................ passim Globe Sav. Bank, F.S.B. v. United States, 65 Fed. Cl. 330 (2005), aff'd in part, vacated in part, 2006 U.S. App. LEXIS 18417 (Fed. Cir. July 20, 2006) ........................................................... 35 Gould, Inc. v. United States, 935 F.2d 1271 (Fed. Cir. 1991) .................................................................................................. 54 Granite Mgmt. Corp. v. United States, 416 F.3d 1373 (Fed. Cir. 2005) ...................................................................................... 43, 44, 68 Hercules Inc. v. United States, 24 F.3d 188 (Fed. Cir. 1994) ....................................................................................................... 42 Home Sav. Of America v. United States, 399 F.3d 1341 (Fed. Cir. 2005) ............................................................................................ 58, 59 Home Savings of America v. United States, 57 Fed. Cl. 694 (2003), aff'd in part, vacated in part, 399 F.3d 1341 (Fed. Cir. 2005) ..................................................... 9 LaSalle Talman Bank, FSB v. United States, 317 F.3d 1363 (Fed. Cir. 2003) .................................................................................................. 41 Landmark Land Co. v. United States, 256 F.3d 1365 (Fed. Cir. 2001) ...................................................................................... 36, 44, 45 Northeast Savings v. United States, 63 Fed. Cl. 507 (2005) .......................................................................................................... 56, 57 Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) ....................................................................................................... 44 v

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Old Stone Corp. v. United States, 450 F.3d 1360 (Fed. Cir. 2006) ........................................................................................... passim Picture Lake Campground, Inc. v. Holiday Inns, Inc., 497 F. Supp. 858 (E.D. Va. 1980) ............................................................................................. 45 Roseburg Lumber Co. v. Madigan, 978 F.2d 660 (Fed. Cir. 1992) .................................................................................................... 40 Rumsfeld v. Applied Cos., 325 F.3d 1328 (Fed. Cir. 2003) .................................................................................................. 40 San Carlos Irrigation & Drainage Dist. v. United States, 111 F.3d 1557 (Fed. Cir. 1997) .................................................................................................. 40 Southern California Fed. Sav. & Loan Ass'n v. United States, 422 F.3d 1319 (Fed. Cir. 2005) .................................................................................................. 44 Southern Pacific Co. v. Darnell-Taenzer Lumber Co., 245 U.S. 531 (1918) ................................................................................................................... 41 United States v. Johnson Controls, Inc., 713 F.2d 1541 (Fed. Cir. 1983) ................................................................................................... 45 United States v. Winstar Corp. 518 U.S. 839 (1996) ..................................................................................................................... 8 Wells Fargo Bank, N.A. v. United States, 88 F.3d 1012 (Fed. Cir. 1996) .................................................................................................... 42 Westfed Holdings Co. v. United States, 407 F.3d 1352 (Fed. Cir. 2005) .................................................................................................. 44

STATUTES 12 C.F.R. § 567 (1990) .............................................................................................................. 15 12 C.F.R. § 567.1(w) ........................................................................................................... 15, 16 12 C.F.R. § 567.5 .................................................................................................................. 15, 16 12 U.S.C. § 1464(s) .............................................................................................................. 15, 16 26 U.S.C. § 61 ............................................................................................................................. 47 vi

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MISCELLANEOUS 11 William Meade Fletcher, Cyclopedia of the Law of Private Corporations § 5096 (perm. ed. 2003) ................................. 44 Dunn, Recovery of Damages For Lost Profits § 5.5 (4th ed. 1992) ............................................. 3 Restatement (Second) of Contracts § 347 (1981) ...................................................................... 36 Restatement (Second) of Contracts § 351 (1981) ................................................................ 36, 38 Restatement (Second) of Contracts § 352 (1981) ................................................................ 36, 40 Rev. Rul. 81-277 ......................................................................................................................... 47 Treatment of Goodwill Acquired in Mergers, 46 FR 42274 (Aug. 20, 1981) ........................... 57

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

No. 92-550C (Judge Williams)

DEFENDANT'S MEMORANDUM OF CONTENTIONS OF FACT AND LAW Pursuant to Paragraph 11, Appendix A of the Rules of the United States Court of Federal Claims, defendant, the United States, submits the following Memorandum of Contentions of Fact and Law. EXECUTIVE SUMMARY Plaintiff Northeast Savings, F.A. ("Northeast") did not generate core earnings during the years before or after the breach. Its lost profits model generates hypothetical profits by the use of hindsight. History tells us that, in the early 1990s, interest rates declined substantially and that California and New England, the areas in which plaintiff operated, suffered from a severe and prolonged recession. Thus, real estate lending that involved higher credit risk, i.e., risk that the borrower will default, resulted in losses. On the other hand, betting heavily on falling rates resulted in profits.1 Dr. Nevens Baxter, plaintiff's expert, builds a portfolio that bets heavily and consistently on falling rates and contains zero credit risk. This was the opposite of plaintiff's actual strategy, behavior, and expectations. Interest rate risk is the risk that the income or value of a portfolio will change based upon changes in interest rates.
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This Court has previously rejected a conceptually identical model from Dr. Baxter. Glendale Federal Bank v. United States, 43 Fed. Cl. 390, 401 n.3 (1999) aff'd in part rev'd in part, 239 F.3d 1374 (Fed. Cir. 2001). "In the end Glendale's model [sponsored by Dr. Baxter] is premised upon the acquisition of low credit risk assets and the ability to accurately manage high interest rate risk." Id. The Court rejected the model in its entirety because "the foregone portfolio would have entailed far greater interest rate risk than the bank otherwise was taking." Id. Moreover, the portfolio was "premised on interest rates falling" which was "inconsistent with Glendale's expectation that interest rates would rise." Id. Finally, contrary to Dr. Baxter's model "Glendale believed at the time that it should continue to invest in higher [credit] risk-weighted assets." Id. at 400. California Fed. Bank v. United States, 54 Fed. Cl. 704, 708 (2002) ("[plaintiff's expert] used a funding proxy in his model that repriced frequently because he knows that interest rates declined during the early 1990's. In reality, the bank thought interest rates were going to rise and would not have taken such a gamble."), aff'd, 395 F.3d 1263 (Fed. Cir. 2005). As we show below, Dr. Baxter replicates the flawed assumptions he made in Glendale here. His model contains far more interest rate risk than Northeast was taking, assumes that Northeast would bet on falling rates at a time it expected rates to rise, and removes credit risk at a time when Northeast wanted to increase credit risk. Because the model is premised upon these and many other counterfactual assumptions, it should be rejected in its entirety. I.. Northeast's Model Is Inconsistent With Its Track Record Plaintiff does not allege that the breach reduced or hampered in any way the profitability of the assets and liabilities that it had in the real world. Rather, plaintiff claims that, but for the 2

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breach, it would have had a portfolio of billions of dollars of additional assets and liabilities and that this hypothetical portfolio that Dr. Baxter models would have yielded some $112 million in profits from September 1989 to March 1995. Yet, plaintiff's real world core earnings were slightly below zero during that same time period. Dr. Baxter defined core earnings as earnings "that come from the normal business operations rather than one time gains on sales or one time gains on or losses on real estate transactions." Baxter Dep. 267. Dr. Baxter testified that "Northeast like any other institution viewed its core earnings as important. Regulators viewed it as important." Baxter Dep. at 270. Yet, he does not know whether Northeast had positive core earnings during either the five years before or the five years after the breach. He admitted that "it's not obvious" whether plaintiff had positive core earnings during either period. Dep. 273-76. Thus, a model that generates $112 million in profits cannot possibly be related to the company's track record, nor can it accurately be called "conservative." This admitted disparity between plaintiff's actual operating results in the real world and the fabulous profits it claims in its model demonstrates that the model does not reflect plaintiff's "track record" and should be rejected. Eleven Line, Inc. v. North Texas State Soccer Assn., Inc. 213 F.3d 198, 207 (5th Cir. 2000) (reversing a jury verdict, as a matter of law, because the damages methodology was inconsistent with the plaintiff's "past track record."); see Dunn, Recovery of Damages For Lost Profits § 5.5 (4th ed. 1992). II.. The Model Takes More Interest Rate Risk Than Plaintiff Wanted to Take Dr. Baxter agrees that "the greater change in earnings for a given change in interest rates, the greater the interest rate risk." Dep. 51. Mr. Brenner, the architect of Northeast's interest rate

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risk policy and the officer tasked with interest rate risk management, testified that Northeast wanted, to the extent practicable, to eliminate the effect of interest rate fluctuations upon the income of its portfolio. Brenner Dep. at 132-33. Q: Is it fair to say that the institution wanted to immunize the value of its portfolio and the income of its portfolio to fluctuations in interest rates to the extent that can prudently be done? A: Absolutely. Brenner Dep. at 136. In stark contrast to Northeast's policy, the spread between the costs of the liabilities and the yield from the assets in Dr. Baxter's model fluctuates from a negative 20 basis points to a positive 226 basis points. PX 243 at Ex. 6 Row 62. He admitted that the real world decline in interest rates was "a primary reason" for this change in spread. Baxter Dep. at 377-78. He further admitted that falling rates were beneficial to the portfolio he models because the liabilities repriced faster than the assets. Baxter Dep. at 379-80. Dr. Baxter's portfolio thus contained far greater interest rate risk than the bank wanted to accept in the real world. III. The Model Assumes That Plaintiff Would Bet On Falling Interest Rates At A Time When Plaintiff Expected Rates To Rise Not only does Dr. Baxter's model contain far more interest rate risk than the actual bank was taking, but it assumes that the bank would bet on falling rates at a time when it believed rates would actually rise. Dr. Baxter admits that the portfolio in his model benefitted from a drop in interest rates in 1992 and 1993, because the liabilities in that portfolio "re-price more rapidly than the assets." Baxter Dep. at 377-79. Thus, as rates decline, the cost of the liabilities falls faster than the yield on the assets, thereby increasing the spread. In the real world, Northeast had the opposite expectation. It believed rates would in fact rise. Consequently it formulated a

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portfolio where the assets re-priced faster than the liabilities. "Mr. Walters [Northeast's Chief Financial Officer ("CFO") at the time] stated that it is projected that long term rates will remain flat while short-term rates will increase moderately over the next three years. A discussion then ensued concerning the probable movement of interest rates following which a consensus was reached that rates will move in accordance with the forecast presented by Mr. Walters." DX 402 at 0050. Consistent with this expectation, Northeast adjusted its assets and liabilities so that "as a consequence, the Association's interest-earning assets can be expected to respond more quickly to changes in interest rates than its interest-bearing liabilities, resulting in an increase in net interest income when rates increase and a decrease when rates decrease." DX 31 at 0605(emphasis added). Thus, Northeast wanted to limit interest rate risk as far as possible. To the extent risk could not be eliminated, it positioned its portfolio in a manner precisely contrary to Dr. Baxter's model. It is Dr. Baxter's counterfactual assumptions that create the alleged "lost profits." For example, in 1992 and 1993, Northeast suffered losses, both in overall earnings and core earnings. DX 56 at 3373. During the same period Dr. Baxter's portfolio generates $70 million in claimed "lost profits." IV. The Model Eliminates Credit Risk Contrary To Northeast's Strategy At The Time Dr. Baxter's model is also based upon a portfolio that contains no credit risk. This assumption insulates the hypothetical portfolio from a severe recession that swept through Northeast's area of operations and caused high rates of foreclosures and loan defaults. Yet, in the real world, Northeast wanted to increase higher credit risk assets, such as commercial, consumer

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and multifamily loans (loans on apartment buildings). It reduced these loans precisely because of the phase out of goodwill. Mr. Albert Brenner, who drafted Northeast's business and capital plans, admitted that, as these plans stated, the phase-out of goodwill caused Northeast to limit business lines with higher credit risk: Q: And this emphasis on lower-risk assets and staying away from higher risk assets [as discussed in Northeast's 1989 revised business plan] is due to the phase out of supervisory goodwill from the institution's capital? A: That was the major reason. Brenner Dep. at 164. Mr. Brenner further admitted that limiting higher credit risk assets was beneficial given the effect of the recession: A: [T]here was a significant economic recession occurred in Connecticut resulting in financial stress on many financial institutions in the state. We felt ourselves fortunate to be positioned the way we were with our balance sheet structure the way it was because we were largely insulated from that economic distress. Q: Because you had fewer of the higher credit risk assets? A: Correct. Id. 180-81. Dr. Baxter admits that, contrary to Northeast's actual portfolio, his model is based upon a portfolio that is 100 percent wholesale assets funded by wholesale liabilities. He acknowledges that his assumption is counterfactual since Northeast wanted to increase its retail business, which would entail taking on higher credit risk than that of Dr. Baxter's portfolio. Northeast also wanted to reduce its wholesale business. Dr. Baxter justifies his admittedly counterfactual assumption by claiming that it is "conservative." However, counterfactual assumptions cannot be the basis of an award. Moreover, since the real bank generated negative

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core earnings while Dr. Baxter's portfolio produces $112 million in profits, his assumptions cannot be "conservative." Moreover Northeast intended to increase its retail residential lending. As a result of the recession, this lending turned out to be unprofitable. Thus, Dr. Baxter's portfolio based upon 100 percent wholesale assets and liabilities and containing zero credit risk is a counterfactual assumption that manufactures profits. V. The Model Is Based Upon A Multitude Of Other Speculative And Implausible Assumptions Northeast's entire damages model is based upon the assumption that, but for the breach Northeast would have maintained an asset size of $6.7 billion. This assumption is contradicted by Northeast's contemporaneous documents, which projected a significant reduction in size even if the goodwill were permitted to count as regulatory capital. DX 286 ¶¶ 28-41. Moreover, Dr. Baxter assumes that none of the goodwill that Northeast wrote off in the real world would have been written off absent the breach. Yet, Northeast listed many reasons for the write-off of goodwill that had absolutely nothing to do with the breach. DX 286 ¶¶ 18-27. Finally, Northeast's wounded bank claim and its claim for the costs of raising capital are premised upon its flawed lost profits claim. The genesis of these claims is that, because Northeast would have generated significant profits, it would not have needed to raise capital. Similarly, because of these same alleged profits, Northeast maintains that it would have been a far stronger bank and would consequently have been charged less for deposit insurance. Since these claims are premised upon the speculative and implausible lost profits claim, they should also be rejected. Moreover, these claims are flawed for many other reasons that we detail below.

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CONTENTIONS OF FACT I. BACKGROUND During the late 1970s and early 1980s, soaring interest rates caused the entire savings and loan industry overwhelming economic problems. Glendale v. United States, 239 F.3d 1374, 1377 (Fed. Cir. 2001). At that time, thrifts' liabilities were principally short-term deposits, while their assets were principally long-term, fixed-rate mortgages. When interest rates increased to unprecedented heights, the value of the long-term fixed-rate assets plummeted. See Id. 239 F.3d at 1377. Because thrifts had to pay higher rates on their liabilities but continued to earn lower rates on their assets, most thrifts reported enormous losses. The industry as a whole became economically insolvent because the market value of its liabilities exceeded the market value of its assets. See United States v. Winstar Corp, 518 U.S. 839, 845 (1996). In these circumstances, the Federal Savings and Loan Insurance Corporation (" FSLIC") and the Federal Home Loan Bank Board ("FHLBB" or "Board") became receptive to proposals for thrifts and outside investors to acquire other thrifts through mergers. See Winstar, 518 U.S. at 847-48. Mergers were attractive to acquiring thrifts because they enabled them to "acquire previously prohibited interstate branches, to acquire high-quality assets that suffered only from the current interest rate squeeze, and to transform an insolvent thrift's net liabilities into an intangible asset called `supervisory goodwill.'" Glendale, 239 F.3d at 1377. Even more importantly, acquiring thrifts had little to lose from the mergers. If rates declined, then the acquired thrifts' major problem would be solved. If rates did not decline, the entire industry would be "doomed" and the Government would be responsible for dealing with all the net liabilities. See Glendale, 239 F.3d at 1382. 8

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A.

The Acquisitions 1. The Schenectady/Hartford Merger

Schenectady Savings, like virtually all other thrifts in the early 1980s, was losing money because of high interest rates. See DX 828 at 0045. Like many other thrifts, it adopted "an aggressive strategy of acquiring savings and loans" to mitigate its short term losses, to expand its market area, and to help it be a survivor. A04024-25, 04026 (Dixon Dep. at 40-41, 47). Ultimately, these mergers gave Northeast ­the renamed thrift-- a "unique interstate franchise" that was "certainly attractive" to investors. A04024-25, 04026 (Dixon Dep. at 40-41, 47);2 see also PX 68 at 043068. DX 655 at 1010. On March 11, 1982, Schenectady Savings acquired troubled Hartford Savings and Loan Association ("Hartford Savings"). The combined association, renamed Northeast, was headquartered in Hartford, Connecticut. DX 270 at 0196. The FHLBB approved the merger by resolution. DX 270 at 0195. At the same time, Northeast and FSLIC entered into a written Assistance Agreement, (DX 274 at 0232-0241) which contained an integration clause incorporating the FHLBB resolution.. Id. at 0238. The FHLBB resolution spelled out terms required by the contract found by the Court, conditioning approval of the merger upon Northeast's strict compliance with Generally Accepted Accounting Principles ("GAAP"). DX 270 at 0196-0197. Importantly, for purposes of Northeast's damages claims, the FHLBB resolution provided no forbearance or exception to GAAP with respect to goodwill. In particular, there was no exception from GAAP's rules
2

Northeast attributed intangible value to the ability to engage in interstate banking because, in 1982, thrifts could not operate deposit branches out of state absent a supervisory merger. Home Savings of America v. United States, 57 Fed. Cl. 694, 699 (2003). 9

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governing when goodwill must be written down due to impairment or due to the sale of assets or how long goodwill could be amortized. Ultimately, Northeast recorded $108.951 million in

goodwill as a result of the Hartford acquisition. DX 549 at 1397. 2. Northeast's Acquisition Of Freedom Federal And First Federal

A few months after the Schenectady/Hartford merger, Northeast acquired Freedom Federal Savings and Loan of Worcester ("Freedom Federal"), and First Federal Savings and Loan Association of Boston ("First Federal"). DX 549 at 1397. The terms of the contracts between the FHLBB and Northeast arising out of these mergers compelled Northeast to account for goodwill in strict accordance with GAAP ­ as GAAP existed on July 12, 1982. DX 277 at 0249; DX 278 at 0602-0603. Indeed, as with the Schenectady/Hartford transaction, the FHLBB conditioned both the Freedom Federal and First Federal acquisitions upon the application of GAAP, as certified by Northeast's independent accountants. E.g., DX 277 at 0249; see also DX 278 at 0602-0603. The forbearance letters that were issued reiterated the FHLBB's requirement for the application of GAAP to Northeast's goodwill. DX 834 at 0390; DX 833 at 0388. Thus, like the Hartford acquisition, FHLBB provided no exception to or forbearance from GAAP concerning the treatment of goodwill or its amortization. B. Northeast's Post-Acquisition, Pre-FIRREA Operations 1. 1982-1988

After the acquisitions, Northeast raised substantial amounts of additional capital and embarked upon a rapid growth strategy focused upon wholesale borrowing and investing. DX 178 at 0145; PX 189 at 0045. Thus, rather than pursue a traditional thrift business plan by raising retail deposits to fund retail loans originated internally at the bank, Northeast pursued 10

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what amounted to a risk-controlled arbitrage strategy by purchasing wholesale loans on the secondary market, and funding them with wholesale liabilities. DX 6 at 1625. This strategy was not successful. DX 72 at 0461. Between 1982 and 1988, Northeast grew substantially, from $1.84 billion in assets to $8.21 billion by December 1988. DX 549 at 1393; DX 72 at 0461. During that period, Northeast reported yearly after-tax net income/(losses) of ($11.69) million for 1982, $11.38 million for 1983, ($3.82) million for 1984, ($10.53) million for 1985, $37.8 million for 1986, $33.28 million for 1987, and $21.1 million for 1988, for a combined $77.52 million in after-tax net income for the period. DX 6 at 1622; DX 10 at 0050. Profits for the period stemmed largely from extraordinary items and gains on the sale of assets. See DX 10 at 0050; DX 8 at 2206. For example, during fiscal year 1983, Northeast reported gains of approximately $18 million on the sale of assets that Northeast had acquired as a result of the acquisitions. DX 2 at 1483, 1492, 1498. Excluding such gains and extraordinary items, Northeast reported "core" operating income/(losses) of ($17.579) million 1982, ($15.299) million for 1983, ($13.614) million for 1984, ($14.947) million for 1985, $5.792 million for 1986, $11.750 million for 1987, and ($3.394) million for 1988. See DX 2 at 1483; DX 6 at 1649; DX 10 at 0076. Northeast converted from a mutual to a stock institution in September 1983. The stock conversion raised net proceeds of approximately $53 million and caused a corresponding increase to Northeast's capital. DX 2 at 1479; DX 702 at 0006. In August 1984, Northeast issued $75 million in adjustable rate preferred stock. DX 4 at 1101, 1129. In 1986, Northeast raised capital yet again by issuing $38 million in preferred stock, $125 million in Eurodollar notes, and $57.5 million in subordinated debt. DX 6 at 1626. Northeast used the proceeds from 11

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both offerings to further its growth strategy, and to pursue profitable opportunities it believed were available. After an unsuccessful attempt to sell the bank in early 1988 (due in part to the goodwill on Northeast's balance sheet), Kent Dixon, Northeast's Chairman, stated that Northeast's "future strategic direction should have as a foundation the improvement of the balance sheet, by reduction of goodwill and the increase of tangible net worth." DX 334 at 2209. 2. 1988-89: Change In Strategic Direction

In July 1988, George Rutland joined Northeast as CEO and Chairman. DX 12 at 00070008. Concerned with the unprofitability of Northeast's wholesale strategy, Mr. Rutland immediately conducted a review of Northeast's strategy and operations. DX 341 at 2285; DX 12 at 0007-0008; DX 664 at 0204-0205. After this review, Mr. Rutland announced a change in Northeast's strategy: Northeast would abandon its wholesale focus in favor of building a retail operation, including residential, non-residential, and commercial investments in New England and California. DX 12 at 0007-0008; DX 178 at 0145. Northeast's executives announced the change in strategy at a September 1988 board meeting, DX 342 at 0149. This new strategy called for Northeast to shrink immediately by $2 billion by selling $2 billion of deposits and $1.9 billion of wholesale assets. DX 854 at 0865; DX 342 at 0149. Because the branches that Northeast intended to sell were viewed as a "primary asset and financial resource by the" FSLIC, the regulators could not support Northeast's plan to shrink by selling branches and deposits. As such, Northeast had to "now focus on less desirable strategic alternatives." DX 343 at 2313. Northeast's shift away from wholesale operations was finally formalized in a business 12

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plan prepared in December 1988. DX 178 at 0145. The key components of the plan were: (1) rebuild a mortgage origination network; (2) build a commercial lending capability; (3) stop growth and substitute loans made by Northeast for wholesale assets; and (4) improve the bank's capital by managing the bank's size and through earnings. Id. While Mr. Rutland and the bank's management had seriously contemplated the immediate shrinkage of Northeast by billions of dollars through the liquidation of the wholesale portfolio of assets and liabilities, id.; DX 664 at 0204-0205; DX 669 at 0179; the initial 1989 plan projected maintaining asset size at roughly $8 billion, replacing wholesale assets with retail assets as they repaid. DX 178 at 0161 (projecting $1.23 billion in repayments in 1989 alone, with reinvestment in residential, commercial, and consumer loans). One of the key, underlying assumptions in the initial 1989 plan was that Northeast would increase capital and realize positive earnings in 1989. DX 178 at 0145-0146. And, as planned, Northeast had little margin for error, as it projected that by December 31, 1989, it would have just $1.3 million in regulatory capital surplus, above the projected four percent pre-FIRREA requirement as of that date. DX 178 at 0164. Indeed, even under the pre-FIRREA standards, Northeast was increasingly concerned with its ability to meet the regulatory requirements. DX 178 at 0146. With the significant rise in short term interest rates between the end of 1988 and the beginning of 1989, management believed that its assumption that Northeast would maintain positive earnings was untenable. DX 286 at ¶ 33; DX 179 at 1335; DX 180 at 0689. The squeeze in earnings led management to conclude, at a March 1989 board committee meeting, that Northeast would have to shrink to $5.2 billion to meet the proposed FHLBB risk-based capital 13

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requirement.3 DX 509 at 0530-0531. Importantly, this projection assumed all of Northeast's goodwill would be included in regulatory capital. Id.; DX 115 at 0818. As negative economic developments continued to unfold in 1989, Northeast's management again revised its projections in April. DX 286 at ¶ 34; DX 510 at 2303-2321. Projecting losses of $21.3 million instead of a $2.1 million profit as originally planned, Northeast determined that it needed to shrink to $4.5 billion by December 31, 1990 to meet FIRREA's proposed risk-based capital requirement. DX 510 at 2308, 2317. These revised projections assumed that all of Northeast's remaining goodwill would be included in regulatory capital. DX 510 at 2317. In May 1989, Northeast formally revised its business plan, calling for a reduction of assets to $4.5 billion in tangible assets by December 1990. DX 179 at 0763, 0765. Again, the revised business plan expressly assumed that goodwill would be grandfathered and that all of Northeast's goodwill would be included in regulatory capital. DX 179 at 1333. As part of its 1989 business plan revision, Northeast also decided to abandon its plan for investments in higher risk non-residential, commercial, and consumer loans. DX 287 at ¶ 19; DX 180 at 0687-0688. Northeast's contemporaneously-stated purpose for reducing credit risk was to increase its capital in the light of its capital constraints. DX 13 at 1397; DX 472 at 0181; DX 16 at 0401-0412; see also DX 679 at 0021. Northeast's officers have stated under oath that, absent the lack of capital, Northeast would have invested in commercial and consumer loans in

The FHLBB itself had issued a proposed risk-based capital standard in December 1988 before the announcement of the proposed FIRREA legislation ­ which came in February 1989. DX 178 at 0165. Because the FIRREA proposal was in its infancy, Northeast's management apparently was still focused upon the pending and separate FHLBB proposal. DX 509 at 0530-0531. 14

3

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New England and California. See (O'Keefe Dep. at 38-39, 109-110); (Brenner Dep. at 219-220); (Coleman Dep. at 220-222); (Hamilton Dep. 29-36); (Walters Dep. at 133). These types of credits faired poorly during the deep recessions in California and New England in the early 1990s. DX 287 at ¶ 20, Ex. J; DX 979 at 0518; (Baxter Dep. 545-59). By December 31, 1989, Northeast reduced its tangible assets to $5.2 billion consistent with its business plan projections. DX 76 at 0227; DX 509 at 0530-0531. Northeast was able to report marginal quarterly pre-tax profits through 1989. DX 12 at 0052; PX 9 at 0041 (1990 Annual Rep.) (reflecting total 1989 pre-tax profit of $392,000). See DX 14 at 0041. C. FIRREA

To resolve the savings and loan crisis, Congress enacted FIRREA on August 9, 1989. The relevant capital provisions of the legislation required, among other things: (1) that all thrifts adhere to three new capital ratio requirements (tangible, core, and risk-based capital); and (2) that thrifts deduct goodwill from regulatory capital requirements, except that "supervisory goodwill" could be phased out of "core" and "risk-based" capital over a five-year period. With FIRREA's mandate, the Office of the Thrift Supervision ("OTS"), the agency created by FIRREA to regulate the thrift industry, implemented the statute through the enforcement of regulations. 12 C.F.R. § 567 (1990). The effect of these governing regulations upon Northeast's goodwill was that, unless the goodwill qualified as "supervisory goodwill" as defined by regulation,4 it would have to be deducted from all three new capital requirement ratios

The term "supervisory goodwill" is one that arose for the first time from the FIRREA legislation. 12 C.F.R. § 567.1(w), 567.5; 12 U.S.C. § 1464(s). It was not a term used

4

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immediately. 12 C.F.R. § 567.1(w), 567.5; 12 U.S.C. § 1464(s). Although supervisory goodwill was deducted immediately from the calculation of tangible capital, this deduction is irrelevant for purposes of damages because Northeast was as constrained with respect to core and risk-based capital as it was with respect to tangible capital. In other words even if Northeast had substantial excess tangible capital to leverage with the inclusion of goodwill, it still would have been constrained by the core and risk-based requirements which, in fact, allowed Northeast to include a substantial portion of its goodwill. See DX 35 at 7528. Northeast, in accordance with GAAP, reexamined goodwill on its balance sheet at fiscal year end March 1990. At that time, it wrote off approximately $109.4 million in its goodwill, leaving $90 million in unamortized contractual goodwill remaining. DX 14 at 0019. Northeast and its accountants explained in public disclosures that the write-off was required due to economic circumstances, including: (1) passage of the Connecticut Interstate Banking Law, which undermined the competitive advantage obtained by Northeast's interstate acquisitions in 1982; (2) the passage of FIRREA; and (3) the deteriorating condition of the banking industry in New England. Having filed a lawsuit before the issuance of its 1990 annual report, Northeast also alluded to the breaching provisions of FIRREA as an additional basis for writing off the goodwill under GAAP. DX 16 at 0422; 0429; DX 14 at 0007. At the end of 1992, Northeast wrote down its remaining goodwill ­ approximately $56.6 million ­ as required by GAAP, explaining that the goodwill was unrecoverable based upon economic factors that spurred the write-down in March 1990. DX 35 at 7489.

or defined by regulators at the time of the transactions at issue in this case. 16

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D.

Northeast's Post-FIRREA Operations

Failing its capital requirements as of December 31, 1989, DX 76 at 0238, Northeast filed a Capital Plan with regulators in January 1990 setting forth its plans to achieve capital compliance.5 DX 208 at 2944-2994. Those plans included the formation of a holding company, securitization of whole loans in order to reduce the risk-weighting of assets, increased retained earnings, and asset shrinkage in the short run. Id. Its Capital Plan, fully accounting for the breach, also projected asset growth to $5.7 billion by 1993. DX 208 at 2961. Pursuant to its Capital Plan, Northeast, with the help of FIRREA's gradual phase-out schedule and the formation of a holding company called Northeast Federal Corp ("NFC"), met FIRREA's higher capital requirements as of July 9, 1990. DX 78 at 1969. Northeast never fell out of capital compliance again. However, Northeast's operations between 1990 and 1994 were negatively affected by deteriorating economic conditions in its primary markets ­ New England and California - and aggressive residential mortgage lending. DX 287 at ¶ 20; DX 979 at 0518; DX 756 at 0034. During this period, Northeast had substantial increases in its non-performing assets and credit losses due to severe recessions in its primary market areas. DX 979 at 0518; DX 287 at Ex. J, Ex. I. In fact, because Northeast's retail lending operations in California were so unsuccessful, it
5

Absent Northeast shrinking as it did, Northeast would have had to file a capital plan even absent the breach because of the FIRREA capital rules excluding cumulative preferred stock from core capital. For example (after shrinking) as of November 1989, excluding cumulative preferred stock but including goodwill, Northeast's core capital would have been $176.4 million ($276.5 million total capital minus $100.4 million in cumulative preferred) versus a requirement of $168.8 million ($5.62 billion in assets times 3 percent). DX 208 at 2947-2948 (Capital Plan). Without shrinking, Northeast's capital requirement would have been substantially higher and it would not have been able to meet that higher requirement even counting all of the goodwill toward all of its capital requirements. 17

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shut down its loan origination network there in 1994. DX 645 at 0674; DX 86 at 1105. For fiscal years ending March 1991 and 1992, it reported net income of $11.7 million and $5.6 million. DX 27 at 1478. With the growing recessions in its market areas and heavy credit losses, Northeast's reported income/(loss) for fiscal years ended December 1992 through 1994 was: ($59.2 million),6 ($14.1 million), and $10.9 million. DX 35 at 7506; DX 979 at 0595; DX 56 at 3373. Notwithstanding projected growth in its Capital Plan, Northeast reduced its assets between 1990 and 1993. By calendar year end 1990, Northeast reduced its assets to $4.9 billion ­ an asset total that, incidently, exceeded Northeast's pre-breach projection that assumed inclusion of all goodwill in capital. DX 78 at 1957; DX 179 at 0763. At years-end 1991, 1992, and 1993, Northeast reduced its assets to $3.7 billion, $3.9 billion, and $3.9 billion, respectively. DX 82 at 0260; DX 35 at 07507; DX 979 at 0596. Northeast attributed this reduction in assets, in part, to non-breach factors such as the phase in of FIRREA's higher risk-based capital requirements (from 6.4 percent in March 1990 to 8 percent by December 1992), and the imposition of yet higher, non-breach capital requirements imposed by the Federal Deposit Insurance Improvement Act of 1991 ("FDICIA"). DX 13 at 1397; DX 472 at 0181; DX 16 at 0401-0402. In 1994, Northeast reduced its assets by approximately $574 million, but plaintiff asserts this reduction had nothing to do with the breach. DX 285 at ¶ 34; DX 56 at 3374. Instead, the company consolidated operations by, among other things, selling branches in preparation for sale of the company. DX 285 at ¶ 34.

The December 1992 reported loss was largely due to the write-off of the remaining goodwill. See DX 35 at 7506. 18

6

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In 1992, Northeast purchased $404 million in deposits from the Resolution Trust Corporation, and acquired four failed Rhode Island credit unions from that state's Depositors Economic Protection Corporation ("DEPCO"). DX 27 at 1483, 1538; DX 35 at 7521; DX 288 at ¶ 29. To acquire the credit unions, Northeast's holding company, NFC, issued to DEPCO $35.2 million in cumulative preferred stock with an 8.5 percent stated dividend yield. DX 288 at ¶ 29. In connection with the preferred stock, NFC also issued warrants to DEPCO, giving DEPCO the option to purchase 600,000 shares of NFC common stock at an exercise price of $2.50 per share, and 200,000 shares at a price of $4.25 per share. Id. NFC also issued $35.95 million of 9 percent sinking fund debentures, $28.95 million of which were sold to the receivers of the failed Rhode Island institutions. The FSLIC preferred which Northeast issued in exchange for the FSLIC ICC from the Freedom Federal transaction, (plus unpaid accumulated dividends) was redeemed for $28 million in cash plus a $7 million note from NFC. NFC also infused a portion of the proceeds raised from DEPCO directly into Northeast as capital. DX 27 at 1483; DX 246 at 3502. In the summer of 1993, Northeast filed proxy material in connection with a shareholder rights offering to raise capital. DX 429 at 2481-2484. Northeast later withdrew this offering because the price of the offering would have been inconsistent with the value of Northeast. (Walters Dep. at 43-44); (Brenner Dep. at 64-67). In June 1995, Shawmut National Corporation acquired Northeast. Northeast's shareholders were compensated at a price higher than Northeast's share price on December 31, 1988, before FIRREA. The acquisition was accounted for using the purchase method. Northeast does not claim the breach caused the sale. 19

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II.

NORTHEAST'S LOST PROFITS MODEL IS CONTRADICTED BY ITS REAL WORLD TRACK RECORD, STRATEGIES, AND EXPECTATIONS As we show below, Northeast, never generated core earnings and it wanted, for reasons

totally independent from the breach, to reduce its interest rate risk, expected rates to increase for most of the early 1990s, and wanted to increase its retail business, which entailed greater credit risk. Its model is premised upon precisely the opposite assumptions and yields core earnings, when Northeast's track record shows losses. A. Northeast's Core Earnings Were Consistently Negative While Its Damages Model Shows $112 million In Core Earnings

Northeast, erroneously claims that it "was profitable prior to the Government's breach." Pl. Br. 10.7 However, in the fiscal year ending March 31, 1989, several months prior to FIRREA, Northeast reported a loss of $12.9 million. DX 285 at Ex. 1. Dr. Baxter admitted that "it's not obvious" whether Northeast had positive core earnings during either the five years prior to or the five years after FIRREA. Dep. at 273-76. Northeast attempts to evade the fact that its actual core earning were consistently negative by attacking the very concept of core earnings as some form of "gerrymandering" by the Government. Pl. Br. at 53, n.18. Northeast's attempt to escape its track record fails for many reasons. First, as Dr. Baxter admitted, core earnings are defined as earnings "that come from the normal business operations rather than one time gains on sales or one time gains on or losses on real estate transactions." Baxter Dep. at 267. Given the definition of core earnings, it is not surprising that as Dr. Baxter admitted "Northeast like any other institution viewed its core

7

Pl. Br. Refers to Northeast's Appendix A brief. 20

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earnings as important. Regulators viewed it as important." Id. 270. Indeed, Northeast's 1988 examination report noted that, "[s]ince its formation in 1982 the institution has never been able to generate except for a small profit in FY 1986 any bona fide core earnings. With the exception of 1986, sizeable losses would have been shown for every year without gains on sales, net purchase accounting and tax benefits and net extraordinary gains." PX 192 at 2208 (emphasis added.). Second, core earnings are precisely what Dr. Baxter's hypothetical portfolio purports to generate. That is, Dr. Baxter's portfolio does not generate the purported $112 million in lost profits through one time events, asset sales, or accounting adjustments. Rather, it purports to generate them by having assets that allegedly generate interest income that exceeds the interest cost of liabilities, credit losses, and operating expenses by $112 million. Since he does not know if Northeast's real world portfolio ever generated any such earnings, there is simply no way that Dr. Baxter's model can be based upon, or even bear any resemblance to, Northeast's track record. Third, even switching to reported earnings (as opposed to core earnings) does not aid Northeast's cause. For example, Northeast's reported earnings in 1992 and 1993 were negative, even excluding the goodwill write-off in 1992, as were its core earnings during that same period. DX 56 at 3373; PX 204 at 0910. Yet during the same period, Dr. Baxter's portfolio yields $70 million in profits. DX 285, Ex. 6. Thus, the model tracks neither core nor reported earnings. In yet another attempt to mask the disparity between reality and its model, Northeast tries to focus upon its wholesale portfolio prior to the arrival of new management in 1988. It contends that the track record of this portfolio lends credence to its damages model because it claims that the new management intended to keep this portfolio for several years while it ran off, and that 21

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this portfolio was supposedly profitable. Again Northeast is wrong on all counts. Northeast mis-cites its 1989 annual report suggesting that the "turnaround would take three to five years." Pl. Br. at 10, citing PX 8. From this, it argues that its wholesale portfolio was going to remain for that period of time. Id. However, this comment by Mr. Rutland in the annual report was in response to the question: "What is your anticipated time frame until Northeast has consistent core operating earnings?" DX 12 at 0011 (emphasis added). Thus, it did not refer at all to how long the wholesale portfolio would remain. Indeed, both the question and the answer explicitly show that both Northeast's shareholders and its management were focused upon "core earnings," that Northeast did not have core earnings at the time, and that it did not expect to have such earnings in the near future. Thus, the document Northeast cites actually shows the stark difference between its real world track record and its damages model. Moreover, the annual report also notes that Northeast "ha[d] also made progress toward our goal of de-emphasizing wholesale activities and ultimately reducing Northeast's asset size." DX 12 at 0007. Furthermore, the annual report and 10-K were signed on May 31, 1989, DX 12 at 0008, and, therefore, by the time the annual report was released, Northeast had already begun to unwind its wholesale operations. Thus, there would no longer have been a need for the asset composition shift from wholesale to retail to take three to five years. Indeed, due to concerns expressed by regulators about Northeast's ability to meet is preFIRREA regulatory capital requirements, in its July 6, 1989, response to the 1988 Report of Examination, Northeast promised to reduce its assets to $5.8 billion by the end of 1989 , and its assessment assumed the retention of supervisory goodwill. July 6, 1989 Response letter from Northeast to Kevin McCarthy at DX 257 at 2362, 2380. 22

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More importantly, Northeast's attempt to use its 1988 wholesale portfolio as a "track record" for its damages model fails because that portfolio was not profitable and it did not even resemble the damages model. Northeast cites a report from its consultants, Kaplan Smith, in support of its current litigation position that its 1988 wholesale portfolio was profitable and can serve as a track record for its model. However, the Kaplan Smith study noted that the market value of Northeast's wholesale assets was $132 million below its purchase price. DX 342 at 0148; DX 854 at 0825. Since the value of the portfolio declined by $132 million, its performance and actual track record can hardly support a lost profits model. Kaplan Smith also commented that the "wholesale bank is earning [a] poor spread." DX 853 at 2488. Further, the wholesale bank to which Kaplan Smith was referring was not a purely wholesale operation, since the total wholesale assets were $6.4 billion while the wholesale liabilities were only $4 billion. Id. This means the wholesale assets could not have been funded entirely by wholesale liabilities. The wholesale assets must have been funded in part by $2.4 billion in retail deposits. The reported spread does not account for the general and administrative costs entailed in gathering and maintaining some $2.4 billion in deposits. Moreover, the real world "wholesale" spread is not comparable to Dr. Baxter's spread because the real world portfolio included junk bonds and purchased loans, both of which would be subject to significant credit risk. 12/88 Exam at DX 228 at 2468-69. The higher expected return from those assets is compensation for this high credit risk. By contrast, Dr. Baxter's portfolio has zero credit risk, and reports zero credit losses. Thus, nothing in the real bank's wholesale portfolio in 1988 can serve as a track record for Dr. Baxter's model.

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Finally, the Kaplan Smith study concludes that the "Pure Retail" bank's profit was $0, and the "Mixed Retail and Wholesale" bank was suffering a loss of $17 million. However, the "Pure Wholesale" bank's "profit" was $9 million, if one disregards its $132 million decline in market value. Kaplan Smith August 19, 1988 Report at DX 853 at 2492. Thus, there is no portion of Northeast's balance sheet that can be "gerrymandered" enough to support a track record of profitability, let alone one that matches Dr. Baxter's model. Moreover, Dr. Baxter admits that his model is based 100 percent upon wholesale assets funded by wholesale liabilities. Baxter Dep. 122-23. Both he and Northeast admit that this assumption is counterfactual. That is, in the real world, Northeast's additional assets would have contained retail assets and liabilities. Pl. Br. 51-52. Dr. Baxter justifies this counterfactual assumption on the grounds that it is "conservative." This explanation is inconsistent with the real track record even as documented in the Kaplan Smith study, which showed that the "pure retail" bank and the "mixed retail and wholesale bank" were both unprofitable. DX 853 at 2492. Thus, Dr. Baxter's admittedly counterfactual assumption of a pure wholesale bank is one of the mechanisms by which his model generates damages. B. Northeast Wanted To Limit Its Exposure To Interest Rate Risk While Its Model Makes a Huge Bet Upon Interest Rates

Northeast argues that it was comfortable with the interest rate risk position of its 1988 wholesale portfolio. This is inconsistent with both its documents and the regulators' instructions at the time. For example, the 1988 examination report concluded that "[Northeast] has been, and is, subject to a significant degree of interest rate risk. This has contributed to operating losses for the nine month period ended December 1988, and a significant deterioration in the net asset

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value of the institution since December 1986. PX 192 at 2224. The regulators concluded that such a strategy was no longer viable. Id. In its response to the examination, Northeast agreed to terminate this strategy. July 6, 1989 response at DX 257 at 2354. In its November 1989 five-year business plan, Northeast states that "[it] has historically been exposed to a high degree of interest rate risk, largely as a result of a high proportion of funding liabilities being in the form of wholesale liabilities with very short repricing periods. These liabilities were extremely interest rate sensitive and were not matched with assets of similar sensitivity." DX 184 at 1759; id. at 1747-1782. "The reduction in the Association's interest rate risk exposure is a deliberate consequence of Northeast's business strategy. Northeast expects that the successful achievement of its business strategy will be the most effective means of managing interest rate risk." Id at 1760. Even Dr. Baxter admitted that the new management wanted to reduce the institutions exposure to interest rate risk for reasons that have nothing to do with the breach. Baxter Dep. at 152-53. A common measure of interest rate risk taken by a thrift was known as "gap" ­ not to be confused with GAAP, the body of accounting rules. DX 288 at ¶ 51. Gap is defined as the dollar amount of assets projected to mature within a given period minus liabilities projected to mature within the same period, divided by total assets. Id. If more assets than liabilities mature, then a thrift will have a positive gap, with its net interest income rising in a rising rate scenario (because more assets than liabilities ride the rates up quickly) and falling in a falling rate scenario. Id. If a thrift's gap is negative, more liabilities reprice faster than assets, leading to higher net interest income in a falling rate scenario and lower net interest income in a rising rate scenario. Id. The goal of banks ­ helped by regulatory requirements limiting permissible interest rate risk ­ is to 25

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match the maturities of assets and liabilities in order to minimize negative and positive gaps. A04056 (Thakor Dep. 393-94). Northeast was no different from most banks. Its management repeatedly warned of the "potentially catastrophic financial consequences" of allowing the bank to take too much interest rate risk. DX 288 at ¶ 54; DX 473 at 2688; A04011-12 (Brenner Dep. at 118-20, 131-33); A04019 (Coleman Dep. at 48). Its goal was to minimize interest rate risk as much as possible. Id. Consistent with this goal, Northeast's six month repricing gap ­ for the entire bank, not just its wholesale portfolio ­ was relatively low in percentage