Article

Note: As a result of the U.S. savings and loan crisis of the 1980s, the U.S. regulatory agency charged with supervision of thrift associations, the Federal Home Loan Bank Board, contracted with Anchor Savings Bank, FSB (Anchor), located in the State of New York, for it to acquire four failing financial institutions so as to avoid the need for their customers to draw on government guarantees. As part of the agreement, Anchor was promised that it could include "supervisory good will" amortized over a 25-to-40 year period as a capital asset which would count towards fulfillment of minimum capital requirements. However, in 1989, the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) disallowed substantially all supervisory good will and forced Anchor to adjust itself significantly to avoid its seizure and liquidation which left it in a crippled, undercapitalized state.

Anchor sued the United States in 1995, alleging breach of contract. Other financial institutions similarly affected also sued the United States for breach of contract following FIRREA's enactment and the U.S. Supreme Court decided in United States v. Winstar Corp., 518 U.S. 839 (1996), a 7-2 decision, that the United States had breached its contract with those financial institutions by enforcing FIRREA's accounting standards.

In light of the Winstar decision, the U.S. Court of Federal Claims ruled in a series of decisions that the United States had breached its contracts with Anchor. The court then addressed the issue of damages caused by the breach. In 2003, the court granted a summary judgment motion by the United States on the recoverability of damages based on a theory of restitution. Summary judgment, however, was denied as to a claim of damages based on lost expectations and so-called "wounded bank" damages. Anchor Sav. Bank, FSB v. United States, 59 Fed. Cl. 126 (2003). This opinion resulted from a trial held in July 2005. In this opinion, Block, J. awarded Anchor "lost profit damages attributable to a forced sale-[US]$137,595,000; expectation damages from reduced stock proceeds-$42,000,000; mitigation costs of lost benefit from the forced sale- $185,900,000; damages attributable to the branch sales-$8,146,125; 'wounded bank' damages- $4,133,226; increased insurance premiums- $4,656,559; and gross-up to be determined; the total before gross-up was $382,430,910."

Ironically, part of the loss claimed by Anchor was a result of its inability to participate in the then evolving mortgage banking industry for which it had been extremely well positioned at the time. Its FIRREArelated fiscal troubles, however, prevented it from playing a decisive role in the unfolding guarantee market. However, after staving off seizure, Anchor acquired Lincoln Savings Bank of New York and subsequently merged with The Dime Savings Bank of New York which acquired the North American Mortgage Company, a major player in the secondary mortgage market. In 2002, Dime was acquired by Washington Mutual, Inc., a victim of the current financial disaster as a result of overextension into the secondary mortgage market, the very market from which Anchor was excluded. Washington Mutual having been sold to JPMorgan Chase & Co. (JPMC), it remains to be seen whether the damages were part of the assets sold to JPMC or retained by the United States.

One of the bases for Anchor's claim was that the breach forced it to sell its subsidiary, the Residential Fund Corporation (RFC), in 1990 in order to obtain capital at a term and under circumstances that generated considerably less than its proper value. Accordingly, Anchor sought lost profits from the forced sale.

In assessing the validity of Anchor's claims, the Judge considered the impact of the risk-based capital requirements resulting from Basel I. The United States argued that the regulatory capital rules would have forced the sale of the RFC regardless of the breach by the United States. The Judge ruled that these arguments were not persuasive because they failed to take into account the context, "namely, Anchor was capital-starved because of the breach."

The court accepted the testimony of Anchor's experts that it could have satisfied the capital adequacy requirements without the sale had there been no breach. In so concluding, the Judge assessed the mechanics and application of the requirement to Anchor.

The United States had argued that RFC's "operational structure required far too much regulatory capital, which made it prohibitive for a thrift like Anchor to own RFC without running afoul of FIRREA's new (and non-breaching) risk-based capital requirement." This argument was based on the treatment of letters of credit-backed structures used by RFC for credit enhancement. The Judge noted, however, that because the LC obligations used as its primary credit enhancement tool were required to be highly capitalized, Anchor "eventually gravitated away from letters of credit as a credit enhancement tool and instead adopted the senior/subordinate structure to credit enhance its [mortgage-backed securities] and held the subordinate securities in its own portfolio." Even as to those arrangements for which RFC had used LCs to enhance credit, there was testimony that pool insurance could have been retroactively substituted for the LCs provided that the amount of the protection remained unchanged. Weighing conflicting expert opinions, the court concluded that RFC could have used alternative credit enhancing mechanisms. It also found compelling the testimony that RFC could have operated as profitably, or more so, by using the alternative mechanisms as a basis for "a concrete, reasonable and appropriate model by which it can develop a damages award that is, in the court's discretion, sound and appropriate."

Comment:

As these comments on LC alternatives indicate, the financial system will never be sound until piecemeal regulation is abandoned in favor of treating products with a similar function in a similar fashion and in following (and stopping) strategies to avoid or circumvent regulatory schemes such as occurred here.

[JEB/plc]

COPYRIGHT OF THE INSTITUTE OF INTERNATIONAL BANKING LAW & PRACTICE

The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.