assets, which resulted in a loss of only $700,000, amounting to only .02% of Lincoln's assets, threatened Lincoln's financial integrity. In Lincoln's view, the examiners' concern was misplaced, especially because this particular investment surrendered no more management control or discretion than FHLBBendorsed investments in mutual funds or open-end management investment companies.

The 1986 Report further concluded that "serious deficiencies" in Lincoln's policies and procedures for investment in high-yield corporate debt and equity securities reflected an inordinately high assumption of risk and disregard for prudent investment underwriting. 507 The 1986 Report noted in particular a lack of diversification, poor underwriting and the absence of written underwriting standards prior to April 1986. This critique, however, rested upon a mistaken view of the relative risks and rewards of such investments and their function in Lincoln's portfolio. Lincoln's holdings in high yield bonds were broadly diversified and constituted only a small part (7% of total assets as of September 1986)517 of Lincoln's highly diversified investment portfolio but yielded an annualized rate of return of 16.43%. As they had done throughout the report, the FHLBB ignored the three years of success of such investments in affixing their pejorative labels.527 In addition, the FHLBB concluded, after completing its own study of junk bonds,537 that the enhanced

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Incredibly, the regulators now have made a criminal referral with respect to Lincoln's preparation of summaries of their underwriting analyses, charging that, notwithstanding that the examiners have acknowledged being told by Lincoln representatives that these descriptions of underwriting analyses were prepared expressly for the examiners, somehow Lincoln management intended to mislead the examiners to believe they were prepared contemporaneously with the transaction at issue. They have pejoratively characterized Lincoln's efforts to assist the examiners in their review of these files as "file-stuffing."

It should be noted that banks were permitted to invest up to 11% of total assets in high yield bonds.

As the Director, Office of Enforcement, Rosemary Stewart
pointed out in her testimony before the House Banking
Committee on November 21, 1989, "there were no large
securities trading losses ... and Lincoln, in fact, had
made a great deal more money on their securities transactions
than they had ever lost by May of 1987."

The findings of the study conducted by Robert Sahadi and Jane
Katz of the Office of Policy and Economic Research of the

The

risk is offset by the increased rates of return, and in the context of an actively managed, well-diversified portfolio, such investments pose no greater risk than many other investments. FHL88's study recommended that the FHLBB not prohibit investment in high-yield bonds. This 1985 FHLBB memorandum regarding "junk" bonds concurred with the conclusions of various studies on the subject that high-yield bonds are of generally higher quality than commercial loans and, in deed, constitute a better investment. That FHLBB memorandum also observed that Securities and Exchange Commission ("SEC") filing requirements impose quality control on corporate debentures and trustee-monitored bonds, whereas commercial loans are controlled only by an association's internal auditing procedures. Significantly, the FHLBB study observed that [1]imiting an investment that has no sufficient data to support the proposition that it poses excessive economic risks and threatens the safety and soundness of insured institutions may raise policy implications and potential legal difficulties.-5%/

Although the 1986 Report criticized Lincoln's high-yield investments as jeopardizing its financial safety, the PHLBB failed to consider that Lincoln's own internal investment policies and practices, while highly successful, also imposed limitations and restrictions on investment in order to minimize risk and protect the safety of investments. Investments were reasonably diversified as to type, issue, company and industry. Lincoln's success in its high-yield bond investments resulted primarily from its self-imposed diversification requirements. Under Lincoln's investment policy, generally, no more than $25 million could be invested in one company,557 thereby reducing Lincoln's exposure with respect to any individual company, insuring liquidity by facilitating sales, and increasing the number of issues comprising the portfolio. The policy further provides that no more than 10% of Lincoln's total assets be invested in high-yield bonds and of that 10%, no more than 25% be invested in any single industry, no more than $25 million be invested in any one issue and no more than 10% of a single company's long-term debt be held by Lincoln. The report's claim that Lincoln's high-yield bond investments were unsound or unsafe was based on misconceptions and the examiners' failure to analyze the extensive and sophisticated policies and practices utilized by Lincoln to reduce risk.

541

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FHLBB were set forth in an October 21, 1986 memorandum to
Chairman Gray and senior executive staff, at p. 16.

Id. at 14.

An exception might be made if the proposed investment was, itself, adequately diversified in accordance with Lincoln's guidelines, as, for example, with a mutual fund or investment partnership.

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Contrary to the 1986 Report's conclusion, Lincoln's investments were based on conscientious, sound and thorough underwriting as required by its internal investment policies. Prior to each bond investment, Lincoln management analyzed the prospectus or private placement memorandum, recent SEC filings and annual reports and information from underwriters and analysts, and its investment committee made its own extensive analysis of all pertinent information. In addition, the examiners failed to evaluate the remainder of Lincoln's portfolio when they evaluated liquidity. Moreover, the reports prepared by the consultants commissioned by the FHLBB were themselves riddled with errors, including failing to recognize significant factors, misconstruing factors which were recognized, and ignoring Lincoln's actual investment practices and policies. The reliance upon these unreliable reports is questionable at best, because they were internally flawed and mutually inconsistent.

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For example, the report by Alan C. Shapiro and Marc I. Weinstein ("Shapiro and Weinstein Report") improperly analyzed risk by concentrating on the purported hazard to the FSLIC insurance fund only from Lincoln's high-yield portfolio, without considering its overall portfolio or its substantial net worth.57/ Additionally neither Shapiro nor Weinstein ever spoke with Lincoln personnel about Lincoln's portfolio, investment policies or other matters relevant to a sound analysis. The report reflected egregious mistakes by the authors so substantial as to render the report useless. The study made false assumptions about the overall risk of Lincoln's portfolio, comparing only 10% of Lincoln's assets to 100% of the assets of investment funds and failed to acknowledge Lincoln's success in these investments. study also attempted to make Lincoln accountable to standards which were not required by statute or regulation and which appeared to have been applied only to Lincoln. In addition, the Shapiro and Weinstein Report misapplied diversification theory; it concluded Lincoln's investments were not diversified because of the size of only two of Lincoln's 27 high-yield bond investments (each a very small percentage of Lincoln's assets), and both of

567

571

The

Interestingly enough, Shapiro was appointed by the FDIC to serve on the Advisory Board to Oversee Lincoln after Lincoln was placed in conservatorship.

Because of the inaccuracies and misconceptions throughout the Shapiro and Weinstein Report, Lincoln commissioned its own study by Lexecon, Inc., (two of whose members received the Nobel Memorial Prize in Economics) whose more sophisticated and more complete analysis stated that Lincoln's investment practices did not threaten the FSLIC fund, but were in fact far superior to those of other savings and loan associations.

which had been liquidated by Lincoln at a profit. The authors apparently confused "diversification with concentration." Although Shapiro and Weinstein state in their report that policies for managing junk bonds must be viewed against the overall asset portfolio, they failed to follow that approach when they analyzed Lincoln's policies.

Second, the report prepared by Houlihan, Lokey, Howard & Zukin, Inc. ("Houlihan, Lokey Report") concluded, based upon an analysis of only 11 of the 40 corporate bonds held by Lincoln, that the investments were highly speculative with high probability of default, concentrated in a small number of issuers and industry groups, relatively sensitive to equity price movements, and more volatile than low grade bond mutual funds, notwithstanding their observation that four of the eleven bonds they reviewed were low or low to medium risk. To evaluate the Houlihan, Lokey Report, Lincoln commissioned an analysis by Patricia Ostrander.587 Ostrander found the Houlihan, Lokey Report "woefully inadequate since it is based on unrepresentative comparisons and on a risk analysis that fails to apply important factors, implies irrelevant factors, and misapplies useful practices." She noted, among others, their errors in analyzing risk of default based on artificially selected criteria which were not in fact indicative of the soundness of the individual bonds and the use of an improper and inadequate control group. The Houlihan, Lokey Report also failed to include significant factors, for example, the quality of management (a factor specifically endorsed by Shapiro and Weinstein) and inaccurately analyzed the concentration and diversification of Lincoln's portfolio, primarily by failing to recognize that the investment in Seemala Limited Partnership was, itself, diversified and failing to analyze the diversification of Lincoln's portfolio by industry.

The 1986 Report concluded that Lincoln and AMCOR Investment's improperly capitalized interest and expenses on certain land development projects because, the examiners asserted, the properties were not undergoing substantial development as required by the regulations. Capitalization was justified, however, since these projects not requirements for interest capitalization set forth in PHLBB Memorandum T 59-3a. Moreover, Lincoln's independent public accountant's approved Lincoln's capitalization method in accordance with GAAP and SPAS No. 34. As required,

587

Patricia Ostrander is the founder and president of Ostrander Capital Management Corp., a portfolio management and investment advisor firm, a graduate of Purdue University with certificates from the Harvard-Ratcliffe Program in Business Administration and from the Stonier Graduate School of Banking. She had over 19 years experience analyzing and managing mutual funds.

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activities necessary for timely completion of the projects occurred throughout the questioned capitalization period. FHLBB Memorandum T 59-3a, assets intended for sale or lease constructed as discrete projects (for example real estate developments or office buildings) were subject to capitalization. Expenditures for the assets had been made by Lincoln, actions necessary to prepare the assets for the intended use were in progress and interest costs were being incurred by Lincoln, the requisite factors for capitalization. The FHLBB examiners failed to consider that the projects, which were intended to be masterplanned communities, were in progress and the physical construction of buildings was perhaps the last and least timeconsuming phase of the development. However, the examiners based their conclusions on the fact that no "visible" construction of homes had occurred. As a first-tier developer, Lincoln purchased raw land, arranged platting, annexation and zoning, prepared plans and constructed an infrastructure, and sold the parcels to builders who constructed the homes and subdivision improvements. All of the above were ongoing, time-consuming activities which needed to be completed before the "visible construction" to which the PHLBB attached such significance could begin.

The FHLBB examiners incorrectly reclassified various acquisition, development and construction loans as joint ventures. PHLBB edicts specifically provided that the assessment of whether a particular ADC transaction was properly a loan, joint venture or real estate investment should be left to the insured institution and its independent public accountant." Written opinions from Arthur Andersen and Arthur Young stated specifically that certain of questioned loans were not joint ventures according to the

The

Given ACC's years of experience and proven record of success as a homebuilder and developer, Lincoln's investment in real estate was a perfect vehicle to diversify Lincoln's asset portfolio and breathe new life into a falling institution. PHLBB concluded that Lincoln was not following prudent investment practices due to what it perceived as Lincoln's rapidly expanded" level of investments in real estate, the potentially overbuilt condition of absorption in Arizona, an excessively risky concentration of land in Phoenix and Tucson, coupled with lack of feasibility studies supporting marketability and underwriting deficiencies.

397

The FHLB-SP's rejection of these opinions and its subsequent unprecedented attack on them is notable in light of its attempt to engage Arthur Young to perform the same analysis; Arthur Young was unable to serve the regulators because it preferred to accept Lincoln's engagement.