Franklin Sav. Ass'n v. Director, Office of Thrift Supervision

• Citation: 934 F.2d 1127
• Decision Date: 28 May 1991
• Docket Number: Nos. 90-3272,90-3281,s. 90-3272
• Parties: FRANKLIN SAVINGS ASSOCIATION, a Kansas Savings & Loan Association; and Franklin Savings Corporation, a Kansas corporation, in behalf of itself and in its derivative capacity as controlling shareholder of Franklin Savings Association, Plaintiffs-Appellees and Cross-Appellants, v. DIRECTOR, OFFICE OF THRIFT SUPERVISION, Defendant-Appellant and Cross-Appellee, and The United States of America, Defendant-Intervenor and Cross-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (10th Circuit)

Page 1127

934 F.2d 1127

59 USLW 2730

FRANKLIN SAVINGS ASSOCIATION, a Kansas Savings & Loan Association; and Franklin Savings Corporation, a Kansas corporation, in behalf of itself and in its derivative capacity as controlling shareholder of Franklin Savings Association, Plaintiffs-Appellees and Cross-Appellants, v. DIRECTOR, OFFICE OF THRIFT SUPERVISION, Defendant-Appellant and Cross-Appellee and The United States of America, Defendant-Intervenor and Cross-Appellee.

Nos. 90-3272, 90-3281.

United States Court of Appeals Tenth Circuit.

May 28, 1991.

Rehearing and Rehearing En Banc Denied Sept. 10, 1991.

Charles W. German of Stinson, Mag & Fizzell, Kansas City, Mo. (David E. Everson, Brant M. Laue, Richard F. Hunter of Stinson, Mag & Fizzell, Kansas City, Mo., Roger D. Stanton of Stinson, Mag & Fizzell, Overland Park, Kan., Paul D. Renner of Renner & Rodman, Denver, Colo., with him on the briefs), for plaintiffs-appellees and cross-appellants.

Kenneth J. Guido, Jr., Sp. Sr. Counsel (Harris Weinstein, Chief Counsel, Thomas J. Segal, Associate Chief Counsel, Steven W. Dimmick, Sr. Trial Atty., with him on the briefs), Office of Thrift Supervision, Washington, D.C., for defendant-appellant and cross-appellee.

Jacob M. Lewis, Dept. of Justice, Washington, D.C. (Stuart M. Gerson, Asst. Atty. Gen., Kansas, Lee Thompson, U.S. Atty., Kansas, Douglas N. Letter, Appellate Litigation Counsel, and Mark B. Stern, Appellate Staff Civ. Div., Dept. of Justice, Washington, D.C., with him on the brief), for defendant-intervenor and cross-appellee.

Before McKAY, SETH, and BRORBY, Circuit Judges.

BRORBY, Circuit Judge.

The Director of the Office of Thrift Supervision (Director) appeals the decision of the trial court ordering the removal of the director appointed conservator of Franklin Savings Association (Franklin).

Background

A generalized and simplified overview of the facts will help reveal the parameters of this litigation.

Franklin is a state chartered, stock savings and loan association that has been doing business since 1889 in Ottawa, Kansas. Franklin has functioned during most of its existence as a traditional savings and loan association, accepting its depositors' money and in turn loaning these funds to borrowers. Loans were usually secured by a first mortgage on residential real estate. Franklin's profits were derived from the difference in interest paid to depositors and that collected from its borrowers.

In 1973, Franklin was acquired by new ownership who set it upon an expansion course. Franklin now has eight branches, all located in eastern Kansas. In addition, Franklin went "public" with approximately six per cent of its stock being publicly traded on NASDAQ.

In 1981, Franklin decided to adopt "innovative operating strateg[ies]" and "nontraditional" pursuits. Over the next eight years its deposits grew from $200 million to over $11 billion, bringing marked changes to the institution.

Franklin's asset base changed as it had acquired numerous forms of mortgage-backed securities. ¹ This resulted in a volatile income stream. Franklin attempted both to predict the swings in its income stream with computer modeling, and to hedge its risks using additional and various forms of mortgage-backed securities. The securities bought and sold by Franklin included deep discounted securities, reverse repurchase agreements, long call and put options and strips (both interest only and principal only). Derivative securities (referred to by the district court as "TB 12 assets") entitle the holder to receive only part of the mortgage payments. Such securities are both higher risk and complex, and have only a thin secondary market. Franklin also began acquiring high-yield, noninvestment grade bonds, commonly known as junk bonds. Ultimately, mortgage-backed derivative securities and junk bonds comprised over thirty-five per cent of Franklin's total assets. In addition, Franklin had entered into several off-balance sheet transactions of the same type. Director identified these and other concerns in the form of a supervisory directive issued to Franklin. The underlying basis for Director's concern was the fact these assets were extremely sensitive to both interest rates and principal repayments. Director was also concerned about the liquidity (the ability to immediately turn the assets into cash), as necessary to pay depositors. Director's primary concern was the level of concentration of these assets, i.e., over thirty-five per cent of Franklin's total asset base.

Franklin's liabilities likewise underwent significant changes. Franklin began soliciting deposits nationwide through the use of brokered deposits. These deposits were typically short term and of high cost to Franklin. By the end of 1989, over seventy per cent of Franklin's deposits were brokered. To attract these deposits Franklin had to pay a higher than normal interest rate for a typical savings and loan and, as the deposits were short term, it had to be in a position to turn assets quickly into cash in order to pay depositors as their deposits matured. Director repeatedly expressed his concerns in regard to the extensive use of and significant reliance upon brokered deposits. In November 1989, Director specifically expressed his concern that Franklin's use of brokered deposits had increased significantly over the last six months, both in dollar amount and in relation to total deposits, again Director's primary concern being the level of concentration of these brokered deposits, i.e., over seventy per cent of Franklin's deposits were brokered.

Franklin's position in regard to its concentration of depositors' funds in these high-risk securities was simple. It maintained that it was accurately predicting the performance of these assets; that a market did exist for these assets; and that it had been shrinking the amount of these assets. Concerning its reliance upon brokered deposits, Franklin maintained that the costs of funds had nothing to do with the investments it acquired and that the cost of these funds was actually less than the cost of normal deposits.

Franklin's earnings were declining. Franklin's net interest margin began declining from over two per cent of its total assets in 1984 to less than one per cent by mid-1989. In the fifteen-month period ending December 31, 1989, Franklin had a loss in excess of $58 million. In August and September of 1989, while the assets were growing by $680 million, the tangible capital decreased by nearly $13 million. Earnings are an important source of capital, and Franklin's prospects of future profit appeared bleak. Director felt Franklin was facing losses in excess of $100 million for its improper deferral of hedging losses; incurred a $47 million loss in connection with letters of credit; and suffered a $185 million potential loss in connection with bonds Franklin had issued. Director again expressed his concerns to Franklin in November 1989, additionally pointing out that in the fiscal year ended June 30, 1989, Franklin paid its eight executive officers $3.5 million ($1.8 million of which was in bonuses) and paid dividends of approximately $15 million. This was done notwithstanding the fact Franklin itself reported a $9 million loss in that same fiscal year. These expenditures further impaired Franklin's earnings.

Director had many concerns about Franklin's capital structure. Franklin had unsuccessfully attempted to raise new outside capital. Franklin had also issued a significant amount of its letters of credit guaranteeing the payment of various bond issues that had originated with land developers. (Franklin euphemistically entitled this a "credit enhancement program.") Director ordered a write-down of capital in the amount of $47 million to reflect the risk associated with this credit program. Franklin used accounting methods to defer its actual cash hedging losses. Director ordered an additional write-down of $9 million in order for Franklin's books to accurately reflect these losses. Franklin had issued a significant amount of its own bonds ($3 billion) and Director also ordered a write-down of $185 million to reflect a possible exposure to a perceived risk of possible default. Director believed such a write-down was necessary to avoid a default in these bonds. Director had expressed these concerns to Franklin by pointing out that Franklin's net interest margin had been shrinking and in fact was negative for the past three quarters. Director criticized Franklin's recent continued, aggressive growth in light of these facts. To understand the significance of these facts, it is important to realize that both prudence and the law demand the owner of a financial institution invest some of his own assets in the institution. While capital requirements are complex and involve many factors, we will attempt to explain this requirement with the following illustration: When $100 is accepted in deposits, the owner must have $6 of his own assets in the institution as capital. The bottom line in this case was simple--Franklin was intentionally and aggressively growing without a corresponding growth in capital. In fact, Franklin's capital was shrinking. Moreover, Director had repeatedly and explicitly expressed to Franklin his concern with these matters.

Franklin's position concerning the write-downs ordered by Director is that they were unnecessary as the risks identified by Director did not exist.

By mid-1989, Franklin's metamorphosis was complete. It had been transformed from a traditional savings and loan into something totally different. On June 30, 1989, Franklin's business consisted primarily of attracting savings deposits from the general public nationwide and investing these funds in various mortgage derivative products and mortgage-related assets. Over eighty-three per cent of its interest-earning assets were designated as "assets held for sale." Only 3.3 per cent of its total assets were contained in its...