[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
FASB DERIVATIVE ACCOUNTING STANDARDS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
JULY 22, 2003
__________
Serial No. 108-37
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas Ranking Member
FRED UPTON, Michigan HENRY A. WAXMAN, California
CLIFF STEARNS, Florida EDWARD J. MARKEY, Massachusetts
PAUL E. GILLMOR, Ohio RALPH M. HALL, Texas
JAMES C. GREENWOOD, Pennsylvania RICK BOUCHER, Virginia
CHRISTOPHER COX, California EDOLPHUS TOWNS, New York
NATHAN DEAL, Georgia FRANK PALLONE, Jr., New Jersey
RICHARD BURR, North Carolina SHERROD BROWN, Ohio
Vice Chairman BART GORDON, Tennessee
ED WHITFIELD, Kentucky PETER DEUTSCH, Florida
CHARLIE NORWOOD, Georgia BOBBY L. RUSH, Illinois
BARBARA CUBIN, Wyoming ANNA G. ESHOO, California
JOHN SHIMKUS, Illinois BART STUPAK, Michigan
HEATHER WILSON, New Mexico ELIOT L. ENGEL, New York
JOHN B. SHADEGG, Arizona ALBERT R. WYNN, Maryland
CHARLES W. ``CHIP'' PICKERING, GENE GREEN, Texas
Mississippi KAREN McCARTHY, Missouri
VITO FOSSELLA, New York TED STRICKLAND, Ohio
ROY BLUNT, Missouri DIANA DeGETTE, Colorado
STEVE BUYER, Indiana LOIS CAPPS, California
GEORGE RADANOVICH, California MICHAEL F. DOYLE, Pennsylvania
CHARLES F. BASS, New Hampshire CHRISTOPHER JOHN, Louisiana
JOSEPH R. PITTS, Pennsylvania TOM ALLEN, Maine
MARY BONO, California JIM DAVIS, Florida
GREG WALDEN, Oregon JAN SCHAKOWSKY, Illinois
LEE TERRY, Nebraska HILDA L. SOLIS, California
ERNIE FLETCHER, Kentucky
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
DARRELL E. ISSA, California
C.L. ``BUTCH'' OTTER, Idaho
Dan R. Brouillette, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
FRED UPTON, Michigan JAN SCHAKOWSKY, Illinois
BARBARA CUBIN, Wyoming Ranking Member
JOHN SHIMKUS, Illinois HILDA L. SOLIS, California
JOHN B. SHADEGG, Arizona EDWARD J. MARKEY, Massachusetts
Vice Chairman EDOLPHUS TOWNS, New York
GEORGE RADANOVICH, California SHERROD BROWN, Ohio
CHARLES F. BASS, New Hampshire JIM DAVIS, Florida
JOSEPH R. PITTS, Pennsylvania PETER DEUTSCH, Florida
MARY BONO, California BART STUPAK, Michigan
LEE TERRY, Nebraska GENE GREEN, Texas
ERNIE FLETCHER, Kentucky KAREN McCARTHY, Missouri
MIKE FERGUSON, New Jersey TED STRICKLAND, Ohio
DARRELL E. ISSA, California DIANA DeGETTE, Colorado
C.L. ``BUTCH'' OTTER, Idaho JOHN D. DINGELL, Michigan,
W.J. ``BILLY'' TAUZIN, Louisiana (Ex Officio)
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Baumann, Martin F., Executive Vice President, Chief Financial
Officer, Freddie Mac....................................... 16
Linsmeier, Thomas J., Russell E. Palmer Endowed Professor and
Chairperson, Department of Accounting and Information
Systems, Eli Broad College of Business, Michigan State
University................................................. 33
Seidman, Leslie F., Member, Financial Accounting Standards
Board...................................................... 9
Wallison, Peter J., Resident Fellow, American Enterprise
Institute.................................................. 22
Additional material submitted for the record:
Accounting and Management Problems at Freddie Mac, CRS Report 55
Fannie Mae, prepared statement of............................ 52
Fannie Mae's Accounting Finds Critics of Its Own, New York
Times, June 23, 2003....................................... 60
(iii)
FASB DERIVATIVE ACCOUNTING STANDARDS
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TUESDAY, JULY 22, 2003
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade,
and Consumer Protection,
Washington, DC.
The subcommittee met, pursuant to notice, at 2 p.m., in
room 2123, Rayburn House Office Building, Hon. Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Bass, Schakowsky,
Markey, Davis, Stupak, Green, and Strickland.
Staff present: David Cavicke, majority counsel; Ramsen
Betfarhad, majority counsel; Jill Latham, legislative clerk;
Jon Tripp, deputy communications director; and Consuela
Washington, minority counsel.
Mr. Stearns. Good afternoon. The Subcommittee on Commerce,
Trade, and Consumer Protection of the Energy and Commerce
Committee, will come to order.
I welcome all our members and witnesses to the
subcommittee's hearings on the Financial Accounting Standards
Board, or as we know FASB, Derivative Accounting Standards. In
particular, I wish to thank Mr. Baumann, Freddie Mac's Chief
Financial Officer, for testifying this afternoon. I fully
appreciate the fact that Mr. Baumann is limited in his ability
to be responsive to all questions as Freddie Mac's restatement
process is ongoing and not yet complete, and that Freddie Mac's
restatement is subject to a number of investigations, including
one by the SEC. I also welcome all the other witnesses, too.
The immediate trigger for this hearing was Freddie Mac
announcing that it will restate its financial statements for
the year 2002 to 2000, and that the restatement, to a great
extent, was due to the misapplication of FAS 133, the 800-page
FASB standard on accenting for derivative instruments and
hedging activities. That misapplication, according to Freddie
Mac's June 25 release, could increase retained earnings as of
December 31, 2002, by between $1.5 to $4.5 billion.
Although the restatement in and of itself is a significant
event worthy of a serious inquiry, it is however not the focus
of this hearing, but the focus of a hearing after the release
of Mr. Dowdy's report, the counsel retained by Freddie Mac's
Board.
The purpose of this hearing is to explore the efficacy,
helpful of course to the investors, of FASB's standard on
accounting for derivative instruments in hedging activities. It
is a standard providing the investor with the transparency and
disclosure to assess the economic impact of derivative
contracts on a company. Does the derivative accounting and
reporting standard enable the investor to compare financial
statements of two similar companies based on their derivative
positions? And essentially, my colleagues, the inquiry before
the subcommittee is whether the standard is providing investors
with meaningful and timely information about the impact of
derivative instruments on a company's true economic condition?
Derivative instruments entail both significant benefit and
risk for companies that have come to rely on them for managing
the operating and market risk. This is significant considering
that the cumulative value of derivative contracts outstanding
today is in excess of $127 trillion. Freddie Mac and its first
cousin, Fannie Mae, together hold over $1.6 trillion worth of
derivative instruments as hedges against interest great risk.
These two government-sponsored enterprises are important
case studies in the testing of the efficacy of accounting
standards governing derivatives. They are important not only
because of the sheer size of their derivative portfolio, but
also because they play a key role in the vibrancy of our
mortgage markets. The two combined either hold, trade, or
guarantee over 50 percent of all conforming mortgages issued in
this country and in securitizing mortgages provide greater
liquidity to the mortgage markets.
The basic rule of FAS 133 is clear. All derivative
instruments must be measured and recorded on the books, both
income statement and balance sheet, at fair value. With that,
the elegant simplicity of the rule ends. Multiple hundreds of
pages are then devoted to the justification and explanation of
``creative construct,'' called ``special hedge accounting.''
If a derivative instrument qualifies as a hedge,
fluctuation in its fair value may be offset by changes in the
fair value of the underlying hedge item, with a net effect on
earnings being zero or nearly zero. Fannie Mae's financial 2002
statement is illustrative of the significance of special hedge
accounting.
In 2002, Fannie Mae reported $4.6 billion in earnings under
GAAP accounting, yet, a review of its annual fair value balance
sheet shows that Fannie Mae lost billions of dollars in
shareholder equity, nearly wiping out its earnings for that
year. In correctly applying FAS 133, Fannie Mae used a special
hedge accounting rule to defer the billions of dollars in lost
shareholder equity to the future. Freddie Mac, on the other
hand, in misapplying the FAS 133 rule, is expected to restate
its earnings for the past few years upward by as much as $4.5
billion.
These are companies that are virtually in the same line of
business encountering and applying FAS 133 with dramatically
different results. Moreover, my colleagues, if two transactions
such as two different hedging techniques bring about the same
economic outcome, GAAP treatment of the two transactions should
be similar, but in many cases are not.
This similar treatment is the objective that FASB should
strive for to achieve through its standards, and I am not sure
why today the accounting results of a transaction should
deviate substantially from the economic results of the same
transaction and, if we are wrong, perhaps our witnesses will
explain that to us.
I understand that FAS 133, for example, is a stepping
stone, an evolutionary step to a full fair value accounting for
all derivative instruments. Such fair value accounting, in my
view, will substantially reduce the difference between the
accounting and economic results of the same transaction.
There are many good reasons for the special hedge
accounting rules. Nonetheless, as I have advocated in the past,
I think financial accounting standards should be free from
special exceptions if such exceptions help obfuscate the real
economic conditions of a company in the company's public
financial statement.
And, last Congress, I, along with Chairman Tauzin,
introduced a bill, H.R. 5058, seeking to establish general
principles and objectives to be followed by FASB when
establishing financial accounting reporting standards. I think
FAS 133 and its application are an example of the need to have
a more principle-based accounting system, free from special
exceptions and undue complexity that, really, I don't think,
serve investors well.
So, I look very much to the testimony of our witnesses and,
with that, I call upon our ranking member for an opening
statement.
Ms. Schakowsky. I want to thank Chairman Stearns for
convening this important hearing today on FASB derivative
accounting standards. Our subcommittee has an important
responsibility to ensure that FASB's accounting rules provide
clear and accurate information on the financial health of
companies for workers, investors, and pension holders.
To their credit, FASB has a long history of working
diligently to create clear accounting standards. Changes and
innovation in our financial markets and political pressure have
made this a daunting challenge. The expanded use of derivatives
in our financial markets provides a clear example of just how
difficult this challenge can be.
Derivatives, as we all know here, we are saying are trading
instruments that are value-based on the price of another
financial instrument like a bond or an exchange rate or an
interest rate. Derivatives are popular in our financial markets
because they enable companies and investors to diversify their
portfolio and therefore reduce their exposure to risk.
The total value of derivatives outstanding is estimated by
one of today's panelists to be $127 trillion, up from $3
trillion in 1990. In response to this market innovation, FASB
went forward and worked to establish accounting rules for
derivatives.
FASB began studying accounting for derivatives in September
1991. In 1996, after nearly 100 public meetings, unveiled a
proposed standard that would require companies to account for
derivatives in their quarterly statements based on their fair
value. The sensible proposal was fiercely opposed by Federal
Reserve Chairman Greenspan, Members of Congress, and nearly
every major bank, securities firm, and insurance company.
In response to the proposal, some Members of Congress went
as far as to introduce legislation that would have abolished
FASB. I should note that Democratic Ranking Member Dingell was
one of the few members who defended FASB. However, in the end,
the opponents of the new standard overwhelmed FASB and, as a
result, FASB's final rule known as FAS 133 created complicated
standards that included over 500 pages of exception. The
standard allowed companies to distort their balance sheets and
hide the true value of their derivatives.
I worry that a FASB attempt to clarify the rule will once
again be overwhelmed by the same opposition and threaten to
weaken the existing rule. I mention the history of FASB's
derivative accounting rule to put today's hearing in its proper
context.
Today we are going to explore Freddie Mac's accounting
scandal. In January, Freddie Mac announced that it is restating
its earnings from the past 3 years, and in June they dismissed
their top three executives. The turmoil at Freddie Mac has put
FASB's rule once again in the public spotlight. It has gotten
the attention of Congress and the press because, as we all
know, Freddie Mac is not just another company. Freddie Mac has
a major impact on the housing market. This government-sponsored
enterprise purchased $592 billion in mortgages in 2002, and
helped finance homes for nearly 2.5 million low and moderate
income families and families living in under-served areas.
It is in the best interest of our constituents to have a
viable secondary housing market, and I am hopeful that Freddie
Mac will emerge from this turmoil in a strong position. Their
experience can help provide insight into how FASB derivative
accounting standards are implemented in the marketplace.
Congress has responsibility to ensure that investors are
protected, but I should note that at this point we do not know
what happened at Freddie Mac, and we do not know its true
impact on investors. In my estimation, this hearing is a bit
premature. Freddie Mac has not yet restated its earnings.
Freddie Mac's internal investigation has not been completed.
In June, Freddie Mac's Board of Directors hired the law
firm of Baker Botts to conduct an internal investigation. I
understand that their report is going to be released any day.
Also, the FEC, the Office of Federal Housing Enterprise
Oversight, and U.S. Attorney's Office are all investigating
Freddie Mac's accounting and corporate governance as we speak.
We will be in a better position to analyze Freddie Mac's
accounting practices once the investigations have been
completed. And so I hope that we will have another hearing once
we gather more facts. I hope that as we continue to study FASB
standards, we will take a closer look at how derivative
accounting standards are used throughout our financial markets,
not just at the GSEs, and I look forward to hearing the
testimony of today's witnesses. Thank you.
Mr. Stearns. Thank the gentlelady. The gentleman from
Florida, Mr. Davis.
Mr. Davis. No statement, Mr. Chairman.
Mr. Stearns. Then I think what we will do is we will go
down and vote and recess the subcommittee, and I will be right
back and we will start with our witnesses. The subcommittee is
recessed.
[Additional statements submitted for the record follow:]
Prepared Statement of Hon. Barbara Cubin, a Representative in Congress
from the State of Wyoming
Thank you, Mr. Chairman, for holding this hearing. It is an
excellent opportunity to further familiarize ourselves with how
derivatives are accounted for and will lay the foundation for future
action taken on this matter.
I would also like to thank the distinguished panelists for coming
before the subcommittee. Your insight today will serve to advance the
discussion of accounting standards so the most appropriate and
effective legislative solution may be reached.
We are not here today to point fingers in search of a financial
scandal. In the fallout of Sarbanes-Oxley we need to be sure we are
seeking transparency and not embarking on a perpetual witch hunt.
Instead, the existing circumstances that led to the need for an
investigation should be the focus of our discussion today. We must
continue to analyze accounting standards and in particular FAS 133.
The factors in this debate are complex and numerous. The questions
we must ask can be dizzying, and I suspect the answers will not differ.
Is this particular rule doing more harm than good? By providing
companies with complex flexibility in their compliance with FAS 133, is
the purpose of this rule negated altogether? The fair value rule is
established in twenty pages, but the next several hundred pages outline
the flexibility afforded to companies in complying with the rule.
I look forward to the testimony and dialogue that will take place
in order to obtain a better understanding of FAS 133, how it is used,
what it communicates and how it can better serve its purpose. In the
end, companies should be required to maintain and disclose accurate
records while simultaneously being afforded the flexibility to
communicate their potential to both investors and consumers without
undermining public faith in our system.
I thank the Chairman again and yield back the remainder of my time.
______
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Energy and Commerce
Derivatives are important financial instruments that provide
companies opportunities to manage risk of core business functions.
Derivatives can also be used as speculative instruments, creating the
potential for enormous windfalls or losses for the parties to the
contracts. Whatever the use, I think we all can agree that investors
deserve to know the value of derivative contracts into which companies
enter. Derivatives are no small part of business today--the total value
of outstanding derivatives is estimated at more than $141 trillion
through the end of last year. This is precisely what makes this hearing
so important.
Today we are going to look at issues of accounting for derivatives.
Federal Accounting Standard (FAS) 133 states that all derivatives
should be accounted for at fair value. But this general rule is
accompanied by a 500-page exception, known as special hedging rules.
The special hedging rules enable companies to avoid recognizing gains
or losses on certain derivatives in their income statements.
When looking at the application of FAS 133 by Freddie Mac and
Fannie Mae, the comparability and transparency problems created by the
special hedging rules become apparent. Both Fannie and Freddie are in
the same business, they have the same charter, and they manage interest
rate risk through derivative contracts. And both Fannie and Freddie use
FAS 133 and its special hedging rules. Yet each comes up with a very
different result. Freddie Mac has revealed that it made an error in its
application of FAS 133 by treating certain derivatives as hedges when
they should have been marked-to-market and reported in earnings. And
while Fannie Mae's application of the special hedging rules is GAAP
compliant, use of FAS 133 allowed Fannie to defer billions of dollars
of losses to future years.
Do these results serve investors well? I ask our experts here
today, should such similarly situated entities have such vastly
different accounting results? If the special hedging rules were
eliminated and all derivatives contracts had to be marked-to-market
would comparability be enhanced?
I am certainly not coming down on the FASB here today--FAS 133 has
much improved derivatives disclosure over the pre-1998 accounting
models. I only suggest it does not go far enough. The examples of
Fannie and Freddie force us to ask whether accounting standards for
derivatives should be re-evaluated. As we address this question, I look
forward to hearing from our distinguished panel. Thank you all for
participating in this important hearing. I would also like to give a
special thanks to Chairman Stearns. He has been a steadfast proponent
of improving accounting standards and accounting disclosure. I thank
him for his dedication to this issue. Mr. Chairman, I yield back my
time.
______
Prepared Statement of Hon. Hilda L. Solis, a Representative in Congress
from the State of California
Mr. Chairman, thank you very much for holding this important
hearing so that we may hear testimony from today's witnesses on the
state of FAS 133 and the role its complexity may have played in the
recent Freddie Mac restatement.
At the outset, Mr. Chairman, I want to say that it's very important
we exercise oversight of our nation's housing GSEs.
However, we should not allow the reported accounting irregularities
at Freddie Mac obscure the important role housing GSEs play in making
affordable mortgage lending available to communities across the United
States. Secondly, I do not want us to lose sight of the significant
role housing has played in stabilizing our economy especially during
this most recent economic downturn.
Housing GSEs were created to bring low cost capital to the housing
market and it is a congressionally mandated obligation that, in my
experience, they have done well.
Fannie Mae and Freddie Mac have harnessed their expertise in
housing finance and greatly advanced access to low cost capital to
millions of low and moderate-income Americans.
So I am eager to learn how these companies use derivatives to make
lending more affordable to our constituents and how it is that FAS133
affects their mission.
I raise these matters because, at a time when we are all struggling
for answers on how to get our nation's economy moving again, it is as
important to focus not only on what needs to be fixed but also what
functions well and should not be disturbed.
Mr. Chairman, we are here today to examine a singular aspect of the
recent Freddie Mac restatement--and that is the role FAS133 played in
that restatement.
I hope that we maintain that focus and sidestep the temptation to
add to today's headlines at the expense potential long-term damage to
one of the most robust segments of the economy.
On the specific subject of derivatives, I want to quote a portion
of Alan Greenspan's testimony before the Senate Banking Committee,
``What we have found over the years in the market place is that
derivatives have been an extraordinarily useful vehicle to transfer
risk from those who shouldn't be taking it to those who are willing to
and are capable of doing so.''
I think Mr. Greenspan's testimony is of particular relevance to us
because it highlights that derivatives are used by any number of
financial interests--not just GSEs--and also clearly indicates that
their use spreads risk rather than concentrating it.
In closing, I look forward to hearing from these witnesses and
learning how this Subcommittee, in guiding FAS 133, can help advance
the missions of these companies.
______
Prepared Statement of Hon. Ed Towns, a Representative in Congress from
the State of New York
Thank you, Mr. Chairman, for holding this second hearing on FASB
issues this year. Your commitment to these issues is commendable. In
particular, I am pleased the Subcommittee today has brought before us
the issue of derivatives accounting standards. The complexity of these
financial instruments seems to pale only when compared to the
accounting for them. I, for one, look forward to the opportunity to
discuss with the FASB witness and our other witnesses the fundamentals
behind derivatives, and explore whether the way we ask companies to
account for them is realistic and valuable to investors and other
market players.
I am especially pleased that Freddie Mac is here today, given the
company's recent prominence in the news on issues relating to
accounting for derivatives and other hedges. It is timely that we hear
from Freddie Mac regarding their use of these instruments and what
pitfalls there may have been in accounting for derivatives. There may
be lessons from this experience not only for Freddie Mac, but for other
companies as well.
In that vein, while I have concerns about the accounting issues at
Freddie Mac, I do want to be clear that I am not supportive of efforts
to abolish Freddie Mac's charter. I support Freddie Mac's mission of
improving affordable housing opportunities for the people of this
country. Freddie Mac and Fannie Mae play a central role in the U.S.
mortgage markets, which are the envy of the world. We must act
carefully--even today--in assuring the capital markets that our
examination is not a witch hunt, but a carefully measured analysis of
derivatives accounting standards.
With that, I look forward to hearing from our witnesses. Again,
thank you, Mr. Chairman.
______
Prepared Statement of Hon. Gene Green, a Representative in Congress
from the State of Texas
Thank you, Chairman Stearns and Ranking Member Schakowsky, for
holding this hearing on derivative accounting standards.
I applaud the subcommittee for its attention to this important
issue.
I must note, however, that the timing of this hearing seems
premature, if, as the Chairman has stated, we are here to examine the
role that derivative accounting standards played in Freddie Mac's
accounting problems.
The SEC, the DOJ, the Office of Federal Housing Enterprise
Oversight and Freddie Mac's outside counsel are all conducting on-going
investigations into Freddie's accounting practices.
Currently, all we know about accounting at Freddie Mac is what has
appeared in the press and what Freddie Mac has told us: that company
personnel made accounting errors in applying generally accepted
accounting principles and that accounting policies were implemented to
smooth earnings.
If we are here to draw policy conclusions from the accounting
mistakes made at Freddie Mac, we should reserve judgment until the
investigations are concluded and the results released. It is my hope
that, at that time, the subcommittee will revisit this issue with
respect to Freddie Mac.
In the meantime, I hope that the witnesses before us today can
provide insight into the Financial Accounting Standards Board and,
specifically, FAS 133.
My primary concern is that investors receive quality information
about a company's financial situation, and I question whether the rule
provides for an adequate level of transparency.
Furthermore, the complexity of this rule raises the question of
whether it is applied in a consistent manner within and among
companies. I am interested to hear from our witnesses if, in their
opinion, the derivative accounting standards applied today open the
door for confusion or misuse, and, ultimately, whether adherence to
this standard paints the most accurate picture for investors concerning
a company's financial health.
I thank the witnesses for appearing before us today and look
forward to hearing their views on this issue.
Thank you, Mr. Chairman, and I yield back the balance of my time.
______
Prepared Statement of Hon. John D. Dingell, a Representative in
Congress from the State of Michigan
I commend both Rep. Tauzin, the chairman of the full committee, and
Rep. Stearns, the chairman of this subcommittee, for opening an inquiry
in early June into the accounting problems at Freddie Mac, and for
asking the Minority to participate in that inquiry. To that end, staff
met with representatives of Freddie Mac on June 12, the Office of
Federal Housing Enterprise Oversight (OFHEO) on June 16, the Financial
Accounting Standards Board (FASB) on June 17, the Securities and
Exchange Commission (SEC) on June 23 and on June 26, with
representatives of the Baker & Botts law firm and FTI Consulting
forensic accountants who are conducting the special investigation for
Freddie Mac's board of directors (the so-called ``Doty report''). The
OFHEO and SEC inquiries had just begun. The committee staff has been
unable to interview the PricewaterhouseCoopers accountants involved in
the restatement or to review any board or accounting documents, nor
have we received the Doty report yet. I look forward to these steps
being completed so that we can make educated decisions on these matters
and on what, if anything, these events may tell us about the efficacy
of FAS 133, the accounting standard for derivative and hedge
accounting.
While I welcome hearings on these issues, I believe today's hearing
is premature. I am not convinced that we have the right witnesses
before us. For example, Mr. Wallison's written statement spends roughly
two pages criticizing GAAP accounting and the effectiveness of
regulation in general, but all the rest of his testimony criticizes the
substantive benefits and risks of the two housing GSEs and calls for
(1) the privatization and breakup of Fannie Mae and Freddie Mac or (2)
alternatively the constraining of their mortgage purchase and pooling
activities, all matters outside the scope of our jurisdiction and the
subject matter of this hearing.
FASB started studying accounting for derivatives and hedging in
September 1991, and held 100 public meetings to discuss the complex
issues in this project. FASB and the SEC went forward respectively with
proposed accounting and disclosure rules after several high-profile
losses at companies and banks and municipalities caught investors,
analysts, and regulators by surprise and pointed to the urgency and
need for reforms. The main purpose of FAS 133 was simple: to get
derivatives on the balance sheet at their fair value and present
derivative gains as assets and derivative losses as liabilities.
The FASB and SEC met strong opposition from key Senators and
Representatives, as well as the chairman of the Federal Reserve Board
and the Comptroller of the Currency. Legislation was introduced in the
Senate to authorize the bank regulators to exempt banks from any final
FASB standard. Legislation was introduced in the House to make FASB an
SRO under the SEC and require explicit SEC approval of all standards
issued by FASB, impose a strict cost benefit analysis and burden on
competition finding on all FASB proposals, and provide for immediate
federal-court challenges of final FASB standards. The American Bankers
Association, ABA Securities Association, International Swaps and
Derivatives Association, Securities Industry Association, The Bankers
Roundtable, and The New York Clearing House Association wrote a strong
letter to FASB and the SEC labeling their proposals ``a radical and
disruptive change'' and warned them to reconsider their plans. The
Administration's nominee to head OFHEO was the chief lobbyist in the
effort to tip over FASB and its proposal. Twenty-two banking,
securities, insurance, and corporate executives, joined by Freddie,
Fannie, and the Federal Home Loan Bank of Chicago also came together in
strong opposition to the proposed standard. Twenty-three Members of the
House Banking Committee wrote to FASB, urging it to consider
alternative models for improving disclosure. I believe I was one of the
few Members of Congress to write FASB in strong support of their goals
and urging them to act promptly on this matter. Attached to this
statement are copies of the aforementioned comment letters. In order to
get a clear picture of FAS 133 practice, we need to look at what all of
the major users are doing, not just at the GSEs.
Recent press reports, (``IASB `to stand firm' following French
attack,'' Financial Times, July 12, 2003) note that French President
Jacques Chirac has written to the European Commission president in
strong opposition to the International Accounting Standards Board's
derivatives accounting reforms and pressing for concessions for the
European banks that oppose the effort. The push toward international
convergence means we have to take a broader look at this and other
accounting issues. This also highlights the push toward principles-
based accounting but I, for one, am skeptical about placing more
reliance on the judgments of company managers and accountants who have
betrayed the trust and confidence of the American public.
Finally, I commend Fannie Mae for successfully registering its
common stock with the SEC in March of this year and, since then, for
complying with all of its periodic reporting responsibilities to the
SEC and to investors. I encourage Freddie Mac to complete its
restatement so that it too can fulfill its commitment to become an SEC-
registered company. This will not be a panacea, however. The GAO
reported in its October 2002 report, Financial Statement Restatements,
that the number of restatements by SEC-registered companies due to
accounting irregularities had grown significantly--about 145 percent--
from January 1997 through June 2002. Those 689 publicly traded
companies lost billions of dollars in market capitalization as a
result. The SEC faces a number of ongoing challenges in this regard.
I look forward to learning more about these matters. And I look
forward to continuing my longstanding support for FASB and for high-
quality and transparent accounting.
[Brief recess]
Mr. Stearns. The subcommittee will reconvene, and I think
we will start--Mr. Bass indicated he is going to waive his
opening statement, so I think we will start with our witnesses,
and we welcome all of them. Ms. Leslie F. Seidman, a member of
the Financial Accounting Standards Board; Mr. Marty Baumann,
Executive Vice President, Chief Financial Officer of Freddie
Mac; Mr. Peter J. Wallison, the Resident Fellow of the American
Enterprise Institute, and Dr. Thomas J. Linsmeier, Ph.D., CPA,
at Russell E. Palmer Endowed Professor and Chairperson,
Department of Accounting and Information Systems, Eli Broad
College of Business, Michigan State University.
Let me welcome you, and I appreciate your patience. Ms.
Seidman, I think we will start with you.
STATEMENTS OF LESLIE F. SEIDMAN, MEMBER, FINANCIAL ACCOUNTING
STANDARDS BOARD; MARTIN F. BAUMANN, EXECUTIVE VICE PRESIDENT,
CHIEF FINANCIAL OFFICER, FREDDIE MAC; PETER J. WALLISON,
RESIDENT FELLOW, AMERICAN ENTERPRISE INSTITUTE; AND THOMAS J.
LINSMEIER, RUSSELL E. PALMER ENDOWED PROFESSOR AND CHAIRPERSON,
DEPARTMENT OF ACCOUNTING AND INFORMATION SYSTEMS, ELI BROAD
COLLEGE OF BUSINESS, MICHIGAN STATE UNIVERSITY
Ms. Seidman. Thank you. I am Leslie F. Seidman, a Member of
the Financial Accounting Standards Board. I am pleased to
appear before you today on behalf of the FASB. I have brief
prepared remarks, and I would respectfully request that the
full text of my testimony and all supporting materials be
entered into the public record.
Mr. Stearns. By unanimous consent, so ordered.
Ms. Seidman. The FASB is an independent private-sector
organization subject to oversight by the United States
Securities and Exchange Commission. Our independence from
enterprises, auditors, and other constituents is fundamental to
achieving our mission--to establish and improve standards of
financial accounting and reporting for both public and private
enterprises. Those standards are essential to the efficient
functioning of the capital markets and the U.S. economy because
investors and other users of financial reports rely heavily on
credible, transparent, comparable, and unbiased financial
information to make rational resource allocation decisions.
Beginning in the 1980's and continuing in the 1990's, as
the use and the complexity of derivatives and hedging
activities grew rapidly, many investors, creditors, and other
users of financial statements were surprised and concerned by
large unexpected losses on derivatives that were reported by
several enterprises that had previously provided little if any
information about those contracts in their financial reports.
Members of Congress, the SEC, the GAO, and the AICPA, as
well as many investors, creditors, and other users of financial
reports urged the FASB to develop and issue a standard that
would provide comprehensive accounting requirements for
derivatives and related hedging activities.
At the time, the existing standards applicable to the
accounting for derivatives and hedging were incomplete. There
were no specific standards for many types of derivatives and
hedging activities. Where standards did exist, they were
inconsistent. Where they did not exist, the practices that had
developed varied widely. As a result, the financial statements
of enterprises that used derivatives did not report their
derivative and hedging activities in a way that users of those
financial statements could compare or understand.
Following an extensive and open due process, described more
fully in the full text of my testimony, in 1998, the FASB
issued Statement of Financial Accounting Standards No. 133,
Accounting for Derivative Instruments and Hedging Activities.
Statement 133 requires that an enterprise report all of its
derivatives as either assets or liabilities on the face of its
financial statements and measure those instruments at their
fair value.
Statement 133 also generally requires that any changes in
the fair value of derivatives, or derivative gains or losses,
be reported in the enterprise's earnings in the period of the
change.
If, however, certain conditions are met, an enterprise may
specifically designate a derivative as a hedge of a related
item and receive special accounting for the combination of the
derivative and the related item.
Hedge accounting reflects an entity's intended strategy
between two separate items. Rather than applying the applicable
standards to each component of the strategy, hedge accounting
allows the entity to recognize the gains or losses on the
derivative in the same period as the income statement effect of
the hedged item. Entities engaged in risk management activities
desire hedge accounting so that the income statement reflects
the effect of their hedging strategies in the same period as
the item being hedged. Because hedge accounting defers
recognition of gains and losses on derivatives, numerous
restrictive conditions must be met at the outset of the
transaction and over the life of the transaction; these are
called hedge criteria. The criteria differ, depending on the
nature of the risk being hedged.
In general, a derivative may be specifically designated as
a hedge of the exposure to changes in the fair value of an
asset or liability, a fair value hedge, or as a hedge of the
exposure to variable cash-flows of a forecasted transaction, a
cash-flow hedge. The accounting for changes in the fair value,
or the gains or losses, of the derivative differs depending on
that designation.
For a derivative designated as hedging the exposure to
changes in the fair value or price of an asset or liability,
the gain or loss on the derivative is recognized in earnings in
the period of change together with the offsetting loss or gain
on the hedge item attributable to the risk being hedged. An
example of a fair value hedge is the use of an interest rate
swap to change the interest rate risk on a fixed-rate bond from
fixed to floating. In a perfect hedge, hedge accounting will
show net interest expense at the new floating rate. However, if
the hedge is not perfect, the differences are required to be
reported in earnings and, thus, are transparent to investors.
For a derivative designated as hedging the exposure to
variable cash-flows of a forecasted transaction, the gain or
loss on the derivative is initially deferred in a balance sheet
account to the extent that the hedge is effective; the gain or
loss is subsequently reclassified into earnings in the period
that the related forecasted transaction affects earnings. An
example of a cash-flow hedge is the use of an interest rate
swap to change the risk profile on a floating-rate loan--the
swap serves to lock in the interest cash-flows associated with
the transaction. In a perfect hedge, hedge accounting will show
net interest income at the new fixed rate. To the extent that
the swap is not effective in offsetting the floating cash-flows
on the loan, any ineffectiveness is reported in earnings
immediately and separately disclosed.
An enterprise that elects to apply special hedge accounting
is required to identify and document at the inception of the
hedge (1) the specific items that are being hedged and the
entity's risk management strategy; (2) the method it will use
for assessing the effectiveness of the hedging derivative, and
(3) the measurement approach for determining the ineffective
aspect of the hedge. Those methods must be consistent with the
entity's overall risk management approach.
At the time Statement 133 was issued, the Board established
a Derivatives Implementation Group of outside experts to assist
the FASB in evaluating questions that companies might face as
they began implementing the statement. More than 150
constituent questions have been answered through that effort.
In April 2003, the FASB issued an amendment to Statement
133 to clarify the scope of the statement and codify several
issues that had been identified and resolved as part of the DOG
process.
Consistent with its mission and Rules of Procedure, the
FASB stands ready to consider any additional guidance or
potential improvements to the accounting for derivatives and
hedging activities.
Thank you, Mr. Chairman. I would be happy to respond to any
questions.
[The prepared statement of Leslie F. Seidman follows:]
Prepared Statement of Leslie F. Seidman, Financial Accounting Standards
Board
Chairman Stearns, Ranking Member Schakowsky, and Members of the
Subcommittee: I am Leslie F. Seidman, a Member of the Financial
Accounting Standards Board (``FASB'' or ``Board''). I am pleased to
appear before you today on behalf of the FASB. My testimony includes a
brief overview of (1) the FASB, (2) derivatives and hedging activities,
(3) the basis for the Board's decision to develop and issue Statement
of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (``Statement 133''), (4) the process
the Board followed in developing Statement 133, (5) some of the key
requirements of Statement 133, and (6) how the FASB has responded to
requests for additional guidance and other improvements to Statement
133.
THE FASB
The FASB is an independent private-sector organization.1
Our independence from enterprises, auditors, and other constituents is
fundamental to achieving our mission--to establish and improve
standards of financial accounting and reporting for both public and
private enterprises.2 Those standards are essential to the
efficient functioning of the capital markets and the United States
(``US'') economy because investors and other users of financial reports
rely heavily on credible, transparent, comparable, and unbiased
financial information to make rational resource allocation decisions.
---------------------------------------------------------------------------
\1\ See Attachment 1 for information about the Financial Accounting
Standards Board.
\2\ See Attachment 2 for a discussion of the importance of the
FASB's independence and neutral accounting standards.
---------------------------------------------------------------------------
The FASB's independence, the importance of which was recently
reaffirmed by the Sarbanes-Oxley Act of 2002 (``Act''),3 is
fundamental to our mission because our work is technical in nature,
designed to provide investors and the capital markets with the most
accurate possible yardstick to measure and report on the underlying
economic transactions of business enterprises. Like investors, Congress
and other policy makers need an independent FASB to maintain the
integrity of a properly designed yardstick in order to obtain the
financial information necessary to appropriately assess and implement
the public policies they favor. While bending the yardstick to favor a
particular outcome may seem attractive to some in the short run, in the
long run an inaccurate yardstick (or a biased accounting standard) is
harmful to investors, the capital markets, and the US economy.
---------------------------------------------------------------------------
\3\ Sarbanes-Oxley Act of 2002, Public Law Number 107-204, Sections
108-109 (July 30, 2002).
---------------------------------------------------------------------------
The FASB's authority with respect to public enterprises comes from
the US Securities and Exchange Commission (``SEC''). The SEC has the
statutory authority to establish financial accounting and reporting
standards for publicly held enterprises. For 30 years, the SEC has
looked to the FASB for leadership in establishing and improving those
standards. The SEC recently issued a Policy Statement reaffirming this
longstanding relationship.4
---------------------------------------------------------------------------
\4\ Policy Statement: Reaffirming the Status of the FASB as a
Designated Private-Sector Standard Setter, Exchange Act Release Nos.
33-8221; 34-47743; IC-26028; FR-70 (April 28, 2003).
---------------------------------------------------------------------------
The Policy Statement, consistent with the language and intent of
the Act,5 also reemphasizes the importance of the FASB's
independence described earlier. It states:
---------------------------------------------------------------------------
\5\ Sections 108-109; The legislative history of the Sarbanes-Oxley
Act of 2002 is clear that the provisions of the Act relating to the
FASB were intended to ``strengthen the independence of the FASB . . .
from . . . companies whose financial statements must conform to FASB's
rules.'' Senate Report 107-205, 107th Congress, 2d Session (July 3,
2002), page 13.
---------------------------------------------------------------------------
By virtue of today's Commission determination, the FASB will
continue its role as the preeminent accounting standard setter
in the private sector. In performing this role, the FASB must
use independent judgment in setting standards and should not be
constrained in its exploration and discussion of issues. This
is necessary to ensure that the standards developed are free
from bias and have the maximum credibility in the business and
investing communities.6
---------------------------------------------------------------------------
\6\ Page 5 of 8.
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The SEC, together with the private-sector Financial Accounting
Foundation,7 maintains active oversight of the FASB's
activities.
---------------------------------------------------------------------------
\7\ See Attachment 1 for information about the Financial Accounting
Foundation.
---------------------------------------------------------------------------
The FASB has no power to enforce its standards. Responsibility for
ensuring that financial reports comply with accounting standards rests
with the officers and directors of the reporting enterprise, with the
auditors of the financial statements, and for public enterprises,
ultimately with the SEC.
WHAT ARE DERIVATIVES AND HEDGING ACTIVITIES?
In general, a derivative is a contract between two or more parties
that involves little or no up-front exchange of assets. The contract
obligates one party to give up cash (or other assets) at some later
date and entitles the other party to receive the cash. The amount of
cash to be exchanged is often derived from two factors specified in the
contract. Those factors are commonly referred to as the ``underlying''
and the ``notional amount.''
The underlying is a variable--usually a price index, an interest
rate or interest rate index, a foreign exchange rate, or the price of a
financial instrument or commodity. The notional amount is an amount of
currency or a physical quantity (for example, a number of bushels or
pounds). The product of the two (the underlying times the notional
amount) determines the amount of cash to be exchanged. Some common
examples of derivatives are options, swaps, forward contracts, and
futures contracts.
Enterprises may use derivatives to hedge against or offset adverse
changes in price or changes in cash flows. Derivatives also are used to
seek extra returns, which is a form of speculation. Of course, a
derivative usually is a two-edged sword. Many derivatives offer as much
potential for loss as for gain.
WHAT WAS THE BASIS FOR THE BOARD'S DECISION TO DEVELOP AND ISSUE
STATEMENT 133?
Beginning in the 1980s and continuing in the 1990s, as the use and
the complexity of derivatives and hedging activities grew rapidly, many
investors, creditors, and other users of financial statements were
surprised and concerned by large unexpected losses on derivatives that
were reported by several enterprises that had previously provided
little if any information about those contracts in their financial
reports.
Members of Congress, the SEC, the General Accounting
Office,8 the American Institute of Certified Public
Accountants,9 and many investors, creditors, and other users
of financial reports urged the FASB to develop and issue a standard
that would provide comprehensive accounting requirements for
derivatives and related hedging activities.
---------------------------------------------------------------------------
\8\ United States General Accounting Office, Report to
Congressional Requesters, Financial Derivatives: Actions Needed to
Protect the Financial System (May 1994).
\9\ AICPA Special Committee on Financial Reporting, Improving
Business Reporting--A Customer Focus (December 1994).
---------------------------------------------------------------------------
At the time, the existing standards applicable to the accounting
and reporting for derivatives and hedging activities were incomplete.
There were no specific standards for many types of derivatives and
hedging activities. Where standards did exist, they were inconsistent.
Where they did not exist, the practices that had developed varied
widely. As a result, the financial statements of enterprises that used
derivatives did not report their derivative and hedging activities in a
way that users of those financial statements could compare or
understand.
Many enterprises reported only the current cash payments or
receipts on their derivatives. For example, enterprises that were users
of interest rate swaps usually reported only the amount of the next
payment or receipt on the contract. Reporting only the next payment or
receipt did not accurately represent the financial position of the
users of the swap. If interest rates changed significantly following
the initiation of the swap, one party could be expected to make
relatively large future payments and the other could be expected to
receive those payments. One party had an unrecorded asset and the other
had an unrecorded liability.
Some of the other results of the incomplete and inconsistent
accounting for derivatives were:
Different enterprises reported very similar derivative activities
differently, and even an individual enterprise could report
similar activities differently.
Gains and losses on derivatives used to hedge risks often were
reported as liabilities and assets, rather than as income or
expenses in the enterprise's income statement. Reporting an
actual loss as an asset or a gain as a liability was misleading
to the users of the financial statements.
WHAT PROCESS DID THE FASB FOLLOW IN DEVELOPING STATEMENT 133?
Because the actions of the FASB affect so many organizations, its
decision-making process must be fair. The FASB carefully considers the
views of all interested parties--users, issuers, and auditors of
financial information. Our Rules of Procedure require an extensive due
process. It involves public meetings, public hearings or roundtables,
and exposure of our proposed standards to external scrutiny and public
comment. The Board makes final decisions after carefully considering
and analyzing the input of all parties. While this process is similar
to the Administrative Procedure Act process used for federal agency
rulemaking, it provides far greater opportunities for interaction with
the Board by interested parties. It is also focused on making
technical, rather than political or legal judgments.
Some of the highlights of the FASB's due process in developing
Statement 133 are as follows:
The Board began deliberating issues related to derivatives and
hedging activities at public meetings in January 1992.
The Board appointed outside experts who represented various points of
views on the issues to a Financial Instruments Task Force
(``FITF''). The FITF provided expertise, a diversity of
viewpoints, and a mechanism for communicating with those who
would be affected by any change to the accounting for
derivatives and hedging.
Between January 1992 and June 1996, the Board discussed issues
related to the accounting for derivatives and hedging at 100
public meetings.
In June 1996, the Board issued an Exposure Draft of a proposed
standard.10
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\10\ FASB Exposure Draft, Accounting for Derivative and Similar
Financial Instruments and for Hedging Activities (June 1996).
---------------------------------------------------------------------------
Approximately 300 organizations and individuals responded to the
Exposure Draft, some with multiple letters.
The Board held four days of public hearings in November 1996. Thirty-
six individuals and organizations testified. In addition, six
enterprises participated in limited field tests of the
provisions of the Exposure Draft.
In December 1996, the Board met with the FITF to discuss the issues
raised during the comment letter process and during the public
hearings and field tests.
The Board considered the comments and field test results during its
redeliberations of the issues addressed by the Exposure Draft
in 21 public meetings in the first 7 months of 1997.
The FITF met again with the Board in April 1997 and discussed, among
other things, proposed changes to the Exposure Draft reflected
in a draft of the final Statement.
In August 1997, a revised draft of the standards section of the final
Statement and related examples was made available to the FITF
and other interested parties for comment on the draft's clarity
and operationality.
The Board received approximately 150 comment letters on the revised
draft and discussed those comments in 10 public meetings. Those
comments led to additional changes to the requirements,
intended to make the Statement clearer and more operational.
The Board issued Statement 133 in June 1998.11 As issued,
Statement 133 was effective for all fiscal quarters of all
fiscal years beginning after June 15, 1999, with earlier
application encouraged.
---------------------------------------------------------------------------
\11\ See Attachment 3 for News Release, ``FASB Derivatives
Statement Now Available'' (June 16, 1998).
---------------------------------------------------------------------------
Following the issuance of Statement 133, some enterprises and
auditors expressed concern about certain challenges they faced
in applying Statement 133. Those challenges included
organization-wide educational efforts and information system
modifications that were made more difficult by the
modifications and testing of systems to ensure their proper
operation in the year 2000.
On May 20, 1999, the Board issued an Exposure Draft that proposed
deferring the effective date of Statement 133 for one
year.12 The Board received 77 letters of comment
from respondents.
---------------------------------------------------------------------------
\12\ FASB Exposure Draft, Accounting for Derivative Instruments and
Hedging Activities--Deferral of the Effective Date of FASB Statement
No. 133 (May 20, 1999).
---------------------------------------------------------------------------
In June 1999, the Board issued Statement of Financial Accounting
Standards No. 137, Accounting for Derivative Instruments and
Hedging Activities--Deferral of the Effective Date of FASB
Statement No. 133 (``Statement 137'').13 Statement
137 deferred the effective date of Statement 133 to all fiscal
quarters of all fiscal years beginning after June 15, 2000.
---------------------------------------------------------------------------
\13\ See Attachment 3 for News Release, ``FASB Delays
Implementation Date for Derivatives and Hedging Standard'' (July 7,
1999).
---------------------------------------------------------------------------
what are some of the key requirements of statement 133? 14
---------------------------------------------------------------------------
\14\ See Attachment 4 for a summary of the requirements of
Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities (June 1998).
---------------------------------------------------------------------------
Statement 133 requires that an enterprise report all of its
derivatives as either assets or liabilities on the face of its
financial statements and measure those instruments at their fair value.
Statement 133 also generally requires that any changes in the fair
value of derivatives (gains or losses) be reported in the enterprise's
earnings in the period of the change. If, however, certain conditions
are met, an enterprise may specifically designate a derivative as a
hedge of a related item and receive special accounting for the
combination of the derivative and the related item in a manner that
matches or offsets the earnings effect.
Hedge accounting is a special accounting practice that reflects an
entity's intended strategy between two separate transactions. Rather
than applying the applicable standards to each component of the
strategy, hedge accounting allows the entity to recognize the gains or
losses on the derivative in the same period as the income statement
effect of the hedged item. Entities engaged in risk management
activities desire hedge accounting so that the income statement
reflects the effect of their hedging strategies in the same period as
the item being hedged. Because hedge accounting defers recognition of
gains and losses on derivatives, numerous conditions must be met at the
outset of the transaction and over the life of the transaction; these
are called hedge criteria. The criteria differ, depending on the nature
of the risk being hedged.
In general, a derivative may be specifically designated (1) as a
hedge of the exposure to changes in the fair value of a recognized
asset or liability or an unrecognized firm commitment or (2) as a hedge
of the exposure to variable cash flows of a forecasted transaction. The
accounting for changes in the fair value (gains or losses) of the
derivative differs depending on that designation.
For a derivative designated as hedging the exposure to changes in
the fair value of a recognized asset or liability or a firm commitment
(referred to as a fair value hedge), the gain or loss on the derivative
is recognized in earnings in the period of change together with the
offsetting loss or gain on the hedged item attributable to the risk
being hedged. An example of a fair value hedge is the use of an
interest rate swap to change the interest rate risk on a fixed-rate
bond from fixed to floating. In a perfect hedge, hedge accounting will
show net interest expense at the new floating rate. However, if the
hedge is not perfect, the differences are required to be reported in
earnings and, thus, are transparent to investors.
For a derivative designated as hedging the exposure to variable
cash flows of a forecasted transaction (referred to as a cash flow
hedge), the gain or loss on the derivative is initially deferred in
other comprehensive income (which is a balance sheet account) to the
extent that the hedge is effective; the gain or loss is subsequently
reclassified into earnings in the period that the related forecasted
transaction affects earnings. An example of a cash flow hedge is the
use of an interest rate swap to change the risk profile on a floating-
rate loan--the swap serves to lock in the cash flows associated with
the transaction. In a perfect hedge, hedge accounting will show net
interest income at the new fixed rate. To the extent that the swap is
not effective in offsetting the cash flows on the loan, any
ineffectiveness is reported in earnings immediately and separately
disclosed. Several other disclosures are required to help investors
understand how and when the deferred amount will be reclassified into
earnings.
An enterprise that elects to apply special hedge accounting is
required to identify and document at the inception of the hedge (1) the
specific item(s) that are being hedged and the entity's risk management
strategy, (2) the method it will use for assessing the effectiveness of
the hedging derivative, and (3) the measurement approach for
determining the ineffective aspect of the hedge. Those methods must be
consistent with the entity's approach to managing risk.
HOW HAS THE FASB RESPONDED TO REQUESTS FOR ADDITIONAL GUIDANCE AND
IMPROVEMENTS TO STATEMENT 133?
Implementation Guidance
At the time Statement 133 was issued in June 1998, the Board was
aware of the complexities associated with transactions involving
derivatives and their prevalent use as hedging instruments. Because of
that, even before Statement 133 was issued, the Board established a
Derivatives Implementation Group (``DIG'') of outside experts to assist
the FASB in answering questions that companies might face as they began
implementing the Statement.15
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\15\ See Attachment 3 for News Release, ``FASB Appoints Task Force
to Aid with Implementation Issues on Derivatives'' (February 5, 1998)
and Attachment 5 for a description of the Derivatives Implementation
Group and a list of its members.
---------------------------------------------------------------------------
The responsibilities of the DIG were to identify practice issues
that arose from applying the requirements of Statement 133 and to
advise the FASB on how to resolve those issues. Public meetings of the
DIG were held bimonthly during 1998, 1999, and 2000. The DIG identified
and assisted the FASB in resolving more than 150 discrete issues
relating to the implementation of Statement 133.
In 2001, as the number of new implementation questions diminished,
the responsibility for addressing Statement 133 implementation issues
was transferred from the DIG to the FASB's Emerging Issues Task
Force.16
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\16\ See Attachment 1 for a description of the Emerging Issues Task
Force.
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Amendments
Prior to Statement 133 becoming effective in July 2000, the FASB
received numerous requests from enterprises and auditors to amend that
Statement. The requests focused mainly on guidance related to specific
issues that, if amended, would ease implementation difficulties. In
analyzing those requests, the Board did not discover any new
significant information suggesting that the framework of Statement 133
was inappropriate or that major changes should be made.
In June 2000, in response to the requests, the FASB issued
Statement of Financial Accounting Standards No. 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activities
(``Statement 138''), amending certain provisions of Statement
133.17 In general, Statement 138 (1) expands the scope of
certain transactions that are excluded from the requirements of
Statement 133, (2) broadens the criteria that permit enterprises to
qualify for special hedge accounting, and (3) clarifies certain
provisions based on the recommendations of the DIG.
---------------------------------------------------------------------------
\17\ See Attachment 3 for News Release, ``FASB Issues Amendment to
Derivatives Standard'' (June 15, 2000).
---------------------------------------------------------------------------
More recently, in April 2003, the Board issued Statement of
Financial Accounting Standards No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities (``Statement
149'').18 Statement 149 amends Statement 133 largely to
revise and further clarify the scope of Statement 133 and codify
several issues that were identified and resolved as part of the DIG
process.
---------------------------------------------------------------------------
\18\ See Attachment 3 for News Release, ``FASB Issues Standard That
Amends and Clarifies Accounting Guidance on Derivatives'' (April 30,
2003).
---------------------------------------------------------------------------
Consistent with the FASB's mission and Rules of Procedure, the FASB
stands ready to consider any additional implementation issues or
proposed improvements to the accounting for derivatives and hedging
activities.
Thank you, Mr. Chairman. I would be happy to respond to any
questions.
[The attachments are retained in subcommittee files.]
Mr. Stearns. I thank the gentlelady.
Mr. Baumann, we welcome your testimony.
STATEMENT OF MARTIN F. BAUMANN
Mr. Baumann. Chairman Stearns and Ranking Member
Schakowsky, thank you for inviting me today to discuss
financial accounting standards for derivatives.
My name is Martin F. Baumann. For more than 30 years, I
worked at PricewaterhouseCoopers, where I was a partner, Global
Banking Leader, and Deputy Chairman of the World Financial
Services Practice. I have also been privileged to chair and
serve on numerous accounting industry committees that prepared
guidance on financial and accounting and reporting issues. In
April of this year, I joined Freddie Mac as Executive Vice
President of Finance.
Mr. Chairman, I applaud you for holding today's hearing,
and for the subcommittee's long-standing commitment to
improving accounting standards. I particularly want to commend
you, Mr. Chairman, for your draft bill that addresses the
important issues of principles-based and fair value accounting.
Before I begin, I would like to say a few words about
recent events at Freddie Mac. Freddie Mac is undergoing the
process of restating prior years' financial results. We
candidly laid out the details of the restatement in a recent
news release, which is attached to my testimony. Our intensive
restatement process is expected to be concluded at the end of
this third quarter. We have a comprehensive and aggressive
remediation program in place which we have reviewed in detail
with our primary regulator, OFHEO. Because the restatement is
underway and the reasons giving rise to the restatement are the
subject of Federal investigations. I am sure you can understand
why I cannot comment further at this time on the restatement.
I also want to mention that, as previously announced, the
outside directors of Freddie Mac's board have retained the firm
of Baker Botts to review the facts and circumstances relating
to certain accounting errors identified during the restatement
process. I understand that the Baker Botts report may be
completed and released by Freddie Mac's Board to the public
very shortly, possibly as early as tomorrow.
The comprehensive nature of our restatement gives rise to
two questions I would like to address. First, let me stress
that Freddie Mac is unquestionably safe and sound. Our
expertise in interest rate and credit risk management is widely
recognized, and we consistently exceed our statutory and risk-
based capital requirements. The restatement will result in
significantly higher retained earnings and an increase in our
regulatory capital.
Second, Freddie Mac will fulfill its commitments to
register with the Securities and Exchange Commission. Following
completion of our restatement, we will proceed expeditiously to
resume our Form 10 registration process with the SEC.
On the subject of financial accounting standards, let me
start with a clear an unequivocal statement. GAAP is the basis
and touchstone for our financial reporting. My observations
today on GAAP are offered as part of a healthy public dialog
and in no way imply less than complete support for the
standard-setting process and our commitment to fully comply
with GAAP standards.
Freddie Mac fully supports the FASB's ongoing projects to
increase the use within GAAP of fair value based measures for
financial instruments. In fact, we have found that fair value
measures are of increasing importance to investors and other
market players. While we already provide a fair value balance
sheet on an annual basis, Freddie Mac is now preparing to
become one of the first financial institutions to provide
investors with a fair value balance sheet on a quarterly basis.
This will provide investors with an additional measurement tool
along with our GAAP financial statements.
In discussing Financial Accounting Standard 133, my written
testimony goes into some detail. Let me summarize by saying
that while the derivatives we use are unquestionably
economically effective in managing our interest rate risk, the
accounting standards that apply to such derivatives go only
part of the way to providing a full fair value presentation in
GAAP reporting. This is because investment securities and
derivatives are accounted for at fair value, but debt
obligations are not. This presents a challenge for financial
reporting because the two techniques we use to manage interest
rate risk have highly similar economic results, yet the GAAP
accounting treatment between them is quite different.
Let me conclude by saying a few words about a principles-
based accounting framework. I believe such an approach holds
the potential to improve financial reporting. Achieving its
promise, however, will require rigorous oversight from
Congress, regulatory and self-regulatory organizations. The
challenges are significant, but the opportunity to improve
investor understanding makes pursuit of principles-based
accounting worthwhile.
Mr. Chairman, Freddie Mac is pleased to work with you
toward meeting the highest standards of financial transparency
and accountability. Thank you again for the opportunity to
appear today.
[The prepared statement of Martin F. Baumann follows:]
Prepared Statement of Martin F. Baumann, Executive Vice President
Finance and Chief Financial Officer, Freddie Mac
Thank you, Chairman Stearns. Good afternoon. It's a pleasure to be
here today. My name is Martin F. Baumann.
For more than 30 years, I worked at PricewaterhouseCoopers, where I
was a partner, deputy chairman of the World Financial Services
Practice, and the Global Banking Leader. Most of my career at
PricewaterhouseCoopers was spent within its Financial Services Group,
where I was responsible for certifying the financial statements for
some of the largest U.S. and international banking, insurance, and
other financial services clients.
During my career I also have been privileged to chair and serve on
a number of accounting industry committees and task forces that
prepared standards and guidance on various financial accounting and
reporting issues. May I say that I am delighted to be on the same panel
today as Leslie Seidman, with whom I have worked on critical banking
industry matters.
In April of this year, I joined Freddie Mac, where I currently
serve as Executive Vice President and Chief Financial Officer.
Mr. Chairman, I applaud the subcommittee for holding today's
hearing, the fifth hearing since 2001 that has focused on financial
accounting standards. The importance of transparent accounting and
reporting standards is clear to everyone. I commend the subcommittee
for laying before the public the importance of financial accounting
standards before those issues hit the front pages. Mr. Chairman, I also
want to state my support for the thrust of your effort to move GAAP
toward a principles-based framework.
RESTATEMENT OF PRIOR YEAR FINANCIAL RESULTS
Before I talk about the issue that prompts today's hearing, let me
say a few words about recent events at Freddie Mac. As you know,
Freddie Mac is undergoing the process of restating its prior year
financial results. This restatement will affect the corporation's
financial statements for 2002, 2001 and 2000. Freddie Mac's financial
results for periods prior to 2000 will also be affected by the
restatement. The impact of these corrections for periods prior to 2000
will be reflected as an adjustment to the beginning balance of retained
earnings as of January 1, 2000.
Freddie Mac issued a progress update on its restatement on June 25,
2003. As we stated in that release, the information we disclosed
``reflects poorly on Freddie Mac's past accounting, control and
disclosure practices.'' A copy of that press release is attached to my
statement. As you'll see from it, while Freddie Mac is now in the
process of correcting accounting errors, it remains an extremely safe
and sound financial institution.
The accounting corrections fall primarily into five categories. The
four major categories are: security classification; accounting for
derivative instruments; asset transfers and securitizations; and
valuations of financial instruments. A fifth category includes numerous
other accounting policies, practices and entries that, individually and
in the aggregate, will have a smaller impact on cumulative retained
earnings than the four other categories.
As we have disclosed to the public, this intensive process is
ongoing and expected to be completed by the end of this third quarter.
In the meantime, the reasons giving rise to the restatement are under
investigation by the Securities and Exchange Commission, the Office of
Federal Housing Oversight, and the Justice Department. In view of these
pending investigations, I am sure you can understand why I cannot
comment at this time on the details of these matters. It is our
understanding with the Chairman that the hearing today is not about
these matters, but rather about the more general policy issues raised
by such accounting standards as FAS 133 relating to financial
derivatives. I am delighted to be here on that basis to address the
Subcommittee's questions.
In addition, as previously announced in our June 25 press release,
the outside directors of Freddie Mac's Board retained the firm of Baker
Botts, LLP to review the facts and circumstances relating to certain of
the principal accounting errors identified during the restatement
process. As previously announced, it is expected that the report of
Board Counsel will be completed and that the Board will determine to
release it to the public shortly.
FREDDIE MAC'S COMMITMENT TO DISCLOSURE
It is important to point out that Freddie Mac's new management took
the initiative to candidly lay out these errors. We said at the time
that the new management team and our Board of Directors is ``determined
to set high standards for candor and transparency in our financial
reporting.'' In fact, I believe that taking the initiative to release
this information is tangible evidence of the type of transparency and
candor that Freddie Mac is working to create.
On the point of disclosure, Freddie Mac agrees with Undersecretary
of the Treasury Peter R. Fisher, who in a speech last November talked
about the importance of improving the quality of information that
investors receive. In that speech, he said: ``. . . investors have a
fundamental right to see the companies in which they invest through the
eyes of management.'' Freddie Mac is determined to meet this standard.
Freddie Mac is continuing to work closely with its independent
auditor and other advisors to complete the labor-intensive restatement
as quickly as possible without sacrificing accuracy. We are working
toward completing the process and releasing results during this third
quarter of 2003. At the same time, we are aggressively addressing the
factors that contributed to the restatement. We know how to fix these
shortcomings--and we will. We will emerge stronger than ever, with
significantly improved accounting and disclosure practices that will
meet the highest standards.
We have a comprehensive and aggressive remediation program in
place, which we call our Finance Function Governance Project, led by me
and reporting to the Governance Committee of our Board of Directors.
This program is designed to ensure that we have the highest level of
accounting expertise, compliance with GAAP and regulatory reporting,
and fully accurate, timely, and transparent financial reporting. We
have reviewed the plan in detail with our primary regulator, the Office
of Federal Housing Enterprise Oversight (OFHEO) and will be providing
them with regular updates.
FREDDIE MAC IS SAFE AND SOUND
The comprehensive nature of our restatement process has raised some
questions I'd like to squarely address.
Freddie Mac is unquestionably safe and sound. As we have stated
previously, we expect the restatement to result in significantly higher
retained earnings. Commensurately, we expect an increase in our
regulatory capital.
Freddie Mac is subject to strong capital requirements, which we
consistently meet. Our regulatory capital requirements incorporate two
different measures. One is a traditional, or minimum capital
requirement. The other is a risk-based capital stress test that
requires Freddie Mac to hold capital sufficient to survive 10 years of
severe economic conditions.
The stress test results released by OFHEO have consistently shown
that Freddie Mac has held substantially more capital than would be
necessary to survive such extreme conditions. In line with this, on
June 30, 2003, OFHEO classified Freddie Mac as adequately capitalized,
OFHEO's highest rating.
Freddie Mac's business fundamentals are as strong as ever. As a
result of our disciplined approach to the investment business, we
expect a material increase in the fair value of shareholder equity in
our fair value balance sheet as of year-end 2002 versus year-end 2001,
in spite of a record low interest rate environment. We continue to
attract funds from around the world to support homeownership in
America. The recent pricing of our 2-year and 10-year debt issuances
was extremely well received despite market volatility.
Freddie Mac will fulfill its commitment to register with the
Securities and Exchange Commission. Freddie Mac is fully committed to
completing the process of voluntarily registering its common stock with
the Securities and Exchange Commission under the Securities Exchange
Act of 1934. Last summer we voluntarily agreed to submit to the full
panoply of the periodic financial disclosure reporting requirements
that apply to registrants. We are enthusiastically, unequivocally, and
irrevocably committed to completing this process, as our President and
CEO, Greg Parseghian, said in a letter last week to Treasury Secretary
John Snow, which is also attached.
Following completion of our restatement and re-audit, we will
proceed expeditiously to resume our Form 10 registration process with
the SEC. Voluntary Exchange Act registration will place our financial
disclosures under the direct oversight of the SEC, thereby ensuring
that our disclosures meet the standards of an SEC registrant. This is
another part of our commitment to transparency in financial reporting.
Freddie Mac uses derivatives to manage risk, not speculate.
Derivatives are a key tool used by Freddie Mac to manage the risk
inherent in long-term fixed-rate prepayable mortgages, the mortgage of
choice for most Americans. Chairman Alan Greenspan of the Federal
Reserve Board, has praised the use of derivatives by Freddie Mac and
Fannie Mae numerous times.
Through the use of derivatives and other asset-liability management
strategies, Freddie Mac and other mortgage investors manage and reduce
the interest rate risk inherent in owning consumer-prepayable
mortgages. They do so by transferring some of the risk to high-quality
third parties that are willing and able to assume and manage that risk.
To say it another way: We use derivatives to hedge existing exposures--
we do not use derivatives to speculate.
The accounting issues related to derivatives identified by Freddie
Mac do not diminish or change the economic effectiveness of those
derivatives. The restatement has no adverse impact whatsoever on the
economic or fair value results we achieve through derivative
instruments, which continue to prove very effective in managing risks.
Our monthly disclosures around our interest rate risk levels and our
forthcoming disclosure regarding the full fair value of Freddie Mac's
balance sheet provide ample evidence that our derivatives usage is
keeping low risk and not adversely affecting fair value.
Because our restatement is still underway, I cannot comment further
at this time on specific accounting issues discussed in our June 25
press release. However, I would be pleased to meet with you again, or
answer any written questions you might have after we have published our
press release announcing the restatement results.
DISCUSSION OF ACCOUNTING ISSUES RELATED TO TODAY'S HEARING
Today I would like to address three matters related to U.S.
generally accepted accounting principles, or GAAP, and the relevant
accounting issues that this subcommittee has shown so much leadership
in raising and addressing. First, I will discuss the increasingly
important role that fair value measurement is having for purposes of
GAAP financial reporting and disclosure. Second, I will discuss how
Statement of Financial Accounting Standards No. 133, ``Accounting for
Derivative Financial Instruments and Hedging Activities,'' as amended,
or SFAS No. 133, applies fair value measurement concepts but still
leaves a mixed measurement model for financial reporting. I will close
with some thoughts concerning the conceptual framework used to craft
new standards: Should they be principles-based or rules-based?
Before I begin, let me make a clear and unequivocal statement: GAAP
is the basis and the touchstone for all financial reporting. For
Freddie Mac, we are entirely committed to using GAAP as the primary
basis for our on-going communications with our shareholders and other
interested parties. Any observations regarding how GAAP works should be
understood as offered as part of a healthy public dialogue regarding
how to improve GAAP and in no way implies anything less than our
wholehearted support for those responsible for standard setting and
commitment to comply fully with all applicable GAAP standards.
FAIR VALUE AND GAAP
Freddie Mac fully supports the FASB's ongoing projects to increase
the use within GAAP of fair value-based measures for financial
instruments. Over the years, the FASB has made significant progress
towards this objective. I agree with the FASB Chairman Robert Herz'
statement that ``. . . I think it's hard to argue with the conceptual
merits of fair value as the most relevant measurement attribute.
Certainly, to those who say that accounting should better reflect true
economic substance, fair value, rather than historical cost, would
generally seem to be the better measure.'' 1 Freddie Mac's
support of fair value concepts is mindful of the views of a number of
important capital markets participants. For example, the Bond Market
Association, the International Swaps Dealers Association and the
Securities Industry Association have expressed support for fair value
measurement concepts in a March 2002 report, stating: ``[S]ince fair
value reflects current market conditions, it provides comparability of
the value of financial instruments bought at different times. In
addition, financial disclosures that use fair value provide investors
with insight into prevailing market values, further helping to ensure
the usefulness of financial reports.'' 2
---------------------------------------------------------------------------
\1\ ``Meeting the Challenges of Financial Reporting in an Era of
Change,'' Address of Robert H. Herz, AICPA 2002 National Conference on
Current SEC Developments.
\2\ Explanation and Benefits of Fair Value Accounting, prepared by
The Bond Market Association, International Swaps & Derivatives
Association, Securities Industry Association, March 26, 2002.
---------------------------------------------------------------------------
For its part, Freddie Mac understands that fair value measures are
of increasing interest and importance to our investors. Our new
management team is committed to providing investors with the
information they need to understand how we view and manage the
business, so that investors can value our business fairly and
accurately. To that end, we announced in our June 25th press release
that we will begin releasing quarterly fair value balances sheets in
addition to our GAAP-based financial statements and related tables.
Freddie Mac already provides a fair value balance sheet on an annual
basis as part of our consolidated notes to financial statements, in
accordance with SFAS 107. We are now preparing to become one of the
first financial institutions to provide investors with a full fair
value balance sheet on a quarterly basis, which will show mark-to-
market gains and losses on our business and provide investors with an
additional measurement tool along with our GAAP financial statements.
SFAS 133 AND APPLICATION OF FAIR VALUE MEASURES TO FINANCIAL
INSTRUMENTS
Let me now turn to a discussion of SFAS 133 and its application of
fair value measures to derivative financial instruments. As an
introductory matter, let me underscore that Freddie Mac applies risk-
management strategies with strict discipline. We use derivatives to
reduce interest-rate risks that any mortgage investor faces. Our use of
derivatives demonstrates our commitment to dispersing economic risks.
We do not use derivatives to speculate or make bets on the direction of
interest rates. To do so would be contrary to our risk management
disciplines and to our statutory mission to provide liquidity to the
mortgage market at all times. Prudent use of derivative instruments is
essential to our ability to manage interest-rate risk in a wide variety
of market scenarios and thus to fulfill the mission that Congress has
directed to accomplish.
While the derivatives we use are unquestionably economically
effective in reducing and dispersing our interest-rate risk, the
accounting standards that currently apply to such derivatives only go
part of the way to providing a full fair value presentation in GAAP
reporting. This is because while investment securities and derivatives
are accounted for at fair value, debt obligations are not. Allow me to
provide a simplified example drawn from our own experience that
describes how investors manage interest-rate risk.
When a mortgage investor purchases standard single-family
mortgages, it faces the risk that the homeowners on these mortgages
will exercise the option to prepay their mortgages in a low interest-
rate environment. For mortgage investors that finance their investment
activities by issuing debt, these prepayments could leave the investor
at risk, because the investor would be forced to re-invest prepaid
mortgage proceeds in lower yielding assets, creating a potential future
shortfall on the amount the investor owes on the debt used to fund the
original mortgages. For this reason, prudent investors find ways to
manage the prepayment risk associated with residential mortgages and
mortgage securities.
A mortgage investor can finance its mortgage purchases using two
techniques to manage this interest-rate, or prepayment, risk. One way
is to issue debt with a call option embedded in it--so called
``callable debt''--which gives the investor a right of prepayment
similar to the one that borrowers have on their mortgages, thus
eliminating most prepayment risk. The second technique for the investor
is to issue non-callable debt while at the same time purchasing stand-
alone options that accomplish the same financial result as the callable
debt--making the investor whole in the event interest rates result in
mortgage prepayments. These stand-alone options (for example, interest-
rate swaps or ``swaptions'') are referred to as ``derivative''
financial instruments. In both funding techniques, the resulting
interest-rate risk economics are the same. When Freddie Mac invests in
mortgages, we choose between these two basic risk management techniques
to achieve the lowest cost, because that translates to lower mortgage
costs for consumers and sound economics for our business operation.
Here's the challenge in our financial reporting in this area: While
these two techniques have highly similar economic results, the GAAP
accounting treatment between them is quite different. Whether callable
or non-callable, the debt that a mortgage investor issues will be
reflected in financial statements on the basis of its historical cost,
without regard to market value changes that might occur with respect to
such debt over a period of time. But with respect to derivative
financial instruments, SFAS 133 provides for the change in market value
of such instruments to be directly reflected in financial statements
from period-to-period.
Please understand that I support fair value measures with respect
to derivative instruments. The crux of our challenge is that GAAP
policies today provide for different measures of economically similar
transactions--requiring fair value treatment for derivatives used with
non-callable debt but requiring historic cost treatment for callable
debt. In other words, current GAAP policies could be characterized as
being in a transitional stage from historic cost to fair value
measures. This mixed measurement model creates a challenge for all
reporting companies in clearly explaining both the accounting results
and the underlying economic results for transactions involving
derivative instruments. It is absolutely essential that the management
of these companies make every effort to provide transparent,
informative and candid financial reporting to their investors. Freddie
Mac is committed to that objective.
TOWARD PRINCIPLES-BASED ACCOUNTING
SFAS No. 133 is a rule-based standard attempting to establish
guidelines for an industry that is growing in complexity and size each
day. SFAS 133 is extremely detailed and highly prescriptive. While I
agree with the underlying principle of this standard, which requires
the recording of derivative instruments at fair value, a legitimate
question can be asked as to whether companies, investors and
practitioners might benefit from an approach that promised to reduce
the enormous complexity in the rule's application. The Securities and
Exchange Commission and the FASB, among others, have been studying the
potential efficacy of adopting a U.S. financial reporting system based
on principle-based standards.3 Proponents of principles-
based accounting in the United States envision that it would result in
a fundamental shift away from the very detailed, rule-based standards,
like SFAS 133, to standards under which companies and their auditors
would determine appropriate accounting policies based on the economic
substance of the transaction rather than its form. This is the
framework on which many international accounting standards are based.
---------------------------------------------------------------------------
\3\ Speech by Cynthia A. Glassman, U.S. Securities and Exchange
Commission, 23rd Annual Ray Garrett Jr. Corporate Goverance and
Securities Law Institute Northwestern University School of Law,
Chicago, IL, April 10, 2003.
---------------------------------------------------------------------------
I believe that a principles-based accounting framework holds the
potential to improve the representational faithfulness of financial
reporting under U.S. GAAP. This is because a principles-based approach
would ensure that all reporting companies meet the substance and not
just the form of accounting rules. However, for such an approach to
work, policymakers, including the Congress, would be well advised to
focus on a number of questions. First, would there be a strong enough
framework of oversight to guide the application of fundamental
principles and ensure consistency? A principles-based framework could
emphasize the judgment of company managers and accounting
professionals. Second, clear, consistent--and, let me emphasize--
readily comparable disclosures could be essential to ensure that a
principles-based approach would provide clear disclosures with the
proper level of information for investors.
Principles-based accounting holds enormous promise, but achieving
its promise will require foresight from Congress and rigorous oversight
from regulatory and self-regulatory organizations. The challenges are
significant, but the opportunity to improve investor understanding
makes pursuit of these challenges worthwhile.
CONCLUSION
Mr. Chairman, let me applaud you for holding this hearing to again
focus on such important issues related to transparent accounting
standards.
Mr. Stearns. Thank you, Mr. Baumann.
Mr. Wallison.
STATEMENT OF PETER J. WALLISON
Mr. Wallison. Thank you, Mr. Chairman. Thank you for
inviting me to testify this afternoon on the subject of Fannie
Mae and Freddie Mac. My testimony will focus on the efficacy of
accounting in general, not specifically on FAS 133, and I ask
that my written testimony be included with the committee's
record.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Wallison. Thank you, sir.
Accounting issues have dominated the news about Fannie and
Freddie recently, for good reason. A failure or serious
financial crisis at either of these companies could cause major
losses to the government, to the taxpayers, and to the economy
as a whole. This is not an enviable position for this country
to be in, and it does not have to be so, but that is where we
are today.
The concern about Freddie Mac's accounting is a reminder
that we are relying on only two safeguards to protect our
economy against a serious problem--accurate accounting and good
regulation. The events of Freddie raise questions about both.
What exactly Freddie's management did is really irrelevant.
The important point is that its management made serious
misjudgments that were not reversed by its auditors, or caught
by its regulator. What this shows is that in relying, as we do,
on accounting and regulation, we are placing a lot of weight on
two very thin reads.
Unfortunately, many people have the impression that
accounting is some kind of exact science, that the numbers are
all there and just have to be added up. This is not the case.
Under Generally Accepted Accounting Principles, known as GAAP,
there is a great deal of room for management judgment, and
these judgments can radically change the financial statements.
Let me give you an example.
On September 13, 2002, Fannie Mae transferred $135 billion
of securities from the balance sheet classification ``Held to
maturity'' to the classification ``Available for sale.'' On
that date, the market value of these securities was higher than
what Fannie had paid for them. By reclassifying these
securities as Available For Sale, Fannie was able to carry them
at their higher market value rather than at their cost. The
effect of this was to add a significant amount to Fannie's
shareholder equity. Thus, a technical management decision which
had no effect on economic reality, made Fannie's balance sheet
look healthier on September 14 than it looked on September 12.
This is what I mean when I say that we are relying on a
weak read when we rely on a company's financial statements to
alert us to impending problems.
The subject of the hearing today, FAS 133 and accounting
for derivatives, only further complicates things and puts more
opportunities for window-dressing into management's hands.
What about regulation? Again, in my view, a weak read. It
appears that OFHEO, Freddie's regulator, was not aware of the
scope of the company's financial problems. This should not
surprise us. The managements of regulated companies frequently
will not tell their regulator about problems until these have
gotten completely out of hand. Before that, the hope is to work
out the problem before the regulator finds out. Once the
regulator knows, everybody knows. Exactly this seems to have
happened in Freddie's case.
Again, the point is not this particular case, it is
importance is that it should alert us to the fact that reliance
on regulation to protect us against financial disaster is
often, very often, misplaced.
Why is it especially important in this case to worry about
accounting and regulation? Because the housing market is
unique. It is at once the largest part of our economy, and it
is dominated by two companies. In most other areas of the
economy, there are a lot of companies. If one fails, as Enron
failed, for example, the market sector carries on virtually
unaffected. The housing market is not like that. If Fannie or
Freddie fails or has a serious financial crisis, we can have
systemic effects on our whole economy. Thus, although we could
withstand some bad accounting and some regulatory failure in
many other areas of the economy, we cannot risk this here.
Since accounting and regulation are such thin reads, the
real question for Congress is whether the benefits provided by
Fannie Mae and Freddie Mac outweigh their cost and the risk
they create.
In my prepared testimony, I argue that Fannie and Freddie
create enormous risk for the economy and the taxpayers, but
provide no significant benefits to homeowners or to the housing
market generally. They do not make homes appreciably more
affordable, do not contribute significantly to home ownership
in the United States, and appear to discriminate against
minority or low-income borrowers.
Under these circumstances, the best course for Congress
would be to eliminate the risks they pose by cutting their
links to government. Although I favor complete privatization,
if Congress is not prepared to do this at this point, there is
a less dramatic way substantially to reduce their risks.
Congress should prohibit Fannie and Freddie from buying back
their mortgage-backed securities or accumulating substantial
portfolios of mortgages.
Most of the limited benefits that Fannie and Freddie
provide to the mortgage market comes from the issuance of their
mortgage-backed securities. When they do this, they take only
credit risk, which is quite small. However, most of the
financial risks come from buying back these securities and
accumulating portfolios of mortgages. In this case, they take
interest rate risk which is the same risk that caused the
collapse of the S&Ls. Yet, buying back mortgage-backed
securities and holding mortgages in portfolio doesn't have any
effect on mortgage rates.
So Congress, simply by prohibiting them from repurchasing
their own MBS, can largely eliminate the risk they create
without affecting mortgage interest rates. I respectfully
recommend this to you, Mr. Chairman, and to the subcommittee.
That concludes my testimony. Thank you.
[The prepared statement of Peter J. Wallison follows:]
Prepared Statement of Peter J. Wallison, Resident Fellow, American
Enterprise Institute
Mr. Chairman and members of the subcommittee: It is a privilege for
me to testify this afternoon on the subject of Fannie Mae and Freddie
Mac, and I'd like to congratulate and thank you, Mr. Chairman, for
taking on an important task that deserves much more attention from
Congress than it has received.
It is important to recognize the significance of the accounting
problems at Freddie Mac--not because these problems are especially
severe, but because they were a surprise and seem to arise from
something so routine. From press accounts, it appears that Freddie
attempted over many years to manage its earnings by manipulating the
valuation of its derivatives. This is known as managing earnings, and
its objective is to create a smooth upward curve. Freddie Mac was so
good at this that it was nicknamed ``Steady Freddie'' on the Street.
Some attention is now also being paid to Fannie Mae's financial
reports, which, despite the vicissitudes of the mortgage market,
interest rates and the economy generally, also showed the same smooth
upward curve. Managing earnings is very easy to do under Generally
Accepted Accounting Principles (GAAP)--so easy that many companies are
suspected of doing it.
That is not so much an indictment of these companies as it is an
indictment of the excessive reliance that has been placed on GAAP
financial disclosure by the SEC, media commentators, and--most
recently--Congress in enacting the Gramm-Leach-Bliley Act. The fact is
that GAAP financials are highly malleable, and should not be considered
an index of the financial condition or prospects of companies. Because
the principal constituents of a GAAP earnings statement are predictions
about the future--what losses will be suffered on a portfolio of
receivables, what reserves should be established for future claims--
bottom line financial results reflect simply the judgments of
management rather than a true picture of the company's financial
condition.
I mention this because many commentators and policymakers seem to
believe that requiring Fannie Mae and Freddie Mac to file reports with
the SEC will substantially reduce the risks they pose to the taxpayers
and to the economy. This idea is as misplaced as requiring a whole new
structure to regulate how accountants do audits, as Congress did in the
Sarbanes-Oxley Act. No matter how effective an audit, it can never make
financial statements prepared under GAAP more ``accurate.'' The key
decisions that are made by management in preparing a company's
financial statements cannot be made by auditors, who can only determine
whether GAAP has been followed. Accordingly, while I believe it would
be worthwhile to have Fannie and Freddie register their securities with
the SEC, we should not think that doing this--even if it produces
improved disclosure--will protect us against the risks they pose.
Because of the uncertainties associated with GAAP, it is not
correct to believe that Fannie Mae and Freddie Mac are financially
strong companies simply because they are producing earnings or have
strong-looking balance sheets. It's likely that they are both
profitable and financially strong, but we really can't know for sure. A
demonstration of this is the fact that OFHEO--Fannie and Freddie's
regulator--was not aware of the true extent of the company's financial
problems until advised of them one day before they were announced. If
their regulator could not find their financial problems, how is the
general public--or Congress--supposed to do it?
This points to another very weak reed in our general defense
against the risks created by Fannie and Freddie. We count on regulators
to find and correct the most serious problems before they grow out of
control. But in relying on regulation we are again deluding ourselves.
Occasionally, regulators stumble upon things like bad accounting, but
in most cases they are in the dark until someone tells them about the
problem. Thus, I don't blame OFHEO, or believe that it is a weak or
incompetent regulator because it failed to uncover or understand the
gravity of the accounting problems at Freddie. This is what we should
expect from any regulator, because it is the most likely outcome.
Regulators work in the bowels of the organizations they regulate, but
the big decisions--the ones that can really cause the losses at a
company--are made at the top level, where regulators generally have no
regular access.
Thus, we ought to be clear-eyed about both the effectiveness of
regulation and the usefulness of GAAP accounting, and adjust our
policies accordingly. In the case of Fannie and Freddie, as I will
argue below, we can't afford to make a mistake. If their financial
statements do not disclose their real vulnerabilities, and no regulator
will find these vulnerabilities, we are courting serious problems if we
continue to let them grow with the support of the federal government.
In effect, we are creating a new S&L crisis, but one that will be much
larger and more consequential for the economy.
We should keep in mind that, together, these companies had--at the
end of 2002--approximately $3.3 trillion in liabilities. $1.5 trillion
of this was in the form of debt, and $1.8 trillion in the form of
guarantees of mortgage backed securities. Against these liabilities
they hold only about 3 percent in capital--a percentage far lower than
that permitted to regulated commercial banks. As outlined later in this
testimony, obligations in this range pose enormous potential problems
for the nation's taxpayers and for the economy at large.
But even these risks might be worth taking if Fannie and Freddie
produced substantial benefits for the economy or for homebuyers.
However, this is not the case. In fact, Fannie and Freddie deliver
relatively little value to the economy or to homebuyers--and certainly
not enough value to justify the risks they are creating. Since we are
not likely to be protected against those risks either by better
financial disclosure or regulation, it seems prudent to consider other
ways that the risks might be reduced, preferably without any adverse
effects on the mortgage markets or on homebuyers.
In the balance of this testimony, I will try to show that Fannie
and Freddie provide relatively little benefit to the economy or to
homebuyers generally, and that what little benefit they provide is
overwhelmed by the risks they create. Since neither better accounting
or auditing, nor better regulation, is likely to save us from the
consequences of these risks, we should consider policies that will
reduce risks in other ways. I believe the best way to eliminate these
risks is to privatize Fannie Mae and Freddie Mac, and break them up
into smaller competitive components, but I recognize that this idea is
not at the moment politically feasible. So at the end of this testimony
I suggest another way to substantially reduce the risks they pose,
without either privatizing Fannie and Freddie or adversely affecting
the mortgage market.
First, however, I will discuss the balance of benefits and costs
that I see in Fannie and Freddie.
WEIGHING BENEFITS VS. RISKS
The case against Fannie Mae and Freddie Mac is very simple: they
create enormous risks for the government, for the taxpayers, and for
the economy as a whole, yet provide no significant benefit to
homebuyers. Accordingly, Congress should take steps to cut their links
to the federal government. Like the S&L crisis many years ago,
procrastinating will only put off the day of reckoning, and the problem
will be worse and more costly when Congress is finally compelled to
act. Fannie and Freddie have been doubling in size every five years,
and now have combined liabilities of $3.3 trillion. This is not a
problem that can be safely or responsibly put off.
Fannie Mae and Freddie Mac were created for a single purpose--to
provide liquidity for the housing finance system by creating a market
for the mortgages made by banks and other mortgage originators. They
did this very well. There is now a vibrant and efficient secondary
market for residential mortgages. The technology has been developed,
investors have been educated, a distribution system has been
established. The structure will now operate without government
assistance of any kind. In fact, in the so-called ``jumbo'' market--
mortgages larger than Fannie and Freddie are permitted to buy--it
operates entirely without any government backing. So Fannie and Freddie
are no longer necessary for their original purpose. They should be
thanked and sent home.
In fact, Fannie and Freddie know all this. So they have been
diligent in creating a rationale for themselves that does not depend on
their providing liquidity to the housing market. They have been
advertising instead that they ``open the doors to home ownership'' by
reducing the cost of mortgages, or that they are in ``the American
dream business'' because they enable people to buy homes who might
otherwise not be able to do so, or--implicitly--that they help
minorities to become homeowners.
However, they do not really do these things. Let me take them one
at a time.
Helping people afford homes. The basis for this claim is the
correct observation that interest rates on mortgages purchased by
Fannie and Freddie are somewhat lower than rates on so-called ``jumbo''
loans--which are sold in an entirely private secondary market. There
have been many studies of the degree to which Fannie and Freddie
provide lower interest rates to buyers who can qualify for conventional
conforming loans. Table 1, attached, is a compilation of such studies
that was presented at an AEI conference in October 2002. It shows that
the effect of Fannie and Freddie's activities is to reduce interest
rates on home mortgages by a very small amount--somewhere in the range
of 25 basis points, or \1/4\ of 1 percent. If I can put this in
perspective, every time the Fed lowers interest rates by one-quarter
point, it has the same effect, and the Fed has done this 12 times in
the last two years. Similarly, every time the Fed raises interest rates
\1/4\ point it has the opposite effect. If that \1/4\ point were as
important as Fannie and Freddie suggest in their advertising, thousands
and thousands of American families would be frozen out of home
ownership every time the Fed raises interest rates by \1/4\ point.
Moreover, this benefit comes almost entirely from the implicit
support Fannie and Freddie receive from the government, not because of
anything particularly special that Fannie and Freddie bring to the
market. The Congressional Budget Office has estimated that in 2000
Fannie and Freddie received implicit government support with a value of
about $10.6 billion, of which about two-thirds was actually made
available to the mortgage market through lower rates. The balance,
presumably, increased the share values of Fannie and Freddie by
increasing their bottom line profitability, and went to management
compensation.
This small one-quarter point benefit, however, is not a very good
argument for continuing the implicit government subsidy. First of all,
it's a very inefficient way of subsidizing the housing market. About
one-third of the benefit the government has conferred on Fannie and
Freddie goes to their shareholders and managements, rather than to
create lower interest rates. This is surely an extreme form of
corporate welfare, in which two managements and their investors are
enriched in order to confer limited indirect benefits on homebuyers. If
Congress wants to subsidize housing, it should be able to find a more
efficient way to do it.
But second, and much more important, it isn't even clear that the
subsidy--limited as it is--goes to homebuyers. It's entirely possible
that it simply causes home prices to rise. In other words, it is a
subsidy to home sellers and developers. I don't know of any studies
that show this--nor of any studies that show the opposite--but it is
common sense that to the extent that the monthly payments required of
homebuyers are reduced, it provides an opportunity for home sellers to
raise their prices.
Putting people in homes. Fannie and Freddie argue that the small
reduction in interest rates that they pass along to the mortgage
markets out of their implicit government subsidy contributes to the
growth of home ownership in the United States by helping people buy
homes. However, a study by the Census Bureau, also presented at an AEI
conference in October, showed that the monthly cost of owning a home is
not the obstacle that prevents renters from buying homes. The obstacle
is the down payment. Renters do not generally have the financial
resources necessary to buy their first home. Accordingly, the claim
that Fannie and Freddie put people in homes by reducing interest rates
is not true. No amount of interest rate reduction will make it possible
for renters to become homeowners, because the problem for them is not
the carrying cost of owning a home--it is the fact that they cannot
accumulate the necessary down payment.
This reality led my colleague at AEI, Professor Charles Calomiris,
to propose that Fannie and Freddie be completely privatized and the
implicit subsidy they now receive used to provide down payment
assistance to families who would otherwise be unable to purchase a
home. Professor Calomiris estimated that this use of the Fannie and
Freddie subsidy would permit more than 600,000 families, now renting,
to buy homes.
Helping minority families. Through their advertising, which
prominently displays photos of minority families in or in front of what
are presumably their homes, Fannie and Freddie suggest that they
provide special assistance to minority families hoping to become
homeowners. And if they did this disproportionately--that is, helped
minorities or low income borrowers more than they helped middle class
borrowers--that would be a powerful argument for preserving their
current status.
But they do not do this. Instead, according to a study by Jonathan
Brown of Essential Information, a Nader-related group, Fannie and
Freddie buy proportionately fewer conventional conforming loans that
banks make in minority areas than they buy in middle class white areas.
Other studies have shown that the automated underwriting systems that
Fannie and Freddie use to select the mortgages they will buy approve
fewer minority homebuyers than similar automated underwriting systems
used by mortgage insurers. There is at least one lawsuit against
Freddie Mac by a minority homebuyer, arguing that he was unable to get
a conventional conforming mortgage because of the exclusionary nature
of Freddie's automated underwriting system.
The sad fact is that Fannie and Freddie--two government sponsored
enterprises that have a government housing-related mission--do less for
minority housing than ordinary commercial banks. Studies have
repeatedly shown that banks and other loan originators make more loans
to minority borrowers than Fannie and Freddie will buy. That in itself
should be a scandal, together with the fact that both companies seek
through their soft-focus advertising to create the impression that they
are actually using their government benefits for the disadvantaged in
our society.
So the US housing finance system gets very little benefit from the
continued existence of Fannie Mae and Freddie Mac as government
sponsored enterprises. The reduction in interest rates that they can
point to as a result of their activities is really the result of their
implicit government support, which is small in any case, and is swamped
by macro changes in interest rates as a result of economic conditions.
In any event, it isn't even clear that the lower rates operate as a
benefit to homebuyers rather than home sellers. This small reduction in
interest rates does not put people in homes or improve homeownership
rates in the United States because most renters lack the down payment
necessary to buy a home, not because they could not afford the monthly
carrying cost of homeownership. And finally, despite the implications
of their advertising, Fannie and Freddie seem to discriminate against
minority homebuyers rather than assist them.
THE COSTS OF FANNIE AND FREDDIE
So the benefits of continuing Fannie and Freddie as GSEs are meager
to non-existent. What then are the costs?
I have already cited the CBO estimate that Fannie and Freddie
receive an implicit subsidy from the US government--in effect an
extension of US government credit--with an annual value of at least
$10.6 billion. That, however, is not the extent of their cost to the
taxpayers. Because their securities directly compete with Treasury
securities--in fact they have begun to issue securities on a regular
schedule, just like Treasury, in order to be a more effective
substitute--they cause Treasury interest rates to rise slightly,
probably by a few basis points. On a total Treasury debt of several
trillion dollars, those few basis points amount to hundreds of millions
of dollars annually.
But these two costs do not begin to describe the potential costs to
the government, the taxpayers and the economy of allowing Fannie Mae
and Freddie Mac to continue to grow. Because Fannie and Freddie are
implicitly backed by the US government, financial problems at either of
them could require a government bailout. This is what Congress has had
to do with other GSEs--most recently the farm credit system in the mid-
1980s--and there is no reason to suppose that Congress would not step
in if Fannie or Freddie, or both, were in financial trouble.
Until June of this year, when Freddie Mac dismissed its top three
officers and announced that it would have to do a considerably bigger
financial cleanup than we initially thought necessary, it was possible
to say that both Fannie and Freddie were in strong financial condition
and that there was no prospect of a bailout. Since then, however, there
has been much more scrutiny of the financial statements of both
companies, and at least some observers have pointed out that while
Freddie might have been more profitable than it reported during the
three years ending in 2002, Fannie Mae might actually have lost money,
or made no profits, last year. That is not what Fannie reported, which
was of course another huge annual increase in profitability. The
problem is, because of the malleable nature of Generally Accepted
Accounting Principles (GAAP), we don't really know how these
complicated companies are doing. We would get a better picture of
Fannie and Freddie's actual condition with better cash flow reporting,
but that is not currently required by GAAP or the SEC.
In any event, however they are doing today, changes in interest
rates and the economy generally could have a significant adverse effect
on their financial health in the future, and the taxpayers are
ultimately responsible for assuring that they meet their obligations.
It is important to remember in this connection that, at the end of
2002, Fannie and Freddie had an aggregate of $3.3 trillion in
liabilities. Even a small part of this obligation--if it has to be made
up by the taxpayers--will make the S&L bailout look like a dimestore
operation.
But even that does not end the risks we all face with these two
companies. Because they are integral to the health of the housing
market, the failure of either of them could have a systemic effect--
meaning an adverse effect on the economy as a whole. It's relatively
easy to see how this might happen. Fannie and Freddie, together,
purchase almost all the conventional conforming mortgages that come on
the market each year. They currently hold or guarantee 75 or 80 percent
of all conventional conforming mortgages and almost half of all
residential mortgages in the United States. If either Fannie or Freddie
were to lose the confidence of the capital markets, and were unable to
purchase their share of new mortgages as these came on line, the entire
residential finance system would be seriously disrupted--at least
temporarily. Interest rates would rise and residential mortgages would
be harder to get. This would rapidly affect the rest of the economy.
Home sales would decline, construction would fall, sales of home
furnishings and appliances would suffer.
This effect would be bad enough as it ripples through the economy.
Much worse would be the effect on the financial system as a whole.
Large numbers of banks and other financial institutions are major
investors in the securities of Fannie and Freddie. They are encouraged
to buy and hold Fannie and Freddie securities by a statutory exemption
for these securities from regular restrictions on loans to one
borrower. Declines in the value of Fannie and Freddie securities will
reduce, and in some cases impair, the capital of all these financial
institutions. Reduced or impaired capital will reduce the amount of
credit they can provide, even outside the mortgage markets.
Altogether, then, the effects of a failure or severe financial
crisis at either Fannie or Freddie could be systemic in character, not
limited to the home mortgage markets. And since there are only two of
these companies, it is accurate to say that the continued health of our
economy depends on decisions by only two corporate managements. If one
of them makes a grave mistake, the entire economy could suffer. And the
recent events at Freddie Mac show that management judgments are far
from infallible. We don't know the extent of the problems at Freddie,
but we do know that the top management made serious errors of judgment.
These, fortunately, do not appear to threaten systemic effects, but
errors of judgment come in many shapes and sizes, and one day the error
may be of a kind that cannot be repaired by accountants working around
the clock.
WHAT TO DO
So what is to be done? We have a situation in which two companies
create enormous risks for the taxpayers and the economy, but offer
little in the way of benefits to anyone. Congress has it within its
power to change this calculus in a number of ways. My preferred answer
would be to privatize Fannie and Freddie and at the same time break
them up into five or six smaller entities. In nature, diversity
protects a species; in finance, diversity can protect an economy.
However, I am aware that this solution is not for the moment on
anyone's radar screen. So I have a more modest proposal: Congress
should prohibit Fannie and Freddie from buying back or accumulating any
substantial portfolio of mortgages or mortgage backed securities (MBS).
Today, these companies do business in two very different ways: (i)
they create pools of mortgages which are used to collateralize MBS that
they guarantee and sell to investors, and (ii) they buy whole mortgages
and repurchase the MBS they have already sold to investors.
These are two very different ways of performing their functions,
and have very different consequences. When Fannie and Freddie create
pools of mortgages and sell MBS backed by these pools, they are
guaranteeing that investors will receive a stream of revenue derived
from the interest and principal paid into the pools by homeowners
paying off their mortgages. In this case, Fannie and Freddie are taking
only credit risk--the risk that homeowners will not meet their mortgage
obligations. This is not a very significant risk, especially today,
when losses on mortgage pools have been running at 1 or 2 basis points.
However, buying and holding mortgages or MBS is an entirely
different story. In that case, Fannie and Freddie must take interest
rate risk in addition to credit risk. Interest rate risk--that rates
will rise or fall--is a far greater risk than credit risk, and requires
Fannie and Freddie to buy derivatives of various kinds to protect
themselves against the vicissitudes of the credit markets. To put this
in perspective, it was interest rate risk that caused the failure of
the S&Ls. They were holding mortgages that were paying, say, 5 percent,
but in order to finance these loans they had to pay 10 or 12 percent
for their funds when interest rates rose. With a negative spread like
that, they weren't solvent for very long. Fannie and Freddie are in the
same position, but their risks run two ways. The same thing happens to
them if interest rates suddenly go up--they are holding mortgages that
may yield less than the new rate they have to pay for their funds. But
they also run risks if interest rates go down, since a portion of their
portfolio is funded with longer term debt. If interest rates decline,
homeowners refinance, and Fannie and Freddie end up holding, say, 4
percent mortgages, that they've funded with 5 percent liabilities.
Another losing proposition.
Why, you might ask would Fannie and Freddie take such risks? Why
would they buy back from investors the MBS on which the investors are
already taking the interest rate risk? The answer is that, even after
buying all that hedging protection through derivatives, it is still
profitable for them to buy and hold their own MBS. In fact, it has been
estimated that Fannie and Freddie own, in the aggregate, 34 percent of
all MBS currently issued. With their government backing, they can
borrow money at rates low enough so that they can do a rather simple
arbitrage, profiting from the spread between their cost of funds and
what the MBS are yielding.
Now one might think that somehow buying back their MBS will have
the effect of lowering interest rates for mortgages, but this is not
the case. Economists point out that borrowing funds to buy back other
credit instruments is simply a wash. It doesn't have any effect on
mortgage rates, which are a product of all the funds available in the
capital markets.
Accordingly, what we have here is the classic case of privatizing
the profits and socializing the risk. Fannie and Freddie profit from
arbitraging their government backing, but the people really taking the
risk are the taxpayers.
Accordingly, if Congress does not currently have the stomach for
privatizing Fannie and Freddie, it can at least reduce the risk they
pose to taxpayers and to the economy generally by prohibiting them from
buying back the MBS they issue and from holding a large portfolio of
mortgages. Instead, their activities should be limited to forming pools
of mortgages and selling MBS that they guarantee. The risks on this--
which is simply credit risk--are far less than the interest rate risk
they have been taking, and it would have no effect on mortgage interest
rates.
This is at least a temporary solution to the problems posed by
Fannie Mae and Freddie Mac. Because we cannot rely on either accounting
or regulation to protect the taxpayers and the economy against a
serious mistake by the managements of Fannie or Freddie, or both, we
should be thinking of ways to reduce that risk. By prohibiting the
purchase of their own MBS or accumulating a large portfolio of
mortgages, we can significantly reduce the risk that these two
enterprises currently create for taxpayers and the economy, without any
effect on interest rates on conventional conforming mortgages.
That concludes my testimony, Mr. Chairman.
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Mr. Stearns. I thank the gentleman. Dr. Linsmeier, welcome.
STATEMENT OF THOMAS J. LINSMEIER
Mr. Linsmeier. Thank you, Chairman Stearns and members of
the subcommittee. I appreciate the opportunity to testify
today.
My written testimony contains my complete evaluation of
FASB derivative accounting standards and my recommendations to
Congress relating to Freddie Mac's situation.
During my oral testimony this afternoon, I would like to
amplify on my written testimony by summarizing the political
process resulting in the issuance of FASB Statement 133,
evaluating the implications of my analysis for Freddie Mac and
Fannie Mae, and outlining some recommendations with the aim
toward providing better information for investors and
regulators.
In part, Statement 133 was issued in response to a long
list of derivative losses in the mid 1990's at companies such
as Gibson Greetings, Proctor and Gamble, and Bankers Trust.
Prior to issuance of new FASB and SEC rules, there was a
lack of transparency about derivatives and derivative risks in
financial reports. To make derivatives risk transparent
required recognition of derivatives at fair value--that is,
estimated selling price--in the balance sheet. However, the
FASB faced strong resistance by the issuer community to fair
valuing any financial instruments in financial statements
because it would make the economic results of their firms look
more volatile.
The degree of income volatility, however, is exactly the
type of information needed to understand the risks in returns
associated with Freddie Mac and Fannie Mae because their
business success depends on their ability to make money in
volatile interest rate markets.
As stated in Statement 133, the FASB recognized that the
ideal standard to make this volatility transparent is to fair
value all financial, not just derivatives, in the balance sheet
and income statement. Ferocious corporate lobbying efforts
precipitating several congressional hearings, in part, caused
the FASB not to propose this standard, but to take the interim
step of fair valuing derivatives, but not other financial
instruments in financial statements.
This political necessity created a demand for hedge
accounting and the need to identify derivatives separately from
all other financial instruments. Two issues that transformed a
simple principle, fair valuing all financial instruments, into
a complex standard.
Emboldened by their successes, corporate lobbyists
increased the intensity of their cries for forms of hedge
accounting models that further reduced income statement
volatility, increasing the standard's complexity. The outcome
is a complicated and lengthy hedge accounting standard that
provides limited insight into overall risk exposures of an
entity.
As suggested in my written testimony, despite these
compromises and increases in complexity, I believe that the
information available to investors post-Statement 133 is
considerably better than pre-Statement 133.
Next, I address the implications of this analysis for
standard-setting especially in relation to Freddie Mac and
Fannie Mae, by raising and answering three questions.
First, is the complexity of FASB's derivative standards to
blame for Freddie Mac's problems? I believe not.
Freddie's accounting problems were not limited to FASB's
derivative standards. Freddie apparently, according to their
press release, misapplied four different sets of accounting
standards, two of which are not complex at all. In addition,
despite the complexity of FASB's derivative standards, in
contrast to Freddie, Fannie Mae prepares its reports in
compliance with GAAP. Fannie's reports provide, to me, useful
and understandable information about its interest rate risk
exposures.
My conclusion is that complex accounting standards do not
necessarily lead to confusing financial reports.
Second question: Would setting principles versus rules-
based standards necessarily minimize financial statement
issuers' problems leading to better information for Freddie's
and Fannie's investors? I think likely not.
Freddie apparently violated both principles and rules-based
standards in achieving its earnings targets. For principles-
based standards to work, people need to apply the standards in
investors' best interest promoting transparency, and that has
been lacking in our markets over the last couple of years.
Rules-based standards have one advantage, they set bounds
that monitors can more easily evaluate. Besides, it is my
opinion that all FASB standards are principles-based,
consistent with the Board's conceptual framework. The only
issue that remains are the degrees of rules needed to make the
standard effective. The extent of rules employed in each
standard necessarily will vary depending on the nature of the
transaction being accounted for, and the extent that political
compromise necessary to get the standard passed. In my opinion,
principles-based standard-setting should not be legislated, but
should be a good foundation from which all standards are
written.
Third, and last, how can Freddie's and Fannie's investors
be better served? I have three recommendations for your
consideration.
First, require the companies to prepare periodic financial
reports in conformity with GAAP. Do not allow such compliance
to be voluntary. This should make monitoring by regulators,
boards of directors, and auditors effective, and will make
Freddie's and Fannie's information more comparable to other
financial institutions exposed to interest rate risk.
Second, redefine core capital measures to include
unrealized derivative gains and losses on cash-flow hedges. As
detailed in the Heard On The Street article in today's Wall
Street Journal, currently these gains and losses resulting from
current interest rate movements are excluded from income and
core capital for periods up to 30 years, causing Fannie's core
capital to be overstated by over $15 billion today.
Last, I recommend that there be facilitation of FASB's
long-term goal of issuing a standard requiring the fair valuing
of all financial instruments. That is the principle. This
outcome will be best facilitated by congressional
nonintervention in the standard-setting process, helping to
insulate the FASB from undue political pressures like they
experienced leading the 133, and allowing the FASB's careful
due process mechanism to work in the best interest of
investors.
Information reported under such a standard will allow
investors to best understand Freddie and Fannie's exposure to
current interest rate changes. Thank you for your attention.
Mr. Stearns. I thank you. I want to commend staff. I think
we have had a balanced hearing here. We have heard pluses and
minuses. Mr. Baumann, I was going to start off with you, but
after hearing Mr. Wallison, I just want to ask him a question.
Do you believe disclosure under GAAP accounting to be
deficient in communicating a true financial picture of a
company to investors? I mean, just give me that overall feeling
that you have, you know, at the very top here.
Mr. Wallison. I don't think, Mr. Chairman, that financial
disclosure under GAAP is, by itself, sufficient to give an
investor, or a regulator, or the American people, or Congress--
--
Mr. Stearns. Or even institutional investors or anybody----
Mr. Wallison. [continuing] institutional investors, none of
them get enough information simply from GAAP. GAAP is
inherently a malleable subject, and the production of a bottom
line number in GAAP depends on many judgments that management
makes. Many of them are predictions about the future.
Mr. Stearns. So if I submitted a GAAP document to you and
said, ``This is a really hot company, you should really invest
in it,'' what would you--you would look at that and say, ``Mr.
Stearns, that just doesn't mean anything to me.'' What would
you ask for?
Mr. Wallison. Well, there are a couple of things that could
be useful. First of all, there could be a lot more information
about cash-flow. I don't think that the GAAP financial
statement, as required now, provides enough information for
investors to evaluate cash-flow.
One of the very interesting things that happened in Enron
was that as Enron was reporting their fake earnings over a
period of time, their stock was falling against the industry
standards. Others in the industry were remaining about the
same, but Enron stock was falling, and that is because their
cash returns were negative while they were reporting earnings.
Mr. Stearns. So you would just look at the cash-flow,
period, and you----
Mr. Wallison. You would look at cash-flow, that is exactly
right. More cash-flow information would give an investor, an
analyst, another way of judging whether the----
Mr. Stearns. If you could wave a magic wand, you would redo
all of FASB to make it more cash-flow based, rather than----
Mr. Wallison. I would include much more cash information. I
would have the SEC provide investors that they could evaluate
cash-flow. I would require more cash-flow disclosure from the--
the SEC should require it from companies. And then, in
addition, there are many other things that could be requested,
including financial indicators that----
Mr. Stearns. Dr. Linsmeier, do you agree with him, or
disagree? He is basically saying the GAAP is really not clear
at all, does not provide any information, and he wants to see
cash-flow.
Mr. Linsmeier. I didn't hear him say that. I heard him say
that given the GAAP basis statements, he would like more cash-
flow to augment those statements to complete the understanding.
Mr. Stearns. Okay. That is a better read of that. And do
you agree with that? Or would you be happy with just a GAAP
statement? Could you make enough analysis to invest your
grandchildren's trust fund, if you just had a GAAP? Would you
be satisfied with that?
Mr. Linsmeier. Well, I think I would always like more
information. I don't know about the cash-flow statement that
Mr. Wallison just talked about because there is a cash-flow
statement already in GAAP. And what I would have to understand
better is what sort of analyses he would like to have in more
detail, to improve that circumstance.
Mr. Stearns. The gentlelady Schakowsky just mentioned in
her opening statement how she hopes we will have a hearing
after the Dowdy report comes out, and I agree with her and we
intend to have that, and I commend her for making that
reference.
Mr. Baumann, I appreciate your coming here. As you know, we
are trying to work through this, and we have been seeking
documents and to interview witnesses from Pricewaterhouse in
connection with an inquiry into the accounting questions raised
by Freddie Mac's restatement. And I guess my question is to
you, will you help us and will you commit to provide us with
the requested documents and access, of course, which is
important for us to study this, to Pricewaterhouse in the next
couple of weeks? Could we get your commitment on that?
Mr. Baumann. We are committed to helping all parties that
are investigating Freddie Mac. There is an investigation
underway by the SEC, by OFHEO, by the U.S. Attorney----
Mr. Stearns. You have got your hands full.
Mr. Baumann. We are actively giving documents and access to
all parties that have an appropriate jurisdiction to
investigate us, and certainly we would be more than happy to
make sure that you get all the information you need.
Mr. Stearns. We had this jurisdiction during FASB, and of
course dealing with FASB, we got to understand through
Pricewaterhouse some questions, so we appreciate your
cooperation here. Let me come back to you, Mr. Baumann.
By using the special hedging rules, FAS 133, Freddie sort
of prevents investors from seeing the gains and losses in their
derivative positions reflected in quarterly earnings that you
report. Will Freddie Mac commit to stop using the special
hedging rules so investors will have an accurate picture of the
gains and losses in Freddie's derivative positions?
Mr. Baumann. Freddie Mac follows GAAP, and will follow GAAP
in the future, to the extent we made some mistakes in the past.
And Freddie Mac has no intention in the past or present to hide
any gains or loss from any investors.
Mr. Stearns. Special hedging rules. I guess the question
is, will you commit to stop using these special hedging rules,
and they are part of GAAP. So, we are just trying to say what
kind of commitment are you going to make dealing with these
special hedging rules?
Mr. Baumann. To the extent we use FAS 133 hedging
standards, we will follow 133 and follow the rules in 133. To
the extent they are special hedging rules or any other type of
hedging rules in 133, we will follow them.
Mr. Stearns. For example, do you think that investors
should have the ability to see Freddie's gains and losses in
derivative positions on a quarterly basis?
Mr. Baumann. Absolutely. First of all, we believe that
there's a lot of information that investors get from financial
statements. Getting back to the question you asked before, the
GAAP financial statements present certain information about
shareholders equity and other gains and losses are included in
shareholders equity, but the fair value balance sheet includes
all financial instruments mark to market at fair value, and
present significant information to investors. We present that
annually now, as all companies are required to do. We are
committed now to present that fair value balance sheet
quarterly so there would be complete transparency about the
fair value of all of our financial instruments.
Mr. Stearns. I appreciate your commitment on that. As we
understand it, though, that if you use special hedging rules--
and, Ms. Seidman, you can help me out here--if you use special
hedging rules, then you are not able to commit to losses and
gains in derivative positions on a quarterly basis, is that
true? If he uses special hedging rules, that you cannot have a
quarterly basis for reporting the gains and losses in these
derivative positions, is that true?
Ms. Seidman. It would depend on what specific type of
hedging transaction they are engaging in. If they are engaging
in a hedge of a fixed rate item, such as a loan or a debt
instrument, the gain or loss on the derivative is reported in
earnings quarterly throughout the life of the hedge. But the
item being hedged is also being mark to market, which is what
gives you the net offset in the income statement, whereas if
they were hedging a floating rate instrument, that is the case
where the gain or loss on the derivative is deferred onto the
balance sheet----
Mr. Stearns. Okay, understand. So the mark to market cannot
be done on a floating interest rate whereas a fixed you can. So
is my question fair to him to say you can't really commit to
quarterly reports on the special hedging derivatives that are
floating.
Ms. Seidman. If the context of the question is limited to
the cash-flow hedges, there remains a question of whether it
would stay deferred on the balance sheet.
Mr. Stearns. Okay. My time is expired. The gentlelady.
Ms. Schakowsky. Thank you. Ms. Seidman, is FASB itself
looking at reviewing its standards of accounting for
derivatives, and are proposals being made? Where are you in
terms of reviewing those standards?
Ms. Seidman. We have on our agenda a long-term project to
potentially report all financial instruments at fair value in
the balance sheet. Part of that effort would include
derivative. However, before we are able to move to that
potential objective, there are several remaining issues that we
need to deal with that are quite important and must be resolved
before we could achieve that goal. They include, first off, the
appropriate level of guidance that is necessary to determine
the fair value of a wide range of financial instruments,
ranging from long-term debt where there are questions about how
to reflect the changes in credit quality of the issuer, as well
as some concern about the possibility in a fair value world, of
reporting a liability at an amount less than what is owed.
Another area that we would like to consider is the
distinction between liabilities and equity, for example, so
that companies would know where the line is for what needs to
be mark to market. And, last, we have a financial performance
reporting project on our agenda which will help clarify the way
gains and losses on all financial instruments would be reported
in the financial statements--that is, whether those amounts
would go to earnings, or whether they would go through other
comprehensive income in a manner similar to some hedges today.
Ms. Schakowsky. And how long do you project that this kind
of review and the recommendations that would result from that
would take?
Ms. Seidman. I am not in a position to give you a specific
date on that, but one other point I would like to make is that
we are working together with international standard-setters on
this effort. To the extent that we could obtain international
convergence on such an important area, that would be the
desirable goal.
So, other standard-setters--for example, the International
Accounting Standards Board--is a little bit behind us in this
area. They have not yet issued their standard on accounting for
derivatives. And I would like to note that the proposal that
they are about to go out with largely mirrors Statement 133,
which is an important point from a convergence standpoint. Here
we have a much more recent standard-setting effort that is
essentially coming to the same conclusion that the FASB did.
So, they, too, view this as an interim step, and down the road
we would like to then consider any remaining issues so that we
could have a goal of all financial instruments at fair value.
Ms. Schakowsky. Thank you. Dr. Linsmeier, I am sorry I came
in so late and didn't hear your testimony, but I have your
testimony and I am looking at it. When you talk about the look
to the future, the way to fix the problem described--I am
looking at your slide show--is to issue a standard that
requires full fair value accounting for all financial
instruments in the balance sheets eliminates fair value hedge
accounting. FASB foreshadowed the need for such a standard in
FAS 133, and is currently considering issuing such a standard.
This standard was not issued previously due to--and I want
to focus on this one--extreme political pressures by
constituencies against fair value accounting for financial
instruments for specific forms of hedge accounting that
minimize the income statement effect of hedging transactions.
I am wondering from you--and I would also like to return
then to Ms. Seidman--to see if you think that those political
pressures are likely once again to thwart the issuance of such
a standard.
Mr. Linsmeier. I think that the political issues will be
very important and there will be large pressure not to proceed
forward on that project on the long-term basis. We can see in
Europe right now that there is a big pushback right now by the
banking community and by the European Union against even a
standard like Statement 133, and the politics are extremely
powerful there. And I would suspect, without a doubt, that if
there was a move to fair value all financial instruments, there
would be significant political pressure to try to stop that.
Ms. Schakowsky. Are you aware of such pressure now, Ms.
Seidman, and do you expect to encounter it as you move forward?
Ms. Seidman. I concur with Dr. Linsmeier's assessment of
the situation overseas. Even to get to the same level of
standards that we have in this country, they are meeting a
great deal of resistance in Europe.
One additional point that I would like to add is that even
when we are able to move to a full fair value model, I think
there is an element of our constituency whose concerns would
still not be addressed, specifically, the large multi-national
corporates whose balance sheets are not predominantly financial
instruments, currently engage in hedging transactions--for
example, to hedge forecasted purchases of inventory or overseas
sales or that type of thing. Those are not financial instrument
transactions per se, and they have expressed a significant
need, and we certainly know that they do employ hedge
accounting. So, a fair value approach doesn't resolve all of
the need for hedge accounting.
Ms. Schakowsky. Thank you.
Mr. Stearns. The gentleman from New Hampshire.
Mr. Bass. Thank you, Mr. Chairman. Mr. Chairman, I am not
an accountant, and I am not a sophisticated investment advisor
or consultant, so I am going to ask just one question of Mr.
Baumann.
Freddie Mac has had some financial problems and I guess
some misreporting of financial data and so forth. And in the
course of presenting your testimony, you discussed a
remediation process. I was wondering if you could take a moment
or two to describe in some detail what the problem was, the
remediation process that you undertook, and how we can be
assured that this process will prevent further problems with
Freddie Mac?
Mr. Baumann. Thank you, I would be glad to address that.
Mr. Bass. By the way, in a manner that people like me can
understand.
Mr. Baumann. I am sure you will understand it. We have
developed a comprehensive mediation plan which we have
presented to our primary regulator, OFHEO. That remediation
plan deals with all of the aspects that go around a company's
financial accounting control and reporting processes. It starts
at the top of the company, it starts at the board level, and
ensuring that the information that--first of all, that the
authorities granted by the board are fully carried out by
officers and employees of Freddie Mac, and that they only
operate in accordance with the boundaries of the authorities
and limits granted by the board of directors, then ensuring
that control processes are in place within the company that
only transactions approved by those authorities are entered
into, and no transactions outside of those authorities are
entered into, and then ensures that all of those transactions
are properly and correctly accumulated in our records and
appropriately and correctly reported both back to the board, to
investors, and to regulators in a very transparent way so that
all constituencies fully understand what the business is we are
in, how we execute it, how we do it in a controlled fashion,
and how we report that to, again, board, shareholders,
regulators, and other interested parties.
Having all the necessary controls in a company isn't always
a very exciting conversation to have, but it is absolutely
fundamentally necessary to have strong accounting controls, to
have experts that we are hiring to deal with the complex
accounting rules that Ms. Seidman has talked about in FAS 133,
and other areas. We need to be able to deal with all those
rules, and we should be able to. There is no excuse for Freddie
Mac's accounting problems other than it didn't have the right
internal controls in place around accounting and financial
reporting, that it didn't have the right expertise in place to
handle all these types of transactions.
So this remediation plan will ensure that we have all those
processes in place. It is a high-level plan. We review it
weekly with the Governance Committee of our board of directors,
and all the progress and steps that we are making are under the
oversight of the board, and we are reviewing it regularly with
our regulator, OFHEO, as well as with our auditors,
PricewaterhouseCoopers.
Mr. Bass. Thank you, Mr. Chairman.
Mr. Stearns. The gentleman from Massachusetts, and he was
here when we put the gavel down, so he is entitled to 8
minutes.
Mr. Markey. I thank the Chair. And I am going to begin with
a little song, if I can, Mr. Chairman. I thought I would break
up the afternoon a little bit, and it goes to the tune of
``Mac, the Knife.'' I just thought it might entertain and
illuminate.
When those earnings rise on your balance sheet, dear,
And you want them out of sight,
Just do a swaps deal, says old Mac's execs,
And defer them with all your might.
You know, when the reserve account with its cash, babe,
Hides those earnings, it helps the spread,
Fancy derivatives has old Mac, dear,
So there is never, never a trace of red.
Now, on the sidewalk some sunny morning,
Lies investors just oozing life,
And someone is sneaking round the corner,
Could that someone be Mac, the Knife?
So that is my opening, Mr. Chairman. And now I am going to
ask Mr. Baumann a few questions.
On page 2, Mr. Baumann, of your June 25, 2003 press release
that you attached to your testimony, it sates that outside
counsel engaged by Freddie Mac's board has found that ``certain
capital market transactions and accounting policies had been
implemented with a view to their effect on earnings in the
context of achieving Freddie Mac's goal of achieving steady
earnings growth, and that the disclosure processes and
disclosure in connection with those transactions and policies
did not meet standards that would be required of Freddie Mac
had it been an SEC registrant.''
Now, Mr. Baumann, for many years Freddie Mac has claimed
that its disclosures were as good, or better, than those
required of SEC registered companies, and that all of its
financial statements complied with generally accepted
accounting principles.
Now we have the company in the middle of a massive
restatement of its earnings for the last 3 years, a restatement
which Freddie Mac has said will increase earnings somewhere
between $1.5 and $4.5 billion.
So let me begin by asking you, how could a company as large
and as well respected as Freddie Mac underreport its earnings
by that much, and why is there such a large margin of
uncertainty about the size of the restatement?
Mr. Baumann. First, I thought the song was excellent, and I
thought the song was very good, also.
With respect to the accounting errors, Freddie Mac didn't
have the right accounting expertise in place to get the
accounting right for certain accounting standards. As a result
of that, certain assets will now be mark to market that were
previously accounted for at cost. Certain derivatives will now
be mark to market without the related asset or liability being
marked with it, and in a declining interest rate environment,
that has resulted in those mark to markets being a large
increase to accumulated earnings in this $1.5 to $4.5 billion
range.
Mr. Markey. And why is the spread so great right now, the
size of the restatement? Why can't you get it closer than 1.5
to 4.5?
Mr. Baumann. We wanted to make sure when we did this--we
still had a lot of work remaining with respect to completing
the restatement. We are dealing with very large numbers in
terms of the size of our balance sheet and the size of the
derivatives involved. And we wanted to make sure that we didn't
announce a number that was either too low or too high such that
we would confuse investors.
Mr. Markey. It just seems like an awful big range of
uncertainty. As a matter of fact, it is almost a scary level of
uncertainty, $1.4 billion to $4.5 billion for one company.
Mr. Baumann. I agree, it is a very large number.
Mr. Markey. Now, the quote I read you earlier from Freddie
Mac's press release seems to acknowledge that Freddie Mac was
managing earnings using derivatives transactions. Isn't it true
that Freddie Mac's management was trying to exploit FASB's
hedge accounting rules in order to avoid having to report the
fair value of its derivatives positions in its earnings
statements?
Mr. Baumann. The report of Baker Botts will be made public
very shortly, possibly as early as tomorrow. Baker Botts was
hired by the board, independent counsel to review all of the
facts and circumstances surrounding the accounting errors and
the issues around it, and that report will get into the
causation of all of these errors. And I think I would be
premature to comment in advance of that.
Mr. Markey. Your press secretary acknowledges that the
disclosure processes and disclosures that were made in
connection with these transactions and policies didn't meet the
standard that would be required of an SEC registrant. Can you
tell us in what specific ways did these disclosure processes
and disclosures not comply with the standards required of SEC
registered companies?
Mr. Baumann. The press release says that board counsel has
presented preliminary findings, and so these comments are from
board counsel. It is board counsel's view as to whether or not
these disclosures met standards of appropriateness or not.
Mr. Markey. So you don't agree with your counsel's
conclusion on that subject?
Mr. Baumann. I didn't say that. I said these were board
counsel's findings, we were referring to the quote, sir.
Mr. Markey. Have you been briefed on the basis for that
statement that was made?
Mr. Baumann. I have reviewed the accounting errors and the
related accounting disclosures.
Mr. Markey. Have you talked to the counsel about the
conclusion which they reached on that subject with regard to
the SEC requirements? Has he talked to you about that?
Mr. Baumann. Certainly, board counsel has been spending a
lot of time----
Mr. Markey. Has he talked to you about it?
Mr. Baumann. Has board counsel talked to me?
Mr. Markey. About the differentiation between the SEC
requirements and what you had been required--did he talk to you
about that?
Mr. Baumann. Not in great detail.
Mr. Markey. But he did talk to you about it?
Mr. Baumann. Yes.
Mr. Markey. And in his outline of the differences, do you
have any reason to disagree with what the counsel said to you?
Mr. Baumann. Based upon what board counsel has presented to
me, I have no disagreements with his findings at this point in
time.
Mr. Markey. Okay. That is that if you had been an SEC
registered company, that you may have avoided this problem in
terms of the disclosure which you would have been required to
make.
Mr. Baumann. Freddie Mac is committed to the registration
process now. We have begun the SEC registration process, and we
will commence completing that process as soon as the
restatement is done.
Mr. Markey. Now, the same statement makes reference to
Freddie Mac's use of certain reserve accounts and other
adjustments that were known departures from GAAP and that were
not considered material at the time, and were made with a view
to their effect on earnings. That is all part of your press
statement.
Now, that says to me that Freddie Mac was using your
reserves to manipulate or manage earnings and that you knew at
the time you were doing this, and that your accounting didn't
conform with GAAP. Can you explain to us how you can make use
of a reserve account to affect earnings and have it not be
material?
Mr. Baumann. I can't explain that, but that is what the
company appeared to have done in the past, according to board
counsel.
Mr. Markey. But if you were successful in affecting
earnings, wouldn't it be, by definition, have been a material
transaction?
Mr. Baumann. I think that largely Staff Accounting Bulletin
99 of the SEC would say that if the adjustment impacts
earnings, that that should be disclosed.
Mr. Markey. So if the transaction caused the company to
meet or exceed the consensual analysis prediction regarding
your earnings, that would be material.
Mr. Baumann. That would probably be material in those
cases.
Mr. Markey. Thank you, Mr. Chairman, my time is expired.
Mr. Stearns. Thank the gentleman. Mr. Strickland, the
gentleman from Ohio.
Mr. Strickland. Thank you, Mr. Chairman. Mr. Wallison, I
read in your testimony that you say that your preferred answer
would be to privatize Fannie and Freddie, and at the same time
break them up into five or six smaller entities. You also say
that you are aware that this solution is not for the moment on
anyone's radar screen. But just speculating for a moment that
this could be accomplished, if these privatizations were to
take place, as you would like to see, how can you say with a
high degree of certainty that their important affordable
housing mission would be met by other financial services
companies. Is that a concern to you?
Mr. Wallison. Yes, it would be a concern to me, but I don't
think the--first of all, I don't think Fannie and Freddie are
meeting the affordable housing objectives that probably
Congress would want them to meet because there is a conflict
between their government mission and their necessity as private
corporations to maximize profitability. And so the benefits
that Freddie and Fannie receive from Congress in the form of
government backing coming from a number of links results in
their using much of that benefit for shareholder compensation
and management compensation, and not fully using that benefit
for the assistance to affordable housing.
So I would not expect that if Fannie and Freddie were
privatized and there was full competition in the market among a
whole range of companies offering secondary mortgage market
services, that there would be any substantial decline in the
amount of affordable housing support that comes from the
government. In fact, if the government, if Congress took the
benefits that Fannie and Freddie get, which has been estimated
by CBO to be about $10 billion a year, and made that available
directly for down payment support for people who cannot
otherwise--or don't otherwise have the down payment necessary
to buy housing, that would really advance the housing
objectives of Congress to a degree that Fannie and Freddie do
not do.
Mr. Strickland. Could I ask the others, how would you
respond to the answer I just received, do you have concerns
about what would happen following privatization, or do you
agree? I am just interested in how you would respond to the
answer you just heard. Mr. Baumann?
Mr. Baumann. Well, let me first respond that I think when
Congress gave certain powers, the charter to Freddie Mac and
Fannie Mae to expand home ownership in America, it has been one
of the true success stories in America about home ownership in
an otherwise dour economy. In the last couple of years, the
housing sector has been enormous, and the increase in value
that people have received in their homes that they have, or the
ability to refinance in this low interest rate environment and
save themselves millions of dollars in total, the benefits to
the consumer from the legislation that was passed that enabled
Freddie Mac and Fannie Mae to do what we do has been one of the
truly enormous success stories around.
Mr. Strickland. So you would take exception with Mr.
Wallison's assessment of the situation regarding the
management's use of the resources available to it?
Mr. Baumann. I would take exception, I would take complete
exception, as I think the facts would demonstrate as well.
Mr. Strickland. And, Dr. Linsmeier, I assume that you may
be sort of the objective observer in this. I am interested in
what you may say.
Mr. Linsmeier. I don't really have a deep opinion about
this. I think both sides of the argument have been put forward
by the two individuals that spoke before me and, frankly, I am
glad I am not a Member of Congress and have to decide between
these two points of view.
Mr. Strickland. Mr. Chairman, I yield back my remaining 25
seconds. Thank you.
Mr. Stearns. Thank the gentleman. The gentleman from
Michigan, Mr. Stupak.
Mr. Stupak. Thank you, Mr. Chairman. First of all, Mr.
Chairman, I ask unanimous consent that members put their
opening statements in the record.
Mr. Stearns. By unanimous consent, so ordered, and all
members will have, after the hearing, sufficient time to put
their additional comments in, and questions.
Mr. Stupak. Did you extend it to all members?
Mr. Stearns. To all members.
Mr. Stupak. Thank you, Mr. Chairman. Ms. Seidman, back in
the late 1990's, I supported FASB's proposal to require that
companies report derivatives at fair value. I know Ranking
Member Dingell was very involved in the issue, and that former
FASB Chairman Jenkins was also supportive of this as well.
Do you believe that the accounting exceptions for hedge
funds should be amended, or that other regulatory measures
regarding GAAP principles could be made to ensure greater
transparency and openness with regard to transactions that are
the subject of today's hearing, so that we can better protect
investors? And I ask this partly because I wonder how it is
that there can be such a differing accounting occurring with
Freddie Mac and Fannie Mae, and whether this means there is too
much wiggle room in the current guidelines, and in light of the
Enrons and everything else, we want to make sure we are doing
all we can to protect future investors and we don't have
anymore scandals like this. Can you try and explain that a
little bit?
Ms. Seidman. May I just clarify the question? You are
essentially asking whether we would continue to support hedge
accounting rules, the need for hedge accounting rules, and my
opinion on whether there is too much wiggle room?
Mr. Stupak. Right.
Ms. Seidman. The first thing, I don't have access to
information about Freddie Mac or Fannie Mae's particular
circumstances. One thing that may be not widely understood, and
for good reason, is that there are different types of hedge
accounting practices going on that are intended to mirror
different transactions. So what you might see in Freddie Mac's
case might actually be responding to a different transaction
than what you see in Fannie's case. And I would agree that the
accounting for them is very different. I would need to know the
facts and circumstances to really give you an informed opinion
about that.
When FAS 133 was developed, though, it carried for many
prevalent hedge accounting practices that had been in place for
decades really before. But what we did that was different in
133 was significantly narrow the circumstances when hedge
accounting was allowed. There had to be a specific transaction
identified, a specific risk. Documentation has to be made at
inception of the transaction, along with a discussion of how
effectiveness is going to be assessed. Those additional
criteria make this accounting standard much more restrictive
than the practices had been in the past. Plus, along with that,
there is a disclosure package to help investors--not to say it
pejoratively--but to unwind it if they so choose.
So it seems that the combination of fair value disclosure,
very restrictive hedge criteria, and supplemental disclosure
about hedge ineffectiveness we would stand behind as giving a
transparent picture of companies that elect hedge accounting at
this point.
Mr. Stupak. Is there anything different you would have us
put in FASB that would help strengthen it, or especially Rule
133? Conceivably the rules are okay, you just have to apply the
proper circumstances to the derivative you are dealing with.
Ms. Seidman. That would be my perspective. We really
couldn't be clearer about the need to designate up front the
transactions that you are entering into, and the methods that
you are going to use to assess effectiveness over time.
Mr. Stupak. Thank you. Dr. Linsmeier, while we do not know
the full extent of the accounting problems at Freddie Mac,
could you clarify whether the accounting mistakes they made
actually had any real economic effect jeopardizing any
underlying financial structure or capital? They understated
their earnings. All the ones we have had up to this, Enron and
everyone else, always overstated their earnings. So is there
any real economic effect jeopardizing capital or financial
structure?
Mr. Linsmeier. I only can react based on my reading of
their press release of their apparent problems, and I am a
little befuddled by the general reaction of the market that it
is a nonissue because income will increase as a result of the
adjustment because what the truth is, if income is increased in
this period, it is going to be decreased in a later period.
That is what happens with accrual-based accounting methods. And
I think the implication of the accounting changes once they are
announced--and we will know much better the truth of that when
they are--will be that there will be greater volatility in
income exhibited by Freddie Mac. Greater volatility might
suggest greater risk, and that might have implications on the
cost of capital. To the extent to which that insignificant and
how it affects the economy in general, it is way too early to
be able to tell, but volatility is an issue.
Mr. Stupak. I think the chairman said we are going to have
some more hearings, maybe we could have a better handle on it
then.
Mr. Baumann, if I may ask one question, just sitting here
listening to all this--and I apologize I didn't make all of it
as I was in some other meetings--but when you take a look at
this, if you earnings are understated, most shareholders who
invested between 2000 and 2002, and let us say they pulled out
because they didn't feel they were getting good enough return,
has any thought been given on how do you make these people
whole? If earnings were greater than they should have been,
they should have gotten greater return on their shares?
Mr. Baumann. The earnings should have been, as you said,
about $1.5 to $4.5 billion greater. Certainly, investors got
very high returns. Freddie Mac stock was one of the highest
performing stocks over the past number of years. So the returns
on equity have been very high in the company. But having said
that, there are a number of class action lawsuits against the
company in the context of bad financial reporting in the past.
So Freddie Mac will have to answer to those shareholders who
feel that they were misled in the past, and the company will
have to resolve those matters.
Our press release on June 24 did acknowledge the fact that
cumulative increases in the past will result in offsets in the
future, so we did acknowledge that, as you have indicated, and
that this would cause greater GAAP earnings volatility, but
that GAAP earnings volatility. The fair value of our equity
will not change under either circumstances, and we think that
is an important supplemental measure that we disclose.
Mr. Bass [presiding]. Thank you. The chair recognizes the
gentleman from Texas for 5 minutes.
Mr. Green. Thank you, Mr. Chairman. Coming from a district
in Houston, it is interesting that we have concern about
accounting standards hiding profits instead of hiding losses.
Our committee has broad jurisdiction, so I am glad we can take
up hiding losses as well as hiding profits.
Mr. Wallison, the American Enterprise Institute suggests--I
agree--that there might have been better use for some of that
profit to buydown down payments, and I have to admit I am
somewhat surprised the American Enterprise Institute would make
that suggestion. Although I understand it is a quasi-government
corporation, they owe a duty to the taxpayers because of that,
and I would hope that would be something Freddie Mac would
consider. And, again, having a very urban area, we work all the
time to try to make housing affordable with both these agencies
in the secondary market, in moderate priced homes.
Ms. Seidman of FASB and Mr. Baumann of Freddie Mac, Mr.
Linsmeier suggests that FASB issue a standard that requires
fair value accounting and eliminates fair value and cash-flow
hedge accounting. I would like you to comment on whether this
suggestion would be practicable and feasible from an accounting
perspective. It seems like it would paint a better picture for
the investors as to the company's true financial health. I
would just like to see how you would respond to that. Again, it
is an unusual situation that you are hedging profits and not
losses over a long-term period but, again, the investors I
think should have the best information possible to make that
determination. Do you have a comment on that?
Ms. Seidman. Sure. Statement 133 was an interim solution to
an immediate problem to address the accounting for derivatives.
The Board at the time absolutely would have preferred to
address the accounting for all financial instruments at fair
value, but given the urgency of the matter and the large number
of unresolved issues that would allow us to move toward a full
mark to market model, we made an interim step in requiring that
all derivatives be reported on the balance sheet at fair value.
Because that left unattended the accounting for a wide variety
of other financial instruments, what we had was what we call a
``multi-attribute'' model--that is, some were carried at cost,
some at market, and some at the lower cost or market--that is
what really causes the need for hedge accounting. If
derivatives are being used to mitigate risk and those other
risks aren't also carried at fair value, hedge accounting
allows you to bridge between the two to recognize the gains and
losses in the same period.
Having said that, we have on our agenda an ongoing project
to consider the issues that would be necessary for us to move
toward a fair value accounting model. Included among those are
specifically how certain types of items should be measured. For
example, there are deposit bases of financial institutions that
raise some very interesting and difficult questions, the whole
area of accounting for liabilities at fair value, and then the
very important question of how should the gains and losses be
reported--should they be in the income statement as part of
earnings, or should they be in the balance sheet as part of
equity.
So we continue to work on those remaining questions with
the ultimate goal of moving toward a mark to market model. That
is something we like to do in concert with international
standard-setters to the extent we possibly can.
Mr. Green. Mr. Baumann.
Mr. Baumann. I agree with the comments of Ms. Seidman. What
I would say is that companies have a responsibility to follow
GAAP, but also to ensure that additional information is
provided to investors at all times so they fully understand the
company's financial condition and results and future prospects.
So that is not only providing GAAP financial statements and
accounting for all transactions in accordance with GAAP, but
providing other information such as quarterly fair value
information so that investors can understand how transactions
might look under a fair value basis at the same time as they
are looking at it under a GAAP basis which may not be fair
value. Beyond that, companies also should disclose much more
information about the nature of the business, the risks and
uncertainties in the business, and how those risks and
uncertainties are being managed. So it is not just the GAAP
financial accounting. I think GAAP rules are fine, there is no
problem with the GAAP rules today, they can always be improved,
but it is the combination of reporting around GAAP, fair value,
and other comprehensive disclosures that enable investors to
get a true picture of a company.
Mr. Green. Mr. Chairman, I know I am out of time, but I
would like to, one, ask if there is a timeline, Ms. Seidman, on
that effort, but also the concern I have after going through
what we did with the energy companies, and Enron in particular,
but also other companies such as WorldCom. Do you think FAS 133
is applied consistently across the board, not depending on the
company but to all companies.
And with that, Mr. Chairman, again, I appreciate your
calling the hearing.
Ms. Seidman. With respect to the timeline, I am not able to
give you an estimate of exactly when we might get to the point
of issuing a fair value statement. There are a number of steps
in the interim that will each take a bit of time.
As I mentioned before, we would like to do this in concert
with international standard-setters who are in a bit of a
catch-up mode with the United States. We are out front on these
issues, and they need to get some basic accounting standards in
place before they are willing to consider a more comprehensive
review of the subject.
Mr. Green. Do you think 133 is applied consistently from
company to company, again, for some stability to the market or
to the investors?
Ms. Seidman. My best way to respond to that is to the
extent that companies have similar transactions, if the
companies both elected hedge accounting using the same
derivative instruments, I believe that the reporting that they
would provide would be consistent.
Having said that, companies enter into hedging transactions
in very different ways, and hedge accounting itself is
elective. So, to some degree, there is a lack of comparability
between companies. However, one guiding principle that 133 does
achieve is that all derivatives that are being used are on the
balance sheet at fair value. And to the extent that these
elections are made, they are required to be disclosed.
Mr. Green. Mr. Chairman, again, thank you, and I am glad
the subcommittee is having this hearing and hope it will keep
this issue on our agenda for sometime in the future so we can
be updated on the progress.
Mr. Stearns I thank the gentleman, and I appreciate his
encouragement because we intend to have a second hearing on
this. And as you know, we have jurisdiction over FASB. We don't
have the Security and Exchange Commission, which the Commerce
Committee did have before the 108th Congress, so we are not
fully engaged with the SEC, but we are with FASB.
Mr. Green. I think we can get to some issues by using our
jurisdiction on FASB.
Mr. Stearns. For sure. Let me conclude perhaps by, Mr.
Baumann and Dr. Linsmeier. Mr. Baumann, you talked about fair
value for securities and for debt and for derivatives. If we
had that, would we need to have special hedging accounting
rules, if we had the fair value mark to market?
Mr. Baumann. No, you are absolutely right. If securities,
assets, liabilities, and derivatives or all financial
instruments were accounted for at fair value, we wouldn't have
any particular hedging rules for accounting purposes. So that
would be the simplest method of accounting reporting.
Mr. Stearns. Dr. Linsmeier, what do you think of that?
Mr. Linsmeier. For financial institutions, very definitely
that would be the case because their assets and liabilities are
virtually all financial instruments.
Ms. Seidman raised the issue whether there should be
special accounting or hedge accounting for multi-national
corporations that use derivatives to hedge risks in non-
financial instruments. I think that will be an issue that will
come to the fore, and that multi-national corporations, or
corporations in general, will push back not to lose that
opportunity. I have no sympathy to continuing hedge accounting
once full fair value of financial instruments occurs.
Mr. Stearns. Ms. Seidman, we have had reform in the banking
industry with the Graham-Leach-Bliley bill. We have had reform
in the auditing with the Sarbanes-Oxley recently. And after
hearing the testimony this morning of the witnesses, don't you
think we should have enormous reform, substantial reform in the
area of auditing? Don't you think the time has come now?
Accounting standard setting, just what you are involved with,
don't you think we need reform, substantial reform?
Ms. Seidman. Mr. Chairman, we have a number of efforts
underway to reconsider the way we are setting standards, the
way we are publishing standards, and----
Mr. Stearns. So you don't agree, you think you are doing
fine?
Ms. Seidman. No, no, no, to the contrary. In response to
the call for, for example, principle-based standards, we issued
a solicitation of comment among our constituents to raise the
question, is there a better way for us to write standards. And
along those lines, there was general agreement that there is
room to improvement to issue less detailed standards with fewer
exceptions. But there is not a consensus on when a principle is
sufficiently robust that it is not a rule.
In terms of the overall standard-setting community, there
have been a number of monumental steps in the last year and a
half where, for example, the AICPA and the FASB reached an
agreement to, over a period of transition, consolidate the
standard-setting efforts in our country so that it is easier
for companies to monitor and comply with standards that are
ultimately set. So we are constantly in a process of re-
evaluating the way we are setting standards and the way they
are communicated, to try and improve.
Mr. Stearns. Revenue recognition, I think you took 20 years
to study that. I think you took 10 years to study special
purpose entities. I don't think anybody, in any industry, would
think it would require that long a period of time for you to
study these things. And having gone through the Enron, the
WorldCom, the Imclone, the Qwest, and all those, I would think
you would answer the question, yes, there should be substantial
reform in FASB, period, with no qualifying comment, because
Members of Congress, when I talk to them, I mean, they feel
pretty strong about this, that there has got to be some change
here and something done. And, of course, Sarbanes-Oxley is
attempting to do it. But I would think if you don't lead the
charge here, that there is going to be some culpability.
Ms. Seidman. I couldn't agree more. I hope that my comments
have not been misunderstood. We agree that we should respond to
issues quickly----
Mr. Stearns. Quickly doesn't mean 20 years or 10 years.
Ms. Seidman. I completely agree with you.
Mr. Stearns. That is indefensible, that you would take 20
years to study revenue recognition. And when we listened to
Enron and all the very complex ways they dealt with special
purpose entities and that you took 10 years to define how that
worked, it made all of us who are on the oversight committee--I
mean, we just couldn't comprehend how this could be more clear.
Ms. Seidman. That particular standard, the consolidations
area, is a much broader project than just special purpose
entities. When the issues involving special purpose entities
came to the fore in the last few years, we identified that as a
more urgent matter and brought it to resolution much more
quickly.
Mr. Stearns. Mr. Wallison, I am going to let you have
perhaps almost the end remark here. What would you do if you
were in a position with FASB, would you suggest substantial
reform of FASB, and what would you do?
Mr. Wallison. Well, I guess the concern that I would have
is that we tend to think that no matter what rules and
principles FASB develops, we will get a better set of
disclosures. In fact, accounting is not really like that, it is
based on predictions of what is going to happen in the future.
Very frequently, it is based on changes in classification, and
it leaves very much open to decisions by management.
As I said at the outset, Mr. Chairman, the most important
thing that we should be considering here with Fannie Mae and
Freddie Mac is to look at the risks that they create and
realize that just by improving accounting we are not going to
be able to inform ourselves adequately about those risks.
Mr. Stearns. I understood that. Do you have documented
anywhere where you said they are getting $10 billion of subsidy
from the Federal Government, both Freddie Mac and Fannie Mae?
Mr. Wallison. That is a report of the Congressional Budget
Office in 2001. They did one in 1996 and they did another in
2001, and in 1996 the estimate was about $6 billion. By 2001,
it had become $10 billion a year. It is probably much higher
now because the larger they get, the larger the subsidy they
are receiving from their government support.
Mr. Stearns. You haven't yet called for privatization of
them, though. I heard you sort of qualify that when you were
talking about it. Is that your position, that you are just
asking that they be more--have quarterly reports that they
report to the SEC, but are you calling for privatization?
Mr. Wallison. Well, my preferred position would be
privatization, complete privatization, and as Mr. Strickland
suggested, breaking them up so that they are not too big to
fail. But I understand that politically that is going to be
very difficult to do, and so there is a very simple way to
reduce their risks very substantially, and that is to forbid
them from buying back their mortgage-backed securities or
accumulating large portfolios of mortgages. That would reduce
their risks and still not make any significant change in their
effect on mortgage interest rates.
Mr. Stearns. Mr. Baumann, I will let you have the closing
comments, if there is anything you want to close before we shut
down?
Mr. Baumann. Thank you. With respect to the risks that have
been addressed, there has been no question that Freddie Mac has
extremely strong interest rate risk and credit risk
capabilities, and GAAP accounting has not called into question
at all the safeness and soundness of Freddie Mac, and how well
Freddie Mac manages those risks.
With respect to Freddie Mac's purchases of mortgage
securities, the fact that we have hundreds of billions of
dollars of purchases of mortgages, we and Fannie Mae, add
further liquidity to the marketplace which, at the end of the
day, gets back into the cost of the mortgage to the consumer
and helps reduce the cost of that mortgage to the consumer.
So, I repeat that Freddie Mac and Fannie Mae have done
tremendous amounts in terms of fulfilling the charter and the
mission that Congress asked us to do many years ago.
Mr. Stearns. Mr. Green, any additional comments?
Mr. Green. No.
Mr. Stearns. If not, again, I want to thank the witnesses,
particularly for your patience when we had to go vote, and the
subcommittee is adjourned.
[Whereupon, at 4:15 p.m., the subcommittee was adjourned.]
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