[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

                              ----------                              


                         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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \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
---------------------------------------------------------------------------
    \16\ See Attachment 1 for a description of the Emerging Issues Task 
Force.
---------------------------------------------------------------------------
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.]
    [Additional material submitted for the record follows:]

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