[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
FREDDIE MAC: ACCOUNTING STANDARDS ISSUES RAISED IN THE DOTY REPORT
=======================================================================
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
__________
SEPTEMBER 25, 2003
__________
Serial No. 108-48
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
89-960 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
------------------------------
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:
Barratt, James W., Senior Managing Director, Forensic and
Litigation Advisory, FTI Consulting........................ 13
Doty, James R., Partner in Charge, Baker Botts, LLP.......... 7
Lev, Baruch, Philips Bardes Professor of Accounting and
Finance, Department of Accounting, Taxation and Business
Law and Department of Finance, Director, Vincent C. Ross
Institute of Accounting Research, Stern School of Business. 14
(iii)
FREDDIE MAC: ACCOUNTING STANDARDS ISSUES RAISED IN THE DOTY REPORT
----------
THURSDAY, SEPTEMBER 25, 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 10 a.m., in
room 2322, Rayburn House Office Building, Hon Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Shimkus, Shadegg,
Radanovich, Bass, Bono, Terry, Otter, Schakowsky, Green,
McCarthy, Strickland, and DeGette.
Staff present: David Cavicke, majority counsel; Ramsen
Betfarhad, majority counsel, Will Carty, legislative clerk; and
Consuela Washington, minority counsel.
Mr. Stearns. Good morning everybody, and welcome to the
Subcommittee on Commerce, Trade, and Consumer Protection of the
Committee on Energy and Commerce. Today we have a very
important hearing. The first opportunity for Congress to hear
the results of an internal investigation at Freddie Mac
regarding accounting problems there. We are privileged to have
Mr. Doty, partner at Baker Botts who was in charge of this
investigation that produced this internal report.
I have had the opportunity to review the report and wish to
compliment him on its thoroughness, rigor and objectivity.
Members on the Energy and Commerce Committee have had an
opportunity in recent years to examine a number of reports on
internal investigations. The Doty report, in my view, is at the
top of those reports in its completeness and its ability to
explain very complicated transactions. Also accompanying Mr.
Doty is Mr. James Barratt, who led a team of forensic
accountants who reviewed Freddie Mac's books. I also commend
you for your work, and I hope Mr. Doty will have the
opportunity to identify the members of his team who I
understand are accompanying him in this hearing.
Finally we have Professor Baruch Lev. Professor Lev has
provided expert testimony to the Congress a number of times on
very complicated accounting matters. So we appreciate his help
today. I also would like to compliment Freddie Mac. They had
cooperated with our inquiry and provided to the committee
information and documents so we can have a better understanding
about these issues. There are two things for us to consider
today, the first is the report itself obviously and the second
is what is permissible under GAAP.
Although Freddie Mac, by its own admission, made serious
accounting misstatements, had they structured some of these
transactions differently, it is possible that GAAP would have
permitted the nondisclosure of the fair value of Freddie Mac's
derivative portfolio. For the benefit of taxpayers who
implicitly guarantee Freddie's portfolio and investors, we need
to ask if GAAP is adequate if it allows a company with $600
billion in mortgages and $1 trillion in derivatives not to have
fair value disclosure of the bulk of these assets. The report
made a number of findings of great significance that we should
consider.
Beginning in December, 2000, senior management of Freddie
Mac engaged in multiple complex transactions in order to hide
the increase in value in its derivatives portfolio. There was
no economic purpose to these transactions other than to simply
hide income. Freddie Mac incurred expenditures to hide income
for accounting purposes. These transactions included the so-
called Giant. This transaction involved shifting $30 billion of
Freddie Mac securities in which Freddie Mac had an unrealized
loss to a third party. The purpose of the Giant was to
recognize a one time loss on selected assets to offset real
gains and then prevent the Giant from being accounted for at
fair value. Freddie Mac took on other actions to hide the $1.5
billion gain in its derivatives portfolio. They included
changing the accounting methodology of options on swaps and a
series of so-called J-Deals in the neighborhood of $700
million. Earnings management: The Doty report found that in 11
of 11 quarters examined, senior management of Freddie Mac
changed the stated value of various reserve accounts in order
to meet or exceed Wall Street's analysts public expectation of
quarterly earnings.
The Doty report states ``there was a longstanding practice
at Freddie Mac of making discretionary accounting judgments
with a view toward producing financial statements that more
closely approximated analysts' estimates. Those involved in the
practice report that they believe they were free to do so under
the GAAP so long as the amounts involved were not
quantitatively material.'' This is on page 57 of the report.
So my colleagues, these are serious issues. We shall listen
carefully to the testimony. We will continue to monitor the
developments as they follow their restatement and we may have,
of course, additional hearings on this restatement. We are
looking for a nonpartisan solution to the challenges of
improving accounting standards. Congress is not the body to set
accounting standards. I believe Congress should consider,
though, in light of what is happening, appointing a Blue Ribbon
Commission of experts to recommend improvements in our
accounting standards today.
So I encourage both members--both parties to share their
ideas and we will work in a bipartisan manner to understand
this and to see how to improve it.
With that, my ranking member, Ms. Schakowsky.
Ms. Schakowsky. Thank you, Mr. Chairman, and I appreciate
especially your final words about the need on the part of the
American public and the economy to work together in a
bipartisan way to seek solutions. This hearing on the Doty
report and FASB's accounting standards is a very important one,
and Mr. Doty, your report provides a detailed account and
analysis of Freddie Mac's accounting scandal. The Doty report
details how Freddie Mac manipulated its earnings reports to
hide a $1.4 billion one-time increase in earnings. This begs
the question, why should--why would Freddie Mac underreport its
profits?
In other corporate scandals, companies inflated their
earnings. The answer is that Freddie Mac hid its profits to
meet Wall Street expectations and perpetrate the impression
that Freddie Mac is a stable profitable company that does not
have volatile earnings. Freddie Mac's deception raises a series
of questions about its corporate governance, internal controls
and regulatory oversight. It also raises the question about
FASB's accounting standards and how they are manipulated in the
marketplace. And today we will focus on the accounting issues
raised by the scandal.
Our subcommittee has an important responsibility to ensure
that all companies provide clear and accurate financial
information to the public. Without clear and accurate
information, workers and investors are left to the whims of
CEOs that may act irresponsibly. Families and institutional
investors alike cannot make sound investment decisions if they
know only half the story. Our publicly traded companies need to
have clear, honest and accurate books. This is especially true
when it comes to Freddie Mac.
Freddie Mac is not just another company. It has a major
impact on the housing market and our capital markets. And this
government-sponsored enterprise purchased $592 billion of
mortgages in 2002. Freddie helped finance homes for nearly 2.5
million low and moderate income families and families living in
underserved areas and provided home ownership opportunities for
many families that are traditionally shut out of the housing
market. Freddie Mac's financial health is also an important
issue for taxpayers. There has always been a general perception
in the marketplace that Freddie is too big to fail. Therefore
for several reasons we need to make sure that Freddie Mac is as
transparent as possible.
That is why I support my colleague Mr. Markey's effort to
improve Freddie Mac's transparency. In fact, Freddie's decision
to register its stock with the SEC in part led to Freddie Mac's
restatement of earnings. And I want to commend Mr. Markey for
his leadership in this issue. And I am pleased to join him in
his efforts. I look forward to hearing from today's witnesses.
This is an important issue for our constituents and the U.S.
Economy. Thank you, Mr. Chairman.
Mr. Stearns. Mr. Shadegg?
Mr. Shadegg. I thank you, Mr. Chairman. I want to thank you
for holding this timely hearing on the accounting problems at
Freddie Mac. As we consider proposals to prevent the
reoccurrence of similar problems, it is vital to first gain an
understanding of what exactly went wrong. The witnesses at
today's hearing will help tremendously in that task. As a
result of these investigations, there will be legislation to
incorporate lessons learned from these problems as well as
other potential problems with these government sponsored
entities.
I believe it is critical to keep two imperatives in mind as
we craft this legislation. First, we must ensure that the
legislative response is geared toward preventing the
reoccurrence of similar problems. Some may argue that the
specific accounting problems identified in the internal
investigation by Baker Botts did not conceal problems with the
financial soundness of Freddie. I believe this argument misses
the point. The same attitude that gave rise to nonstandard
accounting to conceal news of unexpected profits from outside
analysts could just as easily have led to the use of sham
accounting to hide news of significant losses.
To ensure that Freddie and Fannie remain financially sound,
it is critical that legislation be crafted in such a way to
prevent the reoccurrence of such inaccurate accounting and to
give outside regulators and analysts a meaningful opportunity
to identify a problem before it is out of control. Second, we
must keep in mind the law of unintended consequences. These two
institutions play an important role in making home ownership
attainable for millions of Americans and improving liquidity in
the mortgage market, and we must ensure that legislation does
not put these missions at risk.
At the same time, we must ask whether certain privileges
enjoyed by Freddie and Fannie, which are not available to
similar companies--such as the exemption from reporting under
the 1993 Act, are warranted or wise. Above all, we must insist
on greater transparency to allow outside experts, both
regulators and market analysts, to accurately monitor their
financial health. I welcome our panel and appreciate, Mr.
Chairman, you holding this hearing.
Mr. Stearns. I thank my colleague.
The gentleman from Texas, Mr. Green.
Mr. Green. Thank you, Mr. Chairman, and thank you for
holding this follow-up hearing on the accounting practices of
Freddie Mac. Our last hearing occurred right before the Doty
report was released, and even then we were pretty sure that the
senior management at Freddie Mac was manipulating accounting
standards to manage the company's earnings. Today we know that
to be the case, and I am pleased that we have Mr. Doty here to
enlighten us on the specifics of what went wrong with Freddie
Mac.
Coming from Houston and having worked on this committee to
investigate the mismanagement at Enron, I find it ironic that
we are now examining a company that wanted to hide large
earnings. I think the folks at Enron would like to have that
problem. I know my constituents who lost their retirements or
investments in Enron would like to have that problem. At any
rate, we now know that Freddie Mac sought to hide $1.4 million
gained in its derivative portfolio. While this example of
earnings mismanagement certainly sticks out as a major
reporting problem, we must also keep in mind that the company
consistently altered its earnings to meet Wall Street
expectations. In fact the report tells us that the Freddie Mac
managed earnings in each of the 11 quarters it studied. I can
only assume that managing earnings was standard operating
procedure at Freddie Mac. And I can't help but question exactly
how steady, steady Freddie really is. The underlying question
is how do these revelations affect investors.
And I am sure that each of us in this room have
constituents who have called worried about their investments in
Freddie Mac. And the constituents I hear from all say they
chose to invest in Freddie Mac specifically because of its
government sponsorship and its reputation as a safe investment.
In trying to maintain this reputation, however, I am afraid
that Freddie Mac may have tarnished it.
So as we examine Freddie Mac as a case study on accounting
principles in general, I hope we can keep our investors in mind
and ensure that our work on this front ultimately increases
transparency and accountability. And I thank the panel and the
witnesses, Mr. Chairman. And I yield back my time.
Mr. Stearns. I thank my colleague.
And if there is no further opening statements, all opening
statements will be made part of the record. I will start with
my questioning--we are going to have the opening statements
first. A little eager here. So we welcome--we welcome to have
your opening statement, gentleman from Nebraska.
Mr. Terry. Waive the opening statement.
[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 another hearing on this issue.
The situation before us is not simple and it is our responsibility to
address it very deliberately, thoroughly and effectively.
It is an honor to have these witnesses here today. Thank you for
joining us and lending us your expertise and first-hand experience with
accounting standards in the examination of what has happened at Freddie
Mac. It goes without saying that your testimony will be tremendously
valuable to the Committee, and play an important role in the future of
corporate governance.
What has been demonstrated B or continues to come to light B is
that while we have boards and standards that govern corporate
disclosure, it appears that even by complying with these rules and
regulations, there are still instances where shareholders and the
general public have been kept in the dark about a company's true
financial conditions. There is something very wrong here and it is our
responsibility to work to make it right.
Notwithstanding any criminal intent or action, it is clear that we
must question whether the underlying issue of regulatory power handed
down by Congress and the regulations that follow, must be revisited,
reshaped and reformed, if not overhauled completely. The daunting
nature of even posing this question is an indication of the task at
hand.
While it is not something we can answer or accomplish in our
hearing today, this discussion will serve as an integral part of
improving accounting standards and corporate governance. We must not
get lost in the weeds of details, but maintain an accurate overall
picture of what is really going on here.
The jurisdiction of this subcommittee extends its reach to the
examination of accounting standards, though it is important to note
that the entire picture of what has happened at Freddie Mac brings to
light a myriad of issues that demand our attention. There's no question
that this hearing will be another useful tool in our work to realign
and strengthen how the corporate world functions.
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
I want to Commend Cliff Stearns for his leadership today in his
pursuit of accounting questions raised by Freddie Mac. We have
jurisdiction over accounting standards, it is a difficult, technical
area, but one of importance to investors and taxpayers. We have seen
much reform in the past two years resulting from problems at Enron,
Worldcom, Tyco and other names that are now household words. Accounting
standards is an area that has not yet been reformed. It is one that we
should look at on a bipartisan basis.
I want to commend Freddie Mac. They have cooperated with our
inquiry to date, providing information and documents to both the
majority and minority staff that have enhanced our understanding of the
accounting issues there.
I want to draw an important distinction: while I am sure Freddie
Mac regrets much of the conduct detailed in the Doty Report that we
consider today, it is conduct of a lesser magnitude than we have
examined in other areas. I believe that Freddie Mac is not a criminal
enterprise.
I also want to commend Jim Doty. I have reviewed your report. Like
Chairman Stearns, I have found it to be dispassionate, rigorous and
fair. Today you will help us understand what went on at Freddie Mac.
We are also joined today by and old friend, Baruch Lev. Professor
Lev, we are going to look to you and other experts to give us ideas on
how FASB and accounting standard setting can be improved.
There were some serious issues raised by the Doty Report.
1. To avoid realizing a one-time gain in its derivatives portfolio
of $1.4 billion, Freddie Mac manufactured a series of transactions to
generate artificial losses. Freddie Mac wished to hide this derivatives
gain because it felt that it would get no credit from Wall Street if it
were a one-time event. Freddie planned, instead to realize the gain
over time. It also wished to avoid fair value accounting, which it
believed would make its earnings more volatile.
2. In each of eleven quarters examined in the Doty Report, Freddie
Mac took steps to alter its earnings to meet or exceed Wall Street
Analysts expectations by one or two cents per share. This effort to
increase earnings was justified because the quarterly adjustments were
in the $30-$50 million dollar range, which Freddie believed was not
material to its overall performance.
The Doty Report shows that senior management of Freddie Mac went to
great lengths to achieve this accounting chicanery. They spent millions
of dollars on bogus transactions that only served to move income from
one quarter to another. As Professor Lev has pointed out, this is at
best, wasteful of valuable economic resources that could be better used
in providing housing for Americans.
An equally important question is what is permissible under GAAP.
Had these transactions been structured differently, many would have
been permissible.
FASB rules spend ten pages requiring firms to account for their
derivatives at fair value, then 790 pages providing exceptions that
allow companies to avoid the rule completely. Freddie Mac has $600
billion in home mortgages of our constituents and $1 trillion in
derivatives. It, and other entities like it, should provide fair value
accounting of these assets.
We will be looking for ways to improve standard setting. I
encourage all Members to weigh in with ideas on how to achieve this
goal.
______
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
findings raised in the Doty report.
At the outset, Mr. Chairman, I want to say that I'm troubled by the
findings in the Doty report which found significant and costly
financial accounting practices at Freddie Mac.
I must state for the record that I am against corporate
mismanagement, and I believe the steps that Freddie Mac has taken in
recent months to rectify their poor management issues are to be
commended. We as members of Congress must not allow these reported
management irregularities at Freddie Mac to obscure the important role
that housing GSEs play in making affordable mortgage lending available
to communities across the United States. Housing GSEs were created to
bring low cost capital to the housing market, a congressionally-
mandated obligation that, in my experience, has done well.
We must not lose sight of the fact that 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.
In closing, I am eager to learn from the panelists about how these
companies can move forward into a new era of management and corporate
accountability so that they may continue to make lending more
affordable to our constituents.
Mr. Stearns. Mr. James Doty, partner in charge of Baker
Botts, LLP; Mr. James Barratt, senior managing director
forensic and litigation advisory FTI consulting. And Professor
Baruch Lev, Philips Bardes professor of accounting and finance,
department of accounting, taxation and business law and
department of finance, director, Vincent C. Ross institute of
accounting research, Stern School of Business.
Mr. Doty, we will start with you.
STATEMENTS OF JAMES R. DOTY, PARTNER IN CHARGE, BAKER BOTTS,
LLP; JAMES W. BARRATT, SENIOR MANAGING DIRECTOR, FORENSIC AND
LITIGATION ADVISORY, FTI CONSULTING; AND BARUCH LEV, PHILIPS
BARDES PROFESSOR OF ACCOUNTING AND FINANCE, DEPARTMENT OF
ACCOUNTING, TAXATION AND BUSINESS LAW AND DEPARTMENT OF
FINANCE, DIRECTOR, VINCENT C. ROSS INSTITUTE OF ACCOUNTING
RESEARCH, STERN SCHOOL OF BUSINESS
Mr. Doty. Thank you, Chairman Stearns, Ranking Member
Schakowsky, members of the panel, for having us here and giving
us this opportunity. I do want to give full credit to the
investigative team who has accompanied me and who has helped me
do this. You have Sara Kropf, Arma Adams, Brett Scharback, Amy
Gonce, Mike Barta, Steve Richards, Brad Bennett. These are
people who spent a great deal of time digging out the facts of
this situation. And without them, Jim Barratt and I could not
have done what we have done.
I will take responsibility for the shortcomings of the
report, but I want to give credit for its strengths that have
been kindly noted here to this team. I also would like to
inflict on the panel one historical anecdote, which my team may
condemn me for, but there was a very bad man in the 18 century
named Taliran whose accomplishment was that he survived the
French revolution. He was asked in the middle of the terror
whether the execution of a popular nobleman was a crime by the
ruling regime. And Taliran responded quick as a whip as he
wanted to do, well it was really much worse than a crime, it
was a blunder.
Now our values have changed since the 18th century, but
what we find ourselves doing in much of what we are seeing in
corporate America, I think both as lawyers and as legislators,
is distinguishing between crimes and blunders and attempting to
determine how to treat the blunders when they become very
serious threats to our economy and our financial disclosure
system.
With that in mind, I think it is important to say at the
outset what the investigation did not find at Freddie Mac.
There was no indication that the company was creating
fictitious profits. Nothing we found called into question the
fundamental safety and soundness of the company. While we found
misapplications of accounting principles, our investigation did
not reveal rampant criminal conduct, misappropriation of covert
funds for personal gain, or others of the types of intentional
wrongdoing that have characterized recent scandals.
Rather, we found a company that was focused on risk
management, but responsive, probably too responsive to the
market expectation of steady, nonvolatile earning growth. The
market expectation was, at times, clearly at odds with the
reality of the business as the business had developed in the
past decade. To remind the committee, since 1989, the company
has evolved from a quasi-governmental entity to a public
company that is a major participant in international capital
markets. This period also marked a fundamental shift in the
company's business as it retained more of the purchased
mortgages as long-term investments, this is the so-called
retained portfolio.
Many of the challenged transactions were the result of the
tension of the changing business reality of managing that
retained portfolio and the determination of management to
maintain the image of steady Freddie by delivering quarterly
and annual earnings expected by analysts. We will talk about
these transactions, but that tension is what you see in much of
this story. Missing at Freddie, missing at Freddie Mac was a
sufficient boundary marked by the company's accounting
professionals to discipline the goal of steady Freddie and to
ensure that capital market transactions and reserve policies
were accounted for properly. The accounting errors that led to
the restatements resulted, in large part, from inadequacies in
corporate accounting, in responding to the accounting rules
applicable to derivative transactions, most notably SFAS 133
and SFAS 125 and initiatives within corporate accounting with
respect to managing reserves.
The challenges faced by corporate accounting were
exacerbated by rapid growth in the company's retained portfolio
of mortgage loans and the associated exposure to volatility in
reported earnings. However, the practices that enabled the
company to report earnings smoothed to within to two to three
cents per share of analysts expectations involved reserve
adjustments not simply capital market transactions. Combination
of techniques.
It is important to note that notwithstanding the various
accounting errors, we found nothing to suggest that the
transactions at issue had the effect of undermining the
company's risk management policies and practices. Indeed, it
was the maintenance of the risk management policies and the
avoidance of changing the character of the portfolio that
undermines the accounting treatment. As discussed in the
report, we did find problems. We found weaknesses in the
company's internal compliance and governance processes,
disclosure practices that fell below the standards required of
a public company, weaknesses in corporate accounting that
resulted in excessive reliance on independent auditors.
In many of the cases that Mr. Green and others are familiar
with, the company had excluded their independent auditors from
many of the planning of complex transactions that resulted in
accounting error. This is a case that the company relied
excessively on independent auditing advice because it did not
have in house the capacity and the expertise to make these
judgments. The role of senior management is a focus of the
report. Employees in F&I, corporate accounting and other
business units were expected by senior management to take
actions that would help achieve the goal of steady nonvolatile
earnings growth. The board of directors was aware of the goal,
but the flow of information was so controlled by former
management, that the accounting challenges involved in
executing those strategies was not fairly presented to the
board.
Finally, even as the board and its audit committee members
became increasingly concerned over the apparent length of depth
and expertise in corporate accounting, senior management failed
to take prompt corrective action demanded by the board, a
failure that had serious consequences. These governance
problems are the focus of a robust remediation effort now going
forward at Freddie Mac under the oversight of the board and the
direction of the new CFO. But that's the governance side. I
would like to take a bit of time to talk about the underlying
accounting issues that are of interest to this committee. There
are three groups of rules that we think that are within your
purview and are clearly implicated in the issues that you are
concerned with. One is SFAS 135, Statement of Financial
Accounting Standards 133. Our report describes several
transactions that were entered into in late 2000 and early 2001
in response to changes in accounting rules, most notably 133.
SFAS 133 required the company to record derivative
instruments on its balance sheet at fair market value, that is
to say, marked to market through earnings, through income. And
that would have commenced in January 1, 2001. SFAS 133 has been
criticized as an example of a rule based rather than principle
based accounting standard. The concern has been expressed that
as such, SFAS 133 might encourage a check-the-box approach that
eliminates judgment from application of the standard. It is,
nevertheless, GAAP. SFAS 133 was GAAP. Without commenting at
this point on the action the company took in response, we note
two findings that we made.
First, the company believed that the transition to 133
marked to market accounting to distort the financial condition
of the company by producing a one time gain for which the
company would not receive credit from analysts and investors
and by creating artificial in their view artificial earnings
volatility in future periods. Second, in what we saw to be a
common theme in many of these transactions, management believed
that SFAS 133 should be transacted around because it did not
reflect the economic fundamentals of the company's business.
The most instructive business was the Coupon Tradeup Giant
transaction, the CTUG, which involved a reclassification,
portfolio assets with embedded losses from the health to
maturity account to the trading account and then reclassifying
those securities from trading back to available for sale.
And that would have resulted in losses going into the
income statement without avoiding the volatility in the future
of appreciation of those assets. Now although the company and
its independent auditors have now determined that that
transaction was not compliant with GAAP, it is, as was noted
possible that some of the transaction structure adjustments
would have permitted it to avoid failing under 125. But the
important thing for the committee here is what was missing in
this attempt was a real transfer of risk and a real change in
the beneficial ownership and the structure and character of
securities held in the retained portfolio. It is the tension
that I was describing.
In other words the accounting transaction would have gone
through the 133, the SFAS 133 test, if it had met the test of
SFAS 125, which required a real transfer and a beneficial
ownership change. And that did not happen because the persons
managing the retained portfolio were unwilling to compromise
the quality, the character and the structure of that portfolio
merely to accommodate an accounting result.
So you had a tension within the company that results in as
they tried to back away from and avoid 133, they bumped into
SFAS 125 and they did that because they did not engage in real
risk transfer. Again, they violated GAAP. SFAS 91 required the
company to amortize the value of premiums and discounts over
the estimated life of a mortgage pool. Mortgages are prepaid.
Mortgages carry penalties and premiums. The company is required
to book a catch up adjustment to income when those prepayments
and discounts--when those premiums and discounts exceed the
estimated amortization rate or the estimated rate of prepayment
and discount. The model that generates that range of value, if
it is violated by actual experience, results in a charge to
earnings.
The company again believed that this resulted in volatility
in its earnings and it responded by creating a band within
which it charged these adjustments to a reserve account. The
reserve account is not permitted by GAAP. The reserve account
was used to smooth out the effect of prepayments and discounts
in the mortgage pool. But worth noting for the committee, is
that the use of a nonGAAP reserve for this purpose was fully
transparent to the company's then public accounting firm which
tolerated the practice as long as the amounts involved were not
quantitatively material. That is a second category of the
problem we found.
A third category, which is encompassed within the report is
SFAS 5, which many of you know relates to the accounting for
loss contingencies. And it requires that a company's reserves
be based on probable losses. As noted in our report in a number
of instances, the company made management adjustments to
reserve accounts and altered the models that supported reserve
policy with a view to presenting a steady nonvolatile pattern
of earnings growth. These reserve adjustments frequently were
not supported by documentation in accordance with GAAP.
As such, the reserve policy reflected a purpose of moving
earnings to within a penny of two of analysts' estimates of
earnings per share rather than as a balanced assessment of the
underlying experience and losses required by reserve policy.
The foregoing summary is intended just to convey the three
major areas of accounting policy that are implicated by the
transactions involved. There are capital market transactions,
reserve policy and management reserve adjustments. They were
all three affected in violation of GAAP. They were all three
affected without adequate public disclosure. All three of them
raised serious concerns for the company that Freddie Mac is
setting about attempting to fix. And with that, I thank you for
your attention and I would be happy to take your questions when
the other witnesses have testified.
[The prepared statement of James R. Doty follows:]
Prepared Statement of James R. Doty
Chairman Stearns, Ranking Member Schakowsky and members of the
Subcommittee: Thank you for inviting me to testify today concerning our
investigation of certain accounting matters for the Board of Directors
of the Federal Home Loan Mortgage Corporation (``Freddie Mac'' or the
``Company''). Details of the investigation and our conclusions are set
forth in our Report dated July 22, 2003. I would like to speak today to
those findings and their implications for the significant work of this
Subcommittee and your ongoing concern with accounting standards.
I.
It is important at the outset to say what we did not find. There
was no indication that the Company was creating fictitious profits.
Nothing we have found calls into question the fundamental financial
safety and soundness of the Company. While we found misapplications of
accounting principles, our investigation did not reveal rampant,
criminal misconduct, misappropriation of corporate funds for personal
gain, or the other types of intentional wrongdoing that have
characterized recent scandals. Rather, our investigation found a
company focused on risk management, but responsive--perhaps overly so--
to the market expectation of steady, nonvolatile earnings growth. That
market expectation was, at times, apparently at odds with the reality
of the business as it has developed over the past decade.
Since 1989, the Company has evolved from a quasi-governmental
entity to a public company that is a major participant in international
capital markets. This period has also marked a fundamental shift in the
Company's business as it has retained more of the purchased mortgage
loans as investments (the ``Retained Portfolio'').1 Many of
the challenged transactions were the result of the tension between this
changing business reality and the determination of senior management to
maintain the image of ``Steady Freddie'' by delivering the quarterly
and annual earnings expected by analysts.2
---------------------------------------------------------------------------
\1\ The opinions expressed to us by the Company indicate that the
referenced growth of the Retained Portfolio was one factor enabling
Freddie Mac to perform its mission in furthering the liquidity of the
secondary mortgage market through crises such as the implosion of Long
Term Capital Management and other international financial crises of the
1990's.
\2\ These matters are now being investigated by the Securities and
Exchange Commission, the Department of Justice, and the Office of
Federal Housing Enterprise Oversight and nothing in this testimony is
intended as a comment on those investigations.
---------------------------------------------------------------------------
Missing at Freddie Mac was a sufficient boundary, marked by the
Company's accounting professionals, to discipline the goal of ``Steady
Freddie'' and to ensure that capital market transactions and reserve
policies were accounted for properly.
The accounting errors that led to the restatements resulted in
large part from the inadequacies of Corporate Accounting in responding
to the accounting rules applicable to derivative transactions, most
notably SFAS 133 and SFAS 125, and initiatives within Corporate
Accounting with respect to managing reserves. The challenges faced by
Corporate Accounting were exacerbated by rapid growth in the Company's
Retained Portfolio of mortgage loans, and the associated exposure to
volatility in reported earnings. However, the practices that enabled
the Company to report earnings ``smoothed'' to within 2 cents to 3
cents per share of analysts' expectations involved reserve adjustments,
not simply capital market transactions.
It is also important to note that, notwithstanding the various
accounting errors, we found nothing to suggest that the transactions at
issue had the effect of undermining the Company's risk-management
policies and practices. As discussed in our Report, we did find
problems: (i) weaknesses in the Company's internal compliance and
governance processes; (ii) disclosure practices that fell below the
standards required of a public company; and (iii) weaknesses in
Corporate Accounting that resulted in excessive reliance on independent
auditors with respect to accounting decisions and policies.
The role of senior management is a focus of the Report. Employees
in F&I, Corporate Accounting and other business units were expected by
senior management to take actions that would help achieve the goal of
steady, nonvolatile earnings growth. The Board of Directors was aware
of this goal but the flow of information was so controlled by former
management that the accounting challenges involved in executing
particular strategies were not fairly presented.
Finally, even as Board and Audit Committee members became
increasingly concerned over the apparent lack of depth and expertise in
Corporate Accounting, senior management failed to take the prompt
corrective action demanded by the Board, a failure that had serious
consequences. These governance problems are the focus of a robust
remediation effort now going forward at Freddie Mac, under the
oversight of the Board and the direction of the new CFO, Martin
Baumann.
II.
Now, I shall turn to some of the underlying accounting issues that
seem to me most germane for the Subcommittee.
SFAS 133
Our Report describes several transactions 3 that were
entered into in late 2000 and early 2001 in response to changes in
accounting rules, most notably SFAS 133.4
---------------------------------------------------------------------------
\3\ CTUG, Swaptions Portfolio Valuation and J-Deals.
\4\ Statement of Financial Accounting Standard No. 133 (``SFAS
133''), Accounting for Derivative Instruments and Hedging Activities.
The range of the accounting standards involved in the investigated
transactions was not, of course, limited to SFAS 133, but included SFAS
125, SFAS 140, SFAS 107, SFAS 115, SFAS 91, SFAS 5, EITF 99-20 and EITF
D-14.
---------------------------------------------------------------------------
SFAS 133 required the Company to record derivative instruments on
its balance sheet at fair market value (i.e., marked-to-market through
income) beginning January 1, 2001. SFAS 133 has been criticized as an
example of a rule-based, rather than principle-based, accounting
standard. The concern has been expressed that, as such, SFAS 133 might
encourage a check-the-box approach that eliminates judgment from the
application of the standard.
Without commenting further on the action the Company took in
response, we note two findings. First, the Company believed that the
transition to SFAS 133 would distort the financial condition of the
Company by producing a one-time gain for which the Company would not
receive credit from analysts and investors, 5 and by
creating artificial earnings volatility in future periods (requiring
that some derivatives be marked-to-market but not permitting similar
treatment of the debt economically hedged by those derivatives).
Second, in what we saw to be a common theme in many of the transactions
we investigated, management believed that SFAS 133 should be
``transacted around'' because it did not reflect the economic
fundamentals of the Company's business.
---------------------------------------------------------------------------
\5\ This gain would be measured by the difference between the
previous, or carrying, value of the derivative, and its fair value.
---------------------------------------------------------------------------
The most instructive example of this response was the CTUG
transaction, which was intended to offset the one-time transition
adjustment gain under SFAS 133 by reclassifying certain portfolio
assets with embedded losses from ``held-to-maturity'' to ``trading''
(producing a loss that would be reported in the transition adjustment
line on the Company's income statement) and then reclassifying the
securities from ``trading'' to ``available-for-sale'' (an asset
classification that does not require mark-to-market accounting and so
would not produce earnings volatility in the future).
Although the Company and its independent auditors have determined
that the transaction was not compliant with GAAP, it is possible that
with certain adjustments to the transaction structure the Company would
have satisfied GAAP. Specifically, the most serious GAAP problem with
the CTUG arises not under SFAS 133, but under the transfer and control
requirements of SFAS 125.6 These flaws could have been
addressed by transactional changes. SFAS 133, in paragraph 54, invites
reporting companies to attempt precisely what Freddie Mac attempted--to
transfer held-to-maturity derivatives into trading and thereby offset
this one-time gain with the embedded losses.
---------------------------------------------------------------------------
\6\ Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities
---------------------------------------------------------------------------
The Swaptions Portfolio Valuation and the J-Deals were similarly
entered into in order to avoid volatility in financial
results.7 The J-Deals, if structured and executed
differently, could have achieved the Company's intended results
(consistent with SFAS 125 and SFAS 115).
---------------------------------------------------------------------------
\7\ Later in 2001, the Company entered into a series of
transactions known as the ``Linked Swaps,'' which had the effect of
transferring approximately $420 million in operating earnings into
later years. The Linked Swaps, which were executed at the direction of
senior management, had minimal business justification other than the
shifting of operating earnings. Linked Swaps are also problematic in
that they were designed to shift a non-GAAP metric, ``operating
earnings,'' that senior management had identified as the key financial
metric that the market should refer as reflecting the true economics of
the Company.
---------------------------------------------------------------------------
SFAS 91
As described in our Report, SFAS 91 required the Company first to
amortize the value of premiums and discounts over the estimated life of
a mortgage pool, and then to book ``catch up'' adjustments to the
income statement when actual prepayments differed from estimates.
Again, the Company believed that, as applied to it, this accounting
standard produced misleading results that tended to overstate the
volatility of the Company's business. The Company responded by creating
a ``band,'' and by booking the catch up adjustment (so long as it fell
within this band) to a special reserve account, rather than the income
statement. On one occasion, the Company also changed its assumptions
about interest rate yield curves, again with an eye toward reducing
volatility in its reported financial statements.
Worth noting, however, is that the use of a non-GAAP reserve for
this purpose was fully transparent to the Company's then-public
accounting firm, which tolerated the practice so long as the amounts
involved were not quantitatively material.
SFAS 5
SFAS 5 provides that a company's reserves be based on ``probable''
losses. As noted in our Report, in a number of instances, the Company
made ``management adjustments'' to reserve accounts and altered the
models that supported reserve policy, with a view to presenting a
steady, nonvolatile pattern of earnings growth. These reserve
adjustments frequently were not supported by documentation in
accordance with GAAP. As such, the reserve policy reflected a purpose
of moving earnings to within a penny or two of analysts' estimates of
earnings per share, rather than a balanced assessment of the underlying
probable losses.
The foregoing summary covers the three major areas of accounting
policy implicated by the transactions investigated--capital market
transactions, reserve policy and management reserve adjustments.
Thank you again for the opportunity to appear; and I will be happy
to take your questions.
Mr. Stearns. I thank the gentleman and Mr. Barratt.
STATEMENT OF JAMES W. BARRATT
Mr. Barratt. Good morning. Chairman Stearns and members of
the subcommittee, thank you for the invitation to appear here
today. My name is James W. Barratt and I am a senior managing
director in the forensic and litigation advisory practice of
FTI Consulting here in Washington, DC. I am a CPA and have over
19 years of experience in accounting, auditing and
investigations, including several years as an accountant in the
division of enforcement at the SEC. FTI consulting is a multi
discipline consulting firm with practices in the area of
financial restructuring and litigation consulting.
In December 2002, James Doty of the law firm of Baker Botts
retained FTI to provide forensic accounting consulting services
in connection with the internal investigation requested by the
audit committee of the board of Freddie Mac. FTI possessed the
forensic accounting experience and the electronic evidence
consulting resources to assist in conducting this
investigation. Over the course of several months, members of
FTI and Baker Botts worked closely together to conduct the
internal investigation. The FTI forensic accounting teams
performed analyses of various accounting and financial
reporting issues related to derivative transactions and reserve
accounts.
The FTI electronic evidence team supported the forensic
accountants and the attorneys in the electronic evidence
gathering and the analysis. That process included the imaging
of numerous hard drives, obtaining stored e-mails and other
data from network servers and identifying relevant documents
through key word searches and other techniques. On July 23,
2003, the report on the results of the investigation was made
to the board of directors of Freddie Mac. As stated in the
report, our purpose was to conduct a fact-finding
investigation. To that end FTI has assisted Baker Botts in
developing an understanding of the structure, execution and
accounting implications of each of the specific transactions.
Our purpose has not been to test whether the accounting was
correct, because the company had already determined the
accounting was in error. I welcome the opportunity to assist
the subcommittee in the hearing today. Thank you.
[The prepared statement of James W. Barratt follows:]
Prepared Statement of James W. Barratt, Senior Managing Director,
Forensic and Litigation Advisory Practice, FTI Consulting
Chairman Stearns, Ranking Member Schakowsky and members of the
Subcommittee:
Thank you for the invitation to appear here today.
My name is James W. Barratt and I am a Senior Managing Director in
the Forensic and Litigation Advisory Practice of FTI Consulting
(``FTI'') in Washington, DC. I am a CPA and have over 19 years of
combined accounting, auditing, and investigative experience including
serving several years as an accountant in the Division of Enforcement
of the U.S. Securities and Exchange Commission.
FTI Consulting is a publicly traded, multi-disciplined consulting
firm with leading practices in the areas of financial restructuring and
litigation consulting.
In December 2002, James Doty of the law firm of Baker Botts, L.L.P.
(``Baker Botts'') retained FTI to provide forensic accounting
consulting services in connection with an internal investigation
requested by the Audit Committee of the Board of Directors of Freddie
Mac. FTI possessed the forensic accounting experience and electronic
evidence consulting resources to assist in conducting the
investigation.
Over the course of several months, members of FTI and Baker Botts
worked closely together to conduct the internal investigation. The FTI
forensic accounting teams performed analyses of various accounting and
financial reporting issues related to complex derivative transactions
and reserve accounts. The FTI electronic evidence team supported the
forensic accountants and the attorneys in the electronic evidence
gathering and analysis process. That process included the imaging of
numerous hard drives, obtaining and storing e-mails and other data from
network servers, and identifying relevant documents through keyword
searches and other techniques.
On July 23, 2003, the Report on the results of this investigation
into accounting and financial reporting matters was made to the Board
of Directors of Freddie Mac. As stated in the Report, our purpose was
to conduct a fact-finding investigation. To that end, FTI has assisted
Baker Botts in developing an understanding of the structure, execution,
and accounting implications of each of the specific transactions. Our
purpose has not been to test whether the accounting was correct because
the Company has already determined that the accounting was in error.
I welcome the opportunity to assist the Subcommittee in the hearing
today.
Mr. Stearns. I thank the gentleman. Professor Lev.
STATEMENT OF BARUCH LEV
Mr. Lev. Thank you for the opportunity to be here. I would
like to comment briefly on two subjects. One is on several
important issues that if I were writing this report I would
have included them in the report or emphasized them somewhat
differently, although I find the report outstanding. And the
second issue is some serious deficiencies in what is known as
GAAP, generally accepted accounting principles that come to
light once more in Freddie Mac.
So I start with my comments on the several issues in the
report. The first one, I call if it complies with GAAP, it is
fine. I think the attitude, Freddie Mac's attitude at least at
the time, is expressed beautifully in footnote 67 of the report
when they say Parseghian has acknowledged that he was aware of
the use of reserves to meet earnings goals but understood these
reserves are being managed consistent with GAAP.
This means that you can manipulate because using reserves
to meet goals means manipulating your earnings simply. You can
manipulate as long as it is consistent with GAAP. They also
quote the auditor, Arnall indicated to us Arthur Andersen
viewed its role as being focused on GAAP measure. And even the
report itself is somewhat GAAP centric, for example, they
mention several times that a major measure indicator operating
income that was manipulated by Freddie Mac is not a GAAP
measure as if that is a mitigating circumstance. Investors of
course are not really concerned whether financial information
reports are consistent and comply with GAAP. What they are
concerned with is whether they comply with reality. Whether
earnings, asset liabilities that are reported to them are
truthful, that present reality.
Just to give you an example from buying a house which I did
recently, you speak with the engineer and you ask the engineer
about foundations of the house and whether there are leakages,
and suppose he or she tell you, well, the house meets the
ordinance or the regulation. Who cares about this? What you
care is reality. And that is the issue of GAAP or reality
behind GAAP, which I would if I wrote the report I would have
emphasized more.
Second issue I call, what about investors? When you read
the report and again it is an outstanding report, but when you
read the report you somehow get the impression that by the end
of the day no harm was done. I just quote one sentence. They
say on page 31, they say transactions discussed below didn't
compromise the company's risk management strategy, will not
have an apparent effect on safety and soundness. Perhaps I am
not sure about that, but perhaps. But what about compromising
investors. Information was manipulated. Investors made
decisions based on this information, must have compromised
their decision; must have compromised resource allocation in
capital markets, which is a foundation of the economy. Third
issue is which is really related to some extent to the one I
just talked about is the social costs. Mr. Doty and rightfully
so emphasized that they didn't find any misappropriation of
funds, but huge amount of funds were misappropriated, perhaps
not by individuals but just by all the schemes that were done.
If you think about the scores of people that spend hours
and hours probably days and weeks of scheming and perpetrating
these things and then coming up with all kinds of mechanisms
and financial instruments that were very costly, legal fees,
transaction costs, what about this misappropriation of funds.
And probably the most serious of all here is that a climate of
manipulation and intrigue must have permeated Freddie Mac. The
report quotes, and again it is a beautiful thing, they quote a
trader speaking to another trader and the trader says, what we
do is basically book expense now and get it back in 6 months.
Almost like a joke. And he says keep it under your hat. I don't
want to see expletive deleted Bloomberg about this trade
either.
How do you think a major company--I saw Freddie Mac ranked
among the 20 largest companies in the world in terms of
assets--how do you think the business of the company is
conducted when this kind of climate permeates there. And the
last point on the report, I find it a little too forgiving. For
example, the report says Freddie Mac sought to avoid making any
disclosure that would require subsequent explanation or lead
investors to draw any conclusion other than the one management
believed best reflected economics of company's business. There
is a very simple way if managers are convinced that a new
accounting rule doesn't reflect economics of the business,
there is a very simple way or ways dealing with it. Companies
are doing it daily. One is to call a press conference or
financial analyst conference and explain it to them, that this
is just a one time item and will never reoccur again.
And the second which lots of companies are again are to
issue pro forma earnings and to say these are GAAP earnings but
they don't reflect reality. Here are the earnings that reflect
reality and that is the reasons why. You don't resort to
schemes or manipulations which of course you don't disclose in
order to somehow retain the economics of the business. My
second subject and again very briefly is really the big
picture, which Freddie Mac is only a small part of the puzzle.
And that is what comes to be known as GAAP, generally accepted
accounting principles.
All the scandals we had, starting recently, starting with
Enron and culminating now with Freddie Mac, they all expose
fundamental deficiencies, fundamental weaknesses of the
accounting system which now mushroomed to tens of thousands of
pages of extremely detailed instructions of how to account and
how to report for every single transaction, which of course is
a lost cause. It is hopeless, because once the FASB after about
2 years of deliberation comes out with new instructions, smart
bankers, lawyers, accountants take about 10 minutes to transact
around this, change the contract and transact around it--the
new rules and the report gives great examples of how Freddie
Mac did it and it is constantly done. So this whole thing is
really, really hopeless. But what is so dangerous about an
extremely complex system is that crooks thrive in complex
environment.
Crooks thrive in the tax system because it is so complex.
Crooks recently thrived in the worldwide Web because it is so
complex. And crooks definitely thrive in GAAP because it is so
complex. Why do they thrive? Because they have the most to
gain. And they employ the best experts in doing so. So that is
a major problem. Sarbanes-Oxley, I wrote in my report, they
instruct the accounting regulators to study, move away from
rule-based to principle-based. There is some study by the FASB.
I don't see any real change in this direction. And the second
and last issue of major problem with GAAP is the fundamental
ability to manipulation. Non accountants believe that
accounting is about facts.
Accounting is about a few facts and a huge number of
estimates, judgments, even just sheer guesses. Just to give you
one example. One of the largest item in the income statement is
pension expense particularly for labor intensive companies. To
estimate the pension expense, you have to estimate the gain on
your portfolio of pension assets, the money that was put aside;
the gain on this portfolio next year.
Now who can estimate that what the stock market will do
next year. It is absurd. But this is a large part of the
measurement of income. What is really serious is that the huge
amount of reserve and accounting finances has shown two things:
A, that managers are managing, manipulating earnings on a very
large scale, particularly by misusing these estimates because
no one can order an estimate; and second is that investors fall
into the trap and pay for it.
Just to give you an example how widespread this
manipulation is to give you a big picture. I just checked
yesterday with First Call, which is a service that tracks
financial analysts' forecast of earnings and then the earnings
reports by companies. I asked them to give me information about
Standard and Poor 500 companies. These are the 500 largest
companies in the United States, roughly, 70 to 75 percent of
the whole U.S. Economy. 40 percent in the last 4 quarters, 40
percent of Standard and Poor 500 companies exactly matched to
the penny, to the penny analysts forecasts or beat by a penny
analysts forecast. I tell you, based on my experience in
business and accounting, that for a huge organization which is
spread worldwide with sometimes hundreds of thousands of
employees, to meet by a penny an outside target without
manipulation, it is an impossibility.
So this is the environment that you are dealing with. And
we really have to see the large picture here. I really urge you
if I may to do two things: A, come up with ways or generate
ways to strengthen the controls and the transparency of Freddie
Mac, but equally important, to start dealing with the big issue
with the accounting system known as GAAP. Thank you.
[The prepared statement of Baruch Lev follows:]
Prepared Statement of Baruch Lev, Philip Bardes Professor of Accounting
and Finance, Stern School of Business, New York University.
My observations and comments concerning the July 22, 2003 report
(Report) of the board of Freddie Mac (hereafter the Company) prepared
by Baker Botts L.L.P. relate to two issues: (1) What, in my opinion, is
missing from or not sufficiently emphasized in the report, and (2) the
accounting regulatory environment, known as GAAP (generally accepted
accounting principles). I would like to state at the outset that I find
the Report thoughtful, insightful, and very well articulated.
I. MISSING FROM THE REPORT
1. If it complies with GAAP, it's fine.
The attitude of the former management of Freddie Mac toward
financial reporting seems well represented by Mr. Parseghian (a former
top executive): ``Parseghian has acknowledged that he was aware of the
use of reserves to meet earnings goals, but understood that these
reserves were being managed consistent with GAAP.'' (footnote 67).
Thus, according to this view, financial information can be ``managed''
by elaborate devices aimed to make investors believe that the Company's
performance is different from reality (otherwise, why manage?), as long
as the scheme is within the wide latitude allowed by GAAP. This
exclusive GAAP concern is also echoed by the Company's chief auditor:
``Arnall indicated to us that Arthur Andersen viewed its role as being
focused on GAAP measures.'' (p. 85). GAAP is also the standard against
which the Report evaluates the various schemes and transactions
perpetrated by the Company (e.g., ``These errors appear to us to have
been a good faith misapplication of GAAP . . .'' p. 53). Also, a
closely-watched indicator which was manipulated by the Company--
operating earnings--is somewhat mitigated in the Report, because it's a
``non-GAAP metric.''
For investors and other constituencies, GAAP compliance is of
secondary importance. What these users of financial reports need is
information that complies with reality. They need to be assured that
the financial reports portray a truthful and unbiased picture of the
Company's real earnings, assets, and liabilities, rather than that
management's practices conformed with GAAP, known for its wide latitude
and ease of manipulation.
The absence of a culture of honesty and integrity at the Company,
manifested by the extensive efforts to manage the information conveyed
to investors, some in compliance with GAAP and others not, is not
sufficiently condemned in the Report.
2. What about investors?
While detailing the extensive schemes of the Company to manipulate
its financial information, the Report does not elaborate on the damage
inflicted on the information users. One, therefore, may get the
impression that no serious harm was done. Thus for example, the Report
states (p. 31): ``The transactions discussed below did not compromise
the Company's risk management strategy . . . will not have an apparent
effect on safety and soundness.'' But what about compromising the
multitude of investors who relied on the ``managed'' information?
Surely, the Company's managers would not have resorted to such
elaborate and costly schemes as described in the Report, unless they
believed that investors will react in an ``undesired manner'' to the
truth. Tampering with information by a major player in capital markets
such as Freddie Mac adversely affects resource allocation in the
economy. Not a small matter.
3. The social cost of manipulation
Management and manipulation of financial information seriously
damages investors and the resource allocation process of capital
markets, and inflicts additional costs on society at large. The Report
details the extent of the Company's schemes: scores of high ranking
employees from accounting, trade, legal, tax, shareholder relation and
other departments were engage for considerable time periods in a
socially wasteful activity of managing information. This substantial
time, effort and management attention should, of course, have been
devoted to further the real objectives of the Company.
In addition to efforts and time, substantial monetary resources
(legal fees, transaction costs) were wasted in structuring deals and
financial instruments which, according to the Report, had no real
business purpose. All this is a dead weight loss on society.
But, perhaps the most serious damage resulted from the climate of
manipulation and intrigue that must have permeated wide echelons of the
Company, and even spilled outside. Thus, for example, a Company's
trader speaking to a colleague explains that the reason for the trade
is: ``book expense now and get it back in six months.'' He advises the
trader to ``keep that under your hat.'' And states: ``I don't want to
see any [expletive deleted] Bloomberg about this trade either.'' (p.
75). One can only speculate about the adverse impact of a social
climate, where employees are motivated to manage information (Dean's
performance evaluation, p. 45), on Freddie Mac's business activities
and performance.
4. Report too forgiving
A theme that runs through the Report is that the Company's
management ``just'' wanted to portray reality. Apparently, no intention
to deceive. Thus, the Report says: ``Freddie Mac sought to avoid making
any disclosure that would require subsequent explanation or lead
investors to draw any conclusion other than the one management believed
best reflected the economics of the Company's business.'' (p. 53).
This is admirable, if not for the numerous, detailed descriptions
in the Report of different managerial objectives, such as to portray a
steady growth of earnings; to eliminated reported volatility; to meet
analysts' forecasts; to hide large gains until ``needed'' in the
future, and so on. Obscuring earnings volatility, and making investors
believe that the Company meets prescribed targets does not strike me as
just intended to reflect ``the economics of the business.''
II. GAAP DEFICIENCIES
In addition to exposing the reader to what transpired within
Freddie Mac, the Report implies volumes about GAAP, the framework of
accounting and reporting rules governing public companies' financial
reporting. In particular, the Company's nefarious activities shed light
on two major GAAP deficiencies: extreme complexity, and vulnerability
to manipulations. These deficiencies were, of course, evident in the
numerous corporate scandals that surfaced during the last three years,
yet they did not receive adequate attention by policymakers.
1. GAAP Complexity
The Report comments repeatedly on the complexity of GAAP, and in
particular the FASB statements on financial instruments--the trigger of
much of the Company's manipulations (e.g., ``The errors . . . resulted
in large part . . . from inadequacies in responding to complex
accounting rules . . .'' p. V). GAAP developed over time to become an
incredibly detailed set of rules and instructions, stretched over tens
of thousands of pages, constantly changing in an attempt to prescribe
the accounting and reporting of every new event and business
development. By its nature and the long deliberation process, GAAP is
always ``behind events,'' because once a new rule emerges, business
contracts are changed to ``transact around'' the rule. Freddie Mac's
Report provides telling examples of financial instruments and deals
structured and executed solely to thwart GAAP.
The extreme complexity, detail, and the constant change of GAAP
have various unintended consequences. One of the most serious is that
the complexity gives significant advantage to those, like the Company,
who intend to misuse the rules, because those people and entities have
sufficient incentives to invest the time and money required to
comprehend GAAP. It is well known that crooks thrive in complex
environments (e.g., the World Wide Web).
Sarbanes-Oxley attempted to deal with this issue by instructing
accounting regulators to move away from rules-based and toward a
principles-based accounting system. My impression is that such a move
did not reach far. In fact, GAAP complexity marches on.
2. Vulnerability to manipulation
Laymen are generally under the impression that accounting is all
about facts. Few things are farther from the truth. Accounting is about
some facts, and a lot of judgments, estimates, and outright guesses.
The measurement processes underlying the determination of earnings and
the valuation of asset is replete with estimates, such as the
provisions for depreciation and amortization, bad debts, pension
expense, warranties, asset impairments, and so on. The current move of
accounting regulators toward ``fair value accounting'' enhances
considerably the role of estimates in financial reports. Thus, the
Report (p. 47) quotes from GAAP concerning the fair value of financial
instruments which affects both earnings and asset values: ``If quoted
market prices are not available, management's best estimate of fair
value may be used . . .'' The Report is explicit about how the
Company's management ``best estimated'' fair values.
Extensive research has shown that accounting estimates are: (1)
widely used by mangers to manipulate financial reports, and (2)
systematically deceive investors and thwart resource allocation in
capital markets. The reason: good, honest estimates cannot be
regulated, or audited effectively, nor is it straightforward to prove
after the fact that an estimate, even widely far off the mark, was
intentionally misleading.
One can get an idea about the current prevalence of earnings
management by large U.S. corporations, mostly by misusing estimates,
from the startling data (obtained from Thomson's First Call) that
during the last four quarters, over 40% of the S&P 500 companies met to
the penny, or beat by a penny the consensus earnings forecasts by
financial analysts. It is virtually impossible for a large, complex
business enterprise, operating in a volatile environment, to meet to
the penny an external earnings forecast, without some ``management.''
The vulnerability of GAAP to manipulation by misusing the multiple
estimates underlying accounting is amply demonstrated in the Report.
This vulnerability, with its adverse economic and social consequences
has not received the required policymakers' attention.
III. POSTSCRIPT
Freddie Mac adds to the variety of recent corporate scandals the
case of a company that understated, rather than overstated its
earnings. This, however, is not a mitigating factor. Understated
earnings today, are often used to overstate earnings tomorrow. The
accounting manipulations described in the report are serious and
require remedial actions. But one should not lose sight of the bigger
picture: the events described in the Report point once more at
fundamental vulnerabilities of GAAP, which so far have not been
adequately addressed.
Mr. Stearns. Professor Lev, thank you.
At this point I will start to question. Professor Lev, you
have used the word manipulation, scheming, intrigue. So
obviously you would not agree with Mr. Doty's analysis. This is
simply blunders.
Mr. Lev. I will not call those ``blunders.''
Mr. Stearns. Mr. Doty, in light of the fact that you have
used the word ``manipulation,'' manipulation does not imply a
blunder. And Mr. Lev, you are saying 40 percent of the Fortune
500 companies might be doing pretty much the same thing. Is
that what you are implying?
Mr. Lev. I think, of course, investigate it.
Mr. Stearns. You are saying the probability of all of them
coming in with one cent of the analysts' prediction, 40 percent
of the Fortune 500 cannot be done. There is no probability they
would meet that.
Mr. Lev. Extremely low. I don't want to instruct people how
to do these things, but they do really two things: They manage
the forecasts by continuously talking to analysts and gauging
the forecast, and then they manage the earnings to meet the
forecast. So they come from two directions.
Mr. Stearns. This committee has jurisdiction over FASB so
we are trying to understand how to reform and change GAAP. To
do this, let us take a real life example and I will start with
Mr. Doty. In reading through this report, this Giant
transaction is perhaps the most outstanding one. It occurred on
a very large amount, $30 billion and the report said it
occurred within several hours. So we transferred $30 billion to
create a net loss in several hours in a buyback. Can you just
maybe in very simple sentences tell us what a Giant transaction
is and is it used by all the other Fortune 500 companies, or is
that only something Freddie Mac did?
Mr. Doty. Mr. Chairman, we don't know about----
Mr. Stearns. This is not a customary thing. This is
something Freddie Mac created.
Mr. Doty. Doing something which SFAS 133 invites. The new
accounting rule invited companies--and I love this transaction,
chairman, because it does illustrate the complexities that you
are dealing with in your committee. The rule invited companies
to avoid the one-time marked to market spike in their reported
earnings by reclassification transactions. It was permitted to
reclassify securities that were held in the health to maturity
account, out of that account to trading or available for sale.
This transaction was a reclassification of securities first
from health to maturity to trading, involved a sale to a third
party, assemblage in a coupon Giant, transferred back to
Freddie Mac, and then a transferred into available for sale so
that future appreciation would not affect earnings. It failed
not because it was attempting something which was inconsistent
with the purpose of 133, but because the techniques of that
elaborate transaction failed the transfer of risk and the
beneficial ownership and control provisions of SFAS 125.
Mr. Stearns. No real transfer of risk was the violation,
but not what they did.
Mr. Doty. And that is because the division of the company
owning the securities, F&I was not willing to undergo the
change of the security ownership positions that would have been
needed to satisfy the accounting technique. They were insistent
on keeping those securities which they wanted in the portfolio.
So you have, in effect, a tension within GAAP between rules,
SFAS 133, which does not presume that volatility is good and
steady earnings are bad. It is accounting neutral. But it
creates problems for companies that are trying to navigate
that.
Mr. Stearns. You would admit, though, to do a transaction
of that complexity required a lot of foresight and scheming and
intrigue, manipulation. And the fact that no real risk--no real
transfer of risk was involved, these folks knew that when they
did it, didn't they?
Mr. Doty. They did.
Mr. Stearns. People who had that kind of knowledge to do
that kind of transaction surely understand risk and surely
understand that when you do that, you have to transfer that
risk and that wasn't done. Mr. Lev, let me ask you, we are
going to have a second round of questioning here, but how do
you think GAAP should be changed to stop something where people
do this with no real transfer of risk and for the average
person to realize they are transferring $30 billion over 2
hours just to create a bogus number so they can get earnings in
line with expectation of analysts?
And Mr. Doty mentioned that these people felt that the GAAP
did not reflect Freddie Mac's business actions. They made that
decision. So evidently accountants and business people can say
to themselves, you know, we are going to take this into our own
hand, it just doesn't reflect real life, but we are going to do
it and we are going to do it this way. How can GAAP be changed
to make this more realistic or accurate?
Mr. Lev. That is really not a question that can be answered
in a few minutes. This is a huge system that was somehow----
Mr. Stearns. Let me just help you. Would you take GAAP and
make it more like the European Union, principle based rather
than law based.
Mr. Lev. Yes. I will definitely make it much simpler than
it is now based on a few rules and objectives and supplement it
with rather than instructing people exactly how to account for
everything as I said before, which is basically self-defeating,
I would supplement the relatively few rules and instructions
with very detailed full disclosure, just tell the story and
shift the emphasis to the full disclosure. If Freddie Mac would
have fully disclosed these schemes, I have no doubt in my mind
that they would not have entered into them in the first place
if they knew that they had to fully disclose this. That they
bought this and sold this and parked it 2 hours in between.
Full disclosure which may take maybe 10, 15 more pages in the
financial report, I think will do a lot of good.
The second thing that I do and this relates to the
multitude of estimates and judgments that go into it, I would
cut many of them because they don't serve any purpose and they
open the door for the crooks. And I would and I already
suggested it several times, I would distinguish in the
financial reports between facts and estimates, or as some
people say, facts and fictions in this case. You could have an
income statement with rather than one column, you will have two
columns in this case. One will be facts--facts are mostly cash-
flow transactions. And then there are estimates.
So I don't throw all the estimates out, but readers have an
idea about the vulnerability of the report, is it based--are
earnings based on 20 percent of estimates, 50 percent
estimates, 80 percent estimates? This I think will go a long
way. But we also have to think about substantive changes in the
whole process that leads to this mushrooming of rules and
regulations.
Let me say one more thing, with your permission, because
you mentioned at the end of your question about management
didn't believe that GAAP in this case portrayed reality. And we
heard it several times today that as opposed to Enron and
others, they were understating income, not overstating income
as if this is a mitigating factor. Now I, of course, don't know
what the intention of the former management was. I never spoke
with any of them. But I know from experience that most managers
understate income in several periods because they know that
they need these reversed to overstate income in the future.
This is the reason for understating income. It is a very
sinister thing. And it is not somehow a good thing to
understate income. By understating income, you create a
reserve, 2 years, 3 years down the road when earnings are
really low you say, we have a reserve and we can use it. And of
course, Freddie Mac used reserves in this case. So what they
did was not something which is, in my opinion, somehow tame or
even a good thing. It is no better than overstating in my
opinion.
Mr. Stearns. Ms. Schakowsky.
Ms. Schakowsky. Professor Lev, I agree with your
assessment, but there have been times in the past when FASB
tried to rebuild it in a way that created transparency
standards for accounting of derivatives and it was met with
strong opposition from powerful interest groups and Members of
Congress and Federal Reserve Chairman Alan Greenspan. And as a
result of the opposition, SFAS 133 includes over 700 pages of
exemptions. Do you think FASB would encounter the same
opposition if it tried to strengthen SFAS 133 and close the
loopholes?
Mr. Lev. I really don't know. Perhaps. Whenever you hit
vested interests, you encounter opposition. But I think if the
major objective is toward implicit perhaps toward low burden,
you will encounter less antagonism than they encounter now than
just by piling up statement after statement and rules after
rules.
Ms. Schakowsky. So the decrease in the burden of all the
rules that exist right now might be incentive enough.
Mr. Lev. I don't advocate to throw out the rules now. You
know this committee about a year ago, I suggested and the
chairman mentioned it today to set up a blue ribbon committee
because things are really involved in this case. Accounting is
complex. Business becomes more and more complex. Crooks
proliferate. So it is not an easy thing to do, you know, just
to sit here and give a few suggestions. It has to be studied
very carefully, but with an objective in mind. And in my mind,
the main objective is simplify the system as much as you can.
Ms. Schakowsky. Let me just state two more questions I
have. Mr. Doty, Professor Lev said that understating earnings
was not benign at all and that this is a serious problem and
that we should be concerned about. So that is one I want to
ask. The other is because we are talking about Freddie Mac. We
talked about its impact on capital markets, but is there
something to worry about in terms of housing markets, too,
because that is, after all, what its business is.
Mr. Doty. Excellent questions. First, I don't think anyone
should read the facts found about deferral of income as
mitigating factors or as vindication or any of that nature.
That does affect the quality of earnings. The missing piece
here is that the SEC expects that companies will discuss their
critical accounting policies, disclose transactions and
accounting policies and estimates that affect the quality of
earnings. And I think its very clear that we fault Freddie Mac
for a failure to make transparency come about by explaining how
these transactions--and in the CTUG transactions, same was
true.
As to the tension between the housing markets, it is a
point of pride with many at Freddie Mac that the retained
portfolio grew because the company was buying mortgages and
providing liquidity of that market at the time of the collapse
of long-term capital management and during the international
debt crisis. There is an issue for this honorable House and the
Senate as to how you manage that, but it is part of your
accounting, I think responsibilities here and the concern you
are showing for accounting rules that you consider that one
size may not fit all and there may be questions of whether we
want a system in which derivatives are counted for in one
manner in all cases.
Do we want a system in which if--in which the most
conservative accounting is always opted for. Do we want a
system in which companies must include an operating earnings or
a core earnings comparison along with a GAAP-reported
comparison. There are many options before you and before FASB.
And they are going to be worked out I think in the arena of
international accounting standards and they will bear on how
much latitude and how much color or texture we want public
companies to give to financial presentations and how consistent
is that with the rigor and the accuracy that we require of
GAAP. And I do not believe that that is a question that is
susceptible of a simple answer, but I think it is commendable.
Ms. Schakowsky. I would ask you to comment on this notion
that true full disclosure would at the very least be very
helpful, even if we don't throw out GAAP and move to
principles, but this notion of much clearer disclosure and much
more complete disclosure.
Mr. Doty. I think that is what the public wants and I think
that is what Professor Lev is alluding to. It has to do with
the fact that the amount of detail and the length and
complexity of notes I think is deterrent to some person's
feeling when they are reading financial statements. The
Commission has, in the adoption of management discussion and
analysis, attempted to deal with that, but it seems to me the
challenge is to create the understanding for what the
accounting--what the audit represents and what can be expected
of an audit and what the accounting principles really show
without throwing out the level of detail and rigor that our
current system provides. Thank you.
Mr. Stearns. Thank my colleague, Mr. Shadegg.
Mr. Shadegg. Thank you, Mr. Chairman. I want to compliment
you on this panel. I think this has been one of the more
informative discussions that I have heard in any congressional
testimony and I compliment you all for a very elucidating
discussion. Professor Lev, I have to tell you I absolutely
loved your example. I am actually building a house right now
and you are right. I don't whether it meets the building codes.
I want to know if it is built right, if it is sound and if it
is going to stay up. And if the building code is defective and
the engineer says to me that it meets the code but it is going
to fall down next week because the code is defective, it
doesn't mean a thing to me. So I loved that point.
The chairman has already asked the first question begged by
your testimony, which is what can we do for GAAP? And you
explained that is difficult to answer. Though I understand that
as a general proposition, you would say eliminate some of the
detail, move toward principles and guidelines requiring full
disclosure and honest disclosure, and I gather more sunshine in
terms of full reporting; is that correct?
Mr. Lev. Yeah. Definitely.
Mr. Shadegg. I happen to be a lawyer and the code of ethics
for lawyers is, in many ways, susceptible of criticism as being
too vague because it requires you to do the right thing. Then
somebody gets the second guess whether it was the right thing.
Yet, I think your point about complexity being a haven for
crooks is well taken. The second question begged by your
testimony is you said to strengthen the controls and
transparency over Freddie Mac itself. Of those that have been
discussed or of any others, do you have specific
recommendations?
Mr. Lev. I really didn't investigate this issue carefully.
People are saying maybe should move to Treasury, but that is
not an area I feel competent.
Mr. Shadegg. Okay, I understand that you don't have an
opinion about that. Mr. Doty, I also appreciate your report and
I think you have done a great service with it and with your
testimony as well. Let me ask you, do you agree with Professor
Lev with regard to the idea of simplifying GAAP and requiring
it to be more principled-based? And if so, is that a feasible
challenge.
Mr. Doty. I believe we are speaking, Mr. Shadegg, of ideals
that are very difficult to implement. And I think there would
be harm to the system if we allowed rigor in the requirement of
conservatism in the application of principles to be thrown over
in order to get simplification. I don't understand Professor
Lev to be advocating that at all. I do think we have a third
factor pressing on this and that is international accounting
standards, the listings that we want to retain in this country
and the view of some European issuers that our accounting rules
are already too burdensome. And when we talk about principle-
based accounting we mean more lenient presentation of deferral
of earnings or concealment of reserve policies. And then I
realize no one on this panel and not Professor Lev is
advocating that.
So it seems to me the devil is, as always, is going to be
in the details, but that we should be able to accelerate the
release of these standards so that they are more timely to
create an overarching purpose for them that can be understood
by laymen and others and to implement the accounting with more
transparency in the contextual disclosure, and I think that
will go a long way.
Mr. Shadegg. If there were a patina over GAAP, which said
that these rules apply to the extent that they fully disclose
or more carefully, more accurately reflect the true condition
of the company, would that be an improvement?
Mr. Doty. I believe you have just described what would be
set forth as being the guiding principle of GAAP plus. When all
of these transactions were occurring, GAAP plus was not a
household word. It has become a household word, and I think
people want it, but I think what you are describing is intended
to get us to GAAP plus. Show us what the rules provide as a
picture of the company, but put in the context that avoids
hiding behind the rules in order not to tell people what this
means for the company's performance.
Mr. Shadegg. I think you both clearly described that
Freddie Mac took the specific rules and used them to conceal
information rather than to disclose information that was
important to investors and analysts and that put us in the box.
Professor Lev?
Mr. Lev. I think an example that will help here to clarify
the point is differences between principles and rules. Let's
take FASB 133, the financial instrument thing. You can state an
objective, you can state the rules that financial instruments
are assets and liabilities, they should be presented by the
company at fair value or any other value, and then let the
company report, let the auditors be responsible for the report,
rather than the current situation in which, in addition to
this, there are hundreds, sometimes thousands of pages
prescribing specific instruction for everything, for every type
of swap and for every type of option, for everything. That is
what I think is not only redundant, it is even dangerous.
The reason, if I can say one more sentence?
Mr. Shadegg. Sure.
Mr. Lev. The reason, we have to understand the reason.
The reason why it mushroomed in the United States more than
other countries to this extent is that this is a litigious
society. Both corporations and accountants come daily to the
FASB and they said give us a rule. It is not that the FASB
imposes rules. They ask for the rules, because they somehow
feel safer with a rule than just in following or maybe not
following the rule, as in this case, than if there is some kind
of a gray area and they have to take responsibility.
This thing has to be resisted, in my opinion.
Mr. Shadegg. Thank you very much.
Mr. Stearns. I think we will take one more set of
questions, Ms. DeGette, before we go.
Ms. DeGette. Thank you, Mr. Chairman, and I would like to
welcome the panel and ask unanimous consent to put my opening
statement in the record.
Mr. Stearns. So ordered.
Ms. DeGette. Thank you, Mr. Chairman.
[The prepared statement of Hon. Diana DeGette follows:]
Prepared Statement of Hon. Diana DeGette, a Representative in Congress
from the State of Colorado
Thank you, Mr. Chairman. Following the accounting scandals and
subsequent investigations at Enron, WorldCom and Qwest, Congress passed
important legislation in the form of the Sarbanes Oxley Act, which
helped to increase the transparency in financial reporting and proved
to be an important step in cracking down on the financial engineering
within Corporate America. Unfortunately, the recent revelation that
Freddie Mac distorted or ``smoothed'' its earnings and blatantly
disregarded accounting rules in order to bring profits in line with
Wall Street estimates, proves that more must be done. Indeed, the very
fact that Freddie Mac--which is not only one of the largest financial
institutions in the world, but also a Government sponsored entity has
been employing the same sort of fraudulent accounting practices that
Enron used, demonstrates how systemic these crooked financial
engineering practices are.
A little more than 18 months ago, this sub-committee convened to
discuss accounting reform as it related to, what at the time, was
unfolding to be the Enron scandal. At that hearing, we highlighted that
one of Enron's failings was the fact they engaged in highly volatile
transactions without adequately disclosing the risk involved. Enron
turned out to be a major dealer in derivatives and employed several
engineering activities in order to keep their derivatives' losses off
of their financial statements. Although this may be considered the most
innocuous of Enron's violations, it nevertheless brought into question
whether there needs to be stricter accounting regulation regarding
derivatives.
Freddie Mac, while certainly no Enron, nevertheless employed
similar strategies in order to avoid stating the accurate market value
of their derivatives portfolio. In fact, in June 2001, Freddie Mac
engaged in several, extremely complex transactions in order to avoid
realizing a non-recurring gain of $1.4Bn from its hedging portfolio.
While unlike in the cases of Enron and Worldcom, Freddie Mac
understated earnings in June 2001, instead of overstated them, the aim
was nevertheless the same: to manipulate profits to bring them in line
with Wall Street expectations. However, by avoiding a large one-time
gain in June 2001, the Company was able to bleed in the extra earnings
over the next two years, overstating their profits during this time
period. In addition, Freddie Mac's management further manipulated
profits by artificially stating the value of various reserve accounts.
In the end, the effect was that Freddie Mac reversed engineered
their earnings to coincide with Wall Street's expectations--a steady,
but northern moving bottom line. And once again, in the end, the end
consumer, in this case the investor, turns out to be the biggest
victim. It is the public who lose out from the lack of transparency and
from the gross disregard of accepted accounting principles--not only
financially do the consumers lose, but once again their trust in a
system that is supposed to contain safeguards to protect them has once
again been rocked.
Of course, the blatant disregard for accounting rules exhibited by
Freddie Mac simply did not happen in isolation--it entailed cooperation
on many levels: from the management team to Freddie Mac's internal
corporate accountants to the Company's external accounting firm, Arthur
Andersen. Though it would be easy to presume that that the shady
accounting practices at Freddie Mac have been eradicated with the
ousting of key members of the management team and the dissolution of
Arthur Anderson, it is nevertheless incumbent upon us to ensure that
that we not only trim the weed of a culture that embraces accounting
negligence, but pull it up from its very roots.
What potentially may be even more disturbing than Freddie Mac's
blatant manipulation of GAAP and consequent lying to investors, is that
if the Company had structured their transactions more cleverly, they
could have still adhered to GAAP while keeping the fair value of their
hedge portfolio off of the books. Is it possible that even after our
dealings with Enron that we support an accounting system that is so
vulnerable so as to actually invite manipulation? Hopefully, this
hearing will bring us one step closer to understanding--and making--the
necessary reforms that must be made in the accounting system.
At one point, I was under the impression that accounting was a cut-
and-dry practice--similar to math in the sense that there was one right
answer. More and more, however, I realize that many corporations treat
accounting less like a science and more like art--open to creative
interpretation and manipulation. We must not allow companies to employ
fuzzy math or artful accounting in order to line their own pockets.
It is imperative that we do what is in our power to streamline and
correct our current accounting system so that the accounting practices
at the Enrons and the WorldComs--and I am disheartened to say it, at
the Freddie Macs of this world, do not happen again.
Ms. DeGette. Mr. Doty, as I understand it, Freddic Mac
manipulated its earnings for 11 consecutive quarters by
engaging in complex derivative transactions and by artificially
stating the reserve accounts, which were in blatant disregard
of SFAS 91. Is that an accurate statement?
Mr. Doty. It is certainly a statement that some may make.
They----
Ms. DeGette. Do you think it is inaccurate?
Mr. Doty. They achieved--lawyers are prone to take striking
statements and reduce them to more banal statements, I guess.
We see it----
Ms. DeGette. Some lawyers at least.
Mr. Doty. Well, the fact is that they did concoct capital
market transactions in order to defer earnings and to mitigate
volatility. The means whereby they fine-tuned the earnings to
achieve the analyst expectation within two or three cents a
share was largely the reserve accounting in a few selected
reserve funds.
Ms. DeGette. And they did this for 11 quarters, right?
Mr. Doty. They did it and their auditors knew----
Ms. DeGette. For 11 quarters?
Mr. Doty. Yes, and with full knowledge.
Ms. DeGette. So you wouldn't really disagree with this
statement?
Mr. Doty. Well, I think we come down hard on the practice.
Ms. DeGette. Okay. Well, in your report you say these
systematic efforts to change earnings to meet Wall Street's
expectations were a blunder, right?
Mr. Doty. No.
Ms. DeGette. No?
Mr. Doty. We say that in many of the derivative
transactions they involve the unintentional misapplication of
GAAP, a clear misapplication of GAAP.
Ms. DeGette. Do you think it was intentional or
unintentional?
Mr. Doty. We believe that they thought they were complying
with GAAP. This is what a GAAP centric rules-based system can
produce.
Ms. DeGette. Professor Lev, do you believe that? Do you
believe they were complying with GAAP?
Mr. Lev. I really cannot read the minds of these people.
Ms. DeGette. Sure.
Mr. Lev. I didn't speak with them. I don't believe such
elaborate schemes over extended periods will be benign.
Ms. DeGette. See, I am also on the Oversight and
Investigations Subcommittee and we were the ones that did the
investigation into WorldCom and Enron and all of those
evildoers, and they all said the same thing. They all said,
well, we thought we were complying with the accounting
standards when we concocted these elaborate transactions, and I
guess in my mind, as a lawyer, when I see somebody over 11
consecutive quarters making these very elaborate--constructing
these very elaborate transactions, I can only come to the
conclusions that they are using GAAP as a kind of mantle to
shield their actions.
Now, Professor Lev, you are nodding, I hope, in agreement.
Mr. Lev. In principle, I agree with you, yeah.
Ms. DeGette. Something else, I don't have much time left,
and we have a vote on the floor. One of the issues that came
out of the corporate responsibility hearings that we had was
the issue of board accountability, and several of you have
mentioned the concept of trying to have people have a
conservative interpretation of GAAP. I am wondering, Mr. Doty,
in your report, you said that the Board was aware of this
``Steady Freddie'' mentality, but because the flow of
information was so limited the Board did not fully understand
what it complied.
Do you believe that Freddie Mac's board from 2000 to 2002
neglected their fiduciary duty to protect shareholders by not
probing even more deeply into how this goal was being achieved?
Mr. Doty. No, Congressman. I am burdened by the knowledge
that they tried very hard at the end of 2000, going into 2001
and through 2001, to achieve greater control of the accounting
function. This was a very proactive board. It has been
extremely proactive since January, 2000.
Ms. DeGette. I bet they have.
Mr. Doty. But at that time, at the time you are inquiring
of, they were expressing grave discontent with management for
having people in corporate accounting who they thought were not
up to the task.
Ms. DeGette. Well, if I could interrupt you.
Mr. Doty. They were overseeing, they were not managing.
Ms. DeGette. We had the same problem, too, where the Board
was saying we have grave concerns but at the same time these
practices were going on.
I wonder if you have any thoughts as to how we can beef up
information or the Board's oversight responsibility so that
these practices don't continue to go on, even when board
members are expressing concern.
Mr. Doty. Well, I think you can look at what board members
do. Board members are going to be judged by the courts and by
the regulatory agencies as to whether they are actually going
to be doing things that deal with these problems. I think in
the case of the Freddie Mac board it will be seen that they
did. They were seeking to recruit and to obtain a chief
financial accounting officer who had real expertise. They were
thwarted in that goal. They sought to do something about errors
in the accounting that they began to perceive at the end of
2001. They were thwarted. They called in management in the
spring of 2002 and said, unless you fix these problems
immediately your pay is going to suffer. It is probably the
most immediate control a board of directors has over management
is to threaten their pay and the Freddie Mac board was a bit
ahead of their time in doing it.
Ms. DeGette. Thank you.
Mr. Stearns. I thank my colleague.
We are going to take a temporary recess. We appreciate your
patience. We are going to go take a vote and then we will
reconvene.
[Brief recess.]
Mr. Stearns. The subcommittee will come to order.
Mr. Barratt, we want to get you involved here, so we have
got some questions for you. Explain to us why companies would
want to change the characterization of assets from ``held to
maturity'' to ``available for sale,'' and what are the
implications for these changes, and keep it simple for all of
us, for sixth graders.
Mr. Barratt. I will try. I think one way I think of it is
you have kind of three buckets, you have held to maturity, you
have available for sale, and then you have trading, and
depending on which classification you get in, you get different
accounting treatment. So in this case held to maturity is
carried on the books at amortized cost. It is not subject to
the fluctuations and market. It is not market to market, but
the person who makes the decision of what goes in each bucket,
people could make different decisions on what goes in the
bucket, right?
Mr. Stearns. Yes.
Mr. Barratt. And there is another, FASB 115, that goes to
that classification. You have held to maturity, the literature
says there is a positive intent and the ability to hold it to
maturity. So there is a desire instead of just classifying it 1
day one way and then another----
Mr. Stearns. So it is pretty subjective?
Mr. Barratt. Yes, and you can change it. Depending on a
variety of circumstances, you may want to move it, but there is
different treatment depending on what bucket you are in.
Mr. Stearns. Hmm.
Mr. Barratt. And available for sale when they mark to
market, that adjustment goes through the equity part of the
balance sheet, so there is not an income statement effect when
there is changes available for sale.
However, on trading, when it is mark to market, it hits the
income statement and does affect your earnings and volatility.
Mr. Stearns. Does FASB clearly point out what the
requirements are in determining what goes in, for example, each
of these buckets, and so forth?
Mr. Barratt. I think----
Mr. Stearns. Or is it just all subjective?
Mr. Barratt. SFAS 115 does a pretty good job in saying what
it takes to go into each bucket.
Mr. Stearns. Okay. So should the characterization of an
asset determine its accounting treatment?
Let me say that again: Should the characterization of an
asset determine its accounting treatment?
Mr. Barratt. I guess the example to answer that, if you
didn't characterize these assets in one of these buckets or
not?
Mr. Stearns. Right.
Mr. Barratt. That could create problems that you are
alluding to, that you could kind of move things around for your
own purposes, so I think it is important that there is some
characterization and make them accountable to what the intent
is with regard to the securities.
Mr. Stearns. Explain to us on the basis of your work some
of the steps companies take to avoid fair value accounting of
derivatives?
Mr. Barratt. Avoid fair value.
I guess to kind of mitigate the effect of the fair value in
recognizing these gains there is a variety of things. In this
case, for example, there is the swaption valuation change where
you just have a different valuation model to avoid some of that
gain that comes from fair value.
Another thing you can do is there is derivatives that are
not in a hedging relationship, are mark to market, through
earnings, and they affect the income statement. So to the
extent you can pair up those non-hedge derivatives in a hedging
relationship, you can avoid that income hit from fair value
accounting.
Mr. Stearns. Do you think that these actions to avoid fair
value accounting are socially useful? You might have to take
off your forensic and litigation advisory cap to do this.
Mr. Barratt. Mr. Doty may have an opinion on this.
Mr. Doty. Socially useful.
I think, just to step back, I think SFAS 133, in its
intention to have fair value accounting, instead of just having
historical costs that might be on there or not even the balance
sheet, it is a good thing to have more relevant, more timely
information available to investors. So I think it is a
desirable objective, but I think, as we have learned today,
that the rules that set out how you do that create some
difficulty sometimes in achieving it.
Mr. Stearns. So your answer to socially useful is, what,
yes or no?
Mr. Doty. Well, to avoid fair value accounting I would say
is not socially useful.
Mr. Stearns. Okay. Just for my colleagues and perhaps for
the panel, I asked to get the book on this FASB Statement 133,
and this is it, and, you know, there is a lot of appendix here,
but you can see that accounting for derivative instruments and
hedging activities, this is the kind of document that people
must understand, comply with, and this one they try to
manipulate. They have got to understand how to manipulate, and
there are things like how should the basis of a hybrid
instrument be allocated to the host contract in the embedded
derivative when separate accounting for the embedded derivative
is required by Statement 133. So the people who are involved
here are obviously pretty smart and knowledgeable to be able to
even get to the starting line in this thing. So these are not
people that are going to blunder so much as I think work the
system here, and for good or for bad, the GAAP is allowing it.
So that is my 5 minutes.
Ms. McCarthy, would you like----
Ms. McCarthy. Mr. Chairman, thank you both for this hearing
and thank the witnesses for sharing their expertise with us.
The SEC report required by Sarbanes-Oxley concluded that
the principle only standards present enforcement difficulty. I
know you are aware of that. We have all seen issues and
discussion of that in the press, but they are concerned because
they provide little guidance or structure for exercising that
judgment by preparers and auditors, and this is of concern to
me and I am sure other members of the committee. They
recommended something else they called principle-based or
objective-oriented standards which possess the following
characteristics, and I will share them with you, although I am
sure you are familiar with them, that they be based on an
approved and consistently applied conceptual framework, clearly
state the accounting objective of the standard, provide
sufficient detail and structure so that the standard can be
operationalized and applied on a consistent basis, minimize
exceptions from the standard and avoid use of percentage tests,
bright lines, that allow financial engineers to achieve
technical compliance with the standards while evading the
intent of the standards, and I wondered, Professor Lev and Mr.
Doty, if you would support such a solution.
Professor Lev and then Mr. Doty.
Mr. Lev. Let me just say that I am not a great fan,
personally, of principles versus rules, particularly because I
don't know when a principle ends and the rules starts. I mean,
the thing is extremely vague.
What I was proposing, and it is in line with what you just
read, is really simplification, focus on a few governing
objectives. You can call them principles. Definitely avoid, and
I must say the ridiculous thing that was just quoted by the
chairman from FASB 133, which is so incredibly detailed,
dealing with an instrument that maybe even doesn't exist
anymore right now, because things change very quickly, and then
putting emphasis, as I said before, on full disclosure. I heard
someone saying here during the intermission that no one reads
financial reports, and they definitely won't read the full
disclosure.
This is absolutely wrong. My daughter is a financial
analyst. She reads financial reports of the companies that she
follows, every single word, and what she doesn't understand she
pesters management in conference calls about that, so I don't
care whether 95 percent of investors don't read financial
reports.
Those that read determine the price and the volume, so I
just refuse to accept that the only way to go is just making
the system like the book that the chairman is now holding,
which is only the rules. Then you have thousands of pages of
interpretations that follow this thing.
Ms. McCarthy. I thank you, Professor, and I do agree that
rule based standards only provide that vehicle for
circumventing the very intention of the standard that we want
to have met.
Mr. Doty.
Mr. Doty. Well, I think one comes away from this experience
believing there is no substitute for good judgment properly
applied.
One of the things, one of the transactions for which we
fault Freddie Mac was the employment of an account, a reserve
account, with the full knowledge of their independent auditors,
their independent auditors, which was not maintained
consistently with GAAP, and they knew it was a non-GAAP account
but it was allowed to be used for this purpose of earnings
smoothing because the amounts were not material. So it is an
example of what you were pointing to, Ms. McCarthy, of the use
of a quantitative test in a context in which the judgment
should have been quite different from the quantitative test,
and it is clearly the case that professionals have a duty, we
do, as lawyers, accountants have, to use judgment.
It seems to me that there is an historical sea change at
work, a cultures change within professions, and what we are
seeing now at Freddie Mac as they labor through their
restatement is the adoption of a new corporate culture that is
quite different from the one obtained before, and we would hope
and I think we would expect it is going to be much more laden
with correct judgment.
Ms. McCarthy. Thank you very much for your answers and
thank you, Mr. Chairman. I yield back.
Mr. Stearns. I thank the gentlelady. I think we are ready
to conclude. Mr. Doty, I just have a few items.
Who were the counterparties in the Giant and the J deals?
Can you specifically tell us who they were?
Mr. Doty. I can. We have not made a great deal of this in
the report because the transactions were initiated by Freddie
Mac, but Salomon Smith Barney was a counterparty chosen in the
Cetaug transaction and Morgan Stanley in the J deals.
Mr. Stearns. It was just those two then?
Mr. Doty. Yes.
Mr. Stearns. Professor Lev, you have pointed out the two
major problems with GAAP, extreme complexity and vulnerability
to manipulation.
I asked in my first series of questions what should be
done. I guess now I am asking you the problems of earning
management is widespread. I think that is what you are
indicating in your testimony.
Could you take another shot at what should be done and
maybe I will ask the other folks too, and that will be our
conclusion here.
Mr. Lev. In the case of earnings management?
Mr. Stearns. Yeah.
Mr. Lev. I mean, in addition to all the things that----
Mr. Stearns. Or is it benign?
Mr. Lev. It is definitely not benign.
Mr. Stearns. Okay.
Mr. Lev. It is not benign because it affects market prices
and the decisions of people.
I mean, in addition to all the things, you know,
strengthening the board and auditors and so on and so on, it
also behooves some in the investment community to do something.
They basically perpetrate the whole thing. Their complete focus
on quarterly earnings of companies motivate this kind of an
earnings game, a much more reasonable focus, rather than on
quarterly earnings. If you think about earnings of a company,
quarterly earnings are almost completely meaningless. They are
largely effected by random things, transitory things.
If they would have focused more on long-term measures, like
three quarters, four quarters, and so on and so on, the whole
game would lose much of its power. Some leading companies--I
don't see it mushrooming, but there was a beginning. Some
leading companies announce in the wake of all the scandals,
announce we are not going to give any guidance about earnings
or they took themselves out of the earnings game.
I think only giant companies can afford at least at the
beginning to do such things, but this is really a difficult
issue. It is so endemic to the investment process, this focus
on everything short-term.
Mr. Stearns. Mr. Barratt.
Mr. Barratt. My only thoughts there would be I think in
some cases adjustments were considered to be immaterial. They
were so small that either the auditor or the company didn't
necessarily consider it possibly the way they should.
I think Staff Accounting Bulletin 99 that SEC issued has
got some way to address that, and so the other point I would
make is I think now, in light of all, Sarbanes-Oxley and
everything else that is going on, I think auditors in companies
will be looking at all the adjustments that were going on, that
were either proposed, or not made and really I think drilled
down to the point where it is more difficult possibly to----
Mr. Stearns. To do it.
Mr. Barratt. To achieve that, yeah.
Mr. Stearns. Mr. Doty.
Mr. Doty. Three things, disclosure, better disclosure, and
the best disclosure, and I think if you do that I know of no
area in our national life in which disclosure hasn't cured a
great many problems.
Mr. Stearns. Just bring some sunshine in?
Mr. Doty. Yes.
Mr. Stearns. Let me thank all of you for your testimony and
thank you for your patience and indulgence while we voted and
also thank Freddie Mac for their cooperation and directness
here. It has helped and I think jurisdiction of our committee
is such that we are trying to work on some kind of legislative
initiative here, dealing with FASB, and I think you have been
very helpful, and with that, the subcommittee is adjourned.
[Whereupon, at 11:50 a.m., the subcommittee was adjourned.]