[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




                               before the

                            SUBCOMMITTEE ON

                                 of the

                        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/


                            WASHINGTON : 2003
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               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
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
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
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)


                            C O N T E N T S


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





                      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 
    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 
    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 
    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 
    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 
    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 
    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 

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 
    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.


    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 
    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 
    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 
    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.


    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 
    \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 


    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 
    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.
    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 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.


    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 
    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 
    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 
    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 

    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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 
    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. 
    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 
    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 
    Mr. Doty. We believe that they thought they were complying 
with GAAP. This is what a GAAP centric rules-based system can 
    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 
    [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 
    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 
    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 
    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 
    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 
    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 
    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.]