[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
FREDDIE MAC'S ACCOUNTING RESTATEMENT: ARE ACCOUNTING STANDARDS WORKING?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JANUARY 28, 2004
__________
Serial No. 108-105
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
RALPH M. HALL, Texas JOHN D. DINGELL, Michigan
MICHAEL G. OXLEY, Ohio** Ranking Member
MICHAEL BILIRAKIS, Florida HENRY A. WAXMAN, California
JOE BARTON, Texas EDWARD J. MARKEY, Massachusetts
FRED UPTON, Michigan RICK BOUCHER, Virginia
CLIFF STEARNS, Florida EDOLPHUS TOWNS, New York
PAUL E. GILLMOR, Ohio FRANK PALLONE, Jr., New Jersey
JAMES C. GREENWOOD, Pennsylvania SHERROD BROWN, Ohio
CHRISTOPHER COX, California BART GORDON, Tennessee
NATHAN DEAL, Georgia PETER DEUTSCH, Florida
RICHARD BURR, North Carolina BOBBY L. RUSH, Illinois
Vice Chairman ANNA G. ESHOO, California
ED WHITFIELD, Kentucky BART STUPAK, Michigan
CHARLIE NORWOOD, Georgia ELIOT L. ENGEL, New York
BARBARA CUBIN, Wyoming ALBERT R. WYNN, Maryland
JOHN SHIMKUS, Illinois GENE GREEN, Texas
HEATHER WILSON, New Mexico KAREN McCARTHY, Missouri
JOHN B. SHADEGG, Arizona TED STRICKLAND, Ohio
CHARLES W. ``CHIP'' PICKERING, DIANA DeGETTE, Colorado
Mississippi LOIS CAPPS, California
VITO FOSSELLA, New York MICHAEL F. DOYLE, Pennsylvania
ROY BLUNT, Missouri** CHRISTOPHER JOHN, Louisiana
STEVE BUYER, Indiana TOM ALLEN, Maine
GEORGE RADANOVICH, California JIM DAVIS, Florida
CHARLES F. BASS, New Hampshire JANICE D. SCHAKOWSKY, Illinois
JOSEPH R. PITTS, Pennsylvania HILDA L. SOLIS, California
MARY BONO, California CHARLES A. GONZALEZ, Texas
GREG WALDEN, Oregon
LEE TERRY, Nebraska
MIKE FERGUSON, New Jersey
MIKE ROGERS, Michigan
DARRELL E. ISSA, California
C.L. ``BUTCH'' OTTER, Idaho
SUE WILKINS MYRICK, North
Carolina**
JOHN SULLIVAN, Oklahoma
**On Leave of Absence
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 JANICE D. SCHAKOWSKY, Illinois
BARBARA CUBIN, Wyoming Ranking Member
JOHN SHIMKUS, Illinois HILDA L. SOLIS, California
JOHN B. SHADEGG, Arizona EDWARD J. MARKEY, Massachusetts
Vice Chairman EDOLPHUS TOWNS, New York
GEORGE RADANOVICH, California SHERROD BROWN, Ohio
CHARLES F. BASS, New Hampshire JIM DAVIS, Florida
JOSEPH R. PITTS, Pennsylvania PETER DEUTSCH, Florida
MARY BONO, California BART STUPAK, Michigan
LEE TERRY, Nebraska GENE GREEN, Texas
ERNIE FLETCHER, Kentucky KAREN McCARTHY, Missouri
MIKE FERGUSON, New Jersey TED STRICKLAND, Ohio
DARRELL E. ISSA, California DIANA DeGETTE, Colorado
C.L. ``BUTCH'' OTTER, Idaho JOHN D. DINGELL, Michigan,
W.J. ``BILLY'' TAUZIN, Louisiana (Ex Officio)
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Baumann, Martin F., Chief Financial Officer, Freddie Mac..... 28
Falcon, Hon. Armando, Jr., Director, Office of Federal
Housing Enterprise Oversight............................... 7
Additional material submitted for the record by:
Stearns, Hon. Cliff, and Hon. Janice D. Schakowsky:
Letter dated January 28, 2004, to Armando Falcon, Jr.,
requesting material for the record, and response to
same................................................... 46
Letter dated May 13, 2004, to Armando Falcon, Jr.,
requesting material for the record, and response to
same................................................... 49
(iii)
FREDDIE MAC'S ACCOUNTING RESTATEMENT: ARE ACCOUNTING STANDARDS WORKING?
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MONDAY, JANUARY 28, 2004
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,
Ferguson, Issa, Otter, Schakowsky, Solis, Markey, McCarthy, and
Strickland.
Staff present: Brian McCullough, majority counsel; David
Cavicke, majority counsel; Arturo Silva, deputy communications
director; William Carty, legislative clerk; and Consuela
Washington, minority counsel.
Mr. Stearns. Good morning. The subcommittee will come to
order.
My colleagues, this is the third hearing we have held in
the subcommittee on accounting issues raised by Freddie Mac.
The hearing today will focus on two reports: the supplemental
report to the Board of Directors of Freddie Mac known as the
supplement to the Doty report and submitted to the Board on
November 18, 2003; and the report of the special examination of
Freddie Mac by the Office of Federal Housing Enterprise
Oversight, OFHEO, completed in December 2003.
We have two witnesses here today and I'd like to thank them
for appearing before the committee to help us better understand
what happened at Freddie Mac.
I would like to thank Armando Falcon, Director of OFHEO,
Freddie's regulator for OFHEO's work on parsing through the
problems at Freddie that led to Freddie Mac's disregard of
financial accounting standards.
I would also like to thank Martin Baumann, CFO of Freddie
Mac for being here today.
At the last hearing, we held on the accounting standards
issued raised by the Doty report, I complimented Mr. Doty on
his thoroughness and objectivity with regard to the internal
investigation and the report. Although Mr. Doty is not
appearing as witness here today, I wish to acknowledge the
supplemental report was produced with the same rigor as the
initial report. It also will be a useful tool as guiding our
review of accounting standards.
We'll focus on three things today. First, the supplement to
the Doty report; second, the OFHEO report; and finally, on the
implications of the contents of these reports for fair
disclosure under U.S. GAAP.
The supplement to the Doty report addresses issues that
were known to require further inquiry at the time of release
for the initial report. As with the transactions scrutinized in
the final report, hiding income was a primary factor, if not
the sole motivation for several transactions investigated for
the follow-up report.
The supplement reveals further evidence of earnings
management at Freddie Mac. The OFHEO report provides an
overview of the culture at Freddie Mac that facilitated
earnings management over 11 quarters. The report indicates that
Freddie disregarded accounting rules, internal controls, and
disclosure standards to maintain a reputation for steady
earnings.
So I look forward to hearing from Mr. Baumann about what
controls Freddie is putting into place to guard against
improper accounting.
The third issue we need to look at today is what this
information means for accounting standards. Although Freddie
Mac may have made accounting misstatements, it is possible that
if some of the transactions were structured more carefully they
would have been GAAP compliant. It is possible Freddie could
have hidden billions of dollars of income in a way that
complied with GAAP.
I suggest this is not the result we want from our United
States accounting standards. So called ``mixed attribute''
accounting allows companies to decide whether financial assets
are carried at current market price or at historic costs. Let
me repeat. Allows companies to decide whether financial assets
are carried at current market price or at historic costs.
Freddie Mac shifted assets between categories to manipulate
earnings without any change in the underlying economics of its
performance.
Now taxpayers do not have the option of changing the
characterization of assets to change the tax treatment. I think
GAAP should not allow this either. U.S. GAAP was once hailed as
a premiere accounting system. I believe GAAP is still a strong
accounting system and I applaud FASB for all their efforts to
shore up the system over the last 2 years.
While I do not believe Congress is the appropriate body to
set detailed accounting standards, I believe we as a committee
of oversight over accounting standards setting have a
responsibility to ensure standards produce financial statements
that are transparent and comprehensible.
I encourage my colleagues to join me to produce legislation
to reform GAAP.
I look forward to a dialog here today that will further
these efforts and I thank you.
I ask the distinguished Ranking Member for her opening
statement.
Ms. Schakowsky. Thank you, Chairman Stearns, for convening
this important hearing to follow up on the accounting scandal
at Freddie Mac. I appreciate, Mr. Falcon, and accompanied by
Ms. DeLeo this morning and Mr. Baumann's attendance today so
that we can go over the Office of Federal Housing Enterprise
oversight examination of just what went wrong at Freddie Mac
and Freddie Mac's actual restatement of earnings.
According to OFHEO's report, Freddie Mac used a variety of
accounting tricks to move gains and losses around to smooth out
and meet earning expectations. Through their manipulations,
steady Freddie seemed to live up to its name. However, as its
restatement shows, and we all know, the cumulative effect of
their attempts was the hiding of $5 billion of volatility.
Some have been lulled into a sort of complacence with the
accounting scandal at Freddie Mac because they under reported
their earnings. It seemed that while their true earnings
revealed some unsteadiness, what they were hiding was not so
bad. They hid profits. But this reporting has been misleading
as well. In 2001, Freddie's restatement reveals that they over
reported their earnings by $989 million. Earnings for 2001
actually were about $1 billion less than they reported. Again,
that $5 billion was accumulative effect of their restatement.
My concerns today are not just with Freddie Mac but also
with the agency put in charge of their oversight. OFHEO's
oversight was created in 1992 to ensure the safe and sound
operations of Freddie Mac and Fannie Mae. However, as OFHEO's
report reveals, a lot was happening at Freddie Mac under their
oversight.
Today, we'll focus on the accounting issues that were
raised by Freddie Mac. Our subcommittee has the responsibility
to ensure that all companies provide clear and accurate
financial information to the public. The scandal at Freddie Mac
is a clear example of what can happen when corporate officers
do not abide by the rules of clear and accurate accounting.
All publicly traded companies need to have clear and
accurate books. This is especially true for Freddie Mac. What
happens at Freddie Mac has a major impact on the housing
markets. Freddie purchased almost $600 billion in mortgages in
2002. It also has helped finance homes for nearly 2.5 million
low and moderate income families and families living in under
served areas. It was able to do so at least in part because of
the benefits and freedoms enjoyed in an established mission as
a government-sponsored enterprise.
As we all know, with freedoms come responsibilities. While
Freddie was trying to live up to their reputation, they were
not living up to their responsibilities. As a GSE and as one of
the largest players in the housing market, playing accounting
games puts more than the corporation's financial standing at
risk. It puts taxpayers and people's homes in jeopardy.
As I said before, Freddie Mac is not just another company.
Therefore, we need to make sure that Freddie Mac is as
transparent as possible and while I applaud the work that OFHEO
has done since the scandal has come to light, and appreciate
Freddie's restatement of earnings, willingness to take steps
toward remediation, we still have a long way to go.
Freddie Mac needs to be registered with the SEC and
voluntary registration is taking too long and does not have the
same power as mandated. And that is why I support my
colleagues' efforts, Congressmen Shays and Markey, to require
Freddie Mac to abide by the same rules of transparency
available. Because of who you are and place you have in making
money available for home ownership, it is vital that Freddie
Mac is held to at least the same standards as other publicly
traded companies, if not higher.
I thank you, Mr. Chairman.
Mr. Stearns. I thank my colleague. Mr. Shimkus.
Mr. Shimkus. Thank you, Mr. Chairman. It's an important
hearing and it's good to be back and addressing these concerns.
I will be brief.
In the committee summary, obviously we're here to review
Freddie Mac's announced restated financial cumulative net
income increase by $5 billion regulatory per capita increase by
$5.2 billion; stockholders equity increased by $6.7 billion.
These are obviously restated numbers.
In OFHEO's report under the executive summary, it talks
about the corporate culture fostered by the tone at the top
resulting in intense and sometimes improper efforts by the
enterprise to manage its reported earnings. And in another
article in The New York Times dated 30 November, the headline
``Hiding Profits is Just Deceitful.''
We're even more involved because this is a government-
sponsored enterprise. There is connection to us because of that
privilege and I think the public is just getting tired of
whether it's a for profit entity or a government-sponsored
entity of leadership at the top rigging the books for purposes
that are as The New York Times says is deceitful. And so you're
here to help us sort through really the blow by blow of where
we're at. Then we do need to look with my colleagues in how
bills should be written and drafted, laws should be passed to
bring some more accountability. The public is just tired and we
should not claim and go after one sector of the corporate world
while another one goes unscathed for what we would define as
improper activity.
So Mr. Chairman, I think it's an important hearing. Thanks
for calling it and I yield back the balance of my time.
[The prepared statement of Hon. John Shimkus follows:]
Prepared Statement of Hon. John Shimkus, a Representative in Congress
from the State of Illinois
Good Morning. Mr. Chairman, thank you for holding this hearing to
provide a forum for Freddie Mac to restate their financial reports.
This hearing marks the third time in the last 7 months that this
Subcommittee has investigated the accounting practices of Freddie Mac.
I should hope that this hearing will finally produce an answer to what
we have been looking for--the accurate depiction of Freddie Mac's
suspicious transactions. The fact that Freddie Mac, a government
sponsored enterprise, had to make major revisions to the past three
years accounting records only adds fuel to the flame in this era of
corporate distrust. And even these records may not be correct, as
Freddie Mac will not be issuing its 2002 annual report until June of
2004--over a year later than normal.
I am interested to hear from our panel of witnesses and learn more
about the measures that have taken place to correct the improper
reporting by this enterprise. I'm also anxious to hear how Freddie Mac
plans to avoid this type of situation in the future and comply with the
basic accounting standards they have discarded in the past.
Thank you Mr. Chairman, and I yield back the remainder of my time.
Mr. Stearns. I thank my colleague. The gentleman from
Massachusetts.
Mr. Markey. Thank you, Mr. Chairman, and thank you so much
for having this hearing. It is very timely, very important
because Congress did establish Freddie and its sister company,
Fannie Mae, to link Wall Street financing to the goal of
promoting home ownership throughout Main Street America. In
order to advance this objective, Congress has allowed these two
companies many regulatory benefits, such as exemption from
State taxes, a line of credit at the United States Treasury, an
exemption from the registration, financial reporting
requirements of the Federal securities laws.
But while Freddie and Fannie might be ``government-
sponsored enterprises,'' they are also private investor-owned
corporations. As such, they have responsibilities to their
shareholders, including the responsibility to provide full and
complete disclosures regarding their financial and operating
condition and to obtain audited financial statements that
comply with generally accepted accounting principles.
In other words, both of these institutions do a wonderful
job in creating more housing in the United States. No one is
going to debate that. But many of those very same families then
invest their own money into the shares of those companies
thinking that it must be a very good company. The government
sponsors it. But it isn't required to provide all the same
information that other corporations in America are. The
transparency is not there, so that investors can make the right
decision. And that's why Christopher Shays and I introduced
legislation to provide that accurate disclosure and accounting
practices at these companies.
Today, we're going to hear from Freddie Mac's principal
regulator, the Office of Federal Housing Enterprise Oversight
about the results of its investigation into accounting
irregularities at Freddie Mac. OFHEO's December 2003 report on
its special examination of Freddie Mac raises a number of very
disturbing issues that I look forward to hearing about today.
The OFHEO report describes a corporate culture that ``casts
aside accounting rules, internal controls, disclosure standards
and the public trust in the pursuit of steady earnings
growth.''
It details instances in which Freddie Mac ``knowingly
circumvented prevailing public disclosure standards in order to
obfuscate particular policies and specific capital market and
accounting transactions'' and it finds ``a disdain for
appropriate disclosure standards'' that misled investors,
ordinary Americans, putting their money into these companies
and undermined market awareness of the true financial condition
of the enterprise.
In my view, these findings only serve to underscore the
failure of voluntary disclosure to serve the needs of American
investors and of our financial markets. In the aftermath of
this accounting scandal, it is time for Freddie Mac's new
leadership to change course and embrace legislation through
repeal of its special exemption from the Securities and
Exchange Commission registration and reporting requirements.
There is no single step that Freddie Mac could take that
would do more to signal to investors that the corporate culture
at the company has changed. There is no single step that the
Congress could undertake which would better protect investors
from a repetition of the type of accounting problems that we
have seen at Freddie Mac.
Mr. Chairman, again, I want to thank you so much for having
this very important hearing.
Mr. Stearns. I thank my colleague. The gentleman from
Idaho.
Mr. Otter. I have nothing.
Mr. Stearns. Mr. Shadegg, I'm sorry, the gentleman from
Arizona.
Mr. Shadegg. Thank you very much, Mr. Chairman, for holding
this hearing. Since our last hearing on this issue on September
25, the restatement by Freddie Mac of its 2002 financial
information, coupled with the release of the reports by Baker
Botts and OFHEO weren't another look at the accounting problems
which beset Freddie Mac.
I am pleased that we have such knowledgeable witnesses
present and was interested to read in their testimony not only
the description of what went wrong, but also the steps that
Freddie Mac can and in some instances is taking to correct the
situation which gave rise to the accounting problems.
I am also encouraged that Freddie Mac has appointed a chief
compliance officer to ensure that at least one key employee in
the company has legal and regulatory compliance as his primary
function. Important as such structural improvements are,
however, they pale in comparison to the need to instill in all
employees, managers and board members, the understanding that
accounting standards are not a performance metric to be
manipulated or worked around, but rather a gauge which must be
kept accurate.
At the hearing last September, I made the point that
accurate accounting could best be encouraged through the
establishment of guidelines, rather than overly formulaic rules
which can be avoided on technicalities. I'm building a home
right now and there are certain building codes which it must
comply with. Obviously, it's important to comply with those
codes, but it's more important that the home actually be well
constructed and that it will last for decades and so complying
with the code isn't the issue, building a sound home is, in
fact, the issue.
I was interested to see that in the testimony of Mr.
Falcon, he bolstered my position. He notes that ``to maintain
Freddie Mac's image as a smooth and steady earning machine, it
is now clear that management went to extraordinary lengths to
transact around FAS 133 and at times failed to comply with
GAAP.'' He also discusses the culture of deception which
existed among some members of Freddie Mac's management team and
their willingness to disguise earnings.
In the next few weeks we will consider legislation to
institute certain reforms to Freddie Mac and other government-
sponsored enterprises. It is my hope that this legislation will
be structured to not only ensure greater compliance with
technical accounting standards, but will result in greater
attention to the spirit of accurate reporting without which the
standards themselves are meaningless.
I thank you, Mr. Chairman, again for this hearing and look
forward to the testimony of our witnesses.
Mr. Stearns. I thank the gentleman. Good morning, Ms.
Solis, you're welcome. You can take your time and we welcome
your opening statement if you have one?
Ms. Solis. I'd like to submit my statement for the record,
thank you.
Mr. Stearns. By unanimous consent, so ordered.
[The prepared statement of Hon. Hilda L. Solis follows:
Prepared Statement of Hon. Hilda L. Solis, a Representative in Congress
from the State of California
Thank you, Mr. Chairman, for calling this hearing today. I'm
pleased that this Subcommittee is continuing to examine the problems
uncovered at Freddie Mac last year, as well as the state of accounting
standards in general.
I share the concern held by many of my colleagues on this panel
about the lack of transparency in corporate accounting. I believe it is
critical that companies provide thorough and accurate information about
their financial status to the public. We should not leave investors in
the dark, defenseless against sloppy accounting by corporate managers.
Holding corporations accountable is especially important for
government- sponsored entities such as Freddie Mac. We all know that
Freddie Mac, along with Fannie Mae, is crucial to the housing market.
This is especially true in districts such as mine in Los Angeles
County, which is home to many low to moderate income families, the
majority of whom are Latino and Asian. I hope that as we continue to
evaluate this issue, we will keep these consumers--and all taxpayers--
in mind.
It is in the best interest of our constituents to have a viable,
secondary housing market. Improving transparency and disclosure
requirements will help accomplish this goal.
I want to thank the witnesses for joining us today. I look forward
to their testimony.
Thank you.
[Additional statement submitted for the record follows:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Energy and Commerce
This is the third hearing Chairman Stearns has held on accounting
problems at Freddie Mac. I commend Chairman Stearns for his dogged
pursuit of the technical issues associated with accounting questions.
The most important lesson we have leaned from this inquiry is that
GAAP Accounting Standards as set by FASB leave much to be desired.
Although Freddie Mac violated GAAP by hiding billions of dollars in
earnings, had they done their accounting more carefully, some of those
transactions would have been permissible.
So called ``mixed-attribute accounting'' allows some financial
firms to vary the accounting treatment of an asset by characterizing
the asset as ``available for sale'' or ``held for investment''. By
manipulating these categories, some financial firms can alter their
accounting by billions of dollars without any regard to economic
reality. This anomaly should change. FASB should be encouraged to adopt
a rule correcting this.
We know from the corporate scandals that have surfaced in the past
two years that it is difficult to regulate fraud. However, lost in some
of the particular cases is why no one discovered the truth earlier. Are
accounting standards so complex that virtually anything can be hidden
or are they so complex that no one is smart enough to understand the
financial statements? Simply stating that accounting standards should
be simpler sounds great, but will it benefit anyone if the information
is meaningless?
I commend Chairman Stearns for his attention to these questions and
hope that the Subcommittee will continue this inquiry in this Congress.
Mr. Stearns. Mr. Falcon, I think we're taken care of all
our opening statements, so we welcome you this morning, for
your opening statement.
STATEMENT OF HON. ARMANDO FALCON, JR., DIRECTOR, OFFICE OF
FEDERAL HOUSING ENTERPRISE OVERSIGHT
Mr. Falcon. Thank you, Mr. Chairman, Ranking Member
Schakowsky, I apologize for the error in my written testimony
about the misnomer, and members of the subcommittee. Let me
introduce to my left, Ms. Wanda DeLeo, who is the Chief
Accountant at OFHEO. I asked her to join me up here to assist
me in answering any detailed questions about accounting matters
at Freddie Mac.
I appreciate the opportunity to discuss with you OFHEO's
report of the special examination of Freddie Mac. My written
testimony discusses the key findings and conclusions of the
report, focusing largely on accounting and earnings management
issues. I request that the committee include it, as well as the
full text of the report in the record.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Falcon. Thank you. A year ago, Freddie Mac announced
that completion of its 2002 financial audit would be delayed
and that earlier periods would be re-audited and restated. They
switched external auditors from Arthur Anderson to
PriceWaterhouseCoopers. That triggered an assessment of Freddie
Mac's accounting policies and practices.
On June 7, as this re-audit was underway, Freddie Mac
announced the abrupt departure of three of its principal
officers. At the same time, I ordered a special examination of
the circumstances that led to the restatement and management
changes.
Although some aspects of the special examination are not
yet complete, the bulk of the work was finished this past fall.
OFHEO issued a report of the examination containing the
findings and conclusions along with appropriate recommendations
in December.
Let me now turn to the major findings of the special
examination. The report of the special examination of Freddie
Mac reveals how Freddie Mac manipulated its reported earnings
and disclosed other financial information in a misleading way
in 1999 through 2002. The report provides a chronology of
relevant events, reviews the strategies that Freddie Mac
employed to manipulate earnings and indicates that the Board
was made aware of transactions whose sole purpose was to shift
income.
The report also shows how the executive compensation
program of Freddie Mac, particularly the compensation tied to
earnings per share, influenced accounting and management
practices during that period.
On January 1, 2001, Freddie Mac, along with other financial
institutions, was required to implement FAS 133, ``Accounting
for Derivative Instruments and Hedging Activities.'' In
addition to their many operational challenges, FAS 133 was
problematic to Freddie Mac with respect to its goal of steady
earnings growth. Specifically, FAS 133 required management to
record a transition adjustment based upon any embedded gain or
loss in its derivatives portfolio upon adoption of the
standard.
Freddie Mac's derivatives portfolio, in particular, its
portfolio of interest-rate swaptions, had substantial gains
that had to be recognized on the transition date. Management
sought to minimize this transition adjustment, in part to
minimize the appearance of volatility on its balance sheet, as
well as to shift derivative gains into future periods and
recognize them gradually into income.
To maintain Freddie Mac's image as a smooth and steady
earnings machine, never perturbed by changes in interest rates,
mortgage volumes, or other economic factors, it is now clear
that management went to extraordinary lengths to transact
around FAS 133, and at times failed to comply with GAAP. One
example of this was the ``Coupon Trade-Up Giant'' transaction,
referred to in our report as a ``CTUG.''
The purpose of the CTUG transaction was to move securities
with embedded losses from the held-to-maturity portfolio to the
trading portfolio and then into the available for sale
portfolio. Management wanted the benefit of having its
securities in a trading account but only for enough time to
realize a loss and offset its derivative gains.
The CTUG transaction was a transaction with little or no
economic substance that Freddie Mac manufactured in order to
obtain a particular accounting result. Indeed, the economic
aspects of the deal were negative when one considers the
operational hazards created by the transaction which compounded
Freddie Mac's accounting and control weaknesses.
The report of special examination also detailed the use of
a dubious method by Freddie Mac to value its swaptions
portfolio in a way that minimized its derivatives gain. The
report describes how the head of Freddie Mac's Market Risk
Oversight unit worked with Freddie Mac's derivatives desk to
reverse-engineer a lower value for its swaptions portfolio. The
revised swaption valuation method contributed to a $730 million
misstatement of the 2001 financial results of Freddie Mac.
This is illustrative of the culture at Freddie Mac at that
time and highlights the willingness of all levels of management
to disguise earnings.
The FAS 133 transition was not the only episode of improper
earnings management activities. In January 2001, the shape of
the yield curve began to change dramatically in favor of
Freddie Mac which resulted in the windfall of net interest
income for the enterprise. In order to shift some of this
windfall from 2001 into the future, management executed the
first of several interest rate swap transactions that were
referred to in the report as linked swaps. Each pair of swaps
substantially offset each other and was virtually riskless for
Freddie Mac and their counterparts. The link swaps moved
approximately $450 million in operating earnings from 2001 into
future years.
The compensation of senior executives of Freddie Mac,
particularly compensation tied to earnings per share also
contributed to the improper accounting and management practices
of the enterprise. The size of the bonus pool for senior
executives was linked, in part, to meeting or exceeding annual
specified earnings per share targets. While not tied directly
to smoothing earnings growth, actions shifting earnings from
one quarter to future periods helped ensure that earnings per
share goals and consequently the bonuses based upon them would
be achieved in the future.
In some instances, Freddie Mac knowingly circumvented
prevailing public disclosure standards in order to conceal
particular policies and specific capital market and accounting
transactions. A disdain for appropriate disclosure standards,
despite oft-stated management assertions to the contrary,
misled investors and undermined market awareness of the true
financial condition of the enterprise.
Within Freddie Mac, no one took responsibility for public
disclosures. Failure to assign responsibility and
accountability for disclosure to an internal division
contributed directly to inaccurate corporate and financial
reporting. Such a lack of assigned responsibility reflected the
low regard executive management held for that function.
For the most part, the same long-tenured shareholder-
elected directors oversaw the same CEO, COO, and General
Counsel of Freddie Mac from 1990 to 2003. The non-executive
directors became complacent and allowed past performance of
those officers to color their oversight. The oversight
exercised by the Board might have been more vigorous if there
had been a regular turnover of shareholder-elected directors or
if directors had not expected to continue to serve on the board
until the mandatory retirement age or beyond.
The management of a corporation is responsible for
maintaining a control environment that will, among other
things, accurately record transactions to provide for published
financial statements that are consistent with the true
financial condition of the firm. In that regard, the obsession
of Freddie Mac with steady, stable growth in earnings was at
the expense of proper accounting policies and strong accounting
controls. Weaknesses in the staffing, skills and resources in
the Corporate Accounting Department of the enterprise led to
weak or nonexistent accounting policies, an over reliance on
the external auditor, weak accounting controls and an over
reliance on manual systems.
A thorough review and update of accounting policies had not
occurred in over 12 years. Freddie Mac's accounting errors
during this time period were pervasive and persistent occurring
in more than 30 different accounting issue groups. The
weaknesses in accounting policies created an environment that
allowed for and even encouraged transacting around GAAP. These
weaknesses also encouraged an over reliance on Arthur Andersen,
the external auditor. Arthur Andersen was soon in a position of
auditing its own work.
Freddie Mac, as part of the restatement process has
reviewed over 150 accounting policies. Senior management and
the board did not establish and retain a strong internal
control system. Therefore, they could not provide reasonable
assurance that transactions were recorded as necessary to
permit preparation of the financial statements in accordance
with GAAP. As a direct result of management and the board not
addressing these weaknesses in a timely fashion, Freddie Mac
went 10 months without audited financial statements for 2002;
was forced to re-audit and restate both 2000 and 2001 financial
statements and will not be able to provide investors with
quarterly information until at least mid-2004.
An internal audit report dated December 1996 reported that
controls over the derivatives execution, administration, and
accounting processes require improvement and that further
deterioration in controls could affect the reliability of
financial reporting. Neither management, internal audit or the
external auditor addressed these weaknesses during the next 7
years.
It should be noted that inadequate documentation and
controls surrounding the accounting for derivatives were
identified as one of the six major restatement issues and
constitute the largest dollar impact of the restatement. Many
of the weaknesses discussed to date were identified by the
internal audit, but remained outstanding for a number of years.
In evaluating the role of the internal audit department,
the investigation revealed that internal audit did not fully
comply with industry standards or best practices in the areas
of competency and communication with the board and management.
By not following up quickly enough or failing to report the
failure of management to remedy major control weaknesses during
that period of the restatement, the internal audit function
increased the exposure of Freddie Mac to risk.
Based upon these findings, the examination report
recommended that OFHEO and Freddie Mac take a broad range of
actions. As a general matter, the report concluded that OFHEO
must ensure that Freddie Mac establish an adequate remediation
plan and is allocating the necessary resources to establish a
new corporate culture that rewards integrity and the acceptance
of responsibility, and that penalizes the failure to meet
appropriate standards of conduct.
There is a full discussion of these specific
recommendations in my written testimony. OFHEO's report
contains 16 recommendations that I have adopted and am moving
forward to implement. I am pleased to inform the subcommittee
that the majority of these actions have been put in place.
Of the 14 recommendations relating directly to Freddie Mac,
a consent order has applied 11 of these recommendations. I am
now moving within OFHEO on the remaining three. The consent
order entered into on December 9th with Freddie Mac expands on
the recommendations of the report.
The Board of Directors is reviewing the company's bylaws,
codes of conduct and employee training to ensure that changes
are made to avoid problems that were discovered in the course
of the investigation. The Board will review and recommend
changes to its committee structure to meet its oversight
obligations including risk and internal controls that were
issues in the accounting area.
The Board and senior management must be briefed not less
than annually under legal and regulatory responsibilities,
including a meeting with OFHEO personnel.
Freddie Mac is developing with OFHEO oversight, a program
to revise its management culture to give equal weight to
compliance and operational stability alongside other corporate
goals. This includes executive compensation that contributed to
the accounting failures.
The enterprise will have a consultant review its accounting
and financial reporting changes and communicate to OFHEO on
this and improvements to internal controls. The enterprise must
act to improve its internal audit function and internal
accounting.
As to specific unique transactions that did not have a
business purpose, the enterprise will assure that a valid
business purpose exists for transactions and that they are
documented under GAAP.
Finally, the Board must report quarterly on progress in
meeting the requirements of the consent order and our staff and
Freddie Mac's management, I can assure, are meeting on a much
more frequent basis than that.
Overall, I believe that Freddie Mac has been subject to a
rigorous corrective plan by OFHEO and one that establishes
accounting as a central point of concern. Freddie Mac has
engaged with OFHEO actively and has been operating in a manner
that is satisfactory to OFHEO in working through these remedial
steps.
Mr. Chairman, that concludes my prepared remarks and I am
pleased to answer any questions that you or other members of
the subcommittee may have.
[The prepared statement of Hon. Armando Falcon, Jr.
follows:]
Prepared Statement of Hon. Armando Falcon, Jr., Director, OFHEO
Mr. Chairman, Ranking Member Schakowsky, and Members of the
Subcommittee, I appreciate the opportunity to discuss with you OFHEO's
Report of the Special Examination of Freddie Mac. My prepared testimony
will summarize the key findings and conclusions of the report, focusing
largely on the accounting issues, and I request that the Committee
include it as well as the full text of the report in the record. My
testimony expresses my own views and not necessarily those of the
President or the Secretary of Housing and Urban Development.
Mr. Chairman, OFHEO is an independent agency, chartered by Congress
in 1992 and funded by assessments on the government sponsored
enterprises it supervises, Fannie Mae and Freddie Mac. OFHEO's mission
is to ensure the safe and sound operation of the Enterprises. As do
other safety and soundness regulators, OFHEO employs a full range of
supervisory and enforcement tools including examinations, capital
standards, and prompt corrective action procedures.
A year ago, Freddie Mac announced that completion of its 2002
financial audit would be delayed and that earlier periods would be
reaudited. A switch in external auditors--from Arthur Andersen to
PricewaterhouseCoopers--had triggered a reevaluation of Freddie Mac's
accounting policies, especially those relating to hedge accounting
treatments for derivatives occasioned by implementation of FAS 133.
However, the reaudit and restatement process itself raised questions
beyond merely the choice of accounting policies.
On June 7, as Freddie Mac prepared to announce the abrupt departure
of three of its principal officers, I ordered a special examination of
the conditions and activities that led to the accounting failures and
management changes.
Although some aspects of the special examination are not yet
complete, the bulk of the work was finished this past fall. OFHEO
issued a report of the examination containing the findings and
conclusions, along with appropriate recommendations, in December.
Since the early 1990s Freddie Mac promoted itself to investors as
``Steady Freddie,'' a company of strong and steady growth in profits,
and developed a corporate culture that placed a very high priority on
achieving such results. The special examination showed that, to do so,
Freddie Mac used means that failed to meet its obligations to
investors, regulators and the public. The company employed a variety of
techniques ranging from improper reserve accounts to complex derivative
transactions to push earnings into future periods and meet earnings
expectations. Freddie Mac cast aside accounting rules, internal
controls, disclosure standards, and the public trust in the pursuit of
steady earnings growth. The conduct and intentions of the Enterprise
were hidden and were revealed only by a chain of events that began when
Freddie Mac changed auditors in 2002.
improper management of earnings
The Report of the Special Examination of Freddie Mac reveals how
Freddie Mac manipulated its reported earnings and disclosed other
financial information in a misleading way in 1999 through 2002. The
Report provides a chronology of relevant events, reviews the strategies
that Freddie Mac employed to manipulate earnings, and indicates that
the Board was made aware of transactions whose sole purpose was to
shift income. The Report also shows how the executive compensation
program of Freddie Mac, particularly compensation tied to earnings per
share, influenced accounting and management practices during that
period.
In the period covered by the special examination, senior management
at Freddie Mac placed an inordinate emphasis on achieving steady,
stable growth in earnings per share.
Freddie Mac adopted the goal of steady earnings growth in the early
1990s after some investors told management that the Enterprise needed
to communicate clear and simple messages that the public could easily
understand. Fifteen to sixteen percent earnings growth, or ``mid-teens
earnings growth,'' was the simple message that management began to
communicate. That goal was fairly easy when Freddie Mac was primarily a
securitizer of mortgages. However, as the retained mortgage portfolio
of the Enterprise grew and its earnings became more sensitive to
interest rates, steady mid-teens growth became a more challenging goal.
On January 1, 2001, Freddie Mac, along with other financial
institutions, was required to implement FAS 133, Accounting for
Derivative Instruments and Hedging Activities. Given the large size of
Freddie Mac's derivatives portfolio, FAS 133 presented management with
many operational challenges relating to systems, documentation, and
accounting infrastructure. However, in addition to the operational
challenges, FAS 133 was problematic to Freddie Mac with respect to
steady earnings. Specifically, FAS 133 required management to record a
transition adjustment based upon any embedded gain or loss in its
derivatives portfolio upon adoption of the standard. Freddie Mac's
derivatives portfolio, in particular its portfolio of interest-rate
swaptions, had substantial gains that had to be recognized on the
transition date. Management sought to minimize this transition
adjustment, in part to minimize the appearance of volatility on its
balance sheet, as well as to shift derivative gains into future periods
and recognize them gradually into income.
To maintain Freddie Mac's image as a smooth and steady earnings
machine, never perturbed by changes in interest rates, mortgage
volumes, or other economic factors, it is now clear that management
went to extraordinary lengths to transact around FAS 133, and at times
failed to comply with GAAP. One example of this was the ``Coupon Trade-
Up Giant'' transaction, referred to in the Report as ``CTUG.'' The
purpose of the CTUG transaction was to move securities with embedded
losses from the held-to-maturity portfolio (where losses are
unrecognized) to the trading portfolio (where losses would be
immediately recognized in net income and would offset derivative
gains), and then into available-for-sale portfolio (where securities
gains and losses only hit ``other comprehensive income,'' not ``net
income''). The last step was accomplished with the help of Salomon
Smith Barney Holdings, which is now part of Citigroup, and involved
combining $30 billion in mortgage-backed securities into four ``Giant''
securities. Management wanted the benefit of having its securities in a
trading account but only for enough time to realize a loss and offset
its derivative gains.
However, the transfer to the available-for-sale portfolio was
unwound during Freddie Mac's re-audit in 2003. In addition to numerous
operational problems caused by trying to move $30 billion in mortgage-
backed securities in a short period of time, and the fact that Salomon
Smith Barney only took possession of the securities for a few hours
before shipping them back to Freddie Mac, a reaudit ultimately
concluded that the classification from Trading to Available-for-Sale
should not have been permitted. Transfers into or from the trading
category should be rare, and ``rare'' is generally interpreted to mean
``never'' both in practice and by the SEC. The first transfer to
trading was permissible under FAS 133 transition values, but not the
second transfer. That transfer would have required substantive trades.
However, Freddie Mac did not obtain a legal true sale opinion on these
transactions. CTUG was a transaction with little or no economic
substance that Freddie Mac manufactured to obtain a particular
accounting result. Indeed, the economic aspects of the deal were
negative when one considers the operational hazards created by the
transaction, which compounded Freddie Mac's accounting and control
weaknesses.
The Report of Special Examination also detailed the use of a
dubious method used by Freddie Mac to value its swaption portfolio in
order to minimize its derivatives gain at the time of the FAS 133
transition. The Report describes how the head of Freddie Mac Market
Risk Oversight unit worked with Freddie Mac's derivatives desk to
reverse-engineer a justification for a lower value for the swaptions
portfolio. The revised swaption valuation method contributed to a $730
million misstatement of the 2001 financial results of Freddie Mac. The
fact that the head of Market Risk Oversight worked hand-in-glove with a
unit he was responsible for overseeing to craft a dubious valuation
methodology is illustrative of the culture at Freddie Mac at that time
and highlights the willingness at all levels of management to disguise
earnings.
The FAS 133 transition was not the only episode of improper
earnings management activities. For example, in January 2001, the shape
of the yield curve began to change dramatically in favor of Freddie
Mac, as the Federal Reserve began to lower its target for the Fed funds
rate, which resulted in a much steeper yield curve and a windfall of
net interest income for the Enterprise. This windfall was made larger
by derivative positions put in place at the end of 2000 that benefited
from the steeper yield curve. In order to shift some of this windfall
from 2001 into the future, management executed the first of several
interest-rate swap transactions that are referred to in the Report as
the ``linked swaps.'' The terms of each pair of swaps substantially
offset each other and were virtually riskless for Freddie Mac and their
counterparties. The swaps also had little effect on GAAP income but the
negative cash flow from the first swaps in each pair was reflected in
operating earnings, a non-GAAP metric that Freddie Mac highlighted for
the investing public. The linked swaps, in aggregate, moved
approximately $450 million in operating earnings from 2001 into later
years. Handwritten notes from Freddie Mac's Board meeting in September
2001 show that management informed the Board that derivatives were
being used to shift income.
Other earnings management techniques involved keeping the level of
loan loss reserves higher than allowed by GAAP, and maintaining a
reserve account to cushion fluctuations in premiums and discounts
resulting from mortgage prepayments. That reserve, known at Freddie Mac
as the FAS 91 reserve, was not allowed by GAAP, but Freddie Mac's
outside auditor, Arthur Andersen, chose to look past it. When Arthur
Andersen began receiving negative publicity in late 2001 and early 2002
for its work with Enron, the Chief Operating Officer of Freddie Mac
resisted pressure from the Board to change auditors, since he was aware
that hiring new auditors could result in increased ``restatement
risk.'' Ultimately, the Board insisted on hiring new auditors, and his
fears of restatement were realized.
executive compensation
The compensation of senior executives of Freddie Mac, particularly
compensation tied to earnings per share, also contributed to the
improper accounting and management practices of the Enterprise. The
size of the bonus pool for senior executives was tied, in part, to
meeting or exceeding annual specified earnings per share targets. While
not tied directly to smoothing earnings growth, actions shifting
earnings from one quarter to future periods helped ensure that earnings
per share goals, and consequently the bonuses based upon them, would be
achieved in the future.
disclosure
In some instances, Freddie Mac knowingly circumvented prevailing
public disclosure standards in order to obfuscate particular policies
and specific capital market and accounting transactions. A disdain for
appropriate disclosure standards, despite oft-stated management
assertions to the contrary, misled investors and undermined market
awareness of the true financial condition of the Enterprise.
Within Freddie Mac, no one took responsibility for public
disclosures. Failure to assign responsibility and accountability for
disclosure to an internal division contributed directly to inaccurate
corporate and financial reporting. Such a lack of assigned
responsibility reflected the low regard executive management had for
that function.
board of directors
For the most part, the same long-tenured shareholder-elected
Directors oversaw the same CEO, COO, and General Counsel of Freddie Mac
from 1990 to 2003. The non-executive Directors allowed the past
performance of those officers to color their oversight. Directors
should have asked more questions, pressed harder for resolution of
issues, and not automatically accepted the rationale of management for
the length of time needed to address identified weaknesses and
problems. The oversight exercised by the Board might have been more
vigorous if there had been a regular turnover of shareholder-elected
Directors or if Directors had not expected to continue to serve on the
Board until the mandatory retirement age or beyond. Conversely, the
service periods of the presidentially appointed Directors are far too
short, averaging just over 14 months, for them to play a meaningful
role on the Board.
weak accounting, auditing and internal controls
The management of a corporation is responsible for maintaining a
control environment that will, among other things, accurately record
transactions to provide for published financial statements that are
consistent with the true financial condition of the firm. In that
regard, the obsession of Freddie Mac with steady, stable growth in
earnings was at the expense of proper accounting policies and strong
accounting controls. Weaknesses in the staffing, skills, and resources
in the Corporate Accounting Department of the Enterprise led to weak or
nonexistent accounting policies, an over reliance on the external
auditor, weak accounting controls, and an over reliance on manual
systems. Given the size of the company and its role in the housing
finance and capital markets, those weaknesses effectively increased the
systemic risk posed by the Enterprise.
accounting personnel and expertise
The staffing levels and experience in the financial accounting
reporting functions were insufficient throughout the restatement
periods. The key finance functions over this period were unbalanced
with major gaps either left unfilled or filled with interim personnel
with inadequate skills. This shortage of staff and experience caused
key person dependencies in crucial control areas. The need for skill
and experience is heightened when the process is complex, as is the
derivatives and securitization accounting process at Freddie Mac. Many
of the strategies and transactions during this period were not GAAP
compliant; therefore, Freddie Mac was faced with one of the largest
restatements in corporate history.
The primary responsibility for an entity's financial statements
rests with management. Part of that responsibility is to assure that
staffing levels in financial accounting are sufficient to support a
control environment within the financial reporting process to ensure
that significant errors are either prevented or detected at an early
stage. Senior management and the Board failed to provide adequate
resources to the corporate accounting function even though they were
being continuously told about the weaknesses.
Senior management simply ignored warning signs about problems in
Corporate Accounting and/or did not consider the problems important
enough to provide adequate supervision, funding and or insist on a
timely resolution. The lack of attention to staffing, skill set and
resources led to weak or non-existent accounting policies, weak
accounting controls, over reliance on manual systems and over reliance
on the external auditor. Each of these areas will be discussed in turn.
accounting policies
A thorough review and update of accounting policies had not
occurred at Freddie Mac in over twelve years. Accounting policies
should be researched and documented regularly to assure proper
accounting treatment of existing and new business transactions. They
should be used as a mechanism to keep employees informed of how to
account for new and recurring transactions. Many of the transactions
and policies that have been investigated at Freddie Mac did not have
established accounting policy guidance and/or the policies in place
were outdated, insufficient or incorrect, leading to misapplication of
GAAP and, ultimately, to the need to reaudit and restate its financial
statements.
Freddie Mac's accounting errors during this time period had been
pervasive and persistent; occurring in more than 30 different
accounting issue groups. The weaknesses in accounting policies created
an environment that allowed for and even encouraged transacting around
GAAP. These weaknesses also encouraged an over reliance on Arthur
Andersen, the external auditor, a situation which led to questions as
to auditor independence.
Management used the weak accounting policy group and the non-
existent process surrounding the setting of accounting policies to
justify accounting practices after transactions had taken place rather
than allowing the group to set ``best practice''. Freddie Mac, as part
of the restatement process, has rewritten and/or reviewed 150
accounting policies.
over reliance on arthur andersen
Freddie Mac's shortage of accounting staff, inadequate expertise
and weak or non-existent accounting policies led to an environment that
encouraged reliance on the external auditors for basic accounting
functions and decisions. This dependency led to the external auditor
acting in a first-line management capacity, taking part in day-to-day
operations, and, to an extent, and auditing its own work.
In 2001, Arthur Andersen received $1 million for its audit work and
$3.7 million for its consulting fees, of which $1.5 million related to
FAS 133 consulting. OFHEO believes that Arthur Andersen's independence
as an auditor may have been compromised by the size of the consulting
fees compared to the fees charged for the audit work.
SEC requirements for independence of auditors are clear that in
day-to-day operations of the business, external auditors may not
function as management or as an employee of its audit client. Arthur
Andersen appears to have disregarded this principle by counseling the
company on issues ranging from FAS 133 implementation to accounting
affects of new products. The many organizational changes in the
accounting department heads, especially at the controller position, led
to the accounting staff heavily relying on Arthur Andersen.
In this regard, evidence supports the conclusion that Arthur
Andersen was participating in day-to-day decisions and often acting as
an employee or in a management capacity. They also performed extensive
consulting work that may have led them to use extreme and sometimes
unsupportable assumptions to support specific transactions. Couple this
with an environment where management often negotiated accounting
decisions and in some cases went as far as suggesting a change in
auditors if desired results were not achieved, and the result is an
environment which can compromise the auditor's independence.
There are also indicators that the Board was comfortable relying
completely on the external auditor for accounting expertise. This
contradicts current accounting literature, which holds management
accountable for the accuracy of their financial statements.
accounting controls
Senior management and the Board did not establish and maintain a
strong internal control system. Therefore, they could not provide
reasonable assurance that transactions were recorded as necessary to
permit preparation of financial statements in accordance with GAAP. As
a direct result of management and the Board not addressing these
weaknesses in a timely fashion, Freddie Mac went ten months without
audited financial statements for 2002, was forced to reaudit and
restate both 2000 and 2001 financial statements, and will not be able
to provide investors with current quarterly information during 2004.
As noted previously, staffing levels and expertise in the financial
accounting area have been insufficient since at least 1998. It has also
been demonstrated that the enterprise operated from 1991 to 2003 with
non-existent or outdated accounting policies and manuals. Add to this
insufficient controls over the financial reporting process such as
system and data integrity issues in debt and derivatives accounting,
account reconciliation issues, an ineffective process to react promptly
to new transactions, and a labor intensive close-out process and you
have an environment that will not only allow errors but will most
likely result in material misstatements in the financial reporting
process. Discussed below are some of the weaknesses in controls that
existed during the restatement period.
derivatives
In an internal audit report dated December 1996, the General
Auditor reported that controls over the derivatives execution,
administration, and accounting processes require improvement and that
further deterioration in controls could prevent objectives relating to
the effectiveness and efficiency of operations and the reliability of
financial reporting from being achieved.
Management through their internal self-assessment process also
identified these same weaknesses. Weaknesses within the derivative area
continued to be identified, but not addressed by management, internal
audit, or the external auditor during the next seven years. The latest
internal audit report stated that inadequate documentation of hedge
effectiveness and other required information could disqualify the use
of favorable FAS 133 accounting treatment. The report also stated that
procedures for derivatives accounting processes, including
documentation, effectiveness testing, quality control, analysis, and
management review, need improvement to ensure compliance with hedge
accounting standards. Significant functional limitations in the
derivatives accounting systems create an elevated risk of material
operational error. It should be noted that inadequate documentation and
controls surrounding the accounting for derivatives were identified as
one of the six major restatement issues and constitute the largest
dollar impact of the restatement.
reconciliations
General ledger account reconciliations are a key internal control
necessary/used to provide reasonable assurance that the corporation's
financial statements fairly present its financial position and results
of operations. Not reconciling general ledger accounts dramatically
increases the risk that financial reports will not be accurate. The
issue regarding reconciliation was brought to management's attention as
early as 1995. At that time Internal Audit reported that corporate
accounting was not effectively monitoring account reconciliations
performed by the decentralized account unit.
Internal Audit again identified reconciliation weaknesses in their
1998 audit. And in 1998 and 1999 Arthur Andersen addressed the issues
regarding reconciliation and data integrity in its management letters.
In fact, in 1998 Arthur Andersen said that guidance should be provided
for the timely and consistent reconciliation of data to the general
ledger and other approved sources of data. Reconciliation issues were
still outstanding in 2002.
internal audit function
Many of the weaknesses discussed to date were identified by
Internal Audit but remained outstanding for a number of years. In
evaluating the role of the Internal Audit Department the investigation
revealed that Internal Audit did not fully comply with industry
standards or best practices in the areas of competency and
communication with the Board and Management.
Best practices do not require internal auditors to conduct
financial audits, but the Internal Audit Department of Freddie Mac
should have policies and procedures in place to address its obligation
to evaluate risk exposure relative to the reliability and integrity of
the financial information of the Enterprise. Given the volume and wide
range of accounting errors made by Freddie Mac, the conclusion of the
Internal Audit Department that financial accounting and reporting
controls were marginal was a substantial overstatement of their
quality.
Internal auditors should review operations and programs to
ascertain the extent to which results are consistent with established
goals and objectives to determine whether operations and programs are
being implemented or performed as intended. A review of relevant
internal audit reports noted several instances where major control
weaknesses identified as early as 1998 remain unresolved five years
later. In many of these instances, internal audit identified major
control weakness and set agreed upon actions as well as target
completion dates. However, the completion dates of the corrective
actions were repeatedly extended. As a result, each of the issues
remained outstanding.
By not following up quickly enough or failing to report the failure
of management to remedy major control weakness during the period of the
restatement, the internal audit function increased the exposure of
Freddie Mac to risk.
The Internal Audit Department of Freddie Mac did not accept
responsibility for the reliability and integrity of the financial
information of the Enterprise, did not follow-up effectively on
identified deficiencies, and did not communicate effectively with
management and the Board. In combination, the weaknesses in Corporate
Accounting, the Internal Audit Department, and questionable
independence of the external auditor meant that there were weak points
at each major control juncture at Freddie Mac.
conclusion
Weaknesses in the Corporate Accounting area with respect to
staffing, skill set, and resources led to weak or non existent
accounting policies, an over reliance on the external auditors, weak
accounting controls and an over reliance on manual systems. Couple this
with a weak internal audit department that did not accept
responsibility for the reliability and integrity of financial
information, did not maintain effective controls over the review and
follow-up of audit findings and you have an environment with weak
points at each major control juncture.
This weak control environment provided the opportunity for
management to promote an attitude that GAAP was something to be
transacted around. In this regard, the attention of management on
meeting analyst's expectations at the expense of proper accounting
policies and strong accounting controls lead to aggressive accounting
and concurrently resulted in the restatement and reaudit. Management
and the Board continually ignored their responsibility for adopting
sound accounting policies, establishing and maintaining a strong
internal control system to assure that financial statements were
prepared in accordance with GAAP. The Board appeared to be operating
under the misconception that as long as the external accounting firm
signed off on a policy or transaction that management's responsibility
was fulfilled.
Management and the Board must accept full responsibility for the
Company's financial statements. The auditor's responsibility is to
express an opinion on the financial statements. It is management's
responsibility to adopt sound accounting policies and to establish and
maintain an internal control environment that among other things will
ensure the effectiveness of the accounting and financial reporting
processes. Freddie Mac's Senior Management and Board did not live up to
these responsibilities during this timeframe.
recommendations
The examination report recommended that OFHEO and Freddie Mac take
a broad range of actions. I agree with the recommendations and we are
moving to implement them. As a general matter, the report concluded
that OFHEO must ensure that Freddie Mac has established an adequate
remediation plan and is allocating the necessary resources to establish
a new corporate culture that rewards integrity and the acceptance of
responsibility, and that penalizes failure to meet appropriate
standards of conduct.
The report also detailed a number of specific actions. To improve
the effectiveness of the Board of Directors, Freddie Mac should
separate the functions of the Chief Executive Officer and the Chairman
of the Board, impose strict term limits on Directors, and require that
the Board meet more frequently.
To address Freddie Mac's general neglect of operations risks and
compliance issues, the report recommends that Freddie Mac establish a
formal compliance provision and a position of Chief Risk Officer,
reporting directly to the CEO, with explicit responsibility for
operations risk, as well as credit and market risk. In addition,
Freddie Mac's Internal Audit Department needs to be strengthened so
that it can play a more effective role.
To address accounting weaknesses, Freddie Mac will review all
accounting and financial reporting changes and communicate this to
OFHEO. The enterprise must also act to improve its internal audit and
accounting functions. The report also recommends that OFHEO consider
requiring a periodic change of external audit firms. Freddie Mac needs
to establish and maintain superior accounting controls and prevent
undue reliance on its external auditor. It must also document the
legitimate business purpose of every significant business transaction.
To address inappropriate managerial incentives, the report
recommended that Freddie Mac refocus its compensation program more on
long-term goals, not on short-term earnings.
Until remediation efforts have taken full effect, Freddie Mac
remains exposed to substantial management and operations risk. The
report recommends that OFHEO consider addressing this concern by
requiring Freddie Mac to hold significant regulatory capital surpluses,
at least until it can produce timely and GAAP--consistent financial
reports.
Finally, the report recommends that OFHEO take three additional
steps to reduce the possibility of future Enterprise difficulties.
First, OFHEO should implement regulations that provide for mandatory
disclosure, similar to that required of SEC-registered companies, if
Congress does not repeal the exemptions of the Enterprises from
securities law. Second, OFHEO should expand its capacity to detect and
investigate misconduct by including more substantive tests of the
internal control frameworks at the Enterprises, including procedures to
identify pressures to commit fraud and opportunities to carry it out.
Third, OFHEO should conduct a special examination of the accounting
practices of Fannie Mae.
ofheo actions
Mr. Chairman, I am pleased to inform the subcommittee that the
majority of these actions have been put in place. Of the 14
recommendations relating directly to Freddie Mac, a consent order has
applied 11 of these recommendations, while I am moving now within OFHEO
on the remaining three.
The consent order entered into on December 9th with Freddie Mac
expands on the recommendations of the report and Freddie Mac has
initiated a compliance program with the consent order that OFHEO is not
only monitoring but working with the management to see that it moves
along promptly.
Key provisions for accounting matters and related matters are as
follows:
The Board of Directors is reviewing the company's bylaws, code of
conduct and employee training to assure that changes are made that will
support an environment to avoid problems that were discovered in the
course of the investigation. The Board will review and recommend
changes to its committee structure to meet its oversight obligations
including operations risk and internal controls that were issues in the
accounting area. The Board and senior management must be briefed not
less than annually on their legal and regulatory responsibilities; this
includes no less than annually a meeting with OFHEO personnel.
Freddie Mac is developing, with OFHEO oversight, a program to
revise its management culture to give equal weight to compliance and
operational stability along side other corporate goals; this includes
executive compensation that contributed to the accounting failures.
The Enterprise will have a consultant review its accounting and
financial reporting changes and communicate to OFHEO on this and
improvements to internal controls. The Enterprise must act to improve
its internal audit function and internal accounting.
As to specific unique transactions that did not have a business
purpose, the Enterprise will assure that a valid business purpose
exists for transactions and that they are documented under GAAP.
Finally, the Board must report quarterly on progress in meeting the
requirements of the consent order and our staff and Freddie's
management, I can assure you, are meeting on a much more frequent basis
than that.
Overall, I believe that Freddie Mac has been subject to a rigorous
corrective plan by OFHEO and one that establishes accounting as a
central point of concern. Freddie has engaged with OFHEO actively and
has been operating in a manner that is satisfactory to OFHEO in working
through these remedial steps.
That concludes my prepared remarks. I am pleased to answer any
questions that you and Members of the Committee may have.
Mr. Stearns. Mr. Falcon, thank you very much. Does your
associate, Ms. DeLeo, do you have anything that you would like
to say?
Ms. DeLeo. I have no prepared statement.
Mr. Stearns. No prepared statement, okay. I'll start with
the opening questions.
In your statement, as well as in members' here, words like
manipulated, misled, scandal, scheme, deception, disguised
earnings, circumvented, undermanned, undermined, market
awareness, pervasive, these are the terms that have been used.
Freddie Mac's problems were discovered by the board of
directors, as I understand. Is that correct?
Mr. Falcon. This all was uncovered initially as a result in
a change in external auditors by the company.
Mr. Stearns. Mr. Falcon, since your job is oversight, why
didn't your office detect it first, since you had a fiduciary
responsibility, as the oversight for the government, why
wouldn't your office detect it, identify this problem in your
normal accounting and oversight?
Mr. Falcon. That's a fair question, Mr. Chairman. We were
aware of these transactions, but we weren't aware of the
accounting for these transactions. These transactions,
generally, did not pose additional risk to the company from a
safety and soundness perspective. We would have prevented them
from entering into them had we understood the purpose of these
transactions.
So we're familiar with them from a risk management
standpoint, but the accounting for these transactions is really
what's at issue here.
Mr. Stearns. Do you think your office has enough people,
enough expertise to identify these problems?
If you were going to say to someone today, by golly, this
is what I want, so this won't happen again, what would you say?
Mr. Falcon. I think what's required on the part of OFHEO,
Mr. Chairman, is additional resources and expertise, not just
across the board, but more specifically in the accounting area.
Safety and soundness regulators generally do not secondarily
certify that the financial statements----
Mr. Stearns. Only the accountant?
Mr. Falcon. Right, only the external auditor does that.
Mr. Stearns. So really your office could never detect this
kind of mismanagement, misled, schemes, scandals, all these
things. Your office could never have detected this?
Mr. Falcon. We weren't equipped to----
Mr. Stearns. You weren't equipped to detect this.
Mr. Falcon. [continuing] this kind of accounting
misconduct.
Mr. Stearns. Okay.
Mr. Falcon. May I add, we are working to bring this
expertise on board in the agency beginning with the creation of
an office of chief accountants which Ms. DeLeo----
Mr. Stearns. I'm just trying to understand how it occurred
and I'm trying--my next question goes to what our jurisdiction
is which is FASB.
Do you think FASB has to change its ``mixed attribute''
accounting rule? Because as a taxpayer, all of Americans cannot
take their income and segment it. Say I'll report half of this
$50,000 this year and the other $30,000 at a later year, when I
have a low income, so then I don't have to pay taxes on $80,000
or $60,000 or $50,000. I'll just show a very small percentage
of this income this year and then I'll show it next year or 2
years. I'm not sure when, so that I don't have to pay the
taxes. That could put you in jail as a taxpayer.
Yet, our corporations, and I understand what's being done
by Freddie Mac is pretty much done throughout all of the
corporations. Is that your understanding that most other
corporations do the same thing that Freddie Mac--so Freddie Mac
is not alone on this?
It's difficult for you to answer that.
Mr. Falcon. Right.
Mr. Stearns. But I'm just saying what I hear. But let's
forget that for the moment, but should the rules at FASB be
changed to prevent corporations, Freddie Mac, from segmenting
and mixing their assets so that they don't have to pay and show
in a timely fashion these revenues?
Mr. Falcon. I certainly think with respect to Freddie Mac,
the accounting standards were clear to the company, but what we
saw was a disregard for the accounting standards and the
entering of transactions to shift earnings. Now with respect to
the general issue about the accounting standards which you
mentioned, I'm not prepared to answer that question, but I
think Ms. DeLeo can elaborate on that for you.
Mr. Stearns. Sure. I need somebody who is familiar with
this to say FASB's accounting standards are not working. Is
that true?
Ms. DeLeo. I think we would probably all agree that there
are flaws in the current accounting standards that are out
there.
Mr. Stearns. So the accounting standards from FASB are
flawed in this area?
Ms. DeLeo. Let me preface that. In that regard they are
moving with their financial instrument, their fair value
financial instrument in that area and I think that will
certainly help.
Mr. Stearns. Not solved, but help.
Ms. DeLeo. But help, exactly. But the root causes of what
we saw at Freddie Mac were not the existing accounting
standards. It was the inability to implement and apply those
standards correctly that created these problems.
Mr. Stearns. The Doty report indicated that one of the main
activities of the head of the financial engineering was to find
and exploit anomalies, irregularities in GAAP. Now how do we
stop that? I mean tell me what is Freddie Mac's department of
financial engineering? I understand what the finance department
is. What's financial engineering in your estimation?
Ms. DeLeo. May I address the first part of your question?
Mr. Stearns. Sure, absolutely, yes.
Ms. DeLeo. I think what we normally would have seen in a
corporation is three areas, a strong internal accounting group,
a strong internal audit staff and external auditors. What we
found at Freddie was weaknesses in all of those areas, so when
that existed you're going to have a situation where you're
going to have misapplications of GAAP.
Mr. Stearns. Okay, is financial engineering a department,
generally, that's okay? It sounds like a financial engineering
department is one to exploit and--find and exploit anomalies in
GAAP.
Ms. DeLeo. Well, that particular department was, I guess
that name is a misnomer, but had you had a strong accounting--
--
Mr. Stearns. You wouldn't need a financial engineer.
Ms. DeLeo. And they would have prevented or turned down
anything that that group was working on that would have
misapplied GAAP.
Mr. Stearns. Fannie Mae is also under your jurisdiction,
Mr. Falcon.
Mr. Falcon. Yes.
Mr. Stearns. And are you saying here today that there's no
problems in the GAAP accounting compliance in that corporation
too today?
Mr. Falcon. I'm not prepared to say that at this moment. We
do not, as I said, secondarily, review accounting statements
for compliance for GAAP and so we are about to undertake an
extensive review of Fannie Mae to determine and make sure that
there aren't any problems at Fannie Mae.
Mr. Stearns. My time has expired.
Ms. Schakowsky. Thank you, Mr. Chairman. I appreciate your
good questions, too. I was going to start really the same way.
This is a scathing statement that you made. Some of the
language is pretty harsh in here, rightfully so, I think, but
obfuscate particular policies, disdain for appropriate
disclosure standards, misled investors, low regard for
disclosure, obsession with steady stable growth and earnings at
the expense of proper accounting policies and strong accounting
controls, weak or nonexistent accounting policies and on and
on.
It really led me to think really the same question. Since,
as I understand OFHEO, you employ ``a full range of supervisory
and enforcement tools including examination, capital standards
and prompt corrective action procedures.'' Is it simply just
the lack of expertise or is it that in the past you have not
been looking for the thing, since safety and soundness wasn't a
concern that you weren't looking at all for the things that we
have subsequently have been discovered?
Mr. Falcon. This accounting misconduct is not something
that we would--you have to review their financial transactions
and how they applied GAAP to those transactions to be able to
protect against this type of conduct. And this conduct by its
very nature isn't obvious or made plain to the public,
investors or regulators. You have to go in and try to find this
type of misconduct. And with that and an accounting review by
our agency on a regular basis, we can't do that which is why
we're changing this part of our oversight program over these
two enterprises. We will begin with use of our Office of
Compliance as well as an Office of Chief Accounting to begin to
spot check and review the implementing of the accounting
standards.
Ms. Schakowsky. Now if they were forced to register with
the SEC, the SEC would do that kind of work, is that correct?
And let me just ask, and do you support legislation that would
require, since they've been so lackadaisical and to date have
not registered with the SEC.
Mr. Falcon. I think it became very clear to us,
Congresswoman, in the course of this investigation that a
system of voluntary disclosure standards is not adequate and so
I do support the repeal of the company's 1933 and 1934
exemptions.
Ms. Schakowsky. Freddie Mac has been fined $125 million. I
want to ask you, and I don't know the answer to this, is this
sufficient? I think what Americans are feeling right now is
that some of these scandals go largely unpunished that while
there is a little burst of energy at first and isn't this
terrible and a lot of finger pointing and wagging that in the
end it's maybe a slap on the wrist and that's about it.
We have a particular responsibility here. It's one thing to
talk about Enron or some private, totally private company and
isn't this awful and there should be more consequences, but
still we, because it's a GSE, have particular responsibility.
Is this sufficient so far in the way of a fine?
Mr. Falcon. You mentioned the adjectives that were in the
report and the testimony about the type of conduct they
discovered. I'm not pleased about that kind of conduct at all,
any more than you are.
As you pointed out, these are government-sponsored
enterprises. They live off of a public trust to fulfill their
mission.
Ms. Schakowsky. Exactly.
Mr. Falcon. And if that public trust is violated, then our
housing finance system is at risk which is why we are taking as
strong an action as possible. I think the fine of $125 million
was a very substantial fine, one of the largest ever imposed by
a safety and soundness regulator for misconduct. Top management
has been replaced. You'll see over the course of the next year
a turnover on the board and we are implementing a very strong
remedial plan for the company. This week, we'll decide whether
or not the company shouldn't hold additional capital pending
its compliance with the remediation plan.
Ms. Schakowsky. I thank you and thank you, Mr. Chairman.
Mr. Stearns. I thank my colleague. I would just say to her
question that I think Freddie Mac had $900 billion income and
probably had a profit of $10 billion, so $125 million is a
very, very small fee of fine and the gentleman from Arizona.
Mr. Shadegg. Thank you, Mr. Chairman. I appreciate the
questioning of my colleagues. I think you've done an excellent
job of bringing out the points. I guess I'm intrigued by Ms.
DeLeo, a comment you just made, that I think is almost
pervasive here and if I'm misreading what you intended, correct
me.
You said that it was the result of an inability to apply
the standards and I jotted down the words very quickly. I guess
I think that's a mischaracterization, because I don't think it
was an inability. I think it was a chosen intent not to apply
the standards. I don't think it was because they couldn't apply
the appropriate standards. I think they read the standards
carefully. I think they understood what the standards required.
I think they figured out how to deceive, how to get around the
standards through deception to achieve the end they wanted and
that's the course they pursued, which means the fundamental
issue for me is not are the standards appropriate and we
already concede there are some problems with the standards, but
rather, at least as I perceive it, it's not a question of
whether the standards are appropriate. Indeed, they may be
flawed to some degree.
There may be technical loopholes that shouldn't be there,
but it seems to me the issue really is what's the culture? If
the culture is you're going to set down a series of standards
for us, and we're going to look carefully at the letter of
those standards and we're going to manipulate them whatever way
we can to report what we'd like to report and still comply with
the letter of the law; if they claim they can do that, but
we'll be able to get away with doing what we wanted to do, then
I don't think the biggest problem is fixing the standards, I
think the biggest problem is changing the culture. And your
word ``inability to apply the standards'' troubles me.
Am I misperceiving? Do we see this issue differently?
Ms. DeLeo. It's where the inability is used. My comment was
in reference to the expertise in the accounting area. Freddie
did not have the proper expertise to be able to interpret and
apply those standards. That allowed individuals outside
accounting to be able to manipulate and work around that.
I do agree with your comment.
Mr. Falcon. The point is, Congressman, that the lack of a
strong internal audit function, internal accounting office in
the company, allowed those outside that office to work around
the accounting rules without there being someone internal to
police their conduct and additionally with the external
auditor, not objecting to this conduct, in fact, Arthur
Andersen was involved in day to day accounting decisions in the
company, so in essence, they were auditing their own work. The
lack of this expertise internal to the company allowed those in
the financial transactions area to just disregard accounting
standards.
Mr. Shadegg. I agree very strongly with the comments of the
Ranking Member with regard to the fact that this is unlike the
Enron scandal or other public or other private entity scandals.
This one is at our doorstep and I am deeply concerned that
absent some draconian steps, we're not going to be able to
regain the credibility of the public. And I guess you have
already said that you think the exemption from the 1933 and
1934 acts should be repealed? What other steps do you think are
necessary to regain credibility?
Mr. Falcon. I think we've recommended some very good
corporate governance reforms for the companies in our report,
Congressman. We will soon promulgate the corporate governance
rule which will implement these.
We found that there was a conflict between one individual
serving as both the Chairman of the Board and CEO of the
company. The role of the Board is to oversee the management of
the company and when you have a strong Chairman of the Board,
what we found with Freddie Mac is that that is not a best
practice and it allows that individual to sort of weaken the
Board's oversight function.
We are also going to require that the Board become more
active and meet more frequently. This company is still meeting
just four times a year and a company as sophisticated as this I
think needs a more active Board. So we are moving to implement
more corporate governance reforms.
Mr. Shadegg. Some believe that if there had not been a
change in the auditor, there wouldn't have been a restatement
and none of this would have been caught and Freddie Mac would
still be engaged in what it was doing. Do you share that view?
Mr. Falcon. That may be. Absent, our lack of resources and
expertise in this accounting area and our lack of a mission in
looking at how they applied GAAP in their financial statements,
that could be which is why we have to move in that direction,
begin to take on that responsibility.
Mr. Shadegg. So to those who say your criticism of the
entity isn't very credible because you guys didn't catch this,
your response is we didn't have the duty and we didn't have the
resources?
Mr. Falcon. Right. I'm reluctant to say something which
sounds like it wasn't our job, but in essence, the safety and
soundness of a company requires the cooperation of not just the
regulator. Management of the company has to run the company
soundly. The Board of Directors has to fulfill its obligations
and the external auditor has to do its job properly. The role
of the regulator is to try to oversee that all of those
functions are done right. Without the resources and expertise
related to the accounting area, we could not properly oversee
the work of the external auditor.
I don't think we're looking to implement a system where we
secondarily certify the financial statements. More importantly,
we need to make sure that when new accounting standards are
brought on line, like this one involving FAS 133, that we have
the capacity to make sure that the implementation of this
accounting standard is done properly and that on an on-going
basis the company is not using transactions to do anything like
shifting earnings.
Mr. Shadegg. I'm compelled to conclude by just noting, I
think it's Paul Harvey who sometimes self-government without
self-discipline won't work. It looks to me like the situation
here and the situation with the Enron problems is people who
are entrusted with responsibility, there simply isn't a big
enough army of overseers to watch them all. If their basic
motivation is deceit, then it's going to be tough.
Mr. Falcon. Right.
Mr. Shadegg. We're going to have problems with them and
it's really unfortunate because vastly expanding the regulatory
structure just means you need smarter people to get around it
and I'm not certain that's a very good answer. We need a
culture of people who say I'm not looking at the letter of the
law. I'm looking at my obligation to the people for whom the
law was intended to protect.
Mr. Chairman, I yield back the balance of my time.
Mr. Stearns. I thank the gentleman. The gentleman from
Ohio.
Mr. Strickland. No questions.
Mr. Stearns. No questions. The gentlelady from California.
Ms. Solis. Actually, just more of a comment. I too am
overwhelmed to hear all these statements being made and I would
just ask the reforms that you are proposing, do you really
believe that that's going to require a change in behavior?
Mr. Falcon. I think part of the problem has generated from,
as we said in the report, a tone at the top. And aside from all
of the additional corporate governance requirements and
statutory changes that we're requesting to strengthen
oversight, we also fundamentally need to make sure that there
is a new corporate culture that's brought about, where the tone
at the top is one of strict integrity and compliance with rules
and regulations. That's something that we are looking at very
closely and tracking very closely and so far, we're encouraged
by the new tone we're seeing by the new CEO and Chairman that
was brought into the company and the activities that the
company has taken by way of remedial reforms.
So we have to make sure that there's a new corporate
culture. Along the lines of what Mr. Shadegg said, everyone has
to fulfill their own responsibilities.
Ms. Solis. I would just add that obviously these
institutions, Fannie Mae and Freddie Mac, play an essential
role in communities like mine where we are in a phase where
we're not able to secure enough capital to provide sufficient
housing for low income and middle income families and the
integrity of these programs, obviously, are very reflective of
what we as Members of Congress support. We have different
activities, in fact, with some of these organizations in our
Districts, so that doesn't sit well for us when we have to go
home and our constituents are reading about all this
mismanagement and somewhat collusion--I hate to use that word,
but that's what it sounds like to me from reading your
testimony, that there's collusion on the part of the accounting
firms with these organizations.
We're not satisfied with that and I know there's
legislation being proposed and we're certainly going to be
monitoring that and hopefully, we're going to see that there is
more transparency made available to the public.
Mr. Falcon. I fully support that, Congresswoman.
Mr. Stearns. I thank my colleague. I was just going to ask
a couple of questions before you leave, Mr. Falcon and if
anyone else would like to ask a few additional follow-up
questions.
You issued a fine of $125 million and I think you also were
trying to get some of their stock options or some of their
compensation back. How successful have you been on that?
Mr. Falcon. We're taking an action that's pending right now
that I can't discuss too much because it's the subject of
litigation. We are moving to require that the former Chairman
of the Board and CEO, as well as the Chief Financial Officer of
the company, be terminated for cause which could result in
their losing approximately $25 million or more, in addition to
some recovery of past bonuses and other benefits they received.
Mr. Stearns. How much would that add up to? What would be
the whole package that you're asking that they return? $25
million plus bonuses, plus stock options?
Mr. Falcon. For these two individuals, I think the total
might approach possibly $32 million.
Mr. Stearns. $32 million you're asking for a return of?
Mr. Falcon. Right. In the case of another individual, the
former Vice Chairman of the company, he was terminated for
cause which resulted in his loss of substantial severance
benefits. What we're trying to do, Mr. Chairman, is set a clear
standard that if top management of a company engages in
misconduct, those individuals should be terminated for cause
and not just allowed to resign and walk away with the financial
windfall.
We're being challenged on it, but it's a principle that
we're going to continue to fight for.
Mr. Stearns. The other point I wanted to make is you gave a
fine to Freddie Mac, but the question I have, shouldn't the
people who are involved with the accounting, the engineering--
financial engineering, shouldn't some of thee people who are
not the CFO and the president and so forth, chairman of the
board, shouldn't these people also be fired in your opinion and
why haven't--have you recommended that because the people that
are at the highest level of management can set the culture, but
the people who execute the things that have led to the scandal,
shouldn't they also be terminated?
Mr. Falcon. And some of them have, Mr. Chairman, some of
them have.
Mr. Stearns. Have you recommended and identified who those
folks were?
Mr. Falcon. Yes. We've been working with the company, now
the former head of their investment at finance division which
structured many of these transactions, became the CEO of the
company. At the direction of myself, that individual has been
replaced.
Mr. Stearns. Ms. DeLeo, do you also feel that the people
who are in the sort of second tier of management should also be
eliminated and fired?
Don't you think there's culpability there as well as the
top people?
Ms. DeLeo. I think that's a decision that we have to look
at and that Freddie has to look at.
Mr. Stearns. Are you looking at that now and have you
identified those people and know what they did wrong?
Ms. DeLeo. Yes, we have been.
Mr. Stearns. Because the Doty report would indicate that
these folks were exploiting these anomalies and I think if
they're exploiting them that that's wrong and they should be
implicated too and I'm just wondering, we don't hear about the
termination of those people. Had there been many terminations
by those folks?
Mr. Falcon. There have been at least two dozen individuals,
I believe, who have faced the range of sanctions from
reprimands to loss of bonuses to termination for the company,
depending on the level of conduct that they engaged in.
Mr. Stearns. Okay. Anyone else? Yes.
Ms. Schakowsky. Thank you, Mr. Chairman. Mr. Falcon, in
your statement, you talk about executive compensation and I was
wondering--I was hoping in asking if we could get a copy of the
OFHEO study of executive compensation of Freddie and Fannie
which has been presented to the Financial Services Committee.
I understand that Fannie Mae has retained the services of
former Clinton prosecutor Ken Starr who is reportedly trying to
keep the Financial Services Committee from releasing that
report and so I am asking you if we can get a copy of that
report for the record.
[The report is retained in subcommittee files.)
Mr. Falcon. I'd be happy to provide it to you, to the
Committee, Congresswoman. The information was information on
the salary and total benefits of the senior most individuals of
the two companies. We provided it to the House Financial
Services Committee with the understanding that it is
confidential information and I believe we can provide it to you
as well.
Ms. Schakowsky. To the extent that you say that
compensation of senior executives contributed to the improper
accounting and management practices of the enterprise, I would
think that at the very least it should be provided to us, but
also, I would think that the public has a right to see that as
well.
Mr. Falcon. What that is referencing to is their bonus was
structured in a way that I think 40 to 60 percent of the
bonuses were dependent upon achieving these earnings targets.
That's what that is in reference to. But we'll certainly work
to fulfill your request, Congresswoman.
Ms. Schakowsky. And what is the rationale for it being
confidential?
Mr. Falcon. Only the information related to the top five
individuals at the company is subject to the public disclosure
standards. It's the same as for every corporation. This list
went beyond the top five individuals and included compensation
for individuals that are covered by our excessive compensation
regulation. It's a list of approximately 20 or so individuals
for each company.
Ms. Schakowsky. Well, I think it is worth having a
discussion about what portions at the very least of that should
be made public. The issue is one, I think, that should be open
to scrutiny by more than just members of the Committee, but I
thank you for your willingness to make it available to us.
Mr. Issa. Would the gentlelady yield?
Ms. Schakowsky. Yes.
Mr. Issa. If you struck the names of those 20 individuals
and released the information as to their programs and incentive
without personal information, would that eliminate the concern
of privacy and allow for more broad evaluation?
Mr. Falcon. Possibly, Congressman. May I ask that our
counsels work with the Committee on this issue?
Mr. Issa. Would the gentlelady consider that acceptable as
a starting point?
Ms. Schakowsky. Well, as a starting point, but I still
think that full disclosure is in order.
And let me ask you this, have the executive compensation
practices changed at Freddie Mac since your report and since
all of these problems have been revealed?
Mr. Falcon. Yes, they have, Congresswoman. The emphasis on
short-term earnings is no longer part of that compensation, the
bonus of that structure. They have worked to correct that
problem.
Ms. Schakowsky. Thank you. I look forward to seeing it.
Mr. Stearns. Thank you. The gentleman from California
declines. Okay. I think there's no one else, so Mr. Falcon and
Ms. DeLeo, we appreciate both of you being here and we'll go to
the next panel.
Thank you.
Mr. Martin Baumann, Chief Financial Officer, Freddie Mac.
We welcome you to the table and we appreciate your
participation and look forward to your opening statement.
[Off mic conversation.]
Mr. Stearns. Maybe I'll ask counsel if there's any legal
restraining order, but we'll take that when we get to report.
We'll move forward.
Mr. Baumann, let me welcome you and we appreciate your
opening statement.
STATEMENT OF MARTIN F. BAUMANN, CHIEF FINANCIAL OFFICER,
FREDDIE MAC
Mr. Baumann. Thank you, Chairman Stearns, Ranking Member
Schakowsky and members of the subcommittee. It's a pleasure to
be here this morning.
My name is Martin F. Baumann. I am the Executive Vice
President and Chief Financial Officer of Freddie Mac. I joined
Freddie Mac in April 2003. I was hired to build a strong
finance function within Freddie Mac and to restore confidence
in the company's financial reporting. I am committed to
developing an exemplary finance function that produces
accurate, timely, well-controlled and transparent financial
reports.
Prior to joining Freddie Mac, I worked at PriceWater-
houseCoopers for more than 30 years as a partner, as deputy
chairman of the World Financial Services Practice, and as the
Global Banking Leader.
I welcome the opportunity to be here today to provide
Freddie Mac's views on the use of fair value-based measures, to
discuss the accounting errors addressed by our restatement and
to discuss Freddie Mac's on-going corporate-wide remediation
program.
Freddie Mac has been working hard to regain the confidence
of all of our stakeholders. Last year we completed the
restatement and began implementing a corporate-wide remediation
program to ensure that the accounting and financial control
issues that led to the need for the restatement will never
happen again.
Today, Freddie Mac is focused on bringing our financials
current. We believe our accounting policies for the restatement
periods are fully compliant with GAAP and we are completely
committed to using GAAP as the primary underpinning for our on-
going communications with our shareholders and other interested
parties.
Freddie Mac's mission is to ensure a stable supply of low
cost mortgages for America's families, whenever and wherever
they need them. Despite our difficulties last year, we
maintained our focus on fulfilling our special responsibilities
to home buyers, the public, Congress and investors.
Freddie Mac has the right leadership to attain our goals in
our new Chairman and CEO, Dick Syron. Dick has extensive
expertise and is committed to our important public mission and
to regaining the full confidence of the public and our
stakeholders.
Before I comment on the accounting errors addressed by
Freddie Mac's restatement of prior years' results, I would like
to offer some views on principle-based accounting, fair value
and GAAP.
Mr. Chairman, as I stated during my appearance before this
subcommittee last summer, I am fully supportive of your efforts
to move GAAP to a principles-based framework. I believe that a
principles-based approach could ensure that all reporting
companies meet the substance and not simply the form of
accounting rules.
The move to greater use of fair values is another important
step in accounting. Over the years, the FASB has made
significant progress toward increasing the use within GAAP of
fair value-based measures for financial instruments. Freddie
Mac is committed to providing investors with the information
they need to understand how we view and manage our business.
To that end, we are preparing to become one of the first
financial institutions to provide investors with a full, fair
value balance sheet on a quarterly basis which will show mark-
to-market gains and losses on our business and provide
investors with an additional measurement tool, along with our
GAAP financial statements.
The restatement was a significant step in Freddie Mac's
progress toward achieving accurate and timely financial
reporting. We're now completing our annual report for 2002 and
the latest stockholders' meeting will be held on March 31,
2004. We completed the restatement while maintaining our
business fundamentals and delivering on our congressional
mandate to make mortgage credit more available for America's
families.
We remain fully committed to our mission of helping make
housing more affordable for more Americans and maintaining
liquidity in the housing market which, for the past several
years, has bolstered the U.S. economy.
The restatement did not affect the fundamental strength of
Freddie Mac's business. Freddie Mac's business operations
remain strong and interest rate risk and credit risk remain
low. Our risk profile remains conservative with an average
duration gap of zero for December 2003, unchanged since
October.
For anyone not familiar with the concept of a duration gap,
a zero duration gap means that, in general, changes in the
value of assets due to changes in interest rates are expected
to be equally offset by changes in the value of liabilities and
derivative contracts.
Now I'd like to comment on the accounting corrections made
in connection with the restatement of Freddie Mac's financial
statements. The accounting errors addressed by the restatement
fall into five categories: securities classifications,
accounting for derivative instruments, asset transfers and
securitizations, valuation of financial instruments, and other
corrections. Detailed information on these accounting errors is
provided in our restatement press release.
Freddie Mac has accepted the conclusions of the report of
the Board's independent investigative counsel, Baker Botts.
That report found that the principal factors contributing to
the restatement were lack of sufficient accounting expertise
and internal control and management weaknesses as a consequence
of which Freddie Mac personnel made numerous errors in applying
GAAP.
In addition, certain capital market transactions were
executed and certain accounting policies were implemented with
a view to their effect on earnings in the context of Freddie
Mac's goal of achieving steady earnings growth. Also, certain
reserve accounts and other adjustments which were known
departures from GAAP, but were not considered to be material at
the time, were also made with a view to their effect on
earnings.
In addition to completing the restatement of prior year
financial results, Freddie Mac is currently engaged in an
active remediation program that began in the spring of 2003
when the governance committee of the Board of Directors asked
me to develop a remediation program to ensure that the factors
contributing to the need for the restatement would not recur.
Our program combines the steps required by the December 9, 2003
consent order between Freddie Mac and OFHEO, Freddie Mac's
safety and soundness regulator, with the actions that were
underway in our pre-existing remediation program.
The remediation program demonstrates our commitment to
create a corporate culture in which the type of problems that
led to the restatement will never happen again.
We are building upon our very significant efforts to
improve the quality and depth of internal accounting personnel,
the strength of the accounting function and management
oversight of that function. This has been and continues to be a
key priority of the company in the wake of the restatement.
We are also working to create and implement new
infrastructure and systems to ensure the quality, integrity,
transparency and timeliness of our financial reporting.
Together with Freddie Mac's new chairman and CEO, as well as
our senior management team, I will ensure that we set the right
tone at the top, one that promotes integrity, high ethical
standards and the importance of compliance.
Freddie Mac's Board of Directors, current management team
and employees are continuing to improve our reporting,
governance and financial controls. Now that the restatement is
complete, we are focused on bringing our financials up to date.
Our objective is to release quarterly and full year 203 results
by June 30, 2004 and to provide the 2003 annual report and hold
the related stockholders meeting as soon as possible
thereafter.
Freddie Mac remains irrevocably committed to completing the
process of voluntarily registering its common stock with the
Securities and Exchange Commission under the Securities
Exchange Act of 1934, with the objective of completing the
process, as soon as possible, after the company's return to
timely reporting.
Freddie Mac recognizes the importance of transparent
accounting and reporting standards and we're committed to
providing investors with the information they need who
understand how we view and manage our business. We have already
taken significant steps toward achieving our goal of exemplary
financial reporting and controls. The work that we have done
and continue to do as a part of the remediation program will
enable us to reach that goal.
As we complete this work, we are continuing to fulfill our
important public mission, maintain our safety and soundness and
meet our business objectives.
Thank you for the opportunity to appear today. I look
forward to working with you and the members of this
subcommittee, Chairman Stearns, and Congresswoman Schakowsky,
as you focus on financial accounting standards. I will be happy
to answer any questions the subcommittee might have.
[The prepared statement of Martin F. Baumann follows:]
Prepared Statement of Martin F. Baumann, Chief Financial Officer,
Freddie Mac
Thank you, Chairman Stearns and Members of the Subcommittee. It is
a pleasure to be here this morning.
My name is Martin F. Baumann. I am the Executive Vice President and
Chief Financial Officer of Freddie Mac. I joined Freddie Mac in April
2003. I was hired to build a strong finance function within Freddie Mac
and to restore confidence in the company's financial reporting. I am
committed to developing an exemplary finance function that produces
accurate, timely, well-controlled and transparent financial reports.
Prior to joining Freddie Mac, I worked at PricewaterhouseCoopers
for more than 30 years as a partner, as deputy chairman of the World
Financial Services Practice, and as the Global Banking Leader. At
PricewaterhouseCoopers, I was responsible for certifying the financial
statements of some of the largest United States and international
banking, insurance and other financial services companies.
I welcome the opportunity to be here today to provide Freddie Mac's
views on the use of fair value-based measures within generally accepted
accounting principles (GAAP), to discuss the accounting errors and
related corrections addressed by our restatement, and to discuss
Freddie Mac's ongoing corporate-wide remediation program.
Last year was a challenging year for Freddie Mac. In January, we
announced a restatement of prior-year earnings and in June, our Board
of Directors made changes in the company's senior management.
Freddie Mac has been working hard to regain the confidence of all
of our stakeholders. We have completed the restatement of prior-year
financial results and we are implementing a corporate-wide remediation
program to ensure that the accounting and financial control issues that
led to the need for the restatement will never happen again.
Freddie Mac's mission is to ensure a stable supply of low cost
mortgages for America's families--whenever and wherever they need them.
We recognize our special responsibility to homebuyers, the public, the
Congress and investors. Despite our difficulties last year, we
maintained our focus on fulfilling these important responsibilities.
Today, Freddie Mac is focused on bringing our financials current.
We are building an environment that will allow us to provide
comprehensive and understandable information about our company,
incorporating the highest level of financial transparency, accounting
controls, compliance, and professional standards.
GAAP is the foundation for all financial reporting. We believe
Freddie Mac's accounting policies for the restatement periods are fully
compliant with GAAP, and we are completely committed to using GAAP as
the primary underpinning for our on-going communications with our
shareholders and other interested parties.
Freddie Mac has the right leadership to attain our goals in our new
Chairman and Chief Executive Officer, Richard F. Syron. Dick has
extensive industry expertise, and corporate leadership and financial
experience, having led a Fortune 500 firm, served as chairman and chief
executive officer of the American Stock Exchange, and served as the
president of the Federal Reserve Bank of Boston and as president of the
Federal Home Loan Bank of Boston. He is committed to our important
public mission and to regaining the full confidence of the public and
our stakeholders.
Before I provide an overview of the accounting errors and related
corrections addressed by Freddie Mac's restatement of prior-year
results, I would like to offer some views on principles-based
accounting, and fair value and GAAP.
principles-based accounting
The Securities and Exchange Commission and the Financial Accounting
Standards Board (FASB), among others, have been studying the potential
efficacy of adopting a U.S. financial reporting system based on
principles-based standards.
Mr. Chairman, as I stated during my appearance before this
Subcommittee last summer, I am fully supportive of your efforts to move
GAAP toward a principles-based framework. I believe that a principles-
based accounting framework holds the potential to improve the
representational faithfulness of financial reporting under U.S. GAAP. A
principles-based approach could ensure that all reporting companies
meet the substance, and not simply the form, of accounting rules.
I look forward to working with you, Mr. Chairman, and with the
Members of this Subcommittee as you work toward this new accounting
framework.
fair value and gaap
Fair value measurement is having an increasingly important role for
purposes of GAAP financial reporting and disclosure. Over the years,
the FASB has made significant progress toward increasing the use within
GAAP of fair value-based measures for financial instruments.
Capital markets participants have expressed support for fair value
measurement concepts. And, fair value measures are of increasing
interest and importance to our investors. Freddie Mac is committed to
providing investors with the information they need to understand how we
view and manage our business, so that investors can value our business
fairly and accurately. To that end, Freddie Mac is preparing to become
one of the first financial institutions to provide investors with a
full fair value balance sheet on a quarterly basis, which will show
mark-to-market gains and losses on our business and provide investors
with an additional measurement tool, along with our GAAP financial
statements.
completing our restatement and fulfilling our mission in 2003
On November 21, 2003, the Freddie Mac Board of Directors and our
management team announced the release of the company's restated and
revised financial results for the years 2000 through 2002. The
restatement was a significant step in Freddie Mac's progress toward
achieving accurate and timely financial reporting.
Freddie Mac completed this restatement while maintaining our
business fundamentals and delivering on our congressional mandate to
make mortgage credit more available for America's families. For more
than 30 years, Freddie Mac has helped meet the home financing needs of
families at all income levels, in all communities, and in all parts of
the country. Meeting the annual affordable housing goals is a key
aspect of meeting our mission. In fact, Freddie Mac has successfully
met all of the permanent affordable housing goals since they were
established by the Department of Housing and Urban
Development.1
---------------------------------------------------------------------------
\1\ Final calculations for the 2003 goals have not yet been
completed.
---------------------------------------------------------------------------
We remain fully committed to our mission of helping make housing
more affordable for more Americans and maintaining liquidity in the
housing market, which, for the past several years, has bolstered the US
economy.2 In fulfilling our mission, Freddie Mac plays an
important role in maintaining the strength of the housing sector, a
sector that directly accounts for approximately 15 percent of the Gross
Domestic Product (GDP) and has accounted for 36 percent of the growth
in GDP over the last two years.3 Furthermore, we have
contributed to growth in the economy by helping homeowners refinance
into lower rate mortgages and redeploy some of their housing
equity.4 These benefits are directly attributable to the
long-term, prepayable fixed rate mortgage, which our activities make
widely available.
---------------------------------------------------------------------------
\2\ According to the National Association of Realtors' announcement
this past Monday, January 26, 2004, sales of previously owned homes set
a record high in 2003, totaling 6.1 million--a 9.6 percent increase
from the previous record set in 2002. In addition, U.S. census data
through November 2003 show that new home sales continued to increase
over 2002 and 2001 sales.
\3\ These percentages are based on data published by the Bureau of
Economic Analysis, U.S. Department of Commerce for 1996 through 2003
and data for the same years available upon request from Freddie Mac.
\4\ See Remarks by Federal Reserve Chairman Alan Greenspan before
the Annual Convention of the Independent Community Bankers of America,
Orlando, Florida, March 4, 2003, available online at
www.federalreserve.gov.
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The restatement did not affect the fundamental strength of Freddie
Mac's business.
Freddie Mac's business operations remain strong and interest-rate
risk and credit risk remain low. Our risk profile remains conservative,
with an average duration gap of zero for December 2003, unchanged since
October. In fact, we maintained a low duration gap throughout 2003.
Now, I would like to provide an overview of the accounting
corrections made in connection with the restatement and revision of
Freddie Mac's financial statements.
accounting corrections
Freddie Mac has classified the accounting errors and related
corrections addressed by the restatement into five categories. These
five categories involve subjective judgments by Freddie Mac regarding
classification of amounts and particular aspects of these errors may
fall within one or more of these categories. While these
classifications are not required under GAAP, Freddie Mac believes these
classifications may assist investors in understanding the nature and
impact of the corrections made in completing the restatement.
These errors and accounting changes are described in detail in
Freddie Mac's press release announcing the restatement, and in
particular, in Appendix II, ``Detailed Discussion of Accounting Errors
and Other Changes'' and Appendix III, ``Fair Value and Interest-Rate
Risk Measures.'' A copy of our press release and the accompanying
appendices is available online at www.freddiemac.com.
Security Classification
Freddie Mac is required to classify its investments in one of three
categories--held-to-maturity, available-for-sale, or trading--primarily
based on management's investment intention at the time the company
acquires a security. During the restatement period, Freddie Mac engaged
in transactions involving securities in the held-to-maturity category
that management accounted for as financings, but should have accounted
for as sales. Accordingly, GAAP requires management to reclassify all
securities previously classified as held-to-maturity into the
available-for-sale category and to discontinue use of the held-to-
maturity accounting classification for all securities until at least
2004, approximately two years after the last transaction giving rise to
this error.
During the restatement period, management also transferred
mortgage-related securities that it had designated for accounting
purposes as trading into both the held-to-maturity and available-for-
sale classifications when it should have retained the trading
classification for these securities. Management has reversed this
misclassification and recorded unrealized gains and losses on the
securities in earnings for the appropriate period.
Accounting for Derivative Instruments
Freddie Mac applies risk-management strategies with strict
discipline. We use derivatives to manage interest-rate risk associated
with financial assets and liabilities. We believe the accounting issues
associated with derivatives identified in the restatement have not
affected the performance of the company's derivatives from a risk
management perspective. As part of the restatement, management has
corrected several errors in the company's accounting for derivatives.
These corrections consisted of removing from earnings previously
reported gains and losses related to hedged items for a portion of the
company's fair value hedges and recording in earnings previously
deferred gains and losses for a portion of the company's cash flow
hedges.
Asset Transfers and Securitizations
Whenever Freddie Mac sells Mortgage Participation Certificates
(PCs), GAAP requires the guarantee fee stream to be recorded as a
retained interest (the guarantee asset) and the associated obligation,
including the guarantee of payments of principal and interest to
security holders, as a liability (the guarantee obligation). Freddie
Mac failed to do this. To correct this error, management has recorded
the guarantee asset and guarantee obligation for PCs and other mortgage
securities sold by the company during the restatement period and
included these amounts in the determination of gain or loss on sale.
Subsequent to the sale, Freddie Mac has reported the guarantee asset
and obligation at fair value with changes included in earnings.
Valuation of Financial Instruments
During the restatement period, Freddie Mac made numerous errors in
estimating the fair value of the company's derivatives and securities.
Management has corrected these errors in estimating fair value as well
as other errors identified after extensive review of valuation
methodologies and results. In addition to the corrections affecting the
financial statements, management has incorporated the results of this
re-valuation in Freddie Mac's Fair Value Balance Sheets as of December
31, 2002 and 2001.
Other Corrections
During the restatement process, management identified numerous
other accounting policies and practices requiring correction, and has
taken corrective action. These other corrections are discussed in the
restatement press release available online at www.freddiemac.com.
remediation program
In addition to completing the restatement of prior-year financial
results, Freddie Mac is currently engaged in an active remediation
program. This program combines the steps required by the December 9,
2003 Consent Order between Freddie Mac and OFHEO, Freddie Mac's safety
and soundness regulator, with the actions that were underway in our
preexisting remediation program.
Our remediation program began in the spring of 2003 when the
Governance Committee of the Board of Directors asked me to develop a
remediation program to ensure that the factors contributing to the need
for the restatement would not recur. Thereafter, the Board of Directors
approved a comprehensive remediation program that has been--and is--
effecting far-reaching changes in the company's financial reporting,
control and management functions.
The Consent Order added further key items to our existing
remediation program resulting in an enhanced comprehensive remediation
program designed to ensure the integrity of Freddie Mac's financial
reporting, controls and governance, and also to prevent a recurrence of
the problems that led to the need for the restatement.
The activities we have already undertaken as part of the
remediation, and our continuing plans, including fulfilling the
requirements of the Consent Order, demonstrate our commitment to create
a corporate culture in which the type of problems that led to the
restatement will never happen again.
key remediation steps
Freddie Mac is building upon its very significant efforts to
improve the quality and depth of internal accounting personnel, the
strength of the accounting function, and management oversight of that
function. This has been, and continues to be, a key priority of the
company in the wake of the restatement.
The company has added over 100 professionals in the accounting,
reporting and control areas, including a significant number of new
officers and senior managers.
We have also retained leading experts in the areas of public
disclosures and corporate governance to assist the company in designing
and implementing processes and practices in these areas. In October
2003, we hired a Senior Vice President--Chief Compliance Officer who is
responsible for overseeing Freddie Mac's compliance with policies,
procedures and practices, including compliance with laws and
regulations.
Additionally, in October 2003, we created the position of Chief
Enterprise Risk Officer.
We are also working to create and implement new infrastructure and
systems to ensure the quality, integrity, transparency, and timeliness
of our financial reporting.
Finally, we have taken steps to ensure that Freddie Mac's corporate
culture promotes integrity, high ethical standards, and the importance
of compliance. Virtually all of our employees have completed a
corporate-wide training program on the company's Code of Conduct and
the provisions of the Sarbanes-Oxley Act.
looking ahead
Through the extraordinary efforts of Freddie Mac's Board of
Directors, current management team, and employees, we have met the
challenges of the past year, and we are looking forward to continuing
to improve our reporting, governance, and financial controls.
Throughout this difficult and challenging period, Freddie Mac has
focused on ensuring that we will emerge a stronger, more disciplined
company. And, we have done so while remaining fully committed to
fulfilling our mission.
We are bringing our financial statements current and building for
the future. The company expects to provide an annual report for 2002
and has announced the related annual stockholders' meeting to be held
on March 31, 2004. Our objective is to release quarterly and full-year
2003 results by June 30, 2004 and to provide the 2003 annual report and
hold the related stockholders' meeting as soon as possible thereafter.
Freddie Mac remains irrevocably committed to completing the process
of voluntarily registering its common stock with the Securities and
Exchange Commission under the Securities Exchange Act of 1934, with the
objective of completing the process as soon as possible after the
company's return to timely reporting. Freddie Mac reaffirmed this
commitment in a letter to Treasury Secretary John Snow on July 14,
2003, in our restatement announcement and in other public statements.
conclusion
Freddie Mac recognizes the importance of transparent accounting and
reporting standards and we are committed to providing investors with
the information they need to understand how we view and manage our
business. We fully support the Subcommittee's efforts to move toward a
principles-based accounting framework.
While the restatement represented an important milestone, now that
it has been completed, Freddie Mac is focused on bringing our
financials up-to-date. We have already taken very significant steps
toward achieving our goal of exemplary financial reporting and
controls. The work that we have done, and continue to do, as part of
our remediation program will enable us to reach that goal. As we
complete this work, we will continue to fulfill our important public
mission, maintain our safety and soundness, and meet our business
objectives.
Thank you for the opportunity to appear today. I look forward to
working with Chairman Stearns and the Members of this Subcommittee as
you focus on financial accounting standards. I would be happy to answer
any questions the Subcommittee might have.
Mr. Stearns. Mr. Baumann, thank you very much and thank you
for appearing and I think we're all encouraged now that you're
the new CFO, that a lot of the changes will be made and that
you'll stay on top of it.
Were you one of the auditors, not working for the company,
but an outside auditor when this occurred?
In other words, what was your role, before you were CFO you
said your experience was as an auditor.
Mr. Baumann. Yes.
Mr. Stearns. Had you been involved with Freddie Mac in any
way?
Mr. Baumann. I was a partner at PriceWaterhouseCoopers,
with PriceWaterhouseCoopers for 33 years.
Mr. Stearns. And PriceWaterhouseCoopers was their auditors?
Mr. Baumann. PriceWaterhouseCoopers became Freddie Mac's
auditors in 2002, replacing Arthur Andersen. That's correct.
Mr. Stearns. Okay, and when you talked to your colleagues
back at PriceWaterhouse in your new position, did they ever
tell you some things that they feel should still be done?
Mr. Baumann. PriceWaterhouseCoopers issues a variety of
many recommendations to management, to the board about things
that we need to do to improve the internal controls and
accounting expertise at Freddie Mac. I've been meeting with the
Price
WaterhouseCoopers team that's on the ground, doing the work on
a regular basis, listening to their recommendations and
findings and trying to implement as many of those
recommendations as we can, as quickly as we can to improve the
accounting expertise and internal controls of the company.
Mr. Stearns. Does Freddie Mac still have a financial
engineering department?
Mr. Baumann. I don't know that Freddie Mac ever had a
department that was----
Mr. Stearns. Or just financial engineering----
Mr. Baumann. But we do not have any financial engineering
department today. Our transactions are recorded completely in
accordance with GAAP.
Mr. Stearns. What happened to the head of the financial
engineering that I talked to Mr. Falcon about earlier? Is he
still there?
Mr. Baumann. As I said, I don't know about a financial
engineering department, but let me say this, as part of the
program to change prior management, the former CEO, the former
Chief Operating Officer, the former Chief Financial Officer,
the former Comptroller, former Chief Investment Officer, the
former General Counsel and many other people in the company
have been let go from the company.
Mr. Stearns. But Mr. Falcon indicated there was a financial
engineering department. He described what they did. It was
confirmed by Ms. DeLeo, so my question is do you think that
department still exists in maybe some kind of form? Is it still
using its skill to influence earnings?
Mr. Baumann. There is no financial engineering component in
the company today. I am responsible for all financial reporting
of the company and I ensure that financial reporting is fully
in accordance with GAAP and I have no responsibility for bottom
line earnings. My job is to make sure that our financial
results are reported in an unbiased, accurate, reliable and
transparent way.
Mr. Stearns. In your opening statement, I believe you said
this, certain transactions were entered into with a review to
influence toward influencing earnings. Is that true?
Mr. Baumann. I said certain transactions were entered into
with the view to their effect on earnings, yes.
Mr. Stearns. I'm not a security lawyer, but I would
indicate that's code for securities fraud. If you're actually
entering into a review toward influencing earnings, in your
estimation are you still doing that?
Mr. Baumann. We are not entering into any transactions
today with a view to their effect on earnings in terms of
trying to influence what the accounting results will be.
Mr. Stearns. But your statement has indicated that in the
past that's what they were doing?
Mr. Baumann. The Baker Botts report that was done, the
investigative report determined that certain capital markets
transactions and certain reserve accounts were maintained with
the view to their----
Mr. Stearns. Influencing earnings. Now your 30 years with
PriceWaterhouse wouldn't you interpret, if you met some people
in a corporation doing that, you're an outside auditor coming
in and they were using transactions and entering them primarily
to influence earnings, wouldn't you consider that fraudulent
today?
Mr. Baumann. Well, that was not my job at
PriceWaterhouseCoopers. My job was to report on the financial
statements and report matters if they were inappropriate to
Securities and Exchange Commission and other regulatory
authorities who would have the responsibility for making those
determinations.
At Freddie Mac, there have been two investigations so far;
one by the Baker Botts firm, one by OFHEO, who has issued a
comprehensive report. There's an on-going investigation by the
Securities and Exchange Commission, the U.S. Attorney's Office
and there are more than 12 civil suits all looking at what the
causes of the restatement were.
We focus every day on----
Mr. Stearns. I understand. I'm just trying to look at this
as an outsider because if I hear an accountant is trying to be
competent and something occurs because he's incompetent, that's
one thing. But if a person strictly is sitting there trying to
influence earnings by manipulating transaction, I would think
that's a securities fraud. But that's just based upon what you
said in the past.
Let me ask you this, OFHEO's report states that no one at
Freddie Mac took responsibility for public disclosures and this
led to inaccurate financial reporting. I guess what has Freddie
Mac done to remedy this management deficiency?
Mr. Baumann. I have absolute responsibility for financial
disclosures and all disclosures at Freddie Mac and my job is to
ensure that all disclosures are complete, accurate,
transparent, honest and reliable. As I said before, I have no
responsibility to run the businesses and I have no
responsibility for what the earnings are of the company. My job
is to ensure that all of our disclosures are complete and
unbiased and accurate.
Mr. Stearns. In your opinion of 30 years with
PriceWaterhouse and your job now as the CFO, should we
encourage FASB to reform the use of mixed attribute accounting
so that abuses like these described in the Doty report do not
occur in the future? And if so, what would your recommendation
be?
Mr. Baumann. A couple of comments to that. First of all, I
agree with the comments that were made earlier that it isn't
the accounting rules that caused the restatement, it was the
fact that the company lacked expertise in implementing those
rules. That was the real problem. Having said that I do agree
with the initiatives, Congressman Stearns, that you are
embarking upon to improve principles-based accounting, such
that reports cannot be filed, but simply comply with rules, but
at the same time, may not tell the whole story. Principles-
based accounting and disclosures, in my mind, today even,
disclosures in my mind, require companies to ensure that the
entire story is told even if rules are complied with.
So further efforts on principles-based accounting to ensure
that, I agree with.
In addition to that, movement toward fair value accounting
so that there isn't a mixed model of some assets of fair value,
some at cost, some liabilities at cost could create greater
understanding of financial statements.
Mr. Stearns. So you would not be using mixed attribute
accounting in the future?
Mr. Baumann. Freddie Mac has to comply with GAAP and we
will comply with GAAP and today's GAAP does have certain mixed
attribute accounting requirements.
Mr. Stearns. So you'll still use it?
Mr. Baumann. We have to use what the accounting rules are
and fully disclose information. In addition to that, we've said
we are supplementing that with further disclosures quarterly
around fair values.
Mr. Stearns. Will you also provide fair value accounts?
Mr. Baumann. We have said, first of all, GAAP requires that
certain fair value information be provided annually. We have
said that it is our intention, in addition, to provide fair
value information and full fair value balance sheet on a
quarterly basis going forward.
Mr. Stearns. My time has expired.
Ms. Schakowsky. Thank you, Mr. Baumann, I appreciate the
tough talk and I'm serious about that, that an acknowledgement
of the problems that were and a commitment to make the changes.
The one thing I noticed when you talked about what your
responsibilities were for disclosure, you didn't mention
timely.
And I'm concerned in your testimony when you said the
objective of completing the process, that is voluntarily
registering common stock with the SEC ASAP, as soon as
possible, as opposed to exactly when? Now we know that--and you
referred to--you affirmed the commitment that you had made,
that had been made in July--you had made, yes, in July of 2003
in the restatement announcement and other public statements.
So when is this exactly going to happen? Fannie Mae, even
with their accounting problems, already did it last March. I
understand that it will be close to 2005 before you register.
Mr. Baumann. Congresswoman, if I omitted timely in my
response to questions to Chairman Stearns, it was an error. My
oral statement did say that I'm committed to developing an
exemplary finance function that produces accurate, timely, well
controlled and transparent financial reports.
First thing Freddie Mac had to do was to complete the
restatement of prior years and as indicated in our restatement
press release, the company made many accounting errors in the
past. Correcting those errors means also correcting some
financial infrastructure in the company to build accounting
systems that are based on the right rules, not the wrong rules.
We're doing that right now as quickly as possible. I've engaged
all the major, really all the major consulting firms, are
working with us in many ways to build that infrastructure as
quickly as possible and as accurately and reliably as possible
so we can get our financial statements, current, timely and
continue with the 1934 Act registration process.
I've met with the Securities and Exchange Commission
already and they have agreed that as soon as we get our 2002
annual report issued----
Ms. Schakowsky. Which is when?
Mr. Baumann. February, which will be in February, our 2002
annual report, that the SEC is willing to re-engage with us in
discussing the registration process so we can begin a draft of
the filing such that as soon as we become current in our
financial reports, that we could be registered with the SEC as
promptly as possible.
Ms. Schakowsky. And when is 2003 going to be done?
Mr. Baumann. We've stated that our objective is to release
our 2003 results by June 30, 2004. And as I indicated, that's
the function of building the accounting infrastructure that we
need to ultimately get timely in the long term as well as
getting the results out the door.
Ms. Schakowsky. Timely being 6 weeks after the quarter?
Mr. Baumann. Approximately and that's with the SEC
guidelines, that's correct. That's approximately the timeframe.
Ms. Schakowsky. Well, if you were registered with the SEC,
it would be approximately. That would be what it is.
Mr. Baumann. It's 45 days, the rules, and they are coming
down to 35 days over the next year, that's correct.
Ms. Schakowsky. The legislation that would remove the
exemption, does Freddie Mac have a position on that
legislation?
Mr. Baumann. The 1933 Act legislation on the registration
of securities is really designed to help consumers, more so
than to help Freddie Mac. It's very important that consumers
getting mortgages are able to look in an interest rate on their
house. They're able to do that because of the way the mortgage
market operates. Mortgage brokers are able to lock in interest
rates for consumers because of the to be announced mortgage
market that they can lock in the mortgage rates----
Ms. Schakowsky. So you support the legislation?
Mr. Baumann. It would not be good for consumers. It would
increase the cost of mortgages to homeowners. So we do not
support that.
Ms. Schakowsky. I would recommend that you rethink that
position. I think that there are a lot of people out there that
would feel a great deal more confidence if Freddie had to abide
by the same rules as other corporations that already feel that
how come there hasn't been this full disclosure, while it's
voluntary. And I think that it would ultimately be in your
interest to rethink your position on that legislation.
Let me just ask you--I'm out of time. Thank you, Mr.
Chairman.
Mr. Stearns. Thank you. The gentleman from New Jersey is
recognized, Mr. Ferguson.
Mr. Ferguson. Thank you, Mr. Chairman. I appreciate Mr.
Baumann for being here today and certainly appreciate all the
work that the new management team is going through. Obviously,
there was a lot of bad thing going on at Freddie and I
appreciate the tough talk. We appreciate the work that the new
management team has been putting into place, obviously, very,
very disconcerting the things that have come out, the things
that we have learned and the things now that you're sharing
with us and previous panel was sharing with us this morning.
I'm actually just interested, I have a couple of questions
about the restatement and how it's affected the current status
of the company and some of the financial aspects of the
company. First, what is the effect that the restatement has on
your current capital position at the company?
Mr. Baumann. The restatement increased the company's
regulatory capital by $5.2 billion, so the fact that the
earnings were restated upwards strengthened the capital
position in the company. The company is fully in compliance
with our capital guidelines and has a very large and healthy
capital surplus.
Mr. Ferguson. So in addition to the fact that people should
have more confidence in the management team because of what's
been uncovered and the new commitments and the verbal
commitments and other protections that you put in place with
the new management team, in addition to perhaps confidence that
people should have in the new management team, there's also
perhaps reason to have confidence in the new financial position
of the company.
Mr. Baumann. Freddie Mac's financial position has been
strong throughout this, before the restatement and after the
restatement, Freddie Mac's financial condition is very strong,
a strong capital position, as I stated in my testimony. The
risks that we measure and monitor in our business, interest
rate risk which is inherent in mortgages and credit risk that
we guarantee is part of our business, are those risks that we
maintain control of those risks. Our risk measures are low. Our
business fundamentals are very sound.
Mr. Ferguson. So things are actually going very, very well.
The deceptions and what not of the prior management team, it
wasn't as if you were doing really poorly and these--the
misleading facts and reports and accounting practices and what
not made the company look a little bit better. In fact, the
company was doing quite well and things were made to look a
little bit worse than they were because with the restatement
you're position obviously is much stronger. Would you agree
with that?
Mr. Baumann. The reported financial position is $5 billion
of capital greater than previously before the restatement, so
the business fundamentals of Freddie Mac were sound before and
continue to be sound, yes.
Mr. Ferguson. Following the restatement, what do you owe
the Federal Government in taxes?
Mr. Baumann. The additional taxes that were due to the
Federal Government from the restatement were less than--under
$30 million. So the restatement had a pretax accounting impact
of about $7.5 billion, more or less. Then we provided income
tax from a GAAP accounting perspective of about $2.5 billion,
but that's deferred taxes that's really not reportable for
taxes in accordance with tax rules until and unless those
amounts are realized. It's largely unrealized gains there. So
the tax liability that additional tax liability that was owed
was somewhere just slightly less than $30 million.
Mr. Ferguson. That's all I had for questions, I just wanted
to wish you well. You've got a long road ahead of you in terms
of regaining the trust and confidence of people in the
financial community and the public and certainly taxpayers. It
seems to be that you're on the right road and obviously the
company's position is a strong one in terms of financial
status, but in terms of rebuilding that confidence of your new
management team, there's obviously a lot of work that still
needs to be done. You seem to be done on the right track, so we
certainly wish you well and we're going to continue to monitor,
of course, your progress, and look forward to working with you
in the future.
Thank you, Mr. Chairman.
Mr. Baumann. Thank you very much.
Mr. Stearns. And I thank--I echo the encouragement of the
gentleman from New Jersey.
Mr. Markey?
Mr. Markey. Thank you, Mr. Chairman. Mr. Baumann, for
years, Freddie Mac has opposed the Shays-Markey bill to repeal
your SEC registration and reporting exemption. In so doing, the
company has argued that Freddie Mac's current disclosures
already meet or exceed the SEC's requirements and that Freddie
Mac was at the vanguard of financial disclosure, accounting
practices and risk management and that Freddie's disclosure
``met or exceeded SEC requirements.''
Based on what you now know about the accounting
irregularities, disclosure inadequacies and the poor risk
management at Freddie Mac, wouldn't you agree that those claims
were simply not true?
Mr. Baumann. Freddie Mac has acknowledged that the public
disclosures in the past were less than would have been required
of an SEC registrant.
Mr. Markey. Has Freddie Mac reconsidered its previous
opposition to repeal of your exemption from the full compliance
with the SEC registration and reporting requirements? Are you
now willing to support the Shays-Markey bill or some form of
that that would require full disclosure?
Mr. Baumann. Congressman, Freddie Mac is committed to
complete accurate, reliable, transparent, timely disclosures.
We're going to lead the way in the future about the reliability
and timeliness of disclosures. We're irrevocably committed to
registering under the 1934 Act. With respect to the 1933 Act,
as I commented earlier, we don't believe that's in the best
interest of consumers. We think the impact of that would be an
increase in mortgage costs and a lack of availability of locked
in mortgage rates on 30 year mortgages.
Mr. Markey. You understand, Mr. Baumann----
Mr. Baumann. We don't think that's in the best interest----
Mr. Markey. You understand no one trusts Freddie Mac any
more, no one trusts the numbers. They don't trust you saying
that you're voluntarily going to do something. Voluntary
commitments are like oral commitments. They aren't worth the
paper that they aren't printed on.
And we don't trust you. We don't trust your organization.
We need you to comply with the law, the same law that everyone
else complies with. You're not going to have the trust of the
American public, of the investing public, of the Congress,
unless and until you fully comply with the same disclosure that
other companies do.
There's no question that over the years that Freddie has
been lying about its full compliance, has been lying about the
fact that it's meeting the same standards as every other
company in America.
So you're saying that we can't expect Freddie to have final
registration statement filed with the SEC and declared
effective, that you're not going to do that?
Mr. Baumann. Under the 1934 Act----
Mr. Markey. No, under the 1933 Act, you're not going to do
it?
Mr. Baumann. The SEC has studied this. The Administration
has studied this issue just last year and determined that it
was their view that it was not necessary for the agencies to
register under the 1933 Act and felt that 1934 Act registration
was appropriate and we are committed to 1934 Act registration.
Mr. Markey. But you do realize that after that, a scandal
broke out. They evaluated it. They said it wasn't needed and
then one of the hugest scandals in financial history broke out
then at your company. You understand that? You may have made an
evaluation, but it's obviously the same kind of erroneous
evaluation that was made about weapons of mass destruction in
Iran. It turned out that all of the intelligence and analysis
up until the point at which that scandal occurred was
inaccurate.
So I'm asking you again, knowing what you know how, after
the scandal, do you believe that Freddie should have to comply
with the 1933 Act requirements?
Mr. Baumann. Congressman, again, it's our position that
registering under the 1934 Act will have all of the disclosure
requirements about our financial condition, the same as any
other company in America. However, the 1933 Act registration
would not enhance that at all----
Mr. Markey. Fine.
Mr. Baumann. But would be a cost to consumers.
Mr. Markey. Several months ago, my staff and the
subcommittee staff asked your staff to provide us with copies
of the draft registration statement Freddie Mac filed with the
Commission in November 2002, along with copies of any comments
provided by the SEC staff on this draft registration statement
and any related correspondence between Freddie Mac, its legal
counsel and the SEC staff related to this draft registration
statement.
Mr. Baumann, we haven't received any response to this
request and so I would like to ask you if you are willing to
commit to providing these documents to the subcommittee?
Mr. Baumann. As far as we know, we haven't gotten that
request from the committee. We'd be happy to receive that
request and do everything we can----
Mr. Markey. No, you received it. You received that request.
You received that request.
Mr. Baumann. I'm told by our lawyers, we didn't receive it
from the committee, but I'll look into that, Congressman.
Mr. Markey. So will we receive the information? I'm asking
you now, will you send it to us? You have now received the
request. Will you send it to us?
Mr. Baumann. We'll be happy to our lawyers meet with your
lawyers to discuss that----
Mr. Markey. No, I'm asking you, Mr. Baumann. You're in
charge. Will you give us the information? Not your lawyers
talking to my lawyers. I'm talking to you. You're the boss.
Mr. Baumann. Right.
Mr. Markey. Do you want to give us the information or not?
Or are you going to continue to play this hide and seek with us
and the public?
Mr. Baumann. I will review that and I will get back to you.
Mr. Markey. Okay. Again, these voluntary commitments are
like oral agreements. Again, they aren't worth the paper that
they aren't printed on.
Freddie has been issuing press releases for years, claiming
that it meets or exceeds SEC disclosure requirements and that
Freddie is in the vanguard of corporate disclosure and we now
know that those claims were simply not true. And investors in
the financial markets just want you to simply give it up,
comply with public disclosure requirements that every other
public company also has to comply with. And let me ask you one
final question, if I may, and I appreciate your indulgence, Mr.
Chairman.
In your response to Ms. Schakowsky, you said you oppose the
Shays-Markey bill because of concerns over the impact that the
bill would have on the to be issued market for your mortgage-
backed securities.
Are you aware that the bill grants the SEC rulemaking
authority so that it can adopt appropriately tailored rules to
address this type of situation and in light of that authority,
would you be wiling to reconsider your opposition and support
the bill? If that issue could be dealt with, would you then
support the bill?
Mr. Baumann. There are many aspects of registration of the
1933 Act that are problematic, including not just the impact on
the TBA market, which could impact the interest rate lock that
consumers get. It could greatly increase our costs because of
the volume of our security issuances which would have effect,
therefore, in the long term of impacting the cost to consumers.
Also, it would have the significant impact on the
Securities and Exchange Commission's ability to deal with the
volume of securities that the two agencies issue.
A lot of these matters have been studied by the
Administration and by the SEC and as a result of that, studies
today indicate that that registration is not warranted.
Mr. Markey. Again, I think it's just a canard, once again,
and I think it's an excuse not to comply. And I think that your
maintenance here that the SEC is just stupid or incompetent and
can't draft a regulation that would deal with your concerns is
just further evidence that you just don't want to comply with
the same regulations that every other company does. And your
message to the investing public, to the millions of people who
put their money in your company is just caveat emptor, it's
1898 at Freddie. And I just think again you're running an
ahistorical company in terms of the transparency that should be
provided to investors in ensuring that they get the information
which they deserve.
Mr. Chairman, I have a UC request as well. I have three
press releases issued by Freddie Mac, one dated October 19,
2000; one dated March 16, 2001; and one dated July 12, 2002,
that all make claims that Freddie Mac is either in the vanguard
of corporate disclosure and risk management or that Freddie Mac
meets or exceeds SEC reporting standards and I would like to
pass----
Mr. Stearns. By unanimous consent, so ordered. What does
1898 mean to you?
Mr. Markey. That's before the Progressive movement began.
That was before President McKinley passed away and Teddy
Roosevelt took over.
Mr. Stearns. Okay.
Mr. Markey. The Republican Party, by the way.
Mr. Stearns. Right, that's what I was trying to lead to.
Mr. Markey. Thank you.
Mr. Stearns. I was trying to bring out the Republican Party
as being cited here.
The gentleman from Ohio.
Mr. Strickland. Thank you, Mr. Chairman. Mr. Baumann, how
long have you been CFO?
Mr. Baumann. I was hired by Freddie Mac as Executive Vice
President of Finance in April 2003. I received the additional
title of Chief Financial Officer in June of 2003.
Mr. Strickland. So would you say you inherited a large
headache, so to speak when you assumed these positions?
Mr. Baumann. I came into the company with a lot of work to
be done in terms of improving the accounting expertise in the
company, improving internal controls and getting the company
registered under the 1934 Act. There's a lot of work to be
done.
Mr. Strickland. And is it your judgment that you made and
are making progress?
Mr. Baumann. Yes. We are making significant progress. I've
hired--since I've been here, over 100 people into our
accounting functions to build the accounting expertise needed.
We've issued, we've completed the restatement of prior years'
results. We started to build the infrastructure up. We've
greatly improved internal controls and as evidenced by the
restatement press release, improved transparency around
disclosures in terms of a description of those accounting
errors that took place in the past, so we think we're well on
our way to meeting the standards that should be expected of
Freddie Mac which in my view are the highest standards that we
should comply with.
Mr. Strickland. I have one question. Over the last 3\1/2\
years, some of your biggest detractors, Freddie Mac's biggest
detractors, I'm talking about GE, AIG, for example, have lost
billions of dollars of shareholder money. GE has lost, I
understand, about $260 bill; AIG about $70 billion. That's
since the fall of 2000. These losses have hit the union pension
funds particularly hard.
Even with the accounting problems that have existed at
Freddie Mac, and the rather tough economic times that we've
gone through, you haven't lost value over that same period of
time. To what do you attribute Freddie's financial endurance
during this period of time, especially when we consider the
experience of some of your greatest critics?
Mr. Baumann. Well, first of all, understanding investors
and the markets is a challenge for anybody to try to say why
some companies increase in value and others don't increase or
decrease in value, but that's always a challenge. But certainly
Freddie Mac, throughout the restatement, the company has had
very strong business fundamentals.
The company has fulfilled the mission of putting people in
homes. The company has maintained very low interest rate risk
measures. It's maintained very low credit risk measures. It's
been very prudent in its acquisition of mortgages for the
retained portfolio, acquiring mortgages as appropriate in terms
of managing that risk and fulfilling its responsibilities.
So I suspect investors are looking at the Agency and saying
that we are fulfilling our responsibilities, doing it in a
prudent, measured way and the company is safe and sound.
Mr. Strickland. I thank you for the answer. Thank you, Mr.
Chairman.
Mr. Stearns. Thank you. I think we are complete. Mr.
Baumann, I just want to reiterate what you said in your opening
statement is your mission is to supply low cost mortgage for
American families wherever and whenever they need them. You're
doing that job very well and I think Freddie Mac should be
proud of that and as any corporation knows occasionally there's
some people that do things that have to be corrected and we're
doing that and I encourage you and I want to thank you for
testifying and I think you provided enhanced credibility for
your corporation by you being here and your forthright
presentation and your character and personality I think comes
through.
That's why you were hired to be the CFO, so I'm here to
thank you and also say that I think overall we had a pretty
good hearing, bringing out some of the problems. It doesn't
hurt to bring these problems out. If the problems continue,
that's a problem, but it looks like you're on top of them.
You're trying to correct them and I think that's good for the
investors and that's good for America.
So with that, the subcommittee is adjourned.
Mr. Baumann. Thank you, Mr. Chairman.
[Whereupon, at 11:51 a.m., the hearing was concluded.]
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