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





                   SPECIAL EXAMINATION OF FREDDIE MAC

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                   GOVERNMENT SPONSORED ENTEREPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                            JANUARY 21, 2004

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-64


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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice Chair   JULIA CARSON, Indiana
RON PAUL, Texas                      BRAD SHERMAN, California
PAUL E. GILLMOR, Ohio                GREGORY W. MEEKS, New York
JIM RYUN, Kansas                     BARBARA LEE, California
STEVEN C. LaTOURETTE, Ohio           JAY INSLEE, Washington
DONALD A. MANZULLO, Illinois         DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSSELLA, New York              CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              ARTUR DAVIS, Alabama
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  BRAD MILLER, North Carolina
JEB HENSARLING, Texas                DAVID SCOTT, Georgia
SCOTT GARRETT, New Jersey             
TIM MURPHY, Pennsylvania             BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director
  Subcommittee on Capital Markets, Insurance and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
SUE W. KELLY, New York               RUBEN HINOJOSA, Texas
ROBERT W. NEY, Ohio                  KEN LUCAS, Kentucky
JOHN B. SHADEGG, Arizona             JOSEPH CROWLEY, New York
JIM RYUN, Kansas                     STEVE ISRAEL, New York
VITO FOSSELLA, New York,             MIKE ROSS, Arkansas
JUDY BIGGERT, Illinois               WM. LACY CLAY, Missouri
MARK GREEN, Wisconsin                CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
PATRICK J. TOOMEY, Pennsylvania      JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
MELISSA A. HART, Pennsylvania        BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
PATRICK J. TIBERI, Ohio              DAVID SCOTT, Georgia
GINNY BROWN-WAITE, Florida           NYDIA M. VELAZQUEZ, New York
KATHERINE HARRIS, Florida
RICK RENZI, Arizona


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    January 21, 2004.............................................     1
Appendix:
    January 21, 2004.............................................    45

                               WITNESSES
                      Wednesday, January 21, 2004

Baumann, Martin F., Chief Financial Officer, Freddie Mac.........    26
Falcon, Hon. Armando Jr., Director, Office of Federal Housing 
  Enterprise Oversight...........................................     5

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    46
    Gillmor, Hon. Paul E.........................................    48
    Hinojosa, Hon. Ruben.........................................    50
    Kanjorski, Hon. Paul E.......................................    51
    Ney, Hon. Robert W...........................................    52
    Baumann, Martin F............................................    54
    Falcon, Hon. Armando Jr......................................    61

              Additional Material Submitted for the Record

Falcon, Hon. Armando Jr.:
    Report of the Special Examination of Freddie Mac.............    70

 
                   SPECIAL EXAMINATION OF FREDDIE MAC

                              ----------                              


                      Wednesday, January 21, 2004

             U.S. House of Representatives,
         Subcommittee on Capital Markets, Insurance
              and Government Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:05 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Shays, Bachus, Oxley, 
Kelly, Ney, Shadegg, Ryun, Biggert, Kennedy, Harris, Renzi, 
Kanjorski, Inslee, Hinojosa, Lucas of Kentucky, Clay, McCarthy 
and Scott.
    Chairman Baker. I would like to call this meeting of the 
Capital Market Subcommittee to order and welcome back Members 
to start off a new year.
    This morning we are meeting to formally receive the report 
of OFHEO with regard to their special examination of the 
business operations of Freddie Mac. This is indeed an important 
study and analysis, which I believe will assist the committee 
in making important policy determinations as we go forward. But 
we are also pleased to have a representative of Freddie Mac to 
appear later in the hearing this morning to give their analysis 
and comment with regard to the findings and recommendations of 
the Agency.
    I believe it should be clearly understood by now that the 
current regulatory staff has done its best work in attempting 
to supervise and oversee the two most complex financial 
organizations in the world, but they have been historically 
underfunded and, I believe, lacking appropriate regulatory 
tools to be responsive to the complexities of these ever-
changing enterprises.
    The effort to create an enhanced regulatory system, 
however, should be viewed in its proper light, and that is we 
are attempting to provide stability for the secondary mortgage 
market into the next decade. We have been extremely fortunate. 
If any other public operating company had reported multi-
billion-dollar restatements over a multiyear period, market 
reaction to that announcement would have been severe.
    To date, we have seen no market dislocation, interest rates 
continue to remain low, pursuit of home ownership opportunities 
remains high, and we have been blessed with these unique 
circumstances in a time of significant corporate governance 
dislocation.
    We cannot let this window of opportunity pass us by, 
however. We must act on the findings of the regulator. We must 
take advice from all interested stakeholders and ensure in the 
years ahead that the oversight and supervision is more than 
just adequate; that it is world class in nature, and that we 
can be hopefully preemptive in setting aside events which might 
bring adverse consequences to innocent home purchasers.
    I view this as an extremely important effort, and I am 
appreciative of the willingness of the participants in the 
hearing today to give us their perspectives.
    Chairman Baker. Mr. Kanjorski.
    Mr. Kanjorski. Mr. Chairman, we meet for the first time 
this year for the purposes of reviewing the special examination 
report issued and the consent agreement reached in December by 
the Office of Federal Housing Enterprise Oversight regarding 
Freddie Mac's financial restatement of more than $5 billion. 
The report makes serious revelations about how insufficient 
accounting, audit and internal controls and a troubling culture 
nurtured by top managers resulted in an environment that led to 
significant earnings management at Freddie Mac. The constant 
decree also--the consent decree also requires Freddie Mac to 
adopt numerous remedial reforms to prevent a similar situation 
in the future.
    One year ago Freddie Mac first revealed that it would delay 
the release of the 2002 accounting reports pending the 
completion of a restatement of its financial records for 
earlier years. This announcement raised considerable concerns 
for those who monitor GSEs. It also began a period of intense 
scrutiny of the company by its regulators, lawmakers and the 
press.
    Six months later, Freddie Mac's Board announced an 
unexpected management shakeup. This change in corporate 
leadership produced even greater concerns among those with 
knowledge of GSEs. For example, I observed that government-
sponsored enterprises with public responsibilities and private 
capital have a special obligation to operate fairly, safely, 
and soundly. I believe and I continue to believe that today. 
The management of these entities must ensure that they produce 
accounting statements that reflect their real financial 
conditions.
    At the time I also said that Freddie Mac must maintain 
sufficient capital reserves, adopt prudent management reforms, 
expedite completion of its earnings restatements, and employ 
appropriate accounting techniques to prevent similar problems 
in the future. I suspect that, before we complete today's 
hearing, we will discuss each of these issues in great depth. 
We have a responsibility to study these matters and ensure that 
the company follows its statutory mandate to operate in a safe 
and sound manner.
    Additionally, the financial reporting problems by Freddie 
Mac renewed efforts by some to modify GSE regulation. As I said 
at our very first hearing on oversight of government-sponsored 
enterprises in March of 2000, we need to have strong 
independent regulators that have the resources they need to get 
the job done. I continue to support strong GSE regulation. A 
strong regulator will protect the continued validity of our 
capital markets and promote confidence in Freddie Mac and 
Fannie Mae. It will also ensure taxpayers against systemic risk 
and expand opportunities for all Americans.
    Today more than 68 percent of Americans own the homes in 
which they live. Government-sponsored enterprises have 
contributed greatly to this accomplishment. Because our housing 
marketplace is one of the most important sectors in our 
persistently struggling economy, we must also tread carefully 
in our forthcoming debates over any legislation to modify the 
regulation of GSEs.
    In closing, Mr. Chairman, I commend you for your sustained 
leadership in these matters and for convening this timely 
hearing.
    Thank you.
    Chairman Baker. I thank the gentleman for his statement.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 51 in the appendix.]
    Chairman Baker. Mr. Shays?
    Mr. Shays. Thank you, Mr. Chairman.
    Mr. Chairman, Fannie Mae and Freddie Mac constitute the 
twentieth and fortieth largest institutions on the New York 
Stock Exchange and the second and fourth largest financial 
institutions. They play an extraordinary role, they are vital 
to our economy, they are vital to housing, but they play by 
different rules, and when you play by different rules, you have 
to have greater oversight, not lesser oversight, and, frankly, 
we have had both. They do not have to conform to the 1993 act--
excuse me, the 1933 act. They do not have to conform to the 
1934 act.
    When we put them under the 1934 act voluntarily is when the 
problems of Freddie Mac became apparent. It just seems to me is 
an indication that we should get these very excellent companies 
under the same rules and make sure that they have a regulator 
that is going to do the job necessary.
    I think OFHEO has done an excellent job in this report. It 
is just too bad we haven't seen this kind of effort earlier.
    Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Shays.
    Chairman Baker. Mrs. McCarthy?
    Mrs. McCarthy. Thank you, Mr. Chairman. I will wait until 
their testimony. Thank you.
    Chairman Baker. Thank you.
    Mr. Ryun?
    Oh, I am sorry. I did not see your arrival.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman, and I want to thank you 
for convening the hearing today on the recent report issued by 
the Office of Federal Housing Oversight--Enterprise Oversight. 
This report details the causes of Freddie Mac's restatement and 
management reorganization that followed, and this is a 
comprehensive report that highlights many of the concerns we 
have heard about the operations and the oversight of the GSEs.
    As a result of this investigation, OFHEO and Freddie Mac 
have entered into a consent agreement which Freddie Mac agreed 
to pay $125 million in fines and made several significant 
changes to its corporate governance.
    I appreciate all the hard work that Director Falcon and his 
staff has done on this report. Freddie Mac currently has debts 
outstanding in the trillions of dollars. There is no doubt that 
this company is critical to the housing market. Freddie 
supplies liquidity to institutions so they can provide loans to 
consumers seeking to purchase homes; however, with this 
important mission comes an equally important mandate to protect 
the taxpayers and to be honest with investors. As the OFHEO 
report demonstrates, Freddie Mac's senior management misled its 
investors, its Board of Directors and the U.S. taxpayers.
    I am encouraged by the remediation efforts underway at 
Freddie. Mr. Baumann and his team have worked hard at difficult 
times to formulate a plan to return Freddie Mac to financial 
stability, and they should be commended for that. I believe 
with continued diligence and real reforms, confidence can be 
restored in the operation of this important company.
    Director Falcon has presented an in-depth review of Freddie 
Mac, but the question remains where was OFHEO when these 
important trades were taking place? This investigation was not 
commenced when Freddie Mac announced its restatement; rather it 
began after the Chairman and CEO along with two other senior 
executives were released from the company. In fact, if Arthur 
Andersen had not been removed as the auditor for Freddie Mac, 
there would be no guarantee that the improper trading practices 
would not still be going on today.
    I believe that OFHEO is underfunded and lacks many of the 
necessary powers to adequately oversee Freddie and Fannie. I 
support additional funding for OFHEO so it can fully examine 
the GSEs and hire a sufficient number of examiners to monitor 
these financial institutions.
    The report we consider today makes several important 
recommendations for changes both at Freddie and at OFHEO. These 
recommendations are well thought out, and many of them should 
be implemented.
    I look forward to the testimony of Director Falcon and Mr. 
Baumann. I hope this hearing will shed some light on what went 
wrong with Freddie Mac, what steps are being taken to remedy 
the situation, as well as what changes should be made to ensure 
that both Freddie Mac and Fannie Mae are properly regulated.
    Mr. Chairman, I want to personally commend you for your 
steadfast interest in this issue going back years, and there is 
no question that, had you not been a bulldog in pursuing some 
of these issues, many of these would have not come to light. We 
would not be on the--really on the cusp of some major reforms 
with the GSEs, and had it not been for you, this would not have 
happened, and I appreciate the opportunity to be here, and I 
yield back.
    Chairman Baker. Thank you, Mr. Chairman, for your kind 
words.
    [The prepared statement of Michael G. Oxley can be found on 
page 46 in the appendix.]
    Chairman Baker. Mrs. Biggert.
    Mrs. Biggert. No.
    Chairman Baker. Mr. Ney?
    Mr. Ney. I have something for the record.
    Chairman Baker. Mr. Ney submits a statement for the record. 
Without objection, it is adopted.
    [The prepared statement of Hon. Robert W. Ney can be found 
on page 52 in the appendix.]
    Chairman Baker. Ms. Harris, do you have a statement?
    Ms. Harris. Thank you, Mr. Chairman, and thank you for 
having this hearing today. I want to express my appreciation 
for your willingness to conduct these hearings concerning the 
special report of Freddie Mac.
    I also want to thank Mr. Falcon of OFHEO and Mr. Baumann of 
Freddie Mac for their insights and willingness to testify 
before this committee.
    Freddie Mac has taken encouraging organizational steps to 
improve their internal controls and to reform their corporate 
climate. Likewise, the OFHEO has drafted 16 carefully developed 
recommendations.
    The vitality of the housing market and the importance of 
accurate corporate reporting are beyond dispute. Our Nation's 
economy requires beds to thrive. A healthy housing industry has 
helped buoy us, while other sectors of our economy have 
struggled. At the same time our consumer confidence levels have 
remained incredibly resilient, reaching levels typically 
associated with economic expansion. The result is a real growth 
rate in 2003, which is 4.4 percent up from 2.8 percent in 2002.
    We must continue pursuing policies that support economic 
growth. MIT economist Lester Thurow argues that scandal always 
follows boom in capitalism. Ironically, Freddie Mac was still 
booming when the accounting irregularities were discovered, 
making this a truly unique situation requiring special 
attention.
    I am sincerely interested in the measures that would 
restore public confidence while maintaining a strong housing 
industry, and I look forward to your comments.
    Chairman Baker. Thank you, Ms. Harris.
    Chairman Baker. Mr. Renzi, do you have a statement?
    Mr. Renzi. No. Thank you.
    Chairman Baker. You're welcome.
    With that, I would like to welcome back, who is certainly 
no stranger to the committee room, the Director of the Federal 
Office of OFHEO, Mr. Falcon. Thank you very much for being here 
today.

   STATEMENT OF ARMANDO FALCON, DIRECTOR, OFFICE OF FEDERAL 
                  HOUSING ENTERPRISE OVERSIGHT

    Mr. Falcon. I am pleased to be here. Thank you, Mr. 
Chairman. I am pleased to be here.
    Mr. Chairman, Ranking Member Kanjorski, Chairman Oxley 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, and I request the committee include 
it, as well as the full special examination report, in the 
record.
    Chairman Baker. Without objection.
    Mr. Falcon. My testimony expresses my own views and not 
necessarily those of the President or the Secretary of Housing 
and Urban Development.
    A year ago tomorrow, Freddie Mac announced that completion 
of its 2002 financial audit would be delayed and that earlier 
periods would be reaudited. A switch to internal 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 announced the abrupt departure of three 
of its principal officers, I ordered a special examination of 
the conditions 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 
the appropriate recommendations, which the committee received 
in December.
    Since the early 1990s, Freddie Mac promoted itself to 
investors as Steady Freddie, a company strong in profits, and 
developed a corporate culture that placed a very high priority 
on achieving such results. The 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 change of events that began when Freddie Mac 
changed auditors in 2002.
    I will now summarize the areas covered in our report. 
First, the improper management of earnings. By 1999, Freddie 
Mac had established a practice of engaging in transactions for 
the express purpose of managing its reported earnings. Freddie 
Mac used several strategies to shift earnings into future 
reporting periods, reflecting the proclivity of management to 
increase operations risk in the quest for more stable earnings. 
Although some of the most egregious examples relate to earnings 
volatility challenges associated with the implementation of FAS 
133, there were numerous other instances when Freddie Mac 
management engineered transactions with little or no economic 
substance to obtain specific accounting results.
    Second, the incentives created by 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 
earnings per share targets. While not tied directly to 
smoothing earnings growth, actions shifting earnings from one 
quarter to future periods helped to ensure that earnings per 
share goals, and consequently the bonuses tied to them, would 
be achieved in the future.
    Third, weak accounting, auditing, and internal controls. 
The management of any corporation, especially a government-
sponsored one, is responsible for maintaining a control 
environment that will accurately record transactions to provide 
for publicly 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 and 
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 led to 
weak or nonexistent accounting policies and overreliance on the 
external auditor, weak accounting controls and an overreliance 
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.
    Fourth, disclosure. In some instances, Freddie Mac normally 
circumvented prevailing public disclosure patterns in order to 
obfuscate specific market accounting transactions. A disdain 
for appropriate disclosure standards, despite all 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 lack of assigned responsibility reflected a low 
regard that executive management had for that function.
    Fifth, the 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 nonexecutive 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 or shareholder-elected Directors, 
or if Directors had not expected to serve on the Board until 
mandatory retirement age or beyond. Conversely, the service 
periods of Presidentially-appointed Directors are far too 
short, averaging just over 14 months, for them to play a 
meaningful role on the Board.
    Based on 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 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 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 program 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 central audit 
department needs to be strengthened so that it can play a more 
effective role.
    To address accounting weaknesses, the report recommends 
that OFHEO consider and require the exchange of external audit 
firms. Freddie Mac needs to establish and maintain superior 
accounting controls and prevent underreliance on its external 
auditor. It should also document the legitimate business 
purpose of every significant business transaction.
    To address inappropriate management 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 Board recommends that OFHEO take three 
additional steps. 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 laws. Second, 
OFHEO should expand its capacity to investigate and detect 
misconduct by including more substantive tests of 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 Freddie Mac.
    Mr. Chairman, I want to inform you not just about the 
report, but also of actions OFHEO has taken prior and 
subsequent to the report. OFHEO directed the holding of 
termination benefits of senior management pending our review.
    OFHEO directed that the current CEO and general counsel be 
replaced.
    OFHEO entered into a consent order with the company's 
former COO, David Glenn, and secured both his cooperation in 
our investigation and a strong civil money penalty.
    OFHEO entered into a consent order with the company, 
securing a significant money penalty, and imposing a plan of 
remedial action on the company that requires issues identified 
by our investigation be addressed.
    Finally, OFHEO is pursuing legal actions requiring the 
termination for cause of the company's former CEO and CFO.
    I have undertaken actions at OFHEO as well. Our examination 
force is being strengthened. The new Office of Chief Accountant 
will elevate our work in the important field of corporate 
accounting and reporting, and a new office of compliance will 
expand our capacity to conduct in-depth reviews of enterprise 
activities and better ensure their compliance with laws and 
regulations.
    I would like to close my testimony with an urgent appeal to 
the committee for assistance in obtaining our 2004 budget. Once 
again, severe constraints have been placed on our operations. 
The short-term continuing resolution we are operating under 
prevents us from hiring the additional examiners and analysts 
we need to strengthen our oversight. In addition, we are unable 
to hire the help we need to conduct our review of Fannie Mae. 
If the long term is enacted which freezes our budget at 2003 
levels, we will need to scale back oversight at a time when 
greater oversight has never been more urgent.
    I urge the committee to help OFHEO to get the resources its 
needs as soon as possible.
    Thank you, Mr. Chairman, and I would be happy to answer any 
questions the committee may have.
    Chairman Baker. Thank you, Mr. Falcon.
    [The prepared statement of Hon. Armando Falcon Jr. can be 
found on page 61 in the appendix.]
    Chairman Baker. As I understand it, there were 16 different 
recommendations that were made as a result of your analysis, 
and I think it should be clear that, given the circumstances in 
which you addressed the significant attention given to this 
staff by this matter, there is no one better poised to make 
recommendations for reform than your office.
    What troubles me is they are, frankly, recommendations; 
that it is up to the enterprise to determine which, if any, it 
chooses to implement.
    One that I find extremely important, OFHEO should require 
Freddie to hold in a capital surplus limiting growth until they 
produce timely and certified statements. It appears that at 
least June of this year would be the soonest it might occur, 
and, as in the past, that date has the potential to slip.
    Do you have the authority to mandate additional capital at 
this time?
    Mr. Falcon. Let me be clear about these recommendations. I 
may not have been earlier, Mr. Chairman. These recommendations 
were produced by my staff to myself, and these are 
recommendations that I will decide whether or not they get 
implemented, not the enterprise, and I have taken them under 
consideration, and I agree with all of these recommendations.
    Chairman Baker. Well, in light of that determination, do 
you believe you have the authority to implement number 5?
    Mr. Falcon. Yes.
    Chairman Baker. In light of your prior statement this 
morning, wherein you indicate if appropriations are not 
adjusted immediately, you will enter into a period of time in 
which there is great market uncertainty, great congressional 
uncertainty, about the ultimate resolution of these matters, 
why would we not move forward on the great majority or all of 
these recommendations, particularly in light of your inability 
to move forward on the forensic accounting analysis of conduct 
at Fannie Mae?
    Mr. Falcon. It is my intent, Mr. Chairman, to move forward 
on these recommendations. Some will be implemented pursuant to 
an amendment to our corporate governance regulations, which we 
are currently drafting. Some of them will be fulfilled through 
action taken by the company, through working with the company 
to see them implemented, and others we are working to develop 
right now.
    The one of specific interest to you on the capital surplus, 
I expect by the end of next week we will have developed a plan 
which would implement that provision.
    Chairman Baker. Well, given where we are and the 
uncertainty of what may be further determined as to the actual 
accounting conduct, no one hopes for any more bad news, but, in 
light of the fact we do not now know that the Agency may face 
budgetary limitations on its ability to pursue further 
examination at great detail, I would strongly recommend or 
encourage that action be taken as timely as possible, rather 
than waiting on the enterprise to certify its financials.
    Do you have the authority to separate the functions of the 
CEO from the Chairman, or is that an enterprise determination?
    Mr. Falcon. No, that is something we do have the authority 
to do, Mr. Chairman.
    Chairman Baker. Is there any item on your 16 elements that 
you feel you are constrained at this time to act on without 
proper authority to act, or all of these, without reciting them 
all, or is it in the posture of being reviewed by you at this 
time and determinations being made as to whether they will be 
required?
    Mr. Falcon. I believe we have the authority to implement 
all of the recommendations that are included in this report. 
Now, whether or not any of our actions are challenged by one or 
more of the enterprises remains to be seen.
    Chairman Baker. And explain for me what that would mean 
procedurally should someone at the Freddie Mac Board adopt a 
resolution saying, we do not want to do ``X.'' what are their 
rights under the current structure, and what would be your 
ability to impose it under objection?
    Mr. Falcon. Well, we would follow the normal procedures act 
of promulgating regulation and finalizing regulation. Once the 
regulation is final, they would certainly be free to challenge 
it in court.
    Chairman Baker. Back at the beginning of this, when Mr. 
Brendsel's departure occurred, there was an announcement of a 
severance package that amounted to almost $40 million that was 
going to be granted without adequate determination of his 
participation in the accounting manipulations. I wrote at that 
time and asked that you take whatever action might be 
permissible under law to preclude the granting of that bonus 
until such time as final determinations of fault had been made. 
It is my understanding that that is now in some state of legal 
discussion.
    It triggered a similar question that we wrote a letter in 
December to your office asking, first, do you review and 
approve--and I understand that you do review and approve--
compensation and severance terms for both enterprises--for 
executives at both enterprises? We were informed that, perhaps, 
by the middle of January we might receive an answer to our 
request for an analysis of the Fannie Mae severance packages, 
and to date we have not yet received it. Can you give me an 
idea as to when we might receive that information as well?
    Mr. Falcon. Let me--I believe--is that the request where we 
may have partially fulfilled the request, but there is still a 
portion that is outstanding, Mr. Chairman?
    Chairman Baker. There was a request relative to salaries 
and compensation and a second part relative to severance, and 
you have provided the compensation information, but we have not 
yet received the severance information.
    Mr. Falcon. Let me look into that and make every effort to 
try to get that to you by the end of the week.
    Chairman Baker. Terrific, because the principal concern 
there was we had clearly identified wrongdoing, and it 
appears--not factually known--that the executive may have had 
some responsibility for that wrongdoing. And to allow someone 
to profit as a result of those actions is highly inappropriate.
    Before we would enter into--and I am not alleging any 
improper or inappropriate conduct of Fannie Mae, but I think we 
should know and have in advance the disclosure of those terms 
and to ensure that you as a regulator have the ability to stop, 
withhold, and ensure that the taxpayer interest is protected 
before determinations are made about someone's ability to 
mismanage numbers and be rewarded financially.
    I have exceeded my time. I will be back.
    Mr. Kanjorski.
    Mr. Kanjorski. Maybe next year, Mr. Chairman.
    Mr. Director, I listened with great interest in your 
report, and let me see if I understood you correctly.
    First and foremost, it was not your Agency that discovered 
the misstatement. The misstatement or the realization of the 
misstatement came about because sometime in 2002, an accounting 
firm was changed, and, in the process of that change, the 
second accounting firm picked up the restatement; is that 
correct?
    Mr. Falcon. That is correct, Congressman.
    Mr. Kanjorski. That is very disturbing to me, because 
listening to some of your recommendations, I was trying to 
interpose myself as Director of Freddie Mac, and I was trying 
to figure out if the regulator did not pick up this 
manipulation that had been occurring for years, and only a new 
accounting firm picked it up, how would you expect a Director 
to have either access to the information necessary to discover 
this occurrence or to have the expertise necessary to pick up 
that?
    Mr. Falcon. I think what we expect of the Board is that 
they ensure that there are adequate accounting controls and 
internal controls relating to the accounting function, such 
that----
    Mr. Kanjorski. They did. They hired one of the best 
accounting firms in the country.
    Mr. Falcon. Right; but this conduct occurred prior to the 
hiring of PricewaterhouseCoopers. This conduct occurred when 
Arthur Andersen was their external auditor, and it had occurred 
at a time when their internal audit function was very weak, and 
the external auditor was serving in essence as the internal 
auditor for the company as well. So you really had an internal 
auditor auditing their own work.
    Mr. Kanjorski. And I understand that, but how would you 
expect a member of the Board of Directors to know whether or 
not the internal auditing function is reliable? How would you 
know that? I mean, I have sat on Boards, and I rely on what the 
certified accountant firm says the condition of the company is, 
what the report back of the executive management--high 
executive management firm reports to the Board. How would I be 
expected to know whether or not there is compliance, whether 
there is stretching or smoothing of earnings, whether it is 
driven in 2004, for whatever reason?
    In this instance, you suspect it is driven for remuneration 
under the contract, the employment contract, to the high 
management? I am just a little worried about that, because, 
one, we have spent, obviously, millions of dollars to have a 
regulator, and the regulator--I am not attacking you, at all, 
you have done a great job, but it shows the need for regulation 
at these large entities is so great from a standpoint of 
understanding what is going on that it is obviously not clear 
to most people that you would pick up an irregularity like 
this, and yet that irregularity can be horrendous in cost to 
the company and to the taxpayer ultimately.
    I do not know what we do about it, short of having maybe 
dual auditing, or someone came up with the idea in the past a 
change of auditors periodically, because if we had not had a 
change of auditors here, they would still be doing what they 
were doing, and you would not have picked it up. The regulator 
for the government would not have picked it up.
    Mr. Falcon. Right. The nature of the conduct that we found 
with the company was, by its nature, hidden and not transparent 
to regulators and to--fully to the Board as well.
    The Board was aware of weaknesses in the accounting 
function of the company, and, in fact, a plan was developed to 
try to improve the accounting function at the company, but that 
was not adequate to what was ultimately needed at the company. 
This was an area--as far as OFHEO's standpoint goes, this 
involved accounting transactions, the accounting for 
transactions which were designed to shift earnings into future 
periods.
    Now, the role of a safety and soundness regulator is not 
to, on the secondary level, certify the work of the auditor. No 
safety and soundness regulator is equipped to do that, but I do 
not think that is adequate in the future.
    What we are going to work on going forward through the 
creation of an office of a chief accountant is to look at 
expertise where we can look at more closely the work of a 
company to implement new accounting standards, the work of a 
company to account for certain novel or unique transactions 
which might be questionable. We have to do what has not been 
done by the safety and soundness regulators. That is what I 
think is necessary going forward.
    Mr. Kanjorski. The only thing I am trying to relate to you 
is I do not have a high degree of confidence at this point that 
we are any more prepared to meet a challenge of this nature in 
another entity; that we would either discover it, that we have 
the tools to handle it, that we have the transparency within 
the company to pick it up. And it is all nice and good to say, 
well, Directors are going to have to be more cautious and more 
responsible.
    I do not know what you do as a Director. If your top 
manager is lying to you, if your auditors are lying to you, and 
if the government regulator that regulates you cannot pick it 
up, how do you expect the Director to pick it up? Short of 
camping on the site and shadowing the operations of the 
company, I do not know how you do it.
    The other thing I am interested in here: Did you find that 
this was purely a profit-driven vehicle for top management to 
get a better return on their bonus programs or whatever it was?
    Mr. Falcon. That was part of the cause of the problems in 
the company. It was not the only reason for the actions in the 
company.
    The company very much wanted to try to show steady earnings 
growth, and because of market conditions in early 2001, they 
reaped a windfall in net income at the company. The result was 
they sought to shift that money around. In addition, they had 
to try to shift income around that was the result of----
    Mr. Kanjorski. Right, I understand what they did, but do 
you feel you have gotten to the motive? Was the motive for 
self-reward under the schemes of the bonuses or payment system 
of management, or was there some other scheme?
    I am sort of hurt to think that some of these fellows would 
have subjected this company's reputation and assets to 
extraordinary losses. I mean, the way I am running in my mind, 
this is probably a cost of over a billion dollars to this 
company, and certainly they did not get that kind of a package 
return from their--as a motive from their salary situations. So 
it seems the expense to the company far exceeds the benefits, 
the package benefits, these people received, so I am looking 
for some other motive that was there.
    Mr. Falcon. And I think it is addressed in the chapter in 
our book which talks about the tone at the top. The company 
took great pride in meeting the expectations of analysts; 
hence, the nickname Steady Freddie. And ultimately it engaged 
in whatever means were necessary to continue to meet those 
expectations of investors.
    Mr. Kanjorski. I am sorry to be so long. I am shadowing the 
Chairman, however.
    You found some difficulty with the counterparties in the 
derivatives, and, as I understand it in prior discussions with 
you, you do not necessarily know whether or not--how far your 
authority allows you to reach into determining whether the 
counterparties are sufficient to honor the commitments they 
make in derivatives. And of course that is vitally important as 
to whether there is any validity or value in the derivatives.
    If you have a fake counterparty or a less than adequate 
counterparty, you have nothing, and it seems to me when we are 
dealing in the hundreds of billions of dollars, some people say 
trillions of dollars, of derivatives today, particularly with 
these GSEs, what scope of a program do you have to authorize or 
to ask Congress to authorize you with greater authority to get 
into the review, oversight and understanding of the 
effectiveness of counterparties in these transactions, 
derivative transactions, or does not that scare you?
    It scares the hell out of me. I do not sleep very well. If 
these folks are doing what they did in Enron and manipulating 
what they did here, now they are playing a sissy game. They 
ought to be out playing with derivatives and setting off false 
counterparties, and they could be ripping off tens of hundreds 
of billions of dollars. What is your feeling of that?
    Mr. Falcon. We are currently looking at the role of 
counterparties in the Freddie Mac situation, trying to discover 
whether improper conduct was engaged in by facilitating some of 
the key transactions the company used to shift earnings. We 
have not concluded that review yet.
    Ultimately our authority--we do not have direct authority 
over these counterparties; however, we do have authority over 
the two companies we regulate, and if we thought their entering 
into transactions with certain counterparties was an unsafe and 
unsound practice, we could take steps to limit their business 
dealings with those counterparties.
    Mr. Kanjorski. Do you examine or have the authority to 
examine the financial statements of counterparties?
    Mr. Falcon. No, we do not.
    Mr. Kanjorski. So you have no idea whether they are strong 
counterparties or effective and well-asseted counterparties, do 
you?
    Mr. Falcon. We do look at the counterparty's credit rating.
    Mr. Kanjorski. That is the whole point. You are relying on 
secondary, and whoever did the credit rating is probably 
relying on their oversight by a government regulator. There is 
sort of a tendency for everybody to think the other guy is 
making the examination, the study, or the determination; in 
fact, nobody is, and it could just as easily be a very similar 
transaction to Enron. A very bright financial fellow could 
structure counterparties that are straw counterparties, that 
have absolutely no value out there, and yet are handling these 
multi-billion-dollar transactions, with the assistance in a way 
of internal management, because they have a goal to affect 
their income stream as a result of success, but, in fact, the 
counterparty would be interested in eluding the operation, 
getting paid for something that they are not putting value up 
for.
    Chairman Baker. Mr. Kanjorski, if I might, the 
recommendation number 11 is Freddie should document legitimate 
business purpose for every significant derivative transaction, 
so the regulators have identified that as an area of concern. I 
am very anxious to see if they have the ability to enforce 
that.
    Mr. Kanjorski. Right.
    Chairman Baker. I thank the gentleman.
    Mr. Shays.
    Mr. Shays. Thank you. I have questions, but I would like to 
follow other Members and hear what they have to ask.
    Chairman Baker. Mr. Ryun.
    Mrs. Biggert?
    Mrs. Biggert. Thank you, Mr. Chairman, Director Falcon.
    Going back to the Board of Directors, just for 
clarification, the Board is made up of Directors who are 
shareholder-elected, and then there is also the Presidential-
appointed Directors?
    Mr. Falcon. Yes, Congresswoman. There are five of them for 
each company.
    Mrs. Biggert. Five?
    Mr. Falcon. Five.
    Mrs. Biggert. And in your statement you say the 
shareholder-elected Directors, I assume, are going to stay 
until they reach 65 or even beyond?
    What is the average a Director has been a shareholder?
    Mr. Falcon. The average tenure of a Director for Freddie 
Mac?
    Mrs. Biggert. Mm-hmm.
    Mr. Falcon. I believe it is probably over 10 years.
    Mrs. Biggert. Okay. And then you say that, conversely, the 
service of the Presidential Directors is--averages just over 14 
months, or was your statement that that is when they become 
effective?
    Mr. Falcon. That is their average tenure on the Board. 
Their terms are for 1-year appointments, and some of them are 
reappointed, but the average tenure of a Director is 14 months.
    Mrs. Biggert. Right. So do you think if they are serving as 
a Presidential appointment, if the tenure was longer, that 
maybe they would have been more effective, and maybe they would 
have been able to participate to something that was going on, 
misconduct?
    Mr. Falcon. I think they could be more effective on the 
Board if they were allowed a longer term on the Board. However, 
my preferred approach is, I think, corporate governance would 
be better enhanced if shareholders were allowed to elect all 
Directors of the Board, rather than 13 of the 18 Board members.
    Mrs. Biggert. Do you have any background in why there were 
Presidential appointments made, the reasoning for it?
    Mr. Falcon. Just the nature of these being government-
sponsored enterprises and the charters. That was part of the 
original--I believe it was one of the original charter 
provisions of both companies.
    Mrs. Biggert. So there would be more oversight if there 
were just the shareholders?
    Mr. Falcon. I believe shareholders would have a larger 
voice in the company if they elected the members of the Board, 
as opposed to just a portion of the Board members.
    Mrs. Biggert. Okay. One of the--something that companies--
when there is rapid growth, that is often seen as a stress on 
the institution, and we have seen dramatic growth in the 
operations of Freddie Mac over the last several years. Did not 
this growth as much as 30 percent raise concerns at OFHEO?
    Mr. Falcon. Much of the growth has come in the form of the 
retained portfolio, which, over the last 10 years, I think, has 
grown maybe 7--maybe 700-fold. They began their retaining 
portfolio operations with well less than $100 million, and I 
think they were at a 600- or $700 million enterprise, depending 
on what you are talking about.
    That reflects a shift in the company's business strategy. 
As they became more of a portfolio lender, they began to take 
on credit risk associated with guaranteed mortgages, but the 
growth presented a new risk, which was market risk, which was 
part of holding these portfolios.
    Mrs. Biggert. So that does not raise any red flag with 
OFHEO to investigate or ask for an examination?
    Mr. Falcon. It does mean that the company has to devote 
appropriate resources to making sure they adequately understand 
and manage the risk associated with holding those large 
retained portfolios.
    Up to this point we have seen them manage the risk 
associated with those portfolios in a very prudent manner, so 
we do watch the growth rate carefully. As long as they are able 
to manage the growth, we haven't seen the need to step in and 
slow down the growth.
    Mrs. Biggert. So there is nothing that you would want to 
change in that which you think, maybe looking back, that you 
should have?
    Mr. Falcon. No, Congresswoman.
    Mrs. Biggert. All right. So do you know whether the 
enterprise or their auditors conducted their own stress test?
    Mr. Falcon. They did maintain their own stress test while 
we were in the process of developing our stress test. I believe 
they have discontinued the use of those stress tests; in fact, 
I think it was one of their voluntary steps they had taken 
internally at the companies, but with OFHEO's stress test now 
fully implemented, I do not know if they continued to use their 
internal stress test.
    Mrs. Biggert. So did you review their data that they had 
accomplished?
    Mr. Falcon. We are familiar with the operations of the 
stress test they were running during this interim period, but 
we do run our own stress test, based on the data submitted by 
the enterprises to OFHEO, and I believe the stress test is a 
very robust gauge of risk, and it ties capital very closely to 
risk.
    Mrs. Biggert. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mrs. Biggert.
    Mr. Scott?
    Mr. Scott. Thank you, Mr. Chairman.
    Mr. Falcon, let me ask you about the culture at Freddie 
Mac. Do you think there is a permissive corporate culture that 
neglected accounting and oversight and focused on the wrong 
incentives for executive pay there?
    Mr. Falcon. I do, Congressman.
    Mr. Scott. Have you seen any improvement in that culture at 
Freddie Mac?
    Mr. Falcon. I have. Since the time that new management has 
been brought in, including the new Chairman of the Board of the 
company, the company has done a lot of good work in trying to 
implement a remediation plan, as well as steps to bring about a 
new corporate culture within the company, so I think they have 
done a lot of good work.
    I think, since the events of that transpired in the past 
year, the Board has been very active in fulfilling its 
responsibilities, so I think companies also cooperated very 
well with OFHEO. So I think as a general matter the company has 
done a lot to resolve a lot of these problems.
    Mr. Scott. Is there anything particular that you could put 
your finger on that might have caused this permissive culture 
there?
    Mr. Falcon. It was the result of senior management at the 
very top focusing first and foremost on the desire to try to 
meet the earnings expectations of the investment community; and 
it meant trying to smooth out any spikes in income, whether 
they be down or up. In this case, it was upward spikes in 
income that were shifted into future periods. I think the 
company became overly concerned with the fact that if there was 
a spike that went up very high that the analyst community might 
then expect the--raise their expectations for the company. So 
the desire was to try to meet expectations but not by too much, 
not exceed them by too much.
    Mr. Scott. Now, you say that until--you stated that until 
Freddie Mac fully complies with remediation, it remains exposed 
to substantial management and operation risk. Will OFHEO 
require Freddie Mac to hold significant capital surpluses?
    Mr. Falcon. Well, as I have said, they have made good 
progress in turning around the corporate culture at the company 
and focusing on the highest standards. There remains much to be 
done. The company still has a ways to go before it can produce 
timely quarterly financial statements. The requirements of our 
consent order will need time to get fully implemented, and 
there are several very senior management positions that remain 
to be filled. So there is still much to be done at the company. 
In the meantime, these remediation efforts that are required in 
our consent order with the company will work to address 
shortcomings in the accounting area, in the internal controls 
area. However, in the interim, I think it is an appropriate for 
the company to hold additional capital until all of these 
corrective actions have taken full effect; and that is what we 
will address by the end of next week.
    Mr. Scott. Okay. Well one final question, Mr. Chairman, if 
I could. The examination report recommended that OFHEO conduct 
a special examination of the accounting practices of Fannie 
Mae. On January 2nd, the Wall Street Journal stated that Fannie 
Mae has lost so much capital in the past 3 years that its 
capital is now below OFHEO's required minimum. Are you aware of 
that article?
    Mr. Falcon. I am aware of the issue that you raise. I don't 
think it is comparing the same thing though.
    Mr. Scott. What is your opinion on this?
    Mr. Falcon. May I? I think the focus there has been on 
capital as reflected in fair value statements, as opposed to 
capital as calculated in our core capital standard. Our core 
capital standard is similar to that of every other safety and 
soundness regulator and is consistent with GAAP.
    What a fair value statement does is try to market all the 
assets and liabilities of the company; and, in this case, that 
capital as reflected in fair value statements is lower than the 
capital as we calculated for core capital and minimum capital 
purposes. However, while fair value statements are useful 
indicators of the company's current liquidation value, it does 
not reflect--it has some limitations. It does not reflect the 
ongoing concern value of a company. So that is the difference 
between the two standards, Congressman.
    Mr. Scott. Thank you.
    That is all my questions, Mr. Chairman.
    Chairman Baker. I thank you, Mr. Scott.
    Mr. Shadegg, do you have questions? Mr. Bachus?
    Mr. Bachus. I thank the Chairman.
    Director Falcon, as I recall, it was January when Freddie 
Mac made the announcement that it planned to restate its 
earnings. Then in June they announced the departures of Mr. 
Glenn and Mr. Clark and Mr. Brendsel, and it was at that time 
or the next day or two that you formed a special investigative 
unit to investigate.
    Mr. Falcon. Yes, Congressman.
    Mr. Bachus. That is a lag of 6 months. Was there--did you 
do anything with--immediately after the restatement 
announcement or----
    Mr. Falcon. Yes, we did, Congressman. What we did was we 
were primarily focused on making sure that the company got the 
restatement and the reaudit done as soon as possible so that 
the company could be operating with certified financial 
statements. For a company of this size and their importance to 
our housing finance market to be operating without certified 
financial statements was not a good position to be in, and so 
we directed our focus mainly on making sure that that got done 
as quickly as possible. In the meantime, we agreed that the 
Board took the correct action in hiring an outside law firm to 
conduct a review of the circumstances arising from the 
restatement. In time, it turned out that that law firm's 
cooperation and disclosures to us were not adequate, and so we 
decided rather than wait for the completion of the restatement 
whereupon we would decide whether or not to conduct our own 
investigation under the circumstances, I decided it was no 
longer correct to wait any longer for the law firm or the 
restatement to get completed and we would conduct our own 
examination of this.
    Mr. Bachus. Were you caught off guard by the announcement 
that they would restate their earnings?
    Mr. Falcon. I think it is never a position that any 
regulator wants to be in. At the time, until we got deeply into 
this, much of the appearance was, was this a matter of simply a 
disagreement between accountants, two different accounting 
firms or was this more, or was there more to it? As it has 
turned out, there was more to it. This wasn't just a 
disagreement between two accounting firms. This was a result of 
the misapplication of accounting rules, of the misuse of 
transactions to achieve accounting results. All of this was, by 
its very nature, misconduct that was concealed from us. Only 
with greater depth of examination can we try to catch this kind 
of stuff going forward, which is why I have pressed for greater 
resources and I am retooling the agency to be able to better 
focus and catch these kinds of accounting problems.
    Mr. Bachus. Well, let me ask you this. You formed the 
special investigative unit. Actually, it was 6 months after the 
original announcement of restatement. It was a 6-month lag, and 
it wasn't until after--the day after they announced the 
departures, which indicates a really fundamental problem, I 
think, also. But why did it take so long to form this unit? In 
hindsight, would you have been better off to have began 
investigating it with your own unit in January?
    Mr. Falcon. In hindsight, yes. However, this is a common 
practice of safety and soundness regulators, where often 
regulators will direct the Board of a bank or a thrift to hire 
independent outside counsel to undertake a review of any 
particular issues. So it is a common practice of regulators. 
However, given what we now understand was the seriousness of 
this and the conduct that was uncovered, yes, I would have 
preferred to have been in there much sooner.
    Mr. Bachus. Okay. Thank you.
    Chairman Baker. Yield back?
    Mr. Hinojosa.
    Mr. Hinojosa. Thank you, Mr. Chairman.
    Before I ask my question, Mr. Falcon, I want to stress that 
the housing market has served as the foundation of the U.S. 
economy since the stock market declined post-Clinton and post-
9/11. During that time, Fannie Mae, and Freddie Mac have played 
a key role in supplying liquidity for the housing market, 
thereby supporting our economy in a time of need, especially 
when we had gone from a budget surplus to an incredible and 
dangerous deficit. It is my firm belief that whatever action 
that we decide to take in Congress, if any, with respect to any 
of the GSEs, we must not alter their internal structure or any 
aspect of their regulation that would harm them or our economy.
    In your testimony, you ask for increased funding for OFHEO 
for fiscal year 2004. Some critics will say you don't deserve 
it because you failed to uncover Freddie Mac's problem. Others 
would say you need it because otherwise additional problems 
could arise if you don't have the manpower to oversee these two 
giants. Even though there is discussion of the creation of a 
new regulator, that likely will not be up and running until 
2005, if at all. Consequently, you will need funding. How much 
money do you need to oversee the GSEs in this year, and how 
much is in your proposed budget in the omnibus bill which we 
have not yet passed?
    Mr. Falcon. I appreciate your interest in this, 
Congressman. Our budget is $40 million. That is our 2004 
budget. And that $40 million includes an amendment that the 
President requested to our 2004 request which would allow us to 
fund the special review of both Fannie Mae and the continuing 
review of one aspect of the Freddie Mac issue. In addition, it 
will allow us to hire additional examiners, I think some 18 
examiners as well as a few other analysts to help us enhance 
our oversight. They are funds that we do need very much. We 
have developed plans on how we will utilize these additional 
staff resources and we are just waiting for the funding so we 
can begin to hire these people and plug them into our 
oversight.
    Mr. Hinojosa. Finally, Mr. Falcon, I have two short 
questions for you. How much money would you want Congress to 
give you if it decides to pass a supplemental early this year 
in addition to those $40 million? And, also, what is your 
opinion of the various proposals for new regulation of GSEs?
    Mr. Falcon. As far as additional funds beyond the $40 
million, we do have plans to increase the size of our 
examination staff beyond the amount that is included in our 
2004 budget. It would be optimal to be able to begin to hire 
those individuals as soon as we can identify them, however, we 
have to manage our growth appropriately. I think the 2004 
budget is of a sufficient amount that will allow us to do the 
growth that we desire for this year. Beyond this year, we will 
need additional funds to continue to enhance and strengthen our 
supervision. But we have to manage this growth in a proper way. 
So I think the 2004 budget is adequate. However, for 2005 we 
would like additional funds beyond our 2004 budget.
    Mr. Hinojosa. On the second question, what is your opinion 
of those proposals that are out there now for the regulation of 
the GSEs?
    Mr. Falcon. My position remains the same as my testimony 
that I gave the committee last year. I do support strengthening 
of the safety and soundness regulation of Fannie Mae and 
Freddie Mac. I do think that we should start with the premise 
that a safety and soundness regulator for these companies 
should have all the same powers and authorities as every other 
safety and soundness regulator, and that is what I have tried 
to establish since I became Director of OFHEO. That involves a 
strong independent regulator, not part of the appropriations 
process, and I think this is appropriate because we are not 
funded with taxpayer dollars. We are funded through assessments 
on the two companies that we regulate. It also requires, I 
think, expedited hiring authority.
    Let me just, instead of going on, just refer you to my 
testimony from my last appearance at the committee and say that 
remains my position as I stated in that testimony.
    Mr. Hinojosa. Thank you, Mr. Falcon.
    With that, Mr. Chairman, I yield back.
    Chairman Baker. Thank you, Mr. Hinojosa.
    Mr. Shays.
    Mr. Shays. Thank you, Mr. Chairman.
    I can't disagree more strongly with anyone who believes 
that somehow allowing Fannie Mae and Freddie Mac to play by 
different rules than any of the other businesses that they 
compete with should be allowed to continue; and I would just 
like to ask Mr. Falcon, why shouldn't I feel that OFHEO is a 
captive of Freddie and Fannie? What confidence should I have 
that this organization isn't held captive by these--by both 
companies?
    Mr. Falcon. I think since I have been Director of this 
agency we have demonstrated our willingness to take whatever 
action we feel is appropriate as a regulator, whether or not 
the enterprises agree or disagree with our actions. We have 
always conducted ourselves in this way, and we will continue to 
do so.
    Mr. Shays. Let me ask you this: What has been your position 
on getting Fannie and Freddie to be under the 1933 and 1934 
Securities Acts?
    Mr. Falcon. I support removing those exemptions, the 
exemptions from those two acts.
    Mr. Shays. Okay.
    Mr. Falcon. I think our experience with Freddie Mac 
demonstrates that a system of voluntary disclosures just cannot 
work for these two companies.
    Mr. Shays. When did you come to that conclusion?
    Mr. Falcon. I think the report of our examination 
demonstrated that a voluntary system just cannot work well 
enough, and it is when I was presented with the results of our 
special examination that I came to this conclusion.
    Mr. Shays. So we have had Treasury going back over a decade 
and a half recommend they be under Fannie and Freddie. We have 
had the head of the Federal Reserve suggest that they be under 
the 1933 and 1934 Act for many, many years. You come to this 
conclusion based on what you learned recently with what has 
happened with Freddie and this investigation?
    Mr. Falcon. Yes.
    Mr. Shays. Okay. How have you conveyed your feeling that 
this needs to happen?
    Mr. Falcon. The rationale?
    Mr. Shays. No, no. How have you conveyed to Congress and 
others that they should be under the '33 and '34 Act?
    Mr. Falcon. It is a recommendation contained in the report 
that I submitted to the committee.
    Mr. Shays. Okay. Can you cite that and read it for us?
    Mr. Falcon. Yes. Congressman, if you look at the 
recommendations it is contained in page 164 of the report and 
it is number three.
    Mr. Shays. Would you read it?
    Mr. Falcon. Yes. OFHEO should establish a regulatory system 
of mandatory disclosures for the enterprises or their 
securities exemptions should be repealed.
    That is the heading. Would you like me to read the entire--
--
    Mr. Shays. Pick out the most juicy part.
    Mr. Falcon. The disclosure failures of Freddie Mac were 
extensive and damaging to the trust of the public in the future 
disclosures of the enterprise. It is clear that the financial 
disclosures of an enterprise should not be left to a system of 
voluntary commitments. Fannie Mae has registered with the 
Securities and Exchange Commission under the Securities 
Exchange Act of 1934, and Freddie Mac has promised to do so as 
soon as possible. To address the issue of the adequacy of 
enterprise disclosures completely, OFHEO should implement 
mandatory regulations that provide for mandatory disclosure 
similar to that required of SEC-registered companies and build 
staff resources necessary to oversee compliance. Alternatively, 
the Congress should repeal the exemptions of the enterprises 
from the Exchange Act and the Securities Act of 1933. Either 
option should result in the type of mandatory disclosure and 
oversight regime necessary to ensure safe and sound conduct.
    Mr. Shays. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Shays.
    I just have a couple of follow-ups.
    With regard to your assessment of the enterprises' capital 
adequacy, it has been clearly stated that the retained 
portfolios have grown, depending on the enterprise, 6 to 700 
percent. I have knowledge that the purchase of their own 
mortgage back securities which was initially contemplated 
moving more risk out of the portfolio into the other sectors of 
the market now having been brought back in significant amount 
into their retained portfolio has resulted in significant 
increased leverage ratios. Given the uncertainties of 
accounting condition, is there any explanation why we shouldn't 
see some increase in capital surplus and at least some 
consideration of another approach to help with market 
discipline, given the financial constraints which you face and 
the uncertainties of the condition of the enterprises if we 
were to move to quarterly fair value disclosures?
    Now I understand the calculation of fair value is distinct 
and different from core capital calculation. But any consistent 
measure against which previous quarter performance can be 
measured against the current data I think is a helpful tool to 
the markets to better understand the risk profiles of the 
various enterprises. Would you think it advisable or ill-
advised to consider requiring quarterly disclosure of fair 
value?
    Mr. Falcon. I think it might be well-advised if we could 
make sure that the calculations are consistent by both 
companies. They might not necessarily be consistent, and 
therefore you might not be able to properly compare one against 
the other.
    Chairman Baker. And that is the case together with general 
disclosure. We are moving toward comparability, but we don't 
have it today, do we, in a broad sense?
    Mr. Falcon. In a broad sense, yes.
    Chairman Baker. With regard to the point made by members 
previously with the lack of adequate funding, it is my 
understanding--and please confirm if I am correct--that OFHEO 
is the only principal Federal financial regulator that is 
subject to congressional appropriations for its enterprise 
operation, meaning that each year you must submit for budgetary 
consideration a budget which then has to be acted on by the 
Congress as contrasted, for example, with the OCC which 
oversees large commercial banks. They have a formula that 
results in an assessment, and that is an automatic calculation 
that enables that enterprise to engage in its regulatory 
function without the necessity of making its case, as it were, 
to the Congress. Is OFHEO's condition in that regard a unique 
one?
    Mr. Falcon. Absolutely, Congressman.
    Chairman Baker. So that if we were to create a regulatory 
enhancement for your shop, having you funded independently of 
congressional action would be a very significant benefit to 
you.
    Mr. Falcon. Absolutely. It would benefit us in many ways. 
It seems every year we have to slow down our operations as far 
as hiring goes and major acquisitions purchases by the agency 
until we wait for a budget to get enacted after the CR period 
is over. Being out of the appropriations process would allow us 
to engage in long-term planning and meet immediate funding 
needs on a real-time basis. Right now, we have to set our 
budget 2 years in advance and hope that the budget we had put 
together at that time still matches the requirements that we 
have. As we have found with this Freddie Mac situation, our 
budgetary needs have not kept up with our requirements, but we 
are trying to adapt as quickly as possible. We would have much 
more flexibility to do so were we not part of the 
appropriations process.
    Chairman Baker. And if you had those resources you would 
probably implement all 16 and get on with that forensic 
accounting business, too.
    Mr. Falcon. Right, Congressman. Although, appropriations or 
no appropriations, we will look at moving on as many of these 
16 as soon as possible.
    Chairman Baker. As a sort of follow up to Mr. Shays' line 
of questioning, with regard to recommendation number three, if 
you are unable to establish or find it unwise to establish a 
mandatory disclosure regime or part of that recommendation or 
their securities exemption should be repealed, that would 
require action by the Congress, would it not?
    Mr. Falcon. Yes.
    Chairman Baker. Okay.
    Mr. Kanjorski, do you have any follow-up?
    Mr. Kanjorski. Just if I could ask your opinion. After 
having made this detailed study and having the new accounting 
operations at Freddie Mac, do you have an opinion as to whether 
or not there is any systemic risk involved here with these GSEs 
or have you satisfied in your own mind that you know all the 
occurrences that have taken place and in your opinion is there 
any risk now to the system or to the taxpayers?
    Mr. Falcon. There are two aspects of this that I would like 
to get into. First is, as a general matter, we published a 
study a year ago which identified and explained the nature of 
the systemic risk posed by the companies. Now, systemic risk is 
different from an imminent threat of a systemic disruption 
which would happen if either company experienced severe 
financial difficulties such that they would default on 
counterparty obligations or risk insolvency at this point or at 
any time. While Freddie Mac has experienced these accounting 
problems, have we felt that the company's safety and soundness 
was compromised? These were very improper practices which were 
not safe and sound practices, and we have taken all the action 
necessary. But is the company unsafe and unsound? We don't 
think so.
    Mr. Kanjorski. Now, just one other question. I have met 
with a lot of Directors in the Federal Home Loan Bank system 
and they have expressed to me their desire to have more 
expertise in the derivative area and particularly with the 
counterparties they are engaging in. Have you developed any 
scheme within the--your agency as to what can or should be done 
here to take the risk out of the counterparty situation, or are 
we just going along in the way it has occurred before, the 
restatement?
    Mr. Falcon. I think there are mechanisms in place to try to 
manage the risk of counterparty defaults where the company--I 
mentioned the ratings of the companies, but that is not the 
main one. I think when the companies engage in derivative 
transactions they do obtain collateral for their exposure if 
there was a default and a need to replace the derivative. And 
there are netting agreements in place as well for the company. 
So I think there are mechanisms in place to try to deal with a 
potential default of a counterparty. But, ultimately, each 
player in this, whether it is us as the regulator, Fannie, 
Freddie or a bank regulator as a regulator of a bank 
counterpart, has to fulfill their mission in making sure that 
their part remains safe and sound.
    Mr. Kanjorski. Well, what do we do, though, to--I mean, I 
was impressed when Directors come forward and say, look, this 
is beyond our understanding as Directors. We just don't know 
whether we are doing the right things or not doing the right 
things, and we have no one to call upon to provide with us that 
expertise. How can we--with this new derivative area that we 
are in, how can we take that risk or that absence of knowledge 
away and provide the knowledge that the Directors or the 
companies need or the taxpayers need with our oversight to see 
that that risk doesn't exist anymore? Is there any way of 
lessening it?
    Mr. Falcon. On the part of the Board which you have 
mentioned, I think they have to be certain that they have 
adequate expertise within the company to understand and manage 
that risk, and they have to receive frequent and adequate 
reports from management about their activities in managing that 
risk. Now, ultimately, do you expect the Board to be experts in 
derivative transactions? I don't think you can reasonably 
expect that every Board member will have that kind of 
specialized expertise. So it is important for the Board to make 
sure that the company retains that expertise, but they have to 
adequately oversee that expertise as the Board of Directors, 
and it is the responsibility of OFHEO to make sure that all 
that takes place as well.
    Chairman Baker. If I can, I have just been advised that 
approximately noon or shortly thereafter we will have a series 
of votes. If members don't have any additional questions for 
Mr. Falcon at this time, then I would like to express my 
appreciation to him for his appearance so that we may get our 
next witness up.
    Did you have any further, Mr. Bachus?
    Mr. Bachus. Mr. Chairman, if I could just ask one brief 
question.
    Director, I asked earlier--asked a question in January. 
When Freddie Mac announced that they were going to restate 
earnings, I asked you what response OFHEO took; and your 
response was that the outside law firm was hired to investigate 
the circumstances. But now they were hired by the Board of 
Directors, weren't they?
    Mr. Falcon. Yes, that is correct.
    Mr. Bachus. Not by OFHEO.
    Mr. Falcon. Correct.
    Mr. Bachus. Now what you said you all focused on was 
getting the restatements done.
    Mr. Falcon. Yes.
    Mr. Bachus. Now let me ask you two questions. First, the 
outside law firm that was hired by the Board of Directors, they 
made a report which basically did not reveal what your special 
investigating unit found. I mean, it is rather incomplete, 
would you agree?
    Mr. Falcon. It didn't cover all the areas or make the same 
kind of critical analysis that our's did, I believe.
    Mr. Bachus. Right.
    Mr. Falcon. Yes, sir.
    Mr. Bachus. Do you think that there was any concealment? 
The reason maybe they didn't find some of these things, do you 
think there was any concealment?
    Mr. Falcon. I don't have any evidence of that, Congressman.
    Mr. Bachus. Do you think that the report--that their report 
was in some way compromised by----
    Mr. Falcon. In what way? I think----
    Mr. Bachus. Well, that is the Doughty report I think you 
are referring to.
    Mr. Falcon. Yes.
    Mr. Bachus. But your special investigative unit began to 
investigate the same matters, you found additional things, and 
that was--is that correct?
    Mr. Falcon. Yes, that is correct.
    Mr. Bachus. I'm just saying, why do you think that they 
weren't found in the investigation that was authorized by the 
Board of Directors and you were able to find these things?
    Mr. Falcon. Well, I think that report was focused primarily 
on the transactions and the nature of the transactions. We 
tried to get at the root cause of what happened with the 
company and how it got to that point, and we were going to look 
at not just the transactions but also the conduct of management 
and the conduct of the Board of Directors. Now, I guess an 
obvious limitation of that report by the outside law firm was 
its client was the Board and it was hired by the Board and I 
don't think it was going to take as critical a look at the 
conduct of the Board as we were prepared to do.
    Mr. Bachus. All right. Well, that is what I would suspect, 
also, that because it was hired by the Board and not OFHEO, 
does that indicate to you maybe if this were to happen again 
that it would be better for OFHEO to select then or investigate 
itself or at least select and charge the outside firm?
    Mr. Falcon. I think that would be the presumptive course to 
take. Here, again, until a deeper review was conducted, it 
wasn't evident what kind of conduct we were really talking 
about at the company.
    Mr. Bachus. You said, as opposed to investigating the 
circumstances, you allowed the Board to hire an outside 
investigator which was charged with only limited scope which 
is--in hindsight is a mistake. But you said you focused on the 
restatements, but those are still not complete.
    Mr. Falcon. Our position at the time, Congressman, was we 
were focused on getting the timely financial statements and 
getting the reaudit, restatement done. At the same time, the 
Board hired this outside law firm to conduct its analysis of 
the circumstances that brought about the reaudit. At the time, 
we believed were making good progress with the restatement and 
that we would assess the work of this law firm to decide 
whether or not it was necessary for us to conduct additional 
review. When the events of June took place, it became clear 
that we could not wait for the law firm to finish its work and 
we would not wait for the restatement and reaudit to get 
completed either.
    Mr. Bachus. Well, that is why I am saying it only became 
obvious to you after the resignations that it wasn't a 
sufficient investigation of the circumstances.
    Mr. Falcon. Right. And it was beginning to become clear 
that this was not just about a disagreement between the 
auditors but rather there was more going on at the company.
    Mr. Bachus. Okay. Now, there are still restatements to be 
done so Freddie Mac is still not current in that, am I correct?
    Mr. Falcon. Right. Technically, the restatements have been 
done. What is lacking is there aren't quarterly statements for 
2003 nor will there be a year end 2003 financial statement. 
That is what the company is working on right now.
    Mr. Bachus. All right. Thank you.
    Chairman Baker. The gentleman's time has expired.
    Mr. Falcon, I wish to again thank you for your courtesy in 
appearing here today. We look forward anxiously to the final 
recommendations you may choose to make with regard to potential 
reform and certainly into the next year we will do our best to 
be of assistance with those funding concerns. Thank you very 
much for your presence.
    Mr. Falcon. Thank you very much, Mr. Chairman, Congressman 
Kanjorski.
    Chairman Baker. At this time, I would invite Mr. Martin 
Baumann, Chief Financial Officer of Freddie Mac, to come 
forward.
    Welcome to Capital Markets, Mr. Baumann. We certainly 
appreciate your courtesy in appearing here today, given the 
interest the committee has in this important matter.
    As is the usual custom, your formal statement will be made 
part of the record. To the extent possible, if remarks can be 
targeted toward the 5-minute rule then that will enable members 
to ask appropriate follow-up questions.
    With that, we welcome you as the Chief Financial Officer of 
Freddie Mac to make your statement.

   STATEMENT OF MARTIN F. BAUMANN, CHIEF FINANCIAL OFFICER, 
                          FREDDIE MAC

    Mr. Baumann. Thank you, Chairman Baker, Ranking Member 
Kanjorski and members----
    Chairman Baker. I think that button on the bottom will have 
to be pushed. Try that.
    Mr. Baumann. Thank you.
    Chairman Baker. No, try again.
    Mr. Baumann. Can you hear me now?
    Chairman Baker. There we are.
    Mr. Baumann. Thank you Chairman Baker, Ranking Member 
Kanjorski and members of the subcommittee.
    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 of 2003. I was hired to build a strong 
finance function within Freddie Mac and 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.
    2003 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. Last year, we completed 
the restatement of prior year financial results. OFHEO 
completed its special examination, and we entered into the 
consent order. We are implementing a corporate-wide remediation 
program to ensure that the accounting of financial control 
issues that led to the need for the restatement will never 
happen again. We appreciate the subcommittee's patience as we 
have worked through these tough times.
    Freddie Mac's mission is to insure a stable supply of low-
cost mortgages for America's families, whenever and wherever 
they need them. We recognize our special responsibility to home 
owners, the public, Congress and investors. Despite our 
difficulties last year, we maintained our focus on fulfilling 
these responsibilities.
    As the President said last night, the country is 
experiencing record home ownership rates. We are proud of the 
role we are playing in this important accomplishment.
    Our highest priorities are remediation and compliance with 
the consent order, along with bringing our financial statements 
current. We are firmly committed to building a new 
organizational culture based on transparency, openness, and 
building of long-term results. We are headed in the right 
direction, and we have the right leadership to reach our goals 
in our new Chairman and Chief Executive Officer, Richard F. 
Syron.
    Before addressing our remediation and compliance efforts, 
allow me to say a few words about the completion of our 
restatement and prior year results.
    On November 21, 2003, Freddie Mac's Board of Directors and 
management team announced the release of the company's restated 
and revised financial results for the years 2000 through 2002. 
We are now completing our annual report for 2002 and expect to 
hold the related annual stockholders meeting this quarter.
    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. 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. Our 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 November, 2003, unchanged from October.
    Freddie Mac is currently engaged in an active remediation 
program that began in the spring of 2003 when the governance 
committee of the Board asked me to develop a remediation 
program to ensure that the factors contributing to the 
restatement would never recur. Thereafter, the Board 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. We have been working 
closely with OFHEO to make sure that we take the remediation 
steps required by the consent order on a timely basis.
    Our commitment to implementing the requirements of the 
consent order and the remediation program is unwavering. The 
activities we have already taken and are continuing and our 
continuing plans, including fulfillment of 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.
    In implementing the consent order, Freddie Mac will be 
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.
    Freddie Mac has added over 100 professionals in accounting 
reporting and control areas, including a significant numbers of 
new officers and senior managers. We have also retained leading 
experts in the areas of public disclosure and corporate 
governance to assist the company in designing and implementing 
processes and practices in these areas.
    We hired a Senior Vice President and Chief Compliance 
Officer who is responsible for overseeing Freddie Mac's 
compliance with policies, procedures and practices, including 
compliance with laws and regulations; and we have established 
and filled the new position of Chief Enterprise Risk Officer. 
We are also working to implement new 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. In this regard, 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.
    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.
    Together with Freddie Mac's new Chairman and CEO as well as 
our senior management team I will insure that we set the right 
tone at the top.
    Now that the restatement is complete, Freddie Mac is 
focused on bringing our financial statements completely up to 
date. Our objective is to release quarterly and full-year 2003 
results by June 30, 2004, and to provide the 2003 annual report 
shortly thereafter.
    Freddie Mac remains irrevocably committed to completing the 
process of registering our common stock with the Securities and 
Exchange Commission under the 1934 Act, with the objective of 
completing that process as soon as possible after the company's 
return to timely reporting.
    In 2004 we look forward to working with Chairman Baker, 
Congressman Kanjorski and the members of this subcommittee as 
you consider regulatory oversight proposals. Freddie Mac has 
long supported a strong regulator as critical to the 
achievement of our mission.
    As I have outlined today, Freddie Mac is bringing our 
financial statements current and building for the future. We 
have taken 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, together with our commitment to fulfilling the 
obligations of the consent order, will enable us to reach that 
goal. While 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 here today.
    Chairman Baker. Thank you, Mr. Baumann.
    [The prepared statement of Martin F. Baumann can be found 
on page 54 in the appendix.]
    Chairman Baker. I would assume that your public statements 
on the agreement reached with OFHEO came pursuant to direction 
by the Board. In mid December, press accounts give attribution 
to you for several points that appeared to be disputing the 
need for the recommendations of the regulator.
    One, you stated it doesn't believe it needs to slow its 
growth with reference to Freddie Mac. We don't see any reason 
to change our business activities. We don't need to raise more 
capital. Freddie Mac hasn't agreed to OFHEO's recommendations. 
And then, finally, sort of the fitting last piece, putting a 
constraint on our growth could create risk. It would limit 
opportunity to create profits for shareholders.
    Since that time, till now, has the Board's opinions been 
modified or are those your personal views at the time that have 
now been modified? I think the recommendations made by Mr. 
Falcon, or at least that he is contemplating, more accurately, 
are highly appropriate. Can you rectify the two sets of 
statements, or four sets of statements, together with the 
recommendations and your stated intent this morning to move 
toward implementation of those recommendations?
    Mr. Baumann. Yes. Those responses are to a question 
regarding the accuracy of our capital; and as demonstrated by 
our reports that we have filed with OFHEO, we meet our minimum 
capital guidelines and, in fact, we exceed our capital 
guidelines with a healthy surplus. So Freddie Mac has a very 
strong capital base today. Freddie Mac uses this capital base 
to fulfill its housing mission on a day in and day out, buying 
mortgages, entering into transactions, raising our funds in the 
capital markets, bringing debt holders around the world to the 
investors around the world into our--into Freddie Mac to invest 
into the U.S. mortgage market. This is a--this is improving the 
mortgage market all the time and lowering the cost to families 
to acquire their mortgages and their homes.
    So I think our activities have been operated in a safe and 
sound manner, as the Director mentioned today that the safety 
and soundness of Freddie Mac was not in jeopardy during this 
period of time when the financial statements were untimely, but 
our market risk and our credit risk have been well managed 
during all of those times and we have been able to fulfill our 
goal of continuing to invest in the mortgage market, to provide 
liquidity to that market and to attract investors, both in the 
U.S. and around the world, to our securities so that we can 
further invest in that market.
    Chairman Baker. Well, I appreciate the answer with regard 
to capital. I don't necessarily agree with your view of the 
matter. But set capital aside for the moment. There are 15 
other recommendations. I can be specific. Does the Board intend 
to separate the functions of the CEO from the Chairman of the 
Board? That is number one.
    Mr. Baumann. The new Chairman of the Board was appointed 
and it was discussed with the Director of OFHEO before he was 
hired and it is understood that that role would be a combined 
role of the Chairman and CEO at this point in time and that 
over time that that recommendation would be implemented.
    Chairman Baker. Okay. Number two, do you think that the 
financial incentives for compensation that are currently based 
on short-term goals and maintaining earning stability should be 
modified or has it been modified or do you intend to modify it, 
the method by which executives are compensated for performance?
    Mr. Baumann. We are modifying greatly and already have 
modified greatly the way in which executives are compensated. 
There are--in the past, there were short-term earnings targets, 
short-term growth in operating earnings and earnings per share 
targets that were part of the company's scorecard. The current 
year scorecard has no short-term earnings per share or 
operating earnings targets attached to it. Management 
compensation is being driven by a variety of factors. Mission 
is the first and foremost part of that. Building internal 
controls and getting our financial statements current is the 
second largest piece of that. Growing long-term value in the 
company is another part of that. But short-term earnings goals 
are not part of the scorecard for management compensation.
    Chairman Baker. Do you contemplate term limits for Board 
members, Board of Directors?
    Mr. Baumann. These factors with respect to corporate 
governance are under consideration by the Board, and we will be 
talking to OFHEO about these recommendations. Again, these were 
recommendations, first of all, to Director Falcon from his 
staff. Director Falcon is the one who will determine how they 
would be implemented in terms of working with our Board and 
with management.
    Chairman Baker. And to the generic question, do you agree 
with Mr. Falcon's assessment that he has the authority to 
implement all 16 recommendations if he so chooses, or is that a 
position which Freddie would have objection to and take steps 
to litigate the implementation of proposed rules?
    Mr. Baumann. We are working with OFHEO. We understand the 
issues that surrounded Freddie Mac in the past. The questions 
around the internal controls and the lack of accounting 
expertise, I, among others, was hired to fix those problems as 
well as the new CEO Dick Syron was hired to fix those problems 
and change the culture. We are working with OFHEO to accomplish 
all of these needed reforms.
    Chairman Baker. Well, let me hone in one more time because 
my time's expired, and I want to make sure other members have a 
chance for questions before we get into votes.
    For example, go back to number one, splitting the functions 
of the CEO and the Chairman. Given the current understanding of 
the current CEO with regard to the combination of those 
responsibilities, can Mr. Falcon require the enterprise to 
separate those two functions, or is that something that you 
believe you have independent authority to maintain business 
structure?
    Mr. Baumann. I think Director Falcon has already said that 
he can enforce regulation. He can put regulation into law and 
then we would have to comply with that. But having said that, 
we have no--we are not trying to argue these recommendations. 
We have signed a consent order and agreed to that consent order 
and implementing remedial actions. We are working--these 
particular recommendations again are not yet immediate 
recommendations to us. These are recommendations to Director 
Falcon from the staff, and he is working on his determination 
of how they should implemented.
    Chairman Baker. So, to conclude, if Mr. Falcon is to 
determine any or all of these are appropriate actions to 
recommend or put into place, it would be your understanding as 
of today, understanding the Board may direct you at a later 
time, that Freddie Mac would not object to obfuscate, block, 
otherwise take legal actions to preclude the implementation of 
the recommendations of the Director.
    Mr. Baumann. Again, as I said, we are working closely with 
OFHEO to try to implement these recommendations. To the extent 
Director Falcon agrees with all of them, and appropriate 
recommendations, we would work along with them to implement.
    Chairman Baker. And inappropriate ones you would not.
    Mr. Baumann. If Director Falcon believes these 
recommendations are appropriate and makes the recommendations, 
we would work with him to implement them.
    Chairman Baker. Thank you.
    Mr. Kanjorski.
    Mr. Kanjorski. In as simple a way as possible, could you 
tell us what the root core of the failure at Freddie Mac was in 
terms of not getting the restatements done? Do you believe 
that, as Mr. Falcon indicated, that it was just in the interest 
of executive compensation that this action was undertaken and 
no other reason?
    Mr. Baumann. Since I joined the company in April, 2003, I 
have been working hard to improve our financial reporting 
capabilities and our internal controls and to get the 
restatements of prior years results done, which we accomplished 
in November of 2003, now working on getting the 2003 results 
issued. At the same time, the Board engaged Baker Botts to do 
an independent study of the factors leading up to the 
restatement and then OFHEO performed its own investigation of 
the factors leading up to the restatement. I think those 
reports speak for themselves, and I have not done any further 
investigation beyond those.
    Mr. Kanjorski. Are you satisfied that what has been 
indicated today here as to the root cause of this problem was 
simply the executive compensation desires? Or is there 
something more? I am trying to get to whether or not you are 
satisfied now in your nine months with Freddie Mac that we know 
what precipitated and caused this activity and that it is only 
simply a desire to increase compensation of a limited number of 
the executives. Is that your judgment now?
    Mr. Baumann. Well, that is--that was the statement that 
came out of Director Falcon and his interpretation.
    Mr. Kanjorski. Well, I am asking you whether you agree with 
that interpretation or do you have some other sense or are you 
satisfied it was simply this exuberance, if you will, of the 
executives to gain compensation, additional compensation.
    Mr. Baumann. I am satisfied that the investigations done by 
Baker Botts and the investigations done by OFHEO were thorough 
and examined the transactions and the culture in the company 
that led to the use of certain capital markets transactions 
for--with a view towards their effect on earnings. I am 
satisfied that the events have been uncovered that led to the 
conditions at Freddie Mac, and I think those two reports both 
put a lot of facts on the table about them. What individual 
motivations may have been back then I have not done any work to 
understand those individual motivations. I don't know of any 
other motivations other than those expressed so far.
    Mr. Kanjorski. What I am primarily interested in is getting 
to what the cause of this problem was, whether or not it is in 
your mind solved now. But particularly, again, going to the 
role of Directors, it seems to me this whole problem was 
discovered by the need or the decision to change auditors and 
that if auditors hadn't been changed even today these 
occurrences would be occurring and we wouldn't know about it. 
What, internally, have you done or can you do to correct that 
possibility in the future?
    Mr. Baumann. Right. Thank you. We can do a lot, and we have 
done a lot.
    As I mentioned in my oral testimony, I have hired more than 
100, 100 accounting professionals who now work with me in the 
financial function. We have recruited some of the best people 
that we can find to add to accounting expertise needed in this 
company.
    In addition to that, in my job as the Chief Financial 
Officer I don't have any direct responsibility for what the 
earnings numbers are. I don't run any businesses in the 
company, and I don't--and I am not tied to any earnings 
objective. My responsibilities as Chief Financial Officer are 
to ensure that we report results accurately, completely and 
transparently, with no bias whatsoever as to what the outcome 
is as to what those results are. My responsibility is to 
oversee internal controls in the company and to report if there 
were any weaknesses in our internal controls or oversight. So I 
have no responsibility for running the businesses.
    As the Chief Financial Officer I have responsibility 
different than the past in the company. I have responsibility 
for the credibility of financial reporting and the quality of 
our internal controls. That, along with hiring of a new Chief 
Executive Officer, setting the right tone at the top in the 
company, along with building the accounting expertise and using 
consultants to build the right accounting expertise and 
controls will prevent this situation from ever happening again.
    Mr. Kanjorski. Are you completely independent of the 
Chairman, the CEO, and do you report directly to the Board or 
are you still dependent on your superiors in the chain of 
command?
    Mr. Baumann. Okay. I report directly to the Chairman and 
chief executive of the company. I have direct reporting lines 
to the Board. I am the lead liaison in the company to the audit 
committee. I am the lead liaison directly to the chair of the 
audit committee with respect to matters that get reported 
there. But I do have a direct reporting line to our Chief 
Executive Officer.
    Mr. Kanjorski. How do you see that the Board in the future 
would know if there is this problem occurring? What are the 
controls that are in place now that would clearly give the 
Directors or the auditing committee or the Board the insight as 
to the existence or the potential existence of a problem and 
how would they know about it any greater than prior to this 
occurrence?
    Mr. Baumann. In any company, as you were suggesting 
earlier, a Board does have to rely on the quality of the people 
and processes put in place at that company.
    The Board has hired people that they believe are 
appropriate in the circumstances.
    When I was hired in April, I interviewed with the Chairman 
of the Audit Committee, the Chairman of the Compensation 
Committee, the presiding Director of the company, all of whom 
set the ground rules for me, in terms of what their 
expectations were. I spent 33 years in the practice of public 
accounting, working with some of the largest financial 
companies in the world, ensuring that their financial 
statements were accurate and reliable and reporting to those 
audit committees of those companies in doing that.
    I am committed to reporting to this Board of Directors on a 
regular basis on any matter that I think they would find to be 
important, and that is a message that I have delivered 
throughout this company, but this company is going to operate 
in an absolutely open and candid way, and anybody that has 
concerns about any issue, they should be reporting them to 
their superiors and to me, and we will report that to the 
Board.
    We have also implemented certain things such as a hotline, 
which is a call base where employees can call outside of the 
company to a third company to discuss anything that they have a 
concern about, and we have mentioned that in a code of conduct 
in Sarbanes-Oxley that we have conducted.
    Mr. Kanjorski. It seems to me, again, because of your high 
ethical standards and the code you set you are satisfied this 
cannot happen again, but what happens if you get replaced?
    Is it the chief financial officer, depending on what his 
ethical standards are, that could determine whether or not this 
could happen again?
    Mr. Baumann. Certainly, again, the people one hires, the 
people one hires is important to the credibility of the 
process.
    I believe the people I am hiring are highly ethical and 
also that have the same culture with respect to financial 
reporting, so the people I am hiring are of the same type.
    We are also working on a succession planning model, such 
that we have in place, should I disappear for whatever reason, 
have in place succession plans with the right people, with the 
right skill sets, and that the Board will have preapproved that 
succession planning in order to keep this kind of culture of 
accuracy and culture of integrity alive.
    Mr. Kanjorski. One other question: Looking at this whole 
problem, have you estimated what the cost to the company is 
actually, what it has been, and what benefit would flow from 
the people who set up the mechanism of these restatement 
manipulations?
    I am trying to get a proportion.
    Did it cost the Board or the company a billion dollars?
    Mr. Baumann. I do not know what benefit people got in the 
past, and again I----
    Mr. Kanjorski. Not the people now. I am just talking about 
what is the cost in your judgment to the company?
    Mr. Baumann. The cost that we spent in connection with the 
restatement during the year 2003 was a little bit more, 
approximately $100 million, and we anticipate spending similar 
amounts in 2004 on consultants in connection with building 
systems.
    Mr. Kanjorski. 100 million or billion dollars?
    Mr. Baumann. $100 million, $100 million.
    Mr. Kanjorski. Of course, the fine, 125 million.
    Mr. Baumann. $125 million fine is in addition to that, sir.
    Mr. Kanjorski. Now, do you have an idea, a rough 
calculation, as to the perpetrators, what did they gain out of 
this in terms of dollars?
    Mr. Baumann. No, I do not have that, sir.
    Mr. Kanjorski. I mean, did they gain more than that 225 
million or much less?
    Mr. Baumann. I have no way to calculate that.
    Mr. Kanjorski. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Mr. Kanjorski.
    Mr. Shays?
    Mr. Shays. I defer.
    Chairman Baker. Mrs. Biggert?
    Mrs. Biggert. Thank you, Mr. Chairman.
    Mr. Baumann, in your testimony, you set deadlines for 
completion of the financial reporting for 2003 and 2004, and 
additionally I think you thought that the company would be 
registered with the SEC by 2005, and it seems like these dates 
have been moving since the agreement in 2001.
    What steps will Freddie Mac take to meet these deadlines?
    Mr. Baumann. Since I have been hired in April of 2003, as I 
said earlier, I have hired 100 accounting professionals, and I 
am using the resources of the best accounting consulting firms 
to work with us, in terms of building appropriate internal 
accounting systems and financial reporting capability.
    As stated in the Baker Botts report, the company has lacked 
the accounting expertise in the past which led to the 
restatement and has therefore also led to the fact that we are 
not yet registered with the SEC.
    We are 100 percent committed to the improving of the 
accounting expertise in the company and bringing in the kind of 
talent we need to get the financial statements current again 
and then to go on with our registration with the SEC.
    I have met with the SEC on a number of occasions already as 
part of the restatement. They have agreed in discussions with 
me that they would reengage with us as soon as we complete our 
2002 annual report, which I have indicated we expect to 
complete this quarter, and then using the 2002 annual report we 
will begin to go over the registration process and start to 
prepare the registration documents and get the decisions 
regarding disclosure matters for registration agreed with by 
the SEC.
    We cannot become a registrant until our financial 
statements are again timely, but as soon as they are timely we 
hope to complete that as soon as possible thereafter.
    Mrs. Biggert. Just a question about the SEC. If Freddie Mac 
had registered with the SEC, would disclosures that were 
mandated in the forms 10K and 10Q, would those have revealed 
the trading irregularities and the mismanagement misconduct?
    Mr. Baumann. Well, one cannot completely answer those 
questions in hindsight, so the real answer is I do not know, 
but certainly the process of registering with the SEC is a very 
detailed process, where the SEC's Division of Corporation 
Finance reviews the financial statements, asks a lot of deep 
questions about financial reporting and the quality of 
disclosures around accounting principles, and a lot is 
uncovered as part of the registration process, so----
    Mrs. Biggert. With the registry with the SEC, what impact 
will it have on Freddie Mac business?
    Mr. Baumann. Registering with the SEC under the 1934 act 
would not have any particular impact on the business. It will 
demonstrate that the financial reports of Freddie Mac are of 
the same caliber as other companies that are registered. We are 
building that expertise to get that registration done.
    Mrs. Biggert. Okay.
    Thank you, Mr. Chairman. I yield back.
    Chairman Baker. Thank you, Mrs. Biggert.
    Mr. Scott?
    Mr. Scott. Thank you, Mr. Chairman.
    How are you, Mr. Baumann?
    Mr. Baumann. Fine.
    Mr. Scott. I wanted to ask you about the incentive 
compensation plans.
    How have you changed those incentive compensation plans for 
the senior officers at Freddie Mac?
    Mr. Baumann. There are incentive compensation plans that 
officers of Freddie Mac and many employees of Freddie Mac 
participate in, both long-term incentives and short-term 
incentives.
    The short-term incentives no longer have a current year's 
earnings per share or current year's growth in reported 
earnings as a major factor of that; in fact it is not a factor 
at all.
    As I stated earlier, the incentives are based largely on 
meeting our housing mission, meeting our affordable housing 
goals as the largest component of the compensation package, of 
the incentives.
    The second largest is geared towards completion of these 
requirements to get our financial statements current and to get 
financial statements issued by June 30, 2004, which is the 
target for the 2003 results for completing the internal control 
improvements, the remediation plan, and now the consent order 
required by us, by OFHEO.
    There are some other goals about growing the fair value of 
the company, increasing the long-term fair value of the company 
as well, but they are minor parts of the goal, of the 
incentives.
    The longer term incentives are really geared with employees 
involved in the short-term goals over a longer period of time 
and geared to their longer term success in achieving the 
mission of the company. So the answer is the short-term 
earnings goals have been removed, replaced by goals around our 
mission, more goals around our mission, affordable housing, and 
more towards our goals of improving our mission in the company.
    Mr. Scott. One other question, recently Fannie Mae has 
expressed its preference for a new regulator as a Bureau of the 
Treasury Department rather than a new independent agency.
    Has Freddie Mac taken a similar position in terms of a 
nonindependent regulator?
    Mr. Baumann. No, we have not taken a similar position.Our 
position is that we support strong and vital, vigorous 
regulation. We think it is important for us and for the 
credibility of Freddie Mac and the fulfilling of its mission, 
and we are ready to work with this committee and with Congress 
at large and the administration in whatever regulator they 
choose to put in place.
    Mr. Scott. Do you agree with Fannie Mae's preference for 
the Treasury Department?
    Mr. Baumann. We are--we would be happy with that outcome, 
but we would also be happy to work with other outcomes as well. 
We are not stating a particular preference for this outcome, 
other than a strong regulation.
    Mr. Scott. Okay.
    Last December the Federal Reserve released a report that 
stated that Freddie Mac and Fannie Mae provided meager help to 
home purchasers.
    Also, on January 9, in USA Today, they ask whether or not 
Americans were getting a bad return on their tax funded 
subsidies.
    How do you respond to these charges, and if you disagree, 
what efforts will you undertake to further expand home 
ownership to communities that previously have been left behind?
    Mr. Baumann. We do disagree with those findings, and we are 
committed to expanding home ownership, and we are supporting 
and want to work with the administration in initiatives to 
support home ownership.
    Our job is far from complete. Home ownership is great in 
this country. The number of homeowners is great in this 
country, but that is not equal among all the entire population 
of the United States, and it is important to increase minority 
home ownership in the United States.
    We are eager to participate in those efforts. Our new 
chairman and CEO Dick Syron is long a champion of home 
ownership for Americans as President of the Home Loan Banks in 
Boston and as President of the Federal Reserve Bank in Boston. 
He is eager to work with this committee and others to support 
home ownership among minorities and to grow home ownership.
    The study was by an employee of the Fed. Certainly there 
are other third party studies that disagree with that report, 
and one can just look in the papers, as I have done recently, 
this weekend, and if you look at the survey of what the 
interest rates are for jumbo mortgages, which we do not 
participate in, versus conventional mortgages, which Freddie 
and Fannie do participate in, there is a difference of 26 basis 
points on average between the jumbo mortgage and the 
conventional mortgage. On a $200,000 mortgage that adds up to 
$11,900 savings for a purchaser of that home and that mortgage. 
That is a considerable savings for a homeowner, so we think we 
are fulfilling our mission, adding considerable value to 
Americans and home ownership and considerable savings to 
Americans.
    Mr. Scott. Do you think there is any one piece of 
information why the Federal Reserve would release such a 
report, although you say it isn't one individual that was 
released through the Federal Reserve with their permission, 
with their permission, authority, so there must be some 
credibility there?
    What did they hang their hat on to make such a negative 
statement about the performance of your agency?
    Mr. Baumann. Their interpretation of numbers is often 
complex and different parties with the best intentions can come 
to different interpretations of results. A study was made and 
that was that particular person's interpretation of a variety 
of different measurements of economic data. There are other 
studies out there as well that would show a different answer.
    I happen to think the easiest way to look at the 
information is to look at the variation between jumbo rates, 
which Freddie Mac did not participate in, jumbo mortgages, and 
conventional mortgages, which we do, and that is a savings, 
just as I said to you today. That is 26 basis points today, or 
11-, over $11,000 savings to an American who has a $200,000 
mortgage.
    Mr. Scott. My final point, Mr. Chairman, is this: I am 
looking at a chart on home ownership rates, and it is broken 
down into the total USA, the white, black, Hispanic, other 
race, central cities, suburbs, and in each one of these 
categories there has been a slight increase in home ownership 
rate except for one, and that is the African American 
community.
    It went down between 2001, 2002, when all of the other 
categories of, total, white went up, Hispanic went up, other 
races went up, but for the black home ownership, it went down.
    What caused that? Why is there that aberration with that 
particular group when all the other groups, home ownership 
rates went up? What do you think accounted for that?
    Mr. Baumann. I cannot answer that question exactly in terms 
of why that happened. I can tell you unequivocally that Freddie 
Mac is committed to minority home ownership, especially home 
ownership by African Americans of homes.
    I am happy to bring that question back to Freddie Mac and 
ask our people to do--our economists who work in those areas to 
give me a report on their assessment of that, and I would be 
glad to share those findings with you, Congressman.
    Mr. Scott. I would be very interested in that because we 
would be doing our mission a great service if we could come 
back with some valuable information of what we are not doing 
for this minority group as opposed to other groups, because it 
is obvious that there is something there, and I would like for 
us to try to put our fingers on it so we can address it, and I 
appreciate that.
    Mr. Baumann. We will do that.
    Chairman Baker. Thank you, Mr. Scott.
    Mr. Shays.
    Mr. Shays. Thank you, sir.
    I welcome you. Thank you.
    In the report that OFHEO did, it said the special 
examination demonstrated that Freddie Mac knowingly departed 
from good public disclosure practices so as to obfuscate 
particular enterprise policies as well as specific capital 
markets and accounting transactions used to implement them. As 
a result, the public disclosures of Fannie Mae during the 
period investigated by the special investigation failed to 
comport with disclosures required by SEC registered companies 
which were assertively adhered to by the enterprise. The 
deliberate disdain of Freddie Mac for appropriate disclosure 
status in the face of its asserted compliance with best 
practices misled investors and constituted conduct that 
undermined market awareness of the true financial condition of 
the enterprise.
    You would agree with that statement?
    Mr. Baumann. There are many disclosures that were lacking, 
based on my review of transactions in the past, and we have 
said that we have agreed with the findings of the Baker Botts 
report that disclosures that were made in many cases were not 
those that would be expected of a public SEC registrant.
    Mr. Shays. Okay, but I just asked you: Do you agree with 
the paragraph I read?
    Mr. Baumann. I guess I would have to go back and read it 
word for word.
    Mr. Shays. I will read it again.
    Mr. Baumann. Sure.
    Mr. Shays. You had my respect and admiration until you 
failed to even acknowledge what is in this report, and you were 
supposed to be in charge.
    I will read the whole thing over again. I want to know if 
you agree or disagree.
    The special examination has demonstrated that Fannie Mae 
knowingly departed from good public disclosure--Freddie Mac 
knowingly departed from good public disclosure practices so as 
to obfuscate particular enterprise policies as well as specific 
capital market and accounting transactions used to implement 
them. As a result the public disclosures of Fannie Mae--Freddie 
Mac, excuse me, during the period investigated by the specific 
examination failed to comport with disclosures required of SEC 
registered companies that were assertively adhered to by the 
enterprise. The deliberate disdain of Freddie Mac for 
appropriate disclosure status in the face of its asserted 
compliance with best practices misled investors and constituted 
conduct that undermined market awareness of the true financial 
condition of the enterprise.
    Do you agree with that statement?
    Mr. Baumann. I agree with the fact that the public 
disclosures were lacking by Freddie Mac. The characterizations 
of why, et cetera, there are OFHEO's characterizations of why 
they were lacking.
    Mr. Shays. Tell me what you would disagree with this 
statement.
    Mr. Baumann. I have not done the investigation to determine 
what the intentionality was. OFHEO did the investigation. I 
agree that the disclosures were lacking. I have not done the 
investigation to determine----
    Mr. Shays. I will read sentence by sentence, and you tell 
me what you agree or disagree with.
    The specific examination has demonstrated that Freddie Mac 
knowingly departed from good public disclosure practices so as 
to obfuscate particular enterprise policies as well as specific 
capital market of Freddie Mac during the period investigated by 
the special examination.
    Excuse me, I am going to read it over again.
    The special examination has demonstrated that Freddie Mac 
knowingly departed from good public disclosure practices so as 
to obfuscate particular enterprise policies as well as 
particular capital market and accounting transactions used to 
implement them.
    Do you agree with that statement?
    Mr. Baumann. I agree that Freddie Mac's public disclosures 
were lacking in many respects. I do not know the extent to 
which they were knowingly lacking at the time and what 
decisions were made knowingly versus inadvertently. I have not 
done the investigation.
    Mr. Shays. No, you just happen to be the Chief Financial 
Officer of the company.
    Mr. Baumann. I----
    Mr. Shays. As a result the public disclosures of Freddie 
Mac during the period investigated by special examination 
failed to comport with disclosures required of SEC registered 
companies that were assertively adhered to by the Enterprise.
    Do you agree or disagree with that statement?
    Mr. Baumann. I agree our public disclosures in many cases 
failed to meet the disclosures of an SEC registrant.
    Mr. Shays. The deliberate disdain of Freddie Mac for 
appropriate disclosure status in the face of its asserted 
compliance with best practices misled investors and constituted 
conduct that undermined market awareness of the true financial 
condition of the enterprise.
    Do you agree or disagree with that?
    Mr. Baumann. I do not know if there was a deliberate 
disdain or not.
    Mr. Shays. Do you believe that it misled investors and 
constituted conduct that undermined market awareness of the 
true financial condition of the enterprise?
    Mr. Baumann. I do not know whether it did or not. I know 
that there were some.
    Mr. Shays. You do not think investors were misled?
    Mr. Baumann. There is an SEC investigation going on right 
now to look into that, Congressman.
    Mr. Shays. Do you think the disclosures of Freddie Mac did 
not mislead investors?
    Mr. Baumann. We have said in the past that our public 
disclosures were not those----
    Mr. Shays. Why do you have such a difficult time answering 
my questions? It seems to me the answer would be yes and we can 
get on with it. How can I have confidence in your capability to 
run this company if you have a hard time even acknowledging 
that their practices misled investors and constituted conduct 
that undermined market awareness of the true financial 
condition of the enterprise?
    That is a no-brainer for someone in your condition and 
position. Why do you have trouble answering that question?
    Mr. Baumann. I did not do the investigation.
    Mr. Shays. That is not what I asked.
    You came in here and you told us you did not have enough 
people to properly provide information. You are asking us to 
wait 2 more years before you come under the 1934 act.
    Hello?
    You came up to me, shook my hand, said: I am looking 
forward to testifying, and I am asking you a basic question, 
and I thought: Gosh, this is nice. We have someone finally 
taking over, he doesn't have to apologize for the past, and you 
think somehow you have to apologize for the past and obfuscate, 
it seems to me, some very logical questions.
    Let me ask this again: The deliberate disdain of Freddie 
Mac for appropriate disclosure status in the face of its 
asserted compliance with best practices--this is the part I am 
asking--misled investors and constituted conduct that 
undermined market awareness of the true financial condition of 
the enterprise.
    Am I to agree that it misled or not misled?
    Mr. Baumann. The SEC is making an investigation of----
    Mr. Shays. That is not what I asked you.
    Mr. Baumann. It was not my job to make an investigation of 
the past reporting practices.
    Mr. Shays. Do you think past reporting practices misled 
investors?
    Think about it a second before you answer.
    Do you think that the disclosures that have so far happened 
misled investors?
    Mr. Baumann. I do not make answers like that until I do an 
investigation and come to a conclusion. The SEC is doing that.
    Mr. Shays. So you do not think they were misled?
    Mr. Baumann. There were two investigations that have been 
done.
    Mr. Shays. That is not what I asked.
    Were they misled?
    Mr. Baumann. I have not made an investigation of past 
reporting practices to determine whether or not investors----
    Mr. Shays. I did not ask about intentions.
    Why were you hired?
    Mr. Baumann. I was hired to build the financial function 
that has sound internal controls, that produces, going forward, 
accurate, complete, and transparent financial results.
    Mr. Shays. Was the information accurate that was disclosed 
by Freddie Mac?
    Chairman Baker. Mr. Shays, you are going to have to make 
that your last one, because we are going to----
    Mr. Baumann. Freddie Mac has clearly said that the 
financial statements in the past were not accurate. We have 
restated them to the extent of $5 billion.
    Mr. Shays. So if they were not accurate, did not they 
mislead?
    Listen to my question: If they were not accurate, is not it 
true, therefore, they would have misled investors?
    Mr. Baumann. The financial statements in the past were not 
accurate.
    Mr. Shays. And if they were not accurate, would that not 
mean it misled investors?
    Mr. Baumann. I have not done a review to determine whether 
or not financial statements of the past were misleading or not.
    Mr. Shays. If you had looked at the statements, would you 
have been misled?
    Mr. Baumann. I would have been misinformed that the 
financial results were $5 billion different than previously 
recorded.
    Mr. Shays. Let me just put on the record then that, Mr. 
Martin--excuse me, sir--Mr. Baumann, you and I are going to 
have a big problem. We are going to be on your back as much as 
you can imagine because all you had to do was say: Yes, it was 
in the past; that is why I am hired; I am hired to straighten 
out all this mess; I am sorry we misled investors by over $5 
billion of earnings; that is why we hired 100 people; and we 
are going to get on it and we are going to make sure it never 
happens in the past.
    The fact that you find so much trouble even agreeing to the 
basic logic of what was said in this report blows me away.
    Chairman Baker. And the gentleman's time has expired.
    Do you choose to respond, Mr. Baumann?
    Mr. Baumann. We are responding by improving our financial 
reporting, building best in class culture around the company, 
and building accurate, complete, transparent financial 
reporting.
    There were some 20 civil suits that will address the 
question of how investors were either informed or not informed, 
and there is an SEC investigation.
    Mr. Shays. Mr. Chairman, I would submit that the culture 
hasn't changed if the company cannot even acknowledge the fact 
that investors were misled by inaccurate information. Clearly 
the information was inaccurate. Therefore investors are misled. 
It doesn't take a brain surgeon to be able to say yes.
    Chairman Baker. Thank you, Mr. Shays.
    Just a couple quick questions. Mr. Kanjorski wanted to ask 
a question as well.
    On the example of the $200,000 mortgage, in excess of 
$11,000 savings to the home owner, I assume that was if the 
home was held to maturity over the course of the life of the 
loan. Typically, lower income individuals are going to be in 
that lower $100,000 range.
    If you cut that $12,000, I rounded up to 12, over 30 years, 
cut it in half for a $100,000 loan, divide it by 30 years, 
crank it down to a monthly figure, that is $11.50. I am 
assuming that the average residential mortgage in your 
portfolio is somewhere around 100,000, probably is not--
probably a little higher, but if we are trying to help first-
time low-income home buyers, is an $11.50 a month risk worth 
taking?
    I do not have an answer to that. That is just editorial 
comment.
    Secondly, I have concerns and in discussion of GSE 
governance, with regard to guarantee fees and how those are 
apparently assessed varying institutions who engage in business 
activities with the Enterprises. I am not going to take the 
time today to get into it, but I will advise you that I am 
going to forward a letter with some amount of specificity and 
would like to request that a disclosure of the guaranty fee 
relationship at least to the committee be made.
    I understand that as a course of business customarily there 
is a confidentiality clause that is signed by the counterparty 
that precludes them from making public statements about the 
guaranty fees, but it is something that I think has a dramatic 
effect on the cost of home ownership, and with that I yield to 
Mr. Kanjorski.
    Mr. Kanjorski. I just want to say I appreciate your 
responding to some of the questions propounded to you. I think 
it probably was done with good sense and good reality.
    Mr. Shays. Could I ask the gentleman why?
    Mr. Kanjorski. Because this gentleman has testified 
previously in his opening statement why he came to this 
company, what he was charged with, what he has carried out, and 
he should not testify to a matter of subjective conclusion 
which is a matter of lawsuit. He would be putting his company 
at great risk without having done the detailed analysis 
himself, and that would be irresponsible.
    Mr. Shays. Can I ask the gentleman one question, though?
    Is it hard for someone to say that inaccurate information, 
therefore, would mislead?
    Mr. Kanjorski. I do not think it naturally follows that 
inadequate information does mislead. You have to get into the 
mind of the investor or the person that received that 
inadequate information, and in reality we may have found here 
that there in fact was no negative impact on the investor, that 
it was an internal matter of a very small proportion done by 
greedy or self-interested executives that caused this entire 
occurrence to come about, but in fact Freddie Mac may come out 
stronger as a result of what they put in place, and Chris, I 
like you very much but I do not think it is nice. Mr. Baumann 
is an executive of incredible experience and to put him on 
cross-examination, to try to force him to make an overwhelming 
conclusion that is not based on all the facts is, in my mind, 
not fair.
    Now, Mr. Baumann, all that being said, that was just 
editorial on my part, I do want to get to one question.
    In your testimony you said you were in favor of a strong 
regulator, and that is not quite the contest up here. There are 
some of us who believe it should be an independent strong world 
class regulator, something analogous to the OCC, and Mr. Scott 
had asked you questions on that, and it is very important, and 
I was not aware that Fannie Mae has gone back to the idea that 
they want some regulator under Treasury, which upset me quite 
frankly.
    What would be your position if this Congress established a 
strong independent world class regulator analogous to the OCC? 
Would that be proper? Would Fannie Mae support that, or have 
you not taken a position on that?
    Mr. Baumann. We have not taken an official position on 
that, and again we believe that the most important thing is for 
this Congress and the administration to resolve the question of 
regulation and to come to the best answer for Freddie and 
Fannie to support our mission going forward.
    There are a couple of things we do think are important with 
respect to that, more around the level of capital and where it 
is set, between the Congress versus in the regulator itself and 
around approval of programs and activities that are we think 
today appropriate the way it is set up and we think that is an 
important matter so we can fulfill our housing mission. So we 
think those are important to discuss, and we hope they are 
discussed.
    Our CEO Dick Syron is anxious to talk to this committee 
about regulation. He has a very, very enthusiastic interest and 
the best regulatory answer for Freddie and Fannie that winds up 
being in the best interest for the American homeowner.
    Chairman Baker. I thank the gentleman. I certainly express 
to you, Mr. Baumann, my appreciation for your willingness to 
appear here today. Certainly hope that, in the coming weeks and 
months, this committee can, with continuing counsel from the 
Enterprises, construct a regulatory system that is adequate to 
ensure continued home ownership and protection of taxpayers.
    I do not believe they are mutually exclusive. I believe the 
goal can be----
    Mr. Shays. Mr. Chairman?
    Chairman Baker. Yes, Mr. Shays.
    Mr. Shays. I want to apologize to the gentleman based on 
Mr. Kanjorski's comments. If I am getting into intent and they 
have a lawsuit, it was not my intent to try to have impact over 
the lawsuit. I was trying to, with all due respect, understand 
the mind of this company, to see if this company has changed, 
and so to you, sir, I apologize, in that respect, but would you 
just give me some hope that somehow the culture of this company 
is different?
    Chairman Baker. Mr. Shays.
    Mr. Shays. With all due respect, sir.
    Chairman Baker. Sure.
    Mr. Shays. Is there anything you can say that tells me 
there is a difference here and we can see something changed 
about this company?
    Chairman Baker. Mr. Shays, if I can respond, and Mr. 
Baumann can certainly make his own statement.
    I would propose that if this committee forwards legislation 
and the Enterprise refrains from exercising its political power 
in blocking or obstructing meaningful reform, that in itself 
will determine whether or not there has been a change in the 
outlook on an independent regulator, and Mr. Baumann has 
repeatedly said this morning that he does not even wish to 
express an opinion as to the domicile of the regulator, be it 
independent, be it Treasury. If the Congress decides that it is 
an appropriate step for us to take, that the Enterprise would 
accept those determinations as independent judgments of this 
Congress, I respect that, and, Mr. Baumann, would you choose to 
respond to Mr. Shays?
    Mr. Baumann. Thank you. I appreciate your comment, 
Congressman.
    The press release that we issued on November 21, which 
described in excruciating detail the accounting errors that 
were made in the past, the level of the restatement and the 
accounting and control issues of the company, I think are at 
least a start of the evidence to show that we are committed to 
transparency and accuracy and completeness and candidness, and 
going forward we expect that that is what you will see on a 
regular basis, that our financial reports will be very candid, 
very accurate, very transparent and very complete.
    Chairman Baker. We have 4 minutes remaining.
    Mr. Shays. Thank you.
    Chairman Baker. We have 4 minutes remaining. Our meeting 
stands adjourned.
    Thank you.
    [Whereupon, at 12:20 p.m., the subcommittee was adjourned.]


                            A P P E N D I X



                            January 21, 2004


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