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



 
                           THE OFHEO REPORT:
                     ALLEGATIONS OF ACCOUNTING AND
                    MANAGEMENT FAILURE AT FANNIE MAE

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                     CAPITAL MARKETS, INSURANCE AND
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                               __________

                            OCTOBER 6, 2004

                               __________

       Printed for the use of the Committee on Financial Services


                           Serial No. 108-115







97-754                 WASHINGTON : 2004
_________________________________________________________________
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

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

                 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:
    October 6, 2004..............................................     1
Appendix:
    October 6, 2004..............................................   145

                               WITNESSES
                       Wednesday, October 6, 2004

Falcon, Hon. Armando, Director, Office of Federal Housing 
  Enterprise Oversight, accompanied by Wanda Deleo, Chief 
  Accountant, and Christopher Dickerson, Chief Compliance 
  Examiner, Office of Federal Housing Enterprise Oversight.......    22
Howard, Timothy, Vice Chairman and Chief Financial Officer, 
  Fannie Mae.....................................................    76
Korologos, Hon. Ann McLaughlin, Presiding Director, Board of 
  Directors, Fannie Mae..........................................   128
Raines, Franklin D., Chairman and Chief Executive Officer, Fannie 
  Mae............................................................    73

                                APPENDIX

Prepared statements:
    Baker, Hon. Richard H........................................   146
    Oxley, Hon. Michael G........................................   148
    Castle, Hon. Michael N.......................................   150
    Clay, Hon. Wm. Lacy..........................................   151
    Ford, Hon. Harold E. Jr......................................   152
    Gillmor, Hon. Paul E.........................................   154
    Kanjorski, Hon. Paul E.......................................   156
    Miller, Hon. Gary G..........................................   158
    Falcon, Hon. Armando.........................................   160
    Howard, Timothy..............................................   169
    Korologos, Hon. Ann McLaughlin...............................   171
    Raines, Franklin D...........................................   176

              Additional Material Submitted for the Record

Baker, Hon. Richard H.:
    Letter to OFHEO Director Armando Falcon, Jr. with response, 
      November 4, 2003...........................................   183
Castle, Hon. Michael N.:
    Letter to Financial Accounting Standards Board, October 5, 
      2004.......................................................   188
Frank, Hon. Barney:
    ``Deja Vu All Over Again, Thoughts on OFHEO's Special 
      Examination of FNM''.......................................   190
Barnes, Roger, former Manager of Financial Accounting, Fannie 
  Mae, prepared statement........................................   197
Falcon, Hon. Armando:
    Report of Findings to Date, Special Examination of Fannie Mae   223
    Written response to Members questions posed during the 
      hearing....................................................   434
Korologos, Hon. Ann McLaughlin:
    Fannie Mae Board of Directors Work Plan in Response to OFHEO 
      Report on Special Examination..............................   443
Raines, Franklin D.:
    Core and GAAP Earnings Per Share.............................   447










                           THE OFHEO REPORT:
                     ALLEGATIONS OF ACCOUNTING AND
                    MANAGEMENT FAILURE AT FANNIE MAE

                              ----------                              


                       Wednesday, October 6, 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 10:03 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Shays, Gillmor, 
Bachus, Castle, Lucas of Oklahoma, Royce, Manzullo, Kelly, Ney, 
Fossella, Biggert, Miller of California, Toomey, Capito, Hart, 
Kennedy, Tiberi, Brown-Waite, Kanjorski, Sherman, Meeks, 
Inslee, Capuano, Ford, Hinojosa, Lucas of Kentucky, Crowley, 
Clay, McCarthy, Baca, Matheson, Lynch, Miller of North 
Carolina, Scott, and Velazquez.
    Also present: Representatives Oxley (ex officio), Frank (ex 
officio), Watt, Waters, Davis of Alabama, Maloney, and Brown of 
Florida.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Capital Markets Subcommittee to order.
    The Capital Markets Subcommittee meets today for the 
purpose of receipt of a report from the Office of Federal 
Housing Enterprise Oversight.
    It is indeed a very troubling report, but it is a report of 
extraordinary importance not only to those who wish to own a 
home, but also as to the taxpayers of this country who would 
pay the cost of the cleanup of an enterprise failure.
    Although not intended to fuel the effort to bring about 
regulatory reform, the analysis makes clear that more resources 
must be brought to bear to ensure the highest standards of 
conduct are not only required, but more importantly, they are 
actually met.
    For the record, I am not pleased and certainly not happy 
about these revelations. I am saddened by the disclosures. In 
all my years of inquiry in this matter, I was only in pursuit 
of appropriate oversight. Never did I question whether the GSEs 
were professionally managed to the highest standards of 
business conduct. Now I do. The culture of mismanagement 
described in the report must be eliminated and assurances 
gained that the highest standards of conduct will be 
consistently practiced.
    I know there will be those who will still cling to the 
belief that the issues raised are minor or that opinions may 
differ on technical accounting standards. Some may still think 
this is all a plot by the big banks to preserve market share. 
The content of this report, in my view, cannot be legitimately 
questioned. Utilizing the firm of Deloitte & Touche and the 
staff of OFHEO, the director's report is delivered after review 
of over 200,000 documents and e-mails, as well as hundreds of 
interviews and depositions of current and former staff of 
Fannie Mae.
    The statement made in the first page of the executive 
summary unfortunately sums up our circumstance: ``The matters 
detailed in this report are serious and raise concerns 
regarding the validity of previously reported financial 
results, the adequacy of regulatory capital, the quality of 
managerial supervision and the overall safety and soundness of 
the enterprise.'' This finding, in my judgment, makes committee 
action essential.
    For the record, I should also note that the resistance the 
GSEs have expressed toward enhanced housing goals. In light of 
these revelations, their opposition now makes more sense than 
ever. Should the proposals considered in this committee focus 
clearly on the needs of first-time homebuyers actually become 
law, the enterprises would have to allocate resources to those 
goals at the expense of reduced earnings.
    A reduction in earnings would reduce the likelihood of 
paying out bonuses to executives. This same observation holds 
true as to the regulator's decision to increase capital, and 
Fannie's strong objections to such a requirement. We all know 
that the enterprise is thinly capitalized, but the potential 
effect of requiring a responsible capital level would adversely 
affect earnings per share, and consequently affect the bonus 
payments to executives.
    I also wish to inform members of the committee of another 
troubling incident, which I now choose to make public. About a 
year ago, I corresponded with the director's office making 
inquiry about the levels of executive compensation at the 
enterprise for the top 20 executives. This is information that 
had not been made public previously.
    In a matter of days, Fannie Mae had engaged the services of 
Mr. Ken Starr, legal counsel, for the purpose of informing my 
staff and committee council of the potential consequences of 
making that information public. It was made clear that civil 
legal actions would be filed, I presume against me, if the 
information were to be released.
    At that time, I made the decision not to release the data 
since there was no clear relevance to the reform effort under 
way, not out of concern for any litigation that might be filed. 
The realization that the disclosure of this information was so 
sensitive to the enterprise never really fully impacted me 
until I read the director's report. Now I understand why the 
enterprise was so anxious not to have public disclosure of 
compensation, ironically of an entity that was created by the 
Congress and supported by the taxpayer.
    Circumstances have now changed. As a direct result of the 
abhorrent accounting practices, executives have been able to 
award themselves bonuses I do not believe they earned and I do 
not believe they deserve. For that reason alone, disclosure of 
where the money went is highly appropriate.
    At the conclusion of this hearing, I will release the 
compensation information obtained from OFHEO and further, I 
will forward a letter to the director requesting that all 
compensation information for both enterprises be provided to 
the committee for a period covering 10 years for all executives 
that shared in any bonus distributions. This is now essential, 
in that OFHEO has indicated that accounting manipulation has 
impacted the financials on more than one occasion, therefore 
placing the payment of bonuses in question.
    I find this very troublesome business. Much is at stake. 
The ability of this committee and this Congress to act will be 
called into question. Notwithstanding the ultimate outcome, the 
facts will remain and our duty will never be more clear.
    Mr. Kanjorski?
    [The prepared statement of Hon. Richard H. Baker can be 
found on page 146 in the appendix.]
    Mr. Kanjorski. Mr. Chairman, we meet today for what might 
well be our last hearing this year. At our first hearing in 
2004, we reviewed the special examination of Freddie Mac by the 
Office of Federal Housing Enterprise Oversight. It therefore 
seems fitting that we will bookend our hearings this year with 
an evaluation of the findings to date of a similar examination 
of Fannie Mae's accounting policies and practices.
    The recently released preliminary report by the Office of 
Federal Housing Enterprise Oversight includes a number of 
significant charges. The report concludes that Fannie Mae has 
failed to follow generally accepted accounting practices in two 
key areas. They are the accounting of derivatives contracts and 
the amortization of discounts, premiums and fees involved in 
the purchase of home mortgages.
    The report also raises concerns about the company's 
organizational structure and its internal controls. These are 
serious matters that merit our careful attention because 
government-sponsored enterprises with their public 
responsibilities and private capital have, in my view, a 
special obligation to operate fairly, safely and soundly.
    As we proceed today, I must urge my colleagues on both 
sides of the aisle to demonstrate patience and caution when 
approaching these matters. We should not leap to immediate 
conclusions. The report on Fannie Mae is preliminary. It is 
part of an ongoing process.
    We should not overanalyze these findings because we do not 
have all of the information. Fannie Mae's board, as I 
understand, has already agreed to adopt a number of reforms 
based on this initial report and it may ultimately implement 
more. The Office of Federal Housing Enterprise Oversight 
continues to examine the company's books. The Securities and 
Exchange Commission, the arbiter of accounting standards for 
Fannie Mae, is now studying these matters. In short, we need to 
let this process work itself out.
    We should also refrain from hyping these initial findings 
in an effort to achieve some short-term gain. As we well know 
from past experiences, our actions and statements on Capitol 
Hill have the potential to rile the capital markets. They could 
also raise the price of homeownership. We should therefore 
practice caution, prudence and discretion.
    My primary focus at today's hearing will be to determine 
whether the issues raised in the preliminary report constitute 
some form of systemic risk for Fannie Mae. I therefore intend 
to ask each of the witnesses their perceptions regarding this 
issue. I expect them each to offer me their candid assessments 
of these matters.
    As we proceed today, I also suspect that some of my 
colleagues will return to the question of how best to modify 
the regulation of government-sponsored enterprises like Fannie 
Mae and Freddie Mac. As I said at our very first hearing on the 
oversight of government-sponsored enterprises in March 2000, 
``We need to have strong, independent regulators that have the 
resources they need to get the job done.'' I can assure 
everyone involved in these debates that I continue to support 
strong, world-class and independent GSE regulation.
    A strong world-class and independent regulator will protect 
the continued viability of our capital markets and promote 
confidence in Fannie Mae and Freddie Mac. It will also ensure 
taxpayers against systemic risk and expand housing 
opportunities for all Americans.
    Like many of my colleagues, I was greatly disappointed last 
year when the Bush administration rejected our bipartisan 
efforts to create an independent regulator. Politics, in my 
view, should play no role in financial regulation. It is 
therefore my hope that when we revisit this issue in the 109th 
Congress, we will continue to remain resolute and unwavering in 
our bipartisan efforts to create a strong, independent and 
world-class regulator with the powers and resources it needs to 
get the job done.
    In closing, Mr. Chairman, I commend you for your sustained 
leadership in these matters and for convening this timely 
hearing. The preliminary report by the Office of Federal 
Housing Enterprise Oversight and its agreement with Fannie Mae 
deserve careful review and public scrutiny. I consequently look 
forward to hearing from our witnesses today.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 156 in the appendix.]
    Chairman Baker. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. Oxley. Thank you, Chairman Baker, for holding this 
hearing on the recently released report from OFHEO's special 
examination of Fannie Mae. You have followed these issues 
closely and should be commended for your diligent oversight of 
the GSEs. It is my hope that this hearing will highlight the 
concerns raised in the OFHEO report and will help members get 
to the bottom of the accounting and corporate governance issues 
at Fannie Mae.
    It is unfortunate that we are here today. After earnings 
smoothing at Freddie Mac was discovered, the public and the 
markets, and the members of the committee were assured that 
there were no similar issues at Fannie Mae. The findings in 
OFHEO's report, if accurate, are disturbing.
    While we wait for OFHEO, and the Justice Department and the 
Securities and Exchange Commission to complete their respective 
tasks, the management and board of directors at Fannie Mae must 
take real steps to address the issues and continue to cooperate 
with regulators. The agreement between Fannie Mae and OFHEO is 
a beginning of that process, but I seriously doubt it can be 
the end.
    Since the enactment of Sarbanes-Oxley 2 years ago, 
corporate financial statements have become more transparent and 
more reliable. There is no question in my mind that the act is 
at least partially responsible for this progress. The CEO and 
CFO certifications of financial statements have had a profound 
impact on the reporting process.
    Other provisions are working, too, such as the Public 
Company Accounting Oversight Board's inspections regime, 
strengthened and independent audit committees, officer and 
director bars, the Fair Funds, expedited disclosures of insider 
transactions, and internal control requirements, to name just a 
few. That is not to say that we can legislate integrity in 
every case, but we do have a sensible framework of incentives 
and disincentives that will affect behavior.
    The OFHEO report raises serious questions about whether 
Fannie Mae has adequate internal control procedures, ultimately 
one of the core aspects of Sarbanes-Oxley. The multiple and 
conflicting duties of the chief financial officer, who we will 
hear from this morning, calls into question whether there is 
adequate separation between the risk-taking and control 
functions.
    In my view, section 404 is one of the most important parts 
of the Sarbanes-Oxley Act. Internal control over financial 
reporting consists of company policies and procedures that are 
designed to provide reasonable assurance about the reliability 
of a company's financial reporting and the preparation of 
external financial statements in accordance with generally 
accepted accounting principles. Failure to comply with its 
requirements is not an insignificant matter. I am eager to hear 
from the company's senior management officials on their 
adherence to this critical provision.
    Fannie Mae enjoys certain advantages in the marketplace not 
afforded to other financial companies in order to serve a 
public purpose. We have recently learned that the corporate 
structure may have fostered an atmosphere in which senior 
management may have had undue influence over accounting 
policies and procedures, and that corporate earnings and 
management compensation may have been manipulated.
    OFHEO has worked hard in conducting reviews of the GSEs. 
Director Falcon and his staff have been diligent in trying to 
ensure that the GSEs receive the appropriate oversight. The 
findings of this report, if correct, reinforce arguments for 
the creation of a GSE regulator with the powers and authorities 
granted to other financial regulators and commensurate with the 
task of overseeing these large and complicated companies.
    I was dismayed to learn that OFHEO was forced to resort to 
issuing subpoenas this past July in order to obtain cooperation 
with its investigation. It is my sense that if OFHEO had the 
tools possessed by other regulators, this investigation would 
not have reached the subpoena stage. If we had a GSE regulator 
with the powers and authority of a world-class regulator, it is 
possible that these problems at Fannie Mae would have been 
remedied earlier and today's hearing would not be necessary.
    The OFHEO report details problems ranging from possible 
earnings manipulation to management structures that may not 
have been in line with state-of-the-art corporate governance. I 
am very concerned about the possibility that Fannie Mae claims 
to have sound corporate governance standards, when in reality 
these standards are not in practice.
    Fannie Mae's board did the right thing in entering into an 
agreement with OFHEO and beginning the process of remedying the 
problems highlighted in the report. The OFHEO report is not 
finished and it is my hope that Fannie Mae will cooperate with 
this investigation as well as the other investigations 
currently under way at the Securities and Exchange Commission 
and the Department of Justice. Furthermore, I hope that this 
situation does not develop into a war among accountants arguing 
technical points that do not put to rest the issues raised in 
the OFHEO report. We owe it to the housing market and to the 
financial markets to quickly resolve all of the accounting and 
governance uncertainties.
    I want to welcome all the witnesses appearing before the 
subcommittee today. I look forward to your testimony.
    I yield back.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 148 in the appendix.]
    Chairman Baker. Thank you, Mr. Chairman, for your interest 
and leadership in this matter.
    Ranking Member Frank?
    Mr. Frank. Thank you, Mr. Chairman.
    First, I want to address a little history here. The 
committee here was well on the way to adopting legislation that 
would have enhanced the regulatory structure for Fannie Mae and 
Freddie Mac. In the Senate, in fact, the committee actually 
voted out a bill. There was some disagreement between the 
parties over I think a relatively minor section over 
receivership. I think that could have been worked out.
    I believe we were well on the way, the chairman and I and 
the staffs, to putting together a bill that would have enhanced 
the regulator and could have passed. What stopped progress on a 
new bill was the Bush administration's determination to go 
beyond safety and soundness and into provisions that would have 
restricted the housing function.
    What is powerful here are not Fannie Mae and Freddie Mac, 
but the interests of a majority of the members of this 
committee in housing at two levels. First of all, in housing in 
the conventional market, is very important, and the continuance 
of Fannie Mae and Freddie Mac are important to that. We also 
have a subset of issues involving affordable housing, and those 
are very important to many of us.
    What derailed the legislation was an insistence by the Bush 
administration on going beyond safety and soundness and giving 
the regulators, for example, particular power to say, well, 
they are going beyond their charter in housing; they should not 
do these new products. There were specific issues here that 
transcended safety and soundness or went under it, but the 
administration was seeking powers that were not related to 
safety and soundness.
    If they were to have dropped that, we would have a law 
already signed and in place, because on the question of safety 
and soundness regulation, there has not been a significant 
dispute.
    I will give you an example of what concerns me in this 
regard. Many of us on this committee, contrary to what some 
people think, were very aggressive in pushing Fannie Mae to 
stay in the manufactured housing business in full fight when 
they were talking about retrenching, and that was bipartisan--
the gentleman from Wisconsin, Mr. Green, myself and others, 
because you will not get the kind of homeownership we want at 
the right demographic.
    As to safety and soundness, manufactured housing is an 
example. I do not expect Fannie Mae and Freddie Mac to make as 
much money as possible on every single entity. The attitude of 
OFHEO towards manufactured housing is an example of why I am 
concerned about making sure the regulator has safety and 
soundness powers, but not general powers. In manufactured 
housing, it was those of us on this committee, Democratic and 
Republican who care about housing who pushed Fannie Mae to stay 
in it.
    When I wrote to the secretary of HUD to ask him to join us, 
the answer was, several members did, he was much too busy for 
that, his scheduler told us, and we could go talk to the head 
of FHA. So that is the issue.
    Finally, turning to this report, I have to say that I read 
the director's testimony and I will talk to him about it again, 
I regret what seems to me frankly almost boilerplate in his 
report that says at the end of every specific, and this could 
raise safety and soundness issues. It could, but nothing in 
here seems to me that it does.
    To the extent that people played games to get bonuses, I am 
outraged. People making that much money, let me put it this 
way, at the level of compensation of the top officers of Fannie 
Mae, they should get bonuses if they rush into a burning 
building to rescue a kid, maybe a cat, but not for doing their 
job. I think it is unseemly of them to be getting bonuses in 
the first place for doing what they are getting paid very well 
to do.
    To the extent that there was manipulation, that is very 
wrong and should be penalized. But I have seen nothing in here 
that suggests that the safety and soundness are at issue, and I 
think it serves us badly to raise safety and soundness as a 
kind of a general shibboleth, when it does not seem to be the 
issue.
    Last point, and Fannie and Freddie are to some extent 
criticized from both ends. There was an article by Gretchen 
Morgenson in the New York Times on Sunday that said the problem 
is that they have done too much to bring housing to people who 
really cannot afford it and should not be given this chance to 
own the housing. Her article said the problem here has been 
they have overextended by lending money to people who were 
below the economic level that should be there.
    On the other hand, they are criticized by the chairman of 
this subcommittee for not doing enough for lower-income people. 
Both obviously cannot be right. I think what we need to do is 
to go forward as we were ready to do with a tougher safety and 
soundness regulator, but in ways that do not impinge on 
Fannie's and Freddie's ability to do a better job than they 
have been doing with affordable housing and to continue to do 
the job they have been doing with regard to housing in general.
    Chairman Baker. Mr. Shays?
    Mr. Shays. Thank you.
    I am new to this committee and I was absolutely shocked 
when we looked at Enron and WorldCom. The board of directors 
did not do their job. The management did not do its job. The 
employees did not speak out. The lawyers in the firm were 
facilitators. The rating agencies did not do their job. It 
scared the hell out of me, frankly.
    We passed Sarbanes-Oxley, which was a very tough response 
to that. And then I realized that Fannie Mae and Freddie Mac 
would not even come under it. They were not under the 1934 Act. 
They were not under the 1933 Act. They play by their own rules, 
and I am tempted to ask how many people in this room are on the 
payroll of Fannie Mae, because what they do is they basically 
hire every lobbyist they can possibly hire. They hire some 
people to lobby and they hire some people not to lobby so that 
the opposition cannot hire them.
    Fannie Mae has manipulated, in my judgment, OFHEO for 
years. For OFHEO to finally come out with a report as strong as 
it is tells me that has got to be the minimum, not the maximum. 
I congratulate OFHEO for finally stepping up to the plate and 
not being manipulated by the very organization they are 
supposed to regulate.
    I hear these arguments that Fannie Mae and Freddie Mac are 
looking out for the interests of the homeowners, and they score 
worse in helping minorities than the private sector banks under 
the 1934 Act and the 1933 Act.
    Fannie Mae and Freddie Mac are very generous to members of 
Congress and very generous to the organizations of caucuses in 
Congress. They do not have to disclose what they do. They do 
not have to play by the same rules. They are going to crash if 
this Congress does not wake up and do something about it.
    I am absolutely shocked at the extraordinary tolerance that 
has taken place in this Congress. This is just the beginning of 
the story. What did OFHEO say? They said they have accounting 
methods and practices that did not comply with generally 
accepted accounting practices, employed an improper cookie jar 
reserve in its accounting system, deferred expenses to meet 
compensation targets, did not have proper corporate governance 
controls in place.
    We need to wake up and the sooner we do the better it will 
be for Fannie Mae and Freddie Mac and all their investors, and 
the better it will be for our government.
    Chairman Baker. The gentleman yields back.
    Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman.
    This is indeed an important hearing. I am very much 
concerned about the direction that Fannie Mae is moving in. 
Fannie Mae does an extraordinarily important function in our 
society, unique among companies in terms of being a catalyst to 
increase homeownership among middle-income and lower-income 
individuals. So this is a very important hearing.
    Last year, Freddie Mac, another corporation with similar 
duties, had one of the largest corporate financial restatement 
of earnings and saw the ouster of its top executives. Fannie 
Mae representatives assured us then, on this subcommittee, that 
their books were clean and that they should not be associated 
with Freddie Mac's problems.
    Now, we are meeting to discuss OFHEO's report, which shows 
that Fannie Mae inappropriately reduced earnings volatility and 
provided management with the flexibility to determine the 
amount of income and expense recognized in any accounting 
period. In 1998, the management at Fannie Mae needed an 
earnings-per-share target of $3.23 in order to receive the 
maximum bonus for the company. Due to the accounting schemes 
used by Fannie Mae, the executives just hit the earnings-per-
share mark and they earned bonuses totaling nearly $6 million.
    I think the general issue before the public and people all 
across this country is simply, has the time come to decide if 
companies that violate public trust should continue to receive 
special treatment. I think the fundamental question here is, 
why the Fannie Mae board believed it was appropriate to link 
executive pay to earnings per share, and whether this 
compensation scheme resulted in inappropriate incentives for 
management.
    Whether or not the reasons that the company altered 
earnings was to achieve bonuses is not yet known. The report is 
there and we have these hearings to get to the bottom of it. I 
submit to you that we must get to the bottom of it so that we 
can give Fannie Mae a clean bill of health. The Department of 
Justice has opened up a criminal investigation into the 
allegations of the report, and that investigation may clear up 
the intent.
    Congress should carefully review the OFHEO report because 
the special examination is continuing and ongoing. Questions 
have also been raised about OFHEO's ability itself.
    Chairman Baker. Can the gentleman quickly wrap up?
    Mr. Davis.--to act on this report and the method by which 
the report was released.
    I certainly look forward to the hearing from the panel's 
testimony on the OFHEO report and Fannie Mae's report to 
address the criticisms of its accounting practices.
    Chairman Baker. I thank the gentleman. The chair to the 
best of its ability will try to keep members' opening 
statements to the requested 5-minute statement length.
    Mr. Castle?
    Mr. Castle. Thank you, Mr. Chairman.
    The issue before us is an important one today. I share the 
concerns of a lot of the other members who have spoken about 
it, a number of the issues that are before us. It is vast and 
it is disturbing and hopefully we can do something about it. 
Frankly, I think we should have done something about it before 
we started down this alley. Perhaps we can now.
    I am going to keep my opening comments, Mr. Chairman, to 
one issue that concerns me, in what appears to be multiple 
interpretations of generally accepted accounting principles, 
GAAP. In February 2004, OFHEO hired Deloitte & Touche to 
examine the accounting policies of Fannie Mae.
    Specifically, OFHEO's report finds fault with the company's 
accounting treatment of, one, the amortization of premiums, 
discounts and fees related to the purchase of mortgages and 
mortgage-backed assets, understatement of accounting financial 
standards, SFAS 91; and two, financial derivative contracts 
under SFAS 133. KPMG LLP, Fannie Mae's auditor, has stated it 
stands behind its audit work.
    Fannie Mae has also stated they believe they were following 
generally accepted accounting principles. I am concerned that 
two different auditors would have different interpretations of 
SFAS 91 and SFAS 133. Therefore, I have sent a letter to Robert 
Hertz, chairman of the Financial Accounting Standards Board, 
FASB, for their comments on SFAS 91 and 133, and whether these 
standards need to be readdressed to remove any gray areas that 
may exist.
    If improper accounting has occurred, I question how these 
accounting practices were allowed to occur and what was 
management's knowledge of these actions. It bothers me greatly 
to hear the allegation that accounting tricks were used to meet 
specific earnings-per-share targets that resulted in vast 
amounts of executive compensation to be paid.
    I thank all of our witnesses for appearing before us today 
and I hope we will have an exchange on the merits of what has 
occurred and what needs to occur in the future. I welcome the 
news that OFHEO and Fannie Mae have reached an agreement to 
address the improper accounting and internal controls within 
Fannie Mae. I strongly believe, however, that in light the 
likely reforms achieved in the passage of the Sarbanes-Oxley 
Act, we must again be prepared to act.
    Mr. Chairman, I would ask unanimous consent to insert the 
text of my letter to Chairman Hertz for the record. With that 
unanimous consent, I will yield back the balance of my time.
    Chairman Baker. I thank the gentleman. Without objection, 
the letter will be included in the official record.
    I am advised by staff that the opening statement period for 
members is 3 minutes, not 5 minutes.
    Mr. Clay?
    Mr. Clay. Thank you, Mr. Chairman.
    Mr. Chairman, we are rushing to judgment today. OFHEO has 
released a preliminary report which has not been proven, but 
leaked to the press. During the course of the examination, 
Fannie Mae was not given the chance to respond to OFHEO 
findings. Informal communications, which are at the core of the 
GSE's oversight statute, were essentially ignored. At least one 
former examiner of OFHEO questioned the political motivations 
behind OFHEO's rush to judgment.
    Mr. Chairman, we do not normally hold hearings on matters 
before other investigations are complete. Internal findings are 
normally discussed informally and remedies proposed. There are 
other stages of this process that take place before a judgment 
is rendered. Why circumvent the process? Why this hearing?
    If I were a member of Fannie Mae's board, I would find the 
environment very intimidating. Mr. Chairman, why is Senator 
Shelby not holding a hearing on this preliminary report? After 
all, the Senate Banking Committee reported out legislation on 
the GSEs. Maybe this hearing agenda is about something more 
than the accounting procedures at Fannie Mae.
    As you know, Fannie Mae recently entered into an agreement 
with OFHEO in which they focused on accounting, internal 
control, and capital. Fannie Mae has agreed to increase 
additional capital by 30 percent. I am not sure how the new 
requirement promotes affordable housing. Within 45 days OFHEO 
and Fannie Mae will implement additional internal controls. The 
Securities and Exchange Commission, as is intended, should be 
the final arbiter of GAAP. Why can't we let the SEC decide this 
issue? Why must we rush past them?
    This hearing is about the political lynching of Franklin 
Raines. We have seen this happen too many times before. We are 
to go out of session and the deed is to be done before the 
election. Why can't we just say that this is the agenda? Let us 
debate that issue on its own merit. Better still, let due 
process take its course and let the chips then fall where they 
may. That is, unless this is truly a witch hunt.
    We are having a trial by OFHEO leaks, trial by newspaper 
articles, and trial without due process. In this case, the 
Senate has it right.
    Chairman Baker. The gentleman yields back.
    Mr. Royce?
    [The prepared statement of Hon. Wm. Lacy Clay can be found 
on page 151 in the appendix.]
    Mr. Royce. Thank you, Mr. Chairman. I thank you for holding 
this hearing on the OFHEO report allegations of accounting and 
management failure at Fannie Mae, as it is called. I would like 
to commend you, Mr. Chairman, for your continued leadership on 
GSE oversight.
    While there is no question as to where I stand on GSE 
issues generally, the fact of the matter is the GSEs have a 
special relationship to the government. After all, there are 
not many institutions that share common characteristics with 
Fannie Mae, such as a charter created by Congress, an exemption 
from local taxation, an exemption from certain SEC registration 
and fees, and an ability to borrow from the U.S. Treasury 
Department under certain circumstances.
    With this in mind, I believe that Fannie Mae and GSEs in 
general have an important obligation to conduct operations to 
the highest standard. As a member of this oversight 
subcommittee, I expect Fannie Mae to be a role model to other 
businesses as it fulfills its federally mandated mission. 
Fannie Mae should be conducting operations in a safe and sound 
way. In my view, this should include strong internal controls 
in the risk management department, coupled with consistent and 
conservative applications of accounting rules.
    With its newly released report, the Office of Federal 
Housing Enterprise Oversight has called into question many of 
Fannie Mae's risk-mitigating practices. This is very troubling 
to me and there is no doubt that OFHEO has placed the burden on 
Fannie Mae to answer these allegations. As OFHEO has leveled 
some very serious charges, I recognize that we do need to give 
Fannie Mae the opportunity to respond. This hearing is part of 
the process for this committee to learn more facts, and I 
appreciate the participation of all the witnesses today.
    In addition to our important oversight role in this 
committee, I hope that we will move swiftly to create a new 
regulatory structure for Fannie Mae, for Freddie Mac and the 
Federal Home Loan banks. There is a very simple solution. 
Congress must create a new regulator with powers at least equal 
to those of other financial regulators such as the OCC or the 
Federal Reserve.
    I hope this committee will heed the advice of Chairman 
Greenspan and the entire Board of Governors, the Federal 
Reserve Staff, the U.S. Treasury Department, the OECD, the IMF 
and countless others who have urged Congress to act.
    Now, on the approach that was rejected by the Bush 
administration and, by the way, was rejected by myself and many 
others on this committee. Why was that approach rejected by the 
Fed, by the Treasury? Because that legislation was not a true 
effort at reform as it failed to address several of the key 
issues that are essential to true reform of the regulatory 
regime of the housing GSEs.
    Specifically, that non-reform effort would have created a 
regulator without the authority to raise capital standards, 
without the authority to place an ailing GSE into receivership, 
without the authority to oversee all aspects of a GSE's 
operations, leaving much of this oversight at HUD.
    Chairman Baker. Can the gentleman begin to wind up?
    Mr. Royce. I will wind up right now by saying there is a 
difference of opinion on which approach to take if we really 
want a world-class regulator. I thank you again for the 
opportunity for this hearing and for us to hear from these 
witnesses today.
    Chairman Baker. I thank the gentleman.
    Mr. Baca?
    Mr. Baca. Thank you very much, Mr. Chairman and Ranking 
Members. Thank you for holding this hearing. I appreciate the 
opportunity to hear from witnesses about these very important 
issues.
    These are very complex rules and it is possible that we are 
not going to see a resolution until the issue is decided by the 
SEC. As I understand it, there are three broad areas of inquiry 
involving accounting, internal control, and capital. I would 
simply say I am not going to pre-judge the issues, and that 
before any stones are cast, we should see that there is 
culpability. Judge not and not be judged.
    Our country is a country of laws, and there is a process 
that must be followed and respected. Make no mistake, we will 
follow this process wherever it may lead. At the end of the 
day, if anyone, and I stress anyone, has not respected the law 
they will face the consequences.
    Mr. Chairman, I think it is important that in rushing to 
judgment that we not destroy an institution that is helpful in 
providing assistance for first-time homebuyers and minorities. 
Fannie Mae is an integral part of our economy and many of our 
constituents have been able to realize the American dream of 
homeownership due to its programs.
    I am concerned that the regulators follow the procedure 
that exists for investigating potential concerns in a way that 
is consistent, and respectful of confidentiality and impartial. 
We need to follow proper procedures in handling audits before 
they go public. We should ensure that the process is fair. We 
should ensure that the process is fair in getting the facts. 
And that we engage in corrective action if there are any 
deficiencies.
    Like most of us have been involved in nonprofit 
organizations where we had auditors that audited us. They come 
back with a report. They give an opportunity to make 
corrections if any are done. And all of us have been involved 
in nonprofit organizations and on boards of directors. We know 
the consequences if those procedures are not followed.
    I think it is important that we keep the politics out of 
what should be and historically has been a nonpolitical 
process. It concerns me that OFHEO has been Fannie Mae's 
regulator since 1992. OFHEO has been its regulator since 1992, 
and all of a sudden issues are being raised. The regulators had 
an opportunity in the past to address any concerns.
    So we need to ask: What, if anything, has changed? This is 
not about headhunting. It is about positive steps to correct 
any problems. I look forward to hearing the witnesses.
    I yield back the balance of my time. Thank you very much, 
Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Ney?
    Mr. Ney. Thank you, Mr. Chairman, and thank you for holding 
the hearing. I also want to thank, of course, the witnesses for 
appearing today. I look forward to hearing their testimony, as 
I know everybody does, so without objection I will submit all 
of my written statement for the record. I just have a couple of 
comments.
    OFHEO's recent report on the activities of Fannie Mae 
asserts the company engaged in accounting practices that do not 
comply with the generally accepted practices. Of course, it is 
troublesome. In addition, the report raises concerns about 
deferred price adjustments, derivatives and hedging activities, 
internal control issues. I think the stopgap measure was a good 
thing to implement.
    According to OFHEO and what we have read, they are serious 
and it raises concerns regarding the validity of previously 
reported financial results. OFHEO's findings to date are 
obviously very serious. Right now, if you would read the 
accounts in the papers, it looks like the management of Fannie 
Mae is basically looking at the fact of, in the media at least, 
of making them a poster child for regulatory reform.
    It is important to keep in mind, though, that the 
examination is still in the process. So the newspapers and the 
way people are looking at it is one thing, and the reality of 
what we are going to find out today I think is important, and 
the process that OFHEO will finish is obviously important, and 
also the SEC is going to be the final arbiter of compliance 
with the general accounting practices, and has not yet, as I 
understand, offered its opinion on Fannie's accounting methods. 
So that is another part of this puzzle I think that will be out 
there for us to look at.
    Of course, Fannie was chartered by Congress to create a 
secondary market and improve the function of home mortgage 
markets. I think that we can all agree that the United States 
mortgage and credit markets are the envy of the world. A 
strong, vibrant housing market is important to everybody.
    There can be no doubt that we have to take some steps to 
strengthen the GSEs by establishing a new world-class 
regulator. How we do that and who is to be that regulator, I do 
not know today. With the growing presence of GSEs in the 
capital markets and the possible risks they pose to the 
financial system, the cost of a safety and soundness regulator 
would be a prudent step. But I want to add the big ``however.'' 
That ``however'' is we have got to proceed in this endeavor 
with caution. It cannot be mixed with politics.
    If we want to talk about politics or press reports or 
lobbyists, maybe we ought to do a bill to ban lobbyists, then 
we can have a rich Republican and a rich Democrat do the 
lobbying for everybody. We could call them the 527s of 
lobbying. So I think we take that kind of talk out of the 
process because any new regulatory structure has to recognize 
the importance of the GSEs to the secondary mortgage market.
    Everyone agrees that strong regulatory oversight is 
critical to maintaining public confidence in this remarkable 
system. As I have said before, enhanced regulations for GSEs 
should not impede their ability to support affordable housing 
in America.
    So I applaud the chairman for this hearing. I think we have 
to state a public policy as we go down this road and do what is 
right for the good of Americans, and to craft public policy 
that ensures safety and soundness, but let's not throw in this 
process the housing market to the wolves because that hurts the 
average American.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Ms. Inslee?
    Mr. Inslee. Thank you.
    I just wanted to follow up. Our ranking member talked 
about, when you talk about evaluating this, we are looking at 
soundness. It made me sort of think of our obligation of buying 
a horse. You check its soundness. You check its teeth. You 
check it for hoof rot. That is an important part of this 
function here, to check on soundness of Fannie Mae.
    But the problem to date has been some folks do not want to 
check for soundness, check its teeth, check it for hoof rot. 
They want to hobble the horse when it comes to being a main 
stem of the housing supply in this country. Whatever comes of 
these hearings, I hope that we keep in mind those two different 
functions, that we ought to focus on soundness, but not allow 
this what may be, and I do not know yet because I think you 
should have the trial before the execution, but it may be very 
unfortunate things that occurred, to hobble this very, very 
important horse that is carrying the U.S. economy in 
residential homes in this country.
    Thank you.
    Chairman Baker. I thank the gentleman.
    Ms. Kelly?
    Mr. Kelly. Thank you very much, Mr. Chairman.
    I have no statement at this time. I look forward to these 
witnesses.
    Chairman Baker. Mr. Toomey?
    Mr. Toomey. Thank you, Mr. Chairman. I want to congratulate 
you for your long work in this hearing and for holding the 
hearing today.
    I just want to make one quick observation. Many folks have 
already observed that there are considerable complexities in 
the accounting issues that we are going to be addressing today. 
I think it is important to make sure we make it very clear up 
front, and not get bogged down in the complexities of some of 
this accounting because the dispute here that is alleged, I 
should say the allegation that is made by OFHEO, is not that 
there is a dispute over the interpretation of ambiguous and 
complex rules over which reasonable people could disagree, but 
rather the allegation is that there has been a pattern of 
invention of accounting policies and devices which 
systematically and intentionally misrepresent financial 
statements for the purpose of smoothing earnings and achieving 
maximum bonuses.
    Now, if these allegations are true, they are obviously 
extremely disturbing and require I think major changes at 
Fannie Mae. That is what we are going to be talking about and 
hopefully shedding some light on today, not the arcane 
interpretation of accounting rules, but whether or not 
accounting rules were being set aside, and different policies 
were adopted for purposes for which they certainly should not 
have been.
    I think that is what we need to focus on, Mr. Chairman. I 
thank you for holding this hearing and I yield the balance of 
my time.
    Chairman Baker. I thank the gentleman.
    Ms. McCarthy?
    Mr. McCarthy. Thank you, Mr. Chairman.
    I will hand in my statement. I certainly do appreciate 
hearing from the chairman and the ranking members, but we are 
into this hearing 45 minutes and we still have not heard from 
the witnesses, and I personally think that we should be talking 
to the witnesses, and then do our statements and ask questions.
    With that, I yield back the balance of my time.
    Chairman Baker. I thank the gentlelady.
    Mr. Bachus?
    Mr. Bachus. I thank the chairman.
    First of all, chairman, there have been several remarks 
made that we would have addressed these issues had it not been 
for the Bush administration. It is my recollection that the 
Bush administration actually urged this committee and this 
Congress to take strong action and that at that time that was 
in the sort of post-Freddie Mac. At that time, many of the 
Democratic members accused the Bush administration of going on 
a witch hunt against Fannie Mae of saying that things were 
right at Fannie Mae, and that OFHEO was doing a wonderful job, 
and that there was sufficient regulation, that this was simply 
to accuse the Bush administration of wrong motives.
    It was actually a combination of those in the Senate that 
did not want to take action, and members of this committee that 
disagreed with the Bush administration. One thing the Bush 
administration was concerned about is the new products that 
Fannie was offering, and they wanted Treasury to approve those 
new products. It is my recollection that the minority members 
almost to a person resisted those reforms.
    I do think, and I commend Mr. Frank. Mr. Frank actually had 
it right and more accurately when he said the Bush 
administration wanted to go further than this committee. I 
think that is absolutely true. And now all of a sudden, some of 
the things that the Bush administration wanted to do it seemed 
like they would have been very prudent things to have done.
    So to try to, a month before an election, to try to somehow 
create a smokescreen that the Bush administration had done 
something wrong would be inaccurate and would not be factual. 
Of course, it probably is not surprising either.
    We have before us today OFHEO, and Fannie Mae and their 
officers will be before us at a later date. My understanding of 
this hearing is we are to examine OFHEO and you are to testify 
as to the agreement that you have made with Fannie Mae as a 
result of your study of their accounting practices, and that in 
fact you found that they violated two important accounting 
rules.
    My questions would be, all this stuff that you have 
discovered now, why wasn't it discovered 3 or 4 years ago, 
since you have been the regulators for years and years. Why is 
it suddenly coming to light?
    Chairman Baker. Could the gentleman begin to wrap up?
    Mr. Bachus. So I would simply say that I think there are 
some tough questions for Fannie Mae, but I think there are also 
some tough questions for OFHEO because I believe that if they 
have done these things and you were the regulators, you should 
have known before just the last few months. This should have 
come to light.
    Thank you.
    Chairman Baker. The gentleman's time has expired.
    Mr. Hinojosa?
    Mr. Hinojosa. Chairman Baker, over the last 4 years, the 
United States has suffered from immense job loss. We have 
suffered from an increase in the number of people living in 
poverty. We have witnessed an incredible and unsupportable 
switch from federal budget surplus to an ever-growing budget 
deficit.
    We have also experienced a tremendous increase in the 
national debt over the last 4 years. Overall, our economy has 
not been performing very well during this period, with oil 
prices exceeding $50 per barrel. In fact, to say that it has 
been underperforming would be an understatement.
    However, there is one sector of our economy that has been 
performing well consistently, and that is the housing market. 
It has served as the foundation of the U.S. economy since the 
stock market declined many years ago. It is the one sector of 
our economy to which we need to pay the most attention at this 
time. We need to nurture it. We need to ensure that nothing we 
do here in Congress harms it.
    At this point, I think we need to keep our powder dry until 
all the ongoing accounting and adequacy of its capital and the 
quality of management investigations are complete. Then we can 
see where everything stands once all the dust settles.
    Having said that, Mr. Chairman and Congressman Kanjorski, I 
look forward to hearing the testimony of all of today's 
witnesses.
    I yield back the remainder of my time.
    Chairman Baker. I thank the gentleman.
    Ms. Brown-Waite?
    Ms. Brown-Waite. Thank you very much, Mr. Chairman. Thank 
you for your leadership in providing this opportunity for the 
committee to address this important issue.
    I would also like to thank our witnesses for coming to the 
committee this morning.
    As Americans, we have heard in the past couple of years 
about the Enron scandal and other corporate examples of 
``cooking the books.'' As members of Congress and members of 
this committee with oversight over the mortgage and housing 
industries, it is imperative that we ensure that companies with 
as much industry clout as Fannie Mae, are following generally 
accepted accounting principles, or GAAP.
    I was listening to Bloomberg the other day, yesterday as a 
matter of fact, and I heard how much your stock has also 
suffered. So there is obviously a rippling effect of this OFHEO 
report. However, that being said, as committee members we have 
to remember that the report released by OFHEO in September is 
early in its preliminary stages. I think that there are more 
accusations in this report than findings.
    We certainly look forward to hearing how OFHEO completed 
this report. We have had some heartaches with corporate 
scandals in this country, but I do not think we should be 
jumping to conclusions. While we are ensuring that Fannie Mae 
is using honest GAAP-compliant principles, the committee also 
needs to be certain that we are giving Fannie Mae a fair chance 
to be heard.
    Coming from Florida where our state was devastated by 
hurricanes and where a lot of rebuilding is going to take 
place, it is obviously important that we have the availability 
of the funding for home construction that Fannie Mae regularly 
participates in.
    I look forward to hearing what our witnesses from Fannie 
Mae have to say, and I want to again thank you, Mr. Chairman.
    I yield back the balance of my time.
    Chairman Baker. I thank the gentlelady.
    Mr. Lucas of Kentucky?
    Mr. Lucas of Kentucky. Mr. Chairman, I look forward to 
hearing from the witnesses.
    Chairman Baker. I thank the gentleman.
    Mr. Lynch?
    Mr. Lynch. Thank you, Mr. Chairman.
    I am going to be brief. The one thing I do not want to 
forget are the good things that Fannie Mae is doing. I hear 
Enron talked about here this morning. This is not Enron. This 
is not the Enron situation. These are clearly violations of 
accounting principles, but let's not go overboard and make this 
a criminal proceeding.
    I am very interested in hearing exactly what the 
differences in the accounting practices and how we can correct 
them. But this should not be a witch-hunt. This should not be a 
political exercise in punching people who have done a lot of 
good things in this country providing housing opportunities for 
a lot of people that need them. But clearly, we have to get our 
house in order here.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Gillmor?
    Mr. Gillmor. I will enter my statement into the record. 
Thank you, Mr. Chairman.
    Chairman Baker. The member's statement and all members' 
statements will be made part of the official record.
    Mr. Miller?
    Mr. Miller of California. Thank you. I would like to thank 
you, Mr. Chairman, for your continued commitment to ensuring 
the safety and soundness of the secondary market.
    The question of impropriety has surfaced as a result of 
allegations of accounting irregularities at Fannie Mae has sent 
shock waves through the strong housing market. That market has 
kept this nation going in recent years. The United States 
housing market is the envy of the world. We enjoy the lowest 
interest rates and the highest homeownership of any developed 
nation in the world.
    When Americans are homeowners, it spurs economic and 
community development and provides residents with a sense of 
pride in their community. Homeownership is the single largest 
creator of wealth for most Americans. For this reason, it is 
imperative that we work through this process to maintain a 
strong housing market.
    The GSEs have been at the forefront of creating affordable 
housing opportunities for American families. In my district, 
for example, Fannie Mae has created employer-assisted housing 
programs for the city of Boreas Police Department to allow 
police officers to live in the communities they serve. They 
also helped to finance affordable housing initiatives in 
Anaheim, California, and Anaheim is an extremely high-cost 
housing area.
    Across the district, they have been able to offer 
innovative programs to allow those with blemished credit to 
afford the dream of homeownership, to help seniors convert the 
equity in their homes into cash to help them meet their needs, 
and to help families and individuals with special needs become 
homeowners.
    All of this, in partnership with lenders, is intended to 
meet the ever-growing need of our communities. As we address 
deficiencies in GSE supervision, we must not lose sight of 
Congress' original goal in chartering GSEs. The mission of 
Fannie Mae and Freddie Mac is to provide stability and ongoing 
assistance to the secondary market for residential mortgages, 
and to provide access to credit and homeownership in the United 
States.
    As we move forward to make much-needed regulatory reform to 
ensuring the safety and soundness of GSEs, Congress must be 
unwavering in our commitment to help Americans achieve the 
dream of homeownership and continue to ensure the accessibility 
of mortgage funds at the lowest cost. We must completely 
understand the implications of changes in the regulatory 
structure in meeting the goals of the charter, being careful 
not to inadvertently hinder the ability of GSEs to be 
innovative in meeting the needs of potential homebuyers.
    I believe Congress has ample evidence that OFHEO may not 
have the experience necessary to appropriately regulate complex 
financial institutions such as Fannie Mae and Freddie Mac. 
OFHEO released annual reports that the internal and external 
audit functions at Fannie Mae exceeded safety and soundness 
standards and had the appropriate independence. How can we be 
confident in such findings when OFHEO is now issuing a report 
with very different troubling findings about the serious 
accounting irregularities at Fannie Mae?
    We must work to ensure a new regulatory regime under which 
investors in the market can be confident that these companies 
are sound and that their investment in America's housing 
markets are safe. While there is no question that regulatory 
change must be made to ensure that GSEs are held to the 
absolute highest standard of ethical conduct, I urge my 
colleagues to remain mindful that strong regulations provide a 
means to achieve our ultimate goal of expanding the supply of 
affordable housing credit across our nation.
    Mr. Chairman, I again want to thank you for holding these 
hearings. The goal of these two companies is so critical to our 
economy. I look forward to working with you to ensure the 
appropriate regulatory reforms are made.
    I yield back.
    Chairman Baker. I thank the gentleman.
    Mr. Ford?
    Mr. Ford. I am sorry. I do not have anything to say. I am a 
believer that when you hold hearings, you should let the 
witnesses talk.
    So I welcome you all and look forward to hearing from you.
    [The prepared statement of Harold E. Ford, Jr. can be found 
on page 152 in the appendix.]
    Chairman Baker. A commendable attitude.
    We have two members who are not members of the subcommittee 
today, but who are members of Financial Services. I would like 
to recognize them at this time.
    Ms. Waters?
    Ms. Waters. Thank you very much, Mr. Chairman. I would ask 
unanimous consent to make a brief opening statement.
    Chairman Baker. Without objection, please proceed.
    Ms. Waters. I appreciate the opportunity to be here today. 
I must share that I feel like I am in another round in the 
battle between FM Watch and the GSEs. FM Watch, financial 
institutions that decided a long time ago to wage a political 
war to reduce the GSEs' share of the mortgage market, and of 
course I must say, Mr. Chairman, led by you.
    OFHEO has gone from weak and ineffective to the extreme of 
accusing Fannie Mae now of questionable accounting practices in 
order to increase their bonuses. They have gone back to 1996. 
That is a serious allegation. I hope they are prepared to prove 
it. Obviously as we explore the safety and soundness issues 
that are the subject of this hearing, all of us on the 
Financial Services Committee must keep our eye on the housing 
mission of the GSEs, particularly the affordable housing 
mission that we have entrusted to Fannie Mae and Freddie Mac. 
As we proceed, it is critical that we ensure any action that we 
may consider not impair the housing mission of the GSEs.
    Mr. Chairman, I note with interest that the 211-page OFHEO 
report from Mr. Dickerson to Director Falcon that we will 
explore in today's hearing still bears the following notation 
on each page: special examination of Fannie Mae, privileged and 
confidential disclosure, and/or duplication prohibited, even 
though the OFHEO report was posted on the OFHEO Web site and 
has been publicly available for almost two weeks.
    Mr. Chairman, as I understand it, normally the examination 
and regulatory process is a confidential process where the 
regulator raises his concerns with the party being examined and 
the regulator gives that party a full opportunity to respond 
before determining whether regulatory action is required? I 
note that when Director Falcon's September 20 letter expressing 
concerns about Fannie Mae made the papers, the OFHEO report had 
just been completed. By September 22, the September 17 OFHEO 
report was publicly available, and by September 27, an 
agreement had been signed between Fannie Mae and OFHEO. It 
seems highly unlikely to me that the normal kind of regulatory 
dialogue could have occurred within this timeframe.
    So I hope that the witnesses will address whether the 
regulatory process was proper, or whether there were public 
disclosures outside the normal process for reasons having 
nothing to do with safety and soundness. The September 7th 
OFHEO report is fairly characterized as a work in progress. As 
Mr. Dickerson notes in his transmittal memo to Director Falcon, 
it contains the findings to date of the special examination of 
Fannie Mae.
    The report raises a number of highly technical and arcane 
accounting issues, including issues concerning the treatment of 
derivatives. Some of these issues appear to be controversial, 
and may be disputed by Fannie Mae. These issues cannot be 
easily summarized and they may not lend themselves to a brief 
and simple response. I hope that we will have the patience to 
give these issues the time that they may require.
    Mr. Chairman, to my knowledge, apart from a few brief press 
releases from Mr. Raines and Fannie Mae's independent director, 
Mrs. Ann Korologos announcing the intention of Fannie Mae to 
cooperate with the OFHEO investigation, and later announcing 
the September 27 agreement between OFHEO and Fannie Mae, there 
has been no in-depth public response by Fannie Mae to the 
substantive allegations contained in the OFHEO report.
    This is the first chance that our committee and the public 
will have to hear Fannie Mae's response to these allegations, 
and it will be good to hear their side of the story. I am 
particularly concerned about the 30 percent capital set-aside 
or surplus requirement because that takes a lot of money out of 
the market for mortgages.
    Thank you. I yield back the balance of my time.
    Chairman Baker. I thank the gentlelady.
    Mr. Watt?
    Mr. Watt. Thank you, Mr. Chairman.
    I just want to express my thanks to the chairman for 
allowing members who are not part of the subcommittee to 
participate in the hearing.
    I think members of the subcommittee have expressed in 
various ways a number of the concerns that I would have 
expressed had I been a member of the committee. At the end of 
the day, we want to make sure that Fannie and Freddie and 
whatever other institutions are available to encourage and 
support increased homeownership and housing in this country are 
made stronger and more vibrant.
    I also share a number of the process, due process and 
fairness concerns that have been raised by various members of 
the committee. So I am here to participate in this for those 
reasons, because I am a supporter of housing for American 
people and because I believe in fairness and process and due 
process, and not convicting somebody before the process runs 
its course.
    I hope we will keep in mind both of those things, and I 
appreciate the chairman allowing us to participate. I yield 
back the balance of my time.
    Chairman Baker. I thank the gentleman.
    If there are no further opening statement by members at 
this time, I would now proceed to recognize our first witness 
for the hearing today.
    Mr. Armando Falcon is the director of the Office of Federal 
Housing Enterprise Oversight, who I understand today is 
accompanied by Ms. Wanda Deleo, chief accountant, and Mr. 
Christopher Dickerson, chief compliance examiner, Office of 
Federal Housing Enterprise Oversight.
    Before I proceed, I am reminded, I have a statement of Mr. 
Roger Barnes, former manager of financial accounting, deferred 
assets in Fannie Mae's controller division, submitted to the 
committee and asked to be made part of the official record. If 
there is no objection, I now move to incorporate that into our 
hearing record.
    [The prepared statement of Roger Barnes can be found on 
page 197 in the appendix.]
    By prior agreement with Mr. Kanjorski, we have determined 
that given the gravity of the hearing content today, that all 
witnesses should be asked to testify under oath, given the fact 
that this is an investigative hearing.
    Mr. Falcon, do you have any objection to testifying under 
oath?
    Mr. Falcon. Not at all, Mr. Chairman.
    Chairman Baker. It is my understanding that you are 
accompanied by staff. Will they be testifying and answering 
questions during the course of your testimony today?
    Mr. Falcon. They will not have testimony, Mr. Chairman, but 
they will be available to the committee to answer any technical 
questions about the report.
    Chairman Baker. In that light, it would be my opinion and 
advisable, should we solicit information from them, that each 
of you take the oath. Do either of you have any objection to 
testifying under oath if required by the committee?
    Ms. Deleo. No.
    Mr. Dickerson. No.
    Chairman Baker. If that is the case, I would ask that you 
now stand and raise your right hand and affirm the oath.
    (WITNESSES SWORN)
    Chairman Baker. Thank you. Each of you is now considered to 
be under oath.
    Mr. Falcon, I would recognize you. Given the importance of 
your report, we customarily limit our witnesses to 5 minutes in 
presentation. I would encourage you to summarize as best you 
can, but should you find the need to exceed 5 minutes, I am 
certain members of the committee would welcome a full and 
complete discourse from you on this matter.
    Please proceed at your leisure.

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

    Mr. Falcon. Thank you, Mr. Chairman, and thank you Ranking 
Members Kanjorski, Frank and Chairman Oxley, who was here 
earlier, for inviting me to testify about OFHEO's special 
examination of Fannie Mae. As always, my testimony reflects my 
own views and are not necessarily those of the secretary of HUD 
or the President.
    Before getting to my comments on the report, I would like 
to introduce two of my staff who you mentioned earlier. On my 
right is Chris Dickerson, OFHEO's chief compliance examiner and 
one of our derivatives experts. On my left is Ms. Wanda Deleo, 
our chief accountant. Both are leading the work of the special 
examination, and they are here to assist me in answering any 
technical questions the committee may have about the report.
    In July of last year, I announced that OFHEO would conduct 
a special examination of Fannie Mae's accounting policies, 
internal controls and financial reporting. While the special 
examination continues, our safety and soundness mandate 
requires that when we find problems, we move quickly to remedy 
them, rather than wait until the entire examination is 
complete. The report represents our findings to date and it 
serves as the basis for the actions that we have taken.
    The report raised such serious safety and soundness 
concerns that we brought them to the immediate attention of the 
board. To the board's credit, it became very engaged in the 
examination and moved quickly to reach an agreement with OFHEO 
on the plan of remediation. The agreement constitutes an 
important first step towards resolving OFHEO's concerns and 
ensuring safe and sound operations at the enterprise.
    Let me now turn to the substance of the report. It 
documents Fannie Mae's pervasive and willful misapplication of 
generally accepted accounting principles, as well as critical 
operational deficiencies. The report's findings have 
implications in four areas of major concern to OFHEO: the 
validity of Fannie Mae's previously reported financial results; 
the adequacy of its regulatory capital; the quality of senior 
management's supervision of the enterprise; and Fannie Mae's 
overall safety and soundness.
    The accounting violations cannot be dismissed as mere 
differences of opinion in accounting rules. Fannie Mae 
understood the rules and simply chose not to follow them. 
Fannie Mae's development of improper accounting policies and 
practices can be traced back to a corporate culture and 
operating conditions characterized by the following: a desire 
on the part of senior management to portray Fannie Mae as a 
consistent generator of stable and growing earnings; an 
ineffective process for developing accounting policies; an 
operating environment that tolerated weak or nonexistent 
internal controls; key person dependencies and poor segregation 
of duties; incomplete and ineffective reviews by the 
enterprise's office of auditing; an inordinate concentration of 
responsibility rested in the chief financial officer; and an 
executive compensation structure that rewarded senior 
management for meeting goals tied to earnings per share, a 
metric that can be and was subjected to senior management 
manipulation.
    The accounting problems at Fannie Mae that OFHEO has 
uncovered relate mainly to FAS 91 and FAS 133. Let me briefly 
describe each. FAS 91 governs the amortization of balances 
related to mortgages and mortgage-related securities. 
Management developed accounting policies and selected and 
applied accounting methods to improperly reduce earnings 
volatility related to amortization. Fannie Mae improperly 
delayed the recognition of income to create a cookie jar 
reserve that it could dip into whenever it best served the 
interests of senior management. Those interests included 
smoothing earnings and meeting earnings-per-share targets 
linked to executive bonuses.
    An important example of how this worked took place in 1998. 
At that time, external events caused a plunge in interest 
rates, which in turn added to an acceleration of mortgage pre-
payments. As a result, Fannie Mae faced a more rapid premium 
amortization in the enterprise's mortgage portfolio than 
expected. In December, management's own amortization models 
specified that $400 million in premium amortization expenses 
had to be recorded on Fannie Mae's books in 1998. However, 
management decided to record only $200 million of the $400 
million that year.
    Fannie Mae deferred the remaining $200 million to 1999 and 
recorded it incrementally throughout that year. KPMG, Fannie 
Mae's outside auditor, decided the enterprise's action on this 
matter as an ``audit difference,'' a term which means that KPMG 
disagreed with Fannie Mae's action. Had Fannie Mae taken the 
full $400 million charge in 1998, senior managers would have 
lost their eligibility for any bonuses. That is because 
incentive compensation depended on Fannie Mae realizing 
earnings-per-share targets.
    As it happened, the earnings-per-share target which would 
secure senior management the maximum bonus could only be 
reached if Fannie Mae recorded no more than $200 million of the 
expenses in 1998.
    The next year, Fannie Mae kicked off a challenge grant 
initiative which promised to reward management for doubling 
earnings in 5 years. To avoid facing amortization problems 
similar to those in 1998, senior management began a prolonged 
and concerted effort to develop policies for managing 
amortization. The goal was to gain earnings flexibility and the 
ability to minimize earnings volatility. In this regard, the 
1998 violation was not a singular event. It represented a 
continuous effort to artificially guarantee success in meeting 
targets.
    Let me now turn to FAS 133 and hedge accounting. FAS 133 
requires that derivatives be marked to market and that changes 
in fair value be included in earnings unless the derivative is 
designated as and qualifies for hedge accounting. We have found 
that Fannie Mae implemented FAS 133 in a manner that placed 
earnings volatility and maintaining the simplicity of 
operations above compliance with GAAP. These goals to an 
inordinate degree influenced the development of Fannie Mae's 
approach to hedge accounting.
    The prerequisites for receiving hedge accounting treatment 
include effectiveness assessment, ineffectiveness measurement 
and proper hedge documentation. Because Fannie Mae has not met 
these critical requirements, it should not receive hedge 
accounting treatment for many of its derivatives. Instead, 
proper accounting for such derivatives requires that their fair 
value changes be recorded directly through earnings.
    As a result of these issues and Fannie Mae's disregard for 
complying with FAS 133, we are concerned about the validity of 
the amounts Fannie Mae has reported in accumulated other 
comprehensive income, the earnings the enterprise has presented 
in prior quarters, and the adequacy of regulatory capital.
    Let me state plainly that Fannie Mae's accounting was just 
wrong, and must be fixed properly. The stakes are too high to 
just forgive past sins. If any company, especially a government 
sponsored enterprise, is allowed to get away with this type of 
accounting misconduct, then no regulator can do its job and no 
investor is safe. A regulator and an investor must be able to 
trust the books and records of a company.
    Regarding internal controls, OFHEO found that Fannie Mae 
maintained a deficient accounting policy development process, 
key person dependencies and poor segregation of duties, all of 
which contributed in important ways to the enterprise's 
problems. The details of these matters are addressed in the 
report.
    As I mentioned earlier, we took prompt and appropriate 
action to address these serious problems. We entered into an 
agreement with the board requiring that Fannie Mae implement 
correct accounting treatments, hold the 30 percent capital 
surplus, recalculate prior period financial statements using 
correct accounting, appoint an independent chief risk officer, 
and put in place policies to ensure adherence to accounting 
rules and new internal controls.
    I would also like to remind the subcommittee that the 
special examination is continuing. If OFHEO discovers more 
problems, we will take further action.
    Finally, I would like to thank the leadership of the full 
committee and the subcommittee for your support for our 
funding. The current continuing resolution has placed severe 
constraints on our ability to hire additional staff and employ 
outside experts for the continuation of the Fannie Mae 
examination. This could not come at a worse time for the 
agency, and it once again illustrates the need to remove OFHEO 
from the appropriations process.
    Mr. Chairman and members of the subcommittee, I have tried 
to summarize the report as best I could. I would like to ask 
that it be placed into the record, and we are prepared to 
answer any questions that the subcommittee may have.
    [The prepared statement of Hon. Armando Falcon can be found 
on page 160 in the appendix.]
    Chairman Baker. Your full testimony and the report content 
thereof will be included in the official record of the 
committee.
    Mr. Falcon, did you find that management of Fannie Mae had 
adopted and implemented a strategy from a managerial 
perspective to steer accounting reports for two important 
goals. One is to present an image of very stable earnings to 
the broader market; and two, to manage EPS calculations to 
enable maximum bonus payments to be achieved for executives?
    Mr. Falcon. Those are the findings contained in the report, 
Mr. Chairman.
    Chairman Baker. Did you find in at least one instance in 
1998 that manipulation of accounting methods inconsistent with 
GAAP resulted in an EPS calculation which enabled the bonus 
payment to executives that they would not have been entitled to 
if accounting practices consistent with GAAP had been utilized?
    Mr. Falcon. That is the situation we described in 1998, 
yes.
    Chairman Baker. Is it correct that in reaching the 
earnings-per-share trigger of $3.23 that the calculation of 
3.23 in carried to the math resulted in a calculation of 
3.2309. Is that correct?
    Mr. Falcon. Yes.
    Chairman Baker. Has it been established why the decision 
was made to defer $200 million of a $400 million unexpected 
expense was deferred from 1998 into 1999 and not any 
alternative amount?
    Mr. Falcon. We have not received an adequate explanation as 
to why that was done. We do know that their external auditor 
disagreed with that action that was taken.
    Chairman Baker. Is it correct that in at least preliminary 
response that the modeling utilized by the enterprise was 
determined by management to be inaccurate and the feeling was 
expressed that the $400 million expense was actually 
overstated, and their view was that by deferring the $200 
million it perhaps would more reflect economic reality?
    Mr. Falcon. Their own internal modeling for amortization 
clearly demonstrated that they had to take this $400 million 
expense in 1998. It was their internal models that they were 
relying on for amortization expensing.
    Chairman Baker. But they believed that model to be 
accurate?
    Mr. Falcon. Yes.
    Chairman Baker. Then there is no justification. My 
understanding was the $200 million had been deferred because a 
preliminary explanation is that the modeling was believed to be 
inaccurate and had overstated the expensing. More importantly, 
in the subsequent four quarters in 1999, the expensing did 
occur, acknowledging the value, and in fact did not the 
expensing require increases over the $200 million originally 
calculated?
    Mr. Falcon. Let me say something to that. I cannot speak to 
what the company believed as far as this amortization in 1998. 
I can say that we believe that it was not justified under 
generally accepted accounting principles, and that $400 million 
should have been recognized in 1998.
    Chairman Baker. Is it correct that there are, because many 
will allege or suspect to allege, that this was a one-time 
dispute over arcane accounting methodologies? Their outside 
audit, you indicated, agreed that the expense should not be 
deferred and should be taken in 1998. Is that correct?
    Mr. Falcon. Yes.
    Chairman Baker. Isn't it correct that there were other 
accounting irregularities identified in other reporting years 
that placed the earnings calculation in question, and therefore 
the subsequent bonus calculations resulting from those 
earnings?
    Mr. Falcon. I am sorry?
    Chairman Baker. Let me restate. Is it correct that you 
identified in the course of your examination other accounting 
irregularities and inconsistencies in other reporting years 
that placed the earnings for those years in question because of 
the accounting methodologies utilized, and therefore would 
result in placing the bonus payments made to executives in 
question?
    Mr. Falcon. Yes.
    Chairman Baker. Going forward, I wish to reiterate that 
this is an interim report, not a final report. You engaged the 
services of Deloitte & Touche as an outside audit team to 
assist your staff in reaching these conclusions. In the course 
of that examination, you have reviewed, your staff, Deloitte & 
Touche, in excess of 200,000 documents and e-mails over the 
course of the past 8 months. In addition, hundreds of 
interviews and depositions taken.
    This report should be understood as a first step, not a 
final step. As I understood in your opening statement, as you 
discover additional information that should be brought to the 
attention of the committee, you intend to do so. Is it 
appropriate or can you comment today on where your next focus 
of attention will take you within the enterprise's activities?
    Mr. Falcon. I think I cannot at this time, Mr. Chairman, 
but I can tell you that we do this as a two-step process here. 
The first step in this review on these issues was to identify 
whether or not----
    Chairman Baker. Let me do this, Mr. Falcon. I hate to cut 
you off, but my time has expired, and I am going to try to hold 
other members to be accountable. I have one wrap-up question 
that is important for me to ask.
    Given the public statements to date by the executives and 
board members of Fannie, and the testimony I have reviewed that 
Fannie will proceed with today, in essence disputing all of 
your findings, placing your accounting judgment in question, 
the disputes with the opinion of your outside audit firm, the 
fact that you have had to request the issuance of subpoenas to 
get the enterprise to respond to your normal course of inquiry, 
do you believe the culture of mismanagement at Fannie Mae will 
change unless significant personnel alterations are required, 
as they were at Freddie Mac?
    Mr. Falcon. This comes down to a question of whether or not 
we have sufficient confidence in management to promptly 
implement the remediation plan that will be required to put the 
company back fully on sound footing. The issues raised by our 
staff in this report certainly do cause doubts about whether or 
not there is sufficient confidence in management going forward, 
such that there should not be management changes at the top of 
the company.
    We are currently considering that and we are having 
discussions with the board about the issue of management 
accountability and the confidence in current management.
    Chairman Baker. I regret our time is so limited.
    Mr. Kanjorski?
    Mr. Kanjorski. Let me ask the first question right off. Is 
there a systemic risk problem at Fannie Mae, in your opinion, 
at this stage of the preliminary report that you have gone 
through?
    Mr. Falcon. I think that we have managed this process in a 
way such that there is not substantial risk of a systemic 
disruption. Through the actions we have taken, and through the 
board's prompt action in agreeing with us on remedial actions, 
we have precluded the possibility of systemic events.
    Mr. Kanjorski. So we can inform the investing public and 
others that hold securities of Fannie Mae, is there any reason 
in the world that they should worry about the value or the 
credibility of their securities?
    Mr. Falcon. I am not quite comfortable talking about 
recommending whether or not an investor should or should not 
invest in this company.
    Mr. Kanjorski. I am not asking you to make a 
recommendation. Is there anything in your findings, in other 
words, as a result of the audit differences that are being 
attended to, and as a result of some of the accounting wrongs 
that may have been uncovered through your investigation, is 
there any reason to believe that there is a large loss of 
equity or a question of Fannie Mae remaining solvent?
    Mr. Falcon. In the worst-case scenario, the company could 
be undercapitalized, below its minimum capital requirement, but 
not to the extent that the company would be insolvent.
    Mr. Kanjorski. Can you give us a maximum amount of 
undercapitalization that you may have discovered? In other, the 
need to infuse more capital, what would that amount be?
    Mr. Falcon. Now that we have determined that the accounting 
policies of the company were not consistent with GAAP, the next 
step for us to take is to do an evaluation of the impact of 
these improper accounting practices on past financial 
statements, especially the impact of its large derivatives 
portfolio possibly not being eligible for hedging accounting 
treatment, which means the amounts in other comprehensive 
income would have to flow back into the balance sheets through 
earnings, and therefore be recognized.
    We will not know this until we go through all of the 
evaluation exercises. There are $12 billion in negative losses 
in OCI, and if all of that were forced to move over to 
earnings, the company could potentially take a hit of that 
much. But we do not know, congressman, how much, if any of that 
will move into the retained earnings portion of balance sheets 
until we have worked with the company to come to those 
determinations.
    Mr. Kanjorski. Making the worst-case scenario assumption, 
however, that does not constitute in your mind systemic risk? 
Is that correct?
    Mr. Falcon. Yes. The solvency of this company is not 
threatened by the findings we have to date.
    Mr. Kanjorski. Okay. I want to move you along because I 
have a few questions.
    I do not understand what you do as a regulator, but I 
assume you examine auditors' reports. Is that correct?
    Mr. Falcon. Yes.
    Mr. Kanjorski. And I assume that audit differences, as you 
indicated, how they handle the $400 million or the $200 
million, showed up in a finding by the auditor to the 
corporation that was a difference here of opinion and how this 
should be accounted for. Is that correct?
    Mr. Falcon. What we do----
    Mr. Kanjorski. Not what you do. I want to know what papers 
you examine. What I am asking you is did you examine the audit 
report of 1998 and did there exist a finding indicating there 
was a difference between the auditor and the corporate 
leadership as to how this $400 million was accounted for?
    Mr. Falcon. We were not aware of this audit difference 
until we began this accounting examination.
    Mr. Kanjorski. Why were you not aware of it?
    Mr. Falcon. We have not traditionally looked at the work of 
the external auditor to ensure that they were properly 
certifying that the company's financial statements were 
consistent with GAAP.
    Mr. Kanjorski. Do you mean the regulator does not get the 
outside audit report and examine it thoroughly before it 
passes, or examines anything else in a corporation? I would 
think that would be the first tool that you would look at.
    Mr. Falcon. Let me ask our chief accountant about this 
question, Mr. Kanjorski.
    Ms. Deleo. We are certainly taking that approach at this 
point.
    Mr. Kanjorski. I am not worried about 2004. I am asking 
about 1998. I am trying to get an essence of just what a 
regulator does. The only prior experience that I have had 
sitting on a board of a bank was that we would have external 
audits and at the conclusion there would be an exit meeting of 
all the differences or questions raised by the auditor that 
would be presented to the audit committee.
    It just seems rudimentary that if you are going to spend 
hundreds of thousands or maybe millions of dollars to hire an 
auditor, that all of that is laid out in the findings and the 
differences, and that should be the first piece of paper the 
regulator picks up and looks at because a lot of work has been 
done and a very credible auditing company has made differences 
in findings. In 1998, if we had picked up the audit report by 
the external, outside auditor, was there a reflection of an 
audit difference in how that $400 million was handled?
    Chairman Baker. I would ask the gentleman that that be the 
last question on this round.
    Please respond, sir.
    Mr. Falcon. Yes. We look at this, Congressman, as a team 
effort. The safety and soundness of this company is dependent, 
yes, on us doing our job properly. It is dependent on 
management running the company properly, the board properly 
overseeing the company, and the external auditor doing its work 
to ensure that the financial statements are consistent with 
GAAP. We look at the financial statements and the work of the 
external auditor. I do not know where this audit difference was 
reflected.
    Mr. Kanjorski. I just want to follow this line of 
questioning. You mean at this point in time you do not know 
whether or not that was openly displayed in the outside audit 
report?
    Mr. Falcon. Let me ask Mr. Dickerson, please, Congressman, 
to address this.
    Mr. Dickerson. Congressman, we had testimony from the 
controller and the CFO that there was this $200 million audit 
difference between the firm and KPMG. We saw internal documents 
from the company that there was approximately a $400 million 
expense that was estimated.
    Mr. Kanjorski. And it was listed as an audit difference by 
the outside auditor in 1998.
    Mr. Dickerson. Right. And we learned that through testimony 
that we obtained from the CFO.
    Mr. Kanjorski. It took you 6 years and depositions to 
discover something that was on a concluded audit document as a 
finding?
    Mr. Falcon. We need to go back and find out if this was 
included in any documents that were or should have been 
provided to the agency. If we find that this was something that 
was in some documents that we could have had access to, that we 
should have had access to, then it points out a need for us to 
strengthen our program.
    I am not saying that the agency is completely without fault 
here. We have more resources now, with an accounting staff. We 
did not have an office of chief accountant until 2 years ago. 
Ms. Deleo has just joined the agency very recently. But in 
light of the Freddie Mac problems, I think it has highlighted a 
need for this regulator to get heavily involved in accounting 
issues because they do go to the heart of the safety and 
soundness of our work. If we cannot rely on the books and 
records of this company----
    Mr. Kanjorski. Yes, but you do not read the books and 
records of this company as a regulator. It does not matter. It 
would just seem to me that this committee could call up and 
subpoena the outside audit report of 1998 and I will be shocked 
if a finding is not there mentioning this audit difference as 
to how the money was handled. It should have been the first day 
you arrive at the place, looking at the audit. You should know 
what happened.
    I am just worried about, we are calling you a regulator and 
you are scaring hell out of me that you did not see that, and 
everybody should have been alerted to that that sits on a 
board, that you go through your audit findings. That is so 
axiomatic. I guess in law school we used to call that Horn 
book.
    Chairman Baker. The gentleman's time has really expired, if 
I may. I really want to try to hold members. We have much more 
to do today. Please help me here to get through this process.
    Mr. Castle?
    Mr. Castle. Thank you, Mr. Chairman. Even by Washington 
standards, this is an extraordinarily tangled web that we are 
dealing with here and a little bit hard to follow to a degree.
    Fannie Mae clearly has some questions to answer here. I am 
worried that we have not given the regulators, OFHEO in this 
case, sufficient assets to move ahead with what they have to do 
in terms of their work. There are a lot of people hired on the 
outside to try to hold all this off. Frankly, I think we have a 
responsibility as a subcommittee and a committee right here to 
do everything we can to get to the bottom of all of this.
    Let me just start with this, if I may, Director Falcon. And 
that is, as I understand it, you hired an outside auditor 
recently. Did you not hire an outside auditor prior to that 
time because of insufficient funds to do so?
    Mr. Falcon. We have not hired an outside auditor to assist 
us prior to the initiation of this special accounting 
examination. That is right.
    Mr. Castle. Was it because you had insufficient funds to do 
so?
    Mr. Falcon. We have been trying to. We have not undertaken 
a special accounting review like this prior to this point. We 
have not made the request, I guess, for the funds. But even if 
we saw the necessity for it, we would not have had the funds 
and we would have had to come to Congress for the additional 
funding.
    Mr. Castle. Let me ask you another question. Can you tell 
me why, and I can only judge this through press statements of 
my own accord. KPMG is standing by the company's financial 
reports, even after your report, of course. Could this be 
another example of just a difference of opinion as to the 
application of GAAP, such as the one I understand you have with 
this company with regard to their manufactured housing loans? 
Or is it something else?
    Mr. Falcon. We feel very strongly that these are black and 
white accounting issues. These are not issues of 
interpretation. They are not issues where reasonable people can 
disagree. We have taken prompt, strong action in trying to deal 
with this because we do think they were clear violations of 
accounting principles.
    Mr. Castle. So i.e. KPMG then in standing by this is at 
fault in terms of the clear accounting principles which exist. 
Is that what your statement is basically?
    Mr. Falcon. If they are standing behind this accounting 
treatment, then yes, they are wrong as well.
    Mr. Castle. Do you have sufficient powers to carry out your 
responsibilities? I know there has been a lot of discussion 
about changing agencies and all the things that we should do, 
but I am worried about what you can do now in terms of cease 
and desist orders, other regulatory powers which you need, the 
funding which you need in order to carry out your 
responsibilities to make sure all this is handled correctly.
    This is of overwhelming significance, and I think for you 
to be shortchanged in any of these categories would be a 
terrible error. Can you detail for us where there may be needs, 
or if there are not needs at all?
    Mr. Falcon. I think there are several key areas where we 
would like the same powers that are given to every other safety 
and soundness regulator. It begins with the authority to assess 
for budgetary needs outside the appropriations process, to have 
independent funding. It begins with flexibility in a variety of 
areas, including capital requirement setting. Every other 
regulator has that.
    It includes issues like independent litigating authority, 
the ability to freeze the pay of any executives where we find 
potential wrongdoing. We recently had an opinion in district 
court saying that we do not have the same authority that other 
regulators have. So there are quite a few areas where we just 
need strengthening across the board, including general safety 
and soundness powers.
    Mr. Castle. Changing the subject, I wrote down a couple of 
comments, and I do not know if I wrote them down correctly, of 
course. Correct me if you see otherwise, but that you made in 
your opening statement. You said that Fannie Mae understood the 
rules, but chose not to follow them.
    Mr. Falcon. Yes.
    Mr. Castle. What do you mean, Fannie Mae? Do you mean their 
board of directors, their officers? What do you mean by Fannie 
Mae in that circumstance? And are the rules that you are 
referring to accounting rules or something beyond anything that 
has been discussed here today?
    Mr. Falcon. What we mean is, this is not a matter where the 
rules were too complex and the company did not understand them. 
It is not a matter where they made a good-faith effort to try 
to comply with the rules. They did not comply with rules that 
they clearly understood.
    Mr. Castle. Accounting rules?
    Mr. Falcon. Accounting rules.
    Mr. Castle. That they clearly understood. And when you say 
``they,'' you are referring to whom?
    Mr. Falcon. Those responsible in the company for setting 
accounting policy consistent with GAAP.
    Mr. Castle. So it could be officers or it could be 
directors or a combination of the two or something of that 
nature?
    Mr. Falcon. Yes.
    Mr. Castle. Okay. And then you said it is just plain wrong 
and must be fixed and not overlooked. I assume that is just a 
follow-up to what you had said earlier in this particular area. 
When you say ``fixed,'' if a mistake was made, do you mean 
going back and just correcting the accounting principles? Or is 
there something further that needs to be done to so-called 
``fix'' their problems?
    Chairman Baker. That would have to be the gentleman's last 
question.
    Please respond, sir.
    Mr. Castle. Thank you, Mr. Chairman.
    Mr. Falcon. It means making sure that the proper accounting 
policies are put in place going forward. If there was an impact 
on their financial statements going backward, that it would 
mean that there would be a need to correct those financial 
statements going backwards. That is an issue that we are 
working with the SEC on.
    Mr. Castle. Thank you, sir.
    Chairman Baker. I thank the gentleman.
    Ranking Member Frank had to step out. Just for the 
committee's purpose, I have committed on his return to 
recognize him in the proper order for his questions.
    Mr. Clay, you are up next.
    Mr. Clay. Thank you, Mr. Chairman.
    Mr. Falcon, when you and members of OFHEO's staff conducted 
interviews and received company documents, why was Fannie Mae 
not allowed to question their witnesses on the record?
    Mr. Falcon. They were allowed to participate in those 
sessions. I am not aware if they requested such opportunity, 
but the interviews of their employees were held at our request 
in order to gather information about the company's accounting 
policies and practices and internal controls.
    Mr. Clay. Why were Fannie Mae officials not provided the 
opportunity to respond to findings or conclusions reached by 
OFHEO during the course of the examination?
    Mr. Falcon. I think because we followed a regular order 
here. We followed an accepted practice of regulators. Faced 
with findings of significant accounting misconduct by senior 
management and dealing with a management that is resistant to 
regulation, that same management team responsible for this 
accounting misconduct, any regulator would have done what we 
did, take this directly to the board.
    Mr. Clay. Is this due process?
    Mr. Falcon. This is safety and soundness regulation which 
requires prompt action to ensure that the company does not get 
into financial difficulties.
    Mr. Clay. Is this the way you have handled internal 
investigations in the past?
    Mr. Falcon. Other than the Freddie Mac special accounting 
review, this is only the second special examination that we 
have conducted. On more routine matters like our ongoing annual 
risk-based examination of the enterprises, we do have that type 
of a give and take, but this was a different situation.
    Mr. Clay. In May and June of 2003, OFHEO published its 2002 
annual report giving both companies, Fannie Mae and Freddie 
Mac, more than satisfactory grades on accounting and internal 
controls. You and your agency were pretty embarrassed when 
issues were discovered at Freddie Mac. Were you so determined 
to not let this happen again even if it meant denying Fannie 
Mae fundamental fairness that is routinely provided to banks?
    Mr. Falcon. No, congressman. I have testified before this 
committee before that I had no reason to believe that this 
company was engaged in any kind of accounting improprieties 
like Freddie Mac. But given the fact that questions were being 
raised about whether or not the same problems existed at 
Freddie Mac, I thought it appropriate to go in and take a look 
at Fannie Mae. So we did. I am as disappointed as I think you 
are that the company has engaged in this type of conduct. But 
the findings are what they are, and we have taken action.
    Mr. Clay. Let us go back to the process, then. Examiners 
discuss preliminary concerns and possible findings with 
regulated entities. Would it not have been fair to do this with 
Fannie Mae, to sit down and have a discussion with them?
    Mr. Falcon. We did have a discussion, but it was with the 
board, congressman. Like I said, this was a situation where we 
have findings of serious accounting misconduct by management 
and we have that same management being resistant to our efforts 
to deal with these issues, noncompliance with our efforts to 
examine the company such that we had to go to the Justice 
Department and ask for a court enforcement of our subpoena. In 
such situations, any regulator would have gone directly to the 
board, brought the matter to the board's attention, and sought 
immediate action to ensure the safety and soundness of the 
company.
    Mr. Clay. You did not provide Fannie Mae with a draft 
examination report. Banks are given an opportunity to respond 
before finalizing an examination report or discussing matters 
with their company's board. Why not Fannie Mae in this 
instance?
    Mr. Falcon. We do that. In the course of our normal 
examination of the company, we do that. But as I have said, 
this is a different situation.
    Mr. Clay. And you claim that they were hostile to the 
examiners. In what way?
    Mr. Falcon. They were resistant to compliance with our 
request for documents and we had difficulty in scheduling their 
employees for interviews. We eventually had to move to taking 
statements on the record, rather than having informal 
interviews of employees. We had to move to the issuance of 
administrative subpoenas. We had to ultimately try to get those 
subpoenas enforced in court.
    Mr. Clay. Don't you think that all interests are best 
served by ensuring that all relevant data is available to OFHEO 
and that there are no misunderstandings of relevant facts?
    Mr. Falcon. I am sorry, Congressman. That all relevant data 
is available to----
    Mr. Clay. To your agency and there are no misunderstandings 
of relevant facts.
    Mr. Falcon. Yes.
    Chairman Baker. That will need to be the gentleman's last 
question. His time has expired.
    Mr. Clay. Did he answer?
    Chairman Baker. He did respond, I believe ``yes.''
    Mr. Clay. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Director Falcon, 3 years ago our committee was heavily 
involved in the accounting scandals surrounding Enron and 
WorldCom and others. We saw, based on our hearings and 
evidence, manipulation of earnings, corporate governance 
failures, raiding of corporations by their executives in order 
to pad their own wallets.
    After reading your report, it seems that you are alleging 
many of the same problems now exist at Fannie Mae. As you know, 
the Sarbanes-Oxley Act was formulated to prevent future Enrons, 
but has been repeatedly criticized in some quarters as being 
too tough on corporations. Do you believe that Sarbanes-Oxley 
has been a useful tool in your investigation? And do you 
believe that Fannie Mae's executives were in violation of the 
Sarbanes-Oxley Act?
    Mr. Falcon. I think it has been a very useful tool, Mr. 
Chairman, because the spirit of Sarbanes-Oxley is 
accountability, accountability of management and accountability 
of boards in corporate governance issues. Here we have a 
situation where because of the requirements of Sarbanes-Oxley, 
I think the board has stepped up to try to begin to fulfill its 
responsibilities. They have worked with us well in coming to an 
agreement. We are working on developing a good relationship 
going forward to address any future problems.
    The provisions like certification certainly are beneficial. 
There is much at stake when an executive certifies compliance 
with the provisions of Sarbanes-Oxley. It has been a very 
useful tool for the agency, because we also have safety and 
soundness standards that our patterned off of Sarbanes-Oxley as 
well.
    Mr. Oxley. How does your job working with the regulated 
entity, that is Fannie Mae, and in the context of Sarbanes-
Oxley regarding the SEC, explain to the committee a little bit 
about how, as a technical matter, that works?
    Mr. Falcon. We are working with the SEC. Now that Fannie 
Mae is a registered company under the 1934 Act, they are 
covered by Sarbanes-Oxley. We are working with the SEC. We have 
shared with them all of our findings. We are sharing our 
documents with them, everything that they have requested. We 
have a shared interest here. Our interest is safety and 
soundness. The SEC's interest is investor protection. We are 
each working to make sure that our missions are fulfilled here. 
Sarbanes-Oxley has encouraged that kind of interagency 
cooperation between the safety and soundness regulator and the 
SEC to make sure that both interests are properly served.
    Mr. Oxley. Director Falcon, Fannie Mae is one of the 
largest users of derivatives in the world. As such, Fannie Mae 
should be well versed with the rules related to FAS 91 and FAS 
133. Is it your understanding that Fannie was aware of the fact 
that their accounting was not GAAP compliant, but they chose 
not to comply because, to do so, would be too burdensome and 
costly? Or is it your opinion that Fannie Mae made a material 
misapplication of the GAAP rules?
    Mr. Falcon. I think it is both, Mr. Chairman. One, they 
wanted to maintain the accounting principles that they thought 
were best suited to the company. At the same time, they 
willfully did not apply accounting rules properly. This is an 
important point because it was not just a matter of these rules 
being too complex for this large, very sophisticated company. 
They understood the rules. They chose not to follow them.
    These accounting principles have to mean something, Mr. 
Chairman, and they should apply to every company equally. No 
one gets special treatment. What we have done in this report is 
to highlight the issues of how the company has not complied 
with some very critical accounting rules. The company will not 
get special treatment from us. I do not think anyone should 
give it special treatment in making sure it complies with all 
accounting principles.
    Mr. Oxley. The Sarbanes-Oxley Act clearly spells that out. 
So you are saying that basically this was a selective effort on 
the part of Fannie to use accounting principles that would 
benefit them, as opposed to what we would consider to be 
generally accepted accounting principles as enunciated by the 
FASB and ultimately the rules set up by Sarbanes-Oxley and the 
SEC and the Public Company Accounting Oversight Board.
    Mr. Falcon. That is right. They simply did not comply with 
GAAP because compliance with GAAP would have shown more 
volatility in their quarterly financial statements than they 
would have liked. So through the misapplication of GAAP, they 
were able to project an image of the company of smooth 
earnings, which conveys to the markets less risk than is 
actually there because of the volatility of strict compliance, 
of proper compliance with GAAP.
    Mr. Oxley. Okay. So the issue is a selective interpretation 
of GAAP. I would assume that Fannie will come before the 
committee later today and argue that basically it was a 
difference of opinion over those issues, and that they were 
clearly compliant with the GAAP and that you had a different 
interpretation as to whether that was procedurally correct. How 
would you respond in advance to almost certainly they will be 
testifying to?
    Mr. Falcon. It would not surprise me, Mr. Chairman, that 
that would be their position. We have found, not just our chief 
accountant and her staff, but also Deloitte & Touche, we have 
found that these are clear violations of generally accepted 
accounting principles. They are not situations where a company 
can say that they may have been aggressive; they may have been 
consistent in spirit. No, these were noncompliance with GAAP.
    We would not have come to the very firm conclusions we did 
in this report and not have taken prompt corrective action were 
it not for the fact that these were clear violations of GAAP. 
If any company were allowed to engage in this type of 
accounting misconduct, then no investor could rely on the books 
and records of the companies and their financial statements.
    Mr. Oxley. This will be my last question, Mr. Chairman.
    As you know, in Sarbanes-Oxley we specified that insider 
stock sales, instead of the traditional 40-days recording 
requirement, would now be made in real time, that is within 24 
hours of that sale. Did your investigation look into insider, 
that is corporate executives, stock activities? If so, what did 
it tell you?
    Mr. Falcon. We have been monitoring the sales of 
individuals within the company. We are just now beginning to 
shift our focus into other areas like that. Our first objective 
here was to assess compliance with GAAP in these two critical 
accounting areas, and now move to remedy those problems and get 
to valuation issues. But issues like the insider stock sales 
are something that we have been monitoring and perhaps we will 
come back and give you a report on that.
    Mr. Oxley. It would seem to me at least that perhaps would 
be the SEC's role because the Act required them, the insiders 
who sell stock, to report that on the Web site at the SEC. And 
so, I would assume that at least the SEC would assume that 
particular role and that OFHEO would be secondary in that 
regard. Is that correct?
    Mr. Falcon. Yes. They are publicly disclosed, and the SEC 
would have a role in that.
    Mr. Oxley. They would have the primary role, would they 
not, under the law?
    Mr. Falcon. They would have a primary role, but safety and 
soundness requires that we also take action. There is some 
overlap. Safety and soundness requires that we also take action 
when we see violations. It is important that we do coordinate 
with the SEC in areas where there is overlap.
    Mr. Oxley. The purpose, of course, of the provision, as 
Chairman Baker knows and others on the committee, was to 
provide more transparency in real time because perhaps if we 
had that on the books during the Enron case, some of those 
insider sales would have put up a lot of red flags, 
particularly when the employees were locked down and not able 
to sell their shares. So that is why I wanted to bring that 
point up, the idea of the immediacy of it and the transparency 
of it hopefully, at least at some point, will provide some 
deterrent to that kind of behavior, including perhaps smoothing 
out earnings or making earnings look better than they really 
are.
    With that, I yield back.
    Chairman Baker. I thank the chairman.
    Mr. Scott?
    Mr. Scott. Yes, thank you, Mr. Chairman.
    Mr. Falcon, there have been some questions raised as to the 
timing of the release of your report. Could you describe the 
manner in which this report was released, the timing of it? 
Were there systematic leaks to the press? Were they internal? 
And the affected parties such as Fannie Mae were aware of your 
findings before they were released to the press?
    Mr. Falcon. We have kept a tight lid on this as we have 
gone through the process. The first communication we had about 
this report as we got to the end of it was on Friday, the day 
before we met with the board, I do not remember the exact date, 
congressman, but we did contact the company and asked that the 
board assemble itself so that we could present the report to 
the board.
    We did not release the report to anyone prior to that date. 
The first time we released the report outside the agency was to 
the board at that date. We did have on the Friday before that 
Monday meeting, some conversations with other agencies just to 
make them aware of what we were finding and how we were going 
to proceed.
    Then once we went to the board on Monday, the week 
progressed with discussions between us and the board about 
proper remedial action.
    Mr. Scott. Let me ask you this, then, at what point did you 
release it to the press in that order of events? When exactly 
did you do that?
    Mr. Falcon. We did that on Wednesday. I had a commitment to 
the board that we would not release the report as long as they 
objected, and we were in the process of working out the terms 
of this agreement to take care of remedial actions. On 
Wednesday, I had a meeting with a couple of the board members. 
They said that given the intense interest in this, they no 
longer had any objections, and given the fact that there was 
also some expression raised from members of Congress about go 
ahead and put the report out there, I exercised my judgment and 
said, okay, then we will go ahead and release the report.
    Mr. Scott. Okay. Did you consult with the Securities and 
Exchange Commission or FASB prior to making the report's 
findings public, as to whether or not Fannie's accounting was 
consistent with GAAP?
    Mr. Falcon. We spoke to the SEC about this on the Friday 
before we went to see the board. Prior to that time, we did not 
seek their opinion about this. Because we viewed these issues 
as clear violations and the company clearly understood these 
rules, we did not. If we felt that this involved a gray area 
and we needed some guidance about what the rules required and 
whether or not the company was meeting those rules, then we 
would have certainly sought guidance from the SEC.
    Mr. Scott. Okay. Two little points here. How are the 
problems with accounting for derivatives at Fannie, how do they 
compare with what you have found with the examination of 
Freddie Mac? Are they the same? Same abuses?
    Mr. Falcon. We have seen the same cultural issues. We have 
seen the same motivations in terms of smoothing earnings. Some 
role in compensation issues. So certainly much of that appears 
to be consistent between the two companies.
    As far as the actual magnitude of any impact on the 
company's financial statements, I really do not have an answer 
for that until we complete this next phase of the process, 
which is to assess the impact on past financial statements.
    Mr. Scott. Why do you think that Fannie Mae altered their 
earnings? What was the underlying purpose from your report?
    Mr. Falcon. The primary rationale as we see it was a strong 
desire that the company had to present itself to the public and 
investors as a company which had very smooth and consistent and 
reliable earnings growth. The only way to do that was to 
develop these accounting practices which allowed them to smooth 
out the volatility which exists in this line of business.
    Mr. Scott. Do you think that this activity was generated on 
the part of Fannie Mae so that they could increase their 
compensation package?
    Chairman Baker. That would need to be the gentleman's last 
question. His time has expired.
    Please respond, sir.
    Mr. Falcon. It certainly appears that way to us. Given this 
one instance in 1998 and given the fact that for the next 5 
years bonuses were continually tied to earnings per share as a 
metric. That metric was being manipulated in order to create 
smooth earnings. It certainly appears that way to us.
    Mr. Scott. Thank you very much, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Shays?
    Mr. Shays. You are almost becoming a sympathetic figure, 
and your organization. I mean, you have issued a report and you 
are getting attacked on the report. You are being questioned 
why you did not do a better job sooner, and yet your 
organization has not been given the authority or the power by 
Congress to do the job it needs to do.
    And frankly, I do think you needed to show a little more 
energy, which you are starting to do. I am seeing the result of 
that. When did you give them the report? When did you talk to 
them? Why didn't you find out sooner? Instead of having members 
of this Congress try to find out what the hell they did.
    One of the things that I find somewhat astounding is, are 
you saying to this committee that you actually had to issue 
subpoenas against this organization or consider it or threaten 
it to get information you are entitled to get?
    Mr. Falcon. We issued administrative subpoenas to get 
information that we needed for this special examination, yes.
    Mr. Shays. Why would you have to issue administrative 
subpoenas? Why can't you just ask for it?
    Mr. Falcon. We did initially, but we did not get sufficient 
compliance, certainly not timely compliance, partial 
compliance. Therefore, we felt the only way to solve that 
problem was to move toward administrative subpoenas.
    Mr. Shays. So the bottom line is, not only have you found 
this company not in compliance, you are telling us they 
resisted in your initial efforts to find out what was going on. 
They resisted your efforts to do your job. Isn't that correct?
    Mr. Falcon. That was our feeling and that is why we moved 
toward the more formal processes.
    Mr. Shays. And you have stated to us that these findings 
are very serious, correct?
    Mr. Falcon. Yes.
    Mr. Shays. Are investors impacted? Isn't it possible that 
investors, based on reports, will have made decisions that were 
based on faulty information?
    Mr. Falcon. Unfortunately, that very much is the case when 
you have financial statements issued under accounting practices 
that are not consistent with GAAP. GAAP is there to ensure 
consistency of reporting across quarters so that you have the 
ability to compare a company's performance from quarter to 
quarter. If you do not have correct compliance with GAAP, then 
you do not have that comparability from quarter to quarter and 
can judge a company's performance over time.
    Through these catch-up provisions the company had under FAS 
91, it allowed it to minimize earnings volatility and that 
comparability that investors need.
    Mr. Shays. And didn't it also enable them to say they were 
a low-risk enterprise?
    Mr. Falcon. The lack of volatility certainly conveyed that 
impression.
    Mr. Shays. Now, having discovered what you have discovered 
without the cooperation of the organization, are they accepting 
your findings or resisting your findings?
    Mr. Falcon. I feel like the board has been cooperative in 
working with us to address these findings.
    Mr. Shays. Right. And they said that they will change their 
behavior, correct?
    Mr. Falcon. They said they would change their behavior 
going forward. They are going to do the calculations for us 
going backwards so we can assess the magnitude of the incorrect 
accounting in prior periods.
    Mr. Shays. What concerns me is, when Mr. Raines comes and 
testifies, he is not going to give us the feeling that he gets 
it. Why do you think that is the case?
    Mr. Falcon. I cannot speculate on that. I just know that 
our findings, we feel very strongly about what we found. A lot 
of work has gone into this. It does not surprise me that the 
company would continue to stand behind its accounting, but the 
fact is it is wrong.
    Mr. Shays. It is wrong, and there is not going to be any 
doubt about the fact that it is wrong. Now, their auditor was 
paid $3 million in a $1 trillion firm. Doesn't that raise some 
question about their capability, the auditor's capability to do 
the job, with a $1 trillion operation?
    Mr. Falcon. We are now focusing more on the work of the 
external auditor. We have had concern about potentially 
excessive reliance by the external auditor on the internal 
audit function and internal policy-setting by the company, but 
that is something for further review now that we have completed 
this step in the process.
    Mr. Shays. I congratulate you on the work you have done. I 
congratulate you for trying to protect the public. I 
congratulate you for showing courtesy to the company, meeting 
with them first before this report was issued. But the bottom 
line is, what really matters is what your report says and how 
they deal with it. I am somewhat appalled and maybe even a 
little shocked that you would have had to use subpoenas to get 
information to do your job. I thank you for going to that level 
to ensure that you could get your information.
    Chairman Baker. The gentleman's time has expired.
    Ranking Member Frank?
    Mr. Frank. Thank you, Mr. Chairman.
    Let me say, I was pleased and I understand what the 
gentleman said. I guess, if your feelings have been hurt. I am 
sorry. I did not think anybody here was of that sensitivity. I 
was pleased to join with the chairman in objecting to the 
appropriations committee to level-fund you going forward, but 
we thought that was the best thing we could do was to get you 
more money, and the chairman of the committee and I jointly 
protested the decision of the Appropriations Committee, but 
being in the minority we do not get to make those 
appropriations decisions, but we were certainly supportive of 
that.
    I did have a couple of questions. This is important about 
how this was done, because I think there is a problem that a 
perception could be created before we can establish a reality 
that could be damaging. Now, you told the gentleman from 
Georgia how you went about telling people, et cetera. But there 
was a newspaper report over that weekend I think quoting the 
chairman of the subcommittee. He said he had been briefed on 
the content of the report. We on our side, on the Democratic 
side, heard nothing until we read about it in the paper. Was 
the chairman briefed and is it appropriate to brief one side 
and not tell the other?
    Mr. Falcon. That would be certainly not appropriate and not 
consistent with the way I would like to deal with this 
committee, congressman. We did not brief any member of the 
committee. Unfortunately, the press just reported that 
inaccurately.
    Mr. Frank. Wait. Stop. The press mis-reported it. All 
right. Maybe that will make it into the reports of today's 
proceedings.
    So the report that the chairman had been briefed was an 
error on the part of the press. He was not briefed.
    Mr. Falcon. Yes.
    Mr. Frank. Okay.
    Chairman Baker. Would the gentleman yield? I just want to 
confirm. I do not know where the report generated. I was not 
either by SEC or OFHEO given any advance information.
    Mr. Frank. Okay. I appreciate that. I would just caution 
people, and we now have an agreement from all parties that the 
assertion that OFHEO had briefed the chairman of this committee 
was a mistake in the press. If that is the only mistake the 
press has made in this, that would be quite extraordinary.
    Let me ask you, similar. There was one report in one 
newspaper that you had made a referral of a criminal matter to 
the Justice Department. Is that accurate?
    Mr. Falcon. We have not made a formal criminal referral. 
All we have done is given a copy of the report to them.
    Mr. Frank. To everybody. So that means you have not made a 
criminal referral as that is defined.
    Mr. Falcon. Right. We have not made a formal referral.
    Mr. Frank. Okay. That is another one again. I think the 
suggestion that there was a criminal referral is it seems to me 
quite misleading. I am glad we were able to clear that one up.
    Now, on the question of the substance, Fannie Mae has 
agreed to a 30 percent increase in their capital. Is that 
correct, as a result of your conversations with them?
    Mr. Falcon. Yes.
    Mr. Frank. How did you arrive at the decision to make it 30 
percent? My understanding is, as I read this, the smoothing out 
of earnings, if that happened, to give people more pay is 
outrageous, but it does not seem to me to implicate in any way 
the safety and soundness. A smoothing out means up one and down 
another. It does not affect certainly the overall economic 
position.
    Then the question is the derivatives and the hedge 
accounting. The potential misstatement there is I guess part of 
the reason that you asked for the 30 percent increase in 
capital because it might have been a misstatement.
    But my understanding is you have come to no conclusion as 
to what the amount of a potential misstatement was. Is that 
correct?
    Mr. Falcon. That is correct.
    Mr. Frank. Could it have been an under-estimate as well as 
an over-estimate?
    Mr. Falcon. Potentially.
    Mr. Frank. So what we know is that you disagreed with the 
way they did them. I was struck, and I would ask unanimous 
consent to put in the record here a very interesting report, 
September 27th from Merrill Lynch, Thoughts on OFHEO's Special 
Examination of FNM.
    They note, for instance, with regard to the derivative 
issue and the potential problem, the market value of these 
derivatives, just like that of straight fixed-rate debt, is how 
you correlate it with interest rates. When the rates fail, 
these derivatives show losses. When rates rise, they show 
gains. My understanding is rates are probably going to be going 
up in the next time period, so they are more likely to show 
gains than losses.
    Since you have not been able to quantify this and in fact 
you are not clear whether this is going to be a gain or a loss, 
where did the request for a 30 percent increase in capital come 
from? How did you decide it had to be a 30 percent increase?
    Mr. Falcon. It is because of the management and operations 
risk, as well as the uncertainty about their financials.
    Mr. Frank. But how did you calculate 30 percent? What were 
the figures?
    Mr. Falcon. We took the 30 percent because the risk-based 
capital standard requires a 30 percent add-on for management 
and operations risk, but there is not that add-on in the 
minimum capital standard. We decided that given the weaknesses 
we found in internal controls, uncertainty of financial 
statements, we decided----
    Mr. Frank. And the 30 percent, you said that is the 
requirement. That was a preexisting figure that you decided 
applied here?
    Mr. Falcon. That is in the statute.
    Mr. Frank. Okay. Again, I think we ought to be clear. The 
decision to require a 30 percent increase in capital was not 
based at all on any calculation on the extent to which the 
capital might have been impaired, but was a borrowing from the 
statute or an application from the statute of what happens when 
you find management risk.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Royce?
    Mr. Royce. Thank you, Mr. Chairman.
    I would like to learn a little more about FAS 133. One of 
the things I want to know is whether Fannie Mae and Freddie Mac 
apply FAS 133 in a similar manner, or is one more conservative 
and more consistent than the other? Another question, as I 
understand it, FAS 133 went into effect in 2000 or 2001, and to 
qualify for hedge accounting your derivatives have to perfectly 
match what they are hedged against when they are booked, and 
you have to document that. If you do that, then you are allowed 
to use hedge accounting.
    One of the questions I would have is, if they were not 
perfectly matching was it because in your findings, was it 
because Fannie Mae did not have the expertise or the ability to 
do that? Or did they and they simply decided not to for some 
reason? I was wondering why the auditor, KPMG, did not pick 
this up. This is not one of the examples that they originally 
cited, unless it is and I do not know it and you could let me 
know that.
    The other question I have is, how material was this? How 
great were the irregularities? I know it says it has to 
perfectly match, but I do not know from your report the extent 
that this was off, and therefore requiring this long-haul 
accounting approach rather than the hedge accounting. Maybe you 
could help me out so I could better understand what is at issue 
here.
    Mr. Falcon. Sure. On the technicalities of this 133, my 
chief accountant is much more qualified than I am, fortunately, 
to get into the details of that. She can address the difference 
between how Freddie Mac did it and how Fannie Mae did it.
    Mr. Royce. Let us start with that, because I am interested 
if there is a considerable difference in approach. Let me just 
hear that out in terms of a more conservative or consistent 
approach by one of the GSEs over the other.
    Ms. Deleo. Actually, before Freddie's restatement, the 
application of 133 between the two companies was substantially 
different. Of course now after the restatement, because of a 
number of things that happened during that process, they are 
different. You really cannot make that comparison.
    Mr. Royce. You cannot make that comparison because they 
were applying a completely different approach in terms of how 
they were going to value the portfolio on the risk?
    Ms. Deleo. I guess I would not say completely different, 
but substantially different.
    Mr. Royce. Could you help me out and just indicate if 
initially one approach, in your view, was more conservative and 
more consistent than the other in terms of the two GSEs here?
    Ms. Deleo. In both instances, there were misapplications. 
They were just mis-applied in different ways.
    Mr. Royce. I see. Okay, well that answers my first question 
to some extent. Go ahead, Mr. Falcon.
    Mr. Falcon. Mr. Dickerson, if you don't mind, would like to 
add to that, congressman.
    Mr. Dickerson. Freddie Mac had a program where they were 
applying their derivative hedges directly to the mortgages on 
their books. That was one difference. Fannie Mae has chosen to 
apply almost all of their derivatives to specific liabilities 
on their balance sheet. That is one big difference between 
Fannie and Freddie.
    Mr. Royce. Okay. And let's go to the question of why the 
auditor, why KPMG did not pick this up. We are going back to 
the first year that they would have to comply. Did that auditor 
at the time feel they had complied with the standards that 
would allow hedge accounting? Or did they simply not test for 
that? Do we know? I would be interested in that.
    Mr. Falcon. We are now looking into the determinations of 
KPMG on these matters. But let me make clear that the 
responsibility for compliance with accounting rules primarily 
rests with the company. It is not sufficient to simply say that 
the auditors signed off.
    Mr. Royce. I understand that. I wonder, did the company at 
the time feel it was in compliance? I guess your argument would 
be, listen, if it has to match perfectly, then the company knew 
it was not matching perfectly by definition if they are using 
estimates. But I do not know the details here to know how far 
off they were. That is what I am trying to elicit, is a greater 
understanding of the specifics of this.
    Ms. Deleo. Let me address that. Just backing up a second, 
let's talk about 133 because I think it will help in the 
context. One-thirty-three in principle is really a very simple 
pronouncement because it basically says you need to mark to 
market your derivatives. But it goes ahead to say that if you 
qualify for hedge accounting, and what we are looking at there 
is that you are going to go through and make an assessment test 
to see if the derivatives are highly effective. If they are 
highly effective, then you need to measure for ineffectiveness. 
So that is kind of the second step. If they are not highly 
effective, you cannot use hedge accounting.
    Then in addition to that, there are some exceptions in 133, 
very rule-based and very specific, that say if you have matched 
terms, which they do not actually have, and there are very 
specific criteria that you must meet to do that, then in that 
case there is no ineffectiveness. They are perfectly effective 
if the terms are matched. So you would not have to do the 
assessment test and you would not have to measure 
ineffectiveness. That is the problem. It is that they moved to 
that last very specific area and they simply do not qualify 
under that.
    Mr. Royce. One last question. Is that because they do not 
in your opinion have the ability or the expertise to do that?
    Ms. Deleo. They fully understood the rules. That is not in 
doubt. Their systems are not capable at this point of doing 
what we are calling long-haul accounting, doing the assessment 
test and the measurement of ineffectiveness. They could have 
built systems to do that, but that was not done.
    Mr. Royce. I see.
    Chairman Baker. The gentleman's time has expired.
    Mr. Royce. This really has helped me understand.
    Mr. Chairman, thank you.
    Chairman Baker. I thank the gentleman.
    Mr. Hinojosa?
    Mr. Hinojosa. Thank you, Mr. Chairman.
    Director Falcon, I understand that your report hinges on 
the accounting work of Deloitte & Touche. My question is, what 
was your cost to retain Deloitte & Touche for the 8-month 
period that you said they worked for you?
    Mr. Falcon. Let me clarify, congressman. This work is and 
the judgments in it are the product of OFHEO. Deloitte assisted 
us in this work and they support the findings, they agree with 
the findings in this report as well, but this is the work and 
the judgments of OFHEO. They did assist us, but I do not want 
to pass anything off to them. This was our judgment.
    Mr. Hinojosa. So it was your judgment, and they have signed 
off on the OFHEO findings. Correct?
    Mr. Falcon. Yes, congressman.
    Mr. Hinojosa. You also mentioned that you did not speak to 
nor review the working papers of KPMG accounting firm while 
preparing this report. It seems to me that it is less than 
clear, then, that Deloitte has signed off on your OFHEO 
findings.
    Mr. Falcon. Deloitte fully supports the findings and 
conclusions of this report. They also view these accounting 
issues as very clear-cut violations and not matters of 
interpretation.
    Mr. Hinojosa. Aren't the views of the KPMG auditors 
critical to your report? They are a very reputable firm. They 
do the work for my company.
    Mr. Falcon. They are reputable. KPMG may disagree with us, 
but it is not unlike Arthur Anderson. They supported everything 
Freddie Mac did until that got corrected.
    Mr. Hinojosa. I yield back the balance of my time.
    Chairman Baker. I thank the gentleman.
    Mr. Ney?
    Mr. Ney. Thank you, Mr. Chairman.
    Following a little bit in the line of the question the 
gentleman just asked, I think the one thing that has to be, 
from your opinion from what I have heard, it has to be pretty 
well-grounded would be the strength of the comment that OFHEO 
has made that the company willfully did misapply GAAP. Now, at 
the end of the day, the chairman of the SEC does make that call 
whether that statement will be accurate in his view. I am not 
saying your statement is necessarily inaccurate.
    If that happens and the SEC says something, and I am not 
asking you to speculate on what they are going to say, but if 
that happens and you have said one thing and the SEC says 
another, is there any type of discussions? Do we have the 
mechanics in place in the law that allows discussions back and 
forth between OFHEO and SEC to say, wait a minute, we think 
this and SEC says that. I know the SEC is the final decision 
maker on it, but is there any mechanism in current law that 
would allow a debate or a point of view to be discussed in case 
there are two separate opinions?
    Mr. Falcon. I think the way this would work is the SEC 
would determine what is appropriate for purposes of the 
disclosures that are filed as required by the SEC. We also rely 
on the financial statements of the company and its books and 
records in assessing the safety and soundness of the company 
and capital adequacy of the company.
    If we see fit that the books and records are inaccurate and 
need to be changed for purposes of our capital requirements or 
for purposes of assessing their safety and soundness throughout 
our examination program, then we would take appropriate action 
utilizing our safety and soundness authority and they could do 
what they thought was appropriate for purposes of their 
disclosures that they require.
    Mr. Ney. When you presented it to the Fannie Board, the 
fact that they willfully misapplied general accounting 
practice, one, what was the reaction, the statement made back 
to you by Fannie's board? Two, with the auditing firm, KPMG, 
what was their discussion with you, KPMG's, about their work 
papers or why they advised Fannie to do this?
    Mr. Falcon. KPMG was not in the meeting with the board when 
we sat down with the board and presented our report to them. 
The board did hear the entire presentation. They were all 
present either in person or by telephone, and they have taken 
this matter very seriously. Like I said, to their credit they 
moved quickly to reach an agreement with us to assure that 
safety and soundness concerns were properly addressed.
    Mr. Ney. If KPMG signed off on this and advised Fannie, and 
then if OFHEO has not had any discussion or your staff with 
KPMG as to why they advised Fannie, has Deloitte & Touche had a 
discussion or looked at the work papers as to why KPMG advised 
Fannie to do it this way?
    Mr. Falcon. We are now beginning work on the process of 
assessing KPMG's work papers, having discussions with KPMG. In 
addition, just as we are bringing in the SEC into these matters 
surrounding financial disclosures and their adequacy, we are 
also speaking with the Public Company Accounting Oversight 
Board about the adequacy of the external auditor's work in this 
regard.
    Mr. Ney. I just wondered on the process, and it was verging 
on the gentleman's question before, it seems that at some point 
in time Deloitte & Touche would have to have a conversation 
with KPMG to see why they would advise this, and look at their 
point of view because it is a pretty stern statement that it 
has been willfully misapplied. KPMG I would assume at some 
point in time, even though you are not to phase two of this, 
there would be discussions between auditing firms and 
yourselves to at least hear their point of view of why they 
would tell Fannie, yes, this is acceptable.
    Mr. Falcon. We will have those discussions. Let me ask Mr. 
Dickerson to talk about it. He knows more about what happened 
in the past and what we will do going forward.
    Mr. Ney. I know you are going to have those discussions, 
but Deloitte is sitting there in a way, saying yes, this is 
misapplied general accounting practices. I just want to 
understand why there was not a previous conversation to give 
them a comfort level of why, and before this whole report came 
out. That is one thing I would question.
    Mr. Falcon. We at OFHEO have requested work papers from 
KPMG and have talked with their partners about getting those 
work papers. We have actually received some of those work 
papers and have reviewed ourselves, OFHEO examiners, some of 
the work papers in coming to the conclusions that are in our 
report. It is important to note that the report represents the 
views of OFHEO, so it is most important for the examiners at 
OFHEO and the office of the chief accountant to be comfortable 
with what KPMG has done.
    Mr. Ney. Mr. Chairman, my time has expired. At some point 
in time down the road, I would like to get your opinion of what 
tools you would need if you were to become the regulator for 
the future.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Capuano?
    Mr. Capuano. Thank you, Mr. Chairman.
    I would like to ask just a few general questions about FAS 
133, which obviously I am not terribly familiar with, a little 
bit, but not terribly familiar with. As I understand it, it is 
a relatively new regulation. Is that correct?
    Mr. Falcon. It went into effect in 2001.
    Mr. Capuano. So relatively new in these kinds of things. Am 
I right to understand that between the regulations and the 
guidelines and the rules relative to it, it comes to about 900 
pages, give or take. Is that a fair estimate?
    Mr. Falcon. Yes, Congressman.
    Mr. Capuano. So it is a relatively new 900-page regulation.
    In the normal course of events of any new accounting 
standards, any changes in GAAP, any changes in FAS or any of 
these things, am I right to understand, again, not just in 
banking or not just in GSEs or anyplace else, but in every day, 
including individuals and everything else, when something new 
like this comes out that is clearly long, clearly complicated, 
clearly important, and clearly has very important 
ramifications, isn't there a normal period of time in which the 
people who are affected by whatever the rule or regulation is, 
plus the auditors and the accountants who interpret it, isn't 
it a fairly common thing to have a period of time where people 
may interpret things differently, and the systems, through the 
industry, the regulators, the courts, the IRS, whoever it might 
be, the SEC, then over time tends to take different approaches 
to the same rule and regulation and say, well, wait a minute, 
we know you took different approaches, but this is not right 
and this is not right, and little by little they come to a 
consensus.
    Is that not a normal situation?
    Mr. Falcon. I think that grace period you are describing 
occurs prior to the effective date of the implementation of the 
rule. This rule did go through many years of discussion, many 
years of debate and analysis. It had a delayed effective date. 
Even after it was supposed to become effective, I think it was 
delayed for an additional year.
    Mr. Capuano. I understand that. I understand how rules are 
made, but even after rules are made, are you telling me that in 
the normal course of events that every FAS, every GAAP rule is 
then implemented perfectly by everybody in lock-step with no 
disagreement, no discussion, no need to then clarify different 
things that happen in a 900-page report?
    Mr. Falcon. The rules apply as of the effective date of the 
rule.
    Mr. Capuano. I understand the rules apply, but how are they 
interpreted? You are telling me they are clear, concise and 
unequivocal on all counts every time there is a change in the 
FAS, every time there is a change in GAAP? I have to tell you, 
that is not my experience and I do not think that is the 
experience of any accountant or auditor in the country. It is 
not the experience of the IRS, the SEC or you.
    So I understand how rules are made, but I also know that 
once rules are made there is still a period of time afterwards, 
not a set period of time, that different people read different 
things differently and interpret things differently with good 
will. So the thinking that somehow you set a rule and that is 
it, well, if that is the case we do not need courts. We do not 
need the IRS. We certainly do not need the tax court for any 
interpretations because we have thousands and thousands of tax 
rulings, and this is really just one implementation of it.
    I would obviously disagree, or I am not sure that you 
answered the question, but clearly it takes time to work these 
things out.
    I guess in the normal course of events, absent different 
issues, and not all the time, is it not a normal circumstance 
where many entities within the rules of GAAP, within the rules 
of various FAS's and other accounting procedures and tax 
procedures, try to on occasion smooth out earnings? Is that not 
something that happens here and there in the business world?
    Mr. Falcon. If it happens, it is wrong. It is not proper to 
try to smooth out earnings by violating accounting rules.
    Mr. Capuano. I did not say violate it. You did not hear the 
question. Within the rules of accounting, within the rules 
allowed by various regulators, there are times and certain 
situations that it is allowed.
    Mr. Falcon. If it is within the rules of accounting, it is 
not improper.
    Mr. Capuano. That is what I asked. So within the rules, the 
concept of smoothing out earnings in and of itself is not a 
violation, understanding fully well that there are times that 
it is wrong, there are times that it is not, and that is what 
the debate is about is whether these rules are right or wrong.
    I also wonder, are you chasing KPMG at this point in time, 
or are you just kind of letting it float at the moment?
    Mr. Falcon. No, we are starting, as we said, to obtain the 
work papers of KPMG and we will discuss with them their 
assessments.
    Mr. Capuano. Okay. It strikes me again, and I know this is 
very complicated and I understand that, but if they had the 
opportunity to make these decisions, and what they did, as I 
understand it, and again correct me if I am wrong, is in their 
reports they simply cited it as an audit difference.
    For those who do not understand, an audit difference does 
not stop the process. They could have said it was a material 
weakness. Nobody in their right mind wants a material weakness 
noted on their annual report, and hopefully even understaffed 
you would have found something that was cited as a material 
weakness in an annual report. They did not cite it as a 
material weakness. Am I wrong?
    Mr. Falcon. No, it was just an audit difference.
    Mr. Capuano. So then KPMG as an auditor has said, 
basically, look we do not necessarily agree, but it is a minor 
point. Here it is in the footnotes, and we will move on.
    Chairman Baker. This will have to be the gentleman's last 
question. His time has expired.
    Mr. Capuano. Thank you, Mr. Chairman.
    Again, I guess I will just finish by simply stating that 
clearly there are some serious questions. You have raised 
serious concerns, and if you turn out to be right, there will 
be some serious ramifications of it, but I still think that 
some of the concerns and some of the comments that have been 
made here today are kind of jumping the gun and putting the 
cart before the horse relative to allowing people to make a 
determination of what was right and what was wrong; what was 
willful and what was simply just a difference of opinion in the 
ordinary course of business.
    Mr. Toomey. At this time the chair will recognize the 
gentlelady from New York.
    Mr. Kelly. Thank you very much.
    I appreciate the fact that you have delivered a partial 
report. It has been very interesting reading. One of the things 
I am troubled by and I see repeatedly in the report is that 
there are people carrying double roles within the structure of 
Fannie Mae. I understand that the OFHEO has been asking the 
chairman of the board and the CEO of both the GSEs to separate 
people into separate functions. For instance, Janet Honeywell, 
her job was forecasting as well as financial reporting.
    There are numerous examples, starting on page 158, going on 
through, are people, first of all, who are not CPAs that were 
doing financial structuring and analysis. And secondly, they 
were auditing their own work essentially. My question to you 
is, Freddie Mac apparently has agreed to separate roles. 
Apparently, Fannie Mae has not. Are they in the process of 
working with you to try to do that? Can you talk to us about 
why you think this is a healthy thing to do? What is ongoing 
with regard to OFHEO working with Fannie Mae to make sure that 
there is a separation of duties?
    Mr. Falcon. We do think it is important that key functions 
be separated so that there is not a conflict of interest or 
that someone with an incentive to meet some goals also has the 
ability to manage the accounting of those goals such that they 
are met.
    So we have taken action, going to Freddie Mac to make sure 
there was proper separation of offices and functions and 
individual responsibilities. The board of Fannie Mae has agreed 
with us to create a separate chief risk officer. We found that 
the individual responsible for setting goals in this instance 
was also responsible for making sure that they were met.
    We are looking at other issues as well. We have a pending 
corporate governance rule amendment which would separate the 
function of the chairman of the board and the chief executive 
officer. Freddie Mac has already agreed to do that, and once 
this rule is implemented it will also provide the same for 
Fannie Mae.
    Mr. Kelly. I want to go back to page 160 of your report. I 
do not know how to pronounce Sam Rajappa. I do not know how to 
pronounce that last name.
    Mr. Falcon. That would be Rajappa.
    Mr. Kelly. It is Rajappa. Thank you. There is a statement 
in here by Tim Howard noting that Sam Rajappa reports directly 
to the chairman of the audit committee, but for the last I 
think year and a half, maybe 2 years, he has reported on a 
dotted line basis to me.
    In reading your report, I could not quite figure out who 
had a straight firm line and who had a dotted line, because it 
looked to me like a lot of these things were being mixed 
responsibilities. Jeffrey Guliana had a dual responsibility. 
There is one name after another here where I do not see a solid 
structure, but rather an informal structure. I would like you 
to expand on what you have found with regard to this, because I 
am not sure exactly who was the person that was signing off on 
the bottom line here.
    Mr. Falcon. That is a good question. We found that this was 
a big weakness in the way these accounting policies were being 
set. There was not a clear process in place. There were no 
accounting controls. There was not even adequate documentation 
about what the accounting policies were and the roles in 
formulating these accounting policies.
    Let me ask Mr. Dickerson, who can speak very well to these 
internal control issues, to elaborate further.
    Mr. Dickerson. Right. We found, for example, in the 
amortization area that there was one individual who was in 
charge of the modeling and accounting for amortization. That is 
a weak segregation of duties. We found, you mentioned Ms. 
Pennewell, who was in charge of financial reporting and 
financial planning, so she had opportunities at least to help 
meet through accounting financial goals that her group had 
earlier set.
    Mr. Kelly. Is there now in place a structure, because I 
understand from Mr. Falcon, from what he just said, that that 
structure has not really been changed much, and it is still 
unclear to me. Have you established with them now a clear line 
of who reports to whom?
    Mr. Falcon. It will take a little time to fix all of these 
problems, to do the reorganization within the company and 
create the positions and select individuals for the positions. 
But this is something covered by the agreement with the board, 
and we are going to move as expeditiously as possible to get 
these fixes in place.
    Mr. Kelly. Thank you.
    Chairman Baker. The gentlelady yields back.
    Mr. Lynch?
    Mr. Lynch. Thank you, Mr. Chairman.
    I was late in the hearing, but I do want to thank you for 
coming here today and helping the committee with its work. I 
know you have had a rough time with some of my colleagues, but 
I do not think there is anybody here that questions your good 
intentions to help us with this process. That is the position I 
take. You are good to do your work and we need you to do it 
really well, and I am sure that is going to happen.
    However, this is the political side of the table, so some 
of us up here are going to twist and use your information to 
help us grind an axe with Fannie Mae or others, or to defend it 
as I will intend to do. But that is not to discount the good 
work that you are doing.
    I do want to rebut a couple of things, and I want you to 
work with me here. I have heard Enron, Enron, Enron a bunch of 
times here. Quite frankly, the chairman of the subcommittee did 
a wonderful job in helping the committee with its work in that 
case, but even the chairman of the full committee has brought 
that specter to bear in comparing what has happened at Fannie 
Mae to Enron.
    I just want to ask you, we had the Enron situation. We had 
a house of cards there, a financial house of cards where there 
was no strength to the underlying business. They had a very 
unsound business model. We had serious problems in the 
underlying business. Is that what you see here? Is that what 
you see here?
    Mr. Falcon. The business model of the company remains 
sound.
    Mr. Lynch. Remains sound.
    I do not have much time. That is just one thing I wanted to 
get out there.
    Mr. Falcon. Okay.
    Mr. Lynch. We had 19 criminal indictments. We had 96 
criminal charges. We had 78 fraud counts against the people who 
were running Enron. Is that what we have here? Or is it more in 
the line of noncompliance with accounting standards?
    Mr. Falcon. We have deferred any opinions, resolutions of 
any criminal conduct to the Justice Department. We have 
referred to the corporate fraud task force our report. We are 
cooperating, giving information to the U.S. attorney upon 
request about anything we found and documents that we have 
about this. Beyond that, we are not forming judgments about the 
criminality of this, and we have not made any criminal 
referrals to the Justice Department.
    Mr. Lynch. Thank you. In terms of the gross manipulation 
that occurred in the California power market by Enron in which 
investors and employees lost their pensions and their life 
savings. Is that what we are looking at here or is it something 
different?
    Mr. Falcon. I think until the entire review is over, I 
would withhold maybe broad categorical statements about this. 
Certainly, what we have found to date raises serious concerns 
with us about the company's proper accounting, as well as their 
internal controls, doubts about safety and soundness, prior 
financial statements. If we find that this type of conduct 
shows up in other areas that we have yet to begin to review, 
then it would become much more serious than even it is now.
    Mr. Lynch. So you are saying they could be defrauding the 
public and the investors and the employees just like Enron? Is 
that what you are saying, that this could be one of those 
cases?
    Mr. Falcon. No. I do not know. I have no----
    Mr. Lynch. You just said there was a sound business model 
here.
    Mr. Falcon. Exactly, a sound economic business model. But 
as far as any criminal intent or any desire to break laws for 
some criminal purpose, I do not know. I cannot speak to that.
    Mr. Lynch. Okay. Thank you.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Toomey?
    Mr. Toomey. Thank you, Mr. Chairman.
    What I would like to do is address this question of whether 
we are really talking about a difference of interpretations of 
ambiguous rules, or whether we have something that is really 
pretty objective. While this gets a little bit complicated, I 
think it is manageable, I hope within 5 minutes. Let me see if 
I can walk through what I understand to have gone wrong with 
respect to FAS 91. Tell me where I go wrong on this.
    First of all, Fannie Mae buys assets that trade at premiums 
and discounts. Correct? Some of these assets have prepayment 
features.
    Chairman Baker. Mr. Toomey, I hate to interrupt your train, 
but I will let you re-start.
    Just by way of announcement for members, I understand we 
will have a series of two votes. It would be the chair's 
intention upon recessing for those two votes that we would 
recess the committee for 30 minutes to give members and 
witnesses a chance to refresh themselves. That would mean we 
would return here, let's just say 1:30 p.m. We would proceed 
with Mr. Toomey's comments and questions, and then break at 
that point, just so all members are advised, 1:30 p.m.
    If you would like, you can proceed now, or at your leisure; 
if you want to come back. Either way.
    Mr. Toomey. I would like to proceed when we get back.
    Chairman Baker. Okay. Great. The committee will stand in 
recess until 1:30 p.m.
    [Recess.]
    Chairman Baker. At this time I would like to reconvene the 
hearing of the Capital Markets Subcommittee.
    At the time the committee recessed, Mr. Toomey had been 
recognized to proceed, and at this time I recognize the 
gentleman for 5 minutes.
    Mr. Toomey. Thank you, Mr. Chairman.
    I would like to take up where we left off on this 
discussion about whether what we have seen with Fannie Mae has 
been a willful misrepresentation of certain income and expense 
accounts, or whether it is just the difference in 
interpretation of an inherently complex and ambiguous 
accounting laws.
    It seems to me the allegations being made by OFHEO, which 
frankly seem very well substantiated, are very clear: It is the 
former. This is a willful, conscious misrepresentation.
    And in fact, KPMG agrees with you and not with the company 
when they cite this irreconciled item. Is that correct?
    Mr. Falcon. Yes, the $200 million----
    Mr. Toomey. The $200 million--number one, their auditors 
agree with you, not with the company, with respect to this 
treatment.
    Now, I would like to get to the substance of what this 
treatment is about with regard to FAS 91.
    As I understand it--and please correct me when I go wrong 
here--my understanding is that when a financial services firm 
such as Fannie Mae buys assets at either premiums or discounts, 
some of which have prepayment features, they are required to 
amortize the premiums and the discounts over a projected life 
of the asset, which is determined in part by estimating 
prepayment rates and other things.
    My question for you is: When those assumptions are made, 
the model is employed and an amortization schedule for premium 
or discount is arrived at, is that not a very precise figure?
    Mr. Falcon. Yes.
    Mr. Toomey. So it is not a range, it is not a ballpark, 
there is a number. And if you carry it out far enough it goes 
right to the penny. Is that correct?
    Mr. Falcon. Yes, Congressman.
    Mr. Toomey. And then my understanding further is that when 
the next quarter comes around, interest rates very often will 
be different than what was projected in the previous quarter, 
and that requires a reassessment.
    And part of that reassessment is a very precise--it is a 
new number, and the company is required to catch up, if you 
will, on the previous errors that come to light, errors with 
respect to how reality differed from what was projected in the 
previous quarter. Is that correct?
    Mr. Falcon. Yes. We are required to make those adjustments. 
I would not use the term ``catch up'' in the same sense that 
the company called what they were doing a catch-up.
    Mr. Toomey. Okay, but they are required to make an 
adjustment, to affect the cumulative difference between what 
was projected and what in fact occurred in economic reality, 
and that, too, is a very precise number. Is that correct?
    Mr. Falcon. Yes.
    Mr. Toomey. And the rules, do they say that despite the 
fact that a precise number is calculated, you do not have to 
really use that number? Does FAS 91 give any discretion about 
what number you use?
    Mr. Falcon. Let me ask our chief accountant.
    Ms. Deleo. No.
    Mr. Toomey. It does not. Does FAS 91 suggest that you can 
round this number to some degree?
    Ms. Deleo. No.
    Mr. Toomey. Okay, it does not allow that.
    I am looking the testimony from Mr. Raines and from Mr. 
Howard, and it talks about how this estimation process is 
imprecise. In fact, it is not imprecise at all; it is very 
precise.
    It is subject to future revision, but at the point in time 
in which it is calculated, it is perfectly precise. Is that 
correct?
    Ms. Deleo. That is correct.
    Mr. Toomey. The alleged imprecisions are used in Mr. 
Raines's testimony as a justification for creating a range. In 
fact, the range has nothing to do with this calculation. Or 
does it?
    Ms. Deleo. No, the range does not have anything to do with 
it.
    Mr. Toomey. The range was a perfectly arbitrary invention 
of the company, it seems to me. Is that your opinion?
    Ms. Deleo. Correct.
    Mr. Toomey. And the range of $100 million, plus or minus, 
from these adjustments is not even contemplated, much less 
allowed, under FAS 91, is it?
    Ms. Deleo. There is nothing under FAS 91 that would allow 
for a range.
    Mr. Toomey. So it is not as though there is a range that is 
allowed and there is a dispute over how much. There is no such 
concept.
    But you make a further allegation, if I understand it 
correctly, which is that not only is it simply and very 
straightforwardly wrong to not report the full number precisely 
as calculated, which Fannie Mae has done, but that there was a 
policy within company systematically not to report the precise 
number, but rather to have this cushion that you describe as a 
cookie jar, which served the purpose of evening out income. Am 
I correct to understand that?
    Ms. Deleo. You are correct.
    Mr. Toomey. Some seem to suggest that this is not really 
material, you know, Fannie Mae is a big company, you know, it 
has got a lot of income. But this range that they created was 
$100 million. Right?
    Ms. Deleo. Plus or minus 1 percent, but it basically rounds 
to $100 million.
    Mr. Toomey. And it was not an effort to round this number; 
it was derived from a totally different set of calculations 
regarding total--my time has expired. I just want to make the 
point.
    A plus or minus variation here of $l00 million, what does 
Fannie Mae roughly earn in a quarter? What is the total income 
in a quarter?
    Mr. Dickerson. Probably in the neighborhood of a billion.
    Mr. Toomey. About a billion.
    Chairman Baker. I would say $150 million, probably.
    Mr. Toomey. So we are talking over 10 percent of the 
reported income in a given quarter.
    Mr. Dickerson. Actually it could work out larger than that.
    Mr. Toomey. And it could work out larger than that.
    So by virtue of the sheer magnitude, I do not understand 
how someone can say it is material.
    But I would further argue that I am not sure the 
materiality applies as a concept when you are dealing with a 
systematic misrepresentation of the numbers. I do not think 
that is allowed regardless of how big the misrepresentations 
are. Is that correct?
    Ms. Deleo. I would completely agree with that.
    Chairman Baker. Your time is expired. It has been most 
helpful. I appreciate your insights, Mr. Toomey.
    Mr. Meeks?
    Mr. Meeks. Thanks, Mr. Chairman.
    Let me make sure--I think that it has put some things in 
context, especially with reference to some of the process.
    I think it is a matter of fact, I think you would agree 
with me that plenty of people do not like Fannie Maes or 
Freddie Macs for that reason, their current status in the 
market. People wanted to change it.
    Before your report came out there was talk from this 
committee and from others in the private company that one did 
not like the status that Fannie Mae had. You would agree with 
that--right?--the status that Fannie Mae and Freddie Mac 
currently has in the market?
    Mr. Falcon. No, Congressman, I do not support privatization 
of these companies.
    Mr. Meeks. I did not ask you that. I did not ask you 
whether you do or not.
    I said I think that we could all agree that we know from 
either some of your prior testimony, there are individuals in 
some movements that have been afoot that did not like the 
status of Fannie Mae and Freddie Mac had within the market. You 
could agree with that.
    Mr. Falcon. Only certain individuals----
    Mr. Meeks. And is it also true that in fact you, when you 
came here previously to testify on other occasions, many 
individuals on this committee were very critical of you and 
challenged your ability to be able to relate to the largest 
financial entities in this country. Is that not correct?
    Mr. Falcon. Yes, Congressman.
    Mr. Meeks. In fact, they were so upset with you at that 
particular time, there were bells put forward that indicated 
that they may need to create a new regulator for the GSEs. Is 
that not also correct?
    Mr. Falcon. Yes.
    Mr. Meeks. And it is also true that this is a special 
examination, a special examination actually departed from what 
is standard financial institutional examination procedures. Is 
that not also correct?
    Mr. Falcon. No.
    Mr. Meeks. This was not a special examination?
    Mr. Falcon. Yes, it was a special examination, yes.
    Mr. Meeks. All right. And under ordinary procedures, would 
it not also be a situation whereas, you know, there were 
questions in regards to some of the regulations that you were 
overseeing that Fannie Mae, or whoever you are investigating, 
would have had the opportunity to address those issues prior to 
the issuance of the report.
    Mr. Falcon. Any examination follows a pattern where if it 
is a normal examination, like our annual risk-based 
examination, there will be, depending on severity of the issues 
that are found, you could have, would have give and take 
between the management.
    But this was a special examination, or it was situation 
where there were serious concerns raised about the conduct of 
management in this area of accounting and internal controls----
    Mr. Meeks. And some of that is subjective. Because as we 
indicated, I think that when someone was talking before, the 
person that is clearly talking about FAS 133F and FAS 91, the 
ultimate determination is going to be made by the SEC, and 
there could be a question whether discretion, whether or not--
because we do not know, you know, it could be a difference of 
opinion between you and the SEC. We do not know that yet.
    Right now what you are putting out is just more 
allegations.
    And what I am talking about, when I start talking some 
irregularities, I am talking about--well, you know, even 
Senator Bond talked about the leaking of evidence or leaking of 
letters to the Wall Street Journal, other press. That is not 
standard. That does not happen under those circumstances. Is 
that a common procedure, to leak evidence and letters?
    Mr. Falcon. Congressman, we did not release this report 
prior to the board agreeing with us that they did not have any 
objections to this report being put into the public domain. I 
received a letter from members of Congress in fact urging me to 
do so.
    I had a commitment to the board not to release this report 
while we in these discussions. But once they no longer 
objected, I decided to do so.
    Mr. Meeks. But even before they objected, things were 
leaking out. And I do not know if Congress had ever asked for 
it, but things were leaking out before--at one time and 
previously.
    So it has not been the usual type of investigation here, 
with things leaking, to give a hint of something or other. It 
seems to me that it is just curious to me that this is 
happening.
    Well, OFHEO itself was threatened with reference to being 
replaced by a regulatory agency.
    But let me just go to someplace else, because you make 
strong allegations. And, you know, sometimes you throw things 
out there. I know, I used to be a prosecutor. And it is very 
dangerous. And you made some allegations, strong allegations, 
that, you know, I do not know where the evidence--I have not 
heard the evidence of it.
    But, again, coming from the background that we are talking 
about, with reference to the pressure that was put on OFHEO by 
others and members of this committee about doing certain 
things, and all of a sudden I see this report coming out, I see 
things that are being leaked out.
    And then you make some charges that a lot of this is being 
done because of executive bonuses. That is a very serious 
charge. And I don't know exactly how you back this up. Can you 
just tell me? How do you back this up?
    Mr. Falcon. It is our judgment, based on the evidence we 
saw, that this company in 1998, in that instance, when you look 
at the circumstances, the company deferred this $200 million of 
expenses in disagreement with this external auditor, and the 
evidence seemed to us that it was in order to meet these 
compensation bonus targets.
    Chairman Baker. The gentleman's time is expired. Did you 
have a wrap-up?
    I thank the gentleman.
    Mr. Bachus?
    Mr. Bachus. Thank you.
    Director, derivatives have been used to hedge risk and 
actually have been used successfully. In this case, you have 
talked about this particular derivative contract had not been 
approved for hedging. Is that right?
    Mr. Falcon. Their derivatives portfolio, they were 
classifying all but about $43 million of the notional value of 
their derivatives portfolio as eligible for hedge-accounting 
treatment, which means any changes in market value would flow 
through other comprehensive income and not through the----
    Mr. Bachus. To flow to the----
    Mr. Falcon. Yes.
    Mr. Bachus.----to the underlining security of whatever it 
was hedged to, whatever the derivative was based on?
    Mr. Falcon. Whatever change in value occurred in the 
derivative wouldn't flow through earnings to the balance sheet, 
but rather would go through other comprehensive income.
    Mr. Bachus. Okay. Did that affect Fannie Mae from a safety 
and soundness standpoint, in your opinion?
    Mr. Falcon. I think, overall, everything we find in this 
report does raise concerns about the company's safety and 
soundness. We have found practices that are inconsistent with 
safety and soundness, practices about not complying with 
accounting rules, not having accurate financial disclosures, 
not having the appropriate internal controls.
    The report has great detail, I believe, on the reasons why 
we have expressed concerns about the company's safety and 
soundness.
    Mr. Bachus. Just assuming that they had applied with the 
FAS 133 in their risk management, do you believe that Fannie 
overall has made the right economic and risk management 
decisions in terms of protecting its portfolio from market 
risk?
    Mr. Falcon. They use their derivatives to hedge against the 
interest rate risk associated with this retained portfolio that 
they manage. And their use of these derivatives is proper to 
hedge risk. We are not questioning their use of derivatives to 
properly manage the interest rate risk that they face.
    What we are seeing here is a lack of compliance with the 
accounting rules. We are also looking at other things related 
to this derivatives portfolio. This is just the beginning of 
what we have determined. These are our findings to date. And we 
will continue to look at issues raised.
    They use--their policy is to use derivatives only to hedge 
risk and not to speculate. That is also our safety and 
soundness standard.
    Mr. Bachus. How long----
    Mr. Falcon. But we are looking at it to make sure there 
weren't transactions that were inconsistent with that policy.
    Mr. Bachus. Okay. How long--I mean, you have been critical 
of their internal controls and of some of their accounting 
practices. How long have these practices been going on and 
these lack of internal controls, in your opinion?
    Mr. Falcon. The internal controls--I guess we found that--
the policies on FAS 91 date back to 1998 and on 133 date back 
to 2001. So certainly these weaknesses that allowed these 
improper accounting policies to be put in place certainly go 
back as far as that.
    Mr. Bachus. Now, you are examining them on a regular and 
constant basis, right?
    Mr. Falcon. Yes.
    Mr. Bachus. Why did you just now discover those things? Why 
did it take this long?
    Mr. Falcon. We look at many issues related to credit risk, 
interest rate risk, management and operations risk, a wide 
variety of areas of a company's risk profile.
    This is an area where, very recently, as a result of the 
Freddie Mac accounting problems, we decided to go and take a 
very close, detailed look at Fannie Mae. We have not, prior to 
this point, conducted such an in-depth examination focused on 
one area of the company.
    Our examination program assesses their risk and risk-
management practices across a wide range of risk. Focusing in 
narrowly on this subject has uncovered problems that the 
broader review has not uncovered previously.
    Mr. Bachus. Okay. One final. Did you all consult with--now, 
KMPG was their outside auditor, right?
    Mr. Falcon. Yes.
    Mr. Bachus. And Deloitte & Touche, you all used them to do 
your audit, right?
    Mr. Falcon. Yes.
    Mr. Bachus. Is that right? Have you all consulted with KMPG 
about your findings?
    Mr. Falcon. We have begun the process of obtaining KPMG's 
work papers, discussing this with KPMG. But we have not gone 
down a path of trying to--management and the company is 
ultimately responsible for ensuring that the company's policies 
and practices in the accounting area are consistent with GAAP.
    Mr. Bachus. But you were totally unaware that they were 
doing all this until just recently?
    Mr. Falcon. We have not conducted an in-depth accounting 
exam like this previously.
    Mr. Bachus. Had you criticized their internal controls 
prior to this? You are their regulator, right? And internal 
controls would be a basic part of--for instance, who signs off, 
who within the company signs off on these derivative contracts 
and their treatment? Had you questioned those in the past?
    Mr. Falcon. I would have to go back and look at our 
previous examination reports. But if we did, in fact, identify 
these problems in the past, we hadn't conducted this type of an 
in-depth examination before.
    Mr. Bachus. You probably should have, right?
    Mr. Falcon. I would have liked to have done it previously, 
yes, now that we know what we know.
    Chairman Baker. One more question, sir.
    Mr. Bachus. On September the 20th, you were meeting with 
the Fannie Mae board. You all were going to present to them 
your findings, is that correct?
    Mr. Falcon. Yes.
    Mr. Bachus. And you had not made that known to the public 
at that time, had you?
    Mr. Falcon. Right.
    Mr. Bachus. And I know everybody was waiting on that 
meeting. And then that morning I recall picking up The Wall 
Street Journal and seeing it pretty much laid out as to what 
you all's report was going to show in detail. That is a 
violation of your own rules, isn't it?
    Mr. Falcon. Right. We did not authorize--I did not 
authorize the release of any information about what we were 
about to do at the board. All I can tell you is, the Friday 
before that Monday, we did bring some other federal agencies in 
the process in an effort at interagency cooperation to let them 
know what we had found and what we were about to do. Now, that 
Friday we had also had discussions with some board members, in 
order to get them to convene the meeting for Monday.
    Mr. Bachus. But somebody disclosed what was then nonpublic 
information. I know that is a violation of you all's guidelines 
and every agency's. I think your guideline 105 prohibits the 
disclosure of nonpublic information regarding a regulated 
entity and actually provides civil and criminal penalties. So 
somebody would have had to violate that guideline, would they 
not?
    Mr. Falcon. If it was someone in the company, within the 
agency----
    Mr. Bachus. Or in another agency, then they would have----
    Mr. Falcon. Well, our guideline only applies to us. If you 
are citing our guideline, it only applies to OFHEO and not----
    Mr. Bachus. Have you done anything to identify--or, were 
you concerned about that, when you saw that that nonpublic 
information had been disclosed in violation of your own rules 
and regulations?
    Mr. Falcon. I am always concerned about information that 
shows up in the public domain----
    Mr. Bachus. Have you all tried to identify the individual 
or individuals who violated these rules?
    Mr. Falcon. I am not sure, Congressman, what shows up in 
the newspaper, whether it is conjecture, speculation. There is 
an insatiable rumor mill that circulates around everything----
    Mr. Bachus. Actually, it was specific in what they----
    Mr. Falcon. It is hard for me to discern what is 
speculation and what is based on a leak and what is based on 
some authorized release of information.
    Mr. Bachus. You saw that report. It was pretty apparent 
that they had to have inside information.
    Mr. Falcon. I have seen speculation about what we might do 
for months and months now, based on what knowledge people had 
about what we did with Freddie Mac.
    Mr. Bachus. Okay.
    Chairman Baker. Mr. Bachus, you have used almost twice your 
time. You are, like, 5 minutes over.
    Mr. Bachus. I am sorry.
    Mr. Frank. And you are not going to get an answer, no 
matter how you ask, so you might as well move on.
    [Laughter.]
    Chairman Baker. Let us see, Mr. Watt, I think you are next.
    Ms. Waters is next?
    Okay. Ms. Waters?
    Ms. Waters. Thank you very much, Mr. Baker.
    Mr. Falcon, you have been before this committee before. And 
you were pretty much on the hot seat on more than one occasion, 
where you were accused of not doing a good job, not exercising 
your oversight responsibility, of being incompetent.
    And I think a number of members you talk with following 
those hearings, where you not only ask for support but try to 
make the case why OFHEO should remain. Is that true?
    Mr. Falcon. No, I have actually supported a regulator with 
all the authorities and powers and resources to do his job, 
even if it means abolishing my agency.
    Ms. Waters. Did you seek support for yourself and for your 
agency following the criticism that was reaped upon you in this 
committee? Did you talk to any members of Congress?
    Mr. Falcon. Oh, yes, I have----
    Ms. Waters. All right, thank you.
    I would also like to know a little bit more about what has 
happened since the time that you came under such criticism and 
how you got to this point. You talked about when you first 
decided that you were going to do this investigation on Fannie 
Mae.
    Did you at any time talk with any members of Congress 
during the time of this investigation about what you were 
doing, seek any advice, get any suggestions, any members or 
their staffs? You are under oath.
    Mr. Falcon. I recall questions from various members of 
Congress in the Senate who----
    Ms. Waters. Did you talk to any members of Congress or 
their staffs about this investigation, seeking advice, getting 
advice, accepting suggestions, hearing suggestions about this 
investigation?
    Mr. Falcon. Asking advice about--not for the purposes of 
trying to get advice from a member of Congress about what we 
should look at----
    Ms. Waters. So you did talk with some members of Congress 
or their staffs while you were in the process of this 
investigation. Is that correct?
    Mr. Falcon. Yes.
    Ms. Waters. All right. Did any member of Congress or their 
staff offer support for OFHEO or you in exchange for 
suggestions or give you ideas about how you ought to approach 
this investigation?
    Mr. Falcon. Absolutely not.
    Ms. Waters. Did you report to the chairman of this 
committee, this subcommittee, or the chairman of the overall 
committee or the ranking member of this committee at any time 
during this investigation about what you were doing?
    Mr. Falcon. Absolutely not.
    Ms. Waters. Let me go one by one.
    Did you, at any time, report to the chairman of this entire 
committee, Mr. Oxley, about what you were doing?
    Mr. Falcon. About the--no. But----
    Ms. Waters. About the investigation, anything that you were 
doing or undertaking in the investigation.
    Mr. Falcon. No.
    Ms. Waters. Did you, at any time, talk with Mr. Baker about 
whatever was going on in the investigation? Did you seek 
advice, did you get any advice, did you have any conversations 
with him about the investigation?
    Mr. Falcon. I have not sought any advice, any guidance 
about how to--from any member of Congress----
    Ms. Waters. Did you talk with Mr. Baker----
    Mr. Falcon. No.
    Ms. Waters.--about the investigation at any time or his 
staff?
    Mr. Falcon. No. It would have been improper for me----
    Ms. Waters. That is all I want to know. Did you talk with 
Mr. Baker or his staff at any time during this investigation in 
any shape, form or fashion, whether it was seeking advice, just 
hearing advice, advising about what you were doing? That is all 
I want to know. Did you? Yes or no?
    Mr. Falcon. Let me answer the question. I did speak to 
several members of Congress about the investigation, about the 
need for funding for the investigation----
    Ms. Waters. But I specifically asked about Mr. Baker at 
this point.
    Mr. Falcon. Oh, Mr. Baker, yes, and other members of 
Congress----
    Ms. Waters. All right. Thank you.
    Mr. Falcon.----including other senior members of the 
committee about the investigation and my need for resources to 
keep this thing going.
    Mr. Frank. Would the gentlewoman yield?
    Ms. Waters. Yes, I will yield to the gentleman from 
Massachusetts.
    Mr. Frank. I just want to make clear that I was never told 
or any way informed. My understanding was the Republican 
leadership was informed before this broke that this was about 
to break. But I want to make it clear: No one on the Democratic 
side received any notice. And I do believe there was, 
unfortunately, notice on the Republican side in advance.
    Ms. Waters. Taking back my time, this is not simply about 
notifying about this hearing. This is about what was going on 
in the investigation, how it was being approached, what was 
being done.
    Were you talked to at any time?
    Mr. Frank. No. As I said, I didn't even get the notice that 
others got that it was happening, and so we had never heard 
anything.
    Ms. Waters. Okay. Then that is well made.
    Now, did you discuss the 30 percent reserve with any 
members of Congress and get a suggestion about that amount 
prior to concluding that that was the amount that should be in 
reserve?
    Mr. Falcon. No.
    Ms. Waters. Did you talk with any staff member?
    Mr. Falcon. No.
    Ms. Waters. This, again, based on the questioning of Mr. 
Barney Frank, was an amount that you came up with but that 
amount was not based on any calculations, any research that 
would indicate that this would be the proper amount in reserve. 
You did not have any supporting documentation for that, is that 
correct?
    Mr. Falcon. We arrived at the 30 percent requirement 
because we thought that was prudent from a safety and soundness 
standpoint, given the weaknesses in management and operations, 
given the uncertainties of the financial statements----
    Ms. Waters. I am asking about your documentation. Did you 
pull it out of the thin air? Did you pull it out of air? Did 
you have some documentation? Did you have something to compare 
it with? How did you get the 30 percent?
    Chairman Baker. And that would need to be the--if I may, 
that would need to be the lady's last series of questions.
    If you would respond, because the gentlelady has exceeded 
her time significantly. Would you please respond to the 
gentlelady's question?
    Mr. Falcon. Congresswoman, we based--I based that decision, 
using my judgment about what was appropriate, prudential in 
order to ensure the safety and soundness of this company. Given 
the uncertainties about their balance sheets, given the 
operational weaknesses, there was precedent for this with 
Freddie Mac, I took action that I thought was essential to make 
sure that this company, that its safety and soundness was 
ensured.
    And we arrived at 30 percent because there is a 30 percent 
management and operations risk in the statute for risk-based 
capital, so we simply applied the same standard to the minimum 
capital.
    Ms. Waters. You had no documentation.
    Thank you. I yield back the balance of my time.
    Chairman Baker. Mr. Watt?
    Mr. Watt. Mr. Chairman, Mr. Davis from Alabama has a bill 
on the floor and I would like to defer to him, if it is okay.
    Chairman Baker. Oh, I am sorry, Mr. Manzullo, you have been 
patiently waiting.
    I should go to Mr. Manzullo first, and then I will come 
back to Mr. Davis.
    Mr. Manzullo. Thank you.
    I am reading page 11 about the actual amount of the 
bonuses.
    Mr. Johnson got a $1.9 million bonus on a salary of 
$966,000; Mr. Raines, $1.1 million bonus on a $526,000 salary; 
Lawrence Small, $1.1 million on a salary of $783,000; Jamie 
Gorelick, $779,000 bonus on a salary of $567,000; Timothy 
Howard, $493,000 on a salary of $395,000; and Robert Levin, 
$493,000 bonus on a $395,000 salary.
    These are annual bonuses. Is that not correct? Every year 
they have a bonus?
    Mr. Falcon. Yes.
    Mr. Manzullo. And so this is what they make. This is just 
for 1998. Is that correct?
    Mr. Falcon. That was the amount of the AIP award and bonus.
    Mr. Manzullo. What you see on page 11 is nothing less than 
staggering. Because you state that the earnings-per-share 
range, the minimum payout is $3.13, the maximum was $3.23, with 
a target of $3.18.
    And just by happenstance, coincidence, you could almost say 
on your terms that for Fannie Mae to pay out the maximum amount 
in annual incentive payment awards in 1998, the earnings per 
share would have to be $3.23. It is below the $3.13 minimum 
payouts threshold, no bonus would occur.
    And then you state, remarkably, the 1998 earnings-per-share 
number turned out to be $3.23 and nine mills, a result that 
Fannie Mae met the EPS maximum payout goal right down to the 
penny, and that if they had used the correct accounting 
practices--which you say in your testimony, accounting 
violations cannot be dismissed as mere differences of 
interpretation, Fannie Mae understood the rules and simply 
chose not to follow them, but if Fannie had followed the 
practices, there would not have been a bonus that year. Is that 
not correct?
    Mr. Falcon. That is right, Congressman.
    Mr. Manzullo. Well, what are you saying here? Are you 
saying this is coincidence? Or did somebody cook the books to 
come up with $3.23 and nine mills so they got the maximum 
payment.
    Mr. Falcon. I think what we are saying is, there are very 
strong appearances that the management did, in this instance, 
improperly defer $200 million of this $400 million expense to 
the next year for the purposes of achieving these bonus 
targets.
    Mr. Manzullo. So the main purpose was so they could get 
their bonuses. That is what you just said.
    Mr. Falcon. Yes, in addition to the appearances of 
smoothing earnings.
    Like I said, this was the beginning of the implementation 
of their catch-up in their FAS 91 accounting policies which 
allowed them to utilize this amount to project smooth earnings 
over time.
    Mr. Manzullo. I find this staggering. This is absolutely 
astonishing when the oversight organization says that Fannie 
Mae projected its earnings and did its accounting practices for 
the reason so that the executives could get the maximum amount 
of their bonus. That is your conclusion?
    Mr. Falcon. That certainly how it appears to us, yes.
    Mr. Manzullo. And did you look at bonuses for any other 
years besides 1998?
    Mr. Falcon. We have information about the bonuses for the 
years--yes, and it actually included the information that was 
given to Chairman Baker.
    Mr. Manzullo. Can you tell us what the bonuses were for 
subsequent years to 1998?
    Mr. Falcon. I believe for the top five individuals, it is a 
matter of public record because of the disclosures under the 
securities laws.
    Mr. Manzullo. Were they similar amounts, do you recall 
offhand?
    Mr. Falcon. I believe they were similar, yes.
    Mr. Manzullo. Did your research, investigation, look at any 
other years besides 1998 to see if you came up with similar 
conclusions?
    Mr. Falcon. We have not to date, I believe, found a 
transaction like the one in 1998, which was deferred to another 
year with the fact of resulting in full bonuses as opposed to 
no bonuses.
    We have not yet found a similar type transaction in similar 
years, in subsequent years, but we certainly do see the fact 
that the policy of managing their earnings occurred over time 
at the same that their Challenge Grant Initiative was put 
forward.
    Mr. Manzullo. So this is all based upon the fact that you 
are paid according to the--you get your bonus according to the 
earnings per share, regardless how you get those.
    Mr. Falcon. That is the metric that is contained in their 
compensation program.
    Chairman Baker. Mr. Manzullo, you have expired your time, 
but you have one wrap-up.
    Mr. Manzullo. I do have one final question that speaks for 
itself.
    I believe on page 12 that says that if they had done the 
correct accounting method there would not have been a bonus 
that year.
    Mr. Falcon. Yes, that is right.
    Mr. Manzullo. Thank you.
    Chairman Baker. I thank the gentlemen.
    Mr. Davis?
    Mr. Davis. Thank you, Mr. Chairman.
    Let me thank my friend from North Carolina for yielding.
    Mr. Falcon, when Mr. Lynch was questioning you earlier, you 
said something that really caught my attention. You said that 
you wanted to avoid making any broad and categorical statements 
until the investigative process was complete.
    Do you remember saying that?
    Mr. Falcon. Yes.
    Mr. Davis. That sounds like a good goal, and I think that 
is exactly the stance that one would want from someone in your 
position.
    So in light of that, let me ask you about several 
observations that you have made and see if they meet the 
standard that you set out.
    Mr. Manzullo asked you a number of questions and others 
have asked you questions about the motivation for the expenses, 
and you said fairly directly that you think that the motivation 
was to pave the way for bonuses, or to create an appearance of 
earnings to justify bonuses.
    Is that not a pretty broad and categorical statement on 
your part?
    Mr. Falcon. It is.
    Mr. Davis. And second of all--if I can continue, as my time 
is limited--you made the observation or response to someone's 
questions--where you were asked rather point blank: Would it be 
in the interest of Fannie Mae if there was a change in the 
management structure?
    Do you recall those questions?
    Mr. Falcon. Would it be in the interest----
    Mr. Davis. You asked if it would be in the interest of 
Fannie Mae if there were a change in the management structure.
    Mr. Falcon. Yes, we had that.
    Mr. Davis. And I think your answer was in the affirmative 
that it would be. Do you recall that?
    Mr. Falcon. I think what I said was, we were going to 
assess--that the question before us was whether or not we had 
sufficient confidence in this management team going forward, 
trust that they could properly implement this plan of 
remediation and have the confidence of both us and the board 
going forward to properly run this company in compliance with 
all the rules and regulations.
    Mr. Davis. You had various questions about the management 
structure.
    Mr. Falcon. Yes, yes, I did.
    Mr. Davis. Is that not a pretty broad and categorical 
statement to raise questions about the management structure?
    Mr. Falcon. It is.
    Mr. Davis. Furthermore, you make a pretty broad statement 
in your report--in fact, I think I am quoting from you--that 
there was a pervasive and willful misapplication of GAAP in two 
critical areas.
    Is that a quotation from your report?
    Mr. Falcon. Yes.
    Mr. Davis. Is the reference to a pervasive and willful 
misapplication a pretty broad and categorical statement?
    Mr. Falcon. It is, about these two accounting areas.
    Mr. Davis. So let me put this in perspective, because I 
agree with your honesty in all four of those answers, those are 
very broad statements.
    One of the things that has been raised by several of my 
colleagues on this side of the aisle has to do with: As I would 
characterize it, does OFHEO have the appropriate level of arms-
length relationship that is needed with Fannie Mae?
    Several of my colleagues have made the point, and I make 
the point to you now, that as I understand the mission of 
OFHEO, it is to be a regulator, it is to assess the safety and 
soundness of the institution that you are regulating.
    The SEC has the responsibility of making judgments about 
whether accounting fraud occurred.
    This body has the responsibility of making judgments about 
the proper policy course.
    And the Justice Department has the responsibility of making 
proper judgments about whether a criminal act has happened.
    Have I gotten the division of labor just about right, from 
what you know?
    Mr. Falcon. There is some overlap----
    Mr. Davis. There is some overlap, but do I basically have 
it right?
    Mr. Falcon. Yes.
    Mr. Davis. A concern that I have--and I want to give you a 
chance to respond to it--but a concern that I have is you are 
making very specific, what you have correctly acknowledged, 
broad and categorical judgment about the management of this 
institution, about the willfulness of practices that may or may 
not be in controversy.
    You have imputed various motives to the people running the 
organization.
    You went to the board and put a 48-hour ultimatum on them 
without having any specific regulatory authority to put that 
kind of ultimatum on them.
    That sounds like some kind of an invisible line has been 
crossed. That sounds to me as if you have gone from being a 
dispassionate regulator to someone who is very much involved 
and has a stake in this controversy.
    And I will follow up on Ms. Waters's point because I think 
it is very well taken: Her observation is that the political 
context surrounding your investigation was that serious doubts 
were being raised about OFHEO.
    In fact, frankly, doubts were raised about your leadership 
of OFHEO. And all of a sudden, the response to that is to 
produce an enormously critical report.
    My concern is that OFHEO has jumped off the fence--where it 
should be, if it is a dispassionate regulator--and has somehow 
gotten involved in the business of taking a side in this 
controversy.
    Now, I will give you a chance to respond to that.
    Mr. Falcon. Well, Congressman, I appreciate the time to 
respond.
    The categorical statements that I was referencing to with 
Mr. Lynch was, he asked me to make a broad categorical 
statement as to whether or not we had Enron-like fraud going on 
with this company.
    Mr. Davis. No, sir. You said that you had a problem with 
making broad and categorical statements. And your instinct is 
right.
    The reason--and I will make this my last point--the reason 
that you do not want to make broad and categorical statements I 
suspect is because the ultimate concern of OFHEO ought to be 
the safety and soundness of Fannie Mae.
    Is it possible that by casting all of these dispersions and 
all of these doubts upon the board at Fannie Mae, and upon the 
structure of Fannie Mae, that you potentially are weakening 
this institution in the market, that you are potentially 
weakening the housing market in this country?
    Are those possible consequences from the very broad and 
sweeping generalizations you have made about this institution?
    Mr. Falcon. Well, first off, we may disagree on this, but 
it was not what I was telling the congressman about the type of 
categorical statements----
    Mr. Davis. No, please answer the last question that I asked 
you.
    Chairman Baker. And if you would, sir, begin to wrap up----
    Mr. Davis. I will, and then I will wrap up on just a point, 
but I do not want you to answer any question other than the one 
I just asked you, because our time is so limited.
    Is it possible and is it a reasonably foreseeable 
consequence that these kinds of amputations, these kinds of 
insinuations about the board, could end and of themselves 
damage the safety and soundness of Fannie Mae by weakening its 
position in the market? Is that possible?
    Mr. Falcon. Our actions are all designed for the safety and 
soundness of this----
    Mr. Davis. Is that possible?
    Mr. Falcon. If we did our job properly perhaps, but we have 
not.
    Congressman, let me just say, I understand your politics 
running all the issues.
    Mr. Davis. No, I am just asking----
    Mr. Falcon. We are just trying to do our job as a 
regulator. You can question my motives, my judgment, even my 
qualifications----
    Mr. Davis. That is not the question I am asking.
    With all due respect, Mr. Chairman, that is not the 
question I am asking.
    Mr. Falcon.--but that will not change the contents of this 
report.
    Mr. Davis. Is it possible that the market standing of 
Fannie Mae could be weakened by your testimony?
    Chairman Baker. Please be responsive to him.
    Mr. Falcon. It is possible. And if does----
    Mr. Davis. Thank you, you have answered my question.
    Mr. Falcon.----course of actions we have taken, it is 
because of what the company has done, as we have outlined in 
this report.
    Chairman Baker. The gentleman's time has expired.
    Ms. Hart, did you now have questions? Ms. Hart?
    Ms. Hart. Thank you, Mr. Chairman.
    We have been watching this drama play out a little bit. As 
you know, the committee has considered a number of different 
proposals that actually would change your position, as far as 
being the regulator for GSEs.
    And one of the things that I know during this debate that 
you have been seeking--and I think it is important--is to 
separate the roles of chairman of the board and CEO at both 
Fannie and Freddie. And I know that Freddie has agreed to do 
this, but from my understanding, up to this moment, Fannie Mae 
has not agreed to do this.
    Can you tell us, first of all, as far as the agreement that 
you have with them goes, is there anything involving that in 
the agreement that you have with them and why you think that is 
important to have that separation happen?
    Mr. Falcon. The agreement does not specifically cover the 
separation of the chair and CEO positions. It does require a 
review of the organizational structure to address issues of 
possible conflicts in different positions and functions.
    We do have a corporate governance rule pending which would 
separate the position of chair and CEO. And we have proposed 
that and are moving toward a final rule on this because we 
found that, based on the situation at Freddie Mac, that this 
was just best corporate practice for these government-sponsored 
enterprises.
    We found that the board could not properly fulfill its role 
as overseer over management as long as the CEO was also the 
chairman of the board of the company. And so, we entered an 
agreement with Freddie Mac, whereby they agreed to separate the 
positions.
    And I must say that, to the board's credit, that didn't 
take much persuasion. I think they saw that this was 
appropriate in themselves. And so, they took this step. And 
with this corporate governance rule being in place, soon I 
hope, we will then require the same thing of Fannie Mae.
    Our report on Freddie Mac certainly highlights the need for 
a government-sponsored enterprise which has imperfect market 
discipline to have a separation of these positions.
    Ms. Hart. If that is such an important point, why is your 
instruction in the agreement with Fannie so general?
    Mr. Falcon. Well, because we intend to deal with this 
through our corporate governance regulation, while the overall 
issues about organizational structure get addressed by the 
board and us.
    Ms. Hart. Okay. I yield back. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, Ms. Hart.
    Mr. Watt, in the interim Mr. Crowley appeared, and he was 
ahead of you.
    Mr. Crowley?
    Mr. Crowley. Thank you, Mr. Chairman.
    Thank you, Mr. Falcon, for being here today, and thank you 
all for testifying.
    I just want to go back a little bit of ways in the hearing. 
I was in the back room prior to the break for votes when Mr. 
Shays was asking you a number of questions. And in response to 
a question from Mr. Shays, you suggested, at least as I 
interpreted it, that investors could be harmed by the actions 
taken by Fannie Mae.
    Could you tell me where that is in your report? Do you have 
that in your report?
    Mr. Falcon. I think potential harm exists because of 
inaccurate financial statements being issued by the company.
    Mr. Crowley. Is that an observation of yours, or is that in 
the report itself?
    Mr. Falcon. It is in the report.
    Mr. Crowley. Where in the report is that?
    Mr. Falcon. The fact that we think that the company has 
issued inaccurate financial statements as a result of these 
accounting practices? I would have to go through and find the 
exact----
    Mr. Crowley. If you don't mind, I would like to know, if 
you can. Maybe your staff can let my staff know where in the 
report that is.
    Mr. Falcon. Absolutely.
    Mr. Crowley. Just on Mr. Davis's line of questioning, which 
I thought was excellent, what effect do you think this report 
will have on the mortgage market?
    Mr. Falcon. I think what we have seen to date is that the 
mortgage market has functioned well. There is continued 
liquidity being moved into the mortgage market. And despite 
Fannie Mae's problems, as found in this report, there haven't 
been any real disruptions in the mortgage market.
    Mr. Crowley. Do you anticipate there will be any 
disruptions in the mortgage market because of this report?
    Mr. Falcon. As long as the markets and the public see that 
we are working to take prompt corrective action----
    Mr. Crowley. Yes or no?
    Mr. Falcon. No.
    Mr. Crowley. No, you do not.
    Do you believe that this report shows any evidence that 
Fannie Mae may be departing from its mission of increased 
homeownership through making homeownership more affordable in 
this country?
    Mr. Falcon. The report did not address that point.
    Mr. Crowley. For example, I know Mr. Raines has pledged to 
create 6 million new homeowners, including 1.8 million minority 
homeowners, by 2014. Do you believe this goal may be threatened 
now because of this report?
    Mr. Falcon. I don't think----
    Mr. Crowley. I am going to ask Mr. Raines the same 
question, but----
    Mr. Falcon. As long as the company is maintaining its 
adequate capital, as long as we have taken proper steps, along 
with the cooperation of the company, I think we will minimize 
any damage to their ability to meet their affordable housing 
goals.
    Mr. Crowley. Let me finally--thank you. Let me finally ask 
you, while there are some things in this report that are 
damaging, in the text itself, it is the SEC, I believe, and not 
OFHEO that has the final say over whether or not Fannie Mae 
must restate past earnings. Is that correct?
    Mr. Falcon. Yes. Ultimately the SEC has to decide whether 
their statements issued pursuant to laws were accurate.
    Mr. Crowley. And some have argued to me that there is more 
than an even chance that the SEC may disagree with the most 
damaging allegations, such as accounting or derivatives and 
delayed recognition of expenses. Is that correct?
    Mr. Falcon. I guess some have predicted that. I cannot 
speak to what others might predict. All I know is that we find 
these issues to be very clear violations of GAAP. And we feel 
confident that once the SEC takes an objective look at this, 
that they will come to the same conclusions that we have and 
that Deloitte & Touche has.
    Mr. Crowley. Thank you.
    Mr. Frank. Would the gentleman yield to me?
    Mr. Crowley. Yes, I will. I yield to the gentleman from 
Massachusetts.
    Mr. Frank. I thank the gentleman.
    And I appreciate the answers, Mr. Falcon, you gave to Mr. 
Crowley. But it makes me even more disturbed that you, both in 
your written statement and again, sort of threw ``safety and 
soundness'' around almost like kind of boilerplate.
    I think you just accurately answered the questions that, 
no, if everything works out as we expect it to, there are no 
threats, et cetera, this--you seem to be saying, ``Well, these 
are in areas which could raise safety and soundness problems.'' 
I don't see anything in your report that raises safety and 
soundness problems. Your answers to Mr. Crowley certainly 
didn't indicate that there were.
    How does this raise safety and soundness problems, other 
than the kind of, frankly, almost ritualistic saying, ``Well, 
these are areas where safety and soundness could be implicated 
presumably if it went far enough''?
    But I think it is irresponsible--let me be very clear--on 
the basis of this report and what you have concluded so far--I 
mean, we have earnings smoothed out. With regard to 
derivatives, you have told you me you cannot even say at this 
point whether they have under-reported or over-reported 
earnings.
    How does this threaten the safety and soundness, what you 
have uncovered, of Fannie Mae?
    Mr. Falcon. Just the very fact that we have serious doubts 
about the accuracy of the financial statements and their books 
and records, the very fact that we have identified very serious 
internal controls----
    Mr. Frank. Well, let me ask a question. Does any accuracy 
threaten the safety and soundness? That is what bothers me. 
There is a quality and a quantity issue here.
    There are inaccuracies that can be disturbing, and if they 
led to inappropriate compensation, I would be very unhappy. But 
the notion that any inaccuracy implicates safety and soundness, 
I think, based on what you have said here, where you cannot 
even conclude--you have said you cannot even quantify any 
potential amount of loss. To throw ``safety and soundness'' 
around in that thing I think really is, for a regulator, 
irresponsible.
    Mr. Falcon. Well, I think internal controls are a very 
serious safety and soundness concern. A breakdown or a lack of 
internal controls----
    Mr. Frank. Do you think the safety and soundness is at risk 
right now?
    Chairman Baker. Mr. Crowley, that will have to be your last 
question. If you can wrap up.
    Mr. Frank. He accepts that.
    Mr. Crowley. That was my first question, as a matter of 
fact.
    Mr. Frank. Yes, I mean, you have just told Mr. Crowley it 
didn't implicate safety and soundness. Does it, your report, 
what you have reported?
    Mr. Falcon. No, I think our report absolutely does 
implicate safety and soundness.
    Mr. Frank. Is the safety and soundness at risk now?
    Mr. Falcon. Are they at risk of becoming insolvent right 
now? No. We have an agreement with the board in place that will 
address these problems, provide an adequate capital cushion. We 
think we----
    Mr. Frank. That is the answer. The rest is just rhetoric.
    Chairman Baker. The gentleman's time is expired once over.
    Mr. Ose?
    Mr. Ose. Thank you, Mr. Chairman. I yield 15 seconds to Mr. 
Shays. And I am counting.
    Mr. Shays. Thank you.
    I would just like to say to you, Mr. Falcon, what you have 
done is you have exposed illegal activity on the part of Fannie 
Mae, and you are being criticized for exposing it. If they have 
a safety and soundness problem, or if the markets are impacted, 
it will only be impacted based on what Fannie Mae did.
    And I just want to congratulate you. You have more courage 
than I realized you had, because the messenger is being shot 
and not the person who did the wrongdoing. I have seen it here 
in this committee, and I am pretty outraged by what I am 
seeing.
    Congratulations for what you have done.
    Ms. Waters. Would the gentleman yield?
    Mr. Ose. Let me ask my--it is my time.
    Ms. Waters. Would the gentleman yield?
    Chairman Baker. It is Mr. Ose's time, and I think he wants 
to reclaim it.
    Mr. Ose. I do want to reclaim it.
    Ms. Waters. Oh, he is reclaiming his time?
    Mr. Ose. Mr. Falcon, I follow this stuff very carefully 
because, having weathered the storm on the games-playing that 
took place in some of the energy companies, I am very, very 
sensitive to what might be occurring in the financial markets 
underpinning the housing market.
    If I understand correctly, there are questions as to the 
validity of the numbers on an ongoing basis within the 
enterprise known as Fannie Mae.
    Now, Fannie Mae's securities are held as tier-one capital 
by any number of additional institutions. My concern here is 
not so much the direct impact but perhaps the indirect impact 
that might manifest itself as a result of manipulation of 
earnings.
    Could you speak to that issue? In other words, the 
secondary impact, if you will, outside of Fannie Mae, is that a 
possible consequence for banks holding Fannie Mae's securities 
as tier-one capital?
    Mr. Falcon. The banks holdings in the debt of Fannie Mae--
if there is some--might have undue concentration in Fannie Mae 
debt as a percentage of the total capital, if the problems were 
not addressed quickly with Fannie Mae such that we remedied the 
concerns that we have found, I think the bank regulators might 
have some concern about the devaluation in what is being held 
as capital of some financial institutions.
    Mr. Ose. This is exactly the point that I think OFHEO 
properly has made, is that this issue is not constrained to the 
enterprise we know as Fannie Mae. This issue goes beyond the 
enterprise we know as Fannie Mae. That is why it is so 
important that the numbers that Fannie Mae reports accurately 
reflect the enterprise's activity. If they do not reflect the 
enterprise's activity, there are significant adverse effects 
outside the enterprise that we would end up being called upon 
to deal with.
    That is why I am, frankly, pleased to see you bring this to 
our attention. I am troubled by what I hear. I am looking 
forward to the witnesses that follow you. And I thank you for 
your work.
    Chairman Baker. Would the gentleman yield?
    Mr. Ose. And I yield to the Chairman.
    Chairman Baker. I would just like to point out to the 
gentleman, there is approximately 8,400 insured federal 
depository institutions. Of that number, in excess of 3,000 
institutions hold 100 percent, not 50, not 70, 100 percent or 
more of their required tier-one capital in GSE securities.
    It is of extraordinary consequence we fully understand that 
the financials are indeed accurate, because an impairment in 
the issuance of debt, it would not require the insolvency of an 
enterprise, merely an impairment in the ability to issue debt. 
If the regulator increases capital requirements, where are they 
going to go to raise the capital?
    So I think the gentleman has raised an excellent point I 
think heretofore has not been recognized. I thank him for 
yielding.
    Mr. Ose. I yield back the balance of my time.
    Chairman Baker. Mr. Watt?
    Mr. Watt. Thank you, Mr. Chairman. And again, thank the 
Chairman for allowing the nonmembers of the subcommittee to 
participate.
    I think I may be the last questioner, so I want to try to 
follow up on a couple of things. Number one, Mr. Bachus, I 
believe it was, asked about the leak the morning of the day you 
met with the Fannie Mae board.
    My question to you is, are you undertaking any internal 
investigation to determine whether that leak was inside your 
shop at present?
    Mr. Falcon. I will.
    Mr. Watt. Are you presently, or you are planning to in 
light of the comments that were raised today?
    Mr. Falcon. Yes.
    Mr. Watt. Okay.
    Mr. Falcon. And I guess I would also ask----
    Mr. Watt. That is all I need to know.
    Second, you made reference in response to questions that 
Ms. Waters asked to at least some conversations with members of 
Congress leading up to the time that you had the meeting with 
the board of Fannie Mae.
    Would you be kind enough to provide to the chairman and the 
ranking member of this subcommittee a list of those contacts 
and the contents of those contacts? I don't expect you to have 
that with you today, but would you provide that to the chairman 
and ranking member?
    Mr. Falcon. Sure, Congressman.
    Mr. Watt. Okay. Now, let me kind of zero in on the bottom 
lines, as I have gathered them, and contrary to what Mr. Shays 
is saying, I am not second-guessing whatever conclusion the 
study. But I do have some problems with the timing of the 
release of this information.
    Is it correct that you have not concluded whether the 
derivative conduct that you describe in your report either 
resulted in an overstatement or an understatement of Fannie Mae 
earnings?
    Mr. Falcon. Right. The next step----
    Mr. Watt. Okay. Just, is that correct?
    Mr. Falcon. Yes.
    Mr. Watt. Okay. And, now, since we have separated out that, 
we don't know what the financial consequence of that is.
    Let me go to the primary thing that I want to get at, and 
this is at the bottom of page three of your statement. Right 
near the next-to-the-last sentence there you say, ``Fannie Mae 
improperly delayed the recognition of income to create a 
'cookie-jar' reserve that it could dip into whenever it best 
served the interest of senior management.''
    Now, the word ``cookie-jar'' makes it sound pretty small, 
but in actuality, the specific incident you are talking about 
related to $400 million in 1998. Is that correct?
    Mr. Falcon. Yes.
    Mr. Watt. And what you are saying is that in 1998, Fannie 
Mae made a decision to recognize only $200 million of that and 
then amortized the rest of it over 1999. Is that the bottom 
line on what you are saying?
    Mr. Falcon. Yes.
    Mr. Watt. Now, is it also then true that for 1997 and prior 
years, there would have had to be an understatement of revenue 
or income for Fannie Mae in order for Fannie Mae to have been 
able to create this ``cookie jar''?
    I mean, is that not what this means when you say they 
improperly delayed the recognition of income. Does that not 
mean that in some years to prior to 1998, they did not 
recognize income so they understated income. Is that not what 
that means?
    Mr. Falcon. I do not believe so. I would like to have my 
chief accountant to explain to you, but I think it was just a 
function of----
    Mr. Watt. Yes, well, tell your chief accountant to tell me 
what this means.
    Mr. Dickerson. The ``cookie jar'' is really a Securities 
and Exchange Commission term of art for----
    Mr. Watt. I do not care about the term itself, but you 
cannot create a reserve in a cookie jar without having created 
some consequences to prior earnings. Is that correct, Ms. Deleo 
or whoever it is that is going to answer it?
    Mr. Dickerson. Congressman, our analysis and our special 
examination did not go back beyond----
    Mr. Watt. I understand that. That is not the question I am 
asking. But you cannot really determine whether there was an 
overstatement or an understatement of earnings over time at 
Fannie Mae without going back beyond 1998, can you?
    If they were creating a reserve that was supposed to level 
out earnings, they had to understate at some point and 
overstate at some point. Is that not correct?
    Mr. Dickerson. Well, Congressman, our examination found 
that there was $400 million----
    Mr. Watt. I understand that. I have acknowledged that. I 
went through that in some detail and you went through it some 
detail.
    The question I am asking is: In order to create the cookie 
jar reserve, would there not have had to be an understatement 
of income at some point just as there was an overstatement of 
income at some point?
    Chairman Baker. And someone please try to answer his 
question. The gentleman's time has expired.
    Mr. Watt. I thought it was a pretty simple question myself.
    Mr. Dickerson. It was after this experience in 1998 that 
Fannie Mae implemented policies to create these cookie jar 
reserves beginning in 1999----
    Mr. Watt. How can you say that and you did not even look at 
1997? You do not know whether the cookie jar was already there 
or not, do you?
    Mr. Dickerson. I cannot really speak to the years before 
1998, sir.
    Mr. Falcon. Congressman, I think what you are getting at 
is: Was this there in 1997 and they just carried it forward or 
something to that effect.
    This $400 million showed up in 1998 as a result of the 
change in interest rates and the amortization----
    Mr. Watt. Well, what did they offset it against if there 
was not already a reserve? And how did they get the reserve if 
there was not already understated income at some point, or 
overstated income at some point?
    I am just trying to figure out--I mean, this is a balancing 
act, right? And the objective is to smooth out earnings. Is 
that not right?
    Mr. Falcon. This came up as a result of a change in 
interest rates and a change in the amortization of the expenses 
related to the mortgages.
    So it is not something that is necessarily what you are 
suggesting. It is more of a factor of the models showed that 
they----
    Mr. Watt. But is it necessarily what you are suggesting? 
That is the question.
    Chairman Baker. With that, the gentleman's time really has 
expired.
    Mr. Director, would you care to respond to his last 
comment?
    Mr. Falcon. No, Mr. Chairman.
    Mr. Frank. For something clear cut, that is pretty hard to 
explain.
    Chairman Baker. Mr. Director, on behalf of the committee I 
wish to express our appreciation for your courtesy with your 
appearance here today and for the work you do.
    I know that, given the difficulty of this issue and strong 
opinions held by members from many perspectives, that the 
criticisms that you took today may be difficult for you and 
your staff to accept, given the length of time and the amount 
of effort you have put into production of this report.
    I want to express our appreciation publicly for your 
effort, and be assured that our work going forward, like yours, 
will not stop with today's hearing.
    Thank you very much, sir.
    Mr. Falcon. Thank you.
    Chairman Baker. At this time I would like to ask our second 
panel participants to come forward, when it is possible.
    At this time the committee welcomes our next two witnesses: 
Mr. Franklin D. Raines, chairman and chief executive officer of 
Annie Mae, and Mr. Timothy Howard, vice chairman and chief 
financial officer of Fannie Mae.
    Gentlemen, by prior agreement with Mr. Kanjorski, it was 
determined that all witnesses appearing here today will testify 
under oath. Do either of you have any objection to testifying 
under oath?
    Mr. Raines. No, sir.
    Mr. Howard. I do not.
    Chairman Baker. The chair also is required to advise you 
that the rules of the committee and of the House entitle you to 
be advised by counsel. Do you desire to be advised by counsel 
during your testimony today?
    Mr. Raines. No, sir.
    Mr. Howard. Nor do I.
    Chairman Baker. In that event, let me ask you to rise and 
raise your right hand to affirm the oath.
    (WITNESSES SWORN)
    Consider yourself sworn in, gentlemen. Thank you.
    Mr. Raines, we would certainly proceed with your opening 
statement first. Your official statement of course will be made 
part of the record.
    Normally we request that witnesses try to make their 
statement in 5 minutes. However, given the nature of the report 
in question and the importance to your organization, certainly 
we would want you to proceed as you deem appropriate.
    Mr. Raines. Well, thank you, Mr. Chairman.

 STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CHIEF EXECUTIVE 
                      OFFICER, FANNIE MAE

    Mr. Raines. My name is Frank Raines. I am the son of Ida 
and Delano Raines. I grew up in Seattle, went to public school, 
graduated from college and law school. I am a brother, a 
husband, a father and friend.
    For all but two of the last 25 years, I have been in the 
financial services business, and those 2 years I served our 
nation as the director of the Office of Management and Budget.
    I am now the chairman and CEO of Fannie Mae. And Fannie Mae 
is the nation's largest source of funds for homeownership and 
rental housing for low-, moderate-and middle-income Americans.
    We like to say we are in the American dream business.
    I introduce myself in this way not because I am a stranger 
to this committee, but because I do not recognize the person, 
colleagues or company that someone described this morning.
    But I nevertheless hope that I can make a contribution to a 
constructive dialogue this afternoon.
    I do thank you, Chairman Baker, and I thank Ranking Member 
Kanjorski, and Chairman Oxley and Ranking Member Frank for the 
opportunity to be here.
    We appreciate this opportunity to answer your questions 
about issues raised in the September of 2004 report by OFHEO of 
a special examination of Fannie Mae.
    I would like to begin by noting that this is the first 
opportunity that Fannie Mae and its board are taking to respond 
in an official forum to the allegations set forth in the OFHEO 
exam report.
    We take this report seriously.
    Out of respect for the regulatory process and for OFHEO, we 
have sought with great diligence to follow an orderly process 
throughout the special examination, which is ongoing.
    We have chosen not to respond ad hoc to questions about the 
exam report's content or conclusions. Instead, we will provide 
our responses in the appropriate forums, including through the 
boards independent review to the Securities and Exchange 
Commission and to the Congress.
    So I appreciate that the committee has provided this forum 
today.
    Some people have mistakenly concluded that the company's 
agreement with OFHEO constitutes an admission by the company to 
the findings and conclusions of the report.
    Let me clarify that this is not the case. The agreement 
itself states that the company was not admitting or denying any 
wrongdoing as a result of signing the agreement.
    Fannie Mae respects the role of OFHEO as our safety and 
soundness regulator. The strong oversight OFHEO provides is 
critical, given Fannie Mae's significant role in the U.S. 
housing finance system and the financial system as a whole.
    In our view, from a decade of experience working with 
OFHEO, I believe that our overall safety and soundness regime 
makes Fannie Mae a better company.
    OFHEO has more examiners per regulated company than any of 
the bank regulators.
    OFHEO's risk-based capital standard is a model for 
financial institutions globally and goes farther than new risk-
based capital models being proposed for financial institutions 
with more complex operations than Fannie Mae.
    The best financial institutions will tell you the same 
thing. They welcome the exam process because it fosters 
cooperation in making the institution the best that it can be.
    A confidential and cooperative examination process builds 
confidence, both the regulators confidence in the company, but 
also the company's confidence in its own safety and soundness.
    Now, while this special examination unfortunately departed 
from standard financial institution examination procedures, our 
obligation remains the same: to make adjustments needed to 
respond to OFHEO's concerns, just as any financial institution 
would do with respect to its regulator.
    That is why the company, led by our board, promptly entered 
in to a regulatory agreement with Director Falcon to make 
changes to our accounting, capital and internal controls and 
organization.
    And let me thank our board members, particularly our 
presiding director, Ann Korologos, for their dedication and 
efforts on behalf of Fannie Mae in the past 16 days. Their 
diligence made it possible to quickly set forth an orderly 
process to resolve the concerns raised by the OFHEO report.
    In conjunction with the agreement, the board's independent 
review committee has hired the law firm of Paul, Weiss, 
Rifkind, Wharton & Garrison to conduct an independent 
investigation, led by former Senator Warren Rudman, of all the 
allegations in the special examination report.
    The issue of whether our implementation of FAS 91 and FAS 
133 was consistent with generally accepted accounting 
principles remains with the SEC.
    This agreement and these measures are important steps 
toward addressing the matters raised in the OFHEO report and a 
way to move forward. Adopting these measures will make Fannie 
Mae stronger and even better able to pursue our mission and the 
business that fuels our mission.
    That mission, after all, is our central function. Congress 
chartered Fannie Mae to expand access to homeownership for low-
and moderate-income Americans, and we are committed to that 
mission.
    Earlier this year we announced the commitment to create 6 
million first-time homebuyers, including 1.8 million minority 
first-time homebuyers, over the next decade, and to do our part 
to raise the minority homeownership rate to 55 percent and 
beyond.
    By quickly reaching agreement with OFHEO where we could, we 
are able to maintain our mission focus.
    For those that may be concerned that some of these steps, 
particularly the 30 percent capital surcharge, will constrain 
our mission activities, let me say this: Fannie Mae will do 
everything in our power to meet our commitments to expanding 
homeownership and affordable housing while also doing 
everything in our power to try to meet the requirements of the 
agreement.
    Before I close, I would like to touch on the issues raised 
by the OFHEO report concerning our implementation of the 
accounting standards FAS 133 and FAS 91. These accounting 
standards are highly complex and require determinations over 
which experts often disagree.
    First, the report alleges that in 1998 the company 
willfully violated GAAP in order to maximize executive bonuses. 
These are serious allegations. They concern events that 
occurred almost 6 years ago.
    Importantly, I would note that the OFHEO report does not 
cite any documents or witnesses to support these allegations.
    Upon reading of this allegation in the report, the company 
undertook to assemble the relevant facts. And we have learned 
of no facts and no other materials that support the allegation 
that the decision about the amount to book was related to 
bonuses.
    Based on the facts as I understand them, the $240 million 
estimate was arrived at as part of an analysis conducted by our 
accounting and financial staff, independent of any 
considerations of compensation. Additionally, this analysis was 
documented at the time and was disclosed to and fully discussed 
with our independent auditor.
    We intend to turn all of this factual information over to 
the independent committee of the board and its outside counsel 
for review.
    Second, the report alleges that we misapplied GAAP with 
respect to two accounting standards, FAS 91 and FAS 133. We 
believe we applied those standards in accordance with GAAP, and 
our independent auditor, KPMG, reviewed our application of 
those standards and concurred.
    Fannie Mae has previously issued and filed with the SEC 
financial statements that reflect the accounting and financial 
statement presentation that OFHEO has alleged to be 
inappropriate. Those financial statements were certified by me 
and by our chief financial office, Tim Howard, after a thorough 
process and audited by our independent auditor, KPMG.
    Fannie Mae has not withdrawn those financial statements, 
and KPMG has not withdrawn its opinion that those financial 
statements were prepared consistent with GAAP in all material 
respects.
    Rather, the issues that have been raised by OFHEO will be 
taken up directly with the staff of the SEC, which ultimately 
has the final authority over GAAP.
    Our accounting staff has repeatedly determined that our 
policies and practices with regard to FAS 91 and 133 are 
reasonable and in accord with GAAP. And KPMG has issued 
unqualified opinions on our financial statements, and that 
remains their position today.
    In fact, when I certify our financial statements, I certify 
that these documents fairly present, in all material respects, 
the financial condition, results of operations and cash flows 
of the company. That is a very serious statement, and I take it 
very seriously.
    We engage in a rigorous due-diligence process before I ever 
put pen to paper and make that certification. I only certify 
after receiving assurance that I can say with confidence that 
our financial statements fairly present, in all material 
respects, the financial condition, results of operation and 
cash flows of the company.
    Mr. Chairman, no one is more interested in a full and open 
examination of these issues than I am. I cherish this company. 
I believe in the mission that Congress challenged Fannie Mae to 
carry out. And I am inspired by the 5,000 women and men who 
come to work every day trying to help lenders help people get 
into homes.
    Most of all, I believe that Fannie Mae's biggest challenge 
ahead is helping the financial system and mortgage industry to 
meet the growing and changing housing needs or our growing and 
changing nation.
    This decade is expected to produce 30 million more 
Americans, who will create 13 million to 15 million new 
households. Minorities will represent 80 percent of that 
growth. And as a result, we estimate that 46 percent of future 
first-time homebuyers will be minorities and immigrants.
    Serving their housing needs will require new ideas and 
innovations in mortgage financing. And we look forward to 
helping the industry with this challenge.
    Given this public mission for which Congress created us and 
as an instrument of national housing policy, Fannie Mae expects 
and welcomes OFHEO's rigorous oversight to ensure that we are 
safe, sound, solid and stable for the long run. As I said the 
last time I appeared before this committee, strong oversight is 
in the best interest of Fannie Mae, our shareholders, financial 
markets and homeowners.
    I want to make one thing very clear. I have always tried my 
best to ensure that our company does the right thing in the 
right way. And I believe to this day that we did.
    If, however, after a thorough review of all the facts, it 
is determined that our company made significant mistakes, our 
board and our shareholders will hold me accountable. And I will 
hold myself accountable. That comes with being a CEO. I 
accepted that burden on the day I took the job, and I accept it 
today.
    Thank you, Mr. Chairman and members of the committee. And I 
look forward to answering any questions that you may have.
    [The prepared statement of Franklin D. Raines can be found 
on page 176 in the appendix.]
    Chairman Baker. Thank you, sir, for your statement.
    Our next witness is Mr. Timothy Howard, vice chairman and 
chief financial officer of Fannie Mae.
    Please proceed at your leisure, sir.

 STATEMENT OF TIMOTHY HOWARD VICE CHAIRMAN AND CHIEF FINANCIAL 
                      OFFICER, FANNIE MAE

    Mr. Howard. Good afternoon, Ranking Member Frank, 
Chairman----
    Chairman Baker. Make sure that mic is on, or pull it a 
little closer. We can't hear you the way we should.
    Mr. Howard. Is it on now?
    Chairman Baker. Yes, sir. Thank you.
    Mr. Howard. Good morning--or good afternoon, I should say. 
Thank you for inviting me to be here today.
    I joined Fannie Mae in 1982 when the company was in the 
midst of a severe financial crisis brought on by flaws in its 
interest rate risk management. Under the leadership of David 
Maxwell, we were able to turn the company around and establish 
the solid financial footing that has enabled Fannie Mae to 
reliably provide hundreds of billions of dollars in affordable, 
fixed-rate mortgage financing to millions of low-, moderate-and 
middle-income Americans.
    I consider it a privilege to have been able to devote the 
past 22 years of my career to this company and its mission. 
Throughout this time, I have tried my absolute best to do the 
right thing for the homebuyers Fannie Mae helps to serve, the 
employees I lead and the investors who have placed their trust 
in our company.
    All of my judgments regarding accounting issues were made 
in openness and good faith, with the goal of providing 
investors with the most meaningful and understandable 
information possible.
    When accounting issues arose, I worked with the head of my 
accounting policy group, who I know to be knowledgeable and 
highly respected in the industry. I also made certain that any 
accounting approaches we adopted were reviewed with our outside 
auditor.
    I had a clear objective in guiding Fannie Mae's 
implementation of the two accounting standards that are at 
issue in the OFHEO report: FAS 133 and FAS 91. And that was to 
preserve the accuracy and utility to investors of our financial 
statements by reporting on what I honestly believed were the 
true economics of our business.
    At all times, I believe that the accounting applications we 
adopted were within the boundaries defined by GAAP, as 
interpreted and understood by our accounting experts both 
inside and outside the company.
    We filed financial statements with the SEC that were fully 
audited by KPMG, and as Frank said, Fannie Mae has not 
withdrawn these financial statements, and KPMG has not 
withdrawn its opinion that those financial statements were 
prepared consistent with GAAP in all material respects.
    FAS 133 is widely considered to be the most complicated 
accounting standard ever issued. Its implementation had the 
potential to greatly reduce the clarity and utility of Fannie 
Mae's financial statements.
    We recognized this challenge from the outset, but we did 
not attempt either to circumvent the standard or to violate 
GAAP to deal with it. Instead, we developed a separate earnings 
measure, core business earnings, to convey to investors our 
financial results in the absence of FAS 133.
    FAS 91 requires that we estimate the average lives of the 
mortgages in our portfolio to determine the rates at which 
premiums or discounts on these mortgages should be amortized 
into our income statement.
    By definition, this estimation process is imprecise. From 
the inception of FAS 91 in the late 1980s, we have used ranges 
to address this imprecision in estimating mortgage pre-
payments. KPMG concurred with our use of a range.
    Ultimately the SEC will resolve the issue as to whether our 
implementation of FAS 133 and FAS 91 is consistent with GAAP. 
This is entirely appropriate. And I look forward to receiving 
the results of their review.
    It is important to note, however, that the matters to be 
reviewed relate to accounting judgments and not issues of risk 
management. Financially, Fannie Mae is as strong as ever, and 
our ability to carry out our mission remains intact.
    I look forward to responding to your questions on these 
matters.
    [The prepared statement of Timothy Howard can be found on 
page 169 in the appendix.]
    Chairman Baker. Thank you, sir.
    Mr. Raines, prior to the decision being executed to defer 
the $200 million in expenses in the end of 1998 into the 
quarters of 1999, were you consulted or did you have knowledge 
of that proposed transaction?
    Mr. Raines. Mr. Chairman, first, let me be clear. There was 
no decision made to defer any expense from 1998 to 1999.
    Second--and Mr. Howard can go into greater detail into how 
the process actually occurs--but we did not make any deferral. 
I was part of a discussion, as I always am as the CEO, in our 
closing process in which the decisions made in our financial 
area with regard to the calculation of the catch-up provision 
was discussed. But the determination of that was made through 
our normal process of closing our books.
    Chairman Baker. So you did----
    Mr. Raines. But Mr. Howard will be able to give you more 
detail.
    Chairman Baker. Sure. So that you were involved in a 
discussion about the amount of catch-up required. And your view 
is that was that a customary process, not a decision made with 
regard to this specific expensing item.
    Mr. Raines. That was a discussion that we would have at the 
end of each period, discussing a variety of issues related to 
closing the books of any given year.
    Chairman Baker. Were there any discussions related to the 
consequences of that expense treatment in relation to the EPS?
    Mr. Raines. No.
    Chairman Baker. When did you first realize that the 
earnings-per-share figure would be $3.23?
    Mr. Raines. The first time that I would know what the 
earnings figure would be is when our controller would have 
closed the books and done all of the analyses necessary to 
determine what the final results are and then that would be 
reported to me. That would be after any decision that was made 
with regard to the catch-up provision.
    Chairman Baker. Was there any discussion in which you 
participated relative to the determination of the catch-up 
amount?
    Mr. Raines. No, I did not participate in determining the 
amount of the catch-up. That was done, as I mentioned, within 
our financial function, which is their job.
    Chairman Baker. I know you are knowledgeable of the Fannie 
Mae's Challenge Grant Initiative--I believe that was something 
that was organized in your administration in 1999--which 
initiated executive incentives for increased earnings.
    Is it your view, or is it correct to assume that, including 
the $27 million of 1998 bonuses that were not part of the 
Challenge Grant Initiative, because it was implemented I 
understand in 1999, that went forward from 1999 to 2003, that 
the total amount of bonuses granted by Fannie to those entitled 
slightly in the excess of $245 million?
    Mr. Raines. Mr. Chairman, I do not understand what you just 
said. Let me explain to you why.
    Chairman Baker. I will clarify the question for you.
    In 1998, the bonuses reported were $27 million. And I can 
give you the figure for each year.
    In 2003, the total amount of bonuses was $65 million, the 
yearly aggregate, the amount of bonuses each year, per year, 
1998 through 2003, and that comes out to be $245 million.
    If you are not familiar with that number----
    Mr. Raines. I did not understand what the question was.
    Chairman Baker. Did that help?
    Mr. Raines. You told me what the facts were about bonuses.
    The Challenge Grant has nothing to do with bonuses. The 
Challenge Grant has absolutely nothing to do with bonuses.
    Chairman Baker. It does in a sense. Challenge Grants 
incentivizes executives to enhance the growth of the 
corporation's profitability, based on the corporation's 
profitability the EPS has calculated. The calculation of the 
EPS then determines whether the bonus trigger is hit.
    In light----
    Mr. Raines. You just crossed the line again.
    The Challenge Grant has to do with stock options. It has 
nothing to do with bonuses.
    Stock options were granted to every Fannie Mae employee. 
Every employee of Fannie Mae was given a grant and would only 
vest if the company doubled its earnings over 5 years, and then 
it would vest over a delayed period if it did not.
    So the Challenge Grants have nothing to do with bonuses.
    Chairman Baker. Well, let me clarify, then.
    In 2002, Fannie Mae paid out a total of $51 million in 
bonuses of which $12.4 million was paid to the top executives.
    I have a chart that is going up here now that shows total 
compensation.
    Since we have talked about restricted stock awards, we have 
talked about stock options, and we have talked about bonuses, 
that chart characterizes what was awarded in 2002 based upon--
what? If it was not earnings per share, per stock options, if 
it was not earnings per share or restrict stock awards, am I 
misunderstanding that the bonuses were not calculated based 
upon the earnings-per-share number?
    Mr. Raines. Again, Mr. Chairman, I think you are mixing two 
or three things together.
    Chairman Baker. I may be, but let's go through the detail--
--
    Mr. Raines. I would like to be helpful.
    Chairman Baker. I know.
    Mr. Raines. Let me try to answer the question----
    Chairman Baker. I will give you the right question that I 
would like to have answered, if it is possible: Did the $3.23 
earnings-per-share determination in 1998 trigger the payment of 
bonuses to executives?
    Mr. Raines. Yes.
    Chairman Baker. Thank you.
    Does the earnings per share have any effect on any of the 
other benefits awarded that are displayed on this chart, either 
the restricted stock grants or the options?
    Mr. Raines. Well, Mr. Chairman, this is your chart. This is 
the first time I have seen your chart. It has information on 
this chart that was provided to our regulator as confidential 
information, that it was information that is protected, in our 
belief, by the laws of the United States.
    But be that as it may, now that you have displayed it 
before the committee, if I can answer your question.
    Chairman Baker. Sure, but to answer your legal point, I 
have the absolute right to display it, despite Mr. Ken Starr's 
threats to the contrary, in the context of a committee hearing 
discussing the policy of Fannie Mae's compensation.
    Mr. Raines. Mr. Chairman, I am going to answer your 
question.
    Chairman Baker. Well, please proceed.
    Mr. Raines. I am just pointing out the legal status of this 
information.
    If we go across your chart, salary has nothing to do with 
earnings per share. Salary is established at the beginning of 
the year.
    Chairman Baker. I understand that.
    Mr. Raines. The second line you have is bonus. Those, in 
all these years--if I am correct, looking at this because it is 
very small type--is based on earnings per share, but not 
entirely.
    Because individual employee bonuses also have a performance 
factor involved in them. And so the earnings that they would 
earn is not just based on EPS, but there are also on their 
performance.
    Fringe benefits have no relationship at all.
    Chairman Baker. I was not raising that issue here.
    Mr. Frank. Mr. Chairman, are we all going to get this much 
time?
    Chairman Baker. I will be happy to cut him off if you would 
like for me to.
    Mr. Frank. I would like to go with the 5-minute rule.
    Chairman Baker. In order to move ahead, let me recognize 
Mr. Kanjorski.
    Mr. Bachus. Mr. Chairman, does he have a copy of this, 
other than reading off the chart?
    Chairman Baker. I have just recognized Mr. Kanjorski.
    Mr. Frank. I understand that. I wondered why Mr. Bachus was 
talking, then.
    Mr. Bachus. I understand, Mr. Chairman----
    Mr. Frank. Well, Mr. Kanjorski has the floor. Let us go to 
Mr. Kanjorski.
    Chairman Baker. Mr. Kanjorski has the time. He does have 
the information that came from Fannie Mae.
    Mr. Bachus. I did not know if he had this table before----
    Mr. Kanjorski. I do not have that chart. I think it is only 
on one side?
    Chairman Baker. Can we have it distributed?
    It is being distributed now.
    Mr. Kanjorski. Well, shall I wait and hold my time so I 
would have the same information that the other side of the 
aisle has in their possession?
    Chairman Baker. Let me give you mine.
    Mr. Kanjorski. Well, thank you very much.
    Mr. Bachus. What I am saying is, do these two gentlemen 
have this----
    Mr. Kanjorski. Do all the members on our side of the aisle 
have it?
    Mr. Bachus. He is indicating that he does not have it.
    Chairman Baker. Time out. Hold up.
    Ms. Waters. I have not seen it.
    Chairman Baker. Hold up one moment. We will make sure that 
staff distributes it to every member----
    Ms. Waters. And to the panel.
    Mr. Kanjorski.----reproduction costs of the committee, are 
we over the allotted budget amount?
    Mr. Frank. Mr. Chairman?
    Ms. Waters. Parliamentarian query: Is this illegal or is it 
legal? I mean, there was a legal question raised here. Is it 
illegal for us to have this information? Can we display or not?
    Chairman Baker. No, Ms. Waters, it is not illegal.
    Mr. Kanjorski. Not for us.
    Chairman Baker. Not in the course of the committee 
consideration. I would not have released it had it not been. I 
have had it for over a year.
    Mr. Frank. Mr. Chairman?
    Chairman Baker. Mr. Frank?
    Mr. Frank. I have another appointment, but if the gentleman 
from Pennsylvania wanted to study this, I would be glad to go 
now and have him go after.
    Chairman Baker. Would Mr. Kanjorski like to yield his time 
to Mr. Frank?
    Mr. Kanjorski. Actually, Mr. Frank, I am not going to use 
this at all. As a senior member of the committee, I am smart 
enough to----
    Mr. Bachus. Mr. Chairman, I am just saying, I still do not 
think that the panelists have this table----
    Chairman Baker. Your point is well taken, Mr. Bachus. It 
will be delivered. Thank you.
    Mr. Bachus. But as we question them, I just----
    Chairman Baker. I said your point is well taken. It will be 
delivered. Thank you.
    Mr. Kanjorski. You mean there were not sufficient copies 
produced for the committee members.
    Chairman Baker. Let me put it this way: I wanted to make 
sure I released this information. I am accountable for its 
release, and I put it into the public forum pursuant to my 
rights as chairman, subject to a response from the regulator, 
and I wanted to make sure that I did not get criticized for 
leaks. And we had all these accusations that people got 
advanced information inappropriately before it was publicly 
released.
    I have now publicly released it. I am accountable for that 
decision.
    Ms. Waters. Will the gentleman yield?
    Chairman Baker. And every member of the committee, 
everybody in the room has access to it.
    Mr. Kanjorski. Let me make a point, because I was very 
tough on the regulator, and I intend to be tough on Mr. Raines 
and Mr. Howard.
    But, Mr. Chairman, may I point out that you obviously had 
to seek legal opinion as to whether or not you are violating 
the law by distributing this document.
    And may I just say that opinion is opinion. You found a 
lawyer that gave you an opinion contrary to Mr. Kenneth Starr. 
And for the last time I recall, was not Mr. Kenneth Starr 
really most accomplished attorney in another proceeding----
    Mr. Frank. If the gentleman would yield----
    Chairman Baker. That is opinion.
    Who is recognized? Mr. Kanjorski and Mr. Frank.
    Mr. Kanjorski. Mind if I take it now, Barney? Let me take 
the 5 minutes. Do I have 5 minutes?
    Mr. Frank. I have been trying to get to regular order. I am 
glad----
    Chairman Baker. Thank you, Mr. Frank. Please keep your 
members in order, we will be fine.
    Mr. Kanjorski?
    Mr. Kanjorski. Maybe this goes to Mr. Howard and not to Mr. 
Raines, but either one of you, feel free.
    When Mr. Falcon was before us, the regulator, he talked 
about discovering for the first time the smoothing of earnings 
in 1998. And the transaction that he describes as a $400 
million item that should have been in but it was reduced to 
$200 million, but that it was cited somewhere in an audit 
difference.
    I wanted to find out whether--and that was done by your 
outside auditors, as I understand at that time were KPMG. Is 
that correct?
    Mr. Howard. Yes, it is.
    Mr. Kanjorski. Am I being incorrect when I said to Mr. 
Falcon that that would have been a finding or a difference in 
the audit that had to be resolved at the exit audit with either 
the board or management?
    Mr. Howard. Mr. Kanjorski, it typically would have been 
identified by the auditor and discussed with the audit 
committee, and it was.
    Mr. Kanjorski. Now, that document, although it was not the 
final audit, something appeared in the final audit that would 
have reflected that working document draft, that there were 
audit differences expressed by your account.
    Mr. Howard. It was mentioned in the accountant's report.
    Mr. Kanjorski. In the final audit.
    Mr. Howard. Yes.
    Mr. Kanjorski. And the final audit, it seems to me, in 
1998, were not only an internal document for the corporation, 
but that was provided and should have been provided to all the 
shareholders if they wanted it. Is that correct?
    Mr. Howard. It typically is summarized in our annual 
report. The audit itself is not provided to shareholders.
    Mr. Kanjorski. Is it a secret document and not allowed to 
be read or understood by the regulator?
    Mr. Howard. Not to my knowledge.
    Mr. Kanjorski. I am trying to gather: What in the hell does 
the regulator do when they regulate only two entities, and the 
first document they start with is not the outside audit, and 
particularly go to audit differences? Is that not what they 
talked to you about?
    The new auditor found some audit differences there, and we 
want to know how you played it and to pass on whether you did 
it in conformity with the regulator's position that you acted 
properly.
    Mr. Howard. Well, Mr. Kanjorski, I did spend a full day 
being interviewed by the special committee. They had an 
opportunity to ask me about this incident. I believe I could 
have put it in context that would have made it more 
understandable to them. They did not ask me.
    Mr. Kanjorski. No, I am just trying to understand: What 
does the regulator do if he does not start out with audit 
differences?
    Mr. Howard. I cannot answer that.
    Mr. Kanjorski. It seems to me----
    Mr. Raines. The actual document you are referring to has 
been, in my understanding, provided to OFHEO. The working 
papers have already been provided to OFHEO.
    Mr. Kanjorski. But in 1998, did he have access to that 
document?
    Mr. Raines. Yes.
    Mr. Kanjorski. I am trying to figure out whether we really 
should get worried here and that we have not had close 
regulation, whether it is Fannie Mae or Freddie Mac, if they 
are not looking at some base document that would reflect audit 
differences from your outside auditor to see what adjustments 
were made and why, and then that being footnoted in the final 
audit report.
    What happened here? Why 6 years went by and the regulator 
did not say, ``1998, there was a little dispute between the 
outside auditor and the inside auditors in regard to how we 
treat this $400 million, or $200 million, adjustment.''
    Mr. Howard. Well, Mr. Kanjorski, I would say there was not 
even a little dispute. The outside auditor had recorded an 
audit difference similar to this each prior year on our 
treatment of this so-called catch up adjustment on FAS 91. This 
was not unusual, it was not new.
    Mr. Kanjorski. Well, what do we have to do, in terms of the 
committee, in authorizing a new regulator, or whatever powers 
we give a new regulator, so they do not come in here and say 6 
months or 6 years later that there was this difference that 
supposedly then affects bonuses and compensation and all these 
things, but that they did not see it when it was about as clear 
as a battleship in the Potomac would be?
    Mr. Raines. Mr. Kanjorski, I am not sure there is anything 
that the Congress needs to do.
    It is my belief, it is my understanding, that our examiners 
have had access to this information over all these years and 
simply have not made any comment about them.
    So I do not think this is a matter of finding a secret 
document that have not seen before. I believe that the 
examiners had access to all----
    Mr. Kanjorski. I am not suggesting that there was secrecy. 
I am just getting worried about how superficial was the 
regulatory authority on your institution and Freddie Mac if 
they miss something that would have jumped out, audit 
differences.
    Here is your outside auditor saying that, and obviously the 
regulator did not look at it.
    Mr. Raines. I guess what I am saying is, I do not know that 
they missed it back 6 years ago. The question is: How is it 
being characterized? The characterization may have changed.
    Mr. Kanjorski. Let us go to that point.
    From that time in 1998 until now, it is your testimony, as 
I understand it, that KPMG had worked out and resolved in their 
mind, giving a full opinion letter on the audit, how it was 
treated in 1998 and how prior to that and how subsequent to 
that, that type of an adjustment was treated.
    Mr. Raines. Yes. In fact, I can read to you what they said 
to our audit committee in 1999 regarding 1998.
    They said: The principal area of estimates and judgments in 
Fannie Mae's financial statements, including the amortization 
of premium and discount, KPMG did not identify any areas within 
the financial statement that they believe include unreasonable 
estimates.
    That is what they said to our audit committee regarding 
1998, having made that audit exception.
    Mr. Kanjorski. Well, their new auditor went in this last 
year, and did he find or did they find an audit difference 
there that they did not agree with, the opinion of your 
auditor?
    Mr. Howard. Mr. Kanjorski, let me add one additional fact, 
and that is, after 1998 we worked to develop a specific method 
that limited the amount of the catch-up adjustment that we 
could allow not be recorded in a given year.
    Once we put in place that procedure, which was the end of 
the year 2000, KPMG no longer recorded any size catch-up 
adjustment as an audit difference, provided it remained within 
the range that was set by our policy.
    Chairman Baker. Now, if the gentleman has one more and 
then----
    Mr. Kanjorski. Yes, I would like both of you to answer this 
question. It is a very simple question.
    Is there anything of a systemic risk problem at Fannie Mae?
    Mr. Howard. Absolutely not, in my judgment.
    Mr. Raines. No, sir. And the report doesn't indicate any, 
because all of our risk management practices are working very 
well and the company is very strong.
    Mr. Kanjorski. Thank you, Mr. Chair.
    Chairman Baker. Thank you, Mr. Kanjorski.
    Mr. Shays, you are up.
    Mr. Shays. I told your staff that I would like to listen to 
some of the questions before I begin mine.
    Chairman Baker. Mr. Royce?
    Mr. Royce. Okay, thank you, Mr. Chairman.
    In my opening statement, Mr. Howard, I said that, in my 
view, Fannie Mae has a moral obligation to conduct its 
operations to the highest standard of business practices. Do 
you agree with me on that?
    Mr. Howard. Absolutely.
    Mr. Royce. Well, the question I would like to ask is, has 
Fannie Mae acted in a way consistent with that belief? Does 
Fannie Mae have strong internal controls? Does Fannie Mae 
conservatively and consistently apply accounting rules?
    Mr. Howard. I believe we do conservatively and consistently 
apply accounting rules. We exercise judgment in applying them 
to practical business situations, as is consistent with good 
accounting practice.
    As far as the moral tone, I believe that we have an 
entirely honorable, decent staff, full of integrity, who have 
had a very difficult time in the past two weeks, seeing 
themselves characterized in a very unfavorable way.
    Mr. Royce. I understand that. But there was an audit 
difference with your outside auditor----
    Mr. Howard. An audit difference is simply a notation. It is 
not a direction for us to change the way we account for the 
transaction in question. That is a fact.
    Mr. Royce. Well, the question I have there is, when OFHEO 
began the process of going back through the books--and in my 
view, OFHEO obviously has not been a very effective regulator. 
If they were exercising proper oversight, this issue would have 
surfaced in a timely matter and we would not be dealing with it 
now.
    Mr. Howard. I am sorry, which issue?
    Mr. Royce. The FAS 133 issue.
    The other question I wanted to ask you was along the lines 
of what I asked Director Falcon. To follow up on that question, 
how does Fannie Mae's application of FAS 133 compare to other 
major financial institutions? Did you apply the standard the 
same way?
    Mr. Howard. Well, Congressman Royce, I believe we made one 
major step that is different from most institutions. And that 
is that we realized that in order to faithfully implement FAS 
133 in a fashion that did not make our income statements harder 
for investors to interpret and while still permitting us to use 
the hedging techniques that enable us to manage our interest 
rate and other risks, we needed to develop a supplemental 
earnings measure that adjusted for the effects of FAS 133.
    FAS 133 adds an element of fair value accounting to what 
otherwise is a historical cost-income statement. And mixing 
those two concepts makes an income statement unintelligible to 
investors. We did not want that. We did not want to stop 
hedging. And we did not intend to undertake sham transactions 
to smooth out the effects of FAS 133.
    So we developed a supplemental earnings measure called core 
business earnings that we publish to this day. I do not know of 
another institution that has followed that lead.
    Mr. Royce. Okay. I thank you, Mr. Howard.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Frank?
    Mr. Frank. Thank you, Mr. Chairman.
    First, I have to say to Mr. Raines and Mr. Howard, if it 
was--and I take the chairman at his word; I do not believe you 
would have done anything illegal--but if there had been any 
questions, there shouldn't have been. I think it is perfectly 
appropriate for this to be public.
    I am a strong supporter of Fannie Mae and Freddie Mac, but 
you are not simply another private corporation. There is a lot 
of government involvement. I think this is entirely 
appropriate.
    And, Mr. Chairman, I would have maybe given it to them in 
advance.
    And I did have one question. There is either a mistake 
here, or there are either two people in managed capital or 
there is one person in managed capital who is getting twice.
    [Laughter.]
    But other than that, I think, yes, it is entirely 
appropriate.
    And let me add to this. This is not directly relevant, 
but--and here I would say that this is a problem with regard to 
American corporations in general.
    You gentlemen work very hard and you do good work, but I do 
not understand why in the world you need bonuses. At the level 
of compensation you get, we ought to be able to count on you to 
do your very best without any kind of incentive. And I would 
hope you would set a good example.
    If your salary is too low, raise your salary. But I think 
incentive bonuses, particularly if they are connected to stock 
options--and there is no evidence of it happening here, with 
regard to stock options--but with stock options, top executives 
are given a perverse incentive.
    If either one of you runs into a building that is on fire 
and rescues a baby, get a bonus. But doing your job, not at all 
level--my level, your level--I think that is a mistake. And to 
the extent that they are performance-related, we leave 
ourselves open.
    If you want to comment on that at the end, you can do that, 
but I would just ask some questions now, because, to the extent 
that there was smoothing out that might have been affected by 
this--well, let me ask, because that is the major question.
    Was the fact that bonuses were somehow dependent on certain 
earnings a factor in the treatment of earnings? And if you did 
not mean it consciously, might it have affected you, do you 
think? Mr. Howard?
    Mr. Howard. If you are referring to the incident reported 
in the OFHEO report for 1998, as Mr. Raines mentioned, we have 
been looking into that. And so far we have determined that the 
amount that was determined to be accurately recorded in 1998 
was determined as a result of a process that was run in----
    Mr. Frank. I am going to your motives. You both deny that 
trying to hit a certain amount so you could get your bonuses 
was a factor to any extent in your decisions? I think it is 
important to just ask you that question.
    Mr. Howard. Yes, in coming up with that number, yes, we do 
not----
    Mr. Raines. We both deny that.
    Mr. Frank. You both deny that?
    Mr. Howard. Yes.
    Mr. Frank. Okay, I think it is important to get that.
    Next question is, in your reading of these--and I will 
repeat what I said previously, that accounting for derivatives 
does seem to me--and I know Mr. Falcon said, ``Well, it is very 
clear-cut,'' but as Mr. Watt asked Mr. Falcon and his two chief 
aides a fairly straightforward set of questions, it got less 
and less clear to me and it did not appear to them to be as 
clear-cut.
    And I will say, my sense is accounting for derivatives 
ranges somewhere between alchemy and astrology. You are accused 
of being on the alchemy end.
    And that as they have gone over it with you, have they 
pointed out--and Mr. Falcon said no, but is there any decision, 
first of all, whether you are considered by them to be guilty 
on the whole now of under-reporting, of over-reporting? Do you 
know whether they think you over-reported or under-reported?
    Mr. Howard. I do not.
    Mr. Raines. No, we can't tell from reading the report.
    Mr. Frank. So they have not even concluded whether you 
over-reported or under-reported.
    I did notice the Merrill Lynch report said, given this 
category, that it was a situation of the sort where when 
interest rates rose, there would probably be gains, and when 
interest rates dropped, there would probably be losses.
    Mr. Howard, is that accurate?
    Mr. Howard. Well, there is a certain type of derivative 
that we use, which, when interest rates fall, it declines in 
value and, when interest rates rise, it rises in value.
    Mr. Frank. What percentage of the contested derivatives are 
in that category, do you know?
    Mr. Howard. To be honest, Mr. Frank, I am not sure which 
derivative transactions----
    Mr. Frank. Okay. To the extent that they are there, 
obviously we would expect there to be an increased rather than 
a decrease in the near term.
    Mr. Howard. If interest rates rise.
    Mr. Frank. So, now, when you agreed with them to increase 
your capital by 30 percent--I am going to ask you what your 
sense was. Mr. Falcon has acknowledged that since they had not 
come to any conclusion as to whether you had under-reported or 
over-reported, the 30 percent was certainly not based on any 
estimate of to what extent your capital might have been 
impaired.
    In other words, there were no numbers there. It was simply 
that in the statute there is a 30 percent figure that is there, 
really, for somewhat other purposes, not for dealing with 
accounting for derivatives. And he borrowed it because it had 
some reality.
    Did you get any indication why 30 percent was chosen other 
than that?
    Mr. Raines. To be clear, the agreement was negotiated by 
our board.
    Mr. Frank. Oh, okay. So we have to ask Ms. Korologos.
    Mr. Raines. And my understanding is this is the number that 
the director wanted.
    Mr. Frank. And as he said, it is not based on any--we have 
to be very clear. The 30 percent was not based on any analysis 
of inadequacy of capital. It was not based on any conclusion 
that the capital had been impaired.
    Again, to the extent that there was inappropriate smoothing 
out, that is wrong, and it is being looked into. It should be 
corrected. But worst case, it does not seem to me that anything 
has been suggested that jeopardizes your going forward as a 
corporation.
    Mr. Falcon disappointed me, as I told him, when he 
acknowledged to Mr. Watt and others, to me, that there was no 
threat to solvency, no remote threat to solvency that he talked 
about, but said somehow safety and soundness was implicated.
    In their conversations with you, has anything been adduced 
to suggest that you are going to have to curtail, to some 
extent, your activities or that the investors are somehow at 
risk? Mr. Howard or Mr. Raines?
    Mr. Howard. Not in conversation with me directly.
    Mr. Raines. No, sir. There have been no conversations that 
we were at risk, other than what is included in their report.
    There is the issue of how we get to the 30 percent 
additional capital. And there obviously are some people who 
would prefer that we reduce what we do in the market----
    Mr. Frank. Right. And that is my next question, which is, 
you know, HUD--and I will finish in just----
    Chairman Baker. I just want to keep regular order, as you 
suggested.
    Mr. Frank. I understand. I am just trying to keep up with 
you, Mr. Baker. You are my role model.
    Chairman Baker. Start earlier.
    Mr. Frank. Thank you.
    We had HUD last year not exercise its right to increase 
your goals. As you know, HUD had the right, a year before, to--
last year they could have promulgated an increase in your 
affordable housing goals that would have taken effect this 
year. They didn't do it. It was an oversight, according to the 
secretary; they forgot to do it.
    Now they are talking about increasing. And I certainly want 
to see an increase in the amount of affordable housing. But 
obviously if your overall activity shrinks, we are in trouble 
because, if I am correct, your affordable housing goals are not 
absolute but they are percentages of your overall activity.
    So the question is, what will the effect of the 30 percent 
additional capital be on your reaching an absolute amount, in 
terms of affordable housing?
    Mr. Raines. The answer is, we don't know yet. We have a 45-
day period to come up with a capital plan, under the agreement, 
which we will do.
    We don't have a lot of choices. As you know very well, you 
either can reduce the size of your activities or you can 
increase the amount of capital that you have. If we have to 
reduce the size of our activities, then the percentage made up 
of the affordable housing goals will go down because we will be 
doing less business.
    Mr. Frank. So that arbitrary 30 percent might result in a 
diminution in your affordable housing activity?
    Mr. Raines. Well, if the capital plan requires us to reduce 
our activities, yes, it would reduce the impact of the goals as 
a result of our having made those choices.
    Mr. Frank. Thank you, Mr. Chairman.
    Chairman Baker. Thank you, sir.
    Mr. Shays, did you want to go now?
    Mr. Shays. No.
    Chairman Baker. Mr. Ney?
    Mr. Ney. Thank you, Mr. Chairman.
    One of the issues I wanted to ask about is something I was 
asking OFHEO today. It is on the generally accepted accounting 
practices.
    At the point in time, when they came in and said that there 
was a willful violation of the accepted accounting practices, I 
asked if in fact OFHEO had talked to the Fannie auditors and 
whether Deloitte & Touche, in fact, had talked to your auditors 
at that time, to see why those auditors recommended to you to 
use certain accounting practices.
    And I just wondered if you had any comment on that, about 
should Deloitte & Touche sit down prior to this report, is what 
I guess I am getting at. And that was the plan made with OFHEO.
    Mr. Raines. Well, I believe that they should have sat down 
with the auditors and asked them what was their view on these 
issues, because our auditors have obviously been looking at 
these issues for many years and they have an opinion on public 
record as to how they have come out on that question.
    So I believe that they should have sat down with them 
before coming to the conclusions that they have come to, 
because obviously KPMG has come to a different conclusion than 
OFHEO has.
    I don't know what the positions of Deloitte & Touche are. 
The report doesn't tell us, and I think the director testified 
that the findings in the report were OFHEO's. So I can't 
comment on what the positions of Deloitte & Touche are on these 
issues. We know what KPMG's positions are on the issues.
    Mr. Ney. I will speak for what OFHEO said today. If I 
recall correctly, OFHEO said that Deloitte & Touche concurred 
with OFHEO.
    And my follow-up question was, did Deloitte & Touche at any 
point in time communicate with your auditors to see why? And I 
wondered if, at any point in time, if Deloitte & Touche 
concurred, had they at any point in time had any contact or 
working papers of your auditors?
    Mr. Raines. Not to my knowledge.
    Mr. Howard. Nor to mine.
    Mr. Raines. Not to my knowledge that there has been any 
contact either by OFHEO or by Deloitte & Touche with KPMG to 
explore these issues.
    Mr. Ney. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Who is next?
    Mr. Scott?
    Mr. Scott. Thank you, Mr. Chairman.
    Mr. Raines and Mr. Howard, your accuser, OFHEO, has spent 
the better part of four hours this morning making some 
extraordinary accusations. And I want to make sure that you 
have ample opportunity to refute those accusations, a fair 
amount of which is this: that essentially you all cooked your 
books so that you could meet certain earnings targets so that 
you could get bonuses.
    And the chairman has passed down this sheet, and one look 
at this sheet puts, in my estimation, some very strong, strong 
incentives.
    I think we owe you the opportunity to make sure that you 
have the opportunity to refute that charge first.
    And I know, Mr. Chairman, I have 5 minutes, if you will 
allow me to get that question out, then I have two more 
questions on the line of politics and process, but I want you 
to answer that charge because I think that is at the center of 
this hearing this morning.
    Mr. Raines. Well, thank you for that opportunity.
    This is a very serious allegation, and I deny that 
occurred.
    We have looked for the facts. There were no facts in the 
OFHEO report. None. Other than their calculation that said, 
``Oh, there seems to be if we subtract one number from another 
you get this result.''
    But we looked into the facts of what happened back 6 years 
ago, and we found no facts that would support the allegation 
that was included in the report.
    Mr. Scott. Why, then, would OFHEO, in your opinion, make 
that charge?
    Mr. Raines. Well, Congressman, I do not know. This entire 
examination has been unusual. It has been the most unusual 
regulatory endeavor I have seen in the 30-some-odd years I have 
been in this city.
    And I have never seen the case where a regulatory agency 
brought serious allegations against a company without asking 
the company for a response in advance.
    So I do not know. This has been something that is 
inexplicable to me as to why they would follow this path. And I 
do not believe there has been an adequate explanation of why 
they followed this to this moment.
    Mr. Scott. I asked your accuser this morning: When did they 
make this report public and when they did inform you of the 
report?
    I would like to have your interpretation of those chain of 
events.
    Were you made aware and briefed on this report by your 
oversight accuser prior to them making it public?
    Mr. Raines. Let me walk you through the entire sequence 
very quickly.
    We began reading newspaper accounts that OFHEO was about to 
finish a report. I personally called the director to talk to 
him about him, to set up a meeting to talk about it.
    I was unable to have a conversation with him about it or to 
have a meeting with him about it.
    On Friday, at about 4 o'clock Eastern Time, members of our 
board were called and told that the director wanted them to 
assemble on Monday, to meet with OFHEO officials to hear about 
the report.
    On Monday, four OFHEO officials came to Fannie Mae to brief 
our outside directors, and at that same time they handed to 
management a copy of the report.
    They then proceeded to brief the board on Monday.
    But as you know, much of the information about the report 
was not only in the political press, but also was in the 
financial press prior to that Monday.
    Mr. Scott. Let me ask you: When did the board make the 
decision to link, and they did actually make the decision to 
link executive pay bonuses to earnings per share?
    Mr. Raines. Fannie Mae has linked bonuses to earnings per 
share for as long as I have been around the company. That goes 
back to 1991. Tim Howard has been there longer than I have.
    Mr. Howard. I cannot recall a year in which they were not 
linked.
    Mr. Raines. And indeed, virtually every company of which I 
am aware links some part of their compensation to earnings per 
share. So this is not an unusual thing; this is one of the most 
common aspects of corporate----
    Mr. Scott. Well, the point I wanted to get on the record 
was: The linkage was made prior to you being chief executive 
officer.
    Mr. Raines. Absolutely, prior to my even being at the 
company.
    Mr. Scott. So this was not done on your watch. It was done 
and it has been normal procedure to link----
    Mr. Raines. Yes, sir.
    Mr. Scott. Now, Mr. Howard, one point: You are the vice 
chairman of the board----
    Mr. Howard. Yes.
    Mr. Scott.--you are the chief financial officer----
    Mr. Howard. Correct.
    Mr. Scott.----you are the supervisory person over internal 
audit.
    Mr. Howard. That is not correct. The internal auditor 
reports directly to the chairman of our audit committee. He has 
what is called a dotted-line relationship to me, which means I 
am his internal point of contact in the company.
    Mr. Scott. Do you not approve his salary?
    Mr. Howard. I do not. I make a recommendation on his salary 
to our senior management group, and his salary is determined 
collectively in consultation with the chairman of the audit 
committee.
    Mr. Scott. But you do set the targets, financial targets, 
for the year, you said.
    Mr. Howard. The financial targets are set collectively by 
the senior management team.
    Mr. Scott. But you do have the authority to meet those 
targets.
    Mr. Howard. No, I do not.
    Mr. Scott. Oh, you do not. That is good to know, because 
there have been some reports that you did.
    Mr. Howard. There have been lots of things that have been 
said incorrectly.
    Mr. Scott. That is why I want to make sure that you have 
ample opportunity to refute. This is a very serious hearing.
    I think the future, the jeopardy of Fannie Mae is at stake. 
And I want to make sure we give you ample opportunity to answer 
every one of these charges.
    Mr. Howard. If I may take advantage of that opportunity and 
just be very clear in what we are saying, there is no linkage, 
to my knowledge, of compensation to the determination of what 
the catch-up charge would be in 1998.
    We found no evidence of a linkage of that to compensation 
decisions for 1998.
    Mr. Scott. Thank you.
    I yield back the balance of my time, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman.
    Mr. Raines, welcome back.
    I am sorry if I am plodding over old ground, but I just got 
back in the committee room.
    Mr. Raines, I wanted to ask you in regard to the Freddie 
Mac issue: You stated that Freddie Mac to make its GAAP 
earnings less while Fannie Mae--this is your quote--reported 
and explained the volatility. The OFHEO report finds that 
Fannie Mae misapplied GAAP, due to among other things, 
managements desire to portray Fannie Mae as a consistent 
generator of stable and growing earnings.
    I guess the question occurs: What is the difference, in 
your case, between Freddie and Fannie in that regard?
    Mr. Raines. Mr. Chairman, they tried to get me with no 
chart. I had to have one. And this simply illustrates the major 
point.
    That is our reported earnings. That is what we are accused 
of having made stable.
    And if this was what we are trying to make stable, we did a 
very bad job of trying to stabilize our reported earnings.
    And that is really the big difference between what Freddie 
Mac admitted they did and what we are accused of.
    Freddie Mac was accused of trying to straighten out that 
orange line, and that they entered into transactions to 
straighten out the orange line. That is the GAAP earnings line.
    And then they said, yes, that is what they did.
    And what we did instead was, we have two ways of reporting 
the earnings. We simply report the volatility in GAAP, and we 
say,''Here's another way to calculate it in core. You the 
investor now have both ways to calculate it.''
    So I am not exactly sure what is meant by the accusation 
that we were smoothing earnings, because FAS 133 is not even 
included in core--the impact on net income is not even included 
in core business earnings.
    So that is why we have a little difficulty understanding 
what the accusation is.
    But the difference between us and Freddie Mac is that OFHEO 
is saying we have misapplied accounting standards. They link us 
smoothing; we do not understand what that means.
    Freddie Mac said they were trying to smooth.
    Mr. Howard. Mr. Chairman, as you can see from the chart, 
even the core business earnings line is not particularly smooth 
in recent years. So whether it is GAAP, which we made no 
attempt to change with transactions that were not economic, or 
core business earnings, the allegations of transactions to 
smooth earnings, or accounting manipulations to smooth earnings 
does not appear to be substantiated by the actual earnings 
results.
    Mr. Oxley. Let me also ask both of you: On your Web site, 
you claim that the hedge accounting treatment for each 
individual transaction is determined and documented in writing 
before you enter into that transaction.
    And furthermore, you say it cannot subsequently be changed.
    The OHFEO report disagrees with that assessment, citing 
instances where there was no contemporaneous hedge 
documentation as well as instances where staff created hedge 
designations retroactively.
    Do you disagree with those allegations?
    And does FAS 133 not require full documentation for 
transactions----
    Mr. Howard. First of all, Chairman, there are two separate 
issues, which I will address separately.
    The first set of documentation that you were referring to 
was documentation of hedge transaction types.
    Before we can enter into any given hedge transaction type, 
we have a hedge policy developed that is worked out by our 
accounting policy group, that is within our controller's 
department, but independent of other groups.
    So all they do is accounting policy. And that accounting 
policy is reviewed with the outside auditors.
    So before we do a single individual transaction, we have an 
agreed-upon derivatives or hedging policy.
    Now, where the difference of viewpoint in the OFHEO report 
arises is over agreement on whether individual transactions 
were documented sufficiently. We believe they were and 
therefore qualify for hedge accounting.
    OFHEO, in certain instances, contends they were not and 
therefore these transactions may not qualify for hedge 
accounting.
    Mr. Oxley. Does the report cite specifics? And if so, are 
there disagreements on the specifics? Or is this a 
generalization?
    Mr. Howard. The report cites specifics. I am not intimately 
familiar with those specifics since I do not deal with them at 
that level.
    Mr. Oxley. Mr. Raines, do you have any comments?
    Mr. Raines. Again, I do not know about the individual 
specifics in the report, but their general position is that our 
way of documenting, with the combination of contemporaneous 
paper documentation plus automated systems, they believe does 
not meet their test.
    We believe it does meet the test of GAAP.
    Mr. Oxley. And finally, in my opening statement I talked 
quite a bit about the application of the Sarbanes-Oxley Act in 
this particular case.
    You of course are a publicly traded company and are subject 
to the requirements of the act as well as regulations therein.
    Is there anything in your estimation to give any indication 
that any of the provisions of the act or the subsequent 
regulations had been violated or ignored?
    Mr. Raines. No, sir, I do not know of any. In fact, I think 
the act has been very helpful to us, because one of the reasons 
that we have documentation on a lot of these things is because 
we are going through the process as required by the Sarbanes-
Oxley Act. That is why we have, as I described in my written 
testimony, this entire process around certification so that we 
know exactly at the highest levels of the company what 
decisions were being made and by whom.
    And also I can tell you, as a result of the Sarbanes-Oxley, 
I have made a campaign in our company to go around and tell 
people, ``If you think there is something wrong, raise your 
hand. Raise your hand, and it will be looked at that.''
    That has been our policy and that continues to be our 
policy, and I have to say, the direct growth from the reforms 
that were brought in by Sarbanes-Oxley.
    Mr. Oxley. Thank you.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the chairman.
    Mr. Clay?
    Mr. Clay. Thank you, Mr. Chairman.
    And thank you, Mr. Raines and Mr. Howard for being here.
    Mr. Raines, in May of this year, Dow Jones International 
News reported that Senator Kit Bond, Republican from Missouri, 
was so critical of OFHEO's leaks to The Wall Street Journal 
that he asked HUD's inspector general to examine OFHEO's 
practice of handling confidential information with the media.
    This morning I asked Mr. Falcon a question such as: Why did 
the examiners not discuss preliminary concerns of possible 
findings with Fannie Mae? Why was Fannie Mae not provided a 
draft report? And why did Fannie Mae not have the opportunity 
to respond to findings?
    I question why the process for handling these findings was 
altered and done differently for Fannie Mae. I find this to be 
inconsistent and a rush to judgment.
    In informal conversations with the executives from Wall 
Street and individual large brokerage houses, I get the feeling 
that the markets are not worried about the safety and soundness 
of Fannie Mae, as OFHEO says that it is. But of course, the 
markets are not political. I do not see due process being 
carried out with respect to Fannie Mae.
    Do you have an opinion on this, Mr. Raines?
    Mr. Raines. Well, Mr. Clay, as I testified, you know, we 
are a regulated company. We recognize we are a regulated 
company, do everything we can to work cooperatively with our 
regulator. And we will continue to do that regardless of what 
has happened with regard to this special examination. They have 
a job to do and we have a job to do.
    By the same token, I don't believe that because we are a 
cooperation that we are not due due process. And I think we 
have a long tradition in this country of providing due process 
even to people who have done the most heinous things. They have 
been accorded due process. And that is all we have really asked 
for thus far is give us the opportunity to state our case and 
let us take these issues to someone who can resolve them.
    Now there have been many issues like this resolved by other 
regulators, banking regulators, without newspaper headlines. 
The issues that relate to FAS 91 and 133 we can discuss 
forever, but the SEC is going to decide.
    And in my view, there is no reason the issues couldn't have 
just been taken directly to the SEC before any examination was 
completed and just ask them what is the answer. Then we 
wouldn't be having a debate here about, you know, whether or 
not the regulations embodied in this book are simple.
    A regulation that has 172 interpretations that have come 
out since it was--we wouldn't be having that debate if we had 
done the simple step of going to the SEC, in which we would 
have joined in and said what is the answer? And then we would 
all know what to do going forward.
    Mr. Clay. I know that Fannie Mae has agreed to the increase 
in capital and how much in dollars is that increase?
    Mr. Raines. We don't have an exact estimate, but if you 
look back at the most recent periods it would require something 
in excess of $3 billion.
    Mr. Clay. Okay. I commend the company for this and for 
agreeing to other changes that will make for better 
transparency. Nevertheless, how would this almost $3 billion 
have been used were it not required for capital? I mean will 
the housing mission be affected adversely by this increase? And 
will it help the housing mission?
    Mr. Raines. Congressman, the honest answer is I don't know 
yet. We have 45 days to come up with a capital plan, but we 
don't have a lot of choices. And it could require us to reduce 
our activities because we have only 270 days to come up with 
the $3 billion. And that is just one of the issues we are going 
to have to struggle through.
    So, it is possible it could require us to reduce our market 
activities to achieve the goal.
    Mr. Clay. I thank you for your response.
    Mr. Chairman, that is all for me. I yield back the balance.
    Chairman Baker. I thank the gentleman.
    Ms. Kelly?
    Ms. Kelly. Thank you, Mr. Chairman.
    I have very little time, Mr. Raines. And I would appreciate 
it if you could answer my questions within a yes, no format. I 
really appreciate the presence of both of you before the 
committee today.
    Mr. Raines, which member of the executive management team 
is responsible for risk management, accounting, on-balance 
sheet mortgage portfolio, business planning, tax, investor 
relations and internal audit? Do you have one member who----
    Mr. Raines. There is no one responsible for all those 
things unless you are thinking of me. But there is no one 
person responsible for all those things.
    Ms. Kelly. Well in the OFHEO interview with Tim Howard he 
said he had those portfolios.
    Are you aware that, as the director of financial 
accounting, Jeff Guliana has responsibility for modeling 
critical accounting estimates, as well as reporting and 
accounting for model results? Just give me a yes or a no 
please.
    Mr. Raines. I think the answer is yes.
    Ms. Kelly. Thank you.
    Are you also aware that a senior vice president for 
financial reporting and planning, Mrs. Janet Pennewell, is 
responsible for reporting net income, as well as forecasting 
what net income will be? I just need a yes or a no, sir, 
please.
    Mr. Raines. Ms. Kelly, sometimes when you phrase it in a 
way that is not exactly right giving you a yes or a no may be 
misleading to you. So----
    Ms. Kelly. Well, that is in the OFHEO report in that way. 
So, I just----
    Mr. Raines. That may well be----
    Ms. Kelly. Is that true? I mean does this woman have--does 
she report net income, as well as forecast what the net income 
will be? That is what I read in this report.
    Mr. Raines. If you put it that way, no.
    Ms. Kelly. Okay.
    Mr. Raines. But, I was trying to be helpful, but if you put 
it that way, the answer is no.
    Ms. Kelly. I am sorry. I have a bill on the floor and I 
have to get back over and I have to get through this because I 
really need answers to my questions.
    Are you aware that a senior vice President for the 
operations risk, Sam Rajappa, was, and is still, apparently 
responsible for auditing his prior work as controller? Just a 
yes or a no, please, sir.
    Mr. Raines. No, he is not responsible for auditing his 
prior work as controller.
    Ms. Kelly. Okay. That is, again, that was in his interview, 
that is apparently what he said he was doing in the OFHEO 
report. Mr. Rajappa says he was employed as Fannie Mae 
controller from 1994 to the end of 1998, which was the time 
period where earnings manipulations to trigger executive 
bonuses is alleged.
    Were you aware that that arrangement was a clear 
contradiction of the IAA standards relative to the auditor 
independence? Did he assume that he was doing this and he 
wasn't?
    Mr. Howard. I can actually help there. Mr. Rajappa was 
moved in as head of operations risk but the auditor at the time 
was a man named Jack Wassen. Mr. Wassen was the company's 
auditor. Mr. Wassen reported to Mr. Rajappa. So there was no 
violation of that standard at the time.
    Ms. Kelly. Thank you.
    Mr. Howard. You are welcome.
    Ms. Kelly. According to, again, the OFHEO report, Mr. 
Rajappa reports to you, Mr. Howard, is that true?
    Mr. Howard. I have been chief financial officer for 14 
years. For the first----
    Ms. Kelly. Sir, I just need a yes or no answer.
    Mr. Howard. No.
    Ms. Kelly. He is not now or has he ever?
    Mr. Howard. No, he reports to the chairman of the audit 
committee. He does not report to me.
    Ms. Kelly. Okay. What about the members of the executive 
committee? Do you meet, and according to what the OFHEO 
interview shows, the executive team met to cooperatively set 
salary and bonus for Mr. Rajappa, as well as Mr. Rajappa being 
available to audit the executive team. That is what is in the 
report. I just need to know from either one of you a yes or a 
no.
    Mr. Raines. This is very hard to give yes or no answers 
to----
    Ms. Kelly. I understand that, sir----
    Mr. Raines. But----
    Ms. Kelly.----but I have a very limited time.
    Mr. Raines. I understand, but the implication of my giving 
you an answer that is incorrect is so great that I refuse to 
take the risk without telling you what the real answer is.
    The answer is that the compensation for everybody in the 
company, including mine, is in part determined by our executive 
team. We have in process where lots of people are involved in 
setting the compensation. So, the answer is yes, but that is 
not an unusual thing.
    Ms. Kelly. Okay.
    Mr. Raines, as the CEO of a major company this committee 
and I believe the American people, investors, taxpayers and 
homebuyers, expect you both to know about these operations and 
to be so intricately involved in the decisions and processes of 
the company that questions like mine could be able to be 
answered with a quick yes or no. There needs to be bright lines 
for who is reporting to whom and who is doing what.
    When I read this OFHEO report I did not see bright lines. 
If there are bright lines, sir, I would hope that perhaps you 
could get us a construct of exactly what they are. If they do 
not agree with OFHEO so be it. But it would be important for us 
to know how you have Fannie Mae structured because I believe 
quality and transparency is what the American people deserve.
    Thank you. I yield back the balance of my time.
    Chairman Baker. I thank the gentlelady.
    Mr. Baca?
    Mr. Lynch?
    Mr. Lynch. Thank you, Mr. Chairman.
    Well, I don't have a bill on the floor and I have plenty of 
time. So, if either of you gentlemen would like to expand on 
the previous yes/no answers in any respect, feel free to do so 
right now. As someone who has grown up in public housing, I 
have a real investment in Fannie Mae's mission. And I see the 
good work that you do.
    Let me just--you know, the previous speaker mentioned that 
she saw no bright lines in this OFHEO report. This is 200 
pages. I just want to ask you again, just to be sure in my own 
mind, did OFHEO sit down with you and interview you, Mr. Raines 
or Mr. Howard in preparation of this, this examination of your 
corporation, of Fannie Mae?
    Mr. Raines. They did not interview me.
    Mr. Howard. They did interview me on two occasions; one to 
discuss impairments on certain types of securities, and one was 
a more general interview.
    Mr. Lynch. Okay. And what about sitting down with your 
auditors, did they sit down with your auditors about this 
report?
    Mr. Howard. Not to my knowledge.
    Mr. Raines. I do not believe that they have interviewed our 
auditors. But to be clear on your question, since they have 
done the--finished the report, they have not talked to us 
either about the content of the report.
    Mr. Lynch. Well it is not surprising then that there would 
be no bright lines in this and that some of these accounting 
rules are fairly complex and one would certainly understand how 
there might be differences of interpretations as you have 
pointed out.
    In your own minds as the CFO and CEO, is this a usual 
relationship with a regulator that they would go around you and 
not sit down extensively with you to try to bring you into 
compliance with a GAAP that they thought you were in 
noncompliance with?
    Mr. Howard. For me it is an unusual relationship.
    Mr. Raines. Congressman, I would agree that it is an 
unusual relationship. I did note in Director Falcon's testimony 
that he gave a reason why he felt the necessity to go around 
senior management he said was the lack of cooperation by senior 
management. And if I could address that issue, I would----
    Mr. Lynch. I would like you to.
    Mr. Raines.----be delighted.
    We had our first meeting with OFHEO with regard to this 
special examination on January 7. Since that date we produced 
427,466 pages of documents, in 67 different document 
productions and 14 different requests, answering 425 questions. 
We also provided 966,367 pages of e-mail and e-mail 
attachments.
    We have even provided on three different occasions, our own 
consultant to go to OFHEO to help OFHEO with their technology 
in managing their searching of our e-mails. We had 100 people 
working for 4 days to respond to just one of their e-mail 
requests.
    We have made Fannie Mae people available 47 times to be 
interviewed as part of this process. Now we provided to them 
the working papers of KPMG and quite a bit of other 
information.
    I met with Director Falcon and told him, or informed him 
that if there were any problem with Fannie Mae's cooperation in 
this examination call me directly. And I have received no such 
call. Now, the most inflammatory statement I guess is the one 
that says that the--that our cooperation was so bad that it 
required subpoenas to be issued and then subsequently the 
Justice Department was called upon to perhaps enforce those 
subpoenas.
    First, with regard to the issuance of subpoenas, my 
attorneys were told by OFHEO staff that the issuance of 
subpoenas was not related to a lack of cooperation but that 
they were doing this simply to get people on the record.
    Secondly, with regard to the Justice Department, both in-
house and outside counsel for Fannie Mae spoke to the Justice 
Department about OFHEO's referral to it regarding enforcement 
of one subpoena relating to e-mail and the Justice Department 
indicated that this was an issue that they expected to be 
worked out between OFHEO and Fannie Mae without any involvement 
of the Department or the courts.
    So, with regard to our cooperation, I think it has been 
overwhelming. The subpoenas, as we were told, had nothing to do 
with lack of cooperation. And the Justice Department has 
indicated that they believe that this was an issue that could 
and should be resolved between OFHEO and Fannie Mae and it was 
resolved. All of the material requested by OFHEO has been 
provided to them.
    Mr. Lynch. Thank you. And thank you for clearing that up. 
Is there anything else you would want to add in terms of not a 
one-word answer, yes or no, but anything else that you feel 
that you need to clarify?
    Mr. Raines. There is one other point I would like to make, 
and it is an issue I think bears a broader discussion and that 
is the notion that in corporations there should be silos and 
that people should have one function, another function, and 
another function and they should never have any of these 
brought together. In fact, the practice of corporations is to 
bring together these things at a high level.
    Mr. Howard is a vice chairman of Fannie Mae. He is one of 
the three most senior executives. So, of course he has many 
people who report to him. Otherwise, everyone would have to 
report to me and that wouldn't be a very functional 
organization.
    So it is not unusual to have these reporting relationships. 
Indeed, there are many surveys that show that people bearing 
the CFO title quite often have risk management reporting to 
them, quite often have the balance sheet, the management 
reporting to them, quite often have internal audit reporting to 
them.
    So, although it was characterized as being unusual, it is 
actually usual, and, in his role as the vice chairman, his 
duties are far beyond simply being the CFO, and it is quite 
appropriate that he have a large part of the company reporting 
to him.
    Mr. Lynch. Okay. Thank you, gentleman.
    Thank you, Mr. Chairman.
    Chairman Baker. Mr. Toomey?
    Mr. Toomey. Thank you, Mr. Chairman.
    I would like to get to the specifics of one of the 
allegations with regards to FAS 91 in particular. As we all 
understand, FAS 91 deals with the methodology by which a firm 
is required to amortize premiums and discounts. In the case in 
question, I believe specifically the situation arises in which 
these premiums and discounts have to be amortized over 
securities that have prepayment features.
    There are requirements under FAS 91, as I understand it, 
that you do the calculation, you then amortize a very precise 
amount quarterly over an assumed future remaining life of a 
given security, and then, when the next quarter comes around, 
you need to reanalyze this.
    Interest rates very often will, in fact, be somewhat 
different than they were projected to be or assumed to be in 
the modeling in the previous quarter, and you then redo the 
amortization essentially.
    You do this prospectively, but you also do it historically, 
so to speak, with an adjustment to the current quarter, which 
is intended to capture the cumulative historical difference 
between what was estimated in the past and what reality has 
shown.
    My concern and my understanding and the testimony of OFHEO 
is that FAS 91 requires that you come up with a precise number 
and that number be entered in that given quarter, and my 
concern is that you developed a policy whereby you did not use 
that number. You created a considerable discretion, in fact, 
over what number you would use within a range.
    I would like for you to explain to me where it is in FAS 91 
that you are authorized to not use the number that the model 
comes up with and confirm, if you will, that it is, in fact, 
that methodology about which KPMG said they have an audit 
difference with Fannie Mae.
    Mr. Howard. Mr. Toomey, I would be happy to address that.
    In estimating the rate at which we amortize premiums and 
discounts, one has to make a number of assumptions on----
    Mr. Toomey. Understood.
    Mr. Howard.----interest rates and prepayment sensitivities. 
By making assumptions that are reasonable but different, one 
can come up with different sets of very precise numbers, and I 
understand you have to choose one, and we do that.
    So, when interest rates change, we will by practice reflect 
that new estimate in the rate at which we amortize purchases at 
the premium going forward because those adjustments take place 
over time.
    Where we have used in the past a range or a threshold to 
determine at what point we have sufficient certainty around the 
estimates that we are making between the numbers that we 
recorded historically and the numbers a new set of assumptions 
would indicate we should have recorded historically, we have, 
as a matter of policy, since FAS 91 was first implemented, had 
some latitude around zero, typically plus or minus $100 
million, but more than that.
    Mr. Toomey. My point is, does FAS 91 authorize that?
    Mr. Howard. According to our accounting policy team and 
KPMG, it does. KPMG----
    Mr. Toomey. Then why does KPMG have a difference on that 
issue?
    Mr. Howard. KPMG had a difference prior to 1998 because we 
did not have a defined policy in place that governed how much 
latitude we could have--let me finish, please--before we made 
an automatic adjustment.
    Once we put that policy in place and limited the amount or 
the size of that range, KPMG removed its audit difference, 
therefore confirming our view that the treatment of this 
estimate retroactively--not prospectively, but retroactively--
was, indeed, consistent with GAAP, and this is something that 
the SEC will look at, and they will give us their view.
    Mr. Toomey. Yes. Oh, they will. But you have not cited 
anything in FAS 91 that says you are allowed to use a number 
other than what your model comes up with.
    The other thing that raises concern about this is the 
exchange in memos between yourself and others seems to suggest 
that there was a conscious ongoing effort to manage this 
amount. This is a large amount. $100 million on a quarterly 
report out of earnings of $1 billion or so, thereabouts, 
suggests a very substantial percentage of this.
    Mr. Howard. Congressman, let me be very clear. My intent in 
getting involved in the development of the policy was to ensure 
that the numbers we were reporting to investors was as clear 
and as meaningful as they could possibly be.
    I will give you an example of how I thought about this. For 
the five years from 1999 through last year, our net interest 
income averaged about $2 billion per quarter. Now investors are 
looking for changes in our net interest in come for evidence of 
how fast our business is growing.
    A net interest income amount of $2 billion in one quarter, 
growing at 10 percent per year annualized, will be roughly 
$2.05 billion in a quarter. If we are growing at 15 percent 
annualized, it will be $2.075 billion. So the difference 
between 15 percent growth and 10 percent growth in a single 
quarter is $25 million.
    If we adopt a policy that causes us to make these random 
adjustments based on our estimates of prepayments, collapsed 
over a number of years going back into a single quarter that 
is, say, $70 million, we have worsened the quality of our 
financial statements by adding a spurious number--this is our 
view. I am not asking you to agree with it--that is bigger than 
the discernment investors are trying to achieve in looking at 
our quarter-to-quarter financials.
    I made the judgment. Accounting does not only permit but 
also encourages practical applications and judgments in 
financial reporting. This, in my view, was a good judgment 
because it preserves the integrity and the quality of our 
published financial statements.
    Mr. Toomey. Well, I see my time has expired. I have to say 
I am very skeptical about this methodology, in particular this 
catch-up mechanism, this range, using this discretion in terms 
of how much income you show, and it is such a substantial 
portion of total income.
    Mr. Howard. It is not discretion. Let me be clear: It is 
not discretion.
    Mr. Toomey. Well, the report quotes people in your firm who 
describe it as discretion.
    Mr. Howard. For a small period of time historically, we had 
discretion. After the policy was locked in the middle of 2002, 
there has been no discretion from that point forward.
    Mr. Toomey. Well, you are directly contradicting what some 
people from your firm are saying in the OFHEO report in terms 
of the discretion that remained after the policy was adopted.
    Mr. Howard. After the policy was adopted in December 2000, 
in the middle of 2002, we eliminated any potential for 
discussion by changing the policy. So we now have an agreement 
with KPMG that we will use no additional discretion in doing 
the FAS 91 amortization post December of 2002, and that is a 
fact. OFHEO may not have picked that up.
    Mr. Toomey. So, since 2002, you have ceased and desisted 
using this methodology that you used before.
    Mr. Howard. What happens is when our catch-up adjustment is 
within the size limited by the guidelines, roughly plus or 
minus 1 percent on net interest income and 2 percent on 
guarantee fees, we do not make any adjustments at all. So that 
is not discretion.
    When it is outside that, we book to the edge of the range 
and no further. That is not discretion either.
    Mr. Toomey. And the establishment of the range, the 
methodology and the amounts of these ranges, these were all 
developed and established by you. This is not under the 
direction of FAS 91.
    Mr. Howard. Well, by the company.
    Mr. Toomey. By the company.
    Mr. Howard. Yes, that is correct. They are consistent with 
FAS 91.
    Mr. Toomey. Well, that is what we are going to find, the 
SEC's opinion on that.
    Mr. Howard. You are absolutely right.
    Mr. Toomey. Yes.
    Chairman Baker. I thank the gentleman.
    Mr. Baca?
    Mr. Baca. Thank you very much, Mr. Chairman.
    Let me ask this question of Mr. Raines or Mr. Howard, and 
either one of you can respond.
    OFHEO has been the regulator since 1992. Is that correct?
    Mr. Howard. Yes.
    Mr. Baca. That is 12 years. During this 12 years, their 
responsibility is not only to audit you. Is that correct?
    Mr. Raines. Well, they examine us. They have an annual 
examination.
    Mr. Baca. And during that examination, if they find any 
deficiencies, is it their responsibility to let you know of any 
deficiencies, methodologies or other that you are following 
that you should not be following? Is that correct?
    Mr. Raines. Yes, that would be their responsibility.
    Mr. Baca. In this particular case, did they ever come back 
and tell you in terms of standard practices or procedures or 
deficiencies that you had to talk to either one of you two with 
regard to these issues?
    Mr. Raines. Yes, not until we saw the special examination 
report.
    Mr. Baca. Isn't that a normal practice for any accounting 
firm or auditing firm, to basically sit down with the CEO or 
the chairman to discuss any deficiencies or procedures or 
process that they are not following? Is that normal standard?
    Mr. Raines. It is a standard, and we did sit down with them 
each year. In fact, their chief examiner met with our board and 
presented the results of their exam, and none of these issues 
were included in any of those exams over any of those years.
    Mr. Baca. And in any of those years, did they ever sign off 
in terms of your methodology or procedures or methods that you 
used?
    Mr. Raines. Well, you might want to talk about the FAS 133 
exam.
    Mr. Howard. Yes. From what I can recall, when we 
implemented the process for FAS 133, along with the systems, 
OFHEO did do a review of those processes and systems and said 
that it met or exceeded safety and soundness standards.
    Mr. Baca. That meant they had to have signed off, right? 
That said that you are following directions, and they did not 
come back and tell you that you needed to follow a different 
one or the methodology that you are using is now different. Is 
that correct?
    Mr. Howard. I would not know how to characterize it. They 
would have to do the characterization. I can tell you what they 
did.
    Mr. Raines. But did they do it?
    Mr. Howard. Did they?
    Mr. Raines. Did they come back and tell us to do something 
different?
    Mr. Howard. No.
    Mr. Baca. Okay. Thank you.
    This morning, the regulators allegated that Fannie Mae did 
not respond to the initial request for information and that it 
had to issue a subpoena. Can you give us your version of the 
events leading to this release of the information?
    Mr. Raines. Congressman, we have been very responsive to 
OFHEO over this period, specifically relating to subpoenas. Our 
attorneys were told that the use of subpoenas did not relate to 
a lack of cooperation, but that this was because OFHEO wanted 
to move from informal interviews to having them on the record. 
That is what we were told at the time that the first subpoenas 
were issued because we said to them, you know, ``There is no 
need for this. We will produce the people, and we will produce 
the documents.'' They said they wanted to move----
    Mr. Baca. So you were willing to be cooperative with them 
and willing----
    Mr. Raines. We were willing and we were cooperative 
providing hundreds of thousands of pages of material and almost 
a million pages of e-mail to them as the result of their 
requests.
    Mr. Baca. Did OFHEO personally contact you regarding the 
preliminary findings, either one of you?
    Mr. Raines. No.
    Mr. Howard. Not me.
    Mr. Baca. It seems odd that they would not contact you. 
Yet, you know, they have gone to the media and they have gone 
everywhere else. But yet they should have followed, practiced 
standard procedures, which is a total violation.
    Maybe we should have them on the audit out here versus you 
guys in terms of not following practice or not following the 
laws that are in place.
    Where do you think the process will go from here?
    Mr. Raines. Congressman, this process has been so unusual, 
I cannot tell you. I can tell you what we are doing.
    Our board has negotiated an agreement with OFHEO, which we 
are going to faithfully follow and put into effect within the 
timeframes as agreed to between the director and our board.
    We are also going to be cooperating with the independent 
counsel that our board has appointed to look into all of these 
allegations and to see if we can find out what the facts are, 
and so we will cooperate with them.
    We will be attempting to take the two big accounting 
issues, FAS 91 and FAS 133, directly to the SEC and ask them to 
give us resolution on those so we can see, and, if we are 
right, then we are right, and, if we are wrong, we will make 
whatever changes the SEC tells us to make, and we will also 
cooperate with any law enforcement agency that is attempting to 
look at these allegations.
    They are very serious allegations, they have to be looked 
at, and I am delighted that today, for the first time, we are 
allowed to at least partially give our point of view. But, 
certainly, the independent counsel will be looking at every 
document and every person and doing a very thorough review, and 
we look forward to that.
    Mr. Baca. Thank you.
    I served on numerous boards, and, usually, when an audit is 
done by any accounting firm, they usually come up with the 
recommendations, the deficiencies, recommendations for 
improvements.
    You usually give that nonprofit organization an opportunity 
to correct those deficiencies before any kind of action is 
taken, and I am just really appalled at the kind of action that 
has occurred out here without first discussing it with either 
one of you two in terms of any corrections or actions that need 
to be taken. If there was a difference in terms of methodology, 
accounting system, what needed to be done, it seems like they 
would have approached you.
    So, hopefully, we will comply with both the laws that are 
in place right now in terms of standard practices that need to 
be done.
    And, Mr. Chairman, I realize that my time has expired, but 
thank you very much.
    Chairman Baker. Mr. Bachus?
    Mr. Bachus. Thank you.
    Chairman Raines, we are talking about these financial 
reporting issues in a lot of the discussion, whether, you know, 
you violated FASB rules or not, but did these issues, I mean, 
first, undermine your creditworthiness?
    Mr. Raines. Well, I have to say, Congressman, that since 
this report has come out, we have been put on credit watch, and 
one of our credit ratings was dropped, went down as a result of 
this report.
    So a report like this from a regulator has serious 
consequences in the capital markets. You know, our stock price 
dropped by $14 billion as a result of this report coming out in 
the way it did.
    So, yes, this report has a very, very big impact on how we 
do our business from our debt costs to our credit ratings to 
our stock price.
    Mr. Bachus. Okay, but you are not in jeopardy of meeting 
your ordinary course of business, your obligations and that?
    Mr. Raines. No, the fundamental economics of the company 
has not changed.
    Mr. Bachus. Okay.
    Mr. Raines. The company is in fine shape. The only thing 
that has changed is this report.
    Mr. Bachus. Yes, when creditworthiness changes, your credit 
rating changes, you are put on credit watch. Obviously, that 
has implications not only for the housing market, but for the 
general economy as a whole.
    Mr. Raines. Yes.
    Mr. Bachus. I think what we had discussed this morning is 
you heard Director Falcon say you all were uncooperative, but 
you have rebutted here pretty clearly, and, you know, so we 
have a difference of opinion on that.
    The other thing, which a gentleman just mentioned, is he 
says he used best regulatory practices in this special 
investigation. You have been in government business for a long 
time. Is this normal? Is this the best practices for other 
government regulators? How would they have typically handled 
things as opposed to how OFHEO did?
    Mr. Raines. Well, Congressman, when I was in the government 
as the director of the Office of Management and Budget, one of 
my duties was to oversee regulatory matters throughout the 
federal government, and I have never seen a proceeding like 
this. In all of my time, I have never seen a proceeding like 
this.
    The financial regulators are given special powers, very, 
very strong powers. They can put a financial company out of 
business if they choose to. And because they are given those 
special powers, they exercise them very carefully.
    Quite typically, a financial regulator in this 
circumstance, taking everything OFHEO has said at face value, 
as being true, that financial regulatory would have managed 
this without one headline, and they would have done it entirely 
confidentially.
    They would have resolved the issue, and, at the end, the 
resolution would have been announced, and this has happened 
many times. The Fed, the OCC, the OTS have had to do this with 
financial institutions.
    So, if we take everything they said as being exactly right, 
I do not know of any financial regulator who would have done it 
this way. I have never heard of a special examination report 
being made public.
    Mr. Bachus. Well, it certainly has been on the public 
stage, the entire process.
    CFO Howard, do you want to comment?
    Mr. Howard. No.
    Mr. Bachus. Oh, okay. I am sorry.
    Let me ask you this. You know, you all have basically said 
that most of what they have, I think, accused you all of doing 
you had not done or that they had not, at least before now, 
asked you to change your internal controls, very strange, and 
you are defending your practices, I think, by and large.
    That being the case, why did you all enter into this 
September 27 agreement? I mean, you know, if they were not 
right, why would you have sort of consented to do what they 
asked you to do? And I know that you did not acknowledge any 
wrongdoing, but you took some pretty drastic measures, and one 
might say, ``Why would you have done that?"
    Particularly, one thing you have done is you have agreed to 
this capital surplus of 30 percent of minimum capital reserve, 
which if followed could, you know, restrict your activities 
which could negatively impact the financial markets. So I would 
just say is there an explanation for that.
    Mr. Raines. Well, yes, there is. Our board gave tremendous 
consideration to this, and there are several points, I believe, 
that they wanted to make.
    The first point was to acknowledge that we are a regulated 
company, and, if our regulator has concerns, whether we agree 
with them or not, they have to be taken quite seriously. So 
they wanted to demonstrate that on every issue they could agree 
to that they would reach an agreement.
    Second is that the agreement preserves the issues on which 
we do not agree, and those are to go to the appropriate place.
    Third is that we are mindful of the markets, and the idea 
that a company as large as we are would be seen to be having 
some kind of ongoing battle with their regulator struck us as 
to be contrary to our mission, and we did not want to take the 
risk of undermining our mission by appearing to be in an 
ongoing battle with our regulator.
    So the board had to make a judgment. I know some people 
took that agreement as being an admission of guilt. I think it 
was a demonstration of leadership by our board that put our 
mission first as opposed to our reputations or our feelings or 
our gut, all those other things that they could have put first. 
They put the mission first, and I think that is admirable, and 
I applaud them for doing it.
    As I mentioned before, financial regulators are very 
powerful entities. They can put you out of business, and so it 
is imperative for the board to ensure that we have a 
functioning relationship with our regulator on an ongoing 
basis.
    Mr. Bachus. Can I----
    Chairman Baker. Can you wrap up? Yes, sir.
    Mr. Bachus. This is my final question. This will be for 
you, CFO Howard.
    Can you outline for us the exact steps that must be 
followed under FAS 133 for a derivative contract to receive 
hedge treatment and also whether Fannie departed from common 
industry practice in establishing an effective hedge?
    Mr. Howard. We, first of all, do not believe we did depart 
from practice, and, importantly, OFHEO has not contested the 
fact that the transactions that we have entered into are 
economically effective.
    Mr. Bachus. Right.
    Mr. Howard. What they are talking about is whether we have 
met the criteria for hedge accounting. The requirements differ 
according to the nature of the transaction.
    For the derivative transactions at issue, you must first 
identify the transaction as being a certain type of hedge, with 
documentation. We believe we have done that. OFHEO has raised 
some questions over technicalities around the documentation.
    The second thing that has to happen, again, in types of 
transactions we have undertaken, is we need to have a high 
degree of effectiveness. It is called in the literature 
``perfect effectiveness,'' which can be assumed. We have 
assumed perfect effectiveness on these hedges because, in our 
view, that we have buttressed by periodic testing, there is a 
very, very small amount of ineffectiveness.
    Even though I recognize that minimal ineffectiveness and 
perfect effectiveness are not the same thing, our reading of 
the accounting literature, buttressed by KPMG notes it is 
making a practical application in a business context that is 
permissible, and that is what we have done.
    Mr. Bachus. Well, then it is my understanding that there is 
no question that any of these activities undermine the safety 
and soundness. In fact, some of them are prudent business 
practices except where they may have violated, you know, 
financial reporting standards.
    Mr. Howard. And we do not think we have.
    Mr. Bachus. I think that is really the issue, not whether 
you have engaged in any dangerous----
    Mr. Raines. Right. In fact, these hedges are all designed 
to reduce risk.
    Mr. Howard. Exactly right.
    Chairman Baker. The gentleman's time has expired.
    Mr. Meeks?
    Mr. Meeks. Thank you, Mr. Chairman.
    Mr. Raines, Mr. Howard, this may come as a surprise to you, 
but some people just do not like Fannie Mae's current status in 
the market, and that is pre-this OFHEO's report, et cetera. In 
fact, this may be a surprise, that when OFHEO came here--and 
Mr. Falcon--once before, many members of this Congress 
criticized them severely and threatened to put them out of 
business, in fact, wanted a new regulatory agency to come in.
    You know, I understand your statements, Mr. Raines, about 
you do not understand certain things, but let me just let you 
in on a surprise. Some people do not want you in business. They 
do not like the success that you have accomplished by putting 
people with decent homes and roofs over their head. Some people 
just do not like that. And so that might be a surprise to you.
    In fact, let me ask. Prior to this hearing that we had 
where OFHEO was threatened, had there been an occasion or any 
time before where OFHEO may have examined Fannie Mae and noted 
any irregularities or discrepancies in any kind of accounting 
standards?
    And I wonder how did they work with you in the past before 
we had all of these secrets coming out that people do not like 
what you do?
    Mr. Raines. Well, prior to the issuance of this special 
examination report, all of our examinations from OFHEO found 
that we met or exceeded safety and soundness standards, and 
that is going back to when OFHEO first organized itself back 
in, I think, 1993.
    So we had never, to my knowledge, had an outstanding issue 
with OFHEO on accounting, internal controls or any other issue. 
In the course of their examinations, they would make 
recommendations to us and, you know, we would adopt them. But 
we have never had an issue prior to this examination report.
    Mr. Meeks. Were you willing to make those? When OFHEO was 
making those recommendations, et cetera, in the past, would 
that have been shared with the press or members of Congress or 
put in the headlines of the newspapers? Has that ever happened 
before?
    Mr. Raines. No, the examination reports remain confidential 
until OFHEO makes an annual report to Congress, usually 
released in June, and then it is made available, but all of the 
examinations are held confidential, and, in fact, OFHEO has a 
regime for their regular examination function that holds these 
things confidential, and we have had very good experience with 
their regular examination process in that regard.
    Mr. Meeks. So this is a relatively new phenomenon that has 
taken place now as far as your relationship with your 
regulator.
    Mr. Raines. With regard to this special examination, this 
is very new.
    Mr. Meeks. I know that you have indicated in your testimony 
thus far that your board, I understand, had agreed to the 30 
percent capital surplus because you want to show, you know, you 
are part of the market and that you are cooperating, et cetera.
    But I am curious to know is there any other financial 
institution that does anything even close to 30 percent.
    Mr. Raines. As a mandated surplus? Well, Freddie Mac has 
a----
    Mr. Meeks. Other than Freddie Mac.
    Mr. Raines. No, sir. I am not aware personally of a 
financial institution that is otherwise solvent that is 
required to have a mandatory surplus by their regulator, but 
that is not to say it does not exist. I am just not aware of 
it.
    Mr. Meeks. And, Mr. Howard, let me just ask you a question. 
This will be my last question--and I will yield back the 
balance of time--because I am just trying to make sure that I 
understand.
    According to OFHEO, Fannie Mae must supply FAS 91 by 
recognizing only $200 million against expenses for prepaid 
loans, instead of $400 million, and, of course, you state that 
Fannie Mae's treatment was correct and that KPMG agrees with 
you. Just explain to me why are you right and OFHEO wrong.
    Mr. Howard. Prior to 1998, you know, any amount of this so-
called catch-up adjustment, which, again, was the comparison we 
made after the fact between the amount that we had brought into 
income based on an old assumption of average life of the 
portfolio--remember there are millions of loans in the 
portfolio--and a new average life. That difference we had kept 
track of but never recorded in current period income. That was 
the catch-up adjustment.
    In 1998, that dollar amount grew to a large size of 
expense--it was actually closer to $440 million--and we 
determined that some portion of that likely did represent a 
true economic cost. So we put together a group within the 
finance department of portfolio people and comptroller's people 
to come up with a method of determining the best amount to best 
reflect true economic substance.
    The recommendation they made to me and to us as the senior 
management team was that $240 million was that right amount. So 
the remaining amount, which was not deferred because it was an 
amount that never was recorded on the books in previous years--
it was kept track of, and that was the audit difference--that 
turned out to be a judgment that ex-post proved to be correct 
because next year we did not have an audit difference that was 
expense. We had one that was income.
    So the judgment in retrospect turned out to be correct. It 
was made as a part of a process that had integrity, and it was 
independent of any link to compensation.
    Mr. Meeks. Thank you.
    Chairman Baker. The gentleman's time has expired.
    Mr. Shays?
    Mr. Shays. Thank you, Mr. Chairman.
    Mr. Raines, I have a lot of respect for you. I think that 
you are one of the best budget directors. You are very 
articulate. I liked your opening statement, the buck stops with 
me. We do not hear that enough, and I thank you for that.
    My problem with Fannie Mae is I feel it is a bully in the 
marketplace that exercises its incredible advantages and does 
not want to play by the same rules that everyone else plays by, 
and I think you know that is what I think.
    I think that your not being under this 1933 Act and then 
voluntarily agreeing to be under the 1934 Securities Act--
voluntarily--to me is a bit arrogant. I think you should be 
willing to be under those laws.
    I think to suggest that you should have a weak regulator 
like OFHEO, and, when we wanted to strengthen it, you had 
objected to strengthening it, I have a problem with that.
    So I am not surprised by what is happening right now.
    When you say, ``Well, OFHEO never did this before, and we 
played by their rules,'' they were a very weak regulator.
    I am not pleased to learn that you have given $245 million 
worth of bonuses in the last five years. That is aside from 
stock options. So I have a bit of a problem with that.
    But I am particularly curious as to why OFHEO needed to 
have subpoenas in order for them to do their job. Why did they 
have to get subpoenas? So, if you would just tell me that, I 
would start off with my questions with that.
    Mr. Raines. Well, I will just answer your subpoena 
question.
    Mr. Shays. Yes.
    Mr. Raines. There are a lot of other things there, but----
    Mr. Shays. I know that, but that is my time. You have had 
your time.
    Mr. Raines. With regard to the subpoenas, our lawyers were 
told by OFHEO staff that they were issuing subpoenas not 
because of any lack of cooperation by Fannie Mae, but because 
they wanted to move the interviews from being informal 
interviews to interviews on the record with someone there 
keeping a record of exactly what was told. That is what we were 
told contemporaneous with the issuance of the subpoenas.
    Mr. Shays. Can I just say to you I am a little concerned 
with that answer because it seems to conflict with what we had 
been told. So I just--and you are under oath--want to make 
sure.
    Are you suggesting that there was no requirement whatsoever 
for them to get subpoenas, that you, as soon as they asked for 
this information, you, Fannie Mae, voluntarily provided this 
information? Is that your testimony?
    Mr. Raines. That is my testimony.
    Mr. Shays. Is that your testimony, Mr. Howard, as well?
    Mr. Howard. To the best of my recollection, yes.
    Mr. Shays. Okay. To the best of your recollection. In other 
words, this information was asked for, and you voluntarily were 
going to provide it, but, instead, they said, ``Oh, by the way, 
we want to go and get subpoenas.''
    Mr. Raines. We were actually in the process. We had been 
doing this for quite a while. The special exam had been going 
on for a while before the first subpoena was ever issued. We 
had been providing thousands of documents, providing people, 
providing e-mails.
    Mr. Shays. Okay. Did you provide the information they 
wanted, not what you wanted?
    Mr. Raines. Yes. We had provided every piece of information 
they wanted, and we told them they would get that with or 
without subpoenas.
    Mr. Shays. Okay, but I think it is important to put on the 
record because the information is that they had to get 
subpoenas to get this information.
    Mr. Raines. Well, I have testified very clearly that that 
is inaccurate.
    Mr. Shays. Okay. Let me ask you, besides the bonuses, you 
offer stock options as well?
    Mr. Raines. We are a shareholder-owned company, and we pay 
according to what our statute provides, which----
    Mr. Shays. Is that a yes?
    Mr. Raines. We pay comparably to other companies, and we 
use stock options among the various things in our executive 
compensation.
    Mr. Shays. Do you dispute the amount of $245 million over 
the last five years as bonuses? That is a lot of money. It is a 
quarter of a billion dollars. Nodding the head does not get 
transcribed.
    Mr. Raines. Well, I have to go calculate the number. It is 
a number that is calculable, and I do not know what the number 
would be.
    Mr. Shays. Do you think it is in the ballpark?
    Mr. Raines. It could be.
    Mr. Shays. Yes.
    Mr. Raines. But you say it is a very large number. In the 
last five years, we have also probably had after-tax income of 
$30 billion. So our executive compensation----
    Mr. Shays. I know you are a very successful company.
    Mr. Raines.----is a tiny, tiny percentage of our revenue, 
and it is a tiny percentage of our profit.
    Mr. Shays. Why should banks have to set aside between 6 
percent and 8 percent of their portfolio and you guys are in 
the range of about 3 percent?
    Mr. Raines. Banks should do that because they have much 
more risky portfolios. Banks are allowed to invest in a wide 
range of assets. We can only invest in single-family and 
multifamily homes.
    Mr. Shays. So it is your testimony that you do not need to 
have more because you do not feel any of your investments 
potentially could go sour?
    Mr. Raines. If none of them would go south----
    Mr. Shays. No, you set aside a certain sum in case the 
market starts to go bad, and the residential marketplace is 
very volatile, and you have about 3 percent of your portfolio 
set aside. If a bank gets below 4 percent, they are in deep 
trouble. So I just want you to explain to me why I should be 
satisfied with 3 percent.
    Mr. Raines. Because banks do not--there are not any banks 
who only have multifamily and single-family loans. I think if 
you check, banks are now arguing that their capital for those 
loans should only be 2 percent or less. I mean, that is the 
argument they are making right here in Washington today, that 
these assets are so riskless that their capital for holding 
them should be under 2 percent.
    Mr. Shays. Fine, but let me just ask you this question 
because OFHEO was asked this. Before OFHEO issued its report, 
did any of you speak to any people in the press or with any 
members of Congress about their report?
    Mr. Raines. We did not know anything about their report. We 
had never seen their report.
    Mr. Shays. When did you see their report?
    Mr. Raines. We saw their report on Monday.
    Mr. Shays. Did you know of the report? Did you know the 
contents of the report?
    Mr. Raines. No, we had no knowledge of the content of the 
report. In fact, I had been calling the director. I had a 
meeting scheduled with the director to discuss the progress on 
the special examination, which he canceled. I had three calls 
into him to discuss it because of the press reports that we had 
seen, and I never talked to him.
    Mr. Shays. I thank the chairman. Just to verify, we are not 
playing a word game here of a draft of the report.
    Mr. Raines. The report was handed to management as OFHEO 
officials walked into a meeting with our board, literally 
handed to us as they walked in.
    Mr. Shays. And you were not given a draft earlier or a 
working draft or anything like that?
    Mr. Raines. We saw nothing.
    Mr. Shays. So the answer to your question is you never 
spoke to any member of Congress before this report was issued 
or the press about this report before it was issued?
    Mr. Raines. About the contents of the report?
    Mr. Shays. About the report.
    Mr. Raines. Well, if we are going to be this--we never saw 
the report!
    Mr. Shays. I did not ask that. I want an answer to the 
question because I had been told that Fannie Mae had been 
speaking to reporters and press about this report before it was 
issued.
    Mr. Raines. About the content? Is that what you are asking? 
The content--are you--I want to be very clear here.
    Mr. Shays. Not the content. Just concerns that there was 
going to be a report that came out, et cetera, et cetera, et 
cetera, and----
    Mr. Raines. We have talked about concerns. Yes, we have 
talked about concerns about the report that we had been reading 
about in the paper. Yes, indeed. The press was calling us. When 
they were reporting OFHEO is about to do a report, they asked 
us, ``What is your reaction?'' and we said, ``We do not know 
anything about that.''
    Mr. Shays. And that is the extent of your contacts? You did 
not initiate any?
    Mr. Raines. Why don't you give me the example and then I 
can tell you what----
    Mr. Shays. No, no. I do not want to give an example. I do 
not want to give you an example. I want to know if you all 
affirmatively went out to the press to engage them in a 
dialogue about this report which you say you have not seen.
    Chairman Baker. And that will have to be the gentleman's 
last question because your time has expired.
    Mr. Shays. The answer is a yes or no. Did either you or 
your organization do that?
    Mr. Raines. Look, I do not understand what you mean by 
engaged. No doubt----
    Mr. Shays. No, you do not want to answer the question.
    Mr. Raines. No doubt we talked to the press about the 
report we had not seen. No doubt that someone in Fannie Mae 
talked to the press about a report we had not seen because we 
were getting asked questions about a report we had not seen. 
Some questions indicated that they knew more than we did.
    Mr. Shays. And the question I asked, though, which you 
could be responsive to--and I would appreciate it--is: Did you 
affirmatively interact with the press or actively contact the 
press about this report, not respond?
    Chairman Baker. And that is the gentleman's last question.
    Mr. Raines. I am not trying to be difficult.
    Mr. Shays. The answer is a yes or no.
    Mr. Raines. I am not trying to be difficult, Congressman, 
but you are asking me the question, did we ever call a reporter 
and mention it? Probably, but not because we had seen the 
report.
    Mr. Shays. Thank you. I hear you. I hear you.
    Mr. Raines. Okay.
    Chairman Baker. The gentleman's time has expired.
    Ms. Waters?
    Ms. Waters. Thank you very much.
    I just wanted to clear up a little something here. I find 
the information about the bonuses very interesting, and I am 
sure that it will cause a lot of discussion, but that is not 
really why we are here today.
    You raised a question earlier, Mr. Raines, about this being 
proprietary information. Do you still think that this is 
proprietary information that has been released, after you have 
seen what we have?
    Mr. Raines. My concern about proprietary information solely 
goes to not the five people at the top because our information 
is public, but we have people trying to recruit away our people 
every day. Every day, we have recruiters coming to Fannie Mae 
trying to recruit our people away.
    This is a road map as to how to go about recruiting Fannie 
Mae employees. This is private information about people who are 
not public officials, who are not senior officials, and now 
this is being made public for reasons I do not understand.
    Ms. Waters. Well, the reason that I asked is that our 
chairman did indicate that he had a legal opinion. I do not 
have a copy of that legal opinion. I do not think there is 
anything in writing. I think that his conclusions were drawn 
based on some constitutional reference.
    I just wanted to make sure that it is your understanding 
that it is proprietary information so that I can continue my 
follow-up and my investigation to find out whether or not 
proprietary information has been released. But you do think it 
is proprietary?
    Mr. Raines. My only goal here was to not waive any rights 
we have.
    Ms. Waters. All right.
    Mr. Raines. We continue to maintain whatever rights we have 
asserted. I did not want to waive that by sitting here and not 
saying something that was being revealed.
    Ms. Waters. Okay. That is fine. And I think I know what to 
do with that.
    I know you have repeated this any number of times, but I 
think it is very important for you to repeat part of an answer 
that you had given earlier, relative to this business about 
subpoena and information from OFHEO about you had been forced 
somehow to answer questions.
    Part of your information had to do with the Justice 
Department and the fact that they had been contacted. What was 
the Justice Department's response to OFHEO's request to be 
involved in this in some way?
    Mr. Raines. The Justice Department response was that they 
indicated that this was an issue that they expected to be 
worked out between Fannie Mae and OFHEO and that they did not 
believe that there was a need for any involvement of the 
department or the courts in working it out.
    Ms. Waters. Excuse me one second, my colleague, Mr. Shays? 
My colleague, Mr. Shays?
    The question that you asked about whether or not they had 
been forced through a subpoena to cooperate or to answer 
questions, there was one portion of his answer that you were 
not privy to. You were not in the room. I just asked him to 
repeat it. You were being distracted. I would like to ask him 
to report that again.
    The Justice Department had been contacted to ask to be 
involved in some way with this investigation. What did the 
Justice Department say, Mr. Raines?
    Mr. Raines. Let me read to you specifically so you have the 
statement that has been approved.
    ``Both in-house and outside counsel for Fannie Mae spoke to 
the Justice Department about OFHEO's referral to it regarding 
enforcement of one subpoena relating to e-mail, and the Justice 
Department indicated that this was an issue that they expected 
to be worked out between OFHEO and Fannie Mae without any 
involvement of the department or the courts.''
    Ms. Waters. Okay. Thank you very much.
    I also would like to inquire----
    Mr. Shays. I do not know what that means. I do not know 
what the means, so if you would----
    Ms. Waters. Okay. On my time now.
    Mr. Raines. I think what that means is----
    Ms. Waters. Excuse me. This is my time. You may not answer 
him on my time. He can get some additional time.
    Let me just ask you is it true that you absolutely had not 
seen this report until they came to the boardroom with the 
report.
    Mr. Raines. That is true. I did not see the report until 
they went into the boardroom, and they then handed a report 
with my name on it, an envelope with my name on it, saying, 
``This is your copy of the report.''
    Ms. Waters. Were you ever told why it was important to come 
before the board with such haste? From the time the report 
supposedly was finalized and to the time that they came to the 
boardroom, did you ever hear why it was so important to get 
that board organized so that they could receive this report? 
Were you ever explained to why it happened that way?
    Mr. Raines. It was not explained to me. I can believe you 
are going to have our lead director testifying before you. She 
can also answer whether it was ever explained to her.
    Ms. Waters. Did you ever hear that the timing of the board 
meeting had anything to do with the fact that there was a 
desire to have this hearing prior to the recess--congressional 
recess? Did you ever hear any of that discussion?
    Mr. Raines. I did not hear that.
    Ms. Waters. All right. Finally, let me just ask you this.
    Obviously, Fannie Mae is a very sophisticated organization 
with a lot of smart people doing big, big business, and it is--
I cannot understand why you would be involved in any activity 
that could easily be unveiled that was incorrect accounting 
practices or anything else with some kind of investigation. You 
have testified as to your accounting practices and your 
understanding of what is expected of you.
    Finally, when Fannie Mac was investigated, did this raise 
some kind of red flag, and, even though you felt that what you 
were doing, you were doing it correctly, that you were on solid 
ground, did you say, ``Well, let us look at ours again, too, to 
see if there is anything here.'' I mean, I would have done 
that, and I want to know did you two did that?
    Mr. Raines. We did, indeed, do that. We engaged outside 
counsel, we engaged accounting, we looked at everything that 
was alleged about Freddie Mac to see did Fannie Mae have the 
same problems, and our conclusions were that we did not, and, 
to this day, no one has alleged that we had the same problems 
that Freddie Mac had. These issues that are in the OFHEO report 
are brand-new issues to Fannie Mae and they are new to our 
relationship with OFHEO.
    Ms. Waters. And, by the way, I am going to ask you 
something that you may not want to answer.
    Since all of this has been made public, I read an editorial 
in The Wall Street Journal that talked about the fact that 
there had been an investigation and that editorial almost 
jumped to the conclusion that there must be something wrong, 
and, therefore, the investigation, even though there had not 
been a response, there must be something wrong, and even though 
they did not explore it fairly, they came to the conclusion 
that you would not be fit to be the treasurer of the United 
States of America.
    What does the speculation about your being perhaps asked at 
some point in time--should certain people win the presidency, 
what does that have to do with your work now have to do with 
whether or not you should be asked to be the treasurer of the 
United States of America. Have you heard that discussion at 
all?
    Mr. Raines. I have heard that discussion. As you know, I 
have been around this town a long time. It is very said. It is 
very sad to me if any consideration of politics goes into 
something like this. My service in the government, you know, 
has been, I think, service.
    You know, I have never run for office, and I have never 
sought to be a political figure. You know, I have responded 
when a President of the United States has asked me to respond, 
and that--I have been asked twice and I have responded twice to 
that case.
    More than me, my colleague, my former boss, Jim Johnson, 
has been brought into this, and let me say something about that 
directly. He, too, has been mentioned as a potential person to 
be in a future administration. We have done a look at the 1998 
incident that has been alleged by OFHEO, and we have found no 
acts that would relate to Jim Johnson whatsoever.
    Indeed, he was not the CEO when these decisions were made. 
I was. And so any implication that Jim Johnson had something to 
do with this is just totally without factual base. It shows 
what happens in these kinds of frenzies.
    I have to tell you the thing that bothers me far more than 
this treasury thing--far more--is explaining to my kids. That 
is hard.
    Ms. Waters. Well, I----
    Mr. Raines. It is hard when your daughter feels she needs 
to say to her dad, ``I support you.'' I am supposed to be 
supporting her. That is hard.
    Ms. Waters. Well, we are going to be out of here when we go 
on recess, and all of this talk is going to fester. You have 
not had an opportunity to respond.
    You have not been questioned. You have not had an 
opportunity to explain. Most of the members up here on this 
panel do not understand accounting practices. They are learning 
a lot for the first time today.
    What this could potentially do is in some way damage your 
reputation because these allegations are being made without 
your having an opportunity to respond.
    Chairman Baker. Ms. Waters, your time has long expired. Can 
you wrap up, please?
    Ms. Waters. Yes, I will wrap this up. What would you ask 
this committee to do in the interest of fairness that would in 
no way accept OFHEO without the opportunity for the kind of 
response that is always allowed in this kind of setting? What 
would you ask this committee to do?
    Mr. Raines. Ms. Waters, what I would ask the committee to 
do is to insist with all the agencies within your oversight 
they operate within----
    Chairman Baker. Excuse me.
    Ms. Waters. I was trying to hear him.
    Chairman Baker. I thought your time had expired. Please 
proceed.
    Ms. Waters. Yes.
    Mr. Raines. What I would ask this committee to do is to 
insist for all the agencies within your oversight that they 
operate under the commonly accepted rules of due process and 
fair play. I would also like your support to get a resolution 
on these issues that the SEC would give us an answer.
    You know, we did not come here to say today we are perfect 
or even that we know that we are right. We are simply saying we 
approach this with a businesslike approach, with honesty and 
integrity, and if we are wrong, we will make the changes. If we 
are right, you know, then we will go forward.
    All we have asked is that the proper process be used. The 
answers will come out of the proper process. That is the only 
request that we are making, is that at least give us the 
minimal rights that we would expect to be given to any other 
company, to any individual, any organization.
    Chairman Baker. The gentlelady's time has long expired. We 
do have a number of other members wishing to be heard.
    Mr. Ose?
    Mr. Ose. Thank you, Mr. Chairman.
    Mr. Howard, am I correct in understanding you are the chief 
financial officer for Fannie Mae?
    Mr. Howard. Yes, you are.
    Mr. Ose. Am I correct in understanding that questions of 
how to treat income or expense at Fannie Mae--that decision 
would at least go through your office?
    Mr. Howard. It would typically be discussed with me, 
depending on the level of importance.
    Mr. Ose. At what level of importance do issues come to your 
office for a final determination?
    Mr. Howard. That determination is made by the people who 
bring them to me.
    Mr. Ose. Is there typically a threshold dollar amount?
    Mr. Howard. No. It is usually how unusual, new the issue 
is.
    Mr. Ose. In terms of such unusual or new situations, are 
you the final arbiter of such decisions?
    Mr. Howard. Again, it is situational. In some cases, it 
could be the chairman, whoever that may have been, it could be 
me.
    Mr. Ose. Now I recognize that the report in question today 
covered a period prior to Sarbanes-Oxley being in effect.
    Mr. Howard. Yes.
    Mr. Ose. Is that your understanding also? So it predates 
our passage here on the Hill of that particular----
    Mr. Howard. Parts of it do. Yes, that is correct.
    Mr. Ose. All right. Does the audit committee of the board 
of directors get involved in these questions?
    Mr. Howard. Which questions?
    Mr. Ose. Questions of a new or unusual set of circumstances 
having to do with how to treat income or expense.
    Mr. Howard. Again, it would depend on the situation. 
Sometimes they are briefed on it. They are typically not 
consulted for a decision.
    Mr. Ose. The audit committee is not consulted for a 
decision of any nature related to this kind of a situation? It 
is just given to them as a fait accompli?
    Mr. Howard. It is. I am attempting to recall an instance 
where the audit committee may have been consulted in advance on 
a financial decision. I cannot recall one.
    Mr. Ose. So, in effect, what you are saying is that the 
audit committee does not set the standards for the decisions. 
The recommendation is given to them and they will either say 
yea or nay?
    Mr. Howard. Well, no, we typically do not even do that. We 
will report on the financial condition of the company, 
significant accounting issues. Anything that we think ought to 
be brought to their attention for review, we will bring to 
them.
    They can comment on them, they can ask us to do things 
differently, but we do not ask them for a decision because they 
typically do not have the level of expertise to make decisions 
at that level of detail.
    Mr. Ose. I just want to make sure I understand it. Implicit 
in your answer is that such decisions are therefore made at the 
management level, rather than the board level.
    Mr. Howard. That is correct.
    Mr. Ose. Okay. So the final arbiter for such decisions is 
your office?
    Mr. Howard. It, again, depends on the decision. It could be 
the comptroller. It could be the level below the comptroller. 
It could even be at a level below that.
    Mr. Ose. So the decisions may be made within perhaps the 
operating units of Fannie Mae.
    Mr. Howard. Not accounting decisions. They would not be 
made within the operating units. Accounting policy decisions 
are made by the accounting policy person, transactional 
decisions that have accounting ramifications are made in the 
units, but the results are reviewed and assessed by people in 
the comptroller's department.
    Mr. Ose. And then they are run past you as CFO for final 
sign-off or rejection.
    Mr. Howard. It depends on the issue. Most of them do not 
come to me for that step.
    Mr. Ose. Mr. Chairman, we may have the wrong guy here to 
ask these questions on the accounting rules or modifications.
    I am curious whether or not you do play a role in making 
decisions as to what is or is not treated as an expense in one 
case or an income issue in another.
    Mr. Howard. Typically not.
    Mr. Ose. And you are also testifying that the audit 
committee of the board of directors is not involved in those 
decisions either.
    Mr. Howard. Not asked to make them. Informed of them.
    Mr. Ose. Now you are CFO. Am I correctly advised that you 
are CPA trained?
    Mr. Howard. You are incorrectly advised. I am not a CPA.
    Mr. Ose. You are not a CPA. Okay.
    Let me ask a different set of questions, if I might. 
Actually, this goes to Mr. Raines. Prior to this hearing, did 
you or any of your agents or employers or counsel visit with 
any members of this subcommittee about the substance that we 
were going to discuss here?
    Mr. Raines. Yes.
    Mr. Ose. Did you or any of your agents or employers or 
counsel provide questions to members of this subcommittee for 
the purpose of having those questions posed to witnesses during 
this hearing?
    Mr. Raines. I believe we talked to members about or staff 
about questions that they might want to pose, yes.
    Mr. Ose. Okay. The only reason I ask that question is that 
Mr. Falcon, I think, was asked on the previous panel to provide 
to the committee a record of all such contacts that he may have 
had with the committee or his agents or employees. I am asking: 
Will you provide the committee a similar record of all such 
contacts to this committee regarding this hearing?
    Mr. Raines. My answer is I do not know. I mean, we will 
have to talk to our counsel and others.
    Mr. Falcon is a government employee. He is running a 
government agency. There are laws that relate to the ability of 
a government employee to lobby the Congress, and I assume that 
that is what the inquiry was to Mr. Falcon.
    We are not a government agency. We are not prohibited from 
lobbying the Congress, but I would certainly take under 
advisement your request, and we will get back with you with an 
answer.
    Mr. Ose. I am going to take that as a no, Mr. Chairman. 
Thank you.
    Mr. Frank. Mr. Chairman?
    Chairman Baker. Yes, Mr. Frank?
    Mr. Frank. Mr. Chairman, we have a colleague now on the 
committee, the gentlewoman from Florida, Ms. Brown, who is very 
interested in this and a student of Fannie Mae and its 
activities, and I would ask unanimous consent that she be 
allowed to enter a statement into the record of this hearing.
    Chairman Baker. Without objection.
    Mr. Davis, you are recognized.
    Mr. Davis. Thank you, Mr. Chairman.
    Mr. Raines, I had planned to go in a different direction, 
but I want to follow up on Mr. Ose's comments for a moment. You 
have been in D.C. for how many years as a----
    Mr. Raines. I have lived here for about 20-some-odd years.
    Mr. Davis. Okay. But in terms of your work at OMB and your 
work at Fannie Mae, you have been a part of the institutional 
layers in this town for a while, have you not?
    Mr. Raines. Yes, sir.
    DAVIS; And you have seen your share of congressional 
hearings, I assume, over the course of time?
    Mr. Raines. Yes, sir.
    Mr. Davis. Is it a fairly common practice, Mr. Raines, for 
almost every single entity that comes before this committee to 
have some consultation or talk with members of Congress or 
staffers before their folks testify?
    Mr. Raines. Yes, sir. I typically did that when I was in 
the government, and I have done it since I have been out of the 
government.
    Mr. Davis. And that is not an unusual or insidious practice 
in any way?
    Mr. Raines. No way.
    Mr. Davis. And just one final point on this: You were asked 
by Mr. Ose if you or Mr. Howard had talked to your attorneys. 
Are you aware from newspaper reports that there is a Department 
of Justice probe in this matter?
    Mr. Raines. I am aware of that from the newspapers.
    Mr. Davis. And based on your professional experience, Mr. 
Raines, is it not commonplace that if someone is a potential 
subject even, much less a target, of a Justice Department probe 
that they would probably be out of their mind if they did not 
talk to a lawyer?
    Mr. Raines. Yes, sir. You are right.
    Mr. Davis. And especially if you are about to give public 
testimony under oath, wouldn't the prudent thing be to talk to 
a lawyer?
    Mr. Raines. Yes, sir.
    Mr. Davis. Okay. Let me move to a much more important set 
of questions. One of the things that OFHEO is criticizing, as 
you know, is the structure of management at Fannie Mae, and 
they are questioning the structure of responsibilities, and 
there is some argument that there should be a greater 
separation of certain job descriptions.
    Mr. Howard, you understand that is one of the subjects 
here.
    Mr. Howard. I do.
    Mr. Davis. How long has OFHEO been in existence?
    Mr. Raines. The Congress created them in 1992. They 
actually, I think, came into existence in 1994.
    Mr. Davis. Okay. The structure that they are questioning or 
raising issues about--how long has it been in place at Fannie 
Mae?
    Mr. Raines. A version of the current structure has been in 
place since 1991 when I joined the company.
    Mr. Davis. Okay. At any point prior to September of 2004 
has OFHEO raised any questions about the structure or the 
alignment of job responsibilities at Fannie Mae?
    And I will ask both of you that question.
    Mr. Raines. Not to my knowledge.
    Mr. Davis. Mr. Howard?
    Mr. Howard. Nor to mine.
    Mr. Davis. And, as far as you know, has OFHEO been aware of 
that structure for the whole 12 years of its existence?
    Mr. Raines. Yes, sir.
    Mr. Howard. It could have been.
    Mr. Davis. And has OFHEO given you any explanation of why 
they did not raise questions in the previous 12 years?
    Mr. Raines. No.
    Mr. Howard. No, sir.
    Mr. Davis. Does it suggest to you the fact that if they did 
not raise questions in the previous 12 years, they probably did 
not think it was a matter worth questioning?
    Mr. Howard. I do not know.
    Mr. Raines. That would be speculating. They asked us lots 
of questions over the period of time, and, as far as I know, 
this has not been an issue with them.
    Mr. Davis. Neither of you was in the room when I had a 
chance to question Mr. Falcon earlier, but I want to ask you 
for a reaction to some observations that I made.
    As I understand OFHEO, their task is to oversee the safety 
and soundness of Fannie Mae. Am I correct in that 
understanding?
    Mr. Raines. Yes.
    Mr. Howard. Yes.
    Mr. Davis. One of the concerns Ms. Waters has raised, that 
I have raised and other members of the committee have raised is 
that it appears that OFHEO has crossed some line into simply 
being a neutral and dispassionate analyst or neutral and 
dispassionate observer of what the institution does, to having 
a very strong set of opinions about the institution.
    Is that the impression the both of you have?
    Mr. Raines. Congressman, I think that there has been an 
evolution in their thinking that they believe that they either 
have the authority to or have the need to be more directive as 
to how we carry out our responsibility.
    Mr. Davis. Now, Mr. Raines, for the relationship to work 
shouldn't there be some arm's length between OFHEO and Fannie 
Mae?
    Mr. Raines. Yes, I believe we should run the company and 
they should examine the company.
    Mr. Davis. Is that relationship or that desirable 
relationship undermine if OFHEO somehow becomes an advocate and 
if they appear to have developed their own agenda with respect 
to the future of Fannie Mae?
    Mr. Raines. Well, I think it does raise serious questions 
of who is ultimately responsible for the outcomes. I mean, if 
we are doing what they say then who is to be held accountable 
for what happens?
    Mr. Davis. Okay. Let me ask you one final set of questions 
because our time is so limited. The ultimate mission of OFHEO 
is to preserve the safety and soundness, correct?
    Are either of you concerned that by issuing a public 
condemnation of Fannie Mae and its practices, a public 
condemnation of the management structure, a public condemnation 
of its accounting in advance of the SEC doing it, are either of 
you concerned that that could somehow jeopardize Fannie Mae's 
status in the market and that that could, in its own right, 
have an impact on safety and soundness?
    Mr. Howard. I am very concerned about that.
    Mr. Davis. Could you elaborate on that, Mr. Howard, for a 
minute?
    Mr. Howard. Certainly. The markets respond to--as Mr. 
Raines mentioned earlier, regulators have enormous power and 
they are perceived by investors, particularly international 
investors, to have such power. And most regulators do not make 
pronouncements of the nature that we saw over the last two 
weeks without very serious convictions that those are true.
    Mr. Davis. One final question, if the chair will indulge me 
just a few extra seconds, one of the things that we have heard 
about is the fact that OFHEO went to the board of directors and 
essentially put a 48-hour ultimatum in place.
    Do you know of any authority that OFHEO has to give an 
ultimatum to the board of directors with its course of action? 
Is there any statutory authority for that?
    Mr. Raines. I don't know of any such authority, no.
    Mr. Davis. And to your knowledge, did OFHEO give any 
explanation of why it was so time sensitive that the board of 
directors move forward?
    Mr. Raines. I believe what they said to the board was that 
they thought the matters were serious and they wanted to test 
the seriousness of the board in responding to the report.
    Mr. Davis. Is it within OFHEO's charter to test the 
seriousness of the board of Fannie Mae? Is that written 
anywhere in their charter of their job description? That sounds 
like a fairly political purpose, doesn't it? Or a little bit of 
an agenda based purpose; we want to test the seriousness of the 
board.
    Chairman Baker. If you can, make that your last question 
because we do have others and we have another panel too.
    Please respond if you choose.
    Mr. Raines. No, I am unaware of any specific statutory 
reference to that.
    Chairman Baker. The gentleman's time is expired.
    Mr. Castle?
    Mr. Castle. Mr. Chairman, thank you very much.
    I don't want to get into this, it is funny how you think 
you are going to ask one line of questions and then you hear 
something else and you immediately want to follow up on that.
    I don't necessarily agree with Mr. Davis, for whom I have 
tremendous respect I might add, on--or even the answers to some 
of that. I mean, it seems to me OFHEO has a real role in all of 
this and to me, I mean, I agree with you, Mr. Raines, in sort 
of the role of examining.
    But I think when they examine and there is something that 
with which they don't agree I think they have some 
responsibility actually to make it public. I think you would 
agree with that. In fact, it shows in your testimony, your very 
good testimony, here today.
    I mean I am one of those who worries about Fannie Mae. I 
think, you know, you have good people running it and that kind 
of thing, but, frankly, it is very large, some of the practices 
I think are a little marginal. I worry about this perception 
the Congress will back up whatever Fannie Mae does. I just 
think there are a lot of issues.
    I think the regulatory issue is very important though. And 
somehow or another we have lighted a fire under OFHEO who I 
would have written off a year ago and all the sudden they got a 
tiger by the tail type thing. I don't know what is right or 
what is wrong. But, I just want to make sure that Fannie Mae is 
being run correctly because it is very, very important. And I 
worry about the safety and soundness of that.
    But, on the other hand, hey look, we are all running for 
office right now. We are criticized daily by our opponents. So 
a little criticism can't be the end of the world. And perhaps 
if it is justifiable criticism and changes are made, perhaps 
that is positive. I look at your testimony----
    Mr. Raines. Congressman, if you are being accused of 
committing a crime it is a little bit different.
    Mr. Castle. Well, right. But, you know, I am not--the jury 
is out on all of this right now. But the whole point is that 
some review I think is essential.
    For example, if you look at page two of your testimony you 
have made several changes as a result of what OFHEO has done, 
at least as I understand it. You go through the first, second 
or third and I don't need you to go through all the details, 
but you go through all the things that you have done, the 
building up the 30 percent capital surplus, the chief risk 
officer, et cetera, et cetera, some probably more important 
than others. And I couldn't begin to tell you, which you 
probably could.
    But these are changes which you have pretty well agreed to, 
perhaps not totally willingly, but you have looked at it and 
you have made the decision that these are things you probably 
should do that would benefit you that you did not do of your 
own accord but you did because of the OFHEO--because OFHEO was 
involved or is that correct?
    Mr. Raines. Congressman, we don't look for things to 
disagree with OFHEO.
    Mr. Castle. Right.
    Mr. Raines. Many of these things we would have been willing 
to do if OFHEO had approached us in a different way. So this 
isn't an issue of everything OFHEO says is wrong and everything 
we say is right.
    Indeed, I think the fundamental flaw, if I could say what 
the fundamental flaw is in our relationship with OFHEO, it is 
not created by OFHEO. It is created by the fact that the OFHEO 
examination process does not have the same legal protection 
that the bank examination process has. And that has a negative 
effect on the entire relationship.
    Bank examiners are not allowed to make public bank 
examinations, even if they are requested by a member of 
Congress.
    Mr. Castle. I want to go to another line of questioning. I 
am not going to parse that or argue it too much, except to say 
that I think there are certain powers that OFHEO, perhaps, 
should have that they don't have and perhaps there are others 
that they have that they should not have.
    I just think I want to get it straightened out. I mean, my 
sense is that you all have been sort of back and forth on 
whether there should be a successor to OFHEO or not. I hope 
that somehow or another when this is all said and done we can 
get this whole oversight, overview, examination, regulatory 
aspect of it correct.
    Mr. Raines. I agree.
    Mr. Castle. Because I just think that is important for all 
of us. That is my goal and I hope we can get great cooperation 
on that.
    Let me go on to this whole business of 98 because I don't 
totally understand it. But my understanding is when all this 
happened you were CEO, is that correct? Mr. Johnson moved on 
and you were CEO?
    Mr. Raines. I became CEO at the beginning of 1999.
    Mr. Castle. 1999. So this happened at the end of 1998?
    Mr. Raines. No, it would have happened in 1999. The books 
are closed in January. So I would have been CEO.
    Mr. Castle. Okay. Well, with respect to--this change really 
bothers me and I don't know if this is something that has been 
stated. There is no proof of it and I don't know whether it is 
correct or not, so this may even be hypothetical rather than 
practical. But, it concerns me that if, according to the 
report, and dug it out, and it was filed by OFHEO.
    I am sorry, according to the testimony, which we had today 
by Mr. Falcon it basically states that the amortization models 
of management were $400 million, however management decided to 
record only $200 million that year and then spread the rest 
over the next year, which allowed bonuses to be paid.
    My question is, is there any record of that or is that just 
something that happened? Did they look at minutes of meetings 
or e-mails or anything to make that determination?
    I mean, that, frankly, does have overtones to it that we 
can speculate on how serious they might be. But I think we all 
would agree it would be pretty serious if, indeed, a decision 
was made to put extra--to violate a standard accounting 
procedure and to put extra money into a different year to 
resolve the--or to lessen the----
    Mr. Raines. It is a very serious----
    Mr. Castle.----keep the gains high the year before.
    Mr. Raines. It is a very serious allegation. The report 
states no facts. It doesn't cite one piece of paper. It doesn't 
cite one witness who says that that decision was tied to 
compensation.
    As I mentioned earlier, we actually launched an effort, 
once we heard this allegation, we launched an effort to go and 
look at the facts. And if you look at the facts as to how this 
occurred we have found no facts that indicate that this 
decision was tied to compensation.
    Mr. Castle. Did you find any facts--I know my time is 
almost up and I have 15 second I have to yield to Mr. Shays. 
But did you find any facts that would indicate the decision is 
in violation of standard accounting procedures? That is what 
they are stating. That is a pretty serious allegation.
    Mr. Raines. No. We didn't find any of those facts either. 
Our auditors looked at the decision at the time.
    Mr. Castle. Right.
    Mr. Raines. And they approved the financial statements and 
they reported to the audit committee that there were not 
estimates that they believed were unreasonable.
    Mr. Castle. But KPMG apparently found an audit difference 
on this, as I understand it, a term which KPMG, this according 
to his testimony again, disagreed with Fannie Mae.
    Mr. Raines. There was an audit difference. This is what is 
called a subjective difference, which means that there are 
different ways to do it, but when it came to the board, and the 
board--and they would have to report to the board, were there 
any estimates by management that they felt were unreasonable, 
their answer was no.
    Mr. Castle. So the decision was made, there was an 
adjustment made and then the question becomes is what was the 
behind that decision and whether or not it met good accounting 
practices or good corporate practices.
    Mr. Raines. And we looked at the contemporaneous records 
and you can see in the contemporaneous records, in fact, that 
the calculations that OFHEO is relying on were not possible 
because no one knew what the EPS number was on the date that 
this decisions appears to have been made. So this false 
precision of just getting there exactly was impossible to know 
because the books hadn't been completely closed for several 
more days.
    So that is what I am saying. We have looked at the facts. 
There appeared not to be any facts to back this up. And if 
OFHEO has facts that back up, you know, we would be delighted 
to see them.
    Chairman Baker. The gentleman's time has expired.
    Mr. Castle. I was supposed to give 15 seconds to Mr. Shays.
    Chairman Baker. Well, let me suggest this, I had one more 
question and I had not had an opportunity to speak to Mr. 
Howard, if everybody wants to take 2 minutes, let us constrain.
    Mr. Shays. I wonder if I could go now because I have a----
    Chairman Baker. We would be happy if you would leave now.
    Mr. Shays. Would the gentleman yield?
    Chairman Baker. I am sorry, you want to say something 
first, I didn't understand your request. Yes, I would recognize 
the gentleman.
    Mr. Shays. Thank you.
    I just want to put on the record, Mr. Raines, that in 
communicating after your comment about the subpoenas to the 
office of compliance, they said they had requested thousands of 
documents and some of these documents simply were not coming. 
They got concerned about it. They particularly wanted e-mails. 
And only after they provided a subpoena request did the e-mails 
start flowing.
    And in conversation with Justice they basically said 
Justice said it wasn't necessary because now the e-mails were 
flowing, which is not uncommon in Congress when we issue a 
subpoena. Sometimes the threat of the subpoena provides that 
information from flowing.
    And I just want to also say that the reason why this 
information is public and you don't want it to be public now is 
they felt this was so serious that this information shouldn't 
be suppressed. And I happen to agree with them on that account 
as well.
    Mr. Raines. Well, if I might.
    Mr. Shays. I thank the gentleman for yielding.
    Mr. Raines. If I might?
    Mr. Shays. Sure.
    Mr. Raines. Fist of all, what I gave you was what the 
contemporaneous statement was, not what is being said today, 
but what was said at the time the subpoenas were issued.
    Mr. Shays. Right. They didn't need it because you were now 
complying.
    Mr. Raines. No, at the time the subpoenas were issued, not 
the time they went to the Justice Department, the time the 
subpoenas were issued, they told us they were not doing it 
because we were not cooperating. So, that, I think, is a very 
important distinction.
    Mr. Shays. They are saying that they were no longer 
necessary because after the subpoenas were provided that there 
started to be more information flowing, that is----
    Mr. Raines. That is a Justice Department issue. That is not 
why they issued the subpoena in the first place. That is 
where----
    Mr. Shays. So there is a disagreement that we are going to 
have to nail down.
    Mr. Raines. Yes.
    Mr. Shays. You have your opinion, they have their opinion.
    Mr. Raines. I think that is exactly right. But the second 
issue on why this was made public, the exact same kind of 
examinations go on with big banks, small banks, thrifts, 
without special examinations being published. So there are 
other ways to do this. This is an anomaly. OFHEO is the only 
financial regulator who does not have the----
    Mr. Shays. You are under the 1934 act.
    Mr. Raines. I am sorry?
    Mr. Shays. You are under the 1934 act, public disclosure.
    Mr. Raines. No, their examination has nothing to do with 
the 34 act. It is solely to do with the banking laws. Under the 
banking laws, examinations are secret. And that helps the 
relationship between examiners and the bank because they can 
have very free flowing discussions. OFHEO doesn't have that. It 
is not their fault. They have very good examiners. We are not 
quibbling with that.
    But the process is not a good process. We think the process 
that exists between examiners and the examinee is best 
referenced to looking at how the OCC has that work. And that is 
what we strive for. We are going to work with OFHEO to see if 
we can get there. But they do have this one disability that is 
not their fault, which is their examinations are going to be 
made public and that has a negative effect.
    Mr. Shays. What I would like you to do, though, is work 
with Congress to get a stronger enforcement process. That is 
what I would like.
    Chairman Baker. Your time is expired, Mr. Shays.
    Mr. Kanjorski, did you have a follow-up?
    Mr. Kanjorski. You know, a part of what we have to 
ultimately do is come up with a new regulatory scheme here. And 
I have been listening to this testimony and I was thinking 
since we have a regulator for two entities, you know, why can't 
we make an in-resident meat inspector, if you will, that is 
down at your place 24 hours a day or however necessary.
    But when you have these exit strategies where something 
like an audit difference comes up, wouldn't it be more likely 
to end up without disputes or problems if the regulator sat in 
and knew what the issue was on the rulings so that they don't 
miss it?
    Mr. Raines. Congressman, we actually have 40 OFHEO 
examiners resident at Fannie Mae. And so we do have them in 
close proximity. And we do believe that our examiners are aware 
of the closing process and of the findings of our auditor. That 
has never been hidden from our examiners.
    Our normal examining process, I believe, has worked well. 
Our only difference is how the special examination has worked. 
It is not about the normal examination process.
    Mr. Kanjorski. But why didn't somebody in the normal 
examination process be sitting in, to know what this audit 
difference was in 1990?
    Mr. Raines. My personal belief is--and I will go check--my 
personal belief is that our examiners were aware of this.
    Mr. Kanjorski. Well, you ought to examine your records and 
get the worksheets and see whether--somebody should have been 
there, to know that that was discussed, that the issue was 
resolved in one way or another and obviously acceptable to the 
regulator.
    Mr. Raines. And I will come back to you. I will check on 
that. But my belief is that our examiners had been well 
informed, and they have been very professional people. They 
have been aware of each and every one of these accounting 
decisions over the years, and they have exercised their 
judgment on them in that process.
    So, we are not--we have no complaints about the normal 
examination process. We believe it has functioned. And they 
have hired people who examined other large financial 
institutions. They now have a new examiner in charge, who I 
just met with, and he has met with our senior management. And 
we are going to work with him to make sure we have the best 
possible examination relationship that exists.
    Chairman Baker. Mr. Castle, did you wish another 2 minutes?
    Mr. Castle. I just have one comment, if I may, Mr. Raines. 
I heard you say earlier, based on this level--the executive 
officer compensation chart--that it is the road path, that 
people will come and steal your employees.
    I have seen the salaries. You don't have to worry about 
Congress coming up and stealing any of your employees.
    [Laughter.]
    Mr. Raines. Having been a federal employee a couple of 
times----
    Mr. Castle. You know the problem.
    Mr. Raines. I know the problem. I know it well.
    Chairman Baker. Ms. Waters?
    Ms. Waters. SEC has been referenced any number of times 
here today. And I guess Mr. Falcon said that there were 
overlapping responsibilities.
    What is SEC doing now? Have you been examined by SEC in the 
past, since 1998? What have they said about your accounting 
practices? What part of this have they overseen, examined, 
investigated since 1998, and what are they saying now?
    Mr. Raines. Well, the SEC has been enormously cooperative 
with us in our process of becoming a registrant. We are the 
largest business ever to become a new registrant with the SEC. 
They have never had an $800 or $900 billion entity do that.
    They were very helpful in that process, in reviewing our 
initial documents and giving us feedback. So, they have bent 
over backwards to be helpful. I am enormously grateful to them 
for that.
    They have also worked with us on sticky accounting issues. 
And we, like other companies, have presented accounting issues 
to them and asked them for a judgment as to what the 
appropriate accounting is and, again, they have been very 
responsive in giving us answers.
    We, of course, have implemented the answers that they have 
given to us. So, we expect that the SEC will carry out their 
function here. They are busy; they have a lot of things to do. 
I don't know what their timetable may be----
    Ms. Waters. Have they been in touch with you since this 
information became public?
    Mr. Raines. We have had contacts through counsel with the 
SEC Enforcement Division. But also we have had contact not 
through counsel--through business people--and with other parts 
of the SEC. So we try to maintain good communications with 
them.
    It is my desire now--as it would have been my desire before 
the report came out--that these accounting issues simply go to 
the body who can solve them. Then we will have the answer. We 
won't be having a debate about who is right and who is wrong.
    There will be an answer and we will implement it and go 
forward.
    Chairman Baker. Gentlelady's time has expired. I only had 
one further request of you, Mr. Howard. In order to better 
understand your explanation and your responsibility with 
regards to the $200 million expensing issue of 1998, I would 
like to request a written response, which I will submit to you 
at a subsequent time.
    The reason for asking the question in the hearing is that 
if your response would be pursuant to your oath taken during 
the course of the hearing, which would establish some important 
value to your written response.
    The essence of the request will go to the manner in which 
the expense amount was determined, why the figure was arrived 
at, the chronology of that decision-making process, those who 
participated, if it did not rise to your level.
    As you represented earlier in the hearing today, there are 
some financial decisions that come before you, some that do 
not. We need to know if it did not, to what level did it rise? 
Was this matter discussed among all executives? Did it go 
before the board for at least an announcement or some 
disclosure to the board?
    Basically, a process by which we can be sure, as members of 
the committee, we have gotten complete and full explanations as 
to the elements that OFHEO has brought to our attention.
    Please understand, in my capacity, I am presented with a 
very contentious and volatile report. If I were to have left 
Washington D.C. and gone home without addressing the elements 
of this report, I can only imagine the criticisms that would be 
leveled against this committee for its inaction.
    Should the interim report plead OFHEO to take the next step 
and issue some other yet unknown criticism, it certainly would 
leave this Congress in a very untenable position as the entity 
responsible not only for the creation of OFHEO but for creation 
of Fannie itself.
    I certainly hope that the future does not bring ill-advised 
consequences to the institution, its ability to extend credit 
to prospective homeowners or, even worse, to have consequences 
for taxpayers.
    My role is to examine, thoroughly examine, and I hope to 
spring to speedy resolution all of these matters. I have no 
interest in, nor motivation, to bring any adverse consequence 
to the enterprise or to Freddie Mac and, I will continue, 
however, to be the arm's length examiner of enterprise conduct 
that we appear, in your view, not to have with OFHEO.
    With that disclosure and no further comment, thank you. And 
this panel is dismissed.
    If our witness for our third panel is able to make it to 
the desk, we would invite her to do so now.
    Thank you very much for your participation.
    Welcome the presiding director of the board of directors of 
Fannie Mae, the honorable Ann McLaughlin Korologos. Is that 
correct?
    Ms. Korologos. That is right, sir.
    Chairman Baker. It was previously determined by mutual 
discussion that all those who would testify before the 
committee in this proceeding would be asked to take the oath. 
Do you have any objection to being sworn in?
    Ms. Korologos. I do not.
    Chairman Baker. If you would not, do you seek the advice of 
counsel during your testimony?
    Ms. Korologos. I do not.
    Chairman Baker. If you would not mind rising and raising 
your right hand, I will administer the oath.
    (WITNESS SWORN)
    Thank you very much. Please be seated. Consider yourself 
sworn in and under oath.
    As we have extended to all other witnesses in the course of 
the morning and afternoon, we request that the presentation, if 
possible, be limited to 5 minutes. Given the gravity of the 
issue before the committee, however, we would certainly extend 
any courtesy to you to proceed at your discretion.
    Your official testimony will be made part of the record. 
Please proceed.

STATEMENT OF HON. ANN MCLAUGHLIN KOROLOGOS, PRESIDING DIRECTOR, 
                 BOARD OF DIRECTORS, FANNIE MAE

    Ms. Korologos. Thank you, Mr. Chairman, and I hope I can 
keep more or less to the 5 minutes. I know it has been a long 
day, but I appreciate the opportunity to be here.
    I would like to thank Chairman Oxley, Ranking Member Frank, 
Chairman Baker, of course Ranking Member Kanjorski and members 
of the Subcommittee.
    My name is Ann Korologos and I am the presiding director of 
Fannie Mae's board of directors. I also currently serve as 
chair of the Nominating and Corporate Governance Committee and 
on the board's Compensation Committee.
    I am a shareholder-elected, independent director. I have 
served in three Cabinet departments, including as secretary of 
labor under President Ronald Reagan, and I headed the 
Presidential Commission on Aviation Security and Terrorism, 
specifically investigating the bombing of Pan American Airways 
flight number 103.
    The board of Fannie Mae appreciates this committee's 
oversight of the company, of the board and of our regulator. 
And I welcome the opportunity to speak on behalf of the board 
about OFHEO's report to date on its special examination.
    The board takes the issues raised by the OFHEO report very 
seriously. We are here to do the right thing. By that I mean: 
to OFHEO, the SEC and Congress, and to do so in a way that 
protects the shareholders and restores the public's confidence.
    In this way, the company can continue to fulfill its 
critical housing mission: to use the financial flexibility of a 
private company to pursue the societal goals of increased 
homeownership.
    As directors, we must meet our fiduciary duties of loyalty, 
care and good faith. We do not take these responsibilities 
lightly. These duties have meaning. They require us to gather 
the facts, conduct an objective investigation and render 
judgment based on the facts.
    We must look at the issues in the report deeply, 
thoughtfully and carefully, using whatever resources are 
necessary. And we will be held accountable for how we meet our 
responsibility.
    The board, with independent counsel and independent 
accountant, will investigate the issues in the report, and we 
will work expeditiously. So I thank you for this opportunity to 
speak on behalf of the board. We were moving fast before this 
hearing, and I can share with you that we now are continuing to 
do so, and we now know where we are going.
    The board has participated through our audit committee, in 
following the company's response to the examination since it 
began over a year ago. We have received regular reports from 
the audit committee on the examination's progress, as best it 
could be understood.
    On Friday afternoon, September 17, Director Falcon 
contacted me to say that OFHEO wished to share its findings to 
date with the outside directors of the board. I convened a 
meeting of the board for the next business day, which was 
Monday, September 20.
    Every nonmanagement director attended in person or by 
telephone. On that day, we received the written report and 
OFHEO's senior staff made a presentation to the nonmanagement 
directors and the company's outside counsel.
    The staff also gave us a letter from the director and a 
draft agreement, to be signed within 2 days, outlining actions 
to be taken. In addition, the board was informed by management, 
after that meeting, that they had received a call from the SEC 
that these issues would be a part of an informal inquiry by 
that regulator.
    The board immediately began a series of meetings and 
discussions with OFHEO over the week of September 20. I think I 
either spoke or met with Director Falcon every day that week. I 
assured Director Falcon that the board and the company would 
work cooperatively with OFHEO and that we would address all 
their concerns.
    I also expressed the boards hope that our work together 
would build a constructive relationship based on mutual respect 
and trust going forward. I told him, however, that the board 
could not, consistent with its fiduciary responsibilities, sign 
a document in 48 hours.
    On Tuesday, September 21, I advised the director that the 
board had authorized the hiring of independent counsel, former 
Senator Warren Rudman, and his law firm, Paul, Weiss, Rifkind, 
Wharton & Garrison LLP, subject to OFHEO approval, to address 
the questions raised by the OFHEO report.
    I also advised the director that we would provide to him, 
the next day, a draft work plan based on the actions required 
by OFHEO's agreement. On Wednesday, Pat Swygert, a fellow board 
member and President of Howard University, and I met with the 
director and his senior staff at OFHEO offices.
    We provided the draft work plan that was approved by the 
board and, because so much of the report had been leaked to the 
press by that time, I also advised the director that the 
company did not object to OFHEO's public release of the report.
    After reviewing the draft work plan, Director Falcon told 
me later that evening that he thought the plan was substantive 
and addressed each of the areas of concern raised by the 
report. I have attached to my written statement a copy of this 
draft work plan.
    On Thursday, in a conversation with OFHEO's general 
counsel, however, it became clear that OFHEO wanted a written 
agreement to be signed by the board.
    Therefore, at my direction, on behalf of the board the 
company's counsel began meeting with OFHEO staff to reach such 
an agreement. Discussion continued throughout the weekend, and 
after additional board meetings, we and OFHEO announced the 
September 27 agreement.
    With the agreement completed, the thorough process to 
address OFHEO's report is underway. Importantly, management has 
pledged its cooperation to the board in effort and we will hold 
them accountable to that pledge.
    The details of the agreement are well known. The company 
will move immediately to begin making a number of changes 
including a capital surplus plan, accounting policy 
modifications, internal control enhancements and other changes.
    The board's independent counsel, Senator Warren Rudman and 
his law firm were approved by OFHEO yesterday. Senator Rudman 
will hire independent accountants, also subject to OFHEO 
approval.
    Senator Rudman's work will also be reported to the SEC. We 
expect Senator Rudman to conduct his review as described in our 
agreement with OFHEO and to report his findings to the board, 
OFHEO, and the SEC
    The company and its outside auditors have a disagreement 
with OFHEO about some aspects of the implementation of FAS 91 
and FAS 133. The agreement establishes a process going forward 
to resolve these issues.
    This board believes in accountability and objectivity. We 
will not prejudge the outcome of this process, and I 
respectfully ask you not to prejudge it, as well. We vigorously 
share your concerns and want to get to the bottom of this.
    We believe that we have built a sturdy, corporate 
governance structure to be prepared for any challenge this 
organization may face. How this board and the company handle 
themselves when things go wrong is the ultimate character test.
    We have benchmarked our governance against other companies. 
Our nonmanagement directors meet as a group, without 
management, every time the full board meets, and often in 
between. These are candid, probing discussions.
    Our standards for director independence more than meet 
those of the New York Stock Exchange. Mr. Chairman, I would be 
remiss not to comment on the article which questions the 
board's independence in today's paper.
    Two years ago, we applied the New York Stock Exchange 
standards for director independence enhanced for our board's 
accountability. We worked with our outside governance counsel, 
Gibson, Dunn & Crutcher.
    We developed a director questionnaire and a process for 
matching directors' nonprofit and business connections with 
corporate or foundation contributions or business 
relationships.
    For example, for a business relationship, a director is 
considered not independent under these guidelines. We take a 
five-year look back versus a three-year look back under the New 
York Stock Exchange rules.
    On an annual basis, an excess 2 percent of consolidated 
gross revenues or $1 million, whichever is greater, would 
determine independence. And for charitable organizations on an 
annual basis, a $100,000 or 5 percent of gross revenues of the 
charity or the non for profit, whichever is less.
    The New York Stock Exchange permits charitable 
contributions of any size and only requires disclosure of 
donations in excess of $1 million or 2 percent of the 
director's charities gross revenues.
    In addition, no direct compensation other than director pay 
is permitted under our guidelines although the New York Stock 
Exchange permits directors to receive up to $100,000 per year 
in other pay before they are no longer independent.
    In addition, one director has a personal business 
relationship issue, and that was brought to our attention some 
months ago, and a decision on independence will be made at our 
October Governance Committee meeting.
    We have, therefore, regardless of reports in the press, I 
think, applied both the spirit and the fact of the criteria for 
independence and that that is put forth in the New York Stock 
Exchange guidelines.
    If the New York Stock Exchange, governance watchdogs or 
anyone else wants to change those guidelines, you can be 
assured that we would change ours and meet those requirements. 
I thought I might offer to submit, for the record, the board 
guidelines so that you would have them with this testimony.
    If I may speak personally for a moment, I have known some 
of you over the years from my experiences in both public 
service and the private sector. And I think you know my 
commitment to ensuring that our laws are upheld and the 
institutions of our economy maintain the highest levels of 
integrity.
    There is only one way I know how to deal with such a 
difficult situation: to speak the truth, to find the facts 
without bias, to base judgments on those facts, and then to act 
without hesitation. We must do the right think carefully and 
deliberately. We must not rush to judgment or take actions in 
haste today that we will have to correct tomorrow.
    I will commit to you that the board is determined to follow 
a process that will inspire confidence and restore public 
trust.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Ann McLaughlin Korologos 
can be found on page 171 in the appendix.]
    Chairman Baker. Thank you very much for your statement. Let 
me quickly say that I have no question either about your 
service as a board member nor any of the independent board 
members.
    Ms. Korologos. Thank you, Senator.
    Chairman Baker. I do think, as you have stated, today's 
problems present a challenge that will require decisive action 
based on full knowledge and confirmation of all the facts.
    What is problematic in the current environment is that, as 
Mr. Raines was before the committee for some time this 
afternoon, on a number of occasions in response to various 
questions, he would state the report cites no facts, speaking 
to OFHEO's report.
    I find that troublesome with regard to coming to an 
agreement that is in everyone's best interest. I will be the 
first to say that no report is probably 100 percent accurate. 
But I would also quickly observe that few reports are 100 
percent incorrect.
    I note that the board took rather quick and decisive action 
in reaching this first agreement, which would seem to indicate 
to me that there were some reasons the board came to a 
conclusion that it was appropriate to enter into that 
agreement.
    Do you believe that OFHEO is a competent regulator?
    Ms. Korologos. I don't know that I am equipped to make that 
judgment. I had the opportunity to meet with the director about 
8 months ago as chairman of the governance committee, which 
turned out to be fortuitous. So, when I received the call, I 
knew the director.
    Generally speaking, boards don't involve themselves in this 
detail with the regulator, frankly, at least not in the 
companies I am involved in. More so, in financial, I can't make 
that judgment.
    Chairman Baker. Okay. Do you believe, knowing what you know 
now from the substance of the report made available to you, 
that the board has been advised sufficiently, frequently 
enough, and to sufficient detail to have made appropriate 
judgment in the matters of concern in the OFHEO report?
    Ms. Korologos. Do you mean with regard to the agreement or 
generally speaking----
    Chairman Baker. Generally speaking in your capacity as an 
individual board member, do you feel you have been given 
sufficient information about the business judgments made by 
management of the corporation today?
    Ms. Korologos. I would say that the report raises issues 
that clearly are serious. That is why, again, with OFHEO's 
encouragement, through their agreement, we have retained 
independent investigators, both on the accounting side and, as 
you know, for some of these other issues.
    So I don't want to prejudge anything by answering your 
question.
    Chairman Baker. And, my next question is not to lead you to 
a statement that would be interpreted incorrectly.
    I have read accounts from various independent board members 
at different times making the statement that they have full 
confidence in the judgments made by, and fully support the 
current management. As you outlined, going forward, we need to 
know all the facts, follow all of those facts to their end 
conclusion.
    As you encouraged the committee and others not to jump to 
any presumptions before that process is finished, I would hold 
that door open both ways; that we not rise to the defense of 
all parties until we have come to a judgment as to everyone's 
involvement, if there is found to be a substantive accounting 
problem that was inconsistent with GAAP that led either to 
shareholder value being depleted or reports to the markets of 
incorrect financials.
    I think it was clear from the testimony of Mr. Howard and 
Mr. Raines. They first don't see a factual basis for the 
allegations that have been made by OFHEO but, secondly, can't 
make full judgment about the accusations until they have more 
information.
    Is it your view that the board, going forward, will reserve 
judgment in all these matters whether it be positive or 
negative?
    Ms. Korologos. I think so, completely. I will say that they 
have in the past and, if I might comment--since I am one of the 
people who were quoted in the press--I think this is a good 
forum to develop that because I wholeheartedly agree with you. 
My statement asked that none of us prejudge, of course, and we 
should be objective, and this board can be objective and is 
objective.
    When I called Frank Raines, the Chairman of the company, to 
tell him I had received a call at 4 o'clock on Friday from the 
director, his first response when I said I would convene a 
meeting was, ``How can I help?'' That is a first-class CEO.
    Consistently, over these weeks, management has asked, ``How 
can we help?'' That is the spirit of cooperation that we have 
with management in order to achieve all that we want to 
achieve. That does not detract from our objectivity.
    Many of us on the board have been there long enough to have 
worked with management over many issues on a great company 
achieving its mission. So, in that spirit, yes, certainly, we 
have experiences.
    I don't think that is mutually exclusive from the job that 
we have laid out, and I commit to you our objectivity, our 
unbiased tenacity to go forward and find out, if you will, the 
other side of this report and see where it comes out.
    Chairman Baker. Well at least an exploration of all the 
allegations OFHEO makes should be thoroughly vetted and 
conclusions reached. I hope that the findings are not as severe 
as OFHEO has represented them to be, but we all have a duty to 
find out.
    Ms. Korologos. Absolutely.
    Chairman Baker. And I thank you for that.
    Mr. Kanjorski?
    Mr. Kanjorski. Madam Secretary, am I correct that you have 
been on the board at Fannie Mae for 14 years?
    Ms. Korologos. Oh, you are making me older than I am.
    Mr. Kanjorski. Eleven years.
    Ms. Korologos. Ten years; just 11 this year, so 10 and a 
half.
    Mr. Kanjorski. So you predate Mr. Raines tenure.
    Ms. Korologos. I do, sir.
    Mr. Kanjorski. And you predate one of the issues that we 
have had the regulator testify about today, the FASB 91 audit 
difference that was reported in 1998. First of all, I would 
like to test your memory.
    Do you have any recollection at any time of your auditors, 
management or the regulator talking to you or other members of 
the board about this handling of the $400 million or $200 
million in 1998 that has been the object of one of the charges 
made by the regulator?
    Ms. Korologos. I don't have a recollection. I presume it 
would come through an Audit Committee report, and I can't 
promise you that something was said but I don't remember 
anything being said; no.
    Mr. Kanjorski. I know very little about how regulators 
operate and even less about how many analysts they have at your 
agency. Mr. Raines tells me they have 40 in-house meat 
inspectors. Pretty broad exposure.
    Do you, in the last several weeks, in meeting with the 
auditor and getting their report and meeting among the board 
with your various experts that you have retained now, do you 
have a sense as to whether or not there is a systemic risk 
problem at Fannie Mae?
    Ms. Korologos. I do not believe there is a systemic risk 
problem at Fannie Mae nor have I been in any gatherings that 
would lead me to believe that. I certainly would not have 
signed on behalf of the company, the agreement, if I didn't 
take into consideration the impact of the agreement, as well, 
and also the capital plan that is being developed and the 
likes.
    So, no, I don't. I haven't heard that and I don't feel 
that.
    Mr. Kanjorski. Very good. One of the things that amazes me 
is the regulator, in testimony earlier today, indicated, of 
course, that OFHEO has been auditing or regulating since 1991. 
And it is in 1998, one of the audits obviously had a finding 
that was an audit difference as to how to handle this 
particular transaction.
    I was just struck why they didn't pick that problem up in 
1998 or 1999 or any subsequent year that they had to deal with 
that audit report; that is, that the regulator didn't pick it 
up. It seems to me almost the first area that you would begin 
to do your regulation, is to look at the outside audit report.
    Has that struck you at all as being peculiar?
    Ms. Korologos. I have to say I only learned that from these 
hearings today. It strikes me the way it strikes you, sir. I 
would think that would be certainly a first stop; maybe not the 
last stop, but a first stop for a regulator.
    Mr. Kanjorski. One of the things that we have been 
struggling with over the last year and a half is to create an 
independent, world-class regulator for Freddie and Fannie. We 
thought we were going to come close to success not too long ago 
but, for reasons that are in the atmosphere in Washington, that 
didn't occur.
    But, invariably, as a result of this investigation and the 
Freddie Mac investigation and the testimony we received from 
the regulator this morning, I am absolutely thoroughly 
convinced that we have to do something to create a stronger, 
more independent, world-class regulator; other than that, Mr. 
Baker and myself are going to be remiss in carrying out our 
responsibility.
    But in starting that process, I am just at a loss as to how 
something could happen in 1998 and be listed as a finding in an 
audit report, and the regulator didn't ask anybody about it or 
get any information about it or resolve the application of GAAP 
rules to that particular finding.
    It just blows my mind, and $200 or $400 million is a 
significant amount of money, even in a huge institution like 
Fannie Mae.
    So, I am not sure that this was a wasted hearing from any 
standpoint, because we heard, for the first time, really, that 
process that the regulator has gone through. And I am not 
casting aspersion to this point on Mr. Falcon because he was 
not there, as I understand it, in 1998. He came subsequently.
    But, apparently, we have done one poor job as federal 
regulators, particularly of these two institutions. If nothing 
else, we should get that straightened out. There has been a lot 
of press, a lot of it bad, and as all of us know, it had some 
impact on the stock of Fannie Mae.
    Do you feel there is any reason, in your role on the board, 
that going forth from this hearing, both the investing public 
and the purchasers of your obligations should have any fear at 
all as to the security and the position of Fannie Mae, that 
their investments are secure?
    Ms. Korologos. I don't feel so. I feel that the agreement 
that we signed puts us on a very acceptable path to giving 
strength and clarity and openness to the issues that have been 
raised. I think that should be, I hope, assuring to the public. 
That is part of what I think our responsibility is; to the 
public--all the public, employees, investors, shareholders, the 
like.
    Mr. Kanjorski. Well, my sense of you--I should disclose for 
the record, we had the occasion to meet yesterday--I can't 
remember ever being more impressed even though we do differ 
politically. But with your basic competency and capacity, you 
certainly have won my faith that you are going to do a job and 
how you have gone about it really impresses me.
    I want to join my colleague, Mr. Baker. This is not the 
happiest role we have to play, as members of Congress. But 
quite frankly, the testimony of yourself today and the CEO, Mr. 
Raines, and Mr. Howard, the CFO, and even the regulator gave me 
a little bit more confidence that we are not dealing with 
something that is dangerous here to the public or is terribly 
disastrous to Fannie Mae.
    But it is good that we get it over with and if you keep the 
captain of that ship, you are going to let me sleep a lot 
better. Thank you.
    Ms. Korologos. Thank you, sir.
    Chairman Baker. The gentleman yields back.
    Mr. Scott?
    Mr. Scott. Thank you very much, Mr. Chairman. I wanted to 
go back to a line of questioning I started with Mr. Raines, 
which I think gets to the fundamental problem that has been 
brought before this committee, and that is that your board made 
the decision to tie the compensation bonuses to earnings per 
share.
    Can you comment on that? I think it is very important that 
I reaffirm Mr. Raines's comment that this preceded him because 
I think there are several things that I am very concerned 
about. One is the credibility of Mr. Raines, who runs that 
department, which means the credibility of Fannie Mae.
    This serves a very, very important constituency for all of 
us across the country who are concerned about making sure we 
have adequate housing, affordable housing for all income 
levels.
    But I would like to find out why that board felt it 
believed that it was appropriate to link executive compensation 
to earnings per share, and whether or not this move, this 
compensation scheme, resulted in inappropriate incentives for 
management?
    I think that unless we can clear that and try to get some 
common ground on that issue, especially as I mentioned, with 
the chart that Mr. Baker has provided this committee--which I 
am sure we are not the only ones who are going to see that 
chart--it is going to show some stark comparisons between what 
actual salary was and what those bonuses were.
    So, there is certainly meat for incentives here. I think 
this might be something we want to share. Could you give me 
your comments on why this, you felt, was appropriate?
    Ms. Korologos. I would be happy to. Again, I have only been 
on the board since 1994 but, in both my experience at Fannie 
Mae and many other corporate boards--in some case, where I am 
also on comp committees--earnings per share was a very 
acceptable incentive, if you will.
    Generally combined with others, different companies did it 
different ways. So you are not talking about a company that was 
the only one. I wanted to make that clear.
    Why was that? Well, in the late 1980s, early 1990s, the 
acceptable philosophy for compensation besides always, in some 
way being performance based, was to tie management to the 
shareholder, and earnings per share was one way to do that. 
Likewise, options, which we saw become out of favor and the 
like. In a way, I would think we would all take comfort.
    At Fannie Mae, it is a much more, even transparent process 
than at other companies precisely because we are a GSE. Unlike 
other public companies, the amount our executives make is 
somewhat dictated by law, and the law states that OFHEO is 
required to ensure that Fannie Mae's compensation programs are 
reasonable and comparable with compensation for employment in 
similar industries.
    We use the comparability test of looking at peer companies 
and the like and structuring not only the earnings-per-share 
measurement, but in other aspects as well, both tangible and 
intangible performance measures and the like.
    So you generally have salary, you have bonus, you have long 
term, you have short term kind of incentives. So you try and 
strike a balance between financial and nonfinancial measures.
    Earnings per share, for purposes of this report, seem to 
have jumped out and your question is quite a legitimate one. I 
would only say that it is becoming, in recent years because of 
incentives leading, in some companies, to behavior that wasn't 
intended to re-look at compensation. And there are a lot of 
different mixes going on.
    Mr. Scott. You have seen the report that was presented 
before the committee----
    Ms. Korologos. I actually did not see the paper that was 
handed out yet. No, I have not.
    Mr. Scott. But you are familiar with the bonus and the 
structure and the comparison of base----
    Ms. Korologos. Yes, very much so.
    Mr. Scott. Do you stand by that? Do you feel that----
    Ms. Korologos. I stand by what we did; yes, I certainly do, 
and I think that I have found, again, my experience on a number 
of other boards; it is always a work in progress. We use 
outside consultants as well, is what I wanted to assure you.
    So this is not something we plucked out of the air and 
allowed to hang out there to be abused in any way, shape or 
form.
    Mr. Scott. Well I think this is very important to get on 
the record because, as I said earlier, there have been some 
very strong accusations made against Fannie Mae, and I want to 
make sure you have a chance to respond to that.
    If I may continue, in view of that, what changes, if any, 
in corporate governance and some of these compensation policies 
that the board is considering to address in relationship to the 
issues that have been raised by this report and, again, I too 
question the timing of it and I think there probably are some 
motivations there.
    People say politics isn't a part in that, but you really 
can't take politics out of politics. I believe really, as a 
result of today's hearings, that politics has certainly 
manifested in what we have here.
    But, having said all of that, OFHEO has given a report. Are 
you going to make any changes in the way you operate and, if 
so, in governance and in compensation, as a result of this 
board and some of the issues that it has pointed out?
    It runs the gamut of misapplied accounting rules, has kind 
of stabilized the earnings, the inadequacy of the regulatory 
capital, the deferred expenses. It just seems to me, do you 
take this report, just say there is nothing here, or do you 
take it and say here is what we are going to do to try to fix 
this situation.
    Do you give this report credibility?
    Chairman Baker. And, Mr. Scott, that will have to be your 
last question because you are well over time.
    Ms. Korologos. Let me assure you, I think--two significant 
things, perhaps. One, the agreement we signed itself permits 
us--I think there are 32 or 33 issues there--working with 
Senator Warren Rudman and the accounting people that he will 
bring, to do a very deep dive, if you will, and look very 
carefully at all of those issues, some of which may result in 
change, some may not. I can't prejudge that.
    So, that is the route for the report itself, in terms of 
taking it serious, following all of the issues, both through 
the agreement and the report itself.
    Secondly, you ask if there will be changes in governance. 
In terms of the company's governance and its organization, that 
is a part of the agreement, and that will be addressed 
accordingly.
    In terms of corporate board governance, I said in my 
statement, and I really do believe--but I am open always to 
best practices and we follow these issues religiously--that we 
are at a point, because of good governance, that we are able 
to, one, get us this far to keep some stability and calm to a 
process that I think is very important, to exercise our 
fiduciary responsibilities in a thoughtful and informed way, 
and organized ourselves previously to be able to participate in 
the various teams that are going to be created to fulfill our 
obligations under the agreement.
    One board member has particular expertise in capital 
markets and the like; Don Marron, formerly of Payne Webber, he 
will be a very good team person. Another woman, Leslie Rahl, on 
the board, is a derivatives expert; let her work on those 
issues.
    So, we are organizing ourselves with our expertise. So, I 
think that is the corporate board governance piece. Whether 
changes come for board governance from the report, I don't see 
that right now but I am open to it, but I don't see that.
    I think the third issue on compensation, however, obviously 
we welcome any findings from the independent investigation that 
address some of the allegations in that area.
    As a member of the Comp Committee, we have been addressing, 
as we look again, at comparables, at best practices, at the 
structure of compensation, at those in our industry, how to 
base the bonus plan on more than just earnings per share such 
as risk and mission factors.
    That is going to be forthcoming. So, that is a piece of 
work that has already been going on but it has been going on 
because of the marketplace, if you will, in executive 
compensation.
    Chairman Baker. The gentleman's time has expired. Ms. 
Waters?
    Ms. Waters. Thank you very much. Would you please give me 
the correct pronunciation of your name?
    Ms. Korologos. I would be happy to. It is all O's, and it 
is Ko-ro-lo-gos.
    Ms. Waters. Ms. Korologos. I would like to thank you for 
coming here today.
    I don't know how long you have been here but you may know 
by now that some of the questions that I raised to Mr. Falcon 
question the motive of the director as it relates to this so-
called investigation.
    And I know sometimes that is not a nice thing to do, but I 
know a lot of history about this ongoing political battle 
between FM Watch and the GSEs and some of our members' role in 
all of that.
    I also know about the criticisms that were launched at 
OFHEO and its past oversight or lack of the GSEs. So I have a 
historical reference for many of the questions that I have 
asked and some of the accusations that I have may have made.
    Having said all of that, you entered into an agreement with 
OFHEO without having a response from your organization. And it 
appears that you entered into an agreement because you wanted 
to show that you were cooperative, that you were not resisting 
criticism, that if there were problems you wanted to solve 
them.
    It seems to me that is what you did, and you made that 
decision knowing that some people would not understand that 
this was not an admission of any kind of guilt or anything 
else. But I think it is very important for that to be restated 
time and time that, out of the spirit of cooperation, you 
entered into this agreement.
    Now, I have looked at some aspects of this agreement as 
represented to us today. And what it appears is that you have 
entered into agreement that you could easily enter into 
because, as far as I am concerned, what is being asked of you 
is not that difficult to begin with, and it may not require you 
to do any changes at all. You may be correct in some of the 
things that you are doing.
    I don't see any timeframe or time guidelines on any of 
these points made in the agreement that you should have 
something done by a certain date, even though we are led to 
believe this was an emergency.
    The board had to be convened right away because these 
serious accounting problems had been identified and unless you 
do something right away, the safety and soundness of this 
organization was at great risk.
    But even when I look at the number one recommendation--
implement correct accounting treatments that will bring the 
enterprise into compliance with SFAS 91 and SFAS 133--it didn't 
say do this in 30 days, in 60 days, in 90 days.
    It just puts it out there but nobody says--unless it is 
someplace else--how the agreement will be made as to what the 
correct accounting treatments are based on the fact that there 
are some disagreements, perhaps, about the implementation of 
SFAS 91 and 133. That is one example.
    This other requirement--protect its existing capital 
surplus and move to a targeted capital surplus equal to 30 
percent of its required minimum capital--there is no emergency 
relative to this requirement.
    It didn't say that if you don't do this in 30 days, 60 
days, 90 days, something terrible is going to befall this 
agency. It didn't say that we have come up with this percentage 
because this is what we have examined, this is what we have 
looked at and this is the conclusion that we have come to based 
on these facts.
    And, of course, in the spirit of cooperation, you could 
agree to that, because even though it potentially takes capital 
away from being involved in some of these good things that you 
may be doing, it doesn't really admit that something is wrong 
with the surplus of the minimum capital requirements that you 
have now--the 18 percent or whatever that is.
    So, as I go down each one of these, some of them look a 
little weak, they look like little smoking mirrors to say that 
I did an investigation and so now I want you to undertake a top 
to bottom review of your staff structure.
    Duh, I mean, I think this is what you do all the time. And 
as has been indicated, that even in the ongoing meetings that 
you have, where people can raise questions, et cetera, et 
cetera, you are doing this all the time.
    So, having said that, would you confirm for me, your 
understanding of why you entered into this agreement and 
whether or not you believe that this means that you immediately 
make great big changes because you were doing something wrong.
    Or is this just an agreement to say, ``Okay. You want us to 
look at this? We will be happy to look at it. We believe that 
we are right and we believe that in the final analysis, we will 
be proven right.''
    Explain to us where you are coming from.
    Ms. Korologos. I will.
    Chairman Baker. And that would be the gentlelady's question 
because her time has expired now. We would be pleased to hear 
your response.
    Ms. Korologos. Thank you, Mr. Chairman. Yes, it was a very 
difficult, important period for the board to be presented with 
an agreement and then, uncertain at the time, the importance of 
the agreement, per say, because to sign it in 48 hours would 
not have been possible responsibly.
    When, however, we presented, based on the agreement, a work 
plan, I was able to spend the days with management and say, 
``What can be done? Let us break this apart and see what can be 
done on the issues that were raised in the report.''
    And it really came in sort of three chunks. There were the 
accounting issues and, clearly as you heard in testimony today, 
the SEC has a serious role there. There were the capital 
issues, if you will and the capital plan.
    Well that, again, we could bring the best brains together 
and the talent and work with OFHEO and determine that. And 
then, I guess you might say, we had also the organizational 
issues and throughout, we had some very serious allegations 
that could be addressed by an investigator that OFHEO 
encouraged us to have.
    So, as we broke it apart, we were able to develop a work 
plan. Having done that that gave us some background, when I 
understood from the director, or from counsel, they still 
wanted an agreement and they wanted it really before Monday, 
the 27th.
    I think, in part, from what they told me in preparation for 
the quarterly letter that they issue regarding our safety and 
soundness. So that became an issue within the timeframe for 
this agreement.
    The counsels worked together with the board and with me, 
particularly, on the elements of the agreement. And various 
changes were made to your point, to make acceptable. There was 
no way we were going to sign an agreement we couldn't deliver 
on, number one.
    And, number two, we were very eager to get this process 
going so we could give answers to the public, to our investors, 
to our shareholders, to the housing community. We had already 
seen an economic impact because of the swirl and the fire storm 
we are in.
    But how can we stay thoughtful, see through the process of 
developing an agreement that, one, was responsible, that would 
further clarify, explain, investigate, in an open way, the 
issues that had been raised--they were serious--and, at the 
same time, to your point on timing, not commit to something we 
couldn't achieve.
    You will notice in the agreement--you are right--there are 
various timeframes, but not necessarily a timeline for 
delivery. There are 15 days to give the comprehensive plan and 
seek approval or disapproval of OFHEO.
    There are 45 days to have a counsel working for us and 
conduct reviews. There is a compliance committee requirement 
and the like. So, there were different timeframes, all of 
which, in many cases, require OFHEO to approve or disapprove.
    My hope is that we will be able to work with OFHEO so their 
approvals will come in a timely way, too. I think that is an 
important part of keeping going. We will be developing a 
tracking system to monitor implementation and our progress.
    Now, let me say that it is in our interest to be on two 
paths here. One is to implement the agreement, the 
investigation and do so expeditiously because we want to put 
all of this behind. If there are changes to make, we are happy 
to make them. If they are allegations that are proven, we need 
to deal with it.
    At the same time, the other track we are on is to run the 
business. The most important thing we do in this very vibrant, 
wonderful company with a fabulous public mission is to keep the 
business going.
    So, the more these issues hang around, if you will, I think 
is irresponsible for the board not to set our own timelines and 
make sure we can reach them.
    That is my best answer to why we did the agreement, what 
kind of appropriate pressure, if you will, we will keep on the 
process and the special committee that we created to work on 
this to oversee it.
    The individuals within the company we are selecting to help 
us there is to keep this moving because we really want to put 
it behind us. But we want to benefit from the process and do 
it. As I keep saying, we want to do it right the first time and 
we want to do it thoughtfully.
    So, we are not--I frankly don't want to come back before 
this committee or our shareholders or our employees and say, 
``Oh gosh, we didn't do a good job. We have got to redo it.'' 
Let us do it right the first time and I think the process we 
set up will do that.
    So, the timelines that will be developed to implement--I am 
sure there will be some give and take, and that is appropriate 
with the regulator, and what they think we can do in a certain 
timeframe and what we think we can do.
    I would expect in the spirit of cooperation we will work 
out that tracking system and those timelines together.
    Chairman Baker. Let me thank you, Ms. Korologos, for your 
appearance here today and your testimony and also give you an 
assurance.
    Despite the view that the work in the committee may be 
political in its nature, Mr. Kanjorski and I work very closely 
together. Our work, especially in this arena, has been 
bipartisan. We both share the view that strong regulatory 
capacity is absolutely essential. And we will work as a partner 
in this process to assist the board in achieving the desired 
end result.
    This does not mean it will be easy or that everyone will 
always agree on all perspectives. But the public discussion is 
a good thing, and bring it to speedy resolution is even more 
important. I think by making the appropriate assurances of good 
faith on all sides, that we can do something good for 
homeownership as well as ensuring taxpayers they have no 
potential liabilities in these matters.
    Again, I thank you. I will ask unanimous consent to make a 
part of the official record, the addendum and reports that you 
cited in your testimony.
    I have documents that were forwarded from OFHEO, the OFHEO 
report itself, the blue book, and the letter of transmittal of 
November 12, 2003, to me, of the chart. And I think that is all 
of the remaining items that need to be officially made part of 
the record without objection.
    And let me express to all participants and my faithful 
comrades who stayed until 6:11 this evening. Thanks for your 
good work.
    Our meeting stands adjourned.
    Ms. Waters. Thank you very much, Mr. Chairman. And may I--I 
don't know if I need unanimous consent request to make a 
request of you relative to our future work.
    I don't know if you plan on having more hearings anytime 
soon, but my request would be that the responses that will be 
given by Fannie Mae to this investigation be put together, 
prepared in whatever fashion they are going to be and that we 
use those same responses if we are going to have another 
hearing.
    My suggestion is that we not have a hearing until that is 
done so that we are all working from the same information.
    Chairman Baker. By way of disclosure for all interested 
stakeholders, it would be my intent, at this time, to discuss 
probably over the recess, regulatory reform. I don't know 
whether there would be a proposal introduced for discussion 
purposes, but it is not likely, in my view, that this committee 
would reconvene its work until the next Congress.
    With the hope, I think--the long hope for expectation that 
this Congress will leave town this weekend. If that, in fact, 
is the case, there would not be the prospect of an additional 
hearing.
    However, to acknowledge the gentlelady's point, at such 
time as a hearing notice would be issued, I can assure you that 
any information the enterprise would choose to make part of 
that hearing process, we would certainly welcome. I would 
formally ask the chair of the independent board members on any 
report she would choose to provide to the committee, we would 
be happy to receive.
    And likewise, I am sure; there will be work of independent 
members during the course of the recess to get us fully 
prepared to consider whatever ramifications there are from the 
pending study or regulatory reform or any other issue a member 
might choose to bring before the committee.
    Ms. Waters. Am I to understand that the Chairman is saying 
that you possibly will be working on regulatory reform based on 
the book that has been done by OHFEO already?
    Chairman Baker. No. My view is I have been working on 
regulatory reform all my life. That effort would just continue 
into early next year. As you know, we had a proposal in this 
committee which was very close to being adopted and for 
whatever reason, did not get adopted.
    The Senate has moved the proposal out of Senate Banking 
Committee, which is now pending. It would be my hope that 
given--let me take the side of the discussion from those who 
have been critical of Mr. Falcon and OFHEO.
    For those, it would appear it would be likely that you 
would support a different regulatory structure. For those of us 
who feel that enhanced oversight is good from a taxpayer 
perspective, they would support a new regulatory structure.
    I don't know anybody today on the committee who expressed 
objection to the discussion of and passage of a new regulatory 
structure. So, given that, I think it is our duty to take that 
up early next year, and in the intervening months, anyone who 
has suggestions or recommendations, they should be made known 
and we can take them into consideration.
    Ms. Waters. If I may, Mr. Chairman, I certainly agree that 
you have been working on regulatory reform for a long time and 
that the question of whether or not OFHEO was competent to do 
this certainly has been discussed in this committee.
    And some of us, who may have, at one time, supported OFHEO, 
may be with you on your proposed changes. And what you would 
like to do with the Treasury Department, I don't know.
    But my real question is whether or not you anticipate 
working on regulatory reform that will respond to some of these 
allegations that have been surfaced by OFHEO, in the absence of 
the response that I think we just desperately need to have from 
Fannie Mae and they have not had the opportunity to present?
    That is my question.
    Chairman Baker. I don't see further action by this 
committee until additional information is provided from both 
perspectives. I think OFHEO would want the opportunity to 
respond to the testimony today from Fannie Mae, and it is 
evident that Fannie Mae would choose to give us more 
information--the board members as well--as to their findings 
and factual determinations of the OFHEO allegations.
    So, I think both sides are going to be providing members 
with a lot of information. I am trying to say to the 
gentlelady, we won't act until there is something that 
validates acting.
    In the interim, we should be working on our regulatory 
proposal to bring ultimate closure to this whole chapter.
    Ms. Waters. I think I understand that Mr. Chairman. I guess 
just to wrap this up, what I am really getting at is in the 
regulatory reform that you have been working on for a long 
time, we can reasonably anticipate what some of that is all 
about.
    But what I am not certain about is whether or not in that 
regulatory reform I would look in there and see specific 
references to this recent OFHEO investigation as it relates to 
accounting practices that are yet undecided.
    Chairman Baker. That level of analysis would be relegated 
to the new regulator. I do not see the committee getting 
engaged in anything other than the principles of oversight. And 
as I have long said, an independent regulator properly funded 
with the real authority to assess the enterprise's safety and 
soundness.
    That is it. It has always been the principles. And nothing 
beyond that need be in legislation, and I think there are any 
number of proposals I have had in prior sessions, which 
describe in generality what we would be considering, and those 
have no reference to the OFHEO analysis of today.
    Ms. Waters. Thank you.
    Chairman Baker. Mr. Scott?
    Mr. Scott. So, Mr. Chairman, just to make sure we are 
clear, there will be no movement whatsoever on any regulatory 
reform until we have this rebuttal process from both OFHEO and 
Fannie Mae to today's hearings.
    Chairman Baker. Not exactly. What I said was there will be 
no further action by this committee on this subject matter 
until conditions warrant action by this subcommittee.
    Assume, for the moment, if you wish to pursue this 
discussion that OFHEO comes back with another troubling report 
in the next 2 days or the next 2 months. Certainly, the 
committee would want to receive that report and discuss the 
findings.
    I am not suggesting, however, we would move on a 
legislative proposal in the next 5 days. There is certainly not 
time to do so. It would likely be early next year; a reform 
proposal introduced, would go through due process, all members 
would be heard, and certainly the enterprises and all those who 
have a stake in this matter would be given ample opportunity to 
voice their opinion.
    I don't know exactly the sensitivity that you and the 
gentlelady are addressing. There is not going to be anything 
introduced tomorrow that takes page 46 of this report and makes 
it a new regulation. If that is what you are after.
    Mr. Scott. You mentioned in the event that there may be 
another report, is there any indication or evidence on your 
part that OFHEO is contemplating or putting forward another 
report?
    Chairman Baker. Oh, no. Let me make it clear one more time. 
I have no information that any other member does not have. I 
have had no phone calls from anybody. I asked the director in 
the public view today, ``Mr. Director, what is your next 
step,'' hoping that that would send the signal that whatever he 
told me, he was going to tell you.
    Mr. Scott. Right.
    Chairman Baker. That is all I know.
    Mr. Scott. All right.
    Chairman Baker. And when I know more, I will be happy to 
share it and, in the meantime, I hope I don't see you all until 
January.
    Mr. Scott. Thank you.
    Chairman Baker. If there is no further business for this 
committee, we stand adjourned.
    [Whereupon, at 6:19 p.m., the subcommittee was adjourned.]



                            A P P E N D I X



                            October 6, 2004


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