[Senate Hearing 108-833]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-833


                   OVERSIGHT OF GOVERNMENT SPONSORED
                   ENTERPRISES' ACCOUNTING PRACTICES

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

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

  THE ROLE OF A FEDERAL FINANCIAL SAFETY AND SOUNDNESS REGULATOR, AN 
APPROACH TO EXAMINING ACCOUNTING PRACTICES, AND CONTROLS OVER FINANCIAL 
     REPORTING, EXECUTIVE COMPENSATION, CORPORATE GOVERNANCE, AND 
                        LEGISLATIVE ENHANCEMENTS

                               __________

                             JULY 17, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                       Bryan N. Corbett, Counsel

           Mark A. Calabria, Senior Professional Staff Member

               Peggy R. Kuhn, Senior Financial Economist

             Martin J. Gruenberg, Democratic Senior Counsel

             Jonathan Miller, Democratic Professional Staff

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        THURSDAY, JULY 17, 2003

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Johnson..............................................     3
    Senator Enzi.................................................     4
    Senator Schumer..............................................     5
    Senator Bunning..............................................     6
    Senator Sarbanes.............................................     6
    Senator Sununu...............................................     8
    Senator Dole.................................................     9
    Senator Hagel................................................     9
        Prepared statement.......................................    41
    Senator Corzine..............................................    10
        Prepared statement.......................................    41
    Senator Stabenow.............................................    24
        Prepared statement.......................................    42
    Senator Reed.................................................    28
        Prepared statement.......................................    43

                                WITNESS

Armando Falcon, Jr., Director, Office of Federal Housing 
  Enterprise Oversight, Washington, DC...........................    11
    Prepared statement...........................................    43
    Response to written questions of:
        Senator Bunning..........................................    87
        Senator Dole.............................................    87
        Senator Reed.............................................    96

                                 (iii)

 
                   OVERSIGHT OF GOVERNMENT SPONSORED
                    ENTERPRISE ACCOUNTING PRACTICES

                              ----------                              


                        THURSDAY, JULY 17, 2003

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:02 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    I would like to welcome today's witness, Mr. Armando 
Falcon, the Director of OFHEO. Freddie Mac and Fannie Mae play 
an integral role in the national housing market. Through their 
financing activities in the secondary mortgage market, the 
Enterprises bring capital market liquidity to our housing 
markets and have contributed to the unprecedented rate of 
homeownership in the United States, with relatively low 
mortgage interest rates.
    As the number of homeowners has grown, so have the 
Enterprises. Collectively, Fannie Mae and Freddie Mac carry an 
astronomical $1.6 trillion in assets on their balance sheets 
and have outstanding debt of almost $1.5 trillion. Much of this 
debt is held by banks, and more than 80 bond funds have 
invested at least half of their assets in the Enterprises' 
debt. In addition, the Enterprises hold about 45 percent of the 
total outstanding residential debt.
    The investment demand for the Enterprises' debt is 
attributable in part to Fannie Mae and Freddie Mac's status as 
Government Sponsored Enterprises. As such, the Enterprises 
receive a number of statutory benefits, including an exemption 
from State and local taxes and certain regulatory requirements 
and the availability of a line of credit with the U.S. 
Treasury.
    Because of these benefits, Wall Street has assumed the 
Federal Government implicitly guarantees the Enterprises' debt 
and treats the Enterprises' debt as a near equivalent to 
Treasury notes. The market belief in this implied guarantee 
continues, despite explicit disavowals from the Enterprises and 
also the Federal Government.
    As the Enterprises grew their balance sheets and developed 
a more prominent role in the national housing market, Congress 
created OFHEO in 1992 to regulate the safety and soundness of 
the Enterprises. OFHEO has created an examination program that 
analyzes, among other factors, the Enterprises' capital 
reserves, risk portfolio, risk management, and corporate 
governance.
    Effective oversight of the Enterprises' management and 
operations is needed to maintain the market's confidence in the 
fiscal health of the Enterprises and the continued growth of 
the secondary mortgage market.
    On June 4, 2003, OFHEO delivered its annual report to 
Congress and declared that its, ``examinations found both 
enterprises''--that is, Fannie mae and Freddie Mac--``to be 
financially sound and well-managed.''
    While this report noted the ongoing restatement of Freddie 
Mac's financial statements, OFHEO declared that the ``audit 
functions of Freddie Mac are independent and effective.''
    OFHEO also stated in the report that it ``remains 
satisfied'' that Freddie's board of directors and executive 
management are taking the appropriate action to address the 
accounting problems. This report did not discuss the scope of 
the accounting problems at Freddie Mac or any imminent 
management changes.
    Despite OFHEO's positive pronouncement regarding Freddie 
Mac's audit functions, we have come to learn about troubling 
events and issues surrounding Freddie Mac's accounting policies 
and practices.
    Although the proper application of Financial Accounting 
Standard 133 to Freddie Mac's derivatives portfolio appears to 
remain the primary reason for the restatement, the press 
release on June 25 clarified that the accounting problems 
extend beyond the interpretation of an accounting rule. Baker 
Botts, a law firm, reported that Freddie Mac lacked sufficient 
accounting expertise and adequate internal controls and 
management. As a result, Freddie Mac personnel made numerous 
errors in applying the general accepted accounting principles.
    In addition, Baker Botts noted that Freddie Mac knowingly 
executed certain non-GAAP transactions and accounting policies 
in order to ``smooth'' its earnings. I am concerned that Baker 
Botts reported that Freddie Mac lacked sufficient accounting 
expertise and adequate internal controls only a few weeks after 
OFHEO declared that Freddie Mac has effective audit functions.
    In light of these events, I think it is important for the 
Banking Committee to take a critical and deliberative look at 
OFHEO's oversight of the Enterprises. Although we do not yet 
have the final conclusions of the ongoing investigations--that 
will be several months--we do have sufficient information to 
examine OFHEO's role in the process.
    I believe that it is time to analyze the scope and 
sufficiency of OFHEO's regulatory authority over the 
Enterprises. The public must have confidence that OFHEO has the 
necessary authority and resources to effectively regulate the 
Enterprises.
    To date, Freddie Mac has been cooperative with the 
Committee staff. I would expect nothing less and assume that 
this will continue to be the case. While I will refrain from 
judgment until the various investigations are completed, I 
expect complete cooperation with the Committee.
    In due course, I believe the public must come to understand 
the full breadth of the accounting errors and management 
decisions that were made at Freddie Mac. I suspect that upon 
the completion of the various investigations into the 
circumstances surrounding Freddie Mac's restatement, this 
Committee will hold hearings to review the findings and the 
conclusions. I look forward to hearing Director Falcon's 
testimony on this subject today.
    Senator Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. I want to thank Chairman Shelby and 
Ranking Member Sarbanes for convening this oversight hearing on 
how the accounting practices at Government Sponsored 
Enterprises are regulated. I welcome Mr. Falcon here today.
    No doubt the recent accounting problems and the subsequent 
personnel changes at Freddie Mac have rightfully come under 
scrutiny by the Office of Federal Housing Enterprise Oversight. 
Today's focus is not on the details of that review but, rather, 
on whether the current regulatory structure has lived up to 
expectations.
    I believe that we in Congress need to take a measured 
approach on how we proceed in this matter, and it is vital that 
we not politicize the ongoing review.
    That said, I applaud you, Mr. Chairman, for inviting Mr. 
Falcon, the Director of OFHEO, to give the Committee an 
overview of the regulatory structure in place to oversee 
accounting practices at the GSE's. Earlier this week, Mr. 
Falcon requested fiscal year 2003 supplemental appropriations 
to help complete the OFHEO review of Freddie Mac and to embark 
on a review of Fannie Mae's accounting as well. As a Member of 
both the Authorizing Committee and the Appropriations 
Committee, I am committed to ensuring that OFHEO has the 
necessary resources and tools to complete a thorough review and 
report its findings to Congress in a timely manner.
    The OFHEO report will be an important reference for us as 
this Committee considers whether legislative action is needed 
to restore confidence in the regulatory structure of the GSE's. 
However, it is critical that we have full information before 
taking any drastic steps that could roil the housing markets.
    Low interest rates and strong housing markets have played a 
major role in keeping our otherwise sluggish economy afloat. 
We, in Congress, need to be ever mindful of the importance our 
housing markets play in all aspects of our economy. 
Homeownership is one of America's great success stories. 
Homeownership has become essentially a prerequisite for 
entrance to middle-class prosperity in America. Combined, 
Freddie Mac and Fannie Mae have helped more than 75 million 
American families buy homes. Any knee-jerk reactions on the 
part of OFHEO or Congress could have unintended negative 
implications for our economy and for millions of Americans who 
have realized the financial and social benefits of 
homeownership.
    Clearly, Congress will need to take a close look at the 
accounting practices that led to the current problems at 
Freddie Mac, including the role of OFHEO in overseeing such 
accounting. We also need to take a close look at whether OFHEO 
has policies in place to determine whether the GSE's have 
appropriate internal controls and expertise to evaluate when 
advice they receive from an external auditor may be wrong, 
especially with respect to complex financial transactions.
    Mr. Chairman, at 10:30, I have an Appropriations Committee 
markup on four very important appropriations bills, and I will 
excuse myself at that time. I look forward to Mr. Falcon's 
testimony, and I look forward to working with you and Ranking 
Member Sarbanes to see to it that we do justice to this very 
important issue.
    Chairman Shelby. Senator Enzi.

              STATEMENT OF SENATOR MICHAEL B. ENZI

    Senator Enzi. Thank you, Mr. Chairman.
    Today, we will be learning about a situation that appears 
to be very similar to the types of situations that prompted us 
last year to pass the Sarbanes-Oxley Act. However, there are 
significant differences in this situation that warrant us to 
take a step back so that we can thoroughly understand the facts 
before taking any action, if action is necessary.
    Our discussion here today should not be limited to the 
financial accounting of certain derivatives transactions, but 
should include an in-depth discussion as to whether sufficient 
regulatory oversight was present to comprehend those 
transactions.
    Just yesterday, Chairman Greenspan spoke at length about 
how financial derivatives have greatly enhanced our Nation's 
economy. Many types of financial entities use derivatives to 
provide greater stability to their balance sheets. This is 
especially important for the housing industry and, in 
particular, for Government Sponsored Enterprises.
    As an accountant, I understand and appreciate the need to 
have appropriate accounting standards that accurately reflect 
the balance sheet of the company. With respect to accounting 
for derivatives, Financial Accounting Statement 133 extensively 
details how companies account for derivatives transactions.
    I will be very interested to see the final reports of 
investigation underway by the Office of Federal Housing 
Enterprise Oversight and the Securities and Exchange 
Commission, as well as the final report of the outside 
independent investigator hired by Freddie Mac. These reports 
will give us a greater understanding of the true nature of the 
circumstances surrounding the restatement of Freddie Mac's 
financial statements.
    With respect as to whether there was sufficient regulatory 
oversight on this matter, I am not convinced that there was. 
While the Office of Federal Housing Enterprise Oversight claims 
that it was on top of the situation at each step of that 
process, it presents a less than compelling argument for its 
case. It was not too long ago that the Agency requested and 
received monies to hire additional staff. At that time the 
Agency clearly understood that it had sole responsibility to 
oversee the complex financial instruments used by the 
Government Sponsored Enterprises. It appears that the regulator 
placed too much reliance upon the financial statements prepared 
by Arthur Andersen without having sufficient checks and 
balances to review and comprehend the financial statements.
    I would greatly appreciate an explanation of how OFHEO is 
using the new employees it had been authorized to hire. Just 
days ago, the Director of OFHEO wrote to the Senate and House 
appropriators claiming the need for $4.5 million in additional 
funds to support the special investigation of Freddie Mac and 
to commence a new review of Fannie Mae's financial statements. 
I am very troubled by this action as it indicates a significant 
weakness in the Agency's ability to accomplish its statutory 
mission. While I fully support providing the means necessary to 
help a Federal agency fulfill its mission, as we did with the 
Securities and Exchange Commission, I do not believe that we 
have been given sufficient information on how this agency is 
performing and whether new monies are justified.
    Mr. Chairman, I thank you for holding this hearing.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. I want to thank 
you again for holding this series of timely hearings on so many 
of the subjects we hear about. This one is particulary 
important.
    The recent disclosure of the Freddie Mac auditing problems 
has put back on the front burner the issue of the regulation of 
Fannie and Freddie and even the structure of Fannie and 
Freddie. And I guess we have three general options to consider:
    One is to make Fannie and Freddie just completely free 
market enterprises. I would very much oppose that. I think the 
blend of private sector strength, knowledge, acumen, and 
agility and the Federal Government's social responsibility, 
ability to fill in the cracks where the market just does not do 
a job--no one since Adam Smith believes that markets are 
perfect. I believe the public-private blend is the right way to 
go, and those who want to make Fannie and Freddie private I 
think miss that boat. If we can make them private, we can let 
private sector people do some of those functions and compete, 
and they can do it well.
    The second is to leave things as they are regulatorily. If 
you are not going to restructure the public-private blend, what 
do you do regulatorily? And I think here, I, at least, Mr. 
Falcon, have some real doubts about OFHEO's ability to monitor 
safety and soundness. These are extremely complicated areas, 
and at least thus far, the track record is not terribly good.
    So there is a third option, which is to take at least the 
safety and soundness aspects of the monitoring of Fannie and 
Freddie, which have become more and more important as Fannie 
and Freddie get bigger, and maybe even the whole responsibility 
of Fannie and Freddie and move it to Treasury. And that to me, 
at least on its surface, certainly needs exploration, but it 
makes some sense.
    I think the Government should and can play a role in 
housing markets. I think Fannie and Freddie have done a very 
commendable job expanding homeownership in America. I have 
found in my State, as I said, when there are particular needs, 
Fannie and Freddie move into the gap, which private sector 
companies would not do. It is the benefit they gain from some 
association with the Federal Government that importunes them to 
do these things.
    But in terms of just the quickness, speed, and complexity 
of the new products that Fannie and Freddie are putting out, it 
seems to me that in that area, which has effects on our entire 
financial system, Treasury is the most logical place to oversee 
these. And so that is something that I think we should explore, 
and when the question period comes up, Mr. Chairman, I will be 
asking Mr. Falcon why that shouldn't be done. It seems to me 
the burden has switched with the recent changes or with the 
recent things that we have seen.
    So, I thank you again for holding this hearing and hope we 
can really begin actively exploring how we can make Fannie and 
Freddie--and I think they are very good--make them even better.
    Chairman Shelby. Senator Bunning.

                STATEMENT OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman. I would like to 
thank you also for holding this very timely and important 
hearing today. I would like to thank Director Falcon for 
testifying.
    Like my colleagues, I am very concerned about what has 
happened with Freddie Mac. It is very disconcerting that 3 days 
before Freddie's restatement, OFHEO put out a glowing report on 
Freddie. Then after the ouster of Freddie's executives, OFHEO 
put out a letter calling Freddie's situation a crisis and have 
asked for a supplemental appropriation to hire more 
accountants.
    Obviously, everything was not okay when OFHEO put out its 
report. I read in The Wall Street Journal today that Baker 
Botts, who did the investigation of Freddie's accounting, 
disputes your prepared testimony. They say they were fully 
candid with OFHEO. They even go as far as saying the charge in 
your testimony was ``a cheap shot and perhaps reflects the 
advice Director Falcon is getting from his staff.'' That is a 
very disturbing charge.
    I also am concerned about the bill language that was sent 
up. Some of our friends in the House of Representatives have 
been stating that they believe Fannie and Freddie do not have 
an effective regulator. They would like to have the Department 
of the Treasury, like my good friend from New York has 
suggested, to regulate the GSE's.
    Receiving major legislation like we have and requests for 
supplemental appropriations to hire more accounts so you can do 
your job give those friends of ours a lot of heavy ammunition.
    Director Falcon, I have known you since you worked for 
Henry Gonzalez on the House Banking Committee. I know how long 
you have been in public service, and I thank you for that 
service. But I do not think this will be the most pleasant 
hearing you have ever been to.
    I also think the man who will follow you will also have a 
very tough hearing, largely because of what has happened since 
January.
    Once again, Mr. Chairman, thank you for holding the 
hearing.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. This 
is a very timely and important hearing. I should note that 
housing continues to be a bright spot in an otherwise sluggish 
economy. This is because home equity has been a large and 
continuing source of funding to fuel consumer demand.
    One important reason this has been possible is that the 
United States has the deepest, most liquid housing capital 
markets in the world. Fannie Mae and Freddie Mac are at the 
heart of that system--companies that helped to bring $2.5 
trillion to finance millions of homes here in America last 
year. It is very important to understand that we are dealing 
with a major sector of our economy and we have to be ever 
mindful of how what we do well impact upon it.
    To address the system's safety and soundness, Congress 
created the Office of Federal Housing Enterprise Oversight, 
OFHEO. And our job here, of course, is to make sure that OFHEO 
has the tools to do its work, and to make sure that it pursues 
its work vigorously and effectively.
    Fannie Mae and Freddie Mac have assets of about $1.6 
trillion, nearly double the level they had in 1997. Their 
retained portfolios are valued at about $1.4 trillion. 
Together, the two companies have outstanding debt equal to 
about $1.5 trillion, and they have derivatives with a combined 
notional value of over $1.5 trillion. The size and complexity 
of these two companies and the central role housing plays in 
our economy makes it all that much more important to ensure 
that OFHEO has the kind of funding and sophistication it needs 
to do a good job.
    It is in this light that I believe we need to ask whether 
OFHEO was sufficiently knowledgeable about the accounting 
problems as well as the internal control problems at Freddie 
Mac. We need to explore whether or not OFHEO took the 
appropriate action to address these problems, and whether or 
not it did so in a timely manner. Finally, we should consider 
whether or not we have given the regulator the tools it needs 
to do an effective job.
    I should note that Mr. Falcon has been seeking independent 
funding over the last few years for OFHEO, parallel to what 
some financial regulatory agencies have available to them. This 
is a suggestion that has been made by a number of people for 
improving the regulatory structure for Fannie and Freddie.
    I believe as we explore these questions about the 
activities of OFHEO, we should acknowledge that some amount of 
progress has been made in the nearly 3 years that Mr. Falcon 
has served as its Director.
    He has, for example, guided the Agency to the completion of 
the risk-based capital rule that was many, many years overdue. 
In doing so, he resisted considerable pressure to adopt a 
process whereby the regulator would set the parameters of the 
risk-based capital stress test, but the institutions themselves 
would develop and run the actual model. We need to remember the 
dynamics that existed in the not too distant past. I believe 
OFHEO's decision to move forward with its own model has 
contributed to the fact that the current concerns about Freddie 
Mac have not, at least to this point, led to questions about 
the safety and soundness of that company.
    This is a point worth emphasizing. The concerns that have 
led to this hearing today relate to the accounting for 
derivatives at Freddie Mac. But the economic effectiveness of 
those derivatives as hedges against risk have not at yet been 
put into question.
    Finally, Mr. Chairman, as we examine OFHEO's efforts, I 
want to raise a concern I have about the effectiveness of the 
Federal Housing Finance Board. It appears that the Finance 
Board is seeking to reconfigure the membership and expand the 
powers of the Federal Home Loan Bank System; without regard to 
its statutory authority and without regard to the significantly 
increased risk its proposed action would bring to the Home Loan 
Bank System.
    As former Bush Administration official, Assistant Secretary 
of the Treasury Sheila Bair said, ``The Federal Home Loan Bank 
System is taking risks for which it is not prepared and 
inviting scrutiny and controversy by forging ahead with 
activities that far exceed its Congressional charter and with 
which it has had no historic experience or expertise.''
    Mr. Chairman, I hope at some time in the near future we 
might have an opportunity to examine this issue.
    In closing, I want to commend Chairman Shelby for his 
reasoned approach to the serious problems that have come to 
light at Freddie Mac. There are a number of investigations 
ongoing by a number of agencies--OFHEO, the SEC, the Board of 
Directors of Freddie Mac itself, and others. And, Mr. Chairman, 
I think it is prudent to first spend some time gathering the 
facts before coming to the conclusions about what action might 
or might not be appropriate. And I am pleased to join with you 
in that effort.
    Thank you.
    Chairman Shelby. Senator Sununu.

              STATEMENT OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    Welcome, Mr. Falcon, and to the extent that you might be 
taking consolation in the impending grilling of Mr. Brickell, I 
note that I think his confirmation hearing is next week, so you 
might keep that in the back of your mind.
    This is an important hearing, and I thank the Chairman for 
setting the time. There are two broad sets of issues that I 
hope the Committee is able to spend time on in this and any 
subsequent hearings dealing with these issues, these two broad 
issues that I hope you will touch on in your testimony.
    The first is simply the needs and capabilities of OFHEO. It 
is something you have spoken about at length before, not just 
to this Committee but to Appropriations Subcommittees as well, 
and I know it is important to you and it has taken up the focus 
of your time over the years. But it is important that we review 
those needs and capabilities given the current situation of 
personnel needs, financial needs, and the expertise, both for 
accomplishing your ongoing mission, which has been the 
regulator of the GSE's, but also with respect to the current 
accounting crisis, the accounting problems at Freddie Mac. We 
want to understand as deeply as possible--I certainly want to 
understand--the extent to which OFHEO has been properly 
equipped, is properly equipped, and that any changes in your 
organization or the resources and the needs of your 
organization are going to address the problems at hand and be 
effective at dealing with these problems.
    The second set of issues is really looking a little further 
forward with some of the comments that Senator Schumer and 
Senator Sarbanes made, which is the role of OFHEO and the 
relationship OFHEO has to other regulators. The Federal Housing 
Finance Board was mentioned. We have the Office of Thrift 
Supervision, the OCC, and the Federal Reserve. Obviously, all 
of these organizations are involved in regulating financial 
services. All of them will touch on some of the same concerns 
and needs in industry that OFHEO has dealt with in the past. 
And I think it is important that this Committee begin to assess 
the relative strengths and weaknesses of these different 
financial regulators. That is obviously what the legislation 
Senator Bunning mentioned is trying to do. It has been put 
forward in the House. An argument is being made that we need to 
look at the organization of these regulatory bodies and at 
least consider changes in them in order to make them stronger. 
I would assume everyone, whether you are for or against the 
changes, the goal should be to make them as strong as possible 
and enable them to do their job.
    We also want to make sure that these organizations and 
agencies are cooperating. I know you are looking into the 
accounting problems at Freddie Mac. The SEC is also looking 
into the accounting problems at Freddie Mac, and I am sure that 
the U.S. Attorney's office is as well. No matter who the 
enforcement or regulatory body is, we want to make sure that in 
an important investigation like this there is cooperation and, 
finally, that this alphabet soup of different regulators is not 
resulting in unnecessary duplication because that will limit 
the effectiveness of these organizations and perhaps create 
unintended consequences and a failure of the ability to do a 
good job or the allowance that Senator Sarbanes was talking 
about, the allowance of organizations to take on more risk than 
they are appropriately suited to do.
    So, I hope that we can address both of these issues in the 
hearing, and I very much look forward to your testimony. Thank 
you for being here.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dole.

               COMMENTS OF SENATOR ELIZABETH DOLE

    Senator Dole. Mr. Chairman, in the interest of time, I will 
submit my opening statement for the record.
    Chairman Shelby. Without objection, so ordered.
    Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you. And, Director 
Falcon, thank you for coming before the Committee this morning.
    I, too, have a statement, Mr. Chairman, that I will submit 
for the record.
    Chairman Shelby. Without objection, it will be put in the 
record.
    Senator Hagel. Thank you.
    I have, as you know, and as does Senator Sarbanes, for the 
last 7 years on this Committee, been concerned about these 
issues as I have listened to my colleagues this morning talk 
about oversight responsibilities. Are we moving away from the 
original missions of these GSE's? Are they getting into 
troubled waters? And, obviously, we have a number of questions 
here that we are going to ask you that directly relate to 
troubled waters, specifically Freddie Mac. And I understand you 
will be also looking at Fannie Mae here shortly, if you are not 
already.
    We need to take a long, broad, deep look, not just at your 
organization but I think all the GSE's. And I have suggested 
that over the years to the Chairman and to Mr. Sarbanes. So, I 
welcome Senator Sarbanes' thoughts, others, and I will, like 
all on this Committee, look forward to your testimony.
    I would say also that what Senator Sununu has suggested and 
also our colleague from New York I think makes some sense, and 
next week, Mr. Chairman, Senators Sununu, and Dole and I will 
introduce legislation, very much patterned after the House 
legislation, to move OFHEO out of HUD into Treasury, along with 
a number of other dynamics that we think would strengthen your 
organization, institution, do the things that you, Mr. 
Director, have asked for which make some sense to deal with 
this.
    Confidence is the coin of the realm in this business, and 
you know that clearly. And before we try and hang too much on 
you or your organization, we need to look at the institutional 
problems and the structural deficiencies that exist, partly 
because we have not kept up with the new challenges and the 
expanded focus that these GSE's have brought to themselves. And 
I do not think this Committee and other Committees over the 
years have paid much attention to it. So, we appreciate you 
coming before us. We appreciate what you and your team are 
doing. And we want to help you do your job.
    With that, Mr. Chairman, I look forward to hearing the 
Director's comments.
    Chairman Shelby. Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. I join my 
colleagues in thanking you on having this hearing. I think this 
is an absolutely essential oversight function that we need to 
perform with regard to the GSE's. I hope that we do not lose 
track of how important, while we are going to through this 
process, the GSE's are to the provision of liquidity and 
support for the housing market, which is one of the most 
effective in anyone's conception of the beginning and 
institution of these institutions.
    I have a full statement for the record.
    Chairman Shelby. Without objection, it will be made part of 
the record.
    Senator Corzine. And I will save my remarks for the 
questions.
    Chairman Shelby. Mr. Falcon, your written statement will be 
made part of the record in its entirety. You proceed as you 
wish.

                STATEMENT OF ARMANDO FALCON, JR.

              DIRECTOR, OFFICE OF FEDERAL HOUSING

                      ENTERPRISE OVERSIGHT

    Mr. Falcon. Thank you, Mr. Chairman. I will try to 
summarize my statement, but there is much to cover so I hope 
you will allow me to go beyond the normal time frames.
    Chairman Shelby. Go ahead.
    Mr. Falcon. Mr. Chairman, Ranking Member Sarbanes, and 
Members of the Committee, I appreciate the opportunity to 
appear before you. My testimony today will focus on the 
circumstances leading up the Freddie Mac restatement effort and 
OFHEO's role as a safety and soundness regulator.
    By the way, thank you, Mr. Chairman and Ranking Member 
Sarbanes, for the very responsible and judicious manner in 
which the Committee has handled this matter. I also want to 
assure you of OFHEO's full cooperation as the Committee 
proceeds with its own oversight of this matter. Given our 
ongoing investigation, I ask for the Committee's understanding 
if I am restrained in my testimony as facts are still being 
verified and circumstances evaluated.
    On January 22, 2003, Freddie Mac announced it would reaudit 
and restate its financial statements for 2000 and 2001. The 
company also announced that its external auditor would delay 
certification of Freddie's year-end 2002 financial statements 
until the restatement process was complete. Five months later, 
on June 6, the board removed the company's top three officers. 
OFHEO, the SEC, and a U.S. Attorney have ongoing investigations 
of the company and its accounting practices. These 
extraordinary actions reflect the culmination of developments 
over several years, during which time OFHEO has fulfilled its 
safety and soundness mission. I will begin by describing the 
major developments in chronological order.
    The sequence of events begins in 1999 with preparation for 
implementation of FAS 133. FAS 133 is not the only accounting 
rule involved in this matter, but it plays the most important 
role.
    FAS 133 requires an entity to recognize all derivatives as 
either assets or liabilities and reflect those instruments at 
fair value in the financial statements.
    In 1999 and 2000, OFHEO's examiners assessed the 
development and implementation of Freddie Mac's plans with 
respect to several new significant accounting standards, 
including FAS 133. That assessment led us and Freddie Mac to 
the conclusion that the company needed to strengthen its 
accounting expertise and financial reporting internal controls. 
Freddie Mac addressed these issues with the adoption of the 
Financial Reporting Controls Improvement Plan in late 2000. The 
goal of the FRCIP was to achieve the same level of controls in 
the financial accounting and financial reporting area that were 
present across the other areas of the company and in the 
operating business units.
    In the fourth quarter of 2000 and in the first quarter of 
2001, Freddie Mac entered into several FAS 133 transition 
transactions. PricewaterhouseCoopers would later identify these 
transactions as being inconsistent with GAAP and in need of 
correction before the 2002 financial statements could be 
certified. Thus, the problem we address today began in 2000.
    As 2001 began, FAS 133 took effect. Arthur Andersen 
certified each quarter's financial statements under the new FAS 
133 pronouncement as GAAP compliant. Strengthening expertise 
and reducing the reliance on manual systems were important 
aspects of the Improvement Plan introduced in 2000, and in 2001 
OFHEO's examiners continued to evaluate the progress of the 
company against this remediation plan. We continued to press 
management to ensure progress continued in implementing the 
plan. By May 2001, approximately one-third of the plan had been 
completed.
    During this period, OFHEO planned enhancements for its 
examination program. In 2000, I decided to create an 
examination team dedicated to accounting matters. In January 
2001, we designed a comprehensive plan to enhance OFHEO's 
examination program, which included such an accounting team. A 
cornerstone of that plan was to more than double the size of 
the examination staff, adding depth and additional specialized 
skill sets. A portion of the funding was first received in 
2002.
    Late in 2001, Arthur Andersen was under public scrutiny 
because of its role as the audit firm in a number of high-
profile Federal investigations. Given these developments, 
Freddie Mac's Board of Directors considered whether they should 
keep Arthur Andersen or select a new independent accounting 
firm. Freddie Mac solicited OFHEO's views concerning the 
retention of Arthur Andersen. OFHEO opined that, given the 
circumstances, retention of the firm created a higher-risk 
situation for Freddie Mac.
    On March 6, 2002, the audit committee chose PwC as Freddie 
Mac's independent public accountants for the year 2002.
    I should note that up to this point, the audit opinions of 
Arthur Andersen on the consolidated financial statements of 
Freddie Mac for 2000 and 2001 did not contain any adverse 
opinion or disclaimer of opinion, nor were they qualified or 
modified as to uncertainty, audit scope, or accounting 
principles. As it had done for years, Arthur Andersen certified 
the financial statements of Freddie Mac as having been prepared 
in accordance with GAAP.
    PwC began its audit engagement immediately after being 
selected by the audit committee. In the course of its audit, 
PwC initiated a process of identifying various accounting 
policies and accounting issues to be discussed with Freddie 
Mac's management.
    In July 2002, PwC identified the allowance for loan and 
lease losses as a critical accounting matter that needed to be 
resolved before it would certify Freddie Mac's 2002 financial 
statements. OFHEO was actively involved in these discussions.
    PwC felt that Freddie Mac was too conservative in its loss 
estimates and coverage to be consistent with GAAP. Freddie Mac 
agreed to reduce the reserve by $246 million, whereupon PwC 
certified the second quarter financial statements.
    Accounting policies and issues continued to be addressed by 
PwC, management, and the board throughout 2002. Progress 
appeared on track for the certification of fiscal year 2002 
financial statements.
    OFHEO continued to evaluate and monitor the status of the 
accounting policies under discussion between PwC and Freddie 
Mac. Examiners continued in 2002 to evaluate progress on the 
Improvement Plan at least quarterly.
    I will move to 2003 now. In mid-January 2003, PwC informed 
the audit committee that they would be meeting with 
representatives of PwC's national office about unresolved 
policy matters in connection with certification of Freddie 
Mac's financial statements. On Monday, January 20, 2003, PwC 
notified the audit committee that they were uncomfortable with 
certain accounting treatments applied during the FAS 133 
transition, and that until its concerns were resolved, they 
would not be able to certify the company's 2002 financial 
statements using the accounting policies from prior periods. 
Even though the policies had been approved by Arthur Andersen, 
PwC considered that they were not GAAP compliant. OFHEO was 
made aware of these developments that very day and met with 
Freddie Mac officials the following day.
    Arthur Andersen was no longer an operating firm at this 
point. Thus PwC could not undertake a normal transition 
pursuant to the AICPA guidance for successor accountants. 
Instead PwC would have to undertake additional substantive 
testing. The Board of Directors of Freddie Mac decided that PwC 
should conduct a reaudit and restatement of the prior period 
financial statements.
    The net cumulative effect of the new accounting treatments 
was an increase in income in prior periods, thus increasing the 
amount of capital on a cumulative basis. Further, OFHEO, PwC, 
and the audit committee considered the effects of the 
accounting policy changes on the fair value statements of 
Freddie Mac. All the parties involved concluded that there was 
no meaningful impact on the fair value statements. This meant 
the underlying economics for Freddie Mac's positions were 
materially unaffected by the timing changes in recognizing 
income under GAAP.
    During this time, examiners were on-site at Freddie Mac 
gathering more information about the issues and the action plan 
that was being developed in connection with the reaudit. 
Freddie Mac announced the reaudit on January 22, 2003, and that 
there would be a delay in the publication of 2002 certified 
financial statements.
    With the restatement, it was clear that a forensic review 
of the accounting issues raised by PwC would be appropriate. 
The law firm of Baker Botts was retained by the audit committee 
to perform this task. OFHEO's accounting team began continuous 
surveillance of the restatement process on January 22, 2003.
    In May, OFHEO observed slippage in the restatement process 
against established time lines. Since January 2003, PwC and 
Freddie Mac have had more than 500 people working on the 
process 6 days a week. There was considerable work that needed 
to be done between production of statements and producing the 
tables and disclosures to accompany those statements. On May 8, 
PwC informed the senior board members and counsel that PwC 
would not accept the representations of CFO Vaughn Clarke and 
President David Glenn and the reasons therefore.
    On May 27, OFHEO was briefed on the Baker Botts work for 
the audit committee. In response to a question from OFHEO, 
Baker Botts expressed no concern regarding inappropriate or 
improper behavior by management. Subsequent to this meeting, 
OFHEO learned the very troubling information regarding the 
conduct and integrity of management and matters related to the 
restatement process, indicating the board's counsel had not 
been fully forthcoming. This lack of candor contributed to my 
decision on June 7 to initiate an OFHEO investigation rather 
than wait for the Baker Botts report.
    Mr. Chairman, I will begin a discussion of the key events 
from June 4 to June 7 that have drawn so much attention. First, 
I would note that the Freddie Mac Board of Directors was 
holding a regularly scheduled meeting on Thursday, June 5 and 
Friday, June 6.
    On Wednesday, June 4, David Glenn met with the board's 
outside law firm, Baker Botts, and informed them that he had 
altered and, in some cases, could not produce pages from a 
notebook that had been requested by the company. That evening, 
counsel from Baker Botts informed the lead outside Director of 
Mr. Glenn's confession.
    On Thursday, June 5, Freddie Mac's Board was informed of 
Mr. Glenn's admissions and determined that action was required. 
The morning of June 5 OFHEO was informed that Freddie Mac's 
Board wanted an urgent discussion with us when the board 
concluded its deliberations. The board's deliberations 
continued into the next day, Friday, June 6.
    On June 6, during the day, the board made a decision to 
separate from the firm Messrs. Brendsel, Glenn, and Clarke, and 
on the appointment of Messrs. O'Malley, Parseghian, Petersen, 
and Baumann. The board communicated to OFHEO immediately on the 
actions regarding the management changes. Later in the day on 
June 6, I was informed about the circumstances surrounding Mr. 
Glenn's termination. I instructed counsel to the board to 
appear at OFHEO's offices on Saturday, June 7, and report to us 
on all matters surrounding the management changes.
    On the morning of June 7, OFHEO senior staff and I met with 
representatives of Freddie Mac's Board to learn the details of 
recent events. I would note that much of what was addressed 
that day was known to OFHEO and had been subject to the 
restatement process. However, new information relating to Mr. 
Glenn's actions and the termination and the replacement of 
senior management was given to us for the first time. I was 
particularly displeased to learn about the lack of confidence 
in Mr. Glenn expressed a month earlier to Freddie Mac by PwC. I 
considered the disclosures regarding Mr. Glenn to be a clear 
signal of a breakdown in the integrity of Freddie Mac's control 
environment at the highest levels, and sent the letter to the 
board that day, initiating an OFHEO investigation and taking 
additional steps.
    Having discussed our specific regulatory role over the 
restatement process at Freddie Mac, I would now like to put it 
in a more general context. First, the role of a financial 
safety and soundness regulator, and second and more 
specifically, the Agency's regulatory approach in examining 
accounting practices and controls.
    OFHEO uses a safety and soundness approach in supervising 
the Enterprises that is analogous to the Federal Reserve 
System's and the Office of the Comptroller of the Currency's 
approach to supervising large-and-complex banking 
organizations. The foundation of these approaches is that the 
management of these firms should be held responsible for 
monitoring and managing the institution's 
exposure to risk. By looking at the firm's risk management 
procedures and internal controls, the safety and soundness 
regulator assesses whether the firm's ability to manage risk 
matches the level of risk it assumes. In addition, the 
supervisory process also reviews the firm's performance in 
complying with the company's own internal policies as well as 
other prescriptive requirements.
    In short, safety and soundness supervision is directed 
toward identifying material problems or emerging problems and 
seeing that they are appropriately corrected and the company's 
financial solvency is not threatened. Safety and soundness 
regulators do not review accounting policies for conformance 
with GAAP, nor do we certify that the company's financial 
statements are consistent with GAAP. We require an independent 
auditor to certify that a company's financial statements are in 
conformance with GAAP. We review transactions to ensure that 
they are consistent with sound risk management. The work of the 
independent auditor is to conduct its audit and report on the 
company's annual financial statements.
    In regards to executive compensation, I wrote to the board 
of directors on June 7, 2003, indicating that it must explain 
its rationale for any termination packages for Messrs. 
Brendsel, Glenn, and Clarke. Further, I directed the board to 
inform these individuals that their termination packages are 
subject to OFHEO review and approval, and for any employee 
discharged for misconduct, that OFHEO could direct 
indemnification of Freddie Mac for losses incurred. We directed 
Freddie Mac not to transfer funds, stock, or options to these 
three individuals, and Freddie Mac is complying.
    Turning now to the OFHEO report to Congress. We reported 
that Freddie Mac's overall internal control framework and the 
management of the internal control framework are effective. We 
stated, however, that Freddie Mac's release of audited 
financial statements was being delayed pending a reaudit of 
past financial statements, and that Freddie Mac had agreed that 
certain accounting treatments applied in the past were 
incorrect. We informed Congress at that time of our opinion 
regarding the reaudit. We further advised Congress that Freddie 
Mac's Board of Directors had undertaken efforts to enhance 
expertise and controls in the area of financial accounting and 
operational control, that we had evaluated the board's and 
management's plans in that regard and that we were satisfied 
that these actions were appropriate steps to address the 
situation.
    In my view, these statements clearly indicate that although 
the overall framework is effective, OFHEO is ensuring that the 
board and management devote serious attention and remedial 
efforts to the area of financial reporting and related 
controls. OFHEO activities in this regard are highlighted in my 
earlier testimony.
    Finally, Mr. Chairman, I would like to bring to the 
Committee's attention an urgent funding matter. Earlier this 
week, I submitted a fiscal year 2003 Supplemental Funding 
Request of $4.5 million to the Senate and House Appropriations 
Committees. The requested funds will support two critical 
objectives. First, the funds will support the ongoing special 
investigation of Freddie Mac, and the investigation is already 
well under way and is building on information gathered over the 
course of the restatement process. Second, OFHEO intends to 
conduct a special accounting review of Fannie Mae. The special 
review would independently evaluate the accounting policies at 
Fannie Mae and examine whether their implementation is 
resulting in a high-level of conformance with GAAP. While I do 
not have a specific concern about Fannie Mae's accounting 
practices, such a review would be most prudent under the 
circumstances.
    Mr. Chairman, I know this is an oversight hearing and not a 
legislative hearing, so if and when the Committee decides to 
consider legislation in this area, I have attached some 
recommendations for your consideration.
    In summary, Mr. Chairman, is this a serious matter? Yes. Is 
there a crisis? No. While challenges lie ahead, Freddie Mac 
remains safe and sound. At the end of our investigation we will 
present all the facts, conclusions, and recommendations for the 
Committee's consideration.
    Mr. Chairman, thank you for the opportunity to testify, and 
I would be pleased to answer any questions the Committee may 
have.
    Chairman Shelby. Thank you. Mr. Falcon, Freddie Mac has 
reported that it expects the reaudit to increase its earnings 
for 2000 through 2002 by $1.5 to $4.5 billion. This is a rather 
large misstatement to have occurred under your watch. How can 
the public be confident that OFHEO is and has been addressing 
this problem? How can we be confident that a similar problem 
will not occur in the future.
    Mr. Falcon. Mr. Chairman, the range of adjustment to 
earnings will be in the range from, I think it is, $1 to $4.5 
billion.
    Chairman Shelby. That is a spread though.
    Mr. Falcon. That is a spread, yes, Mr. Chairman.
    Chairman Shelby. And a lot of money.
    Mr. Falcon. That is a lot of money, and that is a 
cumulative effect over the 2-year period involved here. It is a 
serious matter. But I would note, Mr. Chairman, that these are 
real earnings. We are not talking here about hypothetical or 
manufactured earnings, and at the end of this process their 
capital will go up by the amount of that spread. So this is a 
serious matter.
    Chairman Shelby. I think their stock has gone up, has it 
not?
    Mr. Falcon. I have not checked today. Mr. Chairman, let me 
also say that while this is a significant amount, my primary 
focus is the conduct of the company. I think it is important 
for us to get to the bottom of all the facts surrounding the 
conduct of the company and everyone involved and ensure that we 
do whatever is necessary so that this does not happen again.
    Chairman Shelby. Would you describe the scope and the 
mandate of your ongoing investigation, and how it differs from 
the annual examination process? In other words, what are you 
trying to determine here in your investigation?
    Mr. Falcon. We are trying to determine the circumstances of 
the restatement, how these transactions were accounted for in 
the company's financial statements, and the role of individuals 
involved. We are also looking to see whether or not there was 
any intentional misapplication of GAAP in order to further some 
company policy. If that is the case, we will certainly take 
appropriate action to make sure that we do whatever is 
necessary so that it does not happen again, Mr. Chairman.
    Chairman Shelby. When do you think this final report will 
be completed?
    Mr. Falcon. We would like to complete it by the end of 
September. We are working very hard to stay on that target. It 
is also essential that we do obtain some additional 
appropriations. That would help us stick to that goal, Mr. 
Chairman.
    Chairman Shelby. There are some differences here between 
your report and the Baker Botts report, which is the law firm 
that Freddie Mac retained to do an inside investigation. Some 
of us are troubled that OFHEO declared in its annual report 
that Freddie Mac's accounting functions were, ``effective.'' 
Yet Baker Botts has reported that Freddie Mac lacked sufficient 
accounting expertise and adequate internal controls. Could you 
explain OFHEO's, your basis for reaching your conclusion, and 
the disparity with the conclusions reached by Baker Botts?
    Mr. Falcon. Mr. Chairman, I do not think there is a 
disagreement between us on that point. If there is a 
misperception based on our annual report, that we were unaware 
of problems or that we were not working to correct those 
problems, I hope I have dispelled that misperception with my 
testimony. I have tried to detail very precisely how going back 
to the year 2000, we had them working to correct accounting 
problems and problems with their internal controls.
    Chairman Shelby. Senator Sarbanes and I have received a 
letter from Baker Botts basically challenging certain 
statements in your testimony today. Of course, I will ask this 
be made part of the record, and if you have not gotten a copy 
of it, we will give it to you.
    Mr. Falcon. I have not, Mr. Chairman.
    Chairman Shelby. We will certainly do this now. I think 
this is important to you and to the Committee. We will 
distribute that.
    Mr. Falcon. May I address that, Mr. Chairman?
    Chairman Shelby. Sure.
    I think Senator Bunning alluded to that earlier.
    Mr. Falcon. Yes.
    Chairman Shelby. I am sure he will want to get into it.
    Mr. Falcon. Since that time Baker Botts has been 
cooperating with us, and they are cooperating fully I think. 
But at this point in time they were asked a direct question, 
Mr. Chairman, ``Are you aware of any inappropriate conduct on 
the part of the company?'' The answer was no. They were further 
asked, ``Is there anything that we should know, related to your 
work up to this date?'' The answer was no.
    About a month before this conversation, the counsel was 
fully aware of circumstances surrounding PwC's inability to 
take the representations of Messrs. Clarke and Glenn. The 
circumstances surrounding their conduct is certainly the type 
of activity that the regulator would expect to be informed 
about by Board's counsel, Mr. Chairman. I stand by what I have 
said in my testimony.
    Chairman Shelby. But it is disputed. They dispute what you 
say. You realize there is a dispute here?
    Mr. Falcon. I accept that, Mr. Chairman.
    Chairman Shelby. Okay. Senator Sarbanes.
    Senator Sarbanes. Thank you, Mr. Chairman.
    I want to go back to a couple of questions that Chairman 
Shelby asked, which I thought were right on point.
    You make the point that the net cumulative effect of the 
new accounting treatments for Freddie Mac was an increase in 
income in prior years, thus increasing the amount of capital on 
a cumulative basis. I think that is in your testimony and you 
just stated it again in response to the question.
    Mr. Falcon. Yes, sir.
    Senator Sarbanes. But this really raises the implication 
that had the errors resulted in a reduction in prior year 
income, that the Enterprise might have been undercapitalized, 
that would all have been unbeknownst to the regulator. As you 
know, the mistake that was made, as it turns out, was such that 
there is an increase in income in prior years and therefore 
there is an increase in the amount of capital. Of course you 
did not know that. It could have turned out that there was a 
reduction in some prior years and therefore a decrease in 
capital. As it turned out, it worked in the right direction, so 
to speak, but how do we get at the fact that it was all 
happening unbeknownst to the regulator?
    Mr. Falcon. That is a good question, Senator Sarbanes, and 
what we are working to do at OFHEO is to build an in-house team 
of accountants. They can take a look at issues like this. While 
we could not possibly have the amount of staff necessary to 
review all policies and transactions to ensure that the 
external auditor is adhering to the highest standards of GAAP, 
we would like to build the capacity in-house to at least be 
able, on a selective basis, review some of the major and the 
perhaps novel issues that come up in accounting when new 
standards are brought into effect. I think that is an important 
part of our program that we are trying to develop going 
forward, and we developed this plan beginning in the year 2001, 
and last year we began to get the appropriations to staff up 
for that expertise.
    Senator Sarbanes. Do you think that the OFHEO reviews have 
been prepared to simply accept the audit functions? In other 
words, I gather you are not going behind the auditor; is that 
correct?
    Mr. Falcon. We are ensuring that they do their job pursuant 
to industry standards as they work to certify the financial 
statements, but we are not taking a qualitative look at the 
judgments they make as to whether a particular accounting 
policy is consistent with GAAP. We did not try to interpret the 
GAAP the way they do. If we did, that is a practice that was, 
as you know, Senator, widely discredited in the 1980's. 
Regulatory Accounting Principles accounting is something that 
we have worked to avoid, not just at OFHEO but all the safety 
and soundness regulators.
    Senator Sarbanes. How do you avoid the situation we just 
had here? I mean, you tell us in your June 2002 report to the 
Congress, ``The audit functions exceed safety and soundness 
standards.'' I am quoting now from your report. ``The internal 
and external audit functions have the appropriate independence. 
The management of the internal audit department is effective.'' 
Then the 2003 report, this past June, ``The audit functions are 
independent and effective. The internal and external audit 
functions have the appropriate independence.''
    Now, only a few days after we received the report the 
Freddie Mac Board got rid of these chief officers because of 
lack of progress on addressing the accounting and internal 
control problems at Freddie Mac.
    Mr. Falcon. Those statements, Senator, reflect our overall 
assessment of various risk factors, and we report in the annual 
report on our overall assessment of how they are doing for that 
calendar year, and we report that in the annual report. My 
testimony points out, and our 2002 annual report points out 
that there is a restatement going on and that we are working on 
improving deficiencies in their financial reporting, internal 
controls, as well as gaps in their accounting expertise.
    What I think is appropriate and what I take from your 
comments, Senator, is that we should go back, and as we begin 
to issue successive annual reports, that perhaps we should have 
a lower threshold of what gets included in this annual report. 
We have included things that we think affect our assessment of 
the company overall. Perhaps we should go back and include 
matters that while they do not affect our assessment of the 
company, might be significant enough that we should include 
them anyway in the annual report, and that is what we have to 
consider doing going forward.
    Senator Sarbanes. My time is up. I just want to be clear on 
one thing. You have an investigation now going on, correct?
    Mr. Falcon. Yes, sir.
    Senator Sarbanes. OFHEO itself has an investigation that 
was launched on June 7; is that correct?
    Mr. Falcon. Yes, sir.
    Senator Sarbanes. And are you looking more broadly than the 
accounting functions or is it focused on the accounting 
functions?
    I know you cannot go into the nature and scope in a public 
session of your investigation, but can you answer that 
question?
    Mr. Falcon. Yes. It is focused on the accounting 
transactions that are at issue here, those issues raised by 
PwC. It does involve more than one accounting rule 
interpretation beyond just FAS 133. We are looking at those 
transactions and circumstances involved in applying GAAP and 
the role of everyone in the company in these matters.
    Senator Sarbanes. And when will that report be submitted?
    Mr. Falcon. Our goal is to complete it and submit it to you 
by the end of September, Senator.
    Senator Sarbanes. Thank you.
    Chairman Shelby. Senator Enzi.
    Senator Enzi. Thank you, Mr. Chairman.
    I do have a series of questions that deal with the request 
for the $4.5 billion in additional moneys. I would hope that I 
could submit those to Mr. Falcon in writing, because the 
answers would probably be more detailed--and probably boring.
    Chairman Shelby. And his answers would be to you and to the 
Committee, I trust?
    Senator Enzi. Yes; I would be happy to share them, and that 
would allow me to ask some other questions. Of course, another 
one of them that I am going to submit is: In your testimony, 
you discuss that OFHEO has adopted corporate governance 
principles similar to those adopted in the Sarbanes-Oxley Act, 
and I would like you to describe the exact corporate governance 
provisions that you have adopted and the parallel sections in 
Sarbanes-Oxley. But I will not ask you to do that while you are 
here, either; I will be submitting that one.
    In your written testimony, you state that ``OFHEO has been 
working with enterprises since 1999 on financial accounting of 
derivatives transactions.'' In 2000 and 2001, did OFHEO give 
any specific written guidance to the Enterprises on how to 
account for derivatives transactions? Did the guidance give 
details on how to account for cashflow derivatives 
transactions? And how many financial experts on derivatives did 
OFHEO employ during those years? Is that another one for the 
record?
    Mr. Falcon. Yes. I do not think we have given the 
Enterprises any written guidance on the implementation of FAS 
133. I will double-check that, but I am pretty certain. Our 
role in this is to oversee the work of the internal controls 
and the work of the external auditor and ensure that if the 
external auditor has any qualifications about their 
certification that those matters are appropriately addressed by 
the company.
    I am sorry, Senator, I do not think I remember the second 
half of your question.
    Senator Enzi. I will submit that one, too.
    In your written testimony, you state that you do not 
conduct forensic accounting work unless a need arises, and that 
you rely on this auditor, and that you require enterprises to 
engage forensic professionals to investigate irregularities 
when they arise.
    How do you determine when an audit statement submitted to 
you would require a forensic accounting professional? Prior to 
this incident with Freddie Mac, have you ever required an 
enterprise to hire a forensic accountant, and what were the 
circumstances if you did?
    Mr. Falcon. We have not. Certainly the circumstances 
surrounding the need for a reaudit and restatement of 2 prior 
years rose to the level of requiring a forensic review.
    I would have to take each circumstance on a case-by-case 
basis to determine whether or not one was necessary as 
additional issues arose.
    Senator Enzi. I will do a follow-up on that one in writing 
as well, because we need some more detail on that.
    The risk-based regulations established by OFHEO require you 
to release a risk-based capital model that the Enterprises can 
use to calculate their risk-based capital reserves. In light of 
these recent events at Freddie Mac, will you need to reissue 
the risk-based model for 2002?
    Mr. Falcon. No, we are not expecting that there is a need 
to do that. However, if we see any significant changes in the 
data that the risk-based capital stress test runs on, we will 
consider whether there is a need to rerun the stress test for 
any particular quarter, and if there is a need to alter our 
capital findings with respect to Freddie Mac. But it is my 
expectation that that will not be necessary. The risk-based 
capital stress test runs on data that is not dependent on the 
accounting issues involved here; it runs off raw data, which is 
not really affected here.
    Senator Enzi. But is it showing the information that you 
need?
    Mr. Falcon. Yes. We are getting all the information we need 
in order to continue to run our risk-based capital stress test.
    Senator Enzi. Okay. I will submit some more questions, if 
they are not covered today, Mr. Chairman.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman.
    I want to go back to this gap of $1.5 to $4.5 billion. It 
sounds to me like we do not yet have a handle on the issues 
that are underlying what is determining the problem that 
actually has come out in all this discussion.
    What is the explanation of such a wide range? It is an 
extraordinary gap that I find hard to understand how it cannot 
be 
explained. I could understand at the margin a couple of hundred 
million here or there on derivatives--even that is a lot of 
money--but $3 billion--I would not understand it in the context 
of reviewing the risk management, the performance of a 
company--any company. It is mind-boggling to me that there is 
such a gap in place.
    What are some explanations that would allow that to 
actually be?
    Mr. Falcon. It is a large number. One of the issues related 
to this is that under FAS 133, if you designated certain 
hedges, certain derivatives as hedging derivatives, they 
qualify for cashflow accounting or fair value accounting. Here, 
they are accounted for as fair value hedges, and they are 
assembled in pools. If the pool gets tainted through inadequate 
documentation for any derivative that makes up this pool, the 
entire pool is tainted, and you have to unwind, and the entire 
pool no longer receives the FAS 133 fair value hedge 
designation. So that is having a large impact on the earnings--
a cumulative effect on their financial statements. That is just 
one of the explanations, but I think one of the largest ones.
    Senator Corzine. The thing I do not understand is that the 
risk-based regulatory structure that has been put in place that 
you all administer to look at has to look at the particular 
transactions that go into the book that is made up. It leads me 
to wonder why there were not red flags about that with regard 
to the pools that you are talking about in the context that is 
different than I am hearing this discussion. It is not just an 
accounting issue, because these pools either had certain risk 
characteristics that fit into the model for measurement or not.
    Mr. Falcon. I guess a point I should make clear, Senator, 
is that the economics of these transactions remain sound--most 
of them, I should say. From a risk standpoint, these are 
effective hedges against the company's risk. This is an 
accounting issue as to when you recognize the income from 
changes in market value on these derivatives. So the accounting 
issues aside, these are sound transactions from a risk 
management standpoint.
    Senator Corzine. I accept that statement, but the fact is 
that they needed to be measured for the risk model to see 
whether the risk model was actually working and doing what it 
is supposed to do for the purposes of safety and soundness that 
your oversight is supposed to derive. So if a particular pool 
or swaption or whatever transaction is going up and down in 
price, it has a different risk-weighting in a model at some 
point in time, and I do not understand why there were not red 
flags thrown out by the risk model that would indicate that 
there were underlying accounting problems. It does that, and it 
bothers me that there are still $3 billion of unexplained 
elements when the risk model needs to be able to tie to the 
accounting factors. It does not make sense to me based on my 
own understanding of how you put together financial statements 
and how the risk models would work from my own experience.
    Without being able to explain this $3 billion, it makes me 
worry about the risk models, I guess is what I am suggesting, 
that we are using for oversight. Is it a concern of yours?
    Mr. Falcon. I would like to go back and take a look at it 
and make sure we adequately address your concern here. What we 
do look at is the underlying economic purpose of these 
transactions and ensure that they are appropriate to hedge 
against the risk of the underlying transaction.
    I will have to go back and look at to what extent a closer 
review of those internal models have helped us identify a 
problem here. I will take that back and look at it.
    Senator Corzine. I actually would like to see--and we can 
do this at a different time and place--but I would like to 
understand why the individual items that are part of the risk 
management tool relating to underlying assets--why that was not 
showing up as a measurable change in value in the oversight 
models that you all use, because it should have been 
reflective, in my view, in the underlying accounting that is 
coming out if we are going to have a comprehensive--but I go 
back to that I cannot explain in my own mind how, at least at 
this stage, we have a $3 billion gap.
    Mr. Falcon. Okay.
    Senator Corzine. Thank you.
    Chairman Shelby. Senator Bunning.
    Senator Bunning. Thank you, Mr. Chairman.
    Director Falcon, why didn't you start your investigation 
when the original restatement was announced? Why did you wait 
until Freddie ousted their top corporate executives?
    Mr. Falcon. Senator, we have remained focus on fulfilling 
our primary mission here. Our mission is to ensure the safety 
and soundness of these two companies. It was my judgment that 
the most important task at hand in order to ensure their safety 
and soundness was to get this reaudit complete, to get the 
restatements done, because it is not a good position for a 
large company like this to be in to not be operating without 
certified financial statements.
    We focused our time and energies on making sure this 
restatement process was brought to a conclusion as soon as 
possible.
    Senator Bunning. But how big a red flag to you have to 
have?
    Mr. Falcon. Oh, certainly, if the board was not going to 
undertake action to get a forensic review going with the use of 
an outside counsel--which is a process that is not uncommon for 
safety and soundness regulators--we frequently task the board 
to take certain actions including the hiring of any outside 
investigators to look at issues.
    Senator Bunning. Well, if the board thought it was so 
essential to fire the top three officials in the company, why 
wouldn't that red flag be the regulator?
    Mr. Falcon. If I had known some of the circumstances that 
would emerge later that led to the termination of these three 
individuals, I would have started our investigation in January.
    Senator Bunning. If you felt that Freddie's outside counsel 
was not being forthcoming, why did not you start your full 
investigation then, instead of waiting until June 7?
    Mr. Falcon. It was June 7, Senator, when I concluded that I 
was not receiving all the information that I should have been 
receiving.
    Senator Bunning. It was not until then?
    Mr. Falcon. Right.
    Senator Bunning. Your staff briefed the Committee staff 
earlier this week. They informed staff that some anonymous 
letters were received and then investigated by Baker Botts, who 
dismissed the charges in the letters. Did the charges in those 
letters have anything to do with what actually happened? If 
Baker Botts was not forthcoming as you have stated in your 
prepared testimony, why did you then rely on them to 
investigate the charges in the anonymous letters?
    Mr. Falcon. That is a subject of our investigation. We are 
looking at the circumstances surrounding the allegations 
contained in those letters.
    Senator Bunning. But why would you give it to someone that 
you have criticized in your own testimony today as not being 
forthcoming?
    Mr. Falcon. As soon as I concluded that they were not being 
entirely forthcoming, I took action to initiate an 
investigation.
    Senator Bunning. But you gave the investigation to them.
    Mr. Falcon. At a point in time when I thought it was 
appropriate that the board should engage outside counsel to 
undertake this, while we focused on ensuring the safety and 
soundness of the company through getting the restatement 
process concluded.
    Senator Bunning. Does it disturb you that 18 months after 
Freddie said they would register with the Securities and 
Exchange Commission, they still have yet to do so? Would that 
have anything to do with the earnings and restatement and all 
the things that have come up, that 18 months ago, Freddie Mac 
said that they were going to register with the Securities and 
Exchange Commission their securities? They still have not done 
it. Does that raise a red flag for you?
    Mr. Falcon. It cannot happen until this restatement is 
concluded.
    Senator Bunning. Well, now it cannot, but we are a month 
later than June, so instead of having 18 months, they had 17 
months prior to that time.
    Mr. Falcon. Up until January of this year, it appeared that 
the audit of the 2002 financial statements was on track. It was 
not until January 2003 that PricewaterhouseCoopers brought to 
the board's attention these FAS 133 issues and notified the 
board that they would not be able to certify those 2002 
statements until these accounting issues were properly 
resolved.
    That is the point in time when it became clear that they 
would not be able to register under the 1934 Act because they 
would have this restatement process pending; and that triggered 
a whole sequence of events that we have been working on since.
    Senator Bunning. Okay. That was a year after they said they 
were going to register with the SEC.
    Mr. Falcon. Right. But it was expected that there would be 
about a year lead time before they actually registered.
    Senator Bunning. So you are saying that the restatement was 
the hang-up?
    Mr. Falcon. No. There was a lead time necessary for the SEC 
to do its due diligence with the company----
    Senator Bunning. I understand that.
    Mr. Falcon. --as preparation for their formal registering 
with the SEC under the 1934 Act, and there was an amount of 
lead time that needed to occur before they got everything lined 
up.
    Senator Bunning. A last question, Mr. Chairman.
    Chairman Shelby. Please go ahead.
    Senator Bunning. Don't you think that after this mess is 
cleaned up, it would be necessary as one of the top priorities 
to make sure that Freddie does register with the SEC so there 
is another body that looks at exactly what the regulating body 
is supposed to be doing?
    Mr. Falcon. A regulating body that oversees the work of----
    Senator Bunning. The SEC would be another group of people 
that would look at the same thing that you are supposed to be 
doing right now in earnings, in statements of earnings, in 
audited reports, and things that are required by the Securities 
and Exchange Commission.
    Mr. Falcon. The SEC's requirements are subject to the SEC's 
enforcement and review, but we have our own set of disclosure 
standards that we require of the company, and we also oversee 
those disclosures and the enforcement of proper disclosures 
under our own standards, Senator.
    Senator Bunning. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Thank you, Mr. Chairman.
    Welcome, Mr. Falcon.
    First, I would ask, Mr. Chairman, that my opening statement 
be placed in the record.
    Chairman Shelby.Your statement will be made part of the 
record without objection.
    Senator Stabenow. Thank you very much.
    Before asking a question, I just want to step back for a 
moment in terms of what is happening in the housing market. We 
all know that the housing sector has really been one of the 
bright spots--the only bright spot--in a stagnant economy, and 
that as we look from the individual's perspective, they are 
more likely now to be counting on the equity in their homes 
than they are to be counting on the stock market when it comes 
to retirement.
    So as we look at these broader issues, I know that in the 
secondary housing market, Fannie Mae and Freddie Mac have been 
very important in providing opportunity for people to be able 
to have that home.
    So, Mr. Chairman, as we move forward, I would just ask that 
we use the same due diligence and deliberation that we have on 
other issues before this Committee, where we will take our time 
to do this right, to make sure that we are looking seriously at 
the issues that are raised----
    Chairman Shelby. You are absolutely right.
    Senator Stabenow. --but not doing it in a way, as the 
Chairman I am sure would agree, that would undercut our ability 
to maintain this very important secondary market, and that we 
look at the regulatory system but that we not assume because 
one piece went wrong that the entire system is broken. So, I am 
pleased to be a part of a discussion about that.
    When we talk about the issues that we have today, in your 
testimony, you point out that safety and soundness regulators 
do not review accounting policies for conformance with GAAP, 
nor do you certify that a company's financial statements are 
consistent with those principles.
    Do you believe that OFHEO should take a more active role in 
determining whether or not the GSE's are following proper 
accounting procedures, or do you believe that should be done by 
private auditors? Where do you fall now, looking back at this, 
and what role do you think--not only that OFHEO currently has--
but what role do you think you should have as it relates to the 
GSE auditors?
    Mr. Falcon. I think that for us to build up the capacity 
to, in effect, certify the financial statements would require a 
massive increase in the size of the Agency. I think that what 
is important for us to do is to be able to have the capacity to 
look at the implementation of new standards as they are brought 
forward by FASB and have more depth in accounting expertise in 
our program so that we can more fully evaluate the 
implementation of those policies and look at the 
interpretations of FASB and be able to just somehow ensure that 
they are using the highest standards of GAAP in implementing 
certainly new standards, at least. But I do not think it would 
be efficient for us to try to bring in the amount of staff that 
will be necessary to substitute our judgment for the external 
auditors' as to what is consistent with GAAP. I do not think we 
want to go down the road of imposing regulatory accounting 
principles.
    The integrity of the external audit function has to be 
ensured here, and hopefully, through some amount of expertise 
in the accounting areas, we can build that up in the company--
hopefully we can do so.
    Senator Stabenow. So you are really indicating that at this 
point, you believe you lack sufficient funds to be able to take 
that next step in terms of more aggressive oversight, more 
specific oversight?
    Mr. Falcon. We would like additional funding, Senator, so 
that we can as quickly as possible continue to build up this 
expertise in the Agency. I do not think the lack of the 
resources has hindered our ability to fulfill our mission--
certainly both companies remain safe and sound because I think 
we are fulfilling our mission--but it would be useful for the 
Agency to have additional resources. And beyond that, it would 
be useful for the Agency to have the ability to establish its 
own resource needs and obtain those resources on a real-time 
basis. That would require giving the Agency permanent funding 
by removing us from the appropriations process, and that is 
something, as Senator Sarbanes said, that I have been 
advocating since I arrived at the Agency.
    Senator Stabenow. One other question, Mr. Chairman, as it 
relates to derivatives.
    Chairman Shelby. Go ahead.
    Senator Stabenow. We have been talking about that a lot 
this morning, and I am wondering--there are two schools of 
thought. One is that use of derivatives is too risky; the other 
is that they are important for hedging risk. I am wondering 
what your position overall is on these financial tools and 
whether or not Fannie Mae and Freddie Mac should be using them.
    Mr. Falcon. Derivatives are an integral part of the 
Enterprises' interest rate risk management. If they are used as 
hedging devices and not as speculative devices, they are a very 
useful risk management tool. Indeed, Fannie Mae's ability to 
manage their risk related to their retained mortgage portfolio 
would be difficult and costly if it were not for the use of 
derivatives. And the way the Enterprises use them, I think they 
are a very appropriate risk management device.
    Senator Stabenow. Mr. Chairman, thank you. I would just say 
on a positive note that I think that as we talk about 
registering with the SEC, we should note that Fannie Mae has 
done so on a voluntary basis, and I would congratulate them for 
that and hope that Freddie Mac would be doing the same.
    Chairman Shelby. Thank you.
    Senator Sununu.
    Senator Sununu. Mr. Falcon, you said that despite these 
accounting irregularities, OFHEO is still confident about the 
safety and soundness of both GSE's; and I believe in an answer 
to Mr. Enzi's question, you indicated that these accounting 
issues did not figure into or affect the result or the outcome 
of the stress test. Is that correct?
    Mr. Falcon. Yes, Senator.
    Senator Sununu. Then, if that is the case--and I reserve 
judgment--why do you need more money to beef up all of these 
accountants and oversight capability in these areas if they are 
not affecting the stress test and have not affected the safety 
and soundness at all?
    Mr. Falcon. First, there is the supplemental. That is 
necessary so that we can finish this investigation of Freddie 
Mac, and I want to be able to come to this Committee and assure 
you with the fullest amount of confidence that there are no 
issues related to Fannie Mae's accounting, and that is why we 
have included funds for that in our supplemental request.
    Senator Sununu. You seem to have concluded, though--and 
maybe this is where there is a misunderstanding--have you 
concluded that any potential issues with Fannie Mae's 
accounting will or will not affect the stress test or the 
safety and soundness?
    Mr. Falcon. Will the--I am sorry, I am not sure I----
    Senator Sununu. In answer to Senator Stabenow's question, 
you suggested that these accounting issues have not affected 
the safety and soundness----
    Mr. Falcon. Yes.
    Senator Sununu. --of either GSE that you oversee; and in 
response to Mr. Enzi's question, you said these accounting 
issues do not affect the stress test. So in this case, what 
additional information do you need to get at or want to get at 
with regard to accounting that the SEC or another regulator 
will not be able to get at?
    Mr. Falcon. For these supplemental funds, we need to ensure 
that our internal resources are not spread so thin on this 
investigation that we cannot continue with the daily work that 
we do at the Agency. In addition, it has been clear to me for a 
long time now that the Agency needed to build the depth in at 
least its examination program, and we are working to try to do 
that. Those resources are needed, and we have needed additional 
resources to utilize our stress test as an analytical tool.
    It is not just a capital standard. We utilize it through 
holding certain variables constant and adjusting others to help 
us analyze where the strengths and weaknesses lie in the 
company. We want to continue to do more with the stress test to 
allow it to help us--it will complement our examinations work 
and our research work.
    Senator Sununu. I appreciate that, and that is of great 
concern to me, which is why I was somewhat surprised to hear 
the answer to Mr. Enzi's question as to whether or not these 
accounting issues affect the performance of the stress test and 
the risk-based capital standard.
    It would seem to me that should not be the case, that these 
accounting issues and variations should have had some impact 
there, and let me at least lay out what I think the reason 
would be.
    There are a lot of things that I might bluff on or suggest 
that I know a little bit about, but FAS 133 is way down on the 
list. I know this is a very complicated accounting standard, 
and I understand the reasons for the standard and the rationale 
and the importance of marked to market in certain 
circumstances.
    But insofar as I do understand it, Freddie was using or 
interpreting FAS 133 in a way that allowed them to smooth out 
their earnings. And you might argue if they did not use it in a 
particular way, their earnings would have been much more 
volatile.
    Earnings volatility should affect your perception of safety 
and soundness, it seems to me, and should affect the market's 
perception of how an entity would perform in an economically 
stressful environment.
    Your answer to Mr. Enzi's question suggested to me that 
earnings volatility is not part of the stress test or part of 
the risk-based capital standard. Is that the case?
    Mr. Falcon. The risk-based capital stress test is a 
snapshot and point in time based on at the end of each quarter 
for each company, and it runs off raw data, millions of pieces 
of raw data that is aggregated into what we call a risk-based 
capital report. This risk-based capital report flows through 
the stress test, and it produces a capital requirement.
    Now, the issues here with respect to GAAP do not affect the 
raw data that the stress test needs to run on. What would be 
affected, Senator, is probably the minimum capital standard, 
but there, because we will see an increase to earnings, their 
capital will go up, and they will actually have a larger 
surplus under our minimum capital standard.
    Senator Sununu. That makes sense, but it did not quite 
answer my question. The stress test is carried out over a time 
series; is that correct?
    Mr. Falcon. Yes.
    Senator Sununu. So you are projecting into the forward 
changes in interest rate and economic information over time. 
But if a company had a specific earnings volatility or very 
high earnings volatility, wouldn't they perform differently in 
that time series?
    Mr. Falcon. The volatility will show up at the end of each 
quarter's statement. As they pull back income from later 
quarters into earlier quarters, that will affect each quarter's 
earnings statement. But again, this runs off of raw data.
    The economics of these transactions are still sound, by and 
large--there are a few transactions which I cannot get into--
but the economics of these transactions are that they are still 
sound risk management practices and that their fair value 
statements are not going to change and did not change as a 
result of this.
    So as we have looked at this very closely, this is a 
serious matter, but it is a matter of the timing of recognition 
of income and not the fact that they do not have this income.
    Senator Sununu. Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman, and thank 
you for holding this hearing.
    We have a very important and fundamental responsibility to 
ensure the safety and soundness of all these GSE's. That is our 
job, and we cannot do it without an effective and vigilant 
OFHEO in this case, because it is a day-to-day proposition to 
monitor the activities of these GSE's, and we have not had that 
capacity or even that focus.
    We all recognize that the GSE's have provided extraordinary 
benefits to our economy and to our people, and that is not the 
question here at all. The question is really do you have the 
tools to do a very important job--and again, we depend upon you 
to ensure the safety and soundness--not the stock market value 
of the companies, not what they are doing, but essentially that 
we can depend that these companies are well-run, safe, and 
sound.
    In that context, let me ask--and at this point in the 
hearing, most of these questions have been asked, and I 
apologize; please indulge me--as I understand it, the major 
issue here was the fact that the accounting treatment caused 
Freddie Mac to essentially smooth out their earnings so that 
they would not have the volatility we talked about. And today, 
you say that your judgment is that it is safe and sound.
    What about the future because of this? I think this was 
part of the dialogue that you had with Senator Sununu. I think 
the future presumes that you found no systemic problems, and 
that the decisions that were made with respect to smoothing out 
will not irrevocably lead to problems in the future. Can you 
make those conclusions today?
    Mr. Falcon. I cannot guarantee you that there will not be 
problems in the future, but I think what you can expect to see 
with the company is that there will be greater volatility in 
its quarterly earnings. That is a result of some of the actions 
that had to be taken to unwind some of these FAS 133 
designations as hedges for some of these derivatives.
    That is probably the biggest impact that you will see going 
forward as a result of the restatement.
    Senator Reed. Now, in a positive light, you are aware of 
those potentials, and you are taking steps at OFHEO to 
anticipate problems and respond to them; is that correct?
    Mr. Falcon. Yes, sir.
    Senator Reed. It seems to me that the reason we are here 
really is because of the presumption--a rebuttable 
presumption--that OFHEO missed some things in this process--and 
again, I say that is a rebuttable presumption. But it seems to 
me that when you get to the questions of regulatory problems in 
terms of regulatory agencies, there are a couple of categories, 
and I would like just for the record to run down these 
categories.
    Sometimes it is a lack of expertise; sometimes it is a lack 
of personnel and resources, you simply do not have enough 
people or computer programmers or consultants that you can 
hire; sometimes it is a lack of emphasis or focus by the 
leadership, and they just miss the point that was the most 
critical point; and then, sometimes it is the lack of 
jurisdiction--you do not have the authority.
    Let us go through those. One, lack of expertise--do you 
think you have the appropriate expertise in the Agency to deal 
with this new world of derivatives and other complicated 
transactions?
    Mr. Falcon. Absolutely, Senator. We would like to add more 
depth to these areas, we absolutely have the expertise 
necessary.
    Senator Reed. Two, lack of personnel and/or resources.
    Mr. Falcon. Again, that gets to the issue about how we 
would like to have more depth across the organization. We would 
like to bring in more resources and personnel.
    Senator Reed. Okay. And that is something that is our 
responsibility to provide; is that correct?
    Mr. Falcon. Yes.
    Senator Reed. Thank you.
    Three, lack of emphasis and focus--do you feel that you 
were looking at the right things, giving guidance--not you, 
personally, but institutional leadership, identifying the right 
potential problems and the right areas you had to focus on?
    Mr. Falcon. I think we will conduct a self-assessment and 
determine whether or not there is anything we could do better. 
But when you have a situation where there is a breakdown in 
integrity, that is not something that you can always catch 
right away. Ultimately, you do catch these things through your 
examination activities and your ongoing surveillance of the 
companies. But I think we were fulfilling our obligations as 
the regulator.
    Senator Reed. Finally four, lack of jurisdiction--were 
there areas of concern that you saw, but you simply did not 
have the authority or the tools to get at them because we had 
not given you those tools?
    Mr. Falcon. No, I do not think so, Senator. Aside from the 
resource question, it would be helpful to have some 
clarification to the Agency's authorities, but we think that 
our enforcement powers are adequate--again, we would like some 
clarifications--and that we do have the tools necessary to do 
our job.
    Senator Reed. Thank you. Again, let me emphasize how 
critical your job is--
    Mr. Falcon. Thank you.
    Senator Reed. --because we assume that these institutions 
are being vigorously regulated and that they are safe and 
sound, and we depend upon you to ensure that our assumption is 
real.
    Mr. Falcon. Thank you.
    Senator Reed. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you.
    Director Falcon, I have not had an opportunity to look 
through the recommendations that you attached to your testimony 
this morning, and I look forward to reviewing those 
recommendations. The first question I have is about 
responsibilities of OFHEO, and in fact this question may be 
included in your recommendations.
    What is your opinion on whether OFHEO should have a 
broader, wider responsibility for its oversight 
responsibilities beyond safety and soundness to include mission 
of GSE's?
    Mr. Falcon. The way this works right now, by way of 
background, to answer your question, is HUD is the mission 
regulator, and they have responsibility for program approval 
and general mission authority. And as a safety and soundness 
regulator, our function--there is a bifurcation between the two 
functions. However, it is the responsibility of every safety 
and soundness regulator to ensure that the companies they 
regulate are in full compliance with all the applicable laws 
and regulations. So where we see a clear violation of any law 
or regulation, it is our responsibility to step in and ensure 
that that conduct does not happen.
    But that is when you are in areas where there is black and 
white. In the area of the Enterprises' charters, there is a 
great deal of ambiguity as to what is permissible and what is 
not. And since we already have the enforcement responsibility, 
including if HUD decided that certain activities could not be 
engaged in by the companies, we are an enforcement arm, and we 
would take enforcement action at HUD's initiation.
    Given that we have the responsibility in these areas, I am 
suggesting just taking it a step further and let us go ahead 
and resolve issues where there is ambiguity as well.
    Senator Hagel. And that is included in your recommendations 
that you included in your testimony?
    Mr. Falcon. We attached them, yes, sir.
    Senator Hagel. Good. Well, I will pursue that, and we will 
have other conversations about it, but I thank you.
    As I have listened to your testimony and the questions here 
today, it is apparent--and you understand this--that we are 
talking about something larger than just a straight accounting 
function, enforcement function, of your agency to help these 
GSE's stay within the boundaries, obviously, of clear, 
accountable standards.
    One of the questions I would have in that regard is do you 
think earnings pressures, coupled with Congressional mandates, 
people pushing down on GSE's sometimes because the mission is 
affordable housing, and the congressional mandates and the 
pressures, do you think that that affects or could affect 
safety and soundness of these institutions because--I know you 
understand where I am going with this--these sometimes are not 
always the best ingredients for the most profitable outcome. I 
am going to follow up with a couple more questions on this 
point, but let us resolve this first with your answer.
    Mr. Falcon. The question is would market pressures----
    Senator Hagel. Do all these earnings pressures, coupled 
with Congressional mandates, the mission being affordable 
housing--and that is not always as profitable as other more 
private institutions--do they present more of a risk, less of a 
risk, or is it neutral to safety and soundness?
    Mr. Falcon. I think that as long as the company maintains 
the highest levels of integrity and the intent to stay 
consistent within the boundaries of the charters, and as long 
as the circumstances are such that they can continue to grow as 
a company without needing to step outside the bounds of their 
charters, it is not clear to me that the market pressures about 
meeting earnings expectations might force them to do something 
that they would not otherwise. Let me just leave it at that, 
Senator.
    Senator Hagel. Let me get into another area, then, that is 
a bit attached to this. Lately, we have all noted that the 
GSE's have been purchasing their own mortgage-backed 
securities. Does that present more or less of a risk, no impact 
to these institutions?
    Mr. Falcon. It does present additional risk in the form of 
interest rate risk to the company. If they did not hold 
mortgages in their retained portfolio, they would not have that 
interest rate risk. It is something that they work to manage 
very diligently. But the maintenance of a retained mortgage 
portfolio does present, in addition to the credit risk, an 
interest rate risk component.
    Senator Hagel. Mr. Chairman, I know my time is up, but may 
I ask one very short question?
    Chairman Shelby. Go ahead, Senator.
    Senator Hagel. Do you consider stockholder equity to be 
relevant in considering the financial health of GSE's?
    Mr. Falcon. The level, or the value of shares?
    Senator Hagel. Both--level, value--any stockholder equity 
in those institutions.
    Mr. Falcon. Shareholder equity is a component of their 
capital.
    Senator Hagel. So it is very relevant?
    Mr. Falcon. Yes, as long as it is a component of their 
capital, and they are required to meet minimum capital 
requirements, yes.
    Senator Hagel. Do you think that is an issue that is a 
problem with GSE's today, Fannie, Freddie?
    Mr. Falcon. Their capital levels?
    Senator Hagel. Yes.
    Mr. Falcon. I think they are able to withstand some very 
severe financial shocks. Our stress test imposes severe swings 
in interest rates, the highest possible historical credit 
losses on the companies. It is a very robust and stressful 
test, and it is one that no one else is subject to. We have 
devised it in a way pursuant to Congressional specifics in law 
that it is very stressful, and they meet it.
    Senator Hagel. Thank you very much, Mr. Chairman.
    Chairman Shelby. Thank you, Senator Hagel.
    Senator Schumer, I know you have been going back and forth 
between Committees.
    Senator Schumer. Thank you, Mr. Chairman.
    I have been going back and forth, and to the witness, I 
apologize. We have a lot of doings in Judiciary, so I am trying 
to run back and forth.
    The first point I want to make--and I just want to 
underscore this--is that I could not agree more with Senator 
Sarbanes in terms of the importance of housing in today's 
economy and the importance of Freddie and Fannie as unique 
tools to help that housing market.
    The real question here, the real riddle, is how do we deal 
with the oversight function. Fannie and Freddie are extremely 
important not only to the housing market--although they are 
probably the two most important entities to that--but also to 
our whole financial structure and markets, because they have 
such a huge amount of loans and everything else that they hold.
    In fact, a while ago, when we were more sanguine about a 
budget surplus, and they thought the 30-year Treasury would go 
the way of all flesh--now there is a move to bring it back--
some people talked about Fannie and Freddie being the marker. 
So very important, and I do not want my concerns about the 
auditing and oversight functions here, which are very serious 
ones, to be misjudged as, well, let us change the function of 
Fannie and Freddie. I would like them to pretty much keep doing 
what they are doing. You might twist the dial a little bit 
here, twist the dial a little bit there, but I think there 
needs to be better oversight and better understanding of how 
they integrate with the general financial markets, and hence, 
that is why I talked earlier about the Treasury doing the 
oversight at least of the auditing function. Treasury does 
oversight of other auditing functions that this Committee might 
regulate here and there, so it is not a unique situation.
    My view would be--and I know that Congressman Baker has a 
bill to put it into the OTS; I am not sure it belongs in OTS; 
that is a path to treat Fannie and Freddie just like another 
bank--my view would tend to be that we should have--or we 
should consider, because all of this is tentative--maybe a 
special office in Treasury, the Office of GSE's, that would 
oversee Fannie and Freddie and maybe some of the other GSE's as 
well which might need some oversight--Home Loan Banks, Sallie 
Mae, and all these other places; who knows?
    So my question--and I guess it is not even a question, 
because you may be the wrong person to ask, Mr. Falcon--but 
have you given some thought to any kind of restructuring? 
Obviously, none of us is very happy here on either side of the 
aisle with what has happened with the recent oversight.
    Do you think that OFHEO structurally is the right place for 
this auditing and oversight function to be, or would Treasury 
be a better place? Tell me what you think.
    Mr. Falcon. I think what is most important here is that you 
have a regulator that is independent, that is adequately funded 
and that has all the authorities necessary to fulfill their 
job. As long as you fulfill those principles, where it resides 
I do not think is of much consequence. If you moved OFHEO to 
Treasury, and you intended to keep its status as an independent 
agency, which I think our lessons from the savings and loan 
crisis tell us we absolutely want to do, then I do not think it 
accomplishes much to move OFHEO from one department to another 
if the goal is to maintain independent regulation.
    I think that what is absolutely essential here is allowing 
the regulator the resources and tools to do its job. Where we 
are currently situated works. We operate as an independent 
agency. We work well with HUD whenever there is a need for us 
to work on issues where there is overlap.
    What I think is important to consider is to just ensure 
that the Agency has what it needs. Beyond that, I do not know 
if just moving OFHEO anywhere else accomplishes much.
    Senator Schumer. Well, I had a fourth factor that you need, 
and maybe it is subsumed in your three, and that is expertise. 
These days, the financial instruments that the GSE's engage in 
are way beyond the understanding of mere mortals. I think it 
would be a safe thing to say that there is not a Senator or a 
Member of Congress who understands these complicated 
derivatives and hedges, and if something happens--if Krakatoa 
explodes 6 years from now, we can figure out a way to hedge 
that and make sure that mortgages are still paid or whatever--
God knows what they do.
    So Treasury seems to know these things better than your 
agency, and I was not here, and I deeply apologize because I am 
very interested in this subject, but we had a very 
controversial nominee in the Judiciary Committee. So the 
question is can OFHEO do this. And the second question--because 
there have been things wrong in the past, and I do not think 
just saying well, we did not have the resources is enough here, 
and I do not think it is going to satisfy any Member of this 
Committee--but the second question is does it make sense to 
split the functions between two agencies. What would you think 
of that--the auditing function, the OFHEO part, in Treasury 
somewhere, I would put it--not in OTS--but the mission part and 
working with the housing market staying in HUD. Could that 
work, or would that provide too many encumbrances? Give me your 
view on that.
    Mr. Falcon. Well, on the second question, it works now. HUD 
is the mission regulator, and we are the safety and soundness 
regulator. We operate as an independent entity within HUD. So 
it works right now, having a bifurcation of the two functions.
    But allow me to respectfully disagree with you, Senator, on 
the issue of expertise. No one knows these companies better 
than the people at OFHEO. The way they use derivatives, the way 
they manage the risk, the way they conduct themselves--I think 
this agency has a body of expertise that is unmatched relative 
to these two companies.
    Senator Schumer. How did it blow it so badly last month?
    Mr. Falcon. The companies are safe and sound. We have 
fulfilled our mission. I do not think we blew it. If we were 
here talking about two companies that were insolvent, then I 
would agree with you----
    Senator Schumer. They actually misstated their results on 
the down side, not the up side, but that would have had effect 
a year or two from now the opposite. You must admit that you 
cannot have been happy with what happened in the last couple of 
months.
    Mr. Falcon. Absolutely. I am unhappy with a lost paperclip 
at the companies. Any slight issue that comes up where it might 
affect their safety and soundness, we try to get on top of as 
quickly as possible.
    This is a situation where you had a breakdown in the 
integrity at a two levels, a breakdown in the integrity of the 
internal controls as a result of the conduct of top management 
of the company, and I think you had a breakdown in the 
integrity of the external auditing process. I venture to say 
that but I probably should not, because our investigation is 
still ongoing, so let me qualify my statements there and 
reserve judgment until we have concluded our investigation.
    But I think we have fulfilled our obligation; the companies 
are safe and sound. I do not like the fact that this 
restatement was necessary. I do not like the fact that the 
magnitude of this is high. But what I am most concerned about 
is their safety and soundness. They remain safe and sound. The 
economics of these transactions remain sound as a risk 
management technique.
    Senator Schumer. Okay. But you are saying that splitting 
the function works now, and you could split it in a different 
way down the road.
    Mr. Falcon. Yes.
    Senator Schumer. Thank you, Mr. Chairman. I appreciate the 
Committee's indulgence.
    Chairman Shelby. Thank you, Senator Schumer.
    Mr. Falcon, Freddie Mac's restatement includes a review of 
Freddie's accounting policies and practices regarding 
derivatives--we have been talking about that this morning--the 
classification of debt instruments and the use of reserve 
accounts.
    In the course of OFHEO, your organization's, examination of 
the Enterprises, has OFHEO noticed significant differences 
between Freddie Mac and Fannie Mae with respect to these 
accounting policies? For example, does Fannie Mae account for 
its derivatives and hedging transactions in a manner that is 
different from Freddie, and did OFHEO ever recommend a 
preferred accounting practice?
    Mr. Falcon. The two companies have taken a different 
approach on the FAS 133 for accounting for derivatives, Mr. 
Chairman. As you know, you can take a fair value approach, you 
can take a cashflow approach, and a third one for foreign 
currency risk.
    Chairman Shelby. But is one necessarily better than the 
other, or are they just different?
    Mr. Falcon. Certainly the approach that Freddie took was 
more difficult to implement. They took the fair value approach, 
which required that they match the derivatives with the 
underlying hedge. Fannie Mae has taken a cashflow approach 
which will result in more volatility, and we have seen that 
since this was implemented.
    Chairman Shelby. Okay. To what extent is your examination 
analysis dependent on audited financial statements? In other 
words, do you have the means to double-check the accuracy of 
the data that you use in the examination process?
    Mr. Falcon. Yes, we do, Mr. Chairman.
    Chairman Shelby. Okay. Regarding Fannie Mae, on July 14, 
you submitted an appropriations request for $4.5 million to 
continue the Freddie Mac investigation and announced the 
initiation of a special review into Fannie Mae. Given the 
similarity between Fannie and Freddie, both GSE's, I understand 
your decision to do so, but the circumstances surrounding the 
two companies, however, appear to be quite different at times. 
Fannie Mae has not, as far as I know, announced a pending 
restatement of its financial statements and has not up until 
now experienced a significant change in management as a result 
of the restatement process. Is that right?
    Mr. Falcon. Yes.
    Chairman Shelby. Aside from your concerns, have there been 
any events or circumstances at Fannie Mae that triggered your 
review, other than you looking at Freddie Mac and saying, Gosh, 
maybe we should look closer at Fannie Mae?
    Mr. Falcon. I think whenever we see a problem at one 
company, we always look at the other, just to make sure.
    Chairman Shelby. Sure. I did not say not do it; I am just 
curious.
    Mr. Falcon. Yes, right. But in answer to your question, Mr. 
Chairman, we are not aware of any specific concerns that we 
have with respect to Fannie Mae.
    Chairman Shelby. Okay. Could you just, for the Committee, 
give us a basic outline of the scope and mandate of this 
special review and how it would differ, if it does, from a 
routine examination practice that you use at OFHEO every day?
    Mr. Falcon. It will differ in the respect that we do not, 
as part of our routine examination process, attempt to 
undertake a qualitative review of the accounting policies of a 
company and determine whether or not the policies are 
consistent with GAAP. This is a one-time, unique situation 
where we are going to, through the use of these funds and some 
outside assistance, take a qualitative look at a high level to 
ensure that there is the highest conformance with GAAP.
    So that is how this is a departure from our normal 
examination process.
    Chairman Shelby. Mr. Falcon, I personally feel that agency 
actions and regulations should receive the maximum amount of 
public input as possible. In your proposal, you request that 
OFHEO be exempt from the Federal Advisory Committee Act. 
Clearly, this would reduce the public oversight of OFHEO's 
activities.
    Currently, it is my understanding that only two--two--
agencies have this exemption--the Central Intelligence Agency 
and the Federal Reserve for the interest rate deliberations 
with the Federal Open Market Committee. Why is this exemption 
authority being requested by you?
    Mr. Falcon. It is also, by the way, Mr. Chairman, being 
requested by others.
    Chairman Shelby. It has not been granted, though; only two, 
the CIA and the Federal Reserve.
    Mr. Falcon. Right.
    Chairman Shelby. And you can see why.
    Mr. Falcon. It is not critical to the Agency, Mr. Chairman.
    Chairman Shelby. Okay. It is just something you would like 
to have, but it is not central to what you do.
    Mr. Falcon. Yes, sir.
    Chairman Shelby. How many formal enforcement actions has 
OFHEO ever taken against either Freddie Mac or Fannie Mae, or 
any other GSE?
    Mr. Falcon. We have not had to take any enforcement actions 
to date. We have taken one supervisory action. But the 
Enterprises do a good job of responding to any concerns we 
raise, so things have not had to rise to the level of an 
enforcement action to date.
    Chairman Shelby. Currently, you have now and have had 
enforcement powers.
    Mr. Falcon. Yes, sir.
    Chairman Shelby. But you have not really exercised them, 
have you?
    Mr. Falcon. Right. Enforcement powers are usually when all 
else fails.
    Chairman Shelby. I will call on Senator Sarbanes, and then 
I will wrap up. Thank you.
    Senator Sarbanes. Thank you, Mr. Chairman.
    It is my understanding that since 1997, five individuals 
have served in the role of Corporate Controller at Freddie Mac, 
three as permanent controllers, and two on an interim or acting 
basis. Can you explain the reason for the high turnover and 
what impact that might have on the company's accounting and 
internal control functions, and is this the thing that OFHEO 
would note and take into account in exercising its oversight 
responsibilities? It seems to me it would be a matter of 
concern if you look at a major enterprise of this sort, and 
they are bouncing the corporate controller in and out of there 
almost every year from these figures, at least.
    Mr. Falcon. That is a good question. Stability in that 
position I think is important to both companies, and the fact 
that they have had such turnover as you referred to in that 
position, you would not prefer that there be that kind of 
turnover.
    The circumstances surrounding--I think three of them were 
permanent, and two were interim; at least one case that I can 
recall was a promotion, and I am not sure of the circumstances 
of the other. It is an area where we would like to see more 
stability in the company, Senator.
    Senator Sarbanes. I take it that your inquiry and that of 
Baker Botts are both directed to what happened or in a sense, 
what went wrong; is that correct?
    Mr. Falcon. Yes, Senator.
    Senator Sarbanes. I am concerned about what is being done 
as we move on and look ahead. In your statement, you say that 
the Governance Committee of the Board of Freddie Mac adopted a 
finance function governance plan back in mid-May, proposed by 
the new executive vice president overseeing the accounting and 
control functions at Freddie Mac.
    Is that plan being implemented? Is it a strong plan? In 
other words, while you are looking at what went wrong, what is 
being done to make sure that things are being brought up to 
standard now?
    Mr. Falcon. That plan incorporates and supersedes the plan 
that was adopted previously, toward the end of 2000, and this 
plan is designed to take that a step further and ensure that 
the company maintains best-in-class standards in the financial 
reporting and accounting areas. We are working closely with the 
company to ensure that it accomplishes that result.
    Senator Sarbanes. We will go back and review what happened, 
but how much confidence do you have as we move forward that any 
gaps have been closed and that we are operating in a--that is 
``gap'' spelled with one ``a'' in this instance, not with two--
that we are operating according to standards that give us some 
sense of security?
    Mr. Falcon. I think that with the new focus of the company 
and with the creation in this area of accounting in our 
examination program, I cannot guarantee that there will not be 
issues that arise, but I think we will be as vigilant as 
possible to ensure that if issues do arise, our utmost priority 
here is to make sure that they do not affect the safety and 
soundness of the companies, that they maintain adequate 
capital, that their credit and interest rate risk are properly 
managed, that their asset quality remains good.
    As long as all those fundamentals remain sound, then we 
expect that they will be able to withstand issues like this 
that arise. So if other instances came up, I think that what we 
want to make sure of is that those issues do not threaten their 
solvency.
    Senator Sarbanes. Of course, one of the things that has 
happened here is that the directors and the audit committee of 
Freddie Mac did move to take corrective action against 
management abuse; is it correct to have that perception?
    Mr. Falcon. Yes, Senator. They replaced top management when 
they were confronted with the evidence of problems with the 
current management, and they did take the appropriate action at 
that time.
    Senator Sarbanes. Well, we will have to follow this very 
closely. Let me ask one final question. Jerry Knight, a 
financial columnist for The Washington Post, wrote on June 30 a 
column in which he said, ``We now know that people at Freddie 
Mac did not understand their derivatives, and they are among 
the biggest users of them in the world.''
    Of course, that is a rather disconcerting statement. And 
recently, Warren Buffett and Alan Greenspan have both noted the 
high concentration of derivatives among a relatively small 
number of financial institutions. This may raise a concern 
about systemic risk in our financial system. The GSE's are 
among two of the largest users of derivatives.
    What special steps, if any, has OFHEO taken to limit the 
likelihood of any systemic problems created by the use of 
derivatives?
    Mr. Falcon. I disagree with the article. These two 
companies do understand derivatives; they do understand how to 
use them as risk management tools. In the case of Freddie Mac, 
what they did not understand how to do properly was account for 
them, and that is what we are looking at right now, at 
accounting issues. These derivatives remain effective risk 
management tools, and the economics are sound with these 
derivatives; it is just the accounting.
    But we will continue to look at the companies' use of 
derivatives. We assess whether or not they are used as sound 
risk management devices and not as speculative devices where 
they might have an exposure to changes in interest rates 
because there is not an offset on the companies' balance 
sheets.
    We have a very active oversight program with our examiners 
through the use of our capital standards and our research 
functions. Earlier in the year, we produced a very significant 
systemic risk report where we also looked at the big picture 
implications of the companies' derivatives use.
    So, I think we are well on top of issues related to the 
companies' use of derivatives, Senator.
    Senator Sarbanes. Would you say that your expertise and 
competence within OFHEO with respect to derivatives exceeds the 
expertise and competence of the two institutions for whom you 
are the regulator?
    Mr. Falcon. I would not necessarily want to say who is 
better than who, but I think we each have the expertise 
necessary to fulfill our functions and our missions, Senator.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Thank you.
    Some of the testimony today that I have been hearing is 
troubling. You are the prime regulator, but it seems from the 
testimony today that you have been in the dark, that it was not 
OFHEO that found something wrong with the accounting problems 
at Freddie Mac, but that Freddie Mac internally did this 
through PricewaterhouseCooper and disclosed this to you or 
alerted you to what was going on. Is that fair?
    Mr. Falcon. Yes. PwC identified these issues, yes.
    Chairman Shelby. Okay. I want to go back to something that 
Senator Sarbanes mentioned earlier in the hearing. If you were 
in the dark--and it seems that you were as a regulator--we have 
been probably lucky, all of us, and fortunate that, assuming 
that these earnings are going to be upward instead of 
downward--in other words, more capital instead of less 
capital--on Freddie Mac, assuming that the restatement at the 
end of the day is between $1.5 and $4.5 billion upward as the 
market seems to indicate and people believe. But you would not 
have known as the regulator had it been a huge loss instead of 
appreciation in value, more money, and that is troubling 
because it seems to me that you cannot assume anything. And if 
you are the primary regulator, I think we will continue to look 
at this. We have a hearing next week on the nomination of your 
successor, and I am sure we will get into this some more.
    We all realize that GSE's have done a lot of good, and as 
you and others have said, they are strong and well-run. But as 
the regulator, I am not sure you knew that, or that you knew 
what was going on, and if Freddie Mac internally through their 
accountants had not disclosed this, would you have ever known? 
So it is deeply troubling to us. Are you basically--and I do 
not mean you individually--but is OFHEO up to the task, 
considering the amount of money that the GSE's are involved in 
and how important they are in the secondary mortgage market to 
our economy, our housing market, and everything that goes with 
it?
    I think these are real questions that we will continue, 
Senator Sarbanes, to grapple with, and we should.
    We appreciate your appearance today.
    Mr. Falcon. May I say something, Mr. Chairman.
    Chairman Shelby. Do you want to respond to some of that?
    Mr. Falcon. Yes, please. Let me try to explain it this way. 
If there were going to be a loss as a result of this 
restatement, I do think we would have known----
    Chairman Shelby. Now, wait a minute--how would you have 
known if you did not know that there was going to be an upward 
thing? I think the statement that Senator Sarbanes got at 
earlier is very important.
    Mr. Falcon. Right. The underlying economics of these 
transactions were sound. These are real earnings. These are not 
manufactured earnings.
    Chairman Shelby. I did not say they were.
    Mr. Falcon. Right. But my point is that had there been a 
loss here, it would have meant that the economics of these 
transactions were not sound, that they were not effectively 
hedging.
    Chairman Shelby. But sir, how would you have known----
    Mr. Falcon. Through our examination process----
    Chairman Shelby. --if you did not know anything about what 
was internally going on--I would not say ``anything,'' but----
    Mr. Falcon. Well, we were fully aware of these 
transactions, and we were aware of the accounting of these 
transactions. We had to examine these transactions to make sure 
that they were effective hedging activities.
    What we were not second-guessing was what was the proper 
accounting treatment for these transactions. But if these 
transactions were not effective as hedging devices, it would 
have shown up in the economics of these transactions, and that 
poor economics would have resulted in a loss to the company, 
and regardless of how you account for that, we would have 
picked that up through our examination program.
    Chairman Shelby. Sir, how would you have known that the 
financials would show a loss if you did not know what was 
really going on inside?
    Mr. Falcon. We would have been aware of the economics of 
the transaction and been able to assess whether----
    Chairman Shelby. But how would you have been aware?
    Mr. Falcon. Through our examination program, we look at all 
these transactions. We look at them at a transactional level to 
ensure that where they have a certain amount of interest rate 
risk or credit risk related to their activities, they are 
effectively managing that risk. And if we saw there was a 
mismatch between the two, it would send a signal to us that 
something needs to be done here. And again, that is why these 
were and are effective economic hedges for the company. It is a 
matter of how you recognize the income--do you recognize it 
over time or do you recognize it all at once--that depends on 
the application of the accounting standards.
    Chairman Shelby. Had you ever inquired about all of that?
    Mr. Falcon. We were making sure that the company and their 
accounting firm were going through the steps that they needed 
to follow, applying industry standards for doing their work----
    Chairman Shelby. Didn't you make a report on about the 
first of June about Freddie Mac and Fannie Mae?
    Mr. Falcon. I am sorry, Senator?
    Chairman Shelby. About their salaries and everything.
    You made a report--didn't OFHEO have a report on them----
    Mr. Falcon. --in our annual report?
    Chairman Shelby. Absolutely.
    Mr. Falcon. Yes, Mr. Chairman, we did.
    Chairman Shelby. And you did not mention any of the other 
problems.
    Mr. Falcon. Yes, and that is where I would like to assure 
you, Mr. Chairman, and the Committee that going forward, I 
think the Agency needs to be sure that even if issues do not 
rise to the level where we have to qualify our assessment of 
the company, we will take a more active look at including more 
detail in that annual report, and I think you have a right to 
expect that out of us.
    Chairman Shelby. I think it has been a troubling but also 
an illuminating hearing. Thank you very much.
    Mr. Falcon. And you have been fair.
    Thank you, Mr. Chairman.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 12:21 p.m., the hearing was adjourned.]
    [Prepared statements and response to written questions 
supplied for the record follow:]

               PREPARED STATEMENT OF SENATOR CHUCK HAGEL

    Mr. Chairman, thank you for convening this important and timely 
hearing, and welcome to Mr. Falcon--I look forward to your testimony.
     There is no doubt that the housing GSE's have been successful in 
carrying out their mission of creating a secondary market for home 
mortgages. The housing market has remained strong through tough 
economic times, and homeownership is at an all time high in this 
country.
     Fannie Mae and Freddie Mac are unique institutions that are 
chartered by Congress, limited in scope, and are imposed with 
Congressional mandates, yet they are publicly traded companies with all 
the earnings pressure that Wall Street demands. Additionally, Fannie 
and Freddie enjoy an implicit guarantee by the Federal Government that 
has aided them in developing substantial clout on Wall Street. With 
their influence in the markets, their ability to raise capital at near-
Treasury Bill rates, and their use of the most sophisticated portfolio 
management tools, Fannie and Freddie today are no longer simply 
secondary market facilitators for mortgages.
     Freddie Mac's recent disclosure of management failures and 
accounting deficiencies resulting in upwards of $4.5 billion in 
understated earnings precipitated the need for Congress to exercise its 
oversight of GSE's. I have been assured by our Chairman that today's 
hearing will not be the only opportunity we have to address this issue 
and other important questions surrounding Government Sponsored 
Enterprises.
     It is critical that this further examination includes a look at 
the extent to which the GSE's have strayed from their central job of 
mortgage securitization. We should look at how exemption from SEC 
regulation, State regulation, and income taxes might create an unfair 
advantage for GSE's as they compete with private-sector 
companies.
     If we are to continue to provide GSE's with the framework to 
operate under an implied Government backing, I believe that they should 
be held to a higher standard than private organizations and subject to 
more scrutiny than the private sector. Furthermore, I believe it is 
possible to realign oversight and operating rules for Fannie and 
Freddie without jeopardizing the strong housing market that America 
enjoys today.
     It is my view that the Office of Federal Housing Enterprise 
Oversight (OFHEO) could better regulate these financial institutions if 
it is moved out of HUD and into the Treasury Department. Treasury 
currently regulates banks and other financial institutions through the 
Office of the Comptroller of the Currency (OCC) and the Office of 
Thrift Supervision (OTS), and it has the experience and expertise 
needed to supervise Fannie Mae and Freddie Mac--it's a natural fit.
     This reform is important to restoring and maintaining the 
confidence that investors and the markets require. In light of the 
recent problems at Freddie Mac, it is even more important.
    Mr. Chairman, I thank you again for holding this hearing today. It 
is a good first step toward awareness of the problems and reform of the 
system. I look forward to working with you and this Committee as this 
issue moves forward.

                               ----------

              PREPARED STATEMENT OF SENATOR JON S. CORZINE

    Mr. Chairman, thank you for convening this important hearing on 
oversight of the accounting practices of Government Sponsored 
Enterprises (GSE's). These institutions serve as pillars of America's 
housing market by providing liquidity that has helped make the American 
Dream of homeownership a reality for millions of families.
    Having said that, recent developments at Freddie Mac serve as cause 
for alarm. The ongoing accounting investigation at the company, the 
shake-up of its management team, and the seeming lack of internal 
controls are all troubling. Viewed together, they call into question, 
and require this Committee to consider, the adequacy of the regulation 
provided for Freddie Mac, as well as Fannie Mae, to ensure their safety 
and soundness.
    The size and complex financial structures of the two 
organizations--which account for billions of dollars in mortgage-
finance dollars--along with their impact on our capital markets, on 
pension and mutual funds, and on individual investors, require a 
regulator that is both credible and capable at providing rigorous 
oversight.
    In my opinion, the current state of GSE regulation fails to meet 
these critical tests. That is why I have come to the conclusion that 
GSE oversight would benefit by moving OFHEO--and its safety and 
soundness responsibilities--to the Department of the Treasury, as a 
new, separate division with funding authority that moves them out of 
the appropriations process. However, in my view, the underlying housing 
mission of the GSE's--the annual housing goals and oversight of fair 
housing--should remain with HUD.
    Such a move would instill confidence in investors, our capital 
markets, and Members of Congress that GSE oversight is in the hands of 
a strong, robust, and credible regulator.
    No doubt, Mr. Chairman, there will be a wide variety of GSE 
``reform'' proposals floated. As we consider these proposals, I hope we 
will ensure they do not alter the structure and regulation of our GSE's 
in a manner that undermines the liquidity, innovation and speed to 
market of the products they bring to our housing market. All these 
features of GSE's have contributed to making America's housing finance 
system the most successful in the world. And our housing market has 
been one of the few positives in this economy.
    I want to thank our witness, OFHEO Director Falcon, for joining us 
and providing us with his testimony today. I look forward to his 
thoughts regarding the Freddie Mac issue, and the current state of GSE 
regulation.

                               ----------

             PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

     Thank you, Mr. Chairman. I appreciate your calling this hearing 
today. Welcome Mr. Falcon. I am glad that you are here before us and I 
look forward to hearing your testimony today.
     Mr. Chairman, the housing sector has been one of the few bright 
spots in a generally stagnant economy. We are very fortunate to have 
had an unprecedented level of homeownership and refinancing activity 
over the past few years. For most Americans, homeownership is a source 
of personal pride. And, for many of our citizens, it is not the stock 
market, but rather the equity they develop in their homes that becomes 
their principal sources of savings for retirement. In addition, cashing 
out equity has enabled many Americans to reduce their higher interest 
debt burdens and continue making personal purchases that boost the 
economy.
     We, in Congress, have always put a premium on homeownership 
through various policies we have enacted. There is, however, much more 
that we should be doing. I believe that there are several pieces of 
housing legislation that we should act on in the 108th Congress. For 
example, I believe that we should support bipartisan initiatives such 
as the housing redevelopment tax credits in S. 875 and S. 198 and the 
First-Time Homebuyers' Tax Credit Act, S. 1175. These bills are 
stimulative and would help to keep housing a thriving part of our 
economy.
     I am much less certain, however, that we should rush to pass new 
legislation affecting the secondary mortgage market. The markets 
created by Freddie Mac and Fannie Mae have been critical to increasing 
the amount of money available to make mortgages and these markets have 
helped to reduce the cost of homeownership. Just because one of the 
GSE's is facing some questions about its accounting is not a sufficient 
reason to assume the entire regulatory system is broken. Indeed, 
recreating the Agency rather than fixing any existing problems could, 
in the short-run, make the regulator less efficient--something we most 
certainly do not want to do.
     Mr. Chairman, I urge caution. There are modest, but obvious and 
important steps Congress can take. We can act to ensure that OFHEO has 
the resources both in the short-run and in the long-run to be an 
effective regulator. I know that senior staff at OFHEO spend a great 
deal of resources worrying about whether or not they will get the 
annual appropriations that they are seeking. We should make sure they 
have a reliable source of funding.
     We should also make sure that, as Mr. Falcon's tenure at OFHEO 
winds down, we approve a new Director only if that new Director will be 
a strong and aggressive regulator. I would like to see someone who will 
inspire confidence in the markets and has widespread support from both 
sides of the aisle.
     I suspect that critics of the good work that Fannie Mae and 
Freddie Mac do every day see a unique opportunity in the current 
controversy at Freddie. I would suggest that they not get too excited 
about using this as an opportunity to attack the two companies on a 
broad set of unrelated issues. This Committee has a history of being 
thorough and cautious about such things. And, no Member on this 
Committee wants to do anything that would roil the housing market.
     Any major changes to the regulatory framework for Fannie and 
Freddie should only be considered after an exhaustive comprehensive 
exploration of any shortcomings in the existing regulation of the 
GSE's.
     I want to work with Chairman Shelby and Ranking Member Sarbanes to 
understand what happened at Freddie Mac and I want to be sure that both 
GSE's are adequately capitalized, well managed, and can continue to 
serve an important role in the housing sector. I hope today's hearing 
will be a starting point to accomplish just that.

                               ----------

                PREPARED STATEMENT OF SENATOR JACK REED

    I would like to thank Chairman Shelby for scheduling this hearing 
on Regulatory Oversight of Government Sponsored Enterprise Accounting 
Practices. I also would like to thank Armando Falcon, Director of the 
Office of Federal Housing Enterprise Oversight (OFHEO), for joining us 
this morning.
    We are here today to talk about OFHEO's oversight of the safety and 
soundness of Freddie Mac and Fannie Mae, in particular its oversight of 
Freddie and Fannie's accounting practices.
    As we all know, the Government Sponsored Enterprises (GSE's) have 
played an invaluable role in creating a stable and liquid secondary 
mortgage market in our country, and this has resulted in our country 
having one of the highest homeownership rates in the world. Strong and 
effective oversight of the GSE's to ensure their safety and soundness 
for the public at large is clearly an important part of their long-term 
success.
    As a result, we need to do everything we can to make sure OFHEO has 
the staff expertise and resources it needs to quickly adapt to 
overseeing new products and methods at the GSE's. We need to make sure 
that OFHEO's mission is focused, the lines of authority are clear, it 
has the tools it needs to thoroughly analyze and evaluate the GSE's 
complicated financial transactions, and that it is well-insulated from 
outside influences.
    Although the GSE's have been given certain benefits by the Federal 
Government, they also must bear certain burdens. They must be subject 
to rigorous government oversight and they must abide by more 
conservative standards than other financial institutions in the market.
    Needless to say, I look forward to today's testimony and hope it 
can clarify some of this Committee's concerns about OFHEO's oversight 
of the GSEs' accounting practices and any potential impacts on the 
ability of OFHEO to ensure the safety and soundness of Fannie Mae and 
Freddie Mac.

                               ----------

               PREPARED STATEMENT OF ARMANDO FALCON, JR.

        Director, Office of Federal Housing Enterprise Oversight
                             July 17, 2003

     Mr. Chairman, Ranking Member Sarbanes, and Members of the 
Committee, I appreciate the opportunity to appear before you. My 
testimony today will focus on the Freddie Mac restatement process, 
OFHEO's role as a safety and soundness regulator, more specifically, 
the Agency's approach to examining accounting practices and financial 
controls at the Enterprises, and a status report on the related issues 
of Executive Compensation and Corporate Governance. In addition, I have 
attached some legislative recommendations for the Committee's 
consideration to enhance OFHEO's role as safety and soundness 
regulator.

Introduction
    On January 22, 2003, Freddie Mac announced that it would reaudit 
and restate its financial statements for 2000 and 2001. The company 
also announced that its' external auditor would delay certification of 
Freddie's year-end 2002 financial statements. Five months later, on 
June 7, the board removed the company's top three officers. OFHEO, the 
SEC, and a U.S. Attorney all have ongoing investigations of the company 
and its accounting practices. These extraordinary actions reflect the 
culmination of developments over several years. Given our ongoing 
investigation, I ask for the Committee's understanding if I am 
restrained in my testimony, as facts are still being verified and 
circumstances evaluated. I will begin by describing the major 
developments in chronological order.

Lead-Up to FAS 133 Preparation and Implementation--1999
    First, the sequence of events begins with the preparation, in 1999, 
for implementation of Financial Accounting Standards Board (FASB) 
Statement No. 133--Accounting for Derivative Instruments and Hedging 
Activities (FAS 133). FAS 133 is not the only accounting standard 
involved in this matter, but it plays the most important role. FAS 133 
establishes accounting and reporting standards for derivative 
instruments, including certain derivative instruments embedded in other 
contracts, (collectively referred to as derivatives) and for hedging 
activities.
    FAS 133 requires an entity to recognize all derivatives as either 
assets or liabilities in the financial statements and reflect those 
instruments at fair value. If certain conditions are met, a derivative 
may be specifically designated as: (a) a hedge of the exposure to 
changes in the fair value of a recognized asset or liability or an 
unrecognized firm commitment; (b) a hedge of the exposure to variable 
cashflows of a forecasted transaction; or (c) a hedge of the foreign 
currency exposure of a net investment in a foreign operation, an 
unrecognized firm commitment, an available-for-sale security, or a 
foreign-currency-denominated forecasted transaction. The accounting for 
changes in the fair value of a derivative (that is, gains and losses) 
depends on the intended use of the derivative and the resulting 
designation.
    Under FAS 133, an entity that elects to apply hedge accounting is 
required to establish at the inception of the hedge the method it will 
use for assessing the effectiveness of the hedging derivative and the 
measurement approach for determining the ineffective aspect of the 
hedge. Those methods must be consistent with the entity's approach to 
managing risk.
    I would now like to turn to OFHEO's examination strategy to cover 
FAS 133 preparation at the Enterprises in 1999. The routine 1999 
examination work was conducted at the same time OFHEO's examiners were 
expending considerable efforts to ensure that both Enterprises were 
prepared for, and all essential systems across the two companies would 
be fully compliant with Y2K goals. Because of the critical nature of 
Y2K readiness, examiners conducted extensive testing and validation of 
systems preparedness. Against this backdrop, the FAS 133 examination 
strategy required the examination team to maintain expertise and 
working knowledge of the accounting standard and its potential effects 
on each Enterprise; evaluate and assess the Enterprises timeline for 
implementation; evaluate the strategy each Enterprise was pursuing for 
its implementation of the accounting pronouncement and analyze the 
effects of FAS 133 on financial statements. In addition, our examiners 
would continue to evaluate the external accountant's position on the 
accounting policy guidance associated with implementing FAS 133; assess 
the systems enhancements to conduct hedging and financial reporting 
under FAS 133; and evaluate and monitor implementation readiness and 
event management, including contingency preparations for the 
transition.
    In the second half of the year, FASB unexpectedly delayed the 
implementation date of FAS 133, from January 1, 2000 to January 1, 
2001, so that companies could focus their attention on Y2K.

Transition Period to FAS 133 Readiness--2000
    In 2000, OFHEO's examiners assessed the development and 
implementation of Enterprise plans with respect to several new 
significant accounting standards, including FAS 133. At the same time, 
they reviewed the effectiveness of Y2K efforts and the effects on the 
financial safety and soundness of a 20 percent decline in the volume of 
originations; an increase in the proportion of Enterprise purchases of 
single-family mortgages evaluated through automated underwriting 
systems; and the increased use of sophisticated technology for risk 
management across the companies.
    In evaluating preparations for the implementation of FAS 133, 
examiners were actively evaluating: systems preparation, implementation 
strategies, impact analysis, documentation specifications, portfolio 
management strategies, and the approvals from management, the board and 
the internal and independent external accountants involving FAS 133 
implementation. We recognized the substantial progress that had been 
made on the preparations and the considerable analysis that had been 
performed. Further, we noted the additional efforts that were underway 
to deal with the remaining systems and documentation challenges 
associated with implementing and operating with FAS 133.
    In late 2000, the audit committee approved the Financial Reporting 
Controls Improvement Plan (FRCIP). The FRCIP was designed to address 
issues affecting financial accounting and financial reporting that had 
been identified by the company, its independent auditors, and OFHEO. 
The goal of the FRCIP was to achieve the same level of controls in the 
financial accounting and financial reporting area that were present 
across the other areas of the company and in the operating business 
units.
    OFHEO's examiners evaluated the FRCIP and Freddie Mac's progress in 
completing the FRCIP in a number of ways. In 2000, examiners evaluated 
and communicated with management about the FRCIP itself, ensuring if it 
was reasonably 
designed to address the root causes of the identified weaknesses. Also, 
in 2000, examiners assessed the design of the tools both management and 
the board's audit committee intended to use to measure and report 
progress in implementing the FRCIP. On a regular basis, examiners were 
assessing the progress toward completion of the FRCIP and communicating 
our assessments to the company.
    In the fourth quarter of 2000 and the first quarter of 2001, 
Freddie Mac entered into several transactions to minimize the impact of 
FAS 133. PwC later identified these FAS 133 transition transactions as 
accounting issues needing correction before the 2002 financial 
statements could be certified.

Implementation of FAS 133--First Quarter 2001
    In 2001, OFHEO's examiners continued their ongoing evaluation of 
FAS 133's implementation and its impact on the Enterprise, with respect 
to business activities, risk management strategies, and portfolio 
management. Among the variety of features our examiners were reviewing, 
were the operational aspects associated with FAS 133 and the company's 
quarterly closing practices. When reviewing the quarterly closings, we 
noted the sign-offs and notations of the company's auditors. Our review 
found no reservations or qualifications associated with Arthur 
Andersen's certification of the quarterly and year-end 2001 financial 
statements and the conformance of those financial statements and 
disclosures with GAAP.
    FAS 133 was implemented in first quarter 2001. Arthur Andersen 
certified each quarter's financial statements under the new FAS 133 
pronouncement as GAAP compliant. At this same time, extensive 
interpretations continued to be produced on FAS 133 by FASB.
    While OFHEO was conducting its FAS 133-related examination 
activities, we were also dedicating examiners to assess the impact of 
record levels of originations, new corporate governance standards and 
record volumes of purchases, and securitization on both Enterprises 
safety and soundness. OFHEO examiners were also evaluating the 
timeliness and effectiveness of the Enterprises actions to meet the 
final Risk-Based Capital Rule.

Need to Strengthen Expertise and Controls--2001
    After preparing for FAS 133, the actual implementation of this 
accounting standard further highlighted aspects of Freddie Mac's 
financial accounting and financial reporting areas that needed 
strengthening. It became more apparent to OFHEO and Freddie Mac that, 
while the overall control structure for the company was strong, in the 
financial accounting and financial reporting area there was an apparent 
need to strengthen expertise and reduce the reliance on manual systems. 
Strengthening expertise and reducing the reliance on manual systems 
were important aspects of the FRCIP introduced in 2000, and examiners 
continued in 2001 to evaluate the progress against this remediation 
plan. We continued to press management to ensure progress continued in 
implementing the FRCIP and maintaining the plan's implementation 
remained an important corporate priority.
    OFHEO felt the control environment at that point in financial 
accounting and financial reporting was stable, but in need of 
strengthening. The FRCIP was designed to address the identified 
weaknesses and to strengthen the control environment in the financial 
control and financial reporting area to a level consistent with the 
control environments across the other parts of Freddie Mac. While there 
were weaknesses in the financial accounting and financial reporting 
area, the manual processes did mitigate those control weaknesses in the 
operating process and resulted in Freddie Mac's ability to produce 
reliable financial records. Upon completion of the work to reengineer 
the financial accounting and financial reporting process, there would 
be a more timely, efficient, and streamlined process that would not 
depend upon manual systems to ensure the reliability of financial 
information.
    In context, Freddie Mac maintained effective internal controls in 
its various business areas. The area covered by FRCIP was the financial 
accounting and financial reporting area, which represents a subset 
within the larger finance area, and an even smaller subset within the 
overall company.
    OFHEO's examiners continued in 2001 to evaluate progress on the 
FRCIP at least quarterly by, for example, analyzing and testing the 
quarterly progress reports to the audit committee, internal audit, 
senior management, and Arthur Andersen, and evaluating the events 
reached or expected, major milestones, schedule overruns, and the level 
of completion of each project. Examiners concluded that by mid-2001 
approximately one-third of the FRCIP had been completed. As a result of 
a national search, Freddie Mac brought in a new Senior Vice President--
Corporate Controller, charged with responsibility for the accounting 
and control function. This key milestone was achieved in October 2001, 
and by year-end 2001 Freddie Mac completed Phase I of the FRCIP, which 
included reconciliations, and deployment of integrated and automated 
cash management, bank account and transactional reconciliations and 
billings/receivables functionalities. In 2002, OFHEO's examiners 
continued their ongoing assessments of progress under the FRCIP, and 
determined that the new accountability model and Operation Risk 
Management Unit, when implemented, would strengthen Freddie Mac's 
financial accounting and reporting processes.
    Also during this period, OFHEO was planning enhancements for its 
examination activities. In 2000, I had meetings with the Chief 
Examiner, and we outlined plans for strengthening OFHEO's examination 
program. Among our discussions was an idea to create an examination 
team dedicated to accounting matters. In January 2001, the Chief 
Examiner delivered a plan designed to enhance OFHEO's examination 
program. A cornerstone of that plan was to more than double the size of 
the examination staff, adding depth and additional specialized skill 
sets to deal with complex issues associated involving the supervision 
of the Enterprises.
    The plan to strengthen OFHEO's examination program included the 
formation of a group for specialized examination activities, including 
a team of accountants. After receiving this plan in January 2001, I 
began advocating within the Administration and with Congress the 
importance of OFHEO obtaining the resources to begin implementing this 
plan and enhancing our examination program. In the second-half of 2002, 
we were able to start populating our team of accountants with skilled 
technicians who would be dedicated to accounting matters at the 
Enterprises.

New Outside Auditor--2001
    Late in 2001, Arthur Andersen was under public scrutiny because of 
its role as the audit firm of record in certain high-profile Federal 
investigations and bankruptcy filings. Given these developments in late 
2001 with Arthur Andersen, Freddie Mac's Board of Directors and 
executive management deliberated whether they should keep that firm or 
select a new independent accounting firm. Freddie Mac solicited OFHEO's 
views concerning the retention of Arthur Andersen. OFHEO opined that 
given the circumstances, retention of the firm created a higher-risk 
situation for Freddie Mac.
    The audit committee decided to change independent accountants and 
interviewed two potential firms in the first quarter of 2002. The 
Committee decided to switch to PwC for Freddie Mac's independent public 
accountants for the year ending December 31, 2002. Freddie Mac made a 
public announcement of this decision on March 6, 2002. The audit 
opinions of Arthur Andersen on the consolidated financial statements of 
Freddie Mac for the fiscal years ending December 31, 2000 and 2001 did 
not contain any adverse opinion or disclaimer of opinion, nor were they 
qualified or modified as to uncertainty, audit scope, or accounting 
principles. In separate management letters, Arthur Andersen shared its 
concern with senior management on a number of items that had also been 
independently noted by OFHEO.

Engagement of PwC--2002
    OFHEO evaluated and tracked changes being made through its routine 
examination activities in 2002 regarding the engagement of PwC and the 
work of the audit committee. PwC began its audit engagement immediately 
after being selected by the audit committee. OFHEO examiners had an 
introductory meeting with PwC managers for the Freddie Mac audit on 
March 5, 2002. PwC was ratified as the independent public accountant at 
Freddie Mac's May 2, 2002 Annual Shareholders Meeting. In the course of 
its audit, PwC initiated a process of identifying various accounting 
policies and accounting issues to discuss with Freddie Mac's 
management. Both Freddie Mac management and PwC conveyed the nature of 
these discussions to the audit committee. In the normal course of 
business, PwC met with the audit committee in executive session on 
these matters.

Additional Expertise Added at Freddie Mac--2002
    Consistent with OFHEO's concerns, some important staffing decisions 
in the finance area were announced at Freddie Mac during 2002, adding 
necessary expertise. In June, a new Senior Vice President for 
Operational Risk Oversight was hired. On June 18, the board announced 
the creation of a new senior level executive position and national 
search, for an Executive Vice President of Finance, consistent with the 
goals outlined in the FRCIP. The newly created position would be 
responsible for the overall finance, accounting, corporate planning, 
tax, shareholder relations, and market risk and operating risk 
oversight functions of the company. The CFO and the Corporate 
Controller would continue in their respective roles and they would 
report to the new Executive Vice President--when hired. Until the new 
position was filled, the Corporate Controller had a direct 
administrative reporting line to the COO and a direct communication 
line with the audit committee, similar to the CFO's reporting line. The 
current EVP and CFO--Mr. Vaughn Clarke--no longer had the Corporate 
Controller reporting through him, and notified the company of his 
intentions to leave Freddie Mac. On March 19, 2003, Freddie Mac 
announced that Mr. Martin Baumann had filled the newly created EVP of 
Finance 
position.

ALLL Accounting Matter Identified--2002
    OFHEO was actively involved in the discussions that were taking 
place between PwC and Freddie Mac regarding the Allowance for Loan and 
Lease Losses (ALLL). The ALLL was identified in July 2002 by PwC as a 
critical accounting matter that needed to be resolved as they worked 
toward certifying Freddie Mac's financial statements.
    A special audit committee meeting was held on July 16, 2002 where 
PwC raised the ALLL issue for Freddie Mac--it was too conservative in 
its loss estimates and coverage per PwC's determination under GAAP. PwC 
felt this matter on the ALLL needed to be resolved before Freddie Mac's 
release of second quarter financial statements on July 23, 2002.
    OFHEO and Freddie Mac representatives met on July 22, 2002 to 
gather information about the final size of the adjustments being made 
to Freddie Mac's financial statements. The adjustment was a $246 
million reduction in the ALLL. On the same day, the audit committee had 
a special meeting to review the final analysis and approve the 
adjustment for release to the public in the July 23, 2002 release of 
financial statements.
    Accounting policies and issues continued to be worked on by PwC, 
management and the board throughout 2002. Progress appeared on track 
for the certification of fiscal year 2002 financial statements. As of 
fourth quarter 2002, the ALLL was the only accounting issue that had 
risen to the level of PwC expressing reservations to the audit 
committee relating to that firm's ability to certify Freddie Mac's 
statements and that had been resolved in July 2002. OFHEO continued to 
evaluate and monitor the status of the accounting policies under 
discussion between PwC and Freddie Mac during 2002, as well as the 
actions and decisionmaking by the audit committee. Examiners continued 
in 2002 to evaluate progress on the FRCIP at least quarterly. This 
included examiners testing selected work products and evaluating 
project management and reporting.

Unresolved Accounting Matters under FAS 133--2003
    PwC came to the Freddie Mac Board in mid-January 2003 and informed 
the audit committee they would be meeting with representatives from 
PwC's national office about unresolved accounting policy matters, 
related to FAS 133 implementation. On Monday, January 20, 2003, PwC 
notified the audit committee that they were uncomfortable with certain 
accounting treatments applied during the FAS 133 transition. 
Furthermore, until its concerns were resolved, it would not be able to 
certify the company's 2002 fiscal financial statements using the 
accounting policies from prior periods, even though the policies had 
been approved by Arthur Andersen as GAAP compliant. OFHEO was made 
aware of these developments on that day and met with Freddie Mac 
officials the following day.
    The nature of the major accounting issues identified through the 
restatement process include:

        1.  The erroneous accounting treatment of the company's 
        Securities Sales and Trading Group (SS&TG) as a third-party 
        broker dealer;
        2.  Inadequate documentation and testing of certain derivative 
        instruments and their valuations accounted for as hedge 
        instruments for accounting purposes;
        3.  The erroneous transfer of mortgage securities out of the 
        ``held-to-maturity'' and trading accounts;
        4.  The treatment of mortgage sales transactions as financings;
        5.  Accounting for certain cash transactions used to manage 
        interest rate risk as if they were derivatives; and
        6.  Omitting the recognition of the guarantee fee and credit 
        obligations embedded within sold PC's.

    These transactions are the subject of our investigation, and I will 
have more to say about them in my final report.
    Because Arthur Andersen was no longer an operating firm at this 
point, PwC could not undertake a normal transition pursuant to the 
AICPA guidance for successor/predecessor accountants. Instead, PwC 
would have to undertake additional substantive testing. The board of 
directors determined that PwC should conduct a reaudit of the prior 
period financial statements.
    OFHEO, PwC, and the audit committee evaluated the nature of the 
accounting issues. Among the factors considered was the cumulative 
effect of the adjustments flowing from the change in accounting 
treatments. The net cumulative effect of the new accounting treatments 
was an increase to income in prior periods, thus increasing the amount 
of capital on a cumulative basis. This would also result in 
considerable volatility in those prior periods. Further, OFHEO, PwC, 
and the audit 
committee considered the effects from the accounting policy changes for 
any potential effect on the fair value statements of Freddie Mac. All 
concluded there was no meaningful impact on the fair value statements, 
which meant the underlying economics for Freddie Mac's risk positions 
were materially unaffected by the timing changes in recognizing income 
for the GAAP statements being restated.
    Examiners were on-site at Freddie Mac gathering more information 
about the issues and the action plan that were being formed to address 
the reaudit. Freddie Mac announced the reaudit and the delay in 2002 
certified financial statements on January 22, 2003.
    Based upon the reaudit of prior periods, Freddie Mac said it would 
be restating 2000 and 2001 annual results and quarterly financial 
results for 2001. Along with delays in issuing certified 2002 financial 
results and prior period restatements, there would be delays in issuing 
certified quarterly financial statements for the first and second 
quarter of 2003. The timeline was to have the restatements done in 
approximately 6 months.
    The restatement process has involved the reevaluation of over 100 
accounting policies, which resulted in the identification of 
approximately 20 major issues that will affect the financial 
statements.
    These accounting changes will result in about half of the company's 
derivatives being marked to market through current period earnings as 
opposed to being deferred and recorded into earnings over time. In 
addition, all mortgage securities will be marked to market either 
through OCI or current period earnings. In addition, previously off-
balance sheet guarantee fees and obligations relating to approximately 
one-half of the guarantee business will now be recorded on balance 
sheet at fair value, with changes reported in current period earnings. 
These changes will most likely result in increased volatility and 
decreased future earnings.

Heightened Focus--January 2003 to Present
    In mid-January 2003, it was clear that a forensic review of 
selected accounting issues raised by PwC would be appropriate. The law 
firm of Baker Botts was retained by the audit committee to perform 
diagnostic and forensic work associated with the restatement process. 
The scope of Baker Botts' engagement is to conduct a review of the 
facts and circumstances surrounding certain transactions and other 
matters related to the restatement process. OFHEO's plans were to 
monitor and consider the work of Baker Botts, while concentrating the 
Agency's efforts on the reaudit and restatement process. When the 
restatement process neared its completion, OFHEO would consider the 
progress and adequacy of the counsel's review and determine whether the 
Agency would need to undertake its own forensic review.
    At this point, OFHEO focused on its mission--safety and soundness--
and emphasized to Freddie Mac the importance of properly concluding the 
reaudit and publishing certified financial statements. In addition, 
OFHEO concurred with the board's decision to engage outside counsel for 
forensic and related work.
    OFHEO's accounting team began continuous surveillance of the 
restatement 
process on January 22, 2003, focusing on: The accounting issues 
surrounding the transactions that triggered the reaudit; the accounting 
policies/issues under consideration--being changed or affirmed; the 
organization and staffing of the project; the analysis of the 
cumulative effect of the restatement process; the preparation of 
adjustments; the methodology for establishing value estimates; the 
process for running ledgers and analyzing results; the quality control 
process; the plan for rolling out the revised financial statements; and 
the status of controls being embedded into the new processes as they 
are being built. In addition to the ongoing work of the accounting 
team, there were periodic updates and evaluations on the restatement 
process from January on.
    February--In February, OFHEO continued its close evaluation of the 
restatement process. Specifically, OFHEO's accounting team scrutinized 
the organizational structure of the effort, the plan of action, and the 
resources and the timeline associated with the work on the restatement 
process.
    March--OFHEO met with the board and its audit committee on March 6. 
In that meeting, there was considerable discussion relating to the 
restatement process, the reaudit, and OFHEO's posture toward completing 
the restatement process. Also in March, as noted earlier, Freddie Mac 
announced the hiring of Mr. Baumann as Executive Vice President for 
Finance. Mr. Baumann was given full responsibility for the restatement 
process by the board of directors and for formulating a plan of action 
for the post-restatement environment. Mr. Baumann is reporting directly 
to the board of directors until the restatement process is completed.
    OFHEO remained engaged during the period the board considered a 
delay in the release of first quarter financial results to coincide 
with the restated financials for prior periods. On March 25, Freddie 
Mac announced the restatement process remained on track. The company's 
expectation was still to have the restatement concluded as soon after 
the close of second quarter 2003 as practical--expecting to restate 
financials by mid-July 2003. Freddie Mac also notified the market they 
would not be releasing first quarter financials, rather, they would 
provide operating statistics and risk measures. The decision to delay 
first quarter financials was to provide those 2003 results consistent 
with the basis upon which the restated financials will be presented. In 
the March 25 release, Freddie Mac also identified additional accounting 
issues.
    April--In April, Freddie Mac was moving toward the final stages of 
a complete review and affirmation of all the accounting policies. OFHEO 
continued to evaluate the work being conducted and the progress against 
the established timeline. Some additional accounting items were adding 
to the complexity of the task. Freddie Mac brought in third-party 
vendors to expedite the process after PwC approved the use of such 
vendors. On April 29, PwC informed the audit committee that they might 
not be able to accept the representations of top management.
    May--In May, OFHEO observed slippage in the restatement process 
against established time frames. PwC and Freddie Mac had more than 500 
people working on the process 6 days a week and this work had been 
continuous since January 2003. They were beginning to complete some of 
the adjustments. There was considerable work that needed to be done 
between production of statements and producing the tables and 
disclosure to accompany those statements. On May 8, PwC informed Senior 
Board members and counsel that PwC would not accept the representations 
of Vaughn Clarke and David Glenn.
    On May 13, the board's Governance Committee at its weekly meeting 
approved the Finance Function Governance Plan (FFGP) presented by Mr. 
Baumann. This plan, superceding the FRCIP, addressed the considerable 
work that has been done to reengineer the process and enhance the 
controls for financial accounting and financial reporting. This plan, 
some of which will take almost 2 years to complete, is intended to 
build a finance environment incorporating a high level of professional 
standards and compliance that delivers comprehensive and understandable 
financial information. The objectives included addressing findings 
which had arisen during the restatement process and the work of Baker 
Botts and PwC.
    In late May, OFHEO again observed the challenges against achieving 
the timeline with the additional accounting issues that were added in 
April. However, Freddie Mac continued to work toward the mid-July 
target. There were no new issues since April. Freddie Mac continued to 
work through all the adjustments and calculated the valuation estimates 
for prior periods. Some opportunities to strengthen controls noted 
during the restatement process continue being implemented by Freddie 
Mac.
    On May 27, OFHEO was briefed on the Baker Botts work for the audit 
committee. The briefing covered the scope of the project, the nature of 
their forensic work and perspective on the status of their findings to 
date. In response to a direct question, Baker Botts expressed no 
concerns regarding the management team of inappropriate or improper 
management behavior. Subsequent to this meeting, OFHEO learned of very 
troubling information regarding the conduct and integrity of management 
in matters related to the restatement process, indicating the board's 
counsel had not been fully forthcoming. This lack of candor contributed 
to my decision on June 7 to initiate an OFHEO investigation.

Events of June 4 through June 7
    Mr. Chairman, I will begin a discussion of the key events of June 
4-7, that have drawn so much attention. First, I would note that the 
Freddie Mac Board of Directors was holding a regularly scheduled 
meeting on Thursday, June 5 and Friday, June 6.
    On Wednesday, June 4, Mr. David Glenn met with the board's outside 
law firm--Baker Botts--and informed them that he had altered parts and 
had removed pages from a document that had been requested by the firm. 
That evening, counsel from Baker Botts informed the lead outside 
director of Mr. Glenn's admission.
    On Thursday, June 5, Freddie Mac's Board was informed of Mr. 
Glenn's admissions and determined that actions were required. The 
morning of June 5, OFHEO was alerted that the board would have an 
urgent communication to discuss with us when the board's deliberations 
were concluded. the board's deliberations continued into Friday, June 
6.
    On Friday June 6, during the day, the board made decisions on the 
separation from the firm of Brendsel, Glenn, and Clarke and on the 
appointment of O'Malley, Parseghian, Petersen, and Baumann. The board 
communicated to OFHEO immediately on its actions regarding the 
management changes. Later that evening, I was informed about the 
circumstances surrounding Mr. Glenn. I instructed board counsel to 
appear at OFHEO's offices on Saturday, June 7, to advise us on all the 
matters surrounding management changes.
    On the morning of June 7, OFHEO senior staff and I met with 
representatives of Freddie Mac's Board to learn the details of recent 
events. I would note that much of what was addressed that day was known 
to OFHEO and had been the subject of the restatement. However, new 
issues relating to Mr. Glenn and the termination and replacement of 
senior management were also presented; particularly the lack of 
confidence in Mr. Glenn expressed a month earlier by PwC. I considered 
the information regarding Mr. Glenn a clear signal of a breakdown in 
the integrity of the Freddie Mac's control environment at the highest 
levels and sent a letter to the board that day initiating an OFHEO 
investigation.
    Following this meeting, as occurred after the meeting on May 27, 
additional matters came to light and, again, reflected a lack of candor 
that concerned me deeply.
    In the June 7 letter, I formalized with the board certain actions 
with respect to the restatement process. In addition, I tasked a 
special investigative team to explore and review accounting practices 
relevant to the restatement process at Freddie Mac and, in addition, 
management's progress in implementing an action plan that OFHEO 
directed the board to provide for the Agency's formal approval. The 
investigative team has also undertaken an investigation of employee 
misconduct. OFHEO is moving expeditiously on this review.

The Role of a Federal Financial Safety and Soundness Regulator
    Having discussed our specific regulatory role over the restatement 
process at Freddie Mac, I would now like to put it in a more general 
context. First the role of a financial safety and soundness regulator 
and second, and more specifically, the Agency's regulatory approach in 
examining accounting practices and controls.
    OFHEO uses a safety and soundness approach in supervising the 
Enterprises that is analogous to the Federal Reserve System's and the 
Office of the Comptroller of the Currency's approach to supervising 
large-and-complex banking organizations. The foundation of these 
approaches is that the management of these firms should be held 
responsible for monitoring and managing the institution's exposure to 
risk. By looking at the firm's risk management procedures and internal 
controls, the safety and soundness regulator assesses whether the 
firm's ability to manage risk matches the level of risk it assumes. In 
addition, the supervisory process also reviews the firm's performance 
in complying with the company's own internal policies, as well as other 
prescriptive requirements. In short, safety and soundness supervision 
is directed toward identifying material problems or emerging problems 
and seeing they are appropriately corrected before the company's 
financial solvency is threatened.
    During the past decade, financial safety and soundness regulators 
and OFHEO have endeavored to continuously enhance the examination 
process to make it more risk-focused and to make greater use of 
technological innovations. Increasingly, safety and soundness 
supervision stresses the need for financial firms to implement sound 
risk management practices for: Active oversight of management by the 
board; clearly defined policies, procedures, and authority; 
comprehensive risk measurement and reporting systems; and adequate 
audits and systems of internal controls.
    OFHEO's supervisory activities are designed to assess the 
Enterprises' risk profiles and require remedies where and when they are 
appropriate. They encompass evaluations of each Enterprise's asset 
quality, management of interest rate risk, liquidity management, 
capital adequacy, and their risk management strategies and risk 
management practices--including their internal controls and governance.
    Safety and soundness regulators do not attempt to prescribe 
``regulatory accounting principles'' for financial reporting. In fact, 
when accounting principles were prescribed in the 1980's by financial 
regulators, many of those standards were criticized after numerous 
financial institutions failed. Congress subsequently expressed its 
desire for financial safety and soundness regulators to rely upon 
established accounting principles (GAAP) for financial reporting 
standards (Section 121 of FDICIA). In OFHEO's 1992 Act, Congress 
directed OFHEO to do the same, that is, to pursue GAAP in their 
regulatory reporting requirements.
    Safety and soundness regulators do not review accounting policies 
for conformance with GAAP, nor do we certify that a company's financial 
statements are consistent with GAAP. We expect an independent auditor 
to certify that a company's financial statements are in conformance 
with GAAP. We review transactions to ensure that they are consistent 
with sound risk management. The work of the independent auditor is to 
conduct its audit and report on the company's annual financial 
statements. The scope of the independent auditor's engagement must be 
sufficient to permit the auditing firm to determine and report upon 
whether the financial statements are presented fairly and in accordance 
with GAAP.
    The internal and external auditors routinely work together in 
establishing the scope and frequency of audits to be performed. The 
independent auditor reviews the scope and adequacy of the internal 
auditing program.
    Safety and soundness supervision does not replace an internal audit 
function for the Enterprises' Board of Directors. Internal audits are a 
governance/management control question. That is, the board of directors 
and executive management need to have the internal controls tested and 
assessed by units without business-line operating responsibilities, 
such as an internal audit group. Internal audit provides the board and 
the CEO, along with other members of senior management, with assurances 
concerning the effectiveness of controls.
    Safety and soundness regulators do not perform forensic work 
(investigative work on what has occurred) unless a need arises. In 
fact, safety and soundness regulators frequently cause the board of 
directors to engage forensic professionals to investigate 
irregularities and share the results of their findings with the 
regulator. Subsequent to the findings from the forensic work, the 
regulator holds the board accountable for ensuring there are 
appropriate remediation plans and action items to address the issues 
that are identified.

OFHEO's Approach to Examining Accounting Practices and
Controls Over Financial Reporting
    The process of examining an Enterprise's accounting practices and 
related internal controls for financial reporting begins with a 
thorough study of the strategies and the techniques the board of 
directors has adopted to set the company's course, and to measure and 
evaluate management's performance in implementing the board's 
strategies. This step includes, for example, an evaluation of the 
board's committee structure, oversight practices and reporting 
conventions, and an assessment of the effectiveness of the overall 
control framework at the board level. The examination process also 
includes a ``mapping'' of the corporate structure management has 
adopted to facilitate the implementation of the board's strategies and 
the achievement of its objectives pertinent to financial reporting. The 
objective of the mapping process is to establish a roadmap of 
management's assigned responsibilities, duties, and functions that can 
then be used to identify key risk points in the internal control 
framework for financial reporting that warrant targeted evaluation and 
attention due to their potential impact on financial safety and 
soundness.
    Having established an appropriate understanding of the overall 
control framework and its risk points by, for example, reviewing 
relevant policies, procedures, systems, tools, and management 
reporting, and by interviewing Enterprise management and personnel, 
examiners then sample selected transactions in order to test whether 
the framework actually functions as designed and intended. Depending on 
the nature of the examiners' focus, these sampling activities may 
include evaluations of the actions of a variety of different 
participants and their respective roles in the control framework, 
including management, technical staff, internal auditors, and 
independent auditors. During the course of their evaluations, examiners 
apply evaluative standards that reflect the professional standards 
appropriate for the actions under review, and reach conclusions that 
address the Enterprises' financial safety and soundness.
    OFHEO's approach to examining accounting practices and internal 
controls for financial reporting should be familiar to the Committee, 
given that our approach is built on the same well-established concepts 
that form the core of applicable provisions of the Sarbanes-Oxley Act 
of 2002 and the SEC's regulations implementing the control-related 
provisions of that Act. Our examination approach also embraces 
fundamental precepts found in widely-recognized control frameworks such 
as the Internal Control-Integrated Framework published by the Committee 
of Sponsoring Organizations of the Treadway Commission (more familiarly 
known as ``COSO''), the Guidance on Assessing Control published by the 
Canadian Institute of Chartered Accountants, and the Turnbull Report 
published by the Institute of Chartered Accountants in England & Wales. 
Moreover, we regularly consider practices adopted by other financial 
safety and soundness regulators, generally accepted auditing standards, 
and control-related methodologies and standards propounded by 
professional associations such as the Institute of Internal Auditors 
and the American Institute of Certified Public Accountants, and we 
enhance our evaluative techniques as necessary to maintain a position 
on the leading edge of this evolving field of expertise.
    The Committee has requested information on OFHEO's role with 
respect to approving termination agreements for the executive officers of 
the Enterprises, including involvement in the recent termination agreements 
of Freddie Mac's executive officers. In addition, you sought 
information on OFHEO's corporate governance rule. Details on both 
follow.

Executive Compensation
    OFHEO has broad authority to consider executive compensation, both 
as a specific matter of excessive compensation as well as a factor in 
the operational integrity of the Enterprises.
    OFHEO draws authority from the explicit and implied authorities of 
its statute, the Federal Housing Enterprises Financial Safety and 
Soundness Act of 1992, PL 102-550, Title XIII; 106 Stat. 3672 (October 
28, 1992). At the same time, other OFHEO authorities are delineated in 
certain sections of the chartering acts for the Enterprises.
    Excessive Compensation. OFHEO is directed by statute to prohibit 
the payment of ``excessive compensation'' to executive officers; 12 
U.S.C. 4513(b)(8). The prohibition on excessive compensation is tied to 
compensation that is ``. . .not reasonable and comparable with 
compensation for employment in other similar businesses. . .;'' 12 
U.S.C. 4518(a). At the same time, OFHEO may not set or prescribe or set 
a specific level or range of compensation for such executives; 12 
U.S.C. 4518(b).
    Termination Benefits. OFHEO has authority to review and provide 
approval for ``termination benefits.'' This authority is contained in 
the charter acts of the two Enterprises.
    For example, in the Freddie Mac charter (Federal Home Loan Mortgage 
Corporation Act, 12 U.S.C. 1451 et seq.), Section 303(h)(2) provides 
that the Corporation may not enter into any agreement or contract to 
provide money or other things of current or potential value in 
connection with the termination of employment of any executive officer 
unless the agreement or contract is approved in advance by OFHEO; 12 
U.S.C. 1452(h)(2). The statute provides for OFHEO to make such 
determination based on comparability of such agreements with officers 
at comparable companies. The statute covers contracts entered after the 
date of enactment, but provides that any ``renegotiation, amendment, or 
change'' after such date of enactment to any contract entered into 
before or after the date of enactment shall be considered entering into 
a new agreement or contract that OFHEO should review and provide its 
opinion.
    In regards to Freddie Mac, OFHEO has undertaken certain actions 
relating to executive compensation. Specifically, I wrote to the board 
of directors on June 7, 2003 indicating it must explain its rationale 
for any termination packages for the individuals leaving the firm, 
specifically for Brendsel, Glenn, and Clarke. Further, I directed the 
board to inform these individuals that their termination packages are 
subject to OFHEO review and approval and, for any employee discharged 
for misconduct, that OFHEO could direct indemnification of Freddie Mac 
for losses incurred.
    We have directed Freddie Mac not to transfer funds, stock, or 
options to these three individuals and Freddie Mac is complying. OFHEO 
is reviewing now the termination packages for Brendsel, Glenn, and 
Clarke.
    I want to reiterate what I noted regarding OFHEO's authority in 
this area. First, we review executive compensation as a stand-alone 
matter, that is: Is such compensation excessive? And, second, as we 
proceed with the investigation, we look to the behavior of management 
and whether it comports with the standards of the corporation, violates 
any corporate governance rules or otherwise harms or threatens the 
safety and soundness of the corporation. If so, OFHEO would consider 
actions that would involve compensation, such as ordering restitution.

Corporate Governance
    OFHEO has had in place for some time an active program of review 
for corporate governance at the Enterprises. Corporate governance is 
considered to be a major component of risk management and a fundamental 
ingredient in the safe and sound operation of the firms. Corporate 
governance under the examination program is composed of separate 
programs entitled Board Governance, Management Processes Program, Audit 
Program, and Management Information Program.
    While OFHEO has strong statutory support for its corporate 
governance regime, in 2000, the Agency began a program of building up 
its regulatory infrastructure, putting in place rules to support its 
various functions and to strengthen its legal position. This program 
included a corporate governance rule. The rule generated a great deal 
of interest and OFHEO issued a Final Rule on June 2, 2002, effective on 
August 5, 2002.
    The rule made clear that corporate governance is a key area of 
safety and soundness and it directed each of the Enterprises to elect a 
State law for the purposes of adhering to a body of corporate law. Both 
have done so. The rule required the companies to have committees and 
that they meet the highest applicable standards; both have such 
committees. A quorum of the board is required to transact business and 
no proxy voting is allowed; both have such policies. The rule required 
conflict of interest policies; both have such policies. The rule 
mandated that the board meet its responsibilities and described the 
areas of key concern for Board oversight of senior management. Finally, 
the rule noted the authority of OFHEO to limit or restrict 
indemnification of current or former board members as part of its 
safety and soundness authority.
    OFHEO's examination team has worked with the Enterprises to see 
that changes that were required have been put in place and that the 
Enterprises continue to address other requirements, such as changes 
mandated in the Sarbanes-Oxley Act.

Legislative Enhancements
    I would like to submit for the Committee's consideration a series 
of legislative recommendations to add to OFHEO's broad authorities and 
to fill in a number of gaps between OFHEO's authorities and those of 
other financial regulators.
    Paramount among these is permanent funding for the Agency. Other 
financial safety and soundness regulators are funded through 
assessments on the institutions they regulate; so is OFHEO. Only OFHEO, 
however, must move through the annual appropriations process. The 
budget process has had a limiting effect on the Agency's resources and 
may affect our ability to effectively address regulatory issues on a 
timely basis.
    OFHEO must have more flexibility to respond to important issues, 
such as Freddie Mac's restatement of income, without stretching thin 
our ability to continually monitor the significant credit and interest 
rate risks being managed by the two Enterprises. The amount of 
resources needed to address the issues surrounding Freddie Mac's 
restatement is straining our resources. Permanent funding is needed to 
ensure that OFHEO can continue to effectively regulate the Enterprises. 
I am pleased that the Administration has endorsed this needed change.
     The other recommendation I would like to highlight relates to 
charter compliance. I believe that the regulatory responsibility for 
ensuring that the Enterprises remain in compliance with their charters 
more properly resides with the safety and soundness regulator. Mission 
regulation would continue to reside in HUD in the form of affordable 
housing goals and fair lending enforcement.
    OFHEO has the authority and responsibility for taking an 
enforcement action when an Enterprise violates any applicable law or 
regulation. In fact, under the current scheme, if HUD found that a new 
program was not permissible, HUD would turn to OFHEO to take any 
necessary enforcement action. In addition, OFHEO would take appropriate 
action if we independently determined that an Enterprise was in clear 
violation of its charter. OFHEO should have full authority, including 
in areas of ambiguity, for interpreting and enforcing charter 
compliance.
    Without casting any doubt on HUD's abilities, I simply believe that 
public policy would be better served if OFHEO, with its active 
examination and oversight of the Enterprises, had full responsibility 
for charter compliance.
    The draft proposal, attached with a summary, strengthens OFHEO with 
explicit receivership authority, removal authority, greater facility in 
hiring examiners, adds criminal penalties for certain violations of 
law, provides independent litigation authority and addresses certain 
gaps in OFHEO's enabling statute that have been addressed previously by 
regulation.

Notes on Recent Events and the OFHEO June 2003 Annual Report
to Congress
    Turning now to the OFHEO Report to Congress, we reported that 
Freddie Mac's overall internal control framework, and the management of 
the internal control framework, are effective. We stated, however, that 
Freddie Mac's release of audited financial statements was being delayed 
pending a reaudit of past financial statements, and that Freddie Mac 
had agreed that certain accounting treatments applied in the past were 
incorrect. We informed Congress at the time, of our opinion regarding 
the reaudit. We further advised Congress that Freddie Mac's Board of 
Directors had undertaken efforts to enhance expertise and controls in 
the area of financial 
accounting and operational control, that we had evaluated the board's 
and management's plans in that regard, and that we were satisfied that 
these actions were 
appropriate steps to address the situation. In my view, these 
statements clearly indicate that, although the overall framework is 
effective, OFHEO is ensuring that the board and management devote 
serious attention and remedial efforts to the area of financial 
reporting and related controls. OFHEO's activities in this regard are 
highlighted in this testimony.
    With regard to internal controls, our examination program is 
consistent with applicable professional standards in that it addresses 
each Enterprise's overall internal control framework; that is, the 
framework that includes the following categories: (1) the effectiveness 
and efficiency of operations; (2) the reliability of financial 
reporting; (3) compliance with applicable laws and regulations; (4) and 
safeguarding the assets of the company. Consider that the term 
``internal control'' encompasses five interrelated components--the 
control environment; risk assessment activities; control activities; 
information/communication; and monitoring. As you might imagine, 
companies as complex as Fannie Mae and Freddie Mac develop equally 
complex internal control frameworks. These frameworks encompass 
hundreds, perhaps thousands, of separate controls, including approvals, 
authorizations, verifications, reconciliations, segregation of duties, 
systems access limitations, and a myriad of others. In short, the 
integrity of the overall internal control framework is determined by 
considering the total picture, and when viewed in its entirety, a 
framework may exceed safety and soundness standards even though there 
are observed weaknesses or deficiencies in particular controls.
    Examples of the application of this principle include practices 
adopted under standards established by the American Institute of 
Certified Public Accountants, and guidance provided by the SEC in 
recent rules implementing provisions in the Sarbanes-Oxley Act that 
pertain to assessments of internal controls over financial reporting. 
Specifically, it is common for an independent auditor to provide an 
unqualified opinion on management's reports of financial condition even 
though the auditor is aware of certain ``reportable conditions.'' In 
the vernacular of the independent auditor, a reportable condition is a 
significant deficiency in the design or operation of the internal 
control structure that could adversely affect a company's ability to 
record, process, summarize, and report financial data consistent with 
the assertions of management in the financial statements. The common 
practice is for the auditor to communicate such deficiencies to 
management in the form of a management letter, while at the same time 
allowing its unqualified opinion to stand. As a separate example, under 
SEC rules, significant deficiencies that do not rise to the level of a 
material weakness do not preclude management from characterizing its 
internal controls over financial reporting as ``effective.'' The SEC 
guidance prohibits management from deeming its controls effective if 
there are one or more 
material weaknesses; however, the SEC also observes that a material 
weakness constitutes a greater deficiency than a significant 
deficiency. In sum, I believe the standards we have applied in reaching 
our examination conclusions on internal controls are consistent with 
those established by both the AICPA and the SEC.
    Before I move on, I would like to emphasize a point or two about 
information flow and the environment that preceded the publication of 
our Annual Report to Congress. The results and conclusions of the 2002 
annual examination were based on the information gathered and evaluated 
during the course of our work during 2002. That information was 
supplemented by information obtained by OFHEO during 2003, from early 
January up to the time of the publication of the Annual Report to 
Congress. As I discussed earlier, OFHEO has devoted considerable effort 
and resources to this matter, and our efforts continue to yield new 
information. One should also consider that the board of directors' 
internal investigation is being conducted during 2003 as well, and that 
the board's investigation may yield new information. In addition, the 
Committee is aware that I initiated OFHEO's own special examination on 
June 7, little more than 1 week before the statutory delivery date for 
the Report to Congress; and it is possible that our special examination 
could give rise to new findings as well. I raise these facts to 
emphasize that the date on which the Report was due fell in the midst 
of a very fluid environment; nevertheless, I believe that the 
examination results and conclusions expressed in the Report to Congress 
regarding the overall internal control and framework at Freddie Mac are 
appropriate. Certainly, we will have more to say about the controls 
over financial reporting, improper earnings management, and corporate 
governance practices after the special examination has concluded. I 
assure you that I will provide the Committee with a timely notification 
and description of any substantive changes in our view of the internal 
control framework and corporate governance practices once I have the 
benefit of the results under the various investigations currently 
underway.

Supplemental Appropriations
    Finally, I would like to bring to the Committee's attention an 
urgent funding matter. Earlier this week, I submitted an fiscal year 
2003 supplemental funding request of $4.5 million to the Senate and 
House Appropriations Committees.
    The requested funds will support two critical objectives: First, 
the funds will support the on going special investigation of Freddie 
Mac. The investigation is already well underway and is building on 
information gathered over the course of the restatement process. The 
requested resources are necessary to obtain contract services for 
investigative support and forensic accounting experts. Second, OFHEO 
intends to conduct a special accounting review of Fannie Mae. The 
special review would independently evaluate the accounting policies at 
Fannie and examine whether their implementation is resulting in a high 
level of conformance to GAAP. While I do not have a specific concern 
about Fannie Mae's accounting practices, such a review would be most 
prudent under the circumstances.
    OFHEO's goal of concluding the investigation of Freddie Mac 
expeditiously is dependent on receiving these funds as soon as 
possible. I would like to ask for the Committee's support in obtaining 
the additional funds.
Conclusion
    In summary, Mr. Chairman, is this a serious matter? Yes. Is there a 
crisis? No. While challenges remain, Freddie Mac remains safe and 
sound. At the end of our investigation, we will present all the facts, 
conclusions, and recommendations for the Committee's consideration. Mr. 
Chairman, thank you for the opportunity to testify. I would be pleased 
to answer any questions you or Committee Members may have.



       RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING 
                    FROM ARMANDO FALCON, JR.

Q.1. I would like to follow-up on my questions about the 
anonymous letters. Your staff briefed Committee staff and 
informed staff that some anonymous letters were received and 
then investigated by Baker Botts who dismissed the charges in 
the letters. Did the charges in those letters have anything to 
do with what actually happened at Freddie? What charges were 
made in the letters? Who were the letters sent to? Is there any 
idea of where they came from, a Freddie employee? An auditor?

A.1. The letters contain a series of charges which can be 
summarized as allegations of wrongdoing against Freddie Mac 
that they overstated their 1999 earnings by several hundred 
million dollars; that they commingled cash collateral in 
violation of security agreements and filed false or misleading 
financial and regulatory 
reports; and that they made a billing error of approximately $6 
million in the account of Bank of America.
    The allegations contained in the letters are not directly 
related to the accounting issues that have led to the company's 
restatement. The letters were sent to Fannie Mae, and Fannie 
Mae delivered them to Freddie. Although the letters indicated 
OFHEO and others were copied, we did not actually receive 
copies. The source of the letters continues to be unknown, they 
are anonymous.

Q.2. Can the Committee receive a copy of the letters?

A.2. OFHEO obtained the letters pursuant to a subpoena and 
confidentiality agreement. We would like to discuss this with 
the Committee and try to find a way to satisfy the Committee's 
request.

         RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE 
                    FROM ARMANDO FALCON, JR.

Q.1. Mr. Falcon, when were you informed of the Freddie Mac 
Board's decision to terminate the President and CEO, force the 
retirement of its CEO and force the resignation of its CFO? 
When you were informed and what exactly did the board or its 
representative tell you? How did they describe the situation?

A.1. I was informed of the board's decision to make the 
management changes on June 6, 2003. I was informed that the 
board had just concluded its deliberations and decided that a 
change was necessary in light of issues raised by the 
restatement.

Q.2. Mr. Falcon, in your testimony you say that Baker Botts 
told you of no management problem on May 27. Earlier in your 
testimony you state that on May 8 that PriceWaterhouseCoopers 
informed some Freddie Board Members that it ``would not accept 
the representations'' of some employees. This appears to be a 
key development in the reaudit. When and how did you learn of 
these PriceWaterhouseCoopers concerns? What did you do when you 
heard of these concerns?

A.2. On May 8, 2003, PriceWaterhouseCoopers (PwC) communicated 
to Freddie Mac's Board their unwillingness to accept the 
representations about the company's financial statements from 
Mr. Glenn and Mr. Clarke. On May 27, OFHEO's Chief Examiner was 
briefed by Mr. Doty on the status and latest developments in 
his investigation. No mention was made of PwC's lack of trust 
in the two individuals, even when specifically asked if there 
was anything else we should know about the restatement and 
investigation.
    OFHEO learned of the communication between PwC and the 
board in the June 7 meeting with Freddie Mac's representatives 
that I convened. I considered PwC's concerns to be a very 
material development. Learning about this material development 
almost 30 days after the information was communicated to the 
board concerned me deeply. The delay in learning this critical 
piece of information, coupled with other considerations, caused 
me to formalize and expedite aspects of our ongoing supervision 
of Freddie Mac's reaudit and restatement process and 
independently investigate certain aspects of potential 
management conduct. The formalization of our oversight 
activities and expediting our own independent evaluation of the 
factors causing the reaudit and restatement were reflected in 
my June 7 letter to Freddie Mac's Board of Directors.

Q.3. Mr. Falcon, I am very interested in the fact that 3 days 
before the board's shakeup OFHEO had publicly approved of the 
management's treatment of an earnings restatement that had been 
pending since January, stating ``we remain satisfied that the 
board of directors and executive management are taking the 
appropriate action.'' How do you reconcile this with your 
letter that weekend which stated that the management shake-up 
``only goes a part of the way toward correcting serious 
problems'' at Freddie Mac?

A.3. In the 2002 Annual Report to Congress, OFHEO included a 
paragraph covering the Freddie Mac reaudit and restatement 
process. The paragraph summarized OFHEO's assessment of Freddie 
Mac's efforts surrounding: The independent auditor's decision 
to delay its 2002 certification of financial statements, the 
board of director's decision to have prior period statements 
reaudited and restate those earlier periods, and the 
remediation program to address control matters in the financial 
accounting and operational control area. OFHEO concluded and 
reported to Congress that Freddie Mac's Board and its 
management took appropriate action to address the delay in the 
2002 certified financial statements.
    When the independent auditor delayed an opinion on the 2002 
financial statements. OFHEO's focus was to ensure the company 
remained committed to getting the restatement process done well 
and in a timely manner. In addition, we evaluated a May 2003 
Board-approved plan to addresses financial accounting and 
operational control weaknesses that superceded the Financial 
Reporting Controls Improvement Plan (FRCIP) approved by the 
board in 2000. Working to ensure that Freddie Mac's reaudit and 
restatement process was done well and in a timely manner had 
been our priority and remains a key concern as the safety and 
soundness regulator.
    Beginning June 4, there were two key developments that 
caused me to send a letter on June 7 to the Freddie Mac Board 
of Director. First, there was the action of a senior Freddie 
Mac official that led to his termination, and triggered the 
board's decision to force the separation of two other senior 
executives on June 6. In tandem with those decisions, the board 
installed a new executive management team to lead the firm. The 
second key development was that on June 7, I was presented with 
information suggesting there may have been past management 
decisions that resulted in smoothing the company's earnings by 
delaying income into future periods.
    Up until June 6, OFHEO had been emphasizing to the board 
and its executive management the importance of getting the 
restatement process done well and in a timely manner. I decided 
to formally reemphasize this as a regulatory priority on June 
7. Following the same rationale, I elevated OFHEO's routine 
supervisory efforts covering Freddie Mac's remediation plan to 
address control weaknesses in the financial accounting and 
operational control areas. I wanted to ensure OFHEO's 
supervisory priorities would remain a key focus of the new 
executive management team.
    Distinct from the supervisory priorities involving the 
restatement process and control weaknesses at Freddie Mac, 
learning about management practices that may have been intended 
to manage earnings and violations of the company's code of 
conduct by a senior executive were troubling. These acts of 
misconduct by executive managers represent a serious problem if 
supported through our investigation.

Q.4. Mr. Falcon, some have suggested that the safety and 
soundness responsibilities of OFHEO should be transferred to 
the Treasury Department. What are your views on this proposal?

A.4. First and foremost, effective safety and soundness 
oversight requires the following three elements:

1. Independence from political influence;
2. Permanent finding outside the appropriations process; and
3. Full powers and authority to conduct oversight and take any 
    necessary regulatory action.

    With those fundamentals in place, OFHEO would be well-
positioned for long-term success in either HUD or Treasury.

Q.5. Mr. Falcon, in your July 14 letter to the Senate 
Appropriations Committee. you indicated that OFHEO will now 
begin an ``independent'' review of Fannie Mae's accounting 
practices. However, the OFHEO handbook includes a lengthy list 
of checks which your examiners are to conduct precisely to 
review accounting and audit quality. I know OFHEO is not 
supposed to be the GSE's auditor, but your own handbook says 
that you were monitoring and ensuring appropriate accounting 
standards. Please comment on this apparent contradiction and 
also explain why OFHEO is only now undertaking an independent 
review of Fannie Mae? Please provide this Committee with a 
detailed list of dates on which examiners reviewed Fannie Mae 
accounting practices, the nature of this review, the manner in 
which it compares with that done by bank examiners, and the 
reasons why this review was not ``independent.''

A.5. There is no contradiction between the work outlined in my 
July 14 letter and the routine supervisory work conducted by 
OFHEO. The special review of Fannie Mae--which will be a 
comprehensive review of their accounting policies and whether 
their implementation is resulting in a high level of 
conformance with GAAP--is work that will be independent of the 
routine supervisory activities at OFHEO. The work proposed in 
my July 14 letter requires a forensic accounting investigation 
to ascertain the intent behind the way Fannie Mae's management 
applies GAAP. OFHEO's routine supervisory activities do not 
include forensic accounting techniques. Similar to the other 
financial safety and soundness regulators, OFHEO does not 
regulate the accounting used by the Enterprises. OFHEO does 
advocate the appropriate 
application of GAAP by the Enterprises and the publication of 
accurate and meaningful financial disclosures. Like the 
depository regulators, OFHEO regards reputable independent 
auditors to possess expertise in accounting. The independent 
auditor's certification of a company's financial statements and 
disclosures is intended to provide assurances that management 
has fairly presented the financial statements in accordance 
with GAAP. Considering the current environment, I want to 
expedite our special forensic review of Fannie Mae's 
application of GAAP accounting, to answer questions that may be 
asked about Fannie Mae.
    OFHEO's approach to reviewing independent audits and 
financial reporting is analogous to the other safety and 
soundness regulators. Allow me to provide more contour for the 
nature and scope of that approach. Over the years, there have 
been two forms of accounting principles that were used by 
financial firms for the preparation and reporting of financial 
condition and results. First, there were the accounting 
principles being prescribed by the regulators. During the 
1980's there were a number of regulatory accounting principles 
(RAP) being prescribed. Many of these RAP standards were 
roundly criticized after the failures of numerous depository 
institutions and Congress expressed its desire for financial 
safety and soundness regulators to rely upon the established 
generally accepted accounting principles (GAAP) for financial 
reporting standards. The second and more widely recognized 
accounting principles are prescribed by GAAP, arguably a set of 
principles that are subject to interpretation and can result in 
similar transactions receiving different accounting treatments.
    Investors and markets have learned to appreciate that GAAP 
is not precise. The accounting principles prescribed through 
GAAP were never meant to be rigid, but intended to allow for 
new business structures, as well as, new and innovative 
transactions. Therefore, GAAP is flexible to allow for the 
adaptation to changing circumstances, and not immune from 
debates in its application.
    Section 121 of FDICIA directs the depository regulators to 
pursue GAAP in their regulatory reporting requirements. In 
OFHEO's 1992 Act, the Congress directed OFHEO to pursue GAAP in 
its regulatory activities.
    Accounting standards are intended to provide the foundation 
for credible financial statements and other disclosures that 
are the key means for communicating a firm's operating result 
and its overall health, as well as making transparent the 
economic value of the firm. In addition, accounting standards' 
are intended to provide the foundation for disclosing reliable 
information to the marketplace which promotes enhanced market 
discipline. The foundation for credible financial statements 
and disclosure has obvious implications for the supervisor in 
its oversight of the safety and soundness of the financial 
firm.
    Many of the accounting standards that have emerged in 
recent years deal with the most esoteric accounting policies 
and transactions that FASB has prescribed. For instance, under 
FAS 133 the application of GAAP for certain transactions may 
very likely not reflect the underlying economics of the 
transactions.
    Fannie Mae and Freddie Mac, like other large financial 
firms are required to engage an independent external auditor to 
audit their financial statements and disclosures. There are 
several roles performed by the independent auditor, and key 
among these roles is the performance of testing to conclude 
whether management has fairly presented the financial 
statements in accordance with GAAP. In that regard, the 
independent auditor provides a level of assurance that the 
financial statements are free of material misstatements and 
renders a final opinion, which carries the accounting firm's 
signature. That audit opinion falls into one of three 
categories: clean, or ``unqualified,'' if the records amount to 
a fair representation of the company's underlying economic 
health; ``qualified,'' if there are exceptions to an otherwise 
fair representation of the financial statements; or a 
``disclaimer,'' meaning the client's recordkeeping is so 
inadequate that the auditor cannot even render an opinion. For 
companies experiencing serious financial difficulties, the 
independent auditor is also supposed to state whether there is 
``substantial doubt'' that the entity can continue as a ``going 
concern'' for a reasonable period of time. Fannie Mae has 
always received unqualified opinions on its financial 
statements from its independent auditors. Freddie Mac has also 
obtained unqualified opinions on its financial statements from 
its independent auditors. The certification of Freddie Mac's 
2002 financial statements has been delayed by the firm's new 
auditors pending the reaudit and restatement of prior periods 
based upon the new firm's interpretation for the application of 
GAAP to certain accounting transactions.
    The importance of the independent auditor's opinion that is 
rendered on a firm's financial statements has been bolstered by 
court cases that have established a public responsibility for 
the independent auditor which transcends any employment 
relationship with the management and board of directors of the 
firm being audited. When the independent auditor certifies the 
public reports of a company, their ultimate allegiance is to 
the corporation's creditors, stockholders, and to the investing 
public.
    Like the depository financial safety and soundness 
regulators, OFHEO evaluates the work performed by the auditor 
and the independence of the auditor and the audit work. Through 
its supervisory programs, OFHEO has routinely considered the 
accounting policies of the Enterprises and tested the 
accounting practices on transactions. In our design, 
implementation and operation of the risk-based capital test, 
OFHEO has considered the accounting policies and practices of 
each Enterprise. We are required to consider the accounting 
treatments used by the Enterprises regularly in the 
administration of the risk-based capital test, in addition to 
carefully considering changes or innovations in accounting for 
transactions. Through our examination program, we routinely 
conduct transactional testing which includes a consideration of 
whether transactions are being accounted for consistent with 
the approved GAAP of the company. In 2002, with the addition of 
more resources to our examination program, we added a team 
dedicated exclusively to accounting issues. This dedicated 
accounting team is used to augment routine examination testing 
that includes the consideration of accounting policies and 
practices. As well, this team of examiners is engaged with the 
Enterprises' accountants discussing and considering the 
proposed application of GAAP for new FASB pronouncements. As 
part of the examination testing, the quarterly closing and 
reporting processes are evaluated to determine if there are 
procedures employed to achieve GAAP compliance and test to see 
there are sign-offs on the financial statements by the 
independent auditors, and whether there are reservations noted 
by the auditor.
    Like the depository regulators, an effective audit program 
is key in a quality risk management framework. We regularly 
evaluate the quality of the audit programs, the appropriateness 
of the audit work performed and the sufficiency of follow-up on 
audit findings in our safety and soundness examinations. When 
there are deficiencies recognized in aspects of the internal or 
independent external audit programs, the regulator ensures 
there is remediation for the deficiency. Generally, the 
examination activities covering the audit program covers: A 
determination of independence, a determination of professional 
proficiency; a determination of the appropriateness of the 
scope of work; a testing and determination of the completeness 
of audit work performed; an evaluation of management of the 
internal audit; a determination of the quality and sufficiency 
of follow-up and oversight by the board's audit committee; a 
determination of the appropriateness of the risk assessment 
process employed by auditors; and a determination of the 
auditors 
involvement in new policies, procedures, or practices. For more 
contour on what examiners are evaluating for the audit programs 
at the Enterprises, please refer to the attachment.



         RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 
                    FROM ARMANDO FALCON, JR.

Q.1. Quoting from your June 15, 2003, Office of Federal Housing 
Enterprise Oversight (OFHEO) Annual Report to Congress, 
``Message From the Director,'' you wrote:

    On the occasion of our 10th Anniversary, it is with great 
pride that I report to Congress that the Office of Federal 
Housing Enterprise Oversight has developed into the strong, 
capable, and innovative regulator that Congress envisioned when 
it created the Agency only a decade ago. OFHEO today is 
actively and aggressively fulfilling its mission of ensuring 
the safety and soundness of Fannie Mae and Freddie Mac (the 
Enterprises).
    the Enterprises have remained safe and sound through 
another year of exceptional growth in the housing sector of our 
economy. In a year when more and more Americans have become 
homeowners, the public can take comfort in knowing that OFHEO 
is on the job, doing its part to ensure the strength and 
vitality of the Nation's housing finance system.

    Later, on pages 37-38 in Chapter 4 of the report, when 
reporting on the Freddie Mac Examination Results and 
Conclusions, the report states:

    [Freddie Mac's] audit functions are dependent and 
effective. The Internal and External Audit Functions have the 
appropriate independence. Auditors performing the work possess 
appropriate professional proficiency. The scope of the audit 
work is appropriate, and the audit work is complete. The 
management of the Internal Audit department is effective. 
Executive management and the board of directors are 
appropriately involved with and follow up' on identified audit 
issues. The auditor's risk assessment process is effective. 
Internal Audit is appropriately involved in new products and 
new initiatives.

    If OFHEO is ``actively and aggressively fulling its 
mission,'' how did such accounting inadequacy fail to be 
addressed in OFHEO's examination of Freddie Mac's operations, 
especially since the implications of FAS 133 have been 
discussed and implemented since 1999? How can the public ``take 
comfort in knowing that OFHEO is on the job'' if it fails to 
effectively oversee such problems in an appropriate time frame? 
How can we be sure that another similar problem at Freddie, or 
Fannie for that matter, is not brewing? Why shouldn't such 
problems be discovered, disclosed, and addressed in real time 
in order for OFHEO to be an effective regulator that the public 
can really trust?

A.1. To begin, the public can take comfort in the fact that 
OFHEO has done its job because Freddie Mac's safety and 
soundness has not been called into question. The issues raised, 
while important, have not been about Freddie Mac's financial 
solvency. There are two distinct issues under discussion. The 
first issue involves the application of generally accepted 
accounting principles (GAAP) and the second issue involves 
questionable motives behind certain management decisions made 
during Freddie Mac's implementation of FAS 133.
    First, there is the issue of accounting adjustments 
involving Freddie Mac's restatement process and PwC's delayed 
certification of Freddie Mac's 2002 financial statements. I 
take seriously the fact that the restatement adjustments will 
be substantial. I also take seriously the delay in 2002 
certified financial statements. My concern was the reason OFHEO 
stressed to Freddie Mac the importance of completing the 
restatement process as expeditiously as possible and the equal 
importance of getting it done well. But, at the heart of the 
restatement process and the size of the adjustments 
contemplated, this remains an accounting issue, more 
specifically the timing of income recognition. There is not a 
question of whether there will be billions of dollars more or 
less in income earned by Freddie Mac over the life of the 
existing transactions. Rather, the accounting issue involves 
the period in which those billions of dollars in income get 
recognized. In short, the fair value of the firm is not 
materially affected by the adjustments. But the GAAP reported 
net income in past and future time periods will fluctuate based 
upon where the income adjustments are recorded.
    Like the other financial safety and soundness regulators, 
OFHEO does not regulate the form of accounting used by the 
Enterprises. OFHEO does, however, advocate the appropriate 
application of GAAP by the Enterprises and the publication of 
accurate and meaningful financial disclosures. Like the 
depository safety and soundness regulators, OFHEO regards 
reputable independent auditors to possess expertise in 
accounting. Fannie Mae and Freddie Mac like other large 
financial firms are required to engage independent external 
auditors to audit their financial statements and disclosures. A 
key role of the independent auditor is the performance of 
testing to conclude whether management has fairly presented the 
financial statements in accordance with GAAP. Freddie Mac 
obtained unqualified opinions through 2001 from its prior 
independent auditor. The new independent auditor's opinion on 
the 2002 financial statements was delayed due to the 
application of GAAP to certain transactions. More specifically, 
PwC expressed reservations about the application of GAAP for 
selected types of hedge accounting treatments due to the hedge 
documentation and the quarterly documentation of hedge 
effectiveness. While PwC was not comfortable with the hedge 
documentation on record, the prior auditor had been comfortable 
and signed-off on the accounting treatments and certified the 
2001 financial statements.
    Freddie Mac's audit functions are independent. Independence 
has been determined using the evaluative standards employed by 
OFHEO which incorporate criteria outlined by recognized 
sources. To determine the ``independence'' of the external 
auditor, examiners: (1) evaluate the ``engagement'' of the 
external audit firm to determine that it is an arm's-length 
transaction; (2) assess the access the external auditor has to 
the board (through the audit committee), including the 
frequency of meetings the external auditor has with the audit 
committee in executive session with no operating management 
present; (3) evaluate the terms and conditions of the 
``engagement,'' and the policies and practices of the external 
audit firm against the independence standards and guidelines of 
the AICPA (American Institute of Certified Public Accountants), 
the NYSE, and the SEC; (4) evaluate the nature and extent of 
nonaudit services provided by the external audit firm; (5) 
evaluate the expertise and staffing of the external auditor for 
the engagement; and (6) test the external auditors work papers 
to determine if identified matters are appropriately 
communicated and recorded. In addition to evaluating the 
independence of the external audit function, examiners evaluate 
other factors in determining the adequacy and sufficiency of 
the external audit.
    In my testimony and in the Annual Report, I noted that for 
several years OFHEO has been working with Freddie Mac to see 
the controls and expertise in the financial accounting and 
financial reporting areas are strengthened. While progress was 
noted, OFHEO continues to work with Freddie Mac to see that 
expertise and controls in the financial accounting and 
financial reporting areas continue to improve.

Q.2. Could you describe in detail what expertise the staff of 
OFHEO has in effectively evaluating and monitoring the various 
complex financial instruments that Fannie and Freddie employ 
for their respective operations on a regular basis? How does 
such expertise compare to your colleagues at the Treasury, the 
Federal Reserve, and private GSE analysts? Please explain in 
detail.

A.2. OFHEO has a talented staff of professionals with 
impressive and varied backgrounds. Our staff is composed of 
experienced professionals and technicians with many years of 
experience in regulation, the capital markets, the mortgage 
markets, in investment management, in financial analysis, in 
hedging, in financial engineering, in accounting, and in 
housing policy and research. Early in my term as the Director, 
I sought to increase the funding for the Agency to build the 
permanent staff and obtain the depth in human resources and 
expertise needed to administer our regulatory program. We have 
made significant progress in obtaining the staff and expertise 
to fulfill our mandate, and the multiyear plan that I am 
implementing seeks to build even further the depth and capacity 
in our personnel. However, there remains considerable work for 
a lean staff of professionals to accomplish in our safety and 
soundness oversight of these two companies.
    OFHEO has deliberately hired seasoned professionals from 
numerous backgrounds. We have hired from within Government, 
from the private sector, and from academia. From the Government 
ranks, we have hired from the banking and thrift regulatory 
agencies (the Federal Reserve System, the Office of the 
Comptroller of the Currency, the Office of Thrift Supervision, 
and the FDIC), from the GAO, and other Federal Agencies. From 
the private sector, we have hired from Wall Street firms, from 
commercial banking companies, from investment management firms, 
from consulting firms, from technology companies, from 
accounting firms, from investments banks, and from law firms. 
From academia, we have hired college professors and 
researchers. Through these three channels of hiring we have 
assembled an experienced group of professionals with a variety 
of technical, managerial, and policy-formulation backgrounds.
    Through the skills sets employed by OFHEO, we have 
excellent knowledge of the mortgage and housing markets, the 
debt markets, the Enterprises' lines of business, investment 
management, hedging activities and techniques, the derivatives 
business, interest rate risk management, credit risk 
management, counterparty risk management, liquidity management, 
accounting, econometrics, and the legal frameworks for the 
Enterprises' business activities.
    OFHEO's collective knowledge and understanding of Fannie 
Mae and Freddie Mac is without a doubt much greater than that 
of any other entity in the Government or private sector.

Q.3. I realize that Fannie and Freddie have voluntarily decided 
to file disclosures on the mortgage-backed securities with SEC, 
despite being exempted from doing so by their charters. 
However, it is also my understanding that they do not want to 
register their debt securities. Would registration of the 
Enterprises' debt securities assist you in being a more 
effective safety and soundness regulator? Please explain in 
detail why or why not.

A.3. the Enterprises' disclosures related to their debt 
securities serve an important function. The disclosures promote 
market understanding and confidence and result in greater 
Enterprise access to the capital markets. Those disclosures are 
thus important to safety and soundness and should be mandatory 
rather than voluntary. This is the more important consideration 
than the actual act of registration. Accordingly, OFHEO has 
under consideration a regulation that would mandate debt 
disclosures equal to those of other publicly held companies.

Q.4. In your testimony, you recommend keeping OFHEO as a quasi-
independent regulator housed within HUD. Please describe in 
detail how moving OFHEO and/or its oversight authority to the 
Office of Thrift Supervision (OTS) or the Department of the 
Treasury would harm or help OFHEO's ability to effectively 
regulate the GSE's.

A.4. First and foremost, effective safety and soundness 
oversight requires the following three elements:

1. Independence from political influence;
2. Permanent finding outside the appropriations process; and
3. Full powers and authority to conduct oversight and take any 
    necessary regulatory action.

    With those fundamentals in place. OFHEO would be well-
positioned for long-term success in either HUD or Treasury.

Q.5.a. In your testimony, you highlight OFHEO's authority to 
review executive compensation packages to ensure they are not 
``excessive'' as allowed in 12 U.S.C. 4518(a), which defines 
``excessive'' compensation as such that is ``. . .not 
reasonable and comparable with compensation for employment in 
other similar businesses.'' Please describe in detail how you 
interpret that definition of excessive compensation.

A.5.a. OFHEO carries out the statutory requirement to prohibit 
excessive compensation by comparing the compensation received 
by senior executive officers at Fannie Mae and Freddie Mac 
including all direct and indirect payment of benefits both cash 
and noncash, granted to or for the benefit of the executive 
officer, to that received by executives for employment in other 
similar businesses.
    In addition to its ongoing review, OFHEO periodically 
undertakes a study to compare compensation provided by each 
Enterprise to executive officers to that provided by similar 
businesses to executive officers doing similar work. OFHEO 
retains an executive compensation consultant to assist in 
conducting the comparability studies. The comparator group for 
each Enterprise includes publicly held financial institutions 
or major financial services companies. The compensation 
policies of Fannie Mae and Freddie Mac are compared to a group 
of similar businesses through the use of proxy statements and 
survey data. OFHEO documents the compensation plans of Fannie 
Mae and Freddie Mac; conducts in-depth interviews with Fannie 
Mae and Freddie Mac executive officers about the nature of 
their work and the compensation, received and examines the 
reasonableness and competitiveness of the compensation packages 
at those firms, as well as the pay mix and the extent to which 
compensation is performance-based. The comparability studies 
update and complement the ongoing monitoring by OFHEO of 
compensation actions taken by the Enterprises as well as 
compensation developments for executives at similar businesses.

Q.5.b. Based on what you know now, is the compensation for 
former Freddie Mac CEO Brendsel, former COO Glenn, and former 
CPO Clarke excessive? Please explain in detail. Have you 
reviewed the compensation of current Freddie Mac executives? If 
so are they excessive, according the above-mentioned 
definition? Please explain in detail.

A.5.b. OFHEO now has a special investigation underway which 
will address, among other matters, whether the compensation of 
former and current executives was excessive under the 
circumstances.

Q.6.a. On July 23, 2003, Baker Botts, LLP released a report on 
its investigations of Freddie Mac and how Freddie improperly 
used various accounting techniques to smooth out earnings. In 
your testimony, you suggested that the Baker Botts, LLP 
investigators were less than cooperative. Why was that the 
case? Please describe in detail the extent of their lack of 
cooperation.

A.6.a. On May 8,2003, PriceWaterhouseCoopers (PwC) communicated 
to Freddie Mac's Board their unwillingness to accept the 
representations about the company's financial statements from 
Mr. Glenn and Mr. Clarke. On May 27, OFHEO's Chief Examiner was 
briefed by Mr. Doty on the status and latest developments in 
his investigation. No mention was made about PwC's lack of 
trust in the two individuals, even when specifically asked if 
there was anything else we should know about the restatement 
and investigation.
    OFHEO learned of the communication between PwC and the 
board in the June 7 meeting with Freddie Mac's representatives 
that I convened. I considered this to be a material 
development. Learning about this material development almost 30 
days after the information was communicated to the board 
concerned me deeply. The delay in learning this critical piece 
of information coupled with other considerations caused me to 
formalize and expedite aspects of our ongoing supervision of 
Freddie Mac's reaudit and restatement process and independently 
investigate certain aspects of 
potential management conduct. The formalization of our 
oversight activities and expediting our own independent 
evaluation of the factors causing the reaudit and restatement 
were reflected in my June 7 letter to Freddie Mac's Board of 
Directors.

Q.6.b. Did OFHEO discover the various accounting techniques 
described in the report as being used by Freddie Mac to smooth 
out earnings as a part of its ongoing examinations activities? 
Please explain in detail why or why not.

A.6.b. OFHEO's Special Investigation Unit is looking at these 
issues; thus, our report will address them at completion of 
this investigation.

Q.6.c. The Baker Botts Report also names the current CEO, 
Gregory Parseghian, as being intimately involved in the various 
questionable transactions that prompted Freddie Mac's Board of 
Directors to dismiss COO Glenn and accept the resignations of 
CEO Brendsel and CFO Clarke. What role will OFHEO play in order 
to determine the extent of Parseghian's involvement? Please 
explain in detail.

A.6.c. OFHEO's Special Investigation Unit is looking at these 
issues; thus, our report will address them at completion of 
this investigation.
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