[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]
REVIEW OF THE RUDMAN
REPORT ON FANNIE MAE
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
MARCH 14, 2006
__________
Printed for the use of the Committee on Financial Services
Serial No. 109-77
U.S. GOVERNMENT PRINTING OFFICE
30-177 WASHINGTON : 2006
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HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
RICHARD H. BAKER, Louisiana PAUL E. KANJORSKI, Pennsylvania
DEBORAH PRYCE, Ohio MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
EDWARD R. ROYCE, California NYDIA M. VELAZQUEZ, New York
FRANK D. LUCAS, Oklahoma MELVIN L. WATT, North Carolina
ROBERT W. NEY, Ohio GARY L. ACKERMAN, New York
SUE W. KELLY, New York, Vice Chair DARLENE HOOLEY, Oregon
RON PAUL, Texas JULIA CARSON, Indiana
PAUL E. GILLMOR, Ohio BRAD SHERMAN, California
JIM RYUN, Kansas GREGORY W. MEEKS, New York
STEVEN C. LaTOURETTE, Ohio BARBARA LEE, California
DONALD A. MANZULLO, Illinois DENNIS MOORE, Kansas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
JUDY BIGGERT, Illinois RUBEN HINOJOSA, Texas
CHRISTOPHER SHAYS, Connecticut JOSEPH CROWLEY, New York
VITO FOSSELLA, New York WM. LACY CLAY, Missouri
GARY G. MILLER, California STEVE ISRAEL, New York
PATRICK J. TIBERI, Ohio CAROLYN McCARTHY, New York
MARK R. KENNEDY, Minnesota JOE BACA, California
TOM FEENEY, Florida JIM MATHESON, Utah
JEB HENSARLING, Texas STEPHEN F. LYNCH, Massachusetts
SCOTT GARRETT, New Jersey BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
J. GRESHAM BARRETT, South Carolina ARTUR DAVIS, Alabama
KATHERINE HARRIS, Florida AL GREEN, Texas
RICK RENZI, Arizona EMANUEL CLEAVER, Missouri
JIM GERLACH, Pennsylvania MELISSA L. BEAN, Illinois
STEVAN PEARCE, New Mexico DEBBIE WASSERMAN SCHULTZ, Florida
RANDY NEUGEBAUER, Texas GWEN MOORE, Wisconsin,
TOM PRICE, Georgia
MICHAEL G. FITZPATRICK, BERNARD SANDERS, Vermont
Pennsylvania
GEOFF DAVIS, Kentucky
PATRICK T. McHENRY, North Carolina
JOHN CAMPBELL, California
Robert U. Foster, III, Staff Director
C O N T E N T S
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Page
Hearing held on:
March 14, 2006............................................... 1
Appendix:
March 14, 2006............................................... 47
WITNESSES
Tuesday, March 14, 2006
Rudman, Warren B., Partner, Paul, Weiss, Rifkind, Wharton &
Garrison, LLP, accompanied by Daniel J. Kramer, Robert P.
Parker, and Alex Young K. Oh, Partners; George Massaro, Vice
Chairman, Huron Consulting Group; and Jeff Ellis, Managing
Director, Huron Consulting Group............................... 6
APPENDIX
Prepared statements:
Oxley, Hon. Michael G........................................ 48
Kelly, Hon. Sue W............................................ 50
Hinojosa, Hon. Ruben......................................... 51
Kanjorski, Hon. Paul E....................................... 52
Rudman, Warren B............................................. 54
Additional Material Submitted for the Record
Baker, Hon. Richard:
Standard & Poor's Article.................................... 100
REVIEW OF THE RUDMAN
REPORT ON FANNIE MAE
----------
Tuesday, March 14, 2006
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 2:00 p.m., in
room 2128, Rayburn House Building, Hon. Michael G. Oxley
[chairman of the committee] presiding.
Present: Representatives Oxley, Baker, Castle, Royce,
Kelly, Feeney, Hensarling, Garrett, Pearce, Neugebauer, Price,
McHenry, Campbell, Frank, Kanjorski, Waters, Maloney, Watt,
Sherman, Moore of Kansas, Baca, Matheson, Davis of Alabama, and
Cleaver.
The Chairman. In early 2003, we were led to believe that
the GSE's were running smoothly with only a routine accounting
restatement in progress at Freddie Mac. What we have learned
since then is that Freddie Mac and Fannie Mae were involved in
large scale misapplication of accounting standards and
irresponsible corporate governance. OFHEO, Congress, and the
American people were misled by the former leadership of these
enterprises. The Federal Home Loan Bank system has had its own
share of accounting and management problems.
In 2004, Fannie Mae's board turned for help to Senator
Warren Rudman who, with his team of legal and accounting
experts, has given us a report of both great quantity and
quality. He has verified much of what OFHEO eventually
uncovered, and the SEC subsequently confirmed, providing an in-
depth understanding of the intent and motive behind the
transactions reviewed.
This voluminous report details widespread departures by
senior management from GAAP accounting, largely to minimize
earnings volatility and meet forecasts and, in 1998, to trigger
maximum executive bonuses. Accounting systems were grossly
inadequate and employees were unqualified.
Senator Rudman found that management, ``paid lip service to
a culture of openness, intellectual honesty and transparency
and discouraged dissenting views, criticism and bad news.''
Arrogance is a descriptive term used more than once. There was
clear disdain for OFHEO.
Fannie Mae claimed to be in line with state-of-the-art
corporate governance when in reality such standards were not
being practiced. Failure to comply with Sarbanes-Oxley
requirements of internal control over financial reporting is
not an insignificant matter.
This report is costing between $60- and $70 million on top
of the $500 million Fannie Mae spent last year on its financial
restatement work, a job that is far from done. Fannie Mae must
also pay the legal expenses of its former Chairman/CEO and CFO.
The encouraging news, according to the Rudman report, is
that Fannie Mae has undergone an extensive transformation in
personnel and structure. There has been a dramatic shift in the
``tone at the top.'' The company has not waited until issuance
of this report to begin making necessary changes.
I welcome the effort that Chairman Steve Ashley and CEO Dan
Mudd are making in this regard. What Senator Rudman and others
have shown us occurred at the GSE's over several years. While
those responsible have left, it's taking the GSE's years to
make corrections. We look forward to OFHEO's final report on
their special exam of Fannie Mae. We must learn from this
experience.
The Rudman report underscores that it's time for a new
combined regulator for the GSE's, with the tools and funding
needed to prevent abuses from developing and permit swift
enforcement action if they do. H.R. 1461 provides strong bank
regulatory-like powers in the vital areas of capital,
portfolios, product approval, and receivership commensurate
with the task of overseeing these large and complicated
companies. H.R. 1461 passed the House overwhelmingly last
October. I urge the Senate to act so that Congress can pass
overdue GSE regulatory reform this year.
Senator Rudman, we appreciate your work on this report and
your appearance here today. I will be giving you a more formal
introduction after the opening statements.
I now yield to our friend from Massachusetts, the Ranking
Member, Mr. Frank.
Mr. Frank. Thank you, Mr. Chairman. As a Member of the
House who worked very closely with Senator Rudman, when he was
in the Senate, on a wide range of issues from legal services to
many others, I was very pleased when the Fannie Mae board had
the good sense to engage him and give him carte blanche.
And I would just say that those of us know him, and that's
pretty widespread in Washington, have such confidence in his
integrity that we benefit from having a report that's not being
challenged. The merits of the issues can be discussed and we
are very appreciative for that.
I think we should make very clear what we are talking about
here and that is a betrayal by some of those at Fannie Mae of
their mission. And I think it's important to make a
distinction. High ranking individuals at Fannie Mae betrayed
the trust. I am hopeful that appropriate action will be taken
based on this report and elsewhere for recouping money and for
other efforts.
It is important, however, that we not let the housing
mission of this entity suffer. This is a case where individuals
misbehaved, some actively, some by not doing their jobs. But
this is not something that ought to be used to undo the housing
mission.
In fact, I join the chairman in his call for the Senate to
act on legislation. And I want to address one particular error
that I keep reading about, frankly, in some of the press, and
that is the assertion that the bill that came out of the Senate
Committee is, in its regulatory structure, tougher in some ways
and more comprehensive than the House bill.
There is a difference between the bills with regard to an
affordable housing fund. We have one, they don't. There's a
difference between the bills concerning mandating a portfolio
reduction. But in those parts of the two bills which deal with
the regulatory structure, which replace OFHEO with a better
armed, better equipped, better funded, and more comprehensive
regulator, there is no difference.
And some of what happens here is a double counting. We read
stories that say, well, the Senate bill is tougher because it
calls for the portfolio reduction and it's got a tougher
regulatory scheme. No, that's only half true. It does call for
the portfolio reduction but we should be very clear that, with
regard to the regulatory structure, we have a very tough bill,
one that indeed included everything that I was told people
thought ought to be in there.
I would commend to people the excellent letter from the
chairman of the subcommittee who has been a longtime critic of
the organization and whose criticisms of some of the leadership
people has been vindicated by this report and other events. The
letter he wrote to The Wall Street Journal--on today's Wall
Street Journal, and it makes it very clear that the regulatory
structure is a good one.
Which leads me now to join in the chairman's plea. To the
extent that we have had problems in the past, as this report
shows here and to some extent, Freddie Mac, the best way to
prevent the recurrence is to act on legislation.
The two bills, the House bill and the Senate Committee
bill, since the Senate hasn't voted on it, are essentially the
same with regard to enhancing the regulatory structure and
those who would kill the bill this year because of their
opposition to the affordable housing fund and because they
have, I think, an ideologically based view that says we
shouldn't be giving housing an advantage in the capital
allocation function and we ought to mandate a portfolio
reduction, if they kill this bill they will leave in place a
regulatory structure that hasn't been adequate, not because of
failings of the individuals.
Everybody agrees that the problem has been the way it was
structured. So that's what's at issue here. Will the Congress
act on what would appear to be an agreement to enhance the
regulatory structure or will ideological differences over
Fannie Mae and insistence on cutting back on its housing goal
lead to the demise of the bill, in which case we'll be left
with this inadequate situation.
Last thing I want to say, there were two other issues here
that deal with general corporate governance. Once again--and
Fannie Mae certainly is not unique in this, nor Freddie Mac--
incentive pay for the top executives, the CEO and the CFO,
seems to me bad for two reasons.
First of all, I have to ask them a question. If they're
making several million dollars a year, why in the world do we
have to bribe them to do their jobs? None of us here get
bonuses for doing our jobs. Giving top executives of major
corporations extra money for doing their jobs makes no sense.
These are very highly compensated people to start with and they
shouldn't have to be bribed to do the job right.
It's especially a problem when, because of the inherent
ambiguities of some of these issues, these bonuses, based on
hitting targets, become incentives to play games with the
accounting. So this whole question of executive compensation
demands attention.
And finally, I am once again persuaded, as I read about the
non-role of the board of directors, that in too many American
corporations the board of directors play the role that Murray
Kempton, the great journalist, once ascribed to editorial
writers, namely that they come down from the hills after the
battle is over and shoot the wounded.
There does not appear to be here, as there was not in many
other cases, any reasonable assertion of authority by boards of
directors. If I had been on the board of directors when this
was happening, I would be examining very closely my failures to
step in. Now, the board did step in later on. They did shoot
the wounded and they hired Rudman to come and cart them away,
and that was a good decision. But both with regard to the
abuses inherent in incentive pay for top executives and the
passivity of the board of directors, there are lessons here not
just about Fannie Mae, but about corporate America.
The Chairman. The gentleman's time has expired. The
gentleman from Louisiana, Chairman of the Capital Markets
Subcommittee.
Mr. Baker. Mr. Chairman, I thank you for calling this
hearing and your longstanding good work. I'm glad we have
arrived at this point today. I certainly want to express my
appreciation to the Senator and his colleagues for their
longsuffering, detailed good work and I think it has been
helpful in attempting to bring closure to a difficult chapter
in American business history.
I think it is also important to recognize that, among the
2,600 pages of documents, it's easy to get side-tracked into
minutiae and detail and arguing about when this or that
occurred and forget for the moment that the larger obligation
is to ensure that the American taxpayer is not held accountable
for the missteps of the administration of a GSE or two.
If someone had 5 or 6 years ago predicted that both Freddie
Mac and Fannie Mae would have large-scale dislocations of
executives as the result of accounting missteps, no one would
have thought it possible. In fact, the rating agencies, prior
to and during the course of these discoveries, all claimed that
both enterprises were at the highest pinnacle of their
corporate governance activities. Indeed, this is a
disappointing chapter to now conclude that all was not what it
appeared.
As we go forward, it's my intention at the appropriate time
to ask more detailed questions about the events of late 1998
and early 1999 and who was engaged in making important
decisions but for the moment I'm merely pleased to be part of
this hearing, Mr. Chairman, and I appreciate your good work.
I look forward to hearing the testimony of the witnesses we
have today and know that, working together, we can get through
this year possibly with the adoption of a new regulatory
structure in place which gives not only the necessary
professional skills but the financial resources to the
regulator to be confident and to make assessments and judgments
about the professional conduct of these enterprises.
It is the only way, in my opinion, that we can assure
taxpayers and homeowners that they will continue to be well-
served by these enterprises.
I yield back, Mr. Chairman.
The Chairman. The gentleman yields back. The gentleman from
Pennsylvania, Mr. Kanjorski.
Mr. Kanjorski. Mr. Chairman, we meet this afternoon to
review the recently-released report prepared by former Senator
Warren Rudman at the request of the special review committee
established by the Fannie Mae board of directors. This report
examines the company's problems related to accounting
standards, internal auditing controls and corporate governance,
among other things.
As I have regularly noted at our past hearings in this
area, it is important for our panel to conduct comprehensive
and regular oversight over our housing government-sponsored
enterprises to ensure that they fulfill their missions and
operate safely and soundly. Today's hearing is, therefore, not
only timely but also appropriate.
In compiling this report, Senator Rudman and his team of
investigators left no stone unturned. As I understand, these
experts reviewed more than 4 million pages of documents over a
period of 17 months. They also conducted in excess of 240
interviews. As we begin today, I want to thank Senator Rudman
and his team. I greatly appreciate their diligence in these
important matters.
Their comprehensive report has helped me to understand what
went wrong with Fannie Mae. In one of its most significant
conclusions, this report identifies no new major accounting
violations not already disclosed by Fannie Mae and the Office
of Federal Housing Enterprise Oversight. In addition, while the
report details many of the major corrective actions that Fannie
Mae has taken to address these matters, it makes no significant
recommendations about further actions needed to address the
firm's past shortcomings.
Importantly, the report also observes that Fannie Mae has
``undergone an extensive transformation both in personnel and
structure'' during the last year-and-a-half. It further finds
that no member of the current management team knowingly
participated in improper conduct.
While this report provides some assurances to Congress, the
American public, and investors that Fannie Mae is turning the
corner by directly and forthrightly addressing its accounting,
auditing, and governance problems, we still must complete
legislative action to improve the oversight of all government-
sponsored enterprises. It is in the public's interest that we
address these regulatory issues promptly and properly.
As I said in March 2000 at our very first meeting in this
long series of hearings on the oversight of government-
sponsored enterprises, ``we need to have strong, independent
regulators that have the resources they need to get the job
done''. I can assure everyone that I continue to support strong
world-class independent regulation for Fannie Mae and Freddie
Mac. Such regulation will protect the continued viability of
our capital markets and promote confidence in Fannie Mae and
Freddie Mac.
By and large, the bill that passed the House last fall by a
vote of 330 to 91 would accomplish these objectives. Before the
109th Congress completes its work, I hope that our colleagues
in the Senate will consider their bill and that we can finally
reach a resolution on these matters.
Before yielding back the remainder of my time, I would be
remiss if I did not note that, while Fannie Mae has cleared one
hurdle with the release of the Rudman report in its ongoing
efforts to restore accountability within the firm, other
investigations by the Office of Federal Housing Enterprise
Oversight, the Securities and Exchange Commission, the Public
Company Accounting Oversight Board, and the Justice Department
remain ongoing.
The determinations of these experts will likely play an
important role in influencing how we will ultimately proceed on
any legislation during the remainder of the 109th Congress. If
and when these entities complete their examinations, I also
suspect that we will meet again to study their conclusions. In
other words, and to paraphrase the work of Robert Frost, we
have promises to keep, and may have miles to go before we
sleep.
In closing, Mr. Chairman, I commend you on your continued
perseverance on these matters and I look forward to hearing
from our distinguished witnesses.
The Chairman. The gentleman's time has expired. We now turn
to our distinguished witness. Senator Rudman, welcome.
Senator Rudman is a partner in the law firm of Paul, Weiss,
Rifkind, Wharton & Garrison here in Washington, and served two
terms in the United States Senate representing the great State
of New Hampshire. Prior to being elected to the Senate, he
served 6 years as attorney general of that State. In recent
years, Senator Rudman has been appointed to chair the Foreign
Intelligence Advisory Board and the U.S. Committee on National
Security 21st Century.
Senator Rudman, again, welcome to the committee and
congratulations on a comprehensive report. We appreciate your
willingness to come before the committee and testify. I know
you brought your expert team with you and I'll let you
introduce them.
STATEMENT OF WARREN B. RUDMAN, PARTNER, PAUL, WEISS, RIFKIND,
WHARTON & GARRISON, LLP; ACCOMPANIED BY DANIEL J. KRAMER,
ROBERT P. PARKER, AND ALEX YOUNG K. OH, PARTNERS; GEORGE
MASSARO, VICE CHAIRMAN, HURON CONSULTING GROUP; AND JEFF ELLIS,
MANAGING DIRECTOR, HURON CONSULTING GROUP
Sen. Rudman. Chairman Oxley, Congressman Frank, and members
of the committee, first let me thank you for your gracious
comments on the work that we've done.
On behalf of this entire Paul, Weiss and Huron team that
was involved in our engagement on behalf of the Special Review
Committee of the Fannie Mae Board of Directors, we want to
thank you for inviting us to participate in this hearing and
sharing our results with you.
Let me introduce you to the members of the team. We have
Dan Kramer, Bob Parker, and Alex Oh from Paul, Weiss and George
Massaro and Jeff Ellis from Huron. They are here because, as
you will see as we develop your questions, we organized this
into a series of discrete investigations. There were so many
complex issues involved, so each of these people ran a number
of teams, I coordinated the entire effort, and so as you ask
your questions, I may well turn to some of them to be able to
give you the full texture of the answers that you're looking
for, such as the one that Congressman Baker has indicated that
he would ask later on.
It's unusual for attorneys to come before a Congressional
committee to speak about a professional representation. In this
instance, Fannie Mae's board of directors, through its Special
Review Committee, instructed us at the outset of our engagement
to be open and transparent to governmental authorities.
Since October 2004, we have provided weekly or bi-weekly
briefings to the government agencies that have an interest in
this matter, including OFHEO, the SEC, the United States
Attorney's Office for the District of Columbia and, of course,
the Public Company Accounting Oversight Board.
Under the instruction of the Special Review Committee and
the board, the company has made the final report of this
investigation public. In that spirit, we were encouraged by our
client to accept your invitation to appear here today and
assist the committee in any way that we can.
I will divide my opening statement into four parts. First,
I will describe our engagement on behalf of the Special Review
Committee of Fannie Mae's board, including the nature and the
scope of this investigation. Second, I will describe our key
findings, with some emphasis on the two most important
accounting issues we considered: Fannie Mae's implementation of
FAS 91 and FAS 133.
Third, I will summarize our findings regarding Fannie Mae's
corporate governance and internal controls with regard both to
our findings concerning the company's historical practices and
to the significant changes that are underway at Fannie Mae
today. I will conclude my statement with brief remarks on what
our investigation did not cover.
Our engagement on behalf of the Special Review Committee
began in September of 2004. At that time, OFHEO was in the
midst of a Special Examination of Fannie Mae's accounting that
began in the wake of the problems revealed at Freddie Mac in
2003.
In mid-September 2004, OFHEO issued a report of its
findings to date that was critical of Fannie Mae's accounting,
principally in two areas: the accounting for premium and
discounts on the company's mortgage loan and mortgage-backed
securities and the accounting for the derivatives Fannie Mae
used to hedge the interest rate risk associated with its debt.
The report also raised concerns about Fannie Mae's systems and
practices in the accounting standards, financial reporting, and
internal control areas.
Soon after OFHEO released its report, OFHEO and Fannie
Mae's board of directors entered into an agreement. Certain
aspects of that agreement were unusual and also vital to an
understanding of this report. In the agreement, the board
agreed to undertake an internal investigation of the matters
raised in the OFHEO report. The board also agreed to study and
address the organizational, structural, internal controls, and
governance issues that OFHEO had identified.
In other words, the board undertook a dual track approach
in which it tasked Paul, Weiss and Huron to conduct an internal
investigation to determine what happened and, at the same time,
the board commissioned an analysis of what remedial measures
should be made promptly to address OFHEO's criticisms.
As a consequence of this dual track process, the
recommendations that we would have made regarding Fannie Mae's
governance, internal controls, internal organization and the
like either have been implemented already or are well underway.
The agreement between OFHEO and the board provided the
focus of our investigation but did not limit the scope of this
inquiry. From the outset, Fannie Mae's board and OFHEO
encouraged us to conduct a broad review of the company's
accounting, financial reporting, governance, and internal
controls policies and systems, and to follow the facts wherever
they might lead.
In February of 2005, OFHEO identified additional accounting
and internal control issues at Fannie Mae and those issues were
added to the scope of this investigation. Finally, the company
identified new issues in a November 2005 Form 12b-25 filing
with the SEC, and we considered those matters as well. The
board placed no restrictions on our work and we received
complete cooperation from the board and from the company's
current management.
Early in our engagement, Paul, Weiss retained Huron
Consulting Group, with the approval of OFHEO, as our forensic
accounting experts. The accounting judgments in our report are
Huron's and we concur in those judgments. We appreciate and
admire Huron's important contributions to this investigation.
The investigation took about 16 months. Our team, including
Huron, reviewed over 4 million pages of documents and conducted
over 240 interviews of 148 Fannie Mae employees or former
employees. Unfortunately, Fannie Mae's former chief financial
officer, J. Timothy Howard, refused to cooperate in our
investigation.
We interviewed the company's former controller, Leanne
Spencer, on several occasions, but she declined to cooperate
further after the company found that she had not produced
certain documents from her files that were relevant to our
investigation.
Our key findings:
Our report to the Special Review Committee is 616 pages
long, and our executive summary, 31 pages. The three-volume
appendix, which includes samples of documents that we discuss
in our report, as well as submissions made by various
executives, including Mr. Raines and Mr. Howard, add about
2,000 additional pages. In my view, anyone who wants a complete
picture of our findings and analysis must review all of these
documents carefully. With that caveat in mind, however, I
believe that our principal findings can be summarized as
follows.
One. The accounting, financial reporting, and internal
audit operations of the second largest financial services
company in the country were inadequate both qualitatively and
quantitatively. The resources dedicated to these functions were
insufficient. Senior managers in critical accounting, financial
reporting, and internal audit roles either were unqualified for
their positions, did not understand their roles, or failed to
carry out their roles properly.
Two. Management's interpretation of FAS 133, dealing with
hedge accounting, departed from generally accepted accounting
principles in a number of important respects. These departures
from GAAP were not mere innocuous practical interpretations or
modest deviations from a strict reading of the standard. In our
view, the company's hedge accounting conflicted with clear and
specific provisions of the authoritative accounting literature.
Moreover, the record shows that the company's
implementation of FAS 133 was motivated by a desire to remove
volatility from reported earnings while avoiding both the
substantial changes to the company's business methods and the
development of the complex accounting systems that otherwise
would have been necessary to implement that standard properly.
Finally, and most importantly, we found that the company's
significant hedge accounting practices were known to, and
accepted by, the company's outside auditor.
Three. Management's application of FAS 91, which concerns
the accounting for premium and discounts on mortgages and
mortgage-backed securities, also violated GAAP. Our most
significant finding in this area concerned the circumstances
surrounding the company's decision to record $240 million of
premium/discount amortization expense in 1998 when the
company's calculations showed that the expense was actually
$439 million.
We believe that there was no justification or rationale to
support the recognition of only $240 million. Moreover, given
other accounting entries and adjustments that the company made
during this period, the evidence overall supports the
conclusion that the company's accounting decisions at that time
were motivated by a desire to meet earnings-per-share targets
and to achieve maximum bonus awards under Fannie Mae's Annual
Incentive Plan.
Once again, it is important to note that Fannie Mae's
outside auditors were aware of these adjustments, although not
necessarily of their motivation.
Four. In our report, we address 16 separate accounting
issues. In virtually every instance we examined, Fannie Mae's
accounting was inconsistent with GAAP. As we summarize in the
executive summary of our report, management often justified
departures from GAAP based on materiality assessments that were
not comprehensive, on the need to accommodate systems
inadequacies, on the unique nature of Fannie Mae's business or
on ``substance over form'' arguments.
We found substantial evidence in a number of specific
instances and overall that the company's accounting and
financial reporting policies and procedures were motivated by a
desire to show stable earnings growth, achieve forecasted
earnings, and avoid income statement volatility.
However, with the exception of the one instance in 1998
that I referred to earlier, we believe that the evidence does
not support the conclusion that these departures from GAAP were
motivated by management's desire to maximize bonuses in a given
period other than the one that I have spoken of.
Five. As an organizational matter, too much authority at
Fannie Mae was concentrated in the former CFO. He had
responsibility for management of the company's portfolio, for
its treasury operations, its accounting and financial reporting
functions. The CFO also functioned as the company's chief risk
officer and had administrative responsibility for the internal
audit function as well.
The CFO and other senior managers operated within silos
that had little interaction with each other and which therefore
lacked a complete appreciation and understanding of the others'
roles and functions. In these circumstances, the checks and
balances that would ordinarily exist in an organization of
Fannie Mae's size and complexity were largely non-existent.
Six. Although Fannie Mae's top management professed a
desire to hear the view of subordinates and to value
intellectual honesty, openness, and transparency, the culture
at Fannie Mae discouraged criticism, dissenting views, and bad
news. This applied to the areas of accounting and financial
reporting, among others.
One area in which senior management in the financial area
was particularly sensitive was in achieving forecasted results.
Even minor differences between forecasted and actual results
appear to have caused great concern.
Seven. Management tightly controlled the flow of
information to the company's board. In many instances, the
information the board received in critical areas involving
accounting, financial reporting, and internal controls was
incomplete or misleading.
In particular, we noted many instances in which management
assured the board, often in the presence of its outside
auditor, that the company's critical accounting policies were
consistent with GAAP. Management also assured the board that
the company's accounting and financial reporting systems were
adequate and that the accounting and financial reporting
functions had adequate resources, even when senior managers,
according to testimony, were aware that such was not the case.
Eight. The board relied heavily on senior management as
well as the views of the company's outside auditor. Until OFHEO
began its Special Exam in 2003, and even in the wake of earlier
announcements of substantial accounting problems at Freddie
Mac, the board received assurances that Fannie Mae's accounting
was proper.
Moreover, through 2002, OFHEO's own reports to Congress on
Fannie Mae gave the company high ratings, including high marks
in such areas as corporate governance and the company's
implementation of FAS 133.
Corporate Governance and Internal Controls.
As I noted earlier, our investigation was part of a dual
track process in which Fannie Mae's board and management
undertook significant reforms of the company's governance,
organization, and internal controls while our work was
underway.
We participated in these efforts at the board's direction
by sharing information, commenting on various proposals and
making suggestions. In our report, we made findings regarding
the company's most significant governance, accounting, and
internal control functions as they existed prior to 2004, and
we also noted the significant changes that have taken place in
each of these areas.
I will briefly summarize our findings.
Number one, the board. Fannie Mae's board of directors
endeavored to operate in a manner consistent with its fiduciary
obligations and evolving corporate governance standards. The
board was open to examination by third parties, including
OFHEO, and it generally received high marks.
The board, and particularly the audit committee, was
sensitive to matters relating to accounting and financial
reporting. The audit committee received regular assurances that
the company's accounting complied with relevant accounting
standards. And I would parenthetically say that a reference to
the full report will give you a full texture of some of the
events that took place.
The board has taken several significant steps since the
release of the OFHEO report in September of 2004, including the
separation of the chairman and the CEO positions, the
establishment of a Risk Policy and Capital Committee to oversee
financial and operational risk management, and the
transformation of its Compliance Committee into a permanent
committee with broad oversight in regulatory and compliance
matters.
Office of the Chair. Fannie Mae's Office of the Chair,
comprising the four most senior officers in a given time,
suffered from functional and organizational problems. As noted
above, a great deal of the authority and responsibilities for
the company's risk management, financial reporting, accounting,
and internal control functions, as well as a substantial
portion of the company's business operations, was concentrated
in the CFO. Senior management also exhibited and cultivated a
culture of arrogance both internally and externally and
perhaps, most of all, towards its regulator, OFHEO.
There have been substantial changes in the past year at the
senior management levels. Structurally, the Office of the Chair
no longer exists. In particular, the functions previously
overseen by the CFO are now divided among a number of different
officers, including the chief financial officer, whose duties
are more consistent with a CFO's typical functions, a chief
risk officer and a chief audit officer.
We have received numerous reports from inside and outside
the company that its attitude has changed materially towards a
more open and cooperative approach to its regulators, to the
Congress, and to the companies with which Fannie Mae deals.
Office of Internal Audit or Auditing. We found that, prior
to September 2004, the head of Internal Audit at Fannie Mae
lacked the requisite expertise and experience to lead the
internal audit operation at a company as large and as complex
as Fannie Mae.
Moreover, on more than one occasion, the head of internal
audit took steps that suggested he did not fully appreciate his
organization's role within the company or his proper
relationship with senior management. I would note
parenthetically, the advent of Section 404 of Sarbanes-Oxley,
which imposed a whole new layer of requirements on Internal
Audit.
In addition, the internal audit group at Fannie Mae lacked
adequate resources, particularly in recent years as the company
grew in size and complexity and as the demands placed on
internal auditors increased commensurately.
The company has a new chief audit officer who reports to
the audit committee, with a separate reporting line to the new
CEO only for administrative purposes. The internal audit
function has been separated from risk management, which is to
be overseen by a chief risk officer, and the structure and
resources of the internal audit group have been enhanced
significantly.
Office of the Controller. Prior to September of 2004, the
controller's office at Fannie Mae suffered from some of the
same weaknesses as the internal audit function. Leadership at
the top lacked the accounting and financial reporting expertise
and experience one would have expected at a company like Fannie
Mae, and the office as a whole lacked the resources necessary
to handle many of the complex accounting and reporting issues
that the company faced, particularly in recent years.
The company's systems in these areas were grossly
inadequate. As I noted earlier in my remarks, the company
historically has justified deviations from GAAP on the ground
that it did not have the systems necessary for strict
compliance.
There have been significant changes in recent months. There
is new leadership in the accounting and financial reporting
areas, including individuals with substantial experience in
public accounting or at large financial institutions.
Certain functions, such as accounting policy and business
forecasting, have been moved outside of the controller's
office. We understand that the company is increasing the
resources dedicated to these areas, including both staffing
resources and systems development resources.
Ethics and Compliance. Fannie Mae's compliance organization
dates back at least 10 years. It has maintained a Code of
Business Conduct and has supported an internal investigative
unit, called the Office of Corporate Justice, to address
employee complaints.
In 2003, the company established an Office of Corporate
Compliance to develop and monitor compliance plans for the
company's business units and provide training to employees. Our
principal concern in this area was that the company's chief
compliance officer, a deputy general counsel, reported directly
to the general counsel and worked on matters involving employee
claims against the company.
The compliance program thus suffered from at least the
appearance of a conflict of interest. In addition, we believe
that the program overall would have been better served by a
chief compliance officer who had no other assigned duties.
In 2005, Fannie Mae established an Office of Compliance,
Ethics and Investigations, OCEI, to oversee the preexisting
ethics and compliance functions as well as a new ethics unit.
The new chief compliance officer who heads OCEI has a direct
reporting line to the CEO and to the compliance committee of
the board.
Finally, I would like to conclude my statement with two
observations on what our investigation did not cover.
I know this committee and your counterpart in the Senate,
as well as the Administration, are concerned about the size and
composition of the Fannie Mae portfolio. This issue, which of
course relates ultimately to safety and soundness matters, was
well beyond the scope of our inquiry. Those who wish to draw
conclusions as to that issue from the contents of our report
are obviously free to do so, but that policy issue is well
beyond the scope of our assignment. We have drawn no
conclusions on that issue, nor do we have the expertise to
address that issue.
Moreover, as you well know, in the report and its
appendices, we have laid out the facts that this 16-month
investigation has produced. Where appropriate, we have been
critical of Fannie Mae and we have assigned general and
specific accountability where we believe that was warranted.
The question of liability and culpability for the conduct we
described is a matter for various government departments and
agencies to decide, as well as eventually the courts. It would
have been decidedly inappropriate for us to reach conclusions
in those areas.
Finally, Mr. Chairman, as you develop your questions, to
the extent that there are documents that your committee is
interested in that appear in the footnotes but are not in our
current appendices, we will be happy to make those available
for the record when requested.
Thank you very much, Mr. Chairman.
[The prepared statement of Senator Rudman can be found on
page 54 of the appendix.]
The Chairman. Thank you, Senator Rudman. We're looking
forward to a good series of inquiries from the committee. Let
me begin.
I have somewhat of a personal interest in Sarbanes-Oxley
and I want to raise a couple of issues with you. Of course,
Fannie Mae is a publicly traded company, subject to the
requirements of the Act. In October 2004, I asked former
Chairman & CEO, Frank Raines, whether, in his view, any of the
law's provisions or subsequent regulations had been violated or
ignored, and he answered no.
He talked about, ``an entire process around certification
so that we know exactly at the highest levels of the company
what decisions were being made and by whom.'' He went on to add
that, ``as a result of Sarbanes-Oxley, I have made a campaign
in our company to go around and tell people, `if you think
there is something wrong, raise your hand. Raise your hand and
it will be looked at'.''
What did you find in terms of application by Fannie Mae of
the Sarbanes-Oxley Act? Was the corporate environment conducive
to its application and what role did Mr. Raines and former CFO
Howard play in that regard?
Sen. Rudman. Let me say that Mr. Raines may have believed
what he said. I have no way of knowing his state of knowledge.
I can tell you--I'm going to ask Mr. Massaro and Mr. Ellis to
comment--but I would tell you from my own experience and
observations, both in practice and otherwise, that the
implementation of Sarbanes-Oxley, Section 404, and all of the
internal audit issues that raises, which lead ultimately to
certification by CEO's and CFO's was grossly inadequate as were
the systems.
So that would be my simple answer. And if George or Jeff
would like to fill in on that, they are experts on Sarbanes-
Oxley. They're actually our experts today on Sarbanes-Oxley.
Mr. Ellis. In terms of internal control environment, I
think the report speaks for itself. The control environment was
extremely weak. The application of accounting principles, we
detected a number of items that is ongoing today. So I think
that whatever the tone was set, it wasn't sufficient to
implement the change that would have been expected.
The Chairman. In your testimony, Senator Rudman, you talked
about the communication or lack thereof between the executives
and the board. It does appear a lot of that was kind of a one-
way street, that the board lacked sufficient quality
information in their decision-making process.
Was that because of this culture of arrogance or did it go
beyond that?
Sen. Rudman. This was a company that, in my view--and we
say so in this report--was not terribly transparent outside of
the tightly controlled area of the top executives of this
company. We have example after example of the board not being
given information that it should have been given,
particularly--and I'm sure this will come out in questions that
are posed here, particularly from what Mr. Baker said in his
opening statement--as it relates to the 1998 and 1999 issues
and what the board was told and what they were not told.
In addition to that, I think one of the most striking
examples to me, having looked at all of the evidence that we
produced and done some of the interviews and read all of them,
the attitude towards the board was one of giving them what they
thought they needed to and not much more.
And a good example of that, which we cite in our report, is
when the Freddie Mac issue broke. There is documentary evidence
that the board attempted to look closely at Fannie Mae's
accounting to get some feel as to whether or not these same
issues existed within the company, both in the audit committee,
and at the full board level.
The board was given assurances, in some cases with the
outside auditors present, that in fact those problems were not
shared by Fannie Mae, when subsequent investigation by OFHEO
and eventually by us indicates that that was not accurate. Did
they believe that? There is no way, Mr. Chairman, for me to get
inside of people's minds but it certainly is apparent to me
that this board was not even given a hint of the severity of
the problems, even when the Freddie Mac issue erupted.
And any board member worth his or her salt would have been
very concerned about it, as they were. But they were not given
information that would have raised the kind of red flags--and I
heard Congressman Frank's opening statement and I respect his
opinion but, you know, unless you have certain information at
least given to you that gives you some indication that all may
not be well, it's very difficult for board members to plumb the
depths of the complexities of accounting systems, and that's
what happened here.
I'm sure had they all to do it over, they might do things
somewhat differently. But based on the record and the evidence
we have, we found that they were not dealt with transparently,
in some cases they were misled, whether intentionally or
negligently is impossible for me to determine.
The Chairman. So in that case, basically, the alarm bells
were heard--alarm bells in terms of Freddie Mac. Was it the
board or a particular committee of the board?
Sen. Rudman. It was the audit committee and the entire
board. Not only were they given loud alarm bells, some of which
they sounded themselves--you couldn't help but do so if you
read all the press that was coming up at that time--but in
particular, it's interesting--and we'll get into this in
subsequent questions--what happened with the writeoff I spoke
of, which should have been $400-some-odd million, was only
$200-some-odd million and how the board was dealt with on that
issue and why it was dealt with that way.
So my best answer I can give you--after all, we only have
evidence we can look at. We can have speculation but I can't
speculate. I have to say that this board was not given the kind
of information that would have led to the kind of vigorous
inquiry that one might expect from an audit committee or a full
board.
The Chairman. Thank you. My time has expired. The gentleman
from Massachusetts.
Mr. Frank. I appreciate that and I should make clear that,
based on what you said, I should have rephrased what I said
about the board, if it gave the impression that I was talking
about personal shortcomings on those board members. What I'm
really more concerned about is the structural weakness of the
board of directors in this situation. This is part of the
problem.
When we are told that we should not intervene too directly,
either through the SEC or, you know, there are people who want
Sarbanes-Oxley repealed, there are people who want it cut back
substantially. And the argument has been that we should rely on
the internal control mechanisms.
And what I should have said--and I appreciate the
corrective, that it's not a criticism of the individual board
members, but it does speak to the structural weakness of the
board as an entity in corporate America. And here we had a case
where they even had an outside regulator. Most corporations
don't have an OFHEO. And even with all of that, the board was
rather easily put off.
And so the question then, is, as a broader issue, should we
be--I mean, we're going to--if the Senate will do something, we
could pass a bill and we will have a very good regulator here.
But in general, this is kind of an object--how easily a board
of directors can be frustrated, even when it's been alerted by
something else.
Do you have any ideas about what we should be doing going
forward?
Sen. Rudman. Well, I certainly do and I think they're
evolving. I think one of the results of Sarbanes-Oxley, which
in my view is a positive impact, is that boards of directors in
general and audit committees specifically are meeting a great
deal more with outside auditors and internal auditors than they
ever did before.
I mean, it was not unusual for major company boards to meet
four, five times a year, audit committees to meet about that
time. Today, in most major corporations, audit committees meet
at least every month or two, have a number of teleconferences
with their auditors and their internal auditors. So the whole
atmosphere has changed and people, because of Section 404 of
Sarbanes-Oxley, have become far more inquisitive about what's
going on in the accounting of a company. Had that existed at
the time, I think you might have had a different result.
Mr. Frank. Although even there we had a problem because you
said they were inquisitive and they are, after all--many of
them, sort of accountants. Should there be as a general rule,
be some kind of staff allotment for the boards? In this case,
they asked the right questions, they were alerted, they got
stiffed, and they didn't really have--including by the outside
auditor, which is a disturbing fact.
But should we try to institutionalize a little more help
for them?
Sen. Rudman. Well, I think you have. As you know, Sarbanes-
Oxley now makes it the job of the audit committee and the board
to hire the outside auditors, rather than the company. So the
audit committee has a far different relationship with outside
auditors. That's number one.
Number two, most boards believe--and I think correctly so--
that they have the right, and in fact do, hire special advisors
to advise them on special subjects--
Mr. Frank. As you were, in fact, hired by the board here.
Sen. Rudman. Exactly.
Mr. Frank. Question--two more. One--and obviously this is
very disturbing what happened at Fannie Mae and it also
happened at Freddie Mac. But I, again, want to separate the
misdeeds of individuals, the misjudgments of individuals from
the important public policy functions. As you review this, was
there at ever any time an--what we're told is, look, these are
entities that some people think have a claim on the Treasury;
they could implicate serious problems for the Federal
Government.
Was there at any time any threat to the safety and
soundness of the entity? Was there a fiscal crisis,
potentially, because of these abuses?
Sen. Rudman. Well, I don't think I can answer that other
than this way. Obviously OFHEO thought there was a problem
because, as you know, they made adjustments to the required
capital of Fannie Mae soon after their--in fact, that was part
of their September intervention, if you will, that resulted in
our being hired.
So shortly thereafter, Fannie Mae in fact changed its
capital structure which leads me to the conclusion that OFHEO
was uncomfortable because of the size of the changing in--or
the write-down of the eleven billion in derivatives. They were
uncomfortable with that so I assume they had a reason to--
Mr. Frank. But even in the inadequate state of the
regulatory structure at the time, they did have the power to
order corrective action.
Sen. Rudman. Absolutely.
Mr. Frank. Last point, and this does not in any way
exonerate or mitigate what Fannie Mae did, but there had been
some question about the relative ease of following the
accounting standards in question, particularly dealing with
derivatives.
Is there--again, we're talking about preventing this from
happening going forward. We've got some special rules and
restrictions at Fannie Mae. Did you or any of your team come to
any opinion about the accounting standards, particularly the
one dealing with derivatives?
Sen. Rudman. Are you talking about the 133 standard?
Mr. Frank. If I knew which number--
Sen. Rudman. The one on hedge accounting and derivatives?
Mr. Frank. If I--yes. That one. If I knew the number, I
would have told you.
Sen. Rudman. I don't know quite what you're asking me about
that particular--
Mr. Frank. Some people have said that part of the problem
is that it's a very difficult standard to apply, that it's
opaque, that it's--and that part of--again, this doesn't
justify what they did because all their mistakes were in one
direction. If it was simply a problem of being confused, the
mistakes would have been more random. So with all the mistakes
going one direction, the complexity isn't the problem, but that
this may have contributed to the ease with which they could
cover it up.
Sen. Rudman. Well, Congressman Frank, I don't know about
the ease of covering up. I want to answer your question very
directly because, in preparing for this hearing today, that
very question that you have asked was raised and I answered it
this way, that there must be a better way to write accounting
standards than the way they are written. It reminds me a lot of
the Internal Revenue Code. It requires a battery of experts to
even figure out what some of the things mean.
Having said that, although that was a very complex
standard, it was clear to us early on in this investigation
that the strict requirements of FAS 133 were not met--
Mr. Frank. I agree. This is not a justification--
Sen. Rudman. Now, are you asking was it easier to evade
them or avoid them? I would say this, that any time documents
like that can be written with greater clarity--and I believe
the SEC and FASB are attempting to do that and have ongoing
programs to do that--that would be in everyone's interest
because I can tell you that this is a very complex standard,
although, to understand what happened here was not that
difficult.
The Chairman. The gentleman's time has expired. The
gentleman from Louisiana, Mr. Baker.
Mr. Baker. Thank you, Mr. Chairman.
Senator, again, I appreciate your work. It's really an
incredible thing to try to read through. I wish I could say
that I made it through all 2,600 pages, but I've gotten through
the first 600, which, even that has been a challenge.
I'm targeting specifically--and there are a lot of areas I
really would like to talk about. Although the lack of
information flow to board members was obvious from the report,
it would seem to me from the environment in which the
corporation found itself with Freddie Mac having difficulty
with the regulator and Congressional criticism, it would have
been a time that board members should have exercised the
highest standard of fiduciary conduct only for their own self-
interest much less for the corporation and taxpayer, but I
don't have enough time to do all that today.
In looking--and I'm not asking you to review this; I'm
reciting it for the record--on page 46 of the report relative
to a memo from Ms. Spencer addressed to Mr. Raines on August
10, 1998, it states in part, priority one, the goal of making
$3.21 per share the managed earnings target which just
establishing as a corporate principle they were engaged in
trying to manage that EPS figure at that time to meet street
expectations.
On page 49, there is referenced by Ms. Spencer an 8:00 a.m.
meeting on Friday morning, January 8th, which for the record
Mr. Raines does not remember participating in; however, Mr.
Howard and Mr. Spencer discussed with Mr. Raines in that
meeting from their view the amount of rollover which should
occur and ultimately, according to their view, Mr. Raines then
became comfortable with the recommendation to record only a
$240 million catchup.
In the hearing memo, which you had not had, I do not
believe, on October 6, 2004, Mr. Raines stated that the
report--and at that time he was alleging the OFHEO report, not
your report--that the company willfully violated GAAP in order
to maximize executive bonuses. He says, going on, upon reading
of this allegation, I reviewed the relevant facts. We have no
facts, no materials, nothing to support the allegations. Based
on the facts as I understand them, the $240 million was arrived
at as part of analysis conducted by accounting.
Then in response to my question which was, was there any
discussion in which you participated relative to the
determination of the catchup amount, Mr. Raines stated on the
record, no, I did not participate in determining the amount of
catchup. That was done, as I mentioned, within our financial
function.
My first question, in light of your review and the facts
you've accumulated, is it possible that the precision with
which the 3.2309 was achieved was a mathematical business
miracle or do you have reason to believe it was a result of
some accounting manipulation?
Sen. Rudman. There's no question in our mind, Congressman
Baker, it was the subject of some manipulation. And to give you
the full texture of that, Alex Oh did that whole section for me
and I think you'd find her response most interesting because it
wasn't just the amount that was not written down. The amount
that was written down then left them with an additional
problem. There were a number of accounting--
Mr. Baker. There's a couple of more steps I'd like to get
to because in--unfortunately we're not like the Senate--
Sen. Rudman. Right. I would think she could answer that
question briefly.
Mr. Baker. But let me do this, because I'm going on a train
and I think it comes right to your station. When you--did you
have reason to believe that audit differences with KPMG,
although not discussed by management to the board, were usual
and customary or would that have been characterized as an
aberrant act where--I can understand an auditor having a
dispute, you sit down, you try to work through it, ultimately
you don't have a formal audit difference recorded. The time of
this happening, management knew, it was not translated to the
board. And I'm building a reason for making these statements.
Since they did not disclose the audit difference, and the
audit difference now is not material simply because the actions
were not GAAP-compliant, it's not material because the amount
in the overall business environment was so small, it is
material and important merely because it enabled ultimately the
ultimate bonus targets to be hit.
As I understand it, the $200 million figure got you within
the bonus subdivision at 3.22 but you weren't home yet. The
second income adjustment got you to 3.2285; your next-door
neighbors, but you're still not home. The third was 3.2309,
which then triggered the $27 million payout in bonuses to the
executives responsible for making these determinations.
My question, and you may be the best person to respond, is,
given this relevant set of facts that it wasn't one unilateral
act where you were having a technical dispute with your
accountant, where you made adjustments still not resulting in
the maximum target not being hit, where you had subsequent,
although minor, intended acts resulting in executives being
rewarded for earnings they did not achieve, is it clear that
this was a manipulation of financials for personal
remuneration?
Sen. Rudman. In that instance the answer is yes, and I say
that because when you look at each of these transactions that
were accumulated, non-GAAP compliant, to reach this number,
that's the conclusion we reach as to 1998, 1999.
Mr. Baker. And at the level that the executives of Fannie
were held from a corporate governance perspective--and by the
way, Mr. Chairman, I just want to stick this Standard & Poors
corporate governance rating, January 30, 2000--let me get my
glasses quick--3, as part of the record for another purpose at
a later time--
The Chairman. No objection.
Mr. Baker. Thank you, Mr. Chairman. My point is that if it
is pretty much acknowledged that these activities occurred, the
next question that came to me is what do we do about it. On one
hand, we have the regulatory necessity to build a corporate
governance box going forward, but with regard to these specific
actions, these fall into a different category. A new regulator
won't necessarily have the historical view we have.
I believe it to be within the board's authority to request
or demand a repayment of bonuses earned when they in fact are
not legitimately earned. I further believe that it's the right
of the regulator at OFHEO to disgorge such earnings if he has a
finding that it was fraudulently obtained. Not asking you to
discuss whether this constitutes fraud. I'm merely asking, are
either of those courses open to consideration by the board or
have you--and you may not be able to disclose if you've had
those discussions with the regulator.
Sen. Rudman. I'm glad to discuss it with you, Congressman
Baker. We, number one, have not had those discussions with the
board but I can tell you that obviously those options are open
to the company. They are always open to the company. There's
much precedent for that. Whether the company decides, based on
this report, to do that is obviously beyond our scope.
I want to just say one other thing to you that's important,
and that is that I believe--and I'm going to have Mr. Massaro
and Mr. Ellis correct me if I'm wrong--that there are now new
standards about materiality and audit differences that are
required to be reported to boards of directors.
Will you comment on that, George, as to what I am referring
to?
Mr. Ellis. Yeah. Subsequently, there are required
communications with--
The Chairman. Can you pull that microphone a little closer?
Mr. Ellis. I'm sorry. There are now subsequent
communications with the audit committee that require the audit
committee be provided with a list of unadjusted differences, so
this would find its way to the audit committee in detail and
that it's been a requirement for several years.
Mr. Baker. I've exhausted my time. That's the reason--
Mr. Frank. Will the gentleman just yield for 10 more
seconds just so I could--
Mr. Baker. I want to jump to one more thing and then I'd be
happy to yield.
Mr. Frank. Because I just want to express my agreement with
him that they should get the money back, that there should be a
request for that--
Sen. Rudman. Congressman Baker, I just want to tell you
that had that been in place, had that type of disclosure been
mandatory at the time of this 1998, 1999 incident that you have
very accurately described, then my sense is that there would
have been a different outcome.
Mr. Baker. Well, all other corporate executives are now
subject to rules of conduct which reward professionalism and
penalize those things which are not within the rails. This is
not within the rails and whatever action that needs to be taken
to make compensation back to the shareholders, I think clearly
it ought to be requested of the board and at appropriate time
we will communicate with them and ask for your support of that
recommendation.
The Chairman. The gentleman's time has expired. The
gentleman from Pennsylvania.
Mr. Kanjorski. I don't know whether to call you Mr.
Chairman or Senator or the Honorable.
In listening to your analysis, particularly of the
regulator's activities up until 2002, it seems to me you had
the CFO, you had the internal auditing, you had the external
auditor, and then you had the regulator in place. So you had
four checks.
How in the world did they miss what was happening that the
regulator could complement them on good governance and
complying with GAAP?
Sen. Rudman. Well, Congressman, let me respond in this way.
As far as the outside auditors were concerned, we of course
were not tasked to investigate KPMG, although we did interview
them and look at work papers and so forth, and my frank answer
is that I don't know how they reached the conclusion they
reached, particularly in the area of FAS 133. That's number
one.
As far as OFHEO was concerned--and I don't think anyone
presently at OFHEO would disagree with this, nor would former
director Falcone--former director Falcone appeared before the
Senate Banking Committee, in I believe it was 2004 or 2003--it
was 2003--and testified at that time that the adequacy of
resources and competence at OFHEO during that period was less
than what it should have been, and pretty much said to the
Senate Banking Committee that our capacity to do our job at
that time was not what it should have been. And I think that,
to a large extent, overhangs all of the efforts of this
committee and your counterpart on the other side of the Capitol
to try to have a stronger regulator.
There is no question that OFHEO blessed not only the
accounting generally but, in 2002, blessed the FAS 133
accounting as well as the governance of the corporation
generally. Mr. Falcone's answer, which I take at face value,
was that they did not have the capacity to do what they should
have been doing at the time. I agree with that.
Mr. Kanjorski. And I understand that. That's testimony in
2003. But by affirmative action, they complemented Fannie Mae
in 2002 and for 4 or 5 years prior to that, that they complied
and they had excellent governance. If he didn't have adequacy
to make that judgment, why did he make that judgment?
Sen. Rudman. Well, I can only say, Congressman, that it is
up to this committee and the Congress as a whole to end up with
a regulator that's adequately funded and strong and competent.
There is no question in the years leading up--and these
problems at Fannie Mae didn't start in 1998 or 1999. Some of
them were more historic than that.
The bottom line is that they, evidently, did not have the
capacity to do the kind of in-depth examination that was
required. As a matter of fact, as I'm sure you're aware, it was
only when they were allowed to hire an outside major accounting
firm to help them with their special examination of Fannie Mae
that they came to the conclusion which they have come to, which
we essentially have confirmed in this report.
Mr. Kanjorski. Well, you've had an opportunity to look over
the legislation this committee has passed through the House and
the legislation that the Senate is putting together in regard
to a new, stronger, world-class regulator. Do you think that we
have now taken the appropriate action to create the type of
regulatory body necessary so that this won't happen in the
future?
Sen. Rudman. I believe you have and I think a wonderful
model for the Congress is what has always been a highly
respected government office, the Comptroller of the Currency.
And when you look at what they do and how they do it and also
certain parts of the Fed, that's the model, it seems, and I
think that's the model you've tried to follow.
Mr. Kanjorski. Very good. I yield back the balance of my
time.
The Chairman. The gentleman yields back. The gentleman from
California, Mr. Royce.
Mr. Royce. Thank you, Mr. Chairman. I think the lesson
today is that things can go wrong at the GSE's and just as
accounting can go wrong, so can other areas within the firm
such as risk management. In the future, I think we have to
recognize that it is possible Fannie Mae could make a mistake
in managing its interest rate risk and could intentionally take
more interest rate risk to meet their profit targets.
And with these possibilities in mind and in light of the
systemic risk that mortgage portfolios pose, I do not think the
enormous interest rate risk consolidated in the hands of two
GSE's is worth any benefit that may or may not result. And I
think that interest rate risk will continue to loom large until
something is done about the size of these mortgage portfolios.
As you noted on page 101 of your report, Fannie Mae's
outstanding debt grew dramatically during the 1990s
commensurate with the growth in its portfolio. The ability to
hedge that debt against interest rate risk was a substantial
component of Fannie Mae's risk management. Fannie Mae used
derivatives to hedge the interest rate risk associated with its
debt and the notional amount of its derivative portfolio also
grew tremendously during the 1990's and into the 2000's.
Now, given that Fannie Mae's portfolio investment business
was the central driver of earnings growth throughout the last
decade, it appears that this became a prime area for
manipulated earnings or for presenting more favorable GAAP
financial results.
If the retained portfolio was significantly smaller, do you
think Fannie Mae would have had problems of similar scale? That
would be my first question. And the second question would be,
during the period covered by your report, a number of key
accounting changes took place, most prominently FAS 133. In
your view, did the size of Fannie Mae's retained portfolio and
its hedging strategy make it arguably too difficult or possibly
too costly to implement these accounting changes properly?
Sen. Rudman. Well, to take your questions in order,
Congressman, number one, obviously, if you had a smaller
portfolio you would have a smaller hedge portfolio, you would
have less risk. So that's obvious.
The second question, I'm not sure from what I've looked at
that the accounting policies developed would have been a great
deal different unless the portfolio was so small that every
match could be done on an individual basis.
Mr. Royce. During the period covered by your report, is it
fair to say that a central part of the company's culture was
focused on steadily increasing earnings, would you think it
likely that operational decisions during this period, such as
the decision on growing the retained portfolio were driven by
the same considerations?
Sen. Rudman. Well, I really don't know if I can answer
that. My sense is that the accounting policies in place, the
systems in place, and the level of competence in place would
not have been any different, although I suppose the scale of
the issue they were facing would have been smaller.
Mr. Royce. It seems to me that when Fannie Mae made the
decision to dramatically grow the outstanding debt and then to
hedge against that with the interest rate risk, with the
derivatives, the reality was that that gave a certain
opportunity for managed earnings.
And one of the points that I have been making for some time
is that to allow that type of interest rate risk on the books
is--and I think my Senate colleagues have come to that same
conclusion--is to tempt people with an awful lot of opportunity
to manage earnings.
Sen. Rudman. The only comment I would make, Congressman, is
that I would agree with you totally that the Fannie Mae
financial management structure we found in place in 2004
certainly was not adequate to do what it was supposed to do.
That is apparent with now, what, 18 departures from GAAP found
in this report.
Whether it is competent to do that today is something this
committee will have to decide.
Mr. Royce. Senator, thank you very much. I appreciate it.
Thank you, Mr. Chairman.
The Chairman. The gentleman's time has expired. The
gentlelady from California, Ms. Waters.
Ms. Waters. Thank you very much, Mr. Chairman. Thank you
for this hearing. This is very important and I would like to
thank the Honorable Senator Rudman for the work that he's done
with all of those who have contributed to getting this report
so that we can begin to really, really, really understand what
the problems are.
Senator, I have this belief that following the problems
with Freddie Mac, that Fannie Mae tried to do everything
possible to avoid falling into the same trap. Certainly, an
organization as big as Fannie Mae, with the resources that they
have, with as many bright people as they had, would have wanted
to clean it up and to get it right after Freddie Mac. It's very
difficult for me to believe that there would be any attempts to
manipulate, to hide, to do something in the name of getting
bonuses after the great exposure of the problem of Freddie Mac.
So I want to know what has gone wrong.
Now, I remember very vividly when Mr. Raines was before
this committee, he said he had sought outside advice on FAS 133
and he had gotten that advice and they had used that advice.
However, it seems that there are some questions about how to do
it and it continues even until today.
As I understand it, Freddie Mac still has accounting
problems that they have to delay their 2005 reports; Fannie Mae
does, too. What's wrong that these big agencies can't seem to
get it right? I can't simply believe that they don't want to,
that somehow, given all of this, they're trying to trick
somebody or fool someone. What's wrong with FAS 133, the
interpretation of how it works? Did you get into that in this
report?
Sen. Rudman. We certainly did and it's covered in detail
and I can only tell you that it's our opinion, and certainly
Huron's opinion, mainly, that as the SEC decided in December of
2004, that they got it wrong, completely wrong. And the reason
for this massive restatement that you referred to in your
comments is because they have a new outside auditor involved in
what will be a year or maybe a two-year dive into the
accounting and financials to be able to furnish certified
financial statements to the--
Ms. Waters. Did they have an outside auditor that gave them
counsel and advice on FAS 133 before?
Sen. Rudman. Indeed.
Ms. Waters. And given that counsel and that advice, did
they follow it? Did they use it as it was given to them, as it
was advised to them?
Sen. Rudman. Well, Madam Congressman, I would say this to
you, that there is some question in our minds as to whether
KPMG really understood how the FAS 133 accounting was being
applied. They certainly were aware of what was being done but
if they understood the detail, it's not clear to me. And
frankly, I don't know how they approved it because it was
fairly obvious to us and to the SEC that it was incorrect.
Ms. Waters. Well, my question is this. If you're getting
advice from an outside auditor--I don't care whether you're
Fannie Mae, Bank of America, whomever you are, and you're
following that advice, and it appears that everybody is having
the same problem with FAS 133, what then do you do?
Sen. Rudman. Well, I know that since the SEC made its
ruling, a number of major American companies have decided to
restate their FASB 133 application--
Ms. Waters. How many other companies fall within this
category?
Sen. Rudman. I don't know how many. I know several major
companies. I have not followed--
Ms. Waters. Bank of America? I mean, who else?
Sen. Rudman. I know General Electric made a public
announcement--
Ms. Waters. General Electric?
Sen. Rudman.--that they were doing some restatement. There
is no question that FAS 133 was misapplied by a lot of people.
The question you ask, however, goes to really another issue and
that was what did the auditors know and to what depth did they
understand the application. I don't know. I cannot answer that
question.
Ms. Waters. All right. Given the SEC's evaluation and their
conclusion about FAS 133, is it clear now that any firm or all
firms can now follow the direction, the instructions of SEC and
do a better job with this?
Sen. Rudman. I believe so, Congresswoman, because it's been
very clear and there's been other literature since that time as
to how this should be applied. But I want to just come back
earlier to something you said. There is no question that if you
had Mr. Raines here today--and we interviewed him at length,
for 8 hours or so--he would tell you that he relied on the
outside auditors and his own financial people. That is his
contention.
Ms. Waters. Did the outside auditors agree with Mr. Raines
that they had given him the advice and information that he said
they had?
Sen. Rudman. Well, the outside auditors did in fact approve
the financials for those years that this restatement is now
being--covering the restatement, so I expect they must have.
Ms. Waters. All right. Well, I think that's important for
us to know. And I appreciate several things about the work that
you have done. Number one, as my cursory review of it, it
appears to be very, very detailed and a lot of work has gone
into it. I also appreciate the fact that you made it very clear
that you're not here to answer the question about whether or
not Fannie Mae is too big. You did not get caught up in
whatever the confrontation is between FM Watch and Fannie Mae.
You're not in that mess.
You're here to talk about whether or not these accounting
practices and some other things are followed; who was
responsible; and the way that the accounting was done and other
issues. So I thank you for clarifying that and I also thank you
for not concluding that some people should go to jail, some
people should have to repay. That's up for others to determine.
Your work is as objective and as well done as you could
possibly do it, and I thank you for not letting people put
words in your mouth.
The Chairman. The gentlelady's time has expired.
Ms. Waters. Thank you. I yield back the balance of my time.
The Chairman. Mr. Garrett.
Mr. Garrett. Thank you, Mr. Chairman, and thank you Senator
Rudman for being with us today to discuss your report. And
after reviewing your report, I think it's only increased my
resolve that something has to be done on a number of fronts as
far as regulation and also changes in other laws as well.
Your report goes into quite a bit of detail as to how
management pressed for specific earning levels to basically
meet Wall Street's expectations, in all of the so-called
accounting areas either tried to hide financial losses or
smooth over the system. I sit up here and I'm amazed, though,
that to this day Fannie Mae does not still have current
financial statements and they will not have them, as I
understand, until the end of the year.
If any other company in this country engaged in any of
these practices and didn't have those results, the investors in
those companies would be trying to sell that stock as quickly
as they possibly can. But because this entity has the backing
or the implied backing of the U.S. Government, when this report
came out people weren't selling the stock; the stock actually
rose and there, I think, is part of the problem.
I think we could get three points out of this. First of
all, after Enron and Worldcom, as we stated before, Sarbanes-
Oxley was passed to try to prevent situations such as those but
it was 3 years later that we found with Fannie Mae the exact
same thing was allowed to occur.
Your report seems to indicate that the board of directors,
the auditing committee, the chairman, and independent auditors
all met the current Sarbanes-Oxley's requirements but they were
still able to mislead everyone to a tune of $11 billion, or
maybe more, since we don't have their financials to this point.
I think that should give everyone on this committee and this
Congress pause, and give us an opportunity to go back and take
a look at Sarbanes-Oxley as well to see how that has been
implemented and whether other changes are made--necessary there
as well.
In addition, I find it amazing that had there not been a
problem with Freddie Mac, that OFHEO would never have known
anything was going on, would never have begun to look into
Fannie Mae, and we might not be having this hearing today
whatsoever.
And finally, I find it interesting to note that, for all
the expense of this report--and it was an expensive $65- or $70
million inquiry--that while we did spend a lot of time and
discussion now on the accounting/mismanagement equation, there
seems to be a lack or dearth of information with also
operational problems. It's my hope that those aspects will come
out with further inquiry into the matter.
Let me raise a couple of questions to you, then. Your
report seems to go at great length but deals with--comes back
with, in my mind at least, an ambiguity as to their accounting
practices, as to why they occurred. At times the report
suggests that it was incompetence or insufficient personnel or
at other times it was intentional. I refer to your report, page
399, where it says, ``with the exception of the 1998 accounting
changes which is previously discussed, we see little evidence
that any individual policy or the policies in the aggregate
were designed or implemented to manipulate Fannie Mae's
financial statements''.
Everything that I've heard so far and everything that I've
seen in the report seems on the face of it--that cannot be
believed that this was just an incident--one incident that you
can say that was intentional and the other cases it was just
purely by incompetence or mismanagement.
I don't believe that if you looked only at those areas that
you can just say it applied to that one case. I would ask you
to look also and comment on the company's handling of
accounting derivatives as you do in the report. It would appear
that if you look at the derivatives and the way that they were
handled, it was intended--it was an intentional action there as
well to have a smooth rate of flow on the cash reports and
resulted in the false application of FAS 133. This is exactly
what occurred with Freddie Mac; they just did it in a slightly
different way.
So to come and say that it's only the one instance where
it's intentional is--troubles me. It's not--certainly suggests
that this was the only instance where it was manipulated for a
particular purpose.
So I guess I would like to move it--the question to you,
then, is were there other instances of that and were the
operational deficiencies affecting the management decisions as
to the earnings? For example, did the company, in other words,
engage in unnecessary exposures in other areas that would
smooth their exposures and smooth their earnings and what-have-
you? And that would go to the question also as the portfolio--
Sen. Rudman. I will let Mr. Parker answer one of the parts
of your question. Let me say that I think what we've said in
this report is that in terms of manipulating accounting for
bonus targets, we did not find any evidence of that other than
in 1998 and 1999. We have said consistently that meeting EPS
targets was an obsession with this company and much of the
accounting that was done was for that purpose, which is, I
think, a little different from what you've said.
I'd like Mr. Parker to address--
Mr. Garrett. So the purposes was purely a managerial style,
we're putting a target on the wall, we're going to aim it, not
for the fact that we're going to get more pay at the end of the
year, it's just that this is what we're going to aim for for
the good of whatever else, we're just going to aim for that
target?
Sen. Rudman. Congressman, if you want to believe that,
that's fine. All we can do--we have strong evidence for 1998
and 1999 and that may be--you may be right. But we can only
deal with evidence that we found. The evidence for 1998 and
1999 is clear, and we would not want to make assumptions or
speculations. Others are free to draw different conclusions
from the same facts.
I want Mr. Parker to address one part of your statement,
which I think is important.
Mr. Baker. And if I may, Mr. Garrett, your time has expired
but the gentleman certainly can respond.
Sen. Rudman. Brief response, Bob.
Mr. Parker. Yes, thank you. Congressman, you pointed out--
Mr. Baker. [presiding] You need to pull your microphone a
little closer. We're still not hearing you well.
Mr. Parker. Thank you. Congressman, you pointed out a
sentence on page 399 and let me just clarify what now appears
to be an ambiguity.
The sentence that you read is from a chapter involving the
accounting for certain affordable housing partnerships. What we
were addressing in that sentence were the general policies--the
general accounting policies regarding the affordable housing
partnerships.
In 1998, one of the accounting changes that was made
coincidentally with the recognition of the $240 million in
premium discount amortization adjustments was a change in
accounting in a related area involving these affordable housing
partnerships. So what we were trying to do in this sentence was
make clear that our 1998 conclusion stands but with respect to
the accounting for the affordable housing partnerships
generally, this was our finding.
And of course, I concur with Senator Rudman's remarks
regarding the findings with respect to other accounting
policies, some of which we do say that there were accounting
decisions made to ensure stable earnings growth or other kinds
of policies in that regard.
Mr. Baker. Thank you. The gentleman's time has expired.
Mr. Watt.
Mr. Watt. Thank you, Mr. Chairman. Senator Rudman,
obviously I haven't read 1,700 pages of your report, but every
report I've seen on it, and certainly the testimony that you've
given today, indicates that you all have done a fantastic job
of getting down in the trenches and figuring out what was going
on, and you've certainly done a great job today in your
testimony of laying it out for this committee. And my
colleagues have asked some exceptionally good questions.
I just have one question, really, and I don't think it will
take 5 minutes, and maybe it will take somebody on your team to
answer it. It's an accounting question. On page 5, in number 3
of your prepared testimony, you talk about this $240 million of
premium discount amortization expense in 1998 when it should
have been $439 million. That's $199 million difference.
I'm just interested in knowing what happens to that $199
million. Did it--as an accounting principle, does it get rolled
to the next year or does it get forgotten about? What happens
to that?
Sen. Rudman. I will have Ms. Oh answer that for you,
Congressman.
Ms. Oh. Under FAS 91, that $199 million was required to be
recognized in 1998, so the entire $439 million should have been
recognized--
Mr. Watt. I understand that. I'm talking about when it
wasn't recognized, what happens to it.
Ms. Oh. What in fact happened here is Fannie Mae deferred
it into 1999, and reduced the $199 million through periodic on
top adjustments of regular $8 million entries per month.
Sen. Rudman. All of which was not compliant with GAAP.
Mr. Watt. Tell me what that means when you say on top
adjustments because I--I mean, when I first heard about this,
it seemed to me that if you got $199 million worth of
difference in expense one year, you don't recognize it one
year, it just gets rolled to the next year. So it might benefit
you one year but the next year it's going to catch up with you.
And if it doesn't catch up with you that year, it's going to
catch up with you at some point unless something happens.
So what I'm trying to figure out is what is this $8 million
adjustment? Did that make it go away or did that just defer it
into some subsequent year? Is it going to catch up at some
point regardless of what you do? That's what I'm trying to
figure out.
Ms. Oh. I understand, Congressman. What happened here--
you're right in your assumption that it eventually will catch
up with you because you have to write off the $199 million in
expense at some point. What happened here is under FAS 91, as
interest rates change, you're supposed to renew your
calculations periodically.
And what happened in 1999 is that the interest rates went
back up and there was no further need to recognize an expense
position on the catch-up. Nevertheless, the company continued
to recognize the $8 million on top entries, which is equivalent
to just writing off $8 million as expense every month because
they were trying to create a reserve for future interest rate
volatility that would generate additional catch-up.
Mr. Watt. So within that 2-year period or within maybe a 5-
year period, would you come out essentially the same place?
Ms. Oh. Well, that would all depend on the interest rates
and mortgage holders prepayment--
Mr. Watt. But if you were taking it as an expense, even if
interest rates went up or down, you're offsetting it against
something that it wouldn't otherwise have been offset against;
isn't that right?
Ms. Oh. Well, if you were to do a periodic assessment of
the catch-up based on current interest rates, it may be that
the expense position flips into an income position entirely so
there's nothing to offset against.
Mr. Watt. Yes. Okay. All right. That's the--I've been
wondering about that $199 million. I could use it, so it kept
me awake at night.
Ms. Oh. Glad I can help.
Mr. Watt. Ever since I first heard about it, I've been
worrying about it.
Mr. Frank. I don't think the question has kept anybody
awake this afternoon.
Sen. Rudman. I think the important part, Congressman, is
that it was not handled the way it should have been handled
under--
Mr. Watt. In that year.
Sen. Rudman.--in that year--
Mr. Watt. Are you saying that in subsequent years it wasn't
handled the way it should have been handled, either?
Ms. Oh. That's correct.
Sen. Rudman. That's correct.
Mr. Watt. Okay. All right. I'm not trying to finesse
anything here. I'm just trying to figure out whether--
Mr. Baker. Would the gentleman yield on that point, just to
make sure I'm getting--I don't want to get confused here. The
on top $8 million going forward was a reserve account against
future volatility which was not GAAP compliant.
Ms. Oh. Right.
Mr. Baker. So even not rolling the $200 million was not
GAAP compliant, but the on top calculation going forward is
akin to a bank which cannot expand its loan loss reserve
account for future volatility. That's prohibited by the FDIC.
So this is a customary understood business practice which they
did not comply with. Is that fair?
Ms. Oh. That's correct.
Mr. Baker. Is that okay?
Mr. Watt. I appreciate the gentleman's edification of that.
It will help me to sleep better tonight. Thank you.
Mr. Baker. I got more where that came from.
Mr. Hensarling.
Mr. Hensarling. Thank you, Mr. Chairman. And Senator,
welcome to the committee. As a former aide to a certain former
senator from Texas with whom you're well acquainted, I recall
fondly the days when half of America thought your first name
was Graham. And even though this is the Financial Services
Committee, and not the Budget Committee, I certainly want to
thank you for your work as being one of the few successful
Members of Congress to actually restrain the growth of the
Federal budget at the expense of the family budget.
Getting down to Financial Services business, obviously
there's been a lot of testimony and focus upon trying to level
out the earnings volatility that Fannie Mae had and you speak
of their kind of corporate culture. And I believe on page 6 of
your testimony--let's see--we found substantial evidence in a
number of specific instances and overall that the company's
accounting and financial reporting policies and procedures were
motivated by a desire to show stable earnings growth, avoid
income statement volatility.
As a former officer of an investment management firm that
ran a hedged equity fund, I know through experience that the
market does place quite a high premium on the smoothness of
earnings, the lack of volatility. Was it within the scope of
your investigation or do you have an opinion as far as Fannie
Mae's activities in artificially smoothing out their earnings,
what did this mean to Fannie Mae? What did it do to their
market cap? How was it valuable to them to engage in this
activity?
Sen. Rudman. Obviously when earnings are managed within the
rules, they're allowed to be managed. Many American
corporations manage earnings through perfectly legitimate
applications of GAAP. What we found was the way Fannie had in
fact established reserves, managed earnings, was beyond GAAP.
I think one of the interesting things about the work that
we've done is that the company going forward has a whole new
approach to accounting policy and I think I could probably
predict with some certainty it will be a long time before
Fannie Mae does any accounting acrobats to hit a particular
target. I think they'd rather face the music in the year that
it happened. And I think that is probably the good result of
all that's happened in the last few years.
But earnings management in this country is not necessarily
a bad word, as long as it's done within legitimate bounds of
GAAP accounting. We found 16 or 17 examples of non-GAAP
accounting, particularly one we've just discussed with the
Congressman who just left and with the chairman of the
subcommittee.
Mr. Hensarling. In looking at your testimony, I read in
virtually every instance we examined, Fannie Mae's accounting
was inconsistent with GAAP. In virtually every instance we
examined. Harken to my colleague from New Jersey's earlier
questioning, but for the implicit guarantee of the Federal
taxpayer given this type of accounting and given the quantity
of the accounting misstatement, which appears to rival that of
Enron and Worldcom--I'm expressing no opinion on any malevolent
intent at this point--but, but for that implied taxpayer
guarantee, do you have an opinion of what would have happened
to Fannie Mae's market cap or how they would have been punished
in the marketplace when this discovery was made?
Sen. Rudman. Well, I can't answer that in any authoritative
way. I think it's fairly obvious that if a company is supposed
to earn a certain amount according to the financial markets and
it doesn't meet the targets, that generally is not healthy for
the stock of the company and the capitalization normally goes
down.
One of the reasons that companies try to maintain stable
earnings is to try to maintain a stable stock price with some
growth. Obviously that is one of the things that we found
happened here.
Mr. Hensarling. Senator, like many other members of this
committee, I have yet to wade through the roughly 700-page
report and 2,000-page addendum and in the interest of candor
I'm unlikely to do that.
My last question, since I'm running out of time here, is
we've had representatives previously, I believe, of Fannie Mae
who've testified that they are capable of hedging their
interest rate and prepayment risk of their mortgage-backed
securities, which I believe is now roughly an $800 billion
portfolio.
Is it a fair reading of your report that there were many
instances when that often was not true?
Sen. Rudman. George, do you want to take that?
Mr. Hensarling. Have I finally stumped the man?
Sen. Rudman. I'm going to let Mr. Ellis take that because
he looked at that particular issue.
Mr. Ellis. I think what we found is we found issues with
the accounting for their derivatives. We did not find anything
that would indicate that economically they had entered into bad
transactions, transactions that did not economically hedge
their portfolio. But again, it was really looking just at the
accounting issues and how they applied the accounting guidance
in FAS 133.
Sen. Rudman. And I want to just follow up if I may, Mr.
Chairman. You know, it's very important that the market
understand what the true value is of these portfolios and
that's the reason that FAS 133 was adopted so that in fact
there was an assessment of value each year. You know, people
talk about the $11 billion restatement. That doesn't
necessarily--that doesn't tell you how much will eventually be
written off, if any. It has much more to do with the timing of
when those--how those affected the income statements over the
years that are covered by the restatement, which is why it's
going to take a year-and-a-half or 2 years to figure it all
out.
Mr. Hensarling. Thank you, Senator. I see my time is up.
Mr. Baker. Let me just--I hate to keep doing this but on
clarifying that issue that the gentleman from Texas was just
raising, there was at one time an issue relative to their
duration gap. They had self-imposed bans of 90 days and they
got out to 14 months. Just as a broad brush, you did not get
into the issue of duration gap.
Sen. Rudman. We did not.
Mr. Baker. Okay. Thank you very much. Mr. Davis.
Mr. Davis. Thank you, Mr. Chairman. Senator, in the same
interest of full disclosure, I've got to make it through Doris
Kearns and Taylor Branch until I get to your 700 pages, so it
may take me a while, too.
Let me make an observation and get your reaction to it and
let me frame it by saying that while I'm a 3-year youngster of
this institution, I remember your work very well and you've had
an enormously honorable career and you clearly continue that in
the work that you do now and you make an interesting point that
one can be in the U.S. Senate and simply decide to be a good,
thoughtful, effective member and never get obsessed with
running for President of the United States. So I thank you for
the power of that example.
Let me tell you, I think, the one criticism that I think
could be advanced frankly of this report, and I mean this as
constructive criticism. Obviously, as you know, this report
will carry an enormous amount of weight because of the power
and the throw weight of your reputation and the power of your
law firm and its reputation.
There's no question this was a thorough, incisive, and
detailed report. There's every reason to believe that the SEC
and the Justice Department will take this document seriously.
Obviously the Justice Department and the SEC are in the process
of making an evaluation as to liability, as to culpability and,
in the real world, this is perhaps something that will inform
their judgment.
Having said that, there's a little bit of a pattern that I
can see in the opening statement that I suspect is contained in
the report of being a little bit indiscriminate in the use of
the word management. Obviously we have two players whose
reputations are at stake: Mr. Raines and Mr. Howard. You make
the observation that Mr. Raines was interviewed for 8 hours;
you make the observation Mr. Howard declined to be interviewed.
Look at page 7, for example, of your opening statement. It
says--
Sen. Rudman. Of today's statement--
Mr. Davis. Today's statement. Paragraph 6 says, ``although
Fannie Mae's top management professed a desire''--and you talk
about the culture of suppressing dissenting viewpoint, it's a
reference to top management. In the next paragraph, paragraph 7
says, ``management tightly controlled the flow of information
to the company's Board''. Then, a few sentences later, ``in
particular, we noted many instances in which management assured
the Board'' of, in effect, falsities, frankly, regarding GAAP
compliance.
Then paragraph 8, ``the Board relied heavily on senior
management''. To a layman reading all of this, to a lawyer
reading all of it, top management may imply Mr. Raines and Mr.
Howard; management may imply them or someone else. It's very
hard to read the report and necessarily follow that particular
track and that's something that strikes me as a concern.
Someone reading this could make certain assumptions about
Mr. Raines that could be erroneous, or could make certain
assumptions about Mr. Raines and Mr. Howard together that could
be erroneous. Do you take that concern as a valid criticism of
this report?
Sen. Rudman. I think when you read the entire 616 pages, it
becomes clear as to who we are talking about. We are talking
about senior management of this company which covers, you know,
the top four, five or six people who changed from time to time
during this period, 1998 to today. We are certainly talking
about the CEO who was also chairman at that time, and the CFO.
We are talking about certain people who had major management
roles, although not in the office of the chairman, in various
control functions, audit functions. That's who we're talking
about.
When we talk about senior management or top management,
we're talking about probably about eight to ten people at the
most, and if you read the report, as I'm sure you eventually
hopefully will get a chance to do on a long flight somewhere,
you will find that it is not hard to identify who we are
talking about.
One of the things we tried to do, Congressman, in this
report is we only could deal with evidence, both testimonial
and documentary. And if we could not support with a footnote,
with a document, what we have said, we didn't say it. We put a
heavy burden on ourselves to make sure we were fair to
everybody but we had no constraints on us and we said whatever
we felt ought to be said, and I'll stand on that.
I would agree with you that maybe it would be clearer if
each time you used the word management or top management you
put out a string of names who we're talking about, but I think
if you look at the report itself you'll find it's self-
explanatory.
Mr. Davis. Let me ask a quick question because time is
running out. The observation that there are instances in which
management assured the board that the accounting policies were
GAAP-compliant, did you come across any direct evidence that
Mr. Raines participated in those assurances to the board?
Sen. Rudman. We have made an affirmative finding in this
report that although we ultimately hold Mr. Raines responsible
for a series of errors that are outlined in numbers one through
eight of today's statement, we could find no evidence,
testimonial or documentary, from anyone or any place that Mr.
Raines knew that what was being suggested to him by his own
accountants and his own internal people was non-GAAP compliant
and he stated that repeatedly during his 8 hours of testimony.
Now, that's all we have to go on.
Mr. Davis. And if the Chair would indulge me a little bit
with just a couple of quick questions.
The first one is obviously you've testified very correctly
about OFHEO's inadequacies, the lack of staffing and so on. Did
you--and I'll ask you for quick answers because of time. Did
you come across any direct evidence that anyone at Fannie Mae
had affirmatively misled OFHEO regarding the accounting
standards and GAAP-compliance?
Sen. Rudman. No, I don't believe we came through evidence
of active misleading of OFHEO or anyone else.
Mr. Davis. And the last question, if the Chair would
indulge--
Mr. Baker. Yes, it's the last question.
Mr. Davis. Last question--
Sen. Rudman. Although I want to say that there is evidence
you'll see in the report of not maybe going forward and getting
further articulation on FAS 133, which maybe they should have
done. There's also a question as to how much they revealed in
certain instances to their outside auditors, and we say that as
well.
Mr. Davis. Last question. Obviously one of the primary
issues from a policy standpoint is what the Congress should do
with respect to the capital requirements, portfolio
limitations. You make it very clear in your report and in your
testimony today that the only concern of your investigation had
to do with issues that don't relate to safety and soundness and
that implicitly suggests that--well, let me frame the question
a slightly different way.
A lot of the momentum behind the portfolio changes and
behind the changes in capital purport to be related to safety
and soundness. The argument is that we need to do these things
to create a stronger safety and soundness structure. I think
it's important that your report seems to indicate that you
wouldn't weigh into that, you wouldn't take a stand on the side
of that position and argue that the portfolio and the capital
changes need to be made for safety and soundness reasons.
Sen. Rudman. I think our report does bear on safety and
soundness in terms of the financial structure because obviously
without a good financial structure, you're not going to have
safety and soundness; good numbers might not mean anything.
As far as the issue of the composition, the character, the
size of the portfolio, I'll only say this: that there are
people in this country who are economists and risk managers and
risk experts that can give testimony to this committee or the
Senate committee as to their assessment of what this risk is
and I'm sure the Chairman of the subcommittee, now presiding
this afternoon, knows who those people are.
We do not consider ourselves to have the expertise to offer
any kind of a reasonable opinion. And I was in the Senate,
Congressman. I offered a lot of opinions in which I had no
expertise. I don't have that liberty anymore.
Mr. Davis. It's a requirement of being in the Congress,
Senator.
Mr. Baker. The gentleman's time has really now expired.
Mr. Campbell.
Mr. Campbell. Thank you, Mr. Chairman, and thank you,
Senator.
We talked a lot about reducing the earnings volatility and
the objective of smoothing earnings. Sometimes when that's your
intent, there is a motivation to understate earnings in
addition to the motivation to overstate earnings. A lot of what
we've heard about today is overstating earnings relative to
GAAP.
Did you find examples of both overstatements and
understatements?
Sen. Rudman. Yes, there was. And the report indicates there
were years where there were certain holdbacks because they felt
the following year might need more income. Yes. The answer is
yes.
Mr. Campbell. If, then, you take all the overstatements and
understatements and offset one against the other, though,
there's an overall general overstatement, I gather, of earnings
and it's not simply just a smoothing exercise that involves
misreporting the earnings in one period or another.
Sen. Rudman. Well, I think that's exactly what Deloitte &
Touche is now engaged in. The reason, as the chairman referred
to, that there is a restatement is nobody really knows the
answer to that question. They have to go through the derivative
portfolio and then through a whole number of accounting issues.
You may have noticed that yesterday Fannie Mae announced
they had found other accounting issues; not major issues, but
other issues. Not surprising. I expect there will be more of
that and when that is all done and a statement is delivered to
the SEC and certified, then that will answer your question. We
have no way of knowing that answer.
Mr. Campbell. At this point we just don't know if it's
merely misstating within a period or if in fact the current
balance sheet--
Sen. Rudman. And the SEC--
Mr. Campbell.--is improperly stated.
Sen. Rudman. The SEC is very concerned about what you
report in a period because that is what the market reacts to.
Mr. Campbell. Obviously. No, I understand that. I'm just
trying to understand whether there's a pattern of continuously
overstating earnings or whether there's this smoothing pattern
and you've indicated it appears to be more the smoothing
pattern.
Sen. Rudman. I cannot say and we won't know that for
another year.
Mr. Campbell. But we don't know where we are. Okay. One
other question relative to the earnings per share and the
bonuses relative to earnings per share. Those earnings per
share bonuses included the chief financial officer and the
controller whose primary responsibility it is to determine the
earnings per share number?
Sen. Rudman. There are a large number of people, 20 or 25,
that were in that pool and it certainly included those people.
Mr. Campbell. Including those people--
Sen. Rudman. Oh, yes.
Mr. Campbell.--in accounting and finance--
Sen. Rudman. Right. Right.
Mr. Campbell.--primary responsibility it was to determine
that number.
Sen. Rudman. Exactly.
Mr. Campbell. Did you in your analysis make a--well, is the
company still paying on that basis--still paying earnings per
share bonuses as they were?
Sen. Rudman. They have changed radically--
Mr. Campbell. To?
Sen. Rudman.--to a system that blends a number of metrics.
They did that with our help and with consultants that they
hired to try to change the methodology for awarding incentive
bonuses. And I will just take 30 seconds of your time,
Congressman.
Mr. Campbell. Please.
Sen. Rudman. It's very interesting to me the evolution of
this whole subject. You all recall that during the 1990's there
was a lot of upset in the Congress about executives being paid
when their companies performed poorly, and that was a
legitimate complaint. Now, they decided to change and they
figured the best target was an EPS target because that was the
purest expression of how the company was doing. We now find the
problem with that is that there are all these accounting shams
and ways to make adjustments from year to year that could make
those targets more achievable.
So what Fannie, recognizing that, did was to bring in an
entirely new compensation consultant. They worked with us to
find out what we were developing from the past history, and
developed a compensation system which has been fully disclosed
to OFHEO and I'm sure available to this committee if it's
interested.
Mr. Campbell. One last question, if I may. I'm actually a
CPA; I don't know how many there are on this committee but
there aren't a lot, but this is very complicated stuff. And
derivatives are very complicated and accounting for derivatives
is even more complicated.
To what degree do you think that this is more incompetence
or under-education--you alluded to that earlier, that there is
at least some of that wherein people were not qualified to
review and make these decisions--versus some kind of
intentional act?
Sen. Rudman. That's always hard to determine based on the
evidence you have, and of course we don't have the right of
subpoena and so, you know, there are some people, one in
particular, I would have liked to have talked to who we didn't.
But my observation would be that, number one, it was a very
difficult standard to interpret but the way they interpreted it
was just flat out wrong and we say that in the report.
This was not some innocuous interpretation. It was very
clear to the SEC several months after this inquiry started back
in 2004 that they weren't on even the right page in their
interpretation and it was our conclusion as well.
Mr. Campbell. Thank you very much. Thank you, Mr. Chairman.
Mr. Baker. The gentleman's time has expired. Mr. Cleaver.
Mr. Cleaver. Thank you, Mr. Chairman. Senator Rudman, I am
very impressed with your great and exhaustive investigation and
I think everyone here has mentioned how much you are revered
around this place. I think it is important for us to know what
went wrong with Fannie Mae and of course we must make whatever
changes we can or take some curative action.
But having said that, and now moving forward, this
committee approved what I consider to be a major change in
Fannie Mae's portfolio that would allow 5 percent of profits to
provide for badly needed affordable housing and we, at this
particular juncture in the history of our Nation, need that
passed more than ever if you consider what's going on in the
Gulf Coast area.
Do you think that these changes that we are proposing,
which are still over in the Senate, are acceptable ways for
Fannie Mae to deal in some areas that they have not previously
touched?
Sen. Rudman. Congressman, you know, I would like to answer
your question but I really--I'm not in a position to, not
because I don't want to but because I don't have an opinion.
The only part of the legislation I have looked at very closely,
both the Senate and the House side, is the legislation in terms
of strengthening the regulator, which I fully concur with.
As far as these policy issues as to how the investments
ought to be made, what should be done with portable housing,
with low income housing, how the portfolio ought to be
adjusted, I really don't have an opinion because I truly don't
know.
Mr. Cleaver. That's the problem. We shouldn't have had a
Senator--I could have probably tricked somebody else into
answering the question. I really didn't think you were going to
answer.
Sen. Rudman. Well, somebody at this table may have an
answer but I don't.
Mr. Cleaver. I'll go to them; it's probably too late, now.
I was just very much interested in whether or not you thought
that Fannie Mae could actually--that the legislation that came
out of this committee was actually legislation that was helpful
to Fannie Mae and would be beneficial to the country, and I
understand your answer.
But going back, you--in the report you said that the
information flow to the board was tightly controlled by
management. Now, is that different than any Corporation, any
eleemosynary institution, even the Congress? I mean, to some
degree we are a board of directors and we don't get
information--
Sen. Rudman. Well, that's a whole different--
Mr. Cleaver.--tightly controlled--but, yeah, that's
another--but, you know, I'm concerned--it seems to me that we
have an issue here that is more related to character than
systems and if that is the case, then there may be some people
whose character flaws are spilling over on some others who
don't deserve to be painted with this broad brush that I think
many people in the country now have of the top people in Fannie
Mae.
Sen. Rudman. Congressman, let me just refer to your
question broadly. There is no question for a lot of years in
this country boards of directors generally were not terribly
active. They tended to be tightly controlled by the company,
they were not independent. That's all changed.
It changed--actually, it started to change before Sarbanes-
Oxley; it's changed in a major way since Sarbanes-Oxley. And
today, the overwhelming number of companies are moving towards
more transparency in terms of the board and boards have more
responsibility and more accountability than they had before the
events of Sarbanes-Oxley and other civil litigation that has
taken place since that time.
So I think that Fannie Mae certainly was not the only
company that tightly managed information flow but I will say
that there were certain aspects of disclosure to the board
which were described in this report which I thought were rather
egregious in the sense that they should have been more informed
than they were.
Mr. Cleaver. I yield back the balance of my time, Mr.
Chairman.
Mr. Baker. I thank the gentleman. Ms. Kelly.
Ms. Kelly. Thank you, Mr. Chairman.
Senator Rudman, were you aware of the First Beneficial case
before you were hired by Fannie Mae?
Sen. Rudman. First Benef--
Ms. Kelly. The First Beneficial case. Were you aware of the
First Beneficial case before you were hired by Fannie Mae?
Sen. Rudman. I was not personally aware of that case.
Ms. Kelly. Did you have the opportunity to review that case
during your investigation?
Sen. Rudman. I seriously doubt it unless it had to do with
something that we were looking at. Is this something up in the
Philadelphia area?
Ms. Kelly. It was a major fraud case, sir, and it involved
Fannie Mae, and I'm curious about how a major fraud case
involving Fannie Mae would not be within your remit to examine
how the internal controls and safety of soundness of the
company.
Our review of the case in my committee found that Fannie
Mae's behavior in this case was motivated by wanting to hit
compensation targets for regional executives. It might be a
good thing if there's somebody else at this desk who could
answer that question.
Sen. Rudman. I don't think anyone here can. You can
understand, Congresswoman, that we were given a scope to look
into. We had a lot of information to look at. What year was
that case decided?
Ms. Kelly. 1998 to 2002.
Sen. Rudman. Yes. We had no knowledge of that case, nor was
there any information about that case produced to us. And I
might say that we put out a major bit of notification to the
company and anyone else who was interested to be in
communication with us and many people were, but nobody informed
us about that case. We're unaware of it.
Ms. Kelly. Senator Rudman, perhaps you could comment on the
compensation culture at Fannie Mae during that time, 1998 to
2002.
Sen. Rudman. Well, what we have said in the report is that
the events of 1998 and 1999, as I've testified before here
previously, led to managing and earnings targets through
improper accounting procedures which also one of the
motivations was to maximize bonuses under the incentive plan
for that year. We did not find that activity in terms of
specifically bonus targets in the years thereafter.
Ms. Kelly. The vice president of Fannie Mae for the region
at the time of this particular case I'm talking about was a man
named Samuel Smith, III. He was promoted from regional vice
president for single family housing to national vice president
of single family housing in spite of his having presided over
Fannie Mae's relations with the First Beneficial case--with
First Beneficial.
It seems--my question now is whether or not Fannie Mae has
sufficient controls on officer promotion within the company to
prevent that kind of behavior from being rewarded in the
future.
Sen. Rudman. Congresswoman, I would say the answer to that
is, frankly, I don't know but it certainly seems to me the sort
of thing you ought to communicate to the company since you
obviously have extensive knowledge of the issue. Understand,
our investigation was based on a set of challenges referred to
us by OFHEO from its September and February issuances to the
company and thus to us and we looked at those issues.
Had someone brought that issue to our attention and had it
had relevance to what we were doing, we certainly would have
looked at it. Neither of those things happened.
Ms. Kelly. So if I understand you correctly, OFHEO did not
ask you to take a look at any of these cases other--they gave
you a straight portfolio and you did not look beyond that
portfolio; is that correct?
Sen. Rudman. Only--well, they gave us a portfolio but we
had full ability to look beyond the portfolio but it would have
had to come within the portfolio of what we looked at. For
instance, it certainly did not come in within any of the
accounting issues. We had 16 accounting issues to look at. I
doubt that what you're talking about is an accounting issue.
Ms. Kelly. Sir, I just wanted to ask you, because I clearly
didn't understand--it sounded to me like it was they gave you a
portfolio and you looked at the portfolio but you were able to
look outside the portfolio but if it wasn't in the portfolio
you couldn't look at it. I didn't quite understand what you
were trying to tell me.
Sen. Rudman. Well, let me try to be clear, Congresswoman.
I'm sorry for being obscure. If you look in the report and the
supplements, you will find two communications from OFHEO, one
in September, one in February. They define the scope of work
they wish us to look at. Had any of that information related to
the case you're talking about, we certainly would have looked
at it. Evidently, it didn't.
Also, I might point out, there are a number of litigation
matters Fannie Mae has been involved with over the years and
unless they had some relevance to what we were doing, we
certainly did not look at them.
Ms. Kelly. Well, in this instance, sir, the--what happened
was Fannie Mae sold bad mortgages to the Federal Government. It
would have been a good thing to take a look at. I've run out of
time. Mr. Chairman, you may want to pick that up.
Sen. Rudman. Mr. Parker might have an additional response
on that issue. Bob?
Mr. Parker. Congresswoman, if I understand--I believe I now
recognize the matter you're referring to. If I understand, I
believe it was down in North Carolina. And the matter arose and
was being investigated. If my recollection is correct, there
were issues of that sort that were raised during the scope of
our investigation. In other words, the matter was broached and
was looked into during our investigation and was being looked
at, as I recall, by other government agencies. So that is not
something we decided to duplicate or to bring within our scope
at that time.
Ms. Kelly. But you did not mention it in your report.
Sen. Rudman. No.
Mr. Parker. No, because we didn't do any activity with
respect to it.
Sen. Rudman. If a governmental agency were actively
involved in an investigation, we certainly would not refer to
that in our report. That would not be appropriate for us to do.
Mr. Baker. The gentlelady's time has expired. Mr. Price.
Mr. Price. Thank you, Mr. Chairman. Senator, I appreciate
you coming today. I also want to lend my voice to those who
have recognized your service, past and present, and I'm honored
to have you before the committee and recognize your budgetary
work that you've done in the past and I appreciate it so much.
I also want to thank your colleagues for joining us today. This
is a remarkable indictment, truly, I think, that we see before
us. I appreciate your candor and it's very sobering
information.
I have a couple of specific questions. The first relates to
the information that you and your colleagues had available to
you as it compared to the information available to the four
levels of review that have already been talked about, the CFO,
the internal auditor, the external auditor and the regulator.
On page 5 of your prepared remarks, item number two talks
about FAS 133. The interpretation ``departed from generally
accepted accounting principles'' or GAAP ``in a number of
important respects. These departures from GAAP were not mere
innocuous practical interpretations or modest deviations from a
strict reading of the standard''. And then the final sentence
there, ``and importantly we found that the company's
significant hedge accounting practices were known to, and
accepted by, the company's outside auditor''.
My question would be, do you believe that those four levels
of review had the same information that you had available to
you with which to determine whether or not the practices were
appropriate?
Sen. Rudman. Well, I certainly know that OFHEO has had
access to all of that because, not only have they had the right
of course under their special examination to gather that
documentation and that information and do a number of
interviews, but we have on an ongoing basis been supplying them
with information since October of 2004.
I have to believe, from the minutes we've looked at and
from the emails we've looked at, that the manager of the
company had consultations with its inside and outside auditors
on these issues and I assume--since all of the documents that
we've received are from their files, I assume they had access
to those documents.
Mr. Price. And there's been some allusion earlier to a
``ease of covering up'' and I can't remember whether it came
from the panel or whether it came from up here. Do you have an
opinion as to whether or not there was an active covering up of
what was going on or--
Sen. Rudman. On the contrary. I go back and I look at the
testimony before Mr. Baker's committee by Mr. Raines and Mr.
Howard, which Mr. Baker has referred to. They were quite open
in their beliefs at that time and they had stated them rather
clearly. I don't think that--if there was, we didn't find
evidence of it. We found evidence of mismanagement,
incompetence, incorrect interpretation of rules, but not anyone
trying to hide that other than, in our opinion--and hiding
wouldn't be the right word--not being at a level of
transparency with the board of directors that I think is
consistent with good governance.
Mr. Price. Right. That leads to my next question. You had a
number of items throughout your prepared testimony. As an
organizational matter, too much authority at Fannie Mae was
concentrated in the former CFO. Checks and balances were non-
existent. The information the board received in critical areas
was either incomplete or misleading.
Would you offer an opinion as to whether or not you believe
the changes that have been put in place at Fannie Mae currently
are satisfactory to correct the problems that you--and the
structural problems that you identified?
Sen. Rudman. I believe they are, for two reasons. Number
one, because in my dealings with the management of the company
since the new management took over, I have found them to be
very open, very transparent and, frankly, a bit on the humble
side compared to the prior management.
Secondly, and even more important, I've looked carefully at
the backgrounds of each of the individuals hired in these new
positions and they're all very high level people with great
backgrounds. Now, does that say they can't make mistakes? I'm
sure they can. But the probability of these kinds of mistakes
with this team it seems to me is far less likely.
Mr. Price. So that would lend credibility to the comment
that was made earlier that this was a character flaw and not a
systems flaw. Is that--
Sen. Rudman. I think it was both. I'm not sure I'd use the
word character. I think it was a competence flaw and a systems
flaw.
Mr. Price. Okay. I've got very little time left but I did
want to offer anybody the opportunity to make any
recommendation regarding any other changes from a Congressional
standpoint, a legislative standpoint that you all would
recommend.
Sen. Rudman. I have said consistently when asked that when
this finally goes to conference, it's vital that a strong
regulator emerge. I think--
Mr. Price. Anything else besides that?
Sen. Rudman. No.
Mr. Price. Does anybody have any other opinion regarding
that?
Sen. Rudman. Comments at all? No.
Mr. Price. Thank you ever so much. I appreciate your
service.
Mr. Baker. The gentleman's time has expired.
Mr. Price. Thank you.
Mr. Baker. Mr. Pearce.
Mr. Pearce. Thank you, Mr. Chairman. Thank you, Senator.
Whenever the bonuses were written out, $27 million more or
less, what string of employees participated in the bonuses? In
other words, how deep in the organization did those go?
Sen. Rudman. Alex Oh will answer that question.
Ms. Oh. The bonuses were distributed from Office of the
Chair personnel down to senior vice president levels.
Mr. Pearce. And what was the largest bonus given?
Ms. Oh. I believe it was slightly less than $2 million for
1998 and that's just the AIP component.
Mr. Pearce. Was it within the scope of your study that you
would look back through the history and see if there was a
pattern of misstatements in order to achieve the bonus levels
or are you just targeting this one experience?
Sen. Rudman. We started in 1998.
Mr. Pearce. The line of questions that was coming from one
of my colleagues is that if we somehow accounted for the stuff
later, it might, really, no harm, no foul, with the exception
that the company is $27 million lighter at the end of one
process than it would be at the end of the other process. Is
that more or less accurate?
Ms. Oh. I don't believe we agreed with the questioner
that--
Mr. Pearce. I understand, but that's the drift. And even if
we gave him the fact that the later sequence was not in
accordance with GAAP principles--but even if we acknowledged
that it might possibly have been, still you have defrauded the
company out of $27 million up-front that is not recovered--
Ms. Oh. That's correct.
Mr. Pearce. Yeah. So there is a foul even though we
eventually--even if we eventually accounted for it, so even the
premise of his question was--
Mr. Baker. Would the gentleman yield just for a moment?
Mr. Pearce. I appreciate that. I would let the gentleman
achieve his own time, if he would.
I would ask about the cooperation between the executives.
How cooperative were they? In other words--
Sen. Rudman. During our investigation?
Mr. Pearce. Uh-huh.
Sen. Rudman. We have had absolute, total cooperation from
the Fannie Mae board, from all of the new management, people
that were still there that had been under the prior management.
None of our requests were--
Mr. Pearce. Except Mr. Howard.
Sen. Rudman.--we received everything we needed and, as you
see, we did about four-and-a-half million documents. We're
still looking at documents to wind up our engagement but we've
had as much cooperation as one could expect and it's been fine.
Mr. Pearce. And then--with the exception of Mr. Howard. Mr.
Howard was non-responsive.
Sen. Rudman. Correct. I'm talking about the current
management and I'm certainly talking about Mr. Raines and other
employees of the company and former employees of the company.
Mr. Pearce. Did the chairman have an observation?
Mr. Baker. Yes, sir. I just wanted to give you some
information. The 1998 to 2003 bonuses paid out was $245
million.
Mr. Pearce. Thank you. How much was Mr. Raines's bonus?
Mr. Baker. In one year, $1.9 million. I can give you more
detail but I've got it up here.
Mr. Pearce. Okay. That's fine. I would look to receive
that.
Back on the gentlelady from New York, she was asking about
First Beneficial. There was a pattern of $7.5 billion of loans
that evidently were suspect that were sold into Fannie Mae and
became a little bit messy, sold back and then maybe sold over
to Ginnie Mae. In other words, they started making the rounds
as bad loans have a tendency to do once no one can collect
them.
Did any of your introspection--any of your looking at the
background of Fannie Mae deal with this sort of a problem that
might be inherent in their operation?
Sen. Rudman. We did not. It was not part of what we were
doing.
Mr. Pearce. Generally one can--
Sen. Rudman. I don't believe that's been settled yet,
either. I believe that's still pending.
Mr. Pearce. Generally one gets a feel for a corporation and
its culture and for the practices. Would you think that you all
studied enough about the culture at the company to realize if
they would engage in practices that were a little bit suspect
in the banking terms?
Sen. Rudman. I think what we say in the report is this
company had a level of--a tone at the top, a level of arrogance
that believed that it was pretty hard for Fannie Mae to be
wrong about anything. Their whole experience with OFHEO and
with the Congress historically as we did our investigation
indicated to us that they believed that they were right and
they would push very hard to prove they were right, either to
the Congress or to OFHEO, depending on the circumstances.
Whether that led to accounting misstatements, I am in no
position to say. What I can say is that the attitude of the
company was not conducive to problem-solving. It was conducive
to essentially defending its turf which it did rather
successfully for a long time.
Mr. Baker. The gentleman may have one more--his time is
expired, but one more question if you'd like.
Mr. Pearce. Well, that's fine. I see the time has expired.
Thank you, Mr. Chairman.
Mr. Baker. We're going to start with a second round because
Mr. Frank and I both have another not lengthy set of questions
and it follows on to Mr. Pearce's general observation. In
looking at the significant volumes prepared by the counsel for
Mr. Raines, there are the following sort of comments I want to
get your reaction to, Senator.
We submit that it is not appropriate based on the record in
front of you to rely on an amorphous criticism of tone or
culture in analyzing Mr. Raines performance. A retrospective
conclusion that there must have been cultural deficiencies
because incorrect results were reached will not stand in the
scrutiny of future adversarial proceedings.
Any attempt to portray Mr. Raines as having created an
inappropriate tone or culture is unsupported. Although the
record does not support an inference that Mr. Raines should be
judged legally culpable for the events, his departure as
chairman and CEO in the wake of the Office of the Chief
Accountant's determination regarding accounting has exacted
accountability for the performance of the company regardless of
legal fault.
It seems to me that--I have a quote I believe it's yours
and I'm not certain--that--or at least a statement of the
report--that Mr. Raines was found to have contributed to the
culture that improperly stressed stable earnings growth. Is
that a correct assessment of the report's findings or to what
extent was Mr. Raines truly the navigator of the ship in the
culture that is troubling?
Sen. Rudman. Well, Chairman Baker, you know, I fully
appreciate the position that counsel for various individuals
take. That is their position. And the reason we published all
of that is we thought that the committee was--and the Fannie
Mae board and the world was entitled to see their position.
We obviously don't agree with that characterization that he
did not contribute to that. As a matter of fact, when you look
at page 5 of our executive summary, we find that he contributed
to a culture that improperly stressed stable earnings growth
and as chairman and CEO 1999 through 2004, he was ultimately
responsible for the failures that occurred on his watch.
There's no question that he was a strong, driven, very
competent presence and that he set the tone and there was no
question in our mind that meeting these earnings targets was
very important to Mr. Raines.
Mr. Baker. And given your background inquiries, even though
Mr. Howard is described as a very independent and powerful CFO,
it is still not probable that in a world of accounting
decisions at the level that has been discussed, that that would
not--if not counseled, at least informed would be the customary
business practice as to the actions being taken before they
would be executed?
Sen. Rudman. Well, you know, Chairman Baker, I must say
that that is one of the reasons we were very disappointed in
being able to talk to Mr. Howard. We only have testimony from
Mr. Raines and a lot of documents. And there is nothing in
those documents that shows us Mr. Raines heavily involved in
some of the financial decisions.
Your assumption may be correct, but we don't have a lot of
evidence about that. I suspect that others may at some
subsequent time. We don't have any.
Mr. Baker. I thank you. Mr. Frank.
Mr. Frank. Thank you, Mr. Chairman. I'm very much concerned
about where we go from here. And you've made some comments
which I appreciate about the strength of the regulator that we
have in this bill and you did note that a contributing factor
to the problems was that, as Mr. Falcone noted, OFHEO was
underfunded and under-resourced.
Had the regulator of Fannie Mae and Freddie Mac at the time
that this arose been the regulator that is contemplated in the
bill that passed the House, does that in your judgment mean
that what happened would have been less likely or at least
caught earlier?
Sen. Rudman. Well, as I said, I don't like to speculate
but, because we're both New Englanders, Congressman Frank, I
will indulge this speculation.
It seems to me from the experiences I've had, both in
private life and public life and serving corporate boards of
various kinds and the work that I've done here at Paul, Weiss,
that had this regulator had the depth of accounting expertise
that it had when it engaged Deloitte & Touche to do a deep
dive, if you will, on Fannie Mae's accounting, that it is
likely, in my view, that they would have uncovered some of the
things that were uncovered in the 2004--
Mr. Frank. And just to close the loop, the bill that we
have passed out of the House, does that, in your judgment,
provide those resources and the likelihood of that being
available to the regulator?
Sen. Rudman. I think it probably does, but I would give you
this caveat. I think any time a regulator like Fannie or the
fed or the comptroller has an issue that could affect
fundamentally large segments of the economy, it's always good
they can come back to the Congress and ask for additional funds
for special assistance.
Mr. Frank. I appreciate it. But the structure would be
appropriate.
Sen. Rudman. It is.
Mr. Frank. There was some reference earlier--and I'm just
interested in the magnitude of this--there was some reference
comparing what you dealt with and examined to Enron and MCI.
And in my judgment of both of those, we had just a woefully
inadequate amount of revenue coming in. Was there that kind of
problem at Fannie Mae? Is it comparable to Enron and MCI in the
macro aspects?
Sen. Rudman. That was not the problem. I'm very familiar
with those matters not only from having read about them but
I've talked to people who were involved actively in and I don't
think these are necessarily comparable. These are different
kinds of issues.
Certainly, our report does not find people actively
engaging--
Mr. Frank. And not the order of magnitude of economic
problem.
Sen. Rudman. No. No.
Mr. Frank. One last question. It was rumored that there was
an important Commission appointed and neither you nor Lee
Hamilton was on it. Is that true?
Sen. Rudman. That's true.
Mr. Frank. I'm surprised to hear that.
Mr. Baker. The gentleman's time has expired. Mr. Pearce,
did you want to take another round?
Mr. Pearce. A couple more questions, pursuing just a little
bit of the line of the questions that were just completed.
It did not in your mind rise to the level of magnitude of
Enron and that particular problem. They put Martha Stewart in
jail for 4,000 shares. Does it rise to that level?
Sen. Rudman. I'm sorry, Congressman. I didn't hear you.
Mr. Pearce. I said Martha Stewart was put in jail--in other
words, we're determining magnitude now. Enron was a larger
magnitude, you said. Martha Stewart--I think there were 4,000
shares involved and she went to jail for obstruction and
whether--and not telling whether or not she got some advance
notice. So does this case rise to that magnitude?
Sen. Rudman. You know, I don't want to back into the
question about culpability but I will just make the general
observation that those cases involved the creation of entities
that really didn't exist, created conspiracies to move funds
around for a very--purposes that were deleterious to the
markets.
We don't find that kind of evidence here. We find a lot of
very serious financial mismanagement and we find some
manipulation of earnings in order to reach bonus targets in a
particular year and a real concern with meeting targets every
year. That was an obsession. But I think that's a different
level from what we're talking about.
Mr. Pearce. Yes. Sure. Enron was the creation of other
entities. But the HealthSouth, that was more of an accounting
problem, WorldCom, again, was accounting fraud. So once you
decide that you're going to--once a culture decides it's going
to misstate, to manage the facts in order to get an outcome of
$240 million bonus, and generally if you look at outcomes that
accounting manipulation is designed for, usually there's some
payoff for the individuals who are willing to get involved in
that and I guess at the end of the day how can we say that one
accounting fraud is different and more substantial, less
substantial than another.
Because if you look, there seems to be a continuum at which
the problem escalates. I can remember at one point Enron was a
fairly straight oil and gas producer out in our particular
area. But they then spun off the energy sector and got faster
and faster players, saw more and more creases in the law, and
then you could take a look at WorldCom, HealthSouth, Tyco,
Commercial Financial Services.
Again, got a lot of players here moving numbers pretty fast
and it appears that they benefitted personally, which appears
to be the case here. How would those cases differ? How would my
linking of those cases I think be inappropriate, I guess is my
question.
Sen. Rudman. My answer would be that what someone in this
government is going to have to decide, not me and not you,
really, but someone in this government at the Department of
Justice is going to have to decide whether or not any of these
rise to the level of the kind of conduct you're talking about.
I truly don't know the answer to it, Congressman. I don't
know.
Mr. Pearce. And I appreciate the straightforwardness of the
answer because many of these things are very difficult.
Mr. Chairman, I appreciate your indulgence.
Mr. Baker. I thank the gentleman. I'll, for the record,
bring us to closure today. I want to acknowledge that it is the
board of Fannie Mae that engaged your firm and your team of
experts to review and prepare an arms-length examination of a
very troubled period of corporate performance. Thanks certainly
on behalf of this committee and the chairman.
I want to make clear that we are very appreciative for the
diligence exercised, the quality of the report generated and
the findings which will be, I believe, of significant help to
us going forward as we attempt to construct a new regulatory
structure to assure homeowners of access to low cost housing
and to assure taxpayers that they will not be placed in
untoward risk.
You have performed a very valuable service and the
committee is very appreciative, and we thank you for your time
and participation here today.
Sen. Rudman. Mr. Chairman, I thank you for those words and
I want to express my appreciation to your staff, Mr. Butler in
particular, for being so helpful in getting us organized to
appear here before you.
Let me also add I know there are a lot of footnotes in this
report and some of your members may be interested in some of
those footnotes, as you are. We will be happy to make them
available.
Mr. Baker. Oh, we have your mailing address and we're going
to be good pen pals. Thank you.
Our meeting is adjourned.
[Whereupon, at 4:30 p.m., the committee was adjourned.]
A P P E N D I X
March 14, 2006
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