[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


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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

                              ----------                              
                                                                   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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