[House Hearing, 109 Congress]
[From the U.S. Government Publishing Office]



                          OFHEO'S FINAL REPORT

                             ON FANNIE MAE

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

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                    CAPITAL MARKETS, INSURANCE, AND
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                    COMMITTEE ON FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                               __________

                              JUNE 6, 2006

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 109-98












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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
 Subcommittee on Capital Markets, Insurance, and Government Sponsored 
                              Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

JIM RYUN, Kansas, Vice Chair         PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              DENNIS MOORE, Kansas
FRANK D. LUCAS, Oklahoma             MICHAEL E. CAPUANO, Massachusetts
DONALD A. MANZULLO, Illinois         HAROLD E. FORD, Jr., Tennessee
EDWARD R. ROYCE, California          RUBEN HINOJOSA, Texas
SUE W. KELLY, New York               JOSEPH CROWLEY, New York
ROBERT W. NEY, Ohio                  STEVE ISRAEL, New York
VITO FOSSELLA, New York,             WM. LACY CLAY, Missouri
JUDY BIGGERT, Illinois               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MARK R. KENNEDY, Minnesota           JIM MATHESON, Utah
PATRICK J. TIBERI, Ohio              STEPHEN F. LYNCH, Massachusetts
J. GRESHAM BARRETT, South Carolina   BRAD MILLER, North Carolina
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
TOM FEENEY, Florida                  NYDIA M. VELAZQUEZ, New York
JIM GERLACH, Pennsylvania            MELVIN L. WATT, North Carolina
KATHERINE HARRIS, Florida            ARTUR DAVIS, Alabama
JEB HENSARLING, Texas                MELISSA L. BEAN, Illinois
RICK RENZI, Arizona                  DEBBIE WASSERMAN SCHULTZ, Florida
GEOFF DAVIS, Kentucky                BARNEY FRANK, Massachusetts
MICHAEL G. FITZPATRICK, 
    Pennsylvania
JOHN CAMPBELL, California
MICHAEL G. OXLEY, Ohio


















                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    June 6, 2006.................................................     1
Appendix:
    June 6, 2006.................................................    23

                               WITNESSES
                         Tuesday, June 6, 2006

Lockhart, Hon. James B. III, Acting Director, Office of Federal 
  Housing Enterprise Oversight...................................     9

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    24
    Gillmor, Hon. Paul E.........................................    26
    Lockhart, Hon. James B. III..................................    27
















 
                          OFHEO'S FINAL REPORT

                             ON FANNIE MAE

                              ----------                              


                         Tuesday, June 6, 2006

             U.S. House of Representatives,
        Subcommittee on Capital Markets, Insurance,
              and Government Sponsored Enterprises,
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to notice, at 2:00 p.m., in 
room 2128, Rayburn House Office Building, Hon. Richard H. Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Gillmor, Royce, Kelly, 
Hensarling, Davis, Oxley (Ex Officio), Moore, Frank, and Watt.
    Also present: Representative Garrett.
    Chairman Baker. Good afternoon. I call this meeting of the 
Subcommittee on Capital Markets to order. Today, the committee 
meets to discuss OFHEO's Report of the Special Examination of 
Fannie Mae.
    Upon preliminary review of the findings, there seems to be 
validation of the work of OFHEO throughout the years, 
particularly that of your predecessor, Mr. Armando Falcon, who 
labored long in the vineyard trying to come to some conclusion. 
This work was highlighted by an appearance before the 
subcommittee 2 years ago, in which rather difficult 
observations were made public by the then-acting director and 
led ultimately to even more strident conversation about the 
advisability and need for strengthening the tools and the 
resources that the current regulatory structure may benefit 
from.
    The work has been difficult, and it is certainly necessary, 
and I would, unfortunately, like to point out that the report 
even gives us greater reasons for concern. The collection of 
facts leads us to a very troubling picture, one in which there 
was, apparent to me, an effort at all costs to hit certain 
earnings and incentives which led to the enrichment of the 
executives in control of preparation of that financial data.
    We will delve today in much more detail into those elements 
and try to appreciate, from the work you have done, how we can 
better prepare the accountability of the agencies themselves as 
well as the regulatory body going forward to oversee these 
increasingly complex financial organizations.
    Although it may not be said necessarily for the committee, 
it should be part of the record that these enterprises are 
enormously important to our housing market. Because of the 
complexity of their counterparty risk and relationships with 
other financial entities, if there were to be adverse economic 
consequences to either of them, it would bring about 
potentially systemic risk--adverse effects--and for that reason 
alone, much less the exposure of the American taxpayer, the 
committee should spend considerable time and effort in trying 
to get our legislative proposal for reform adopted during this 
term of the Congress.
    Mr. Lockhart, I look forward to your testimony and your 
response to the questions of the subcommittee at the 
appropriate time.
    Mr. Watt, do you have an opening statement?
    Mr. Watt. Thank you, Mr. Chairman, and I thank Mr. 
Kanjorski, the ranking member of this subcommittee, for asking 
me to sit in for him today. He has an irreconcilable conflict 
and could not be here. I wish it were an indication that I was 
in training either as a ranking member or a chair of one of the 
subcommittees, but my--
    Chairman Baker. The ranking member seems to be aggressive 
enough, if I might.
    Mr. Watt. --my seniority status is such that both of those 
probably would appear to be somewhat out of reach at this 
point, so I am just here substituting for him and doing the 
best I can at today's hearing which is the fifth in a series of 
hearings of accountings of irregularities at Fannie Mae. At 
each of these hearings we have learned more details about what 
went wrong at the government sponsored enterprise and what 
needs to be done to prevent similar situations in the future.
    Mr. Kanjorski, the ranking member, has been very vocal in 
his statements that government sponsored enterprises with their 
public responsibilities and private capital have a special 
obligation to operate fairly, safely, and soundly, and I 
certainly agree with his assessment. The management at these 
entities must ensure that they produce accounting statements 
that reflect their real financial condition, and I think we, 
hopefully, are headed back in that direction.
    While the report that we are having the hearing about 
represents one more important step in the process of examining 
the accounting issues and management issues, we must also keep 
our focus on completing the legislative action that is 
necessary to improve the oversight of all government sponsored 
enterprises going forward. It is certainly in the public's 
interest that we address regulatory issues promptly and 
properly.
    OFHEO has leveraged its existing general safety and 
soundness authority through the adoption of specific safety and 
soundness standards. The authority to adopt these standards and 
any other safety and soundness standards deemed necessary would 
be clearly established in the House-passed bill, which also 
would strengthen the enforcement authority of the regulator, 
including enforcement of safety and soundness requirements.
    Additionally, the House bill gives the regulator authority 
to order reductions in assets for safety and soundness reasons, 
similar to the action that is taken as one of the resolutions 
of today's report.
    Mr. Kanjorski is also a strong supporter, as am I, of the 
concept that a strong, world-class, independent regulator is 
needed for the GSE's, and we hope that we can move in that 
direction following these series of hearings focused primarily 
on what went wrong and tangentially on looking forward to how 
we can ``right the ship'' and go forward.
    After reviewing OFHEO's report, I have two specific 
questions that I hope will be answered. First, it would be nice 
to know whether OFHEO believes it now has an appropriate level 
of cooperation from the management and board of the company. 
Second, it would be nice to learn how long it will take for 
Fannie Mae to get back into financial shape and current with 
its reporting and be able to move forward aggressively with the 
housing mission that I believe most, if not all, of the members 
of this committee support.
    So we thank you for being here, Mr. Lockhart, and look 
forward to your testimony.
    Mr. Frank. Mr. Chairman, I wonder if I could proceed out of 
order to note the presence of a former chairman of this 
committee in this room, our former colleague from Rhode Island, 
Mr. St. Germain--my former colleague, because I don't know if 
anybody else is still here. You are, I guess, and Mr. Oxley.
    Chairman Baker. Welcome back, sir. Nice to see you here.
    Mr. St. Germain. Oh, I am looking for Rick Milano, my 
former staff director.
    Chairman Baker. Some things never change. We are constantly 
looking for our staff.
    Mr. Frank. Protocol has been tightened up since you have 
been here, so you have to sit down.
    Chairman Baker. Chairman Oxley.
    The Chairman. Mr. Chairman, coming on the heels of Senator 
Redman's work, OFHEO's staff is to be commended for giving us 
the comprehensive report from the agency special exam of Fannie 
Mae. I congratulate former OFHEO Director Falcon for initiating 
examination and former Acting Director Blumenthal for 
completing this report.
    Mr. Lockhart, congratulations are in order for you on your 
nomination by the President to head OFHEO, and I look forward 
to your presentation today.
    OFHEO's story of Fannie Mae is, unfortunately, fact, not 
fiction. We are told that Fannie Mae's best-in-class image was 
a facade. According to the report, the company's board of 
directors was a complacent entity controlled by senior 
management which systematically withheld vital information. 
Management routinely violated GAAP in order to maximize bonuses 
and mislead shareholders. Reported details are that Fannie Mae 
sought to oversee OFHEO, instead of the other way around, even 
orchestrating a HUD Inspector General investigation and 
reduction in appropriations for the purpose of discrediting the 
agency, as well as a report that we review today.
    According to this report, in October of 2004, Fannie Mae's 
former chairman and CEO Raines and CFO Howard made, 
``inaccurate statements'', in sworn testimony before this 
subcommittee when they denied that expense deferrals had been 
made.
    Compensation for senior executives tied to earnings per 
share targets dwarfed basic salary and benefits. From 1998 to 
2003, more than half of $200 million in compensation received 
by the top five executives was EPS related. OFHEO found that 
the message at Fannie Mae was clear: EPS results mattered, not 
how they were achieved.
    Last March, in an SEC filing, Fannie Mae reported 
accounting errors in over 20 separate categories. There is no 
doubt that those accounting errors were in part due to a weak 
and outdated internal control system. It was only in 2005, when 
making certain that the company complied with the section 404 
internal control requirements of the Sarbanes-Oxley Act, that 
Fannie Mae's senior management finally admitted, ``that the 
company's internal control over financial reporting was 
ineffective.''
    The failure of internal controls and the audit function at 
Fannie Mae reinforces a need for the Sarbanes-Oxley Act. In 
fact, if not for Sarbanes-Oxley, I wonder how much of this 
would have come to light at all.
    OFHEO and the SEC imposed one of the largest penalties ever 
paid by an individual company, making Fannie Mae the Enron of 
the financial services industry. $350 million of the $400 
million penalty will go to the Fair Fund, which was 
strengthened and created by the Sarbanes-Oxley Act, and will 
ultimately be returned to investors. The rest goes to the U.S. 
Treasury.
    This report reminds us how crucial it is for Congress to 
approve legislation to strengthen regulations of the GSE's. We 
need to prevent abuses from developing and permit swift 
enforcement if they do.
    In OFHEO's request, Fannie Mae has agreed to cap the growth 
of its mortgage portfolio. I would point out again to those who 
characterize it incorrectly that the House bill gives a new GSE 
regulator clear discretionary authority to require portfolio 
adjustments. OFHEO's action shows why the regulators should 
have the flexibility to respond, not be directed by Congress. 
It is imperative that this new regulator have the authority to 
adjust portfolios as called for under the House-passed Baker 
bill.
    I concur that Treasury possesses the authority to approve 
GSE debt issuances. The 2004 Congressional Research Service 
legal analysis stated, ``If Congress wanted to limit the 
Treasury Department's approval authority, then Congress could 
have done so. Because Congress chose instead to use broad 
language in describing Treasury's authority, it follows that a 
broad interpretation of that authority would likely be judged 
to be reasonable.''
    I understand that the Department of Justice has given 
Treasury a similar opinion. While I endorse the belief that 
Treasury possesses this authority, I do not offer an opinion as 
to whether the Department should use it at this time.
    Congress correctly provided Treasury with broad discretion 
in this area, just as we should do in the area of portfolio 
powers. I only note that the Administration's rhetoric on the 
matter suggests that the matter is urgent. I would like to see 
that sense of urgency find a better outlet than repeatedly 
asking Congress to tie the new regulators' hands on portfolio 
authority.
    If OFHEO's report doesn't motivate our colleagues in the 
other body to act on this legislation, nothing will. Only after 
full Senate action is complete will we be able to work together 
on a conference committee to send the President the GSE bill in 
this Congress.
    And let me say to the chairman of the subcommittee, who had 
been a lone wolf on this issue and alone in the wilderness for 
a number of years, that his hard work, persistence, vision, and 
tenacity have paid off with the revelations in the OFHEO report 
and with the successful passage of his legislation by a large 
bipartisan majority in the House of Representatives. We can 
only hope that the other body will respond in kind.
    And I yield back.
    Chairman Baker. Thank you, Mr. Chairman, for your kind 
words.
    Mr. Frank.
    Mr. Frank. Thank you, Mr. Chairman.
    I have never been a fan of people in our business who 
invoke various ancestors for what always seems to me to be very 
convenient reasons, and I strongly suspect that about 90 
percent of what is attributed to our dead relatives they never 
said but can't defend themselves. But, in this case, I am 
reminded strongly of something I do remember hearing my father 
say.
    He was a man of great charity. And once he got into a major 
dispute with the people who were running the Jewish Community 
Center in town, which was a very important institution, and 
shortly thereafter he made a large donation to them, as was his 
habit. Someone expressed surprise that, after having this 
argument with the people on the board of directors about the 
policy of the institution, he would continue to be so 
supportive, and he said, ``I am not mad at the bricks.''
    And that is my attitude here. I think it is very important 
for us to separate out the individuals and the institutions.
    The chairman of the committee is right. The gentleman from 
Louisiana, earlier than anyone else to my knowledge, saw that 
there were abusive practices being engaged in by individuals 
who were running Fannie Mae. There were also abusive practices 
being engaged in by people running Freddie Mac, and that is 
instructive because the Freddie Mac abuses, having been 
uncovered earlier, we now see there is life after manipulation. 
Because we have today, I believe, with Freddie Mac a good, 
forthright, honorable set of leaders who have managed to rescue 
that institution from a pattern of abuse, excessive 
compensation, and manipulation.
    Clearly, condemnation is in order for those who ran Fannie 
Mae so abusively. What is important is for us to differentiate 
between their behavior, which should be condemned, and the lack 
of constraints which allowed that behavior to go forward and 
the underlying institutions.
    We continue to have in this country a serious crisis in 
housing affordability not just for very low-income people but 
in many parts of the country, including my own, the price of 
housing for people in middle income has gone beyond what it 
should be. So I want to continue to do everything we can not 
just to preserve, but to improve, the ability of Fannie Mae and 
Freddie Mac to help us with housing, as this committee recently 
did with regard to the FHA. They all worked together.
    That is an important point to keep in mind, that we do not 
punish the institution. The institution is not the value here. 
The value here is the housing that is built for people, and it 
is very important that we not do anything that compromises 
that.
    I believe that what OFHEO has done shows the way. OFHEO has 
shown us how you can, in fact, correct the abuses without 
interfering with the mission.
    And I am struck, as the chairman is, by the testimony this 
gives to the legislation we passed. I think much of what we did 
anticipates this, the question of portfolio limits. We clearly, 
in our legislation, foresaw the importance of giving the 
regulator, when it became appropriate because of abuses or 
dangers or problems, to be able to deal with the portfolio. So 
I am very grateful that we have that example.
    And I share his frustration that the Senate is refusing to 
act. There can be no justification for that.
    If people think that the powers of the regulator need to be 
enhanced, I would be willing to listen. I must say I haven't 
heard any suggestion other than kind of automatic restriction 
on the portfolio, but in terms of the powers it doesn't seem to 
me that they have been critiqued with any force.
    One last point. In a perverse way, these events and this 
report are a testimony, I believe, to the underlying strengths 
of Fannie Mae and Freddie Mac. That is--and we have had 
comparisons to Enron and MCI, and, in fact, of the abuses there 
was that kind of abuse. But the abuses at Enron and MCI led to 
collapses of the institutions.
    What is heartening to me here is that the underlying 
structure of Fannie Mae and Freddie Mac, the strength of the 
housing market, the strength of that model, allowed them to 
withstand being misrun--Freddie Mac earlier, Fannie Mae today. 
We have not had a serious problem--for those who say there is a 
terrible drain on the taxpayers, we have seen these abuses and 
the taxpayers were left whole. So I think the lesson of this is 
that we need to do a better job going forward in giving the 
regulator the power to prevent these kinds of abuses from 
happening without in any way endangering or inhibiting the 
housing mission. I think the legislation that we passed that is 
gathering dust somewhere in the Senate is a very good way to 
deal with that.
    And I know the Senate has very pressing business. I know 
the Senate has got to act immediately to prevent me from 
wrecking marriages all over America. Once they have put that 
safely behind them, I hope they will get down to serious 
business.
    Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman, and let me add my 
voice to that of the chairman and ranking member and thank you 
for your great leadership. Since I first came to Congress, 
indeed, you have often been a lone voice in the wilderness in 
trying to bring the disinfectant of the sunshine into the 
activities of the GSE's and ensure that the proper regulatory 
regime is in place to save both the housing markets and the 
taxpayers. I am happy to note, though, that the analogy just 
goes so far, since your head seems to be thoroughly attached to 
your shoulder blades, and I assume that before this process is 
all said and done that there will be other heads that indeed 
roll.
    I also want to thank Mr. Lockhart and OFHEO for the good 
work done, much of it by his predecessor and that team, in 
wading through often complex and arcane issues.
    I suppose what we have today is the end of a 2- to 3-year 
process that for many of us is reinforcing and giving us more 
concrete evidence on what we already know, and that is, for the 
period 1998 through 2004, the company systematically misapplied 
GAAP relating to the amortization of certain fees on its 
securities and their hedge accounting and that this was done at 
the direction of senior management, which led to materially 
false, incorrect, and misleading financial statements that were 
publicly issued and relied upon.
    And I suppose what else is new is, if I read the comments 
of the SEC chairman correctly, I believe that this marks the 
first time that there has been an official designation of 
Fannie Mae's accounting practices as fraud. So, because of 
that, I look forward to hearing more about the end result of 
this report.
    We also know that, Mr. Chairman, we simply cannot turn our 
backs on the systemic risks that are posed by the GSE's. Right 
now, I think what we have is the second largest borrower in the 
world, second only to Uncle Sam himself, an institution holding 
a Federal charter, an asset portfolio worth over a trillion 
dollars, and they can't produce a reliable financial statement 
for the bulk of this decade. That is troubling, to say the 
least.
    So, not unlike our other colleagues, I certainly urge the 
other body to act, and act quickly, on this legislation so that 
we may go to conference and again protect the taxpayer, protect 
the consumer, and protect the housing market.
    With that, I yield back.
    Chairman Baker. I thank the gentleman.
    Chairman Baker. Mr. Royce.
    Mr. Royce. Thank you, Mr. Chairman.
    I guess the upshot is--and let me begin by thanking 
Director Lockhart for appearing before our committee today. But 
I think that what we notice here is that we now have temporary 
portfolio caps to try to do something about this systemic risk. 
But that does not alleviate the need for portfolio authority to 
be in GSE legislation, and I think the OFHEO report highlights 
for us pretty clearly the fact that Fannie Mae did not have 
sufficient controls in place to manage its large and risky 
portfolio. Indeed it is very, very difficult at this--given the 
size of these portfolios, basically, Fannie Mae concocted its 
own accounting rules to cover up the weakness in its ability to 
manage its portfolio.
    So we notice that OFHEO still does not have the power to 
adjust the portfolio levels of the GSE's. They can only do that 
with the permission of Fannie Mae. That is basically what was 
done here. This is not a strong regulatory position to be in, 
and that is the position we will be in unless the Senate 
language passes.
    Even with the agreement between Fannie Mae and OFHEO, we 
should reflect on the fact that the portfolio still stands at 
close to three-quarters of a trillion dollars.
    The reason that bankruptcy is not likely is because of the 
presumption that the U.S. Government will come in and prop up 
and subsidize the GSE's if there are losses.
    The size of this portfolio continues to be a risk to the 
domestic and the international financial system. You know it is 
not just our regulators that are concerned in the United 
States. It is a worldwide concern and has been for some time. 
Without specific guidance to reduce the size of these 
portfolios, OFHEO will continue to be unable to address the 
risks to taxpayers in the financial system these portfolios 
provide.
    Also, the portfolio cap agreed to by Fannie Mae will only 
be in place on a temporary basis. Once Fannie Mae has submitted 
a plan and met the requirements set by OFHEO, they will be 
permitted to go back to growing the portfolio at risky levels, 
and this portfolio cap only applies to one of the GSE's, only 
Fannie Mae. Freddie Mac is not a party to it. Thus, the ability 
to grow the risky portfolio remains, and, thus, the problem 
which we will get to during questions remain.
    But we thank you very much, Director Lockhart, for the 
leadership you have taken on this and your willingness to be 
with us today.
    Chairman Baker. I thank the gentleman.
    Mr. Garrett.
    Mr. Garrett. Thank you, Mr. Chairman, and I also applaud 
you for being the lone voice in the wilderness for so many 
years. Hopefully, you are now among a chorus at this point 
addressing the issue.
    I would just like to say that it seems it is quite a 
coincidence that the very same week that OFHEO delivers its 
report outlining the multiple counts of corporate greed 
committed by the executives of Fannie Mae that the one man who 
so epitomizes for the 21st Century so far, Ken Lay, received 
his guilty verdict in the wake of the Enron scandal. I believe 
that the comparison between Fannie Mae and Enron cannot be 
ignored. Both companies manipulated their financial statements. 
They put our financial systems at risk for the specific intent 
of allowing their executives to make their already fat pockets 
even fatter.
    Now, due to the government benefits enjoyed by Fannie Mae--
and I think this would explain to the ranking member why their 
house of cards remains standing when Enron's do not--and their 
callous and negligent behavior did more than just mislead and 
defraud the investors. It did this at the expense of the 
American taxpayer. This has led former OFHEO Director Falcon to 
suggest that Fannie Mae is, ``the Enron of government on 
government steroids.''
    Furthermore, as Fannie Mae was putting in overtime and 
using a vast amount of their internal resources to hit these 
specific earning targets, they were using less of their 
resources to help accomplish what their mission is, and that is 
to provide affordable low-income and minority housing. This 
means that Frank Raines, Jim Johnson, and the rest were 
enriching themselves at the expense of the Nation's least 
fortunate. They were taking advantage of the exact people that 
the company was chartered to help.
    Now I appreciate you coming here to testify today, and I 
will be asking some questions later on.
    We know that Freddie Mac said last month that it will not 
be providing quarterly financial statements for 2006 until some 
time later next year. This means, honestly, that is up to OFHEO 
to protect the financial markets and the taxpayers from risks, 
because no one else can. No one else will have definitive 
market information about what is going on in that company. They 
will not have the regular market discipline to make sure to 
send signals to it about what is going on.
    Freddie Mac said it would curtail new initiatives because 
of its huge problems. But, at the same time, it said it would 
expand purchases of high-risk, nontraditional mortgages. I will 
ask you, and I will ask you later on, why should OFHEO permit 
either GSE to engage in anything new and potentially risky 
until all the financial information has been made available to 
the public?
    Finally, Mr. Chairman, in 2002, Fannie Mae's duration GAAP 
spiked to 14 months. At that time, Director Falcon said, ``that 
the regulatory process is working as it should.'' In fact, your 
report makes clear that the regulatory process was grievously 
off course, because Fannie Mae took in billions of economic 
losses to bring its interest rates risk back in line. These 
billions were never even noticed by OFHEO until Fannie Mae's 
SEC registration.
    Now I recognize, and other people have already indicated, 
that you have only been on the job for a short period of time. 
I realize that, and it has been a very busy time for you as 
well. But the questions I will be looking for you in the future 
is what can we hear from you today to make sure that nothing of 
this magnitude or scope will ever, ever, ever, happen again 
with either of the GSE's.
    And I yield back, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    It is my pleasure to welcome, I believe for the first time 
to a Congressional hearing in your capacity as acting Director 
of the Office of Federal Housing Enterprise Oversight, to 
testify here today on the agency's findings, Mr. James B. 
Lockhart III. I believe from a review of your resume, however, 
you are, by prior government experience, more than adequately 
qualified to take on this difficult mission, although I suspect 
that this subject matter may even have a few surprises for 
someone as experienced as yourself. So please proceed at your 
leisure.

   STATEMENT OF THE HONORABLE JAMES B. LOCKHART III, ACTING 
    DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

    Mr. Lockhart. Thank you, and good afternoon.
    Thank you, Chairman Baker, Chairman Oxley, Congressman 
Watt, and members of the subcommittee. Thank you for your 
support of OFHEO over the years and for this team that is 
behind me. They are the ones who really put in all the work to 
get this report out. I really welcome the opportunity to 
discuss the findings of our Special Examination of Fannie Mae 
and the settlement agreements.
    As a government sponsored enterprise, Fannie Mae has a very 
special position among American corporations and an extremely 
important mission--facilitating the growth of affordable 
housing in the United States.
    The previous management team, led by Chairman Franklin 
Raines, violated that public trust. By encouraging rapid 
growth, unconstrained by proper internal controls, risk 
management, and accounting systems, they did serious harm to 
Fannie Mae, while enriching themselves through manipulating 
earnings per share. The result was an estimated $10.6 billion 
of overstated profits, well over a billion dollars of cost to 
fix the problems, and ill-gotten bonuses in the hundreds of 
millions of dollars.
    In September of 2004, OFHEO issued an interim report that 
detailed serious problems relating to Fannie Mae's accounting. 
The SEC agreed and ordered Fannie Mae to restate its financial 
statements.
    The just-released Special Examination Report details what 
can only be characterized as an arrogant and unethical 
corporate culture. The image of Fannie Mae as one of the 
lowest-risk and best-in-class institutions was a facade. The 
examination found an environment where the ends justified the 
means.
    The executive compensation program at Fannie Mae focused on 
managing earnings rather than risk. Indeed, Fannie Mae took 
significant amounts of interest rate risk and, when interest 
rates fell in 2002, incurred billions of dollars of economic 
losses. Fannie Mae also had very significant and very large 
operational exposures that were not properly managed. Senior 
executives were managing Fannie Mae in an ``unsafe and 
unsound'' manner. They also co-opted their internal auditors. 
They stonewalled OFHEO.
    During the period covered by this report, Fannie Mae hit 
earnings per share targets with uncanny precision each quarter 
by deliberately and systematically using inappropriate 
accounting and improper earnings management. Senior management 
of Fannie Mae benefited greatly from these manipulations. From 
1998 to 2003, the total compensation of ex-CEO, Franklin 
Raines, exceeded $90 million, of which $52 million was directly 
tied to achieving earnings per share goals.
    This inappropriate ``tone at the top'' spread throughout 
the organization and, in a blatant conflict of interest, the 
head of the Office of Auditing told his staff, in reference to 
Mr. Raines' goal of double earnings per share by 2003, that 
they must have, ``$6.46 branded in their brains.''
    I will now turn to some of their improper accounting and 
controls.
    First, to prevent large, unpredictable earnings 
fluctuations, Fannie Mae chose to implement investments, 
derivatives, and other accounting standards in a fashion that 
reduced volatility while ignoring GAAP.
    Fannie Mae management also went to extraordinary lengths to 
avoid recording and then hiding GAAP required impairment losses 
on assets whose values had declined.
    By keeping earnings within what could be considered a 
predictable range, management was in a position every quarter 
end to manipulate and manage earnings to hit specific targets, 
and they did that through the use of cookie-jar reserves, 
income shifting transactions, and inappropriate debt 
repurchases.
    The report details the conscious decisions made by 
management to use outdated accounting systems and to create a 
weak internal control environment.
    Internal Audit failed to properly confirm compliance with 
GAAP or consistently audit critical accounting issues. 
Similarly, external audits performed by KPMG failed to include 
an adequate review of Fannie Mae's significant accounting 
policies for GAAP compliance, and when they did become aware of 
the non-GAAP compliant provisions, they still continued to 
issue totally unqualified opinions on Fannie Mae's financial 
statements.
    The board of directors is really the last line of defense 
in a company, and they again failed to be sufficiently informed 
and independent. Their oversight failings meant that they did 
not discover, let alone correct, the wide variety of unsafe and 
unsound practices at Fannie Mae, even after Freddie Mac's 
problems became apparent. The Auditing Committee did not 
provide proper oversight of the internal audit function, 
critical accounting policies, and the whistle-blower claims.
    In the report, OFHEO's staff makes recommendations to 
enhance safety and soundness. They recommended that we continue 
to strengthen and expand our regulatory infrastructure and 
regular examination programs and, also importantly, that we 
continue to support legislation to provide the powers essential 
to meeting our mission of assuring safe and sound operations at 
both Fannie Mae and Freddie Mac.
    The recommendations directed to Fannie Mae were 
incorporated into the settlement agreement where we had about 
60 different items we agreed to. Some of the key ones were: 
Fannie Mae agreed to pay a $400 million penalty; Fannie Mae 
agreed to freeze the growth of its portfolio at last year end 
numbers (December 31, 2005); and Fannie Mae agreed to undertake 
a comprehensive reform program aimed at a top to bottom change, 
from its board of directors, internal audit, risk management, 
compliance, external relations, internal controls, accounting 
systems, and data quality. All of those areas need improvement. 
Fannie Mae also agreed to review current and separated 
employees for remedial actions.
    During the joint settlement announcement, as was mentioned, 
Chairman Christopher Cox of the SEC said that, ``The accounting 
fraud charges that the SEC is filing against Fannie Mae reflect 
the failure by Fannie Mae to maintain the kinds of internal 
controls that could have prevented what in all likelihood would 
have been one of the largest restatements in American corporate 
history.''
    Thank you. I am looking forward to working with members of 
this committee, and I would be pleased to answer questions at 
this point.
    Chairman Baker. Thank you, Mr. Lockhart.
    [The prepared statement of Mr. Lockhart can be found on 
page 27 of the appendix.]
    Chairman Baker. I wanted to start off by analyzing the 2002 
and 2003 income periods. That is when they experienced their 
significant negative duration GAAP problem and, to extricate 
themselves, they spent a big amount of money to cancel pay-
fixed swaps that were the cause of the interest rate losses. Am 
I understanding the report correctly, that if the actual 
economic consequences of that period of time were reported 
accurately that the enterprise would have had about a $12 
billion adjustment to its revenue?
    Mr. Lockhart. Certainly, at that point in time, they 
discovered and they thought before the interest rates fell 
dramatically that they didn't have as big an issue as they 
ended up having. We saw--
    Chairman Baker. Let me make it simpler, because my time 
will run quick on me. I have got a lot.
    My point is that, 2002, enterprise suffered an economic 
loss, earnings per share targets were still hit, so maximum 
bonuses were still paid, while shareholder value was depleted.
    Mr. Lockhart. That is correct.
    Chairman Baker. Great. Not great, but that is what I was 
trying to get at.
    In a separate direction, reading from the report in several 
selected areas, Fannie Mae reported extremely smooth profit 
growth, hit earnings per share targets with uncanny precision--
I think you read that earlier. During the period in question, 
1998 through 2003, CEO Raines earned $90 million, of which 52 
was directly tied to earnings per share. It is my understanding 
during the same period, aggregated for the top executives, the 
total compensation--excuse me, total bonus paid was somewhere 
in the neighborhood of $250 million, is that about correct?
    Mr. Lockhart. That is about correct.
    And you are right. That chart over there shows that the 
line is the targets and the blue bars are the reported, and it 
is really uncanny that they could hit those year after year 
after year. And it is because of the quarter to quarter 
accounting gimmicks, and it resulted in very large bonuses in 
the range of several hundred million dollars, tied just to EPS.
    Chairman Baker. In the October 2004 hearing, I asked Mr. 
Raines, prior to the decision being executed to defer the $200 
million in expense at the end of 1998 into the quarters of 
1999, were you consulted or did you have knowledge of the 
transaction?
    Raines' response--there was no decision made to defer any 
expense from 1998 to 1999. Howard can go into greater detail as 
to how the process actually occurs, but we did not make any 
deferral. I was part of a discussion, as I always am as CEO, in 
the closing process in which decisions made in our financial 
area with regard to the calculation of the catch-up provision 
was discussed--that is why he got paid that much; you can't 
understand anything--but the determination of that was made 
through our normal process of closing our books.
    In a separate question, were there any discussions related 
to the consequences of that expense treatment in relation to 
the earnings per share, Raines responds no.
    I asked, then when did you first realize that earnings per 
share would be $3.23? To which he responded, the first time I 
would know what earnings figures would be is when our 
comptroller would have closed the books and done all of the 
analyses necessary to determine what the final results are, and 
then that would be reported to me. That would be after any 
decision that was made in regard to the catch-up provision.
    Now a summary of the facts that we have just gone through 
from your report, your testimony as well today, and then 
reading through the responses of the CEO to this committee, you 
can't make a legal judgment, I understand.
    There seems to be clear evidence in my mind that Mr. Raines 
perjured himself to this committee in answering those 
questions. Would there be any reason for a person to dispute 
that conclusion after listening to those facts and hearing his 
responses?
    Mr. Lockhart. You are right; I cannot make a legal 
judgment. But I think the report, if you read it--and you have 
read it, obviously--does contradict the statements that he 
made.
    Chairman Baker. We will examine that further.
    Some discussion was made earlier today by some members 
relative to portfolio constraint. The bill passed by the House 
does provide authority to the director of the new entity to 
adjust portfolio in any manner. In fact, it is my understanding 
that if the powers conferred in that legislation were given to 
you, you would have the authority, for appropriate reasons, to 
reduce portfolio to zero. Is that a responsive tool that you 
feel is appropriate in light of the current portfolio risk that 
is presented by the enterprises?
    Mr. Lockhart. I believe that there is significant risk 
provided by these portfolios, when you add the two of them 
together, about $1.5 trillion, half and half now, from the two 
companies, and it is an issue that really does have to be 
looked at.
    When we froze the portfolio as part of the agreement, that 
was really based on their continuing internal controls, lack of 
risk management, and lack of accounting systems. It did not 
address the issue of systemic risk and operational risk and, I 
think if you are going to look at these companies, you have to 
include that in their capital calculations and how that might 
impact their portfolios.
    Chairman Baker. I am out of time, but one quick follow-up. 
What other tool should be given a regulator to address this 
problem other than the discretionary authority to reduce, 
increase, or leave alone the size of the portfolio?
    Mr. Lockhart. The whole legislative package passed by the 
House would be very helpful to give us a whole series of tools 
to make us a better safety and soundness regulator. We don't 
have the comparable tools that the banking regulators do. We 
need receivership. We need not to be appropriated. We need a 
whole series of tools that will make us a stronger regulator.
    Chairman Baker. Thank you.
    Mr. Watt.
    Mr. Watt. Mr. Lockhart, I want to focus on the remedial 
agreements that you all have reached with Fannie Mae as part of 
the agreement to move forward, not because I am concerned about 
the provisions of them, but because I am concerned about the 
understanding, and knowing the impact of them.
    If you take the combination of the growth limit, limiting 
portfolio assets to the level as of December 31, 2005, and the 
capital restrictions previously agreed requirement for a 30 
percent capital surplus, can you tell us what the impact of 
those two in combination will have on the housing mission of 
Fannie Mae? Has OFHEO made any assessment of that?
    Mr. Lockhart. We have certainly looked at the issue and, 
from our standpoint, we do not see an impact. There is enough 
capital there certainly to continue the mortgage-backed 
security packaging that it does.
    On the portfolio side, they certainly have assets that can 
be sold as they want to acquire new assets, and that is really 
what will happen over time. They will sell some assets off, 
place them in the marketplace, and use the money to invest in 
new assets.
    Mr. Watt. So your testimony is that from your perspective, 
OFHEO's perception, there will be no adverse impact on the 
housing mission from those things?
    Mr. Lockhart. For the housing mission, and especially the 
affordable housing mission, I see no impact. They obviously 
have a lot of work to do in those areas and continue to do 
work, but these two things should not interfere with that.
    Mr. Watt. Focusing further on the part of the agreement 
related to personnel, I am wondering how you--how OFHEO will 
assess--how will you define success, so to speak, in there is a 
part of the agreement that says, Fannie Mae's board must have a 
third party review of Fannie Mae's government and industry 
relations programs, and adopt a plan for setting new policies 
and controls on lobbying efforts.
    How would you assess the effectiveness of that? I mean, are 
there criteria that you would use in evaluating the board's 
performance in that regard going forward, or will this be 
solely up to the board to make those determinations?
    Mr. Lockhart. Certainly in that case we will look at the 
review and discuss it with the board and the management team 
and we will do that with many of the other proposals in the 
agreement. The board of directors is responsible for the 
oversight of this company and we are responsible as a safety 
and soundness regulator. Because the company has so many unsafe 
and sound practices at the moment, let alone in the past, we 
are very, very actively involved in this company, and I might 
add also in Freddie Mac from that standpoint because they also 
have continuing unsafe and unsound practices. Both of these 
companies are probably several years away from having adequate 
accounting internal controls, so we are going to be involved in 
the discussion, and in particular in this review of the 
government relations area. We will look at the review and make 
sure that they don't re-engage in unsafe and unsound practices.
    Mr. Watt. I am about to run out of time. So I don't mean to 
cut you off. I wish I had more time to allow you to elaborate, 
but it sounds like there is some subjectivity involved in this 
on the board's part and on your part and that's fine. I am not 
being critical. I'm just trying to figure out what--how you 
will define success.
    Let me focus on one other area and that's the $400 million 
penalty and the use of that for the benefit of--I mean, who 
gets the benefit of that, and I guess the related question is, 
is there a legal mechanism in place now for shareholders who 
may have been adversely affected to get redress?
    Mr. Lockhart. Of the $400 million, $50 million went to the 
U.S. Treasury and it's a monetary penalty provided under our 
law. The Sarbanes-Oxley law provided for the shareholder funds 
and in consultation with the SEC, we agreed that it made a lot 
of sense to put it there. The SEC will be setting up rules 
related to the fund.
    Mr. Watt. But is there a shareholder right of action here 
or is there--
    Mr. Lockhart. There are already shareholder suits going on 
and, as I understand it, I believe potentially some of this 
money could be used to settle those suits.
    Mr. Watt. But does this cap--
    Mr. Lockhart. This does not.
    Mr. Watt. Okay. I appreciate it, Mr. Chairman. I yield.
    Chairman Baker. The gentleman's time has expired. Chairman 
Oxley.
    The Chairman. I would say to my friend from North Carolina 
that the Fair Fund was set up in Sarbanes-Oxley Act to be a 
receptacle for fines and disgorgement. That money is now 
accumulating in the billions.
    Chairman Baker. Seven.
    The Chairman. $7 billion plus, which will then be returned 
on a pro rata basis to shareholders who were injured. A lot of 
people don't like Sarbanes-Oxley. I think most people like that 
part of it, particularly if you are a shareholder and you lost 
your shirt.
    Let me ask a couple of questions here, Mr. Lockhart. On the 
executive compensation issue in the chart that was provided by 
Chairman Baker, the earnings or the executive compensation 
based on earnings per share and the bonuses thereon, Senator 
Rudman's testimony and his committee investigating could only 
cite 1 year--that was 1998--where they could conclusively say 
that those earnings were manipulated. Your report is very clear 
that 8 years, why this difference? Why is yours so definitive 
in covering an 8-year period and Senator Rudman's just 1 year?
    Mr. Lockhart. First of all, I would say that our team did a 
great job, and as a government regulator we had more incentive 
to really go in and really get the details. If you read the 
report, it is very clear by year to year that there was 
manipulation of the earnings. Some years they were looking in 
the cookie jar to make earnings higher, other years they were 
doing financial transactions and other things to hide earnings 
for 1 year and push it out in the future. It is hard for me to 
speculate why the reports are different except to say that I 
believe that our team really did a good job and went thoroughly 
through the accounting issues.
    The Chairman. You also mentioned that the auditors had been 
co-opted and could you help us with that? How did that happen?
    Mr. Lockhart. The internal auditors in particular were 
being paid and had bonuses related again just to EPS.
    The Chairman. So you are referring to internal auditors?
    Mr. Lockhart. That is what I am referring to and I read the 
statement about the $6.46 target and that was the 5-year bonus 
target and every member of Fannie Mae's team got a bonus 
related to that. So the internal auditor in that speech where 
he talks about that and thanks Frank Raines for doing it for 
him, is a total conflict of interest.
    The Chairman. The Enron case was just concluded with 
convictions, WorldCom and many of the others had a common 
thread, and that was they were described, I think accurately, 
as accounting scandals. At the heart of this, this was really 
an accounting scandal too, is it not?
    Mr. Lockhart. Yes, it was. And there is another similarity. 
These two firms were many times thought of as the best in their 
class and, to a certain extent, I think that the management 
team started to believe that, and believed that they could 
almost walk on water and maybe they didn't have to pay 
attention to the accounting rules.
    The Chairman. The legislation that passed the House, and I 
can characterize it a little bit with a--I think, a clear 
memory. When Chairman Baker started this quest, I think it is 
safe to say that he felt, first of all, that he had about 2 
votes. But secondly, he had a vision to create a world class 
regulator. And we have had discussions with that. I think at 
that time, given the political realities, Chairman Baker felt 
that if we could restructure the regulatory function that that 
would be a big win. Since that time and events that have moved 
in that direction, we passed legislation on a bipartisan basis 
to allow the new world class regulator to determine minimum 
risk base capital standard review and adjust portfolio 
holdings, approve new programs and business activities, mandate 
prudential management and operational standards, take prompt 
corrective and enforcement actions, put a critically 
undercapitalized GSE into receivership, which was very 
controversial not too many months ago, and require corporate 
government improvements, higher examination of accounting 
experts.
    Pretty comprehensive in my estimation dealing with the 
problem at hand and, besides all of that, they have to comply 
with Sarbanes-Oxley requirements for establishing internal 
controls and in defining risk, and that is a pretty effective 
package, it seems to me. I just wondered if you would just 
comment again in a global sense about how this legislation that 
passed, the Baker bill that passed the House along with the 
requirements of section 404 and Sarbanes-Oxley worked together 
to hopefully prevent, because after all we can punish all we 
want but at the end of the day when investors lose money and 
people's lives are destroyed, it is great, maybe that they can 
feel good about some executive going to jail but at the end of 
the day they would rather have their money back, and if we 
could prevent this kind of activity from happening in the first 
place with the Baker bill combined with the internal control 
provisions of Sarbanes-Oxley, seems to me we got a pretty good 
package.
    Mr. Lockhart. My belief is if 8 years ago we would have had 
Sarbanes-Oxley and a stronger regulator, which your bill, and 
Chairman Baker's bill does, it would have been very, very 
helpful. There is the issue, I think, that needs to be stressed 
as to how the regulator sets the capital limits related to 
portfolio levels and other issues, but my view is that it is a 
very excellent start and we would be a lot better off today if 
we had had it.
    The Chairman. Thank you, Mr. Chairman.
    Chairman Baker. Mr. Hensarling.
    Mr. Hensarling. Thank you, Mr. Chairman.
    Mr. Lockhart, I am curious to know what your decisionmaking 
process is going to be as far as unfreezing Fannie Mae's 
ability to increase the size of their mortgage portfolio 
assets. Specifically, I am sure you are familiar with the fact 
that the former chairman of the Fed, Alan Greenspan, was quite 
outspoken on the issue of the purpose of the GSE's holding 
their own securities. In fact, in a speech he delivered roughly 
a year ago, if I can quote, ``the key activity of the GSE is 
the provision of liquidity to the primary mortgage market can 
be accomplished exclusively through the securitization of 
mortgages''; GSE portfolios of mortgage-related assets cannot 
serve this function. To sell mortgage-backed securities to 
purchase other mortgage-backed securities clearly adds no net 
support to the mortgage markets.
    So again, the former chairman of the Fed was quite 
outspoken on this issue, and so I am curious, number one, 
whether you agree with that assessment. If you don't agree with 
that assessment, what is the thinking behind when you would 
permit Fannie Mae to increase its mortgage portfolio?
    Mr. Lockhart. Certainly I have read the testimony by the 
chairman and obviously everybody respects what he has to say. I 
have been in the job just a little over a month now, and most 
of it has been, at this point, related to the Fannie Mae 
report. So I haven't had a lot of time to really get my hands 
around how you set up capital for systemic risk. I know a lot 
about how you set up capital for operational risk, and those 
are two of the things we must think about when we are setting 
limits on portfolios or at least reserving capital against 
those limits.
    As for the freeze that Fannie Mae agreed to, we said in the 
agreement that there is a way to get some flexibility once they 
give us a report in a couple of months. There are a lot of 
requirements. The risk management, liquidity, housing policy, 
and internal controls would really be the concerns and frankly, 
if legislation is passed, you know, the limits may be 
superseded by something else. Certainly market concerns would 
be another issue. We have given the company guidelines, but we 
have also told them that it is really at the discretion of the 
regulator when those will be lifted, and frankly it is hard to 
see a total removal of limits for several years.
    Mr. Hensarling. In your testimony, you talk about former 
chairman and CEO Franklin Raines violating a trust. You speak 
of earnings manipulation, you speak of ill gotten bonuses, and 
you speak of an arrogant and unethical corporate culture. If I 
read your testimony properly, though, I didn't see the term, 
``fraud,'' although I have seen that used by SEC Chairman Cox, 
who claims that these activities consist of accounting fraud. 
Is this a mere manner of semantics or should I be reading 
something into the fact that your testimony does not include 
the word, ``fraud''?
    Mr. Lockhart. Maybe a little semantics. It may be that the 
SEC is more the keeper of the word ``fraud'' than we are as a 
safety and soundness regulator.
    Mr. Hensarling. In your testimony you also state that the, 
``goal of senior management was straightforward to force OFHEO 
to rely on the enterprise for information and expertise to such 
a degree that Fannie Mae would essentially regulate itself.'' 
So we are--did you believe that Fannie Mae was trying to 
regulate you or were you trying--was it the other way around?
    Mr. Lockhart. That goes back into the history well before I 
arrived. If you look at some of the indicators, the agency was 
incredibly underfunded 6 years ago. It may have been under-
skilled as well. It was hard to build up the culture and the 
money to really to be a first class regulator. As you all know, 
Fannie Mae was an extremely strong agency. The corporation had 
very strong lobbying activities and other things that I think--
and again I wasn't there but I have heard--really made it very 
hard for OFHEO to do the job it should have been doing. The law 
needs to be strengthened too.
    Mr. Hensarling. Though I had other questions, my time has 
expired. I am not a subcommittee chairman, so I can't go on.
    Chairman Baker. Point well taken.
    Mr. Royce.
    Mr. Royce. Thank you, Mr. Chairman.
    Mr. Lockhart, in the President's Fiscal Year 2007 budget, 
the Administration calls for the creation of, in its words, a 
GSE regulator with new and explicit authorities currently not 
possessed by the agency. You have been nominated in this case 
to lead, which is OFHEO. And the budget outlines the systemic 
risks to the financial system posed by, as it explains, the 
GSEs' large holdings of mortgage-backed securities. In order to 
mitigate these risks, the President has called for Congress to 
instruct, ``a new GSE regulator that asset portfolios are a 
significant source of systemic risk and should be limited by 
the GSE regulator accordingly.''
    In the Administration view, ``mitigating systemic risk 
requires taking action before a crisis occurs.'' And that a 
regulator, in their words, limited to consideration of safety 
and soundness and risk may not fully consider potential 
consequences to others in the mortgage markets and the larger 
economy, which is along the lines of some of the issues you 
raised with regard to systemic risk and operational risk and 
not having the power to the receivership authority and so 
forth.
    But clearly from what the Administration says, it believes 
that Congress should grant the new regulator statutory 
authority to address both safety and soundness and systemic 
risk. Now in Congress, the House has passed legislation that 
deals with part of this. We deal with the safety and soundless 
regulation, in my view, whereas, the Senate Banking Committee 
has passed legislation that would allow the new regulator to 
address systemic risk by giving clear and unambiguous guidance 
to the new regulator about the size and composition of the GSE 
portfolios along the lines that our Fed regulators have talked 
about. So in essence, the Senate bill would anchor the GSE 
portfolios to their public mission.
    As the acting Director and likely future Director of OFHEO, 
I would like to know if you prefer the House legislation or if 
you agree with the Administration and prefer the Senate Banking 
Committee legislation. That is what is on my mind.
    Mr. Lockhart. First of all, I agree with this committee, 
and the Senate committee, and former Chairman Greenspan, that 
there is very significant systemic risk, and it is not just the 
assets. It is the liabilities, it is the borrowing, and it is 
the derivatives that tie it all together, and between those 
three things, there is a giant exposure to the world economy, 
and if things went wrong, there could be a very large impact.
    Systemic risk has to be addressed. I believe that the 
regulator must address it, and I believe that it would be 
helpful to give some guidance on that, that we need to address 
the systemic risk and, as I say, also operational risk in a 
more broad based way than we have in the past.
    Mr. Royce. I thank you, and I yield back.
    Chairman Baker. The gentleman yields back. Mr. Davis. I am 
sorry. Mrs. Kelly.
    Mrs. Kelly. Thank you, Mr. Chairman.
    Mr. Lockhart, the Subcommittee on Oversight held a hearing 
last year in which it was revealed that Fannie Mae had 
deliberately withheld information from the United States 
Government about fraudulent mortgages.
    I quoted the Inspector General of HUD here. He said Fannie 
Mae did not pass information on First Beneficial's 
transgressions to others, allowing First Beneficial to issue 
more than $7.5 million in fraudulent loans ensured by 
taxpayers.
    In response to that hearing, I have worked with a number of 
my colleagues to include in H.R. 1461 legislative language 
requiring Fannie Mae to report fraudulent transactions to a 
third party--by a third party rather--to OFHEO's successor 
agency, which is the Federal Housing Finance Agency. I 
understand that your agency has now taken regulatory steps to 
accomplish that goal and is working with FinCEN so Federal 
housing enterprises will no longer occupy a unique position, 
not being accessible to the Federal agencies that are fighting 
money laundering or terrorist finance, and I wonder if you will 
please explain to the committee your thoughts on what happened 
in the First Beneficial case, how it ties in to the corruption 
that was shown in the Rudman report and what your agency is 
doing to ensure that every one of the people involved in this 
case who failed to act as good corporate citizens, in the words 
of the HUD Inspector General, are not allowed to work at a 
regulated enterprise.
    Mr. Lockhart. The First Beneficial case was extremely 
unfortunate and I think it does show some of the arrogance of 
Fannie Mae and as this was done, I think, out of the Atlanta 
office, it was further down the organization. We obviously got 
involved. We worked with the company and the company, I 
believe, paid us a $7 million fine. The person who was the lead 
on this was reprimanded. But as you pointed out, and I think 
more importantly going forward, we will now be reporting 
mortgage fraud to FinCEN and we are continuing to work with 
other government agencies to try to prevent things like this 
from happening in the future.
    Mrs. Kelly. I appreciate that, but I want to go back to the 
idea that someone who has essentially committed fraud in a 
government agency is then allowed to go on and work at another 
government agency that is a regulated agency. Is there any kind 
of step being put in place to prevent people from moving from 
job to job?
    Mr. Lockhart. At this point, I am not really sure of the 
details of that. I thought this individual was actually working 
at Fannie Mae. But I can tell you that, in some cases, we can, 
and have, exercised debarment, which is effectively what you 
are talking about in the Fannie Mae case, and Frank Raines and 
CFO Howard had been debarred as part of our agreement and, yes, 
we can do that if these situations reach that proportion.
    Mrs. Kelly. Thank you very much. I have one other question. 
I want to know if you think that OFHEO's risk-based capital 
rule needs revision.
    Mr. Lockhart. OFHEO's risk-based capital rule is useful but 
it is really just a stress test in my mind, and coming out of 
the insurance and banking industries, and having worked 
actually at a leading firm that was a risk management firm for 
4 years, my view is that it needs a lot of work. We need to--
and hopefully part of the legislation will give the agency the 
power to do that--start looking at how to set up a best in 
class, if I can use that phrase, enterprise risk management 
risk-based capital standard.
    Mrs. Kelly. I would hope that you would work diligently to 
do that. I think that is an oversight piece that needs to be 
done, and I am glad you are willing to jump in and help. Thank 
you very much.
    I yield back, Mr. Chairman.
    Chairman Baker. I thank the gentlelady. I have a few 
follow-up questions.
    First on the gentlelady's comment, legislation pending 
provides explicit authority for the Director to engage in a 
whole set of binocular observations and microscopic analysis, 
so I think we have got you well-tooled.
    Going back to the portfolio discussion because that really 
is where we are today, is the linchpin on being able to get a 
legislative remedy moving forward. I would not suspect, but I 
have to ask, that you would have today a methodology nor a 
dollar figure in mind to which portfolios would be reduced if 
you are confirmed and if legislation grants you by whatever 
mechanism the authority to reduce. Or would that rather be 
something arrived at by some counsel study with staff over some 
period of time?
    Mr. Lockhart. Certainly not a dollar figure because I am 
not sure a dollar figure is the right way to go. I think there 
is a methodology and we have to look at the methodology.
    Chairman Baker. You don't have that in your pocket?
    Mr. Lockhart. I do not have a methodology especially for 
systemic risk. I may have a methodology from operational risk 
given my background. I basically believe that we need to do 
further study and we are starting to do that kind of study.
    Chairman Baker. That is the reason for my question, to get 
to that study conclusion because whether it was Secretary Snow 
or other financial regulators, no individual has yet 
recommended a particular target or a particular formula by 
which you get to a target, but rather some sort of studied 
approach. The bill now pending does provide and I want to 
address--Mr. Royce has stepped out--but for the record, the 
study requires the new Director over a period of 12 months to 
assess a general description of portfolio, a description of the 
risk implications, an analysis of the portfolio for safety and 
soundness purposes, which everybody points to, analysis of 
whether the holdings fulfill the mission purposes, which is not 
often mentioned, an analysis of the potential systemic risk, 
which has been missed on occasion, for the enterprises, for the 
housing and capital markets and for the entire U.S. financial 
system. So it is a very broad-based risk assessment strategy 
and coupled with that is the clear mandate to reach a 
conclusion and report as to whether those portfolios should be 
reduced, limited in growth. Whatever conclusion that is 
appropriately to be reached we specifically--specifically and 
intended to leave out the word, ``grow'' or ``enlarge'', so the 
bias in the bill as it stands is to give the new Director the 
tool to say within 12 months you got to, and here are the 
guidelines which you must utilize, and come back with a reason 
why, and a method to get to a specific target.
    We also, on the subject of capital, had very intentional 
language on page 56 of the bill pending, notwithstanding the 
capital classifications of the enterprise, that the Director by 
order may require, and goes on with a bunch of things. Today 
they have to be significantly capital-impaired in order for you 
to take certain actions. As I understand it, the basis on which 
the consent agreement was reached with Fannie Mae was 
principally leveraged by the uncertainty of their financial 
conditions because of the inability to certify financials. 
Therefore, you could then, as Director, enter into negotiations 
and reach an agreement, which ultimately was signed, leveraged 
by the underlying financial uncertainty. If Freddie Mac's 
financials were not certified, you could impose the portfolio 
limit on them at this time, utilizing that same ability, that 
legal leverage. But as I understand it, the agency has found 
Freddie Mac's financial condition at this time is sufficiently 
well to certify therefore that you are not in a regulatory 
position to engage in a portfolio limit as you did with Fannie 
Mae, is that correct?
    Mr. Lockhart. Not necessarily.
    Chairman Baker. Okay.
    Mr. Lockhart. Freddie Mac is still years away, at least 2 
years away, from really having acceptable accounting and 
internal controls and a risk management system.
    Chairman Baker. That being the case and that was the 
leverage point which you entered into the discussion with 
Fannie Mae and reached a consent agreement which limited the 
growth of portfolio, what is the regulatory impairment to doing 
a similar strategy with Freddie Mac because I am an equal 
treatment GSE guy? I believe whatever you do to one you should 
do to both. Is there any impairment in your ability to enter 
into a consent agreement for that purpose?
    Mr. Lockhart. Again, we can enter into a consent agreement 
if they consent and, because the law is not as strong as we 
would like, it may be difficult if they didn't consent. The 
chairman of Freddie Mac mentioned that, I believe last week, in 
a press conference he did mention that we have discussed the 
idea that there should be some sort of freeze there as well. 
And, frankly, it is not that well known but over the last 3 or 
4 years, Freddie Mac has grown its portfolio by 20 percent, 
while Fannie Mae has shrunk its portfolio by 20 percent. So 
there is an issue there that we are considering, but I can't 
say at this point whether we are going to do anything about it 
or not.
    Chairman Baker. If you fail to act on that point, it will 
not be due to a regulatory impairment to act, it will be a 
question of whether or not it is appropriate to act?
    Mr. Lockhart. I believe that is correct, yes.
    Chairman Baker. Mr. Watt.
    Mr. Watt. I chose not to focus on the shortcomings of OFHEO 
because I think everybody is aware that there was a period of 
time, for whatever reason, that OFHEO was being duped just like 
the internal auditors and the external auditors were being 
duped.
    I want to get your assessment generally of how much better 
equipped OFHEO is now. I mean, are you confident that OFHEO has 
the capacity currently, and the resources currently, to do what 
the current regulatory scheme allows you to do, as well as what 
both the House and Senate bills might allow OFHEO to do in the 
future?
    Mr. Lockhart. Certainly we would like a bill, and that will 
give us some of the strength that we need to be the safety and 
soundness regulator we should be. We want to work with 
everybody and make that happen. On the resource side, we were 
significantly under-resourced. Over the last 6 or 7 years, we 
probably tripled the number of people in our budget. We have 
added some really good people, some very professional people. 
We are going to need to continue to hire people. We are going 
to continue to need to do training and we are going to need to 
have to have occasionally a team that we can put in the field 
very quickly if there is a crisis, which then speaks to getting 
outside the appropriations process which this bill does.
    Mr. Watt. I am not sure you answered my question.
    Mr. Lockhart. I guess the answer is yes, we have a very 
good team. I think we can build on this team and continue to 
get better and better, but we do need legislation to really get 
us to where we want to be.
    Mr. Watt. Thank you, Mr. Chairman.
    Chairman Baker. I thank the gentleman.
    Mr. Lockhart, some of us have said they are paving the way 
to home ownership. Nobody had ever in mind it would be an 
interstate system to go from coast to coast to get us to final 
resolution on this manner. I appreciate very much, and all 
members of the committee do, your participation here today, but 
it is a very long road. We have a long way to go. We look 
forward to working with you as Director in the coming months.
    Mr. Lockhart. I thank you and I look forward to working 
with you.
    Chairman Baker. Our meeting stands adjourned.
    [Whereupon, at 3:20 p.m., the subcommittee was adjourned.]
                            A P P E N D I X


 
                              June 6, 2006


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