    [Senate Hearing 109-1057]
    [From the U.S. Government Publishing Office]

                                                           S. Hrg. 109-1057

           THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF FANNIE MAE

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

                                    HEARING

                                   before the

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

                           ONE HUNDRED NINTH CONGRESS

                                 SECOND SESSION

                                       ON

    THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF THE WIDESPREAD PROBLEMS
                             PRESENT AT FANNIE MAE

                                   __________

                                 JUNE 15, 2006

                                   __________

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

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

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                COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                      RICHARD C. SHELBY, Alabama, Chairman

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

                 Kathleen L. Casey, Staff Director and Counsel

         Steven B. Harris, Democratic Staff Director and Chief Counsel

                             Mark Oesterle, Counsel

                     Peggy Kuhn, Senior Financial Economist

               Mark A. Calabria, Senior Professional Staff Member

                     Dean V. Shahinian, Democratic Counsel

                 Jonathan Miller, Democratic Professional Staff

                     Lynsey Graham Rea, Democratic Counsel

       Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                           George E. Whittle, Editor

                                      (ii)

                                C O N T E N T S

                                  ----------

                            THURSDAY, JUNE 15, 2006

                                                                       Page

    Opening statement of Chairman Shelby.............................     1
        Prepared statement...........................................    71

    Opening statements, comments, or prepared statements of:
        Senator Dodd.................................................     3
        Senator Bennett..............................................     4
        Senator Sarbanes.............................................     4
        Senator Allard...............................................     5
        Senator Reed.................................................     6
        Senator Hagel................................................     7
        Senator Stabenow.............................................     8
        Senator Sununu...............................................     9
        Senator Dole.................................................    11
            Prepared statement.......................................    72
        Senator Martinez.............................................    12
        Senator Carper...............................................    27
        Senator Schumer..............................................    31

                                   WITNESSES

    James B. Lockhart III, Acting Director, Office of Federal Housing
      Enterprise Oversight...........................................    13
        Prepared statement...........................................    72
        Response to written questions of:
            Senator Hagel............................................    89
            Senator Crapo............................................    96
            Senator Martinez.........................................    97
    Christopher Cox, Chairman, Securities and Exchange Commission....    15
        Prepared statement...........................................    77
        Response to written questions of:
            Senator Hagel............................................   101
            Senator Martinez.........................................   104
    Stephen B. Ashley, Chairman of the Board of Directors, Fannie Mae    38
        Prepared statement...........................................    79
        Response to written questions of:
            Senator Hagel............................................   109
            Senator Martinez.........................................   113
    Daniel H. Mudd, President and CEO, Fannie Mae....................    40
        Prepared statement...........................................    81
        Response to written questions of:
            Senator Hagel............................................   117
            Senator Crapo............................................   123
            Senator Martinez.........................................   131

                                     (iii)

           THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF FANNIE MAE

                                  ----------

                            THURSDAY, JUNE 15, 2006

                                           U.S. Senate,
              Committee on Banking, Housing, and Urban Affairs,
                                                        Washington, DC.
        The Committee met, pursuant to notice, at 10:33 a.m., in
    room SD-538, Dirksen Senate Office Building, Senator Richard
    Shelby (Chairman of the Committee) presiding.

            OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Chairman Shelby. The Committee will come to order.
        This morning, the Committee will conduct an oversight
    hearing on OFHEO's report on the special examination of Fannie
    Mae. The report provides an unfortunately familiar story of a
    company plagued by fraudulent accounting practices, inadequate
    internal controls, and failed corporate governance.
        OFHEO's report provides great detail on the widespread
    problems present at Fannie Mae. Congress, as we all know,
    chartered Fannie Mae to serve an important public purpose: that
    is, to build a strong and vibrant secondary market to
    strengthen our nation's housing finance system. In the hundreds
    of pages of OFHEO's report, we do not read about the noble
    mission of making homeownership possible for more Americans.
    OFHEO's report clearly proves that Fannie Mae has lost focus on
    its mission. It appears that their primary business mission
    was, in fact, to engage in earnings management in order to
    yield maximum possible executive compensation.
        This is a company whose management developed an obsession
    with achieving performance targets, with little else seeming of
    consequence. In fact, so great was this obsession that the head
    of the Office of Auditing, ostensibly charged with ensuring
    accurate financial reports, was instead preaching Chairman
    Raines' goal of doubling earnings per share, telling his staff
    that they must have $6.46 branded in their brains, $6.46
    branded in their brains. That even the audit staff was so
    compromised, one can only conclude that greed served as the
    sole force driving management's behavior.
        It is also clear that more than one check on corporate
    misbehavior failed. The lack of attention and investment by the
    company in systems, internal controls, and risk management
    should be an embarrassment to this company, including the Board
    of Directors. The report also calls into question the role of
    the external auditor and the independence of the internal audit
    process.
        The themes of this report should certainly resound in the
    ears of the Committee Members. This is certainly not the first
    time that we have heard of them. The overstatement of earnings,
    the lack of transparency, the inattention of the Board of
    Directors, and the near-record settlement with the Securities
    and Exchange Commission would pose a threat to the viability of
    many a private corporation.
        Yet, there is one very tangible difference in the Fannie
    Mae story, and this difference is critical to our consideration
    of any regulatory reform proposals. Unlike other companies,
    which were felled by corporate misdeeds, Fannie Mae continues
    to operate in the capital markets as if nothing has happened.
    Wall Street analysts have not clamored to downgrade Fannie Mae
    debt, and the company continues to issue significant volumes of
    debt that domestic and international investors remain eager to
    buy and to hold.
        These market conditions should make clear to the Congress
    that market discipline plays little if any role in policing
    Fannie Mae and by extension Freddie Mac. Because of the
    perception that these entities are implicitly backed by the
    Government, it is clear that we cannot count on the normal
    private market mechanism to temper the risk taking behavior of
    the GSEs. The GSEs' creditors have little incentive to pay
    attention until the point where irreparable harm has occurred,
    corrections are impossible, and the thin levels of capital have
    evaporated.
        In other cases where the behavior of companies such as
    Enron, WorldCom, and others were egregious, this Committee
    acted to change the ground rules. We took vigorous action to
    protect the investors from similar behaviors in the future. The
    question now is how do we go about doing this for the GSEs? We
    must be mindful of the fact that these companies do not operate
    under the same set of rules that apply to other private
    companies. Thus, part of our regulatory effort must address the
    fact that market discipline is not present. For this reason, we
    must be sure that the regulator has the necessary authority and
    guidance from Congress to ensure that the GSEs stay focused on
    their mission, while minimizing their ability to take advantage
    of their special status by abusing their charter.
        For our first panel today, we welcome two distinguished
    witnesses: Mr. James Lockhart, Acting Director of the Office of
    Federal Housing Enterprise Oversight, which we call OFHEO; and
    Mr. Christopher Cox, Chairman of the Securities and Exchange
    Commission. For our second panel, the Committee will hear from
    Mr. Daniel Mudd, Chief Executive Officer, Fannie Mae; and Mr.
    Stephen Ashley, Chairman of the Board of Directors of Fannie
    Mae.
        I thank all of you for being here today to discuss some of
    these disturbing findings recently released by OFHEO. The
    Committee did invite two additional witnesses for the hearing
    this morning. We extended an invitation to Mr. Franklin Raines,
    the former Chief Executive Officer and Chairman of the Board of
    Fannie Mae. On the advice of his counsel, he has chosen not to
    appear, and I would like to include the response we received
    from his attorney in the record this morning.
        The Committee also believes that it would be useful to hear
    from other members of the Board of Directors. OFHEO's report
    highlights the failure of the Audit and Governance and
    Compensation Committee of the Board of Directors. We did invite
    Mr. Thomas Gerrity, who headed the Audit Committee for a number
    of years, but he had a prior commitment and could not attend
    today.
        We believe that it will be necessary to hear additional
    views from the Board members and perhaps from other entities,
    such as S&P, who rated Fannie Mae so highly on corporate
    governance less than 2 years ago. We will schedule this hearing
    as expeditiously as possible, and without objection, the letter
    from Franklin Raines' attorney, Mr. Kevin M. Downey's letter to
    me as Chairman of the Banking Committee advising that Mr.
    Raines would not testify will be made part of the record.
        Senator Sarbanes. Mr. Chairman----
        Chairman Shelby. You want to defer to Dodd?
        OK; Senator Dodd.

                 STATEMENT OF SENATOR CHRISTOPHER DODD

        Senator Dodd. Well, thank you, Mr. Chairman, and I thank my
    colleague from Maryland. I will be very, very brief in these
    opening comments.
        First of all, thank you, Mr. Chairman for holding these
    hearings and the timeliness of them as well and for our
    witnesses who will be testifying before us this morning. The
    abusive practices detailed in this nearly 350-page report are
    both disturbing and incredibly disappointing, to put it mildly.
    It is difficult to completely absorb the significant accounting
    irregularities, the pattern of earnings management, and the
    clear intent of enriching certain employees, widespread
    corporate governance failures, and the total failure of both
    internal controls and external oversight.
        I view the measures taken by OFHEO in ensuring capital
    adequacy and safety and soundness of Fannie Mae to be wholly
    appropriate, and I commend the staff of OFHEO and you, Mr.
    Lockhart, for the work done by you and the people who worked
    with you on this effort. It is extremely important. I would
    also like to commend Chairman Cox, Christopher Cox, and his
    staff for their contributions to this effort as well, and we
    are anxious to hear your thoughts this morning.
        In the consent decree, OFHEO and the SEC have provided a
    very clear set of directions to Fannie Mae and its Board to
    change the way that they do business, and it is my hope that
    these changes have already begun. And I probably should have
    said this at the outset, Mr. Chairman. I think we want to keep
    the distinction between the underlying purpose originally
    intended for these GSEs and the tremendous contribution they
    make to a very critical component of our economy, and that is
    in housing: the fact that 70 percent of adult Americans today
    own their own home, in no small measure, it is due to the work
    supported by these GSEs.
        But confusing purpose with practices here, and what is at
    stake is the very point I just made: that if these GSEs do not
    start operating correctly, we may see the loss of this critical
    component to our economy. I am very worried about that. I know
    there are others who frankly have an underlying problem with
    the whole notion of Fannie Mae and Freddie Mac. I do not. I
    have deep concerns about what has occurred here, but I would
    hope in our analysis of this, we do not destroy critical
    components of the housing industry as a result of our efforts
    here to clean up a very, very big and sloppy mess, to put it
    mildly.
        So to you, Mr. Lockhart, and your staff, I commend you
    immensely, but I hope, Mr. Chairman, in the process of working
    through this, we do not destroy the critical component that
    these GSEs can play in such a vital piece of our economy.
        Chairman Shelby. Senator Bennett.

                  STATEMENT OF SENATOR ROBERT BENNETT

        Senator Bennett. Thank you very much, Mr. Chairman.
        I appreciate the comments of my friend from Connecticut and
    generally agree with what he has said here. We have a common
    friend, long-time Washington observer who has said Congress,
    whenever faced with a crisis, has one of two responses: do
    nothing or overreact. And in this case, we seem to be headed
    toward doing both. I think we do need a strong regulator. I do
    think we need a piece of legislation, but I think we do need
    also to be careful that we do not overreact.
        I know the press particularly keeps saying this is another
    Enron, which it clearly is not. Fannie Mae has taken its lumps.
    Fannie Mae is paying a very large fine. Fannie Mae is under a
    very, very strong microscope, which it needs to be. But it is
    still operating, which Enron was unable to do. It has not
    closed its doors. No criminal charges have been filed against
    its people as happened almost immediately after Enron, and let
    us understand, as Senator Dodd has said, it and Freddie Mac
    play a very significant role in the housing market. So let us
    not do nothing, and at the same time, let us not overreact.
        Senator Dodd. Well said.
        Chairman Shelby. Senator Sarbanes.

                   STATEMENT OF SENATOR PAUL SARBANES

        Senator Sarbanes. Well, thank you very much, Mr. Chairman.
        The report of the special examination of Fannie Mae issued
    by OFHEO documents a number of very serious problems at Fannie
    Mae. I will not enumerate them. In fact, Mr. Chairman, you have
    done so to some extent in your opening statement. But the
    report underscores clearly the necessity of maintaining,
    documenting, and being held accountable for strong and
    effective internal controls and other financial and risk
    management systems.
        As the Chairman of the SEC, a former colleague of ours in
    the Congress, Chairman Cox, said in announcing the $400 million
    settlement with Fannie Mae, the accounting and 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, will be one of
    the largest restatements in American corporate history.
        The professional staff at OFHEO have worked hard over the
    last 3 years to complete this thorough examination and to reach
    a consent order with Fannie Mae. Likewise, the staff at the SEC
    have made a very significant contribution to the resolution of
    this matter, and I want to thank all of them for their work. In
    the consent order, OFHEO has required the Board of Directors
    and senior management to take steps to improve corporate
    governance at Fannie Mae by requiring that the Board put in
    place policies and procedures to ensure appropriate oversight.
        Among the mandates in the agreement are requirements that
    Fannie Mae maintain a chief risk officer responsible for
    directing the organization to oversee risk management
    throughout the company; maintain an independent internal
    auditor and require the auditor to report directly to the Audit
    Committee; maintain procedures directing the Chief Compliance
    Officer to report any information relating to possible
    misconduct directly to the Board of Directors in a timely
    fashion; maintain at least one Board member with sufficient
    technical expertise to fully understand the implications of
    accounting policies through financial statements; and
    presenting proposals for enhanced public disclosures of its
    performance and risk measures.
        The governance requirements contained in the consent order
    are the result of ongoing oversight by OFHEO. It is imperative
    that the leadership at Fannie Mae implement these
    recommendations as quickly and thoroughly as possible, so the
    company can turn its full attention to meeting its mission of
    supporting the housing market and affordable housing in the
    United States.
        By all evaluations, we have a financing system for the
    housing market that is sort of envied across the world in terms
    of what it has been able to accomplish, and we need to keep
    that, I think, constantly in mind. The GSEs play an important
    role in supporting the housing market and in helping us to
    obtain affordable housing. They have a very important public
    mission with respect to housing.
        This public mission places upon them an obligation to meet
    high standards of corporate behavior, both with regard to their
    corporate governance and their business practices. Our
    objective must be to ensure that these standards are met so
    that the GSEs can meet their public mandate with respect to the
    nation's housing.
        Mr. Chairman, I look forward to the hearing.
        Chairman Shelby. Senator Allard.

                   STATEMENT OF SENATOR WAYNE ALLARD

        Senator Allard. Mr. Chairman, I would like to join my
    colleagues in thanking you for holding this very important
    hearing. And like my colleagues, I was disappointed to learn
    that Fannie Mae manipulated the books so that executives could
    collect their multimillion dollar bonuses.
        OFHEO's report laid out a shocking and disturbing picture
    of irresponsible behavior. Both Congress and the public are
    very concerned about the fact that a company with Government
    ties, the sort of organization that should be of the very
    highest ethics, perpetrated such a scheme. OFHEO's report
    demonstrates that we need strong, fundamental reform of GSE
    oversight, and we need it quickly.
        I know that some disagree with the approach we took in
    Chairman Shelby's bill. Personally, I think it was the right
    approach and that the report demonstrates the need for the
    strongest possible reform. As to those who disagree, I think
    they should make their case on the Senate floor. If they can
    make their case, we will be able to pass amendments. If they do
    not, then, they will not. Either way, we need to stop delaying.
        Clearly, the status quo of accounting manipulation or
    simply an environment in which it was able to happen is the
    most unacceptable of all circumstances. I would also strongly
    encourage the Securities and Exchange Commission and the
    Justice Department to closely examine the circumstances
    revealed by OFHEO's report to determine if it is appropriate to
    bring criminal charges against those involved.
        A failure of confidence in the stability and reliability of
    Fannie Mae could have dire consequences for a large sector of
    our economy. Just as we pursue wrongdoing in the private
    sector, it is even more important that we enforce responsible
    standards of Government-Sponsored Enterprises such as Fannie
    Mae. I look forward to hearing from our witnesses. Their
    testimony will be helpful as we continue our efforts to ensure
    this sort of thing can never happen again.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Reed.

                     STATEMENT OF SENATOR JACK REED

        Senator Reed. Well, thank you very much, Mr. Chairman.
        We are here this morning to hear about the results of
    OFHEO's special examination of Fannie Mae. This report relates
    more of the details of the accounting scandal at Fannie Mae,
    describes how accounting transgressions, including inaccurate
    report of amortizations, a lack of documentation for account
    entries, and debt repurchasing to ensure earnings per share in
    subsequent years were used to create an appearance of an almost
    risk-free corporation with steadily increasing earnings year
    after year.
        This report also sheds light on how many individuals and
    entities look the other way or simply fail to scrutinize
    Fannie's troubling course and confirms to me that Fannie was in
    need of stronger oversight, not only by its regulator but also
    by its Board, which is why this Committee has had hearing after
    hearing on what we can do to strengthen regulation and how to
    create a world-class regulator for Fannie and Freddie and the
    Federal Home Loan Banks.
        This report confirms what we already know: that OFHEO or a
    newly created GSE regulator must have the funding, authority,
    and independence it needs to make sure that the GSEs are safe
    and sound and not posing unacceptable risks to the American
    taxpayers. At the same time, we need to make sure that any new
    regulatory setup enhances the GSEs' mission of making housing
    more affordable for millions of middle and lower income
    Americans.
        At a time when housing is becoming less affordable, when
    homes are doubling in price every 6 years and incomes are
    increasing by a mere 1 percent per year, Fannie's mission is of
    paramount importance. Through a unique public-private
    partnership, Fannie Mae and Freddie Mac have succeeded in
    creating a considerable mortgage market in the United States.
    They have succeeded in facilitating the emergence of one of the
    highest homeownership rates in the world, and they have
    succeeded in allowing millions of Americans to own affordable
    homes.
        In fact, Fannie and Freddie can do more, a lot more toward
    this mission. I have offered and if given the opportunity will
    offer again an amendment to the GSE reform bill that would
    improve and clarify Fannie's affordable housing goals. This
    amendment would also require Fannie and Freddie to create an
    affordable housing fund for underserved housing markets in our
    country.
        Thanks in large part to OFHEO's oversight and the consent
    decree reached with Fannie, I am hopeful that Fannie Mae is
    returning to safe and sound business practices; that it is
    reconciling with the failures of its past; and that it is
    reemerging with a focus on its mission of affordable housing. I
    hope that the accounting failures at Freddie and Fannie Mae do
    not cause us to lose sight of the overall success of the GSEs'
    mission.
        I look forward to the hearing and the testimony and thank
    you again, Mr. Chairman.
        Chairman Shelby. Senator Hagel.

                    STATEMENT OF SENATOR CHUCK HAGEL

        Senator Hagel. Mr. Chairman, thank you.
        Mr. Chairman, what we are dealing with is an astounding, an
    astounding failure of management and Board responsibility,
    driven clearly by self-interest and greed. And when we
    reference this issue in the context of the best we can say is
    it is no Enron, now, that is a hell of a high standard.
        [Laughter.]
        Senator Hagel. This issue needs to be dealt with, and just
    as the distinguished Senior Senator from Colorado noted, it
    needs to come to the floor of the Senate. And I hope the
    Majority and Minority Leader of the Senate or their staff are
    taking note of this hearing this morning and the testimony that
    will be presented, and I hope the Majority Leader and the
    Minority Leader get some sense of urgency and understanding
    what is involved here.
        There is a story in the Wall Street Journal today that
    talks about the $11 billion in losses on derivatives that were
    deferred, hidden, mismanaged. You talk about not another Enron,
    I suppose; we are not there yet. We do not know. Chairman
    Greenspan and others who have served this country rather
    responsibly, Senator Bunning's notations notwithstanding.
        [Laughter.]
        Senator Hagel. In all due respect to the distinguished
    Senator from Kentucky, we have been warned, this Committee has
    been warned time after time, year after year, about the
    systemic failure that is at risk here.
        And my goodness: when will the Congress act? When will we
    find the courage to deal with this? I understand the
    significance of what these GSEs have meant for our housing
    industry; of course, that is the point, that is exactly the
    point, that we do not want to risk that. They have done
    incredibly good work for millions of Americans, and we are,
    just as the distinguished Senator from Connecticut noted, we
    are at risk in seeing that come unwound, and we may see, if we
    do not deal with this in a responsible way this year, that the
    future of GSEs is maybe over.
        And I do not believe I overstate that. I, like any Senator,
    any elected official can say what we want. We have no
    responsibility for anything. But the fact is that when you are
    dealing with this massive amount of fraud and mismanagement,
    something has to be done. And if we do nothing else around
    here, if we are elected to do nothing else, this is certainly
    something that would come within the purview of why we are
    here.
        And I hope that with these hearings this morning and the
    more information that will be presented that the Majority
    Leader of the U.S. Senate, the Minority Leader of the U.S.
    Senate will understand the severity and the need to act on
    this, and this bill that we have produced in this Committee
    will be brought to the floor of the Senate and will be voted on
    this year. We will have a conference committee; we will have a
    resolution of this and put this fiasco behind us and solid,
    responsible management back on track for not only the citizens
    of this country and the taxpayers but for the housing industry.
        Mr. Chairman, I look forward to our witnesses. Thank you.
        Chairman Shelby. Senator Stabenow.

                  STATEMENT OF SENATOR DEBBIE STABENOW

        Senator Stabenow. Well, thank you, Mr. Chairman, and thank
    you to Mr. Lockhart and OFHEO and all of the work that has been
    done, and Chairman Cox, it is good to see both of you.
        I think the challenge for us on this Committee is to not
    only to be able to understand that your report and the
    agreement and so on allows us to know what has happened, and
    the fact of the matter is there have been serious problems,
    serious issues, and Fannie Mae, Freddie Mac, our whole GSE
    system has an obligation to hold to the highest possible
    standards of corporate conduct.
        But we also have a challenge in making sure we do not throw
    the baby out with the bath water, and I think that is what
    other colleagues have said, and I certainly agree with Senator
    Bennett, Senator Dodd, and others who have spoken about that
    balance that we really have to find, to act but not to
    overreact. And that is my concern as we move through this.
        And as we look at this, I feel compelled to say that when
    Fannie Mae was set up in February 1938, it was set up to do
    exactly what they have done: to help families own a home, to be
    able to help families have the American dream. And to quote
    President Eisenhower back in 1954, he said this has been one of
    our major legislative goals. It will raise the housing
    standards of our people, help our communities, improve older
    neighborhoods, and strengthen our mortgage credit.
        So despite--and in no way am I an apologist for what has
    happened, and there is no question that we have to focus on a
    strong regulator and on GSE reform, but I hope that we will
    also understand that the commitment to homeownership and the
    impact on Americans has been significant over the years. And
    more recently, I am very concerned about what has been
    happening as it relates to our country. There have been
    numerous warnings that a housing slowdown is on the horizon.
        In fact, the most recent CPI numbers indicate that another
    increase in interest rates is just around the corner. This will
    put even more pressure on family budgets which are already
    squeezed, certainly in my State and other States as it relates
    to exporting of our jobs and increased health care costs and
    energy costs, and I am very concerned that families who cannot
    afford the rate increases may find themselves without a Fannie
    Mae or Freddie Mac to turn to in order to keep their homes if
    we are not careful.
        So, Mr. Chairman, I would just hope--I am interested in
    hearing about the changes that have already been made by Fannie
    Mae, changes that need to be made as well as a focus on their
    core mission, which has not changed, and I hope we will not
    take actions that will force them to change, because the
    families in this country right now need this opportunity as
    much as they ever have.
        Thank you.
        Chairman Shelby. Thank you.
        Senator Sununu.

                    STATEMENT OF SENATOR JOHN SUNUNU

        Senator Sununu. Thank you, Mr. Chairman.
        We certainly welcome the witnesses, and I do not have
    prepared testimony, but I want to respond to a few of the
    points that have been made. First, with regard to overreaction:
    I am pleased to say this is one case where I think that it
    cannot be argued, and it cannot be argued effectively because
    this process did not begin 6 months ago or a year ago or 2
    years ago.
        This process of crafting legislation began 3 years ago,
    before anyone was talking about crisis or Enrons or anything
    else, when a few of us recognized that perhaps because we had
    worked on housing issues in the past or worked with OFHEO in
    the past on regulation that we just needed a stronger, better,
    more effective regulator with more staff, with more money, with
    better supervisory powers commensurate with those in other
    areas of the financial service industry.
        So 3 years ago, Senator Dole, Senator Hagel, and I
    introduced legislation that contains most of the key core
    elements of the bill that this Committee has recently been
    discussing, and it has certainly changed since then. The fact
    is it has been a 3-year process, listening to those who would
    be affected by the legislation, listening to housing advocates,
    listening to other Members of the Committee. The Chairman, the
    Ranking Member, and their staff had a lot of suggestions in
    this legislation, and it has changed a good deal over those 3
    years.
        But the suggestion that we should all be concerned about
    overreacting I think is an argument for more delay, and I think
    it should be avoided. I think we should be serious and honest
    about our work, serious and honest about the amount of work
    that has already gone into this product, and we should be
    realistic about the importance of moving forward with
    legislation that has been very thoroughly discussed and vetted.
    And we may agree about or disagree with certain technical
    aspects of the legislation, but it has been well worked through
    the legislative process.
        We would have completed this much earlier, at a much
    different time, and in an atmosphere that did not carry the
    suggestion of crisis if it had not been for the stonewalling of
    the GSEs and the stonewalling of their allies 3 years ago, 2
    years ago, and 1\1/2\ years ago. I think recently, the work of
    the Committee has been substantive, and we have made good
    progress. But if you go back in the record to 2 or 3 years ago,
    there was nothing but stonewalling on the part of the GSEs and
    their allies.
        Second, concerns about the value of the GSEs, their housing
    mission, and the housing market: this is an issue on which all
    of us agree. And that agreement is not verified by what we
    happen to say here in front of the Committee. It is verified
    and validated in the legislation itself. The legislation does
    not change the charter or the mission of the GSEs one whit. It
    does not restrict it; it does not reduce it; it does not modify
    it. That charter and that mission, to provide liquidity in the
    secondary mortgage markets is affirmed, in fact, affirmed and
    reaffirmed throughout the legislation.
        And perhaps the one area where we might make modification
    is in the important area that Senator Reed mentions, which is
    to expand that mission and charter where affordable housing is
    concerned, and I think that is an area where we have got a
    great deal of agreement, and we are going to end up. This
    legislation, I think, will and should end up with a provision
    very similar to what has been proposed by Senator Reed.
        So to continually assert that we are concerned that we will
    hurt their mission or hurt their charter suggests that you have
    not read the legislation or that you are questioning the
    motives of all of the staff members and Democrats and
    Republicans who have worked on the legislation, and I think
    that is wrong, because we have reaffirmed the mission and
    reaffirmed the charter, and it is just simply wrong to set up a
    choice, that we have a choice between good regulation or a
    strong housing market. That is just simply wrong.
        There is nothing in the provisions, the restrictions on
    portfolios or guidelines for the portfolios, enforcement or
    flexibility of the regulator to set capital limits, none of
    that affects or undermines the mission and the charter of the
    GSEs.
        Third, the concern that this is not an Enron. I think
    Senator Hagel made a very fair point. There are differences,
    but as I read a suggestion that was made in a newspaper
    yesterday, perhaps the biggest difference at the moment is that
    the guys at Enron have been convicted. What we have here is a
    situation where there were $11 billion in intentional earnings
    misstatements that were designed to affect the stock price,
    affect bonuses, and, in effect, mislead shareholders and
    investors, all done at an entity where we all agree there is an
    implicit taxpayer guarantee. The implication is that taxpayers
    are on the hook.
        So in terms of the concerns or the fears or the potential
    impact on the taxpayer, it is fair to argue that this is
    perhaps more significant or more grave than Enron. I think to a
    certain extent, we should step back from the rhetoric here, but
    we should recognize that this is very, very serious. People
    intentionally misstate earnings, manipulate earnings to mislead
    shareholders in a way that affects their own compensation and
    in a way that is arrogant and unethical and illegal, we have a
    problem, and it is magnified, not minimized but magnified by
    the nature of these institutions.
        I put those concerns out to try to address some of the
    points that we have made. I think we have very good legislation
    here. It has been worked thoroughly; includes suggestions from
    both sides of the aisle. Everyone understands that the
    technical details of some of these provisions, whether they are
    the precise powers having to do with capital standards or
    portfolio limits or the exact details of the affordable housing
    piece will be worked out in conference. But it is a serious
    mistake to continue to delay of this legislation at a time when
    the need for it, both from the perspective of the capital
    markets and the taxpayers, is greater than ever.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Dole.

                  STATEMENT OF SENATOR ELIZABETH DOLE

        Senator Dole. I want to thank you, Chairman Shelby, for
    holding today's hearing regarding the OFHEO report. This report
    not only confirms my deep concerns about Fannie Mae; it
    demonstrates that the GSEs' actions were far worse than I could
    have imagined.
        Nearly 3 years ago, as we have heard, after it was revealed
    that Freddie Mac had misstated its earnings, Senators Hagel,
    Sununu, and I introduced legislation to strengthen the
    regulation of the GSEs. And Fannie and Freddie responded,
    dispatching an army of lobbyists to Capitol Hill and spending
    tens of millions of dollars to oppose our bill. In 2004, their
    lobbying tab totaled $26 million and just last year, more than
    $24 million. At times, it has truly felt like David and
    Goliath.
        No one has better described Fannie's mindset than the
    current CEO, who, in an internal memorandum of November 2004,
    asserted, and I quote, the old political reality was that we
    always won. We took no prisoners. And we faced little organized
    political opposition, end of quote.
        Even today, after all that we now know about Fannie and
    Freddie, the GSEs' influence on the Hill remains strong. But we
    in Congress must stand up to any political influence the GSEs
    continue to wield. The facts speak for themselves: on May 23,
    the Securities and Exchange Commission concluded that, and I
    quote, between 1998 and 2004, Fannie Mae engaged in a financial
    fraud involving multiple violations of Generally Accepted
    Accounting Principles in connection with the preparation of its
    annual and quarterly financial statements. The SEC went on to
    explain that these violations had the effect, among other
    things, of falsely portraying stable earnings growth and
    reduced income statement volatility, and for the year ended
    1998, of maximizing bonuses and achieving forecasted earnings,
    end of quote.
        Some had earlier claimed that Fannie and Freddie's problems
    were an understandable misapplication of complicated, obscure
    accounting rules. We now know that this was not the case; that,
    in fact, Fannie and Freddie were committing fraud for many
    years, in part driven by certain executives' personal greed.
        There can no longer be any doubt about what we must do here
    in the Congress. Fannie Mae and Freddie Mac need strong
    regulation to ensure that fraud and manipulation in their
    accounting practices have been forever banished from these
    institutions, and we need it now. This report represents a
    clarion call for the swift consideration and passage of
    legislation to create a new, independent regulator of these
    enterprises. This new regulator should have the ability to
    limit the sizable portfolios of Fannie and Freddie, thereby
    redirecting the GSEs to their original mission and preventing
    them from engaging in activities that could undermine their
    safety and soundness or place them at systemic risk.
        I thank both OFHEO and the SEC for their tenacious and
    diligent work on this issue. Director Lockhart, your report
    provides a complete and detailed expose, not only of the many
    complex transactions that underlay the problems at Fannie Mae
    but also of the broader culture of venality that developed at
    the GSEs. I thank you and the other witnesses for joining us
    here today.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Martinez.

                   STATEMENT OF SENATOR MEL MARTINEZ

        Senator Martinez. Mr. Chairman, thank you very much for
    holding this very important hearing on this very, very timely
    topic. I would like to make my prepared remarks a part of the
    record, but I really think----
        Chairman Shelby. Without objection, it shall be made a part
    of the record.
        Senator Martinez [continuing]. ----I should just speak
    about a little bit of the history of this.
        And let me say that some years ago, not too many years ago,
    around 3 years ago, I guess, when my colleagues introduced a
    bill, I was sitting at the table testifying. It was as a result
    of some concerns that I had had and others in the current
    administration had had about the GSEs. And the concerns were
    greatly about the size of the GSEs, the implied guarantee, the
    fact that the taxpayers were on the hook, and they continued to
    grow exponentially, and also a concern that OFHEO was an
    inadequate regulator. Part of the GSE oversight was at HUD.
    OFHEO was under HUD but not really a part of HUD, and in fact,
    if you were to have wanted to design a regulatory scheme, which
    is still in effect today, by the way, that was fairly
    ineffectual, you would have designed exactly what was in place.
        Now, as was just mentioned by Senator Dole, in fact, this
    was something of this culture of arrogance and disdain for
    regulation that permeated Fannie Mae. It was a culture that
    basically said we do not have to be normal, as noted by Mr.
    Mudd in his memo to Raines. We can write or have written rules
    that work for us, and that worked for a long time, and unless
    we pass this legislation, unless it comes to the floor and
    becomes law, that is still what is happening today.
        But now, our concerns brought by my testimony and this bill
    that has been referenced was because we were concerned. But we
    had no idea what really was transpiring, what really was going
    on. We had no idea that the executives of Fannie Mae had given
    themselves, through manipulation of the stock price, bonuses
    and compensation in excess of $200 million. How many homes
    could Habitat for Humanity build if you were to give them a
    donation of $200 million? This was the compensation that was
    given to about four or five of the chief executives at this
    entity. One of them is the CEO today.
        So what I would suggest is that there is great urgency, and
    I would not fear overreaction. I would fear underreacting to
    what is, in fact, a crisis for America's taxpayers who are on
    the hook. I want to commend Mr. Lockhart, but also, I want to
    commend Armando Falcon, who was the head of OFHEO during the
    period of time when these initial reports were made with little
    staff and very little resources, because OFHEO was
    systematically starved from resources by the lobbying power of
    Fannie Mae for years to make it an incapable regulator, to keep
    it understaffed and undermanned so they could not do the job
    right, just like they, themselves kept their own financial
    staffs understaffed and their own financial system antiquated
    and complicated that they would turn up all of a sudden with a
    problem of $11 billion in magnitude.
        When we talk about these not being an Enron, it may not be
    an Enron, but you know what it is? It is a WorldCom. WorldCom
    was a scandal of $11 billion. This happens to be $11 billion.
    The only difference between WorldCom and this, in addition to
    the fact that, you know, as Senator Sununu said, some people
    are in jail and others are not, is the fact that this
    particular company, this particular entity, was chartered to
    help America's poor find a place to live, and for that, the
    American taxpayer said we will be on the hook. There is an
    implicit guarantee; it is not a specific guarantee, but one
    that I know everyone around this table would know if these
    entities were to fail, the taxpayers of America would be on the
    hook.
        So, Mr. Chairman, I am very much one of those who believes
    that we have to get this legislation through; that we have to
    ask the hard questions of current Fannie executives as well as
    the Board, and that we must give OFHEO the necessary powers so
    that they can be the regulator that we all believe they should
    be.
        I look forward to the witnesses and thank you for the
    hearing.
        Chairman Shelby. Thank you.
        Mr. Lockhart, Mr. Cox, we welcome you again. Both of you
    have been here and will probably be here many times.
        We will start with you, Mr. Lockhart.
        Senator Bennett. Mr. Chairman?
        Chairman Shelby. Yes.
        Senator Bennett. Could I just make one quick sentence?
        Chairman Shelby. Sure, Senator Bennett.
        Senator Bennett. I would remind my colleagues I voted for
    the bill.
        [Laughter.]
        Senator Bennett. Thank you.
        Chairman Shelby. Mr. Lockhart.

                  STATEMENT OF JAMES B. LOCKHART III,

                            ACTING DIRECTOR,

             OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

        Mr. Lockhart. Good morning, Chairman Shelby, Ranking Member
    Sarbanes, and Members of the Committee. Thank you for the
    opportunity to discuss the findings of our Special Examination
    of Fannie Mae and the settlement agreement. It is a pleasure to
    be here with Chairman Cox, as the investigation and settlement
    agreements are excellent examples of government agencies
    working well together.
        Before starting, I would like to mention that OFHEO will
    submit later today our Report to Congress on the 2005
    examinations of Fannie Mae and Freddie Mac, which reinforces
    the message that significant remedial actions are still needed
    at both enterprises. As Government-Sponsored Enterprises, they
    have unique positions among American corporations and an
    extremely important mission: facilitating the growth of
    affordable housing in the United States. Franklin Raines and
    his previous management team violated that 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 $1
    billion in expenses to fix the problems, and ill-gotten bonuses
    in the hundreds of millions of dollars.
        The report details an unethical, take no prisoners,
    corporate culture where the ends justified the means. The image
    of Fannie Mae as one of the lowest risk and ``best in class''
    institutions was a facade. Senior executives were managing
    Fannie Mae in an ``unsafe and unsound manner.''
        As you see in the chart, in order to receive maximum
    bonuses, senior executives hit earnings per share targets with
    uncanny precision by deliberately and systematically using
    inappropriate accounting and improper earnings management.
    Chairman Raines' 6-year compensation exceeded $90 million, of
    which $52 million was directly tied to achieving earnings per
    share targets. The inappropriate ``tone at the top'' spread.
    Incredibly, the Internal Auditor told his staff when discussing
    Raines' goal of doubling EPS that they had a moral obligation
    to ``help him'' and to help make ``tangible contributions to
    Frank's goals.''
        Fannie Mae used a four-step approach to manipulating
    earnings: first, to prevent large, unpredictable earnings
    fluctuation, Fannie Mae implemented investment, derivatives,
    and other accounting standards to reduce volatility, and they
    did that while ignoring GAAP. Second, they went to
    extraordinary lengths to avoid recording losses on assets whose
    values had declined. Third, management then manipulated
    earnings to hit specific targets, using cookie jar reserves,
    income shifting transactions, and debt repurchases. And fourth,
    the report details the conscious decisions to use outdated
    accounting systems and to create a weak internal control
    environment which made it harder to uncover that manipulation.
        The company's internal and external auditors failed to
    properly confirm compliance with GAAP, and even when KPMG
    became aware of the non-GAAP accounting practices, they
    continued to issue unqualified opinions. The last line of
    defense, the Board of Directors, failed to be sufficiently
    informed and independent. Their oversight failings meant that
    they did not discover, let alone correct, the multitude of
    unsafe and unsound practices, even after Fannie Mae's problems
    became apparent.
        The Board approved bonus plans focused on managing earnings
    rather than risk. In 2002, Fannie Mae incurred billions of
    dollars in economic losses from interest rate risks. The
    operational risk losses were among the largest ever incurred.
    The settlement agreement has nearly 60 provisions designed to
    repair the damage and to prevent reocurrence.
        Fannie Mae agreed to undertake a comprehensive reform
    program aimed at really top to bottom changes, including its
    Board of Directors, internal audit, risk management,
    compliance, internal controls, accounting systems, and external
    relations. Fannie Mae agreed to review current and former
    employees for remedial actions. Fannie Mae agreed to pay a $400
    million penalty, and Fannie Mae agreed to freeze the growth of
    its portfolio mortgage assets.
        The need for a settlement agreement full of so many
    remedial actions exemplifies why the report recommends
    strengthening OFHEO's regulatory process and supporting
    legislation to strengthen our safety and soundness powers. It
    is difficult to say whether the proposed legislation would have
    totally prevented the mismanagement, but I believe with the
    proposed legislation and proper staffing levels, OFHEO could
    have uncovered the problems well before such serious damage was
    done.
        Thank you. I would be pleased to answer questions.
        Chairman Shelby. Chairman Cox.

                     STATEMENT OF CHRISTOPHER COX,

                               CHAIRMAN,

                   SECURITIES AND EXCHANGE COMMISSION

        Mr. Cox. Thank you, Chairman Shelby, Ranking Member
    Sarbanes, Members of the Committee. It is a pleasure, likewise,
    for me to be here. I appreciate the invitation but particularly
    to be here with Director Lockhart. His team at OFHEO has done,
    as you know, an outstanding job, and the Securities and
    Exchange Commission has very much appreciated the opportunity
    to work with them.
        I would like to testify to the Securities and Exchange
    Commission's own recent enforcement action against Fannie Mae.
    I know that this Committee has spent a great deal of time
    examining the issues surrounding Government-Sponsored
    Enterprises, and I appreciate the opportunity to bring our
    point of view to the table. Since my written testimony contains
    many of the details of the accounting violations that our
    enforcement action was based upon, I would like to ask your
    permission to summarize that part of my testimony and then turn
    to----
        Chairman Shelby. Proceed.
        Mr. Cox [continuing]. ----important disclosure issues that
    I believe may be of interest to the Committee.
        On May 23, the Commission and the Office of Federal Housing
    Enterprise Oversight----
        Chairman Shelby. Chairman Cox, could you bring the
    microphone just a little closer to you, please?
        Mr. Cox. On May 23, our Commission and the Office of
    Federal Housing Enterprise Oversight jointly announced
    settlements with Fannie Mae for accounting fraud. The
    Commission's action alleges that Fannie misstated its financial
    reports from at least 1998 through 2004. In settling these
    charges, as Director Lockhart mentioned, Fannie Mae has agreed
    to pay civil penalties totaling $400 million. The lion's share
    of these penalties will be returned to defrauded shareholders
    through our Fair Fund program.
        Both Director Lockhart and I agree that a penalty of this
    size represents a meaningful sanction that is necessary to
    address the egregiousness of Fannie Mae's conduct. In addition
    to the $400 million in penalties, Fannie Mae will be
    permanently enjoined from future violations of the anti-fraud
    provisions of the Federal securities laws. It will also be
    subject to a permanent injunction against violations of the
    reporting, books and records, and internal control provisions
    of the Federal securities laws.
        The significance of the corporate failings at Fannie Mae
    cannot be overstated. The company has estimated its
    restatements for 2003 and 2002 and for the first two quarters
    of 2004 will result in at least an $11 billion reduction of
    previously reported net income. This will be one of the largest
    restatements in American corporate history.
        Fannie Mae's size and status make it a financial giant, but
    despite its prominent position in our financial marketplace,
    the company's internal controls were wholly inadequate for the
    size, complexity, and sophistication of Fannie Mae's business.
    Its failure in key areas highlights the critical need for
    senior management to constantly reassess the adequacy of
    internal controls as the business matures. That kind of
    attention to internal controls is necessary for the good of the
    business, for the protection of investors, and for the health
    of our capital markets.
        Fannie Mae is a clear example that neglecting internal
    controls can be devastating for a company and for its
    investors. We are considering our investigation of the
    individuals and entities whose actions and inactions led to
    this result. The public should have full confidence that we
    will vigorously pursue those individuals who have violated the
    Federal securities laws.
        Until the investigation is complete, I cannot comment
    further on the alleged conduct of particular individuals or the
    specifics of the investigation, but I would like to address
    several important and closely related disclosure issues. Fannie
    Mae's settlement of accounting fraud charges raises a very
    significant policy issue that I know has been carefully
    considered by Members of this Committee: Should the Congress
    require mandatory registration and periodic reporting under the
    Exchange Act by Fannie Mae as well as Freddie Mac and the
    Federal Home Loan Banks?
        As you know, the securities issued by Fannie Mae are exempt
    securities under current laws issued by the SEC. But there is
    no question that the word ``Government'' in Government-
    Sponsored Enterprise leaves many members of the investing
    public with the mistaken impression that GSEs' securities are
    backed by the full faith and credit of the U.S. Government,
    when in fact, there is no such guarantee.
        So we have a situation in which GSEs sell securities to the
    public. They have public investors, and they do not have the
    full faith and credit of the U.S. Government backing their
    securities, yet they are not required to comply with the
    disclosure rules under the Federal securities laws which exist
    for the protection of investors. That is why, going back at
    least as far as 1992, the Securities and Exchange Commission
    has consistently urged that GSEs should comply with the
    disclosure requirements of the Federal securities laws.
        In July 2002, Fannie Mae announced that it would
    voluntarily register its common stock with the SEC under
    Section 12(g) of the Exchange Act. The registration of its
    common stock became effective on March 31, 2003, and Fannie
    subsequently began filing periodic reports with the SEC; but,
    after that, many of Fannie Mae's periodic disclosures have been
    late, incomplete, or not filed at all. Most notably, as of
    today, Fannie has not filed an annual report, its 10-K, for
    either 2004 or 2005, and it has not filed its quarterly report
    on form 10-Q for any of the preceding seven quarters.
        I have no doubt that our recent enforcement action has
    focused the attention of Fannie Mae's management on improving
    its disclosure to investors. At the same time, there can be no
    question that, in the future, Fannie Mae would be far more
    likely to maintain consistent compliance with our disclosure
    regime if the Congress were to terminate its special status of
    voluntary registration and reporting and make its registration
    and reporting mandatory. That is a far better way to protect
    investors.
        I know that this Committee is considering legislation that
    would require compliance with the Exchange Act reporting
    requirements by Fannie Mae, Freddie Mac, and the Federal Home
    Loan Banks. I commend you for your attention to this issue and
    encourage your consideration of this legislation. We stand
    ready to support you in these efforts, and the Securities and
    Exchange Commission is prepared to enforce mandatory compliance
    should you choose to change the requirements for these
    Government-Sponsored Enterprises.
        I also wanted to bring the Committee up-to-date on a
    related issue involving the New York Stock Exchange's listing
    requirements. The NYSE rules authorize suspension and delisting
    when a listed company fails to file its annual report with the
    SEC in a timely manner. As you know, because of Fannie Mae's
    failure to file its 2004 and 2005 annual reports, the NYSE
    amended its general delisting rules to provide a unique
    exception for Fannie Mae, even though it is not explicitly
    phrased in these terms.
        Since the NYSE put this new rule in place, questions have
    been raised about whether the exemption is appropriate. As I
    testified before this Committee in April, the exemption needs
    to be considered in light of the unusual circumstances not only
    of Fannie Mae's voluntary transition to Exchange Act financial
    reporting compliance but also its requirements for a massive
    restatement.
        As I testified then, however, this exemption must be
    temporary and only for the purpose of allowing Fannie Mae to
    come into initial compliance with Exchange Act reporting. To
    respond to concerns that this exception might become a
    permanent rather than a temporary policy, I want to inform the
    Committee that we have encouraged the New York Stock Exchange
    to amend its rule to put an expiration date on this exception.
    That way, Fannie Mae and its investors will understand that we
    expect Fannie, like any other listed company, to remain in full
    compliance with NYSE listing standards.
        The Commission's action against Fannie Mae, our support for
    mandatory GSE registration and reporting under the Exchange
    Act, and our support for an expiration date on Fannie's unique
    exception under the NYSE's listing rules are all animated by
    the same principle: that investors are best served by applying
    the Federal securities laws in an evenhanded manner to all
    companies participating in the public markets.
        Thank you again, Mr. Chairman, for giving me the
    opportunity to testify today, and I am pleased to respond to
    any questions the Committee might have.
        Chairman Shelby. I will start with you, Mr. Cox, but I will
    address it to both of you.
        With most private companies, we rely on market participants
    to raise questions and send alarms when numbers for a company
    do not look right. Likewise, we anticipate that most private
    companies cannot remain unscathed in debt markets or in
    dealings with their customers when scandal taints that company.
    But with reference to Fannie Mae, at least one analyst
    indicates that he places, and I quote, very little risk on
    delisting and expects a lot of regulatory forbearance, end
    quote.
        Chairman Cox, given that the GSEs have an advantage that
    other private companies do not, how can we tailor a regulatory
    structure to pick up where market discipline might leave off?
        Mr. Cox. Mr. Chairman, these GSEs have been around for
    awhile. We have a lot of experience with their strengths and
    now their weaknesses. I think what we want to do is attract all
    of the strength and support that market discipline can provide.
    After all, these are public entities that are taking capital
    from the public.
        I would commend you for the focus that you have on
    strengthening the regulatory side. I think we also need to
    strengthen the market side. The regime that we administer at
    the Securities and Exchange Commission is in the main a
    disclosure regime, and so great emphasis needs to be placed on
    getting out good, high quality information about these
    enterprises to the public. We have failed in that respect, I
    think it is very, very clear with Fannie; and, if we are to get
    on the right track, we need to make sure that normal market
    disciplines apply in the future.
        Chairman Shelby. Mr. Lockhart, do you have anything to add?
        Mr. Lockhart. The only point that I would add is if these
    companies were not Government-Sponsored Enterprises, the end
    might be significantly different than it is today. If it had
    been a financial institution, they would have lost their debt
    ratings and that would have been unfortunate.
        Chairman Shelby. Chairman Cox, some people have questioned
    whether any real harm has resulted from Fannie Mae's conduct.
    We hear this. If one buys into this argument, it would suggest
    that under certain circumstances, some amount of fraud is
    acceptable, even fraud that results in a $400 settlement with
    the Securities and Exchange Commission. You are the Chairman of
    the SEC. Is there some level of fraud that is acceptable in
    corporate America?
        Mr. Cox. Our job at the Securities and Exchange Commission
    is to police the markets against fraud.
        Chairman Shelby. All fraud, right?
        Mr. Cox. Of course, of course, and I think it is not so
    much a matter of accepting an argument in this case as it is
    noticing that what is attempting to pass for an argument is an
    egregious misstatement of fact. There was harm. It is
    objectively measured. Investors paid for $11 billion in
    earnings that were not there. A company with $47.5 billion in
    market capitalization chartered by the Congress, a private
    company with a public mission, as it calls itself, was for a
    period of several years raising capital on the basis of
    financial statements that were the result of fraud. Its senior
    management was manipulating earnings and did so to enrich
    themselves.
        The harm to investors is both direct and measurable. The
    stock price of Fannie Mae fell from over $75 to very recently
    under $49. As Director Lockhart has pointed out, they have
    spent over $1 billion thus far just trying to fix some of these
    problems. That is investors' money.
        The harm to the markets, the diminution in confidence, is
    broad and immeasurable. Perhaps, as Senator Sununu pointed out,
    the gravest potential harm would be to the taxpayers if Fannie
    Mae were to fail, because Fannie has long traded on the mirage
    of the full faith and credit of the Federal Government backing
    those securities when, in fact, no such guarantee exists.
        Chairman Shelby. Mr. Lockhart, some other people would
    contend that Fannie Mae's improper accounting and earnings
    management never represented a risk to the safety and soundness
    of Fannie Mae itself or the financial markets. I personally
    believe it has simply been a matter of luck. It is clear that a
    great deal of management's focus was on earnings targets and
    not much else. I also believe that it was simply fortunate that
    we learned of the fraudulent practices at Fannie Mae before
    more serious safety and soundness issues arose.
        How would it be possible that fraudulent accounting and a
    lack of internal controls would not pose a threat to safety and
    soundness for any financial company?
        Mr. Lockhart. It would be impossible.
        Chairman Shelby. It would be impossible. Thank you.
        Chairman Cox, corporate governance. In January of 2003--I
    believe it was January 2003--Standard and Poors, S&P, assigned
    the company a corporate, that is, the company, Fannie Mae, a
    corporate governance score of 9, when 10 was the highest
    possible score. S&P said then that Fannie, quote, is not only
    demonstrating its own strong governance practices, but it is
    also showing leadership in the United States with regard to
    providing greater openness and disclosure about its corporate
    governance standards, end quote.
        The company received the highest possible score in the
    areas of board structure and processes and financial
    disclosure. Fannie was the only company among S&P's first 10
    clients to make its corporate governance grade public. It also
    paid, of course, for this rating. In retrospect, Mr. Lockhart,
    Mr. Cox and Lockhart, in retrospect, what do you make of this
    sterling review by SEC? Chairman Cox, obviously, they were way
    off the mark.
        Mr. Cox. I think that, when we answer that question in
    retrospect, it is very easy to see that the rating was not
    deserved. I think S&P, were they to be able to write their
    report in the light of what we all know today, under no
    circumstances would issue it. So I think what we have
    highlighted here are some of the inherent inadequacies of
    fortune telling when it comes to the job that these rating
    agencies have. I think the same can be true with respect to the
    financials of Fannie. I mean, obviously, anybody who was
    evaluating them on the basis of those financial statements had
    to contend with the fact that we now know that, to a certain
    extent, they were fraudulent.
        Chairman Shelby. Mr. Lockhart, do you have any comment?
        Mr. Lockhart. Well, I agree on the S&P report. Obviously,
    they were wrong, and it probably should have been a 0 or a 1,
    as it turned out. But there were some obvious things that were
    there; for instance, the Chairman and the CEO was the same
    person, and we made sure that that is not going to happen in
    the future with these two entities, and there is a lot of
    corporate governance in the settlement agreement, as you know,
    that we did with both Freddie and Fannie, and we are going to
    stay on top of it.
        Chairman Shelby. Thank you.
        Senator Sarbanes.
        Senator Sarbanes. Thank you very much, Mr. Chairman.
        Mr. Lockhart, this Committee has reported out your
    nomination, as you know, unanimously, and it is pending over on
    the Senate calendar now and presumably will be taken up in the
    very near future. Now, you have been the acting director at
    OFHEO now for 2 months or so?
        Mr. Lockhart. About one and a half.
        Senator Sarbanes. One and a half months. What is your sense
    of how on top of this situation OFHEO is?
        Mr. Lockhart. At the moment, I have been very pleased with
    the team. Many of them have been hired since the problems
    occurred 3 or 4 years ago. We built up--we have probably
    doubled the staff since then. We have hired a lot of
    experienced bank examiners. We have two teams now and they are
    in Fannie and Freddie every day looking at the issues.
        So I have been pleased that we have been making some good
    progress, but also, I have to tell you I am convinced that we
    do not have all the tools we need, and that is one of the
    reasons we are obviously supporting the legislation.
        Senator Sarbanes. Well, we are trying to sort out those
    tools here in the Committee when we considered it, and in fact,
    I think there was a unanimous position with respect to many of
    the tools that have been suggested being provided to OFHEO.
    There are some differences that remain. Many of us think an
    affordable housing provision is extremely important. That is
    not in the Committee-reported bill, and then, there are some
    questions about portfolio limitations which raise important
    issues. I wanted to ask you about that.
        As I understand it, the consent decree that was arrived at
    with Fannie Mae freezes the portfolios at the end of the year
    2005 level. Is that correct?
        Mr. Lockhart. That is correct.
        Senator Sarbanes. And then provides that this growth
    limitation shall expire when the Director determines that it is
    appropriate to let them grow again, based on information
    regarding capital, market liquidity issues, housing goals, risk
    management improvements, outside auditor's opinion that Fannie
    Mae's consolidated financial statements present fairly in all
    material respects the financial condition of the company,
    receipt of an unqualified opinion from an outside audit firm
    that Fannie Mae internal controls are effective pursuant to
    Section 404 of the Sarbanes-Oxley Act.
        Now, I take it from this language, and the agreement also
    says that you will allow Fannie to grow even ahead of meeting
    those conditions a moderate amount per annum; I take it an
    adjustment as inflation goes or something of that sort?
        Mr. Lockhart. No, what it says is that they can come
    forward with a plan in 60 days, and we will look at it. But
    again, it is at the discretion of the Director whether we agree
    to the plan. There is no automatic acceleration.
        And I want to put in context why we put that limit in. This
    company has serious internal controls, risk management, and
    operational risk problems, as well as accounting systems
    problems, and we felt it was just imprudent to let it continue
    to grow until it has fixed those problems.
        Senator Sarbanes. Yes, I understand that, and it seems to
    me a fairly prudent and rational thing to do. But the point is
    that these controls, as I understand it, are to stay in place
    until such time as you are convinced that the company can grow
    in a safe and sound manner, as demonstrated by the fact that it
    is well enough capitalized, is meeting its legal obligations
    with regard to its housing goals, and can demonstrate and
    document that the company is being run in a safe and sound
    manner, is that correct?
        Mr. Lockhart. That is correct, sir.
        Senator Sarbanes. Now, I also wanted to ask you about, in
    this effort to sort of see how we are doing and where we are
    getting, whether things are under control and so forth and so
    on; the report notes that Fannie's strategy was to match
    between 50 and 60 percent of the optionality of its mortgage
    assets with comparable options on the liability side.
        This indicates that the company was taking on a lot of
    interest rate risk, which was reflected in some significant
    increases in Fannie's duration gap, which reached as high as 14
    months at one point.
        Mr. Lockhart. Right.
        Senator Sarbanes. Can you tell us, without revealing
    confidential information, whether or not Fannie is more closely
    matching now its assets with its liabilities? I have heard
    reports that the duration gap now, like Freddie's, where I do
    not think this was really any significant issue at Freddie, is
    now between 0 and 2 months; is that correct?
        Mr. Lockhart. That is correct, Senator. They have narrowed
    the duration gap significantly since then.
        Senator Sarbanes. And this is a matter, I take it, you all
    are following very closely.
        Mr. Lockhart. We get weekly capital reports from the
    company. As I said, we have examiners in there every day, and
    we are following it very closely. We are also looking at the
    hedging activity on the optionality as well.
        Senator Sarbanes. What is your view of how well they are
    moving and how quickly on putting into place a system of
    internal controls? I mean, the report says that they were
    grossly inadequate; in fact, contravened supervisory standards,
    and I know a great deal of focus has been placed on that. What
    progress is being made in that regard?
        Mr. Lockhart. Certainly, some progress was being made in
    both companies, but they have a very, very long way to go; a
    couple of years, really, 3 years, and as you will see in the
    report that we are putting out today, the annual report where
    we do the report of the examinations of the two companies, we
    do show there are a lot of issues these companies have to face,
    in the controls, accounting, risk management, human resources,
    getting the people there. They have a whole series of issues,
    and it is going to take several years to correct.
        Senator Sarbanes. What are they falling short in doing in
    terms of moving on this front? I mean, obviously, you need,
    like Chairman Cox--I forget where he was--recently gave the
    speech in which he emphasized the importance of an effective
    system of internal controls, not just in this instance but for
    all companies. What more, if anything, can be done to get
    there, or is it just it cannot be done overnight, and it is a
    time problem we have to work through?
        Mr. Lockhart. A lot has to be done. As Chairman Cox
    mentioned, neither of these companies are timely reporting at
    this point, so they are not getting their accounts out. From
    the internal controls standpoint, they are not even close to
    conforming with Sarbanes-Oxley at this point. Again, it is
    going to take several years to get there. They have lots of
    consultants. They have a lot of people and a lot of manpower
    devoted to these issues, but these companies were so poorly run
    that it is going to take many years to fix.
        Senator Sarbanes. Meanwhile, I presume OFHEO is monitoring
    that situation very closely. You now have your people sort of
    in the company day by day; is that right?
        Mr. Lockhart. We have people in the company day by day, our
    examination teams, and I can tell you that we have meetings at
    all levels with those companies on a very regular basis. But we
    are still, I have to tell you, occasionally finding problems;
    i.e., there are still control problems that we are discovering
    even in the last several weeks.
        Senator Sarbanes. Mr. Chairman, I see my time has expired.
    Thank you very much.
        Chairman Shelby. Thank you.
        Senator Sununu.
        Senator Sununu. Thank you, Mr. Chairman.
        Mr. Lockhart, does the consent decree deal at all with
    compensation methodology?
        Mr. Lockhart. Well, we have the powers to review the
    compensation of executives.
        Senator Sununu. But as part of the agreement, were there
    any limitations or restrictions placed on compensation policy?
        Mr. Lockhart. We will review any changes, and we have told
    them, and they have agreed, that they have to change from the
    EPS-only bonus plan to one that covers a lot more areas.
        Senator Sununu. Are there any members of the executive team
    today that are compensated in any part based on earnings per
    share or stock price?
        Mr. Lockhart. Last year, there were no bonuses paid at the
    company. This year, I am not sure what the plan is, because I
    have not seen it yet, but I assume from what they have told me
    that there may be some EPS, but it will be a much smaller part.
        Senator Sununu. We have heard testimony here before this
    Committee, and it has been presented in other Committees as
    well by the past Fed Chairman and others in the regulatory
    environment that the powers proposed in the legislation
    addressing the guidelines for the GSE portfolios would not have
    any negative effect on their mission; specifically, the Fed
    provided material to this Committee showing that the size of
    the portfolios had no impact on availability of 30-year
    mortgages, on mortgage rates, or in the area of providing a
    critical buffer in cases of financial crises.
        Do you agree with that assessment that has been made by the
    Federal Reserve?
        Mr. Lockhart. I generally agree. I have not looked through
    all the details, but yes, I do. You have to think of these
    companies as really two lines of business. One is packaging
    mortgages and securitizing them, and that, under the
    legislation, would continue to grow, and one is just really a
    substitute for the other: buying the mortgages and keeping them
    or just buying them and securitizing them. So certainly, if
    they continue to securitize mortgages, they will support the
    housing market.
        Senator Sununu. Chairman Cox, in your testimony, you talked
    about the stock exchange rules, the New York Stock Exchange
    rules regarding delisting. You note that you have encouraged
    the New York Stock Exchange to amend its rule to put an
    expiration date on the exception it has provided to Fannie Mae
    regarding delisting procedures.
        What is the mechanism for that encouragement? Has there
    been any formal communication or formal request from the SEC to
    the NYSE to establish a fixed duration, an expiration
        Mr. Cox. Yes; the communications between the SEC and the
    NYSE are taking place at the professional staff level. In
    addition, Chairman Thain and I have had these discussions
    directly.
        Senator Sununu. What specific duration do you recommend
    that they impose on the exception?
        Mr. Cox. Our discussions are general at this point. What we
    have agreed is that while we are not trying in any way to
    precipitate or force delisting, we want to be sure that both
    Fannie and its shareholders understand that there are
    consequences for failure, and we want to provide every
    encouragement to get Fannie into a position where it can be
    Exchange Act compliant and thus compliant with the NYSE listing
    standards that apply to every other listed company.
        So we will move forward on this as quickly as we can. I
    have been having these discussions as well with other
    Commissioners, and we will report back in real time.
        Senator Sununu. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Reed.
        Senator Reed. Well, thank you very much, Mr. Chairman.
        Mr. Lockhart, I think that the issue that is dividing the
    Committee in terms of the language of the bill turns on this
    notion of systemic risk. Operational risk, I think we
    understand. That is essentially the focus of this hearing,
    whether the organization is run well, whether the Audit
    Committee operates, whether the outside auditors are there, and
    I presume, based on your agreement with the company, that you
    have essentially at least established in your mind that this
    operational risk issue has been handled effectively at this
    point; is that fair to say?
        Mr. Lockhart. No, I would not say that. They have not
    handled the operational risk yet. They are putting plans in
    place to handle it. I do not think, for instance, that they
    actually have a good operational risk capital model at the
    moment, and they certainly are not complying with Sarbanes-
    Oxley; they are not there.
        Senator Reed. But you are confident that given the
    framework that you have established, that you will be able,
    through your regulatory authority, to achieve that? Are you
    that confident?
        Mr. Lockhart. I am hopeful, yes.
        Senator Reed. Now, the other risk that they run constantly
    is interest rate risk. And that goes to their hedging
    activities, et cetera. You are looking into that, too, and you
    have provided for that?
        Mr. Lockhart. We certainly look at their market risk, their
    interest rate risk, yes, and their credit risk also.
        Senator Reed. And their asset risk also?
        Mr. Lockhart. Yes, that is credit risk basically.
        Senator Reed. Now, we are in this category of systemic
    risk. Assuming you have covered all of these other risks, what
    do you mean by systemic risk? And I ask the question because I
    think it is the question that might divide us.
        Mr. Lockhart. Well, I think systemic risk is a very big
    issue for these two companies, primarily because they are so
    large, and they represent such a large portion of the financial
    markets in this country and the housing markets.
        There is no doubt in my mind that these companies are
    highly leveraged and more highly leveraged, potentially, than
    any other financial institution in this country. They have $1.5
    trillion of debt outstanding, and they have used that debt to
    buy $1.4 trillion of assets. To hedge those assets, they have
    $1.3 trillion of derivatives, and on top of that, they have
    $2.6 trillion in guarantees. And that is all built on a
    combined capital of only $75 billion.
        This is a very large exposure, built on a very small
    capital base. And so, a systemic risk means what happens if
    there is a problem in the financial markets, and could these
    companies cause such a problem? We are certainly very hopeful
    that they will not, but I do not think we necessarily have all
    the protections built in at this point.
        Senator Reed. And correct me if I am wrong, but my numbers
    suggest that in terms of their retained portfolio, it is about
    14 percent of the overall market, which is not trivial, but
    that leaves 86 percent of the market controlled by hundreds of
    other entities, some regulated, most regulated, and some,
    presumably, not regulated. So I think in this regard, there is
    also a systemic risk on the other side, outside of this
    company, which is regulated presumably by the Fed and by
    others.
        Mr. Lockhart. This is a concentrated risk. These two
    companies represent 40 percent of the mortgage market in this
    country. The 15 percent that you mentioned is on mortgages that
    they own and about 26 percent on the guarantees. So that is a
    very, very large exposure. Systemic risk can potentially be on
    both.
        Senator Reed. Absolutely. But the focus, I think, of this
    legislation is on their retained portfolio; is that correct?
        Mr. Lockhart. Right, and one of the reasons is because not
    only is it a retained portfolio; there are the derivatives that
    go with it.
        Senator Reed. Yes.
        Mr. Lockhart. So it is a double exposure, if you will.
        Senator Reed. But I think, just trying to think clearly,
    and I think when we talk about the systemic risk, and this is a
    serious topic, obviously, but I think we have to be very
    careful. On the other side, the mortgage-backed security side,
    where they do have 26 percent of the market, you seem to be
    less concerned about that in terms of systemic risk; is that--
    --
        Mr. Lockhart. We are less concerned about that, but you
    have to look at the whole ball of wax, if you will, and I think
    there is more risk on the portfolio side, and as you know, the
    portfolios have tripled in market share in the last 15 years;
    in fact, at the peak in 2003, it was quadruple the market
    share. They were up at about 20 percent. I think that is a
    serious issue that should be addressed by Congress and the
    regulator.
        Senator Reed. Well, I guess, I think it is a serious issue.
    But typically, the way we have addressed this issue with
    respect to the Federal Reserve is to give them the tools with
    respect to the safety and soundness issue, raising capital, et
    cetera. I do not think we have given them a category of
    systemic risk which they can sort of improvise or, you know,
    innovate in terms of regulation.
        I say this not suggesting it might not be appropriate, but
    I do not think we have yet understood precisely what tools you
    want, precisely what the risks are. In fact, the systemic risks
    posed to many companies is a huge deficit by the Federal
    Government and the interest rate policy by the Federal Reserve.
    That is pretty systemic, but I suspect you are not asking for
    that authority.
        Mr. Lockhart. What we are asking for--and I think the
    Senate bill covers a lot of the issues, as does the House
    bill--are stronger safety and soundness; obviously, we need
    that. We need stronger capital powers, part of which could
    address systemic risk, and we need to look at these portfolios
    to see if they need to be as large as they are.
        Senator Reed. Do you think the Federal Reserve needs those
    same powers when it looks at the portfolios of Citigroup and
    Bank of America and others?
        Mr. Lockhart. I think that they can control the growth of
    those companies. In fact, in the case of Citigroup, I think
    they were told not to grow awhile ago.
        Senator Reed. But that is based upon, and I do not want to
    belabor this, it is based on the existing powers. Here is where
    I think the dilemma is: I do not think there is a big debate
    about giving you the financial powers that the Fed has, that
    the OCC has with respect to national banks and others. It is
    just what do you mean by this systemic risk? Is this an
    undefined term which you will make of it is what you want to?
    And I think that is the real issue, a substantive issue, a
    principal issue that we have to sort out amongst ourselves, and
    we need more guidance from you.
        And my time has expired.
        Chairman Shelby. Thank you, Senator Reed.
        Senator Dole.
        Senator Dole. Chairman Cox, you stated that Fannie Mae
    would be far more likely to maintain consistent compliance with
    our disclosure regime if the Congress were to terminate its
    special status of voluntary registration and reporting and make
    its registration and reporting mandatory. Does this mean that
    the SEC now supports full GSE compliance with the 1933 and 1934
    securities acts, and if not, why not, and what provisions are
    you suggesting should apply?
        Mr. Cox. I focused in my testimony, and indeed, the SEC has
    focused in more than a decade-long look at this issue, on the
    Exchange Act reporting obligations rather than the 1933 Act.
    They are essentially the same kind of information, and what we
    are concerned about is getting that information to the
    marketplace. I think there is an additional layer of issues
    that you might want to consider as you consider application of
    the 1933 Act: specifically, what effect, if any, would that
    have on costs? And would that, in turn, translate into directly
    or indirectly higher mortgage costs?
        If the cost-benefit tradeoff is determined to work
    satisfactorily, then, there is certainly no conceptual reason
    that the 1933 act requirements as well as the 1934 Act
    requirements should not be applied. And I would point out that,
    if currently Fannie were subject to the 1933 Act, it would not
    be able to issue any securities, because one of the
    requirements is that you be current in your 1934 Act reporting
    requirements, which, of course, they are not.
        Senator Dole. As you have said, in all likelihood, this
    will be one of the largest restatements in American corporate
    history. Given that fact, how can the New York Stock Exchange,
    how can the SEC permit the stock of Fannie Mae to be traded
    without additional disclaimers or warnings to investors that
    there are still no current financials for this company?
        Mr. Cox. Well, I think that those have to be and are being
    transmitted. There have been several 8-K filings by Fannie. One
    of the things that we want to be sure of and that the NYSE
    clearly wishes to be sure of is that that kind of current
    information is being provided to the marketplace. It is
    entirely because of the unique circumstance by which Fannie,
    starting in 2002, determined voluntarily to subject itself to
    these requirements that we find ourselves in this unusual spot.
        But, as I mentioned, I think it is very important that we
    focus on the ``why.'' And the reason that the New York Stock
    Exchange has amended its listing standards with respect to
    Fannie is so that we can get them into compliance, so that they
    could make the transition to both registration and reporting
    under Section 12 of the Exchange Act.
        It is a little bit of jargon, but the purpose of that is to
    protect investors. I mean, there are shareholders whose
    interests are paramount, and we want to be sure that they have
    liquidity, they have a place to trade, that we do not drive up
    their cost, and so on. And so, to the maximum extent possible
    in protecting their interests, we want to get the show on the
    road; get Fannie compliant.
        Senator Dole. Thank you.
        On page 5 of your written statement, you note that Fannie
    Mae did not have adequate systems or personnel in place to
    comply with FAS 133. Yet Congress, investors, and American
    taxpayers were told repeatedly that Fannie Mae had world-class
    controls and disclosure. Was that assertion based on ignorance,
    or was it a blatant lie? I do not know which is worse, but both
    scenarios are outrageous.
        Mr. Cox. Well, I think we were ignorant, the public,
    investors, the market, because some people were intentionally
    manipulating Fannie's earnings, both with respect to FAS 133,
    as you mentioned, and also FAS 91.
        Senator Dole. Let me direct this question to both of you:
    Do either of you believe that there should be a moratorium on
    all new GSE initiatives unless or until the GSEs, their
    external auditors, the SEC, and OFHEO agree that the GSEs have
    resolved their serious problems?
        Mr. Lockhart. From my view, I am not sure a moratorium is
    needed, but I think that managements need to concentrate on the
    issues you just mentioned. Developing new products at this
    point when they are stretched for manpower, new products that
    would require new systems, new risk management, and everything
    to go with it, when they are telling us that they cannot really
    fix the problems for several years just does not make sense to
    me at this point.
        Senator Dole. Chairman Cox.
        Mr. Cox. I concur. The focus, of course, of the SEC right
    now is our ongoing investigation of individuals and
    organizations who have contributed to the problems we have
    already uncovered with the respect to the question you and I
    were just discussing about getting them current in their
    registration reporting obligations under the Exchange Act. It
    would be awfully nice to have these restatements accomplished,
    to get them current, to give shareholders the comfort that they
    are meeting the listing standards of the New York Stock
    Exchange and to do first things first.
        Senator Dole. Thank you, Mr. Chairman. I think my time has
    expired.
        Chairman Shelby. Senator Carper.

                   STATEMENT OF SENATOR THOMAS CARPER

        Senator Carper. Thanks, Mr. Chairman. I apologize for not
    being able to be here to hear your statements. Gentlemen, we
    thank you for joining us today. We have just concluded our
    markup of the Chemical Security bill that Chairman Cox and I
    were talking about and reported it out unanimously, if you can
    believe that.
        Mr. Cox. Congratulations.
        Senator Carper. One of my disappointments as a Member of
    this Committee is that we were unable to pass something out
    with bipartisan support with respect to GSE regulation. The
    bill that is now languishing before the Senate is one that I
    hope we can come back to, take it up, and find common ground
    amongst ourselves. And I believe your testimony and that which
    will follow will be helpful toward that end.
        Senator Dole has asked you a question that I was going to
    ask, but I want to follow up a little bit with respect to
    registration with the SEC. And I just wanted to ask you,
    Chairman Cox, if you will, to just further explain the costs to
    the GSEs for compliance and what effect, if any, that might
    have on the GSEs' ability to comply with their mission.
        Mr. Cox. It has been asserted by some that there would be
    material incremental costs. I cannot tell you today that I
    believe that to be true, but I think it is appropriate for
    Congress to weigh the costs and benefits, and the SEC, and our
    professional staff, including our economists, would be very
    happy to cooperate with you in that endeavor.
        Senator Carper. Thanks.
        Mr. Lockhart, if I could direct a question to you: you may
    have already been asked this question. If you have, I
    apologize. I am going to ask it again.
        When you look at the changes that have been made at Fannie
    Mae, and we will just stick with Fannie Mae, but if you look at
    the changes that have been made there over the last year, would
    you handicap those which you find favor in and those which you
    find still fall a bit short of what is needed?
        Mr. Lockhart. I would say they have made progress, but it
    is disappointingly slow, and I would say the same thing about
    Freddie Mac. The Chairman of Freddie Mac was quoted this week
    saying the company is materially different than Fannie Mae. If
    you read the report we are putting out today, these two
    companies are still very far away from really being where they
    should be. And I think that an important part of their mission
    is they are supposed to be these world class companies that
    they claim to be to fulfill this mission of affordable housing,
    and they are not there yet, not even close.
        Senator Carper. The two issues, as I am sure you already
    discussed it, that kept us apart when we reported a bill out of
    Committee were the provisions dealing with affordable housing
    and the issues that relate to the portfolio, what can be in the
    portfolio, the size of the portfolio, the growth of the
    portfolio.
        Would you just, in layman's terms, both of you, just
    explain--Chairman Cox, you are really good at this, as I have
    noted before, just in layman's terms, what concerns should we
    bring to our final negotiations, which hopefully will get us a
    resolution and able to move a bill? With respect to the
    portfolio, what especially should we focus on trying to
    address?
        Mr. Cox. Well, both with respect to the affordable housing
    piece and the limitations on the portfolio, I think it is
    slightly outside or at least slightly tangential to our main
    focus at the Commission. What we would like to see, and I would
    hope that we can keep our eye on this ball, too, is that Fannie
    would become a normal, in this sense, private issuer of
    securities to the public that reports under the Exchange Act
    requirements.
        And, if that were accomplished, and if, in consequence, it
    met the NYSE local listing standards, then, I think it would be
    a much more salutary discipline on Fannie by the markets based
    on genuine information. The next order of concern at the SEC,
    as Senator Sarbanes has mentioned several times, is internal
    controls. I know this is an issue to Director Lockhart as well,
    so focus on both the way that Fannie and the GSEs are devoted
    to their missions and on the way the regulator has an
    opportunity to discipline that. I think it is of vital
    importance.
        Senator Carper. Mr. Lockhart, can you just briefly respond
    to my question?
        Mr. Lockhart. I think some of the key issues are the
    systemic risk that we were talking about with Senator Reed and
    the operational risk inherent in those portfolios, not only
    from the investments they are making but from the derivatives
    that help support those portfolios. That has to be a major
    concern.
        We also, in limiting the portfolios, have to look at what
    is in the portfolios. And to the extent that they are taking
    more risk, we are going to have to look very hard at that as
    well. It is the size that is a systemic risk issue, as well as
    the operational market and credit risk issues in those
    portfolios.
        Senator Carper. My time has expired. Thanks very much.
        Chairman Shelby. Senator Bennett.
        Senator Bennett. Thank you, Mr. Chairman. I apologize for
    having to leave and just catching the tail end of Mr.
    Lockhart's comment.
        I think you may have covered the issue that I want to talk
    about. Assuming that we get the kind of world class regulator
    that we are hoping for as the result of legislation, would you
    feel comfortable with the regulator having the authority to
    deal with the portfolio issue rather than having Congress
    mandate any aspect of it?
        Mr. Lockhart. It would be very helpful for Congress to give
    us guidance, and that is what the Senate bill does, gives some
    guidance to the regulator. The regulator does need flexibility.
    I think there are two ways to go about this, and we may have to
    look at both. One is guidance on portfolio limits, and the
    other is risk-based capital and minimum capital requirements.
    As I said earlier, I believe we have to look seriously at risk-
    based capital rules and the minimum capital rules, because I am
    not sure that these companies are as well capitalized as they
    should be going forward.
        Senator Bennett. Well, I am a little reluctant about the
    Congressional guidance. Guidance is a very vague word. And I
    think there are two aspects to this, and give me your reaction.
    One is the safety and soundness of Fannie Mae and Freddie Mac.
    The other is the systemic risk arising from their laying off
    the risk through hedges and derivatives. I think the regulator
    has to look at both. As I understand it, the House bill is
    almost exclusively the safety and soundness of Fannie and
    Freddie; is that correct?
        Mr. Lockhart. It is almost exclusively, although they do
    ask us to do a study, and they mention systemic risk as one of
    the things we are supposed to be looking at.
        Senator Bennett. OK, if we write it into the law, the
    standards that might apply in 2006 could turn out in the fast-
    changing financial services world to be inappropriate as early
    as 2009 or 2010. Guidance is one thing; specificity is another.
    Do you have any views as to where the guidance ought to be that
    would give the regulator the maximum flexibility to respond if
    there were changes in the derivatives market that we cannot
    conceive of now but that could have significant bearing on the
    way the portfolio is managed?
        Mr. Lockhart. Guidance can be part of legislation, as it is
    in the Senate bill. Certainly, there needs to be that
    flexibility going forward. We do not want to have to come back
    to Congress every year to get a fix. I agree with you entirely
    there.
        Senator Bennett. That is my concern.
        Mr. Lockhart. And one of my concerns when I was at PBGC,
    for example, you do not get a chance to have major legislation
    every year in this country.
        Senator Bennett. Yes.
        Mr. Lockhart. At PBGC, I fought 3 or 4 years. Senator Dole
    remembers this well as my boss: and we finally got legislation,
    but it did not go far enough. One of the important things we
    want to do here is to make sure that we go far enough at this
    point but also give the regulator the powers to make changes.
        Senator Bennett. We are having this hearing as if the bill
    were still before us, and of course, it is not. The bill has
    passed out of Committee. So these are just discussions that
    would inform the debate on the floor.
        Let me ask one question just for my own information. You
    spoke of tremendous earnings being restructured, the earnings
    restatement. Are there any earnings that will be put into
    future quarters that were brought into previous quarters in an
    effort to make the earnings look good when, in fact, they
    should have been delayed to some future time?
        Mr. Lockhart. I am not sure about that, because we have not
    gotten all the details. There were some financial transactions
    that did move earnings out to the future, and I assume they
    will be restated. We may have actually passed that time by now.
        Senator Bennett. Yes.
        Mr. Lockhart. Basically, I would assume that there will be
    some ups and downs, yes.
        Senator Bennett. That is a question probably I ought to ask
    Mr. Mudd.
        Mr. Lockhart. Right.
        Senator Bennett. Because if, in fact, there are substantial
    earnings yet to come in future quarters, that might explain why
    the stock market has not reacted as strongly. If all of the
    money was completely lost and would never, ever be seen again,
    that is one thing, but if some of it is going to be seen future
    down----
        Mr. Lockhart. You can ask that of CEO Mudd. But I think the
    issue is, when they correct the accounting, that those
    transactions will disappear, basically, because they were not
    GAAP-compliant, and when they make them GAAP-compliant, they
    will put the earnings back where they are supposed to be.
        Senator Bennett. Yes, but the thing I am trying to find out
    is were there earnings? If they were improperly allocated or
    improperly apportioned, obviously, that is not GAAP-compliant,
    and obviously, that falls under the----
        Mr. Lockhart. As I understand it, that $11 billion
    restatement is a net number.
        Senator Bennett. Is a net number; OK, that is what I was
    trying to find out.
        Mr. Lockhart. And the future earnings will be depending on
    what they do in the future, basically.
        Senator Bennett. Yes, OK.
        Mr. Lockhart. Because they are going to be keeping their
    books by GAAP and, now, they have lost most of their hedge
    accounting, so we will see a relatively volatile set of
    earnings in these companies.
        Senator Bennett. I see; but that is the point I had not had
    before: the $11 billion is a net number.
        Mr. Lockhart. That is my understanding, yes, Senator.
        Senator Bennett. I see.
        OK; thank you, Mr. Chairman.
        Chairman Shelby. Senator Schumer.

                STATEMENT OF SENATOR CHARLES E. SCHUMER

        Senator Schumer. Thank you, Mr. Chairman, and thank you,
    witnesses.
        I have some real concerns here. Obviously, there have been
    some misdeeds at Fannie and Freddie. I think a lot of people
    are being opportunistic, taking those and then throwing out the
    baby with the bath water, saying let us dramatically
    restructure Fannie Mae and Freddie Mac when that is not what is
    called for as a result of what has happened here. First, I want
    to ask you, Mr. Lockhart: the new administration at Fannie and
    Freddie have taken some real reforms, including the $400
    million settlement. Do you think what they have done is good,
    and do you think it is adequate?
        Mr. Lockhart. The steps they are taking have been good, but
    they are not adequate yet. As I said before, it is going to
    take several years to be SEC-compliant and certainly to meet
    our----
        Senator Schumer. But what more should they be doing now? It
    will take years, but that is because of what happened in the
    past. What more should the new management at Fannie and Freddie
    be doing that they are not doing now, or at Fannie, anyway,
    that they are not doing now?
        Mr. Lockhart. They need to continue to work on internal
    controls, risk management, accounting systems, recruiting
    people, and reviewing the people that they have. There is a
    whole series of actions that we have set out in the agreement.
        Senator Schumer. But are they not in the process of doing
    all of those?
        Mr. Lockhart. They are in the process of doing it.
        Senator Schumer. Do you think they are doing it too slowly?
        Mr. Lockhart. They are doing it slowly. Whether it is too
    slowly, I am not sure, because of the resources available.
        Senator Schumer. OK, I am a little concerned, also, at the
    independence of you and the regulator. There seems to be this
    coordinated effort to go after Fannie and Freddie. On the same
    day that Treasury announces it is going to try to do what
    cannot be accomplished legislatively, Secretary Jackson
    announces HUD's intention to initiate a review of Fannie and
    Freddie's holdings. Have you had conversations with the
    administration, with the Treasury, the White House, or the
    Federal Reserve, about the Senate GSE bill?
        Mr. Lockhart. I have had conversations, obviously, when
    they were looking at appointing me to the job.
        Senator Schumer. And what did you say? Did you say you
    supported it?
        Mr. Lockhart. I said at that point, I did not know enough
    to say I supported it, but I certainly support the principles
    of a stronger regulator.
        Senator Schumer. Well, that, we agree with, but let us go
    to that issue of, you know, the problems that are here, the
    accounting problems and others, I do not think you are going to
    have any dispute. But then, there is, again, the idea to
    dismantle or greatly diminish Fannie and Freddie at a time when
    we are having a tougher time for middle class people to find
    housing. So I want to ask you about systemic risk, which is a
    different issue.
        Mr. Lockhart. Can I just say about dismantling----
        Senator Schumer. Yes.
        Mr. Lockhart. Because I would not have taken this job if it
    was a dismantling job. To me, it is a rebuilding job, and that
    is what needs to be done.
        Senator Schumer. Well, do you not think that if you greatly
    limit portfolios, if you put in pretty strong portfolio limits,
    it will greatly limit what Fannie and Freddie can do in the
    future compared to what they do now?
        Mr. Lockhart. It will change what they do, but I do not
    think it is going to greatly limit them because as I said
    earlier, they do continue to have the power to securitize
    mortgages. They package them up and sell them to the
    marketplace. In fact, that is their bigger business. And
    really, what happens is they are either going to issue
    securitized mortgages or debt and buy mortgages. And to the
    investor, they can make the choice of which they want, and at
    the moment----
        Senator Schumer. Let me ask you this: have you had specific
    conversations with Treasury, White House, Federal Reserve about
    systemic risk?
        Mr. Lockhart. I have had conversations again about systemic
    risk prior to my appointment with now Fed Governor----
        Senator Schumer. How did you define to them, how do you
    define today what systemic risk is, and do you think Fannie and
    Freddie in their present status contribute or possibly create
    systemic risk?
        Mr. Lockhart. I do believe that they create systemic risk.
    OFHEO put out a report three or 4 years ago that gave some
    scenarios of how that could be created.
        Senator Schumer. How do you define it?
        Mr. Lockhart. I define systemic risk as actions by these
    companies that they could cause a major problem in the economy.
        Senator Schumer. OK, it says here, page 21 of the report to
    Congress, based on OFHEO's examination activities to date, it
    is the overall conclusion of OFHEO that Fannie Mae has strong
    asset quality and prudential credit risk management policies.
    Do you agree with that?
        Mr. Lockhart. Yes.
        Senator Schumer. So how is the systemic risk--let me just
    ask----
        Mr. Lockhart. They have market and credit risk capabilities
    that are reasonably strong. They do need to be improved in
    several areas. Their operational risk is not acceptable at this
    point.
        Senator Schumer. Their----
        Mr. Lockhart. Operational risk management.
        Senator Schumer. Let me ask you this: basically, the
    systemic risk argument says something terrible can happen, and
    they have so much that you better be careful. How is it
    different than the systemic risk that any private institution
    has, CitiGroup, I do not know, some of the others which are
    immense as well? Is there any difference?
        Mr. Lockhart. There is some difference, because first of
    all, this is a very concentrated risk. Citigroup is a very
    diversified financial institution. This is all concentrated,
    really, in one market. And they have a tremendous market share,
    40 percent.
        Senator Schumer. Is it not stable market than many of the
    other markets the financial institutions are in?
        Mr. Lockhart. Housing goes up and down. Interest rates go
    up and down, and they are two of the real drivers here. As I
    was saying earlier, you are going to see these companies have a
    lot more volatility in the future----
        Senator Schumer. But generally the----
        Mr. Lockhart. It is not totally stable.
        Senator Schumer. But generally, the market there is
    regarded as one of the more stable risks by investment grade,
    by interest rates, by everything else.
        Mr. Lockhart. If you are referring to the credit quality of
    the borrowers and the asset coverage----
        Senator Schumer. Yes.
        Mr. Lockhart [continuing]. ----that is more stable than
    some of the other investments. But one of the things that has
    happened in this market from time to time is they have done
    transactions that create risk.
        Senator Schumer. And so could a private institution.
        Mr. Lockhart. Private institutions have, yes.
        Senator Schumer. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Martinez.
        Senator Martinez. Thank you, Mr. Chairman.
        Let me back up a moment for the benefit of those who might
    have missed part of the hearing. But when we talk about
    misdeeds, we are really talking about accounting fraud, is that
    not, Mr. Cox, your testimony, that what we had here was
    accounting fraud?
        Mr. Cox. That is certainly the basis for what the SEC
    charged Fannie with.
        Senator Martinez. Now, and the magnitude of the misdeeds
    which are accounting fraud was $11 billion. That is the
    magnitude of the restatement, correct?
        Mr. Cox. That is, I believe, the lower bound of the
    estimate. We do not know yet what the real number will be.
        Senator Martinez. But that will be the bottom of it? It
    could be higher?
        Mr. Cox. That is right.
        Senator Martinez. Which puts it at about the same level as
    WorldCom if we were to compare.
        Now, also, we have talked about new management. Mr.
    Lockhart, I want to ask you about that, because it really is of
    great concern to me about where we are on that issue. In fact,
    the CEO is not new to Fannie Mae, correct?
        Mr. Lockhart. That is correct.
        Senator Martinez. One of the concerns that I have is
    whether, in fact, the manipulation of the numbers, the
    manipulation of earnings which is part of what this accounting
    fraud is about triggered certain bonuses to members of an elite
    group of executives, correct?
        Mr. Lockhart. That is correct.
        Senator Martinez. My understanding from your report is that
    Mr. Mudd, the current CEO, benefited to the tune of $13 million
    to $14 million in these bonuses.
        Mr. Lockhart. Yes, he did. I think it was actually $15
    million.
        Senator Martinez. $15 million?
        Mr. Lockhart. $15 million out of $26 million.
        Senator Martinez. His compensation over a 5-year period was
    $26 million, of which $15 million of those were triggered
    precisely by the very earnings that were tilted through
    accounting fraud in part to stabilize the earnings and in part
    to benefit the executives with these outlandish bonuses.
        Mr. Lockhart. To me, it is not just accounting fraud. This
    is mismanagement of the company. And I am not referring
    necessarily to the present management, but I am talking about
    the management during this period. It is more than just
    accounting fraud. They underinvested in systems; they tried to
    do a series of activities to weaken the agency, as you know,
    and so, it is much more than just accounting fraud in my mind.
        Senator Martinez. When we talk about your recommendations
    or the actions you have suggested, and I know Chairman Cox,
    perhaps you cannot comment on this, but I am anxious to know
    whether, in fact, there will be an opportunity for a recovery
    to the investors of these bonuses which may have been as a
    result of accounting fraud, and if it is not appropriate to
    answer at this time, I would be happy to wait until another
    point to hear the answer.
        Mr. Cox. Well, I think I can state in the very abstract
    that disgorgement is always a remedy that is available. Since
    we are in the midst of an investigation right now, I cannot
    fast forward to what might be the result.
        Senator Martinez. Do you have an estimate, Chairman Cox, of
    the loss to shareholders created by the accounting fraud that
    is documented in the OFHEO report?
        Mr. Cox. Well, certainly, there is a market measure. On the
    basis of the change in share price--the share price was over
    $75 a share. Now, it is below $49 as of about June 7, I think,
    the last figure I have in my head.
        Chairman Shelby. How many billions of dollars roughly, just
    calculate--
        Mr. Lockhart. It is about a billion shares, so that is
    about $25 billion, $25 billion to $30 billion.
        Chairman Shelby. $25 billion.
        Senator Martinez. So that is about $25 billion in magnitude
    in terms of what it represents to the investors, and this is to
    folks who just, in good faith, believing the numbers, believing
    the reports, bought the stock. Now, you know, we went back and
    forth here on risk, and my understanding of the systemic risk
    that this company undertakes, one of the things that makes them
    different from a private company is the fact that they have
    this implicit guarantee from the Federal Government.
        Mr. Lockhart. That is correct; they do have the implicit
    guarantee, and that is one of the reasons that these companies
    are still standing. As I said earlier, they would have probably
    lost their credit rating if they were a normal company. And
    that has been very helpful to keep supporting the housing
    market, which we all agree is an extremely important mission of
    these companies.
        Senator Martinez. Which is, at the end of the day, what
    they are chartered to do, support the housing market and to try
    to help first-time homebuyers and, you know, bring affordable
    housing to the marketplace. There are other parts of OFHEO's
    and HUD's analysis, more HUD analysis of these GSEs which would
    suggest that they trail, they lag behind the market in terms of
    providing assistance or mortgage assistance to low and moderate
    income homeowners, first time home buyers. Are you familiar
    with that as well?
        Mr. Lockhart. I have heard that, but I have not gotten into
    the details.
        Senator Martinez. You ought to take a look. It is there.
        Mr. Lockhart. I will.
        Senator Martinez. Mr. Chairman, my time has expired. Thank
    you very much.
        Chairman Shelby. We have two votes on the floor. We have
    one now in the second warning. We are going to take about a 20-
    minute recess. So the Committee is in recess.
        [Recess.]
        Chairman Shelby. The Committee will come back to order.
        Senator Hagel.
        Senator Hagel. Mr. Chairman, thank you.
        Gentlemen, I very much appreciate you indulging our
    Committee and in particular giving me an opportunity to get
    back, and thank you. I know Chairman Cox is well aware of these
    kinds of procedures, votes and all that go with it, so thank
    you very much, and I do not have a great number of questions,
    and the ones that I do, in the interests of time, Mr. Chairman,
    I will submit for the record, but I do appreciate the
    opportunity to ask a couple of questions.
        Mr. Lockhart, I apologize also, since I had to go manage
    one of the amendments on the floor, and I may be covering
    ground here that others have asked. So if that is the case,
    just tell me, and we will move on to something else. Thank you.
    Mr. Lockhart, given the level of fraud and mismanagement
    outlined in your recent OFHEO report on Fannie and previous
    report on Freddie, how concerned is OFHEO about the ability of
    the GSEs, Fannie and Freddie, to manage the $1.5 trillion
    portfolios they have?
        Mr. Lockhart. OFHEO is concerned about the management of
    both GSEs. The internal controls are not there. Risk management
    is not there. Accounting systems are not there. We did put a
    freeze on Fannie Mae for that very reason and are not allowing
    them to grow their portfolios from year-end levels. We are in
    discussions with Freddie Mac at the moment on that same issue.
        Senator Hagel. Obviously, if we can pass new regulation
    reform legislation which would give OFHEO additional authority,
    additional resources, I assume that would be significantly
    important, in fact, to address the concern that you have, the
    authority. And if you could just develop that in a brief way,
    how critical is that authority? And by the way, you know where
    the two bills are, the bill that we passed out of this
    Committee plus what the House has done. If you do not think
    that authority is sufficient, I would like to hear that as
    well.
        Mr. Lockhart. Both bills go a long way to where we need to
    get to on the safety and soundness issue. There is just no
    doubt about it: we need more authority and a whole series of
    things that the bills do cover. In particular, capital
    authority, receivership authority, and we need more budget
    flexibility. On the issue of portfolio limits, the Senate bill
    does give better guidance of where they want to be, and that is
    helpful.
        And there may be pieces in both bills; I believe the House
    bill has better language on disgorgement, for instance.
    Basically, legislation is what we need. We need to strengthen
    this agency. We need to be a much stronger safety and soundness
    regulator.
        Senator Hagel. Thank you. As you know, the OFHEO report
    states, and I will quote from the report, quote, by
    deliberately and intentionally manipulating accounting to hit
    earnings targets, Fannie's senior management maximized the
    bonuses and other executive compensation that they received at
    the expense of the shareholders. That, end of quote, comes from
    your report.
        Can you tell the Committee, were any members of the Fannie
    Board aware of this accounting manipulation? Or how many were
    at least aware generally, or how many knew anything about it?
    How many tangentially had some sense of what was going on?
        Mr. Lockhart. I am not sure that we were able to show that
    any Board member really knew, and that is the fault of the
    Board, because their job is to be informed of what is going on
    in the company, and they were too passive. I say any Board
    member; obviously, the Chairman of the Board, Raines, was
    aware, and the other management members of the Board were
    aware. I am talking about the outside Board members.
        Senator Hagel. And what are we going to do to address that?
    Because we all understand that that is a primary, certainly a
    basic fiduciary responsibility of Boards of Directors. Do we
    need new authorities? Do we need a new Board? Do we need new
    management? What do we do?
        Mr. Lockhart. In part of our various settlement agreements,
    we put in a whole series of rules for the Board, and they are
    starting to make some of those changes. One of the things we
    did was to separate the CEO and the Chairman job. We are
    strengthening the Board committees. They have, I think, four or
    five new Board members and a new member of one of the key
    committees, the new chair of the Audit Committee, which we
    really applaud.
        So they are making progress, and you will hear from
    Chairman Ashley later, and he will tell you that they are
    making progress in the Board. I believe they are, but they may
    have to go farther. As you know, we have asked the Board to
    look at the Board members and the management team that are
    still in place to see if there need to be any additional
    changes.
        Senator Hagel. How many members of management are still at
    Fannie who benefited from these bonuses and executive
    compensation during the period of your investigation?
        Mr. Lockhart. I cannot give you an exact number, but I
    would guess it is probably over 10 still.
        Senator Hagel. Still there at Fannie Mae, OK.
        Mr. Lockhart. Right.
        Senator Hagel. OK, regarding the lobbying efforts that we
    have heard a great deal about, which your report focuses on
    with some detail; in fact, again, I will just quote something
    very quickly, and then I am going to ask you a question about
    it from your report: Fannie Mae lobbyists worked to ensure that
    the agency, OFHEO, was poorly funded and used longstanding
    relationships with Congressional staff to interfere with
    OFHEO's special examination of Fannie Mae, end of quote.
        The Fannie Mae lobbying effort to generate the HUD
    Inspector General's fourth investigation of OFHEO and all the
    other pieces that you addressed, did you direct your attention
    to, or do you know who, in fact, directed Fannie Mae lobbyists
    in this regard, members of management there at Fannie Mae?
        Mr. Lockhart. The lobbyists reported to very senior
    managers, and as I understand it, they were certainly in
    contact with the chief executive officer. This was a
    longstanding tradition at the company, as we have already heard
    several times today. They were extremely active in lobbying
    Congress and spent an awful lot of money at it.
        Senator Hagel. So does that then imply, or are you then
    saying it was directed out of the CEO's office? My question
    would then be was that Mr. Raines? What role did Mr. Mudd have
    in this, who, of course, is now the CEO but at the time was the
    chief operating officer. So what did the investigation develop
    in the way of who was direction----
        Mr. Lockhart. This is an area I have not paid as much
    attention to. One of the things that we did in our consent
    decree was we told them to relook at this whole group and do a
    study of how it is being organized. Mr. Donilon, who sat over
    this group, as I understand it, was the corporate secretary,
    and he was in contact with the senior management and Chairman
    Raines, on what was going on. This whole organization was
    extremely active at trying to prevent OFHEO from doing its job.
    And that is the unfortunate truth.
        Senator Hagel. Well, that is a rather significant statement
    that you have just made, because you have, starting with Mr.
    Mudd, who is still there, who is managing, as the CEO, this
    organization, so if, in fact, he was involved in doing what you
    had just stated the institution, the enterprise as a whole,
    that is a pretty disturbing point.
        I intend to ask Mr. Mudd, when he is up here in a few
    minutes, what role he played, but you, being the director of
    the regulatory agency that made this examination and came up
    with this report, I would ask that this Committee then be
    informed, as you have noted, further developing more
    information and a report on this.
        Mr. Lockhart. We will. I can tell you that he has made some
    significant changes in this group. Maybe more need to be made,
    but they are certainly a lot less active than they were, and he
    has promised me that they will continue to be that way.
        Senator Hagel. Well, and I appreciate that, but again, I
    will ask him the question, because if he was party to directing
    efforts, significant multimillion dollar efforts to undermine
    the institution's regulator, which we found out from your
    report they were doing, but, if it is that great, they, and I
    think this Committee and I certainly would like to know who,
    especially because they all benefited rather significantly from
    undermining the interest of the American people and the
    American taxpayer by their conduct and behavior and
    mismanagement.
        As the Chairman of the SEC noted in a more private setting
    and as was brought out in this hearing this morning, there
    would be probably some indictments in a private corporation.
    There may be indictments yet. But in the interests of time, Mr.
    Chairman, I very much appreciate both what you and Chairman Cox
    are doing at your agencies. They are important, you know that,
    at an important time, and I appreciate again your generous
    efforts to accommodate my schedule. Thank you.
        Mr. Chairman, thank you.
        Chairman Shelby. Gentlemen, we appreciate your appearance
    today and your contribution to good corporate governance and to
    the GSEs.
        Mr. Cox. Thank you, Mr. Chairman.
        Mr. Lockhart. Thank you, Mr. Chairman.
        Chairman Shelby. We are going to call up our second panel
    now: Mr. Daniel Mudd, President and Chief Executive Officer of
    Fannie Mae, and Mr. Stephen Ashley, Chairman of the Board of
    Directors of Fannie Mae.
        Mr. Mudd, Mr. Ashley, your written testimony will be made
    part of the hearing record of the Banking Committee. We will
    first call on you, Mr. Mudd, for any opening statement you want
    to make.
        Mr. Mudd. Yes, sir, if I might, Mr. Chairman, defer to my
    Chairman, Mr. Ashley, to open and follow him briefly.
        Chairman Shelby. That is OK. If you want to do that, that
    is OK with us.
        Mr. Ashley, then.

                    STATEMENT OF STEPHEN B. ASHLEY,

                  CHAIRMAN OF THE BOARD OF DIRECTORS,

                               FANNIE MAE

        Mr. Ashley. Thank you, Mr. Chairman, Senator Sarbanes,
    Members of the Committee, my name is Steve Ashley. I have been
    in the mortgage business for over 40 years, and the last time I
    had the privilege of testifying before this Committee was when
    I served as President of the Mortgage Bankers Association of
    America.
        Eighteen months ago, I was asked to become the independent
    chairman of the Fannie Mae Board of Directors, and I appreciate
    the opportunity to appear before the Committee today. The
    Fannie Mae of 1998 to 2004 portrayed in the final OFHEO report
    of its special examination is a far different company than was
    portrayed to the Fannie Mae Board by departed management, our
    former external auditor, and annual regular examination
    reports. I would like to comment briefly on the Board and the
    company's response to the OFHEO special examination of Fannie
    Mae and the changes we have made and are continuing to make to
    address the problems identified.
        On September 20, 2004, when we received OFHEO's interim
    report, we acted immediately to examine and respond to its
    findings. Within a week of receiving the report, we reached an
    agreement on a process to resolve the issues raised by the
    report. We pledged to work cooperatively with OFHEO, and we
    began supervising the work of fixing the company. Also in
    September 2004, the Special Review Committee of the Board
    initiated an independent review of the issues raised in the
    OFHEO report and other matters relating to the company's
    accounting, governance, structure, and internal controls.
        To conduct the review, the Committee engaged former Senator
    Warren Rudman and his law firm of Paul Weiss, which retained
    the services of a forensic accounting firm. The Board directed
    that the work of Paul Weiss be transparent to OFHEO, the SEC,
    and the Department of Justice during the entire period of
    review.
        In October 2004, the Board established an ongoing
    Compliance Committee. And by the end of 2004, working with
    OFHEO, we had taken action to replace our outside auditor,
    launch our restatement, and replace our chief executive officer
    and chief financial officer. Since September 27, 2004, the full
    Board has met 43 times; Board committees have met 146 times.
        Since January 1, 2005, I have met directly with the
    director or acting director of OFHEO 17 times. As independent
    chairman of Fannie Mae, I typically spend 2 to 3 days a week at
    the company providing direct oversight. Working with OFHEO, we
    also agreed to take steps to further strengthen the company's
    corporate governance. Let me describe some of these and other
    changes the Board has made.
        We separated the roles of the chief executive officer and
    the chairman of the Board. Five of the 12 nonmanagement members
    are new since 2004, and the newest member, Dennis Beresford, is
    a former chairman of the Financial Accounting Standards Board
    and is serving as chairman of the Audit Committee. All five of
    the new Board members are independent of management. We
    eliminated two seats held by management, retaining just one, to
    increase the proportion of independent Board members. In
    addition, in accordance with our corporate policy and OFHEO's
    corporate governance rules on length of service, another Board
    member, Ann Korologos, will be leaving the Board effective July
    31. As lead director and chairman of the Governance Committee
    in 2004, she felt it was her duty to remain on the Board an
    extra 2 years to see us through the investigative phase, which
    is now complete.
        To ensure accountability and the timely flow of
    information, we established reporting lines to the Board for
    the positions of chief audit executive, chief compliance and
    ethics officer, and chief risk officer. During this period, the
    Board exercised one of its paramount functions: to select and
    review the performance of the CEO of the company. We made a
    change in leadership at Fannie Mae when we appointed Dan Mudd
    as interim CEO on December 21, 2004.
        We directed Mr. Mudd to begin working with the Board and
    with OFHEO to implement our regulatory agreements, carry out
    other necessary and appropriate changes to the company, and put
    Fannie Mae on the right track. More specifically, we made clear
    that his duties included the following: restoring the company's
    capital; restating Fannie Mae's financial results; building a
    new management team, particularly in the areas of finance,
    accounting, and audit; rebuilding relationships with
    regulators, customers, and stakeholders; garnering credibility
    with the investment community; boosting the company's
    investments in our financial systems and internal controls; and
    rebuilding the company's culture.
        In June 2005, the Board selected Dan Mudd as permanent
    president and CEO of Fannie Mae, after consultation with OFHEO
    and a very thorough review by Senator Rudman. As interim CEO,
    Mr. Mudd demonstrated an ability to lead a large financial
    institution through a major and challenging transition,
    including the ability to reach out and rebuild confidence with
    our regulators, Congress, and others. He demonstrated his
    capacity for the job by doing the job.
        On May 23 of this year, the company took a big step forward
    when we reached settlements with the Securities and Exchange
    Commission and OFHEO. The settlement with OFHEO addresses the
    recommendations found in the OFHEO final report. The Board is
    committed to ensuring full and total compliance with these
    agreements.
        Mr. Chairman, I can report to this Committee that there is
    a strong determination on the part of the Board, management,
    and the employees for Fannie Mae to grow into a different
    company than it was from 1998 to 2004, and that changes have
    been made up, down, and across the organization. At the same
    time, the Board understands that Fannie Mae still has much more
    to do, and working with our regulators and with this Committee
    and the counterpart committees in the House, we intend to hold
    ourselves and the management team accountable for the changes
    to be made.
        I welcome this chance to report to you, and I am happy to
    answer any questions.
        Chairman Shelby. Mr. Mudd, do you have a statement?

                      STATEMENT OF DANIEL H. MUDD,

                           PRESIDENT AND CEO,

                               FANNIE MAE

        Mr. Mudd. Yes, thank you, Mr. Chairman, Senator Sarbanes,
    and Members of the Committee. I appreciate this opportunity to
    appear before you today, and to update you on the progress that
    we have made at Fannie Mae since I began in the role as chief
    executive officer in December 2004.
        It is clear from the Rudman report, from the OFHEO report,
    that Fannie Mae got a lot of things wrong from 1998 to 2004.
    Bad decisions about accounting and many other matters let a lot
    of people down and in so doing broke a public trust. We have
    learned some painful lessons about getting things right and
    about hubris and about humility, and we have made changes. We
    are making progress. But we have much more to do, and I am
    determined to do it.
        We began with a plan to fix the company on December 31,
    2004, the day that I was appointed as interim CEO. We set out
    to restore our capital, restate our prior financial statements,
    rebuild our relationships with our regulators, partners,
    stakeholders, and Members of Congress to manage our business
    and recenter our company on serving the families who need
    affordable housing, armor-plate our financial controls, and
    finally, to fix our corporate culture, which the OFHEO report
    makes clear led to a lot of our problems.
        I have heard your comments today, and I have heard,
    certainly, many more comments in private. The days of the
    arrogant, defiant, ``my way'' Fannie Mae had to end. We have
    begun to build a Fannie Mae that listens better, that welcomes
    accountability, that works with our regulators and with
    Congress and serves the market by putting our mission to serve
    housing first.
        Let me describe briefly some of the tangible steps we have
    taken starting with the people. First, we have established a
    new senior management team to provide the leadership, the
    talent, and the ethical standards worthy of our role and our
    mission. We have a new chief financial officer; we have a new
    comptroller; a new chief audit executive; a new chief of
    accounting policy; a new general counsel; a new chief risk
    officer; and a new head of corporate strategy.
        Second, in cooperation and consultation with OFHEO, we are
    fundamentally reorganizing the company to ensure that strong
    checks and balances are in place. We have separated the
    portfolio business from the chief financial officer's
    responsibility. We have reorganized the finance function and
    brought in entirely new leadership from outside the company. We
    are reorganizing and strengthening internal audit.
        We have also replaced our outside auditor with Deloitte and
    Touche, which is conducting a comprehensive re-audit of the
    entire company. They have over 300 auditors onsite as I speak
    at Fannie Mae. We are making further key organizational
    changes, which include establishing a new and separate
    compliance and ethics organization. We have written and
    publicly pledged ourselves to a standard of ethical, honest,
    and transparent conduct. We have established a new chief risk
    organization with an independent and comprehensive view of all
    of the risks the company is taking. We have disbanded the so-
    called Law and Policy Division.
        Third, we have restored and maintained our capital
    adequacy. We now have roughly $39 billion of capital in
    reserve, and our ratio of capital to assets is higher than it
    has ever been in our history.
        Fourth, we are paying people to do the job, not to hit
    targets. We have adopted a new executive compensation structure
    with broad performance goals.
        Fifth, we are making steady progress on completing our
    financial restatement, which will be done by the end of 2006.
    We have already completed the restatement of significant
    portions of our balance sheet and developed the systems to
    support and control our business. We are in the process of
    putting in place systems and controls to ensure that we are
    GAAP and Sarbanes-Oxley compliant. There is absolutely no
    routine or process or control anywhere in the company that is
    beyond the scope of overhaul and improvement to the highest
    standard. We can get this done. Our overarching goal is to get
    it done once, to get it done right, and to make sure the
    investments occur so that this will never happen again.
        Mr. Chairman, I would also like to reiterate a commitment
    that I made to the Committee last April, which is that Fannie
    Mae will work cooperatively with Congress to put legislation
    for GSE regulation in place. We do want a bill. In particular,
    we continue to support legislation to create a strong, well
    funded regulator that would oversee both the safety and
    soundness and the mission attainment of the enterprises.
        With respect to how we engage Congress, that is part of the
    new Fannie Mae as well. I hope that you have seen a new tone
    and manner of quiet, fact-based engagement from us. Where we
    disagree, I hope we disagree respectfully. You have my pledge
    to do all I can to move this process forward.
        Mr. Chairman, from the day I was appointed to lead Fannie
    Mae, we have been moving forward aggressively to identify the
    problems identified by OFHEO. The question may be: Why is this
    worth doing? The reason this company exists is because of our
    housing and liquidity mission, with the goal of putting people
    into homes. In the last 18 months, we have purchased or
    guaranteed more than 4 million home loans. We have helped to
    create 136,000 more minority homeowners and serve 600,000
    moderate- and low-income families. We have helped provide
    financing to build, rehab, or finance over half a million units
    of affordable rental housing. Nearly two-thirds of our overall
    business serves one or more of our HUD affordable housing
    goals. And, we are investing literally billions of dollars in
    the Gulf Coast region to help finance and rebuild the homes and
    communities there.
        During the past 18 months, we attracted more than $21
    billion of overseas investment to provide liquidity here in the
    U.S. housing market. And, this year, we are providing roughly
    half a trillion dollars to finance homes for 3 million
    Americans, 25 percent of them African-American, Hispanic, and/
    or first-time homebuyers; all of them Americans looking to own
    or rent a home and become part of a community.
        I know that you are counting on us to fulfill our mission
    and to help us serve this growing Nation and its growing
    housing needs. I believe that is what makes this worth doing.
    Mr. Chairman, the company is changing and will continue to
    change thanks to these lessons we have been given to learn. My
    obligation and my pledge to you in Congress is to move forward
    and to get this right, to build a Fannie Mae that is truly able
    to serve affordable housing in America.
        Thank you for the opportunity, and we look forward to your
    questions.
        Chairman Shelby. Mr. Ashley, you and Mr. Mudd both referred
    to the Rudman Report. How much did that cost Fannie Mae to get
    Mr. Rudman's law firm to do that inside?
        Mr. Ashley. Mr. Chairman, the last number that I heard on
    the total investigation, which would include the costs of not
    only the work of the Paul Weiss team but also the forensic
    accounting team that was engaged plus search firms that were
    engaged----
        Chairman Shelby. Sure.
        Mr. Ashley [continuing]. ----was around $70 million.
        Chairman Shelby. $70 million. And, of course, there was a
    lot of difference between the Rudman report and the OFHEO/SEC
    report.
        Mr. Mudd, you wanted to work with us on legislation. When
    are you going to start, because I see no evidence of that
    myself in the last 6 months?
        Mr. Mudd. Senator, I hope we have been----
        Chairman Shelby. And I would like for you to.
        Mr. Mudd. Yes, sir, we are available any time, 24 by 7.
        Chairman Shelby. We are, too, but we have not seen any
    evidence of any change in tone that you talked about.
        Mr. Mudd. Well, Senator, I apologize for that, and if there
    is anything that we have missed, I would be happy to address
    it. Believe me, I believe it is in the interest of the
    enterprises to have a strong, credible, well funded regulator
    that has all the normal bank-like authorities that any
    regulator that we are familiar with would have, and if there is
    anything I can do to support that, I will.
        Chairman Shelby. We are going to give you an opportunity,
    and we hope you do it.
        Mr. Mudd, in your testimony, you suggested that Fannie Mae
    got a lot of things wrong from 1998 to 2004: bad decisions
    about accounting and many other matters that let a lot of
    people down and in so doing broke a public trust. Those are
    your words. Mr. Mudd, by bad decisions about accounting, I am
    assuming you are referring to the accounting fraud that Fannie
    Mae was found to have engaged in and was penalized by the SEC.
    Is that what you are talking about?
        Mr. Mudd. That is part of it, Senator. I think the
    routines, the processes, the controls, the investments that we
    had in place were clearly inadequate. But I actually paint the
    picture a little bit broader than that and talked in my
    statement about the culture, about the focus, and other areas
    that we are focusing on to try to get it right.
        Chairman Shelby. You are not suggesting, though, here in
    your words, I hope, that they were just bad decisions, not
    fraud, are they? The SEC has said that you all were guilty of
    fraud. You agreed to pay $400 million. You are not trying to
    minimize that here at this hearing, are you?
        Mr. Mudd. No, sir, we have reached a settlement on all
    those matters with the SEC.
        Chairman Shelby. I am just using your words.
        Mr. Mudd. And we certainly do not disagree----
        Chairman Shelby. I am just quoting your own words.
        Would you agree that fraud is a little more serious and
    much more significant than just, quote, your words, letting
    people down and breaking the public trust?
        Mr. Mudd. Yes, sir, I would.
        Chairman Shelby. Mr. Ashley, where does the buck stop? For
    example, the SEC and OFHEO said, quote, that an extensive
    financial fraud--extensive financial fraud--was committed at
    Fannie Mae. But, of course, corporations are abstract entities
    that cannot commit fraud in a sense; somebody does it. Mr. Mudd
    and Mr. Ashley, both: Who are the individuals primarily
    responsible for the extensive financial fraud at Fannie Mae
    that SEC Chairman Cox talked about?
        Mr. Mudd. Senator, there are processes in place going on
    right now at the SEC and at the Department of Justice.
        Chairman Shelby. Sure.
        Mr. Mudd. We are cooperating with all those. That is
    ultimately their determination, but I assure you----
        Chairman Shelby. We know it is under investigation still.
        Mr. Mudd. Yes, sir.
        Chairman Shelby. Mr. Ashley, during the time addressed in
    the special exam that we have talked about here, it would be
    helpful for the Committee and for the record if you could give
    us a basic understanding of how the Board, which you have been
    a member of before you were chairman, operated in providing
    oversight of Fannie Mae's management; for example, perhaps you
    can outline for the Committee what typically happened at a
    Board meeting, such as did the Board typically hear
    presentations from Fannie Mae staff other than senior
    management? Did the Board ask questions--you were a member of
    the Board--regarding these briefings? And were Board members
    encouraged to raise agenda items for the next Board meeting?
    Was the company's relationship with OFHEO ever discussed at
    these meetings?
        Mr. Ashley. Mr. Chairman, typically, Fannie Mae's Board
    meetings, which would be calendared seven to eight times a
    year, now eight times a year, would be 2 day meetings, with 1
    day devoted to committee meetings. The Board functioned through
    the traditional governance committee meetings: Audit;
    Compensation; Governance, Assets, and Liability, which is now
    renamed the Risk Policy Committee; Housing and Community
    Development.
        Those meetings would contain presentations and discussion
    from management within the jurisdiction that those committees
    had. During the Board meeting, the committee chairs would
    report on the work of the committees. In addition, there would
    be regular reports from various members of management--not
    simply the CEO--including, perhaps, in-depth items, such as
    financial reports and so forth.
        Chairman Shelby. Mr. Mudd, the House testimony on initial
    findings, on October 6, 2004, Mr. Raines and Mr. Howard gave
    testimony to the House Subcommittee denying OFHEO's preliminary
    report on Fannie's accounting and culture. Did you disagree
    with any of their comments? Did any of their comments strike
    you as untrue, inappropriate, misleading? Did you communicate,
    if so, your views to anyone either inside the company, to the
    Board, or anyone else?
        Mr. Mudd. Senator, I----
        Chairman Shelby. Did those comments bother you? You were
    inside the company then.
        Mr. Mudd. Yes, sir; I was not involved in the preparation
    for those comments, nor did I hear them at the time. Clearly--
    --
        Chairman Shelby. But you are aware of what was said.
        Mr. Mudd. Yes, sir.
        Chairman Shelby. You have reviewed it since.
        Mr. Mudd. And as I have worked through----
        Chairman Shelby. Do those comments bother you?
        Mr. Mudd. Yes, sir, they do.
        Chairman Shelby. Did they bother you when you first learned
    about them?
        Mr. Mudd. Senator, I would say that they bothered me. As I
    came into this job and had to work through what the actual
    facts were and had to get to the bottom of where the financial
    issues were, the sheer scope of the financial accounting
    matters that we had to address and the depth of the issues in
    terms of our Financial Accounting Department, our Controls
    Department, and the environment there over that period of time
    when I saw what the issues looked like on the ground, did
    increasingly bother me.
        Chairman Shelby. Mr. Mudd, there are people who question
    you are the appropriate person to head Fannie Mae. We know you
    are the CEO, and you were elected by the Board. Given your role
    in senior management at the time in question we are talking
    about here, as chief operating officer of the company during
    this time, how is it that you were not aware of any of these
    practices?
        Did you ever question how it was possible that the company
    that you were the chief operating officer of then could achieve
    such stable earnings in light of the business model being
    pursued and the accounting required under FAS 133? And if so,
    to whom did you raise these questions if you were troubled by
    them, and what efforts did you undertake to further examine
    them and to remedy them.
        Mr. Mudd. Yes, sir. It is a tough question, Senator.
        Chairman Shelby. That is part of our job up here. You know
    that.
        Mr. Mudd. It is one that I think about an awful lot myself.
    And since the time I came into the interim job here, I have
    been----
        Chairman Shelby. No, I am referring back to when you were
    the chief operating officer.
        Mr. Mudd. Yes, sir, yes, sir, and I just wanted to give you
    a bit of background.
        Chairman Shelby. OK.
        Mr. Mudd. Five years worth of my e-mails, my appointments,
    my letters, the meetings that I had, and the documents that I
    saw were fully reviewed by both OFHEO transparently and in the
    Rudman report.
        Chairman Shelby. That is not what I am asking you. When you
    were the chief operating officer, were you aware of what was
    going on in the company? You should have been.
        Mr. Mudd. Yes, sir.
        Chairman Shelby. And if so, I am not asking you about your
    e-mails and OFHEO now; I am asking you specifically, were you
    aware of this if you were--and you were the chief operating
    officer before you were promoted to be the CEO.
        Mr. Mudd. Yes, sir. In my role as chief operating officer,
    my responsibilities were principally dealing with the customers
    and dealing with the systems technology. I would say that as
    the issues unfolded, there was no moment where someone was hit
    by lightning on the road to Damascus and saw everything for
    what it was as a piece. Rather, I would answer your question by
    saying----
        Chairman Shelby. If you were not hit by lightning on the
    road to Damascus, was the sky lit up for you where you could
    see a little better?
        Mr. Mudd. I would say the clouds gathered, the lightning
    began to strike, and things got worse from there, Senator.
        Chairman Shelby. Did it take a lightning strike to wake you
    up, and you were the chief operating officer?
        Mr. Mudd. No, sir, it took understanding a train of events
    and a series of issues that enabled the Board, management,
    those that are there now, independent auditors, and OFHEO who
    you heard from earlier today, to take all of those pieces and
    put them together to understand the full scope of where things
    had been. I would not suggest to you that any one single piece
    of information or evidence brought all that to light at once.
        Chairman Shelby. Were you ever deeply troubled where you
    could not sleep at night? I mean, you are the chief operating
    officer, and you have got to, in the culture, know what is
    going on. And if you did not know what is going on, you know,
    what is your job?
        Mr. Mudd. Yes, Senator, my job was focused on the customers
    and on the technology systems. I was not responsible for
    financial accounting. I was not responsible for the mortgage
    portfolio. I was not responsible for internal audit, and I was
    as shocked as anyone in the company or anyone in Congress or
    anyone in the market when these issues were uncovered and came
    to light.
        Chairman Shelby. Senator Sarbanes, thanks for your
    indulgence.
        Senator Sarbanes. Thanks, Mr. Chairman.
        Mr. Ashley, in light of these questions, I would be
    interested in understanding the Board process that led to Mr.
    Mudd now assuming the CEO position at Fannie Mae.
        Mr. Ashley. Yes, sir, I am happy to go through that.
    Clearly, in December 2004, when it became obvious to the Board
    that Messrs. Raines and Howard could no longer lead the
    company, we reached out to Dan to serve as an interim CEO and
    President.
        Soon thereafter, right around the first of 2005, the Board
    created a Search Committee, which was chaired by Director Ann
    Korologos, engaged in a very thorough, nationwide, and very
    competitive search. The search was pretty well discussed in the
    media with some names at the time. That search went through
    until the latter part of April 2005. During this time period, I
    was serving as independent chair, nonmanagement chair, and Mr.
    Mudd was serving as an interim CEO.
        Senator Sarbanes. When did you become the interim chair?
        Mr. Ashley. I never served as an interim chair, Senator. I
    was elected chair of the Board on the 21st or 22nd of December
    2004, as a nonexecutive chair, I think is the terminology.
        Senator Sarbanes. Previously, had the chair and the
    executive been combined in one position?
        Mr. Ashley. Yes, sir, that is correct.
        As we moved through the spring of 2005, it became clear
    that Mr. Mudd was doing a very good job, and indeed, I would
    say an excellent job of moving the company from where it had
    been, starting the process of change in culture that was
    necessary, developing a new organization for the company,
    weeding through people, terminating people, and then, most
    importantly, starting the process of recruiting individuals of
    excellent talent and new to the company beginning first in the
    finance area and the comptroller's area.
        When it became clear that Mr. Mudd was going to be a
    finalist--not necessarily the finalist, and, indeed, at that
    point in time, he was not the finalist--I approached Senator
    Rudman as well and had discussions with the then-director of
    OFHEO as to was there anything in their knowledge, their
    background, that would suggest that the Board should not move
    forward considering Mr. Mudd as a finalist. Senator Rudman's
    team spent approximately 2 to 3 weeks doing very in-depth
    reviews. I believe that these were the things that Mr. Mudd was
    referencing earlier in his response to Chairman Shelby's
    question. They did a very detailed review of every aspect of
    Mr. Mudd's work at the company, seeking to discover whether he
    was in any way implicated in any of the wrongdoing that had
    been identified in the interim report of examination from OFHEO
    that was given to us in September 2004.
        Senator Rudman's investigation was thorough. He met with
    the Search Committee and then later with the full Board
    discussing the results of his investigation, and at that point
    in time, the Board felt that there was no reason why Mr. Mudd
    should not be considered for the CEO position, and indeed, we
    did elect him as President and CEO, I believe, in 2005.
        Senator Sarbanes. Now, if I heard you correctly, you said
    just a moment or two ago not only that you took this up with
    Rudman but with the Director of OFHEO.
        Mr. Ashley. I had discussions with the director of OFHEO,
    yes, Senator.
        Senator Sarbanes. Is that Mr. Falcon at the time?
        Mr. Ashley. That would have been Mr. Falcon.
        Senator Sarbanes. And what was the gist of those
    discussions?
        Mr. Ashley. My recollection, Senator, is that I had one
    discussion where I outlined that Mr. Mudd was going to be
    considered as one of two finalists. I asked whether there was
    any reason that we should not consider him, because if there
    was, I wanted to be sure that that was clear to the committee
    and the Board at that time. He asked for some time to do
    whatever work he needed to do and to check, I am sure, with
    colleagues at OFHEO.
        At a subsequent point in time, I cannot remember exactly
    what the time lapse was, we had another discussion, and he
    indicated that, in his view, there was no reason that we could
    not go further considering Mr. Mudd for this position.
        Senator Sarbanes. Has the Board reexamined this question in
    light of the recent OFHEO report?
        Mr. Ashley. Senator, we have, and when the OFHEO report was
    ready several weeks ago, approximately a week before it was
    released, it was made available to a small group under
    confidentiality for fact checking. At that time, it became
    certainly obvious to those reading the report that Mr. Mudd was
    named a number of times in this report, and therefore, I felt
    that the Board had to examine those findings and discuss them
    thoroughly.
        The Board did so. We asked Senator Rudman to read the
    report, to come back to us and to address questions as to
    whether there were new findings, whether there were new
    material findings, and whether there was anything on what we
    had previously known of Dan's involvement that had turned up in
    the Rudman Report that was new or different or that would cause
    Senator Rudman or his team to change their opinion and their
    recommendation to the Board that they had made in the spring of
    2005.
        He reported that there was not any reason that they would
    change their opinion on that. The Board read the report,
    examined every notation that was made in the report regarding
    Mr. Mudd, discussed it. We met in an executive session. We had
    the benefit of counsel. The Board did not take action until
    after full discussion with and without Senator Rudman and in
    all cases without Mr. Mudd. We discussed further, and then, on
    the morning that the OFHEO report was released, we expressed
    our confidence in Mr. Mudd to continue in service as CEO of
    Fannie Mae.
        Senator Sarbanes. Well, my time is up. If I could just put
    one more question, the report of OFHEO on the special
    examination of Freddie Mac, not Fannie Mae now, but Freddie
    Mac, which came earlier, said the corporate culture fostered by
    that tone at the top resulted in intense and sometimes improper
    efforts by the enterprise to manage its reported earnings. And
    they go on then to discuss this.
        Now, it sounds very familiar as we look through the report
    of the special examination of Fannie Mae. I would put it to
    both of you: did you read the Freddie Mac report, and did it
    register on you in terms of, well, you know, what are we doing
    here, here being at Fannie Mae? Did anyone pick up on that,
    both in management and on the Board? So I put the question to
    both of you.
        Mr. Ashley. Senator, I will respond.
        Senator Sarbanes. And I apologize to my colleagues.
        Chairman Shelby. That is all right.
        Mr. Ashley. I will respond as to the involvement of the
    Board and the discussion of the Board around the Freddie Mac
    report.
        Certainly, the Board was well aware of the issues that had
    surfaced at Freddie Mac. They had been publicized; copies of
    the executive summary of the report were distributed to the
    Board. I believe that there was discussion in the Audit
    Committee with KPMG, Fannie Mae's auditors. There was clearly
    discussion at several Board meetings during that early time
    period about whether Fannie Mae had any of these problems.
    Questions were addressed to CEO Raines and CFO Howard in the
    Board meetings.
        The Board received complete and full assurance from both
    executives every time the issue was discussed that Fannie Mae
    did not have those problems. At the same time, the Audit
    Committee was receiving assurances from KPMG that that indeed
    was the case.
        Mr. Mudd. Nothing to add, Senator, other than that the same
    level of reading and review was done across management, but,
    broadly, the process and the conclusions followed Mr. Ashley's
    comments.
        Senator Sarbanes. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Bennett.
        Senator Bennett. Thank you very much, Mr. Chairman.
        I would like to follow up on the questions that I asked the
    Director of OFHEO with respect to the earnings. I am not quite
    clear, and I am not quite sure of his answer. It is my
    understanding that one of the problems was that the earnings
    were placed in the wrong quarter or the wrong fiscal reporting
    period in an effort to make that period look better and that in
    the restructuring and restating, the earnings are not going to
    go away. They are going to reappear in another financial
    reporting period.
        Now, he said that the $11 billion figure was a net figure
    and that they all went away. So I am confused: the newspaper
    reports led me to believe one thing; his statement was the
    other. Given the degree of analysis that you have made of all
    of those earnings, I think you probably are in a better
    position to answer that question. I do not know if you heard my
    question to the Director, but could you respond to that area,
    either one of you?
        Mr. Mudd. I would be happy to, Senator.
        The restatement goes back for the years 2001 to 2004, and
    those amounts of earnings recognition will be retimed.
    Approximately $11 billion, actually somewhat less than that,
    was overstated in the prior periods. Those periods will be
    corrected, and, by and large, there will be some fine-tuning
    differences with respect to where some securities are priced in
    the market and so forth; but, as a broad theme, your assumption
    in your question is correct: those amounts will then flow back
    into future periods as the restatement is completed.
        Senator Bennett. Do you have a dollar figure on what the
    net really is, then? Because from what you have just said, the
    net was not the $11 billion that he was quoting.
        Mr. Mudd. No, sir. To use parallel terms, the gross amount
    potentially under restatement is slightly under $11 billion,
    but exactly how those specific amounts apply from period to
    period is exactly what we are determining----
        Senator Bennett. I see.
        Mr. Mudd [continuing]. ----in the process of the
    restatement, and I will not be able to give you that answer
    until the restatement is completed this year.
        Senator Bennett. What would you be surprised if it were
    more than? That is an unfair question, but just ball park. Do
    you think that half of the $11 billion will show up in some
    future statements?
        Chairman Shelby. This is pure speculation, is it not, Mr.
    Mudd?
        Mr. Mudd. Senator, I would not--we have made significant
    progress on the restatement. We have now been through all of
    the policies that apply, understand where there were
    misapplications of GAAP, and understand how each of those
    securities were priced during that period under the relevant
    accounting rules that were applied. We have rewritten the
    systems to do that. We have completed the process of restating
    significant portions of that, and small adjustments aside, the
    overwhelming proportion of the balance of that flows back in.
        Senator Bennett. OK, so it would be more than half of the
    $11 billion will flow back in at some future time?
        Mr. Mudd. Yes, sir, well more than half.
        Senator Bennett. All right, thank you. I appreciate that
    clarification.
        Thank you, Mr. Chairman.
        Chairman Shelby. Senator Hagel.
        Senator Hagel. Thank you.
        Let me stay on that point for a moment, because I am a
    little lost in this conversation. I take a pretty simple view
    of all this, Mr. Mudd. Dishonesty is dishonesty, whether it is
    $11 billion or $5 billion. Do you agree with that, Mr. Mudd?
        Mr. Mudd. Yes, sir, I do.
        Senator Hagel. So intentional, fraudulent behavior,
    intentionally misstating anything is irrelevant, it seems to
    me, as to the numbers. Do you agree with that or not agree with
    that?
        Mr. Mudd. I do agree with that, Senator.
        Senator Hagel. Let us just get the record straight on this:
    whether it is $11 billion or $6 billion, if fraud was
    committed, it was committed, and that is what the OFHEO report
    says.
        Chairman Shelby. That is also what the SEC said.
        Senator Bennett. And I am not suggesting that there is not
    fraud. I am just wanting to know the financial condition of the
    company, and the financial condition of the company is affected
    enormously.
        Senator Hagel. Senator, the financial condition of any
    company reflects on the culture and the management and the
    honesty and the ethics of a company.
        Senator Bennett. I agree.
        Chairman Shelby. That is right.
        Senator Martinez. The fact is they do not know the
    financial condition of the company and have not known it for
    years.
        Senator Hagel. That is the other element. We do not know.
    And what is interesting, Senator, is we keep finding out more
    and more.
        Now let me, if I might, get on to some other questions.
    Thank you for clearing that up, Mr. Mudd. I will have some
    questions for you in a moment.
        Mr. Chairman, how long have you been on the Board?
        Mr. Ashley. Senator, I have been on the Board since May
    1995.
        Senator Hagel. You have been there quite awhile.
        Mr. Ashley. It seems like a long time, yes, Senator.
        Senator Hagel. So you have seen an awful lot.
        Mr. Ashley. I have seen a lot in the last 2 years that I
    never expected to see, Senator.
        Senator Hagel. Well, apparently, there was a lot you did
    not see.
        Mr. Ashley. Senator, I share your concern and your sense
    of, I think, righteous outrage on this.
        Senator Hagel. Oh, do not give me any righteous outrage,
    Mr. Ashley. This is not about righteous outrage. It is about
    fraudulent conduct in the interests of those who were managing
    an institution with their own greed and their own self
    interest. So this is not righteous outrage. That is for the
    confessional or for your spiritual advisor, Mr. Ashley.
        You have a fiduciary responsibility, and I think you
    failed, and the entire Board failed, and according to the
    reports, it is pretty clear that you failed. Now, can you sit
    there and tell this Committee that you knew nothing about what
    was going on? Because to hear the two of you talk or somebody
    else, the chief operating officer said he was not aware of much
    of this, which we will get to the chief operating officer in a
    moment.
        But you seem that you do not know anything about what
    happened, what was developing, the lobbying, the money, the
    compensation. You have seen the compensation here that Mr. Mudd
    received as well as Mr. Raines and a number of others here.
    Now, you are a man of great experience and depth in this
    business. Was that strange to you at all that was going on, no
    questions asked?
        Mr. Ashley. Senator, I have worked 40 years in the mortgage
    banking business, and I have had a great passion for this
    business. And I cannot express to you the deep disappointment
    and anger that I as a member of the Board, and I know this is
    shared by my colleagues on the Board, feel at this moment in
    time when a company and a management and people that we put our
    trust in was broken, not just broken, but shattered.
        And the fact that the Board trusted Frank Raines and Tim
    Howard I think is reasonable for any Board to be able to trust
    their management. To the point that they do not trust that
    management, they should remove that management.
        Senator Hagel. What about Mr. Mudd? Was Mr. Mudd exempt
    from this? He was chief operating officer according to the
    records here.
        Mr. Ashley. Senator, I think in my response, I believe, to
    Senator Sarbanes' question, I explained the process that the
    Board went through to affirm the trust and to be sure that we
    could place trust in Mr. Mudd going forward in his leadership,
    in his judgment, in his management decisions.
        Senator Hagel. Well, I do not know how much you read of any
    of these reports. The question was asked by Mr. Sarbanes a few
    minutes ago. But let me just respond to this comment about Mr.
    Mudd. This comes from the OFHEO report. There are a number of
    indications of Mr. Mudd's awareness of what was going on. This
    one, in particular, is an e-mail that Mr. Mudd wrote in 2003.
    It is in the OFHEO report; quote, Mr. Mudd says in the e-mail,
    I spoke to a Treasury Department official. He had agreed to
    talk to the SEC on what to do if OFHEO was not falling in line.
    Already, another Treasury official had already bent his ear
    about OFHEO obstructionism--OFHEO obstructionism--promised me
    he would check in to see where things were and would call the
    SEC when we needed to, end of quote.
        Now, this is an e-mail from Mr. Mudd, chief operating
    officer, who does not know anything about what is going on, nor
    do you as a member of the Board. So how do you respond to that
    when you say that you were offended by Mr. Raines and Howard
    and others who just bamboozled you all, because you really did
    not know what was going on?
        Mr. Ashley. Senator, the e-mail in question, I believe, and
    Mr. Mudd can explain it in more detail, I believe related to a
    call that was made at the time the company was seeking SEC
    registration.
        Senator Hagel. What do you know about the lobbying efforts?
    Did Mr. Mudd have anything to do with that? Did you have
    anything to do with that? How many Board members had contracts
    who did lobbying on behalf of the institution? Do you know
    anything about those things?
        Mr. Ashley. Senator, I was----
        Senator Hagel. Does Mr. Mudd know anything about those
    things?
        Mr. Ashley. I think Mr. Mudd can respond to that. I was not
    engaged in lobbying activities on behalf of the company. There
    is one Board member, which is, this is public information,
    where there is a contract, a consulting contract with his firm.
        Senator Hagel. Is this still active?
        Mr. Ashley. It is still active.
        Senator Hagel. You do not find any conflict with that?
        Mr. Ashley. He is not an independent director under the
    Board's independence guidelines. The director in question
    provides good counsel to the Board and to myself.
        Senator Hagel. So you have a Board member who is
    compensated, I understand; is that right?
        Mr. Ashley. He is.
        Senator Hagel. Then, in addition to that compensation, that
    Board member is hired as a lobbyist.
        Mr. Ashley. His firm is hired as a lobbying consultant to
    the company.
        Senator Hagel. And you find nothing irregular about that?
        Mr. Ashley. Certainly in the standards of independence and
    governance going forward, I would choose to see every director,
    other than the single management director, be completely
    independent in every way, shape, and form, and this Board is
    moving in that direction.
        Senator Hagel. What is the answer? I did not get your
    answer, the answer to my question.
        Mr. Ashley. Senator----
        Senator Hagel. Do you find nothing inappropriate about that
    relationship?
        Mr. Ashley. Senator, the relationship has been handled
    appropriately during the period that that conflict has existed
    since that director has been on the Board. My further response
    is that the rules of governance that I see for this company
    going forward would dictate that every nonmanagement director
    be independent in the fullest sense of the word.
        Senator Hagel. So what is your answer? You find nothing
    inappropriate with that kind of----
        Mr. Ashley. The relationship has been handled
    appropriately, Senator.
        Senator Hagel. So it is not inappropriate to have a member
    of the Board who is not part of management but have his firm
    being paid contractually for lobbying efforts and also a member
    of the Board of Directors.
        Mr. Ashley. The issue, really, for governance is whether
    that matter has been appropriately disclosed and the
    relationship is handled appropriately. I feel very strongly
    that there should be no conflicts with Board members going
    forward.
        Senator Hagel. You obviously do not think that is a
    conflict.
        Mr. Ashley. Senator, at the present time, this relationship
    is handled within the rules of the road.
        Senator Hagel. That is not my question, and you know it,
    Mr. Ashley. Mr. Ashley, part of the problem we have, you have,
    your institution has, is because you do not give straight
    answers. This is not complicated. Now, I do not know, maybe
    because you have been on the Board too long, but I do just find
    it astounding that neither of you really know anything that has
    been going on.
        Now, Mr. Mudd, I am going to read something here: Regulator
    says Mudd knew of misdeeds. This is from the May 24, 2006,
    story by Terence O'Hara, Washington Post, and it says this:
    Fannie Mae Chief Executive Daniel H. Mudd was aware as early as
    the fall of 2003 of serious allegations of accounting misdeeds
    and failed to pass key information on to the company's Board of
    Directors according to Fannie Mae's Federal regulator. In the
    first detailed account of Mudd's involvement in the management
    lapses at the mortgage giant, the Office of Federal Housing
    Enterprise Oversight also cited an instance in which Mudd asked
    a Treasury Department official to intervene on the company's
    behalf to rein in OFHEO during its examination of Fannie Mae's
    accounting practices, and I am sure you have read it, and it
    goes further.
        Would you care to respond to that, Mr. Mudd?
        Mr. Mudd. I would.
        Senator Hagel. Inaccurate, wrong, right?
        Mr. Mudd. Well, Senator, the Post itself corrected that
    headline the next day.
        Senator Hagel. I am not talking about the headline. I am
    talking about what it says, the story. Was the story
    inaccurate?
        Mr. Mudd. Senator, I was never aware of any misdeed, any
    mischaracterization, any intentional violation of accounting
    rules. Looking back, are there things that I regret?
    Absolutely.
        Senator Hagel. Did you benefit from the $6.46 obsession? Do
    you know what I am talking about? Let me refresh your memory.
    In the same year--this is from the OFHEO report--Sampath
    Rajappa, Fannie's senior vice president for operations, risk,
    and head of internal audit told Fannie's Internal Audit Group,
    quote, you must be obsessed, he says to all of you, on $6.46.
    After all, thanks to Frank, we all have a lot of money riding
    on it. Remember, now, Frank has given us an opportunity to earn
    not just our salaries, benefits, raises, employee stock
    purchase programs, but substantially over that if we make
    $6.46, end of quote.
        You recall, I suspect, maybe you do not; maybe you do not
    know this either. The final EPS number for 2003 was $7.29,
    which triggered the bonuses. Now, I am sure you remember
    bonuses and what everybody got. Now, this report from OFHEO
    cites a number of you which did pretty well. And according to
    this, if this is accurate, your compensation over that period,
    those last 4 years that we had the investigation, 2000 through
    2003, is $26,306,057; is that accurate?
        Mr. Mudd. Yes, as reported, Senator.
        Senator Hagel. So you did not really have much to win or
    lose, obviously, on any of the fraudulent behavior that was
    going on in the $6.46 memo. Let me ask, did you ever see that
    memo?
        Mr. Mudd. Senator, there is no place for fraud or cheating
    or misuse of rules in any company that I work for. And as I
    stated in the prior question, I did not participate in any of
    that; I was not aware of that; I did not go to any meeting
    where any of that was discussed. I think the attitude is
    inappropriate. I think it is inappropriate in the company. I
    think it is inappropriate for an independent auditor to be
    saying anything at all like that. I reject those comments. We
    have changed it entirely.
        Senator Hagel. Did you see the memo?
        Mr. Mudd. I did not see the memo, and I did not hear the
    speech.
        Senator Hagel. Well, this memo had wide circulation.
        Mr. Mudd. I am sorry; I have seen it since the time. I
    thought you meant in the actual timeframe it was given; I am
    sorry.
        Senator Hagel. No, I am asking in the actual timeframe.
        Mr. Mudd. No, I did not.
        Senator Hagel. You did not see it. You must be one of the
    only senior members who did not see it, because according to
    the OFHEO report, this was given wide circulation, and the
    chief operating officer did not see it.
        Mr. Mudd. Sir, if you are referring to Mr. Rajappa's
    comments about the $6.46----
        Senator Hagel. Yes, sir.
        Mr. Mudd [continuing]. ----my understanding, having read
    through the report, is that that was a speech that he gave to
    his own group of employees, and not being one, I was not
    present there.
        Senator Hagel. Just for the record, Mr. Raines, in that
    period, it was actually a 6-year period, he comes out according
    to the compensation, according to the OFHEO report, over $90
    million; Mr. Howard comes out with $30 million; Jamie Gorelick,
    for a 4-year period, comes out with about $27 million. You are
    right in there at over $26 million. We have Mr. Levin at $26
    million. So there was a rather significant interest, I suspect,
    by senior management to reflect those numbers that Frank stated
    for everyone. And the Board knew nothing about any of this; is
    that correct, Mr. Ashley?
        Mr. Ashley. Did the Board know anything about Mr.
    Rajappa's----
        Senator Hagel. No, no, no. The Board knew nothing about any
    of this $6.46, not necessarily the memo but the target numbers
    that would incentivize management to get all the stock deals,
    the bonuses, the compensation? The Board knew nothing about any
    of that?
        Mr. Ashley. The Board would have received periodic updates
    on earnings throughout the year and forecasted earnings to year
    end as any Board, I would hope, would receive that information.
        Senator Hagel. Thank you.
        Mr. Chairman, I have gone over my time.
        Chairman Shelby. No, you take time, whatever you need.
        Senator Hagel. Thank you. Another point here.
        [Laughter.]
        Senator Hagel. This is a memo as well from independent
    analysis, and it quotes you, Mr. Mudd, and this is a memo that
    evidently, you wrote in 2000. And it says this: we also need to
    continue to focus on our 2003 challenge. We still have a gap of
    nearly $375 million in pre-tax income. I know that the numbers
    in our third quarter forecasts around our big bets are still
    being refined as we iron out the issues and that those revenue
    numbers may well change. It is clear that these new products
    may not be sufficient to get us to our $6.46 goal. And we as a
    company must be looking hard at what it will take to make it.
    Now, this is from OFHEO report, page 78.
        According to the report, you wrote that memo.
        Mr. Mudd. Yes, sir, that is true. All companies that I am
    familiar with in my time have budgets, have targets for
    revenues and expenses, have compensation plans that have
    targets in them. Part of my responsibilities were to manage
    those P&Ls for the businesses that I was running. And I spent
    most of my time doing that. Never at any point would I sanction
    any departure from the rules in order to hit those targets.
    Part of managing a business is to try to attain the results
    that the organization has set out for, and that was my focus,
    Senator.
        Senator Hagel. I see. I find it interesting, because in
    response to the Rajappa memo, you acted like you were not aware
    of this target number, this $6.46.
        Mr. Mudd. No, sir; no, sir, if I conveyed that impression,
    I did not mean it. I was aware of the target number.
        Senator Hagel. But you were not aware of the memo.
        Mr. Mudd. I was not aware of Mr. Rajappa's speech to his
    own group of employees.
        Senator Hagel. All right; well, I think I received what I
    needed.
        Let me ask one last question. I have a number of questions
    for the record that we will submit. Mr. Mudd, in light of all
    of this, I mean, first, are you thinking seriously about giving
    any of this money to charity that you received through all the
    fraudulent misrepresentations? And am astounded that you would
    even stay with this institution. Have you thought about
    resigning?
        Mr. Mudd. Senator, I have thought about an awful lot of
    things. I did not like the old Fannie Mae any more than I
    understand from your emotions and words about this that you
    liked the old Fannie Mae. And I thought about leaving the old
    Fannie Mae a lot of times, and I did not, because I am not a
    quitter. I stayed around. If the standard is now, if you quit,
    you get off scot free, and if you stay around, and you try to
    fix it, you are a bad guy, Senator, I cannot do anything about
    that standard.
        Senator Hagel. What is your compensation now?
        Mr. Mudd. I am focused on getting the problems fixed and
    getting this organization to where it needs to be.
        Senator Hagel. Thank you. What is your compensation now?
        Mr. Mudd. I think the last year, the number was around $8
    million, including salary, bonus, and long-term.
        Senator Hagel. What about this year?
        Mr. Mudd. I do not know what the targets are. I would be
    happy to send----
        Senator Hagel. Well, $8 million is not a bad number. I can
    see why you would also want to stay around for that incentive.
    I mean, that is not altogether something that I suspect is not
    part of your consideration. Mr. Chairman, I appreciate----
        Chairman Shelby. Thank you, Senator.
        Senator Hagel [continuing]. ----the indulgence of the
    Committee, and I will submit some questions for the record.
    Thank you very much.
        Chairman Shelby. Thank you.
        Senator Carper.
        Senator Carper. Mr. Mudd, Mr. Ashley, I would like to try
    to refocus the questioning a little bit if I might.
        One of my disappointments in serving on this Committee in
    the last 5 years was our inability to find common ground to
    develop consensus on how best to regulate GSEs going forward.
    We had a vote here right along party lines. We sent a bill to
    the floor which is not going to see, frankly, in my view, the
    light of day until we can bridge our differences in two
    critical areas. One of those is affordable housing, and second
    is the issue of portfolios, what should be in the portfolio,
    how large should the portfolio be, how quickly can it grow?
        I have observed and had an opportunity to discuss with a
    number of my colleagues on both sides of the aisle here in this
    committee; we have discussed these two issues, with the real
    focus on the affordable housing position. Over in the Federal
    Home Loan Bank, they have an Affordable Housing Program where
    they are required by law to set aside, I think, 10 percent of
    their net income into an affordable housing fund. Those numbers
    go to the States and are divided up, distributed, and mingled
    with State monies, local monies, nonprofit monies, for profit
    housing dollars in order to create affordable housing for the
    residents of probably all 50 States.
        I sensed in recent weeks, maybe last couple of months, a
    growing consensus on this Committee that we should put in the
    final bill that we take up for debate and hopefully pass in the
    Senate this year an affordable housing provision. Senator Reed
    has worked hard on it; I know others have as well.
        Would you take just a minute or two, Mr. Mudd, and talk
    with us to share your counsel and your views on what makes
    sense with respect to an affordable housing provision; maybe
    looking at the Home Loan Bank; is the model a good model or a
    bad one? Looking at the House bill as either a good model or
    bad bill, and tell us in your own view what we should keep in
    mind as we attempt to craft our own provision on the floor.
        Mr. Mudd. I will do my best, Senator.
        I think that the housing goals are an important and an
    intimate part of what we do, and I support them fully. Over the
    years, the administration of the housing goals has been on the
    HUD side, and the safety and soundness administration has been
    on the OFHEO side. So the counsel, I guess, that I would have
    on that is that both pieces of legislation, as I understand
    them, are correct in contemplating a single regulator. I think
    it is important to have a single regulator, because in one
    place, you can balance out the safety and soundness goals with
    the mission goals and see the whole thing of a piece. So I
    think the regulator having a broad view of everything that goes
    on in the enterprise is certainly an important thing.
        The goal structure that we have right now was originally a
    set of goals expressed as a percentage of business. There is
    now a set of subgoals in place that represent a percentage of
    business for purchase money mortgages, really, first-time
    homebuyers, principally. And the idea that has been discussed
    in the course of the legislation is an affordable housing fund.
        I think all those are eminently good ideas, and my only
    encouragement would be that they be considered all of a piece,
    all of a piece together so that all of our activities are
    pointed in the right direction, and it is the direction that
    Congress and the administrative agencies want us to go in.
        Senator Carper. By the way, the Federal Home Loan Banks, as
    I recall, under the law, they have a requirement to set aside
    10 percent of their net income into an affordable housing fund.
    I am not sure what the approach is in the House, but I think it
    is similar to that. In conversations I have had with one of our
    Republican colleagues, we have talked about establishing an
    affordable housing fund, and instead of having some percentage
    of net income, to have a transaction fee that would be related
    to the magnitude of, I guess, the bonds that are underwritten
    and securitized.
        Any comment on which of those may be more appropriate?
        Mr. Mudd. Just a couple of thoughts. As I understand the
    Home Loan Bank program, as it exists, there are no percentage
    of business goals. So that is really their one focus in terms
    of the affordable housing piece of it. So again, if we, per the
    discussion earlier, considered all of those of a piece, I think
    that would be a good idea.
        Second, the Federal Home Loan Banks have in place the
    apparatus, really, to dispense those monies in the form of
    grants. We could do it. We could build out the infrastructure,
    but my encouragement would be that instead of the focus on
    grantmaking, per se, which is not something we do, that it be
    focused on the type of activities that the GSEs are already
    into, which are funding loans and making investments in the
    areas that need it most.
        Senator Carper. All right, one other question, if I may:
    The other critical issue that has divided us, I believe, deals
    with portfolios: what is in a portfolio, how large, how quickly
    can it grow. And I am not sure that all of us have a very good
    understanding of the nature of your portfolios, what is
    included, to what extent the assets in your portfolio help
    support housing authorities, like our State housing authority
    in Delaware or municipal housing authorities and those, frankly
    of other States as well.
        Just take a couple of minutes, if you will; give us a
    primer, just lay out for us the nature of the assets that
    comprise your portfolio, how those assets maybe relate to your
    mission, and any concerns that you might want to share with us
    with regard to limitations that could be imposed on those
    portfolio, maybe that should or should not in your view.
        Mr. Mudd. Yes, sir, it is a great question. I will try to
    start.
        We have two lines of business: a guarantee business, which
    provides guarantees on mortgage-backed securities held by
    others and a portfolio business which are investments on our
    own balance sheet. That portfolio is approximately $722 billion
    as we speak today.
        Contrary to some of the thoughts, there is nothing in that
    portfolio that is not related to housing or finance or
    mortgages but for a small component, I think about 7 percent,
    that is a liquidity fund per an agreement we have with the
    Treasury Department to ensure that we have nonmortgage
    liquidity in the event of some dislocation in the mortgage
    market.
        So within the portfolio, what we hold are 50 percent
    conventional, conforming mortgage-backed securities, the
    principal business that we are in. We hold 35 percent whole
    loans, so there are mortgage loans that, instead of being
    packaged already into a mortgage-backed security, exist each
    unto themselves, and about 14 percent municipal securities,
    sub-prime securities, Alt-A securities, mortgage revenue bonds
    and so forth. And, we have, in addition to that, a Low-Income
    Housing Tax Credit portfolio and a fund investment, a set of
    funds in specific projects in communities all across the United
    States.
        Those are the activities that are really encompassed on the
    balance sheet of Fannie Mae. They are all housing related. As
    some of the Senators have indicated, the portfolio is the first
    business that we were in. That was the business that we were
    first put in business to pursue. And the idea was that that
    portfolio would be used to provide liquidity into the secondary
    market for mortgages, so that there is a steady supply of funds
    into the mortgage market so that in the event of a dislocation,
    a Katrina, a 9/11, or those types of things, there is still a
    steady flow of funds there. That kind of gives some confidence
    to the mortgage market.
        We have this liquidity mission, and we have an
    affordability mission. My own view, Senator, is that those two
    things are pretty intimately linked, and they are pretty
    intimately linked into the overall structure of the mortgage
    market in the United States. And, I would just add a point,
    which is that I do not think it should be an unrestricted
    portfolio, and that is reflected in the sanctions imposed by
    OFHEO in the course of this settlement agreement, in which they
    said you have got some issues; hold the portfolio flat; fix the
    issues, and when we are comfortable with it, you can move
    again.
        Those are normal, bank-like regulatory authorities that
    exist in a lot of institutions. I am not uncomfortable with
    that, but I also do not know what the future might bring. And
    there is a provision in the discussions with OFHEO that if
    there is one of those dislocations, we would obviously
    immediately be in touch with OFHEO to make sure we could
    respond and continue to serve that liquidity mission.
        Senator Carper. Thanks.
        Mr. Chairman, thank you for being generous with this time.
    I just want to say in conclusion, we should be able to work
    this out, and you are----
        Chairman Shelby. You are talking about the legislation now.
        Senator Carper. Yes, yes, and you are as gifted as any
    Chairman I have ever worked with. And you have got willing
    people on this side and I know with my colleagues on the other
    side. We ought to be able to work this out, and these are the
    two critical points. And I would just offer whatever help and
    service that I can be in trying to get us to develop a
    consensus. I want to do that. I would like to see us have a
    strong regulator. We need to regulate these folks, and we can
    certainly do better. And those are the two points that are
    holding us apart. And we have got to be smart enough to figure
    out how to find common ground there. I think we can.
        Chairman Shelby. We are also going to need the help of
    Fannie Mae. Mr. Mudd knows that. And I hope we will get it, but
    we have not gotten it thus far.
        Senator Martinez.
        Senator Martinez. Thank you, Mr. Chairman.
        Mr. Ashley, does the Board currently have a Compensation
    Committee?
        Mr. Ashley. The Board does have a Compensation Committee,
    Senator.
        Senator Martinez. I am astounded that, given the level of
    scrutiny under which this company is today--we can talk about
    the past, but I am talking about today, now, that Mr. Mudd's
    compensation is, as he revealed a moment ago, $8 million last
    year, and I do not even know what it will be this year. But is
    your Compensation Committee comfortable with that level of
    compensation? And are they still derived from the same types of
    schemes as was in the past, the way in which compensation was
    derived?
        Mr. Ashley. I will answer the second part of your question
    first. No. Mr. Mudd and all other executive compensation is not
    derived on the same formulaic basis that it was previously
    where the bonuses were tied singularly to an achievement of an
    EPS target. There are multiple factors currently that go into
    evaluating the bonus levels, which are decided by essentially
    each committee of the Board that has oversight for that
    particular function of the organization, and then, those flow
    into the Compensation Committee for composite review, and
    ultimately, the entire Board is engaged in the discussion. It
    is a fulsome process. It is not tied to EPS; certainly today
    not at all, because we do not have earnings.
        Now, to the first part of your question, Senator, the
    approach that this company, first of all, is chartered, but
    second must undertake is competitive compensation for those
    skill sets that we must have in the company. And those come
    primarily from the financial services sector, so this company
    is competing with the 20 or so major financial services
    companies in the country. So competitiveness is one factor.
    There is a second factor that must be brought in given the
    charter status that this company has and the mission status,
    and that is appropriateness.
        Senator Martinez. How much is the compensation for the CEO
    of Freddie?
        Mr. Ashley. I do not know. We would be glad to supply that
    for you.
        Senator Martinez. I can find it, but you do not know.
        Mr. Ashley. I do not know.
        Senator Martinez. But you believe it to be comparable?
        Mr. Ashley. I actually believe it to be in excess of Mr.
    Mudd's. Those comparabilities were examined by the Comp
    Committee at the beginning of the year when Mr. Mudd's salary
    was established.
        Senator Martinez. What is the Board doing about the
    compensation that was paid in bonuses as a result of what has
    now been acknowledged, and I presume you would agree, was
    through fraudulent accounting practices? Let me clarify that.
    Would you agree that the accounting precisely were fraudulent
    in nature as alleged in the report by OFHEO?
        Mr. Ashley. Senator, that is a very difficult question for
    me to answer, because there are legal proceedings around this.
    I, speaking individually, have a great deal of discomfort with
    what was done. There is a process in place----
        Chairman Shelby. Senator, could you yield just a second?
        Senator Martinez. Yes, sir.
        Chairman Shelby. You have great discomfort, and you entered
    into an agreement to pay a $400 million fine, you, as the
    Chairman of the Board of Fannie Mae and so forth; excuse me,
    but that is troubling to this Senator.
        Mr. Ashley. Senator, I wish I could speak as affirmatively
    as I feel inside.
        Chairman Shelby. OK.
        Mr. Ashley. My lawyers are tugging at my coattails.
        Chairman Shelby. OK, the Senator has the time.
        Senator Martinez. Given that there is obviously a problem
    with the prior compensation and the scheme by which it was
    derived, and whether we would call it fraud, I mean, I can be
    freer; I can understand the constraints under which you may be
    testifying, would it be appropriate for the Board to take
    action to receive or to obtain a payback, a repayment, to ask
    these folks who obtained these very large bonuses for payback
    for the benefit of the investors, to help pay the fine, to
    restore the faith in the company, to restore the trust of the
    public, because it is a Government-Sponsored Enterprise,
    because the mission is to provide housing for the least of our
    people, for all of those reasons?
        Mr. Ashley. I agree with all of those reasons. Let me tell
    you the process that the Board has in place. First of all,
    there is no reward of any form for those who have committed
    fraud. Let us be very clear on that. The Board is working with
    the SEC, with the DOJ, with OFHEO, and there are ongoing
    investigations of the individuals at this point in time, which
    is one of the constraining factors that I am speaking under
    here.
        The Board will be informed by those investigations, and I
    have said several times publicly that every option is available
    to the Board when we are informed by those investigations and
    in consultation with counsel. And that is a process that must
    play out. I would like to be able to sit here today and tell
    you it was concluded and give you finality to it. It is not,
    but it will be.
        Senator Martinez. In terms of your current CEO, Mr. Mudd,
    and his current role and the appropriateness of his current
    role, he was the COO, chief operating officer previously. You
    can say to this Committee that your Board is comfortable that
    this is the best person to lead Fannie Mae at this point in
    history, at that point in time, given the prior participation
    in the company at a time that seemed to have been so troubled
    in management as well as in other activities?
        Mr. Ashley. Senator, I can.
        Senator Martinez. OK, now, Mr. Mudd, and you and I have
    talked a number of times, and I appreciate the candor with
    which you have dealt with me, and I appreciate that greatly.
    And I do not find this comfortable, because I like you.
        One of the things that has come to light is your commentary
    to Mr. Raines in November of 2004, which states in part, and I
    only have part of this memo; I hope it is not out of context:
    the old political reality was that we always win; we took no
    prisoners; and we face little organized political opposition.
    We used to, by virtue of our peculiarity, be able to write or
    have written rules that worked for us. We now operate in a
    world where we will have to be normal.
        That culture, that type of environment, you are the COO,
    you are being compensated, as has been stated, in very
    substantial amounts, including bonuses of about $15 million
    over the period of those several years. And what I would ask is
    a question that often arises in these types of situations: Mr.
    Mudd, what did you know about the practices at the company that
    you were the COO of, and when did you know it?
        Mr. Mudd. Thank you, Senator.
        I indicated in the earlier question, my knowledge of the
    issues, the challenges, the problems, the misdeeds unfolded
    over a period of time, and what I would ask your indulgence to
    do is, because I think it is responsive to your question, is to
    give you the context that might not have existed in that memo.
    Because, in fact, what I was doing then in the prior regime was
    encouraging the company to change.
        Senator Martinez. I will allow you to do that, and I am
    delighted for you to do it.
        Mr. Mudd. Yes, sir.
        Senator Martinez. When you talk in this memo, you are
    talking about we. We always won. We took no prisoners. We faced
    little organized political opposition. We used to, by virtue of
    our peculiarity, be able to write or have written rules that
    worked for us, and we now operate in a world where we will have
    to be normal.
        Mr. Mudd. Yes, sir.
        Senator Martinez. You are including yourself as part of
    that culture. And I understand that perhaps what you were doing
    here is signaling that there needed to be a change, and you
    were a change agent, and in that regard, I compliment you. But
    I also wonder what did you know, and when did you know it? And
    I will be glad to hear your memo, but I would like an answer to
    that question: when did you know of what was happening at
    Fannie Mae that we all today find so troubling?
        Mr. Mudd. Senator, I became aware of the problem in its
    full manifestation the day that you did, the day that the SEC
    announcement was made. I was shocked and stunned by that. I
    understood that there were issues in the culture. I understood
    that there were management issues along the way. I understood
    that we did not quite have all the skills we needed in all the
    areas we needed to to keep up with the increasing cycle of new
    accounting standards that need to be implemented.
        But never, never, never, did I have any indication that
    that would lead to the type of problems that have now come to
    light. And so, my whole focus now is on getting those fixed. I
    was never aware of any misdeed, any intentional misapplication
    of any accounting procedure, any fraud, any cheating; none of
    those activities. My own focus was on getting things done
    right.
        The sentence immediately after the one that you cite in the
    memo was: the new reality--because there are approximately 10
    or 12 paragraphs that are missing between those two lines that
    you have quoted--was the new reality is that 4 years of
    continuous fighting has worn out even our friends. We no longer
    get the benefit of the doubt. The fight has resulted in
    relationships that are worse than they were when we started,
    and the new reality is that legislation can happen without our
    acquiescence. Finally, all this action has supported our idea,
    our brand of affordable homeownership, with a political brand,
    just as feared. We were lightly regulated for a long time. Now,
    we have the SEC, OFHEO, other governmental bodies essentially
    telling us for the areas in their purview how to operate. We
    will have to, and have started to, forge a new constructive
    relationship with OFHEO.
        That is the type of thing that I was writing back in those
    days, Senator. I did not always win.
        Senator Martinez. When was that memo? November of 2004?
        Mr. Mudd. Yes, sir.
        Senator Martinez. OK, I would like to have that memo, Mr.
    Chairman, attached as part of the record. I think it would be
    helpful for us to have the entirety of that.
        Chairman Shelby. Will you furnish a copy of that for the
    record?
        Mr. Mudd. Yes, I will, sir.
        Chairman Shelby. That will be made part of the hearing
    record without objection.
        Senator Martinez. So what you are saying, basically, is
    that when you wrote that memo, was that prior to the SEC
    report?
        Mr. Mudd. Yes, it was.
        Senator Martinez. So at that point, at some point prior to
    the SEC report, you had knowledge that all was not well at
    Disneyland, right?
        Mr. Mudd. I had knowledge that we were not--that we did not
    have the culture that we needed; we did not have the financial
    skills that we needed; and we needed to get them in place
    quickly, remembering that----
        Senator Martinez. That is prior to the SEC report.
        Mr. Mudd. Yes, sir, that was.
        Senator Martinez. Let me ask you this: did you know, or did
    it occur to you that--you were the COO--that the Audit
    Department was concerned with their own compensation, with EPS
    as an obvious conflict of interest? I mean, would it not be a
    little troubling to suggest that the Auditing Department's
    compensation to the members of the Auditing Department was
    going to be dependent on the EPS of the company, and what could
    an Audit Department do to impact the EPS other than cook the
    books?
        Mr. Mudd. Senator, that is deeply troubling to me. I do not
    think that is the way an audit staff should be compensated or
    focused, and I have changed that since I took this job. The
    audit team is----
        Senator Martinez. Did you know about that before then? When
    you were the chief operating officer, did you know that the
    Auditing Department's compensation was derived from the EPS?
        Mr. Mudd. Senator, the compensation of the entire company
    at that time was derived in some measure off of the ultimate
    financial results of the company.
        Senator Martinez. So you were, as COO, aware that your
    Audit Department's compensation depended on the EPS of the
    company.
        Mr. Mudd. Yes, that is true. And that was also the
    understanding that I had in other prior companies that I had
    worked for.
        Senator Martinez. The Audit Department is special, is it
    not?
        Mr. Mudd. Yes, it is.
        Senator Martinez. Is it not the arbiter, is that not the
    one that sets the books is the one that the investors rely
    upon? I mean, you are a publicly traded company.
        Mr. Mudd. It is a very important function. It is a very
    important check. It is very important for it to be independent
    and report directly to the Board, as it does now. It is very
    important that all of its compensation, any of its compensation
    really be aligned toward telling the truth, not toward being
    aligned with the result of the company.
        Senator Martinez. But you knew of it then, and you did not
    do anything to seek to change that at that time.
        Mr. Mudd. I knew that their compensation was aligned with
    the rest of the company.
        Senator Martinez. Which depended on the EPS.
        Mr. Mudd. Ultimately, it did depend on the results of the
    company, and those results were expressed in EPS, yes, sir.
        Senator Martinez. As a member of the Board, sir, did you
    know that?
        Mr. Ashley. Senator, the fact that all employees of Fannie
    Mae shared in one way or another in an EPS target was known to
    the Board. I would point out that during the 1990s and the
    early part of the decade of 2000 that this was an accepted and
    indeed promulgated form of compensation, in addition to base
    compensation, that most of corporate America, publicly owned
    corporate America, engaged in in one form or another. The
    purpose was to align the management of the company with the
    interests of the shareholders. Fannie Mae----
        Senator Martinez. The Audit Department is not part of
    management.
        Mr. Ashley. No, I quite agree.
        Senator Martinez. That goes well below management, does it
    not?
        Mr. Ashley. I quite agree with your point on this.
        Senator Martinez. My question is: did the Board know that
    at the time, and were there any bells that went off? Did you
    have any concerns about the obvious conflict of interest?
        Mr. Ashley. I do not recall any discussion in the Board
    about the Audit Committee compensation. It may have taken place
    in the Audit Committee, per se, which would have been the
    proper venue for it.
        Senator Martinez. Let me just ask one last question, Mr.
    Chairman.
        Chairman Shelby. You go ahead. It is important.
        Senator Martinez. Mr. Mudd, as we go forward, we have a
    bill pending. Three years ago, some of us were working, I as
    the HUD Secretary and others of this Committee to get a bill
    done. You and I have discussed before the fact that your
    predecessor, Mr. Raines, told me that he would be favorable to
    that bill. He then proceeded to scuttle it, to come over here
    and lobby against it and send the very vast array of lobbyists
    at the disposal of Fannie Mae to do just that. Do you employ as
    many lobbyists today as you did then? Friendly question; I know
    the answer.
        Mr. Mudd. I am sorry?
        Senator Martinez. Is that a friendly question? I know the
    answer.
        Mr. Mudd. The answer would be no, we do not, sir.
        Senator Martinez. You have told me that you want a
    regulatory bill that would help your company; I believe it
    would help your share price to have a good, strong regulator in
    place as soon as possible; is that correct?
        Mr. Mudd. Yes, sir, I agree with you on that.
        Senator Martinez. Why can we not get complete support for
    our bill, including portfolio limits? I mean, should your
    portfolio limitations--be obvious that you need them, that you
    must have them, that the risk is too great, that the taxpayers
    bear that risk? Can we not persuade you to support the bill
    currently on the floor so that we can move forward, give you a
    strong regulator, fulfill the promise that Raines made to me
    some time ago that he did not fulfill but that I believe is so
    apparent a need of this company to have a strong regulator in
    place, even if you have to swallow hard about the portfolio
    limits? Because maybe the times are such that you have just got
    to operate differently. Maybe there is a new normal. Maybe you
    cannot make your own rules. Maybe you cannot set your own
    standards. Maybe you cannot continue to operate with a weak
    regulator. Maybe this needs to be part of the new culture and
    go ahead and endorse this bill and not continue to fight the
    portfolio limits aspect of this bill, because you still do have
    friends.
        Mr. Mudd. Senator, thank you for the question and the
    sentiments.
        I would like there to be a bill. As far as I know, the
    discussions have not included a change in our mission, and as I
    understand it and as I interpret it, our charter is still for
    us to provide liquidity in the secondary market for mortgages.
        There are other companies I am sure that the Committee is
    familiar with that have many different divisions and many
    different operations. We only have two lines of business: our
    guarantee business and our portfolio. And, my own perspective,
    as much as I enjoy being here today, I have no vote in the
    process, my own perspective is that it is very important to
    understand that those two businesses operate together in order
    for us to perform our mission.
        And if, through the legislative process, Congress still
    wants us to accomplish the same mission, I have got those two
    tools to do it, and I think it would be much more difficult for
    me to represent to you that I could do that if I had fewer
    tools to accomplish it, sir.
        Senator Martinez. Thank you, Mr. Chairman.
        Chairman Shelby. Senator Hagel, but then, I have got a few
    questions after you.
        Senator Hagel. Thank you. I just have a couple of follow-up
    questions to Senator Martinez's line of questioning on lobbying
    expenses. If I understood that exchange, Mr. Mudd, in your
    answer to Senator Martinez as to less lobbyists employed today,
    is that what you said? What did you say?
        Mr. Mudd. Do you want me to elaborate?
        Senator Hagel. I do not want you to elaborate. Say again
    what you said to Senator Martinez.
        Senator Martinez. I believe he said they had fewer
    lobbyists.
        Senator Hagel. Is that what you said?
        Mr. Mudd. Yes, sir.
        Senator Hagel. Well, I have before me information that
    says, in fact, your lobbying expenses have increased every
    year. Is that not right or----
        Mr. Mudd. Senator, having looked at this, the way that the
    formula works----
        Senator Hagel. What formula?
        Mr. Mudd. There is a formula under which we report our
    lobbying expenses to Congress and so forth. And what we have
    done is stopped using outside lobbyists, by and large, to carry
    any water for us but rather to, in order to pursue the type of
    constructive engagement on this that I think is most
    appropriate, have folks in the company who are in management,
    who are familiar with these issues, visit with Members of
    Congress or with others in order to explain the very types of
    questions we are talking about today.
        As I understand the way that the formulation works, the
    amount of time, for example, that anyone would spend doing that
    is divided across your base of expenses, and that becomes
    effectively attributable lobbying expense. We are spending less
    on outsiders carrying any water for us. We are having more
    folks come up and explain where we are. But that results in the
    number being larger than it would be otherwise.
        Senator Hagel. But that does not exactly square with your
    answer to Senator Martinez. According to that formula or
    whatever formula you use, and I would like for the record to
    show, and you can get more information on that, as to who is
    lobbying from your organization and how you are compensating
    them and how much money, regardless of the formula, then, what
    you are telling me is that there is more lobbying going on. Or
    you are paying your people inside more than you were paying
    outside people.
        Mr. Mudd. No, sir.
        Senator Hagel. Why is the number up? Regardless of the
    formula----
        Mr. Mudd. It is expressed as a percentage of our expenses.
        Senator Hagel. I am not talking about percentages. I am
    talking about raw numbers. 2005 is what I have before me right
    now: $10,080,000; 2004, $8,790,000; 2003, $8,700,000; 2002,
    $7,500,000. These are dollar numbers; not percentage numbers,
    they are dollar numbers. So again, explain to me your answer to
    Senator Martinez. You are spending more on lobbying according
    to the reports.
        Mr. Mudd. Those numbers, Senator, are expressed as a
    percentage of time spent against the total expense for
    lobbying. Therefore, because our expenses have gone up due to
    the restatement and due to other reasons, the factor against
    which we are multiplying it to produce that has gone up. The
    amount of time, the number of firms that are involved in this--
    --
        Senator Hagel. That does not make any sense.
        Chairman Shelby. That is not the question he is asking you.
        Senator Hagel. That is not the question I am asking anyway.
        Senator Martinez. How much are you paying for lobbyists?
    Are you paying more money out for lobbyists? Do you have more
    lobbyists? Do you have fewer lobbyists?
        Senator Hagel. Obviously, he is paying more.
        Senator Martinez. That is part of the culture that we are
    talking about fixing that your memo--you know, we need to have
    confidence that this is in fact changing.
        Mr. Mudd. In terms of the number of individuals inside the
    company that are working on that, fewer. In terms of the number
    of outside firms that are working on that, fewer. In terms of
    the number of management individuals that have spent time on
    the Hill talking about these issues, explaining these issues,
    those are counted in the equation, Senator. That is all.
        Senator Hagel. Go ahead.
        Senator Martinez. So you come to the Hill to meet with a
    Member of Congress.
        Mr. Mudd. Yes, sir.
        Senator Martinez. Somehow or other, your time allocation to
    that is made as part of your lobbying expenses.
        Mr. Mudd. Yes, sir. That is my understanding.
        Senator Hagel. I would like to see those numbers, and I
    would like to see those records and how you keep those records,
    if you will provide all that for these years, these last 4
    years for the Committee, and how much out of your salary--your
    compensation last year was $8 million, you said; is that right?
    $8 million was what your compensation was last year? Total
    compensation.
        Mr. Mudd. I can get you the exact numbers in terms of
    reporting.
        Senator Hagel. Well, you used the term $8 million a few
    minutes ago.
        Senator Martinez. W-2.
        Senator Hagel. Well, then, I would like to see how much of
    that $8 million is allocated to lobbying for you, and I would
    like to see that breakdown, as you have just said that you have
    fewer lobbyists, outside lobbyists, more internal people doing
    the work.
        Now, let me ask both of you a question, since you seem not
    to have good memories on these things. In April of 2004, Fannie
    ran a very significant series of television ads attacking GSE
    reform the week before a Senate Banking Committee markup on GSE
    reform. Now, obviously, each of you were at Fannie in 2004;
    each of you were there in fairly responsible positions. You
    just happened to see the ads? Did you know about the ads? How
    did the lobbying work? You were chief operating officer, Mr.
    Mudd. What did you know about ads, how much money they were
    spending, and the content of the ad?
        I remember at the hearing, as Chairman Shelby, I suspect,
    recalls, I was astounded that a GSE, a Government-Sponsored
    Enterprise, was running television ads against the oversight
    Committee that chartered it, the Congress. I was astounded by
    that. Now, what did you know about that?
        Mr. Mudd. I had a general awareness that those ads were
    running, Senator, and when this came on my watch, we have
    essentially stopped any advertising like that, because I agree
    with you.
        Chairman Shelby. So this was advertising, you call it, not
    lobbying.
        Senator Hagel. Yes.
        Chairman Shelby. Although, the end result is lobbying. Is
    that how you attribute it in your accounting? Was it attributed
    to advertising by Fannie Mae rather than lobbying?
        Mr. Mudd. I am sorry, Senator, I was just trying to respond
    to Senator Hagel's question.
        Chairman Shelby. Well let me ask you, if Senator Hagel will
    permit me.
        Senator Hagel. Yes, Mr. Chairman.
        Chairman Shelby. All these TV ads that you were running
    that he is referring to, did you deem that advertising rather
    than part of your lobbying shop, although the end result, it
    was lobbying against our legislation?
        Mr. Mudd. I can go back and look at----
        Chairman Shelby. We would be interested in that.
        Mr. Mudd [continuing]. ----what the reporting was at that
    time to understand it. It was up through a different division,
    so I was not familiar with it at the time.
        Chairman Shelby. It is a lot of money, though.
        Mr. Mudd. But I would be happy to provide for the Senators
    how that was characterized.
        Chairman Shelby. If you would do that for the record along
    with the others.
        Thank you, Senator Hagel.
        Senator Hagel. Yes, Mr. Chairman, thank you.
        Did the Board have any idea of what was going on? Or the
    overall numbers, since you have been on the Board, for example,
    Mr. Ashley, the numbers I have, Fannie has spent a lot of money
    on lobbying. Did the Board know anything about expenditures? I
    mean, we are getting into tens of millions of dollars is where
    we have been since 1998, about $61 million, according to the
    report spent on lobbying. Did the Board know about this?
        Mr. Ashley. The details of the lobbying expenses were not
    known to the Board, Senator.
        Senator Hagel. Not even the numbers? You had no idea that
    $60 million was being spent over that period of time?
        Mr. Ashley. I was unaware of these numbers until I became
    nonexecutive chair.
        Senator Hagel. Do you think the Audit Committee of the
    Board knew anything about it?
        Mr. Ashley. If they did, I am not aware, Senator. I do not
    recall this ever being reported out as a numerical number to
    the Board.
        Senator Hagel. I will have additional questions for the
    record. Thank you.
        Chairman Shelby. Mr. Ashley, you were a member of the Board
    of Directors of Fannie Mae from 1995; is that correct?
        Mr. Ashley. That is correct, Mr. Chairman.
        Chairman Shelby. And you are still a member, and you are
    Chairman of the Board now.
        Mr. Ashley. That is correct, Mr. Chairman.
        Chairman Shelby. There is no break in that service for 11
    years?
        Mr. Ashley. There is not, Mr. Chairman.
        Chairman Shelby. Did you have an Audit Committee at Fannie
    Mae?
        Mr. Ashley. Yes, sir.
        Chairman Shelby. On the Board of Directors, an Audit
    Committee?
        Mr. Ashley. That is right, sir.
        Chairman Shelby. Were you ever on that Audit Committee?
        Mr. Ashley. I was on that Audit Committee for a very brief
    time----
        Chairman Shelby. When was this?
        Mr. Ashley [continuing]. ----at the end of 2004, for about
    2 months at the end of 2004.
        Chairman Shelby. Oh, that is interesting. You were there
    for 2 months. Were you chairman of the Auditing Committee?
        Mr. Ashley. No, sir, I was never chairman.
        Chairman Shelby. Who was chairman of the Audit Committee?
        Mr. Ashley. At that time, Mr. Gerrity was chairman of the
    Audit Committee.
        Chairman Shelby. And who was the Chairman before that time?
        Mr. Ashley. I would have to verify this. I believe it was
    Mr. Mai.
        Chairman Shelby. Mister who?
        Mr. Ashley. Mai, M-A-I.
        Chairman Shelby. OK, how many members of the Board of
    Directors of Fannie Mae were on the Audit Committee of the
    Board of Directors?
        Mr. Ashley. It would have varied over that time; anywhere,
    usually, from three to perhaps four or five members.
        Chairman Shelby. Did you ever interact with these members
    before you went on as a member of the----
        Mr. Ashley. The chair of the Audit Committee reported
    regularly at each Board meeting following an Audit Committee
    meeting or an audit call.
        Chairman Shelby. Did you ever ask questions of the Audit
    Committee as a member of the Board of Directors?
        Mr. Ashley. There were regular interchanges between all
    members of the Board and in response to the report of the Audit
    Committee chair to the Board.
        Chairman Shelby. Were there any questions asked about
    questionable accounting practiced during that time?
        Mr. Ashley. Yes, sir; as the Freddie Mac issues became
    known, this was clearly a matter of discussion within the
    Board, and the Audit Committee chair was asked and reported on
    what KPMG had indicated to the Audit Committee.
        Chairman Shelby. Was Mr. Raines part of the Audit Committee
    when he was Chairman of the Board?
        Mr. Ashley. Mr. Raines would not have been a member of the
    Audit Committee as a member of management.
        Chairman Shelby. Was Mr. Mudd ever a part of the Audit
    Committee?
        Mr. Ashley. The same answer, Senator.
        Chairman Shelby. OK, all of that is troubling to me.
        Senator Carper.
        Senator Carper. Thanks, Mr. Chairman.
        As we wind up here, I want to come back and focus on a path
    forward and focus a bit less on the sins of Fannie Mae and
    those who ran this enterprise in recent years. I have asked
    Fannie Mae to provide certain information to my office that we
    think will be helpful in crafting a legislative language with
    respect to portfolio limits.
        Mr. Chairman, I will just say in my own State, I used to be
    Governor there, as you know, and made housing, especially
    homeownership, a big priority. And one of the things that I
    want to make sure that we do going forward is we address
    portfolio limits and what can go into a portfolio. I want to
    make sure that we do not somehow disadvantage our own housing
    authorities, whether they are State housing authorities or
    local municipal housing authorities in their ability to meet
    their missions of providing affordable housing.
        I have said to Fannie Mae, it would be interesting to know
    how the assets in Fannie Mae's portfolios relate to the
    affordable housing missions of our housing authorities. I have
    asked for that information. They provided it for my State, and
    they are beginning to provide it for the other States.
        I suspect I am not the only Member of this Committee that
    has asked Fannie Mae to provide information that might be
    helpful in enabling us to craft compromises in these two major
    areas: portfolios and affordable housing fund. Can you give us
    an example of any other requests for information that you have
    received, that you are mindful of from any of us, that you have
    provided a response for or maybe that you have not?
        Mr. Mudd. Senator, as far as I know, we are relatively up
    to date on any requests for information from Congress. There
    has been, I think appropriately, an interest both in the
    activities of the company as they relate broadly to providing
    mortgage financing in each of the States as well as with
    respect to specific investment projects on a community by
    community basis. Any of that information that the Senators
    would like to see that is relevant to their States, we will
    provide.
        Others have requested information in terms of our financial
    position and our capital related to the $39 billion in capital
    that we have related to the ongoing progress that we are making
    on the completion of the restatement related to how
    increasingly firm our understanding of how we are going to get
    that work done and when it is going to be done.
        And for those and any other requests, we would be
    delighted, because my general view has been that the more
    information we can provide in terms of what we actually do,
    provided that we are doing it appropriately with the right set
    of controls and the right safety and soundness approach, the
    more we will be in the right space in terms of both our
    business and our mission.
        Senator Carper. In my time here in the Senate, from time to
    time, I have colleagues who say to me work with me on a
    particular issue. And what they really mean is accept my
    proposal. And I heard my friend Senator Martinez essentially
    say well, why do you not just embrace the language in the
    Senate Banking Committee bill as it pertains to portfolio
    limits?
        And, you know, if this were a House Banking Committee, and
    the Chairman here and I used to serve on the House Banking
    Committee, my suspicion is that the House Banking Committee, if
    you were sitting before them, might say, well, why do you not
    just embrace our proposals with respect to portfolio limits and
    frankly with an affordable housing fund? And I do not know that
    it is appropriate for you to embrace either of these proposals.
        Our responsibility, in my judgment, is to use you as a
    resource, to use the lessons that you have learned and we have
    learned through the misbehavior of those that you have worked
    with and to figure out what is the right thing to do going
    forward.
        You can provide a great service for us in helping to
    address, I think, particularly these two issues. I do not think
    it is appropriate for us to say you should embrace either the
    language that is in our bill or, frankly, the language that is
    in the House bill but to give us the best advice and counsel
    from what you have learned and some hard lessons and to enable
    us to craft a better course going forward.
        And I would close, Mr. Chairman, simply by stating what I
    have stated before: we ought to be able to work this out. The
    taxpayers of this country expect that from us. The folks who
    depend on these folks at Fannie Mae and Freddie Mac doing their
    job, they are depending on us as well. And I pledge to work
    with you to help us find that common ground.
        Chairman Shelby. Mr. Mudd, you said you were going to work
    with us. I assume Mr. Ashley as the Chairman is going to, too,
    but that will be soon tested in the next several weeks. You
    talked about this as a new Fannie Mae. We are going to see,
    because if you want to help us bring forth a substantive,
    meaningful bill, you are going to have that chance. We will
    have to wait and see.
        Thank you for your testimony. The Committee is adjourned.
        [Whereupon, at 3:02 p.m., the hearing was adjourned.]
        [Prepared statements, response to written questions, and
    additional material supplied for the record follow:]
                PREPARED STATEMENT OF CHAIRMAN RICHARD C. SHELBY

            Letter Received from Kevin M. Downey to Chairman Shelby

                                     ______

                  PREPARED STATEMENT OF SENATOR ELIZABETH DOLE
        I want to thank you, Chairman Shelby, for holding today's hearing
    regarding the OFHEO Report of the Special Examination of Fannie Mae.
    This report not only confirms my deep concerns about Fannie Mae--it
    demonstrates that the GSE's actions were far worse than I could have
    imagined.
        Nearly 3 years ago, as we've heard, after it was revealed that
    Freddie Mac had misstated its earnings, Senators Hagel, Sununu and I
    introduced legislation to strengthen the regulation of the GSE's. And
    Fannie and Freddie responded, dispatching an army of lobbyists to
    Capitol Hill and spending tens of millions of dollars to oppose our
    bill. In 2004, their lobbying tab totaled $26 million--and just last
    year, more than $24 million. At times it has truly felt like David and
    Goliath! No one has better described Fannie's mindset than the current
    CEO, who in an internal memorandum of November 2004 asserted, and I
    quote: ``the old political reality was that we always won, we took no
    prisoners, and we faced little organized political opposition.'' End of
    quote. Even today, after all that we now know about Fannie and Freddie,
    the GSEs' influence on the Hill remains strong. But we in Congress must
    stand up to any political influence the GSEs continue to wield. The
    facts speak for themselves: On May 23 the Securities and Exchange
    Commission concluded that, and I quote, ``between 1998 and 2004, Fannie
    Mae engaged in a financial fraud involving multiple violations of
    Generally Accepted Accounting Principles in connection with the
    preparation of its annual and quarterly financial statements.'' The SEC
    went on to explain that, ``these violations had the effect, among other
    things, of falsely portraying stable earnings growth and reduced income
    statement volatility, and--for [the] year-ended 1998--of maximizing
    bonuses and achieving forecasted earnings'' end of quote. Some had
    earlier claimed that Fannie and Freddie's problems were an
    understandable misapplication of complicated, obscure accounting rules.
    We now know that this was not the case--that in fact Fannie and Freddie
    were committing fraud . . . for many years . . . in part driven by
    certain executives' personal greed. There can no longer be any doubt
    about what we must do here in Congress--Fannie Mae and Freddie Mac need
    strong regulation, to ensure that fraud and manipulation in their
    accounting practices have been forever banished from these
    institutions. This report represents a clarion call . . . for the swift
    consideration and passage of legislation to create a new, independent
    regulator of these enterprises. This new regulator should have the
    authority to limit the sizable portfolios of both Fannie and Freddie,
    thereby redirecting the GSEs to their original mission and preventing
    them from engaging in activities that could undermine their safety and
    soundness, or place them in systemic risk
        I thank both OFHEO and the SEC for their tenacious and diligent
    work on this issue. Director Lockhart, your report provides a detailed
    and complete expose, not only of the many complex transactions that
    underlay the problems at Fannie Mae, but also of the broader culture of
    venality that developed at the GSEs. I thank you and the other
    witnesses for joining us here today.
                                     ______

                  PREPARED STATEMENT OF JAMES B. LOCKHART III
                                Acting Director,
                 Office of Federal Housing Enterprise Oversight
                                 June 15, 2006
        Good morning. Chairman Shelby, Ranking Member Sarbanes and members
    of the Committee, thank you for the opportunity to discuss the findings
    of our Special Examination of the Federal National Mortgage
    Association, better known as Fannie Mae. I will also discuss the
    settlement agreements reached by the OFHEO and the Securities and
    Exchange Commission (SEC) with Fannie Mae. My testimony reflects my
    views and not necessarily those of the President or the Secretary of
    Housing and Urban Development.
        It is a pleasure to be here with Chairman Christopher Cox as the
    investigation and settlement agreements are excellent examples of
    government agencies working together. Before turning to a detailed
    discussion of the Special Examination and settlement, I would also note
    that later today OFHEO will submit its 2006 Report to Congress on the
    Examinations for both Enterprises pursuant to its statutory mandate.
        As a Government Sponsored Enterprise (GSE), Fannie Mae has a
    special position among American corporations and an extremely important
    mission--facilitating the growth of affordable housing in the United
    States. Despite its recent downsizing, Fannie Mae remains one of the
    largest financial institutions in the United States. As a GSE, Fannie
    Mae has a special mandate and position of public trust. The previous
    management team, led by Chairman and Chief Executive Officer (CEO)
    Franklin Raines, violated that trust. By encouraging rapid growth,
    unconstrained by proper internal controls, risk management and other
    systems, they did serious harm to Fannie Mae while enriching themselves
    through earnings manipulation.
        Let me provide a brief history about OFHEO's Special Examination.
    Despite Fannie Mae's protests, in July 2003, OFHEO informed this
    committee that it intended to conduct a special accounting review of
    Fannie Mae to evaluate whether it complied with Generally Accepted
    Accounting Principles or GAAP.
        In September 2004, OFHEO issued an interim report that detailed
    serious problems relating to Fannie Mae's accounting. Importantly,
    OFHEO found that Fannie Mae did not comply with GAAP for FAS 91, which
    deals with amortization of loan fees, premiums and discounts, and FAS
    133, which covers derivatives and hedge accounting. The SEC concurred
    with OFHEO's findings and ordered Fannie Mae to restate its financial
    statements filed with the Commission.
        Since then, OFHEO and the Board of Directors of Fannie Mae have
    entered into three agreements requiring remedial steps. The last
    agreement was signed on May 23, 2006.
        The OFHEO report details an arrogant and unethical corporate
    culture. Perhaps the best written record of this culture is a memo from
    the Chief Operating Officer to the CEO 2 months after OFHEO's interim
    report. He was discussing the need to change and wrote: ``The old
    political reality was that we always won, we took no prisoners . . . ''
    and he added, ``we used to . . . be able to write, or have written
    rules that worked for us.''
        Fannie Mae's management directed employees to manipulate accounting
    and earnings to trigger maximum bonuses for senior executives from 1998
    to 2003. 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
        Senior Fannie Mae executives were precisely managing earnings per
    share (EPS) to the one-hundredth of a penny to maximize their bonuses
    while neglecting investments in systems, internal controls, and risk
    management. The combination of earnings manipulation, mismanagement,
    and unconstrained growth resulted in an estimated $10.6 billion of
    overstated profits, well over a billion dollars in expenses to fix the
    problems, and ill-gotten bonuses in the hundreds of millions of
    dollars. Senior executives were flat-out wrong, or, to use the proper
    regulatory phrase, were managing Fannie Mae in an ``unsafe and
    unsound'' manner. Senior management manipulated accounting; reaped
    maximum, undeserved bonuses; and prevented the rest of the world from
    knowing about it. They co-opted their internal auditors and other
    managers. They stonewalled OFHEO.
        The Board of Directors, the last line of defense, failed to be
    sufficiently informed and independent. Their oversight failings meant
    that they did not discover, let alone correct, the unsafe and unsound
    practices at Fannie Mae, even after the Freddie Mac problems became
    apparent.
    Management Manipulated Earnings
        During the period covered by our report, Fannie Mae reported
    extremely smooth profit growth and hit EPS targets with uncanny
    precision each quarter. By deliberately and intentionally manipulating
    accounting, senior management maximized their bonuses and other
    compensation, which came at the expense of shareholders. In 1998,
    management should have recognized significant losses from the
    amortization of premiums and the impairment of guaranty-fee buy-ups,
    but much of the actual loss was deferred so that management could meet
    bonus targets, as well as the expectations of analysts. In other years,
    such as 2001, when very low short-term rates resulted in higher-than-
    forecasted earnings, management engaged in various manipulations,
    including debt repurchases and structured transactions with no
    legitimate business purpose, to save earnings for a rainy day. For
    example, the total compensation of former Chairman and CEO Frank Raines
    exceeded $90 million from 1998 through 2003. Of that amount, more than
    $52 million was directly tied to achieving EPS targets.
        Senior executives at Fannie Mae consistently reminded managers and
    other employees of their personal stake in meeting EPS targets. Indeed,
    the head of the Office of Auditing told his staff, in reference to
    Chairman Raines' goal of doubling earnings per share from $3.23 to
    $6.46 by 2003, that they must have ``$6.46 branded in their brains.''
    That statement implies a blatant conflict of interest for an internal
    auditor.
        Now, I want to spend a few minutes briefly describing the
    accounting tools that management used to achieve their desired earnings
    targets and the control environment--or lack thereof.
    Specific Accounting and Earnings Management Issues
        In brief, the extreme predictability of the financial results
    reported by Fannie Mae from 1998 through 2003, and the ability to hit
    EPS targets precisely each quarter, were illusions deliberately and
    systematically created by management. The real question is how was
    management able to accomplish this when their business is volatile by
    nature and accounting was moving toward measuring and reporting assets
    and liabilities at fair value.
        First, they had to assure that large unpredictable changes in fair
    value were not recognized. FAS 115, Accounting for Certain Investment
    in Debt and Equity Securities and FAS 133, Accounting for Derivative
    Instruments and Hedging Activities are examples of accounting
    standards, if implemented properly, that would have recognized and
    recorded earnings volatility. Faced with that outcome, Fannie Mae chose
    to implement these and other accounting standards in a fashion that
    reduced volatility while ignoring the fact that these practices did not
    comport with GAAP.
        During this same period, Fannie Mae management went to
    extraordinary lengths to avoid recording GAAP-required impairment
    losses on assets whose values had declined. Examples of such assets are
    manufactured-housing and aircraft-lease-backed securities, interest-
    only securities, and ``buy-ups.'' Not only did they not record these
    losses but the report details the extraordinary measures management
    took to keep this information off the books and out of the view of
    their external auditor and regulatory bodies.
        By utilizing the above strategies, management was able to keep
    earnings within a predictable range, placing management in a position
    to employ several techniques to manipulate and manage earnings more
    directly, including the use of cookie-jar reserves, income shifting
    transactions and inappropriate debt repurchases.
        The natural question at this juncture is where were the internal
    controls that should have prevented this type of behavior and where
    were the internal and external auditors? The report details the
    conscious decision made by management to use existing systems even when
    proper implementation of new accounting pronouncements and rapid growth
    necessitated the need for new systems. It also discusses the weak
    internal control environment that management created or allowed to
    exist. In fact, this underinvestment in internal controls, accounting
    systems, risk management, and staff helped them to manage earnings as
    it made it much easier to hide improper actions that smoothed earnings.
        The report also discusses the serious failures in the Office of
    Auditing. Internal Audit failed to properly confirm compliance with
    GAAP as specified in its audit objectives or to consistently audit
    critical accounting policies, practices, and estimates in a timely way.
    When Internal Audit did find shortcomings they were not adequately
    addressed or communicated. Internal Audit failed to perform its primary
    task and issued misleading reports about its work. Finally, it failed
    to exercise due professional care in investigating allegations of
    accounting improprieties raised by two employees in the Office of the
    Controller.
        Similarly, external audits performed by KPMG failed to include an
    adequate review of Fannie Mae's significant accounting policies for
    GAAP compliance. KPMG was aware of the non-GAAP provisions of Fannie
    Mae's FAS 91 policy as well as the non-GAAP practices the Enterprise
    was using in the application of FAS 133. That notwithstanding, KPMG
    issued unqualified opinions on Fannie Mae's financial statements for
    the years in question when these statements included significant
    departures from GAAP. Last, the external auditor performed a cursory
    review, at best, of the allegations of fraud raised by Roger Barnes.
    The procedures performed by the external auditor were not sufficient to
    make a determination regarding the propriety of the internal
    investigation performed by Fannie Mae or to evaluate the Enterprise's
    conclusions regarding Mr. Barnes' assertions.
    The Role of the Board
        The Board-approved executive compensation program at Fannie Mae
    sent senior executives the message to focus on increasing earnings
    rather than controlling risk. Indeed, during much of the period covered
    by the report, Fannie Mae took significant amounts of interest rate
    risk and, when interest rates fell in 2002, incurred billions of
    dollars in economic losses, despite the smooth reported earnings.
    Fannie Mae also had significant operational risk exposures.
        The report also provides some insight on matters of corporate
    governance that gave rise to many of these problems. For example, the
    Special Examination found that the Board of Directors of Fannie Mae
    contributed to the Enterprise's problems by failing to be sufficiently
    informed and failing to act independently of its chairman, Frank
    Raines, and other senior executives. The Board failed to exercise the
    requisite oversight over the Enterprise's operations, and failed to
    discover or ensure the correction of a wide variety of unsafe and
    unsound practices. These failures occurred even after serious
    accounting and earnings management problems at Freddie Mac became
    widely known.
        In particular, the Audit Committee did not provide adequate
    oversight of the internal audit function, and did not monitor the
    development and implementation of critical accounting policies. These
    failures resulted from the Committee's own neglecting to develop the
    specialized financial knowledge necessary for its oversight
    responsibilities. The Audit Committee also failed to initiate an
    independent investigation of Roger Barnes' whistleblower claims of
    accounting irregularities when they arose.
        The failure of the Audit Committee was compounded by failures of
    the Compensation Committee. The primary role of this committee is to
    ensure that senior management is properly compensated for its role in
    directing the affairs of the Enterprise. Nevertheless, the Compensation
    Committee approved a compensation structure based on a single measure
    that was easily manipulated by management. The Compensation Committee
    also did not monitor the executive compensation system for signs of
    abuse by senior management.
    Recommendations
        Based on the report's findings, staff made specific recommendations
    to me, as Acting Director, to enhance the safety and soundness of
    Fannie Mae. I have accepted all of the recommendations. Several of them
    were directed to OFHEO, including:

        OFHEO needs to continue to strengthen and expand its
            regulatory infrastructure and regular examination programs.
        Matters identified for remediation by Fannie Mae should be
            considered for Freddie Mac.
        OFHEO should continue to support legislation to provide the
            powers essential to meeting its mission of assuring safe and
            sound operations at Fannie Mae and Freddie Mac.

        However, the majority of these recommendations are directed at
    Fannie Mae and I am pleased to say they have all been incorporated into
    the agreement that was signed on May 23, 2006.
    Settlement
        OFHEO reached a settlement with Fannie Mae to address the various
    problems found in the course of the Special Examination. The settlement
    represents a step toward correcting a dangerous course that had been
    followed by one of the largest financial institutions in the United
    States. Unprincipled corporate behavior and inadequate controls simply
    will not be tolerated. The settlement addresses both specific
    misconduct and weaknesses as well as the overall culture that permitted
    such misconduct and mismanagement to occur.
        I am pleased that the settlement reached by OFHEO could be
    concluded at the time the Report of the Special Examination was
    released and in close consultation and cooperation with the SEC.
    Chairman Cox said at the OFHEO press conference, ``Fraudulent financial
    reporting directly undermines the fairness of our capital markets, and
    the very purpose of those markets to allocate capital to its best
    uses.''
        The key components of the agreement, that contains nearly 60
    remedial provisions, include:

        OFHEO directed Fannie Mae to pay a $400 million penalty to
            the government. This level of penalty signals that unsafe and
            unsound conditions cannot be tolerated at firms that have a
            public mission and enjoy public benefits.
        OFHEO directed that Fannie Mae freeze the growth of its
            portfolio mortgage assets to the level of December 31, 2005.
            OFHEO's action is based on the ongoing internal controls, risk
            management and accounting deficiencies and the need for the
            Enterprise to provide OFHEO an acceptable business plan for
            managing its market activities. Sole discretion lies with the
            Director of OFHEO to modify or lift the limits based on his
            assessment of plans and progress. The preexisting surplus
            capital requirements and capital planning along with limits on
            corporate actions such as dividend payments remain in effect.
        Fannie Mae must strengthen its Board of Directors
            procedures to enhance Board oversight of Fannie Mae's
            management and the Enterprise must create new Board committees
            to address new legal and reporting obligations and must demand
            and receive improved reporting to the Board by management.
        Fannie Mae must make a major investment in internal
            controls. From a clear policy on the role of outside
            consultants to external testing of controls and greater
            emphasis on operational risk to simple, prudent controls for
            ledger entries, the Enterprise must address its control
            environment that suffered under prior management. The external
            relations program must be reviewed and internal controls
            created as well.
        Fannie Mae must remediate its accounting structures,
            personnel, and reports to management and the Board. Accounting
            staff must be skilled and adequately funded and significant
            transactions must be flagged and detailed for the Board.
        Fannie Mae is undertaking a review of current and separated
            employees who are mentioned in our report for remedial actions;
            additional employees discovered during this review may be
            subject to sanction. This review is underway and OFHEO monitors
            the Enterprise's progress. If the Enterprise does not or cannot
            proceed, then OFHEO will proceed against individuals under the
            authority it possesses. Chairman Cox indicated that the SEC is
            undertaking its own review for possible action against
            personnel involved in matters within its jurisdiction.
        Fannie Mae must establish succession plans; comprehensive
            budget, staffing, and training plans for individual offices;
            and must continue to work with OFHEO on its determinations
            regarding appointments to senior offices. Fannie Mae is
            directed to put in place qualified individuals with appropriate
            skills and adequate resources, and to provide a strong training
            program that includes training on the code of conduct and law
            compliance.
        Fannie Mae must assure that compensation programs are not
            tied solely to EPS measures.

        The emphasis on specific reforms is coupled with requirements to
    alter tone and culture. These are critical to any company. Be it direct
    action or the failure to correct behavior--that is, be it intentional
    policy or a policy of neglect--the key to most corporate failures is
    tone at the top. OFHEO's settlement seeks to remedy both the conduct
    and the culture that permitted that conduct at Fannie Mae.
        Finally, let me note that the remedial steps undertaken by OFHEO
    underscore the need for legislation. If the agency had sufficient
    budget authority to enhance its staff, more robust legal authority over
    individuals and those affiliated with the Enterprise, other powers
    similar to those of other financial regulators including receivership,
    flexible capital standards, new product and growth controls, and more
    streamlined enforcement authorities, then there is a strong possibility
    OFHEO could have prevented the many unsafe and unsound practices cited
    in our report rather than seeking to remedy them through settlements.
    Clear and explicit authorities aimed at remediation will have a
    beneficial effect in prevention of unsafe practices. OFHEO clearly
    needs legislation to make this a reality. That concludes my prepared
    remarks.

                                     ______

                     PREPARED STATEMENT OF CHRISTOPHER COX
                                   Chairman,
                    U.S. Securities and Exchange Commission
                                 June 15, 2006
        Chairman Shelby, Ranking Member Sarbanes, and Members of the
    Committee:
        Thank you for giving me the opportunity to be here today to testify
    about the Securities and Exchange Commission's recent enforcement
    action against the Federal National Mortgage Association (``Fannie
    Mae''). Under Chairman Shelby's leadership, this Committee has spent a
    great deal of time and effort examining the issues surrounding
    Government-Sponsored Enterprises and I appreciate the opportunity to
    appear before you this morning on behalf of the Commission.
    SEC Enforcement Action Against Fannie Mae
        On May 23rd, the Commission and the Office of Federal Housing
    Enterprise Oversight jointly announced settlements with Fannie Mae for
    accounting fraud. The settlements require the company to pay a penalty
    of $400 million. This is a meaningful penalty designed to deter future
    misconduct. Moreover, as a result of the Fair Fund provisions of the
    Sarbanes-Oxley Act, most of the penalty will likely be used to
    compensate defrauded investors. Both Director Lockhart and I agree that
    a penalty of this size represents a meaningful sanction that is
    necessary to address the egregiousness of Fannie Mae's conduct.
    Fraudulent financial reporting directly undermines the fairness of our
    capital markets, and the very purpose of those markets to allocate
    capital to its best uses.
        By interfering with the full and fair disclosure that underpins our
    markets, fraudulent financial reporting cheats investors of their
    savings. That is why the extensive financial fraud that you will hear
    described today required such an emphatic deterrent response.
        The Commission's action alleges that Fannie Mae misstated its
    financial statements from at least 1998 through 2004. In settling these
    charges, Fannie Mae has agreed to pay $400 million, the lion's share of
    which will be paid to the Commission, who will in turn return it to
    defrauded shareholders through our Fair Fund program. Fannie Mae also
    agreed to be permanently enjoined from future violations of the anti-
    fraud, reporting, books and records, and internal control provisions of
    the Federal securities laws.
        The significance of the corporate failings at Fannie Mae cannot be
    overstated. The company has said that it estimates the restatement of
    its financial statements for the years ended December 31, 2003, and
    2002, and for the quarters ended June 30, 2004, and March 31, 2004,
    will result in at least an $11 billion reduction of previously reported
    net income. In all likelihood this will be one of the largest
    restatements in American corporate history.
        Fannie Mae's size and status make it a financial giant. Yet despite
    its prominent position in the financial marketplace the company's
    internal controls were wholly inadequate in light of the size,
    complexity, and sophistication of Fannie Mae's business. Its failure in
    key areas highlights the critical need for senior management to
    constantly assess internal controls as their business grows. Such an
    investment is necessary for the good of the business, for the
    protection of shareholders, and for the health of our capital markets.
    Fannie Mae is a clear example that neglecting internal controls can be
    devastating for a company and its investors.
        The Commission's complaint lays out in detail the many accounting
    failures that occurred at Fannie Mae from books and records violations
    to fraud. The complaint also describes the corporate culture at Fannie
    Mae that emphasized stable earnings growth and reduced income statement
    volatility that was the backdrop for the fraud. As a result of this
    conduct, the company's financial results were smoothed through
    misapplications of Generally Accepted Accounting Principles, or GAAP.
        Two accounting principles are critical to Fannie Mae's business:
    accounting for nonrefundable fees and costs associated with loans,
    known as Financial Accounting Standard 91, or FAS 91, and accounting
    for derivative instruments and hedge activities, known as FAS 133.
        In connection with FAS 91, the Commission's allegations contained
    two key components. First, at the end of 1998, senior management
    intentionally manipulated earnings in order to obtain the highest
    available bonus payout. Senior management of the company determined
    that certain expenses would not be booked even though GAAP required
    they be recorded. At the same time, senior management engaged in a
    series of additional inappropriate adjustments to the company's income
    statement so that the company hit the earnings per share target
    necessary to trigger maximum management bonuses.
        Second, under FAS 91, companies are required to recognize loan
    fees, premiums and discounts as an adjustment over the life of the
    applicable loans. For groups of similar loans, a company can use
    estimates of prepayments to calculate the effective interest rate of
    the loans and determine the portion of such fees and related items to
    be recognized in the income statement. If actual prepayments differ
    from estimates, or estimates change, the net investment in the loans
    must be adjusted with an offsetting entry to the income statement. From
    before 2000 through 2004, Fannie Mae improperly used a threshold to
    determine when certain of these adjustments would be recorded to its
    income statement. If the amount to be recorded did not exceed the
    company-calculated threshold, Fannie Mae did not record it. This
    practice was an improper departure from GAAP and had the effect of
    reducing earnings volatility.
        In connection with FAS 133, without proper basis in the relevant
    accounting literature, Fannie Mae sought to fit the vast majority of
    its transactions into a simplified method of applying hedge accounting
    that assumed no ineffectiveness in the hedge relationship. By assuming
    no ineffectiveness, Fannie Mae avoided measuring and recording in its
    income statement the difference between the change in value of its
    derivatives and the change in value of the items being hedged by the
    derivatives.
        The transactions in question simply did not qualify for such
    treatment under FAS 133. One reason Fannie Mae adopted this approach
    was that it did not have adequate systems or personnel in place to
    comply with FAS 133's provisions--in particular, with provisions that
    require periodic assessment of effectiveness and measurement of
    ineffectiveness. Had Fannie Mae applied such provisions, it would have
    resulted in income statement volatility that senior management of the
    company wanted to avoid. Most of Fannie Mae's anticipated restatement
    of at least an $11 billion reduction of previously reported net income
    is a result of its improper hedge accounting.
        The Commission continues its investigation regarding the
    individuals and entities whose actions and inactions have led to this
    result. The public should have full confidence that we will vigorously
    pursue those individuals who have violated the Federal securities laws.
    Until the investigation is complete, I cannot comment further on the
    alleged conduct of particular individuals or the specific stage of the
    investigation.
    Improved Disclosure to Fannie Investors
        Fannie Mae's settlement of accounting fraud charges raises another
    very significant policy issue, one that has been carefully considered
    by members of this Committee: whether to require mandatory registration
    and periodic reporting under the Exchange Act by Fannie Mae, Freddie
    Mac, and the Federal Home Loan Banks.
        As you well know, the securities issued by Fannie Mae are ``exempt
    securities'' under current laws administered by the SEC. However, there
    is no question that the word ``Government'' in ``Government-Sponsored
    Enterprises'' leaves many members of the investing public with the
    mistaken impression that GSE securities are backed by the full faith
    and credit of the U.S. Government, when in fact there is no such
    guarantee.
        For this reason, the Commission--going at least as far back as
    1992--has consistently advocated the view that, because GSEs sell
    securities to the public, have public investors, and do not have the
    ``full faith and credit'' government backing of government securities,
    GSE disclosures should comply with the disclosure requirements of the
    Federal securities laws.
        In July 2002, Fannie Mae took a step forward by announcing that it
    would voluntarily register its common stock with the SEC under Section
    12(g) of the Exchange Act. The registration of its common stock became
    effective on March 31, 2003, and Fannie Mae subsequently began filing
    periodic reports with the SEC. Unfortunately, many of Fannie Mae's
    periodic disclosures have been late or incomplete. Most notably, Fannie
    has to date not filed an annual report (10-K) for either 2004 or 2005,
    and has not filed quarterly reports (10-Q) in any of the preceding
    seven quarters.
        While our recent enforcement action has assuredly focused the
    attention of Fannie Mae's management on improving its disclosure to
    investors, there is no question that, in the future, Fannie Mae would
    be far more likely to maintain consistent compliance with our
    disclosure regime if the Congress were to terminate its special status
    of voluntary registration and reporting, and make its registration and
    reporting mandatory. That, in my view, is a far better way to protect
    investors.
        I know this Committee is considering legislation that would require
    compliance with the Exchange Act periodic reporting requirements by
    Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. I commend you
    for your attention to this issue, and encourage your consideration of
    this legislation. As I mentioned, the Commission has historically been
    in strong support of mandatory compliance by the GSEs with these
    disclosure requirements. We stand ready to support you in these
    efforts, and will be prepared to enforce mandatory compliance, should
    you choose to change the requirements for these Government-Sponsored
    Enterprises.
        I also wanted to bring the Committee up to date on a related issue
    of the New York Stock Exchange's rules, which authorize suspension and
    delisting when a listed company fails to file its annual report with
    the SEC in a timely manner. As you know, because of Fannie Mae's
    failure to file its 2004 and 2005 annual reports on time, the NYSE
    amended its general delisting rules to provide a unique exemption for
    Fannie Mae, though it is not specifically phrased in those terms.
        Since NYSE put this new rule in place, questions have been raised
    about whether this exemption is appropriate. As I testified before this
    Committee on April 25, 2006, the exemption needs to be considered in
    light of the unusual circumstances not only of Fannie Mae's voluntary
    transition to Exchange Act financial reporting compliance, but also its
    massive restatement. I also expressed my view that this exemption must
    be temporary, only for the purpose of allowing Fannie Mae to come into
    initial compliance with Exchange Act reporting. To respond to concerns
    that this exception might become a permanent, rather than temporary,
    policy, I want to inform the Committee that we have encouraged the NYSE
    to amend its rule to put an expiration date on this exception, so that
    Fannie Mae--and its investors--understand that we expect Fannie Mae,
    like any other listed company, to remain in full compliance with NYSE's
    listing standards.
        In conclusion, the Commission's action against Fannie Mae and its
    position on the appropriate treatment of Government-Sponsored
    Enterprises under the Exchange Act's periodic reporting regime are
    animated by the same principle--that investors are best served by
    applying the Federal securities laws in an even-handed and judicious
    manner to all companies participating in the public markets.
        Thank you again for giving me the opportunity to be here today. I
    am pleased to try to respond to any questions you may have.
                                     ______

                    PREPARED STATEMENT OF STEPHEN B. ASHLEY
                      Chairman of the Board of Directors,
                                   Fannie Mae
                                 June 15, 2006
        Mr. Chairman, Senator Sarbanes, and Members of the Committee. My
    name is Stephen B. Ashley. I have been in the mortgage business for
    over 40 years, and the last time I had the privilege of testifying
    before this Committee was when I served as President of the Mortgage
    Bankers Association of America. I appreciate the opportunity to appear
    before the Committee today.
        Eighteen months ago, I was asked to become independent Chairman of
    the Fannie Mae Board of Directors, whose job it is to protect the
    interests of shareholders and stakeholders by holding management
    accountable, putting in place the proper corporate governance, and
    ensuring that the company is operated in a safe and sound manner.
        The Fannie Mae of 1998-2004 portrayed in the final OFHEO report of
    its special examination is a far different company than was portrayed
    to the Fannie Mae Board by departed management, our former external
    auditor, and annual regular examination reports. I would like to
    comment briefly on the Board and the company's response to the OFHEO
    special examination of Fannie Mae and the changes we have made and are
    continuing to make to address the problems identified.
        On September 20, 2004, when we received OFHEO's interim report, we
    acted immediately to examine and respond to its findings. Within a week
    of receiving the report, we reached an agreement on a process to
    resolve the issues raised by the report, we pledged to work
    cooperatively with OFHEO, and we began supervising the work of fixing
    the company.
        Also in September 2004, the Special Review Committee of the Board
    initiated an independent review of the issues raised in the OFHEO
    report and other matters relating to the company's accounting,
    governance, structure, and internal controls. To conduct the review,
    the Committee engaged former Senator Warren Rudman and his law firm of
    Paul, Weiss, which retained the services of a forensic accounting firm.
    The Board directed that the work of Paul, Weiss be transparent to
    OFHEO, the SEC and the Department of Justice through the entire period
    of the review.
        In October 2004, the Board established an ongoing Compliance
    Committee to ensure that the company fulfilled its agreement with OFHEO
    and all the company's legal and regulatory obligations.
        By the end of 2004, working with OFHEO, we had taken action to
    replace our outside auditor; launch our restatement; and replace our
    Chief Executive Officer and Chief Financial Officer. Since September
    27, 2004, the full Board has met 43 times; Board Committees have met
    146 times. Since January 1, 2005, I have met directly with the Director
    or Acting Director of OFHEO 17 times. As independent Chairman of Fannie
    Mae, I typically spend 2 to 3 days a week at the company, providing
    direct oversight.
        In March, 2005, the Board also entered into a supplemental
    agreement with OFHEO to enhance Fannie Mae's internal financial
    controls and accounting policies and practices to ensure they conform
    to GAAP, disclosure and other regulatory standards.
        We also agreed to take steps to further strengthen the company's
    corporate governance. Let me describe some of these and other changes
    the Board has made:

        We separated the roles of the chief executive officer and
            the chairman of the board, as it was essential to establish the
            appropriate governance and oversight of management, assuring
            all parties that we were progressing on our agreed upon goals.
        Five of the 12 nonmanagement members are new since 2004,
            and the newest member, Dennis Beresford, is a former chairman
            of the Financial Accounting Standards Board and will serve as
            chairman of the Audit Committee. All five of the new Board
            members are independent of management. We eliminated two of the
            seats held by management, retaining just one, to increase the
            proportion of independent board members.
        In addition, in accordance with our corporate policy and
            OFHEO's corporate governance rules on length of service,
            another Board member, Ann Korologos, will be leaving the Board
            effective July 31. As lead director and chairman of the
            Governance Committee in 2004, she felt it was her duty to
            remain on the Board an extra 2 years to see us through the
            investigative phase, which is now complete.
        To ensure accountability and the timely flow of
            information, we established reporting lines to the Board for
            the positions of Chief Audit Executive, Chief Compliance and
            Ethics Officer, and Chief Risk Officer.
        To improve our relationship with our regulators and to hear
            about any problems directly, I and other members of the Board
            have established regular interactions with OFHEO.

        During this period the Board exercised one of its paramount
    functions: to select and review the performance of the CEO of the
    company. We made a change in leadership at Fannie Mae when we appointed
    Dan Mudd as interim CEO of Fannie Mae on December 21, 2004.
        We directed Mr. Mudd to begin working with the Board and OFHEO to
    implement our regulatory agreements, carry out other necessary and
    appropriate changes to the company, and put Fannie Mae on a new track.
        More specifically, we made clear that his duties included the
    following:

        Restoring the company's capital;
        Restating Fannie Mae's financial results;
        Building a new management team, particularly in the areas
            of finance, accounting, and audit;
        Rebuilding relationships with regulators, customers, and
            stakeholders;
        Garnering credibility with the investment community, both
            the debt and equity markets;
        Boosting the company's investments in our financial systems
            and internal controls; and
        Rebuilding the company's culture on a foundation of
            service, respect, and openness.

        In June 2005, the Board selected Dan Mudd as permanent President
    and CEO of Fannie Mae, after an extensive, competitive nationwide
    search and careful and deliberate consideration, including consultation
    with OFHEO and a very thorough review by Senator Rudman. As interim
    CEO, Mr. Mudd demonstrated an ability to lead a large financial
    institution through a major and challenging transition, including the
    ability to reach out and rebuild confidence with our regulators,
    Congress and others. He demonstrated his capacity for the job by doing
    the job.
        On May 23 of this year, the company took a big step forward when we
    reached settlements with the Securities and Exchange Commission and
    OFHEO. The settlement with OFHEO addresses the recommendations found in
    the OFHEO final report. The Board is committed to ensuring full and
    total compliance with these agreements.
         Mr. Chairman, I can report to this Committee that there is a
    strong determination--on the part of the Board, management, and
    employees--for Fannie Mae to grow into a very different company than it
    was from 1998 to 2004, and that changes have been made up, down and
    across the organization. At the same time, the Board understands that
    Fannie Mae has much more to do, and working with our regulators and
    with this Committee and the counterpart committees in the House, we
    intend to hold ourselves and the management team accountable for the
    changes that need to be made.
        I welcome this chance to report to you and to answer any questions
    you have.
                                     ______

                      PREPARED STATEMENT OF DANIEL H. MUDD
                               President and CEO,
                                   Fannie Mae
                                 June 15, 2006
        Mr. Chairman, Senator Sarbanes, and members of the Committee. My
    name is Daniel H. Mudd, and I appreciate the opportunity to appear
    before you today to update you on the progress we have made at Fannie
    Mae, where I have served as Chief Executive Officer since December
    2004.
        The final OFHEO report, and the special investigation by former
    Senator Warren Rudman and the law firm of Paul, Weiss for our Board of
    Directors, have provided a detailed picture of the failings at Fannie
    Mae during the years 1998 through 2004.
        I appreciate the opportunity to comment on that period, and I would
    like to report on what we have done to overhaul the company since the
    start of 2005, and also respond to your questions.
        It is clear from the reports that Fannie Mae got a lot of things
    wrong from 1998 to 2004. Bad decisions about accounting and many other
    matters let a lot of people down, and in doing so, broke a public
    trust. We have learned some painful lessons about getting things right,
    and about hubris and humility.
        We have made changes. We are making progress. And we have much more
    to do. I am determined to do it.
        We began with a plan to fix the company on December 21, 2004, the
    day I was appointed as Fannie Mae's interim CEO. We set out to: Restore
    our capital; restate our prior financial statements; rebuild
    relationships with our regulators, partners, stakeholders, and
    Congress; manage our business; recenter the company on serving families
    who need affordable housing; armor-plate our financial controls; and
    finally, fix our corporate culture, which the OFHEO report makes clear
    led to a lot of our problems.
        I have heard your comments today, and I have heard many more in
    private. The days of arrogant, defiant, ``my way'' Fannie Mae had to
    end. We have begun to build a Fannie Mae that listens better, welcomes
    accountability, works with our regulators and with Congress, and serves
    the market by putting our mission to serve housing first.
        Let me describe some of the tangible steps we're taking, starting
    with the people.
        First, we have established a new senior management team to provide
    the leadership, talent and ethical standards worthy of our role and
    mission.
        Of the 55 members of the company's senior-most management, 75
    percent are new or in different positions and a third are entirely new
    to the company, especially in the critical finance, accounting, and
    risk areas.
        We have a new Chief Financial Officer, we have a new Controller, a
    new Chief Audit Executive, a new Chief of Accounting Policy, we have a
    new General Counsel, a new Chief Risk Officer, and a new head of
    Corporate Strategy. These leaders join us from important roles in major
    financial institutions, large corporations, and highly regarded firms.
        Second, in cooperation and consultation with OFHEO, we are
    fundamentally reorganizing the company to ensure that strong checks and
    balances are in place. For example:

        To ensure appropriate segregation of duties, we have
            separated the portfolio business from the CFO's
            responsibilities.
        Under the new CFO, we have reorganized the Finance function
            and brought in entirely new leadership from outside the
            company.
        We are reorganizing and strengthening Internal Audit, and
            the new Chief Audit Executive has a direct and independent line
            to the Board's Audit Committee.

        We have also replaced our outside auditor with Deloitte and Touche,
    which is conducting a comprehensive re-audit of the entire company.
    Deloitte, which formerly provided advice to OFHEO when several of the
    accounting problems were first identified, has over 300 auditors onsite
    at Fannie Mae.
        We are making further key organizational changes, which include:

        Establishing a new and separate Compliance and Ethics
            Organization to provide a robust compliance and internal
            investigation function, led by a senior executive, with a
            reporting line to the Board. We have written and pledged
            ourselves to a standard of ethical, honest, and transparent
            conduct inside and outside the company.
        Establishing a new Risk Organization with an independent
            and comprehensive view of all the risks the company is taking,
            and again, with a reporting line to the Board. We have
            recruited and hired a senior executive from JP Morgan Chase to
            lead this function.
        Disbanding the so-called Law and Policy division so that
            each function reports directly and separately to me. These are
            staff functions that exist to support our business and our
            mission--not a center of command and control.

        Third, we have restored and maintained our capital adequacy,
    including the 30-percent surplus mandated in our agreement with OFHEO
    and supervised by their examiners. We now have roughly $39 billion
    dollars of capital in reserve; our ratio of capital to assets is higher
    than it has ever been in our history.
        Fourth, we are paying people to do the job--not to hit targets. We
    have adopted a new executive compensation structure with broad
    performance goals that include achieving affordable housing mission
    goals, improving our culture, complying with regulatory standards, and
    delivering shareholder value.
        Fifth, we are making steady progress on completing our financial
    restatement, which will be done by the end of 2006.
        We have put over 1,000 full-time and 2,500 contract employees on
    the job and invested over $800 million, a large part of that on new
    systems. We have completed an exhaustive review of our accounting
    policies and practices to determine their consistency with Generally
    Accepted Accounting Principles.
        We have completed the restatement of several, significant portions
    of our balance sheet, and developed systems to support and control our
    business. We are in the process of putting in place systems and
    controls to ensure we are GAAP and Sarbanes-Oxley compliant. There is
    absolutely no routine, process, or control anywhere in the company that
    is beyond the scope of overhaul and improvement to the highest
    standard. We have over 150 projects underway and 200 associates working
    on this alone. We can get this done--our overarching goal is to get it
    done right the first time, and to make the investments to ensure this
    never happens again.
        Mr. Chairman, I would like to reiterate a commitment I made in my
    testimony last April, that Fannie Mae will work cooperatively to
    support the efforts of Congress to pass legislation to strengthen GSE
    regulation.
        In particular, we continue to support legislation to create a
    strong, well-funded regulator that would oversee both the safety and
    soundness and the housing mission of the enterprises.
        We believe the regulator should have bank-like regulatory powers,
    including the authority to reduce on-balance sheet activities, based on
    safety and soundness. We also support housing goals, and an affordable
    housing fund, that strengthen our affordable housing mission and our
    role in the U.S. housing economy.
        With respect to how we engage with Congress--that is part of the
    new Fannie Mae as well. I hope you have seen a new tone and manner of
    quiet, fact-based engagement from us. Where we disagree, we do so
    respectfully. You have my pledge to do all we can to help move this
    process forward.
        Mr. Chairman, from the day I was appointed to lead Fannie Mae, we
    have been moving forward aggressively to fix the problems OFHEO has
    cited. The question may be, why is this worth doing? The reason this
    company exists is because of our housing and liquidity mission to help
    put people into homes.
        Indeed, in these past 18 months:

        We have purchased or guaranteed more than four million home
            loans.
        We helped to create 136,000 more minority homeowners and
            serve 600,000 low- and moderate-income families overall.
        We helped provide financing to build, rehab or refinance
            600,000 units of affordable rental housing.
        Nearly two-thirds of our overall business serves one or
            more of our HUD affordable housing goals.
        We are investing literally billions of dollars in the Gulf
            Coast region to help finance and rebuild homes and communities
            there.
        We attracted more than $21 billion of overseas investment
            to provide liquidity to the U.S. housing finance market.
        Most important, we are providing what we estimate is
            roughly half a trillion dollars this year to finance homes for
            three million Americans, 25 percent of them African-American,
            Hispanic, and/or first-time home buyers.

        I know that you are counting on us to fulfill our mission, and help
    to serve this growing Nation and its growing housing needs. That is
    what makes this worth doing.
        Mr. Chairman, this company is changing and will continue to change
    thanks to the lessons we have been given to learn. My obligation and
    pledge to you, the Congress, and the market we serve is to get this
    right and move forward. We are building a new Fannie Mae that is able
    to truly serve affordable housing in America.
        I thank you for the opportunity to appear before you today. I look
    forward to your questions.

    Addendum

                       Memo to Frank Raines from Dan Mudd

                                     ______

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM JAMES B.
                              LOCKHART III

    Q.1. Former Federal Reserve Chairman Greenspan and Treasury
    Secretary Snow testified before this Committee about the need
    for GSE reform and specifically warned about the systemic risks
    posed by the GSEs' large portfolios that stand at about $1.5
    trillion.
        Given the level of fraud and mismanagement outlined in the
    recent OFHEO report on Fannie and a previous report on Freddie,
    how concerned are you about the ability of the GSEs to manage
    these large portfolios?
        The Senate Banking Committee passed a GSE reform bill last
    July that gives the GSE regulator the ability to limit the
    portfolios based on their systemic risk and anchor them to
    their mission. Former OFHEO Director Armando Falcon recently
    wrote an op-ed arguing that this is critical authority the new
    regulator must have.
        In your opinion, how critical is this authority?

    A.1. First, as OFHEO's special examination reports on the two
    Enterprises and our most recent regular annual examination
    reports in our 2006 Report to Congress have made clear, both
    Enterprises have had and continue to face major controls and
    systems problems, areas critical to managing their very large
    asset portfolios. They each have literally years of work ahead
    of them to expand, strengthen, and rebuild the infrastructure
    they must have. Even after the Enterprises rectify their
    current unsatisfactory conditions, operational risks associated
    with their asset portfolios promise to remain considerable
    because of the size of the portfolios and the complexities of
    managing the interest rate risks involved.
        Second, the interest rate and operational risks to the
    Enterprises created by the portfolios are accompanied by
    significant systemic risks affecting others. The Enterprises'
    size and importance to mortgage markets means that their
    problems could become broad housing finance issues. Their
    interdependencies with other institutions that hold their debt
    securities or are derivatives counterparties mean that that
    their problems could become broad financial market issues.
    Their high leverage and the lack of market discipline on their
    debt yields make their mortgage holdings more precarious than
    for less leveraged firms subject to normal market discipline.
    In view of these risks, I think it is critical that the new
    regulator Congress creates for the Enterprises should receive
    guidance from Congress on what assets can be held by the
    Enterprises and the authority to set limits based on safety and
    soundness and systemic risk.
        Reducing the portfolios will not, as some have claimed,
    cause mortgage market turmoil while just transferring the
    systemic risk elsewhere. Over the past 2 years, the
    Enterprises' agency mortgage-backed securities (MBS) portfolios
    shrank by more than $280 billion without market disruption. In
    many cases, investors replace Fannie Mae and Freddie Mac direct
    debt with higher yield MBS guaranteed by them. The new
    investors will generally be less leveraged than the Enterprises
    and often better able to take the risk of long-term mortgage
    assets, which might lessen the need to utilize the derivative
    markets, as well.

    Q.2. The OFHEO report states that ``by deliberately and
    intentionally manipulating accounting to hit earnings targets,
    [Fannie's] senior management maximized the bonuses and other
    executive compensation they received, at the expense of
    shareholders.''
        Specifically, which senior management benefited from these
    bonuses? How much did they make? Is OFHEO going to ask that
    this money be returned?
        Who specifically directed the accounting manipulation? Who
    was aware of it? What was the specific role of then Chief
    Operating Officer Daniel Mudd, former Chief Executive Officer
    Franklin Raines and former Chief Financial Officer Timothy
    Howard?

    A.2. As described in Chapter V of our report, Fannie Mae
    employees at and above the level of Director (here, Director
    being a managerial level below Vice President, not a member of
    the Board) participated in the Annual Incentive Plan (AIP),
    which was directly tied to growth in earnings per share (EPS).
    For the years 1998-2001, the range of funding of the AIP bonus
    was 50 percent of a target amount for minimum corporate EPS
    achievement to 150 percent of a target amount for maximum
    achievement. Beginning in 2002, the Board tightened the funding
    range to 75 percent for minimum achievement of EPS goals and
    125 percent for maximum achievement. By 2002, AIP bonus award
    eligibility included the Chief Executive Officer (CEO), two
    Vice-Chairs, six Executive Vice Presidents, 35 Senior Vice
    Presidents, 117 Vice Presidents, and 495 Directors.
        In addition to AIP, senior executives benefited from the
    Performance Share Plan (PSP), which included financial goals
    tied directly to EPS on a rolling 3-year basis. On top of this,
    virtually all employees were awarded ``EPS Challenge Grants,''
    the award of which was based upon doubling EPS from $3.23 at
    the end of 1998 to $6.46 at the end of 2003.
        Shown below is a table from our report showing the
    compensation of the five highest-paid Fannie Mae executives
    from 1998 through 2003. Note that the compensation shown for
    bonus, PSP, and the EPS Grants was directly tied to EPS goals.

        In the consent order executed by Fannie Mae and accepted by
    the Director of OFHEO on May 23, 2006, the Enterprise agreed to
    conduct reviews of current employees, as well as Board members,
    mentioned in the OFHEO report. The report based on this review
    will include the Enterprise's plans to seek restitution,
    disgorgement, or other remedies to recover funds from
    individuals. OFHEO will review this report and take enforcement
    actions, if necessary, with respect to these matters. As part
    of the consent order, Fannie Mae has agreed to review the
    possibility of pursuing former executives to disgorge their
    bonuses.
        The Report of the Special Examination of Fannie Mae cites
    instances where management directed accounting decisions that
    did not comply with GAAP and that allowed management to
    maximize their bonus compensation. For example, in January
    1999, Chairman and CEO Franklin Raines approved a
    recommendation made by the Chief Financial Officer (CFO) (Tim
    Howard) and the Controller (Leanne Spencer) to defer the
    recognition of $200 million in amortization expense. This
    deferral, along with other accounting decisions made at that
    time relating to provisions for loan losses and the recognition
    of low-income housing tax credits, allowed management to meet
    the EPS threshold for maximum bonuses.
        In addition to Fannie Mae management, personnel from KPMG,
    including Julie Theobald, Ken Russell, and Eric Smith, were
    aware in January 1999 that amortization expense was understated
    by about $200 million. KPMG posted an audit difference for that
    amount, but then waived it, stating that it was immaterial.
    However, the expense deferral was material, as it allowed
    management to meet its 1998 earnings targets and achieve
    maximum AIP bonus payouts.
        Ms. Theobald told OFHEO examiners that the $200 million
    expense deferral was disclosed to Audit Committee Chair Thomas
    Gerrity, but this was done in early February 1999--more than 2
    weeks after Fannie Mae's mid-January public release of its 1998
    earnings. The appropriate time for KPMG to advise Gerrity about
    the expense deferral would have been before the 1998 earnings
    release.
        The desire to minimize earnings volatility was well known
    throughout the ranks of senior management. For example, in a
    November 4, 2001, memorandum from Ms. Spencer to Mr. Raines
    entitled ``Update on Earnings,'' Ms. Spencer provided
    information on earnings management and ``smoothing ideas.'' Ms.
    Spencer also described to Mr. Raines plans to ``pull the
    earnings down'' to $6.30 EPS in the following year (2002), with
    an indication that CFO Howard had asked the Senior Vice
    President for Portfolio Strategy, Peter Niculescu, for ideas on
    how to accomplish that. In part, this strategy to push earnings
    out of 2002 to future periods was accomplished through the use
    of income-shifting REMICs, which had no substantive economic
    purpose, but which altered the recognition of book income,
    allowing management to smooth earnings. This strategy to shift
    income was presented in a November 2001 Quarterly Business
    Review, which was attended by Messrs. Raines, Mudd, and Howard,
    among others.
        The process used by Fannie Mae for amortizing deferred
    premiums and discounts relating to mortgages and MBS was a key
    component of the earnings management process. Had management
    complied with SFAS 91, which prescribes the rules for these
    activities, Fannie Mae would have recognized significantly more
    earnings volatility than they actually did. A former employee
    of Fannie Mae, Roger Barnes, alerted management to significant
    accounting and control problems relating to amortization,
    including Messrs. Raines and Howard, as well as the head of the
    Office of Auditing (Sam Rajappa) and management in the
    Controller's Office, including Leanne Spencer, Janet Pennewell,
    and Mary Lewers. Problems with Fannie Mae's amortization
    accounting were also raised by Michelle Skinner in an informal
    employee meeting chaired by Daniel Mudd, who was then Chief
    Operating Officer. As the OFHEO Report describes, Mr. Mudd
    failed to adequately follow-up on the concerns raised by Ms.
    Skinner.

    Q.3. The OFHEO report states that Fannie Mae lobbyists ``worked
    to ensure that the agency (OFHEO) was poorly funded'' and
    ``used longstanding relationships with Congressional staff . .
    . to interfere with OFHEO's special examination'' of Fannie
    Mae.
        Specifically, explain this in more detail. How did Fannie
    lobbyists interfere with your investigation?
        Please comment on Fannie's lobbying effort to generate the
    HUD Inspector General's fourth investigation of OFHEO.
        Who specifically directed Fannie Mae lobbyists to do this?
    Who specifically was aware of this? What was the role of Mudd,
    Raines, and Howard?
        Your report states the Board was notified by a Fannie
    employee of the HUD Inspector General's results. What was the
    Board's role in all of this? Were they aware of what was going
    on? Why were they notified?

    A.3. The aggressive policy of Fannie Mae toward its regulator
    was, in part, developed by its Government and Industry
    Relations unit, which was led by Thomas Donilon and involved
    Government and Industry Relations employees, William Maloni and
    Duane Duncan, during the period reviewed for the Special
    Examination. What began as aggressive lobbying later became a
    systematic attempt to undermine the work of the Special
    Examination. This strategy manifested itself in several ways:

      1.  Working with Senate Appropriations staff, Fannie Mae
            sought to attack former OFHEO Director Falcon and the
            agency through the generation of a Department of
            Housing and Urban Development (HUD) Inspector General
            (IG) examination investigating travel and employee
            salaries in the OFHEO legislative/external office. An
            e-mail from Duane Duncan to Donilon dated October 27,
            2002, describes these efforts. It is noteworthy that
            OFHEO was not asked for this information directly.
            Evidence discovered during the exam shows a company
            policy of generating HUD IG investigations, with the
            implication of possible wrongdoing, in an effort to
            undermine the reputation and credibility of the agency.
      2.  Documentary evidence demonstrates continuous efforts
            between Fannie Mae and congressional staff to establish
            percentage guidelines to govern agency use of
            appropriated funds, which was seen as a way to divert
            funds from the Special Examination.
      3.  Working with staff of the VA-HUD Subcommittee of the
            Appropriations Committee of the U.S. Senate, Fannie Mae
            was able to get language inserted into an
            appropriations bill that would have withheld $10
            million from OFHEO appropriations until a new director
            was appointed to replace Armando Falcon, who, as the
            Director of OFHEO, initiated the Special Examination of
            Fannie Mae.
      4.  A fourth effort, resulting from extensive interaction
            between a Fannie Mae lobbyist and congressional staff,
            was the initiation of a HUD IG examination to determine
            if OFHEO was spending an appropriate percentage of its
            budget on examinations. The HUD IG concluded that OFHEO
            met the appropriate requirements and was comparable to
            other Federal financial regulators in its allocation of
            funds and staff. However, key OFHEO resources were
            diverted for almost 10 months while complying with the
            requirements of the examination.
      5.  Again, working with congressional staff, Fannie Mae
            lobbyists succeeded in initiating another HUD IG
            examination (the ``fourth'') to investigate whether the
            leadership of OFHEO had, as part of their personal
            political agenda, overstated accounting problems of
            Fannie Mae. In sworn testimony, Duane Duncan, head of
            Government and Industry Relations at Fannie Mae,
            admitted that Fannie Mae had initiated the HUD IG
            examination in an effort order to discredit the
            findings of the Special Examination and the agency.

        In a sworn interview with OFHEO examiners, Duane Duncan
    testified that it was the desire of Fannie Mae senior
    management that the report of the HUD IG's fourth investigation
    to discredit the agency and Special Examination be made public.
    Mr. Duncan received direction from his superiors during
    meetings of the External Affairs Committee, which met each
    Monday. Franklin Raines, Thomas Donilon, Timothy Howard, and
    sometimes Daniel Mudd attended those meetings, with Mr. Raines
    and Mr. Donilon deciding what positions Fannie Mae would take
    on any given issue. Mr. Duncan implemented the decisions made
    at those meetings. Mr. Duncan also met with Mr. Donilon at the
    end of each workday in order for Mr. Donilon to manage the
    implementation of the decisions.
        The management of Fannie Mae wanted the report of the HUD
    IG's investigation published, even though it was nonpublic and
    legally restricted information. Accordingly, the Enterprise
    began a campaign to enlist support for the release of the
    report. Fannie Mae eventually succeeded in getting the document
    published on a congressional Web site for 1 hour, during which
    time management downloaded the report for further
    dissemination, including to its Board of Directors, analysts,
    and congressional staff. Thus, management succeeded in its
    efforts to distract attention from its multi-billion dollar
    accounting errors by creating a large volume of publicity about
    OFHEO.
        In an interview with lawyers from Paul, Weiss (counsel to
    the Board of Directors), Ken Duberstein, a director on the
    Board of Fannie Mae, said that he recalled Mr. Raines saying
    that the HUD IG report would undermine OFHEO and that Mr.
    Raines could obtain an early release copy of the report.
    According to Mr. Duberstein, he told Mr. Raines that such an
    approach could backfire and that Mr. Raines should stay away
    from any such approaches.

    Q.4. The OFHEO report states that the:

            Board contributed to those problems by failing to be
            sufficiently informed and to act independently of its
            chairman, Franklin Raines, and other senior executives;
            by failing to exercise the requisite oversight over the
            Enterprise's operations; and by failing to discover or
            ensure the correction of a wide variety of unsafe and
            unsound practices.

            The Board's failures continued in the wake of
            revelations of accounting problems and improper
            earnings management at Freddie Mac and other high
            profile firms, the initiation of OFHEO's special
            examination, and credible allegations of improper
            earnings management made by an employee of the
            Enterprise's Office of the Controller.

        Can you give specific examples of the Board's failures?
    Explain also the ``credible allegations of improper earnings
    management'' made by a Fannie employee.

    A.4. The Fannie Mae Board of Directors failed in numerous ways
    that put the safety and soundness of the Enterprise at risk.
    Among other things, the Board:

        Failed to stay informed about Fannie Mae corporate
            strategy, major plans of action, and risk policy;
        Approved an executive compensation program that
            created incentives to manipulate earnings;
        Failed to provide delegations of authority to
            management that reflected the current size and
            complexity of the Enterprise;
        Failed to ensure the effective operation of its own
            Audit and Compensation Committees;
        Failed to act as a check on the authority of
            Chairman and CEO Franklin Raines;
        Failed to initiate an independent inquiry into
            Fannie Mae's accounting following the announcement of
            Freddie Mac's restatement and subsequent investigation;
            and
        Failed to properly look into the allegations of
            Roger Barnes.

        In August 2003, Roger Barnes, a former Manager in Fannie
    Mae's Controllers' Office, approached the Office of Auditing to
    raise concerns regarding Fannie Mae's accounting practices
    related to SFAS 91. By that time, the Baker Botts report had
    been released detailing accounting manipulations at Freddie
    Mac. OFHEO had also announced plans to commence a special
    investigation of Fannie Mae's accounting practices. Against
    that backdrop, Mr. Barnes questioned the propriety of
    amortization accounting, and asserted his belief that
    amortization amounts recorded in the financial statements were
    manipulated in order for them to ``agree'' with forecasted
    amortization expenses. Such actions would constitute
    inappropriate earnings management. The Office of Auditing was
    responsible for investigating those allegations. In the
    September 2004 Report of Findings to Date, Special Examination
    of Fannie Mae, OFHEO found that the Office conducted a hurried
    investigation into Mr. Barnes' allegations that culminated in
    the head of the Office of Auditing certifying GAAP compliance
    to the Board of Directors.
        Fannie Mae rushed into a severance agreement with Mr.
    Barnes on November 3, 2003. Given its responsibilities for
    regulatory compliance and investigation of complaints related
    to accounting, internal controls, and auditing matters, the
    Audit Committee was required to ensure a timely, thorough, and
    independent investigation into Mr. Barnes' allegations. The
    allegations, and subsequent settlement agreement, should have
    raised the concern of every member of the Audit Committee,
    especially when considered against the background of the
    recently released Baker Botts report on Freddie Mac's internal
    investigation and the initiation of the OFHEO Special
    Examination.
        The Audit Committee failed to make further inquiries or
    convene a special investigation after being informed at the
    November 17, 2003, Audit Committee meeting that Fannie Mae had
    reached a settlement with Mr. Barnes. The news of the
    settlement was received by the Audit Committee just 3 days
    after the Committee had been convened in order to discuss
    certification of the third quarter financial statements. Fannie
    Mae settled the case before bringing the matter to the Audit
    Committee and elected to postpone discussion of the matter
    until after the financial statements had been certified. Given
    that OFHEO had just announced a Special Examination of Fannie
    Mae's accounting practices, the allegations made by Mr. Barnes
    warranted further investigation. At a minimum, the Audit
    Committee had an obligation to ensure that the matter be
    disclosed to OFHEO. Instead, the matter was ignored until
    February 2004, when it was reviewed as part of the Special
    Examination.
                                    ------

      RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JAMES B.
                              LOCKHART III

    Q.1. Fannie Mae signed a consent agreement on May 23, 2006,
    with the Office of Federal Housing Enterprise Oversight
    agreeing to cap its retained mortgage related portfolio to $727
    billion, its level on December 31, 2005.
        Using Fannie Mae's $727 billion portfolio as a model, what
    would Fannie Mae's portfolio size be with the limits of S. 190?
    Please include an explanation of the assumptions that you used
    to arrive at this number?

    A.1. S. 190 would restrict mortgage and mortgage securities to
    those held for the purpose of securitization, those that are
    not readily securitized, and those held solely for the purpose
    of supporting the guarantee business. More than half of Fannie
    Mae's mortgage asset portfolio at the end of last year
    comprised securities already guaranteed by Fannie Mae, or by
    Freddie Mac or Ginnie Mae. Those would not generally be
    permitted. The remaining $355 billion is roughly divided
    between private label MBS (11 percent) and whole mortgages (35
    percent), and a large portion do not qualify under HUD's rules
    as supporting affordable housing. More work would be necessary
    to determine how much would be permitted under S. 190, but a
    strict reading of the language might qualify only a small
    portion.

    Q.2. What are the public policy benefits and risks of the two
    different portfolio sizes?

    A.2. Enterprise asset portfolios can contribute to the
    availability of funding for affordable housing and to the
    stability and liquidity of the secondary market for mortgages
    and the market for mortgage securities. These benefits,
    however, could still be achieved with much smaller portfolios,
    while risks would be greatly reduced.
        The major portion of the Enterprises' public policy
    benefits stem from their guarantee business. By guaranteeing
    securities backed by pools of mortgages, they make use of their
    GSE status to make mortgage investments more desirable to a
    wider range of investors. That lowers mortgage interest rates
    on conforming loans, with estimates of the effects ranging from
    2 to 25 basis points. Purchasing mortgage securities for their
    asset portfolios has little effect, in general, because it
    simply substitutes one type of debt for another, with
    Enterprise borrowings replacing mortgages and MBS. This is
    especially true when an Enterprise acquires mortgage securities
    already guaranteed by an Enterprise. Much the same is true when
    an Enterprise buys and holds mortgage loans that it could
    easily securitize. However, the Enterprises also buy mortgages
    and hold them for a short time while they are securitizing
    them.
        Assessing the effects of the remainder is more complex
    because Enterprise acquisition of these assets not only
    withdraws them from the debt market, but it also replaces them
    with Enterprise debt. This category includes Enterprise
    purchases of private label securities backed by subprime loans,
    manufactured housing, and municipal revenue bonds. The
    magnitude of benefits for loans in these categories is
    uncertain, as is the extent to which they could be maintained
    if the Enterprises did not retain the securities on their
    balance sheets, but instead guaranteed the securities and
    resold them. As for stability and liquidity, an active trading
    capability coupled with a small inventory of securities backed
    by the ability to expand rapidly to cope with market liquidity
    emergencies should serve those purposes.
        While the benefits of the Enterprises' large asset
    portfolios are limited, the risks are quite significant.
    Mortgages, especially fixed-rate mortgages, have complex and
    difficult to anticipate payment patterns requiring extensive
    hedging activities. The interest rate risk in its portfolio
    caused massive losses to Fannie Mae in the early 1980s and more
    recently in 2002, and the operational risk in their portfolios
    has caused serious problems for both Enterprises in recent
    years. Because of their size and importance to housing finance
    markets, counterparties, and holders of their securities; and
    because of their high leverage ratios, the lack of market
    discipline, and lack of bankruptcy or receivership provisions,
    these institutions also entail significant systemic risk that
    stems to a large degree from their asset portfolios. Weighing
    the benefits and the risks, it seems clear that Enterprise
    mortgage portfolios should be much smaller without affecting
    their missions of affordable housing, stability, and liquidity.
                                    ------

      RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM JAMES
                            B. LOCKHART III

    Q.1. In your testimony today you stated that the OFHEO report
    details an arrogant and unethical corporate culture at Fannie
    Mae from 1998 to 2004. You also stated that, ``perhaps the best
    written record of this culture is a memo from the Chief
    Operating Officer Dan Mudd to the CEO 2 months after OFHEO's
    interim report.'' In that memo Mr. Mudd was discussing the need
    to change and wrote:

            The old political reality was that we always won, we
            took no prisoners, and we faced little organized
            political opposition . . . We used to, by virtue of our
            peculiarity, be able to write, or have written, rules
            that worked for us. We now operate in a world where we
            will have to be `normal.'

        Given your selections of this memo as the best example of
    what went wrong at Fannie Mae, to what degree was Dan Mudd
    responsible for what happened at Fannie Mae? How should he be
    held accountable?

    A.1. Mr. Mudd was Chief Operating Officer at Fannie Mae from
    February 2000 through December 2004, when he was elevated to
    CEO upon the resignation of Mr. Raines. Mr. Mudd, in addition
    to broad responsibilities for ensuring that Fannie Mae had an
    adequate operating infrastructure, also had responsibilities to
    monitor the profit and loss statements of the business units
    reporting to him. We now know through the Special Examination
    that the accounting policies used by these business units were
    seriously deficient, particularly as they relate to the
    impairment of mortgage assets. The finite insurance
    transactions discussed in our report, which involved little or
    no transfer of risk, affected business units reporting to Mr.
    Mudd. Mr. Mudd also chaired Quarterly Business Review meetings,
    during which senior executives sometimes presented strategies
    relating to income shifting.
        Given these circumstances, plus the problems noted in our
    report regarding the lack of appropriate action by Mr. Mudd
    when accounting concerns were raised to him by Michelle
    Skinner, we think it is appropriate for the Board to include
    Mr. Mudd in its review of current employees with respect to
    possible disgorgement of compensation. OFHEO will assess the
    results of the Board's review upon completion.

    Q.2. How confident are you with Fannie (and Freddie's) most
    current financial reporting? When will each company complete
    their accounting restatements?

    A.2. OFHEO is not satisfied with the Enterprises' current
    reporting given the control weaknesses that have been found to
    date. Both companies are devoting significant resources to
    improve their financial reporting capabilities and they are
    making progress toward having audited financial statements.
    Much work and testing remains to be done.
        OFHEO and the Enterprises' external auditors are engaged
    and are carefully monitoring the remediation of the financial
    reporting process. Both Enterprises are implementing major new
    systems and processes to facilitate more timely and accurate
    financial reporting. OFHEO must remain vigilant as the
    introduction of new systems, processes and personnel can
    initially increase the risk of operational errors.
        Currently Freddie Mac has completed its financial
    restatement, however they have not yet returned to timely
    financial reporting. Their objective is to return to quarterly
    reporting with the release of full-year 2006 financial results.
    After that, they will begin the process of registering their
    common stock with the SEC. Fannie Mae is still in the process
    of completing its financial restatement for the years 2002-
    2004, and they expect to be complete by the end of 2006.

    Q.3. Fannie is required to continue maintaining a 30 percent
    capital surplus, as part of its capital restoration plan. Under
    what conditions may you decide that this requirement should be
    modified or expire?

    A.3. The 30 percent capital surplus is required due to
    operational weaknesses at Fannie Mae, including accounting and
    internal control deficiencies. Until such weaknesses are
    demonstratively corrected to OFHEO's satisfaction, and assuming
    no other safety and soundness issues emerge, the surplus will
    stay in place. OFHEO evaluates capital on an ongoing basis,
    assessing existing and emerging issues, to determine the
    adequacy of Fannie Mae's capital. At this time, it is therefore
    not possible to predict when the capital surplus requirement
    may be modified. As you know, the pending legislation gives
    OFHEO more flexibility in setting both minimum capital and
    risk-based capital requirements. Operational risk will be a
    component of each.

    Q.4. Fannie Mae is required to report to you whether any former
    officers should be terminated. What action could OFHEO take
    against these individuals.

    A.4. Fannie Mae must report to OFHEO whether the company will
    seek damages or other remedies against former officers. If the
    company fails to taken action, OFHEO has available, under a 2-
    year statute of limitations, the ability to seek restitution,
    disgorgement, or reimbursement of such individuals as well as
    civil money penalties that could exceed any actual damages. As
    noted in comments transmitted to the Banking Committee on the
    legislation, the procedures for (and, thereby, the
    effectiveness of) OFHEO's current remedies would be improved by
    the pending legislation.

    Q.5. Freddie Mac has announced that its accounting restatement
    will be further delayed. What is the status of Freddie Mac's
    compliance with its written agreement with OFHEO and the
    company's outlook from your standpoint?

    A.5. As noted previously, Freddie Mac now has completed its
    financial restatement, but is not yet a timely filer of
    financial statements. The Enterprise is currently in compliance
    with the Agreement, and they continue to work to improve their
    governance and operational issues. Specific plans has been
    executed by the Enterprise but it may take several years to
    implement them.

    Q.6. The Chairman of the Board and CEO positions, held jointly
    by Franklin Raines, have been separated and Chairman Stephen
    Ashley appears to have cast the nonexecutive chairman roll as
    an independent check on the CEO. What are the benefits of those
    changes in structure and practices and what is your assessment
    of Ashley's performance?

    A.6. OFHEO determined that in the instance of both Fannie Mae
    and Freddie Mac the position of Chairman of the Board and CEO
    should be separated. This has been effectuated with Fannie Mae
    and we are working with Freddie Mac to do the same. Such
    separation of positions has been adopted by a growing number of
    public companies. The Enterprises hold unique positions,
    including a public mission, and the need for Board oversight of
    that mission is enhanced with separation of the two positions.
    Further, where both companies need to focus their energies on
    remediation--a primary responsibility of management--the
    separation permits a more efficient use of personnel.

    Q.7. The report states ``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.'' Would you agree that
    Fannie Mae sought to oversee OFHEO, instead of the other way
    around?

    A.7. As a matter of corporate policy, Fannie Mae sought to
    circumvent, constrain, and undercut OFHEO. Some of the
    techniques used by Fannie Mae included personal attacks on the
    competence, integrity, and motivation of officers at the
    agency, limiting the budget of the agency through the
    appropriations process, and creating conflicts with other
    independent and executive branch regulatory agencies. Further,
    after the initiation of the Special Examination, Fannie Mae
    undertook a concerted effort to limit and interfere with the
    examination by working with legislators and their staff to
    generate repeated IG investigations. This was done in order to
    divert agency resources and attention away from the Special
    Examination, to disparage the agency and its officers, and to
    restrict the use of appropriated funds.

    Q.8. Were efforts to generate interagency conflict, between
    OFHEO and HUD, SEC, OMB, and others, made at Fannie Mae's
    highest levels, and if so by whom?

    A.8. The practice of opposing, circumscribing, and constraining
    its regulator became a firmly established practice at Fannie
    Mae. One method Fannie Mae employed to accomplish this involved
    creating conflict between OFHEO and other agencies whenever
    OFHEO attempted to craft regulations or take other regulatory
    actions. For example, correspondence between Fannie Mae's
    outside counsel (WilmerHale) and Ann Kappler, who was Fannie
    Mae's General Counsel at the time, reveal efforts to contact
    the Secretary of HUD and the HUD General Counsel in order to
    convince them of a ``legal flaw'' in the then-proposed OFHEO
    risk-based capital rule, which then would provide justification
    to ``kick the legal issue to Justice for resolution.'' This
    would allow the dispute to be seen as one between OFHEO and
    another regulatory agency, not between Fannie Mae and its
    regulator.
        Other correspondence reveal efforts on the part of Fannie
    Mae to scuttle OFHEO's then-proposed corporate governance
    regulations by supporting arguments that the SEC and the Stock
    Exchanges--not OFHEO--had the legal authority to do rulemaking
    in this area. Further, when the OFHEO Special Examination of
    Fannie Mae commenced, correspondence describes a call to the
    General Counsel of the SEC from Fannie Mae's General Counsel,
    who stated that ``We do not believe that OFHEO has authority to
    opine on GAAP, or to order us to restate our financial
    statements. We would like to reach an understanding with the
    Commission on this matter.''

    Q.9. It is my understanding that the size and aggressiveness of
    the company's lobbying and grass roots activities have been
    substantially reduced. Can you give me more specifics about in-
    house and external activities in terms of personnel, costs, and
    approach?

    A.9. Fannie Mae, in the consent order issued by OFHEO, is
    required to conduct a review of and develop enhanced internal
    controls for the operation of the Government and Industry
    Relations office. The purpose is to have adequate supervision
    in place to assure control by the Enterprise of this operation
    such that the mission and positions taken by the Enterprise are
    subject to control and review. As part of the review, we will
    secure information on expenses, broadly defined, as well as
    costs and controls.

    Q.10. Did you evaluate the role of Fannie Mae's Community
    Business Centers, formerly known as Partnership Offices, in
    community or political activities?

    A.10. Fannie Mae CEO Daniel Mudd announced changes to the
    partnership offices and changes to the name, mission, and role
    in political matters. OFHEO will be examining these functions
    and will be able to provide additional information. By way of
    background, I would note the following points.
        Although an evaluation of the Partnership Offices was not a
    primary focus of the Special Examination, many of the documents
    that we reviewed indicate that a primary factor in deciding
    where Partnership Offices would be located was the perceived
    need to build relationships with key Members of Congress. Rob
    Levin, currently Executive Vice President and Chief Business
    Officer of Fannie Mae, testified to the nature of so-called
    ``affinity'' contacts in particular Partnership Offices, and
    that Fannie Mae staff would be ``aware of '' relationships with
    Members of Congress and other government officials when making
    decisions regarding Partnership Offices.
                                    ------

    RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM CHRISTOPHER
                                  COX

    Q.1. In your testimony, you note that you have encouraged the
    New York Stock Exchange (NYSE) to amend its rule, which
    exempted Fannie Mae from having to delist from the NYSE, by
    putting an expiration date on this exemption.
        Can you comment as to specifically when this expiration
    date is? What is the status and timetable of Fannie's
    restatement and registration with the SEC? When will Fannie be
    in total compliance with its financial disclosure?
        Just to be clear, my understanding is that if Fannie does
    not meet any part of this timetable, then the SEC will ensure
    that the listing rules are enforced and no further special
    exemptions are granted. Is this correct?
        For that matter, what is the status of Freddie's
    registration? When will Freddie be in total compliance with its
    financial disclosures?

    A.1. On January 30, 2007, Commission staff, acting pursuant to
    delegated authority, approved a proposed rule change (attached
    and available at: http://www.scc.uovlrulcs/sro/nvsc/2007/34-
    55198.pdf) by the NYSE to eliminate a provision of NYSE Rule
    802.01E, which operated to permit Fannie Mae to continue
    listing on the NYSE even though it was more than 12 months late
    in filing its annual report. Under the NYSE's rule change, the
    Exchange's discretion to allow a company to continue listing
    that is more than 12 months late shall expire on December 31,
    2007. The NYSE's rule change also provides that if prior to
    December 31, 2007, the Exchange had determined to continue
    listing a company that was more than 12 months late pursuant to
    that provision of Rule 802.01E, and that company fails to file
    its late annual report by December 31, 2007, suspension and
    delisting procedures will commence in accordance with the
    NYSE's Listed Company Manual.
        Fannie Mae filed its 2004 Annual Report on Form 10-K with
    the Commission on December 6, 2006. The filing provides
    consolidated financial statements for 2004, and a restatement
    of previously issued financial information for years 2002,
    2003, and the first two quarters of 2004.
        Although Freddie Mac agreed to voluntarily register under
    the Exchange Act, it has not yet formally filed a registration
    statement with the Commission. Freddie Mac has stated it
    intends to complete the Exchange Act registration process when
    it completes its restatement and audit of its financial
    statements.
        Freddie Mac has publicly indicated its accounting and
    disclosure practices are the subject of a pending investigation
    by the Commission's Enforcement Division.

    Q.2. In your testimony, you note that ``the Commission--going
    at least as far back as 1992--has consistently advocated the
    view that, because GSEs sell securities to the public, have
    public investors, and do not have the `full faith and credit'
    government backing of government securities, GSE disclosures
    should comply with the disclosure requirements of the Federal
    securities laws.''
        In your opinion, should Fannie and Freddie be required to
    register their debt and mortgage backed securities with the SEC
    (not just their common stock) as well? Why should Fannie and
    Freddie get a free pass when other companies don't? What's
    wrong with more disclosure?
        Wouldn't this requirement send a clear message to the
    markets that GSE debt is not backed by the full faith and
    credit of the Federal Government? Wouldn't this be good public
    policy for the American taxpayer?

    A.2. The Commission participated with the Department of
    Treasury and the Board of Governors of the Federal Reserve
    System in a 1992 Joint Report on the Government Securities
    Market (1992 Report) that addressed these issues, among other
    things.\1\
    ---------------------------------------------------------------------------
        \1\ Department of the Treasury, Securities and Exchange Commission,
    Board of Governors of the Federal Reserve System, Joint Report on the
    Government Securities Market, January 1992.
    ---------------------------------------------------------------------------
        As an introductory matter, please note that the two Federal
    securities laws that are relevant to the question--the
    Securities Exchange Act of 1934 and the Securities Act of
    1933--have very different, though related, purposes.

        The Exchange Act requires registration of various
            categories of public securities. Exchange Act
            registration results in ongoing periodic reporting of
            detailed narrative and financial disclosure regarding
            the corporation. This corporate information is the
            information on which the Commission and staff have
            focused in urging disclosure by GSEs. Registration
            under the Exchange Act also subjects reporting
            companies to the provisions of the Sarbanes-Oxley Act
            applicable to Issuers.
        The Securities Act requires registration of
            transactions, namely public offerings of securities. In
            addition to information about the securities being
            offered, registration under the Securities Act requires
            disclosure of essentially the same corporate
            information as is required under the Exchange Act.
            Commission staff review of Securities Act registration
            statements may affect the timing of securities
            offerings and other registered transactions.

        The 1992 Report did not recommend removal of the exemption
    from the Securities Act for the offer and sale of mortgage-
    backed and related securities of Fannie Mae and Freddie Mac as
    it is not clear what impact registration and reporting of
    mortgage-backed offerings might have had on the secondary
    mortgage market.
        In 2002, staff of the Commission, Department of Treasury,
    and OFHEO conducted a joint study of disclosure regarding
    mortgage-backed securities with a view to ensuring that
    investors in mortgage-backed securities are provided with the
    information that they should have.\2\ The report, which was
    issued in January 2003 concluded that some additional
    disclosures would be both useful and feasible in the mortgage-
    backed securities market. Each of Fannie Mae and Freddie Mac
    has implemented these new disclosures.
    ---------------------------------------------------------------------------
        \2\ Department of Treasury, Office of Federal Housing Enterprise
    Oversight, Securities and Exchange Commission, Staff Report: Enhancing
    Disclosure in the Mortgage-Backed Securities Market, January 2003.
    ---------------------------------------------------------------------------
        Consideration of Securities Act registration of the GSE's
    mortgage-backed and related securities raises a very
    significant and unique complexity, as discussed in the January
    2003 report, due to the fact that a substantial portion,
    recently a majority, of the GSE's mortgage backed securities
    have been issued in the so-called ``To Be Announced,'' or
    ``TBA,'' market. We understand that the TBA market is
    significant, as it is used to set or ``lock in'' mortgage rates
    in the U.S. housing market. Transactions in this market involve
    forward sales of pools of mortgages that are not yet identified
    and, in most cases, are not yet in existence. Because actual
    pools are not established at the time of the transactions,
    there can be no disclosure of pool characteristics beyond the
    TBA standards already available to the market. Therefore, the
    registration of offers and sale of mortgage-backed securities
    would necessitate a consideration of the impact of such
    registration on TBA transactions.
        Finally, the matter of requiring the registration of Fannie
    Mae's and Freddie Mac's mortgage-backed and related securities
    should be considered in light of that registration's likely
    impact on other GSEs that are exempt from the Federal
    securities laws. For example, the Federal Home Loan Bank
    System, which was created prior to enactment of the Securities
    Act or creation of the Securities and Exchange Commission in
    1934, is comprised of twelve banks that are GSEs and operate
    independently. The Federal Home Loan Bank System, through the
    Office of Finance, is one of the largest issuers of debt
    securities in the world and the Federal Home Loan Banks compete
    with Fannie Mae and Freddie Mac for debt investors. While the
    Finance Board adopted a rule requiring Exchange Act
    registration of the common stock of each Bank and almost all of
    the Banks have now completed that registration, the Banks
    continue to be exempt from the Securities Act and the other
    Federal securities laws.
                                    ------

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM
                            CHRISTOPHER COX

    Q.1. What is your estimate of the loss to shareholders created
    by the accounting scandal documented in the OFHEO Report? Some
    estimates are that there have been $1.3 billion in expenses
    related to correcting the accounting fraud not to mention the
    billions in market losses?

    A.1. The Commission's Office of Economic Analysis (OEA)
    estimates that the fraud at Fannie Mae caused its common stock
    to be overvalued by an amount ranging from $12.5 billion to
    $16.5 billion. This estimate is based on OEA's determination
    that Fannie Mae's stock declined by about 25 percent as the
    news of the fraud became public over the course of more than a
    year. As news of the fraud became public, the market realized
    that not only was Fannie Mae very different from what it
    represented itself to be, but also that Fannie would have to
    spend a considerable amount correcting the accounting fraud.
    Thus the $12.5 to $16.5 billion figure includes the market's
    expectation of the cost of correcting the accounting fraud at
    the time it was revealed.
        Shareholders who bought their stock after the fraud began
    and held onto it as the fraud was revealed very likely lost
    money as the stock fell. Because Fannie Mae's stock was heavily
    traded during the lengthy period of the fraud, it would have
    been extremely difficult to calculate such trading losses with
    precision, and doing so would have consumed extraordinary
    resources.
        Instead, the Commission's OEA staff examined Fannie Mae's
    offerings of securities during the fraud period to determine
    whether Fannie Mae derived an improper benefit from its
    financial fraud. OEA determined that the prices of the debt
    securities sold by Fannie during the fraud period were not
    inflated. However, OEA found that the fraud nevertheless
    benefited Fannie Mae by allowing it to meet its minimum capital
    requirements with less capital than was required under
    Generally Accepted Accounting Principles and applicable law.
    This improper benefit allowed Fannie Mae to operate on a larger
    scale than it was entitled to operate, allowing it to generate
    larger profits than it was entitled to generate.

    Q.2. How did you determine the $350 million fine for Fannie
    Mae, and do you believe that figure even approaches full
    restitution for shareholders?

    A.2. In determining the fine in the Fannie Mae case, the
    Commission applied the principles set forth in its statement on
    financial penalties issued in January 2006. That statement sets
    forth nine factors that the staff should consider in evaluating
    the appropriateness of financial penalties.
        In applying these factors, the Commission consults with,
    among others, the professional staff in its Office of Economic
    Analysis (OEA). OEA is particularly helpful in determining
    whether the corporation derived a direct benefit as a result of
    the violation, which is one of the primary factors in the
    Commission's penalties statement.
        In this case, OEA determined that, but for the fraud,
    Fannie Mae would not have met the minimum capital requirements
    set for it by its primary regulator, the Office of Federal
    Housing Enterprise Oversight. In other words, the fraudulent
    accounting allowed Fannie Mae to operate on a larger scale--and
    therefore to earn larger profits--than it would have been able
    to do if it had complied with Generally Accepted Accounting
    Principles and applicable law. Using a conservative analysis,
    OEA determined that Fannie Mae's misconduct allowed it to
    derive an overall illicit benefit that was likely at least $400
    million.
        Based on this analysis of benefit, the other factors in the
    Commission's penalties statement, and the $50 million penalty
    imposed by OFHEO, the Commission decided that a $350 million
    penalty in its action was appropriate even though this amount
    is likely far less than full restitution, which is measured by
    the actual losses incurred by investors as a result of Fannie
    Mae's fraud. Restitution historically has been awarded in
    criminal securities cases, not in civil or administrative ones.
    As the Committee knows, the Commission's jurisdiction is civil
    and administrative; consequently, restitution is not a measure
    of relief that the Commission has won in cases like this one.
    Nonetheless, the Commission, in doing what it can to provide
    financial relief to investors, always strives to secure maximum
    disgorgement and legally appropriate penalties in its cases,
    including the case against Fannie Mae.

    Addendum

                Securities and Exchange Commission Rule Changes

                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM STEPHEN B.
                                 ASHLEY

    Q.1. The OFHEO report states that Fannie lobbyists ``used their
    longstanding relationships . . . to interfere with OFHEO's
    special examination'' of Fannie Mae. The Rudman report states
    that Fannie had ``a reputation for lecturing lawmakers'' and
    ``a sophisticated lobbying organization that was known to be
    aggressive.'' In July 2004, Fannie ran television
    advertisements that were critical of GSE regulatory reform
    efforts the week before a Senate Banking Committee mark-up.
    Both of you were at Fannie when this occurred. Were the costs
    of these television advertisements reported in your lobbying
    disclosure expenses? How does lobbying further your statutory
    housing mission? Is it appropriate for a congressionally
    chartered institution to use funds earned under the benefit of
    its GSE status to lobby against congressional efforts to
    strengthen that institution's oversight? Has FASB looked at any
    additional studies to see whether this might be a possibility?

    A.1. The 2004 advertising referred to was included in the total
    reportable lobbying expenses under Fannie Mae's 2004 Lobbying
    Disclosure Act (LDA) report. The company has not undertaken any
    advocacy advertising since 2004.
        Fannie Mae's management and board have made repairing our
    working relationships with our regulators and Congress, and
    establishing a new tone and manner in the way we communicate
    with policymakers, customers, and partners top corporate
    priorities. The company has reduced its lobbying operation
    significantly since 2004, and we remain committed to reversing
    the sometimes heavy-handed nature in which the company engaged
    with policymakers in the past.
        We believe it is very important that the company maintain
    an appropriate, professional, and responsive relationship with
    the regulators who oversee our business and with Congress,
    which chartered us to fulfill our housing mission.
        Fannie Mae communicates with government officials at all
    levels to provide information about the company and its role in
    the secondary mortgage market. Communication between government
    officials and Fannie Mae facilitates the exchange of important
    information and ideas on a variety of topics including
    mortgages, affordable housing, and capital markets. The
    company's government relations activities comply with
    applicable disclosure regulations.
        Fannie Mae continues to support passage of legislation to
    create a strong, well-funded regulator that would oversee the
    safety and soundness and the housing mission of the
    enterprises, and the company's government relations staff
    provides information to policymakers as appropriate with
    regards to this effort.
        We are unaware of any studies by the Financial Accounting
    Standards Board (FASB) about this matter.

    Q.2. How many outside lobbyists and consultants does Fannie Mae
    have a contract with? What is the total number from 1998-2006?
    What was the total amount of money paid to these individuals
    for consulting and/or lobbying services for each of these
    years? How much of that money was ultimately reported under the
    lobbying disclosure act?

    A.2. Currently, Fannie Mae has 19 external lobbying firms that
    are expected to file Federal LDA reports identifying Fannie Mae
    as a client for the semiannual period January to June 2006.
        From 1998 to 2005, the total number of firms that reported
    lobbying activities identifying Fannie Mae as a client and were
    registered lobbyists under the LDA ranged from 11 to 24 firms
    per year. The number of lobbying firms by year is provided
    below:

    ------------------------------------------------------------------------
      1998      1999      2000     2001     2002     2003     2004     2005
    ------------------------------------------------------------------------
        11        16        14       19       24       22       23       23
    ------------------------------------------------------------------------

        The total amount of retainers and expenses paid by Fannie
    Mae to these firms by year is identified below. A number of the
    firms were law firms that, in addition to providing lobbying
    services, also provided legal services to Fannie Mae on matters
    unrelated to lobbying (such as litigation, real estate, and
    securities disclosure). The costs for all of these services is
    included.

    ----------------------------------------------------------------------------------------------------------------
         1998           1999          2000          2001          2002          2003          2004          2005
    ----------------------------------------------------------------------------------------------------------------
        $2.09M         $3.45M        $3.41M        $5.56M        $7.94M       $11.67M        $7.36M        $4.67M
    ----------------------------------------------------------------------------------------------------------------

        The total amount of lobbying income related to lobbying
    activities on behalf of Fannie Mae reported by these lobbying
    firms on LDA reports is as follows:

    ----------------------------------------------------------------------------------------------------------------
         1998           1999          2000          2001          2002          2003          2004          2005
    ----------------------------------------------------------------------------------------------------------------
        $1.00M         $1.69M        $2.03M        $2.49M        $2.79M        $2.32M        $2.95M        $2.16M
    ----------------------------------------------------------------------------------------------------------------

        As allowed by the LDA, Fannie Mae has always used the tax
    method to report its lobbying expenses; the company is required
    to make a good faith estimate of lobbying expenses that are
    nondeductible.
        To derive this estimate, Fannie Mae uses the ``ratio
    method'' whereby a corporation multiplies its total costs of
    operations by a fraction. The numerator of the fraction is the
    number of hours employees spent on lobbying activities, and the
    denominator is the total work hours of all the company's
    employees on all company activities.
        The corporation adds the result of this calculation to its
    third party lobbying costs (such as amounts paid to outside
    lobbying firms, dues, legal fees associated with lobbying,
    etc.) to determine its total lobbying expenses.
        As noted, this method of calculating a company's lobbying
    expenditures is heavily impacted by the corporation's overall
    costs. Accordingly, despite a reduction in the amount paid to
    outside lobbying firms, Fannie Mae's overall lobbying costs as
    reported in its 2005 LDA filing grew, mostly due to the
    significant increase in the company's overall operating costs
    that year, which in 2005 were related to the company's
    restatement.
        Accordingly, Fannie Mae reported the following total
    lobbying expenditures through the company's LDA filings:

    ----------------------------------------------------------------------------------------------------------------
         1998           1999          2000          2001          2002          2003          2004          2005
    ----------------------------------------------------------------------------------------------------------------
        $5.55M         $7.01M         $7.0M        $6.57M        $7.59M         $8.7M        $8.79M       $10.08M
    ----------------------------------------------------------------------------------------------------------------

    Q.3. The OFHEO report states that the ``Board contributed to
    those problems by failing to be sufficiently informed and to
    act independently of its chairman, Franklin Raines, and other
    senior executives; by failing to exercise the requisite
    oversight over the Enterprise's operations; and by failing to
    discover or ensure the correction of a wide variety of unsafe
    and unsound practices.''
        It further reads ``the members of the Board were all
    knowledgeable and qualified individuals, fully capable of
    understanding the business and corporate governance duties with
    which they were charged.''
        ``The Board's failures continued in the wake of revelations
    of accounting problems and improper earnings management at
    Freddie Mac and other high profile firms, the initiation of
    OFHEO's special examination, and credible allegations of
    improper earnings management made by an employee of the
    Enterprise's Office of the Controller.''

    A.3. As I testified, the Fannie Mae of 1998-2004 portrayed in
    the final OFHEO report of its special examination is a far
    different company than was portrayed to the Fannie Mae Board by
    departed management, our former external auditor, and annual
    regular examination reports.
        I agree that Fannie Mae's board was composed of capable and
    qualified directors who in my perception were concerned with
    the strength of the Enterprise and its important mission.
    During the years examined in the OFHEO report, I believed the
    board came prepared for our meetings, asked the right
    questions, and appeared to be actively engaged in their duties
    of oversight. It was not my impression at the time that my
    colleagues on the board lacked independence from Mr. Raines or
    other senior executives. As a result of the investigations by
    both Senator Rudman and OFHEO, however, I have learned of a
    number of matters that I did not know at the time and that, in
    hindsight, I would have wanted to know as a member of the
    board.
        Following the issuance of OFHEO's report on its special
    examination of Freddie Mac, the board asked Fannie Mae's senior
    management and its outside auditors whether the issues
    identified in that report were also issues at Fannie Mae. The
    board as a whole received reports from different members of
    senior management on several separate occasions in response to
    these questions. In addition, the Audit Committee of the board
    received its own detailed presentation on these issues from
    senior management and the outside auditors. Throughout these
    presentations, we were assured that the problems identified at
    Freddie Mac were not present at Fannie Mae.
        In addition, it is my understanding that management
    informed the Audit Committee about accounting allegations made
    by Roger Barnes and that the allegations had been investigated.
    I also understand that the committee was told that Mr. Barnes
    had agreed that appropriate action had been taken in response
    to his concerns.
        The board has learned a lot of lessons, and we have worked
    to apply what we have learned. As I testified, since the
    initial OFHEO special examination report of September 2004, the
    board has continued to make significant changes to its
    composition, structure, and relationship to management:

        We separated the roles of the Chief Executive
            Officer and the Chairman of the Board, as it was
            essential to establish the appropriate governance and
            oversight of management, assuring all parties that we
            were progressing on our agreed-upon goals.
        Five of the 12 nonmanagement members are new since
            2004, and the newest member, Dennis Beresford, is a
            former chairman of the FASB and serves as chair of the
            Audit Committee. All five of the new board members are
            independent of management. We eliminated two of the
            seats held by management, retaining just one, to
            increase the proportion of independent board members.
            In accordance with our corporate policy and OFHEO's
            corporate governance rules on length of service,
            another board member, Ann Korologos, will be leaving
            the board effective July 31, 2006.
        To ensure accountability and the timely flow of
            information, we established reporting lines to the
            board for the positions of Chief Audit Executive, Chief
            Compliance and Ethics Officer, and Chief Risk Officer.
        To improve our relationship with our regulators and
            to hear about any problems directly, I and other
            members of the board have established regular
            interactions with OFHEO.

    Q.4. The OFHEO report states that Fannie Mae lobbyists ``worked
    to insure that the agency (OFHEO) was poorly funded'' and
    ``used longstanding relationships with Congressional staff . .
    . to interfere with OFHEO's special examination'' of Fannie
    Mae.
        What is your knowledge of this? Were you aware of this
    lobbying effort? If you were aware of it why didn't you stop
    it?
        The OFHEO report states the Board was notified of the HUD
    Inspector General's results. Mr. Ashley, the report also states
    (on page 276) you were notified about the results in 2004. Why
    were you notified about the results. Do you encourage this type
    of behavior at Fannie? If not, what did you do to specifically
    discourage it?

    A.4. Throughout the course of the special examination the board
    directed the company to cooperate fully with OFHEO. We received
    periodic reports about the company's responses and were
    repeatedly assured that the company was cooperating and would
    continue to cooperate fully. Throughout this period, I never
    saw or heard anything that suggested that the company was
    attempting to obstruct OFHEO's special examination through
    lobbying efforts or otherwise.
        As for the HUD Inspector General's (IG) review of OFHEO, I
    recall learning the results of the review at the time they were
    reported in the press in November 2004. As noted in the OFHEO
    report (p. 276, fn. 165) I was also sent an e-mail from a
    Fannie Mae officer summarizing the press reporting on the
    topic. Keeping myself informed of the results of such a review
    of the company's regulator was fully consistent with my
    obligations as a board member.
        At no time was I ever informed that the IG's review of
    OFHEO was part of any effort by Fannie Mae to obstruct OFHEO's
    special examination of Fannie Mae. As I previously testified,
    management and the board have made establishing a new tone,
    manner, and approach in the way we interact with regulators and
    policymakers a top corporate priority.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM STEPHEN
                               B. ASHLEY

    Q.1. Acting Director Lockhart has noted that Dan Mudd's memo
    where Mr. Mudd stated:

            The old political reality was that we always won, we
            took no prisoners, and we faced little organized
            political opposition . . . We used to, by virtue of our
            peculiarity, be able to write, or have written, rules
            that worked for us. We now operate in a world where we
            will have to be `normal' is the best written record of
            the arrogant and unethical corporate culture at Fannie
            Mae from 1998 to 2004.

        Given such an assessment, why do you feel that Dan Mudd is
    the best man to lead Fannie Mae into the future?

    A.1. I will elaborate further about our comprehensive review of
    Dan in the context of our agreement with OFHEO in response to a
    subsequent question.
        As I testified, the board selected Dan Mudd as President
    and CEO of Fannie Mae in June 2005 after an extensive,
    competitive nationwide search and careful and deliberate
    consideration, including consultation with OFHEO and a targeted
    review by Senator Rudman. As interim CEO, Dan demonstrated an
    ability to lead a large financial institution through a major
    and challenging transition, including the ability to reach out
    and rebuild confidence with our regulators, Congress, and
    others. He demonstrated his capacity for the job by doing the
    job and he retains the confidence of the board. Since taking
    the helm, I believe Dan has effected positive changes in the
    culture of Fannie Mae. He has met our expectations. We chose
    him for his excellence in critical areas, and he has justified
    our choice.
        With regard to Dan's memorandum, I accept what he has
    explained in answering these questions from the Committee:

            As discussed during my June 15, 2006, testimony, the
            thrust of my November 16, 2004, memorandum was in no
            way an endorsement of the preexisting tone and attitude
            at Fannie Mae. The purpose of the memorandum was to
            reject the preexisting tone and attitude and encourage
            the company to change. A central theme of the
            memorandum was the importance of improving our
            relationships with OFHEO and our other regulators,
            including the SEC. My memorandum was attempting to
            provide a `wake up call' that change was necessary to
            meet the challenges of the more competitive and
            evolving financial markets.

            For much of its life span, Fannie Mae had a practically
            unique position in American financial markets. This
            `peculiarity' meant that rules had to be created to
            address aspects of Fannie Mae's business that were
            different from other financial institutions. Thus, as
            my memorandum noted, we `faced little organized
            political opposition' during that era. However, as the
            financial markets have become more sophisticated and
            competitive, Fannie Mae became less unique and there
            was less need for Fannie Mae-specific rules. My
            memorandum does not indicate that the `old political
            reality' from the bygone era was appropriate. Nor did I
            suggest or condone any effort to eliminate political
            opposition. There are and will be strongly opposing
            views about the financial markets and Fannie Mae's role
            in that arena. Fannie Mae recognizes that robust debate
            in this area is appropriate and healthy.

            I strongly believe that a properly functioning,
            professional relationship with our regulators is in the
            best interest of our company and the housing markets,
            and I have made it a top priority since becoming CEO to
            repair and strengthen those relationships. I have also
            made it clear from day one that the approach, tone and
            manner with which we engage policymakers has needed to
            change, and I hope we have made significant strides in
            this regard.

    Q.2. Responsibility for overseeing operational risk was
    primarily given to Frank Raines, but was then handed to Dan
    Mudd, Fannie's current CEO. What was Mudd's role as COO and to
    what degree was he responsible for what happened at Fannie Mae?
    How should he be held accountable?

    A.2. When he was Chief Operating Officer, Dan Mudd's
    responsibilities primarily were dealing with Fannie Mae's
    customers and with the systems technology, and employees in
    those areas reported to him. While reporting structures changed
    from time to time at Fannie Mae during my tenure on the board,
    by 2003 all credit and risk personnel, including the Senior
    Vice President for Operations and Risk, reported to the Chief
    Financial Officer. Dan also did not oversee financial
    accounting, the mortgage portfolio, or internal audit.
        As I testified, the board selected Dan Mudd as President
    and CEO of Fannie Mae in June 2005 after an extensive,
    competitive nationwide search and careful and deliberate
    consideration, including consultation with OFHEO and a targeted
    review by Senator Rudman. Indeed, when it was clear that Dan
    was going to be a finalist for the position, I approached
    Senator Rudman, and had discussions with the then-director of
    OFHEO, as to whether there was anything in their knowledge that
    would suggest that the board should not move forward in
    considering Dan as a finalist. Senator Rudman's team spent
    about 2 to 3 weeks doing very in-depth reviews of Dan's work at
    the company, examining whether he was in any way implicated in
    any of the wrongdoing that had been identified in the September
    2004 OFHEO report. Senator Rudman's investigation was thorough.
    He met with the board's search committee and then later with
    the full board to discuss the results of his investigation. At
    that point, the board felt there was no reason why Dan should
    not be considered for the CEO position, and we subsequently
    appointed him CEO.
        Then, a week before OFHEO released its final special
    examination report in May of this year, a draft was made
    available to a small group under confidentiality for fact
    checking. At that time, we learned Dan was named several times
    in the report. Therefore, I felt that the board had to examine
    those findings and discuss them thoroughly, and did so. We
    asked Senator Rudman to read the report, to come back to us and
    address questions as to whether there were any new or different
    material findings that would cause the Senator and his team to
    change their opinion and their previous recommendation to the
    board regarding Dan's service as CEO. Senator Rudman reported
    that there was not any reason to change his opinion.
        The board continues to have full confidence in Dan Mudd as
    CEO of Fannie Mae.
        Under Fannie Mae's May 23, 2006, settlement agreement with
    OFHEO, the board of directors appointed a special committee of
    four independent board members (three of whom have joined the
    company subsequent to the end of 2004) which is conducting the
    personnel review prescribed by the agreement, including ``plans
    to seek restitution, disgorgement, or other remedies to recover
    funds from individuals.'' Mr. Mudd has stated publicly that he
    will abide by the decisions of the committee with regard to
    this matter.

    Q.3. Fannie Mae senior executives omitted critical information
    to the Board leaving directors with a false sense of
    reassurance. Management is at fault, but what role should the
    board have played and why did they just accept and not question
    what management presented? The OFHEO report holds the Board
    more responsible than the Rudman report did, why is that?

    A.3. The board of directors of every public company is
    responsible to act diligently, independently and on an informed
    basis in its oversight of the management of the corporation. In
    my view, Fannie Mae's board of directors discharged these
    responsibilities even though, in hindsight, information has
    come to light that was not made known to the board of directors
    at the time. As I discussed in responding to a question from
    Senator Hagel, in my opinion, the members of Fannie Mae's Board
    of Directors were well-qualified for their position,
    thoughtful, informed and engaged in the interactions that I
    observed with the management of the company.
        As I testified, the Fannie Mae of 1998-2004 portrayed in
    the final OFHEO report of its special examination is a far
    different company than was portrayed to the Fannie Mae board by
    departed management, our former external auditor, and annual
    regular examination reports. During the years examined in the
    OFHEO report, I believed the board came prepared for our
    meetings, asked the right questions, and appeared to be
    actively engaged in their duties of oversight. It was not my
    impression at the time that my colleagues on the board lacked
    independence from Mr. Raines or other senior executives. As a
    result of the investigations by both Senator Rudman and OFHEO,
    however, I have learned of a number of matters that I did not
    know at the time and that, in hindsight, I would have wanted to
    know as a member of the board.
        We learned a lot of lessons, and have worked hard to apply
    what we have learned. As I testified, since the initial OFHEO
    special examination report of September 2004, the board has
    continued to make significant changes to its composition,
    structure, and relationship to management:

        We separated the roles of the Chief Executive
            Officer and the Chairman of the Board, as it was
            essential to establish the appropriate governance and
            oversight of management, assuring all parties that we
            were progressing on our agreed-upon goals.
        Five of the 12 nonmanagement members are new since
            2004, and the newest member, Dennis Beresford, is a
            former chairman of the FASB and serves as chair of the
            Audit Committee. All five of the new board members are
            independent of management. We eliminated two of the
            seats held by management, retaining just one, to
            increase the proportion of independent board members.
            In accordance with our corporate policy and OFHEO's
            corporate governance rules on length of service,
            another board member, Ann Korologos, will be leaving
            the board effective July 31, 2006.
        To ensure accountability and the timely flow of
            information, we established reporting lines to the
            board for the positions of Chief Audit Executive, Chief
            Compliance and Ethics Officer, and Chief Risk Officer.
        To improve our relationship with our regulators and
            to hear about any problems directly, I and other
            members of the board have established regular
            interactions with OFHEO.

        As for the question why the OFHEO report holds the board
    more responsible than did Senator Rudman's report, I
    respectfully wish to defer to the authors of those reports. But
    I emphasize that the board takes the findings of both of those
    reports seriously, and we are committed to addressing the
    issues therein.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM DANIEL H.
                                  MUDD

    Q.1. Mr. Mudd, in your testimony, you noted that ``Fannie Mae
    will work cooperatively to support the efforts of Congress to
    pass legislation to strengthen GSE regulation.'' Senators
    Sununu, Dole, and I have been circulating a letter to Chairman
    Shelby and Majority Leader Frist expressing the need to pass
    effective GSE reform this year and urging Senate leadership to
    bring 8.190 to the floor where the full Senate can debate the
    merits of the bill. To date, we have 26 Senators on the letter
    and the list is growing. Do you support the merits of this
    letter?

    A.1. As I testified in my opening statement before the
    Committee in June, our position remains the same as when I
    testified in April 2005. While it would be inappropriate for
    Fannie Mae to comment on how or when the Senate should take up
    this debate, I can assure you that we will continue to work
    cooperatively to support the efforts of Congress to pass
    legislation to strengthen GSE regulation. In particular, we
    continue to support legislation:

        To create a single independent, well-funded
            regulator with oversight for safety and soundness and
            mission;
        To provide the regulator with strong bank-like
            regulatory powers over capital, activities,
            supervision, and prompt corrective action;
        To provide the regulator with bank-like authority
            to reduce on-balance sheet activities, based on safety
            and soundness; and
        To provide a structure for housing goals that
            includes an affordable housing fund that strengthens
            our housing and liquidity mission.

    Q.2. According to the OFHEO report, you wrote in an e-mail in
    2003:

            I spoke to [a Treasury Department official], he had
            agreed to talk to [the SEC] on `what to do if OFHEO was
            not falling in line' already ([another Treasury
            official] had already bent his ear about OFHEO
            obstructionism) . . . promised me he'd check in to see
            where things were and would call [the SEC] when needed.

        Can you respond to this? How does this fit in with your
    calls to change the tone of Fannie Mae?

    A.2. The e-mail related to a call I made to a Treasury official
    during the time Fannie Mae was seeking and preparing for our
    voluntary registration with the SEC, an effort I supported to
    improve Fannie Mae's transparency and bring the company into
    line with other large public financial institutions. As the
    date approached for the filing of our first Form 10-K with the
    SEC, we learned that OFHEO disagreed with Treasury and the SEC
    about some aspects of the registration process. I called the
    Treasury official for guidance and clarification of the
    positions of the three agencies, solely with respect to
    interagency disagreements regarding the registration process.
        I want to emphasize that I did not make the call to
    generate conflict or to interfere, in any way, with OFHEO
    regulation of Fannie Mae. I meant the call as a good-faith
    attempt to obtain guidance about our regulatory obligations as
    we expanded Fannie Mae's financial reporting through SEC
    registration.
        As for Fannie Mae's tone and manner, I could not agree with
    you more--as I testified, the days of the arrogant, defiant,
    ``my way'' Fannie Mae had to end. As CEO, I have explicitly
    made building stronger, cooperative relationships with our
    regulators and Congress, and changing our culture to one of
    service and humility, among our top corporate priorities. We
    have made many changes, and we are committed to making more.

    Q.3. The OFHEO report states that ``by deliberately and
    intentionally manipulating accounting to hit earnings targets,
    (Fannie's) senior management maximized the bonuses and other
    executive compensation they received, at the expense of
    shareholders.'' You received a total of $26.3 million in
    executive compensation from Fannie between 2000-2004. Do you
    plan to return any of it? What is your total compensation for
    2005 and 2006?

    A.3. Under Fannie Mae's settlement agreement with OFHEO, the
    board of directors has appointed a special committee of four
    independent board members (three of whom joined the company
    subsequent to the end of 2004), which is conducting the
    personnel review prescribed by the agreement, including ``plans
    to seek restitution, disgorgement, or other remedies to recover
    funds from individuals.'' I have stated publicly that I will
    abide by the decisions of the committee with regard to this
    matter.
        Prior to being named the company's President and CEO on
    June 1, 2005, I earned a base salary of $850,000. Upon being
    named President and CEO, my base salary rose to $950,000 for
    the remainder of the year. I also received a cash bonus of
    $2,591,875 for the 2005 performance year, and was granted
    restricted shares of company stock valued at $8,000,000,
    subject to a vesting period of 4 years.
        My annual salary for 2006 remains at $950,000. My 2006
    annual cash bonus award target is 275 percent of my annual base
    salary. Decisions on additional compensation provisions for
    2006 are at the discretion of the company's board of directors
    and have not been determined.

    Q.4. The OFHEO [report] states that

            In 2003, three Fannie Mae employees expressed serious
            concerns about the Enterprise's accounting. Roger
            Barnes, then a manager in the Office of the Controller,
            made allegations about Fannie Mae's accounting for
            deferred price adjustments under FAS 91 to Sampath
            Rajappa, Senior Vice President for Operations Risk, who
            then reported those concerns promptly to Ann Kappler,
            Senior Vice President and General Counsel.

            Another employee in Securities Accounting also
            expressed concerns about amortization accounting to
            Chief Operating Officer Daniel Mudd, and a third
            employee echoed those concerns. Ms. Kappler and Mr.
            Mudd initiated flawed investigations into those
            allegations and concerns. When those investigations
            were completed, Ms. Kappler made statements about the
            issues raised and their disposition--in one case, to
            the Audit Committee of the Board of Directors--that
            were false and misleading.

        Can you respond to this? When did you become aware of
    Fannie's accounting problems? What were your responsibilities
    as Chief Operating Officer? Which employees reported to you?
    Did the Senior Vice President for Operations and Risk report to
    you?

    A.4. While I carried the title of Chief Operating Officer
    (COO), my responsibilities, as assigned by the Chainnan and CEO
    at the time, primarily were working with Fannie Mae's customers
    and dealing with the systems, technology, and employees in
    those areas that reported to me. While reporting structures
    changed from time to time at Fannie Mae during my tenure as
    COO, by 2003 all credit and risk personnel, including the
    Senior Vice President for Operations Risk, who ran internal
    audit, reported directly or indirectly to the Chief Financial
    Officer. I also did not oversee financial accounting or the
    mortgage portfolio.
        I first learned that OFHEO had concluded that certain
    aspects of Fannie Mae's accounting were wrong upon release of
    the September 2004 OFHEO report. Like a lot of people, I was
    stunned.
        As CEO, my number-one priority has been to get our
    accounting right and fix our systems, internal controls,
    organization, and other issues as we complete our restatement
    by the end of this year.
        The Securities Accounting employee cited in the OFHEO
    report, Michelle Skinner, raised a question about accounting
    during an open-forum, town hall-style meeting I held with
    employees on a regular basis, which the company called an
    ``unplugged'' meeting. For unplugged meetings, employees were
    invited to ask questions on any type of issue or concern--
    ranging from complicated business and work issues, to the food
    served in the cafeteria, and the coverage limits of the dental
    plan. In the September 9, 2003, session, Ms. Skinner asked a
    complex accounting question. Because I am not a trained
    accountant and do not have expertise in the field, and because
    the financial accounting function did not report to me during
    my service as COO, I could not answer her question on the spot.
    So I invited Ms. Skinner to send an e-mail to me explaining her
    concerns in greater detail.
        When I received her e-mail, I asked my assistant--a former
    securities lawyer--to ensure answers were provided in response
    to Ms. Skinner's questions. The matter was referred to Internal
    Audit, the General Counsel, and the Controller's Office. By
    late September, Internal Audit provided to me its assurance
    that issues raised by Ms. Skinner were being handled by the
    company in a manner consistent with GAAP. I was also told that
    our external auditor, KPMG, reviewed these issues and found the
    treatment acceptable.
        At my direction, a November 17, 2003, tutorial session was
    organized to address the questions that had been raised by Ms.
    Skinner in greater depth and in an open dialog with interested
    employees. It is my understanding that Ms. Skinner and Mr.
    Anthony Lloyd (the ``third employee'' referenced in the
    question) stated that they were satisfied with the response and
    that their concerns had been addressed. At the time, I believed
    that the issues were being thoroughly reviewed and that a full
    and accurate response was provided by offices and individuals
    experienced and knowledgeable in the area. At all times, I
    tried to address Ms. Skinner's inquiry openly and thoroughly.

    Q.5. The OFHEO report states Fannie's ``corporate culture was
    intensively focused on attaining Earning Per Share (EPS)
    goals'' and ``senior management provided an incentive to
    employees to double EPS to $6.46 by year-end 2003.''
        In the same year, Sampath Rajappa, Fannie's Senior Vice
    President for Operations Risk and head of Internal Audit told
    Fannie's internal audit group: ``you must be obsessed on $6.46.
    After all, thanks to Frank [Raines], we all have a lot of money
    riding on it . . . Remember, Frank has given us an opportunity
    to earn not just our salaries, benefits, raises, ESPP [Employee
    Stock Purchase Program] but substantially over that if we make
    $6.46.'' The final EPS number for 2003 was $7.29 which
    triggered the bonuses.
        Is this the right message to be sending to your company's
    internal audit group?
        According to the OFHEO report, meeting this goal--and
    triggering the option grants and bonuses--was a primary goal of
    senior management. In a 2000 memo, you wrote:

            We also need to continue to focus on our 2003 challenge
            . . . we still have a gap of nearly $375 million in
            pre-tax income . . . ! know that the numbers in our Q3
            forecast around our `big bets' are still being refined
            as we iron out the issues--and that those revenue
            numbers may well change. It is clear that these new
            products may not be sufficient to get us to our $6.46
            goal--and we as a company must be looking hard at what
            it will take to make it.

        When did you become aware of this EPS incentive plan? Were
    you aware that this incentive plan was extended to internal
    audit employees? Who reviewed these targets? Did you have the
    ability to review these targets? Can you also provide the
    Banking Committee a copy of this memo?

    A.5. As I testified, I was not aware of Mr. Rajappa's speech at
    the time, and it is deeply troubling to me. I don't think
    that's the way that an audit staff should be focused, and I and
    the board have made a priority of changing that since I took
    the job of CEO. As I also testified, I believe it's very
    important that the audit staff be independent and report
    directly to the board, and that its compensation be independent
    of the company's financial results.
        With these principles in mind the board and management have
    completely overhauled the internal audit function to ensure it
    is the corporate guardian it is supposed to be. The Chief Audit
    Executive is a new external hire who reports directly to the
    Audit Committee of the board of directors with a dotted line
    reporting to the CEO. This position has increased direct
    interactions with, and enhanced detailed reporting to, the
    board's Audit Committee and its chair (who is a new Fannie Mae
    board member, Dennis Beresford, a former chair of the Financial
    Accounting Standards Board). The Internal Audit function also
    has undergone a comprehensive organizational and process
    redesign, including new structure, staffing levels, skill
    assessments, audit planning processes, execution, and
    reporting. The company has also replaced its outside auditor
    with Deloitte and Touche, LLP, which formerly provided advice
    to OFHEO when several of the accounting problems were first
    identified and is now conducting a comprehensive re-audit of
    the entire company with more than 300 auditors onsite at Fannie
    Mae.
        As Fannie Mae Chairman, Steve Ashley, said during his
    testimony:

            During the 1990s and the early part of the decade of
            2000 this was an accepted and indeed promulgated form
            of compensation in addition to base compensation that
            most of corporate America publicly owned corporate
            America--engaged in one Finn or another. The purpose
            was to align the management of the company with the
            interests of the shareholders.

        I was aware of the EPS goal when I arrived at Fannie Mae in
    2000 because the company announced it broadly--publicly and
    internally--when it was launched in 1999, and it remained a
    corporate financial stretch goal through 2003. The incentive
    was available to all full-time employees of the company. And as
    I noted in my appearance before the committee, this was a
    compensation structure similar to other companies that I had
    worked for previously and which I thought appropriate in those
    circumstances.
        The company has now adopted a new executive compensation
    structure with broad performance goals that include achieving
    affordable housing mission goals, improving our culture,
    complying with regulatory standards, and delivering shareholder
    value. In addition, Fannie Mae's Consent Order with OFHEO
    explicitly requires the board to ensure that our compensation
    practices ``include financial and nonfinancial metrics and
    shall not be tied exclusively to earning per share'' and that
    ``compensation metrics for the internal auditor, chief
    compliance officer, controller, and such others, as determined
    in consultation with OFHEO, be appropriate to their roles and
    do not create a conflict of interest.''
        Regarding my memorandum of October 12, 2000, as I
    testified, all companies that I'm familiar with have budgets
    with targets for revenues and expenses, and compensation plans
    that have targets in them. Part of my responsibilities as COO
    was to review the profits and losses of that part of the
    business I was running and to try to attain the goals set by
    the organization. Never at any point would I sanction any
    departure from the rules in order to hit EPS targets.
        In response to your request, my memorandum is being
    provided to the Committee as an attachment to these responses.

    Addendum

                            Memorandum from Dan Mudd

                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DANIEL H.
                                  MUDD

    Q.1. Fannie Mae signed a consent agreement on May 23, 2006,
    with the Office of Federal Housing Enterprise Oversight
    agreeing to cap its retained mortgage related portfolio to $727
    billion, its level on December 31, 2005. Using Fannie Mae's
    $727 billion portfolio as a model, what would Fannie Mae's
    portfolio size be with the limits of S. 190? Please include an
    explanation of the assumptions that you used to arrive at this
    number?

    A.1. Under S. 190, the size of Fannie Mae's portfolio would be
    the sum of the seven permissible assets listed in the bill.
    While several of these asset definitions could be subject to
    some interpretation (e.g., ``mortgages and mortgage-backed
    securities for the purpose of securitization'' and a ``limited
    inventory of mortgages solely for the purpose of supporting the
    guarantee business''), in our analysis a literal reading of the
    bill would lead to a reduction in the size of our portfolio to
    a range of $10 billion to $100 billion.
        We summarize below our best estimates of the projected size
    of Fannie Mae's portfolio under the provisions of S. 190,
    broken down into the seven permissible asset categories listed
    in the bill. We note, where appropriate, any assumptions we
    make concerning the bill's provisions and/or future conditions
    and behavior in the housing, secondary mortgage, and capital
    markets.

      1.  Mortgages and mortgage-backed securities for the purpose
            of securitization: $2-20 billion. We assume this
            category would consist of whole loans purchased from
            lenders that are in the process of conversion into
            mortgage-backed securities (MBS) and eventual sale.
            These loans may need to be held on the balance sheet to
            optimize security sales. Loans or packages of loans
            from disparate lenders, delivery mechanisms, or
            delivery months may need to be aggregated over some
            period of time to achieve the best available price in
            the securities market.

      2.  Mortgages acquired to meet affordable housing goals, if
            such assets are not readily securitizable: $2-20
            billion. Currently, Fannie Mae holds approximately $250
            billion of mortgage loans on our balance sheet. A
            literal reading of the phrase ``if such assets are not
            readily securitizable'' would preclude us from holding
            almost all of these loans, whether or not they qualify
            as affordable housing loans, since almost all loans are
            readily securitizable at some price. Of the loans on
            our balance sheet, more than 90 percent could be
            securitized by lenders through programs currently
            offered by Fannie Mae. In general, loans acquired and
            held on our balance sheet tend to meet our affordable
            housing goals criteria at a greater rate than loans
            placed in MBS. For example, of loans acquired on our
            balance sheet in 2005, 61 percent met our low and
            moderate-income affordable goal (compared to 46 percent
            of loans in MBS), 35 percent met our special-affordable
            goal (compared to 18 percent of loans in MBS), and 40
            percent met our underserved goal (compared to 37
            percent of loans in MBS).

      3.  A limited inventory of mortgages solely for the purpose
            of supporting the guarantee business: $2-50 billion. We
            interpret this category to include only those mortgage
            holdings that directly and solely support the guarantee
            business. We include loans and securities that we may
            need to purchase from lenders as a means of retaining
            or improving the guarantee business with those lenders.
            We specifically did not include MBS holdings that
            provide liquidity support and thus, improve the price
            performance of MBS securities.

      4.  Real estate acquired through foreclosure: $2-5 billion.
            We base this estimate on our recent holdings of this
            asset class. We assume these holdings would grow
            somewhat as the credit guarantee business grows, but
            would not exceed $5 billion in scale (absent any
            significant rise in the rate of foreclosures).

      5.  and 7. Cash and liquid investments: $1-3 billion.

      6.  Real estate, intellectual property fixtures, and
            equipment for use in the business operations of the
            enterprise: $1-2 billion.

        Based on our reading, S. 190 would bar the GSEs from
    investing in almost all instances in MBS. This prohibition
    would encompass MBS backed by loans to finance affordable
    housing for low- and moderate-income families, very low-income
    families, or underserved communities. The prohibition would
    also apply if the GSEs' investment in MBS promoted the
    liquidity of loans, especially fixed-rate loans, for middle-
    class homebuyers.
        The Charter Act assigns important obligations to Fannie
    Mae, including obligations to:

        Provide stability in the secondary market for
            residential mortgages;
        Provide ongoing assistance to the secondary market
            for residential mortgages; and
        Promote access to mortgage credit throughout the
            Nation . . . by increasing the liquidity of mortgage
            investments and improving the distribution of
            investment capital available for residential mortgage
            financing.

        Currently, in meeting our Charter Act obligations, Fannie
    Mae fulfills a broader role than we could under the list of
    permissible investments in the bill. Consequently, the company
    has a much larger loan portfolio ($731 billion at the end of
    June 2006) than would be the case if S. 190 were enacted. Thus,
    we believe the bill would require the company to liquidate
    approximately $600 billion to $700 billion in assets.

    Q.2. What are the public policy benefits and risks of the two
    different portfolio sizes?

    A.2. As Fannie Mae testified before the Committee in April
    2005, we believe that our mortgage portfolio--our original line
    of business since 1938--fosters liquidity and affordability in
    the U.S. mortgage market, especially in times of economic
    distress or market disruption. Unlike any other investor in
    U.S. mortgages, the GSEs are required by law to operate in all
    50 states, under all economic conditions. This helps ensure the
    availability of mortgage capital through good times and bad.
        We believe that mandating a large reduction in the size of
    our portfolio could make it difficult for the GSEs to help
    provide these benefits for low-, moderate-, and middle income
    homeowners and renters currently served by the U.S. mortgage
    market. We also believe the risks that have been suggested
    about the current GSE portfolios would be effectively addressed
    by granting a new GSE regulator with bank-like powers to ensure
    the safety and soundness of the GSEs' operations.
        As we have previously testified, we believe the GSEs'
    current portfolio business provides several important public
    policy benefits for housing.
        First, the GSEs' current portfolios increase the stability
    of the U.S. housing sector.
        Today, the U.S. housing finance system draws funds from the
    entire U.S. and global capital markets (including banks, Wall
    Street, pension funds, foreign central banks, and others)
    through the sale of GSE debt instruments. This vastly improves
    on the system it replaced, which drew funds almost entirely
    from U.S. bank deposits. It also is considered improbable that
    myriad small financial companies and mortgage bankers could
    access the international capital markets with the efficiency
    and scale that are hallmarks of the GSEs' role. Under the
    former system, Americans' ability to get a mortgage at
    reasonable rates and terms was heavily dependent on the state
    of the overall U.S. economy. Housing in general, including
    builders and the housing trades, was subject to a series of
    boom-bust cycles that often amplified economic cycles in the
    broader economy.
        The capital markets funding system, backed by the GSEs'
    portfolios, has smoothed out chronic boom-bust housing cycles.
    Housing has gone from a source of general economic instability
    and disruption to a stabilizer, and even a driver, of economic
    growth. The GSEs, both in their guarantee and portfolio roles,
    play a central role in this capital markets model and, in fact,
    there has been a pronounced reduction in housing cycle
    volatility that correlates closely with the growth of the GSEs'
    portfolios over the course of the 1990s.
        Susan Wachter, Professor of Real Estate and Finance at the
    University of Pennsylvania's Wharton School, testified last
    year before the Senate Banking Committee that:

            The role of mortgage market access to global capital
            markets as an automatic stabilizer for the U.S. economy
            is demonstrated by the strength of the housing sector
            and its role in moving the economy out of the 2001
            recession. Access to international capital markets
            during a period of low and falling interest rates and
            possible deflation has resulted in additional consumer
            spending which has supported the U.S. economy. This
            benefit that the GSEs and secondary markets provide the
            American consumer is a major contributory factor to the
            strength of America's economy today and to the long-run
            stability of America's economy going forward. [Emphasis
            added]

        Second, the GSEs' current portfolios increase the liquidity
    and affordability of U.S. mortgages.
        The GSE portfolio purchases increase the demand for U.S.
    mortgages and mortgage backed securities, thus making them more
    tradable (i.e., liquid) and putting downward pressure on the
    interest rates charged to homeowners. They do so in several
    ways.
        By issuing debt to purchase mortgages, the GSEs draw in
    hundreds of billions of dollars from investors at home and
    abroad to expand the availability and lower the cost of
    mortgage capital. For example, Fannie Mae's senior, long-term
    Benchmark Securities outstanding represented 42 percent of our
    total long-term debt outstanding as of the end of the second
    quarter of 2006, and we know that over the last eight and a
    half years, international investors purchased approximately
    one-third of those Benchmark issuances in aggregate, or $160
    billion. Smaller U.S. banks (e.g., community banks,
    agricultural banks, commercial lenders ) are also substantial
    investors in GSE debt, demonstrating a strong preference for
    investing in GSE debt versus MBS issued by the GSEs. It is not
    at all clear that these investors would place their money in
    the U.S. housing market without the predictability and
    convenience provided by GSE debt issuances.
        In addition, by investing in their own mortgage-backed
    securities, the GSEs create a ``backstop bid'' which acts as a
    safety net and is relied upon by other investors. A number of
    securities dealers have acknowledged the stabilizing force of
    the GSE backstop bid. Lehman Brothers, for example, has stated
    that ``weakening of the backstop bid from the agencies . . .
    increases the risk in owning mortgages from a liquidity
    standpoint.''\1\
    ---------------------------------------------------------------------------
        \1\ Lehman Brothers, Mortgage Strategy Weekly, MBS and ABS
    Research,4-25-2005, p.  3.
    ---------------------------------------------------------------------------
        Substantially restricting the GSEs' portfolios effectively
    would eliminate the backstop bid and make mortgages less liquid
    and less attractive investments. This could cause other
    investors to withdraw from the mortgage market. One respected
    Wall Street analyst described the process involved as follows:

            The mortgage-backed securities market is a multi-
            trillion dollar market. For the last 10 years they have
            relied quite heavily on the idea that there is a
            backstop bid from Fannie and Freddie when spreads widen
            out. Without that backstop bid, it just simply makes
            sense to most people on Wall Street that that's going
            to add volatility and some spread widening to the
            mortgage markets. It's very difficult to see how
            lenders can absorb those extra costs, and so you would
            have to assume some are going to get passed on to
            homeowners in some size or fashion.\2\
    ---------------------------------------------------------------------------
        \2\ Jim Vogel, FTN Financial, Memphis, Tennessee quoted on
    Bloomberg, August 1, 2005.

        In short, the Fannie Mae and Freddie Mac portfolios,
    combined, finance approximately one and a half trillion dollars
    of U.S. conforming mortgages. Removing the GSE investment
    demand from the market would tend to decrease the availability
    of mortgage financing and increase its cost.
        Third, the GSEs' current portfolio operations provide key
    support for the 30-year fixed rate mortgage, with a prepayment
    option, a home loan that distinguishes our system from most
    others in the world.
        By creating two companies that invest only in residential
    mortgages, Congress laid the foundation for the 30-year fixed-
    rate pre-payable mortgage, which is an important tool for
    wealth creation, stabilizing communities and neighborhoods, and
    allowing low- and middle-income homeowners to manage their
    other financial obligations without having to worry about their
    mortgage costs changing.
        While no one can state with certainty the full impacts of
    portfolio restrictions on the availability of the 30-year
    fixed-rate mortgage, there is a real-world laboratory that
    shows what the market might be like without the GSEs. This is
    the jumbo market, which the GSEs are, by law, prohibited from
    participating in. There, one finds a marked difference in the
    incidence of fixed-rate mortgages. In 2005, the percent of
    mortgages used to purchase homes that were fixed rate was 74
    percent in the conforming market compared to only 35 percent in
    the jumbo market.
        The GSEs' portfolio operations in the conforming market
    appear to be a big factor in explaining this discrepancy. It is
    well recognized that ARMs tend to have higher credit risk than
    fixed-rate mortgages. Therefore, the absence of a GSE guarantee
    on a jumbo mortgage should, if anything, drive the market
    toward a higher supply of fixed-rate loans in the jumbo market
    than in the conforming market. That the opposite occurs
    suggests that it is the GSEs' willingness to invest in fixed-
    rate conforming mortgages through portfolio operations (rather
    than their guarantee of such mortgages) that is the driving
    force behind the much greater frequency of fixed-rate mortgages
    in the conforming market.
        Fourth, the GSEs' current mortgage portfolios allow the
    companies to play a shock-absorbing function for the finance
    system during times of potential difficulty, such as the debt
    crisis of 1998.
        The GSEs' experience in mortgage trading operations and the
    willingness of a broad array of investors to invest in GSE
    bonds gives the companies an ability to act quickly to buy
    mortgages in times of crisis, supporting the liquidity of the
    broader mortgage market.
        For example, in an independent study, economists Joe Peek
    and James A. Wilcox asked, ``How can GSEs stabilize mortgage
    flows?'' and wrote:

            First, they may directly increase mortgage flows during
            recessions by purchasing whole mortgages and mortgage-
            backed securities to at least partially offset the
            procyclicality of supplies by others . . .

            Thus, when housing-related GSEs increase their supplies
            of mortgage activities in response to financial
            disruptions, they serve as shock absorbers that lessen
            the fall-off in the supplies of home mortgages . . .

            Having increased during (the comparison period
            associated with) each recession, intermediation by
            Fannie Mae and Freddie Mac combined was countercyclical
            . . . [T]he behavior of the other participants in the
            mortgage market was procyc1ical . . .

            During periods of international financial crises or of
            domestic economic stress . . . GSEs may be particularly
            well suited to facilitating mortgage flows. So long as
            there are such crises and stresses, GSEs may be
            particularly effective in stabilizing mortgage markets
            and moderating business cycles.\3\ [Emphasis added]
    ---------------------------------------------------------------------------
        \3\ Peek, Joe, University of Kentucky and James A. Wilcox, Haas
    School of Business, UC Berkeley, Secondary Mortgage Markets, GSEs, and
    the Changing Cyclicality of Mortgage Flows, Ed. Andrew H. Chen.
    Research in Finance 20, January 2003, various pages. For online copy,
    follow link from http://207.36.165.114/Denver/Papers/
    DenverProgram818.htm

        Severely restricting the size of the GSEs' mortgage
    portfolios would reduce their capacity to serve this
    stabilizing role. The GSEs' charter obligations to increase
    liquidity and to bring stability to the market in periods of
    stress are complementary activities. In order to be able to
    fulfill the role of mortgage market stabilizers in times of
    market distress, a GSE must have established, during normal
    times, a liquid market for its securities, rather than relying
    upon untried securities.
        In addition, the GSEs have to maintain systems
    infrastructure, a network of broker/dealers and a cadre of
    experienced staff in order to be able to conduct stabilizing
    operations during periods of turmoil.
        In conclusion, the current GSE portfolios provide
    substantial liquidity and affordability benefits to the U.S.
    mortgage market and the homeowners and consumers that are
    served by that market. Restricting the GSEs to the list of
    investments permitted in S. 190 could make it difficult or
    impossible for the GSEs to help provide these benefits,
    especially during cycles when other investors shy away from
    mortgages. Finally, as we have previously stated, we believe
    that any risks posed by the current system would be effectively
    addressed through ensuring that the GSE regulator has bank-like
    powers to ensure the safety and soundness of the GSE
    operations.

    Q.3. It has come to my attention that HUD Secretary Jackson
    plans to review the nonmortgages that Fannie currently holds,
    in keeping with its government charter to maintain proper
    safety and soundness levels. Could you please comment on what
    nonmortgage financial products Fannie currently holds, and also
    give your thoughts on the soundness of those products?

    A.3. Fannie Mae's nonmortgage assets fall into three
    categories:

        First: The company maintains a Liquid Investment Portfolio
    (LIP) consisting of money market and fixed-income assets with
    high credit quality. The purpose of the LIP is two-fold: (1) to
    reduce risk by providing a pool of nonmortgage investments to
    ensure the company could meet all of its obligations if it did
    not have access to the debt markets for as long as 3 months;
    and (2) to provide for the temporary investment of excess
    capital. The LIP is one major component of the company's
    contingent liquidity program, as detailed in a September 2005
    agreement with OFHEO. We report on our nonmortgage asset
    holdings to HUD every quarter, and OFHEO regularly reviews our
    liquidity plan.
        The LIP consists of money market instruments, asset-backed
    notes, corporate debt, and bank deposits. By corporate policy
    this portfolio is restricted in the type of assets it is
    allowed to hold as well as the overall credit quality,
    maturity, and duration of those assets. The average credit
    rating of the LIP is in the AA category. The size of the LIP
    varies due to changing liquidity and capital management
    requirements. Again, the express requirement is that Fannie Mae
    maintains this portfolio of nonmortgage assets in order to
    ensure the safety and soundness of our overall financial
    activities.

        Second: Low Income Housing Tax Credits (LIHTC)--In addition
    to providing mortgage financing to multifamily housing, Fannie
    Mae also works with nonprofit and for-profit housing sponsors
    to increase the availability of funds to affordable multifamily
    housing by making equity investments in properties that qualify
    for Federal LIHTC.
        Congress created LIHTC in 1986. The credit generates about
    $8 billion of private investment each year to produce more than
    125,000 affordable apartments for low income families and the
    elderly.
        Properties developed under LIHTC target residents who earn
    60 percent or less of the area's median income. In a 1997
    study, the General Accounting Office found that average Housing
    Credit apartment renters earn only 37 percent of area median
    income. Many earn less than 30 percent.
        Fannie Mae's participation in the LIHTC market provides
    day-in day-out liquidity to this important affordable housing
    market. Fannie Mae's LIHTC investments span all parts of the
    country and all types of properties that have received an
    allocation of the tax credit.
        Fannie Mae's credit performance from its LIHTC portfolio
    has been very strong. Total losses on the total book over the
    17 years of LIHTC investment activity equal approximately one-
    tenth of a percent.

        Third: In addition to the LIP and LIHTC assets described
    above, as of June 30, 2006, Fannie Mae holds approximately $5
    billion of other nonmortgage assets (.6 percent of our total
    assets). There are four types of investments in this category:
    (1) Debt and equity investments entered into through activities
    of the American Communities Fund (ACF), $2.4 billion; (2)
    Market-rate equity investments, $0.4 billion; (3) Tax-
    advantaged investments in synthetic fuels and wind energy, $7.0
    million; and (4) Corporate-owned life insurance, $2.0 billion.
    These are described below:

        ACF Investments--ACF provides various types of
            financing to help meet community development needs,
            including: predevelopment loans to nonprofit
            developers, participations in acquisition, development
            and construction financing, and construction lines of
            credit or letters of credit. As an equity investor,
            Fannie Mae acts as a limited partner or nonmanaging
            member of a limited liability corporation (LLC) that
            invests in real estate operating properties, mezzanine
            loans, and historic tax credits. Fannie Mae either
            invests directly in a property or through a fund that
            holds direct investments. Fannie Mae also has
            investments in common or preferred shares of community
            development financial institutions (CDFIs).
        Market-rate Equity Investments--These investments
            comprise limited partner or LLC member equity interests
            in direct or fund investments in rehabilitation
            properties.
        Investments in Synfuels and Wind Energy--Between
            1998 and 2000, Fannie Mae invested in limited
            partnerships that acquired and operated plants that
            produce synthetic fuel from coal and wind energy plants
            designed to produce electricity. The investment in
            plants that produce energy from nonconventional sources
            qualifies for tax credits under the Internal Revenue
            Code.
        Corporate Owned Life Insurance--As is typical in
            major corporations, Fannie Mae has purchased corporate-
            owned life insurance (COLI) that covers the lives of
            certain directors and officers. This insurance provides
            a benefit to the company in the event of the death of a
            key employee, which reduces the costs associated with
            the related loss of talent, expertise, and knowledge.
            The company also uses these investments as a means of
            funding deferred compensation and supplemental
            retirement programs.
                                    ------

     RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM DANIEL
                                H. MUDD

    Q.1. The OFHEO Report on pp. 269-271 asserts that you missed an
    opportunity to recognize that there were similarities between
    Freddie Mac and Fannie Mae's situation. Can you explain why you
    didn't refer the complaints by Michelle Skinner (which were
    confirmed by the Head of the Office of Auditing, Sampath
    Rajappa) to the Board Audit Committee?

    A.1. The Securities Accounting employee cited in the OFHEO
    report, Michelle Skinner, raised the question about accounting
    during an open-forum, town hall-style meeting I held with
    employees on a regular basis, which the company called an
    ``unplugged'' meeting. In the unplugged meetings, employees are
    invited to ask questions on any type of issue or concern-
    ranging from complicated business and work issues to the food
    served in the cafeteria and the limits of coverage under the
    dental plan. In the September 9, 2003, session, Ms. Skinner
    asked a complex accounting question. Because I am not a trained
    accountant and do not have expertise in the field and because
    the financial accounting function did not report to me during
    my service as COO, I could not answer her question on the spot.
    So I invited Ms. Skinner to send an e-mail to me explaining her
    concerns in greater detail.
        When I received her e-mail, I asked my assistant--a former
    securities lawyer--to ensure answers were provided in response
    to Ms. Skinner's questions. The matter was referred to Internal
    Audit, the General Counsel and the Controller's Office. By late
    September, Internal Audit provided to me its assurance that
    issues raised by Ms. Skinner were being handled by the company
    in a manner consistent with GAAP. I was also told that our
    external auditor, KPMG, reviewed these issues and found the
    treatment acceptable.
        At my direction, a November 17, 2003, tutorial session was
    organized to address the questions that had been raised by Ms.
    Skinner in greater depth and in an open dialog with interested
    employees. It is my understanding that Ms. Skinner and Mr.
    Anthony Lloyd (another employee who shared similar concerns)
    stated that they were satisfied with the response and that
    their concerns had been addressed. At the time, I believed that
    the issues were being thoroughly reviewed and that a full and
    accurate response was provided by offices and individuals
    experienced and knowledgeable in the area. At all times, I
    tried to address Ms. Skinner's inquiry openly and thoroughly.

    Q.2. Based on the OFHEO report (p. 34) you were describing
    needed changes and you stated:

            The old political reality was that we always won, we
            took no prisoners, and we faced little organized
            political opposition . . . We used to, by virtue of our
            peculiarity, be able to write, or have written, rules
            that worked for us. We now operate in a world where we
            will have to be `normal.'

        Can you explain to me what you were trying to say in that
    memo? If you were simply operating Fannie Mae pursuant to its
    government charter and playing by the rules why would you have
    needed (in the past) to eliminate any political opposition and
    I am assuming you meant both Congress and more specifically
    OFHEO?

    A.2. As discussed during my June 15, 2006, testimony, the
    thrust of my November 16, 2004, memorandum was in no way an
    endorsement of the preexisting tone and attitude at Fannie Mae.
    The purpose of the memorandum was to reject the preexisting
    tone and attitude and encourage the company to change. A
    central theme of the memorandum was the importance of improving
    our relationships with OFHEO and our other regulators,
    including the SEC. My memorandum was attempting to provide a
    ``wake-up call'' that change was necessary to meet the
    challenges of the more competitive and evolving financial
    markets.
        For much of its life span, Fannie Mae had a practically
    unique position in American financial markets. This
    ``peculiarity'' meant that rules had to be created to address
    aspects of Fannie Mae's business that were different from other
    financial institutions. Thus, as my memorandum noted, we
    ``faced little organized political opposition'' during that
    era. However, as the financial markets have become more
    sophisticated and competitive, Fannie Mae became less unique
    and there was less need for Fannie Mae-specific rules. My
    memorandum does not indicate that the ``old political reality''
    from the bygone era was appropriate. Nor did I suggest or
    condone any effort to eliminate political opposition. There
    are, and will be, strongly opposing views about the financial
    markets and Fannie Mae's role in that arena. Fannie Mae
    recognizes that robust debate in this area is appropriate and
    healthy.
        I strongly believe that a properly functioning,
    professional relationship with our regulators is in the best
    interest of our company and the housing markets, and I have
    made it a top priority since becoming CEO to repair and
    strengthen those relationships. I have also made it clear from
    day one that the approach, tone, and manner with which we
    engage policymakers has needed to change, and I hope we have
    made significant strides in this regard.

    Q.3. It appears that on page 37 of the OFHEO Report we have
    evidence of what used to be the case at Fannie Mae (e-mail
    dated January 13, 2003). Can you explain what you meant by
    ``what to do if OFHEO was not falling in line?''

    A.3. The e-mail related to a call I made to a Treasury official
    during the time Fannie Mae was seeking and preparing for our
    voluntary registration with the SEC--an effort I supported to
    improve Fannie Mae's transparency and bring the company into
    line with other large public financial institutions. As the
    date approached for the filing of our first Form 10-K with the
    SEC, we learned that OFHEO disagreed with Treasury and the SEC
    about some aspects of the registration process. I called the
    Treasury official for guidance and clarification of the
    positions of the three agencies, solely with respect to
    interagency disagreements regarding the registration process.
        I want to emphasize that I did not make the call to
    generate conflict or to interfere, in any way, with OFHEO
    regulation of Fannie Mae. I meant the call as a good-faith
    attempt to obtain guidance about our regulatory obligations as
    we expanded Fannie Mae's financial reporting through SEC
    registration.

    Q.4. I'd like an explanation of your reasoning for not
    procuring more resources for the Auditing Department. Based on
    the e-mail referenced on by footnote 82 on p. 206, I assume you
    were aware, or at least should have been aware, that audits
    were being postponed or canceled. How do you explain your
    oversight of this issue given that you were growing your
    business during these years, not to mention the new compliance
    requirements from Sarbanes-Oxley (2002)?

    A.4. That particular e-mail reflects the regular adjustment
    process that the Audit Department would undertake mid-year in
    its audit plans. The e-mail specifically indicates that the
    original plans were being adjusted due to the Audit
    Department's focus on Sarbanes-Oxley and the OFHEO Special Exam
    during 2004. At this time (August 2004), the Audit Department
    did not report to me; I was provided this e-mail as a courtesy
    so that I would be generally informed of the Audit Department's
    plans for the rest of 2004. The e-mail did not state that the
    Audit Department wanted or needed additional staff, but rather
    explained that Sarbanes-Oxley requirements and the OFHEO
    Special Exam (which began in 2003) had caused adjustments in
    the work done by the Audit Department. It made sense to me then
    that the Audit Department should be focused on those issues.
    Indeed, it was publicly reported that many American
    corporations were reevaluating resources and plans in light of
    the advent of Sarbanes-Oxley. In addition, at the time I
    believed that the Audit Committee and the CFO (which both had
    oversight responsibility for the Audit Department) were
    properly monitoring the Audit Department's needs and taking any
    appropriate steps, when needed, to provide additional resources
    to the Audit Department.

    Q.5. Did it not occur to you that to connect the compensation
    of the Auditing Dept with EPS was an obvious conflict of
    interest? What could the auditing department possibly do to
    help meet the EPS of $6.46?

    A.5. As I stated in my appearance before the committee, I agree
    that the Audit function is a very important function and a very
    important check that requires independence. It is critical that
    its compensation be independent of the company's financial
    results.
        As Fannie Mae Chairman, Steve Ashley, said during his
    testimony, ``during the 1990s and the early part of the decade
    of 2000 this was an accepted and indeed promulgated form of
    compensation in addition to base compensation that most of
    corporate America--publicly owned corporate America--engaged in
    one form or another. The purpose was to align the management of
    the company with the interests of the shareholders.''
        The EPS goal was announced broadly--publicly and
    internally--when it was launched in 1999, and it remained a
    corporate financial stretch goal through 2003. The incentive
    was available to all full-time employees. And as I noted in my
    appearance before the committee, this was a compensation
    structure similar to other companies that I had worked for
    previously and which I thought was appropriate in those
    circumstances.
        Fannie Mae has now adopted a new executive compensation
    structure with broad performance goals that include achieving
    affordable housing mission goals, improving our culture,
    complying with regulatory standards, and delivering shareholder
    value. In addition, Fannie Mae's Consent Order with OFHEO
    explicitly requires the board to ensure that our compensation
    practices ``include financial and nonfinancial metrics and
    shall not be tied exclusively to earning per share'' and that
    ``compensation metrics for the internal auditor, chief
    compliance officer, controller, and such others, as determined
    in consultation with OFHEO, be appropriate to their roles and
    do not create a conflict of interest.''
        To ensure proper oversight moving forward, the board and
    management have completely overhauled the internal audit
    function to ensure it is the corporate guardian it is supposed
    to be. The Chief Audit Executive is a new external hire who
    reports directly to the Audit Committee of the board of
    directors with a dotted line reporting to the CEO. This
    position has increased direct interactions with, and enhanced
    detailed reporting to, the board's Audit Committee and its
    chair (who is a new Fannie Mae board member, Dennis Beresford,
    a former chair of the Financial Accounting Standards Board).
    The Internal Audit function also has undergone a comprehensive
    organizational and process redesign, including new structure,
    staffing levels, skill assessments, audit planning processes,
    execution, and reporting. The company has also replaced its
    outside auditor with Deloitte and Touche, LLP, which formerly
    provided advice to OFHEO when several of the accounting
    problems were first identified and is now conducting a
    comprehensive re-audit of the entire company with more than 300
    auditors onsite at Fannie Mae.

    Q.6. Next, I would like to discuss your e-mail/memo regarding
    restricting Board access to management. In your e-mail which
    begins on the bottom of page 271 of the Report, you appear to
    infer that in restricting the Board's access to management
    (essentially giving CEO /Chairman Raines sole discretion in
    what is communicated to the Board) is a ``best in class''
    principle for corporate governance. Do you still believe that?

    A.6. The e-mail you ask about addressed unique circumstances
    specific to the employee who received it, our former SVP for
    Human Resources, Kathy Gallo. I did not intend this
    communication to limit employee access to the board or its
    committees in general.
        Here are the circumstances behind the e-mail. In 2003, Ms.
    Gallo told me she had received direction on specific issues
    from a board committee chair, Ann Mulcahy. When I discussed the
    matter with Ms. Mulcahy, she informed me that the Committee in
    fact had not provided any such direction to Ms. Gallo. At Ms.
    Mulcahy's direction, I sent Ms. Gallo an e-mail--addressed to
    her alone (with certain appropriate people copied)--directing
    her to use regular channels of communication with the board and
    its committees to ensure a clear record of board and committee
    decisions. This guidance to Ms. Gallo did not limit or affect
    any board member's ability to seek information from any Fannie
    Mae employee. As indicated by the limited distribution of the
    e-mail, I intended it solely to address the situation that
    arose concerning Ms. Gallo. In addition, the channel of
    communication (the Office of the Corporate Secretary)
    identified in the e-mail to Ms. Gallo did not give Mr. Raines
    sole discretion over the information communicated to the board.
        I believe in the principle that the board should have full
    and unfettered access to management and employees. Many of the
    organizational, structural and reporting changes Fannie Mae has
    made since I became CEO--within the company and with the board,
    and to fulfill our regulatory agreements and otherwise--are
    designed to ensure this access.

    Q.7. Hedge accounting is of great importance to Fannie Mae
    because of its large derivative portfolio used to hedge
    interest rate risk associated with its debt issuances. The SEC
    announced in December 2004 that Fannie Mae's hedge accounting
    policies and procedures did not comply with GAAP (FAS 133).
    Would you explain FAS 133, the differences between the short-
    cut and long-haul methods of hedge accounting and their
    implications, particularly the potential earnings volatility,
    and why Fannie Mae did not comply?

    A.7. Fannie Mae uses interest rate derivative instruments to
    manage and reduce the interest rate risk that, for all mortgage
    investors, is inherent in holding mortgage assets, particularly
    fixed-rate loans, which are our specialty. These derivatives,
    in essence, help us to match the duration of our liabilities
    (the debt we issue to purchase mortgages) with the duration of
    the mortgage assets we purchase.
        FAS 133, Accounting for Derivative Instruments and Hedging
    Activities requires that derivatives be carried on financial
    statements at fair value with changes in fair value (mark)
    included in earnings unless the company applies hedge
    accounting. Thus, without applying hedge accounting, the fair
    value mark on the derivative is included in earnings without an
    offsetting mark related to the hedge item.
        As I currently understand it, the so-called ``short-cut''
    method is a provision in FAS 133 that allows for an assumption
    that the gain or loss on the derivative instrument will exactly
    offset the gain or loss on the hedged item. This method
    significantly simplifies the computations necessary to make the
    accounting entries because it does not require the periodic
    calculation of how well changes in the fair value of the
    derivative mirror changes in the fair value of the hedged item.
    Thus, under the short-cut method, no amount of ineffectiveness
    is included in earnings during the life of the hedge
    relationship. Companies may only apply the short-cut method if
    the critical terms of the derivatives precisely match the
    critical terms of the hedged item.
        In contrast, the long-haul method requires quarterly
    calculations of the ``effectiveness'' of each hedging
    relationship. To the extent the change in fair value of the
    derivative is not offset by the change in the fair value of the
    hedged item, ``ineffectiveness'' results. Any amount of
    ineffectiveness is included in earnings in the period in which
    it occurs. As it has been explained to me, Fannie Mae applied
    the short-cut method to its hedging relationships under the
    belief that it had met the requirements of the standard. The
    SEC determined in December 2004 that this application of FAS
    133 was not appropriate.

    Q.8. Do you believe that Fannie Mae did not engage in innocuous
    practical interpretations or modest deviations from a strict
    reading of FAS 133, but the company clearly departed from FAS
    133 requirements?

    A.8. As it has been explained to me, Fannie Mae applied a
    short-cut method to its hedging relationships under the belief
    that it had met the requirements of the standard. The
    requirements of FAS 133 have challenged many companies,
    resulting in a large number of restatements. Prior to SEC
    pronouncements, the company believed that its interpretation of
    FAS 133 was reasonable. It has now been determined that these
    interpretations were not appropriate under the short-cut
    method.

    Q.9. Mr. Raines committed to double Fannie Mae's EPS in 5
    years. This strategy meant aggressively expanding the credit
    guarantee and portfolio investment business, with the latter
    offering the better prospect for growing earnings. Would you
    explain the interest rate risk taken and how the asset duration
    gap changed? Why should the board have recognized the
    inconsistency between reporting stable EPS growth and taking
    significant interest rate risk and implementing FAS 133
    properly?

    A.9. Interest rate risk is the risk of loss to future earnings
    or long-term value that may result from changes in interest
    rates. Fannie Mae's principal source of interest rate risk
    stems from holding mortgages that homeowners may prepay at any
    time without penalty. The so-called ``borrower's option'' is a
    fundamental underpinning of the U.S. system and is made
    possible by the GSEs' liquidity function. The cash-flows from
    mortgage assets are highly sensitive to changes in interest
    rates because of the borrower's option, exposing the company to
    interest rate risk because the cash-flows of mortgage assets
    and the liabilities that fund them are not perfectly matched
    through time and across all possible interest rate scenarios.
    As interest rates decrease, borrowers are more likely to
    refinance fixed-rate mortgages, resulting in increased
    prepayments and mortgage cash-flows that are received earlier
    than expected. Conversely, an increase in interest rates may
    result in slower than expected prepayments and mortgage cash-
    flows that are received later than expected.
        The company assesses exposure to changes in interest rates
    using a diverse set of analyses and measures, including the
    duration gap. The duration gap is the difference between the
    estimated durations of portfolio assets and liabilities.
    Duration gap summarizes the extent to which estimated cash-
    flows for assets and liabilities are matched, on average, over
    time and across interest rate scenarios. A positive duration
    gap signals a greater exposure to rising interest rates because
    it indicates that the duration of assets exceeds the duration
    of liabilities. A negative duration gap signals a greater
    exposure to declining interest rates because the duration of
    the company's assets is less than the duration of its
    liabilities. It should be noted that the duration gap reflects
    the mortgage portfolio at a point in time and not projected
    future business activity. Since October 2000, the company has
    publicly disclosed its duration gap on a monthly basis.
        Prior to 2003, the company maintained a preferred range for
    its duration gap of plus or minus 6 months. From 1992 to 2002,
    the company's duration gap was wider than plus or minus 6
    months approximately one-third of the time. The company's
    duration gap experienced a negative shift during 2002 primarily
    as a result of a significant decline in interest rates that
    resulted in a surge in mortgage refinancing activity. The
    significant increase in expected mortgage prepayments caused
    the durations of the company's mortgages to shorten by more
    than the duration of the company's debt. The company's duration
    gap peaked at minus 14 months in August 2002 before narrowing
    to minus 5 months by the end of the year. The reduction in the
    duration gap was accomplished primarily through portfolio
    rebalancing action taken by the company. For all of 2002, the
    company's duration gap was wider than plus or minus 6 months in
    3 months of the year, slightly less than the company's
    historical average of approximately one-third of the time.
        Beginning in 2003, the company has followed a risk
    discipline that requires a duration gap of plus or minus 6
    months substantially all of the time. To maintain the duration
    gap within this tighter risk tolerance, the company began
    taking rebalancing actions earlier and with more frequency than
    it previously had. The company's monthly duration gap has been
    within the range of plus or minus 6 months in every month since
    October 2002, and has been within a range of plus or minus 1
    month in every month since October 2004.
        Fannie Mae's financial results as measured under generally
    accepted accounting principles (GAAP) do not capture the full
    impact of changes in the fair value of our mortgage assets or
    our debt. Hence, changes in fair value of the mortgage assets
    or debt due to changes in interest rates are only recognized in
    earnings when realized through assets sales or debt
    repurchases. Conversely, GAAP requires derivatives to be
    measured at fair value with changes in fair value recorded
    through earnings unless a qualifying hedge accounting
    relationship has been established. As a result of this GAAP
    mismatch, without hedge accounting, even if the duration gap is
    managed to zero, earnings and EPS volatility will result from
    the changes in the fair value of derivatives. It is equally
    possible that a financial institution exposed to interest rate
    risk from a significant duration gap could expect little short-
    term GAAP earnings and EPS volatility because their derivatives
    have been appropriately designated in hedging relationships.

    Q.10. Fannie Mae buys derivative instruments that will offset
    the impact of interest rate movements on the company's debt
    obligations and thereby maintain its spread. The notional
    amount of their derivative portfolio passed the $1 trillion
    mark in 2003. Their menu of hedge transactions has increased to
    approximately 70 different combinations of debt and
    derivatives. Fannie Mae's debt is sold primarily to purchase
    mortgages and mortgage-backed securities (MBS) to hold in
    portfolio. What is your view of the risk and complexity
    involved in managing this retained portfolio? The retained
    portfolio is considerably more profitable than guaranteeing
    MBS. Is this an example of the earnings at any cost culture at
    the company? What, if any, correlation is there between the
    size of the portfolio and the company's achievement of its
    mission?

    A.10. Fannie Mae is one of many large U.S. financial
    institutions, including large federally insured commercial
    banks--that have and manage a retained portfolio of residential
    mortgages. Fannie Mae's portfolio holds only about 7 percent of
    the $10 trillion mortgage debt outstanding assets, and the
    retained portfolios of some of the largest banks are growing,
    with one beginning to rival the size of Fannie Mae's (Bank of
    America's is nearly $500 billion).
        All mortgage investors face similar risks and complexities
    of managing their mortgage portfolios. Fannie Mae differs from
    most other mortgage investors in two major ways. First, unlike
    most of these other mortgage investors, Fannie Mae invests
    exclusively in residential mortgages--among the safest assets
    in the world--which allows us to focus on managing their risks,
    making it less complex for us than managing the range of assets
    that others do. Second, Fannie Mae's ability to raise capital
    by issuing debt securities in various and variable durations
    gives us the ability to match our funding with the mortgages we
    purchase and hold, and thus better manage the risks
    effectively.
        Regardless of our profitability, Fannie Mae has managed a
    retained mortgage portfolio since our inception in 1938 for a
    critical reason: to achieve our chartered purpose of providing
    liquidity to the housing finance system by raising capital
    globally and domestically, and purchasing mortgage assets,
    providing lenders with a steady supply of funds, at favorable
    rates and terms, in all markets across the Nation under all
    economic conditions. Indeed, as a result of their charters, the
    GSEs are the only mortgage investors that are required to be in
    all markets at all times, even when banks and other investors
    pull away.
        The 70 different combinations of debt and derivatives cited
    in the question refers to the accounting classifications Fannie
    Mae had historically used in linking its derivatives to
    specific debt issues or anticipated debt issues. The types of
    derivatives used fall into only four classes: (1) interest rate
    swaps; (2) interest rate swaptions; (3) interest rate caps; and
    (4) foreign currency swaps. Interest rate swaps are among the
    most liquid derivative instruments in the market, and are used
    to manage the duration of the portfolio. Swaptions and caps are
    used to manage the prepayment or convexity risk of mortgages we
    own. The smallest group of derivatives we use are foreign
    currency hedges which basically swap all debt we issue
    denominated in foreign currency into U.S. dollars.
        It also should be noted that the mortgage portfolio is not
    always our most profitable business, nor is it ``considerably
    more profitable than guaranteeing MBS.'' Any of our businesses,
    like those in other institutions, may be more or less
    profitable at a given time.

    Q.11. The company claimed its hedges exactly matched its risk
    exposure in the portfolio when it did not. Critics focus on the
    extent of interest rate and prepayment risk, but shouldn't the
    risk involved in accounting for the derivatives and hedging be
    a major concern?

    A.11. Fannie Mae uses interest rate derivative instruments to
    adjust the duration of our debt to manage the interest rate
    exposures of our mortgage related assets. The reasons why we
    enter into derivatives--to allow us to manage our interest rate
    exposures--is unaffected by the accounting.
        As with any complex accounting standard, and particularly
    in the case of FAS 133, subjective judgments and
    interpretations are required that create risk that there could
    be differing interpretations. Many of the most complex
    interpretations of FAS 133 relate to hedge accounting. Given
    the challenges presented by the hedge accounting requirements,
    Fannie Mae is not currently applying hedge accounting.
        Fannie Mae's financial results as measured under generally
    accepted accounting principles (GAAP) do not capture the full
    impact of the changes in the fair value of our mortgage assets
    or our debt. Hence, changes in fair value of mortgage assets or
    debt due to changes in interest rates are only recognized in
    earnings when realized through assets sales or debt
    repurchases. Conversely, GAAP requires derivatives to be
    measured at fair value with changes in fair value recorded
    through earnings unless a qualifying hedge accounting
    relationship has been established. As a result of this GAAP
    mismatch, without hedge accounting, even if the duration gap is
    managed to zero, earnings and EPS volatility will result from
    the changes in the fair value of derivatives. It is equally
    possible that a financial institution exposed to interest rate
    risk from a significant duration gap could expect little short-
    term GAAP earnings and EPS volatility because their derivatives
    have been appropriately designated in hedging relationships.
    That said, our number-one corporate priority is to complete the
    restatement under this, and other accounting standards, and we
    are leaving no stone unturned to do the job right.

    Q.12. The controller's office lacked adequate staffing and
    systems, as well as sufficient accounting and financial
    reporting expertise for a company as complex as Fannie Mae. The
    Controller, at one time, was not a certified public accountant.
    What, if any, active support did this office receive from
    senior management, especially following the company's voluntary
    SEC registration and what steps has current management taken?

    A.12. Overall, the company has established a new management
    team, particularly in the critical control functions, including
    finance, accounting, audit, and risk to provide the leadership,
    experience, talent, and ethical standards necessary for a
    company with the scope of Fannie Mae. In cooperation and
    consultation with our regulator, we are fundamentally
    reorganizing the company to ensure that strong checks and
    balances are in place. The standard the company has put forth
    during the transformation in this regard is straightforward--
    the average businessperson should be able to look at the
    organization chart and understand key roles and
    responsibilities and identify clear checks and balances.
        The company has a new Chief Financial Officer, a new Chief
    Risk Officer, a new Chief Audit Executive, a new Senior Vice
    President for Accounting Policy, and a new Controller. As part
    of the Controller's department, we have bolstered the staffing
    considerably with 17 officers working in this area compared to
    five previously. Accounting policy, accounting application and
    budgeting are all separate now, with each group headed by new
    senior leadership from Big Four accounting firms or major
    corporations and eight of the staff, including the Controller
    himself, are certified public accountants.
        The company has taken other concrete steps in this regard:

        The CFO, Robert Blakely, who headed up the
            restatement at MCI, does not run a business--he is
            focused solely on Finance.
        To ensure proper oversight, we have reorganized and
            strengthened Internal Audit, and the new Chief Audit
            Executive has a direct and independent reporting line
            to the board's Audit Committee. The board's Audit
            Committee is now chaired by Dennis Beresford, a former
            member of FASB who joined the board this year.
        The company has replaced its outside auditor with
            Deloitte and Touche, which formerly provided advice to
            OFHEO when several of the accounting problems were
            first identified and is now conducting a comprehensive
            re-audit of the entire company with more than 300
            auditors onsite at Fannie Mae.
        To integrate strong risk management into the
            accounting, controls, and audit areas and throughout
            the entire enterprise, the company has put in a place a
            strong risk management function headed by Chief Risk
            Officer Enrico Dallavecchia. Mr. Dallavecchia had been
            with JP Morgan Chase as head of market risk management,
            and he comes to the company with almost 20 years of
            experience in banking and risk management.
        As part of the company's restatement and
            remediation efforts, Fannie Mae has invested hundreds
            of millions of dollars in new systems to ensure that
            the company's technologies in this area will meet high
            standards, ensure proper controls, and fully support
            the accurate and transparent financial reporting
            required of an SEC registrant.

    Q.13. The head of internal audit did not have training or
    experience as an auditor. Internal audit had to clear
    communications with the board's audit committee through senior
    management and told the committee that Fannie Mae's accounting
    complied with GAAP, when it actually audited only for
    compliance with the company's policies interpreting GAAP. What
    steps have been taken to reorganize the internal audit
    function?

    A.13. Management and the board's Audit Committee appointed a
    new Chief Audit Executive, Jean Hinrichs, from outside the
    company who reports directly to the Audit Committee with a
    dotted line to the CEO. The Chief Audit Executive has over 25
    years of internal audit and risk management experience. She has
    increased direct interactions with the board's Audit Committee
    and its chairman, and enhanced detailed reporting to the
    committee monthly. The Internal Audit function has implemented
    a comprehensive organizational and process redesign, including
    a new structure, staffing levels, skill assessments, audit
    planning processes, execution, and reporting.
        As part of the organizational restructure, the Internal
    Audit department has three new vice presidents who have an
    average of 23 years of experience in audit and risk management
    with top-tier financial institutions and public accounting
    firms. As a result of targeted recruiting and training, the
    Internal Audit department has 20 certified public accountants
    and 70 percent of the department has an auditing, accounting or
    technology professional certification.

    Q.14. Fannie Mae voluntarily registered its stock with the SEC;
    as a result, the enterprise was required to comply with
    Sarbanes-Oxley, effective in 2004. The OFHEO Report states:
    ``Although the Office of Auditing lacked the requisite
    knowledge, skills, and resources, Fannie Mae delegated to the
    Office the responsibility of building and maintaining the SOX
    404 compliance system.'' This addition to existing duties was
    ``overwhelming.'' How has this affected the company's SOX
    compliance?

    A.14. The Internal Audit department had project oversight for
    the company's efforts to develop and assess internal control
    over financial reporting in 2004 pursuant to Section 404 of the
    Sarbanes-Oxley Act and related rules of the SEC. The department
    coordinated with KPMG, the company's independent auditor at the
    time. Upon announcement of the restatement and senior
    management changes, the company engaged PricewaterhouseCoopers
    LLP (PwC) to assist with SOX 404 compliance efforts. The
    company also engaged Deloitte and Touche LLP as its new
    independent auditor.
        With the assistance of PwC, we have been assessing the
    effectiveness of our internal control over financial reporting
    that existed as of December 31, 2004, and as of December 31,
    2005. To date, we have identified control deficiencies in a
    number of areas, including: financial systems and other
    information technology systems; entity-level controls relating
    to risk oversight, staffing and expertise of the internal audit
    and accounting departments, and documentation of policies and
    procedures; design and application of accounting policies; the
    valuation of our assets and liabilities; and financial
    reporting processes. We expect to conclude that many of these
    identified deficiencies are either material weaknesses or
    significant deficiencies that in the aggregate constitute
    material weaknesses. We also may uncover additional
    deficiencies as this assessment process continues.
        Management has taken a number of steps since December 2004
    to address control deficiencies, including completely
    reorganizing the company's finance area and hiring a new Chief
    Financial Officer, a new Controller, a new Chief Audit
    Executive and several other new accounting officers,
    reorganizing the company's risk management and corporate
    compliance functions and appointing a new Chief Risk Officer
    and a new Chief Compliance and Ethics Officer.
        Our report on internal control over financial reporting in
    our Annual Report on Form 10-K for both 2004 and 2005 will
    conclude that our internal control over fmancia1 reporting was
    ineffective due to the presence of material weaknesses. Our
    reports for 2004 and 2005 will identify material weaknesses and
    address our plans for remediation. We believe that Deloitte and
    Touche will not be able to issue opinions on the effectiveness
    of our internal control over financial reporting as of December
    31, 2004, or on management's assessment of the effectiveness of
    our internal control over financial reporting as of December
    31, 2004, but will be able to issue these opinions in
    connection with our internal control over financial reporting
    as of December 31, 2005.

    Q.15. It is my understanding that the size and aggressiveness
    of the company's lobbying and grass roots activities have been
    substantially reduced. Can you give me more specifics about in-
    house and external activities in terms of personnel, costs, and
    approach?

    A.15. Management and the board have made establishing a new
    tone, manner, and approach in the way we communicate with
    policymakers a top corporate priority. Specific actions taken
    include:

        The company discontinued retainers with six outside
            lobbying firms since the end of 2004, though
            contractual obligations required additional retainer
            payments to some firms in the first quarter of 2005.
        The company discontinued all advocacy advertising.
        The total operating expenses for the internal
            Government and Industry Relations Department decreased
            by 21 percent from 2004 to 2005.
        Fannie Mae continues to reduce its external
            lobbying costs, and remains committed to its overall
            objective of cutting external lobbying retainers by
            one-third from previous levels.
        The company discontinued its regional public
            affairs director positions, and has restructured its
            Community Business Centers to focus on supporting local
            business objectives.