THE OFHEO REPORT:

ALLEGATIONS OF ACCOUNTING AND

MANAGEMENT FAILURE AT FANNIE MAE

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

OCTOBER 6, 2004

Printed for the use of the Committee on Financial Services

Serial No. 108–115

(

THE OFHEO REPORT: ALLEGATIONS OF ACCOUNTING AND MANAGEMENT FAILURE AT

FANNIE MAE

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97–754 PDF 2004

THE OFHEO REPORT:

ALLEGATIONS OF ACCOUNTING AND

MANAGEMENT FAILURE AT FANNIE MAE

HEARING

BEFORE THE

SUBCOMMITTEE ON 

CAPITAL MARKETS, INSURANCE AND 

GOVERNMENT SPONSORED ENTERPRISES

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

SECOND SESSION

OCTOBER 6, 2004

Printed for the use of the Committee on Financial Services

Serial No. 108–115

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES 

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa 

RICHARD H. BAKER, Louisiana 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

ROBERT W. NEY, Ohio 

SUE W. KELLY, New York, Vice Chair 

RON PAUL, Texas 

PAUL E. GILLMOR, Ohio 

JIM RYUN, Kansas 

STEVEN C. LATOURETTE, Ohio 

DONALD A. MANZULLO, Illinois 

WALTER B. JONES, JR., North Carolina 

DOUG OSE, California 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

PATRICK J. TOOMEY, Pennsylvania 

CHRISTOPHER SHAYS, Connecticut 

JOHN B. SHADEGG, Arizona 

VITO FOSSELLA, New York 

GARY G. MILLER, California 

MELISSA A. HART, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

PATRICK J. TIBERI, Ohio 

MARK R. KENNEDY, Minnesota 

TOM FEENEY, Florida 

JEB HENSARLING, Texas 

SCOTT GARRETT, New Jersey 

TIM MURPHY, Pennsylvania 

GINNY BROWN-WAITE, Florida 

J. GRESHAM BARRETT, South Carolina 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

JIM GERLACH, Pennsylvania 

BARNEY FRANK, Massachusetts 

PAUL E. KANJORSKI, Pennsylvania 

MAXINE WATERS, California 

CAROLYN B. MALONEY, New York 

LUIS V. GUTIERREZ, Illinois 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

JULIA CARSON, Indiana 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

BARBARA LEE, California 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

WM. LACY CLAY, Missouri 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

ARTUR DAVIS, Alabama 

CHRIS BELL, Texas 

BERNARD SANDERS, Vermont

Robert U. Foster, III, Staff Director 

(III)

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE AND GOVERNMENT SPONSORED

ENTERPRISES

RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman 

CHRISTOPHER SHAYS, Connecticut 

PAUL E. GILLMOR, Ohio 

SPENCER BACHUS, Alabama 

MICHAEL N. CASTLE, Delaware 

PETER T. KING, New York 

FRANK D. LUCAS, Oklahoma 

EDWARD R. ROYCE, California 

DONALD A. MANZULLO, Illinois 

SUE W. KELLY, New York 

ROBERT W. NEY, Ohio 

JOHN B. SHADEGG, Arizona 

JIM RYUN, Kansas 

VITO FOSSELLA, New York, 

JUDY BIGGERT, Illinois 

MARK GREEN, Wisconsin 

GARY G. MILLER, California 

PATRICK J. TOOMEY, Pennsylvania 

SHELLEY MOORE CAPITO, West Virginia 

MELISSA A. HART, Pennsylvania 

MARK R. KENNEDY, Minnesota 

PATRICK J. TIBERI, Ohio 

GINNY BROWN-WAITE, Florida 

KATHERINE HARRIS, Florida 

RICK RENZI, Arizona 

PAUL E. KANJORSKI, Pennsylvania 

GARY L. ACKERMAN, New York 

DARLENE HOOLEY, Oregon 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

JAY INSLEE, Washington 

DENNIS MOORE, Kansas 

MICHAEL E. CAPUANO, Massachusetts 

HAROLD E. FORD, JR., Tennessee 

RUBE ́ N HINOJOSA, Texas 

KEN LUCAS, Kentucky 

JOSEPH CROWLEY, New York 

STEVE ISRAEL, New York 

MIKE ROSS, Arkansas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

JOE BACA, California 

JIM MATHESON, Utah 

STEPHEN F. LYNCH, Massachusetts 

BRAD MILLER, North Carolina 

RAHM EMANUEL, Illinois 

DAVID SCOTT, Georgia 

NYDIA M. VELA ́ ZQUEZ, New York 

(V)

C O N T E N T S 

Page 

Hearing held on: 

October 6, 2004 ................................................................................................. 1

Appendix: 

October 6, 2004 ................................................................................................. 145

WITNESSES 

WEDNESDAY, OCTOBER 6, 2004

Falcon, Hon. Armando, Director, Office of Federal Housing Enterprise Oversight, accompanied by Wanda Deleo, Chief Accountant, and Christopher 

Dickerson, Chief Compliance Examiner, Office of Federal Housing Enterprise Oversight ..................................................................................................... 22

Howard, Timothy, Vice Chairman and Chief Financial Officer, Fannie Mae .... 76

Korologos, Hon. Ann McLaughlin, Presiding Director, Board of Directors, 

Fannie Mae ........................................................................................................... 128

Raines, Franklin D., Chairman and Chief Executive Officer, Fannie Mae ........ 73

APPENDIX 

Prepared statements: 

Baker, Hon. Richard H. ................................................................................... 146

Oxley, Hon. Michael G. .................................................................................... 148

Castle, Hon. Michael N. ................................................................................... 150

Clay, Hon. Wm. Lacy ....................................................................................... 151

Ford, Hon. Harold E. Jr. .................................................................................. 152

Gillmor, Hon. Paul E. ....................................................................................... 154

Kanjorski, Hon. Paul E. ................................................................................... 156

Miller, Hon. Gary G. ........................................................................................ 158

Falcon, Hon. Armando ..................................................................................... 160

Howard, Timothy .............................................................................................. 169

Korologos, Hon. Ann McLaughlin ................................................................... 171

Raines, Franklin D. .......................................................................................... 176

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Baker, Hon. Richard H.: 

Letter to OFHEO Director Armando Falcon, Jr. with response, November 

4, 2003 ............................................................................................................ 183

Castle, Hon. Michael N.: 

Letter to Financial Accounting Standards Board, October 5, 2004 .............. 188

Frank, Hon. Barney: 

‘‘De ́ja` Vu All Over Again, Thoughts on OFHEO’s Special Examination 

of FNM’’ ......................................................................................................... 190

Barnes, Roger, former Manager of Financial Accounting, Fannie Mae, prepared statement ................................................................................................... 197

Falcon, Hon. Armando: 

Report of Findings to Date, Special Examination of Fannie Mae ................ 223

Written response to Members questions posed during the hearing ............. 434

Korologos, Hon. Ann McLaughlin: 

Fannie Mae Board of Directors Work Plan in Response to OFHEO Report 

on Special Examination ................................................................................ 443

Raines, Franklin D.: 

Core and GAAP Earnings Per Share .............................................................. 447

(1)

THE OFHEO REPORT: 

ALLEGATIONS OF ACCOUNTING AND 

MANAGEMENT FAILURE AT FANNIE MAE 

Wednesday, October 6, 2004

U.S. HOUSE OF REPRESENTATIVES, 

SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, 

AND GOVERNMENT SPONSORED ENTERPRISES, 

COMMITTEE ON FINANCIAL SERVICES, 

Washington, D.C. 

The subcommittee met, pursuant to call, at 10:03 a.m., in Room 

2128, Rayburn House Office Building, Hon. Richard H. Baker 

[chairman of the subcommittee] presiding. 

Present: Representatives Baker, Ose, Shays, Gillmor, Bachus, 

Castle, Lucas of Oklahoma, Royce, Manzullo, Kelly, Ney, Fossella, 

Biggert, Miller of California, Toomey, Capito, Hart, Kennedy, 

Tiberi, Brown-Waite, Kanjorski, Sherman, Meeks, Inslee, Capuano, 

Ford, Hinojosa, Lucas of Kentucky, Crowley, Clay, McCarthy, Baca, 

Matheson, Lynch, Miller of North Carolina, Scott, and Velazquez. 

Also present: Representatives Oxley (ex officio), Frank (ex officio), Watt, Waters, Davis of Alabama, Maloney, and Brown of Florida. 

Chairman BAKER. [Presiding.] I would like to call this meeting 

of the Capital Markets Subcommittee to order. 

The Capital Markets Subcommittee meets today for the purpose 

of receipt of a report from the Office of Federal Housing Enterprise 

Oversight. 

It is indeed a very troubling report, but it is a report of extraordinary importance not only to those who wish to own a home, but 

also as to the taxpayers of this country who would pay the cost of 

the cleanup of an enterprise failure. 

Although not intended to fuel the effort to bring about regulatory 

reform, the analysis makes clear that more resources must be 

brought to bear to ensure the highest standards of conduct are not 

only required, but more importantly, they are actually met. 

For the record, I am not pleased and certainly not happy about 

these revelations. I am saddened by the disclosures. In all my years 

of inquiry in this matter, I was only in pursuit of appropriate oversight. Never did I question whether the GSEs were professionally 

managed to the highest standards of business conduct. Now I do. 

The culture of mismanagement described in the report must be 

eliminated and assurances gained that the highest standards of 

conduct will be consistently practiced. 

2

I know there will be those who will still cling to the belief that 

the issues raised are minor or that opinions may differ on technical 

accounting standards. Some may still think this is all a plot by the 

big banks to preserve market share. The content of this report, in 

my view, cannot be legitimately questioned. Utilizing the firm of 

Deloitte & Touche and the staff of OFHEO, the director’s report is 

delivered after review of over 200,000 documents and e-mails, as 

well as hundreds of interviews and depositions of current and 

former staff of Fannie Mae. 

The statement made in the first page of the executive summary 

unfortunately sums up our circumstance: ‘‘The matters detailed in 

this report are serious and raise concerns regarding the validity of 

previously reported financial results, the adequacy of regulatory 

capital, the quality of managerial supervision and the overall safety 

and soundness of the enterprise.’’ This finding, in my judgment, 

makes committee action essential. 

For the record, I should also note that the resistance the GSEs 

have expressed toward enhanced housing goals. In light of these 

revelations, their opposition now makes more sense than ever. 

Should the proposals considered in this committee focus clearly on 

the needs of first-time homebuyers actually become law, the enterprises would have to allocate resources to those goals at the expense of reduced earnings. 

A reduction in earnings would reduce the likelihood of paying out 

bonuses to executives. This same observation holds true as to the 

regulator’s decision to increase capital, and Fannie’s strong objections to such a requirement. We all know that the enterprise is 

thinly capitalized, but the potential effect of requiring a responsible 

capital level would adversely affect earnings per share, and consequently affect the bonus payments to executives. 

I also wish to inform members of the committee of another troubling incident, which I now choose to make public. About a year 

ago, I corresponded with the director’s office making inquiry about 

the levels of executive compensation at the enterprise for the top 

20 executives. This is information that had not been made public 

previously. 

In a matter of days, Fannie Mae had engaged the services of Mr. 

Ken Starr, legal counsel, for the purpose of informing my staff and 

committee council of the potential consequences of making that information public. It was made clear that civil legal actions would 

be filed, I presume against me, if the information were to be released. 

At that time, I made the decision not to release the data since 

there was no clear relevance to the reform effort under way, not 

out of concern for any litigation that might be filed. The realization 

that the disclosure of this information was so sensitive to the enterprise never really fully impacted me until I read the director’s report. Now I understand why the enterprise was so anxious not to 

have public disclosure of compensation, ironically of an entity that 

was created by the Congress and supported by the taxpayer. 

Circumstances have now changed. As a direct result of the abhorrent accounting practices, executives have been able to award 

themselves bonuses I do not believe they earned and I do not beVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
3

lieve they deserve. For that reason alone, disclosure of where the 

money went is highly appropriate. 

At the conclusion of this hearing, I will release the compensation 

information obtained from OFHEO and further, I will forward a 

letter to the director requesting that all compensation information 

for both enterprises be provided to the committee for a period covering 10 years for all executives that shared in any bonus distributions. This is now essential, in that OFHEO has indicated that accounting manipulation has impacted the financials on more than 

one occasion, therefore placing the payment of bonuses in question. 

I find this very troublesome business. Much is at stake. The ability of this committee and this Congress to act will be called into 

question. Notwithstanding the ultimate outcome, the facts will remain and our duty will never be more clear. 

Mr. Kanjorski? 

[The prepared statement of Hon. Richard H. Baker can be found 

on page 146 in the appendix.] 

Mr. KANJORSKI. Mr. Chairman, we meet today for what might 

well be our last hearing this year. At our first hearing in 2004, we 

reviewed the special examination of Freddie Mac by the Office of 

Federal Housing Enterprise Oversight. It therefore seems fitting 

that we will bookend our hearings this year with an evaluation of 

the findings to date of a similar examination of Fannie Mae’s accounting policies and practices. 

The recently released preliminary report by the Office of Federal 

Housing Enterprise Oversight includes a number of significant 

charges. The report concludes that Fannie Mae has failed to follow 

generally accepted accounting practices in two key areas. They are 

the accounting of derivatives contracts and the amortization of discounts, premiums and fees involved in the purchase of home mortgages. 

The report also raises concerns about the company’s organizational structure and its internal controls. These are serious matters 

that merit our careful attention because government-sponsored enterprises with their public responsibilities and private capital have, 

in my view, a special obligation to operate fairly, safely and soundly. 

As we proceed today, I must urge my colleagues on both sides of 

the aisle to demonstrate patience and caution when approaching 

these matters. We should not leap to immediate conclusions. The 

report on Fannie Mae is preliminary. It is part of an ongoing process. 

We should not overanalyze these findings because we do not have 

all of the information. Fannie Mae’s board, as I understand, has already agreed to adopt a number of reforms based on this initial report and it may ultimately implement more. The Office of Federal 

Housing Enterprise Oversight continues to examine the company’s 

books. The Securities and Exchange Commission, the arbiter of accounting standards for Fannie Mae, is now studying these matters. 

In short, we need to let this process work itself out. 

We should also refrain from hyping these initial findings in an 

effort to achieve some short-term gain. As we well know from past 

experiences, our actions and statements on Capitol Hill have the 

potential to rile the capital markets. They could also raise the price 

4

of homeownership. We should therefore practice caution, prudence 

and discretion. 

My primary focus at today’s hearing will be to determine whether the issues raised in the preliminary report constitute some form 

of systemic risk for Fannie Mae. I therefore intend to ask each of 

the witnesses their perceptions regarding this issue. I expect them 

each to offer me their candid assessments of these matters. 

As we proceed today, I also suspect that some of my colleagues 

will return to the question of how best to modify the regulation of 

government-sponsored enterprises like Fannie Mae and Freddie 

Mac. As I said at our very first hearing on the oversight of government-sponsored enterprises in March 2000, ‘‘We need to have 

strong, independent regulators that have the resources they need 

to get the job done.’’ I can assure everyone involved in these debates that I continue to support strong, world-class and independent GSE regulation. 

A strong world-class and independent regulator will protect the 

continued viability of our capital markets and promote confidence 

in Fannie Mae and Freddie Mac. It will also ensure taxpayers 

against systemic risk and expand housing opportunities for all 

Americans. 

Like many of my colleagues, I was greatly disappointed last year 

when the Bush administration rejected our bipartisan efforts to 

create an independent regulator. Politics, in my view, should play 

no role in financial regulation. It is therefore my hope that when 

we revisit this issue in the 109th Congress, we will continue to remain resolute and unwavering in our bipartisan efforts to create a 

strong, independent and world-class regulator with the powers and 

resources it needs to get the job done. 

In closing, Mr. Chairman, I commend you for your sustained 

leadership in these matters and for convening this timely hearing. 

The preliminary report by the Office of Federal Housing Enterprise 

Oversight and its agreement with Fannie Mae deserve careful review and public scrutiny. I consequently look forward to hearing 

from our witnesses today. 

[The prepared statement of Hon. Paul E. Kanjorski can be found 

on page 156 in the appendix.] 

Chairman BAKER. I thank the gentleman for his statement. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Chairman Baker, for holding this hearing 

on the recently released report from OFHEO’s special examination 

of Fannie Mae. You have followed these issues closely and should 

be commended for your diligent oversight of the GSEs. It is my 

hope that this hearing will highlight the concerns raised in the 

OFHEO report and will help members get to the bottom of the accounting and corporate governance issues at Fannie Mae. 

It is unfortunate that we are here today. After earnings smoothing at Freddie Mac was discovered, the public and the markets, 

and the members of the committee were assured that there were 

no similar issues at Fannie Mae. The findings in OFHEO’s report, 

if accurate, are disturbing. 

While we wait for OFHEO, and the Justice Department and the 

Securities and Exchange Commission to complete their respective 

tasks, the management and board of directors at Fannie Mae must 

5

take real steps to address the issues and continue to cooperate with 

regulators. The agreement between Fannie Mae and OFHEO is a 

beginning of that process, but I seriously doubt it can be the end. 

Since the enactment of Sarbanes-Oxley 2 years ago, corporate financial statements have become more transparent and more reliable. There is no question in my mind that the act is at least partially responsible for this progress. The CEO and CFO certifications of financial statements have had a profound impact on the 

reporting process. 

Other provisions are working, too, such as the Public Company 

Accounting Oversight Board’s inspections regime, strengthened and 

independent audit committees, officer and director bars, the Fair 

Funds, expedited disclosures of insider transactions, and internal 

control requirements, to name just a few. That is not to say that 

we can legislate integrity in every case, but we do have a sensible 

framework of incentives and disincentives that will affect behavior. 

The OFHEO report raises serious questions about whether 

Fannie Mae has adequate internal control procedures, ultimately 

one of the core aspects of Sarbanes-Oxley. The multiple and conflicting duties of the chief financial officer, who we will hear from 

this morning, calls into question whether there is adequate separation between the risk-taking and control functions. 

In my view, section 404 is one of the most important parts of the 

Sarbanes-Oxley Act. Internal control over financial reporting consists of company policies and procedures that are designed to provide reasonable assurance about the reliability of a company’s financial reporting and the preparation of external financial statements in accordance with generally accepted accounting principles. 

Failure to comply with its requirements is not an insignificant matter. I am eager to hear from the company’s senior management officials on their adherence to this critical provision. 

Fannie Mae enjoys certain advantages in the marketplace not afforded to other financial companies in order to serve a public purpose. We have recently learned that the corporate structure may 

have fostered an atmosphere in which senior management may 

have had undue influence over accounting policies and procedures, 

and that corporate earnings and management compensation may 

have been manipulated. 

OFHEO has worked hard in conducting reviews of the GSEs. Director Falcon and his staff have been diligent in trying to ensure 

that the GSEs receive the appropriate oversight. The findings of 

this report, if correct, reinforce arguments for the creation of a GSE 

regulator with the powers and authorities granted to other financial regulators and commensurate with the task of overseeing these 

large and complicated companies. 

I was dismayed to learn that OFHEO was forced to resort to 

issuing subpoenas this past July in order to obtain cooperation 

with its investigation. It is my sense that if OFHEO had the tools 

possessed by other regulators, this investigation would not have 

reached the subpoena stage. If we had a GSE regulator with the 

powers and authority of a world-class regulator, it is possible that 

these problems at Fannie Mae would have been remedied earlier 

and today’s hearing would not be necessary. 

6

The OFHEO report details problems ranging from possible earnings manipulation to management structures that may not have 

been in line with state-of-the-art corporate governance. I am very 

concerned about the possibility that Fannie Mae claims to have 

sound corporate governance standards, when in reality these standards are not in practice. 

Fannie Mae’s board did the right thing in entering into an agreement with OFHEO and beginning the process of remedying the 

problems highlighted in the report. The OFHEO report is not finished and it is my hope that Fannie Mae will cooperate with this 

investigation as well as the other investigations currently under 

way at the Securities and Exchange Commission and the Department of Justice. Furthermore, I hope that this situation does not 

develop into a war among accountants arguing technical points 

that do not put to rest the issues raised in the OFHEO report. We 

owe it to the housing market and to the financial markets to quickly resolve all of the accounting and governance uncertainties. 

I want to welcome all the witnesses appearing before the subcommittee today. I look forward to your testimony. 

I yield back. 

[The prepared statement of Hon. Michael G. Oxley can be found 

on page 148 in the appendix.] 

Chairman BAKER. Thank you, Mr. Chairman, for your interest 

and leadership in this matter. 

Ranking Member Frank? 

Mr. FRANK. Thank you, Mr. Chairman. 

First, I want to address a little history here. The committee here 

was well on the way to adopting legislation that would have enhanced the regulatory structure for Fannie Mae and Freddie Mac. 

In the Senate, in fact, the committee actually voted out a bill. 

There was some disagreement between the parties over I think a 

relatively minor section over receivership. I think that could have 

been worked out. 

I believe we were well on the way, the chairman and I and the 

staffs, to putting together a bill that would have enhanced the regulator and could have passed. What stopped progress on a new bill 

was the Bush administration’s determination to go beyond safety 

and soundness and into provisions that would have restricted the 

housing function. 

What is powerful here are not Fannie Mae and Freddie Mac, but 

the interests of a majority of the members of this committee in 

housing at two levels. First of all, in housing in the conventional 

market, is very important, and the continuance of Fannie Mae and 

Freddie Mac are important to that. We also have a subset of issues 

involving affordable housing, and those are very important to many 

of us. 

What derailed the legislation was an insistence by the Bush administration on going beyond safety and soundness and giving the 

regulators, for example, particular power to say, well, they are 

going beyond their charter in housing; they should not do these 

new products. There were specific issues here that transcended 

safety and soundness or went under it, but the administration was 

seeking powers that were not related to safety and soundness. 

7

If they were to have dropped that, we would have a law already 

signed and in place, because on the question of safety and soundness regulation, there has not been a significant dispute. 

I will give you an example of what concerns me in this regard. 

Many of us on this committee, contrary to what some people think, 

were very aggressive in pushing Fannie Mae to stay in the manufactured housing business in full fight when they were talking 

about retrenching, and that was bipartisan—the gentleman from 

Wisconsin, Mr. Green, myself and others, because you will not get 

the kind of homeownership we want at the right demographic. 

As to safety and soundness, manufactured housing is an example. I do not expect Fannie Mae and Freddie Mac to make as much 

money as possible on every single entity. The attitude of OFHEO 

towards manufactured housing is an example of why I am concerned about making sure the regulator has safety and soundness 

powers, but not general powers. In manufactured housing, it was 

those of us on this committee, Democratic and Republican who care 

about housing who pushed Fannie Mae to stay in it. 

When I wrote to the secretary of HUD to ask him to join us, the 

answer was, several members did, he was much too busy for that, 

his scheduler told us, and we could go talk to the head of FHA. So 

that is the issue. 

Finally, turning to this report, I have to say that I read the director’s testimony and I will talk to him about it again, I regret what 

seems to me frankly almost boilerplate in his report that says at 

the end of every specific, and this could raise safety and soundness 

issues. It could, but nothing in here seems to me that it does. 

To the extent that people played games to get bonuses, I am outraged. People making that much money, let me put it this way, at 

the level of compensation of the top officers of Fannie Mae, they 

should get bonuses if they rush into a burning building to rescue 

a kid, maybe a cat, but not for doing their job. I think it is unseemly of them to be getting bonuses in the first place for doing 

what they are getting paid very well to do. 

To the extent that there was manipulation, that is very wrong 

and should be penalized. But I have seen nothing in here that suggests that the safety and soundness are at issue, and I think it 

serves us badly to raise safety and soundness as a kind of a general shibboleth, when it does not seem to be the issue. 

Last point, and Fannie and Freddie are to some extent criticized 

from both ends. There was an article by Gretchen Morgenson in 

the New York Times on Sunday that said the problem is that they 

have done too much to bring housing to people who really cannot 

afford it and should not be given this chance to own the housing. 

Her article said the problem here has been they have overextended 

by lending money to people who were below the economic level that 

should be there. 

On the other hand, they are criticized by the chairman of this 

subcommittee for not doing enough for lower-income people. Both 

obviously cannot be right. I think what we need to do is to go forward as we were ready to do with a tougher safety and soundness 

regulator, but in ways that do not impinge on Fannie’s and 

Freddie’s ability to do a better job than they have been doing with 

8

affordable housing and to continue to do the job they have been 

doing with regard to housing in general. 

Chairman BAKER. Mr. Shays? 

Mr. SHAYS. Thank you. 

I am new to this committee and I was absolutely shocked when 

we looked at Enron and WorldCom. The board of directors did not 

do their job. The management did not do its job. The employees did 

not speak out. The lawyers in the firm were facilitators. The rating 

agencies did not do their job. It scared the hell out of me, frankly. 

We passed Sarbanes-Oxley, which was a very tough response to 

that. And then I realized that Fannie Mae and Freddie Mac would 

not even come under it. They were not under the 1934 Act. They 

were not under the 1933 Act. They play by their own rules, and 

I am tempted to ask how many people in this room are on the payroll of Fannie Mae, because what they do is they basically hire 

every lobbyist they can possibly hire. They hire some people to 

lobby and they hire some people not to lobby so that the opposition 

cannot hire them. 

Fannie Mae has manipulated, in my judgment, OFHEO for 

years. For OFHEO to finally come out with a report as strong as 

it is tells me that has got to be the minimum, not the maximum. 

I congratulate OFHEO for finally stepping up to the plate and not 

being manipulated by the very organization they are supposed to 

regulate. 

I hear these arguments that Fannie Mae and Freddie Mac are 

looking out for the interests of the homeowners, and they score 

worse in helping minorities than the private sector banks under 

the 1934 Act and the 1933 Act. 

Fannie Mae and Freddie Mac are very generous to members of 

Congress and very generous to the organizations of caucuses in 

Congress. They do not have to disclose what they do. They do not 

have to play by the same rules. They are going to crash if this Congress does not wake up and do something about it. 

I am absolutely shocked at the extraordinary tolerance that has 

taken place in this Congress. This is just the beginning of the 

story. What did OFHEO say? They said they have accounting 

methods and practices that did not comply with generally accepted 

accounting practices, employed an improper cookie jar reserve in 

its accounting system, deferred expenses to meet compensation targets, did not have proper corporate governance controls in place. 

We need to wake up and the sooner we do the better it will be 

for Fannie Mae and Freddie Mac and all their investors, and the 

better it will be for our government. 

Chairman BAKER. The gentleman yields back. 

Mr. Scott? 

Mr. SCOTT. Thank you very much, Mr. Chairman. 

This is indeed an important hearing. I am very much concerned 

about the direction that Fannie Mae is moving in. Fannie Mae does 

an extraordinarily important function in our society, unique among 

companies in terms of being a catalyst to increase homeownership 

among middle-income and lower-income individuals. So this is a 

very important hearing. 

Last year, Freddie Mac, another corporation with similar duties, 

had one of the largest corporate financial restatement of earnings 

9

and saw the ouster of its top executives. Fannie Mae representatives assured us then, on this subcommittee, that their books were 

clean and that they should not be associated with Freddie Mac’s 

problems. 

Now, we are meeting to discuss OFHEO’s report, which shows 

that Fannie Mae inappropriately reduced earnings volatility and 

provided management with the flexibility to determine the amount 

of income and expense recognized in any accounting period. In 

1998, the management at Fannie Mae needed an earnings-pershare target of $3.23 in order to receive the maximum bonus for 

the company. Due to the accounting schemes used by Fannie Mae, 

the executives just hit the earnings-per-share mark and they 

earned bonuses totaling nearly $6 million. 

I think the general issue before the public and people all across 

this country is simply, has the time come to decide if companies 

that violate public trust should continue to receive special treatment. I think the fundamental question here is, why the Fannie 

Mae board believed it was appropriate to link executive pay to 

earnings per share, and whether this compensation scheme resulted in inappropriate incentives for management. 

Whether or not the reasons that the company altered earnings 

was to achieve bonuses is not yet known. The report is there and 

we have these hearings to get to the bottom of it. I submit to you 

that we must get to the bottom of it so that we can give Fannie 

Mae a clean bill of health. The Department of Justice has opened 

up a criminal investigation into the allegations of the report, and 

that investigation may clear up the intent. 

Congress should carefully review the OFHEO report because the 

special examination is continuing and ongoing. Questions have also 

been raised about OFHEO’s ability itself. 

Chairman BAKER. Can the gentleman quickly wrap up? 

Mr. DAVIS.—to act on this report and the method by which the 

report was released. 

I certainly look forward to the hearing from the panel’s testimony 

on the OFHEO report and Fannie Mae’s report to address the criticisms of its accounting practices. 

Chairman BAKER. I thank the gentleman. The chair to the best 

of its ability will try to keep members’ opening statements to the 

requested 5-minute statement length. 

Mr. Castle? 

Mr. CASTLE. Thank you, Mr. Chairman. 

The issue before us is an important one today. I share the concerns of a lot of the other members who have spoken about it, a 

number of the issues that are before us. It is vast and it is disturbing and hopefully we can do something about it. Frankly, I 

think we should have done something about it before we started 

down this alley. Perhaps we can now. 

I am going to keep my opening comments, Mr. Chairman, to one 

issue that concerns me, in what appears to be multiple interpretations of generally accepted accounting principles, GAAP. In February 2004, OFHEO hired Deloitte & Touche to examine the accounting policies of Fannie Mae. 

Specifically, OFHEO’s report finds fault with the company’s accounting treatment of, one, the amortization of premiums, disVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
10

counts and fees related to the purchase of mortgages and mortgagebacked assets, understatement of accounting financial standards, 

SFAS 91; and two, financial derivative contracts under SFAS 133. 

KPMG LLP, Fannie Mae’s auditor, has stated it stands behind its 

audit work. 

Fannie Mae has also stated they believe they were following generally accepted accounting principles. I am concerned that two different auditors would have different interpretations of SFAS 91 

and SFAS 133. Therefore, I have sent a letter to Robert Hertz, 

chairman of the Financial Accounting Standards Board, FASB, for 

their comments on SFAS 91 and 133, and whether these standards 

need to be readdressed to remove any gray areas that may exist. 

If improper accounting has occurred, I question how these accounting practices were allowed to occur and what was management’s knowledge of these actions. It bothers me greatly to hear 

the allegation that accounting tricks were used to meet specific 

earnings-per-share targets that resulted in vast amounts of executive compensation to be paid. 

I thank all of our witnesses for appearing before us today and I 

hope we will have an exchange on the merits of what has occurred 

and what needs to occur in the future. I welcome the news that 

OFHEO and Fannie Mae have reached an agreement to address 

the improper accounting and internal controls within Fannie Mae. 

I strongly believe, however, that in light the likely reforms 

achieved in the passage of the Sarbanes-Oxley Act, we must again 

be prepared to act. 

Mr. Chairman, I would ask unanimous consent to insert the text 

of my letter to Chairman Hertz for the record. With that unanimous consent, I will yield back the balance of my time. 

Chairman BAKER. I thank the gentleman. Without objection, the 

letter will be included in the official record. 

I am advised by staff that the opening statement period for members is 3 minutes, not 5 minutes. 

Mr. Clay? 

Mr. CLAY. Thank you, Mr. Chairman. 

Mr. Chairman, we are rushing to judgment today. OFHEO has 

released a preliminary report which has not been proven, but 

leaked to the press. During the course of the examination, Fannie 

Mae was not given the chance to respond to OFHEO findings. Informal communications, which are at the core of the GSE’s oversight statute, were essentially ignored. At least one former examiner of OFHEO questioned the political motivations behind 

OFHEO’s rush to judgment. 

Mr. Chairman, we do not normally hold hearings on matters before other investigations are complete. Internal findings are normally discussed informally and remedies proposed. There are other 

stages of this process that take place before a judgment is rendered. Why circumvent the process? Why this hearing? 

If I were a member of Fannie Mae’s board, I would find the environment very intimidating. Mr. Chairman, why is Senator Shelby 

not holding a hearing on this preliminary report? After all, the 

Senate Banking Committee reported out legislation on the GSEs. 

Maybe this hearing agenda is about something more than the accounting procedures at Fannie Mae. 

11

As you know, Fannie Mae recently entered into an agreement 

with OFHEO in which they focused on accounting, internal control, 

and capital. Fannie Mae has agreed to increase additional capital 

by 30 percent. I am not sure how the new requirement promotes 

affordable housing. Within 45 days OFHEO and Fannie Mae will 

implement additional internal controls. The Securities and Exchange Commission, as is intended, should be the final arbiter of 

GAAP. Why can’t we let the SEC decide this issue? Why must we 

rush past them? 

This hearing is about the political lynching of Franklin Raines. 

We have seen this happen too many times before. We are to go out 

of session and the deed is to be done before the election. Why can’t 

we just say that this is the agenda? Let us debate that issue on 

its own merit. Better still, let due process take its course and let 

the chips then fall where they may. That is, unless this is truly a 

witch hunt. 

We are having a trial by OFHEO leaks, trial by newspaper articles, and trial without due process. In this case, the Senate has it 

right. 

Chairman BAKER. The gentleman yields back. 

Mr. Royce? 

[The prepared statement of Hon. Wm. Lacy Clay can be found on 

page 151 in the appendix.] 

Mr. ROYCE. Thank you, Mr. Chairman. I thank you for holding 

this hearing on the OFHEO report allegations of accounting and 

management failure at Fannie Mae, as it is called. I would like to 

commend you, Mr. Chairman, for your continued leadership on 

GSE oversight. 

While there is no question as to where I stand on GSE issues 

generally, the fact of the matter is the GSEs have a special relationship to the government. After all, there are not many institutions that share common characteristics with Fannie Mae, such as 

a charter created by Congress, an exemption from local taxation, 

an exemption from certain SEC registration and fees, and an ability to borrow from the U.S. Treasury Department under certain circumstances. 

With this in mind, I believe that Fannie Mae and GSEs in general have an important obligation to conduct operations to the 

highest standard. As a member of this oversight subcommittee, I 

expect Fannie Mae to be a role model to other businesses as it fulfills its federally mandated mission. Fannie Mae should be conducting operations in a safe and sound way. In my view, this 

should include strong internal controls in the risk management department, coupled with consistent and conservative applications of 

accounting rules. 

With its newly released report, the Office of Federal Housing Enterprise Oversight has called into question many of Fannie Mae’s 

risk-mitigating practices. This is very troubling to me and there is 

no doubt that OFHEO has placed the burden on Fannie Mae to answer these allegations. As OFHEO has leveled some very serious 

charges, I recognize that we do need to give Fannie Mae the opportunity to respond. This hearing is part of the process for this committee to learn more facts, and I appreciate the participation of all 

the witnesses today. 

12

In addition to our important oversight role in this committee, I 

hope that we will move swiftly to create a new regulatory structure 

for Fannie Mae, for Freddie Mac and the Federal Home Loan 

banks. There is a very simple solution. Congress must create a new 

regulator with powers at least equal to those of other financial regulators such as the OCC or the Federal Reserve. 

I hope this committee will heed the advice of Chairman Greenspan and the entire Board of Governors, the Federal Reserve Staff, 

the U.S. Treasury Department, the OECD, the IMF and countless 

others who have urged Congress to act. 

Now, on the approach that was rejected by the Bush administration and, by the way, was rejected by myself and many others on 

this committee. Why was that approach rejected by the Fed, by the 

Treasury? Because that legislation was not a true effort at reform 

as it failed to address several of the key issues that are essential 

to true reform of the regulatory regime of the housing GSEs. 

Specifically, that non-reform effort would have created a regulator without the authority to raise capital standards, without the 

authority to place an ailing GSE into receivership, without the authority to oversee all aspects of a GSE’s operations, leaving much 

of this oversight at HUD. 

Chairman BAKER. Can the gentleman begin to wind up? 

Mr. ROYCE. I will wind up right now by saying there is a difference of opinion on which approach to take if we really want a 

world-class regulator. I thank you again for the opportunity for this 

hearing and for us to hear from these witnesses today. 

Chairman BAKER. I thank the gentleman. 

Mr. Baca? 

Mr. BACA. Thank you very much, Mr. Chairman and Ranking 

Members. Thank you for holding this hearing. I appreciate the opportunity to hear from witnesses about these very important 

issues. 

These are very complex rules and it is possible that we are not 

going to see a resolution until the issue is decided by the SEC. As 

I understand it, there are three broad areas of inquiry involving accounting, internal control, and capital. I would simply say I am not 

going to pre-judge the issues, and that before any stones are cast, 

we should see that there is culpability. Judge not and not be 

judged. 

Our country is a country of laws, and there is a process that 

must be followed and respected. Make no mistake, we will follow 

this process wherever it may lead. At the end of the day, if anyone, 

and I stress anyone, has not respected the law they will face the 

consequences. 

Mr. Chairman, I think it is important that in rushing to judgment that we not destroy an institution that is helpful in providing 

assistance for first-time homebuyers and minorities. Fannie Mae is 

an integral part of our economy and many of our constituents have 

been able to realize the American dream of homeownership due to 

its programs. 

I am concerned that the regulators follow the procedure that exists for investigating potential concerns in a way that is consistent, 

and respectful of confidentiality and impartial. We need to follow 

proper procedures in handling audits before they go public. We 

13

should ensure that the process is fair. We should ensure that the 

process is fair in getting the facts. And that we engage in corrective 

action if there are any deficiencies. 

Like most of us have been involved in nonprofit organizations 

where we had auditors that audited us. They come back with a report. They give an opportunity to make corrections if any are done. 

And all of us have been involved in nonprofit organizations and on 

boards of directors. We know the consequences if those procedures 

are not followed. 

I think it is important that we keep the politics out of what 

should be and historically has been a nonpolitical process. It concerns me that OFHEO has been Fannie Mae’s regulator since 1992. 

OFHEO has been its regulator since 1992, and all of a sudden 

issues are being raised. The regulators had an opportunity in the 

past to address any concerns. 

So we need to ask: What, if anything, has changed? This is not 

about headhunting. It is about positive steps to correct any problems. I look forward to hearing the witnesses. 

I yield back the balance of my time. Thank you very much, Mr. 

Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Ney? 

Mr. NEY. Thank you, Mr. Chairman, and thank you for holding 

the hearing. I also want to thank, of course, the witnesses for appearing today. I look forward to hearing their testimony, as I know 

everybody does, so without objection I will submit all of my written 

statement for the record. I just have a couple of comments. 

OFHEO’s recent report on the activities of Fannie Mae asserts 

the company engaged in accounting practices that do not comply 

with the generally accepted practices. Of course, it is troublesome. 

In addition, the report raises concerns about deferred price adjustments, derivatives and hedging activities, internal control issues. I 

think the stopgap measure was a good thing to implement. 

According to OFHEO and what we have read, they are serious 

and it raises concerns regarding the validity of previously reported 

financial results. OFHEO’s findings to date are obviously very serious. Right now, if you would read the accounts in the papers, it 

looks like the management of Fannie Mae is basically looking at 

the fact of, in the media at least, of making them a poster child 

for regulatory reform. 

It is important to keep in mind, though, that the examination is 

still in the process. So the newspapers and the way people are looking at it is one thing, and the reality of what we are going to find 

out today I think is important, and the process that OFHEO will 

finish is obviously important, and also the SEC is going to be the 

final arbiter of compliance with the general accounting practices, 

and has not yet, as I understand, offered its opinion on Fannie’s 

accounting methods. So that is another part of this puzzle I think 

that will be out there for us to look at. 

Of course, Fannie was chartered by Congress to create a secondary market and improve the function of home mortgage markets. I think that we can all agree that the United States mortgage 

and credit markets are the envy of the world. A strong, vibrant 

housing market is important to everybody. 

14

There can be no doubt that we have to take some steps to 

strengthen the GSEs by establishing a new world-class regulator. 

How we do that and who is to be that regulator, I do not know 

today. With the growing presence of GSEs in the capital markets 

and the possible risks they pose to the financial system, the cost 

of a safety and soundness regulator would be a prudent step. But 

I want to add the big ‘‘however.’’ That ‘‘however’’ is we have got to 

proceed in this endeavor with caution. It cannot be mixed with politics. 

If we want to talk about politics or press reports or lobbyists, 

maybe we ought to do a bill to ban lobbyists, then we can have a 

rich Republican and a rich Democrat do the lobbying for everybody. 

We could call them the 527s of lobbying. So I think we take that 

kind of talk out of the process because any new regulatory structure has to recognize the importance of the GSEs to the secondary 

mortgage market. 

Everyone agrees that strong regulatory oversight is critical to 

maintaining public confidence in this remarkable system. As I have 

said before, enhanced regulations for GSEs should not impede their 

ability to support affordable housing in America. 

So I applaud the chairman for this hearing. I think we have to 

state a public policy as we go down this road and do what is right 

for the good of Americans, and to craft public policy that ensures 

safety and soundness, but let’s not throw in this process the housing market to the wolves because that hurts the average American. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Ms. Inslee? 

Mr. INSLEE. Thank you. 

I just wanted to follow up. Our ranking member talked about, 

when you talk about evaluating this, we are looking at soundness. 

It made me sort of think of our obligation of buying a horse. You 

check its soundness. You check its teeth. You check it for hoof rot. 

That is an important part of this function here, to check on soundness of Fannie Mae. 

But the problem to date has been some folks do not want to 

check for soundness, check its teeth, check it for hoof rot. They 

want to hobble the horse when it comes to being a main stem of 

the housing supply in this country. Whatever comes of these hearings, I hope that we keep in mind those two different functions, 

that we ought to focus on soundness, but not allow this what may 

be, and I do not know yet because I think you should have the trial 

before the execution, but it may be very unfortunate things that occurred, to hobble this very, very important horse that is carrying 

the U.S. economy in residential homes in this country. 

Thank you. 

Chairman BAKER. I thank the gentleman. 

Ms. Kelly? 

Mr. KELLY. Thank you very much, Mr. Chairman. 

I have no statement at this time. I look forward to these witnesses. 

Chairman BAKER. Mr. Toomey? 

15

Mr. TOOMEY. Thank you, Mr. Chairman. I want to congratulate 

you for your long work in this hearing and for holding the hearing 

today. 

I just want to make one quick observation. Many folks have already observed that there are considerable complexities in the accounting issues that we are going to be addressing today. I think 

it is important to make sure we make it very clear up front, and 

not get bogged down in the complexities of some of this accounting 

because the dispute here that is alleged, I should say the allegation 

that is made by OFHEO, is not that there is a dispute over the interpretation of ambiguous and complex rules over which reasonable 

people could disagree, but rather the allegation is that there has 

been a pattern of invention of accounting policies and devices 

which systematically and intentionally misrepresent financial 

statements for the purpose of smoothing earnings and achieving 

maximum bonuses. 

Now, if these allegations are true, they are obviously extremely 

disturbing and require I think major changes at Fannie Mae. That 

is what we are going to be talking about and hopefully shedding 

some light on today, not the arcane interpretation of accounting 

rules, but whether or not accounting rules were being set aside, 

and different policies were adopted for purposes for which they certainly should not have been. 

I think that is what we need to focus on, Mr. Chairman. I thank 

you for holding this hearing and I yield the balance of my time. 

Chairman BAKER. I thank the gentleman. 

Ms. McCarthy? 

Mr. MCCARTHY. Thank you, Mr. Chairman. 

I will hand in my statement. I certainly do appreciate hearing 

from the chairman and the ranking members, but we are into this 

hearing 45 minutes and we still have not heard from the witnesses, 

and I personally think that we should be talking to the witnesses, 

and then do our statements and ask questions. 

With that, I yield back the balance of my time. 

Chairman BAKER. I thank the gentlelady. 

Mr. Bachus? 

Mr. BACHUS. I thank the chairman. 

First of all, chairman, there have been several remarks made 

that we would have addressed these issues had it not been for the 

Bush administration. It is my recollection that the Bush administration actually urged this committee and this Congress to take 

strong action and that at that time that was in the sort of postFreddie Mac. At that time, many of the Democratic members accused the Bush administration of going on a witch hunt against 

Fannie Mae of saying that things were right at Fannie Mae, and 

that OFHEO was doing a wonderful job, and that there was sufficient regulation, that this was simply to accuse the Bush administration of wrong motives. 

It was actually a combination of those in the Senate that did not 

want to take action, and members of this committee that disagreed 

with the Bush administration. One thing the Bush administration 

was concerned about is the new products that Fannie was offering, 

and they wanted Treasury to approve those new products. It is my 

16

recollection that the minority members almost to a person resisted 

those reforms. 

I do think, and I commend Mr. Frank. Mr. Frank actually had 

it right and more accurately when he said the Bush administration 

wanted to go further than this committee. I think that is absolutely 

true. And now all of a sudden, some of the things that the Bush 

administration wanted to do it seemed like they would have been 

very prudent things to have done. 

So to try to, a month before an election, to try to somehow create 

a smokescreen that the Bush administration had done something 

wrong would be inaccurate and would not be factual. Of course, it 

probably is not surprising either. 

We have before us today OFHEO, and Fannie Mae and their officers will be before us at a later date. My understanding of this 

hearing is we are to examine OFHEO and you are to testify as to 

the agreement that you have made with Fannie Mae as a result 

of your study of their accounting practices, and that in fact you 

found that they violated two important accounting rules. 

My questions would be, all this stuff that you have discovered 

now, why wasn’t it discovered 3 or 4 years ago, since you have been 

the regulators for years and years. Why is it suddenly coming to 

light? 

Chairman BAKER. Could the gentleman begin to wrap up? 

Mr. BACHUS. So I would simply say that I think there are some 

tough questions for Fannie Mae, but I think there are also some 

tough questions for OFHEO because I believe that if they have 

done these things and you were the regulators, you should have 

known before just the last few months. This should have come to 

light. 

Thank you. 

Chairman BAKER. The gentleman’s time has expired. 

Mr. Hinojosa? 

Mr. HINOJOSA. Chairman Baker, over the last 4 years, the 

United States has suffered from immense job loss. We have suffered from an increase in the number of people living in poverty. 

We have witnessed an incredible and unsupportable switch from 

federal budget surplus to an ever-growing budget deficit. 

We have also experienced a tremendous increase in the national 

debt over the last 4 years. Overall, our economy has not been performing very well during this period, with oil prices exceeding $50 

per barrel. In fact, to say that it has been underperforming would 

be an understatement. 

However, there is one sector of our economy that has been performing well consistently, and that is the housing market. It has 

served as the foundation of the U.S. economy since the stock market declined many years ago. It is the one sector of our economy 

to which we need to pay the most attention at this time. We need 

to nurture it. We need to ensure that nothing we do here in Congress harms it. 

At this point, I think we need to keep our powder dry until all 

the ongoing accounting and adequacy of its capital and the quality 

of management investigations are complete. Then we can see where 

everything stands once all the dust settles. 

17

Having said that, Mr. Chairman and Congressman Kanjorski, I 

look forward to hearing the testimony of all of today’s witnesses. 

I yield back the remainder of my time. 

Chairman BAKER. I thank the gentleman. 

Ms. Brown-Waite? 

Ms. BROWN-WAITE. Thank you very much, Mr. Chairman. Thank 

you for your leadership in providing this opportunity for the committee to address this important issue. 

I would also like to thank our witnesses for coming to the committee this morning. 

As Americans, we have heard in the past couple of years about 

the Enron scandal and other corporate examples of ‘‘cooking the 

books.’’ As members of Congress and members of this committee 

with oversight over the mortgage and housing industries, it is imperative that we ensure that companies with as much industry 

clout as Fannie Mae, are following generally accepted accounting 

principles, or GAAP. 

I was listening to Bloomberg the other day, yesterday as a matter of fact, and I heard how much your stock has also suffered. So 

there is obviously a rippling effect of this OFHEO report. However, 

that being said, as committee members we have to remember that 

the report released by OFHEO in September is early in its preliminary stages. I think that there are more accusations in this report 

than findings. 

We certainly look forward to hearing how OFHEO completed this 

report. We have had some heartaches with corporate scandals in 

this country, but I do not think we should be jumping to conclusions. While we are ensuring that Fannie Mae is using honest 

GAAP-compliant principles, the committee also needs to be certain 

that we are giving Fannie Mae a fair chance to be heard. 

Coming from Florida where our state was devastated by hurricanes and where a lot of rebuilding is going to take place, it is obviously important that we have the availability of the funding for 

home construction that Fannie Mae regularly participates in. 

I look forward to hearing what our witnesses from Fannie Mae 

have to say, and I want to again thank you, Mr. Chairman. 

I yield back the balance of my time. 

Chairman BAKER. I thank the gentlelady. 

Mr. Lucas of Kentucky? 

Mr. LUCAS OF KENTUCKY. Mr. Chairman, I look forward to hearing from the witnesses. 

Chairman BAKER. I thank the gentleman. 

Mr. Lynch? 

Mr. LYNCH. Thank you, Mr. Chairman. 

I am going to be brief. The one thing I do not want to forget are 

the good things that Fannie Mae is doing. I hear Enron talked 

about here this morning. This is not Enron. This is not the Enron 

situation. These are clearly violations of accounting principles, but 

let’s not go overboard and make this a criminal proceeding. 

I am very interested in hearing exactly what the differences in 

the accounting practices and how we can correct them. But this 

should not be a witch-hunt. This should not be a political exercise 

in punching people who have done a lot of good things in this counVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
18

try providing housing opportunities for a lot of people that need 

them. But clearly, we have to get our house in order here. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Gillmor? 

Mr. GILLMOR. I will enter my statement into the record. Thank 

you, Mr. Chairman. 

Chairman BAKER. The member’s statement and all members’ 

statements will be made part of the official record. 

Mr. Miller? 

Mr. MILLER OF CALIFORNIA. Thank you. I would like to thank 

you, Mr. Chairman, for your continued commitment to ensuring the 

safety and soundness of the secondary market. 

The question of impropriety has surfaced as a result of allegations of accounting irregularities at Fannie Mae has sent shock 

waves through the strong housing market. That market has kept 

this nation going in recent years. The United States housing market is the envy of the world. We enjoy the lowest interest rates and 

the highest homeownership of any developed nation in the world. 

When Americans are homeowners, it spurs economic and community development and provides residents with a sense of pride in 

their community. Homeownership is the single largest creator of 

wealth for most Americans. For this reason, it is imperative that 

we work through this process to maintain a strong housing market. 

The GSEs have been at the forefront of creating affordable housing opportunities for American families. In my district, for example, Fannie Mae has created employer-assisted housing programs 

for the city of Boreas Police Department to allow police officers to 

live in the communities they serve. They also helped to finance affordable housing initiatives in Anaheim, California, and Anaheim 

is an extremely high-cost housing area. 

Across the district, they have been able to offer innovative programs to allow those with blemished credit to afford the dream of 

homeownership, to help seniors convert the equity in their homes 

into cash to help them meet their needs, and to help families and 

individuals with special needs become homeowners. 

All of this, in partnership with lenders, is intended to meet the 

ever-growing need of our communities. As we address deficiencies 

in GSE supervision, we must not lose sight of Congress’ original 

goal in chartering GSEs. The mission of Fannie Mae and Freddie 

Mac is to provide stability and ongoing assistance to the secondary 

market for residential mortgages, and to provide access to credit 

and homeownership in the United States. 

As we move forward to make much-needed regulatory reform to 

ensuring the safety and soundness of GSEs, Congress must be unwavering in our commitment to help Americans achieve the dream 

of homeownership and continue to ensure the accessibility of mortgage funds at the lowest cost. We must completely understand the 

implications of changes in the regulatory structure in meeting the 

goals of the charter, being careful not to inadvertently hinder the 

ability of GSEs to be innovative in meeting the needs of potential 

homebuyers. 

I believe Congress has ample evidence that OFHEO may not 

have the experience necessary to appropriately regulate complex fiVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00026 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
19

nancial institutions such as Fannie Mae and Freddie Mac. OFHEO 

released annual reports that the internal and external audit functions at Fannie Mae exceeded safety and soundness standards and 

had the appropriate independence. How can we be confident in 

such findings when OFHEO is now issuing a report with very different troubling findings about the serious accounting irregularities 

at Fannie Mae? 

We must work to ensure a new regulatory regime under which 

investors in the market can be confident that these companies are 

sound and that their investment in America’s housing markets are 

safe. While there is no question that regulatory change must be 

made to ensure that GSEs are held to the absolute highest standard of ethical conduct, I urge my colleagues to remain mindful that 

strong regulations provide a means to achieve our ultimate goal of 

expanding the supply of affordable housing credit across our nation. 

Mr. Chairman, I again want to thank you for holding these hearings. The goal of these two companies is so critical to our economy. 

I look forward to working with you to ensure the appropriate regulatory reforms are made. 

I yield back. 

Chairman BAKER. I thank the gentleman. 

Mr. Ford? 

Mr. FORD. I am sorry. I do not have anything to say. I am a believer that when you hold hearings, you should let the witnesses 

talk. 

So I welcome you all and look forward to hearing from you. 

[The prepared statement of Harold E. Ford, Jr. can be found on 

page 152 in the appendix.] 

Chairman BAKER. A commendable attitude. 

We have two members who are not members of the subcommittee 

today, but who are members of Financial Services. I would like to 

recognize them at this time. 

Ms. Waters? 

Ms. WATERS. Thank you very much, Mr. Chairman. I would ask 

unanimous consent to make a brief opening statement. 

Chairman BAKER. Without objection, please proceed. 

Ms. WATERS. I appreciate the opportunity to be here today. I 

must share that I feel like I am in another round in the battle between FM Watch and the GSEs. FM Watch, financial institutions 

that decided a long time ago to wage a political war to reduce the 

GSEs’ share of the mortgage market, and of course I must say, Mr. 

Chairman, led by you. 

OFHEO has gone from weak and ineffective to the extreme of accusing Fannie Mae now of questionable accounting practices in 

order to increase their bonuses. They have gone back to 1996. That 

is a serious allegation. I hope they are prepared to prove it. Obviously as we explore the safety and soundness issues that are the 

subject of this hearing, all of us on the Financial Services Committee must keep our eye on the housing mission of the GSEs, particularly the affordable housing mission that we have entrusted to 

Fannie Mae and Freddie Mac. As we proceed, it is critical that we 

ensure any action that we may consider not impair the housing 

mission of the GSEs. 

20

Mr. Chairman, I note with interest that the 211-page OFHEO report from Mr. Dickerson to Director Falcon that we will explore in 

today’s hearing still bears the following notation on each page: special examination of Fannie Mae, privileged and confidential disclosure, and/or duplication prohibited, even though the OFHEO report 

was posted on the OFHEO Web site and has been publicly available for almost two weeks. 

Mr. Chairman, as I understand it, normally the examination and 

regulatory process is a confidential process where the regulator 

raises his concerns with the party being examined and the regulator gives that party a full opportunity to respond before determining whether regulatory action is required? I note that when Director Falcon’s September 20 letter expressing concerns about 

Fannie Mae made the papers, the OFHEO report had just been 

completed. By September 22, the September 17 OFHEO report was 

publicly available, and by September 27, an agreement had been 

signed between Fannie Mae and OFHEO. It seems highly unlikely 

to me that the normal kind of regulatory dialogue could have occurred within this timeframe. 

So I hope that the witnesses will address whether the regulatory 

process was proper, or whether there were public disclosures outside the normal process for reasons having nothing to do with safety and soundness. The September 7th OFHEO report is fairly characterized as a work in progress. As Mr. Dickerson notes in his 

transmittal memo to Director Falcon, it contains the findings to 

date of the special examination of Fannie Mae. 

The report raises a number of highly technical and arcane accounting issues, including issues concerning the treatment of derivatives. Some of these issues appear to be controversial, and may 

be disputed by Fannie Mae. These issues cannot be easily summarized and they may not lend themselves to a brief and simple response. I hope that we will have the patience to give these issues 

the time that they may require. 

Mr. Chairman, to my knowledge, apart from a few brief press releases from Mr. Raines and Fannie Mae’s independent director, 

Mrs. Ann Korologos announcing the intention of Fannie Mae to cooperate with the OFHEO investigation, and later announcing the 

September 27 agreement between OFHEO and Fannie Mae, there 

has been no in-depth public response by Fannie Mae to the substantive allegations contained in the OFHEO report. 

This is the first chance that our committee and the public will 

have to hear Fannie Mae’s response to these allegations, and it will 

be good to hear their side of the story. I am particularly concerned 

about the 30 percent capital set-aside or surplus requirement because that takes a lot of money out of the market for mortgages. 

Thank you. I yield back the balance of my time. 

Chairman BAKER. I thank the gentlelady. 

Mr. Watt? 

Mr. WATT. Thank you, Mr. Chairman. 

I just want to express my thanks to the chairman for allowing 

members who are not part of the subcommittee to participate in 

the hearing. 

I think members of the subcommittee have expressed in various 

ways a number of the concerns that I would have expressed had 

21

I been a member of the committee. At the end of the day, we want 

to make sure that Fannie and Freddie and whatever other institutions are available to encourage and support increased homeownership and housing in this country are made stronger and more vibrant. 

I also share a number of the process, due process and fairness 

concerns that have been raised by various members of the committee. So I am here to participate in this for those reasons, because I am a supporter of housing for American people and because 

I believe in fairness and process and due process, and not convicting somebody before the process runs its course. 

I hope we will keep in mind both of those things, and I appreciate the chairman allowing us to participate. I yield back the balance of my time. 

Chairman BAKER. I thank the gentleman. 

If there are no further opening statement by members at this 

time, I would now proceed to recognize our first witness for the 

hearing today. 

Mr. Armando Falcon is the director of the Office of Federal Housing Enterprise Oversight, who I understand today is accompanied 

by Ms. Wanda Deleo, chief accountant, and Mr. Christopher 

Dickerson, chief compliance examiner, Office of Federal Housing 

Enterprise Oversight. 

Before I proceed, I am reminded, I have a statement of Mr. Roger 

Barnes, former manager of financial accounting, deferred assets in 

Fannie Mae’s controller division, submitted to the committee and 

asked to be made part of the official record. If there is no objection, 

I now move to incorporate that into our hearing record. 

[The prepared statement of Roger Barnes can be found on page 

197 in the appendix.] 

By prior agreement with Mr. Kanjorski, we have determined that 

given the gravity of the hearing content today, that all witnesses 

should be asked to testify under oath, given the fact that this is 

an investigative hearing. 

Mr. Falcon, do you have any objection to testifying under oath? 

Mr. FALCON. Not at all, Mr. Chairman. 

Chairman BAKER. It is my understanding that you are accompanied by staff. Will they be testifying and answering questions 

during the course of your testimony today? 

Mr. FALCON. They will not have testimony, Mr. Chairman, but 

they will be available to the committee to answer any technical 

questions about the report. 

Chairman BAKER. In that light, it would be my opinion and advisable, should we solicit information from them, that each of you 

take the oath. Do either of you have any objection to testifying 

under oath if required by the committee? 

Ms. DELEO. No. 

Mr. DICKERSON. No. 

Chairman BAKER. If that is the case, I would ask that you now 

stand and raise your right hand and affirm the oath. 

(WITNESSES SWORN) 

Chairman BAKER. Thank you. Each of you is now considered to 

be under oath. 

22

Mr. Falcon, I would recognize you. Given the importance of your 

report, we customarily limit our witnesses to 5 minutes in presentation. I would encourage you to summarize as best you can, but 

should you find the need to exceed 5 minutes, I am certain members of the committee would welcome a full and complete discourse 

from you on this matter. 

Please proceed at your leisure. 

STATEMENT OF HON. ARMANDO FALCON, DIRECTOR, OFFICE 

OF FEDERAL HOUSING ENTERPRISE OVERSIGHT 

Mr. FALCON. Thank you, Mr. Chairman, and thank you Ranking 

Members Kanjorski, Frank and Chairman Oxley, who was here 

earlier, for inviting me to testify about OFHEO’s special examination of Fannie Mae. As always, my testimony reflects my own views 

and are not necessarily those of the secretary of HUD or the President. 

Before getting to my comments on the report, I would like to introduce two of my staff who you mentioned earlier. On my right is 

Chris Dickerson, OFHEO’s chief compliance examiner and one of 

our derivatives experts. On my left is Ms. Wanda Deleo, our chief 

accountant. Both are leading the work of the special examination, 

and they are here to assist me in answering any technical questions the committee may have about the report. 

In July of last year, I announced that OFHEO would conduct a 

special examination of Fannie Mae’s accounting policies, internal 

controls and financial reporting. While the special examination continues, our safety and soundness mandate requires that when we 

find problems, we move quickly to remedy them, rather than wait 

until the entire examination is complete. The report represents our 

findings to date and it serves as the basis for the actions that we 

have taken. 

The report raised such serious safety and soundness concerns 

that we brought them to the immediate attention of the board. To 

the board’s credit, it became very engaged in the examination and 

moved quickly to reach an agreement with OFHEO on the plan of 

remediation. The agreement constitutes an important first step towards resolving OFHEO’s concerns and ensuring safe and sound 

operations at the enterprise. 

Let me now turn to the substance of the report. It documents 

Fannie Mae’s pervasive and willful misapplication of generally accepted accounting principles, as well as critical operational deficiencies. The report’s findings have implications in four areas of 

major concern to OFHEO: the validity of Fannie Mae’s previously 

reported financial results; the adequacy of its regulatory capital; 

the quality of senior management’s supervision of the enterprise; 

and Fannie Mae’s overall safety and soundness. 

The accounting violations cannot be dismissed as mere differences of opinion in accounting rules. Fannie Mae understood the 

rules and simply chose not to follow them. Fannie Mae’s development of improper accounting policies and practices can be traced 

back to a corporate culture and operating conditions characterized 

by the following: a desire on the part of senior management to portray Fannie Mae as a consistent generator of stable and growing 

earnings; an ineffective process for developing accounting policies; 

23

an operating environment that tolerated weak or nonexistent internal controls; key person dependencies and poor segregation of duties; incomplete and ineffective reviews by the enterprise’s office of 

auditing; an inordinate concentration of responsibility rested in the 

chief financial officer; and an executive compensation structure 

that rewarded senior management for meeting goals tied to earnings per share, a metric that can be and was subjected to senior 

management manipulation. 

The accounting problems at Fannie Mae that OFHEO has uncovered relate mainly to FAS 91 and FAS 133. Let me briefly describe 

each. FAS 91 governs the amortization of balances related to mortgages and mortgage-related securities. Management developed accounting policies and selected and applied accounting methods to 

improperly reduce earnings volatility related to amortization. 

Fannie Mae improperly delayed the recognition of income to create 

a cookie jar reserve that it could dip into whenever it best served 

the interests of senior management. Those interests included 

smoothing earnings and meeting earnings-per-share targets linked 

to executive bonuses. 

An important example of how this worked took place in 1998. At 

that time, external events caused a plunge in interest rates, which 

in turn added to an acceleration of mortgage pre-payments. As a 

result, Fannie Mae faced a more rapid premium amortization in 

the enterprise’s mortgage portfolio than expected. In December, 

management’s own amortization models specified that $400 million 

in premium amortization expenses had to be recorded on Fannie 

Mae’s books in 1998. However, management decided to record only 

$200 million of the $400 million that year. Fannie Mae deferred the remaining $200 million to 1999 and recorded it incrementally throughout that year. KPMG, Fannie Mae’s 

outside auditor, decided the enterprise’s action on this matter as an 

‘‘audit difference,’’ a term which means that KPMG disagreed with 

Fannie Mae’s action. Had Fannie Mae taken the full $400 million 

charge in 1998, senior managers would have lost their eligibility for 

any bonuses. That is because incentive compensation depended on 

Fannie Mae realizing earnings-per-share targets. 

As it happened, the earnings-per-share target which would secure senior management the maximum bonus could only be 

reached if Fannie Mae recorded no more than $200 million of the 

expenses in 1998. 

The next year, Fannie Mae kicked off a challenge grant initiative 

which promised to reward management for doubling earnings in 5 

years. To avoid facing amortization problems similar to those in 

1998, senior management began a prolonged and concerted effort 

to develop policies for managing amortization. The goal was to gain 

earnings flexibility and the ability to minimize earnings volatility. 

In this regard, the 1998 violation was not a singular event. It represented a continuous effort to artificially guarantee success in 

meeting targets. 

Let me now turn to FAS 133 and hedge accounting. FAS 133 requires that derivatives be marked to market and that changes in 

fair value be included in earnings unless the derivative is designated as and qualifies for hedge accounting. We have found that 

Fannie Mae implemented FAS 133 in a manner that placed earnVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
24

ings volatility and maintaining the simplicity of operations above 

compliance with GAAP. These goals to an inordinate degree influenced the development of Fannie Mae’s approach to hedge accounting. 

The prerequisites for receiving hedge accounting treatment include effectiveness assessment, ineffectiveness measurement and 

proper hedge documentation. Because Fannie Mae has not met 

these critical requirements, it should not receive hedge accounting 

treatment for many of its derivatives. Instead, proper accounting 

for such derivatives requires that their fair value changes be recorded directly through earnings. 

As a result of these issues and Fannie Mae’s disregard for complying with FAS 133, we are concerned about the validity of the 

amounts Fannie Mae has reported in accumulated other comprehensive income, the earnings the enterprise has presented in 

prior quarters, and the adequacy of regulatory capital. 

Let me state plainly that Fannie Mae’s accounting was just 

wrong, and must be fixed properly. The stakes are too high to just 

forgive past sins. If any company, especially a government sponsored enterprise, is allowed to get away with this type of accounting misconduct, then no regulator can do its job and no investor is 

safe. A regulator and an investor must be able to trust the books 

and records of a company. 

Regarding internal controls, OFHEO found that Fannie Mae 

maintained a deficient accounting policy development process, key 

person dependencies and poor segregation of duties, all of which 

contributed in important ways to the enterprise’s problems. The details of these matters are addressed in the report. 

As I mentioned earlier, we took prompt and appropriate action 

to address these serious problems. We entered into an agreement 

with the board requiring that Fannie Mae implement correct accounting treatments, hold the 30 percent capital surplus, recalculate prior period financial statements using correct accounting, 

appoint an independent chief risk officer, and put in place policies 

to ensure adherence to accounting rules and new internal controls. 

I would also like to remind the subcommittee that the special examination is continuing. If OFHEO discovers more problems, we 

will take further action. 

Finally, I would like to thank the leadership of the full committee and the subcommittee for your support for our funding. The 

current continuing resolution has placed severe constraints on our 

ability to hire additional staff and employ outside experts for the 

continuation of the Fannie Mae examination. This could not come 

at a worse time for the agency, and it once again illustrates the 

need to remove OFHEO from the appropriations process. 

Mr. Chairman and members of the subcommittee, I have tried to 

summarize the report as best I could. I would like to ask that it 

be placed into the record, and we are prepared to answer any questions that the subcommittee may have. 

[The prepared statement of Hon. Armando Falcon can be found 

on page 160 in the appendix.] 

Chairman BAKER. Your full testimony and the report content 

thereof will be included in the official record of the committee. 

25

Mr. Falcon, did you find that management of Fannie Mae had 

adopted and implemented a strategy from a managerial perspective 

to steer accounting reports for two important goals. One is to 

present an image of very stable earnings to the broader market; 

and two, to manage EPS calculations to enable maximum bonus 

payments to be achieved for executives? 

Mr. FALCON. Those are the findings contained in the report, Mr. 

Chairman. 

Chairman BAKER. Did you find in at least one instance in 1998 

that manipulation of accounting methods inconsistent with GAAP 

resulted in an EPS calculation which enabled the bonus payment 

to executives that they would not have been entitled to if accounting practices consistent with GAAP had been utilized? 

Mr. FALCON. That is the situation we described in 1998, yes. 

Chairman BAKER. Is it correct that in reaching the earnings-pershare trigger of $3.23 that the calculation of 3.23 in carried to the 

math resulted in a calculation of 3.2309. Is that correct? 

Mr. FALCON. Yes. 

Chairman BAKER. Has it been established why the decision was 

made to defer $200 million of a $400 million unexpected expense 

was deferred from 1998 into 1999 and not any alternative amount? 

Mr. FALCON. We have not received an adequate explanation as 

to why that was done. We do know that their external auditor disagreed with that action that was taken. 

Chairman BAKER. Is it correct that in at least preliminary response that the modeling utilized by the enterprise was determined 

by management to be inaccurate and the feeling was expressed 

that the $400 million expense was actually overstated, and their 

view was that by deferring the $200 million it perhaps would more 

reflect economic reality? 

Mr. FALCON. Their own internal modeling for amortization clear- ly demonstrated that they had to take this $400 million expense in 

1998. It was their internal models that they were relying on for 

amortization expensing. 

Chairman BAKER. But they believed that model to be accurate? 

Mr. FALCON. Yes. 

Chairman BAKER. Then there is no justification. My under- standing was the $200 million had been deferred because a preliminary explanation is that the modeling was believed to be inaccurate 

and had overstated the expensing. More importantly, in the subsequent four quarters in 1999, the expensing did occur, acknowledging the value, and in fact did not the expensing require increases over the $200 million originally calculated? 

Mr. FALCON. Let me say something to that. I cannot speak to 

what the company believed as far as this amortization in 1998. I 

can say that we believe that it was not justified under generally 

accepted accounting principles, and that $400 million should have 

been recognized in 1998. 

Chairman BAKER. Is it correct that there are, because many will 

allege or suspect to allege, that this was a one-time dispute over 

arcane accounting methodologies? Their outside audit, you indicated, agreed that the expense should not be deferred and should 

be taken in 1998. Is that correct? 

Mr. FALCON. Yes. 

26

Chairman BAKER. Isn’t it correct that there were other accounting irregularities identified in other reporting years that placed the 

earnings calculation in question, and therefore the subsequent 

bonus calculations resulting from those earnings? 

Mr. FALCON. I am sorry? 

Chairman BAKER. Let me restate. Is it correct that you identified 

in the course of your examination other accounting irregularities 

and inconsistencies in other reporting years that placed the earnings for those years in question because of the accounting methodologies utilized, and therefore would result in placing the bonus 

payments made to executives in question? 

Mr. FALCON. Yes. 

Chairman BAKER. Going forward, I wish to reiterate that this is 

an interim report, not a final report. You engaged the services of 

Deloitte & Touche as an outside audit team to assist your staff in 

reaching these conclusions. In the course of that examination, you 

have reviewed, your staff, Deloitte & Touche, in excess of 200,000 

documents and e-mails over the course of the past 8 months. In addition, hundreds of interviews and depositions taken. 

This report should be understood as a first step, not a final step. 

As I understood in your opening statement, as you discover additional information that should be brought to the attention of the 

committee, you intend to do so. Is it appropriate or can you comment today on where your next focus of attention will take you 

within the enterprise’s activities? 

Mr. FALCON. I think I cannot at this time, Mr. Chairman, but I 

can tell you that we do this as a two-step process here. The first 

step in this review on these issues was to identify whether or 

not——

Chairman BAKER. Let me do this, Mr. Falcon. I hate to cut you 

off, but my time has expired, and I am going to try to hold other 

members to be accountable. I have one wrap-up question that is 

important for me to ask. 

Given the public statements to date by the executives and board 

members of Fannie, and the testimony I have reviewed that Fannie 

will proceed with today, in essence disputing all of your findings, 

placing your accounting judgment in question, the disputes with 

the opinion of your outside audit firm, the fact that you have had 

to request the issuance of subpoenas to get the enterprise to respond to your normal course of inquiry, do you believe the culture 

of mismanagement at Fannie Mae will change unless significant 

personnel alterations are required, as they were at Freddie Mac? 

Mr. FALCON. This comes down to a question of whether or not 

we have sufficient confidence in management to promptly implement the remediation plan that will be required to put the company back fully on sound footing. The issues raised by our staff in 

this report certainly do cause doubts about whether or not there is 

sufficient confidence in management going forward, such that there 

should not be management changes at the top of the company. 

We are currently considering that and we are having discussions 

with the board about the issue of management accountability and 

the confidence in current management. 

Chairman BAKER. I regret our time is so limited. 

Mr. Kanjorski? 

27

Mr. KANJORSKI. Let me ask the first question right off. Is there 

a systemic risk problem at Fannie Mae, in your opinion, at this 

stage of the preliminary report that you have gone through? 

Mr. FALCON. I think that we have managed this process in a way 

such that there is not substantial risk of a systemic disruption. 

Through the actions we have taken, and through the board’s 

prompt action in agreeing with us on remedial actions, we have 

precluded the possibility of systemic events. 

Mr. KANJORSKI. So we can inform the investing public and others 

that hold securities of Fannie Mae, is there any reason in the world 

that they should worry about the value or the credibility of their 

securities? 

Mr. FALCON. I am not quite comfortable talking about recommending whether or not an investor should or should not invest in 

this company. 

Mr. KANJORSKI. I am not asking you to make a recommendation. 

Is there anything in your findings, in other words, as a result of 

the audit differences that are being attended to, and as a result of 

some of the accounting wrongs that may have been uncovered 

through your investigation, is there any reason to believe that 

there is a large loss of equity or a question of Fannie Mae remaining solvent? 

Mr. FALCON. In the worst-case scenario, the company could be 

undercapitalized, below its minimum capital requirement, but not 

to the extent that the company would be insolvent. 

Mr. KANJORSKI. Can you give us a maximum amount of undercapitalization that you may have discovered? In other, the need to 

infuse more capital, what would that amount be? 

Mr. FALCON. Now that we have determined that the accounting 

policies of the company were not consistent with GAAP, the next 

step for us to take is to do an evaluation of the impact of these improper accounting practices on past financial statements, especially 

the impact of its large derivatives portfolio possibly not being eligible for hedging accounting treatment, which means the amounts in 

other comprehensive income would have to flow back into the balance sheets through earnings, and therefore be recognized. 

We will not know this until we go through all of the evaluation 

exercises. There are $12 billion in negative losses in OCI, and if all 

of that were forced to move over to earnings, the company could potentially take a hit of that much. But we do not know, congressman, how much, if any of that will move into the retained earnings 

portion of balance sheets until we have worked with the company 

to come to those determinations. 

Mr. KANJORSKI. Making the worst-case scenario assumption, 

however, that does not constitute in your mind systemic risk? Is 

that correct? 

Mr. FALCON. Yes. The solvency of this company is not threatened 

by the findings we have to date. 

Mr. KANJORSKI. Okay. I want to move you along because I have 

a few questions. 

I do not understand what you do as a regulator, but I assume 

you examine auditors’ reports. Is that correct? 

Mr. FALCON. Yes. 

28

Mr. KANJORSKI. And I assume that audit differences, as you indi- cated, how they handle the $400 million or the $200 million, 

showed up in a finding by the auditor to the corporation that was 

a difference here of opinion and how this should be accounted for. 

Is that correct? 

Mr. FALCON. What we do——

Mr. KANJORSKI. Not what you do. I want to know what papers 

you examine. What I am asking you is did you examine the audit 

report of 1998 and did there exist a finding indicating there was 

a difference between the auditor and the corporate leadership as to 

how this $400 million was accounted for? 

Mr. FALCON. We were not aware of this audit difference until we 

began this accounting examination. 

Mr. KANJORSKI. Why were you not aware of it? 

Mr. FALCON. We have not traditionally looked at the work of the 

external auditor to ensure that they were properly certifying that 

the company’s financial statements were consistent with GAAP. 

Mr. KANJORSKI. Do you mean the regulator does not get the outside audit report and examine it thoroughly before it passes, or examines anything else in a corporation? I would think that would 

be the first tool that you would look at. 

Mr. FALCON. Let me ask our chief accountant about this question, Mr. Kanjorski. 

Ms. DELEO. We are certainly taking that approach at this point. 

Mr. KANJORSKI. I am not worried about 2004. I am asking about 

1998. I am trying to get an essence of just what a regulator does. 

The only prior experience that I have had sitting on a board of a 

bank was that we would have external audits and at the conclusion 

there would be an exit meeting of all the differences or questions 

raised by the auditor that would be presented to the audit committee. 

It just seems rudimentary that if you are going to spend hundreds of thousands or maybe millions of dollars to hire an auditor, 

that all of that is laid out in the findings and the differences, and 

that should be the first piece of paper the regulator picks up and 

looks at because a lot of work has been done and a very credible 

auditing company has made differences in findings. In 1998, if we 

had picked up the audit report by the external, outside auditor, 

was there a reflection of an audit difference in how that $400 million was handled? 

Chairman BAKER. I would ask the gentleman that that be the 

last question on this round. 

Please respond, sir. 

Mr. FALCON. Yes. We look at this, Congressman, as a team effort. 

The safety and soundness of this company is dependent, yes, on us 

doing our job properly. It is dependent on management running the 

company properly, the board properly overseeing the company, and 

the external auditor doing its work to ensure that the financial 

statements are consistent with GAAP. We look at the financial 

statements and the work of the external auditor. I do not know 

where this audit difference was reflected. 

Mr. KANJORSKI. I just want to follow this line of questioning. You 

mean at this point in time you do not know whether or not that 

was openly displayed in the outside audit report? 

29

Mr. FALCON. Let me ask Mr. Dickerson, please, Congressman, to 

address this. 

Mr. DICKERSON. Congressman, we had testimony from the controller and the CFO that there was this $200 million audit difference between the firm and KPMG. We saw internal documents 

from the company that there was approximately a $400 million expense that was estimated. 

Mr. KANJORSKI. And it was listed as an audit difference by the 

outside auditor in 1998. 

Mr. DICKERSON. Right. And we learned that through testimony 

that we obtained from the CFO. 

Mr. KANJORSKI. It took you 6 years and depositions to discover 

something that was on a concluded audit document as a finding? 

Mr. FALCON. We need to go back and find out if this was included in any documents that were or should have been provided 

to the agency. If we find that this was something that was in some 

documents that we could have had access to, that we should have 

had access to, then it points out a need for us to strengthen our 

program. 

I am not saying that the agency is completely without fault here. 

We have more resources now, with an accounting staff. We did not 

have an office of chief accountant until 2 years ago. Ms. Deleo has 

just joined the agency very recently. But in light of the Freddie 

Mac problems, I think it has highlighted a need for this regulator 

to get heavily involved in accounting issues because they do go to 

the heart of the safety and soundness of our work. If we cannot 

rely on the books and records of this company——

Mr. KANJORSKI. Yes, but you do not read the books and records 

of this company as a regulator. It does not matter. It would just 

seem to me that this committee could call up and subpoena the 

outside audit report of 1998 and I will be shocked if a finding is 

not there mentioning this audit difference as to how the money was 

handled. It should have been the first day you arrive at the place, 

looking at the audit. You should know what happened. 

I am just worried about, we are calling you a regulator and you 

are scaring hell out of me that you did not see that, and everybody 

should have been alerted to that that sits on a board, that you go 

through your audit findings. That is so axiomatic. I guess in law 

school we used to call that Horn book. 

Chairman BAKER. The gentleman’s time has really expired, if I 

may. I really want to try to hold members. We have much more 

to do today. Please help me here to get through this process. 

Mr. Castle? 

Mr. CASTLE. Thank you, Mr. Chairman. Even by Washington 

standards, this is an extraordinarily tangled web that we are dealing with here and a little bit hard to follow to a degree. 

Fannie Mae clearly has some questions to answer here. I am 

worried that we have not given the regulators, OFHEO in this 

case, sufficient assets to move ahead with what they have to do in 

terms of their work. There are a lot of people hired on the outside 

to try to hold all this off. Frankly, I think we have a responsibility 

as a subcommittee and a committee right here to do everything we 

can to get to the bottom of all of this. 

30

Let me just start with this, if I may, Director Falcon. And that 

is, as I understand it, you hired an outside auditor recently. Did 

you not hire an outside auditor prior to that time because of insufficient funds to do so? 

Mr. FALCON. We have not hired an outside auditor to assist us 

prior to the initiation of this special accounting examination. That 

is right. 

Mr. CASTLE. Was it because you had insufficient funds to do so? 

Mr. FALCON. We have been trying to. We have not undertaken 

a special accounting review like this prior to this point. We have 

not made the request, I guess, for the funds. But even if we saw 

the necessity for it, we would not have had the funds and we would 

have had to come to Congress for the additional funding. 

Mr. CASTLE. Let me ask you another question. Can you tell me 

why, and I can only judge this through press statements of my own 

accord. KPMG is standing by the company’s financial reports, even 

after your report, of course. Could this be another example of just 

a difference of opinion as to the application of GAAP, such as the 

one I understand you have with this company with regard to their 

manufactured housing loans? Or is it something else? 

Mr. FALCON. We feel very strongly that these are black and 

white accounting issues. These are not issues of interpretation. 

They are not issues where reasonable people can disagree. We have 

taken prompt, strong action in trying to deal with this because we 

do think they were clear violations of accounting principles. 

Mr. CASTLE. So i.e. KPMG then in standing by this is at fault 

in terms of the clear accounting principles which exist. Is that what 

your statement is basically? 

Mr. FALCON. If they are standing behind this accounting treatment, then yes, they are wrong as well. 

Mr. CASTLE. Do you have sufficient powers to carry out your responsibilities? I know there has been a lot of discussion about 

changing agencies and all the things that we should do, but I am 

worried about what you can do now in terms of cease and desist 

orders, other regulatory powers which you need, the funding which 

you need in order to carry out your responsibilities to make sure 

all this is handled correctly. 

This is of overwhelming significance, and I think for you to be 

shortchanged in any of these categories would be a terrible error. 

Can you detail for us where there may be needs, or if there are not 

needs at all? 

Mr. FALCON. I think there are several key areas where we would 

like the same powers that are given to every other safety and 

soundness regulator. It begins with the authority to assess for 

budgetary needs outside the appropriations process, to have independent funding. It begins with flexibility in a variety of areas, including capital requirement setting. Every other regulator has that. 

It includes issues like independent litigating authority, the ability to freeze the pay of any executives where we find potential 

wrongdoing. We recently had an opinion in district court saying 

that we do not have the same authority that other regulators have. 

So there are quite a few areas where we just need strengthening 

across the board, including general safety and soundness powers. 

31

Mr. CASTLE. Changing the subject, I wrote down a couple of comments, and I do not know if I wrote them down correctly, of course. 

Correct me if you see otherwise, but that you made in your opening 

statement. You said that Fannie Mae understood the rules, but 

chose not to follow them. 

Mr. FALCON. Yes. 

Mr. CASTLE. What do you mean, Fannie Mae? Do you mean their 

board of directors, their officers? What do you mean by Fannie Mae 

in that circumstance? And are the rules that you are referring to 

accounting rules or something beyond anything that has been discussed here today? 

Mr. FALCON. What we mean is, this is not a matter where the 

rules were too complex and the company did not understand them. 

It is not a matter where they made a good-faith effort to try to 

comply with the rules. They did not comply with rules that they 

clearly understood. 

Mr. CASTLE. Accounting rules? 

Mr. FALCON. Accounting rules. 

Mr. CASTLE. That they clearly understood. And when you say 

‘‘they,’’ you are referring to whom? 

Mr. FALCON. Those responsible in the company for setting accounting policy consistent with GAAP. 

Mr. CASTLE. So it could be officers or it could be directors or a 

combination of the two or something of that nature? 

Mr. FALCON. Yes. 

Mr. CASTLE. Okay. And then you said it is just plain wrong and 

must be fixed and not overlooked. I assume that is just a followup to what you had said earlier in this particular area. When you 

say ‘‘fixed,’’ if a mistake was made, do you mean going back and 

just correcting the accounting principles? Or is there something 

further that needs to be done to so-called ‘‘fix’’ their problems? 

Chairman BAKER. That would have to be the gentleman’s last 

question. 

Please respond, sir. 

Mr. CASTLE. Thank you, Mr. Chairman. 

Mr. FALCON. It means making sure that the proper accounting 

policies are put in place going forward. If there was an impact on 

their financial statements going backward, that it would mean that 

there would be a need to correct those financial statements going 

backwards. That is an issue that we are working with the SEC on. 

Mr. CASTLE. Thank you, sir. 

Chairman BAKER. I thank the gentleman. 

Ranking Member Frank had to step out. Just for the committee’s 

purpose, I have committed on his return to recognize him in the 

proper order for his questions. 

Mr. Clay, you are up next. 

Mr. CLAY. Thank you, Mr. Chairman. 

Mr. Falcon, when you and members of OFHEO’s staff conducted 

interviews and received company documents, why was Fannie Mae 

not allowed to question their witnesses on the record? 

Mr. FALCON. They were allowed to participate in those sessions. 

I am not aware if they requested such opportunity, but the interviews of their employees were held at our request in order to gathVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
32

er information about the company’s accounting policies and practices and internal controls. 

Mr. CLAY. Why were Fannie Mae officials not provided the opportunity to respond to findings or conclusions reached by OFHEO 

during the course of the examination? 

Mr. FALCON. I think because we followed a regular order here. 

We followed an accepted practice of regulators. Faced with findings 

of significant accounting misconduct by senior management and 

dealing with a management that is resistant to regulation, that 

same management team responsible for this accounting misconduct, any regulator would have done what we did, take this directly to the board. 

Mr. CLAY. Is this due process? 

Mr. FALCON. This is safety and soundness regulation which requires prompt action to ensure that the company does not get into 

financial difficulties. 

Mr. CLAY. Is this the way you have handled internal investigations in the past? 

Mr. FALCON. Other than the Freddie Mac special accounting review, this is only the second special examination that we have conducted. On more routine matters like our ongoing annual riskbased examination of the enterprises, we do have that type of a 

give and take, but this was a different situation. 

Mr. CLAY. In May and June of 2003, OFHEO published its 2002 

annual report giving both companies, Fannie Mae and Freddie 

Mac, more than satisfactory grades on accounting and internal controls. You and your agency were pretty embarrassed when issues 

were discovered at Freddie Mac. Were you so determined to not let 

this happen again even if it meant denying Fannie Mae fundamental fairness that is routinely provided to banks? 

Mr. FALCON. No, congressman. I have testified before this committee before that I had no reason to believe that this company was 

engaged in any kind of accounting improprieties like Freddie Mac. 

But given the fact that questions were being raised about whether 

or not the same problems existed at Freddie Mac, I thought it appropriate to go in and take a look at Fannie Mae. So we did. I am 

as disappointed as I think you are that the company has engaged 

in this type of conduct. But the findings are what they are, and we 

have taken action. 

Mr. CLAY. Let us go back to the process, then. Examiners discuss 

preliminary concerns and possible findings with regulated entities. 

Would it not have been fair to do this with Fannie Mae, to sit down 

and have a discussion with them? 

Mr. FALCON. We did have a discussion, but it was with the 

board, congressman. Like I said, this was a situation where we 

have findings of serious accounting misconduct by management 

and we have that same management being resistant to our efforts 

to deal with these issues, noncompliance with our efforts to examine the company such that we had to go to the Justice Department 

and ask for a court enforcement of our subpoena. In such situations, any regulator would have gone directly to the board, brought 

the matter to the board’s attention, and sought immediate action 

to ensure the safety and soundness of the company. 

33

Mr. CLAY. You did not provide Fannie Mae with a draft examination report. Banks are given an opportunity to respond before finalizing an examination report or discussing matters with their company’s board. Why not Fannie Mae in this instance? 

Mr. FALCON. We do that. In the course of our normal examination of the company, we do that. But as I have said, this is a different situation. 

Mr. CLAY. And you claim that they were hostile to the examiners. In what way? 

Mr. FALCON. They were resistant to compliance with our request 

for documents and we had difficulty in scheduling their employees 

for interviews. We eventually had to move to taking statements on 

the record, rather than having informal interviews of employees. 

We had to move to the issuance of administrative subpoenas. We 

had to ultimately try to get those subpoenas enforced in court. 

Mr. CLAY. Don’t you think that all interests are best served by 

ensuring that all relevant data is available to OFHEO and that 

there are no misunderstandings of relevant facts? 

Mr. FALCON. I am sorry, Congressman. That all relevant data is 

available to——

Mr. CLAY. To your agency and there are no misunderstandings 

of relevant facts. 

Mr. FALCON. Yes. 

Chairman BAKER. That will need to be the gentleman’s last question. His time has expired. 

Mr. CLAY. Did he answer? 

Chairman BAKER. He did respond, I believe ‘‘yes.’’

Mr. CLAY. Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Mr. Chairman. 

Director Falcon, 3 years ago our committee was heavily involved 

in the accounting scandals surrounding Enron and WorldCom and 

others. We saw, based on our hearings and evidence, manipulation 

of earnings, corporate governance failures, raiding of corporations 

by their executives in order to pad their own wallets. 

After reading your report, it seems that you are alleging many 

of the same problems now exist at Fannie Mae. As you know, the 

Sarbanes-Oxley Act was formulated to prevent future Enrons, but 

has been repeatedly criticized in some quarters as being too tough 

on corporations. Do you believe that Sarbanes-Oxley has been a 

useful tool in your investigation? And do you believe that Fannie 

Mae’s executives were in violation of the Sarbanes-Oxley Act? 

Mr. FALCON. I think it has been a very useful tool, Mr. Chairman, because the spirit of Sarbanes-Oxley is accountability, accountability of management and accountability of boards in corporate governance issues. Here we have a situation where because 

of the requirements of Sarbanes-Oxley, I think the board has 

stepped up to try to begin to fulfill its responsibilities. They have 

worked with us well in coming to an agreement. We are working 

on developing a good relationship going forward to address any future problems. 

The provisions like certification certainly are beneficial. There is 

much at stake when an executive certifies compliance with the proVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00041 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
34

visions of Sarbanes-Oxley. It has been a very useful tool for the 

agency, because we also have safety and soundness standards that 

our patterned off of Sarbanes-Oxley as well. 

Mr. OXLEY. How does your job working with the regulated entity, 

that is Fannie Mae, and in the context of Sarbanes-Oxley regarding 

the SEC, explain to the committee a little bit about how, as a technical matter, that works? 

Mr. FALCON. We are working with the SEC. Now that Fannie 

Mae is a registered company under the 1934 Act, they are covered 

by Sarbanes-Oxley. We are working with the SEC. We have shared 

with them all of our findings. We are sharing our documents with 

them, everything that they have requested. We have a shared interest here. Our interest is safety and soundness. The SEC’s interest is investor protection. We are each working to make sure that 

our missions are fulfilled here. Sarbanes-Oxley has encouraged 

that kind of interagency cooperation between the safety and soundness regulator and the SEC to make sure that both interests are 

properly served. 

Mr. OXLEY. Director Falcon, Fannie Mae is one of the largest 

users of derivatives in the world. As such, Fannie Mae should be 

well versed with the rules related to FAS 91 and FAS 133. Is it 

your understanding that Fannie was aware of the fact that their 

accounting was not GAAP compliant, but they chose not to comply 

because, to do so, would be too burdensome and costly? Or is it 

your opinion that Fannie Mae made a material misapplication of 

the GAAP rules? 

Mr. FALCON. I think it is both, Mr. Chairman. One, they wanted 

to maintain the accounting principles that they thought were best 

suited to the company. At the same time, they willfully did not 

apply accounting rules properly. This is an important point because 

it was not just a matter of these rules being too complex for this 

large, very sophisticated company. They understood the rules. They 

chose not to follow them. 

These accounting principles have to mean something, Mr. Chairman, and they should apply to every company equally. No one gets 

special treatment. What we have done in this report is to highlight 

the issues of how the company has not complied with some very 

critical accounting rules. The company will not get special treatment from us. I do not think anyone should give it special treatment in making sure it complies with all accounting principles. 

Mr. OXLEY. The Sarbanes-Oxley Act clearly spells that out. So 

you are saying that basically this was a selective effort on the part 

of Fannie to use accounting principles that would benefit them, as 

opposed to what we would consider to be generally accepted accounting principles as enunciated by the FASB and ultimately the 

rules set up by Sarbanes-Oxley and the SEC and the Public Company Accounting Oversight Board. 

Mr. FALCON. That is right. They simply did not comply with 

GAAP because compliance with GAAP would have shown more volatility in their quarterly financial statements than they would have 

liked. So through the misapplication of GAAP, they were able to 

project an image of the company of smooth earnings, which conveys 

to the markets less risk than is actually there because of the volatility of strict compliance, of proper compliance with GAAP. 

35

Mr. OXLEY. Okay. So the issue is a selective interpretation of 

GAAP. I would assume that Fannie will come before the committee 

later today and argue that basically it was a difference of opinion 

over those issues, and that they were clearly compliant with the 

GAAP and that you had a different interpretation as to whether 

that was procedurally correct. How would you respond in advance 

to almost certainly they will be testifying to? 

Mr. FALCON. It would not surprise me, Mr. Chairman, that that 

would be their position. We have found, not just our chief accountant and her staff, but also Deloitte & Touche, we have found that 

these are clear violations of generally accepted accounting principles. They are not situations where a company can say that they 

may have been aggressive; they may have been consistent in spirit. 

No, these were noncompliance with GAAP. 

We would not have come to the very firm conclusions we did in 

this report and not have taken prompt corrective action were it not 

for the fact that these were clear violations of GAAP. If any company were allowed to engage in this type of accounting misconduct, 

then no investor could rely on the books and records of the companies and their financial statements. 

Mr. OXLEY. This will be my last question, Mr. Chairman. 

As you know, in Sarbanes-Oxley we specified that insider stock 

sales, instead of the traditional 40-days recording requirement, 

would now be made in real time, that is within 24 hours of that 

sale. Did your investigation look into insider, that is corporate executives, stock activities? If so, what did it tell you? 

Mr. FALCON. We have been monitoring the sales of individuals 

within the company. We are just now beginning to shift our focus 

into other areas like that. Our first objective here was to assess 

compliance with GAAP in these two critical accounting areas, and 

now move to remedy those problems and get to valuation issues. 

But issues like the insider stock sales are something that we have 

been monitoring and perhaps we will come back and give you a report on that. 

Mr. OXLEY. It would seem to me at least that perhaps would be 

the SEC’s role because the Act required them, the insiders who sell 

stock, to report that on the Web site at the SEC. And so, I would 

assume that at least the SEC would assume that particular role 

and that OFHEO would be secondary in that regard. Is that correct? 

Mr. FALCON. Yes. They are publicly disclosed, and the SEC 

would have a role in that. 

Mr. OXLEY. They would have the primary role, would they not, 

under the law? 

Mr. FALCON. They would have a primary role, but safety and 

soundness requires that we also take action. There is some overlap. 

Safety and soundness requires that we also take action when we 

see violations. It is important that we do coordinate with the SEC 

in areas where there is overlap. 

Mr. OXLEY. The purpose, of course, of the provision, as Chairman 

Baker knows and others on the committee, was to provide more 

transparency in real time because perhaps if we had that on the 

books during the Enron case, some of those insider sales would 

have put up a lot of red flags, particularly when the employees 

36

were locked down and not able to sell their shares. So that is why 

I wanted to bring that point up, the idea of the immediacy of it and 

the transparency of it hopefully, at least at some point, will provide 

some deterrent to that kind of behavior, including perhaps smoothing out earnings or making earnings look better than they really 

are. 

With that, I yield back. 

Chairman BAKER. I thank the chairman. 

Mr. Scott? 

Mr. SCOTT. Yes, thank you, Mr. Chairman. 

Mr. Falcon, there have been some questions raised as to the timing of the release of your report. Could you describe the manner 

in which this report was released, the timing of it? Were there systematic leaks to the press? Were they internal? And the affected 

parties such as Fannie Mae were aware of your findings before 

they were released to the press? 

Mr. FALCON. We have kept a tight lid on this as we have gone 

through the process. The first communication we had about this report as we got to the end of it was on Friday, the day before we 

met with the board, I do not remember the exact date, congressman, but we did contact the company and asked that the board assemble itself so that we could present the report to the board. 

We did not release the report to anyone prior to that date. The 

first time we released the report outside the agency was to the 

board at that date. We did have on the Friday before that Monday 

meeting, some conversations with other agencies just to make them 

aware of what we were finding and how we were going to proceed. 

Then once we went to the board on Monday, the week progressed 

with discussions between us and the board about proper remedial 

action. 

Mr. SCOTT. Let me ask you this, then, at what point did you release it to the press in that order of events? When exactly did you 

do that? 

Mr. FALCON. We did that on Wednesday. I had a commitment to 

the board that we would not release the report as long as they objected, and we were in the process of working out the terms of this 

agreement to take care of remedial actions. On Wednesday, I had 

a meeting with a couple of the board members. They said that 

given the intense interest in this, they no longer had any objections, and given the fact that there was also some expression raised 

from members of Congress about go ahead and put the report out 

there, I exercised my judgment and said, okay, then we will go 

ahead and release the report. 

Mr. SCOTT. Okay. Did you consult with the Securities and Exchange Commission or FASB prior to making the report’s findings 

public, as to whether or not Fannie’s accounting was consistent 

with GAAP? 

Mr. FALCON. We spoke to the SEC about this on the Friday before we went to see the board. Prior to that time, we did not seek 

their opinion about this. Because we viewed these issues as clear 

violations and the company clearly understood these rules, we did 

not. If we felt that this involved a gray area and we needed some 

guidance about what the rules required and whether or not the 

37

company was meeting those rules, then we would have certainly 

sought guidance from the SEC. 

Mr. SCOTT. Okay. Two little points here. How are the problems 

with accounting for derivatives at Fannie, how do they compare 

with what you have found with the examination of Freddie Mac? 

Are they the same? Same abuses? 

Mr. FALCON. We have seen the same cultural issues. We have 

seen the same motivations in terms of smoothing earnings. Some 

role in compensation issues. So certainly much of that appears to 

be consistent between the two companies. 

As far as the actual magnitude of any impact on the company’s 

financial statements, I really do not have an answer for that until 

we complete this next phase of the process, which is to assess the 

impact on past financial statements. 

Mr. SCOTT. Why do you think that Fannie Mae altered their 

earnings? What was the underlying purpose from your report? 

Mr. FALCON. The primary rationale as we see it was a strong desire that the company had to present itself to the public and investors as a company which had very smooth and consistent and reliable earnings growth. The only way to do that was to develop these 

accounting practices which allowed them to smooth out the volatility which exists in this line of business. 

Mr. SCOTT. Do you think that this activity was generated on the 

part of Fannie Mae so that they could increase their compensation 

package? 

Chairman BAKER. That would need to be the gentleman’s last 

question. His time has expired. 

Please respond, sir. 

Mr. FALCON. It certainly appears that way to us. Given this one 

instance in 1998 and given the fact that for the next 5 years bonuses were continually tied to earnings per share as a metric. That 

metric was being manipulated in order to create smooth earnings. 

It certainly appears that way to us. 

Mr. SCOTT. Thank you very much, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Shays? 

Mr. SHAYS. You are almost becoming a sympathetic figure, and 

your organization. I mean, you have issued a report and you are 

getting attacked on the report. You are being questioned why you 

did not do a better job sooner, and yet your organization has not 

been given the authority or the power by Congress to do the job 

it needs to do. 

And frankly, I do think you needed to show a little more energy, 

which you are starting to do. I am seeing the result of that. When 

did you give them the report? When did you talk to them? Why 

didn’t you find out sooner? Instead of having members of this Congress try to find out what the hell they did. 

One of the things that I find somewhat astounding is, are you 

saying to this committee that you actually had to issue subpoenas 

against this organization or consider it or threaten it to get information you are entitled to get? 

Mr. FALCON. We issued administrative subpoenas to get information that we needed for this special examination, yes. 

38

Mr. SHAYS. Why would you have to issue administrative subpoenas? Why can’t you just ask for it? 

Mr. FALCON. We did initially, but we did not get sufficient compliance, certainly not timely compliance, partial compliance. Therefore, we felt the only way to solve that problem was to move toward 

administrative subpoenas. 

Mr. SHAYS. So the bottom line is, not only have you found this 

company not in compliance, you are telling us they resisted in your 

initial efforts to find out what was going on. They resisted your efforts to do your job. Isn’t that correct? 

Mr. FALCON. That was our feeling and that is why we moved toward the more formal processes. 

Mr. SHAYS. And you have stated to us that these findings are 

very serious, correct? 

Mr. FALCON. Yes. 

Mr. SHAYS. Are investors impacted? Isn’t it possible that investors, based on reports, will have made decisions that were based 

on faulty information? 

Mr. FALCON. Unfortunately, that very much is the case when you 

have financial statements issued under accounting practices that 

are not consistent with GAAP. GAAP is there to ensure consistency 

of reporting across quarters so that you have the ability to compare 

a company’s performance from quarter to quarter. If you do not 

have correct compliance with GAAP, then you do not have that 

comparability from quarter to quarter and can judge a company’s 

performance over time. 

Through these catch-up provisions the company had under FAS 

91, it allowed it to minimize earnings volatility and that comparability that investors need. 

Mr. SHAYS. And didn’t it also enable them to say they were a 

low-risk enterprise? 

Mr. FALCON. The lack of volatility certainly conveyed that impression. 

Mr. SHAYS. Now, having discovered what you have discovered 

without the cooperation of the organization, are they accepting 

your findings or resisting your findings? 

Mr. FALCON. I feel like the board has been cooperative in working with us to address these findings. 

Mr. SHAYS. Right. And they said that they will change their behavior, correct? 

Mr. FALCON. They said they would change their behavior going 

forward. They are going to do the calculations for us going backwards so we can assess the magnitude of the incorrect accounting 

in prior periods. 

Mr. SHAYS. What concerns me is, when Mr. Raines comes and 

testifies, he is not going to give us the feeling that he gets it. Why 

do you think that is the case? 

Mr. FALCON. I cannot speculate on that. I just know that our 

findings, we feel very strongly about what we found. A lot of work 

has gone into this. It does not surprise me that the company would 

continue to stand behind its accounting, but the fact is it is wrong. 

Mr. SHAYS. It is wrong, and there is not going to be any doubt about the fact that it is wrong. Now, their auditor was paid $3 million in a $1 trillion firm. Doesn’t that raise some question about 

39

their capability, the auditor’s capability to do the job, with a $1 

trillion operation? 

Mr. FALCON. We are now focusing more on the work of the external auditor. We have had concern about potentially excessive reliance by the external auditor on the internal audit function and internal policy-setting by the company, but that is something for further review now that we have completed this step in the process. 

Mr. SHAYS. I congratulate you on the work you have done. I congratulate you for trying to protect the public. I congratulate you for 

showing courtesy to the company, meeting with them first before 

this report was issued. But the bottom line is, what really matters 

is what your report says and how they deal with it. I am somewhat 

appalled and maybe even a little shocked that you would have had 

to use subpoenas to get information to do your job. I thank you for 

going to that level to ensure that you could get your information. 

Chairman BAKER. The gentleman’s time has expired. 

Ranking Member Frank? 

Mr. FRANK. Thank you, Mr. Chairman. 

Let me say, I was pleased and I understand what the gentleman 

said. I guess, if your feelings have been hurt. I am sorry. I did not 

think anybody here was of that sensitivity. I was pleased to join 

with the chairman in objecting to the appropriations committee to 

level-fund you going forward, but we thought that was the best 

thing we could do was to get you more money, and the chairman 

of the committee and I jointly protested the decision of the Appropriations Committee, but being in the minority we do not get to 

make those appropriations decisions, but we were certainly supportive of that. 

I did have a couple of questions. This is important about how 

this was done, because I think there is a problem that a perception 

could be created before we can establish a reality that could be 

damaging. Now, you told the gentleman from Georgia how you 

went about telling people, et cetera. But there was a newspaper report over that weekend I think quoting the chairman of the subcommittee. He said he had been briefed on the content of the report. We on our side, on the Democratic side, heard nothing until 

we read about it in the paper. Was the chairman briefed and is it 

appropriate to brief one side and not tell the other? 

Mr. FALCON. That would be certainly not appropriate and not 

consistent with the way I would like to deal with this committee, 

congressman. We did not brief any member of the committee. Unfortunately, the press just reported that inaccurately. 

Mr. FRANK. Wait. Stop. The press mis-reported it. All right. 

Maybe that will make it into the reports of today’s proceedings. 

So the report that the chairman had been briefed was an error 

on the part of the press. He was not briefed. 

Mr. FALCON. Yes. 

Mr. FRANK. Okay. 

Chairman BAKER. Would the gentleman yield? I just want to confirm. I do not know where the report generated. I was not either 

by SEC or OFHEO given any advance information. 

Mr. FRANK. Okay. I appreciate that. I would just caution people, 

and we now have an agreement from all parties that the assertion 

that OFHEO had briefed the chairman of this committee was a 

40

mistake in the press. If that is the only mistake the press has 

made in this, that would be quite extraordinary. 

Let me ask you, similar. There was one report in one newspaper 

that you had made a referral of a criminal matter to the Justice 

Department. Is that accurate? 

Mr. FALCON. We have not made a formal criminal referral. All 

we have done is given a copy of the report to them. 

Mr. FRANK. To everybody. So that means you have not made a 

criminal referral as that is defined. 

Mr. FALCON. Right. We have not made a formal referral. 

Mr. FRANK. Okay. That is another one again. I think the suggestion that there was a criminal referral is it seems to me quite misleading. I am glad we were able to clear that one up. 

Now, on the question of the substance, Fannie Mae has agreed 

to a 30 percent increase in their capital. Is that correct, as a result 

of your conversations with them? 

Mr. FALCON. Yes. 

Mr. FRANK. How did you arrive at the decision to make it 30 percent? My understanding is, as I read this, the smoothing out of 

earnings, if that happened, to give people more pay is outrageous, 

but it does not seem to me to implicate in any way the safety and 

soundness. A smoothing out means up one and down another. It 

does not affect certainly the overall economic position. 

Then the question is the derivatives and the hedge accounting. 

The potential misstatement there is I guess part of the reason that 

you asked for the 30 percent increase in capital because it might 

have been a misstatement. 

But my understanding is you have come to no conclusion as to 

what the amount of a potential misstatement was. Is that correct? 

Mr. FALCON. That is correct. 

Mr. FRANK. Could it have been an under-estimate as well as an 

over-estimate? 

Mr. FALCON. Potentially. 

Mr. FRANK. So what we know is that you disagreed with the way 

they did them. I was struck, and I would ask unanimous consent 

to put in the record here a very interesting report, September 27th 

from Merrill Lynch, Thoughts on OFHEO’s Special Examination of 

FNM. 

They note, for instance, with regard to the derivative issue and 

the potential problem, the market value of these derivatives, just 

like that of straight fixed-rate debt, is how you correlate it with interest rates. When the rates fail, these derivatives show losses. 

When rates rise, they show gains. My understanding is rates are 

probably going to be going up in the next time period, so they are 

more likely to show gains than losses. 

Since you have not been able to quantify this and in fact you are 

not clear whether this is going to be a gain or a loss, where did 

the request for a 30 percent increase in capital come from? How did 

you decide it had to be a 30 percent increase? 

Mr. FALCON. It is because of the management and operations 

risk, as well as the uncertainty about their financials. 

Mr. FRANK. But how did you calculate 30 percent? What were the 

figures? 

41

Mr. FALCON. We took the 30 percent because the risk-based capital standard requires a 30 percent add-on for management and operations risk, but there is not that add-on in the minimum capital 

standard. We decided that given the weaknesses we found in internal controls, uncertainty of financial statements, we decided——

Mr. FRANK. And the 30 percent, you said that is the requirement. 

That was a preexisting figure that you decided applied here? 

Mr. FALCON. That is in the statute. 

Mr. FRANK. Okay. Again, I think we ought to be clear. The decision to require a 30 percent increase in capital was not based at 

all on any calculation on the extent to which the capital might have 

been impaired, but was a borrowing from the statute or an application from the statute of what happens when you find management 

risk. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Royce? 

Mr. ROYCE. Thank you, Mr. Chairman. 

I would like to learn a little more about FAS 133. One of the 

things I want to know is whether Fannie Mae and Freddie Mac 

apply FAS 133 in a similar manner, or is one more conservative 

and more consistent than the other? Another question, as I understand it, FAS 133 went into effect in 2000 or 2001, and to qualify 

for hedge accounting your derivatives have to perfectly match what 

they are hedged against when they are booked, and you have to 

document that. If you do that, then you are allowed to use hedge 

accounting. 

One of the questions I would have is, if they were not perfectly 

matching was it because in your findings, was it because Fannie 

Mae did not have the expertise or the ability to do that? Or did 

they and they simply decided not to for some reason? I was wondering why the auditor, KPMG, did not pick this up. This is not 

one of the examples that they originally cited, unless it is and I do 

not know it and you could let me know that. 

The other question I have is, how material was this? How great 

were the irregularities? I know it says it has to perfectly match, 

but I do not know from your report the extent that this was off, 

and therefore requiring this long-haul accounting approach rather 

than the hedge accounting. Maybe you could help me out so I could 

better understand what is at issue here. 

Mr. FALCON. Sure. On the technicalities of this 133, my chief accountant is much more qualified than I am, fortunately, to get into 

the details of that. She can address the difference between how 

Freddie Mac did it and how Fannie Mae did it. 

Mr. ROYCE. Let us start with that, because I am interested if 

there is a considerable difference in approach. Let me just hear 

that out in terms of a more conservative or consistent approach by 

one of the GSEs over the other. 

Ms. DELEO. Actually, before Freddie’s restatement, the application of 133 between the two companies was substantially different. 

Of course now after the restatement, because of a number of things 

that happened during that process, they are different. You really 

cannot make that comparison. 

42

Mr. ROYCE. You cannot make that comparison because they were 

applying a completely different approach in terms of how they were 

going to value the portfolio on the risk? 

Ms. DELEO. I guess I would not say completely different, but substantially different. 

Mr. ROYCE. Could you help me out and just indicate if initially 

one approach, in your view, was more conservative and more consistent than the other in terms of the two GSEs here? 

Ms. DELEO. In both instances, there were misapplications. They 

were just mis-applied in different ways. 

Mr. ROYCE. I see. Okay, well that answers my first question to 

some extent. Go ahead, Mr. Falcon. 

Mr. FALCON. Mr. Dickerson, if you don’t mind, would like to add 

to that, congressman. 

Mr. DICKERSON. Freddie Mac had a program where they were applying their derivative hedges directly to the mortgages on their 

books. That was one difference. Fannie Mae has chosen to apply almost all of their derivatives to specific liabilities on their balance 

sheet. That is one big difference between Fannie and Freddie. 

Mr. ROYCE. Okay. And let’s go to the question of why the auditor, 

why KPMG did not pick this up. We are going back to the first 

year that they would have to comply. Did that auditor at the time 

feel they had complied with the standards that would allow hedge 

accounting? Or did they simply not test for that? Do we know? I 

would be interested in that. 

Mr. FALCON. We are now looking into the determinations of 

KPMG on these matters. But let me make clear that the responsibility for compliance with accounting rules primarily rests with the 

company. It is not sufficient to simply say that the auditors signed 

off. 

Mr. ROYCE. I understand that. I wonder, did the company at the 

time feel it was in compliance? I guess your argument would be, 

listen, if it has to match perfectly, then the company knew it was 

not matching perfectly by definition if they are using estimates. 

But I do not know the details here to know how far off they were. 

That is what I am trying to elicit, is a greater understanding of the 

specifics of this. 

Ms. DELEO. Let me address that. Just backing up a second, let’s 

talk about 133 because I think it will help in the context. One-thirty-three in principle is really a very simple pronouncement because 

it basically says you need to mark to market your derivatives. But 

it goes ahead to say that if you qualify for hedge accounting, and 

what we are looking at there is that you are going to go through 

and make an assessment test to see if the derivatives are highly 

effective. If they are highly effective, then you need to measure for 

ineffectiveness. So that is kind of the second step. If they are not 

highly effective, you cannot use hedge accounting. 

Then in addition to that, there are some exceptions in 133, very 

rule-based and very specific, that say if you have matched terms, 

which they do not actually have, and there are very specific criteria 

that you must meet to do that, then in that case there is no ineffectiveness. They are perfectly effective if the terms are matched. So 

you would not have to do the assessment test and you would not 

have to measure ineffectiveness. That is the problem. It is that 

43

they moved to that last very specific area and they simply do not 

qualify under that. 

Mr. ROYCE. One last question. Is that because they do not in 

your opinion have the ability or the expertise to do that? 

Ms. DELEO. They fully understood the rules. That is not in doubt. 

Their systems are not capable at this point of doing what we are 

calling long-haul accounting, doing the assessment test and the 

measurement of ineffectiveness. They could have built systems to 

do that, but that was not done. 

Mr. ROYCE. I see. 

Chairman BAKER. The gentleman’s time has expired. 

Mr. ROYCE. This really has helped me understand. 

Mr. Chairman, thank you. 

Chairman BAKER. I thank the gentleman. 

Mr. Hinojosa? 

Mr. HINOJOSA. Thank you, Mr. Chairman. 

Director Falcon, I understand that your report hinges on the accounting work of Deloitte & Touche. My question is, what was your 

cost to retain Deloitte & Touche for the 8-month period that you 

said they worked for you? 

Mr. FALCON. Let me clarify, congressman. This work is and the 

judgments in it are the product of OFHEO. Deloitte assisted us in 

this work and they support the findings, they agree with the findings in this report as well, but this is the work and the judgments 

of OFHEO. They did assist us, but I do not want to pass anything 

off to them. This was our judgment. 

Mr. HINOJOSA. So it was your judgment, and they have signed 

off on the OFHEO findings. Correct? 

Mr. FALCON. Yes, congressman. 

Mr. HINOJOSA. You also mentioned that you did not speak to nor 

review the working papers of KPMG accounting firm while preparing this report. It seems to me that it is less than clear, then, 

that Deloitte has signed off on your OFHEO findings. 

Mr. FALCON. Deloitte fully supports the findings and conclusions 

of this report. They also view these accounting issues as very clearcut violations and not matters of interpretation. 

Mr. HINOJOSA. Aren’t the views of the KPMG auditors critical to 

your report? They are a very reputable firm. They do the work for 

my company. 

Mr. FALCON. They are reputable. KPMG may disagree with us, 

but it is not unlike Arthur Anderson. They supported everything 

Freddie Mac did until that got corrected. 

Mr. HINOJOSA. I yield back the balance of my time. 

Chairman BAKER. I thank the gentleman. 

Mr. Ney? 

Mr. NEY. Thank you, Mr. Chairman. 

Following a little bit in the line of the question the gentleman 

just asked, I think the one thing that has to be, from your opinion 

from what I have heard, it has to be pretty well-grounded would 

be the strength of the comment that OFHEO has made that the 

company willfully did misapply GAAP. Now, at the end of the day, 

the chairman of the SEC does make that call whether that statement will be accurate in his view. I am not saying your statement 

is necessarily inaccurate. 

44

If that happens and the SEC says something, and I am not asking you to speculate on what they are going to say, but if that happens and you have said one thing and the SEC says another, is 

there any type of discussions? Do we have the mechanics in place 

in the law that allows discussions back and forth between OFHEO 

and SEC to say, wait a minute, we think this and SEC says that. 

I know the SEC is the final decision maker on it, but is there any 

mechanism in current law that would allow a debate or a point of 

view to be discussed in case there are two separate opinions? 

Mr. FALCON. I think the way this would work is the SEC would 

determine what is appropriate for purposes of the disclosures that 

are filed as required by the SEC. We also rely on the financial 

statements of the company and its books and records in assessing 

the safety and soundness of the company and capital adequacy of 

the company. 

If we see fit that the books and records are inaccurate and need 

to be changed for purposes of our capital requirements or for purposes of assessing their safety and soundness throughout our examination program, then we would take appropriate action utilizing our safety and soundness authority and they could do what 

they thought was appropriate for purposes of their disclosures that 

they require. 

Mr. NEY. When you presented it to the Fannie Board, the fact 

that they willfully misapplied general accounting practice, one, 

what was the reaction, the statement made back to you by Fannie’s 

board? Two, with the auditing firm, KPMG, what was their discussion with you, KPMG’s, about their work papers or why they advised Fannie to do this? 

Mr. FALCON. KPMG was not in the meeting with the board when 

we sat down with the board and presented our report to them. The 

board did hear the entire presentation. They were all present either in person or by telephone, and they have taken this matter 

very seriously. Like I said, to their credit they moved quickly to 

reach an agreement with us to assure that safety and soundness 

concerns were properly addressed. 

Mr. NEY. If KPMG signed off on this and advised Fannie, and 

then if OFHEO has not had any discussion or your staff with 

KPMG as to why they advised Fannie, has Deloitte & Touche had 

a discussion or looked at the work papers as to why KPMG advised 

Fannie to do it this way? 

Mr. FALCON. We are now beginning work on the process of assessing KPMG’s work papers, having discussions with KPMG. In 

addition, just as we are bringing in the SEC into these matters 

surrounding financial disclosures and their adequacy, we are also 

speaking with the Public Company Accounting Oversight Board 

about the adequacy of the external auditor’s work in this regard. 

Mr. NEY. I just wondered on the process, and it was verging on 

the gentleman’s question before, it seems that at some point in 

time Deloitte & Touche would have to have a conversation with 

KPMG to see why they would advise this, and look at their point 

of view because it is a pretty stern statement that it has been willfully misapplied. KPMG I would assume at some point in time, 

even though you are not to phase two of this, there would be discussions between auditing firms and yourselves to at least hear 

45

their point of view of why they would tell Fannie, yes, this is acceptable. 

Mr. FALCON. We will have those discussions. Let me ask Mr. 

Dickerson to talk about it. He knows more about what happened 

in the past and what we will do going forward. 

Mr. NEY. I know you are going to have those discussions, but 

Deloitte is sitting there in a way, saying yes, this is misapplied 

general accounting practices. I just want to understand why there 

was not a previous conversation to give them a comfort level of 

why, and before this whole report came out. That is one thing I 

would question. 

Mr. FALCON. We at OFHEO have requested work papers from 

KPMG and have talked with their partners about getting those 

work papers. We have actually received some of those work papers 

and have reviewed ourselves, OFHEO examiners, some of the work 

papers in coming to the conclusions that are in our report. It is important to note that the report represents the views of OFHEO, so 

it is most important for the examiners at OFHEO and the office of 

the chief accountant to be comfortable with what KPMG has done. 

Mr. NEY. Mr. Chairman, my time has expired. At some point in 

time down the road, I would like to get your opinion of what tools 

you would need if you were to become the regulator for the future. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Capuano? 

Mr. CAPUANO. Thank you, Mr. Chairman. 

I would like to ask just a few general questions about FAS 133, 

which obviously I am not terribly familiar with, a little bit, but not 

terribly familiar with. As I understand it, it is a relatively new regulation. Is that correct? 

Mr. FALCON. It went into effect in 2001. 

Mr. CAPUANO. So relatively new in these kinds of things. Am I 

right to understand that between the regulations and the guidelines and the rules relative to it, it comes to about 900 pages, give 

or take. Is that a fair estimate? 

Mr. FALCON. Yes, Congressman. 

Mr. CAPUANO. So it is a relatively new 900-page regulation. 

In the normal course of events of any new accounting standards, 

any changes in GAAP, any changes in FAS or any of these things, 

am I right to understand, again, not just in banking or not just in 

GSEs or anyplace else, but in every day, including individuals and 

everything else, when something new like this comes out that is 

clearly long, clearly complicated, clearly important, and clearly has 

very important ramifications, isn’t there a normal period of time in 

which the people who are affected by whatever the rule or regulation is, plus the auditors and the accountants who interpret it, isn’t 

it a fairly common thing to have a period of time where people may 

interpret things differently, and the systems, through the industry, 

the regulators, the courts, the IRS, whoever it might be, the SEC, 

then over time tends to take different approaches to the same rule 

and regulation and say, well, wait a minute, we know you took different approaches, but this is not right and this is not right, and 

little by little they come to a consensus. 

Is that not a normal situation? 

46

Mr. FALCON. I think that grace period you are describing occurs 

prior to the effective date of the implementation of the rule. This 

rule did go through many years of discussion, many years of debate 

and analysis. It had a delayed effective date. Even after it was supposed to become effective, I think it was delayed for an additional 

year. 

Mr. CAPUANO. I understand that. I understand how rules are 

made, but even after rules are made, are you telling me that in the 

normal course of events that every FAS, every GAAP rule is then 

implemented perfectly by everybody in lock-step with no disagreement, no discussion, no need to then clarify different things that 

happen in a 900-page report? 

Mr. FALCON. The rules apply as of the effective date of the rule. 

Mr. CAPUANO. I understand the rules apply, but how are they interpreted? You are telling me they are clear, concise and unequivocal on all counts every time there is a change in the FAS, every 

time there is a change in GAAP? I have to tell you, that is not my 

experience and I do not think that is the experience of any accountant or auditor in the country. It is not the experience of the IRS, 

the SEC or you. 

So I understand how rules are made, but I also know that once 

rules are made there is still a period of time afterwards, not a set 

period of time, that different people read different things differently and interpret things differently with good will. So the 

thinking that somehow you set a rule and that is it, well, if that 

is the case we do not need courts. We do not need the IRS. We certainly do not need the tax court for any interpretations because we 

have thousands and thousands of tax rulings, and this is really just 

one implementation of it. 

I would obviously disagree, or I am not sure that you answered 

the question, but clearly it takes time to work these things out. 

I guess in the normal course of events, absent different issues, 

and not all the time, is it not a normal circumstance where many 

entities within the rules of GAAP, within the rules of various FAS’s 

and other accounting procedures and tax procedures, try to on occasion smooth out earnings? Is that not something that happens here 

and there in the business world? 

Mr. FALCON. If it happens, it is wrong. It is not proper to try to 

smooth out earnings by violating accounting rules. 

Mr. CAPUANO. I did not say violate it. You did not hear the question. Within the rules of accounting, within the rules allowed by 

various regulators, there are times and certain situations that it is 

allowed. 

Mr. FALCON. If it is within the rules of accounting, it is not improper. 

Mr. CAPUANO. That is what I asked. So within the rules, the concept of smoothing out earnings in and of itself is not a violation, 

understanding fully well that there are times that it is wrong, 

there are times that it is not, and that is what the debate is about 

is whether these rules are right or wrong. 

I also wonder, are you chasing KPMG at this point in time, or 

are you just kind of letting it float at the moment? 

Mr. FALCON. No, we are starting, as we said, to obtain the work 

papers of KPMG and we will discuss with them their assessments. 

47

Mr. CAPUANO. Okay. It strikes me again, and I know this is very 

complicated and I understand that, but if they had the opportunity 

to make these decisions, and what they did, as I understand it, and 

again correct me if I am wrong, is in their reports they simply cited 

it as an audit difference. 

For those who do not understand, an audit difference does not 

stop the process. They could have said it was a material weakness. 

Nobody in their right mind wants a material weakness noted on 

their annual report, and hopefully even understaffed you would 

have found something that was cited as a material weakness in an 

annual report. They did not cite it as a material weakness. Am I 

wrong? 

Mr. FALCON. No, it was just an audit difference. 

Mr. CAPUANO. So then KPMG as an auditor has said, basically, 

look we do not necessarily agree, but it is a minor point. Here it 

is in the footnotes, and we will move on. 

Chairman BAKER. This will have to be the gentleman’s last question. His time has expired. 

Mr. CAPUANO. Thank you, Mr. Chairman. 

Again, I guess I will just finish by simply stating that clearly 

there are some serious questions. You have raised serious concerns, 

and if you turn out to be right, there will be some serious ramifications of it, but I still think that some of the concerns and some of 

the comments that have been made here today are kind of jumping 

the gun and putting the cart before the horse relative to allowing 

people to make a determination of what was right and what was 

wrong; what was willful and what was simply just a difference of 

opinion in the ordinary course of business. 

Mr. TOOMEY. At this time the chair will recognize the gentlelady 

from New York. 

Mr. KELLY. Thank you very much. 

I appreciate the fact that you have delivered a partial report. It 

has been very interesting reading. One of the things I am troubled 

by and I see repeatedly in the report is that there are people carrying double roles within the structure of Fannie Mae. I understand that the OFHEO has been asking the chairman of the board 

and the CEO of both the GSEs to separate people into separate 

functions. For instance, Janet Honeywell, her job was forecasting 

as well as financial reporting. 

There are numerous examples, starting on page 158, going on 

through, are people, first of all, who are not CPAs that were doing 

financial structuring and analysis. And secondly, they were auditing their own work essentially. My question to you is, Freddie Mac 

apparently has agreed to separate roles. Apparently, Fannie Mae 

has not. Are they in the process of working with you to try to do 

that? Can you talk to us about why you think this is a healthy 

thing to do? What is ongoing with regard to OFHEO working with 

Fannie Mae to make sure that there is a separation of duties? 

Mr. FALCON. We do think it is important that key functions be 

separated so that there is not a conflict of interest or that someone 

with an incentive to meet some goals also has the ability to manage the accounting of those goals such that they are met. 

So we have taken action, going to Freddie Mac to make sure 

there was proper separation of offices and functions and individual 

48

responsibilities. The board of Fannie Mae has agreed with us to 

create a separate chief risk officer. We found that the individual responsible for setting goals in this instance was also responsible for 

making sure that they were met. 

We are looking at other issues as well. We have a pending corporate governance rule amendment which would separate the function of the chairman of the board and the chief executive officer. 

Freddie Mac has already agreed to do that, and once this rule is 

implemented it will also provide the same for Fannie Mae. 

Mr. KELLY. I want to go back to page 160 of your report. I do 

not know how to pronounce Sam Rajappa. I do not know how to 

pronounce that last name. 

Mr. FALCON. That would be Rajappa. 

Mr. KELLY. It is Rajappa. Thank you. There is a statement in 

here by Tim Howard noting that Sam Rajappa reports directly to 

the chairman of the audit committee, but for the last I think year 

and a half, maybe 2 years, he has reported on a dotted line basis 

to me. 

In reading your report, I could not quite figure out who had a 

straight firm line and who had a dotted line, because it looked to 

me like a lot of these things were being mixed responsibilities. Jeffrey Guliana had a dual responsibility. There is one name after another here where I do not see a solid structure, but rather an informal structure. I would like you to expand on what you have found 

with regard to this, because I am not sure exactly who was the person that was signing off on the bottom line here. 

Mr. FALCON. That is a good question. We found that this was a 

big weakness in the way these accounting policies were being set. 

There was not a clear process in place. There were no accounting 

controls. There was not even adequate documentation about what 

the accounting policies were and the roles in formulating these accounting policies. 

Let me ask Mr. Dickerson, who can speak very well to these internal control issues, to elaborate further. 

Mr. DICKERSON. Right. We found, for example, in the amortization area that there was one individual who was in charge of the 

modeling and accounting for amortization. That is a weak segregation of duties. We found, you mentioned Ms. Pennewell, who was 

in charge of financial reporting and financial planning, so she had 

opportunities at least to help meet through accounting financial 

goals that her group had earlier set. 

Mr. KELLY. Is there now in place a structure, because I understand from Mr. Falcon, from what he just said, that that structure 

has not really been changed much, and it is still unclear to me. 

Have you established with them now a clear line of who reports to 

whom? 

Mr. FALCON. It will take a little time to fix all of these problems, 

to do the reorganization within the company and create the positions and select individuals for the positions. But this is something 

covered by the agreement with the board, and we are going to 

move as expeditiously as possible to get these fixes in place. 

Mr. KELLY. Thank you. 

Chairman BAKER. The gentlelady yields back. 

Mr. Lynch? 

49

Mr. LYNCH. Thank you, Mr. Chairman. 

I was late in the hearing, but I do want to thank you for coming 

here today and helping the committee with its work. I know you 

have had a rough time with some of my colleagues, but I do not 

think there is anybody here that questions your good intentions to 

help us with this process. That is the position I take. You are good 

to do your work and we need you to do it really well, and I am sure 

that is going to happen. 

However, this is the political side of the table, so some of us up 

here are going to twist and use your information to help us grind 

an axe with Fannie Mae or others, or to defend it as I will intend 

to do. But that is not to discount the good work that you are doing. 

I do want to rebut a couple of things, and I want you to work 

with me here. I have heard Enron, Enron, Enron a bunch of times 

here. Quite frankly, the chairman of the subcommittee did a wonderful job in helping the committee with its work in that case, but 

even the chairman of the full committee has brought that specter 

to bear in comparing what has happened at Fannie Mae to Enron. 

I just want to ask you, we had the Enron situation. We had a 

house of cards there, a financial house of cards where there was 

no strength to the underlying business. They had a very unsound 

business model. We had serious problems in the underlying business. Is that what you see here? Is that what you see here? 

Mr. FALCON. The business model of the company remains sound. 

Mr. LYNCH. Remains sound. 

I do not have much time. That is just one thing I wanted to get 

out there. 

Mr. FALCON. Okay. 

Mr. LYNCH. We had 19 criminal indictments. We had 96 criminal 

charges. We had 78 fraud counts against the people who were running Enron. Is that what we have here? Or is it more in the line 

of noncompliance with accounting standards? 

Mr. FALCON. We have deferred any opinions, resolutions of any 

criminal conduct to the Justice Department. We have referred to 

the corporate fraud task force our report. We are cooperating, giving information to the U.S. attorney upon request about anything 

we found and documents that we have about this. Beyond that, we 

are not forming judgments about the criminality of this, and we 

have not made any criminal referrals to the Justice Department. 

Mr. LYNCH. Thank you. In terms of the gross manipulation that 

occurred in the California power market by Enron in which investors and employees lost their pensions and their life savings. Is 

that what we are looking at here or is it something different? 

Mr. FALCON. I think until the entire review is over, I would withhold maybe broad categorical statements about this. Certainly, 

what we have found to date raises serious concerns with us about 

the company’s proper accounting, as well as their internal controls, 

doubts about safety and soundness, prior financial statements. If 

we find that this type of conduct shows up in other areas that we 

have yet to begin to review, then it would become much more serious than even it is now. 

Mr. LYNCH. So you are saying they could be defrauding the public and the investors and the employees just like Enron? Is that 

what you are saying, that this could be one of those cases? 

50

Mr. FALCON. No. I do not know. I have no——

Mr. LYNCH. You just said there was a sound business model 

here. 

Mr. FALCON. Exactly, a sound economic business model. But as 

far as any criminal intent or any desire to break laws for some 

criminal purpose, I do not know. I cannot speak to that. 

Mr. LYNCH. Okay. Thank you. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Toomey? 

Mr. TOOMEY. Thank you, Mr. Chairman. 

What I would like to do is address this question of whether we 

are really talking about a difference of interpretations of ambiguous rules, or whether we have something that is really pretty objective. While this gets a little bit complicated, I think it is manageable, I hope within 5 minutes. Let me see if I can walk through 

what I understand to have gone wrong with respect to FAS 91. Tell 

me where I go wrong on this. 

First of all, Fannie Mae buys assets that trade at premiums and 

discounts. Correct? Some of these assets have prepayment features. 

Chairman BAKER. Mr. Toomey, I hate to interrupt your train, but 

I will let you re-start. 

Just by way of announcement for members, I understand we will 

have a series of two votes. It would be the chair’s intention upon 

recessing for those two votes that we would recess the committee 

for 30 minutes to give members and witnesses a chance to refresh 

themselves. That would mean we would return here, let’s just say 

1:30 p.m. We would proceed with Mr. Toomey’s comments and 

questions, and then break at that point, just so all members are 

advised, 1:30 p.m. 

If you would like, you can proceed now, or at your leisure; if you 

want to come back. Either way. 

Mr. TOOMEY. I would like to proceed when we get back. 

Chairman BAKER. Okay. Great. The committee will stand in recess until 1:30 p.m. 

[Recess.] 

Chairman BAKER. At this time I would like to reconvene the 

hearing of the Capital Markets Subcommittee. 

At the time the committee recessed, Mr. Toomey had been recognized to proceed, and at this time I recognize the gentleman for 5 

minutes. 

Mr. TOOMEY. Thank you, Mr. Chairman. 

I would like to take up where we left off on this discussion about 

whether what we have seen with Fannie Mae has been a willful 

misrepresentation of certain income and expense accounts, or 

whether it is just the difference in interpretation of an inherently 

complex and ambiguous accounting laws. 

It seems to me the allegations being made by OFHEO, which 

frankly seem very well substantiated, are very clear: It is the 

former. This is a willful, conscious misrepresentation. 

And in fact, KPMG agrees with you and not with the company 

when they cite this irreconciled item. Is that correct? 

Mr. FALCON. Yes, the $200 million——

51

Mr. TOOMEY. The $200 million—number one, their auditors agree 

with you, not with the company, with respect to this treatment. 

Now, I would like to get to the substance of what this treatment 

is about with regard to FAS 91. 

As I understand it—and please correct me when I go wrong 

here—my understanding is that when a financial services firm 

such as Fannie Mae buys assets at either premiums or discounts, 

some of which have prepayment features, they are required to amortize the premiums and the discounts over a projected life of the 

asset, which is determined in part by estimating prepayment rates 

and other things. 

My question for you is: When those assumptions are made, the 

model is employed and an amortization schedule for premium or 

discount is arrived at, is that not a very precise figure? 

Mr. FALCON. Yes. 

Mr. TOOMEY. So it is not a range, it is not a ballpark, there is 

a number. And if you carry it out far enough it goes right to the 

penny. Is that correct? 

Mr. FALCON. Yes, Congressman. 

Mr. TOOMEY. And then my understanding further is that when 

the next quarter comes around, interest rates very often will be different than what was projected in the previous quarter, and that 

requires a reassessment. 

And part of that reassessment is a very precise—it is a new 

number, and the company is required to catch up, if you will, on 

the previous errors that come to light, errors with respect to how 

reality differed from what was projected in the previous quarter. Is 

that correct? 

Mr. FALCON. Yes. We are required to make those adjustments. I 

would not use the term ‘‘catch up’’ in the same sense that the company called what they were doing a catch-up. 

Mr. TOOMEY. Okay, but they are required to make an adjustment, to affect the cumulative difference between what was projected and what in fact occurred in economic reality, and that, too, 

is a very precise number. Is that correct? 

Mr. FALCON. Yes. 

Mr. TOOMEY. And the rules, do they say that despite the fact 

that a precise number is calculated, you do not have to really use 

that number? Does FAS 91 give any discretion about what number 

you use? 

Mr. FALCON. Let me ask our chief accountant. 

Ms. DELEO. No. 

Mr. TOOMEY. It does not. Does FAS 91 suggest that you can 

round this number to some degree? 

Ms. DELEO. No. 

Mr. TOOMEY. Okay, it does not allow that. 

I am looking the testimony from Mr. Raines and from Mr. Howard, and it talks about how this estimation process is imprecise. In 

fact, it is not imprecise at all; it is very precise. 

It is subject to future revision, but at the point in time in which 

it is calculated, it is perfectly precise. Is that correct? 

Ms. DELEO. That is correct. 

52

Mr. TOOMEY. The alleged imprecisions are used in Mr. Raines’s 

testimony as a justification for creating a range. In fact, the range 

has nothing to do with this calculation. Or does it? 

Ms. DELEO. No, the range does not have anything to do with it. 

Mr. TOOMEY. The range was a perfectly arbitrary invention of 

the company, it seems to me. Is that your opinion? 

Ms. DELEO. Correct. 

Mr. TOOMEY. And the range of $100 million, plus or minus, from 

these adjustments is not even contemplated, much less allowed, 

under FAS 91, is it? 

Ms. DELEO. There is nothing under FAS 91 that would allow for 

a range. 

Mr. TOOMEY. So it is not as though there is a range that is allowed and there is a dispute over how much. There is no such concept. 

But you make a further allegation, if I understand it correctly, 

which is that not only is it simply and very straightforwardly 

wrong to not report the full number precisely as calculated, which 

Fannie Mae has done, but that there was a policy within company 

systematically not to report the precise number, but rather to have 

this cushion that you describe as a cookie jar, which served the 

purpose of evening out income. Am I correct to understand that? 

Ms. DELEO. You are correct. 

Mr. TOOMEY. Some seem to suggest that this is not really material, you know, Fannie Mae is a big company, you know, it has got 

a lot of income. But this range that they created was $100 million. 

Right? 

Ms. DELEO. Plus or minus 1 percent, but it basically rounds to 

$100 million. 

Mr. TOOMEY. And it was not an effort to round this number; it 

was derived from a totally different set of calculations regarding 

total—my time has expired. I just want to make the point. 

A plus or minus variation here of $l00 million, what does Fannie 

Mae roughly earn in a quarter? What is the total income in a quarter? 

Mr. DICKERSON. Probably in the neighborhood of a billion. 

Mr. TOOMEY. About a billion. 

Chairman BAKER. I would say $150 million, probably. 

Mr. TOOMEY. So we are talking over 10 percent of the reported 

income in a given quarter. 

Mr. DICKERSON. Actually it could work out larger than that. 

Mr. TOOMEY. And it could work out larger than that. 

So by virtue of the sheer magnitude, I do not understand how 

someone can say it is material. 

But I would further argue that I am not sure the materiality applies as a concept when you are dealing with a systematic misrepresentation of the numbers. I do not think that is allowed regardless of how big the misrepresentations are. Is that correct? 

Ms. DELEO. I would completely agree with that. 

Chairman BAKER. Your time is expired. It has been most helpful. 

I appreciate your insights, Mr. Toomey. 

Mr. Meeks? 

Mr. MEEKS. Thanks, Mr. Chairman. 

53

Let me make sure—I think that it has put some things in context, especially with reference to some of the process. 

I think it is a matter of fact, I think you would agree with me 

that plenty of people do not like Fannie Maes or Freddie Macs for 

that reason, their current status in the market. People wanted to 

change it. 

Before your report came out there was talk from this committee 

and from others in the private company that one did not like the 

status that Fannie Mae had. You would agree with that—right?—

the status that Fannie Mae and Freddie Mac currently has in the 

market? 

Mr. FALCON. No, Congressman, I do not support privatization of 

these companies. 

Mr. MEEKS. I did not ask you that. I did not ask you whether 

you do or not. 

I said I think that we could all agree that we know from either 

some of your prior testimony, there are individuals in some movements that have been afoot that did not like the status of Fannie 

Mae and Freddie Mac had within the market. You could agree with 

that. 

Mr. FALCON. Only certain individuals——

Mr. MEEKS. And is it also true that in fact you, when you came 

here previously to testify on other occasions, many individuals on 

this committee were very critical of you and challenged your ability 

to be able to relate to the largest financial entities in this country. 

Is that not correct? 

Mr. FALCON. Yes, Congressman. 

Mr. MEEKS. In fact, they were so upset with you at that particular time, there were bells put forward that indicated that they 

may need to create a new regulator for the GSEs. Is that not also 

correct? 

Mr. FALCON. Yes. 

Mr. MEEKS. And it is also true that this is a special examination, 

a special examination actually departed from what is standard financial institutional examination procedures. Is that not also correct? 

Mr. FALCON. No. 

Mr. MEEKS. This was not a special examination? 

Mr. FALCON. Yes, it was a special examination, yes. 

Mr. MEEKS. All right. And under ordinary procedures, would it 

not also be a situation whereas, you know, there were questions in 

regards to some of the regulations that you were overseeing that 

Fannie Mae, or whoever you are investigating, would have had the 

opportunity to address those issues prior to the issuance of the report. 

Mr. FALCON. Any examination follows a pattern where if it is a 

normal examination, like our annual risk-based examination, there 

will be, depending on severity of the issues that are found, you 

could have, would have give and take between the management. 

But this was a special examination, or it was situation where 

there were serious concerns raised about the conduct of management in this area of accounting and internal controls——

Mr. MEEKS. And some of that is subjective. Because as we indicated, I think that when someone was talking before, the person 

54

that is clearly talking about FAS 133F and FAS 91, the ultimate 

determination is going to be made by the SEC, and there could be 

a question whether discretion, whether or not—because we do not 

know, you know, it could be a difference of opinion between you 

and the SEC. We do not know that yet. 

Right now what you are putting out is just more allegations. 

And what I am talking about, when I start talking some irregularities, I am talking about—well, you know, even Senator Bond 

talked about the leaking of evidence or leaking of letters to the 

Wall Street Journal, other press. That is not standard. That does 

not happen under those circumstances. Is that a common procedure, to leak evidence and letters? 

Mr. FALCON. Congressman, we did not release this report prior 

to the board agreeing with us that they did not have any objections 

to this report being put into the public domain. I received a letter 

from members of Congress in fact urging me to do so. 

I had a commitment to the board not to release this report while 

we in these discussions. But once they no longer objected, I decided 

to do so. 

Mr. MEEKS. But even before they objected, things were leaking 

out. And I do not know if Congress had ever asked for it, but things 

were leaking out before—at one time and previously. 

So it has not been the usual type of investigation here, with 

things leaking, to give a hint of something or other. It seems to me 

that it is just curious to me that this is happening. 

Well, OFHEO itself was threatened with reference to being replaced by a regulatory agency. 

But let me just go to someplace else, because you make strong 

allegations. And, you know, sometimes you throw things out there. 

I know, I used to be a prosecutor. And it is very dangerous. And 

you made some allegations, strong allegations, that, you know, I do 

not know where the evidence—I have not heard the evidence of it. 

But, again, coming from the background that we are talking 

about, with reference to the pressure that was put on OFHEO by 

others and members of this committee about doing certain things, 

and all of a sudden I see this report coming out, I see things that 

are being leaked out. 

And then you make some charges that a lot of this is being done 

because of executive bonuses. That is a very serious charge. And 

I don’t know exactly how you back this up. Can you just tell me? 

How do you back this up? 

Mr. FALCON. It is our judgment, based on the evidence we saw, 

that this company in 1998, in that instance, when you look at the 

circumstances, the company deferred this $200 million of expenses 

in disagreement with this external auditor, and the evidence 

seemed to us that it was in order to meet these compensation 

bonus targets. 

Chairman BAKER. The gentleman’s time is expired. Did you have 

a wrap-up? 

I thank the gentleman. 

Mr. Bachus? 

Mr. BACHUS. Thank you. 

Director, derivatives have been used to hedge risk and actually 

have been used successfully. In this case, you have talked about 

55

this particular derivative contract had not been approved for hedging. Is that right? 

Mr. FALCON. Their derivatives portfolio, they were classifying all 

but about $43 million of the notional value of their derivatives 

portfolio as eligible for hedge-accounting treatment, which means 

any changes in market value would flow through other comprehensive income and not through the——

Mr. BACHUS. To flow to the——

Mr. FALCON. Yes. 

Mr. BACHUS.——to the underlining security of whatever it was 

hedged to, whatever the derivative was based on? 

Mr. FALCON. Whatever change in value occurred in the derivative wouldn’t flow through earnings to the balance sheet, but rather would go through other comprehensive income. 

Mr. BACHUS. Okay. Did that affect Fannie Mae from a safety and 

soundness standpoint, in your opinion? 

Mr. FALCON. I think, overall, everything we find in this report 

does raise concerns about the company’s safety and soundness. We 

have found practices that are inconsistent with safety and soundness, practices about not complying with accounting rules, not having accurate financial disclosures, not having the appropriate internal controls. 

The report has great detail, I believe, on the reasons why we 

have expressed concerns about the company’s safety and soundness. 

Mr. BACHUS. Just assuming that they had applied with the FAS 

133 in their risk management, do you believe that Fannie overall 

has made the right economic and risk management decisions in 

terms of protecting its portfolio from market risk? 

Mr. FALCON. They use their derivatives to hedge against the interest rate risk associated with this retained portfolio that they 

manage. And their use of these derivatives is proper to hedge risk. 

We are not questioning their use of derivatives to properly manage 

the interest rate risk that they face. 

What we are seeing here is a lack of compliance with the accounting rules. We are also looking at other things related to this 

derivatives portfolio. This is just the beginning of what we have determined. These are our findings to date. And we will continue to 

look at issues raised. 

They use—their policy is to use derivatives only to hedge risk 

and not to speculate. That is also our safety and soundness standard. 

Mr. BACHUS. How long——

Mr. FALCON. But we are looking at it to make sure there weren’t 

transactions that were inconsistent with that policy. 

Mr. BACHUS. Okay. How long—I mean, you have been critical of 

their internal controls and of some of their accounting practices. 

How long have these practices been going on and these lack of internal controls, in your opinion? 

Mr. FALCON. The internal controls—I guess we found that—the 

policies on FAS 91 date back to 1998 and on 133 date back to 2001. 

So certainly these weaknesses that allowed these improper accounting policies to be put in place certainly go back as far as that. 

56

Mr. BACHUS. Now, you are examining them on a regular and constant basis, right? 

Mr. FALCON. Yes. 

Mr. BACHUS. Why did you just now discover those things? Why 

did it take this long? 

Mr. FALCON. We look at many issues related to credit risk, interest rate risk, management and operations risk, a wide variety of 

areas of a company’s risk profile. 

This is an area where, very recently, as a result of the Freddie 

Mac accounting problems, we decided to go and take a very close, 

detailed look at Fannie Mae. We have not, prior to this point, conducted such an in-depth examination focused on one area of the 

company. 

Our examination program assesses their risk and risk-management practices across a wide range of risk. Focusing in narrowly 

on this subject has uncovered problems that the broader review has 

not uncovered previously. 

Mr. BACHUS. Okay. One final. Did you all consult with—now, 

KMPG was their outside auditor, right? 

Mr. FALCON. Yes. 

Mr. BACHUS. And Deloitte & Touche, you all used them to do 

your audit, right? 

Mr. FALCON. Yes. 

Mr. BACHUS. Is that right? Have you all consulted with KMPG 

about your findings? 

Mr. FALCON. We have begun the process of obtaining KPMG’s 

work papers, discussing this with KPMG. But we have not gone 

down a path of trying to—management and the company is ultimately responsible for ensuring that the company’s policies and 

practices in the accounting area are consistent with GAAP. 

Mr. BACHUS. But you were totally unaware that they were doing 

all this until just recently? 

Mr. FALCON. We have not conducted an in-depth accounting 

exam like this previously. 

Mr. BACHUS. Had you criticized their internal controls prior to 

this? You are their regulator, right? And internal controls would be 

a basic part of—for instance, who signs off, who within the company signs off on these derivative contracts and their treatment? 

Had you questioned those in the past? 

Mr. FALCON. I would have to go back and look at our previous 

examination reports. But if we did, in fact, identify these problems 

in the past, we hadn’t conducted this type of an in-depth examination before. 

Mr. BACHUS. You probably should have, right? 

Mr. FALCON. I would have liked to have done it previously, yes, 

now that we know what we know. 

Chairman BAKER. One more question, sir. 

Mr. BACHUS. On September the 20th, you were meeting with the 

Fannie Mae board. You all were going to present to them your findings, is that correct? 

Mr. FALCON. Yes. 

Mr. BACHUS. And you had not made that known to the public at 

that time, had you? 

Mr. FALCON. Right. 

57

Mr. BACHUS. And I know everybody was waiting on that meeting. 

And then that morning I recall picking up The Wall Street Journal 

and seeing it pretty much laid out as to what you all’s report was 

going to show in detail. That is a violation of your own rules, isn’t 

it? 

Mr. FALCON. Right. We did not authorize—I did not authorize 

the release of any information about what we were about to do at 

the board. All I can tell you is, the Friday before that Monday, we 

did bring some other federal agencies in the process in an effort at 

interagency cooperation to let them know what we had found and 

what we were about to do. Now, that Friday we had also had discussions with some board members, in order to get them to convene 

the meeting for Monday. 

Mr. BACHUS. But somebody disclosed what was then nonpublic 

information. I know that is a violation of you all’s guidelines and 

every agency’s. I think your guideline 105 prohibits the disclosure 

of nonpublic information regarding a regulated entity and actually 

provides civil and criminal penalties. So somebody would have had 

to violate that guideline, would they not? 

Mr. FALCON. If it was someone in the company, within the agency——

Mr. BACHUS. Or in another agency, then they would have——

Mr. FALCON. Well, our guideline only applies to us. If you are citing our guideline, it only applies to OFHEO and not——

Mr. BACHUS. Have you done anything to identify—or, were you 

concerned about that, when you saw that that nonpublic information had been disclosed in violation of your own rules and regulations? 

Mr. FALCON. I am always concerned about information that 

shows up in the public domain——

Mr. BACHUS. Have you all tried to identify the individual or individuals who violated these rules? 

Mr. FALCON. I am not sure, Congressman, what shows up in the 

newspaper, whether it is conjecture, speculation. There is an insatiable rumor mill that circulates around everything——

Mr. BACHUS. Actually, it was specific in what they——

Mr. FALCON. It is hard for me to discern what is speculation and 

what is based on a leak and what is based on some authorized release of information. 

Mr. BACHUS. You saw that report. It was pretty apparent that 

they had to have inside information. 

Mr. FALCON. I have seen speculation about what we might do for 

months and months now, based on what knowledge people had 

about what we did with Freddie Mac. 

Mr. BACHUS. Okay. 

Chairman BAKER. Mr. Bachus, you have used almost twice your 

time. You are, like, 5 minutes over. 

Mr. BACHUS. I am sorry. 

Mr. FRANK. And you are not going to get an answer, no matter 

how you ask, so you might as well move on. 

[Laughter.] 

Chairman BAKER. Let us see, Mr. Watt, I think you are next. 

Ms. Waters is next? 

Okay. Ms. Waters? 

58

Ms. WATERS. Thank you very much, Mr. Baker. 

Mr. Falcon, you have been before this committee before. And you 

were pretty much on the hot seat on more than one occasion, where 

you were accused of not doing a good job, not exercising your oversight responsibility, of being incompetent. 

And I think a number of members you talk with following those 

hearings, where you not only ask for support but try to make the 

case why OFHEO should remain. Is that true? 

Mr. FALCON. No, I have actually supported a regulator with all 

the authorities and powers and resources to do his job, even if it 

means abolishing my agency. 

Ms. WATERS. Did you seek support for yourself and for your 

agency following the criticism that was reaped upon you in this 

committee? Did you talk to any members of Congress? 

Mr. FALCON. Oh, yes, I have——

Ms. WATERS. All right, thank you. 

I would also like to know a little bit more about what has happened since the time that you came under such criticism and how 

you got to this point. You talked about when you first decided that 

you were going to do this investigation on Fannie Mae. 

Did you at any time talk with any members of Congress during 

the time of this investigation about what you were doing, seek any 

advice, get any suggestions, any members or their staffs? You are 

under oath. 

Mr. FALCON. I recall questions from various members of Congress in the Senate who——

Ms. WATERS. Did you talk to any members of Congress or their 

staffs about this investigation, seeking advice, getting advice, accepting suggestions, hearing suggestions about this investigation? 

Mr. FALCON. Asking advice about—not for the purposes of trying 

to get advice from a member of Congress about what we should 

look at——

Ms. WATERS. So you did talk with some members of Congress or 

their staffs while you were in the process of this investigation. Is 

that correct? 

Mr. FALCON. Yes. 

Ms. WATERS. All right. Did any member of Congress or their staff 

offer support for OFHEO or you in exchange for suggestions or give 

you ideas about how you ought to approach this investigation? 

Mr. FALCON. Absolutely not. 

Ms. WATERS. Did you report to the chairman of this committee, 

this subcommittee, or the chairman of the overall committee or the 

ranking member of this committee at any time during this investigation about what you were doing? 

Mr. FALCON. Absolutely not. 

Ms. WATERS. Let me go one by one. 

Did you, at any time, report to the chairman of this entire committee, Mr. Oxley, about what you were doing? 

Mr. FALCON. About the—no. But——

Ms. WATERS. About the investigation, anything that you were 

doing or undertaking in the investigation. 

Mr. FALCON. No. 

Ms. WATERS. Did you, at any time, talk with Mr. Baker about 

whatever was going on in the investigation? Did you seek advice, 

59

did you get any advice, did you have any conversations with him 

about the investigation? 

Mr. FALCON. I have not sought any advice, any guidance about 

how to—from any member of Congress——

Ms. WATERS. Did you talk with Mr. Baker——

Mr. FALCON. No. 

Ms. WATERS.—about the investigation at any time or his staff? 

Mr. FALCON. No. It would have been improper for me——

Ms. WATERS. That is all I want to know. Did you talk with Mr. 

Baker or his staff at any time during this investigation in any 

shape, form or fashion, whether it was seeking advice, just hearing 

advice, advising about what you were doing? That is all I want to 

know. Did you? Yes or no? 

Mr. FALCON. Let me answer the question. I did speak to several 

members of Congress about the investigation, about the need for 

funding for the investigation——

Ms. WATERS. But I specifically asked about Mr. Baker at this 

point. 

Mr. FALCON. Oh, Mr. Baker, yes, and other members of Congress——

Ms. WATERS. All right. Thank you. 

Mr. FALCON.——including other senior members of the committee about the investigation and my need for resources to keep 

this thing going. 

Mr. FRANK. Would the gentlewoman yield? 

Ms. WATERS. Yes, I will yield to the gentleman from Massachusetts. 

Mr. FRANK. I just want to make clear that I was never told or 

any way informed. My understanding was the Republican leadership was informed before this broke that this was about to break. 

But I want to make it clear: No one on the Democratic side received any notice. And I do believe there was, unfortunately, notice 

on the Republican side in advance. 

Ms. WATERS. Taking back my time, this is not simply about notifying about this hearing. This is about what was going on in the 

investigation, how it was being approached, what was being done. 

Were you talked to at any time? 

Mr. FRANK. No. As I said, I didn’t even get the notice that others 

got that it was happening, and so we had never heard anything. 

Ms. WATERS. Okay. Then that is well made. 

Now, did you discuss the 30 percent reserve with any members 

of Congress and get a suggestion about that amount prior to concluding that that was the amount that should be in reserve? 

Mr. FALCON. No. 

Ms. WATERS. Did you talk with any staff member? 

Mr. FALCON. No. 

Ms. WATERS. This, again, based on the questioning of Mr. Barney 

Frank, was an amount that you came up with but that amount was 

not based on any calculations, any research that would indicate 

that this would be the proper amount in reserve. You did not have 

any supporting documentation for that, is that correct? 

Mr. FALCON. We arrived at the 30 percent requirement because 

we thought that was prudent from a safety and soundness standVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00067 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
60

point, given the weaknesses in management and operations, given 

the uncertainties of the financial statements——

Ms. WATERS. I am asking about your documentation. Did you 

pull it out of the thin air? Did you pull it out of air? Did you have 

some documentation? Did you have something to compare it with? 

How did you get the 30 percent? 

Chairman BAKER. And that would need to be the—if I may, that 

would need to be the lady’s last series of questions. 

If you would respond, because the gentlelady has exceeded her 

time significantly. Would you please respond to the gentlelady’s 

question? 

Mr. FALCON. Congresswoman, we based—I based that decision, 

using my judgment about what was appropriate, prudential in 

order to ensure the safety and soundness of this company. Given 

the uncertainties about their balance sheets, given the operational 

weaknesses, there was precedent for this with Freddie Mac, I took 

action that I thought was essential to make sure that this company, that its safety and soundness was ensured. 

And we arrived at 30 percent because there is a 30 percent management and operations risk in the statute for risk-based capital, 

so we simply applied the same standard to the minimum capital. 

Ms. WATERS. You had no documentation. 

Thank you. I yield back the balance of my time. 

Chairman BAKER. Mr. Watt? 

Mr. WATT. Mr. Chairman, Mr. Davis from Alabama has a bill on 

the floor and I would like to defer to him, if it is okay. 

Chairman BAKER. Oh, I am sorry, Mr. Manzullo, you have been 

patiently waiting. 

I should go to Mr. Manzullo first, and then I will come back to 

Mr. Davis. 

Mr. MANZULLO. Thank you. 

I am reading page 11 about the actual amount of the bonuses. 

Mr. Johnson got a $1.9 million bonus on a salary of $966,000; 

Mr. Raines, $1.1 million bonus on a $526,000 salary; Lawrence 

Small, $1.1 million on a salary of $783,000; Jamie Gorelick, 

$779,000 bonus on a salary of $567,000; Timothy Howard, $493,000 

on a salary of $395,000; and Robert Levin, $493,000 bonus on a 

$395,000 salary. 

These are annual bonuses. Is that not correct? Every year they 

have a bonus? 

Mr. FALCON. Yes. 

Mr. MANZULLO. And so this is what they make. This is just for 

1998. Is that correct? 

Mr. FALCON. That was the amount of the AIP award and bonus. 

Mr. MANZULLO. What you see on page 11 is nothing less than 

staggering. Because you state that the earnings-per-share range, 

the minimum payout is $3.13, the maximum was $3.23, with a target of $3.18. 

And just by happenstance, coincidence, you could almost say on 

your terms that for Fannie Mae to pay out the maximum amount 

in annual incentive payment awards in 1998, the earnings per 

share would have to be $3.23. It is below the $3.13 minimum payouts threshold, no bonus would occur. 

61

And then you state, remarkably, the 1998 earnings-per-share 

number turned out to be $3.23 and nine mills, a result that Fannie 

Mae met the EPS maximum payout goal right down to the penny, 

and that if they had used the correct accounting practices—which 

you say in your testimony, accounting violations cannot be dismissed as mere differences of interpretation, Fannie Mae understood the rules and simply chose not to follow them, but if Fannie 

had followed the practices, there would not have been a bonus that 

year. Is that not correct? 

Mr. FALCON. That is right, Congressman. 

Mr. MANZULLO. Well, what are you saying here? Are you saying 

this is coincidence? Or did somebody cook the books to come up 

with $3.23 and nine mills so they got the maximum payment. 

Mr. FALCON. I think what we are saying is, there are very strong 

appearances that the management did, in this instance, improperly 

defer $200 million of this $400 million expense to the next year for 

the purposes of achieving these bonus targets. 

Mr. MANZULLO. So the main purpose was so they could get their 

bonuses. That is what you just said. 

Mr. FALCON. Yes, in addition to the appearances of smoothing 

earnings. 

Like I said, this was the beginning of the implementation of their 

catch-up in their FAS 91 accounting policies which allowed them 

to utilize this amount to project smooth earnings over time. 

Mr. MANZULLO. I find this staggering. This is absolutely astonishing when the oversight organization says that Fannie Mae projected its earnings and did its accounting practices for the reason 

so that the executives could get the maximum amount of their 

bonus. That is your conclusion? 

Mr. FALCON. That certainly how it appears to us, yes. 

Mr. MANZULLO. And did you look at bonuses for any other years 

besides 1998? 

Mr. FALCON. We have information about the bonuses for the 

years—yes, and it actually included the information that was given 

to Chairman Baker. 

Mr. MANZULLO. Can you tell us what the bonuses were for subsequent years to 1998? 

Mr. FALCON. I believe for the top five individuals, it is a matter 

of public record because of the disclosures under the securities 

laws. 

Mr. MANZULLO. Were they similar amounts, do you recall offhand? 

Mr. FALCON. I believe they were similar, yes. 

Mr. MANZULLO. Did your research, investigation, look at any 

other years besides 1998 to see if you came up with similar conclusions? 

Mr. FALCON. We have not to date, I believe, found a transaction 

like the one in 1998, which was deferred to another year with the 

fact of resulting in full bonuses as opposed to no bonuses. 

We have not yet found a similar type transaction in similar 

years, in subsequent years, but we certainly do see the fact that 

the policy of managing their earnings occurred over time at the 

same that their Challenge Grant Initiative was put forward. 

62

Mr. MANZULLO. So this is all based upon the fact that you are 

paid according to the—you get your bonus according to the earnings per share, regardless how you get those. 

Mr. FALCON. That is the metric that is contained in their compensation program. 

Chairman BAKER. Mr. Manzullo, you have expired your time, but 

you have one wrap-up. 

Mr. MANZULLO. I do have one final question that speaks for 

itself. 

I believe on page 12 that says that if they had done the correct 

accounting method there would not have been a bonus that year. 

Mr. FALCON. Yes, that is right. 

Mr. MANZULLO. Thank you. 

Chairman BAKER. I thank the gentlemen. 

Mr. Davis? 

Mr. DAVIS. Thank you, Mr. Chairman. 

Let me thank my friend from North Carolina for yielding. 

Mr. Falcon, when Mr. Lynch was questioning you earlier, you 

said something that really caught my attention. You said that you 

wanted to avoid making any broad and categorical statements until 

the investigative process was complete. 

Do you remember saying that? 

Mr. FALCON. Yes. 

Mr. DAVIS. That sounds like a good goal, and I think that is exactly the stance that one would want from someone in your position. 

So in light of that, let me ask you about several observations that 

you have made and see if they meet the standard that you set out. 

Mr. Manzullo asked you a number of questions and others have 

asked you questions about the motivation for the expenses, and you 

said fairly directly that you think that the motivation was to pave 

the way for bonuses, or to create an appearance of earnings to justify bonuses. 

Is that not a pretty broad and categorical statement on your 

part? 

Mr. FALCON. It is. 

Mr. DAVIS. And second of all—if I can continue, as my time is 

limited—you made the observation or response to someone’s questions—where you were asked rather point blank: Would it be in the 

interest of Fannie Mae if there was a change in the management 

structure? 

Do you recall those questions? 

Mr. FALCON. Would it be in the interest——

Mr. DAVIS. You asked if it would be in the interest of Fannie 

Mae if there were a change in the management structure. 

Mr. FALCON. Yes, we had that. 

Mr. DAVIS. And I think your answer was in the affirmative that 

it would be. Do you recall that? 

Mr. FALCON. I think what I said was, we were going to assess—

that the question before us was whether or not we had sufficient 

confidence in this management team going forward, trust that they 

could properly implement this plan of remediation and have the 

confidence of both us and the board going forward to properly run 

this company in compliance with all the rules and regulations. 

63

Mr. DAVIS. You had various questions about the management 

structure. 

Mr. FALCON. Yes, yes, I did. 

Mr. DAVIS. Is that not a pretty broad and categorical statement 

to raise questions about the management structure? 

Mr. FALCON. It is. 

Mr. DAVIS. Furthermore, you make a pretty broad statement in 

your report—in fact, I think I am quoting from you—that there was 

a pervasive and willful misapplication of GAAP in two critical 

areas. 

Is that a quotation from your report? 

Mr. FALCON. Yes. 

Mr. DAVIS. Is the reference to a pervasive and willful 

misapplication a pretty broad and categorical statement? 

Mr. FALCON. It is, about these two accounting areas. 

Mr. DAVIS. So let me put this in perspective, because I agree 

with your honesty in all four of those answers, those are very broad 

statements. 

One of the things that has been raised by several of my colleagues on this side of the aisle has to do with: As I would characterize it, does OFHEO have the appropriate level of arms-length relationship that is needed with Fannie Mae? 

Several of my colleagues have made the point, and I make the 

point to you now, that as I understand the mission of OFHEO, it 

is to be a regulator, it is to assess the safety and soundness of the 

institution that you are regulating. 

The SEC has the responsibility of making judgments about 

whether accounting fraud occurred. 

This body has the responsibility of making judgments about the 

proper policy course. 

And the Justice Department has the responsibility of making 

proper judgments about whether a criminal act has happened. 

Have I gotten the division of labor just about right, from what 

you know? 

Mr. FALCON. There is some overlap——

Mr. DAVIS. There is some overlap, but do I basically have it 

right? 

Mr. FALCON. Yes. 

Mr. DAVIS. A concern that I have—and I want to give you a 

chance to respond to it—but a concern that I have is you are making very specific, what you have correctly acknowledged, broad and 

categorical judgment about the management of this institution, 

about the willfulness of practices that may or may not be in controversy. 

You have imputed various motives to the people running the organization. 

You went to the board and put a 48-hour ultimatum on them 

without having any specific regulatory authority to put that kind 

of ultimatum on them. 

That sounds like some kind of an invisible line has been crossed. 

That sounds to me as if you have gone from being a dispassionate 

regulator to someone who is very much involved and has a stake 

in this controversy. 

64

And I will follow up on Ms. Waters’s point because I think it is 

very well taken: Her observation is that the political context surrounding your investigation was that serious doubts were being 

raised about OFHEO. 

In fact, frankly, doubts were raised about your leadership of 

OFHEO. And all of a sudden, the response to that is to produce an 

enormously critical report. 

My concern is that OFHEO has jumped off the fence—where it 

should be, if it is a dispassionate regulator—and has somehow gotten involved in the business of taking a side in this controversy. 

Now, I will give you a chance to respond to that. 

Mr. FALCON. Well, Congressman, I appreciate the time to respond. 

The categorical statements that I was referencing to with Mr. 

Lynch was, he asked me to make a broad categorical statement as 

to whether or not we had Enron-like fraud going on with this company. 

Mr. DAVIS. No, sir. You said that you had a problem with making 

broad and categorical statements. And your instinct is right. 

The reason—and I will make this my last point—the reason that 

you do not want to make broad and categorical statements I suspect is because the ultimate concern of OFHEO ought to be the 

safety and soundness of Fannie Mae. 

Is it possible that by casting all of these dispersions and all of 

these doubts upon the board at Fannie Mae, and upon the structure of Fannie Mae, that you potentially are weakening this institution in the market, that you are potentially weakening the housing market in this country? 

Are those possible consequences from the very broad and sweeping generalizations you have made about this institution? 

Mr. FALCON. Well, first off, we may disagree on this, but it was 

not what I was telling the congressman about the type of categorical statements——

Mr. DAVIS. No, please answer the last question that I asked you. 

Chairman BAKER. And if you would, sir, begin to wrap up——

Mr. DAVIS. I will, and then I will wrap up on just a point, but 

I do not want you to answer any question other than the one I just 

asked you, because our time is so limited. 

Is it possible and is it a reasonably foreseeable consequence that 

these kinds of amputations, these kinds of insinuations about the 

board, could end and of themselves damage the safety and soundness of Fannie Mae by weakening its position in the market? Is 

that possible? 

Mr. FALCON. Our actions are all designed for the safety and 

soundness of this——

Mr. DAVIS. Is that possible? 

Mr. FALCON. If we did our job properly perhaps, but we have not. 

Congressman, let me just say, I understand your politics running 

all the issues. 

Mr. DAVIS. No, I am just asking——

Mr. FALCON. We are just trying to do our job as a regulator. You 

can question my motives, my judgment, even my qualifications——

Mr. DAVIS. That is not the question I am asking. 

65

With all due respect, Mr. Chairman, that is not the question I 

am asking. 

Mr. FALCON.—but that will not change the contents of this report. 

Mr. DAVIS. Is it possible that the market standing of Fannie Mae 

could be weakened by your testimony? 

Chairman BAKER. Please be responsive to him. 

Mr. FALCON. It is possible. And if does——

Mr. DAVIS. Thank you, you have answered my question. 

Mr. FALCON.——course of actions we have taken, it is because of 

what the company has done, as we have outlined in this report. 

Chairman BAKER. The gentleman’s time has expired. 

Ms. Hart, did you now have questions? Ms. Hart? 

Ms. HART. Thank you, Mr. Chairman. 

We have been watching this drama play out a little bit. As you 

know, the committee has considered a number of different proposals that actually would change your position, as far as being the 

regulator for GSEs. 

And one of the things that I know during this debate that you 

have been seeking—and I think it is important—is to separate the 

roles of chairman of the board and CEO at both Fannie and 

Freddie. And I know that Freddie has agreed to do this, but from 

my understanding, up to this moment, Fannie Mae has not agreed 

to do this. 

Can you tell us, first of all, as far as the agreement that you 

have with them goes, is there anything involving that in the agreement that you have with them and why you think that is important to have that separation happen? 

Mr. FALCON. The agreement does not specifically cover the separation of the chair and CEO positions. It does require a review of 

the organizational structure to address issues of possible conflicts 

in different positions and functions. 

We do have a corporate governance rule pending which would 

separate the position of chair and CEO. And we have proposed that 

and are moving toward a final rule on this because we found that, 

based on the situation at Freddie Mac, that this was just best corporate practice for these government-sponsored enterprises. 

We found that the board could not properly fulfill its role as overseer over management as long as the CEO was also the chairman 

of the board of the company. And so, we entered an agreement with 

Freddie Mac, whereby they agreed to separate the positions. 

And I must say that, to the board’s credit, that didn’t take much 

persuasion. I think they saw that this was appropriate in themselves. And so, they took this step. And with this corporate governance rule being in place, soon I hope, we will then require the same 

thing of Fannie Mae. 

Our report on Freddie Mac certainly highlights the need for a 

government-sponsored enterprise which has imperfect market discipline to have a separation of these positions. 

Ms. HART. If that is such an important point, why is your instruction in the agreement with Fannie so general? 

Mr. FALCON. Well, because we intend to deal with this through 

our corporate governance regulation, while the overall issues about 

organizational structure get addressed by the board and us. 

66

Ms. HART. Okay. I yield back. Thank you, Mr. Chairman. 

Chairman BAKER. Thank you, Ms. Hart. 

Mr. Watt, in the interim Mr. Crowley appeared, and he was 

ahead of you. 

Mr. Crowley? 

Mr. CROWLEY. Thank you, Mr. Chairman. 

Thank you, Mr. Falcon, for being here today, and thank you all 

for testifying. 

I just want to go back a little bit of ways in the hearing. I was 

in the back room prior to the break for votes when Mr. Shays was 

asking you a number of questions. And in response to a question 

from Mr. Shays, you suggested, at least as I interpreted it, that investors could be harmed by the actions taken by Fannie Mae. 

Could you tell me where that is in your report? Do you have that 

in your report? 

Mr. FALCON. I think potential harm exists because of inaccurate 

financial statements being issued by the company. 

Mr. CROWLEY. Is that an observation of yours, or is that in the 

report itself? 

Mr. FALCON. It is in the report. 

Mr. CROWLEY. Where in the report is that? 

Mr. FALCON. The fact that we think that the company has issued 

inaccurate financial statements as a result of these accounting 

practices? I would have to go through and find the exact——

Mr. CROWLEY. If you don’t mind, I would like to know, if you can. 

Maybe your staff can let my staff know where in the report that 

is. 

Mr. FALCON. Absolutely. 

Mr. CROWLEY. Just on Mr. Davis’s line of questioning, which I 

thought was excellent, what effect do you think this report will 

have on the mortgage market? 

Mr. FALCON. I think what we have seen to date is that the mortgage market has functioned well. There is continued liquidity being 

moved into the mortgage market. And despite Fannie Mae’s problems, as found in this report, there haven’t been any real disruptions in the mortgage market. 

Mr. CROWLEY. Do you anticipate there will be any disruptions in 

the mortgage market because of this report? 

Mr. FALCON. As long as the markets and the public see that we 

are working to take prompt corrective action——

Mr. CROWLEY. Yes or no? 

Mr. FALCON. No. 

Mr. CROWLEY. No, you do not. 

Do you believe that this report shows any evidence that Fannie 

Mae may be departing from its mission of increased homeownership through making homeownership more affordable in this country? 

Mr. FALCON. The report did not address that point. 

Mr. CROWLEY. For example, I know Mr. Raines has pledged to 

create 6 million new homeowners, including 1.8 million minority 

homeowners, by 2014. Do you believe this goal may be threatened 

now because of this report? 

Mr. FALCON. I don’t think——

67

Mr. CROWLEY. I am going to ask Mr. Raines the same question, 

but——

Mr. FALCON. As long as the company is maintaining its adequate 

capital, as long as we have taken proper steps, along with the cooperation of the company, I think we will minimize any damage to 

their ability to meet their affordable housing goals. 

Mr. CROWLEY. Let me finally—thank you. Let me finally ask you, 

while there are some things in this report that are damaging, in 

the text itself, it is the SEC, I believe, and not OFHEO that has 

the final say over whether or not Fannie Mae must restate past 

earnings. Is that correct? 

Mr. FALCON. Yes. Ultimately the SEC has to decide whether 

their statements issued pursuant to laws were accurate. 

Mr. CROWLEY. And some have argued to me that there is more 

than an even chance that the SEC may disagree with the most 

damaging allegations, such as accounting or derivatives and delayed recognition of expenses. Is that correct? 

Mr. FALCON. I guess some have predicted that. I cannot speak to 

what others might predict. All I know is that we find these issues 

to be very clear violations of GAAP. And we feel confident that once 

the SEC takes an objective look at this, that they will come to the 

same conclusions that we have and that Deloitte & Touche has. 

Mr. CROWLEY. Thank you. 

Mr. FRANK. Would the gentleman yield to me? 

Mr. CROWLEY. Yes, I will. I yield to the gentleman from Massachusetts. 

Mr. FRANK. I thank the gentleman. 

And I appreciate the answers, Mr. Falcon, you gave to Mr. Crowley. But it makes me even more disturbed that you, both in your 

written statement and again, sort of threw ‘‘safety and soundness’’ 

around almost like kind of boilerplate. 

I think you just accurately answered the questions that, no, if everything works out as we expect it to, there are no threats, et 

cetera, this—you seem to be saying, ‘‘Well, these are in areas which 

could raise safety and soundness problems.’’ I don’t see anything in 

your report that raises safety and soundness problems. Your answers to Mr. Crowley certainly didn’t indicate that there were. 

How does this raise safety and soundness problems, other than 

the kind of, frankly, almost ritualistic saying, ‘‘Well, these are 

areas where safety and soundness could be implicated presumably 

if it went far enough’’? 

But I think it is irresponsible—let me be very clear—on the basis 

of this report and what you have concluded so far—I mean, we 

have earnings smoothed out. With regard to derivatives, you have 

told you me you cannot even say at this point whether they have 

under-reported or over-reported earnings. 

How does this threaten the safety and soundness, what you have 

uncovered, of Fannie Mae? 

Mr. FALCON. Just the very fact that we have serious doubts 

about the accuracy of the financial statements and their books and 

records, the very fact that we have identified very serious internal 

controls——

68

Mr. FRANK. Well, let me ask a question. Does any accuracy 

threaten the safety and soundness? That is what bothers me. There 

is a quality and a quantity issue here. 

There are inaccuracies that can be disturbing, and if they led to 

inappropriate compensation, I would be very unhappy. But the notion that any inaccuracy implicates safety and soundness, I think, 

based on what you have said here, where you cannot even conclude—you have said you cannot even quantify any potential 

amount of loss. To throw ‘‘safety and soundness’’ around in that 

thing I think really is, for a regulator, irresponsible. 

Mr. FALCON. Well, I think internal controls are a very serious 

safety and soundness concern. A breakdown or a lack of internal 

controls——

Mr. FRANK. Do you think the safety and soundness is at risk 

right now? 

Chairman BAKER. Mr. Crowley, that will have to be your last 

question. If you can wrap up. 

Mr. FRANK. He accepts that. 

Mr. CROWLEY. That was my first question, as a matter of fact. 

Mr. FRANK. Yes, I mean, you have just told Mr. Crowley it didn’t 

implicate safety and soundness. Does it, your report, what you 

have reported? 

Mr. FALCON. No, I think our report absolutely does implicate 

safety and soundness. 

Mr. FRANK. Is the safety and soundness at risk now? 

Mr. FALCON. Are they at risk of becoming insolvent right now? 

No. We have an agreement with the board in place that will address these problems, provide an adequate capital cushion. We 

think we——

Mr. FRANK. That is the answer. The rest is just rhetoric. 

Chairman BAKER. The gentleman’s time is expired once over. 

Mr. Ose? 

Mr. OSE. Thank you, Mr. Chairman. I yield 15 seconds to Mr. 

Shays. And I am counting. 

Mr. SHAYS. Thank you. 

I would just like to say to you, Mr. Falcon, what you have done 

is you have exposed illegal activity on the part of Fannie Mae, and 

you are being criticized for exposing it. If they have a safety and 

soundness problem, or if the markets are impacted, it will only be 

impacted based on what Fannie Mae did. 

And I just want to congratulate you. You have more courage 

than I realized you had, because the messenger is being shot and 

not the person who did the wrongdoing. I have seen it here in this 

committee, and I am pretty outraged by what I am seeing. 

Congratulations for what you have done. 

Ms. WATERS. Would the gentleman yield? 

Mr. OSE. Let me ask my—it is my time. 

Ms. WATERS. Would the gentleman yield? 

Chairman BAKER. It is Mr. Ose’s time, and I think he wants to 

reclaim it. 

Mr. OSE. I do want to reclaim it. 

Ms. WATERS. Oh, he is reclaiming his time? 

Mr. OSE. Mr. Falcon, I follow this stuff very carefully because, 

having weathered the storm on the games-playing that took place 

69

in some of the energy companies, I am very, very sensitive to what 

might be occurring in the financial markets underpinning the housing market. 

If I understand correctly, there are questions as to the validity 

of the numbers on an ongoing basis within the enterprise known 

as Fannie Mae. 

Now, Fannie Mae’s securities are held as tier-one capital by any 

number of additional institutions. My concern here is not so much 

the direct impact but perhaps the indirect impact that might manifest itself as a result of manipulation of earnings. 

Could you speak to that issue? In other words, the secondary impact, if you will, outside of Fannie Mae, is that a possible consequence for banks holding Fannie Mae’s securities as tier-one capital? 

Mr. FALCON. The banks holdings in the debt of Fannie Mae—if 

there is some—might have undue concentration in Fannie Mae 

debt as a percentage of the total capital, if the problems were not 

addressed quickly with Fannie Mae such that we remedied the concerns that we have found, I think the bank regulators might have 

some concern about the devaluation in what is being held as capital of some financial institutions. 

Mr. OSE. This is exactly the point that I think OFHEO properly 

has made, is that this issue is not constrained to the enterprise we 

know as Fannie Mae. This issue goes beyond the enterprise we 

know as Fannie Mae. That is why it is so important that the numbers that Fannie Mae reports accurately reflect the enterprise’s activity. If they do not reflect the enterprise’s activity, there are significant adverse effects outside the enterprise that we would end 

up being called upon to deal with. 

That is why I am, frankly, pleased to see you bring this to our 

attention. I am troubled by what I hear. I am looking forward to 

the witnesses that follow you. And I thank you for your work. 

Chairman BAKER. Would the gentleman yield? 

Mr. OSE. And I yield to the Chairman. 

Chairman BAKER. I would just like to point out to the gentleman, 

there is approximately 8,400 insured federal depository institutions. Of that number, in excess of 3,000 institutions hold 100 percent, not 50, not 70, 100 percent or more of their required tier-one 

capital in GSE securities. 

It is of extraordinary consequence we fully understand that the 

financials are indeed accurate, because an impairment in the 

issuance of debt, it would not require the insolvency of an enterprise, merely an impairment in the ability to issue debt. If the regulator increases capital requirements, where are they going to go 

to raise the capital? 

So I think the gentleman has raised an excellent point I think 

heretofore has not been recognized. I thank him for yielding. 

Mr. OSE. I yield back the balance of my time. 

Chairman BAKER. Mr. Watt? 

Mr. WATT. Thank you, Mr. Chairman. And again, thank the 

Chairman for allowing the nonmembers of the subcommittee to 

participate. 

I think I may be the last questioner, so I want to try to follow 

up on a couple of things. Number one, Mr. Bachus, I believe it was, 

70

asked about the leak the morning of the day you met with the 

Fannie Mae board. 

My question to you is, are you undertaking any internal investigation to determine whether that leak was inside your shop at 

present? 

Mr. FALCON. I will. 

Mr. WATT. Are you presently, or you are planning to in light of 

the comments that were raised today? 

Mr. FALCON. Yes. 

Mr. WATT. Okay. 

Mr. FALCON. And I guess I would also ask——

Mr. WATT. That is all I need to know. 

Second, you made reference in response to questions that Ms. 

Waters asked to at least some conversations with members of Congress leading up to the time that you had the meeting with the 

board of Fannie Mae. 

Would you be kind enough to provide to the chairman and the 

ranking member of this subcommittee a list of those contacts and 

the contents of those contacts? I don’t expect you to have that with 

you today, but would you provide that to the chairman and ranking 

member? 

Mr. FALCON. Sure, Congressman. 

Mr. WATT. Okay. Now, let me kind of zero in on the bottom lines, 

as I have gathered them, and contrary to what Mr. Shays is saying, 

I am not second-guessing whatever conclusion the study. But I do 

have some problems with the timing of the release of this information. 

Is it correct that you have not concluded whether the derivative 

conduct that you describe in your report either resulted in an overstatement or an understatement of Fannie Mae earnings? 

Mr. FALCON. Right. The next step——

Mr. WATT. Okay. Just, is that correct? 

Mr. FALCON. Yes. 

Mr. WATT. Okay. And, now, since we have separated out that, we 

don’t know what the financial consequence of that is. 

Let me go to the primary thing that I want to get at, and this 

is at the bottom of page three of your statement. Right near the 

next-to-the-last sentence there you say, ‘‘Fannie Mae improperly 

delayed the recognition of income to create a ’cookie-jar’ reserve 

that it could dip into whenever it best served the interest of senior 

management.’’

Now, the word ‘‘cookie-jar’’ makes it sound pretty small, but in 

actuality, the specific incident you are talking about related to 

$400 million in 1998. Is that correct? 

Mr. FALCON. Yes. 

Mr. WATT. And what you are saying is that in 1998, Fannie Mae 

made a decision to recognize only $200 million of that and then 

amortized the rest of it over 1999. Is that the bottom line on what 

you are saying? 

Mr. FALCON. Yes. 

Mr. WATT. Now, is it also then true that for 1997 and prior 

years, there would have had to be an understatement of revenue 

or income for Fannie Mae in order for Fannie Mae to have been 

able to create this ‘‘cookie jar’’? 

71

I mean, is that not what this means when you say they improperly delayed the recognition of income. Does that not mean that in 

some years to prior to 1998, they did not recognize income so they 

understated income. Is that not what that means? 

Mr. FALCON. I do not believe so. I would like to have my chief 

accountant to explain to you, but I think it was just a function 

of——

Mr. WATT. Yes, well, tell your chief accountant to tell me what 

this means. 

Mr. DICKERSON. The ‘‘cookie jar’’ is really a Securities and Exchange Commission term of art for——

Mr. WATT. I do not care about the term itself, but you cannot create a reserve in a cookie jar without having created some consequences to prior earnings. Is that correct, Ms. Deleo or whoever 

it is that is going to answer it? 

Mr. DICKERSON. Congressman, our analysis and our special examination did not go back beyond——

Mr. WATT. I understand that. That is not the question I am asking. But you cannot really determine whether there was an overstatement or an understatement of earnings over time at Fannie 

Mae without going back beyond 1998, can you? 

If they were creating a reserve that was supposed to level out 

earnings, they had to understate at some point and overstate at 

some point. Is that not correct? 

Mr. DICKERSON. Well, Congressman, our examination found that 

there was $400 million——

Mr. WATT. I understand that. I have acknowledged that. I went 

through that in some detail and you went through it some detail. 

The question I am asking is: In order to create the cookie jar reserve, would there not have had to be an understatement of income 

at some point just as there was an overstatement of income at 

some point? 

Chairman BAKER. And someone please try to answer his question. The gentleman’s time has expired. 

Mr. WATT. I thought it was a pretty simple question myself. 

Mr. DICKERSON. It was after this experience in 1998 that Fannie 

Mae implemented policies to create these cookie jar reserves beginning in 1999——

Mr. WATT. How can you say that and you did not even look at 

1997? You do not know whether the cookie jar was already there 

or not, do you? 

Mr. DICKERSON. I cannot really speak to the years before 1998, 

sir. 

Mr. FALCON. Congressman, I think what you are getting at is: 

Was this there in 1997 and they just carried it forward or something to that effect. 

This $400 million showed up in 1998 as a result of the change 

in interest rates and the amortization——

Mr. WATT. Well, what did they offset it against if there was not 

already a reserve? And how did they get the reserve if there was 

not already understated income at some point, or overstated income at some point? 

72

I am just trying to figure out—I mean, this is a balancing act, 

right? And the objective is to smooth out earnings. Is that not 

right? 

Mr. FALCON. This came up as a result of a change in interest 

rates and a change in the amortization of the expenses related to 

the mortgages. 

So it is not something that is necessarily what you are suggesting. It is more of a factor of the models showed that they——

Mr. WATT. But is it necessarily what you are suggesting? That 

is the question. 

Chairman BAKER. With that, the gentleman’s time really has expired. 

Mr. Director, would you care to respond to his last comment? 

Mr. FALCON. No, Mr. Chairman. 

Mr. FRANK. For something clear cut, that is pretty hard to explain. 

Chairman BAKER. Mr. Director, on behalf of the committee I 

wish to express our appreciation for your courtesy with your appearance here today and for the work you do. 

I know that, given the difficulty of this issue and strong opinions 

held by members from many perspectives, that the criticisms that 

you took today may be difficult for you and your staff to accept, 

given the length of time and the amount of effort you have put into 

production of this report. 

I want to express our appreciation publicly for your effort, and 

be assured that our work going forward, like yours, will not stop 

with today’s hearing. 

Thank you very much, sir. 

Mr. FALCON. Thank you. 

Chairman BAKER. At this time I would like to ask our second 

panel participants to come forward, when it is possible. 

At this time the committee welcomes our next two witnesses: Mr. 

Franklin D. Raines, chairman and chief executive officer of Annie 

Mae, and Mr. Timothy Howard, vice chairman and chief financial 

officer of Fannie Mae. 

Gentlemen, by prior agreement with Mr. Kanjorski, it was determined that all witnesses appearing here today will testify under 

oath. Do either of you have any objection to testifying under oath? 

Mr. RAINES. No, sir. 

Mr. HOWARD. I do not. 

Chairman BAKER. The chair also is required to advise you that 

the rules of the committee and of the House entitle you to be advised by counsel. Do you desire to be advised by counsel during 

your testimony today? 

Mr. RAINES. No, sir. 

Mr. HOWARD. Nor do I. 

Chairman BAKER. In that event, let me ask you to rise and raise 

your right hand to affirm the oath. 

(WITNESSES SWORN) 

Consider yourself sworn in, gentlemen. Thank you. 

Mr. Raines, we would certainly proceed with your opening statement first. Your official statement of course will be made part of 

the record. 

73

Normally we request that witnesses try to make their statement 

in 5 minutes. However, given the nature of the report in question 

and the importance to your organization, certainly we would want 

you to proceed as you deem appropriate. 

Mr. RAINES. Well, thank you, Mr. Chairman. 

STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CHIEF 

EXECUTIVE OFFICER, FANNIE MAE 

Mr. RAINES. My name is Frank Raines. I am the son of Ida and 

Delano Raines. I grew up in Seattle, went to public school, graduated from college and law school. I am a brother, a husband, a 

father and friend. 

For all but two of the last 25 years, I have been in the financial 

services business, and those 2 years I served our nation as the director of the Office of Management and Budget. 

I am now the chairman and CEO of Fannie Mae. And Fannie 

Mae is the nation’s largest source of funds for homeownership and 

rental housing for low-, moderate-and middle-income Americans. 

We like to say we are in the American dream business. 

I introduce myself in this way not because I am a stranger to 

this committee, but because I do not recognize the person, colleagues or company that someone described this morning. 

But I nevertheless hope that I can make a contribution to a constructive dialogue this afternoon. 

I do thank you, Chairman Baker, and I thank Ranking Member 

Kanjorski, and Chairman Oxley and Ranking Member Frank for 

the opportunity to be here. 

We appreciate this opportunity to answer your questions about 

issues raised in the September of 2004 report by OFHEO of a special examination of Fannie Mae. 

I would like to begin by noting that this is the first opportunity 

that Fannie Mae and its board are taking to respond in an official 

forum to the allegations set forth in the OFHEO exam report. 

We take this report seriously. 

Out of respect for the regulatory process and for OFHEO, we 

have sought with great diligence to follow an orderly process 

throughout the special examination, which is ongoing. 

We have chosen not to respond ad hoc to questions about the 

exam report’s content or conclusions. Instead, we will provide our 

responses in the appropriate forums, including through the boards 

independent review to the Securities and Exchange Commission 

and to the Congress. 

So I appreciate that the committee has provided this forum 

today. 

Some people have mistakenly concluded that the company’s 

agreement with OFHEO constitutes an admission by the company 

to the findings and conclusions of the report. 

Let me clarify that this is not the case. The agreement itself 

states that the company was not admitting or denying any wrongdoing as a result of signing the agreement. 

Fannie Mae respects the role of OFHEO as our safety and soundness regulator. The strong oversight OFHEO provides is critical, 

given Fannie Mae’s significant role in the U.S. housing finance system and the financial system as a whole. 

74

In our view, from a decade of experience working with OFHEO, 

I believe that our overall safety and soundness regime makes 

Fannie Mae a better company. 

OFHEO has more examiners per regulated company than any of 

the bank regulators. 

OFHEO’s risk-based capital standard is a model for financial institutions globally and goes farther than new risk-based capital 

models being proposed for financial institutions with more complex 

operations than Fannie Mae. 

The best financial institutions will tell you the same thing. They 

welcome the exam process because it fosters cooperation in making 

the institution the best that it can be. 

A confidential and cooperative examination process builds confidence, both the regulators confidence in the company, but also the 

company’s confidence in its own safety and soundness. 

Now, while this special examination unfortunately departed from 

standard financial institution examination procedures, our obligation remains the same: to make adjustments needed to respond to 

OFHEO’s concerns, just as any financial institution would do with 

respect to its regulator. 

That is why the company, led by our board, promptly entered in 

to a regulatory agreement with Director Falcon to make changes to 

our accounting, capital and internal controls and organization. 

And let me thank our board members, particularly our presiding 

director, Ann Korologos, for their dedication and efforts on behalf 

of Fannie Mae in the past 16 days. Their diligence made it possible 

to quickly set forth an orderly process to resolve the concerns 

raised by the OFHEO report. 

In conjunction with the agreement, the board’s independent review committee has hired the law firm of Paul, Weiss, Rifkind, 

Wharton & Garrison to conduct an independent investigation, led 

by former Senator Warren Rudman, of all the allegations in the 

special examination report. 

The issue of whether our implementation of FAS 91 and FAS 133 

was consistent with generally accepted accounting principles remains with the SEC. 

This agreement and these measures are important steps toward 

addressing the matters raised in the OFHEO report and a way to 

move forward. Adopting these measures will make Fannie Mae 

stronger and even better able to pursue our mission and the business that fuels our mission. 

That mission, after all, is our central function. Congress chartered Fannie Mae to expand access to homeownership for low-and 

moderate-income Americans, and we are committed to that mission. 

Earlier this year we announced the commitment to create 6 million first-time homebuyers, including 1.8 million minority first-time 

homebuyers, over the next decade, and to do our part to raise the 

minority homeownership rate to 55 percent and beyond. 

By quickly reaching agreement with OFHEO where we could, we 

are able to maintain our mission focus. 

For those that may be concerned that some of these steps, particularly the 30 percent capital surcharge, will constrain our mission activities, let me say this: Fannie Mae will do everything in 

75

our power to meet our commitments to expanding homeownership 

and affordable housing while also doing everything in our power to 

try to meet the requirements of the agreement. 

Before I close, I would like to touch on the issues raised by the 

OFHEO report concerning our implementation of the accounting 

standards FAS 133 and FAS 91. These accounting standards are 

highly complex and require determinations over which experts 

often disagree. 

First, the report alleges that in 1998 the company willfully violated GAAP in order to maximize executive bonuses. These are serious allegations. They concern events that occurred almost 6 years 

ago. 

Importantly, I would note that the OFHEO report does not cite 

any documents or witnesses to support these allegations. 

Upon reading of this allegation in the report, the company undertook to assemble the relevant facts. And we have learned of no 

facts and no other materials that support the allegation that the 

decision about the amount to book was related to bonuses. 

Based on the facts as I understand them, the $240 million estimate was arrived at as part of an analysis conducted by our accounting and financial staff, independent of any considerations of 

compensation. Additionally, this analysis was documented at the 

time and was disclosed to and fully discussed with our independent 

auditor. 

We intend to turn all of this factual information over to the independent committee of the board and its outside counsel for review. 

Second, the report alleges that we misapplied GAAP with respect 

to two accounting standards, FAS 91 and FAS 133. We believe we 

applied those standards in accordance with GAAP, and our independent auditor, KPMG, reviewed our application of those standards and concurred. 

Fannie Mae has previously issued and filed with the SEC financial statements that reflect the accounting and financial statement 

presentation that OFHEO has alleged to be inappropriate. Those financial statements were certified by me and by our chief financial 

office, Tim Howard, after a thorough process and audited by our 

independent auditor, KPMG. 

Fannie Mae has not withdrawn those financial statements, and 

KPMG has not withdrawn its opinion that those financial statements were prepared consistent with GAAP in all material respects. 

Rather, the issues that have been raised by OFHEO will be 

taken up directly with the staff of the SEC, which ultimately has 

the final authority over GAAP. 

Our accounting staff has repeatedly determined that our policies 

and practices with regard to FAS 91 and 133 are reasonable and 

in accord with GAAP. And KPMG has issued unqualified opinions 

on our financial statements, and that remains their position today. 

In fact, when I certify our financial statements, I certify that 

these documents fairly present, in all material respects, the financial condition, results of operations and cash flows of the company. 

That is a very serious statement, and I take it very seriously. 

We engage in a rigorous due-diligence process before I ever put 

pen to paper and make that certification. I only certify after receivVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00083 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
76

ing assurance that I can say with confidence that our financial 

statements fairly present, in all material respects, the financial 

condition, results of operation and cash flows of the company. 

Mr. Chairman, no one is more interested in a full and open examination of these issues than I am. I cherish this company. I believe in the mission that Congress challenged Fannie Mae to carry 

out. And I am inspired by the 5,000 women and men who come to 

work every day trying to help lenders help people get into homes. 

Most of all, I believe that Fannie Mae’s biggest challenge ahead 

is helping the financial system and mortgage industry to meet the 

growing and changing housing needs or our growing and changing 

nation. 

This decade is expected to produce 30 million more Americans, 

who will create 13 million to 15 million new households. Minorities 

will represent 80 percent of that growth. And as a result, we estimate that 46 percent of future first-time homebuyers will be minorities and immigrants. 

Serving their housing needs will require new ideas and innovations in mortgage financing. And we look forward to helping the industry with this challenge. 

Given this public mission for which Congress created us and as 

an instrument of national housing policy, Fannie Mae expects and 

welcomes OFHEO’s rigorous oversight to ensure that we are safe, 

sound, solid and stable for the long run. As I said the last time I 

appeared before this committee, strong oversight is in the best interest of Fannie Mae, our shareholders, financial markets and 

homeowners. 

I want to make one thing very clear. I have always tried my best 

to ensure that our company does the right thing in the right way. 

And I believe to this day that we did. 

If, however, after a thorough review of all the facts, it is determined that our company made significant mistakes, our board and 

our shareholders will hold me accountable. And I will hold myself 

accountable. That comes with being a CEO. I accepted that burden 

on the day I took the job, and I accept it today. 

Thank you, Mr. Chairman and members of the committee. And 

I look forward to answering any questions that you may have. 

[The prepared statement of Franklin D. Raines can be found on 

page 176 in the appendix.] 

Chairman BAKER. Thank you, sir, for your statement. 

Our next witness is Mr. Timothy Howard, vice chairman and 

chief financial officer of Fannie Mae. 

Please proceed at your leisure, sir. 

STATEMENT OF TIMOTHY HOWARD VICE CHAIRMAN AND 

CHIEF FINANCIAL OFFICER, FANNIE MAE 

Mr. HOWARD. Good afternoon, Ranking Member Frank, Chairman——

Chairman BAKER. Make sure that mic is on, or pull it a little 

closer. We can’t hear you the way we should. 

Mr. HOWARD. Is it on now? 

Chairman BAKER. Yes, sir. Thank you. 

Mr. HOWARD. Good morning—or good afternoon, I should say. 

Thank you for inviting me to be here today. 

77

I joined Fannie Mae in 1982 when the company was in the midst 

of a severe financial crisis brought on by flaws in its interest rate 

risk management. Under the leadership of David Maxwell, we were 

able to turn the company around and establish the solid financial 

footing that has enabled Fannie Mae to reliably provide hundreds 

of billions of dollars in affordable, fixed-rate mortgage financing to 

millions of low-, moderate-and middle-income Americans. 

I consider it a privilege to have been able to devote the past 22 

years of my career to this company and its mission. Throughout 

this time, I have tried my absolute best to do the right thing for 

the homebuyers Fannie Mae helps to serve, the employees I lead 

and the investors who have placed their trust in our company. 

All of my judgments regarding accounting issues were made in 

openness and good faith, with the goal of providing investors with 

the most meaningful and understandable information possible. 

When accounting issues arose, I worked with the head of my accounting policy group, who I know to be knowledgeable and highly 

respected in the industry. I also made certain that any accounting 

approaches we adopted were reviewed with our outside auditor. 

I had a clear objective in guiding Fannie Mae’s implementation 

of the two accounting standards that are at issue in the OFHEO 

report: FAS 133 and FAS 91. And that was to preserve the accuracy and utility to investors of our financial statements by reporting on what I honestly believed were the true economics of our 

business. 

At all times, I believe that the accounting applications we adopted were within the boundaries defined by GAAP, as interpreted 

and understood by our accounting experts both inside and outside 

the company. 

We filed financial statements with the SEC that were fully audited by KPMG, and as Frank said, Fannie Mae has not withdrawn 

these financial statements, and KPMG has not withdrawn its opinion that those financial statements were prepared consistent with 

GAAP in all material respects. 

FAS 133 is widely considered to be the most complicated accounting standard ever issued. Its implementation had the potential to 

greatly reduce the clarity and utility of Fannie Mae’s financial 

statements. 

We recognized this challenge from the outset, but we did not attempt either to circumvent the standard or to violate GAAP to deal 

with it. Instead, we developed a separate earnings measure, core 

business earnings, to convey to investors our financial results in 

the absence of FAS 133. 

FAS 91 requires that we estimate the average lives of the mortgages in our portfolio to determine the rates at which premiums or 

discounts on these mortgages should be amortized into our income 

statement. 

By definition, this estimation process is imprecise. From the inception of FAS 91 in the late 1980s, we have used ranges to address this imprecision in estimating mortgage pre-payments. 

KPMG concurred with our use of a range. 

Ultimately the SEC will resolve the issue as to whether our implementation of FAS 133 and FAS 91 is consistent with GAAP. 

78

This is entirely appropriate. And I look forward to receiving the results of their review. 

It is important to note, however, that the matters to be reviewed 

relate to accounting judgments and not issues of risk management. 

Financially, Fannie Mae is as strong as ever, and our ability to 

carry out our mission remains intact. 

I look forward to responding to your questions on these matters. 

[The prepared statement of Timothy Howard can be found on 

page 169 in the appendix.] 

Chairman BAKER. Thank you, sir. Mr. Raines, prior to the decision being executed to defer the $200 

million in expenses in the end of 1998 into the quarters of 1999, 

were you consulted or did you have knowledge of that proposed 

transaction? 

Mr. RAINES. Mr. Chairman, first, let me be clear. There was no 

decision made to defer any expense from 1998 to 1999. 

Second—and Mr. Howard can go into greater detail into how the 

process actually occurs—but we did not make any deferral. I was 

part of a discussion, as I always am as the CEO, in our closing 

process in which the decisions made in our financial area with regard to the calculation of the catch-up provision was discussed. But 

the determination of that was made through our normal process of 

closing our books. 

Chairman BAKER. So you did——

Mr. RAINES. But Mr. Howard will be able to give you more detail. 

Chairman BAKER. Sure. So that you were involved in a discussion about the amount of catch-up required. And your view is that 

was that a customary process, not a decision made with regard to 

this specific expensing item. 

Mr. RAINES. That was a discussion that we would have at the 

end of each period, discussing a variety of issues related to closing 

the books of any given year. 

Chairman BAKER. Were there any discussions related to the consequences of that expense treatment in relation to the EPS? 

Mr. RAINES. No. 

Chairman BAKER. When did you first realize that the earnings- per-share figure would be $3.23? 

Mr. RAINES. The first time that I would know what the earnings 

figure would be is when our controller would have closed the books 

and done all of the analyses necessary to determine what the final 

results are and then that would be reported to me. That would be 

after any decision that was made with regard to the catch-up provision. 

Chairman BAKER. Was there any discussion in which you participated relative to the determination of the catch-up amount? 

Mr. RAINES. No, I did not participate in determining the amount 

of the catch-up. That was done, as I mentioned, within our financial function, which is their job. 

Chairman BAKER. I know you are knowledgeable of the Fannie 

Mae’s Challenge Grant Initiative—I believe that was something 

that was organized in your administration in 1999—which initiated 

executive incentives for increased earnings. Is it your view, or is it correct to assume that, including the $27 

million of 1998 bonuses that were not part of the Challenge Grant 

79

Initiative, because it was implemented I understand in 1999, that 

went forward from 1999 to 2003, that the total amount of bonuses 

granted by Fannie to those entitled slightly in the excess of $245 

million? 

Mr. RAINES. Mr. Chairman, I do not understand what you just 

said. Let me explain to you why. 

Chairman BAKER. I will clarify the question for you. In 1998, the bonuses reported were $27 million. And I can give 

you the figure for each year. In 2003, the total amount of bonuses was $65 million, the yearly 

aggregate, the amount of bonuses each year, per year, 1998 

through 2003, and that comes out to be $245 million. 

If you are not familiar with that number——

Mr. RAINES. I did not understand what the question was. 

Chairman BAKER. Did that help? 

Mr. RAINES. You told me what the facts were about bonuses. 

The Challenge Grant has nothing to do with bonuses. The Challenge Grant has absolutely nothing to do with bonuses. 

Chairman BAKER. It does in a sense. Challenge Grants 

incentivizes executives to enhance the growth of the corporation’s 

profitability, based on the corporation’s profitability the EPS has 

calculated. The calculation of the EPS then determines whether the 

bonus trigger is hit. 

In light——

Mr. RAINES. You just crossed the line again. 

The Challenge Grant has to do with stock options. It has nothing 

to do with bonuses. 

Stock options were granted to every Fannie Mae employee. Every 

employee of Fannie Mae was given a grant and would only vest if 

the company doubled its earnings over 5 years, and then it would 

vest over a delayed period if it did not. 

So the Challenge Grants have nothing to do with bonuses. 

Chairman BAKER. Well, let me clarify, then. In 2002, Fannie Mae paid out a total of $51 million in bonuses of which $12.4 million was paid to the top executives. 

I have a chart that is going up here now that shows total compensation. 

Since we have talked about restricted stock awards, we have 

talked about stock options, and we have talked about bonuses, that 

chart characterizes what was awarded in 2002 based upon—what? 

If it was not earnings per share, per stock options, if it was not 

earnings per share or restrict stock awards, am I misunderstanding 

that the bonuses were not calculated based upon the earnings-pershare number? 

Mr. RAINES. Again, Mr. Chairman, I think you are mixing two 

or three things together. 

Chairman BAKER. I may be, but let’s go through the detail——

Mr. RAINES. I would like to be helpful. 

Chairman BAKER. I know. 

Mr. RAINES. Let me try to answer the question——

Chairman BAKER. I will give you the right question that I would like to have answered, if it is possible: Did the $3.23 earnings-pershare determination in 1998 trigger the payment of bonuses to executives? 

80

Mr. RAINES. Yes. 

Chairman BAKER. Thank you. 

Does the earnings per share have any effect on any of the other 

benefits awarded that are displayed on this chart, either the restricted stock grants or the options? 

Mr. RAINES. Well, Mr. Chairman, this is your chart. This is the 

first time I have seen your chart. It has information on this chart 

that was provided to our regulator as confidential information, that 

it was information that is protected, in our belief, by the laws of 

the United States. 

But be that as it may, now that you have displayed it before the 

committee, if I can answer your question. 

Chairman BAKER. Sure, but to answer your legal point, I have 

the absolute right to display it, despite Mr. Ken Starr’s threats to 

the contrary, in the context of a committee hearing discussing the 

policy of Fannie Mae’s compensation. 

Mr. RAINES. Mr. Chairman, I am going to answer your question. 

Chairman BAKER. Well, please proceed. 

Mr. RAINES. I am just pointing out the legal status of this information. 

If we go across your chart, salary has nothing to do with earnings per share. Salary is established at the beginning of the year. 

Chairman BAKER. I understand that. 

Mr. RAINES. The second line you have is bonus. Those, in all 

these years—if I am correct, looking at this because it is very small 

type—is based on earnings per share, but not entirely. 

Because individual employee bonuses also have a performance 

factor involved in them. And so the earnings that they would earn 

is not just based on EPS, but there are also on their performance. 

Fringe benefits have no relationship at all. 

Chairman BAKER. I was not raising that issue here. 

Mr. FRANK. Mr. Chairman, are we all going to get this much 

time? 

Chairman BAKER. I will be happy to cut him off if you would like 

for me to. 

Mr. FRANK. I would like to go with the 5-minute rule. 

Chairman BAKER. In order to move ahead, let me recognize Mr. 

Kanjorski. 

Mr. BACHUS. Mr. Chairman, does he have a copy of this, other 

than reading off the chart? 

Chairman BAKER. I have just recognized Mr. Kanjorski. 

Mr. FRANK. I understand that. I wondered why Mr. Bachus was 

talking, then. 

Mr. BACHUS. I understand, Mr. Chairman——

Mr. FRANK. Well, Mr. Kanjorski has the floor. Let us go to Mr. 

Kanjorski. 

Chairman BAKER. Mr. Kanjorski has the time. He does have the 

information that came from Fannie Mae. 

Mr. BACHUS. I did not know if he had this table before——

Mr. KANJORSKI. I do not have that chart. I think it is only on one 

side? 

Chairman BAKER. Can we have it distributed? 

It is being distributed now. 

81

Mr. KANJORSKI. Well, shall I wait and hold my time so I would 

have the same information that the other side of the aisle has in 

their possession? 

Chairman BAKER. Let me give you mine. 

Mr. KANJORSKI. Well, thank you very much. 

Mr. BACHUS. What I am saying is, do these two gentlemen have 

this——

Mr. KANJORSKI. Do all the members on our side of the aisle have 

it? 

Mr. BACHUS. He is indicating that he does not have it. 

Chairman BAKER. Time out. Hold up. 

Ms. WATERS. I have not seen it. 

Chairman BAKER. Hold up one moment. We will make sure that 

staff distributes it to every member——

Ms. WATERS. And to the panel. 

Mr. KANJORSKI.——reproduction costs of the committee, are we 

over the allotted budget amount? 

Mr. FRANK. Mr. Chairman? 

Ms. WATERS. Parliamentarian query: Is this illegal or is it legal? 

I mean, there was a legal question raised here. Is it illegal for us 

to have this information? Can we display or not? 

Chairman BAKER. No, Ms. Waters, it is not illegal. 

Mr. KANJORSKI. Not for us. 

Chairman BAKER. Not in the course of the committee consideration. I would not have released it had it not been. I have had it 

for over a year. 

Mr. FRANK. Mr. Chairman? 

Chairman BAKER. Mr. Frank? 

Mr. FRANK. I have another appointment, but if the gentleman 

from Pennsylvania wanted to study this, I would be glad to go now 

and have him go after. 

Chairman BAKER. Would Mr. Kanjorski like to yield his time to 

Mr. Frank? 

Mr. KANJORSKI. Actually, Mr. Frank, I am not going to use this 

at all. As a senior member of the committee, I am smart enough 

to——

Mr. BACHUS. Mr. Chairman, I am just saying, I still do not think 

that the panelists have this table——

Chairman BAKER. Your point is well taken, Mr. Bachus. It will 

be delivered. Thank you. 

Mr. BACHUS. But as we question them, I just——

Chairman BAKER. I said your point is well taken. It will be delivered. Thank you. 

Mr. KANJORSKI. You mean there were not sufficient copies produced for the committee members. 

Chairman BAKER. Let me put it this way: I wanted to make sure 

I released this information. I am accountable for its release, and I 

put it into the public forum pursuant to my rights as chairman, 

subject to a response from the regulator, and I wanted to make 

sure that I did not get criticized for leaks. And we had all these 

accusations that people got advanced information inappropriately 

before it was publicly released. 

I have now publicly released it. I am accountable for that decision. 

82

Ms. WATERS. Will the gentleman yield? 

Chairman BAKER. And every member of the committee, everybody in the room has access to it. 

Mr. KANJORSKI. Let me make a point, because I was very tough 

on the regulator, and I intend to be tough on Mr. Raines and Mr. 

Howard. 

But, Mr. Chairman, may I point out that you obviously had to 

seek legal opinion as to whether or not you are violating the law 

by distributing this document. 

And may I just say that opinion is opinion. You found a lawyer 

that gave you an opinion contrary to Mr. Kenneth Starr. And for 

the last time I recall, was not Mr. Kenneth Starr really most accomplished attorney in another proceeding——

Mr. FRANK. If the gentleman would yield——

Chairman BAKER. That is opinion. 

Who is recognized? Mr. Kanjorski and Mr. Frank. 

Mr. KANJORSKI. Mind if I take it now, Barney? Let me take the 

5 minutes. Do I have 5 minutes? 

Mr. FRANK. I have been trying to get to regular order. I am 

glad——

Chairman BAKER. Thank you, Mr. Frank. Please keep your members in order, we will be fine. 

Mr. Kanjorski? 

Mr. KANJORSKI. Maybe this goes to Mr. Howard and not to Mr. 

Raines, but either one of you, feel free. 

When Mr. Falcon was before us, the regulator, he talked about 

discovering for the first time the smoothing of earnings in 1998. 

And the transaction that he describes as a $400 million item that 

should have been in but it was reduced to $200 million, but that 

it was cited somewhere in an audit difference. 

I wanted to find out whether—and that was done by your outside 

auditors, as I understand at that time were KPMG. Is that correct? 

Mr. HOWARD. Yes, it is. 

Mr. KANJORSKI. Am I being incorrect when I said to Mr. Falcon 

that that would have been a finding or a difference in the audit 

that had to be resolved at the exit audit with either the board or 

management? 

Mr. HOWARD. Mr. Kanjorski, it typically would have been identified by the auditor and discussed with the audit committee, and it 

was. 

Mr. KANJORSKI. Now, that document, although it was not the 

final audit, something appeared in the final audit that would have 

reflected that working document draft, that there were audit differences expressed by your account. 

Mr. HOWARD. It was mentioned in the accountant’s report. 

Mr. KANJORSKI. In the final audit. 

Mr. HOWARD. Yes. 

Mr. KANJORSKI. And the final audit, it seems to me, in 1998, 

were not only an internal document for the corporation, but that 

was provided and should have been provided to all the shareholders if they wanted it. Is that correct? 

Mr. HOWARD. It typically is summarized in our annual report. 

The audit itself is not provided to shareholders. 

83

Mr. KANJORSKI. Is it a secret document and not allowed to be 

read or understood by the regulator? 

Mr. HOWARD. Not to my knowledge. 

Mr. KANJORSKI. I am trying to gather: What in the hell does the 

regulator do when they regulate only two entities, and the first 

document they start with is not the outside audit, and particularly 

go to audit differences? Is that not what they talked to you about? 

The new auditor found some audit differences there, and we 

want to know how you played it and to pass on whether you did 

it in conformity with the regulator’s position that you acted properly. 

Mr. HOWARD. Well, Mr. Kanjorski, I did spend a full day being 

interviewed by the special committee. They had an opportunity to 

ask me about this incident. I believe I could have put it in context 

that would have made it more understandable to them. They did 

not ask me. 

Mr. KANJORSKI. No, I am just trying to understand: What does 

the regulator do if he does not start out with audit differences? 

Mr. HOWARD. I cannot answer that. 

Mr. KANJORSKI. It seems to me——

Mr. RAINES. The actual document you are referring to has been, 

in my understanding, provided to OFHEO. The working papers 

have already been provided to OFHEO. 

Mr. KANJORSKI. But in 1998, did he have access to that document? 

Mr. RAINES. Yes. 

Mr. KANJORSKI. I am trying to figure out whether we really 

should get worried here and that we have not had close regulation, 

whether it is Fannie Mae or Freddie Mac, if they are not looking 

at some base document that would reflect audit differences from 

your outside auditor to see what adjustments were made and why, 

and then that being footnoted in the final audit report. 

What happened here? Why 6 years went by and the regulator did 

not say, ‘‘1998, there was a little dispute between the outside auditor and the inside auditors in regard to how we treat this $400 million, or $200 million, adjustment.’’

Mr. HOWARD. Well, Mr. Kanjorski, I would say there was not 

even a little dispute. The outside auditor had recorded an audit difference similar to this each prior year on our treatment of this socalled catch up adjustment on FAS 91. This was not unusual, it 

was not new. 

Mr. KANJORSKI. Well, what do we have to do, in terms of the 

committee, in authorizing a new regulator, or whatever powers we 

give a new regulator, so they do not come in here and say 6 months 

or 6 years later that there was this difference that supposedly then 

affects bonuses and compensation and all these things, but that 

they did not see it when it was about as clear as a battleship in 

the Potomac would be? 

Mr. RAINES. Mr. Kanjorski, I am not sure there is anything that 

the Congress needs to do. 

It is my belief, it is my understanding, that our examiners have 

had access to this information over all these years and simply have 

not made any comment about them. 

84

So I do not think this is a matter of finding a secret document 

that have not seen before. I believe that the examiners had access 

to all——

Mr. KANJORSKI. I am not suggesting that there was secrecy. I am 

just getting worried about how superficial was the regulatory authority on your institution and Freddie Mac if they miss something 

that would have jumped out, audit differences. 

Here is your outside auditor saying that, and obviously the regulator did not look at it. 

Mr. RAINES. I guess what I am saying is, I do not know that they 

missed it back 6 years ago. The question is: How is it being characterized? The characterization may have changed. 

Mr. KANJORSKI. Let us go to that point. 

From that time in 1998 until now, it is your testimony, as I understand it, that KPMG had worked out and resolved in their 

mind, giving a full opinion letter on the audit, how it was treated 

in 1998 and how prior to that and how subsequent to that, that 

type of an adjustment was treated. 

Mr. RAINES. Yes. In fact, I can read to you what they said to our 

audit committee in 1999 regarding 1998. 

They said: The principal area of estimates and judgments in 

Fannie Mae’s financial statements, including the amortization of 

premium and discount, KPMG did not identify any areas within 

the financial statement that they believe include unreasonable estimates. 

That is what they said to our audit committee regarding 1998, 

having made that audit exception. 

Mr. KANJORSKI. Well, their new auditor went in this last year, 

and did he find or did they find an audit difference there that they 

did not agree with, the opinion of your auditor? 

Mr. HOWARD. Mr. Kanjorski, let me add one additional fact, and 

that is, after 1998 we worked to develop a specific method that limited the amount of the catch-up adjustment that we could allow not 

be recorded in a given year. 

Once we put in place that procedure, which was the end of the 

year 2000, KPMG no longer recorded any size catch-up adjustment 

as an audit difference, provided it remained within the range that 

was set by our policy. 

Chairman BAKER. Now, if the gentleman has one more and 

then——

Mr. KANJORSKI. Yes, I would like both of you to answer this 

question. It is a very simple question. 

Is there anything of a systemic risk problem at Fannie Mae? 

Mr. HOWARD. Absolutely not, in my judgment. 

Mr. RAINES. No, sir. And the report doesn’t indicate any, because 

all of our risk management practices are working very well and the 

company is very strong. 

Mr. KANJORSKI. Thank you, Mr. Chair. 

Chairman BAKER. Thank you, Mr. Kanjorski. 

Mr. Shays, you are up. 

Mr. SHAYS. I told your staff that I would like to listen to some 

of the questions before I begin mine. 

Chairman BAKER. Mr. Royce? 

Mr. ROYCE. Okay, thank you, Mr. Chairman. 

85

In my opening statement, Mr. Howard, I said that, in my view, 

Fannie Mae has a moral obligation to conduct its operations to the 

highest standard of business practices. Do you agree with me on 

that? 

Mr. HOWARD. Absolutely. 

Mr. ROYCE. Well, the question I would like to ask is, has Fannie 

Mae acted in a way consistent with that belief? Does Fannie Mae 

have strong internal controls? Does Fannie Mae conservatively and 

consistently apply accounting rules? 

Mr. HOWARD. I believe we do conservatively and consistently 

apply accounting rules. We exercise judgment in applying them to 

practical business situations, as is consistent with good accounting 

practice. 

As far as the moral tone, I believe that we have an entirely honorable, decent staff, full of integrity, who have had a very difficult 

time in the past two weeks, seeing themselves characterized in a 

very unfavorable way. 

Mr. ROYCE. I understand that. But there was an audit difference 

with your outside auditor——

Mr. HOWARD. An audit difference is simply a notation. It is not 

a direction for us to change the way we account for the transaction 

in question. That is a fact. 

Mr. ROYCE. Well, the question I have there is, when OFHEO 

began the process of going back through the books—and in my 

view, OFHEO obviously has not been a very effective regulator. If 

they were exercising proper oversight, this issue would have surfaced in a timely matter and we would not be dealing with it now. 

Mr. HOWARD. I am sorry, which issue? 

Mr. ROYCE. The FAS 133 issue. 

The other question I wanted to ask you was along the lines of 

what I asked Director Falcon. To follow up on that question, how 

does Fannie Mae’s application of FAS 133 compare to other major 

financial institutions? Did you apply the standard the same way? 

Mr. HOWARD. Well, Congressman Royce, I believe we made one 

major step that is different from most institutions. And that is that 

we realized that in order to faithfully implement FAS 133 in a 

fashion that did not make our income statements harder for investors to interpret and while still permitting us to use the hedging 

techniques that enable us to manage our interest rate and other 

risks, we needed to develop a supplemental earnings measure that 

adjusted for the effects of FAS 133. 

FAS 133 adds an element of fair value accounting to what otherwise is a historical cost-income statement. And mixing those two 

concepts makes an income statement unintelligible to investors. We 

did not want that. We did not want to stop hedging. And we did 

not intend to undertake sham transactions to smooth out the effects of FAS 133. 

So we developed a supplemental earnings measure called core 

business earnings that we publish to this day. I do not know of another institution that has followed that lead. 

Mr. ROYCE. Okay. I thank you, Mr. Howard. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Mr. Frank? 

86

Mr. FRANK. Thank you, Mr. Chairman. 

First, I have to say to Mr. Raines and Mr. Howard, if it was—

and I take the chairman at his word; I do not believe you would 

have done anything illegal—but if there had been any questions, 

there shouldn’t have been. I think it is perfectly appropriate for 

this to be public. 

I am a strong supporter of Fannie Mae and Freddie Mac, but you 

are not simply another private corporation. There is a lot of government involvement. I think this is entirely appropriate. 

And, Mr. Chairman, I would have maybe given it to them in advance. 

And I did have one question. There is either a mistake here, or 

there are either two people in managed capital or there is one person in managed capital who is getting twice. 

[Laughter.] 

But other than that, I think, yes, it is entirely appropriate. 

And let me add to this. This is not directly relevant, but—and 

here I would say that this is a problem with regard to American 

corporations in general. 

You gentlemen work very hard and you do good work, but I do 

not understand why in the world you need bonuses. At the level 

of compensation you get, we ought to be able to count on you to 

do your very best without any kind of incentive. And I would hope 

you would set a good example. 

If your salary is too low, raise your salary. But I think incentive 

bonuses, particularly if they are connected to stock options—and 

there is no evidence of it happening here, with regard to stock options—but with stock options, top executives are given a perverse 

incentive. 

If either one of you runs into a building that is on fire and rescues a baby, get a bonus. But doing your job, not at all level—my 

level, your level—I think that is a mistake. And to the extent that 

they are performance-related, we leave ourselves open. 

If you want to comment on that at the end, you can do that, but 

I would just ask some questions now, because, to the extent that 

there was smoothing out that might have been affected by this—

well, let me ask, because that is the major question. 

Was the fact that bonuses were somehow dependent on certain 

earnings a factor in the treatment of earnings? And if you did not 

mean it consciously, might it have affected you, do you think? Mr. 

Howard? 

Mr. HOWARD. If you are referring to the incident reported in the 

OFHEO report for 1998, as Mr. Raines mentioned, we have been 

looking into that. And so far we have determined that the amount 

that was determined to be accurately recorded in 1998 was determined as a result of a process that was run in——

Mr. FRANK. I am going to your motives. You both deny that trying to hit a certain amount so you could get your bonuses was a 

factor to any extent in your decisions? I think it is important to 

just ask you that question. 

Mr. HOWARD. Yes, in coming up with that number, yes, we do 

not——

Mr. RAINES. We both deny that. 

Mr. FRANK. You both deny that? 

87

Mr. HOWARD. Yes. 

Mr. FRANK. Okay, I think it is important to get that. 

Next question is, in your reading of these—and I will repeat 

what I said previously, that accounting for derivatives does seem 

to me—and I know Mr. Falcon said, ‘‘Well, it is very clear-cut,’’ but 

as Mr. Watt asked Mr. Falcon and his two chief aides a fairly 

straightforward set of questions, it got less and less clear to me and 

it did not appear to them to be as clear-cut. 

And I will say, my sense is accounting for derivatives ranges 

somewhere between alchemy and astrology. You are accused of 

being on the alchemy end. 

And that as they have gone over it with you, have they pointed 

out—and Mr. Falcon said no, but is there any decision, first of all, 

whether you are considered by them to be guilty on the whole now 

of under-reporting, of over-reporting? Do you know whether they 

think you over-reported or under-reported? 

Mr. HOWARD. I do not. 

Mr. RAINES. No, we can’t tell from reading the report. 

Mr. FRANK. So they have not even concluded whether you overreported or under-reported. 

I did notice the Merrill Lynch report said, given this category, 

that it was a situation of the sort where when interest rates rose, 

there would probably be gains, and when interest rates dropped, 

there would probably be losses. 

Mr. Howard, is that accurate? 

Mr. HOWARD. Well, there is a certain type of derivative that we 

use, which, when interest rates fall, it declines in value and, when 

interest rates rise, it rises in value. 

Mr. FRANK. What percentage of the contested derivatives are in 

that category, do you know? 

Mr. HOWARD. To be honest, Mr. Frank, I am not sure which derivative transactions——

Mr. FRANK. Okay. To the extent that they are there, obviously 

we would expect there to be an increased rather than a decrease 

in the near term. 

Mr. HOWARD. If interest rates rise. 

Mr. FRANK. So, now, when you agreed with them to increase your 

capital by 30 percent—I am going to ask you what your sense was. 

Mr. Falcon has acknowledged that since they had not come to any 

conclusion as to whether you had under-reported or over-reported, 

the 30 percent was certainly not based on any estimate of to what 

extent your capital might have been impaired. 

In other words, there were no numbers there. It was simply that 

in the statute there is a 30 percent figure that is there, really, for 

somewhat other purposes, not for dealing with accounting for derivatives. And he borrowed it because it had some reality. 

Did you get any indication why 30 percent was chosen other than 

that? 

Mr. RAINES. To be clear, the agreement was negotiated by our 

board. 

Mr. FRANK. Oh, okay. So we have to ask Ms. Korologos. 

Mr. RAINES. And my understanding is this is the number that 

the director wanted. 

88

Mr. FRANK. And as he said, it is not based on any—we have to 

be very clear. The 30 percent was not based on any analysis of inadequacy of capital. It was not based on any conclusion that the 

capital had been impaired. 

Again, to the extent that there was inappropriate smoothing out, 

that is wrong, and it is being looked into. It should be corrected. 

But worst case, it does not seem to me that anything has been suggested that jeopardizes your going forward as a corporation. 

Mr. Falcon disappointed me, as I told him, when he acknowledged to Mr. Watt and others, to me, that there was no threat to 

solvency, no remote threat to solvency that he talked about, but 

said somehow safety and soundness was implicated. 

In their conversations with you, has anything been adduced to 

suggest that you are going to have to curtail, to some extent, your 

activities or that the investors are somehow at risk? Mr. Howard 

or Mr. Raines? 

Mr. HOWARD. Not in conversation with me directly. 

Mr. RAINES. No, sir. There have been no conversations that we 

were at risk, other than what is included in their report. 

There is the issue of how we get to the 30 percent additional capital. And there obviously are some people who would prefer that we 

reduce what we do in the market——

Mr. FRANK. Right. And that is my next question, which is, you 

know, HUD—and I will finish in just——

Chairman BAKER. I just want to keep regular order, as you suggested. 

Mr. FRANK. I understand. I am just trying to keep up with you, 

Mr. Baker. You are my role model. 

Chairman BAKER. Start earlier. 

Mr. FRANK. Thank you. 

We had HUD last year not exercise its right to increase your 

goals. As you know, HUD had the right, a year before, to—last year 

they could have promulgated an increase in your affordable housing goals that would have taken effect this year. They didn’t do it. 

It was an oversight, according to the secretary; they forgot to do 

it. 

Now they are talking about increasing. And I certainly want to 

see an increase in the amount of affordable housing. But obviously 

if your overall activity shrinks, we are in trouble because, if I am 

correct, your affordable housing goals are not absolute but they are 

percentages of your overall activity. 

So the question is, what will the effect of the 30 percent additional capital be on your reaching an absolute amount, in terms of 

affordable housing? 

Mr. RAINES. The answer is, we don’t know yet. We have a 45-

day period to come up with a capital plan, under the agreement, 

which we will do. 

We don’t have a lot of choices. As you know very well, you either 

can reduce the size of your activities or you can increase the 

amount of capital that you have. If we have to reduce the size of 

our activities, then the percentage made up of the affordable housing goals will go down because we will be doing less business. 

Mr. FRANK. So that arbitrary 30 percent might result in a diminution in your affordable housing activity? 

89

Mr. RAINES. Well, if the capital plan requires us to reduce our 

activities, yes, it would reduce the impact of the goals as a result 

of our having made those choices. 

Mr. FRANK. Thank you, Mr. Chairman. 

Chairman BAKER. Thank you, sir. 

Mr. Shays, did you want to go now? 

Mr. SHAYS. No. 

Chairman BAKER. Mr. Ney? 

Mr. NEY. Thank you, Mr. Chairman. 

One of the issues I wanted to ask about is something I was asking OFHEO today. It is on the generally accepted accounting practices. 

At the point in time, when they came in and said that there was 

a willful violation of the accepted accounting practices, I asked if 

in fact OFHEO had talked to the Fannie auditors and whether 

Deloitte & Touche, in fact, had talked to your auditors at that time, 

to see why those auditors recommended to you to use certain accounting practices. 

And I just wondered if you had any comment on that, about 

should Deloitte & Touche sit down prior to this report, is what I 

guess I am getting at. And that was the plan made with OFHEO. 

Mr. RAINES. Well, I believe that they should have sat down with 

the auditors and asked them what was their view on these issues, 

because our auditors have obviously been looking at these issues 

for many years and they have an opinion on public record as to 

how they have come out on that question. 

So I believe that they should have sat down with them before 

coming to the conclusions that they have come to, because obviously KPMG has come to a different conclusion than OFHEO has. 

I don’t know what the positions of Deloitte & Touche are. The report doesn’t tell us, and I think the director testified that the findings in the report were OFHEO’s. So I can’t comment on what the 

positions of Deloitte & Touche are on these issues. We know what 

KPMG’s positions are on the issues. 

Mr. NEY. I will speak for what OFHEO said today. If I recall correctly, OFHEO said that Deloitte & Touche concurred with 

OFHEO. 

And my follow-up question was, did Deloitte & Touche at any 

point in time communicate with your auditors to see why? And I 

wondered if, at any point in time, if Deloitte & Touche concurred, 

had they at any point in time had any contact or working papers 

of your auditors? 

Mr. RAINES. Not to my knowledge. 

Mr. HOWARD. Nor to mine. 

Mr. RAINES. Not to my knowledge that there has been any contact either by OFHEO or by Deloitte & Touche with KPMG to explore these issues. 

Mr. NEY. Thank you, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Who is next? 

Mr. Scott? 

Mr. SCOTT. Thank you, Mr. Chairman. 

Mr. Raines and Mr. Howard, your accuser, OFHEO, has spent 

the better part of four hours this morning making some extraorVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00097 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
90

dinary accusations. And I want to make sure that you have ample 

opportunity to refute those accusations, a fair amount of which is 

this: that essentially you all cooked your books so that you could 

meet certain earnings targets so that you could get bonuses. 

And the chairman has passed down this sheet, and one look at 

this sheet puts, in my estimation, some very strong, strong incentives. 

I think we owe you the opportunity to make sure that you have 

the opportunity to refute that charge first. 

And I know, Mr. Chairman, I have 5 minutes, if you will allow 

me to get that question out, then I have two more questions on the 

line of politics and process, but I want you to answer that charge 

because I think that is at the center of this hearing this morning. 

Mr. RAINES. Well, thank you for that opportunity. 

This is a very serious allegation, and I deny that occurred. 

We have looked for the facts. There were no facts in the OFHEO 

report. None. Other than their calculation that said, ‘‘Oh, there 

seems to be if we subtract one number from another you get this 

result.’’

But we looked into the facts of what happened back 6 years ago, 

and we found no facts that would support the allegation that was 

included in the report. 

Mr. SCOTT. Why, then, would OFHEO, in your opinion, make 

that charge? 

Mr. RAINES. Well, Congressman, I do not know. This entire examination has been unusual. It has been the most unusual regulatory endeavor I have seen in the 30-some-odd years I have been 

in this city. 

And I have never seen the case where a regulatory agency 

brought serious allegations against a company without asking the 

company for a response in advance. 

So I do not know. This has been something that is inexplicable 

to me as to why they would follow this path. And I do not believe 

there has been an adequate explanation of why they followed this 

to this moment. 

Mr. SCOTT. I asked your accuser this morning: When did they 

make this report public and when they did inform you of the report? 

I would like to have your interpretation of those chain of events. 

Were you made aware and briefed on this report by your oversight accuser prior to them making it public? 

Mr. RAINES. Let me walk you through the entire sequence very 

quickly. 

We began reading newspaper accounts that OFHEO was about 

to finish a report. I personally called the director to talk to him 

about him, to set up a meeting to talk about it. 

I was unable to have a conversation with him about it or to have 

a meeting with him about it. 

On Friday, at about 4 o’clock Eastern Time, members of our 

board were called and told that the director wanted them to assemble on Monday, to meet with OFHEO officials to hear about the report. 

91

On Monday, four OFHEO officials came to Fannie Mae to brief 

our outside directors, and at that same time they handed to management a copy of the report. 

They then proceeded to brief the board on Monday. 

But as you know, much of the information about the report was 

not only in the political press, but also was in the financial press 

prior to that Monday. 

Mr. SCOTT. Let me ask you: When did the board make the decision to link, and they did actually make the decision to link executive pay bonuses to earnings per share? 

Mr. RAINES. Fannie Mae has linked bonuses to earnings per 

share for as long as I have been around the company. That goes 

back to 1991. Tim Howard has been there longer than I have. 

Mr. HOWARD. I cannot recall a year in which they were not 

linked. 

Mr. RAINES. And indeed, virtually every company of which I am 

aware links some part of their compensation to earnings per share. 

So this is not an unusual thing; this is one of the most common 

aspects of corporate——

Mr. SCOTT. Well, the point I wanted to get on the record was: 

The linkage was made prior to you being chief executive officer. 

Mr. RAINES. Absolutely, prior to my even being at the company. 

Mr. SCOTT. So this was not done on your watch. It was done and 

it has been normal procedure to link——

Mr. RAINES. Yes, sir. 

Mr. SCOTT. Now, Mr. Howard, one point: You are the vice chairman of the board——

Mr. HOWARD. Yes. 

Mr. SCOTT.—you are the chief financial officer——

Mr. HOWARD. Correct. 

Mr. SCOTT.——you are the supervisory person over internal 

audit. 

Mr. HOWARD. That is not correct. The internal auditor reports directly to the chairman of our audit committee. He has what is 

called a dotted-line relationship to me, which means I am his internal point of contact in the company. 

Mr. SCOTT. Do you not approve his salary? 

Mr. HOWARD. I do not. I make a recommendation on his salary 

to our senior management group, and his salary is determined collectively in consultation with the chairman of the audit committee. 

Mr. SCOTT. But you do set the targets, financial targets, for the 

year, you said. 

Mr. HOWARD. The financial targets are set collectively by the 

senior management team. 

Mr. SCOTT. But you do have the authority to meet those targets. 

Mr. HOWARD. No, I do not. 

Mr. SCOTT. Oh, you do not. That is good to know, because there 

have been some reports that you did. 

Mr. HOWARD. There have been lots of things that have been said 

incorrectly. 

Mr. SCOTT. That is why I want to make sure that you have 

ample opportunity to refute. This is a very serious hearing. 

92

I think the future, the jeopardy of Fannie Mae is at stake. And 

I want to make sure we give you ample opportunity to answer 

every one of these charges. 

Mr. HOWARD. If I may take advantage of that opportunity and 

just be very clear in what we are saying, there is no linkage, to my 

knowledge, of compensation to the determination of what the catchup charge would be in 1998. 

We found no evidence of a linkage of that to compensation decisions for 1998. 

Mr. SCOTT. Thank you. 

I yield back the balance of my time, Mr. Chairman. 

Chairman BAKER. I thank the gentleman. 

Chairman Oxley? 

Mr. OXLEY. Thank you, Mr. Chairman. 

Mr. Raines, welcome back. 

I am sorry if I am plodding over old ground, but I just got back 

in the committee room. 

Mr. Raines, I wanted to ask you in regard to the Freddie Mac 

issue: You stated that Freddie Mac to make its GAAP earnings less 

while Fannie Mae—this is your quote—reported and explained the 

volatility. The OFHEO report finds that Fannie Mae misapplied 

GAAP, due to among other things, managements desire to portray 

Fannie Mae as a consistent generator of stable and growing earnings. 

I guess the question occurs: What is the difference, in your case, 

between Freddie and Fannie in that regard? 

Mr. RAINES. Mr. Chairman, they tried to get me with no chart. 

I had to have one. And this simply illustrates the major point. 

That is our reported earnings. That is what we are accused of 

having made stable. 

And if this was what we are trying to make stable, we did a very 

bad job of trying to stabilize our reported earnings. 

And that is really the big difference between what Freddie Mac 

admitted they did and what we are accused of. 

Freddie Mac was accused of trying to straighten out that orange 

line, and that they entered into transactions to straighten out the 

orange line. That is the GAAP earnings line. 

And then they said, yes, that is what they did. 

And what we did instead was, we have two ways of reporting the 

earnings. We simply report the volatility in GAAP, and we 

say,’’Here’s another way to calculate it in core. You the investor 

now have both ways to calculate it.’’

So I am not exactly sure what is meant by the accusation that 

we were smoothing earnings, because FAS 133 is not even included 

in core—the impact on net income is not even included in core business earnings. 

So that is why we have a little difficulty understanding what the 

accusation is. 

But the difference between us and Freddie Mac is that OFHEO 

is saying we have misapplied accounting standards. They link us 

smoothing; we do not understand what that means. 

Freddie Mac said they were trying to smooth. 

Mr. HOWARD. Mr. Chairman, as you can see from the chart, even 

the core business earnings line is not particularly smooth in recent 

93

years. So whether it is GAAP, which we made no attempt to 

change with transactions that were not economic, or core business 

earnings, the allegations of transactions to smooth earnings, or accounting manipulations to smooth earnings does not appear to be 

substantiated by the actual earnings results. 

Mr. OXLEY. Let me also ask both of you: On your Web site, you 

claim that the hedge accounting treatment for each individual 

transaction is determined and documented in writing before you 

enter into that transaction. 

And furthermore, you say it cannot subsequently be changed. 

The OHFEO report disagrees with that assessment, citing instances where there was no contemporaneous hedge documentation 

as well as instances where staff created hedge designations retroactively. 

Do you disagree with those allegations? 

And does FAS 133 not require full documentation for transactions——

Mr. HOWARD. First of all, Chairman, there are two separate 

issues, which I will address separately. 

The first set of documentation that you were referring to was 

documentation of hedge transaction types. 

Before we can enter into any given hedge transaction type, we 

have a hedge policy developed that is worked out by our accounting 

policy group, that is within our controller’s department, but independent of other groups. 

So all they do is accounting policy. And that accounting policy is 

reviewed with the outside auditors. 

So before we do a single individual transaction, we have an 

agreed-upon derivatives or hedging policy. 

Now, where the difference of viewpoint in the OFHEO report 

arises is over agreement on whether individual transactions were 

documented sufficiently. We believe they were and therefore qualify for hedge accounting. 

OFHEO, in certain instances, contends they were not and therefore these transactions may not qualify for hedge accounting. 

Mr. OXLEY. Does the report cite specifics? And if so, are there 

disagreements on the specifics? Or is this a generalization? 

Mr. HOWARD. The report cites specifics. I am not intimately familiar with those specifics since I do not deal with them at that 

level. 

Mr. OXLEY. Mr. Raines, do you have any comments? 

Mr. RAINES. Again, I do not know about the individual specifics 

in the report, but their general position is that our way of documenting, with the combination of contemporaneous paper documentation plus automated systems, they believe does not meet 

their test. 

We believe it does meet the test of GAAP. 

Mr. OXLEY. And finally, in my opening statement I talked quite 

a bit about the application of the Sarbanes-Oxley Act in this particular case. 

You of course are a publicly traded company and are subject to 

the requirements of the act as well as regulations therein. 

94

Is there anything in your estimation to give any indication that 

any of the provisions of the act or the subsequent regulations had 

been violated or ignored? 

Mr. RAINES. No, sir, I do not know of any. In fact, I think the 

act has been very helpful to us, because one of the reasons that we 

have documentation on a lot of these things is because we are 

going through the process as required by the Sarbanes-Oxley Act. 

That is why we have, as I described in my written testimony, this 

entire process around certification so that we know exactly at the 

highest levels of the company what decisions were being made and 

by whom. 

And also I can tell you, as a result of the Sarbanes-Oxley, I have 

made a campaign in our company to go around and tell people, ‘‘If 

you think there is something wrong, raise your hand. Raise your 

hand, and it will be looked at that.’’

That has been our policy and that continues to be our policy, and 

I have to say, the direct growth from the reforms that were brought 

in by Sarbanes-Oxley. 

Mr. OXLEY. Thank you. 

Thank you, Mr. Chairman. 

Chairman BAKER. I thank the chairman. 

Mr. Clay? 

Mr. CLAY. Thank you, Mr. Chairman. 

And thank you, Mr. Raines and Mr. Howard for being here. 

Mr. Raines, in May of this year, Dow Jones International News 

reported that Senator Kit Bond, Republican from Missouri, was so 

critical of OFHEO’s leaks to The Wall Street Journal that he asked 

HUD’s inspector general to examine OFHEO’s practice of handling 

confidential information with the media. 

This morning I asked Mr. Falcon a question such as: Why did the 

examiners not discuss preliminary concerns of possible findings 

with Fannie Mae? Why was Fannie Mae not provided a draft report? And why did Fannie Mae not have the opportunity to respond 

to findings? 

I question why the process for handling these findings was altered and done differently for Fannie Mae. I find this to be inconsistent and a rush to judgment. 

In informal conversations with the executives from Wall Street 

and individual large brokerage houses, I get the feeling that the 

markets are not worried about the safety and soundness of Fannie 

Mae, as OFHEO says that it is. But of course, the markets are not 

political. I do not see due process being carried out with respect to 

Fannie Mae. 

Do you have an opinion on this, Mr. Raines? 

Mr. RAINES. Well, Mr. Clay, as I testified, you know, we are a 

regulated company. We recognize we are a regulated company, do 

everything we can to work cooperatively with our regulator. And 

we will continue to do that regardless of what has happened with 

regard to this special examination. They have a job to do and we 

have a job to do. 

By the same token, I don’t believe that because we are a cooperation that we are not due due process. And I think we have a long 

tradition in this country of providing due process even to people 

who have done the most heinous things. They have been accorded 

95

due process. And that is all we have really asked for thus far is 

give us the opportunity to state our case and let us take these 

issues to someone who can resolve them. 

Now there have been many issues like this resolved by other regulators, banking regulators, without newspaper headlines. The 

issues that relate to FAS 91 and 133 we can discuss forever, but 

the SEC is going to decide. 

And in my view, there is no reason the issues couldn’t have just 

been taken directly to the SEC before any examination was completed and just ask them what is the answer. Then we wouldn’t be 

having a debate here about, you know, whether or not the regulations embodied in this book are simple. 

A regulation that has 172 interpretations that have come out 

since it was—we wouldn’t be having that debate if we had done the 

simple step of going to the SEC, in which we would have joined in 

and said what is the answer? And then we would all know what 

to do going forward. 

Mr. CLAY. I know that Fannie Mae has agreed to the increase 

in capital and how much in dollars is that increase? 

Mr. RAINES. We don’t have an exact estimate, but if you look 

back at the most recent periods it would require something in excess of $3 billion. 

Mr. CLAY. Okay. I commend the company for this and for agreeing to other changes that will make for better transparency. Nevertheless, how would this almost $3 billion have been used were it 

not required for capital? I mean will the housing mission be affected adversely by this increase? And will it help the housing mission? 

Mr. RAINES. Congressman, the honest answer is I don’t know yet. 

We have 45 days to come up with a capital plan, but we don’t have 

a lot of choices. And it could require us to reduce our activities because we have only 270 days to come up with the $3 billion. And 

that is just one of the issues we are going to have to struggle 

through. 

So, it is possible it could require us to reduce our market activities to achieve the goal. 

Mr. CLAY. I thank you for your response. 

Mr. Chairman, that is all for me. I yield back the balance. 

Chairman BAKER. I thank the gentleman. 

Ms. Kelly? 

Ms. KELLY. Thank you, Mr. Chairman. 

I have very little time, Mr. Raines. And I would appreciate it if 

you could answer my questions within a yes, no format. I really appreciate the presence of both of you before the committee today. 

Mr. Raines, which member of the executive management team is 

responsible for risk management, accounting, on-balance sheet 

mortgage portfolio, business planning, tax, investor relations and 

internal audit? Do you have one member who——

Mr. RAINES. There is no one responsible for all those things unless you are thinking of me. But there is no one person responsible 

for all those things. 

Ms. KELLY. Well in the OFHEO interview with Tim Howard he 

said he had those portfolios. 

96

Are you aware that, as the director of financial accounting, Jeff 

Guliana has responsibility for modeling critical accounting estimates, as well as reporting and accounting for model results? Just 

give me a yes or a no please. 

Mr. RAINES. I think the answer is yes. 

Ms. KELLY. Thank you. 

Are you also aware that a senior vice president for financial reporting and planning, Mrs. Janet Pennewell, is responsible for reporting net income, as well as forecasting what net income will be? 

I just need a yes or a no, sir, please. 

Mr. RAINES. Ms. Kelly, sometimes when you phrase it in a way 

that is not exactly right giving you a yes or a no may be misleading 

to you. So——

Ms. KELLY. Well, that is in the OFHEO report in that way. So, 

I just——

Mr. RAINES. That may well be——

Ms. KELLY. Is that true? I mean does this woman have—does she 

report net income, as well as forecast what the net income will be? 

That is what I read in this report. 

Mr. RAINES. If you put it that way, no. 

Ms. KELLY. Okay. 

Mr. RAINES. But, I was trying to be helpful, but if you put it that 

way, the answer is no. 

Ms. KELLY. I am sorry. I have a bill on the floor and I have to 

get back over and I have to get through this because I really need 

answers to my questions. 

Are you aware that a senior vice President for the operations 

risk, Sam Rajappa, was, and is still, apparently responsible for auditing his prior work as controller? Just a yes or a no, please, sir. 

Mr. RAINES. No, he is not responsible for auditing his prior work 

as controller. 

Ms. KELLY. Okay. That is, again, that was in his interview, that 

is apparently what he said he was doing in the OFHEO report. Mr. 

Rajappa says he was employed as Fannie Mae controller from 1994 

to the end of 1998, which was the time period where earnings manipulations to trigger executive bonuses is alleged. 

Were you aware that that arrangement was a clear contradiction 

of the IAA standards relative to the auditor independence? Did he 

assume that he was doing this and he wasn’t? 

Mr. HOWARD. I can actually help there. Mr. Rajappa was moved 

in as head of operations risk but the auditor at the time was a man 

named Jack Wassen. Mr. Wassen was the company’s auditor. Mr. 

Wassen reported to Mr. Rajappa. So there was no violation of that 

standard at the time. 

Ms. KELLY. Thank you. 

Mr. HOWARD. You are welcome. 

Ms. KELLY. According to, again, the OFHEO report, Mr. Rajappa 

reports to you, Mr. Howard, is that true? 

Mr. HOWARD. I have been chief financial officer for 14 years. For 

the first——

Ms. KELLY. Sir, I just need a yes or no answer. 

Mr. HOWARD. No. 

Ms. KELLY. He is not now or has he ever? 

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Mr. HOWARD. No, he reports to the chairman of the audit committee. He does not report to me. 

Ms. KELLY. Okay. What about the members of the executive committee? Do you meet, and according to what the OFHEO interview 

shows, the executive team met to cooperatively set salary and 

bonus for Mr. Rajappa, as well as Mr. Rajappa being available to 

audit the executive team. That is what is in the report. I just need 

to know from either one of you a yes or a no. 

Mr. RAINES. This is very hard to give yes or no answers to——

Ms. KELLY. I understand that, sir——

Mr. RAINES. But——

Ms. KELLY.——but I have a very limited time. 

Mr. RAINES. I understand, but the implication of my giving you 

an answer that is incorrect is so great that I refuse to take the risk 

without telling you what the real answer is. 

The answer is that the compensation for everybody in the company, including mine, is in part determined by our executive team. 

We have in process where lots of people are involved in setting the 

compensation. So, the answer is yes, but that is not an unusual 

thing. 

Ms. KELLY. Okay. 

Mr. Raines, as the CEO of a major company this committee and 

I believe the American people, investors, taxpayers and homebuyers, expect you both to know about these operations and to be 

so intricately involved in the decisions and processes of the company that questions like mine could be able to be answered with 

a quick yes or no. There needs to be bright lines for who is reporting to whom and who is doing what. 

When I read this OFHEO report I did not see bright lines. If 

there are bright lines, sir, I would hope that perhaps you could get 

us a construct of exactly what they are. If they do not agree with 

OFHEO so be it. But it would be important for us to know how you 

have Fannie Mae structured because I believe quality and transparency is what the American people deserve. 

Thank you. I yield back the balance of my time. 

Chairman BAKER. I thank the gentlelady. 

Mr. Baca? 

Mr. Lynch? 

Mr. LYNCH. Thank you, Mr. Chairman. 

Well, I don’t have a bill on the floor and I have plenty of time. 

So, if either of you gentlemen would like to expand on the previous 

yes/no answers in any respect, feel free to do so right now. As 

someone who has grown up in public housing, I have a real investment in Fannie Mae’s mission. And I see the good work that you 

do. 

Let me just—you know, the previous speaker mentioned that she 

saw no bright lines in this OFHEO report. This is 200 pages. I just 

want to ask you again, just to be sure in my own mind, did 

OFHEO sit down with you and interview you, Mr. Raines or Mr. 

Howard in preparation of this, this examination of your corporation, of Fannie Mae? 

Mr. RAINES. They did not interview me. 

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Mr. HOWARD. They did interview me on two occasions; one to discuss impairments on certain types of securities, and one was a 

more general interview. 

Mr. LYNCH. Okay. And what about sitting down with your auditors, did they sit down with your auditors about this report? 

Mr. HOWARD. Not to my knowledge. 

Mr. RAINES. I do not believe that they have interviewed our auditors. But to be clear on your question, since they have done the—

finished the report, they have not talked to us either about the content of the report. 

Mr. LYNCH. Well it is not surprising then that there would be no 

bright lines in this and that some of these accounting rules are 

fairly complex and one would certainly understand how there 

might be differences of interpretations as you have pointed out. 

In your own minds as the CFO and CEO, is this a usual relationship with a regulator that they would go around you and not sit 

down extensively with you to try to bring you into compliance with 

a GAAP that they thought you were in noncompliance with? 

Mr. HOWARD. For me it is an unusual relationship. 

Mr. RAINES. Congressman, I would agree that it is an unusual 

relationship. I did note in Director Falcon’s testimony that he gave 

a reason why he felt the necessity to go around senior management 

he said was the lack of cooperation by senior management. And if 

I could address that issue, I would——

Mr. LYNCH. I would like you to. 

Mr. RAINES.——be delighted. 

We had our first meeting with OFHEO with regard to this special examination on January 7. Since that date we produced 

427,466 pages of documents, in 67 different document productions 

and 14 different requests, answering 425 questions. We also provided 966,367 pages of e-mail and e-mail attachments. 

We have even provided on three different occasions, our own consultant to go to OFHEO to help OFHEO with their technology in 

managing their searching of our e-mails. We had 100 people working for 4 days to respond to just one of their e-mail requests. 

We have made Fannie Mae people available 47 times to be interviewed as part of this process. Now we provided to them the working papers of KPMG and quite a bit of other information. 

I met with Director Falcon and told him, or informed him that 

if there were any problem with Fannie Mae’s cooperation in this 

examination call me directly. And I have received no such call. 

Now, the most inflammatory statement I guess is the one that says 

that the—that our cooperation was so bad that it required subpoenas to be issued and then subsequently the Justice Department 

was called upon to perhaps enforce those subpoenas. 

First, with regard to the issuance of subpoenas, my attorneys 

were told by OFHEO staff that the issuance of subpoenas was not 

related to a lack of cooperation but that they were doing this simply to get people on the record. 

Secondly, with regard to the Justice Department, both in-house 

and outside counsel for Fannie Mae spoke to the Justice Department about OFHEO’s referral to it regarding enforcement of one 

subpoena relating to e-mail and the Justice Department indicated 

that this was an issue that they expected to be worked out between 

99

OFHEO and Fannie Mae without any involvement of the Department or the courts. 

So, with regard to our cooperation, I think it has been overwhelming. The subpoenas, as we were told, had nothing to do with 

lack of cooperation. And the Justice Department has indicated that 

they believe that this was an issue that could and should be resolved between OFHEO and Fannie Mae and it was resolved. All 

of the material requested by OFHEO has been provided to them. 

Mr. LYNCH. Thank you. And thank you for clearing that up. Is 

there anything else you would want to add in terms of not a oneword answer, yes or no, but anything else that you feel that you 

need to clarify? 

Mr. RAINES. There is one other point I would like to make, and 

it is an issue I think bears a broader discussion and that is the notion that in corporations there should be silos and that people 

should have one function, another function, and another function 

and they should never have any of these brought together. In fact, 

the practice of corporations is to bring together these things at a 

high level. 

Mr. Howard is a vice chairman of Fannie Mae. He is one of the 

three most senior executives. So, of course he has many people who 

report to him. Otherwise, everyone would have to report to me and 

that wouldn’t be a very functional organization. 

So it is not unusual to have these reporting relationships. Indeed, there are many surveys that show that people bearing the 

CFO title quite often have risk management reporting to them, 

quite often have the balance sheet, the management reporting to 

them, quite often have internal audit reporting to them. 

So, although it was characterized as being unusual, it is actually 

usual, and, in his role as the vice chairman, his duties are far beyond simply being the CFO, and it is quite appropriate that he 

have a large part of the company reporting to him. 

Mr. LYNCH. Okay. Thank you, gentleman. 

Thank you, Mr. Chairman. 

Chairman BAKER. Mr. Toomey? 

Mr. TOOMEY. Thank you, Mr. Chairman. 

I would like to get to the specifics of one of the allegations with 

regards to FAS 91 in particular. As we all understand, FAS 91 

deals with the methodology by which a firm is required to amortize 

premiums and discounts. In the case in question, I believe specifically the situation arises in which these premiums and discounts 

have to be amortized over securities that have prepayment features. 

There are requirements under FAS 91, as I understand it, that 

you do the calculation, you then amortize a very precise amount 

quarterly over an assumed future remaining life of a given security, and then, when the next quarter comes around, you need to 

reanalyze this. 

Interest rates very often will, in fact, be somewhat different than 

they were projected to be or assumed to be in the modeling in the 

previous quarter, and you then redo the amortization essentially. 

You do this prospectively, but you also do it historically, so to 

speak, with an adjustment to the current quarter, which is inVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00107 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
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tended to capture the cumulative historical difference between 

what was estimated in the past and what reality has shown. 

My concern and my understanding and the testimony of OFHEO 

is that FAS 91 requires that you come up with a precise number 

and that number be entered in that given quarter, and my concern 

is that you developed a policy whereby you did not use that number. You created a considerable discretion, in fact, over what number you would use within a range. 

I would like for you to explain to me where it is in FAS 91 that 

you are authorized to not use the number that the model comes up 

with and confirm, if you will, that it is, in fact, that methodology 

about which KPMG said they have an audit difference with Fannie 

Mae. 

Mr. HOWARD. Mr. Toomey, I would be happy to address that. 

In estimating the rate at which we amortize premiums and discounts, one has to make a number of assumptions on——

Mr. TOOMEY. Understood. 

Mr. HOWARD.——interest rates and prepayment sensitivities. By 

making assumptions that are reasonable but different, one can 

come up with different sets of very precise numbers, and I understand you have to choose one, and we do that. 

So, when interest rates change, we will by practice reflect that 

new estimate in the rate at which we amortize purchases at the 

premium going forward because those adjustments take place over 

time. 

Where we have used in the past a range or a threshold to determine at what point we have sufficient certainty around the estimates that we are making between the numbers that we recorded 

historically and the numbers a new set of assumptions would indicate we should have recorded historically, we have, as a matter of 

policy, since FAS 91 was first implemented, had some latitude 

around zero, typically plus or minus $100 million, but more than 

that. 

Mr. TOOMEY. My point is, does FAS 91 authorize that? 

Mr. HOWARD. According to our accounting policy team and 

KPMG, it does. KPMG——

Mr. TOOMEY. Then why does KPMG have a difference on that 

issue? 

Mr. HOWARD. KPMG had a difference prior to 1998 because we 

did not have a defined policy in place that governed how much latitude we could have—let me finish, please—before we made an 

automatic adjustment. 

Once we put that policy in place and limited the amount or the 

size of that range, KPMG removed its audit difference, therefore 

confirming our view that the treatment of this estimate retroactively—not prospectively, but retroactively—was, indeed, consistent with GAAP, and this is something that the SEC will look 

at, and they will give us their view. 

Mr. TOOMEY. Yes. Oh, they will. But you have not cited anything 

in FAS 91 that says you are allowed to use a number other than 

what your model comes up with. 

The other thing that raises concern about this is the exchange 

in memos between yourself and others seems to suggest that there 

was a conscious ongoing effort to manage this amount. This is a 

101

large amount. $100 million on a quarterly report out of earnings 

of $1 billion or so, thereabouts, suggests a very substantial percentage of this. 

Mr. HOWARD. Congressman, let me be very clear. My intent in 

getting involved in the development of the policy was to ensure 

that the numbers we were reporting to investors was as clear and 

as meaningful as they could possibly be. 

I will give you an example of how I thought about this. For the 

five years from 1999 through last year, our net interest income 

averaged about $2 billion per quarter. Now investors are looking 

for changes in our net interest in come for evidence of how fast our 

business is growing. A net interest income amount of $2 billion in one quarter, grow- ing at 10 percent per year annualized, will be roughly $2.05 billion 

in a quarter. If we are growing at 15 percent annualized, it will be 

$2.075 billion. So the difference between 15 percent growth and 10 

percent growth in a single quarter is $25 million. 

If we adopt a policy that causes us to make these random adjustments based on our estimates of prepayments, collapsed over a 

number of years going back into a single quarter that is, say, $70 

million, we have worsened the quality of our financial statements 

by adding a spurious number—this is our view. I am not asking 

you to agree with it—that is bigger than the discernment investors 

are trying to achieve in looking at our quarter-to-quarter financials. 

I made the judgment. Accounting does not only permit but also 

encourages practical applications and judgments in financial reporting. This, in my view, was a good judgment because it preserves the integrity and the quality of our published financial 

statements. 

Mr. TOOMEY. Well, I see my time has expired. I have to say I am 

very skeptical about this methodology, in particular this catch-up 

mechanism, this range, using this discretion in terms of how much 

income you show, and it is such a substantial portion of total income. 

Mr. HOWARD. It is not discretion. Let me be clear: It is not discretion. 

Mr. TOOMEY. Well, the report quotes people in your firm who describe it as discretion. 

Mr. HOWARD. For a small period of time historically, we had discretion. After the policy was locked in the middle of 2002, there has 

been no discretion from that point forward. 

Mr. TOOMEY. Well, you are directly contradicting what some people from your firm are saying in the OFHEO report in terms of the 

discretion that remained after the policy was adopted. 

Mr. HOWARD. After the policy was adopted in December 2000, in 

the middle of 2002, we eliminated any potential for discussion by 

changing the policy. So we now have an agreement with KPMG 

that we will use no additional discretion in doing the FAS 91 amortization post December of 2002, and that is a fact. OFHEO may not 

have picked that up. 

Mr. TOOMEY. So, since 2002, you have ceased and desisted using 

this methodology that you used before. 

Mr. HOWARD. What happens is when our catch-up adjustment is 

within the size limited by the guidelines, roughly plus or minus 1 

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percent on net interest income and 2 percent on guarantee fees, we 

do not make any adjustments at all. So that is not discretion. 

When it is outside that, we book to the edge of the range and 

no further. That is not discretion either. 

Mr. TOOMEY. And the establishment of the range, the methodology and the amounts of these ranges, these were all developed 

and established by you. This is not under the direction of FAS 91. 

Mr. HOWARD. Well, by the company. 

Mr. TOOMEY. By the company. 

Mr. HOWARD. Yes, that is correct. They are consistent with FAS 

91. 

Mr. TOOMEY. Well, that is what we are going to find, the SEC’s 

opinion on that. 

Mr. HOWARD. You are absolutely right. 

Mr. TOOMEY. Yes. 

Chairman BAKER. I thank the gentleman. 

Mr. Baca? 

Mr. BACA. Thank you very much, Mr. Chairman. 

Let me ask this question of Mr. Raines or Mr. Howard, and either one of you can respond. 

OFHEO has been the regulator since 1992. Is that correct? 

Mr. HOWARD. Yes. 

Mr. BACA. That is 12 years. During this 12 years, their responsibility is not only to audit you. Is that correct? 

Mr. RAINES. Well, they examine us. They have an annual examination. 

Mr. BACA. And during that examination, if they find any deficiencies, is it their responsibility to let you know of any deficiencies, methodologies or other that you are following that you 

should not be following? Is that correct? 

Mr. RAINES. Yes, that would be their responsibility. 

Mr. BACA. In this particular case, did they ever come back and 

tell you in terms of standard practices or procedures or deficiencies 

that you had to talk to either one of you two with regard to these 

issues? 

Mr. RAINES. Yes, not until we saw the special examination report. 

Mr. BACA. Isn’t that a normal practice for any accounting firm 

or auditing firm, to basically sit down with the CEO or the chairman to discuss any deficiencies or procedures or process that they 

are not following? Is that normal standard? 

Mr. RAINES. It is a standard, and we did sit down with them 

each year. In fact, their chief examiner met with our board and 

presented the results of their exam, and none of these issues were 

included in any of those exams over any of those years. 

Mr. BACA. And in any of those years, did they ever sign off in 

terms of your methodology or procedures or methods that you 

used? 

Mr. RAINES. Well, you might want to talk about the FAS 133 

exam. 

Mr. HOWARD. Yes. From what I can recall, when we implemented 

the process for FAS 133, along with the systems, OFHEO did do 

a review of those processes and systems and said that it met or exceeded safety and soundness standards. 

103

Mr. BACA. That meant they had to have signed off, right? That 

said that you are following directions, and they did not come back 

and tell you that you needed to follow a different one or the methodology that you are using is now different. Is that correct? 

Mr. HOWARD. I would not know how to characterize it. They 

would have to do the characterization. I can tell you what they did. 

Mr. RAINES. But did they do it? 

Mr. HOWARD. Did they? 

Mr. RAINES. Did they come back and tell us to do something different? 

Mr. HOWARD. No. 

Mr. BACA. Okay. Thank you. 

This morning, the regulators allegated that Fannie Mae did not 

respond to the initial request for information and that it had to 

issue a subpoena. Can you give us your version of the events leading to this release of the information? 

Mr. RAINES. Congressman, we have been very responsive to 

OFHEO over this period, specifically relating to subpoenas. Our attorneys were told that the use of subpoenas did not relate to a lack 

of cooperation, but that this was because OFHEO wanted to move 

from informal interviews to having them on the record. That is 

what we were told at the time that the first subpoenas were issued 

because we said to them, you know, ‘‘There is no need for this. We 

will produce the people, and we will produce the documents.’’ They 

said they wanted to move——

Mr. BACA. So you were willing to be cooperative with them and 

willing——

Mr. RAINES. We were willing and we were cooperative providing 

hundreds of thousands of pages of material and almost a million 

pages of e-mail to them as the result of their requests. 

Mr. BACA. Did OFHEO personally contact you regarding the preliminary findings, either one of you? 

Mr. RAINES. No. 

Mr. HOWARD. Not me. 

Mr. BACA. It seems odd that they would not contact you. Yet, you 

know, they have gone to the media and they have gone everywhere 

else. But yet they should have followed, practiced standard procedures, which is a total violation. 

Maybe we should have them on the audit out here versus you 

guys in terms of not following practice or not following the laws 

that are in place. 

Where do you think the process will go from here? 

Mr. RAINES. Congressman, this process has been so unusual, I 

cannot tell you. I can tell you what we are doing. 

Our board has negotiated an agreement with OFHEO, which we 

are going to faithfully follow and put into effect within the timeframes as agreed to between the director and our board. 

We are also going to be cooperating with the independent counsel 

that our board has appointed to look into all of these allegations 

and to see if we can find out what the facts are, and so we will 

cooperate with them. 

We will be attempting to take the two big accounting issues, FAS 

91 and FAS 133, directly to the SEC and ask them to give us resolution on those so we can see, and, if we are right, then we are 

104

right, and, if we are wrong, we will make whatever changes the 

SEC tells us to make, and we will also cooperate with any law enforcement agency that is attempting to look at these allegations. 

They are very serious allegations, they have to be looked at, and 

I am delighted that today, for the first time, we are allowed to at 

least partially give our point of view. But, certainly, the independent counsel will be looking at every document and every person and doing a very thorough review, and we look forward to that. 

Mr. BACA. Thank you. 

I served on numerous boards, and, usually, when an audit is 

done by any accounting firm, they usually come up with the recommendations, the deficiencies, recommendations for improvements. 

You usually give that nonprofit organization an opportunity to 

correct those deficiencies before any kind of action is taken, and I 

am just really appalled at the kind of action that has occurred out 

here without first discussing it with either one of you two in terms 

of any corrections or actions that need to be taken. If there was a 

difference in terms of methodology, accounting system, what needed to be done, it seems like they would have approached you. 

So, hopefully, we will comply with both the laws that are in place 

right now in terms of standard practices that need to be done. 

And, Mr. Chairman, I realize that my time has expired, but 

thank you very much. 

Chairman BAKER. Mr. Bachus? 

Mr. BACHUS. Thank you. 

Chairman Raines, we are talking about these financial reporting 

issues in a lot of the discussion, whether, you know, you violated 

FASB rules or not, but did these issues, I mean, first, undermine 

your creditworthiness? 

Mr. RAINES. Well, I have to say, Congressman, that since this report has come out, we have been put on credit watch, and one of 

our credit ratings was dropped, went down as a result of this report. 

So a report like this from a regulator has serious consequences 

in the capital markets. You know, our stock price dropped by $14 

billion as a result of this report coming out in the way it did. 

So, yes, this report has a very, very big impact on how we do our 

business from our debt costs to our credit ratings to our stock price. 

Mr. BACHUS. Okay, but you are not in jeopardy of meeting your 

ordinary course of business, your obligations and that? 

Mr. RAINES. No, the fundamental economics of the company has 

not changed. 

Mr. BACHUS. Okay. 

Mr. RAINES. The company is in fine shape. The only thing that 

has changed is this report. 

Mr. BACHUS. Yes, when creditworthiness changes, your credit 

rating changes, you are put on credit watch. Obviously, that has 

implications not only for the housing market, but for the general 

economy as a whole. 

Mr. RAINES. Yes. 

Mr. BACHUS. I think what we had discussed this morning is you 

heard Director Falcon say you all were uncooperative, but you have 

105

rebutted here pretty clearly, and, you know, so we have a difference of opinion on that. 

The other thing, which a gentleman just mentioned, is he says 

he used best regulatory practices in this special investigation. You 

have been in government business for a long time. Is this normal? 

Is this the best practices for other government regulators? How 

would they have typically handled things as opposed to how 

OFHEO did? 

Mr. RAINES. Well, Congressman, when I was in the government 

as the director of the Office of Management and Budget, one of my 

duties was to oversee regulatory matters throughout the federal 

government, and I have never seen a proceeding like this. In all of 

my time, I have never seen a proceeding like this. 

The financial regulators are given special powers, very, very 

strong powers. They can put a financial company out of business 

if they choose to. And because they are given those special powers, 

they exercise them very carefully. 

Quite typically, a financial regulator in this circumstance, taking 

everything OFHEO has said at face value, as being true, that financial regulatory would have managed this without one headline, 

and they would have done it entirely confidentially. 

They would have resolved the issue, and, at the end, the resolution would have been announced, and this has happened many 

times. The Fed, the OCC, the OTS have had to do this with financial institutions. 

So, if we take everything they said as being exactly right, I do 

not know of any financial regulator who would have done it this 

way. I have never heard of a special examination report being 

made public. 

Mr. BACHUS. Well, it certainly has been on the public stage, the 

entire process. 

CFO Howard, do you want to comment? 

Mr. HOWARD. No. 

Mr. BACHUS. Oh, okay. I am sorry. 

Let me ask you this. You know, you all have basically said that 

most of what they have, I think, accused you all of doing you had 

not done or that they had not, at least before now, asked you to 

change your internal controls, very strange, and you are defending 

your practices, I think, by and large. 

That being the case, why did you all enter into this September 

27 agreement? I mean, you know, if they were not right, why would 

you have sort of consented to do what they asked you to do? And 

I know that you did not acknowledge any wrongdoing, but you took 

some pretty drastic measures, and one might say, ‘‘Why would you 

have done that?′′

Particularly, one thing you have done is you have agreed to this 

capital surplus of 30 percent of minimum capital reserve, which if 

followed could, you know, restrict your activities which could negatively impact the financial markets. So I would just say is there an 

explanation for that. 

Mr. RAINES. Well, yes, there is. Our board gave tremendous consideration to this, and there are several points, I believe, that they 

wanted to make. 

106

The first point was to acknowledge that we are a regulated company, and, if our regulator has concerns, whether we agree with 

them or not, they have to be taken quite seriously. So they wanted 

to demonstrate that on every issue they could agree to that they 

would reach an agreement. 

Second is that the agreement preserves the issues on which we 

do not agree, and those are to go to the appropriate place. 

Third is that we are mindful of the markets, and the idea that 

a company as large as we are would be seen to be having some 

kind of ongoing battle with their regulator struck us as to be contrary to our mission, and we did not want to take the risk of undermining our mission by appearing to be in an ongoing battle with 

our regulator. 

So the board had to make a judgment. I know some people took 

that agreement as being an admission of guilt. I think it was a 

demonstration of leadership by our board that put our mission first 

as opposed to our reputations or our feelings or our gut, all those 

other things that they could have put first. They put the mission 

first, and I think that is admirable, and I applaud them for doing 

it. 

As I mentioned before, financial regulators are very powerful entities. They can put you out of business, and so it is imperative for 

the board to ensure that we have a functioning relationship with 

our regulator on an ongoing basis. 

Mr. BACHUS. Can I——

Chairman BAKER. Can you wrap up? Yes, sir. 

Mr. BACHUS. This is my final question. This will be for you, CFO 

Howard. 

Can you outline for us the exact steps that must be followed 

under FAS 133 for a derivative contract to receive hedge treatment 

and also whether Fannie departed from common industry practice 

in establishing an effective hedge? 

Mr. HOWARD. We, first of all, do not believe we did depart from 

practice, and, importantly, OFHEO has not contested the fact that 

the transactions that we have entered into are economically effective. 

Mr. BACHUS. Right. 

Mr. HOWARD. What they are talking about is whether we have 

met the criteria for hedge accounting. The requirements differ according to the nature of the transaction. 

For the derivative transactions at issue, you must first identify 

the transaction as being a certain type of hedge, with documentation. We believe we have done that. OFHEO has raised some questions over technicalities around the documentation. 

The second thing that has to happen, again, in types of transactions we have undertaken, is we need to have a high degree of 

effectiveness. It is called in the literature ‘‘perfect effectiveness,’’ 

which can be assumed. We have assumed perfect effectiveness on 

these hedges because, in our view, that we have buttressed by periodic testing, there is a very, very small amount of ineffectiveness. 

Even though I recognize that minimal ineffectiveness and perfect 

effectiveness are not the same thing, our reading of the accounting 

literature, buttressed by KPMG notes it is making a practical apVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00114 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
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plication in a business context that is permissible, and that is what 

we have done. 

Mr. BACHUS. Well, then it is my understanding that there is no 

question that any of these activities undermine the safety and 

soundness. In fact, some of them are prudent business practices except where they may have violated, you know, financial reporting 

standards. 

Mr. HOWARD. And we do not think we have. 

Mr. BACHUS. I think that is really the issue, not whether you 

have engaged in any dangerous——

Mr. RAINES. Right. In fact, these hedges are all designed to reduce risk. 

Mr. HOWARD. Exactly right. 

Chairman BAKER. The gentleman’s time has expired. 

Mr. Meeks? 

Mr. MEEKS. Thank you, Mr. Chairman. 

Mr. Raines, Mr. Howard, this may come as a surprise to you, but 

some people just do not like Fannie Mae’s current status in the 

market, and that is pre-this OFHEO’s report, et cetera. In fact, this 

may be a surprise, that when OFHEO came here—and Mr. Falcon—once before, many members of this Congress criticized them 

severely and threatened to put them out of business, in fact, wanted a new regulatory agency to come in. 

You know, I understand your statements, Mr. Raines, about you 

do not understand certain things, but let me just let you in on a 

surprise. Some people do not want you in business. They do not 

like the success that you have accomplished by putting people with 

decent homes and roofs over their head. Some people just do not 

like that. And so that might be a surprise to you. 

In fact, let me ask. Prior to this hearing that we had where 

OFHEO was threatened, had there been an occasion or any time 

before where OFHEO may have examined Fannie Mae and noted 

any irregularities or discrepancies in any kind of accounting standards? 

And I wonder how did they work with you in the past before we 

had all of these secrets coming out that people do not like what you 

do? 

Mr. RAINES. Well, prior to the issuance of this special examination report, all of our examinations from OFHEO found that we 

met or exceeded safety and soundness standards, and that is going 

back to when OFHEO first organized itself back in, I think, 1993. 

So we had never, to my knowledge, had an outstanding issue 

with OFHEO on accounting, internal controls or any other issue. 

In the course of their examinations, they would make recommendations to us and, you know, we would adopt them. But we have 

never had an issue prior to this examination report. 

Mr. MEEKS. Were you willing to make those? When OFHEO was 

making those recommendations, et cetera, in the past, would that 

have been shared with the press or members of Congress or put in 

the headlines of the newspapers? Has that ever happened before? 

Mr. RAINES. No, the examination reports remain confidential 

until OFHEO makes an annual report to Congress, usually released in June, and then it is made available, but all of the examinations are held confidential, and, in fact, OFHEO has a regime for 

108

their regular examination function that holds these things confidential, and we have had very good experience with their regular 

examination process in that regard. 

Mr. MEEKS. So this is a relatively new phenomenon that has 

taken place now as far as your relationship with your regulator. 

Mr. RAINES. With regard to this special examination, this is very 

new. 

Mr. MEEKS. I know that you have indicated in your testimony 

thus far that your board, I understand, had agreed to the 30 percent capital surplus because you want to show, you know, you are 

part of the market and that you are cooperating, et cetera. 

But I am curious to know is there any other financial institution 

that does anything even close to 30 percent. 

Mr. RAINES. As a mandated surplus? Well, Freddie Mac has 

a——

Mr. MEEKS. Other than Freddie Mac. 

Mr. RAINES. No, sir. I am not aware personally of a financial institution that is otherwise solvent that is required to have a mandatory surplus by their regulator, but that is not to say it does not 

exist. I am just not aware of it. 

Mr. MEEKS. And, Mr. Howard, let me just ask you a question. 

This will be my last question—and I will yield back the balance of 

time—because I am just trying to make sure that I understand. 

According to OFHEO, Fannie Mae must supply FAS 91 by recog- nizing only $200 million against expenses for prepaid loans, instead of $400 million, and, of course, you state that Fannie Mae’s 

treatment was correct and that KPMG agrees with you. Just explain to me why are you right and OFHEO wrong. 

Mr. HOWARD. Prior to 1998, you know, any amount of this socalled catch-up adjustment, which, again, was the comparison we 

made after the fact between the amount that we had brought into 

income based on an old assumption of average life of the portfolio—

remember there are millions of loans in the portfolio—and a new 

average life. That difference we had kept track of but never recorded in current period income. That was the catch-up adjustment. 

In 1998, that dollar amount grew to a large size of expense—it was actually closer to $440 million—and we determined that some 

portion of that likely did represent a true economic cost. So we put 

together a group within the finance department of portfolio people 

and comptroller’s people to come up with a method of determining 

the best amount to best reflect true economic substance. 

The recommendation they made to me and to us as the senior management team was that $240 million was that right amount. 

So the remaining amount, which was not deferred because it was 

an amount that never was recorded on the books in previous 

years—it was kept track of, and that was the audit difference—

that turned out to be a judgment that ex-post proved to be correct 

because next year we did not have an audit difference that was expense. We had one that was income. 

So the judgment in retrospect turned out to be correct. It was 

made as a part of a process that had integrity, and it was independent of any link to compensation. 

Mr. MEEKS. Thank you. 

109

Chairman BAKER. The gentleman’s time has expired. 

Mr. Shays? 

Mr. SHAYS. Thank you, Mr. Chairman. 

Mr. Raines, I have a lot of respect for you. I think that you are 

one of the best budget directors. You are very articulate. I liked 

your opening statement, the buck stops with me. We do not hear 

that enough, and I thank you for that. 

My problem with Fannie Mae is I feel it is a bully in the marketplace that exercises its incredible advantages and does not want to 

play by the same rules that everyone else plays by, and I think you 

know that is what I think. 

I think that your not being under this 1933 Act and then voluntarily agreeing to be under the 1934 Securities Act—voluntarily—

to me is a bit arrogant. I think you should be willing to be under 

those laws. 

I think to suggest that you should have a weak regulator like 

OFHEO, and, when we wanted to strengthen it, you had objected 

to strengthening it, I have a problem with that. 

So I am not surprised by what is happening right now. 

When you say, ‘‘Well, OFHEO never did this before, and we 

played by their rules,’’ they were a very weak regulator. I am not pleased to learn that you have given $245 million worth 

of bonuses in the last five years. That is aside from stock options. 

So I have a bit of a problem with that. 

But I am particularly curious as to why OFHEO needed to have 

subpoenas in order for them to do their job. Why did they have to 

get subpoenas? So, if you would just tell me that, I would start off 

with my questions with that. 

Mr. RAINES. Well, I will just answer your subpoena question. 

Mr. SHAYS. Yes. 

Mr. RAINES. There are a lot of other things there, but——

Mr. SHAYS. I know that, but that is my time. You have had your 

time. 

Mr. RAINES. With regard to the subpoenas, our lawyers were told 

by OFHEO staff that they were issuing subpoenas not because of 

any lack of cooperation by Fannie Mae, but because they wanted 

to move the interviews from being informal interviews to interviews on the record with someone there keeping a record of exactly 

what was told. That is what we were told contemporaneous with 

the issuance of the subpoenas. 

Mr. SHAYS. Can I just say to you I am a little concerned with 

that answer because it seems to conflict with what we had been 

told. So I just—and you are under oath—want to make sure. 

Are you suggesting that there was no requirement whatsoever 

for them to get subpoenas, that you, as soon as they asked for this 

information, you, Fannie Mae, voluntarily provided this information? Is that your testimony? 

Mr. RAINES. That is my testimony. 

Mr. SHAYS. Is that your testimony, Mr. Howard, as well? 

Mr. HOWARD. To the best of my recollection, yes. 

Mr. SHAYS. Okay. To the best of your recollection. In other 

words, this information was asked for, and you voluntarily were 

going to provide it, but, instead, they said, ‘‘Oh, by the way, we 

want to go and get subpoenas.’’

110

Mr. RAINES. We were actually in the process. We had been doing 

this for quite a while. The special exam had been going on for a 

while before the first subpoena was ever issued. We had been providing thousands of documents, providing people, providing e-mails. 

Mr. SHAYS. Okay. Did you provide the information they wanted, 

not what you wanted? 

Mr. RAINES. Yes. We had provided every piece of information 

they wanted, and we told them they would get that with or without 

subpoenas. 

Mr. SHAYS. Okay, but I think it is important to put on the record 

because the information is that they had to get subpoenas to get 

this information. 

Mr. RAINES. Well, I have testified very clearly that that is inaccurate. 

Mr. SHAYS. Okay. Let me ask you, besides the bonuses, you offer 

stock options as well? 

Mr. RAINES. We are a shareholder-owned company, and we pay 

according to what our statute provides, which——

Mr. SHAYS. Is that a yes? 

Mr. RAINES. We pay comparably to other companies, and we use 

stock options among the various things in our executive compensation. 

Mr. SHAYS. Do you dispute the amount of $245 million over the 

last five years as bonuses? That is a lot of money. It is a quarter 

of a billion dollars. Nodding the head does not get transcribed. 

Mr. RAINES. Well, I have to go calculate the number. It is a number that is calculable, and I do not know what the number would 

be. 

Mr. SHAYS. Do you think it is in the ballpark? 

Mr. RAINES. It could be. 

Mr. SHAYS. Yes. 

Mr. RAINES. But you say it is a very large number. In the last 

five years, we have also probably had after-tax income of $30 billion. So our executive compensation——

Mr. SHAYS. I know you are a very successful company. 

Mr. RAINES.——is a tiny, tiny percentage of our revenue, and it 

is a tiny percentage of our profit. 

Mr. SHAYS. Why should banks have to set aside between 6 percent and 8 percent of their portfolio and you guys are in the range 

of about 3 percent? 

Mr. RAINES. Banks should do that because they have much more 

risky portfolios. Banks are allowed to invest in a wide range of assets. We can only invest in single-family and multifamily homes. 

Mr. SHAYS. So it is your testimony that you do not need to have 

more because you do not feel any of your investments potentially 

could go sour? 

Mr. RAINES. If none of them would go south——

Mr. SHAYS. No, you set aside a certain sum in case the market 

starts to go bad, and the residential marketplace is very volatile, 

and you have about 3 percent of your portfolio set aside. If a bank 

gets below 4 percent, they are in deep trouble. So I just want you 

to explain to me why I should be satisfied with 3 percent. 

Mr. RAINES. Because banks do not—there are not any banks who 

only have multifamily and single-family loans. I think if you check, 

111

banks are now arguing that their capital for those loans should 

only be 2 percent or less. I mean, that is the argument they are 

making right here in Washington today, that these assets are so 

riskless that their capital for holding them should be under 2 percent. 

Mr. SHAYS. Fine, but let me just ask you this question because 

OFHEO was asked this. Before OFHEO issued its report, did any 

of you speak to any people in the press or with any members of 

Congress about their report? 

Mr. RAINES. We did not know anything about their report. We 

had never seen their report. 

Mr. SHAYS. When did you see their report? 

Mr. RAINES. We saw their report on Monday. 

Mr. SHAYS. Did you know of the report? Did you know the contents of the report? 

Mr. RAINES. No, we had no knowledge of the content of the report. In fact, I had been calling the director. I had a meeting scheduled with the director to discuss the progress on the special examination, which he canceled. I had three calls into him to discuss it 

because of the press reports that we had seen, and I never talked 

to him. 

Mr. SHAYS. I thank the chairman. Just to verify, we are not playing a word game here of a draft of the report. 

Mr. RAINES. The report was handed to management as OFHEO 

officials walked into a meeting with our board, literally handed to 

us as they walked in. 

Mr. SHAYS. And you were not given a draft earlier or a working 

draft or anything like that? 

Mr. RAINES. We saw nothing. 

Mr. SHAYS. So the answer to your question is you never spoke 

to any member of Congress before this report was issued or the 

press about this report before it was issued? 

Mr. RAINES. About the contents of the report? 

Mr. SHAYS. About the report. 

Mr. RAINES. Well, if we are going to be this—we never saw the 

report! 

Mr. SHAYS. I did not ask that. I want an answer to the question 

because I had been told that Fannie Mae had been speaking to reporters and press about this report before it was issued. 

Mr. RAINES. About the content? Is that what you are asking? The 

content—are you—I want to be very clear here. 

Mr. SHAYS. Not the content. Just concerns that there was going 

to be a report that came out, et cetera, et cetera, et cetera, and——

Mr. RAINES. We have talked about concerns. Yes, we have talked 

about concerns about the report that we had been reading about 

in the paper. Yes, indeed. The press was calling us. When they 

were reporting OFHEO is about to do a report, they asked us, 

‘‘What is your reaction?’’ and we said, ‘‘We do not know anything 

about that.’’

Mr. SHAYS. And that is the extent of your contacts? You did not 

initiate any? 

Mr. RAINES. Why don’t you give me the example and then I can 

tell you what——

112

Mr. SHAYS. No, no. I do not want to give an example. I do not 

want to give you an example. I want to know if you all affirmatively went out to the press to engage them in a dialogue about this 

report which you say you have not seen. 

Chairman BAKER. And that will have to be the gentleman’s last 

question because your time has expired. 

Mr. SHAYS. The answer is a yes or no. Did either you or your organization do that? 

Mr. RAINES. Look, I do not understand what you mean by engaged. No doubt——

Mr. SHAYS. No, you do not want to answer the question. 

Mr. RAINES. No doubt we talked to the press about the report we 

had not seen. No doubt that someone in Fannie Mae talked to the 

press about a report we had not seen because we were getting 

asked questions about a report we had not seen. Some questions 

indicated that they knew more than we did. 

Mr. SHAYS. And the question I asked, though, which you could 

be responsive to—and I would appreciate it—is: Did you affirmatively interact with the press or actively contact the press about 

this report, not respond? 

Chairman BAKER. And that is the gentleman’s last question. 

Mr. RAINES. I am not trying to be difficult. 

Mr. SHAYS. The answer is a yes or no. 

Mr. RAINES. I am not trying to be difficult, Congressman, but you 

are asking me the question, did we ever call a reporter and mention it? Probably, but not because we had seen the report. 

Mr. SHAYS. Thank you. I hear you. I hear you. 

Mr. RAINES. Okay. 

Chairman BAKER. The gentleman’s time has expired. 

Ms. Waters? 

Ms. WATERS. Thank you very much. 

I just wanted to clear up a little something here. I find the information about the bonuses very interesting, and I am sure that it 

will cause a lot of discussion, but that is not really why we are here 

today. 

You raised a question earlier, Mr. Raines, about this being proprietary information. Do you still think that this is proprietary information that has been released, after you have seen what we 

have? 

Mr. RAINES. My concern about proprietary information solely 

goes to not the five people at the top because our information is 

public, but we have people trying to recruit away our people every 

day. Every day, we have recruiters coming to Fannie Mae trying 

to recruit our people away. 

This is a road map as to how to go about recruiting Fannie Mae 

employees. This is private information about people who are not 

public officials, who are not senior officials, and now this is being 

made public for reasons I do not understand. 

Ms. WATERS. Well, the reason that I asked is that our chairman 

did indicate that he had a legal opinion. I do not have a copy of 

that legal opinion. I do not think there is anything in writing. I 

think that his conclusions were drawn based on some constitutional 

reference. 

113

I just wanted to make sure that it is your understanding that it 

is proprietary information so that I can continue my follow-up and 

my investigation to find out whether or not proprietary information 

has been released. But you do think it is proprietary? 

Mr. RAINES. My only goal here was to not waive any rights we 

have. 

Ms. WATERS. All right. 

Mr. RAINES. We continue to maintain whatever rights we have 

asserted. I did not want to waive that by sitting here and not saying something that was being revealed. 

Ms. WATERS. Okay. That is fine. And I think I know what to do 

with that. 

I know you have repeated this any number of times, but I think 

it is very important for you to repeat part of an answer that you 

had given earlier, relative to this business about subpoena and information from OFHEO about you had been forced somehow to answer questions. 

Part of your information had to do with the Justice Department 

and the fact that they had been contacted. What was the Justice 

Department’s response to OFHEO’s request to be involved in this 

in some way? 

Mr. RAINES. The Justice Department response was that they indicated that this was an issue that they expected to be worked out 

between Fannie Mae and OFHEO and that they did not believe 

that there was a need for any involvement of the department or the 

courts in working it out. 

Ms. WATERS. Excuse me one second, my colleague, Mr. Shays? 

My colleague, Mr. Shays? 

The question that you asked about whether or not they had been 

forced through a subpoena to cooperate or to answer questions, 

there was one portion of his answer that you were not privy to. You 

were not in the room. I just asked him to repeat it. You were being 

distracted. I would like to ask him to report that again. 

The Justice Department had been contacted to ask to be involved 

in some way with this investigation. What did the Justice Department say, Mr. Raines? 

Mr. RAINES. Let me read to you specifically so you have the 

statement that has been approved. 

‘‘Both in-house and outside counsel for Fannie Mae spoke to the 

Justice Department about OFHEO’s referral to it regarding enforcement of one subpoena relating to e-mail, and the Justice Department indicated that this was an issue that they expected to be 

worked out between OFHEO and Fannie Mae without any involvement of the department or the courts.’’

Ms. WATERS. Okay. Thank you very much. 

I also would like to inquire——

Mr. SHAYS. I do not know what that means. I do not know what 

the means, so if you would——

Ms. WATERS. Okay. On my time now. 

Mr. RAINES. I think what that means is——

Ms. WATERS. Excuse me. This is my time. You may not answer 

him on my time. He can get some additional time. 

Let me just ask you is it true that you absolutely had not seen 

this report until they came to the boardroom with the report. 

114

Mr. RAINES. That is true. I did not see the report until they went 

into the boardroom, and they then handed a report with my name 

on it, an envelope with my name on it, saying, ‘‘This is your copy 

of the report.’’

Ms. WATERS. Were you ever told why it was important to come 

before the board with such haste? From the time the report supposedly was finalized and to the time that they came to the boardroom, did you ever hear why it was so important to get that board 

organized so that they could receive this report? Were you ever explained to why it happened that way? 

Mr. RAINES. It was not explained to me. I can believe you are 

going to have our lead director testifying before you. She can also 

answer whether it was ever explained to her. 

Ms. WATERS. Did you ever hear that the timing of the board 

meeting had anything to do with the fact that there was a desire 

to have this hearing prior to the recess—congressional recess? Did 

you ever hear any of that discussion? 

Mr. RAINES. I did not hear that. 

Ms. WATERS. All right. Finally, let me just ask you this. 

Obviously, Fannie Mae is a very sophisticated organization with 

a lot of smart people doing big, big business, and it is—I cannot 

understand why you would be involved in any activity that could 

easily be unveiled that was incorrect accounting practices or anything else with some kind of investigation. You have testified as to 

your accounting practices and your understanding of what is expected of you. 

Finally, when Fannie Mac was investigated, did this raise some 

kind of red flag, and, even though you felt that what you were 

doing, you were doing it correctly, that you were on solid ground, 

did you say, ‘‘Well, let us look at ours again, too, to see if there is 

anything here.’’ I mean, I would have done that, and I want to 

know did you two did that? 

Mr. RAINES. We did, indeed, do that. We engaged outside counsel, we engaged accounting, we looked at everything that was alleged about Freddie Mac to see did Fannie Mae have the same 

problems, and our conclusions were that we did not, and, to this 

day, no one has alleged that we had the same problems that 

Freddie Mac had. These issues that are in the OFHEO report are 

brand-new issues to Fannie Mae and they are new to our relationship with OFHEO. 

Ms. WATERS. And, by the way, I am going to ask you something 

that you may not want to answer. 

Since all of this has been made public, I read an editorial in The 

Wall Street Journal that talked about the fact that there had been 

an investigation and that editorial almost jumped to the conclusion 

that there must be something wrong, and, therefore, the investigation, even though there had not been a response, there must be 

something wrong, and even though they did not explore it fairly, 

they came to the conclusion that you would not be fit to be the 

treasurer of the United States of America. 

What does the speculation about your being perhaps asked at 

some point in time—should certain people win the presidency, what 

does that have to do with your work now have to do with whether 

115

or not you should be asked to be the treasurer of the United States 

of America. Have you heard that discussion at all? 

Mr. RAINES. I have heard that discussion. As you know, I have 

been around this town a long time. It is very said. It is very sad 

to me if any consideration of politics goes into something like this. 

My service in the government, you know, has been, I think, service. 

You know, I have never run for office, and I have never sought 

to be a political figure. You know, I have responded when a President of the United States has asked me to respond, and that—I 

have been asked twice and I have responded twice to that case. 

More than me, my colleague, my former boss, Jim Johnson, has 

been brought into this, and let me say something about that directly. He, too, has been mentioned as a potential person to be in 

a future administration. We have done a look at the 1998 incident 

that has been alleged by OFHEO, and we have found no acts that 

would relate to Jim Johnson whatsoever. 

Indeed, he was not the CEO when these decisions were made. I 

was. And so any implication that Jim Johnson had something to 

do with this is just totally without factual base. It shows what happens in these kinds of frenzies. 

I have to tell you the thing that bothers me far more than this 

treasury thing—far more—is explaining to my kids. That is hard. 

Ms. WATERS. Well, I——

Mr. RAINES. It is hard when your daughter feels she needs to say 

to her dad, ‘‘I support you.’’ I am supposed to be supporting her. 

That is hard. 

Ms. WATERS. Well, we are going to be out of here when we go 

on recess, and all of this talk is going to fester. You have not had 

an opportunity to respond. 

You have not been questioned. You have not had an opportunity 

to explain. Most of the members up here on this panel do not understand accounting practices. They are learning a lot for the first 

time today. 

What this could potentially do is in some way damage your reputation because these allegations are being made without your having an opportunity to respond. 

Chairman BAKER. Ms. Waters, your time has long expired. Can 

you wrap up, please? 

Ms. WATERS. Yes, I will wrap this up. What would you ask this 

committee to do in the interest of fairness that would in no way 

accept OFHEO without the opportunity for the kind of response 

that is always allowed in this kind of setting? What would you ask 

this committee to do? 

Mr. RAINES. Ms. Waters, what I would ask the committee to do 

is to insist with all the agencies within your oversight they operate 

within——

Chairman BAKER. Excuse me. 

Ms. WATERS. I was trying to hear him. 

Chairman BAKER. I thought your time had expired. Please proceed. 

Ms. WATERS. Yes. 

Mr. RAINES. What I would ask this committee to do is to insist 

for all the agencies within your oversight that they operate under 

the commonly accepted rules of due process and fair play. I would 

116

also like your support to get a resolution on these issues that the 

SEC would give us an answer. 

You know, we did not come here to say today we are perfect or 

even that we know that we are right. We are simply saying we approach this with a businesslike approach, with honesty and integrity, and if we are wrong, we will make the changes. If we are 

right, you know, then we will go forward. 

All we have asked is that the proper process be used. The answers will come out of the proper process. That is the only request 

that we are making, is that at least give us the minimal rights that 

we would expect to be given to any other company, to any individual, any organization. 

Chairman BAKER. The gentlelady’s time has long expired. We do 

have a number of other members wishing to be heard. 

Mr. Ose? 

Mr. OSE. Thank you, Mr. Chairman. 

Mr. Howard, am I correct in understanding you are the chief financial officer for Fannie Mae? 

Mr. HOWARD. Yes, you are. 

Mr. OSE. Am I correct in understanding that questions of how to 

treat income or expense at Fannie Mae—that decision would at 

least go through your office? 

Mr. HOWARD. It would typically be discussed with me, depending 

on the level of importance. 

Mr. OSE. At what level of importance do issues come to your office for a final determination? 

Mr. HOWARD. That determination is made by the people who 

bring them to me. 

Mr. OSE. Is there typically a threshold dollar amount? 

Mr. HOWARD. No. It is usually how unusual, new the issue is. 

Mr. OSE. In terms of such unusual or new situations, are you the 

final arbiter of such decisions? 

Mr. HOWARD. Again, it is situational. In some cases, it could be 

the chairman, whoever that may have been, it could be me. 

Mr. OSE. Now I recognize that the report in question today covered a period prior to Sarbanes-Oxley being in effect. 

Mr. HOWARD. Yes. 

Mr. OSE. Is that your understanding also? So it predates our passage here on the Hill of that particular——

Mr. HOWARD. Parts of it do. Yes, that is correct. 

Mr. OSE. All right. Does the audit committee of the board of directors get involved in these questions? 

Mr. HOWARD. Which questions? 

Mr. OSE. Questions of a new or unusual set of circumstances 

having to do with how to treat income or expense. 

Mr. HOWARD. Again, it would depend on the situation. Sometimes they are briefed on it. They are typically not consulted for 

a decision. 

Mr. OSE. The audit committee is not consulted for a decision of 

any nature related to this kind of a situation? It is just given to 

them as a fait accompli? 

Mr. HOWARD. It is. I am attempting to recall an instance where 

the audit committee may have been consulted in advance on a financial decision. I cannot recall one. 

117

Mr. OSE. So, in effect, what you are saying is that the audit committee does not set the standards for the decisions. The recommendation is given to them and they will either say yea or nay? 

Mr. HOWARD. Well, no, we typically do not even do that. We will 

report on the financial condition of the company, significant accounting issues. Anything that we think ought to be brought to 

their attention for review, we will bring to them. 

They can comment on them, they can ask us to do things differently, but we do not ask them for a decision because they typically do not have the level of expertise to make decisions at that 

level of detail. 

Mr. OSE. I just want to make sure I understand it. Implicit in 

your answer is that such decisions are therefore made at the management level, rather than the board level. 

Mr. HOWARD. That is correct. 

Mr. OSE. Okay. So the final arbiter for such decisions is your office? 

Mr. HOWARD. It, again, depends on the decision. It could be the 

comptroller. It could be the level below the comptroller. It could 

even be at a level below that. 

Mr. OSE. So the decisions may be made within perhaps the operating units of Fannie Mae. 

Mr. HOWARD. Not accounting decisions. They would not be made 

within the operating units. Accounting policy decisions are made by 

the accounting policy person, transactional decisions that have accounting ramifications are made in the units, but the results are 

reviewed and assessed by people in the comptroller’s department. 

Mr. OSE. And then they are run past you as CFO for final signoff or rejection. 

Mr. HOWARD. It depends on the issue. Most of them do not come 

to me for that step. 

Mr. OSE. Mr. Chairman, we may have the wrong guy here to ask 

these questions on the accounting rules or modifications. 

I am curious whether or not you do play a role in making decisions as to what is or is not treated as an expense in one case or 

an income issue in another. 

Mr. HOWARD. Typically not. 

Mr. OSE. And you are also testifying that the audit committee of 

the board of directors is not involved in those decisions either. 

Mr. HOWARD. Not asked to make them. Informed of them. 

Mr. OSE. Now you are CFO. Am I correctly advised that you are 

CPA trained? 

Mr. HOWARD. You are incorrectly advised. I am not a CPA. 

Mr. OSE. You are not a CPA. Okay. 

Let me ask a different set of questions, if I might. Actually, this 

goes to Mr. Raines. Prior to this hearing, did you or any of your 

agents or employers or counsel visit with any members of this subcommittee about the substance that we were going to discuss here? 

Mr. RAINES. Yes. 

Mr. OSE. Did you or any of your agents or employers or counsel 

provide questions to members of this subcommittee for the purpose 

of having those questions posed to witnesses during this hearing? 

Mr. RAINES. I believe we talked to members about or staff about 

questions that they might want to pose, yes. 

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Mr. OSE. Okay. The only reason I ask that question is that Mr. 

Falcon, I think, was asked on the previous panel to provide to the 

committee a record of all such contacts that he may have had with 

the committee or his agents or employees. I am asking: Will you 

provide the committee a similar record of all such contacts to this 

committee regarding this hearing? 

Mr. RAINES. My answer is I do not know. I mean, we will have 

to talk to our counsel and others. 

Mr. Falcon is a government employee. He is running a government agency. There are laws that relate to the ability of a government employee to lobby the Congress, and I assume that that is 

what the inquiry was to Mr. Falcon. 

We are not a government agency. We are not prohibited from lobbying the Congress, but I would certainly take under advisement 

your request, and we will get back with you with an answer. 

Mr. OSE. I am going to take that as a no, Mr. Chairman. Thank 

you. 

Mr. FRANK. Mr. Chairman? 

Chairman BAKER. Yes, Mr. Frank? 

Mr. FRANK. Mr. Chairman, we have a colleague now on the committee, the gentlewoman from Florida, Ms. Brown, who is very interested in this and a student of Fannie Mae and its activities, and 

I would ask unanimous consent that she be allowed to enter a 

statement into the record of this hearing. 

Chairman BAKER. Without objection. 

Mr. Davis, you are recognized. 

Mr. DAVIS. Thank you, Mr. Chairman. 

Mr. Raines, I had planned to go in a different direction, but I 

want to follow up on Mr. Ose’s comments for a moment. You have 

been in D.C. for how many years as a——

Mr. RAINES. I have lived here for about 20-some-odd years. 

Mr. DAVIS. Okay. But in terms of your work at OMB and your 

work at Fannie Mae, you have been a part of the institutional layers in this town for a while, have you not? 

Mr. RAINES. Yes, sir. 

DAVIS; And you have seen your share of congressional hearings, 

I assume, over the course of time? 

Mr. RAINES. Yes, sir. 

Mr. DAVIS. Is it a fairly common practice, Mr. Raines, for almost 

every single entity that comes before this committee to have some 

consultation or talk with members of Congress or staffers before 

their folks testify? 

Mr. RAINES. Yes, sir. I typically did that when I was in the government, and I have done it since I have been out of the government. 

Mr. DAVIS. And that is not an unusual or insidious practice in 

any way? 

Mr. RAINES. No way. 

Mr. DAVIS. And just one final point on this: You were asked by 

Mr. Ose if you or Mr. Howard had talked to your attorneys. Are 

you aware from newspaper reports that there is a Department of 

Justice probe in this matter? 

Mr. RAINES. I am aware of that from the newspapers. 

119

Mr. DAVIS. And based on your professional experience, Mr. 

Raines, is it not commonplace that if someone is a potential subject 

even, much less a target, of a Justice Department probe that they 

would probably be out of their mind if they did not talk to a lawyer? 

Mr. RAINES. Yes, sir. You are right. 

Mr. DAVIS. And especially if you are about to give public testimony under oath, wouldn’t the prudent thing be to talk to a lawyer? 

Mr. RAINES. Yes, sir. 

Mr. DAVIS. Okay. Let me move to a much more important set of 

questions. One of the things that OFHEO is criticizing, as you 

know, is the structure of management at Fannie Mae, and they are 

questioning the structure of responsibilities, and there is some argument that there should be a greater separation of certain job descriptions. 

Mr. Howard, you understand that is one of the subjects here. 

Mr. HOWARD. I do. 

Mr. DAVIS. How long has OFHEO been in existence? 

Mr. RAINES. The Congress created them in 1992. They actually, 

I think, came into existence in 1994. 

Mr. DAVIS. Okay. The structure that they are questioning or raising issues about—how long has it been in place at Fannie Mae? 

Mr. RAINES. A version of the current structure has been in place 

since 1991 when I joined the company. 

Mr. DAVIS. Okay. At any point prior to September of 2004 has 

OFHEO raised any questions about the structure or the alignment 

of job responsibilities at Fannie Mae? 

And I will ask both of you that question. 

Mr. RAINES. Not to my knowledge. 

Mr. DAVIS. Mr. Howard? 

Mr. HOWARD. Nor to mine. 

Mr. DAVIS. And, as far as you know, has OFHEO been aware of 

that structure for the whole 12 years of its existence? 

Mr. RAINES. Yes, sir. 

Mr. HOWARD. It could have been. 

Mr. DAVIS. And has OFHEO given you any explanation of why 

they did not raise questions in the previous 12 years? 

Mr. RAINES. No. 

Mr. HOWARD. No, sir. 

Mr. DAVIS. Does it suggest to you the fact that if they did not 

raise questions in the previous 12 years, they probably did not 

think it was a matter worth questioning? 

Mr. HOWARD. I do not know. 

Mr. RAINES. That would be speculating. They asked us lots of 

questions over the period of time, and, as far as I know, this has 

not been an issue with them. 

Mr. DAVIS. Neither of you was in the room when I had a chance 

to question Mr. Falcon earlier, but I want to ask you for a reaction 

to some observations that I made. 

As I understand OFHEO, their task is to oversee the safety and 

soundness of Fannie Mae. Am I correct in that understanding? 

Mr. RAINES. Yes. 

Mr. HOWARD. Yes. 

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Mr. DAVIS. One of the concerns Ms. Waters has raised, that I 

have raised and other members of the committee have raised is 

that it appears that OFHEO has crossed some line into simply 

being a neutral and dispassionate analyst or neutral and dispassionate observer of what the institution does, to having a very 

strong set of opinions about the institution. 

Is that the impression the both of you have? 

Mr. RAINES. Congressman, I think that there has been an evolution in their thinking that they believe that they either have the 

authority to or have the need to be more directive as to how we 

carry out our responsibility. 

Mr. DAVIS. Now, Mr. Raines, for the relationship to work 

shouldn’t there be some arm’s length between OFHEO and Fannie 

Mae? 

Mr. RAINES. Yes, I believe we should run the company and they 

should examine the company. 

Mr. DAVIS. Is that relationship or that desirable relationship undermine if OFHEO somehow becomes an advocate and if they appear to have developed their own agenda with respect to the future 

of Fannie Mae? 

Mr. RAINES. Well, I think it does raise serious questions of who 

is ultimately responsible for the outcomes. I mean, if we are doing 

what they say then who is to be held accountable for what happens? 

Mr. DAVIS. Okay. Let me ask you one final set of questions because our time is so limited. The ultimate mission of OFHEO is to 

preserve the safety and soundness, correct? 

Are either of you concerned that by issuing a public condemnation of Fannie Mae and its practices, a public condemnation of the 

management structure, a public condemnation of its accounting in 

advance of the SEC doing it, are either of you concerned that that 

could somehow jeopardize Fannie Mae’s status in the market and 

that that could, in its own right, have an impact on safety and 

soundness? 

Mr. HOWARD. I am very concerned about that. 

Mr. DAVIS. Could you elaborate on that, Mr. Howard, for a 

minute? 

Mr. HOWARD. Certainly. The markets respond to—as Mr. Raines 

mentioned earlier, regulators have enormous power and they are 

perceived by investors, particularly international investors, to have 

such power. And most regulators do not make pronouncements of 

the nature that we saw over the last two weeks without very serious convictions that those are true. 

Mr. DAVIS. One final question, if the chair will indulge me just 

a few extra seconds, one of the things that we have heard about 

is the fact that OFHEO went to the board of directors and essentially put a 48-hour ultimatum in place. 

Do you know of any authority that OFHEO has to give an ultimatum to the board of directors with its course of action? Is there 

any statutory authority for that? 

Mr. RAINES. I don’t know of any such authority, no. 

Mr. DAVIS. And to your knowledge, did OFHEO give any explanation of why it was so time sensitive that the board of directors 

move forward? 

121

Mr. RAINES. I believe what they said to the board was that they 

thought the matters were serious and they wanted to test the seriousness of the board in responding to the report. 

Mr. DAVIS. Is it within OFHEO’s charter to test the seriousness 

of the board of Fannie Mae? Is that written anywhere in their 

charter of their job description? That sounds like a fairly political 

purpose, doesn’t it? Or a little bit of an agenda based purpose; we 

want to test the seriousness of the board. 

Chairman BAKER. If you can, make that your last question because we do have others and we have another panel too. 

Please respond if you choose. 

Mr. RAINES. No, I am unaware of any specific statutory reference 

to that. 

Chairman BAKER. The gentleman’s time is expired. 

Mr. Castle? 

Mr. CASTLE. Mr. Chairman, thank you very much. 

I don’t want to get into this, it is funny how you think you are 

going to ask one line of questions and then you hear something else 

and you immediately want to follow up on that. 

I don’t necessarily agree with Mr. Davis, for whom I have tremendous respect I might add, on—or even the answers to some of 

that. I mean, it seems to me OFHEO has a real role in all of this 

and to me, I mean, I agree with you, Mr. Raines, in sort of the role 

of examining. 

But I think when they examine and there is something that with 

which they don’t agree I think they have some responsibility actually to make it public. I think you would agree with that. In fact, 

it shows in your testimony, your very good testimony, here today. 

I mean I am one of those who worries about Fannie Mae. I think, 

you know, you have good people running it and that kind of thing, 

but, frankly, it is very large, some of the practices I think are a 

little marginal. I worry about this perception the Congress will 

back up whatever Fannie Mae does. I just think there are a lot of 

issues. 

I think the regulatory issue is very important though. And somehow or another we have lighted a fire under OFHEO who I would 

have written off a year ago and all the sudden they got a tiger by 

the tail type thing. I don’t know what is right or what is wrong. 

But, I just want to make sure that Fannie Mae is being run correctly because it is very, very important. And I worry about the 

safety and soundness of that. 

But, on the other hand, hey look, we are all running for office 

right now. We are criticized daily by our opponents. So a little criticism can’t be the end of the world. And perhaps if it is justifiable 

criticism and changes are made, perhaps that is positive. I look at 

your testimony——

Mr. RAINES. Congressman, if you are being accused of committing a crime it is a little bit different. 

Mr. CASTLE. Well, right. But, you know, I am not—the jury is out 

on all of this right now. But the whole point is that some review 

I think is essential. 

For example, if you look at page two of your testimony you have 

made several changes as a result of what OFHEO has done, at 

least as I understand it. You go through the first, second or third 

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and I don’t need you to go through all the details, but you go 

through all the things that you have done, the building up the 30 

percent capital surplus, the chief risk officer, et cetera, et cetera, 

some probably more important than others. And I couldn’t begin to 

tell you, which you probably could. 

But these are changes which you have pretty well agreed to, perhaps not totally willingly, but you have looked at it and you have 

made the decision that these are things you probably should do 

that would benefit you that you did not do of your own accord but 

you did because of the OFHEO—because OFHEO was involved or 

is that correct? 

Mr. RAINES. Congressman, we don’t look for things to disagree 

with OFHEO. 

Mr. CASTLE. Right. 

Mr. RAINES. Many of these things we would have been willing to 

do if OFHEO had approached us in a different way. So this isn’t 

an issue of everything OFHEO says is wrong and everything we 

say is right. 

Indeed, I think the fundamental flaw, if I could say what the 

fundamental flaw is in our relationship with OFHEO, it is not created by OFHEO. It is created by the fact that the OFHEO examination process does not have the same legal protection that the 

bank examination process has. And that has a negative effect on 

the entire relationship. 

Bank examiners are not allowed to make public bank examinations, even if they are requested by a member of Congress. 

Mr. CASTLE. I want to go to another line of questioning. I am not 

going to parse that or argue it too much, except to say that I think 

there are certain powers that OFHEO, perhaps, should have that 

they don’t have and perhaps there are others that they have that 

they should not have. 

I just think I want to get it straightened out. I mean, my sense 

is that you all have been sort of back and forth on whether there 

should be a successor to OFHEO or not. I hope that somehow or 

another when this is all said and done we can get this whole oversight, overview, examination, regulatory aspect of it correct. 

Mr. RAINES. I agree. 

Mr. CASTLE. Because I just think that is important for all of us. 

That is my goal and I hope we can get great cooperation on that. 

Let me go on to this whole business of 98 because I don’t totally 

understand it. But my understanding is when all this happened 

you were CEO, is that correct? Mr. Johnson moved on and you 

were CEO? 

Mr. RAINES. I became CEO at the beginning of 1999. 

Mr. CASTLE. 1999. So this happened at the end of 1998? 

Mr. RAINES. No, it would have happened in 1999. The books are 

closed in January. So I would have been CEO. 

Mr. CASTLE. Okay. Well, with respect to—this change really 

bothers me and I don’t know if this is something that has been 

stated. There is no proof of it and I don’t know whether it is correct 

or not, so this may even be hypothetical rather than practical. But, 

it concerns me that if, according to the report, and dug it out, and 

it was filed by OFHEO. 

123

I am sorry, according to the testimony, which we had today by 

Mr. Falcon it basically states that the amortization models of management were $400 million, however management decided to record 

only $200 million that year and then spread the rest over the next 

year, which allowed bonuses to be paid. 

My question is, is there any record of that or is that just something that happened? Did they look at minutes of meetings or emails or anything to make that determination? 

I mean, that, frankly, does have overtones to it that we can speculate on how serious they might be. But I think we all would agree 

it would be pretty serious if, indeed, a decision was made to put 

extra—to violate a standard accounting procedure and to put extra 

money into a different year to resolve the—or to lessen the——

Mr. RAINES. It is a very serious——

Mr. CASTLE.——keep the gains high the year before. 

Mr. RAINES. It is a very serious allegation. The report states no 

facts. It doesn’t cite one piece of paper. It doesn’t cite one witness 

who says that that decision was tied to compensation. 

As I mentioned earlier, we actually launched an effort, once we 

heard this allegation, we launched an effort to go and look at the 

facts. And if you look at the facts as to how this occurred we have 

found no facts that indicate that this decision was tied to compensation. 

Mr. CASTLE. Did you find any facts—I know my time is almost 

up and I have 15 second I have to yield to Mr. Shays. But did you 

find any facts that would indicate the decision is in violation of 

standard accounting procedures? That is what they are stating. 

That is a pretty serious allegation. 

Mr. RAINES. No. We didn’t find any of those facts either. Our 

auditors looked at the decision at the time. 

Mr. CASTLE. Right. 

Mr. RAINES. And they approved the financial statements and 

they reported to the audit committee that there were not estimates 

that they believed were unreasonable. 

Mr. CASTLE. But KPMG apparently found an audit difference on 

this, as I understand it, a term which KPMG, this according to his 

testimony again, disagreed with Fannie Mae. 

Mr. RAINES. There was an audit difference. This is what is called 

a subjective difference, which means that there are different ways 

to do it, but when it came to the board, and the board—and they 

would have to report to the board, were there any estimates by 

management that they felt were unreasonable, their answer was 

no. 

Mr. CASTLE. So the decision was made, there was an adjustment 

made and then the question becomes is what was the behind that 

decision and whether or not it met good accounting practices or 

good corporate practices. 

Mr. RAINES. And we looked at the contemporaneous records and 

you can see in the contemporaneous records, in fact, that the calculations that OFHEO is relying on were not possible because no 

one knew what the EPS number was on the date that this decisions appears to have been made. So this false precision of just getting there exactly was impossible to know because the books hadn’t 

been completely closed for several more days. 

124

So that is what I am saying. We have looked at the facts. There 

appeared not to be any facts to back this up. And if OFHEO has 

facts that back up, you know, we would be delighted to see them. 

Chairman BAKER. The gentleman’s time has expired. 

Mr. CASTLE. I was supposed to give 15 seconds to Mr. Shays. 

Chairman BAKER. Well, let me suggest this, I had one more question and I had not had an opportunity to speak to Mr. Howard, if 

everybody wants to take 2 minutes, let us constrain. 

Mr. SHAYS. I wonder if I could go now because I have a——

Chairman BAKER. We would be happy if you would leave now. 

Mr. SHAYS. Would the gentleman yield? 

Chairman BAKER. I am sorry, you want to say something first, 

I didn’t understand your request. Yes, I would recognize the gentleman. 

Mr. SHAYS. Thank you. 

I just want to put on the record, Mr. Raines, that in communicating after your comment about the subpoenas to the office of 

compliance, they said they had requested thousands of documents 

and some of these documents simply were not coming. They got 

concerned about it. They particularly wanted e-mails. And only 

after they provided a subpoena request did the e-mails start flowing. 

And in conversation with Justice they basically said Justice said 

it wasn’t necessary because now the e-mails were flowing, which is 

not uncommon in Congress when we issue a subpoena. Sometimes 

the threat of the subpoena provides that information from flowing. 

And I just want to also say that the reason why this information 

is public and you don’t want it to be public now is they felt this 

was so serious that this information shouldn’t be suppressed. And 

I happen to agree with them on that account as well. 

Mr. RAINES. Well, if I might. 

Mr. SHAYS. I thank the gentleman for yielding. 

Mr. RAINES. If I might? 

Mr. SHAYS. Sure. 

Mr. RAINES. Fist of all, what I gave you was what the contemporaneous statement was, not what is being said today, but what 

was said at the time the subpoenas were issued. 

Mr. SHAYS. Right. They didn’t need it because you were now complying. 

Mr. RAINES. No, at the time the subpoenas were issued, not the 

time they went to the Justice Department, the time the subpoenas 

were issued, they told us they were not doing it because we were 

not cooperating. So, that, I think, is a very important distinction. 

Mr. SHAYS. They are saying that they were no longer necessary 

because after the subpoenas were provided that there started to be 

more information flowing, that is——

Mr. RAINES. That is a Justice Department issue. That is not why 

they issued the subpoena in the first place. That is where——

Mr. SHAYS. So there is a disagreement that we are going to have 

to nail down. 

Mr. RAINES. Yes. 

Mr. SHAYS. You have your opinion, they have their opinion. 

Mr. RAINES. I think that is exactly right. But the second issue 

on why this was made public, the exact same kind of examinations 

125

go on with big banks, small banks, thrifts, without special examinations being published. So there are other ways to do this. This 

is an anomaly. OFHEO is the only financial regulator who does not 

have the——

Mr. SHAYS. You are under the 1934 act. 

Mr. RAINES. I am sorry? 

Mr. SHAYS. You are under the 1934 act, public disclosure. 

Mr. RAINES. No, their examination has nothing to do with the 34 

act. It is solely to do with the banking laws. Under the banking 

laws, examinations are secret. And that helps the relationship between examiners and the bank because they can have very free 

flowing discussions. OFHEO doesn’t have that. It is not their fault. 

They have very good examiners. We are not quibbling with that. 

But the process is not a good process. We think the process that 

exists between examiners and the examinee is best referenced to 

looking at how the OCC has that work. And that is what we strive 

for. We are going to work with OFHEO to see if we can get there. 

But they do have this one disability that is not their fault, which 

is their examinations are going to be made public and that has a 

negative effect. 

Mr. SHAYS. What I would like you to do, though, is work with 

Congress to get a stronger enforcement process. That is what I 

would like. 

Chairman BAKER. Your time is expired, Mr. Shays. 

Mr. Kanjorski, did you have a follow-up? 

Mr. KANJORSKI. You know, a part of what we have to ultimately 

do is come up with a new regulatory scheme here. And I have been 

listening to this testimony and I was thinking since we have a regulator for two entities, you know, why can’t we make an in-resident 

meat inspector, if you will, that is down at your place 24 hours a 

day or however necessary. 

But when you have these exit strategies where something like an 

audit difference comes up, wouldn’t it be more likely to end up 

without disputes or problems if the regulator sat in and knew what 

the issue was on the rulings so that they don’t miss it? 

Mr. RAINES. Congressman, we actually have 40 OFHEO examiners resident at Fannie Mae. And so we do have them in close 

proximity. And we do believe that our examiners are aware of the 

closing process and of the findings of our auditor. That has never 

been hidden from our examiners. 

Our normal examining process, I believe, has worked well. Our 

only difference is how the special examination has worked. It is not 

about the normal examination process. 

Mr. KANJORSKI. But why didn’t somebody in the normal examination process be sitting in, to know what this audit difference 

was in 1990? 

Mr. RAINES. My personal belief is—and I will go check—my personal belief is that our examiners were aware of this. 

Mr. KANJORSKI. Well, you ought to examine your records and get 

the worksheets and see whether—somebody should have been 

there, to know that that was discussed, that the issue was resolved 

in one way or another and obviously acceptable to the regulator. 

Mr. RAINES. And I will come back to you. I will check on that. 

But my belief is that our examiners had been well informed, and 

126

they have been very professional people. They have been aware of 

each and every one of these accounting decisions over the years, 

and they have exercised their judgment on them in that process. 

So, we are not—we have no complaints about the normal examination process. We believe it has functioned. And they have hired 

people who examined other large financial institutions. They now 

have a new examiner in charge, who I just met with, and he has 

met with our senior management. And we are going to work with 

him to make sure we have the best possible examination relationship that exists. 

Chairman BAKER. Mr. Castle, did you wish another 2 minutes? 

Mr. CASTLE. I just have one comment, if I may, Mr. Raines. I 

heard you say earlier, based on this level—the executive officer 

compensation chart—that it is the road path, that people will come 

and steal your employees. 

I have seen the salaries. You don’t have to worry about Congress 

coming up and stealing any of your employees. 

[Laughter.] 

Mr. RAINES. Having been a federal employee a couple of 

times——

Mr. CASTLE. You know the problem. 

Mr. RAINES. I know the problem. I know it well. 

Chairman BAKER. Ms. Waters? 

Ms. WATERS. SEC has been referenced any number of times here 

today. And I guess Mr. Falcon said that there were overlapping responsibilities. 

What is SEC doing now? Have you been examined by SEC in the 

past, since 1998? What have they said about your accounting practices? What part of this have they overseen, examined, investigated 

since 1998, and what are they saying now? 

Mr. RAINES. Well, the SEC has been enormously cooperative with 

us in our process of becoming a registrant. We are the largest business ever to become a new registrant with the SEC. They have 

never had an $800 or $900 billion entity do that. 

They were very helpful in that process, in reviewing our initial 

documents and giving us feedback. So, they have bent over backwards to be helpful. I am enormously grateful to them for that. 

They have also worked with us on sticky accounting issues. And 

we, like other companies, have presented accounting issues to them 

and asked them for a judgment as to what the appropriate accounting is and, again, they have been very responsive in giving us answers. 

We, of course, have implemented the answers that they have 

given to us. So, we expect that the SEC will carry out their function here. They are busy; they have a lot of things to do. I don’t 

know what their timetable may be——

Ms. WATERS. Have they been in touch with you since this information became public? 

Mr. RAINES. We have had contacts through counsel with the SEC 

Enforcement Division. But also we have had contact not through 

counsel—through business people—and with other parts of the 

SEC. So we try to maintain good communications with them. 

It is my desire now—as it would have been my desire before the 

report came out—that these accounting issues simply go to the 

127

body who can solve them. Then we will have the answer. We won’t 

be having a debate about who is right and who is wrong. 

There will be an answer and we will implement it and go forward. 

Chairman BAKER. Gentlelady’s time has expired. I only had one 

further request of you, Mr. Howard. In order to better understand 

your explanation and your responsibility with regards to the $200 

million expensing issue of 1998, I would like to request a written 

response, which I will submit to you at a subsequent time. 

The reason for asking the question in the hearing is that if your 

response would be pursuant to your oath taken during the course 

of the hearing, which would establish some important value to your 

written response. 

The essence of the request will go to the manner in which the 

expense amount was determined, why the figure was arrived at, 

the chronology of that decision-making process, those who participated, if it did not rise to your level. 

As you represented earlier in the hearing today, there are some 

financial decisions that come before you, some that do not. We need 

to know if it did not, to what level did it rise? Was this matter discussed among all executives? Did it go before the board for at least 

an announcement or some disclosure to the board? 

Basically, a process by which we can be sure, as members of the 

committee, we have gotten complete and full explanations as to the 

elements that OFHEO has brought to our attention. 

Please understand, in my capacity, I am presented with a very 

contentious and volatile report. If I were to have left Washington 

D.C. and gone home without addressing the elements of this report, 

I can only imagine the criticisms that would be leveled against this 

committee for its inaction. 

Should the interim report plead OFHEO to take the next step 

and issue some other yet unknown criticism, it certainly would 

leave this Congress in a very untenable position as the entity responsible not only for the creation of OFHEO but for creation of 

Fannie itself. 

I certainly hope that the future does not bring ill-advised consequences to the institution, its ability to extend credit to prospective homeowners or, even worse, to have consequences for taxpayers. 

My role is to examine, thoroughly examine, and I hope to spring 

to speedy resolution all of these matters. I have no interest in, nor 

motivation, to bring any adverse consequence to the enterprise or 

to Freddie Mac and, I will continue, however, to be the arm’s 

length examiner of enterprise conduct that we appear, in your 

view, not to have with OFHEO. 

With that disclosure and no further comment, thank you. And 

this panel is dismissed. 

If our witness for our third panel is able to make it to the desk, 

we would invite her to do so now. 

Thank you very much for your participation. 

Welcome the presiding director of the board of directors of 

Fannie Mae, the honorable Ann McLaughlin Korologos. Is that correct? 

Ms. KOROLOGOS. That is right, sir. 

128

Chairman BAKER. It was previously determined by mutual discussion that all those who would testify before the committee in 

this proceeding would be asked to take the oath. Do you have any 

objection to being sworn in? 

Ms. KOROLOGOS. I do not. 

Chairman BAKER. If you would not, do you seek the advice of 

counsel during your testimony? 

Ms. KOROLOGOS. I do not. 

Chairman BAKER. If you would not mind rising and raising your 

right hand, I will administer the oath. 

(WITNESS SWORN) 

Thank you very much. Please be seated. Consider yourself sworn 

in and under oath. 

As we have extended to all other witnesses in the course of the 

morning and afternoon, we request that the presentation, if possible, be limited to 5 minutes. Given the gravity of the issue before 

the committee, however, we would certainly extend any courtesy to 

you to proceed at your discretion. 

Your official testimony will be made part of the record. Please 

proceed. 

STATEMENT OF HON. ANN MCLAUGHLIN KOROLOGOS, 

PRESIDING DIRECTOR, BOARD OF DIRECTORS, FANNIE MAE 

Ms. KOROLOGOS. Thank you, Mr. Chairman, and I hope I can 

keep more or less to the 5 minutes. I know it has been a long day, 

but I appreciate the opportunity to be here. 

I would like to thank Chairman Oxley, Ranking Member Frank, 

Chairman Baker, of course Ranking Member Kanjorski and members of the Subcommittee. 

My name is Ann Korologos and I am the presiding director of 

Fannie Mae’s board of directors. I also currently serve as chair of 

the Nominating and Corporate Governance Committee and on the 

board’s Compensation Committee. 

I am a shareholder-elected, independent director. I have served 

in three Cabinet departments, including as secretary of labor under 

President Ronald Reagan, and I headed the Presidential Commission on Aviation Security and Terrorism, specifically investigating 

the bombing of Pan American Airways flight number 103. 

The board of Fannie Mae appreciates this committee’s oversight 

of the company, of the board and of our regulator. And I welcome 

the opportunity to speak on behalf of the board about OFHEO’s report to date on its special examination. 

The board takes the issues raised by the OFHEO report very seriously. We are here to do the right thing. By that I mean: to 

OFHEO, the SEC and Congress, and to do so in a way that protects the shareholders and restores the public’s confidence. 

In this way, the company can continue to fulfill its critical housing mission: to use the financial flexibility of a private company to 

pursue the societal goals of increased homeownership. 

As directors, we must meet our fiduciary duties of loyalty, care 

and good faith. We do not take these responsibilities lightly. These 

duties have meaning. They require us to gather the facts, conduct 

an objective investigation and render judgment based on the facts. 

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We must look at the issues in the report deeply, thoughtfully and 

carefully, using whatever resources are necessary. And we will be 

held accountable for how we meet our responsibility. 

The board, with independent counsel and independent accountant, will investigate the issues in the report, and we will work expeditiously. So I thank you for this opportunity to speak on behalf 

of the board. We were moving fast before this hearing, and I can 

share with you that we now are continuing to do so, and we now 

know where we are going. 

The board has participated through our audit committee, in following the company’s response to the examination since it began 

over a year ago. We have received regular reports from the audit 

committee on the examination’s progress, as best it could be understood. 

On Friday afternoon, September 17, Director Falcon contacted 

me to say that OFHEO wished to share its findings to date with 

the outside directors of the board. I convened a meeting of the 

board for the next business day, which was Monday, September 20. 

Every nonmanagement director attended in person or by telephone. On that day, we received the written report and OFHEO’s 

senior staff made a presentation to the nonmanagement directors 

and the company’s outside counsel. 

The staff also gave us a letter from the director and a draft 

agreement, to be signed within 2 days, outlining actions to be 

taken. In addition, the board was informed by management, after 

that meeting, that they had received a call from the SEC that these 

issues would be a part of an informal inquiry by that regulator. 

The board immediately began a series of meetings and discussions with OFHEO over the week of September 20. I think I either 

spoke or met with Director Falcon every day that week. I assured 

Director Falcon that the board and the company would work cooperatively with OFHEO and that we would address all their concerns. 

I also expressed the boards hope that our work together would 

build a constructive relationship based on mutual respect and trust 

going forward. I told him, however, that the board could not, consistent with its fiduciary responsibilities, sign a document in 48 

hours. 

On Tuesday, September 21, I advised the director that the board 

had authorized the hiring of independent counsel, former Senator 

Warren Rudman, and his law firm, Paul, Weiss, Rifkind, Wharton 

& Garrison LLP, subject to OFHEO approval, to address the questions raised by the OFHEO report. 

I also advised the director that we would provide to him, the next 

day, a draft work plan based on the actions required by OFHEO’s 

agreement. On Wednesday, Pat Swygert, a fellow board member 

and President of Howard University, and I met with the director 

and his senior staff at OFHEO offices. 

We provided the draft work plan that was approved by the board 

and, because so much of the report had been leaked to the press 

by that time, I also advised the director that the company did not 

object to OFHEO’s public release of the report. 

After reviewing the draft work plan, Director Falcon told me 

later that evening that he thought the plan was substantive and 

130

addressed each of the areas of concern raised by the report. I have 

attached to my written statement a copy of this draft work plan. 

On Thursday, in a conversation with OFHEO’s general counsel, 

however, it became clear that OFHEO wanted a written agreement 

to be signed by the board. 

Therefore, at my direction, on behalf of the board the company’s 

counsel began meeting with OFHEO staff to reach such an agreement. Discussion continued throughout the weekend, and after additional board meetings, we and OFHEO announced the September 

27 agreement. 

With the agreement completed, the thorough process to address 

OFHEO’s report is underway. Importantly, management has 

pledged its cooperation to the board in effort and we will hold them 

accountable to that pledge. 

The details of the agreement are well known. The company will 

move immediately to begin making a number of changes including 

a capital surplus plan, accounting policy modifications, internal 

control enhancements and other changes. 

The board’s independent counsel, Senator Warren Rudman and 

his law firm were approved by OFHEO yesterday. Senator Rudman 

will hire independent accountants, also subject to OFHEO approval. 

Senator Rudman’s work will also be reported to the SEC. We expect Senator Rudman to conduct his review as described in our 

agreement with OFHEO and to report his findings to the board, 

OFHEO, and the SEC 

The company and its outside auditors have a disagreement with 

OFHEO about some aspects of the implementation of FAS 91 and 

FAS 133. The agreement establishes a process going forward to resolve these issues. 

This board believes in accountability and objectivity. We will not 

prejudge the outcome of this process, and I respectfully ask you not 

to prejudge it, as well. We vigorously share your concerns and want 

to get to the bottom of this. 

We believe that we have built a sturdy, corporate governance 

structure to be prepared for any challenge this organization may 

face. How this board and the company handle themselves when 

things go wrong is the ultimate character test. 

We have benchmarked our governance against other companies. 

Our nonmanagement directors meet as a group, without management, every time the full board meets, and often in between. These 

are candid, probing discussions. 

Our standards for director independence more than meet those 

of the New York Stock Exchange. Mr. Chairman, I would be remiss 

not to comment on the article which questions the board’s independence in today’s paper. 

Two years ago, we applied the New York Stock Exchange standards for director independence enhanced for our board’s accountability. We worked with our outside governance counsel, Gibson, 

Dunn & Crutcher. 

We developed a director questionnaire and a process for matching directors’ nonprofit and business connections with corporate or 

foundation contributions or business relationships. 

131

For example, for a business relationship, a director is considered 

not independent under these guidelines. We take a five-year look 

back versus a three-year look back under the New York Stock Exchange rules. 

On an annual basis, an excess 2 percent of consolidated gross revenues or $1 million, whichever is greater, would determine independence. And for charitable organizations on an annual basis, a 

$100,000 or 5 percent of gross revenues of the charity or the non 

for profit, whichever is less. 

The New York Stock Exchange permits charitable contributions 

of any size and only requires disclosure of donations in excess of 

$1 million or 2 percent of the director’s charities gross revenues. 

In addition, no direct compensation other than director pay is 

permitted under our guidelines although the New York Stock Exchange permits directors to receive up to $100,000 per year in 

other pay before they are no longer independent. 

In addition, one director has a personal business relationship 

issue, and that was brought to our attention some months ago, and 

a decision on independence will be made at our October Governance Committee meeting. 

We have, therefore, regardless of reports in the press, I think, 

applied both the spirit and the fact of the criteria for independence 

and that that is put forth in the New York Stock Exchange guidelines. 

If the New York Stock Exchange, governance watchdogs or anyone else wants to change those guidelines, you can be assured that 

we would change ours and meet those requirements. I thought I 

might offer to submit, for the record, the board guidelines so that 

you would have them with this testimony. 

If I may speak personally for a moment, I have known some of 

you over the years from my experiences in both public service and 

the private sector. And I think you know my commitment to ensuring that our laws are upheld and the institutions of our economy 

maintain the highest levels of integrity. 

There is only one way I know how to deal with such a difficult 

situation: to speak the truth, to find the facts without bias, to base 

judgments on those facts, and then to act without hesitation. We 

must do the right think carefully and deliberately. We must not 

rush to judgment or take actions in haste today that we will have 

to correct tomorrow. 

I will commit to you that the board is determined to follow a 

process that will inspire confidence and restore public trust. 

Thank you, Mr. Chairman. 

[The prepared statement of Hon. Ann McLaughlin Korologos can 

be found on page 171 in the appendix.] 

Chairman BAKER. Thank you very much for your statement. Let 

me quickly say that I have no question either about your service 

as a board member nor any of the independent board members. 

Ms. KOROLOGOS. Thank you, Senator. 

Chairman BAKER. I do think, as you have stated, today’s problems present a challenge that will require decisive action based on 

full knowledge and confirmation of all the facts. 

What is problematic in the current environment is that, as Mr. 

Raines was before the committee for some time this afternoon, on 

132

a number of occasions in response to various questions, he would 

state the report cites no facts, speaking to OFHEO’s report. 

I find that troublesome with regard to coming to an agreement 

that is in everyone’s best interest. I will be the first to say that no 

report is probably 100 percent accurate. But I would also quickly 

observe that few reports are 100 percent incorrect. 

I note that the board took rather quick and decisive action in 

reaching this first agreement, which would seem to indicate to me 

that there were some reasons the board came to a conclusion that 

it was appropriate to enter into that agreement. 

Do you believe that OFHEO is a competent regulator? 

Ms. KOROLOGOS. I don’t know that I am equipped to make that 

judgment. I had the opportunity to meet with the director about 8 

months ago as chairman of the governance committee, which 

turned out to be fortuitous. So, when I received the call, I knew the 

director. 

Generally speaking, boards don’t involve themselves in this detail with the regulator, frankly, at least not in the companies I am 

involved in. More so, in financial, I can’t make that judgment. 

Chairman BAKER. Okay. Do you believe, knowing what you know 

now from the substance of the report made available to you, that 

the board has been advised sufficiently, frequently enough, and to 

sufficient detail to have made appropriate judgment in the matters 

of concern in the OFHEO report? 

Ms. KOROLOGOS. Do you mean with regard to the agreement or 

generally speaking——

Chairman BAKER. Generally speaking in your capacity as an individual board member, do you feel you have been given sufficient 

information about the business judgments made by management of 

the corporation today? 

Ms. KOROLOGOS. I would say that the report raises issues that 

clearly are serious. That is why, again, with OFHEO’s encouragement, through their agreement, we have retained independent investigators, both on the accounting side and, as you know, for some 

of these other issues. 

So I don’t want to prejudge anything by answering your question. 

Chairman BAKER. And, my next question is not to lead you to a 

statement that would be interpreted incorrectly. 

I have read accounts from various independent board members 

at different times making the statement that they have full confidence in the judgments made by, and fully support the current 

management. As you outlined, going forward, we need to know all 

the facts, follow all of those facts to their end conclusion. 

As you encouraged the committee and others not to jump to any 

presumptions before that process is finished, I would hold that door 

open both ways; that we not rise to the defense of all parties until 

we have come to a judgment as to everyone’s involvement, if there 

is found to be a substantive accounting problem that was inconsistent with GAAP that led either to shareholder value being depleted or reports to the markets of incorrect financials. 

I think it was clear from the testimony of Mr. Howard and Mr. 

Raines. They first don’t see a factual basis for the allegations that 

have been made by OFHEO but, secondly, can’t make full judgment about the accusations until they have more information. 

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Is it your view that the board, going forward, will reserve judgment in all these matters whether it be positive or negative? 

Ms. KOROLOGOS. I think so, completely. I will say that they have 

in the past and, if I might comment—since I am one of the people 

who were quoted in the press—I think this is a good forum to develop that because I wholeheartedly agree with you. My statement 

asked that none of us prejudge, of course, and we should be objective, and this board can be objective and is objective. 

When I called Frank Raines, the Chairman of the company, to 

tell him I had received a call at 4 o’clock on Friday from the director, his first response when I said I would convene a meeting was, 

‘‘How can I help?’’ That is a first-class CEO. 

Consistently, over these weeks, management has asked, ‘‘How 

can we help?’’ That is the spirit of cooperation that we have with 

management in order to achieve all that we want to achieve. That 

does not detract from our objectivity. 

Many of us on the board have been there long enough to have 

worked with management over many issues on a great company 

achieving its mission. So, in that spirit, yes, certainly, we have experiences. 

I don’t think that is mutually exclusive from the job that we have 

laid out, and I commit to you our objectivity, our unbiased tenacity 

to go forward and find out, if you will, the other side of this report 

and see where it comes out. 

Chairman BAKER. Well at least an exploration of all the allegations OFHEO makes should be thoroughly vetted and conclusions 

reached. I hope that the findings are not as severe as OFHEO has 

represented them to be, but we all have a duty to find out. 

Ms. KOROLOGOS. Absolutely. 

Chairman BAKER. And I thank you for that. 

Mr. Kanjorski? 

Mr. KANJORSKI. Madam Secretary, am I correct that you have 

been on the board at Fannie Mae for 14 years? 

Ms. KOROLOGOS. Oh, you are making me older than I am. 

Mr. KANJORSKI. Eleven years. 

Ms. KOROLOGOS. Ten years; just 11 this year, so 10 and a half. 

Mr. KANJORSKI. So you predate Mr. Raines tenure. 

Ms. KOROLOGOS. I do, sir. 

Mr. KANJORSKI. And you predate one of the issues that we have 

had the regulator testify about today, the FASB 91 audit difference 

that was reported in 1998. First of all, I would like to test your 

memory. 

Do you have any recollection at any time of your auditors, management or the regulator talking to you or other members of the 

board about this handling of the $400 million or $200 million in 

1998 that has been the object of one of the charges made by the 

regulator? 

Ms. KOROLOGOS. I don’t have a recollection. I presume it would 

come through an Audit Committee report, and I can’t promise you 

that something was said but I don’t remember anything being said; 

no. 

Mr. KANJORSKI. I know very little about how regulators operate 

and even less about how many analysts they have at your agency. 

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Mr. Raines tells me they have 40 in-house meat inspectors. Pretty 

broad exposure. 

Do you, in the last several weeks, in meeting with the auditor 

and getting their report and meeting among the board with your 

various experts that you have retained now, do you have a sense 

as to whether or not there is a systemic risk problem at Fannie 

Mae? 

Ms. KOROLOGOS. I do not believe there is a systemic risk problem 

at Fannie Mae nor have I been in any gatherings that would lead 

me to believe that. I certainly would not have signed on behalf of 

the company, the agreement, if I didn’t take into consideration the 

impact of the agreement, as well, and also the capital plan that is 

being developed and the likes. 

So, no, I don’t. I haven’t heard that and I don’t feel that. 

Mr. KANJORSKI. Very good. One of the things that amazes me is 

the regulator, in testimony earlier today, indicated, of course, that 

OFHEO has been auditing or regulating since 1991. And it is in 

1998, one of the audits obviously had a finding that was an audit 

difference as to how to handle this particular transaction. 

I was just struck why they didn’t pick that problem up in 1998 

or 1999 or any subsequent year that they had to deal with that 

audit report; that is, that the regulator didn’t pick it up. It seems 

to me almost the first area that you would begin to do your regulation, is to look at the outside audit report. 

Has that struck you at all as being peculiar? 

Ms. KOROLOGOS. I have to say I only learned that from these 

hearings today. It strikes me the way it strikes you, sir. I would 

think that would be certainly a first stop; maybe not the last stop, 

but a first stop for a regulator. 

Mr. KANJORSKI. One of the things that we have been struggling 

with over the last year and a half is to create an independent, 

world-class regulator for Freddie and Fannie. We thought we were 

going to come close to success not too long ago but, for reasons that 

are in the atmosphere in Washington, that didn’t occur. 

But, invariably, as a result of this investigation and the Freddie 

Mac investigation and the testimony we received from the regulator this morning, I am absolutely thoroughly convinced that we 

have to do something to create a stronger, more independent, 

world-class regulator; other than that, Mr. Baker and myself are 

going to be remiss in carrying out our responsibility. 

But in starting that process, I am just at a loss as to how something could happen in 1998 and be listed as a finding in an audit 

report, and the regulator didn’t ask anybody about it or get any information about it or resolve the application of GAAP rules to that 

particular finding. It just blows my mind, and $200 or $400 million is a significant 

amount of money, even in a huge institution like Fannie Mae. 

So, I am not sure that this was a wasted hearing from any standpoint, because we heard, for the first time, really, that process that 

the regulator has gone through. And I am not casting aspersion to 

this point on Mr. Falcon because he was not there, as I understand 

it, in 1998. He came subsequently. 

But, apparently, we have done one poor job as federal regulators, 

particularly of these two institutions. If nothing else, we should get 

135

that straightened out. There has been a lot of press, a lot of it bad, 

and as all of us know, it had some impact on the stock of Fannie 

Mae. 

Do you feel there is any reason, in your role on the board, that 

going forth from this hearing, both the investing public and the 

purchasers of your obligations should have any fear at all as to the 

security and the position of Fannie Mae, that their investments are 

secure? 

Ms. KOROLOGOS. I don’t feel so. I feel that the agreement that 

we signed puts us on a very acceptable path to giving strength and 

clarity and openness to the issues that have been raised. I think 

that should be, I hope, assuring to the public. That is part of what 

I think our responsibility is; to the public—all the public, employees, investors, shareholders, the like. 

Mr. KANJORSKI. Well, my sense of you—I should disclose for the 

record, we had the occasion to meet yesterday—I can’t remember 

ever being more impressed even though we do differ politically. But 

with your basic competency and capacity, you certainly have won 

my faith that you are going to do a job and how you have gone 

about it really impresses me. 

I want to join my colleague, Mr. Baker. This is not the happiest 

role we have to play, as members of Congress. But quite frankly, 

the testimony of yourself today and the CEO, Mr. Raines, and Mr. 

Howard, the CFO, and even the regulator gave me a little bit more 

confidence that we are not dealing with something that is dangerous here to the public or is terribly disastrous to Fannie Mae. 

But it is good that we get it over with and if you keep the captain of that ship, you are going to let me sleep a lot better. Thank 

you. 

Ms. KOROLOGOS. Thank you, sir. 

Chairman BAKER. The gentleman yields back. 

Mr. Scott? 

Mr. SCOTT. Thank you very much, Mr. Chairman. I wanted to go 

back to a line of questioning I started with Mr. Raines, which I 

think gets to the fundamental problem that has been brought before this committee, and that is that your board made the decision 

to tie the compensation bonuses to earnings per share. 

Can you comment on that? I think it is very important that I reaffirm Mr. Raines’s comment that this preceded him because I 

think there are several things that I am very concerned about. One 

is the credibility of Mr. Raines, who runs that department, which 

means the credibility of Fannie Mae. 

This serves a very, very important constituency for all of us 

across the country who are concerned about making sure we have 

adequate housing, affordable housing for all income levels. 

But I would like to find out why that board felt it believed that 

it was appropriate to link executive compensation to earnings per 

share, and whether or not this move, this compensation scheme, resulted in inappropriate incentives for management? 

I think that unless we can clear that and try to get some common ground on that issue, especially as I mentioned, with the chart 

that Mr. Baker has provided this committee—which I am sure we 

are not the only ones who are going to see that chart—it is going 

136

to show some stark comparisons between what actual salary was 

and what those bonuses were. 

So, there is certainly meat for incentives here. I think this might 

be something we want to share. Could you give me your comments 

on why this, you felt, was appropriate? 

Ms. KOROLOGOS. I would be happy to. Again, I have only been 

on the board since 1994 but, in both my experience at Fannie Mae 

and many other corporate boards—in some case, where I am also 

on comp committees—earnings per share was a very acceptable incentive, if you will. 

Generally combined with others, different companies did it different ways. So you are not talking about a company that was the 

only one. I wanted to make that clear. 

Why was that? Well, in the late 1980s, early 1990s, the acceptable philosophy for compensation besides always, in some way 

being performance based, was to tie management to the shareholder, and earnings per share was one way to do that. Likewise, 

options, which we saw become out of favor and the like. In a way, 

I would think we would all take comfort. 

At Fannie Mae, it is a much more, even transparent process than 

at other companies precisely because we are a GSE. Unlike other 

public companies, the amount our executives make is somewhat 

dictated by law, and the law states that OFHEO is required to ensure that Fannie Mae’s compensation programs are reasonable and 

comparable with compensation for employment in similar industries. 

We use the comparability test of looking at peer companies and 

the like and structuring not only the earnings-per-share measurement, but in other aspects as well, both tangible and intangible 

performance measures and the like. 

So you generally have salary, you have bonus, you have long 

term, you have short term kind of incentives. So you try and strike 

a balance between financial and nonfinancial measures. 

Earnings per share, for purposes of this report, seem to have 

jumped out and your question is quite a legitimate one. I would 

only say that it is becoming, in recent years because of incentives 

leading, in some companies, to behavior that wasn’t intended to relook at compensation. And there are a lot of different mixes going 

on. 

Mr. SCOTT. You have seen the report that was presented before 

the committee——

Ms. KOROLOGOS. I actually did not see the paper that was handed out yet. No, I have not. 

Mr. SCOTT. But you are familiar with the bonus and the structure and the comparison of base——

Ms. KOROLOGOS. Yes, very much so. 

Mr. SCOTT. Do you stand by that? Do you feel that——

Ms. KOROLOGOS. I stand by what we did; yes, I certainly do, and 

I think that I have found, again, my experience on a number of 

other boards; it is always a work in progress. We use outside consultants as well, is what I wanted to assure you. 

So this is not something we plucked out of the air and allowed 

to hang out there to be abused in any way, shape or form. 

137

Mr. SCOTT. Well I think this is very important to get on the 

record because, as I said earlier, there have been some very strong 

accusations made against Fannie Mae, and I want to make sure 

you have a chance to respond to that. 

If I may continue, in view of that, what changes, if any, in corporate governance and some of these compensation policies that the 

board is considering to address in relationship to the issues that 

have been raised by this report and, again, I too question the timing of it and I think there probably are some motivations there. 

People say politics isn’t a part in that, but you really can’t take 

politics out of politics. I believe really, as a result of today’s hearings, that politics has certainly manifested in what we have here. 

But, having said all of that, OFHEO has given a report. Are you 

going to make any changes in the way you operate and, if so, in 

governance and in compensation, as a result of this board and some 

of the issues that it has pointed out? 

It runs the gamut of misapplied accounting rules, has kind of 

stabilized the earnings, the inadequacy of the regulatory capital, 

the deferred expenses. It just seems to me, do you take this report, 

just say there is nothing here, or do you take it and say here is 

what we are going to do to try to fix this situation. 

Do you give this report credibility? 

Chairman BAKER. And, Mr. Scott, that will have to be your last 

question because you are well over time. 

Ms. KOROLOGOS. Let me assure you, I think—two significant 

things, perhaps. One, the agreement we signed itself permits us—

I think there are 32 or 33 issues there—working with Senator Warren Rudman and the accounting people that he will bring, to do a 

very deep dive, if you will, and look very carefully at all of those 

issues, some of which may result in change, some may not. I can’t 

prejudge that. 

So, that is the route for the report itself, in terms of taking it 

serious, following all of the issues, both through the agreement and 

the report itself. 

Secondly, you ask if there will be changes in governance. In 

terms of the company’s governance and its organization, that is a 

part of the agreement, and that will be addressed accordingly. 

In terms of corporate board governance, I said in my statement, 

and I really do believe—but I am open always to best practices and 

we follow these issues religiously—that we are at a point, because 

of good governance, that we are able to, one, get us this far to keep 

some stability and calm to a process that I think is very important, 

to exercise our fiduciary responsibilities in a thoughtful and informed way, and organized ourselves previously to be able to participate in the various teams that are going to be created to fulfill 

our obligations under the agreement. 

One board member has particular expertise in capital markets 

and the like; Don Marron, formerly of Payne Webber, he will be a 

very good team person. Another woman, Leslie Rahl, on the board, 

is a derivatives expert; let her work on those issues. 

So, we are organizing ourselves with our expertise. So, I think 

that is the corporate board governance piece. Whether changes 

come for board governance from the report, I don’t see that right 

now but I am open to it, but I don’t see that. 

138

I think the third issue on compensation, however, obviously we 

welcome any findings from the independent investigation that address some of the allegations in that area. 

As a member of the Comp Committee, we have been addressing, 

as we look again, at comparables, at best practices, at the structure 

of compensation, at those in our industry, how to base the bonus 

plan on more than just earnings per share such as risk and mission 

factors. 

That is going to be forthcoming. So, that is a piece of work that 

has already been going on but it has been going on because of the 

marketplace, if you will, in executive compensation. 

Chairman BAKER. The gentleman’s time has expired. Ms. Waters? 

Ms. WATERS. Thank you very much. Would you please give me 

the correct pronunciation of your name? 

Ms. KOROLOGOS. I would be happy to. It is all O’s, and it is Koro-lo-gos. 

Ms. WATERS. Ms. Korologos. I would like to thank you for coming 

here today. 

I don’t know how long you have been here but you may know by 

now that some of the questions that I raised to Mr. Falcon question 

the motive of the director as it relates to this so-called investigation. 

And I know sometimes that is not a nice thing to do, but I know 

a lot of history about this ongoing political battle between FM 

Watch and the GSEs and some of our members’ role in all of that. 

I also know about the criticisms that were launched at OFHEO 

and its past oversight or lack of the GSEs. So I have a historical 

reference for many of the questions that I have asked and some of 

the accusations that I have may have made. 

Having said all of that, you entered into an agreement with 

OFHEO without having a response from your organization. And it 

appears that you entered into an agreement because you wanted 

to show that you were cooperative, that you were not resisting criticism, that if there were problems you wanted to solve them. 

It seems to me that is what you did, and you made that decision 

knowing that some people would not understand that this was not 

an admission of any kind of guilt or anything else. But I think it 

is very important for that to be restated time and time that, out 

of the spirit of cooperation, you entered into this agreement. 

Now, I have looked at some aspects of this agreement as represented to us today. And what it appears is that you have entered 

into agreement that you could easily enter into because, as far as 

I am concerned, what is being asked of you is not that difficult to 

begin with, and it may not require you to do any changes at all. 

You may be correct in some of the things that you are doing. 

I don’t see any timeframe or time guidelines on any of these 

points made in the agreement that you should have something 

done by a certain date, even though we are led to believe this was 

an emergency. 

The board had to be convened right away because these serious 

accounting problems had been identified and unless you do something right away, the safety and soundness of this organization was 

at great risk. 

139

But even when I look at the number one recommendation—implement correct accounting treatments that will bring the enterprise into compliance with SFAS 91 and SFAS 133—it didn’t say 

do this in 30 days, in 60 days, in 90 days. 

It just puts it out there but nobody says—unless it is someplace 

else—how the agreement will be made as to what the correct accounting treatments are based on the fact that there are some disagreements, perhaps, about the implementation of SFAS 91 and 

133. That is one example. 

This other requirement—protect its existing capital surplus and 

move to a targeted capital surplus equal to 30 percent of its required minimum capital—there is no emergency relative to this requirement. 

It didn’t say that if you don’t do this in 30 days, 60 days, 90 

days, something terrible is going to befall this agency. It didn’t say 

that we have come up with this percentage because this is what 

we have examined, this is what we have looked at and this is the 

conclusion that we have come to based on these facts. 

And, of course, in the spirit of cooperation, you could agree to 

that, because even though it potentially takes capital away from 

being involved in some of these good things that you may be doing, 

it doesn’t really admit that something is wrong with the surplus of 

the minimum capital requirements that you have now—the 18 percent or whatever that is. 

So, as I go down each one of these, some of them look a little 

weak, they look like little smoking mirrors to say that I did an investigation and so now I want you to undertake a top to bottom 

review of your staff structure. 

Duh, I mean, I think this is what you do all the time. And as 

has been indicated, that even in the ongoing meetings that you 

have, where people can raise questions, et cetera, et cetera, you are 

doing this all the time. 

So, having said that, would you confirm for me, your understanding of why you entered into this agreement and whether or 

not you believe that this means that you immediately make great 

big changes because you were doing something wrong. 

Or is this just an agreement to say, ‘‘Okay. You want us to look 

at this? We will be happy to look at it. We believe that we are right 

and we believe that in the final analysis, we will be proven right.’’

Explain to us where you are coming from. 

Ms. KOROLOGOS. I will. 

Chairman BAKER. And that would be the gentlelady’s question 

because her time has expired now. We would be pleased to hear 

your response. 

Ms. KOROLOGOS. Thank you, Mr. Chairman. Yes, it was a very 

difficult, important period for the board to be presented with an 

agreement and then, uncertain at the time, the importance of the 

agreement, per say, because to sign it in 48 hours would not have 

been possible responsibly. 

When, however, we presented, based on the agreement, a work 

plan, I was able to spend the days with management and say, 

‘‘What can be done? Let us break this apart and see what can be 

done on the issues that were raised in the report.’’

140

And it really came in sort of three chunks. There were the accounting issues and, clearly as you heard in testimony today, the 

SEC has a serious role there. There were the capital issues, if you 

will and the capital plan. 

Well that, again, we could bring the best brains together and the 

talent and work with OFHEO and determine that. And then, I 

guess you might say, we had also the organizational issues and 

throughout, we had some very serious allegations that could be addressed by an investigator that OFHEO encouraged us to have. 

So, as we broke it apart, we were able to develop a work plan. 

Having done that that gave us some background, when I understood from the director, or from counsel, they still wanted an agreement and they wanted it really before Monday, the 27th. 

I think, in part, from what they told me in preparation for the 

quarterly letter that they issue regarding our safety and soundness. So that became an issue within the timeframe for this agreement. 

The counsels worked together with the board and with me, particularly, on the elements of the agreement. And various changes 

were made to your point, to make acceptable. There was no way 

we were going to sign an agreement we couldn’t deliver on, number 

one. 

And, number two, we were very eager to get this process going 

so we could give answers to the public, to our investors, to our 

shareholders, to the housing community. We had already seen an 

economic impact because of the swirl and the fire storm we are in. 

But how can we stay thoughtful, see through the process of developing an agreement that, one, was responsible, that would further clarify, explain, investigate, in an open way, the issues that 

had been raised—they were serious—and, at the same time, to 

your point on timing, not commit to something we couldn’t achieve. 

You will notice in the agreement—you are right—there are various timeframes, but not necessarily a timeline for delivery. There 

are 15 days to give the comprehensive plan and seek approval or 

disapproval of OFHEO. 

There are 45 days to have a counsel working for us and conduct 

reviews. There is a compliance committee requirement and the like. 

So, there were different timeframes, all of which, in many cases, 

require OFHEO to approve or disapprove. 

My hope is that we will be able to work with OFHEO so their 

approvals will come in a timely way, too. I think that is an important part of keeping going. We will be developing a tracking system 

to monitor implementation and our progress. 

Now, let me say that it is in our interest to be on two paths here. 

One is to implement the agreement, the investigation and do so expeditiously because we want to put all of this behind. If there are 

changes to make, we are happy to make them. If they are allegations that are proven, we need to deal with it. 

At the same time, the other track we are on is to run the business. The most important thing we do in this very vibrant, wonderful company with a fabulous public mission is to keep the business 

going. 

141

So, the more these issues hang around, if you will, I think is irresponsible for the board not to set our own timelines and make sure 

we can reach them. 

That is my best answer to why we did the agreement, what kind 

of appropriate pressure, if you will, we will keep on the process and 

the special committee that we created to work on this to oversee 

it. 

The individuals within the company we are selecting to help us 

there is to keep this moving because we really want to put it behind us. But we want to benefit from the process and do it. As I 

keep saying, we want to do it right the first time and we want to 

do it thoughtfully. 

So, we are not—I frankly don’t want to come back before this 

committee or our shareholders or our employees and say, ‘‘Oh gosh, 

we didn’t do a good job. We have got to redo it.’’ Let us do it right 

the first time and I think the process we set up will do that. 

So, the timelines that will be developed to implement—I am sure 

there will be some give and take, and that is appropriate with the 

regulator, and what they think we can do in a certain timeframe 

and what we think we can do. 

I would expect in the spirit of cooperation we will work out that 

tracking system and those timelines together. 

Chairman BAKER. Let me thank you, Ms. Korologos, for your appearance here today and your testimony and also give you an assurance. 

Despite the view that the work in the committee may be political 

in its nature, Mr. Kanjorski and I work very closely together. Our 

work, especially in this arena, has been bipartisan. We both share 

the view that strong regulatory capacity is absolutely essential. 

And we will work as a partner in this process to assist the board 

in achieving the desired end result. 

This does not mean it will be easy or that everyone will always 

agree on all perspectives. But the public discussion is a good thing, 

and bring it to speedy resolution is even more important. I think 

by making the appropriate assurances of good faith on all sides, 

that we can do something good for homeownership as well as ensuring taxpayers they have no potential liabilities in these matters. 

Again, I thank you. I will ask unanimous consent to make a part 

of the official record, the addendum and reports that you cited in 

your testimony. 

I have documents that were forwarded from OFHEO, the 

OFHEO report itself, the blue book, and the letter of transmittal 

of November 12, 2003, to me, of the chart. And I think that is all 

of the remaining items that need to be officially made part of the 

record without objection. 

And let me express to all participants and my faithful comrades 

who stayed until 6:11 this evening. Thanks for your good work. 

Our meeting stands adjourned. 

Ms. WATERS. Thank you very much, Mr. Chairman. And may I—

I don’t know if I need unanimous consent request to make a request of you relative to our future work. 

I don’t know if you plan on having more hearings anytime soon, 

but my request would be that the responses that will be given by 

Fannie Mae to this investigation be put together, prepared in whatVerDate 0ct 09 2002 15:02 Feb 01, 2005 Jkt 000000 PO 00000 Frm 00149 Fmt 6633 Sfmt 6633 G:\DOCS\97754.TXT FIN1 PsN: MICAH
142

ever fashion they are going to be and that we use those same responses if we are going to have another hearing. 

My suggestion is that we not have a hearing until that is done 

so that we are all working from the same information. 

Chairman BAKER. By way of disclosure for all interested stakeholders, it would be my intent, at this time, to discuss probably 

over the recess, regulatory reform. I don’t know whether there 

would be a proposal introduced for discussion purposes, but it is 

not likely, in my view, that this committee would reconvene its 

work until the next Congress. 

With the hope, I think—the long hope for expectation that this 

Congress will leave town this weekend. If that, in fact, is the case, 

there would not be the prospect of an additional hearing. 

However, to acknowledge the gentlelady’s point, at such time as 

a hearing notice would be issued, I can assure you that any information the enterprise would choose to make part of that hearing 

process, we would certainly welcome. I would formally ask the 

chair of the independent board members on any report she would 

choose to provide to the committee, we would be happy to receive. 

And likewise, I am sure; there will be work of independent members during the course of the recess to get us fully prepared to consider whatever ramifications there are from the pending study or 

regulatory reform or any other issue a member might choose to 

bring before the committee. 

Ms. WATERS. Am I to understand that the Chairman is saying 

that you possibly will be working on regulatory reform based on 

the book that has been done by OHFEO already? 

Chairman BAKER. No. My view is I have been working on regulatory reform all my life. That effort would just continue into early 

next year. As you know, we had a proposal in this committee which 

was very close to being adopted and for whatever reason, did not 

get adopted. 

The Senate has moved the proposal out of Senate Banking Committee, which is now pending. It would be my hope that given—

let me take the side of the discussion from those who have been 

critical of Mr. Falcon and OFHEO. 

For those, it would appear it would be likely that you would support a different regulatory structure. For those of us who feel that 

enhanced oversight is good from a taxpayer perspective, they would 

support a new regulatory structure. 

I don’t know anybody today on the committee who expressed objection to the discussion of and passage of a new regulatory structure. So, given that, I think it is our duty to take that up early 

next year, and in the intervening months, anyone who has suggestions or recommendations, they should be made known and we can 

take them into consideration. 

Ms. WATERS. If I may, Mr. Chairman, I certainly agree that you 

have been working on regulatory reform for a long time and that 

the question of whether or not OFHEO was competent to do this 

certainly has been discussed in this committee. 

And some of us, who may have, at one time, supported OFHEO, 

may be with you on your proposed changes. And what you would 

like to do with the Treasury Department, I don’t know. 

143

But my real question is whether or not you anticipate working 

on regulatory reform that will respond to some of these allegations 

that have been surfaced by OFHEO, in the absence of the response 

that I think we just desperately need to have from Fannie Mae and 

they have not had the opportunity to present? 

That is my question. 

Chairman BAKER. I don’t see further action by this committee 

until additional information is provided from both perspectives. I 

think OFHEO would want the opportunity to respond to the testimony today from Fannie Mae, and it is evident that Fannie Mae 

would choose to give us more information—the board members as 

well—as to their findings and factual determinations of the 

OFHEO allegations. 

So, I think both sides are going to be providing members with 

a lot of information. I am trying to say to the gentlelady, we won’t 

act until there is something that validates acting. 

In the interim, we should be working on our regulatory proposal 

to bring ultimate closure to this whole chapter. 

Ms. WATERS. I think I understand that Mr. Chairman. I guess 

just to wrap this up, what I am really getting at is in the regulatory reform that you have been working on for a long time, we 

can reasonably anticipate what some of that is all about. 

But what I am not certain about is whether or not in that regulatory reform I would look in there and see specific references to 

this recent OFHEO investigation as it relates to accounting practices that are yet undecided. 

Chairman BAKER. That level of analysis would be relegated to 

the new regulator. I do not see the committee getting engaged in 

anything other than the principles of oversight. And as I have long 

said, an independent regulator properly funded with the real authority to assess the enterprise’s safety and soundness. 

That is it. It has always been the principles. And nothing beyond 

that need be in legislation, and I think there are any number of 

proposals I have had in prior sessions, which describe in generality 

what we would be considering, and those have no reference to the 

OFHEO analysis of today. 

Ms. WATERS. Thank you. 

Chairman BAKER. Mr. Scott? 

Mr. SCOTT. So, Mr. Chairman, just to make sure we are clear, 

there will be no movement whatsoever on any regulatory reform 

until we have this rebuttal process from both OFHEO and Fannie 

Mae to today’s hearings. 

Chairman BAKER. Not exactly. What I said was there will be no 

further action by this committee on this subject matter until conditions warrant action by this subcommittee. 

Assume, for the moment, if you wish to pursue this discussion 

that OFHEO comes back with another troubling report in the next 

2 days or the next 2 months. Certainly, the committee would want 

to receive that report and discuss the findings. 

I am not suggesting, however, we would move on a legislative 

proposal in the next 5 days. There is certainly not time to do so. 

It would likely be early next year; a reform proposal introduced, 

would go through due process, all members would be heard, and 

144

certainly the enterprises and all those who have a stake in this 

matter would be given ample opportunity to voice their opinion. 

I don’t know exactly the sensitivity that you and the gentlelady 

are addressing. There is not going to be anything introduced tomorrow that takes page 46 of this report and makes it a new regulation. If that is what you are after. 

Mr. SCOTT. You mentioned in the event that there may be another report, is there any indication or evidence on your part that 

OFHEO is contemplating or putting forward another report? 

Chairman BAKER. Oh, no. Let me make it clear one more time. 

I have no information that any other member does not have. I have 

had no phone calls from anybody. I asked the director in the public 

view today, ‘‘Mr. Director, what is your next step,’’ hoping that that 

would send the signal that whatever he told me, he was going to 

tell you. 

Mr. SCOTT. Right. 

Chairman BAKER. That is all I know. 

Mr. SCOTT. All right. 

Chairman BAKER. And when I know more, I will be happy to 

share it and, in the meantime, I hope I don’t see you all until January. 

Mr. SCOTT. Thank you. 

Chairman BAKER. If there is no further business for this committee, we stand adjourned. 

[Whereupon, at 6:19 p.m., the subcommittee was adjourned.] 

(145)

A P P E N D I X

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