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21–517 PDF 2005

S. HRG. 108–833

OVERSIGHT OF GOVERNMENT SPONSORED

ENTERPRISES’ ACCOUNTING PRACTICES

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

THE ROLE OF A FEDERAL FINANCIAL SAFETY AND SOUNDNESS REGULATOR, AN APPROACH TO EXAMINING ACCOUNTING PRACTICES, AND

CONTROLS OVER FINANCIAL REPORTING, EXECUTIVE COMPENSATION, CORPORATE GOVERNANCE, AND LEGISLATIVE ENHANCEMENTS

JULY 17, 2003

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

(

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

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

BRYAN N. CORBETT, Counsel

MARK A. CALABRIA, Senior Professional Staff Member

PEGGY R. KUHN, Senior Financial Economist

MARTIN J. GRUENBERG, Democratic Senior Counsel

JONATHAN MILLER, Democratic Professional Staff

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

THURSDAY, JULY 17, 2003

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Johnson ............................................................................................... 3

Senator Enzi ..................................................................................................... 4

Senator Schumer .............................................................................................. 5

Senator Bunning ............................................................................................... 6

Senator Sarbanes .............................................................................................. 6

Senator Sununu ................................................................................................ 8

Senator Dole ...................................................................................................... 9

Senator Hagel ................................................................................................... 9

Prepared statement ................................................................................... 41

Senator Corzine ................................................................................................ 10

Prepared statement ................................................................................... 41

Senator Stabenow ............................................................................................. 24

Prepared statement ................................................................................... 42

Senator Reed ..................................................................................................... 28

Prepared statement ................................................................................... 43

WITNESS

Armando Falcon, Jr., Director, Office of Federal Housing Enterprise Oversight, Washington, DC ......................................................................................... 11

Prepared statement .......................................................................................... 43

Response to written questions of:

Senator Bunning ....................................................................................... 87

Senator Dole .............................................................................................. 87

Senator Reed .............................................................................................. 96

(III)

(1)

OVERSIGHT OF GOVERNMENT SPONSORED

ENTERPRISE ACCOUNTING PRACTICES

THURSDAY, JULY 17, 2003

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS,

Washington, DC.

The Committee met at 10:02 a.m., in room SD–538, Dirksen Senate Office Building, Senator Richard C. Shelby (Chairman of the

Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

I would like to welcome today’s witness, Mr. Armando Falcon,

the Director of OFHEO. Freddie Mac and Fannie Mae play an integral role in the national housing market. Through their financing

activities in the secondary mortgage market, the Enterprises bring

capital market liquidity to our housing markets and have contributed to the unprecedented rate of homeownership in the United

States, with relatively low mortgage interest rates.

As the number of homeowners has grown, so have the Enterprises. Collectively, Fannie Mae and Freddie Mac carry an astronomical $1.6 trillion in assets on their balance sheets and have outstanding debt of almost $1.5 trillion. Much of this debt is held by

banks, and more than 80 bond funds have invested at least half of

their assets in the Enterprises’ debt. In addition, the Enterprises

hold about 45 percent of the total outstanding residential debt.

The investment demand for the Enterprises’ debt is attributable

in part to Fannie Mae and Freddie Mac’s status as Government

Sponsored Enterprises. As such, the Enterprises receive a number

of statutory benefits, including an exemption from State and local

taxes and certain regulatory requirements and the availability of a

line of credit with the U.S. Treasury.

Because of these benefits, Wall Street has assumed the Federal

Government implicitly guarantees the Enterprises’ debt and treats

the Enterprises’ debt as a near equivalent to Treasury notes. The

market belief in this implied guarantee continues, despite explicit

disavowals from the Enterprises and also the Federal Government.

As the Enterprises grew their balance sheets and developed a

more prominent role in the national housing market, Congress created OFHEO in 1992 to regulate the safety and soundness of the

Enterprises. OFHEO has created an examination program that

analyzes, among other factors, the Enterprises’ capital reserves,

risk portfolio, risk management, and corporate governance.

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Effective oversight of the Enterprises’ management and operations is needed to maintain the market’s confidence in the fiscal

health of the Enterprises and the continued growth of the secondary mortgage market.

On June 4, 2003, OFHEO delivered its annual report to Congress

and declared that its, ‘‘examinations found both enterprises’’—that

is, Fannie mae and Freddie Mac—‘‘to be financially sound and

well-managed.’’

While this report noted the ongoing restatement of Freddie Mac’s

financial statements, OFHEO declared that the ‘‘audit functions of

Freddie Mac are independent and effective.’’

OFHEO also stated in the report that it ‘‘remains satisfied’’ that

Freddie’s board of directors and executive management are taking

the appropriate action to address the accounting problems. This report did not discuss the scope of the accounting problems at

Freddie Mac or any imminent management changes.

Despite OFHEO’s positive pronouncement regarding Freddie

Mac’s audit functions, we have come to learn about troubling

events and issues surrounding Freddie Mac’s accounting policies

and practices.

Although the proper application of Financial Accounting Standard 133 to Freddie Mac’s derivatives portfolio appears to remain

the primary reason for the restatement, the press release on June

25 clarified that the accounting problems extend beyond the interpretation of an accounting rule. Baker Botts, a law firm, reported

that Freddie Mac lacked sufficient accounting expertise and adequate internal controls and management. As a result, Freddie Mac

personnel made numerous errors in applying the general accepted

accounting principles.

In addition, Baker Botts noted that Freddie Mac knowingly executed certain non-GAAP transactions and accounting policies in

order to ‘‘smooth’’ its earnings. I am concerned that Baker Botts reported that Freddie Mac lacked sufficient accounting expertise and

adequate internal controls only a few weeks after OFHEO declared

that Freddie Mac has effective audit functions.

In light of these events, I think it is important for the Banking

Committee to take a critical and deliberative look at OFHEO’s

oversight of the Enterprises. Although we do not yet have the final

conclusions of the ongoing investigations—that will be several

months—we do have sufficient information to examine OFHEO’s

role in the process.

I believe that it is time to analyze the scope and sufficiency of

OFHEO’s regulatory authority over the Enterprises. The public

must have confidence that OFHEO has the necessary authority

and resources to effectively regulate the Enterprises.

To date, Freddie Mac has been cooperative with the Committee

staff. I would expect nothing less and assume that this will continue to be the case. While I will refrain from judgment until the

various investigations are completed, I expect complete cooperation

with the Committee.

In due course, I believe the public must come to understand the

full breadth of the accounting errors and management decisions

that were made at Freddie Mac. I suspect that upon the completion

of the various investigations into the circumstances surrounding

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Freddie Mac’s restatement, this Committee will hold hearings to

review the findings and the conclusions. I look forward to hearing

Director Falcon’s testimony on this subject today.

Senator Johnson.

STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. I want to thank Chairman Shelby and Ranking Member Sarbanes for convening this oversight hearing on how

the accounting practices at Government Sponsored Enterprises are

regulated. I welcome Mr. Falcon here today.

No doubt the recent accounting problems and the subsequent

personnel changes at Freddie Mac have rightfully come under scrutiny by the Office of Federal Housing Enterprise Oversight. Today’s

focus is not on the details of that review but, rather, on whether

the current regulatory structure has lived up to expectations.

I believe that we in Congress need to take a measured approach

on how we proceed in this matter, and it is vital that we not politicize the ongoing review.

That said, I applaud you, Mr. Chairman, for inviting Mr. Falcon,

the Director of OFHEO, to give the Committee an overview of the

regulatory structure in place to oversee accounting practices at the

GSE’s. Earlier this week, Mr. Falcon requested fiscal year 2003

supplemental appropriations to help complete the OFHEO review

of Freddie Mac and to embark on a review of Fannie Mae’s accounting as well. As a Member of both the Authorizing Committee

and the Appropriations Committee, I am committed to ensuring

that OFHEO has the necessary resources and tools to complete a

thorough review and report its findings to Congress in a timely

manner.

The OFHEO report will be an important reference for us as this

Committee considers whether legislative action is needed to restore

confidence in the regulatory structure of the GSE’s. However, it is

critical that we have full information before taking any drastic

steps that could roil the housing markets.

Low interest rates and strong housing markets have played a

major role in keeping our otherwise sluggish economy afloat. We,

in Congress, need to be ever mindful of the importance our housing

markets play in all aspects of our economy. Homeownership is one

of America’s great success stories. Homeownership has become essentially a prerequisite for entrance to middle-class prosperity in

America. Combined, Freddie Mac and Fannie Mae have helped

more than 75 million American families buy homes. Any knee-jerk

reactions on the part of OFHEO or Congress could have unintended negative implications for our economy and for millions of

Americans who have realized the financial and social benefits of

homeownership.

Clearly, Congress will need to take a close look at the accounting

practices that led to the current problems at Freddie Mac, including the role of OFHEO in overseeing such accounting. We also need

to take a close look at whether OFHEO has policies in place to determine whether the GSE’s have appropriate internal controls and

expertise to evaluate when advice they receive from an external

auditor may be wrong, especially with respect to complex financial

transactions.

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Mr. Chairman, at 10:30, I have an Appropriations Committee

markup on four very important appropriations bills, and I will excuse myself at that time. I look forward to Mr. Falcon’s testimony,

and I look forward to working with you and Ranking Member Sarbanes to see to it that we do justice to this very important issue.

Chairman SHELBY. Senator Enzi.

STATEMENT OF SENATOR MICHAEL B. ENZI

Senator ENZI. Thank you, Mr. Chairman.

Today, we will be learning about a situation that appears to be

very similar to the types of situations that prompted us last year

to pass the Sarbanes-Oxley Act. However, there are significant differences in this situation that warrant us to take a step back so

that we can thoroughly understand the facts before taking any action, if action is necessary.

Our discussion here today should not be limited to the financial

accounting of certain derivatives transactions, but should include

an in-depth discussion as to whether sufficient regulatory oversight

was present to comprehend those transactions.

Just yesterday, Chairman Greenspan spoke at length about how

financial derivatives have greatly enhanced our Nation’s economy.

Many types of financial entities use derivatives to provide greater

stability to their balance sheets. This is especially important for

the housing industry and, in particular, for Government Sponsored

Enterprises.

As an accountant, I understand and appreciate the need to have

appropriate accounting standards that accurately reflect the balance sheet of the company. With respect to accounting for derivatives, Financial Accounting Statement 133 extensively details how

companies account for derivatives transactions.

I will be very interested to see the final reports of investigation

underway by the Office of Federal Housing Enterprise Oversight

and the Securities and Exchange Commission, as well as the final

report of the outside independent investigator hired by Freddie

Mac. These reports will give us a greater understanding of the true

nature of the circumstances surrounding the restatement of

Freddie Mac’s financial statements.

With respect as to whether there was sufficient regulatory oversight on this matter, I am not convinced that there was. While the

Office of Federal Housing Enterprise Oversight claims that it was

on top of the situation at each step of that process, it presents a

less than compelling argument for its case. It was not too long ago

that the Agency requested and received monies to hire additional

staff. At that time the Agency clearly understood that it had sole

responsibility to oversee the complex financial instruments used by

the Government Sponsored Enterprises. It appears that the regulator placed too much reliance upon the financial statements prepared by Arthur Andersen without having sufficient checks and

balances to review and comprehend the financial statements.

I would greatly appreciate an explanation of how OFHEO is

using the new employees it had been authorized to hire. Just days

ago, the Director of OFHEO wrote to the Senate and House appropriators claiming the need for $4.5 million in additional funds to

support the special investigation of Freddie Mac and to commence

5

a new review of Fannie Mae’s financial statements. I am very troubled by this action as it indicates a significant weakness in the

Agency’s ability to accomplish its statutory mission. While I fully

support providing the means necessary to help a Federal agency

fulfill its mission, as we did with the Securities and Exchange

Commission, I do not believe that we have been given sufficient information on how this agency is performing and whether new monies are justified.

Mr. Chairman, I thank you for holding this hearing.

Chairman SHELBY. Senator Schumer.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman. I want to thank

you again for holding this series of timely hearings on so many of

the subjects we hear about. This one is particulary important.

The recent disclosure of the Freddie Mac auditing problems has

put back on the front burner the issue of the regulation of Fannie

and Freddie and even the structure of Fannie and Freddie. And I

guess we have three general options to consider:

One is to make Fannie and Freddie just completely free market

enterprises. I would very much oppose that. I think the blend of

private sector strength, knowledge, acumen, and agility and the

Federal Government’s social responsibility, ability to fill in the

cracks where the market just does not do a job—no one since Adam

Smith believes that markets are perfect. I believe the public-private blend is the right way to go, and those who want to make

Fannie and Freddie private I think miss that boat. If we can make

them private, we can let private sector people do some of those

functions and compete, and they can do it well.

The second is to leave things as they are regulatorily. If you are

not going to restructure the public-private blend, what do you do

regulatorily? And I think here, I, at least, Mr. Falcon, have some

real doubts about OFHEO’s ability to monitor safety and soundness. These are extremely complicated areas, and at least thus far,

the track record is not terribly good.

So there is a third option, which is to take at least the safety and

soundness aspects of the monitoring of Fannie and Freddie, which

have become more and more important as Fannie and Freddie get

bigger, and maybe even the whole responsibility of Fannie and

Freddie and move it to Treasury. And that to me, at least on its

surface, certainly needs exploration, but it makes some sense.

I think the Government should and can play a role in housing

markets. I think Fannie and Freddie have done a very commendable job expanding homeownership in America. I have found in my

State, as I said, when there are particular needs, Fannie and

Freddie move into the gap, which private sector companies would

not do. It is the benefit they gain from some association with the

Federal Government that importunes them to do these things.

But in terms of just the quickness, speed, and complexity of the

new products that Fannie and Freddie are putting out, it seems to

me that in that area, which has effects on our entire financial system, Treasury is the most logical place to oversee these. And so

that is something that I think we should explore, and when the

question period comes up, Mr. Chairman, I will be asking Mr. FalVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
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con why that shouldn’t be done. It seems to me the burden has

switched with the recent changes or with the recent things that we

have seen.

So, I thank you again for holding this hearing and hope we can

really begin actively exploring how we can make Fannie and

Freddie—and I think they are very good—make them even better.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman. I would like to

thank you also for holding this very timely and important hearing

today. I would like to thank Director Falcon for testifying.

Like my colleagues, I am very concerned about what has happened with Freddie Mac. It is very disconcerting that 3 days before

Freddie’s restatement, OFHEO put out a glowing report on

Freddie. Then after the ouster of Freddie’s executives, OFHEO put

out a letter calling Freddie’s situation a crisis and have asked for

a supplemental appropriation to hire more accountants.

Obviously, everything was not okay when OFHEO put out its report. I read in The Wall Street Journal today that Baker Botts, who

did the investigation of Freddie’s accounting, disputes your prepared testimony. They say they were fully candid with OFHEO.

They even go as far as saying the charge in your testimony was

‘‘a cheap shot and perhaps reflects the advice Director Falcon is

getting from his staff.’’ That is a very disturbing charge.

I also am concerned about the bill language that was sent up.

Some of our friends in the House of Representatives have been

stating that they believe Fannie and Freddie do not have an effective regulator. They would like to have the Department of the

Treasury, like my good friend from New York has suggested, to

regulate the GSE’s.

Receiving major legislation like we have and requests for supplemental appropriations to hire more accounts so you can do your job

give those friends of ours a lot of heavy ammunition.

Director Falcon, I have known you since you worked for Henry

Gonzalez on the House Banking Committee. I know how long you

have been in public service, and I thank you for that service. But

I do not think this will be the most pleasant hearing you have ever

been to.

I also think the man who will follow you will also have a very

tough hearing, largely because of what has happened since January.

Once again, Mr. Chairman, thank you for holding the hearing.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. This is

a very timely and important hearing. I should note that housing

continues to be a bright spot in an otherwise sluggish economy.

This is because home equity has been a large and continuing

source of funding to fuel consumer demand.

One important reason this has been possible is that the United

States has the deepest, most liquid housing capital markets in the

world. Fannie Mae and Freddie Mac are at the heart of that sysVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
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tem—companies that helped to bring $2.5 trillion to finance millions of homes here in America last year. It is very important to

understand that we are dealing with a major sector of our economy

and we have to be ever mindful of how what we do well impact

upon it.

To address the system’s safety and soundness, Congress created

the Office of Federal Housing Enterprise Oversight, OFHEO. And

our job here, of course, is to make sure that OFHEO has the tools

to do its work, and to make sure that it pursues its work vigorously

and effectively. Fannie Mae and Freddie Mac have assets of about $1.6 trillion,

nearly double the level they had in 1997. Their retained portfolios

are valued at about $1.4 trillion. Together, the two companies have

outstanding debt equal to about $1.5 trillion, and they have derivatives with a combined notional value of over $1.5 trillion. The size

and complexity of these two companies and the central role housing

plays in our economy makes it all that much more important to ensure that OFHEO has the kind of funding and sophistication it

needs to do a good job.

It is in this light that I believe we need to ask whether OFHEO

was sufficiently knowledgeable about the accounting problems as

well as the internal control problems at Freddie Mac. We need to

explore whether or not OFHEO took the appropriate action to address these problems, and whether or not it did so in a timely manner. Finally, we should consider whether or not we have given the

regulator the tools it needs to do an effective job.

I should note that Mr. Falcon has been seeking independent

funding over the last few years for OFHEO, parallel to what some

financial regulatory agencies have available to them. This is a suggestion that has been made by a number of people for improving

the regulatory structure for Fannie and Freddie.

I believe as we explore these questions about the activities of

OFHEO, we should acknowledge that some amount of progress has

been made in the nearly 3 years that Mr. Falcon has served as its

Director.

He has, for example, guided the Agency to the completion of the

risk-based capital rule that was many, many years overdue. In

doing so, he resisted considerable pressure to adopt a process

whereby the regulator would set the parameters of the risk-based

capital stress test, but the institutions themselves would develop

and run the actual model. We need to remember the dynamics that

existed in the not too distant past. I believe OFHEO’s decision to

move forward with its own model has contributed to the fact that

the current concerns about Freddie Mac have not, at least to this

point, led to questions about the safety and soundness of that company.

This is a point worth emphasizing. The concerns that have led

to this hearing today relate to the accounting for derivatives at

Freddie Mac. But the economic effectiveness of those derivatives as

hedges against risk have not at yet been put into question.

Finally, Mr. Chairman, as we examine OFHEO’s efforts, I want

to raise a concern I have about the effectiveness of the Federal

Housing Finance Board. It appears that the Finance Board is seeking to reconfigure the membership and expand the powers of the

8

Federal Home Loan Bank System; without regard to its statutory

authority and without regard to the significantly increased risk its

proposed action would bring to the Home Loan Bank System.

As former Bush Administration official, Assistant Secretary of

the Treasury Sheila Bair said, ‘‘The Federal Home Loan Bank System is taking risks for which it is not prepared and inviting scrutiny and controversy by forging ahead with activities that far exceed its Congressional charter and with which it has had no historic experience or expertise.’’

Mr. Chairman, I hope at some time in the near future we might

have an opportunity to examine this issue.

In closing, I want to commend Chairman Shelby for his reasoned

approach to the serious problems that have come to light at

Freddie Mac. There are a number of investigations ongoing by a

number of agencies—OFHEO, the SEC, the Board of Directors of

Freddie Mac itself, and others. And, Mr. Chairman, I think it is

prudent to first spend some time gathering the facts before coming

to the conclusions about what action might or might not be appropriate. And I am pleased to join with you in that effort.

Thank you.

Chairman SHELBY. Senator Sununu.

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman.

Welcome, Mr. Falcon, and to the extent that you might be taking

consolation in the impending grilling of Mr. Brickell, I note that I

think his confirmation hearing is next week, so you might keep

that in the back of your mind.

This is an important hearing, and I thank the Chairman for setting the time. There are two broad sets of issues that I hope the

Committee is able to spend time on in this and any subsequent

hearings dealing with these issues, these two broad issues that I

hope you will touch on in your testimony.

The first is simply the needs and capabilities of OFHEO. It is

something you have spoken about at length before, not just to this

Committee but to Appropriations Subcommittees as well, and I

know it is important to you and it has taken up the focus of your

time over the years. But it is important that we review those needs

and capabilities given the current situation of personnel needs, financial needs, and the expertise, both for accomplishing your ongoing mission, which has been the regulator of the GSE’s, but also

with respect to the current accounting crisis, the accounting problems at Freddie Mac. We want to understand as deeply as possible—I certainly want to understand—the extent to which OFHEO

has been properly equipped, is properly equipped, and that any

changes in your organization or the resources and the needs of

your organization are going to address the problems at hand and

be effective at dealing with these problems.

The second set of issues is really looking a little further forward

with some of the comments that Senator Schumer and Senator Sarbanes made, which is the role of OFHEO and the relationship

OFHEO has to other regulators. The Federal Housing Finance

Board was mentioned. We have the Office of Thrift Supervision,

the OCC, and the Federal Reserve. Obviously, all of these organizaVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
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tions are involved in regulating financial services. All of them will

touch on some of the same concerns and needs in industry that

OFHEO has dealt with in the past. And I think it is important that

this Committee begin to assess the relative strengths and weaknesses of these different financial regulators. That is obviously

what the legislation Senator Bunning mentioned is trying to do. It

has been put forward in the House. An argument is being made

that we need to look at the organization of these regulatory bodies

and at least consider changes in them in order to make them

stronger. I would assume everyone, whether you are for or against

the changes, the goal should be to make them as strong as possible

and enable them to do their job.

We also want to make sure that these organizations and agencies

are cooperating. I know you are looking into the accounting problems at Freddie Mac. The SEC is also looking into the accounting

problems at Freddie Mac, and I am sure that the U.S. Attorney’s

office is as well. No matter who the enforcement or regulatory body

is, we want to make sure that in an important investigation like

this there is cooperation and, finally, that this alphabet soup of different regulators is not resulting in unnecessary duplication because that will limit the effectiveness of these organizations and

perhaps create unintended consequences and a failure of the ability

to do a good job or the allowance that Senator Sarbanes was talking about, the allowance of organizations to take on more risk than

they are appropriately suited to do.

So, I hope that we can address both of these issues in the hearing, and I very much look forward to your testimony. Thank you

for being here.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dole.

COMMENTS OF SENATOR ELIZABETH DOLE

Senator DOLE. Mr. Chairman, in the interest of time, I will submit my opening statement for the record.

Chairman SHELBY. Without objection, so ordered.

Senator Hagel.

STATEMENT OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you. And, Director Falcon,

thank you for coming before the Committee this morning.

I, too, have a statement, Mr. Chairman, that I will submit for the

record.

Chairman SHELBY. Without objection, it will be put in the record.

Senator HAGEL. Thank you.

I have, as you know, and as does Senator Sarbanes, for the last

7 years on this Committee, been concerned about these issues as

I have listened to my colleagues this morning talk about oversight

responsibilities. Are we moving away from the original missions of

these GSE’s? Are they getting into troubled waters? And, obviously,

we have a number of questions here that we are going to ask you

that directly relate to troubled waters, specifically Freddie Mac.

And I understand you will be also looking at Fannie Mae here

shortly, if you are not already.

10

We need to take a long, broad, deep look, not just at your organization but I think all the GSE’s. And I have suggested that over

the years to the Chairman and to Mr. Sarbanes. So, I welcome Senator Sarbanes’ thoughts, others, and I will, like all on this Committee, look forward to your testimony.

I would say also that what Senator Sununu has suggested and

also our colleague from New York I think makes some sense, and

next week, Mr. Chairman, Senators Sununu, and Dole and I will

introduce legislation, very much patterned after the House legislation, to move OFHEO out of HUD into Treasury, along with a

number of other dynamics that we think would strengthen your organization, institution, do the things that you, Mr. Director, have

asked for which make some sense to deal with this.

Confidence is the coin of the realm in this business, and you

know that clearly. And before we try and hang too much on you

or your organization, we need to look at the institutional problems

and the structural deficiencies that exist, partly because we have

not kept up with the new challenges and the expanded focus that

these GSE’s have brought to themselves. And I do not think this

Committee and other Committees over the years have paid much

attention to it. So, we appreciate you coming before us. We appreciate what you and your team are doing. And we want to help you

do your job.

With that, Mr. Chairman, I look forward to hearing the Director’s comments.

Chairman SHELBY. Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman. I join my colleagues

in thanking you on having this hearing. I think this is an absolutely essential oversight function that we need to perform with regard to the GSE’s. I hope that we do not lose track of how important, while we are going to through this process, the GSE’s are to

the provision of liquidity and support for the housing market,

which is one of the most effective in anyone’s conception of the beginning and institution of these institutions.

I have a full statement for the record.

Chairman SHELBY. Without objection, it will be made part of the

record.

Senator CORZINE. And I will save my remarks for the questions.

Chairman SHELBY. Mr. Falcon, your written statement will be

made part of the record in its entirety. You proceed as you wish.

STATEMENT OF ARMANDO FALCON, JR.

DIRECTOR, OFFICE OF FEDERAL HOUSING

ENTERPRISE OVERSIGHT

Mr. FALCON. Thank you, Mr. Chairman. I will try to summarize

my statement, but there is much to cover so I hope you will allow

me to go beyond the normal time frames.

Chairman SHELBY. Go ahead.

Mr. FALCON. Mr. Chairman, Ranking Member Sarbanes, and

Members of the Committee, I appreciate the opportunity to appear

before you. My testimony today will focus on the circumstances

11

leading up the Freddie Mac restatement effort and OFHEO’s role

as a safety and soundness regulator.

By the way, thank you, Mr. Chairman and Ranking Member Sarbanes, for the very responsible and judicious manner in which the

Committee has handled this matter. I also want to assure you of

OFHEO’s full cooperation as the Committee proceeds with its own

oversight of this matter. Given our ongoing investigation, I ask for

the Committee’s understanding if I am restrained in my testimony

as facts are still being verified and circumstances evaluated.

On January 22, 2003, Freddie Mac announced it would reaudit

and restate its financial statements for 2000 and 2001. The company also announced that its external auditor would delay certification of Freddie’s year-end 2002 financial statements until the restatement process was complete. Five months later, on June 6, the

board removed the company’s top three officers. OFHEO, the SEC,

and a U.S. Attorney have ongoing investigations of the company

and its accounting practices. These extraordinary actions reflect

the culmination of developments over several years, during which

time OFHEO has fulfilled its safety and soundness mission. I will

begin by describing the major developments in chronological order.

The sequence of events begins in 1999 with preparation for implementation of FAS 133. FAS 133 is not the only accounting rule

involved in this matter, but it plays the most important role.

FAS 133 requires an entity to recognize all derivatives as either

assets or liabilities and reflect those instruments at fair value in

the financial statements.

In 1999 and 2000, OFHEO’s examiners assessed the development

and implementation of Freddie Mac’s plans with respect to several

new significant accounting standards, including FAS 133. That assessment led us and Freddie Mac to the conclusion that the company needed to strengthen its accounting expertise and financial

reporting internal controls. Freddie Mac addressed these issues

with the adoption of the Financial Reporting Controls Improvement

Plan in late 2000. The goal of the FRCIP was to achieve the same

level of controls in the financial accounting and financial reporting

area that were present across the other areas of the company and

in the operating business units.

In the fourth quarter of 2000 and in the first quarter of 2001,

Freddie Mac entered into several FAS 133 transition transactions.

PricewaterhouseCoopers would later identify these transactions as

being inconsistent with GAAP and in need of correction before the

2002 financial statements could be certified. Thus, the problem we

address today began in 2000.

As 2001 began, FAS 133 took effect. Arthur Andersen certified

each quarter’s financial statements under the new FAS 133 pronouncement as GAAP compliant. Strengthening expertise and reducing the reliance on manual systems were important aspects of

the Improvement Plan introduced in 2000, and in 2001 OFHEO’s

examiners continued to evaluate the progress of the company

against this remediation plan. We continued to press management

to ensure progress continued in implementing the plan. By May

2001, approximately one-third of the plan had been completed.

During this period, OFHEO planned enhancements for its examination program. In 2000, I decided to create an examination team

12

dedicated to accounting matters. In January 2001, we designed a

comprehensive plan to enhance OFHEO’s examination program,

which included such an accounting team. A cornerstone of that

plan was to more than double the size of the examination staff,

adding depth and additional specialized skill sets. A portion of the

funding was first received in 2002.

Late in 2001, Arthur Andersen was under public scrutiny because of its role as the audit firm in a number of high-profile Federal investigations. Given these developments, Freddie Mac’s Board

of Directors considered whether they should keep Arthur Andersen

or select a new independent accounting firm. Freddie Mac solicited

OFHEO’s views concerning the retention of Arthur Andersen.

OFHEO opined that, given the circumstances, retention of the firm

created a higher-risk situation for Freddie Mac.

On March 6, 2002, the audit committee chose PwC as Freddie

Mac’s independent public accountants for the year 2002.

I should note that up to this point, the audit opinions of Arthur

Andersen on the consolidated financial statements of Freddie Mac

for 2000 and 2001 did not contain any adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope, or accounting principles. As it had done for

years, Arthur Andersen certified the financial statements of

Freddie Mac as having been prepared in accordance with GAAP.

PwC began its audit engagement immediately after being selected by the audit committee. In the course of its audit, PwC initiated a process of identifying various accounting policies and accounting issues to be discussed with Freddie Mac’s management.

In July 2002, PwC identified the allowance for loan and lease

losses as a critical accounting matter that needed to be resolved before it would certify Freddie Mac’s 2002 financial statements.

OFHEO was actively involved in these discussions.

PwC felt that Freddie Mac was too conservative in its loss estimates and coverage to be consistent with GAAP. Freddie Mac

agreed to reduce the reserve by $246 million, whereupon PwC certified the second quarter financial statements.

Accounting policies and issues continued to be addressed by

PwC, management, and the board throughout 2002. Progress appeared on track for the certification of fiscal year 2002 financial

statements.

OFHEO continued to evaluate and monitor the status of the accounting policies under discussion between PwC and Freddie Mac.

Examiners continued in 2002 to evaluate progress on the Improvement Plan at least quarterly.

I will move to 2003 now. In mid-January 2003, PwC informed the

audit committee that they would be meeting with representatives

of PwC’s national office about unresolved policy matters in connection with certification of Freddie Mac’s financial statements. On

Monday, January 20, 2003, PwC notified the audit committee that

they were uncomfortable with certain accounting treatments applied during the FAS 133 transition, and that until its concerns

were resolved, they would not be able to certify the company’s 2002

financial statements using the accounting policies from prior periods. Even though the policies had been approved by Arthur Andersen, PwC considered that they were not GAAP compliant. OFHEO

13

was made aware of these developments that very day and met with

Freddie Mac officials the following day.

Arthur Andersen was no longer an operating firm at this point.

Thus PwC could not undertake a normal transition pursuant to the

AICPA guidance for successor accountants. Instead PwC would

have to undertake additional substantive testing. The Board of Directors of Freddie Mac decided that PwC should conduct a reaudit

and restatement of the prior period financial statements.

The net cumulative effect of the new accounting treatments was

an increase in income in prior periods, thus increasing the amount

of capital on a cumulative basis. Further, OFHEO, PwC, and the

audit committee considered the effects of the accounting policy

changes on the fair value statements of Freddie Mac. All the parties involved concluded that there was no meaningful impact on the

fair value statements. This meant the underlying economics for

Freddie Mac’s positions were materially unaffected by the timing

changes in recognizing income under GAAP.

During this time, examiners were on-site at Freddie Mac gathering more information about the issues and the action plan that

was being developed in connection with the reaudit. Freddie Mac

announced the reaudit on January 22, 2003, and that there would

be a delay in the publication of 2002 certified financial statements.

With the restatement, it was clear that a forensic review of the

accounting issues raised by PwC would be appropriate. The law

firm of Baker Botts was retained by the audit committee to perform this task. OFHEO’s accounting team began continuous surveillance of the restatement process on January 22, 2003.

In May, OFHEO observed slippage in the restatement process

against established time lines. Since January 2003, PwC and

Freddie Mac have had more than 500 people working on the process 6 days a week. There was considerable work that needed to be

done between production of statements and producing the tables

and disclosures to accompany those statements. On May 8, PwC informed the senior board members and counsel that PwC would not

accept the representations of CFO Vaughn Clarke and President

David Glenn and the reasons therefore.

On May 27, OFHEO was briefed on the Baker Botts work for the

audit committee. In response to a question from OFHEO, Baker

Botts expressed no concern regarding inappropriate or improper behavior by management. Subsequent to this meeting, OFHEO

learned the very troubling information regarding the conduct and

integrity of management and matters related to the restatement

process, indicating the board’s counsel had not been fully forthcoming. This lack of candor contributed to my decision on June 7

to initiate an OFHEO investigation rather than wait for the Baker

Botts report.

Mr. Chairman, I will begin a discussion of the key events from

June 4 to June 7 that have drawn so much attention. First, I would

note that the Freddie Mac Board of Directors was holding a regularly scheduled meeting on Thursday, June 5 and Friday, June 6.

On Wednesday, June 4, David Glenn met with the board’s outside law firm, Baker Botts, and informed them that he had altered

and, in some cases, could not produce pages from a notebook that

had been requested by the company. That evening, counsel from

14

Baker Botts informed the lead outside Director of Mr. Glenn’s confession.

On Thursday, June 5, Freddie Mac’s Board was informed of Mr.

Glenn’s admissions and determined that action was required. The

morning of June 5 OFHEO was informed that Freddie Mac’s Board

wanted an urgent discussion with us when the board concluded its

deliberations. The board’s deliberations continued into the next

day, Friday, June 6.

On June 6, during the day, the board made a decision to separate

from the firm Messrs. Brendsel, Glenn, and Clarke, and on the appointment of Messrs. O’Malley, Parseghian, Petersen, and

Baumann. The board communicated to OFHEO immediately on the

actions regarding the management changes. Later in the day on

June 6, I was informed about the circumstances surrounding Mr.

Glenn’s termination. I instructed counsel to the board to appear at

OFHEO’s offices on Saturday, June 7, and report to us on all matters surrounding the management changes.

On the morning of June 7, OFHEO senior staff and I met with

representatives of Freddie Mac’s Board to learn the details of recent events. I would note that much of what was addressed that

day was known to OFHEO and had been subject to the restatement

process. However, new information relating to Mr. Glenn’s actions

and the termination and the replacement of senior management

was given to us for the first time. I was particularly displeased to

learn about the lack of confidence in Mr. Glenn expressed a month

earlier to Freddie Mac by PwC. I considered the disclosures regarding Mr. Glenn to be a clear signal of a breakdown in the integrity

of Freddie Mac’s control environment at the highest levels, and

sent the letter to the board that day, initiating an OFHEO investigation and taking additional steps.

Having discussed our specific regulatory role over the restatement process at Freddie Mac, I would now like to put it in a more

general context. First, the role of a financial safety and soundness

regulator, and second and more specifically, the Agency’s regulatory approach in examining accounting practices and controls.

OFHEO uses a safety and soundness approach in supervising the

Enterprises that is analogous to the Federal Reserve System’s and

the Office of the Comptroller of the Currency’s approach to supervising large-and-complex banking organizations. The foundation of

these approaches is that the management of these firms should be

held responsible for monitoring and managing the institution’s

exposure to risk. By looking at the firm’s risk management procedures and internal controls, the safety and soundness regulator assesses whether the firm’s ability to manage risk matches the level

of risk it assumes. In addition, the supervisory process also reviews

the firm’s performance in complying with the company’s own internal policies as well as other prescriptive requirements.

In short, safety and soundness supervision is directed toward

identifying material problems or emerging problems and seeing

that they are appropriately corrected and the company’s financial

solvency is not threatened. Safety and soundness regulators do not

review accounting policies for conformance with GAAP, nor do we

certify that the company’s financial statements are consistent with

GAAP. We require an independent auditor to certify that a comVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00018 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
15

pany’s financial statements are in conformance with GAAP. We review transactions to ensure that they are consistent with sound

risk management. The work of the independent auditor is to conduct its audit and report on the company’s annual financial statements.

In regards to executive compensation, I wrote to the board of directors on June 7, 2003, indicating that it must explain its rationale for any termination packages for Messrs. Brendsel, Glenn, and

Clarke. Further, I directed the board to inform these individuals

that their termination packages are subject to OFHEO review and

approval, and for any employee discharged for misconduct, that

OFHEO could direct indemnification of Freddie Mac for losses incurred. We directed Freddie Mac not to transfer funds, stock, or options to these three individuals, and Freddie Mac is complying.

Turning now to the OFHEO report to Congress. We reported that

Freddie Mac’s overall internal control framework and the management of the internal control framework are effective. We stated,

however, that Freddie Mac’s release of audited financial statements

was being delayed pending a reaudit of past financial statements,

and that Freddie Mac had agreed that certain accounting treatments applied in the past were incorrect. We informed Congress at

that time of our opinion regarding the reaudit. We further advised

Congress that Freddie Mac’s Board of Directors had undertaken efforts to enhance expertise and controls in the area of financial accounting and operational control, that we had evaluated the board’s

and management’s plans in that regard and that we were satisfied

that these actions were appropriate steps to address the situation.

In my view, these statements clearly indicate that although the

overall framework is effective, OFHEO is ensuring that the board

and management devote serious attention and remedial efforts to

the area of financial reporting and related controls. OFHEO activities in this regard are highlighted in my earlier testimony.

Finally, Mr. Chairman, I would like to bring to the Committee’s

attention an urgent funding matter. Earlier this week, I submitted

a fiscal year 2003 Supplemental Funding Request of $4.5 million

to the Senate and House Appropriations Committees. The requested funds will support two critical objectives. First, the funds

will support the ongoing special investigation of Freddie Mac, and

the investigation is already well under way and is building on information gathered over the course of the restatement process. Second, OFHEO intends to conduct a special accounting review of

Fannie Mae. The special review would independently evaluate the

accounting policies at Fannie Mae and examine whether their implementation is resulting in a high-level of conformance with

GAAP. While I do not have a specific concern about Fannie Mae’s

accounting practices, such a review would be most prudent under

the circumstances.

Mr. Chairman, I know this is an oversight hearing and not a legislative hearing, so if and when the Committee decides to consider

legislation in this area, I have attached some recommendations for

your consideration.

In summary, Mr. Chairman, is this a serious matter? Yes. Is

there a crisis? No. While challenges lie ahead, Freddie Mac remains safe and sound. At the end of our investigation we will

16

present all the facts, conclusions, and recommendations for the

Committee’s consideration.

Mr. Chairman, thank you for the opportunity to testify, and I

would be pleased to answer any questions the Committee may

have.

Chairman SHELBY. Thank you. Mr. Falcon, Freddie Mac has reported that it expects the reaudit to increase its earnings for 2000

through 2002 by $1.5 to $4.5 billion. This is a rather large

misstatement to have occurred under your watch. How can the

public be confident that OFHEO is and has been addressing this

problem? How can we be confident that a similar problem will not

occur in the future.

Mr. FALCON. Mr. Chairman, the range of adjustment to earnings

will be in the range from, I think it is, $1 to $4.5 billion.

Chairman SHELBY. That is a spread though.

Mr. FALCON. That is a spread, yes, Mr. Chairman.

Chairman SHELBY. And a lot of money.

Mr. FALCON. That is a lot of money, and that is a cumulative effect over the 2-year period involved here. It is a serious matter. But

I would note, Mr. Chairman, that these are real earnings. We are

not talking here about hypothetical or manufactured earnings, and

at the end of this process their capital will go up by the amount

of that spread. So this is a serious matter.

Chairman SHELBY. I think their stock has gone up, has it not?

Mr. FALCON. I have not checked today. Mr. Chairman, let me

also say that while this is a significant amount, my primary focus

is the conduct of the company. I think it is important for us to get

to the bottom of all the facts surrounding the conduct of the company and everyone involved and ensure that we do whatever is

necessary so that this does not happen again.

Chairman SHELBY. Would you describe the scope and the mandate of your ongoing investigation, and how it differs from the annual examination process? In other words, what are you trying to

determine here in your investigation?

Mr. FALCON. We are trying to determine the circumstances of the

restatement, how these transactions were accounted for in the company’s financial statements, and the role of individuals involved.

We are also looking to see whether or not there was any intentional misapplication of GAAP in order to further some company

policy. If that is the case, we will certainly take appropriate action

to make sure that we do whatever is necessary so that it does not

happen again, Mr. Chairman.

Chairman SHELBY. When do you think this final report will be

completed?

Mr. FALCON. We would like to complete it by the end of September. We are working very hard to stay on that target. It is also

essential that we do obtain some additional appropriations. That

would help us stick to that goal, Mr. Chairman.

Chairman SHELBY. There are some differences here between your

report and the Baker Botts report, which is the law firm that

Freddie Mac retained to do an inside investigation. Some of us are

troubled that OFHEO declared in its annual report that Freddie

Mac’s accounting functions were, ‘‘effective.’’ Yet Baker Botts has

reported that Freddie Mac lacked sufficient accounting expertise

17

and adequate internal controls. Could you explain OFHEO’s, your

basis for reaching your conclusion, and the disparity with the conclusions reached by Baker Botts?

Mr. FALCON. Mr. Chairman, I do not think there is a disagreement between us on that point. If there is a misperception based

on our annual report, that we were unaware of problems or that

we were not working to correct those problems, I hope I have dispelled that misperception with my testimony. I have tried to detail

very precisely how going back to the year 2000, we had them working to correct accounting problems and problems with their internal controls.

Chairman SHELBY. Senator Sarbanes and I have received a letter

from Baker Botts basically challenging certain statements in your

testimony today. Of course, I will ask this be made part of the

record, and if you have not gotten a copy of it, we will give it to

you.

Mr. FALCON. I have not, Mr. Chairman.

Chairman SHELBY. We will certainly do this now. I think this is

important to you and to the Committee. We will distribute that.

Mr. FALCON. May I address that, Mr. Chairman?

Chairman SHELBY. Sure.

I think Senator Bunning alluded to that earlier.

Mr. FALCON. Yes.

Chairman SHELBY. I am sure he will want to get into it.

Mr. FALCON. Since that time Baker Botts has been cooperating

with us, and they are cooperating fully I think. But at this point

in time they were asked a direct question, Mr. Chairman, ‘‘Are you

aware of any inappropriate conduct on the part of the company?’’

The answer was no. They were further asked, ‘‘Is there anything

that we should know, related to your work up to this date?’’ The

answer was no.

About a month before this conversation, the counsel was fully

aware of circumstances surrounding PwC’s inability to take the

representations of Messrs. Clarke and Glenn. The circumstances

surrounding their conduct is certainly the type of activity that the

regulator would expect to be informed about by Board’s counsel,

Mr. Chairman. I stand by what I have said in my testimony.

Chairman SHELBY. But it is disputed. They dispute what you

say. You realize there is a dispute here?

Mr. FALCON. I accept that, Mr. Chairman.

Chairman SHELBY. Okay. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

I want to go back to a couple of questions that Chairman Shelby

asked, which I thought were right on point.

You make the point that the net cumulative effect of the new accounting treatments for Freddie Mac was an increase in income in

prior years, thus increasing the amount of capital on a cumulative

basis. I think that is in your testimony and you just stated it again

in response to the question.

Mr. FALCON. Yes, sir.

Senator SARBANES. But this really raises the implication that

had the errors resulted in a reduction in prior year income, that

the Enterprise might have been undercapitalized, that would all

have been unbeknownst to the regulator. As you know, the mistake

18

that was made, as it turns out, was such that there is an increase

in income in prior years and therefore there is an increase in the

amount of capital. Of course you did not know that. It could have

turned out that there was a reduction in some prior years and

therefore a decrease in capital. As it turned out, it worked in the

right direction, so to speak, but how do we get at the fact that it

was all happening unbeknownst to the regulator?

Mr. FALCON. That is a good question, Senator Sarbanes, and

what we are working to do at OFHEO is to build an in-house team

of accountants. They can take a look at issues like this. While we

could not possibly have the amount of staff necessary to review all

policies and transactions to ensure that the external auditor is adhering to the highest standards of GAAP, we would like to build

the capacity in-house to at least be able, on a selective basis, review some of the major and the perhaps novel issues that come up

in accounting when new standards are brought into effect. I think

that is an important part of our program that we are trying to develop going forward, and we developed this plan beginning in the

year 2001, and last year we began to get the appropriations to staff

up for that expertise.

Senator SARBANES. Do you think that the OFHEO reviews have

been prepared to simply accept the audit functions? In other words,

I gather you are not going behind the auditor; is that correct?

Mr. FALCON. We are ensuring that they do their job pursuant to

industry standards as they work to certify the financial statements,

but we are not taking a qualitative look at the judgments they

make as to whether a particular accounting policy is consistent

with GAAP. We did not try to interpret the GAAP the way they

do. If we did, that is a practice that was, as you know, Senator,

widely discredited in the 1980’s. Regulatory Accounting Principles

accounting is something that we have worked to avoid, not just at

OFHEO but all the safety and soundness regulators.

Senator SARBANES. How do you avoid the situation we just had

here? I mean, you tell us in your June 2002 report to the Congress,

‘‘The audit functions exceed safety and soundness standards.’’ I am

quoting now from your report. ‘‘The internal and external audit

functions have the appropriate independence. The management of

the internal audit department is effective.’’ Then the 2003 report,

this past June, ‘‘The audit functions are independent and effective.

The internal and external audit functions have the appropriate

independence.’’

Now, only a few days after we received the report the Freddie

Mac Board got rid of these chief officers because of lack of progress

on addressing the accounting and internal control problems at

Freddie Mac.

Mr. FALCON. Those statements, Senator, reflect our overall assessment of various risk factors, and we report in the annual report

on our overall assessment of how they are doing for that calendar

year, and we report that in the annual report. My testimony points

out, and our 2002 annual report points out that there is a restatement going on and that we are working on improving deficiencies

in their financial reporting, internal controls, as well as gaps in

their accounting expertise.

19

What I think is appropriate and what I take from your comments, Senator, is that we should go back, and as we begin to issue

successive annual reports, that perhaps we should have a lower

threshold of what gets included in this annual report. We have included things that we think affect our assessment of the company

overall. Perhaps we should go back and include matters that while

they do not affect our assessment of the company, might be significant enough that we should include them anyway in the annual report, and that is what we have to consider doing going forward.

Senator SARBANES. My time is up. I just want to be clear on one

thing. You have an investigation now going on, correct?

Mr. FALCON. Yes, sir.

Senator SARBANES. OFHEO itself has an investigation that was

launched on June 7; is that correct?

Mr. FALCON. Yes, sir.

Senator SARBANES. And are you looking more broadly than the

accounting functions or is it focused on the accounting functions?

I know you cannot go into the nature and scope in a public session of your investigation, but can you answer that question?

Mr. FALCON. Yes. It is focused on the accounting transactions

that are at issue here, those issues raised by PwC. It does involve

more than one accounting rule interpretation beyond just FAS 133.

We are looking at those transactions and circumstances involved in

applying GAAP and the role of everyone in the company in these

matters.

Senator SARBANES. And when will that report be submitted?

Mr. FALCON. Our goal is to complete it and submit it to you by

the end of September, Senator.

Senator SARBANES. Thank you.

Chairman SHELBY. Senator Enzi.

Senator ENZI. Thank you, Mr. Chairman.

I do have a series of questions that deal with the request for the $4.5 billion in additional moneys. I would hope that I could submit

those to Mr. Falcon in writing, because the answers would probably

be more detailed—and probably boring.

Chairman SHELBY. And his answers would be to you and to the

Committee, I trust?

Senator ENZI. Yes; I would be happy to share them, and that

would allow me to ask some other questions. Of course, another

one of them that I am going to submit is: In your testimony, you

discuss that OFHEO has adopted corporate governance principles

similar to those adopted in the Sarbanes-Oxley Act, and I would

like you to describe the exact corporate governance provisions that

you have adopted and the parallel sections in Sarbanes-Oxley. But

I will not ask you to do that while you are here, either; I will be

submitting that one.

In your written testimony, you state that ‘‘OFHEO has been

working with enterprises since 1999 on financial accounting of derivatives transactions.’’ In 2000 and 2001, did OFHEO give any

specific written guidance to the Enterprises on how to account for

derivatives transactions? Did the guidance give details on how to

account for cashflow derivatives transactions? And how many financial experts on derivatives did OFHEO employ during those

years? Is that another one for the record?

20

Mr. FALCON. Yes. I do not think we have given the Enterprises

any written guidance on the implementation of FAS 133. I will

double-check that, but I am pretty certain. Our role in this is to

oversee the work of the internal controls and the work of the external auditor and ensure that if the external auditor has any qualifications about their certification that those matters are appropriately addressed by the company.

I am sorry, Senator, I do not think I remember the second half

of your question.

Senator ENZI. I will submit that one, too.

In your written testimony, you state that you do not conduct forensic accounting work unless a need arises, and that you rely on

this auditor, and that you require enterprises to engage forensic

professionals to investigate irregularities when they arise.

How do you determine when an audit statement submitted to

you would require a forensic accounting professional? Prior to this

incident with Freddie Mac, have you ever required an enterprise to

hire a forensic accountant, and what were the circumstances if you

did?

Mr. FALCON. We have not. Certainly the circumstances surrounding the need for a reaudit and restatement of 2 prior years

rose to the level of requiring a forensic review.

I would have to take each circumstance on a case-by-case basis

to determine whether or not one was necessary as additional issues

arose.

Senator ENZI. I will do a follow-up on that one in writing as well,

because we need some more detail on that.

The risk-based regulations established by OFHEO require you to

release a risk-based capital model that the Enterprises can use to

calculate their risk-based capital reserves. In light of these recent

events at Freddie Mac, will you need to reissue the risk-based

model for 2002?

Mr. FALCON. No, we are not expecting that there is a need to do

that. However, if we see any significant changes in the data that

the risk-based capital stress test runs on, we will consider whether

there is a need to rerun the stress test for any particular quarter,

and if there is a need to alter our capital findings with respect to

Freddie Mac. But it is my expectation that that will not be necessary. The risk-based capital stress test runs on data that is not

dependent on the accounting issues involved here; it runs off raw

data, which is not really affected here.

Senator ENZI. But is it showing the information that you need?

Mr. FALCON. Yes. We are getting all the information we need in

order to continue to run our risk-based capital stress test.

Senator ENZI. Okay. I will submit some more questions, if they

are not covered today, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

I want to go back to this gap of $1.5 to $4.5 billion. It sounds

to me like we do not yet have a handle on the issues that are underlying what is determining the problem that actually has come

out in all this discussion.

What is the explanation of such a wide range? It is an extraordinary gap that I find hard to understand how it cannot be

21

explained. I could understand at the margin a couple of hundred

million here or there on derivatives—even that is a lot of money—

but $3 billion—I would not understand it in the context of reviewing the risk management, the performance of a company—any company. It is mind-boggling to me that there is such a gap in place.

What are some explanations that would allow that to actually

be?

Mr. FALCON. It is a large number. One of the issues related to

this is that under FAS 133, if you designated certain hedges, certain derivatives as hedging derivatives, they qualify for cashflow

accounting or fair value accounting. Here, they are accounted for

as fair value hedges, and they are assembled in pools. If the pool

gets tainted through inadequate documentation for any derivative

that makes up this pool, the entire pool is tainted, and you have

to unwind, and the entire pool no longer receives the FAS 133 fair

value hedge designation. So that is having a large impact on the

earnings—a cumulative effect on their financial statements. That is

just one of the explanations, but I think one of the largest ones.

Senator CORZINE. The thing I do not understand is that the riskbased regulatory structure that has been put in place that you all

administer to look at has to look at the particular transactions that

go into the book that is made up. It leads me to wonder why there

were not red flags about that with regard to the pools that you are

talking about in the context that is different than I am hearing this

discussion. It is not just an accounting issue, because these pools

either had certain risk characteristics that fit into the model for

measurement or not.

Mr. FALCON. I guess a point I should make clear, Senator, is that

the economics of these transactions remain sound—most of them,

I should say. From a risk standpoint, these are effective hedges

against the company’s risk. This is an accounting issue as to when

you recognize the income from changes in market value on these

derivatives. So the accounting issues aside, these are sound transactions from a risk management standpoint.

Senator CORZINE. I accept that statement, but the fact is that

they needed to be measured for the risk model to see whether the

risk model was actually working and doing what it is supposed to

do for the purposes of safety and soundness that your oversight is

supposed to derive. So if a particular pool or swaption or whatever

transaction is going up and down in price, it has a different riskweighting in a model at some point in time, and I do not understand why there were not red flags thrown out by the risk model

that would indicate that there were underlying accounting problems. It does that, and it bothers me that there are still $3 billion

of unexplained elements when the risk model needs to be able to

tie to the accounting factors. It does not make sense to me based

on my own understanding of how you put together financial statements and how the risk models would work from my own experience.

Without being able to explain this $3 billion, it makes me worry

about the risk models, I guess is what I am suggesting, that we are

using for oversight. Is it a concern of yours?

Mr. FALCON. I would like to go back and take a look at it and

make sure we adequately address your concern here. What we do

22

look at is the underlying economic purpose of these transactions

and ensure that they are appropriate to hedge against the risk of

the underlying transaction.

I will have to go back and look at to what extent a closer review

of those internal models have helped us identify a problem here.

I will take that back and look at it.

Senator CORZINE. I actually would like to see—and we can do

this at a different time and place—but I would like to understand

why the individual items that are part of the risk management tool

relating to underlying assets—why that was not showing up as a

measurable change in value in the oversight models that you all

use, because it should have been reflective, in my view, in the underlying accounting that is coming out if we are going to have a

comprehensive—but I go back to that I cannot explain in my own

mind how, at least at this stage, we have a $3 billion gap.

Mr. FALCON. Okay.

Senator CORZINE. Thank you.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you, Mr. Chairman.

Director Falcon, why didn’t you start your investigation when the

original restatement was announced? Why did you wait until

Freddie ousted their top corporate executives?

Mr. FALCON. Senator, we have remained focus on fulfilling our

primary mission here. Our mission is to ensure the safety and

soundness of these two companies. It was my judgment that the

most important task at hand in order to ensure their safety and

soundness was to get this reaudit complete, to get the restatements

done, because it is not a good position for a large company like this

to be in to not be operating without certified financial statements.

We focused our time and energies on making sure this restatement process was brought to a conclusion as soon as possible.

Senator BUNNING. But how big a red flag to you have to have?

Mr. FALCON. Oh, certainly, if the board was not going to undertake action to get a forensic review going with the use of an outside

counsel—which is a process that is not uncommon for safety and

soundness regulators—we frequently task the board to take certain

actions including the hiring of any outside investigators to look at

issues.

Senator BUNNING. Well, if the board thought it was so essential

to fire the top three officials in the company, why wouldn’t that red

flag be the regulator?

Mr. FALCON. If I had known some of the circumstances that

would emerge later that led to the termination of these three individuals, I would have started our investigation in January.

Senator BUNNING. If you felt that Freddie’s outside counsel was

not being forthcoming, why did not you start your full investigation

then, instead of waiting until June 7?

Mr. FALCON. It was June 7, Senator, when I concluded that I was

not receiving all the information that I should have been receiving.

Senator BUNNING. It was not until then?

Mr. FALCON. Right.

Senator BUNNING. Your staff briefed the Committee staff earlier

this week. They informed staff that some anonymous letters were

received and then investigated by Baker Botts, who dismissed the

23

charges in the letters. Did the charges in those letters have anything to do with what actually happened? If Baker Botts was not

forthcoming as you have stated in your prepared testimony, why

did you then rely on them to investigate the charges in the anonymous letters?

Mr. FALCON. That is a subject of our investigation. We are looking at the circumstances surrounding the allegations contained in

those letters.

Senator BUNNING. But why would you give it to someone that

you have criticized in your own testimony today as not being forthcoming?

Mr. FALCON. As soon as I concluded that they were not being entirely forthcoming, I took action to initiate an investigation.

Senator BUNNING. But you gave the investigation to them.

Mr. FALCON. At a point in time when I thought it was appropriate that the board should engage outside counsel to undertake

this, while we focused on ensuring the safety and soundness of the

company through getting the restatement process concluded.

Senator BUNNING. Does it disturb you that 18 months after

Freddie said they would register with the Securities and Exchange

Commission, they still have yet to do so? Would that have anything

to do with the earnings and restatement and all the things that

have come up, that 18 months ago, Freddie Mac said that they

were going to register with the Securities and Exchange Commission their securities? They still have not done it. Does that raise

a red flag for you?

Mr. FALCON. It cannot happen until this restatement is concluded.

Senator BUNNING. Well, now it cannot, but we are a month later

than June, so instead of having 18 months, they had 17 months

prior to that time.

Mr. FALCON. Up until January of this year, it appeared that the

audit of the 2002 financial statements was on track. It was not

until January 2003 that PricewaterhouseCoopers brought to the

board’s attention these FAS 133 issues and notified the board that

they would not be able to certify those 2002 statements until these

accounting issues were properly resolved.

That is the point in time when it became clear that they would

not be able to register under the 1934 Act because they would have

this restatement process pending; and that triggered a whole sequence of events that we have been working on since.

Senator BUNNING. Okay. That was a year after they said they

were going to register with the SEC.

Mr. FALCON. Right. But it was expected that there would be

about a year lead time before they actually registered.

Senator BUNNING. So you are saying that the restatement was

the hang-up?

Mr. FALCON. No. There was a lead time necessary for the SEC

to do its due diligence with the company——

Senator BUNNING. I understand that.

Mr. FALCON. —as preparation for their formal registering with

the SEC under the 1934 Act, and there was an amount of lead time

that needed to occur before they got everything lined up.

Senator BUNNING. A last question, Mr. Chairman.

24

Chairman SHELBY. Please go ahead.

Senator BUNNING. Don’t you think that after this mess is cleaned

up, it would be necessary as one of the top priorities to make sure

that Freddie does register with the SEC so there is another body

that looks at exactly what the regulating body is supposed to be

doing?

Mr. FALCON. A regulating body that oversees the work of——

Senator BUNNING. The SEC would be another group of people

that would look at the same thing that you are supposed to be

doing right now in earnings, in statements of earnings, in audited

reports, and things that are required by the Securities and Exchange Commission.

Mr. FALCON. The SEC’s requirements are subject to the SEC’s

enforcement and review, but we have our own set of disclosure

standards that we require of the company, and we also oversee

those disclosures and the enforcement of proper disclosures under

our own standards, Senator.

Senator BUNNING. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman.

Welcome, Mr. Falcon.

First, I would ask, Mr. Chairman, that my opening statement be

placed in the record.

Chairman SHELBY.Your statement will be made part of the

record without objection.

Senator STABENOW. Thank you very much.

Before asking a question, I just want to step back for a moment

in terms of what is happening in the housing market. We all know

that the housing sector has really been one of the bright spots—

the only bright spot—in a stagnant economy, and that as we look

from the individual’s perspective, they are more likely now to be

counting on the equity in their homes than they are to be counting

on the stock market when it comes to retirement.

So as we look at these broader issues, I know that in the secondary housing market, Fannie Mae and Freddie Mac have been

very important in providing opportunity for people to be able to

have that home.

So, Mr. Chairman, as we move forward, I would just ask that we

use the same due diligence and deliberation that we have on other

issues before this Committee, where we will take our time to do

this right, to make sure that we are looking seriously at the issues

that are raised——

Chairman SHELBY. You are absolutely right.

Senator STABENOW. —but not doing it in a way, as the Chairman

I am sure would agree, that would undercut our ability to maintain

this very important secondary market, and that we look at the regulatory system but that we not assume because one piece went

wrong that the entire system is broken. So, I am pleased to be a

part of a discussion about that.

When we talk about the issues that we have today, in your testimony, you point out that safety and soundness regulators do not

review accounting policies for conformance with GAAP, nor do you

25

certify that a company’s financial statements are consistent with

those principles.

Do you believe that OFHEO should take a more active role in determining whether or not the GSE’s are following proper accounting procedures, or do you believe that should be done by private

auditors? Where do you fall now, looking back at this, and what

role do you think—not only that OFHEO currently has—but what

role do you think you should have as it relates to the GSE auditors?

Mr. FALCON. I think that for us to build up the capacity to, in

effect, certify the financial statements would require a massive increase in the size of the Agency. I think that what is important for

us to do is to be able to have the capacity to look at the implementation of new standards as they are brought forward by FASB and

have more depth in accounting expertise in our program so that we

can more fully evaluate the implementation of those policies and

look at the interpretations of FASB and be able to just somehow

ensure that they are using the highest standards of GAAP in implementing certainly new standards, at least. But I do not think it

would be efficient for us to try to bring in the amount of staff that

will be necessary to substitute our judgment for the external auditors’ as to what is consistent with GAAP. I do not think we want

to go down the road of imposing regulatory accounting principles.

The integrity of the external audit function has to be ensured

here, and hopefully, through some amount of expertise in the accounting areas, we can build that up in the company—hopefully we

can do so.

Senator STABENOW. So you are really indicating that at this

point, you believe you lack sufficient funds to be able to take that

next step in terms of more aggressive oversight, more specific oversight?

Mr. FALCON. We would like additional funding, Senator, so that

we can as quickly as possible continue to build up this expertise

in the Agency. I do not think the lack of the resources has hindered

our ability to fulfill our mission—certainly both companies remain

safe and sound because I think we are fulfilling our mission—but

it would be useful for the Agency to have additional resources. And

beyond that, it would be useful for the Agency to have the ability

to establish its own resource needs and obtain those resources on

a real-time basis. That would require giving the Agency permanent

funding by removing us from the appropriations process, and that

is something, as Senator Sarbanes said, that I have been advocating since I arrived at the Agency.

Senator STABENOW. One other question, Mr. Chairman, as it relates to derivatives.

Chairman SHELBY. Go ahead.

Senator STABENOW. We have been talking about that a lot this

morning, and I am wondering—there are two schools of thought.

One is that use of derivatives is too risky; the other is that they

are important for hedging risk. I am wondering what your position

overall is on these financial tools and whether or not Fannie Mae

and Freddie Mac should be using them.

Mr. FALCON. Derivatives are an integral part of the Enterprises’

interest rate risk management. If they are used as hedging devices

26

and not as speculative devices, they are a very useful risk management tool. Indeed, Fannie Mae’s ability to manage their risk related to their retained mortgage portfolio would be difficult and

costly if it were not for the use of derivatives. And the way the Enterprises use them, I think they are a very appropriate risk management device.

Senator STABENOW. Mr. Chairman, thank you. I would just say

on a positive note that I think that as we talk about registering

with the SEC, we should note that Fannie Mae has done so on a

voluntary basis, and I would congratulate them for that and hope

that Freddie Mac would be doing the same.

Chairman SHELBY. Thank you.

Senator Sununu.

Senator SUNUNU. Mr. Falcon, you said that despite these accounting irregularities, OFHEO is still confident about the safety

and soundness of both GSE’s; and I believe in an answer to Mr.

Enzi’s question, you indicated that these accounting issues did not

figure into or affect the result or the outcome of the stress test. Is

that correct?

Mr. FALCON. Yes, Senator.

Senator SUNUNU. Then, if that is the case—and I reserve judgment—why do you need more money to beef up all of these

accountants and oversight capability in these areas if they are not

affecting the stress test and have not affected the safety and soundness at all?

Mr. FALCON. First, there is the supplemental. That is necessary

so that we can finish this investigation of Freddie Mac, and I want

to be able to come to this Committee and assure you with the fullest amount of confidence that there are no issues related to Fannie

Mae’s accounting, and that is why we have included funds for that

in our supplemental request.

Senator SUNUNU. You seem to have concluded, though—and

maybe this is where there is a misunderstanding—have you concluded that any potential issues with Fannie Mae’s accounting will

or will not affect the stress test or the safety and soundness?

Mr. FALCON. Will the—I am sorry, I am not sure I——

Senator SUNUNU. In answer to Senator Stabenow’s question, you

suggested that these accounting issues have not affected the safety

and soundness——

Mr. FALCON. Yes.

Senator SUNUNU. —of either GSE that you oversee; and in response to Mr. Enzi’s question, you said these accounting issues do

not affect the stress test. So in this case, what additional information do you need to get at or want to get at with regard to accounting that the SEC or another regulator will not be able to get at?

Mr. FALCON. For these supplemental funds, we need to ensure

that our internal resources are not spread so thin on this investigation that we cannot continue with the daily work that we do at the

Agency. In addition, it has been clear to me for a long time now

that the Agency needed to build the depth in at least its examination program, and we are working to try to do that. Those resources are needed, and we have needed additional resources to

utilize our stress test as an analytical tool.

27

It is not just a capital standard. We utilize it through holding

certain variables constant and adjusting others to help us analyze

where the strengths and weaknesses lie in the company. We want

to continue to do more with the stress test to allow it to help us—

it will complement our examinations work and our research work.

Senator SUNUNU. I appreciate that, and that is of great concern

to me, which is why I was somewhat surprised to hear the answer

to Mr. Enzi’s question as to whether or not these accounting issues

affect the performance of the stress test and the risk-based capital

standard.

It would seem to me that should not be the case, that these accounting issues and variations should have had some impact there,

and let me at least lay out what I think the reason would be.

There are a lot of things that I might bluff on or suggest that

I know a little bit about, but FAS 133 is way down on the list. I

know this is a very complicated accounting standard, and I understand the reasons for the standard and the rationale and the importance of marked to market in certain circumstances.

But insofar as I do understand it, Freddie was using or interpreting FAS 133 in a way that allowed them to smooth out their

earnings. And you might argue if they did not use it in a particular

way, their earnings would have been much more volatile.

Earnings volatility should affect your perception of safety and

soundness, it seems to me, and should affect the market’s perception of how an entity would perform in an economically stressful

environment.

Your answer to Mr. Enzi’s question suggested to me that earnings volatility is not part of the stress test or part of the risk-based

capital standard. Is that the case?

Mr. FALCON. The risk-based capital stress test is a snapshot and

point in time based on at the end of each quarter for each company,

and it runs off raw data, millions of pieces of raw data that is aggregated into what we call a risk-based capital report. This riskbased capital report flows through the stress test, and it produces

a capital requirement.

Now, the issues here with respect to GAAP do not affect the raw

data that the stress test needs to run on. What would be affected,

Senator, is probably the minimum capital standard, but there, because we will see an increase to earnings, their capital will go up,

and they will actually have a larger surplus under our minimum

capital standard.

Senator SUNUNU. That makes sense, but it did not quite answer

my question. The stress test is carried out over a time series; is

that correct?

Mr. FALCON. Yes.

Senator SUNUNU. So you are projecting into the forward changes

in interest rate and economic information over time. But if a company had a specific earnings volatility or very high earnings volatility, wouldn’t they perform differently in that time series?

Mr. FALCON. The volatility will show up at the end of each quarter’s statement. As they pull back income from later quarters into

earlier quarters, that will affect each quarter’s earnings statement.

But again, this runs off of raw data.

28

The economics of these transactions are still sound, by and

large—there are a few transactions which I cannot get into—but

the economics of these transactions are that they are still sound

risk management practices and that their fair value statements are

not going to change and did not change as a result of this.

So as we have looked at this very closely, this is a serious matter, but it is a matter of the timing of recognition of income and

not the fact that they do not have this income.

Senator SUNUNU. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Senator Reed.

COMMENTS OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman, and thank

you for holding this hearing.

We have a very important and fundamental responsibility to ensure the safety and soundness of all these GSE’s. That is our job,

and we cannot do it without an effective and vigilant OFHEO in

this case, because it is a day-to-day proposition to monitor the activities of these GSE’s, and we have not had that capacity or even

that focus.

We all recognize that the GSE’s have provided extraordinary

benefits to our economy and to our people, and that is not the question here at all. The question is really do you have the tools to do

a very important job—and again, we depend upon you to ensure

the safety and soundness—not the stock market value of the companies, not what they are doing, but essentially that we can depend

that these companies are well-run, safe, and sound.

In that context, let me ask—and at this point in the hearing,

most of these questions have been asked, and I apologize; please

indulge me—as I understand it, the major issue here was the fact

that the accounting treatment caused Freddie Mac to essentially

smooth out their earnings so that they would not have the volatility we talked about. And today, you say that your judgment is

that it is safe and sound.

What about the future because of this? I think this was part of

the dialogue that you had with Senator Sununu. I think the future

presumes that you found no systemic problems, and that the decisions that were made with respect to smoothing out will not irrevocably lead to problems in the future. Can you make those conclusions today?

Mr. FALCON. I cannot guarantee you that there will not be problems in the future, but I think what you can expect to see with the

company is that there will be greater volatility in its quarterly

earnings. That is a result of some of the actions that had to be

taken to unwind some of these FAS 133 designations as hedges for

some of these derivatives.

That is probably the biggest impact that you will see going forward as a result of the restatement.

Senator REED. Now, in a positive light, you are aware of those

potentials, and you are taking steps at OFHEO to anticipate problems and respond to them; is that correct?

Mr. FALCON. Yes, sir.

29

Senator REED. It seems to me that the reason we are here really

is because of the presumption—a rebuttable presumption—that

OFHEO missed some things in this process—and again, I say that

is a rebuttable presumption. But it seems to me that when you get

to the questions of regulatory problems in terms of regulatory

agencies, there are a couple of categories, and I would like just for

the record to run down these categories.

Sometimes it is a lack of expertise; sometimes it is a lack of personnel and resources, you simply do not have enough people or

computer programmers or consultants that you can hire; sometimes

it is a lack of emphasis or focus by the leadership, and they just

miss the point that was the most critical point; and then, sometimes it is the lack of jurisdiction—you do not have the authority.

Let us go through those. One, lack of expertise—do you think you

have the appropriate expertise in the Agency to deal with this new

world of derivatives and other complicated transactions?

Mr. FALCON. Absolutely, Senator. We would like to add more

depth to these areas, we absolutely have the expertise necessary.

Senator REED. Two, lack of personnel and/or resources.

Mr. FALCON. Again, that gets to the issue about how we would

like to have more depth across the organization. We would like to

bring in more resources and personnel.

Senator REED. Okay. And that is something that is our responsibility to provide; is that correct?

Mr. FALCON. Yes.

Senator REED. Thank you.

Three, lack of emphasis and focus—do you feel that you were

looking at the right things, giving guidance—not you, personally,

but institutional leadership, identifying the right potential problems and the right areas you had to focus on?

Mr. FALCON. I think we will conduct a self-assessment and determine whether or not there is anything we could do better. But

when you have a situation where there is a breakdown in integrity,

that is not something that you can always catch right away. Ultimately, you do catch these things through your examination activities and your ongoing surveillance of the companies. But I think we

were fulfilling our obligations as the regulator.

Senator REED. Finally four, lack of jurisdiction—were there areas

of concern that you saw, but you simply did not have the authority

or the tools to get at them because we had not given you those

tools?

Mr. FALCON. No, I do not think so, Senator. Aside from the resource question, it would be helpful to have some clarification to

the Agency’s authorities, but we think that our enforcement powers

are adequate—again, we would like some clarifications—and that

we do have the tools necessary to do our job.

Senator REED. Thank you. Again, let me emphasize how critical

your job is—

Mr. FALCON. Thank you.

Senator REED. —because we assume that these institutions are

being vigorously regulated and that they are safe and sound, and

we depend upon you to ensure that our assumption is real.

Mr. FALCON. Thank you.

Senator REED. Thank you, Mr. Chairman.

30

Chairman SHELBY. Senator Hagel.

Senator HAGEL. Mr. Chairman, thank you.

Director Falcon, I have not had an opportunity to look through

the recommendations that you attached to your testimony this

morning, and I look forward to reviewing those recommendations.

The first question I have is about responsibilities of OFHEO, and

in fact this question may be included in your recommendations.

What is your opinion on whether OFHEO should have a broader,

wider responsibility for its oversight responsibilities beyond safety

and soundness to include mission of GSE’s?

Mr. FALCON. The way this works right now, by way of background, to answer your question, is HUD is the mission regulator,

and they have responsibility for program approval and general mission authority. And as a safety and soundness regulator, our function—there is a bifurcation between the two functions. However, it

is the responsibility of every safety and soundness regulator to ensure that the companies they regulate are in full compliance with

all the applicable laws and regulations. So where we see a clear

violation of any law or regulation, it is our responsibility to step

in and ensure that that conduct does not happen.

But that is when you are in areas where there is black and

white. In the area of the Enterprises’ charters, there is a great deal

of ambiguity as to what is permissible and what is not. And since

we already have the enforcement responsibility, including if HUD

decided that certain activities could not be engaged in by the companies, we are an enforcement arm, and we would take enforcement action at HUD’s initiation.

Given that we have the responsibility in these areas, I am suggesting just taking it a step further and let us go ahead and resolve

issues where there is ambiguity as well.

Senator HAGEL. And that is included in your recommendations

that you included in your testimony?

Mr. FALCON. We attached them, yes, sir.

Senator HAGEL. Good. Well, I will pursue that, and we will have

other conversations about it, but I thank you.

As I have listened to your testimony and the questions here

today, it is apparent—and you understand this—that we are talking about something larger than just a straight accounting function, enforcement function, of your agency to help these GSE’s stay

within the boundaries, obviously, of clear, accountable standards.

One of the questions I would have in that regard is do you think

earnings pressures, coupled with Congressional mandates, people

pushing down on GSE’s sometimes because the mission is affordable housing, and the congressional mandates and the pressures,

do you think that that affects or could affect safety and soundness

of these institutions because—I know you understand where I am

going with this—these sometimes are not always the best ingredients for the most profitable outcome. I am going to follow up with

a couple more questions on this point, but let us resolve this first

with your answer.

Mr. FALCON. The question is would market pressures——

Senator HAGEL. Do all these earnings pressures, coupled with

Congressional mandates, the mission being affordable housing—

and that is not always as profitable as other more private instituVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
31

tions—do they present more of a risk, less of a risk, or is it neutral

to safety and soundness?

Mr. FALCON. I think that as long as the company maintains the

highest levels of integrity and the intent to stay consistent within

the boundaries of the charters, and as long as the circumstances

are such that they can continue to grow as a company without

needing to step outside the bounds of their charters, it is not clear

to me that the market pressures about meeting earnings expectations might force them to do something that they would not otherwise. Let me just leave it at that, Senator.

Senator HAGEL. Let me get into another area, then, that is a bit

attached to this. Lately, we have all noted that the GSE’s have

been purchasing their own mortgage-backed securities. Does that

present more or less of a risk, no impact to these institutions?

Mr. FALCON. It does present additional risk in the form of interest rate risk to the company. If they did not hold mortgages in

their retained portfolio, they would not have that interest rate risk.

It is something that they work to manage very diligently. But the

maintenance of a retained mortgage portfolio does present, in addition to the credit risk, an interest rate risk component.

Senator HAGEL. Mr. Chairman, I know my time is up, but may

I ask one very short question?

Chairman SHELBY. Go ahead, Senator.

Senator HAGEL. Do you consider stockholder equity to be relevant in considering the financial health of GSE’s?

Mr. FALCON. The level, or the value of shares?

Senator HAGEL. Both—level, value—any stockholder equity in

those institutions.

Mr. FALCON. Shareholder equity is a component of their capital.

Senator HAGEL. So it is very relevant?

Mr. FALCON. Yes, as long as it is a component of their capital,

and they are required to meet minimum capital requirements, yes.

Senator HAGEL. Do you think that is an issue that is a problem

with GSE’s today, Fannie, Freddie?

Mr. FALCON. Their capital levels?

Senator HAGEL. Yes.

Mr. FALCON. I think they are able to withstand some very severe

financial shocks. Our stress test imposes severe swings in interest

rates, the highest possible historical credit losses on the companies.

It is a very robust and stressful test, and it is one that no one else

is subject to. We have devised it in a way pursuant to Congressional specifics in law that it is very stressful, and they meet it.

Senator HAGEL. Thank you very much, Mr. Chairman.

Chairman SHELBY. Thank you, Senator Hagel.

Senator Schumer, I know you have been going back and forth between Committees.

Senator SCHUMER. Thank you, Mr. Chairman.

I have been going back and forth, and to the witness, I apologize.

We have a lot of doings in Judiciary, so I am trying to run back

and forth.

The first point I want to make—and I just want to underscore

this—is that I could not agree more with Senator Sarbanes in

terms of the importance of housing in today’s economy and the imVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00035 Fmt 6633 Sfmt 6633 21517.TXT SBANK4 PsN: SBANK4
32

portance of Freddie and Fannie as unique tools to help that housing market.

The real question here, the real riddle, is how do we deal with

the oversight function. Fannie and Freddie are extremely important not only to the housing market—although they are probably

the two most important entities to that—but also to our whole financial structure and markets, because they have such a huge

amount of loans and everything else that they hold.

In fact, a while ago, when we were more sanguine about a budget

surplus, and they thought the 30-year Treasury would go the way

of all flesh—now there is a move to bring it back—some people

talked about Fannie and Freddie being the marker. So very important, and I do not want my concerns about the auditing and oversight functions here, which are very serious ones, to be misjudged

as, well, let us change the function of Fannie and Freddie. I would

like them to pretty much keep doing what they are doing. You

might twist the dial a little bit here, twist the dial a little bit there,

but I think there needs to be better oversight and better understanding of how they integrate with the general financial markets,

and hence, that is why I talked earlier about the Treasury doing

the oversight at least of the auditing function. Treasury does oversight of other auditing functions that this Committee might regulate here and there, so it is not a unique situation.

My view would be—and I know that Congressman Baker has a

bill to put it into the OTS; I am not sure it belongs in OTS; that

is a path to treat Fannie and Freddie just like another bank—my

view would tend to be that we should have—or we should consider,

because all of this is tentative—maybe a special office in Treasury,

the Office of GSE’s, that would oversee Fannie and Freddie and

maybe some of the other GSE’s as well which might need some

oversight—Home Loan Banks, Sallie Mae, and all these other

places; who knows?

So my question—and I guess it is not even a question, because

you may be the wrong person to ask, Mr. Falcon—but have you

given some thought to any kind of restructuring? Obviously, none

of us is very happy here on either side of the aisle with what has

happened with the recent oversight.

Do you think that OFHEO structurally is the right place for this

auditing and oversight function to be, or would Treasury be a better place? Tell me what you think.

Mr. FALCON. I think what is most important here is that you

have a regulator that is independent, that is adequately funded

and that has all the authorities necessary to fulfill their job. As

long as you fulfill those principles, where it resides I do not think

is of much consequence. If you moved OFHEO to Treasury, and you

intended to keep its status as an independent agency, which I

think our lessons from the savings and loan crisis tell us we absolutely want to do, then I do not think it accomplishes much to move

OFHEO from one department to another if the goal is to maintain

independent regulation.

I think that what is absolutely essential here is allowing the regulator the resources and tools to do its job. Where we are currently

situated works. We operate as an independent agency. We work

33

well with HUD whenever there is a need for us to work on issues

where there is overlap.

What I think is important to consider is to just ensure that the

Agency has what it needs. Beyond that, I do not know if just moving OFHEO anywhere else accomplishes much.

Senator SCHUMER. Well, I had a fourth factor that you need, and

maybe it is subsumed in your three, and that is expertise. These

days, the financial instruments that the GSE’s engage in are way

beyond the understanding of mere mortals. I think it would be a

safe thing to say that there is not a Senator or a Member of Congress who understands these complicated derivatives and hedges,

and if something happens—if Krakatoa explodes 6 years from now,

we can figure out a way to hedge that and make sure that mortgages are still paid or whatever—God knows what they do.

So Treasury seems to know these things better than your agency,

and I was not here, and I deeply apologize because I am very interested in this subject, but we had a very controversial nominee in

the Judiciary Committee. So the question is can OFHEO do this.

And the second question—because there have been things wrong in

the past, and I do not think just saying well, we did not have the

resources is enough here, and I do not think it is going to satisfy

any Member of this Committee—but the second question is does it

make sense to split the functions between two agencies. What

would you think of that—the auditing function, the OFHEO part,

in Treasury somewhere, I would put it—not in OTS—but the mission part and working with the housing market staying in HUD.

Could that work, or would that provide too many encumbrances?

Give me your view on that.

Mr. FALCON. Well, on the second question, it works now. HUD

is the mission regulator, and we are the safety and soundness regulator. We operate as an independent entity within HUD. So it

works right now, having a bifurcation of the two functions.

But allow me to respectfully disagree with you, Senator, on the

issue of expertise. No one knows these companies better than the

people at OFHEO. The way they use derivatives, the way they

manage the risk, the way they conduct themselves—I think this

agency has a body of expertise that is unmatched relative to these

two companies.

Senator SCHUMER. How did it blow it so badly last month?

Mr. FALCON. The companies are safe and sound. We have fulfilled our mission. I do not think we blew it. If we were here talking about two companies that were insolvent, then I would agree

with you——

Senator SCHUMER. They actually misstated their results on the

down side, not the up side, but that would have had effect a year

or two from now the opposite. You must admit that you cannot

have been happy with what happened in the last couple of months.

Mr. FALCON. Absolutely. I am unhappy with a lost paperclip at

the companies. Any slight issue that comes up where it might affect their safety and soundness, we try to get on top of as quickly

as possible.

This is a situation where you had a breakdown in the integrity

at a two levels, a breakdown in the integrity of the internal controls as a result of the conduct of top management of the company,

34

and I think you had a breakdown in the integrity of the external

auditing process. I venture to say that but I probably should not,

because our investigation is still ongoing, so let me qualify my

statements there and reserve judgment until we have concluded

our investigation.

But I think we have fulfilled our obligation; the companies are

safe and sound. I do not like the fact that this restatement was

necessary. I do not like the fact that the magnitude of this is high.

But what I am most concerned about is their safety and soundness.

They remain safe and sound. The economics of these transactions

remain sound as a risk management technique.

Senator SCHUMER. Okay. But you are saying that splitting the

function works now, and you could split it in a different way down

the road.

Mr. FALCON. Yes.

Senator SCHUMER. Thank you, Mr. Chairman. I appreciate the

Committee’s indulgence.

Chairman SHELBY. Thank you, Senator Schumer.

Mr. Falcon, Freddie Mac’s restatement includes a review of

Freddie’s accounting policies and practices regarding derivatives—

we have been talking about that this morning—the classification of

debt instruments and the use of reserve accounts.

In the course of OFHEO, your organization’s, examination of the

Enterprises, has OFHEO noticed significant differences between

Freddie Mac and Fannie Mae with respect to these accounting policies? For example, does Fannie Mae account for its derivatives and

hedging transactions in a manner that is different from Freddie,

and did OFHEO ever recommend a preferred accounting practice?

Mr. FALCON. The two companies have taken a different approach

on the FAS 133 for accounting for derivatives, Mr. Chairman. As

you know, you can take a fair value approach, you can take a

cashflow approach, and a third one for foreign currency risk.

Chairman SHELBY. But is one necessarily better than the other,

or are they just different?

Mr. FALCON. Certainly the approach that Freddie took was more

difficult to implement. They took the fair value approach, which required that they match the derivatives with the underlying hedge.

Fannie Mae has taken a cashflow approach which will result in

more volatility, and we have seen that since this was implemented.

Chairman SHELBY. Okay. To what extent is your examination

analysis dependent on audited financial statements? In other

words, do you have the means to double-check the accuracy of the

data that you use in the examination process?

Mr. FALCON. Yes, we do, Mr. Chairman.

Chairman SHELBY. Okay. Regarding Fannie Mae, on July 14, you

submitted an appropriations request for $4.5 million to continue

the Freddie Mac investigation and announced the initiation of a

special review into Fannie Mae. Given the similarity between

Fannie and Freddie, both GSE’s, I understand your decision to do

so, but the circumstances surrounding the two companies, however,

appear to be quite different at times. Fannie Mae has not, as far

as I know, announced a pending restatement of its financial statements and has not up until now experienced a significant change

35

in management as a result of the restatement process. Is that

right?

Mr. FALCON. Yes.

Chairman SHELBY. Aside from your concerns, have there been

any events or circumstances at Fannie Mae that triggered your review, other than you looking at Freddie Mac and saying, Gosh,

maybe we should look closer at Fannie Mae?

Mr. FALCON. I think whenever we see a problem at one company,

we always look at the other, just to make sure.

Chairman SHELBY. Sure. I did not say not do it; I am just curious.

Mr. FALCON. Yes, right. But in answer to your question, Mr.

Chairman, we are not aware of any specific concerns that we have

with respect to Fannie Mae.

Chairman SHELBY. Okay. Could you just, for the Committee, give

us a basic outline of the scope and mandate of this special review

and how it would differ, if it does, from a routine examination practice that you use at OFHEO every day?

Mr. FALCON. It will differ in the respect that we do not, as part

of our routine examination process, attempt to undertake a qualitative review of the accounting policies of a company and determine

whether or not the policies are consistent with GAAP. This is a

one-time, unique situation where we are going to, through the use

of these funds and some outside assistance, take a qualitative look

at a high level to ensure that there is the highest conformance with

GAAP.

So that is how this is a departure from our normal examination

process.

Chairman SHELBY. Mr. Falcon, I personally feel that agency actions and regulations should receive the maximum amount of public input as possible. In your proposal, you request that OFHEO be

exempt from the Federal Advisory Committee Act. Clearly, this

would reduce the public oversight of OFHEO’s activities.

Currently, it is my understanding that only two—two—agencies

have this exemption—the Central Intelligence Agency and the Federal Reserve for the interest rate deliberations with the Federal

Open Market Committee. Why is this exemption authority being

requested by you?

Mr. FALCON. It is also, by the way, Mr. Chairman, being requested by others.

Chairman SHELBY. It has not been granted, though; only two, the

CIA and the Federal Reserve.

Mr. FALCON. Right.

Chairman SHELBY. And you can see why.

Mr. FALCON. It is not critical to the Agency, Mr. Chairman.

Chairman SHELBY. Okay. It is just something you would like to

have, but it is not central to what you do.

Mr. FALCON. Yes, sir.

Chairman SHELBY. How many formal enforcement actions has

OFHEO ever taken against either Freddie Mac or Fannie Mae, or

any other GSE?

Mr. FALCON. We have not had to take any enforcement actions

to date. We have taken one supervisory action. But the Enterprises

36

do a good job of responding to any concerns we raise, so things

have not had to rise to the level of an enforcement action to date.

Chairman SHELBY. Currently, you have now and have had enforcement powers.

Mr. FALCON. Yes, sir.

Chairman SHELBY. But you have not really exercised them, have

you?

Mr. FALCON. Right. Enforcement powers are usually when all

else fails.

Chairman SHELBY. I will call on Senator Sarbanes, and then I

will wrap up. Thank you.

Senator SARBANES. Thank you, Mr. Chairman.

It is my understanding that since 1997, five individuals have

served in the role of Corporate Controller at Freddie Mac, three as

permanent controllers, and two on an interim or acting basis. Can

you explain the reason for the high turnover and what impact that

might have on the company’s accounting and internal control functions, and is this the thing that OFHEO would note and take into

account in exercising its oversight responsibilities? It seems to me

it would be a matter of concern if you look at a major enterprise

of this sort, and they are bouncing the corporate controller in and

out of there almost every year from these figures, at least.

Mr. FALCON. That is a good question. Stability in that position

I think is important to both companies, and the fact that they have

had such turnover as you referred to in that position, you would

not prefer that there be that kind of turnover.

The circumstances surrounding—I think three of them were permanent, and two were interim; at least one case that I can recall

was a promotion, and I am not sure of the circumstances of the

other. It is an area where we would like to see more stability in

the company, Senator.

Senator SARBANES. I take it that your inquiry and that of Baker

Botts are both directed to what happened or in a sense, what went

wrong; is that correct?

Mr. FALCON. Yes, Senator.

Senator SARBANES. I am concerned about what is being done as

we move on and look ahead. In your statement, you say that the

Governance Committee of the Board of Freddie Mac adopted a finance function governance plan back in mid-May, proposed by the

new executive vice president overseeing the accounting and control

functions at Freddie Mac.

Is that plan being implemented? Is it a strong plan? In other

words, while you are looking at what went wrong, what is being

done to make sure that things are being brought up to standard

now?

Mr. FALCON. That plan incorporates and supersedes the plan

that was adopted previously, toward the end of 2000, and this plan

is designed to take that a step further and ensure that the company maintains best-in-class standards in the financial reporting

and accounting areas. We are working closely with the company to

ensure that it accomplishes that result.

Senator SARBANES. We will go back and review what happened,

but how much confidence do you have as we move forward that any

gaps have been closed and that we are operating in a—that is

37

‘‘gap’’ spelled with one ‘‘a’’ in this instance, not with two—that we

are operating according to standards that give us some sense of security?

Mr. FALCON. I think that with the new focus of the company and

with the creation in this area of accounting in our examination program, I cannot guarantee that there will not be issues that arise,

but I think we will be as vigilant as possible to ensure that if

issues do arise, our utmost priority here is to make sure that they

do not affect the safety and soundness of the companies, that they

maintain adequate capital, that their credit and interest rate risk

are properly managed, that their asset quality remains good.

As long as all those fundamentals remain sound, then we expect

that they will be able to withstand issues like this that arise. So

if other instances came up, I think that what we want to make

sure of is that those issues do not threaten their solvency.

Senator SARBANES. Of course, one of the things that has happened here is that the directors and the audit committee of Freddie

Mac did move to take corrective action against management abuse;

is it correct to have that perception?

Mr. FALCON. Yes, Senator. They replaced top management when

they were confronted with the evidence of problems with the current management, and they did take the appropriate action at that

time.

Senator SARBANES. Well, we will have to follow this very closely.

Let me ask one final question. Jerry Knight, a financial columnist

for The Washington Post, wrote on June 30 a column in which he

said, ‘‘We now know that people at Freddie Mac did not understand

their derivatives, and they are among the biggest users of them in

the world.’’

Of course, that is a rather disconcerting statement. And recently,

Warren Buffett and Alan Greenspan have both noted the high concentration of derivatives among a relatively small number of financial institutions. This may raise a concern about systemic risk in

our financial system. The GSE’s are among two of the largest users

of derivatives.

What special steps, if any, has OFHEO taken to limit the likelihood of any systemic problems created by the use of derivatives?

Mr. FALCON. I disagree with the article. These two companies do

understand derivatives; they do understand how to use them as

risk management tools. In the case of Freddie Mac, what they did

not understand how to do properly was account for them, and that

is what we are looking at right now, at accounting issues. These

derivatives remain effective risk management tools, and the economics are sound with these derivatives; it is just the accounting.

But we will continue to look at the companies’ use of derivatives.

We assess whether or not they are used as sound risk management

devices and not as speculative devices where they might have an

exposure to changes in interest rates because there is not an offset

on the companies’ balance sheets.

We have a very active oversight program with our examiners

through the use of our capital standards and our research functions. Earlier in the year, we produced a very significant systemic

risk report where we also looked at the big picture implications of

the companies’ derivatives use.

38

So, I think we are well on top of issues related to the companies’

use of derivatives, Senator.

Senator SARBANES. Would you say that your expertise and competence within OFHEO with respect to derivatives exceeds the expertise and competence of the two institutions for whom you are

the regulator?

Mr. FALCON. I would not necessarily want to say who is better

than who, but I think we each have the expertise necessary to fulfill our functions and our missions, Senator.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Thank you.

Some of the testimony today that I have been hearing is troubling. You are the prime regulator, but it seems from the testimony

today that you have been in the dark, that it was not OFHEO that

found something wrong with the accounting problems at Freddie

Mac, but that Freddie Mac internally did this through

PricewaterhouseCooper and disclosed this to you or alerted you to

what was going on. Is that fair?

Mr. FALCON. Yes. PwC identified these issues, yes.

Chairman SHELBY. Okay. I want to go back to something that

Senator Sarbanes mentioned earlier in the hearing. If you were in

the dark—and it seems that you were as a regulator—we have

been probably lucky, all of us, and fortunate that, assuming that

these earnings are going to be upward instead of downward—in

other words, more capital instead of less capital—on Freddie Mac,

assuming that the restatement at the end of the day is between

$1.5 and $4.5 billion upward as the market seems to indicate and

people believe. But you would not have known as the regulator had

it been a huge loss instead of appreciation in value, more money,

and that is troubling because it seems to me that you cannot assume anything. And if you are the primary regulator, I think we

will continue to look at this. We have a hearing next week on the

nomination of your successor, and I am sure we will get into this

some more.

We all realize that GSE’s have done a lot of good, and as you and

others have said, they are strong and well-run. But as the regulator, I am not sure you knew that, or that you knew what was

going on, and if Freddie Mac internally through their accountants

had not disclosed this, would you have ever known? So it is deeply

troubling to us. Are you basically—and I do not mean you individually—but is OFHEO up to the task, considering the amount of

money that the GSE’s are involved in and how important they are

in the secondary mortgage market to our economy, our housing

market, and everything that goes with it?

I think these are real questions that we will continue, Senator

Sarbanes, to grapple with, and we should.

We appreciate your appearance today.

Mr. FALCON. May I say something, Mr. Chairman.

Chairman SHELBY. Do you want to respond to some of that?

Mr. FALCON. Yes, please. Let me try to explain it this way. If

there were going to be a loss as a result of this restatement, I do

think we would have known——

Chairman SHELBY. Now, wait a minute—how would you have

known if you did not know that there was going to be an upward

39

thing? I think the statement that Senator Sarbanes got at earlier

is very important.

Mr. FALCON. Right. The underlying economics of these transactions were sound. These are real earnings. These are not manufactured earnings.

Chairman SHELBY. I did not say they were.

Mr. FALCON. Right. But my point is that had there been a loss

here, it would have meant that the economics of these transactions

were not sound, that they were not effectively hedging.

Chairman SHELBY. But sir, how would you have known——

Mr. FALCON. Through our examination process——

Chairman SHELBY. —if you did not know anything about what

was internally going on—I would not say ‘‘anything,’’ but——

Mr. FALCON. Well, we were fully aware of these transactions, and

we were aware of the accounting of these transactions. We had to

examine these transactions to make sure that they were effective

hedging activities.

What we were not second-guessing was what was the proper accounting treatment for these transactions. But if these transactions

were not effective as hedging devices, it would have shown up in

the economics of these transactions, and that poor economics would

have resulted in a loss to the company, and regardless of how you

account for that, we would have picked that up through our examination program.

Chairman SHELBY. Sir, how would you have known that the financials would show a loss if you did not know what was really

going on inside?

Mr. FALCON. We would have been aware of the economics of the

transaction and been able to assess whether——

Chairman SHELBY. But how would you have been aware?

Mr. FALCON. Through our examination program, we look at all

these transactions. We look at them at a transactional level to ensure that where they have a certain amount of interest rate risk

or credit risk related to their activities, they are effectively managing that risk. And if we saw there was a mismatch between the

two, it would send a signal to us that something needs to be done

here. And again, that is why these were and are effective economic

hedges for the company. It is a matter of how you recognize the income—do you recognize it over time or do you recognize it all at

once—that depends on the application of the accounting standards.

Chairman SHELBY. Had you ever inquired about all of that?

Mr. FALCON. We were making sure that the company and their

accounting firm were going through the steps that they needed to

follow, applying industry standards for doing their work——

Chairman SHELBY. Didn’t you make a report on about the first

of June about Freddie Mac and Fannie Mae?

Mr. FALCON. I am sorry, Senator?

Chairman SHELBY. About their salaries and everything.

You made a report—didn’t OFHEO have a report on them——

Mr. FALCON. —in our annual report?

Chairman SHELBY. Absolutely.

Mr. FALCON. Yes, Mr. Chairman, we did.

Chairman SHELBY. And you did not mention any of the other

problems.

40

Mr. FALCON. Yes, and that is where I would like to assure you,

Mr. Chairman, and the Committee that going forward, I think the

Agency needs to be sure that even if issues do not rise to the level

where we have to qualify our assessment of the company, we will

take a more active look at including more detail in that annual report, and I think you have a right to expect that out of us.

Chairman SHELBY. I think it has been a troubling but also an illuminating hearing. Thank you very much.

Mr. FALCON. And you have been fair.

Thank you, Mr. Chairman.

Chairman SHELBY. The hearing is adjourned.

[Whereupon, at 12:21 p.m., the hearing was adjourned.]

[Prepared statements and response to written questions supplied

for the record follow:]

41

PREPARED STATEMENT OF SENATOR CHUCK HAGEL

Mr. Chairman, thank you for convening this important and timely hearing, and

welcome to Mr. Falcon—I look forward to your testimony.

There is no doubt that the housing GSE’s have been successful in carrying out

their mission of creating a secondary market for home mortgages. The housing market has remained strong through tough economic times, and homeownership is at

an all time high in this country.

Fannie Mae and Freddie Mac are unique institutions that are chartered by Congress, limited in scope, and are imposed with Congressional mandates, yet they are

publicly traded companies with all the earnings pressure that Wall Street demands.

Additionally, Fannie and Freddie enjoy an implicit guarantee by the Federal Government that has aided them in developing substantial clout on Wall Street. With

their influence in the markets, their ability to raise capital at near-Treasury Bill

rates, and their use of the most sophisticated portfolio management tools, Fannie

and Freddie today are no longer simply secondary market facilitators for mortgages.

Freddie Mac’s recent disclosure of management failures and accounting defi- ciencies resulting in upwards of $4.5 billion in understated earnings precipitated the

need for Congress to exercise its oversight of GSE’s. I have been assured by our

Chairman that today’s hearing will not be the only opportunity we have to address

this issue and other important questions surrounding Government Sponsored Enterprises.

It is critical that this further examination includes a look at the extent to which

the GSE’s have strayed from their central job of mortgage securitization. We should

look at how exemption from SEC regulation, State regulation, and income taxes

might create an unfair advantage for GSE’s as they compete with private-sector

companies.

If we are to continue to provide GSE’s with the framework to operate under an

implied Government backing, I believe that they should be held to a higher standard than private organizations and subject to more scrutiny than the private sector.

Furthermore, I believe it is possible to realign oversight and operating rules for

Fannie and Freddie without jeopardizing the strong housing market that America

enjoys today.

It is my view that the Office of Federal Housing Enterprise Oversight (OFHEO)

could better regulate these financial institutions if it is moved out of HUD and into

the Treasury Department. Treasury currently regulates banks and other financial

institutions through the Office of the Comptroller of the Currency (OCC) and the

Office of Thrift Supervision (OTS), and it has the experience and expertise needed

to supervise Fannie Mae and Freddie Mac—it’s a natural fit.

This reform is important to restoring and maintaining the confidence that investors and the markets require. In light of the recent problems at Freddie Mac, it is

even more important.

Mr. Chairman, I thank you again for holding this hearing today. It is a good first

step toward awareness of the problems and reform of the system. I look forward to

working with you and this Committee as this issue moves forward.

—————

PREPARED STATEMENT OF SENATOR JON S. CORZINE

Mr. Chairman, thank you for convening this important hearing on oversight of the

accounting practices of Government Sponsored Enterprises (GSE’s). These institutions serve as pillars of America’s housing market by providing liquidity that has

helped make the American Dream of homeownership a reality for millions of families.

Having said that, recent developments at Freddie Mac serve as cause for alarm.

The ongoing accounting investigation at the company, the shake-up of its management team, and the seeming lack of internal controls are all troubling. Viewed together, they call into question, and require this Committee to consider, the adequacy

of the regulation provided for Freddie Mac, as well as Fannie Mae, to ensure their

safety and soundness.

The size and complex financial structures of the two organizations—which account

for billions of dollars in mortgage-finance dollars—along with their impact on our

capital markets, on pension and mutual funds, and on individual investors, require

a regulator that is both credible and capable at providing rigorous oversight.

In my opinion, the current state of GSE regulation fails to meet these critical

tests. That is why I have come to the conclusion that GSE oversight would benefit

by moving OFHEO—and its safety and soundness responsibilities—to the Department of the Treasury, as a new, separate division with funding authority that moves

42

them out of the appropriations process. However, in my view, the underlying housing mission of the GSE’s—the annual housing goals and oversight of fair housing—

should remain with HUD.

Such a move would instill confidence in investors, our capital markets, and Members of Congress that GSE oversight is in the hands of a strong, robust, and credible

regulator.

No doubt, Mr. Chairman, there will be a wide variety of GSE ‘‘reform’’ proposals

floated. As we consider these proposals, I hope we will ensure they do not alter the

structure and regulation of our GSE’s in a manner that undermines the liquidity,

innovation and speed to market of the products they bring to our housing market.

All these features of GSE’s have contributed to making America’s housing finance

system the most successful in the world. And our housing market has been one of

the few positives in this economy.

I want to thank our witness, OFHEO Director Falcon, for joining us and providing

us with his testimony today. I look forward to his thoughts regarding the Freddie

Mac issue, and the current state of GSE regulation.

—————

PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

Thank you, Mr. Chairman. I appreciate your calling this hearing today. Welcome

Mr. Falcon. I am glad that you are here before us and I look forward to hearing

your testimony today.

Mr. Chairman, the housing sector has been one of the few bright spots in a generally stagnant economy. We are very fortunate to have had an unprecedented level

of homeownership and refinancing activity over the past few years. For most Americans, homeownership is a source of personal pride. And, for many of our citizens,

it is not the stock market, but rather the equity they develop in their homes that

becomes their principal sources of savings for retirement. In addition, cashing out

equity has enabled many Americans to reduce their higher interest debt burdens

and continue making personal purchases that boost the economy.

We, in Congress, have always put a premium on homeownership through various

policies we have enacted. There is, however, much more that we should be doing.

I believe that there are several pieces of housing legislation that we should act on

in the 108th Congress. For example, I believe that we should support bipartisan initiatives such as the housing redevelopment tax credits in S. 875 and S. 198 and the

First-Time Homebuyers’ Tax Credit Act, S. 1175. These bills are stimulative and

would help to keep housing a thriving part of our economy.

I am much less certain, however, that we should rush to pass new legislation affecting the secondary mortgage market. The markets created by Freddie Mac and

Fannie Mae have been critical to increasing the amount of money available to make

mortgages and these markets have helped to reduce the cost of homeownership.

Just because one of the GSE’s is facing some questions about its accounting is not

a sufficient reason to assume the entire regulatory system is broken. Indeed, recreating the Agency rather than fixing any existing problems could, in the short-run,

make the regulator less efficient—something we most certainly do not want to do.

Mr. Chairman, I urge caution. There are modest, but obvious and important steps

Congress can take. We can act to ensure that OFHEO has the resources both in

the short-run and in the long-run to be an effective regulator. I know that senior

staff at OFHEO spend a great deal of resources worrying about whether or not they

will get the annual appropriations that they are seeking. We should make sure they

have a reliable source of funding.

We should also make sure that, as Mr. Falcon’s tenure at OFHEO winds down,

we approve a new Director only if that new Director will be a strong and aggressive

regulator. I would like to see someone who will inspire confidence in the markets

and has widespread support from both sides of the aisle.

I suspect that critics of the good work that Fannie Mae and Freddie Mac do every

day see a unique opportunity in the current controversy at Freddie. I would suggest

that they not get too excited about using this as an opportunity to attack the two

companies on a broad set of unrelated issues. This Committee has a history of being

thorough and cautious about such things. And, no Member on this Committee wants

to do anything that would roil the housing market.

Any major changes to the regulatory framework for Fannie and Freddie should

only be considered after an exhaustive comprehensive exploration of any shortcomings in the existing regulation of the GSE’s.

I want to work with Chairman Shelby and Ranking Member Sarbanes to understand what happened at Freddie Mac and I want to be sure that both GSE’s are

43

adequately capitalized, well managed, and can continue to serve an important role

in the housing sector. I hope today’s hearing will be a starting point to accomplish

just that.

—————

PREPARED STATEMENT OF SENATOR JACK REED

I would like to thank Chairman Shelby for scheduling this hearing on Regulatory

Oversight of Government Sponsored Enterprise Accounting Practices. I also would

like to thank Armando Falcon, Director of the Office of Federal Housing Enterprise

Oversight (OFHEO), for joining us this morning.

We are here today to talk about OFHEO’s oversight of the safety and soundness

of Freddie Mac and Fannie Mae, in particular its oversight of Freddie and Fannie’s

accounting practices.

As we all know, the Government Sponsored Enterprises (GSE’s) have played an

invaluable role in creating a stable and liquid secondary mortgage market in our

country, and this has resulted in our country having one of the highest homeownership rates in the world. Strong and effective oversight of the GSE’s to ensure their

safety and soundness for the public at large is clearly an important part of their

long-term success.

As a result, we need to do everything we can to make sure OFHEO has the staff

expertise and resources it needs to quickly adapt to overseeing new products and

methods at the GSE’s. We need to make sure that OFHEO’s mission is focused, the

lines of authority are clear, it has the tools it needs to thoroughly analyze and

evaluate the GSE’s complicated financial transactions, and that it is well-insulated

from outside influences.

Although the GSE’s have been given certain benefits by the Federal Government,

they also must bear certain burdens. They must be subject to rigorous government

oversight and they must abide by more conservative standards than other financial

institutions in the market.

Needless to say, I look forward to today’s testimony and hope it can clarify some

of this Committee’s concerns about OFHEO’s oversight of the GSEs’ accounting

practices and any potential impacts on the ability of OFHEO to ensure the safety

and soundness of Fannie Mae and Freddie Mac.

—————

PREPARED STATEMENT OF ARMANDO FALCON, JR.

DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

JULY 17, 2003

Mr. Chairman, Ranking Member Sarbanes, and Members of the Committee, I appreciate the opportunity to appear before you. My testimony today will focus on the

Freddie Mac restatement process, OFHEO’s role as a safety and soundness regulator, more specifically, the Agency’s approach to examining accounting practices

and financial controls at the Enterprises, and a status report on the related issues

of Executive Compensation and Corporate Governance. In addition, I have attached

some legislative recommendations for the Committee’s consideration to enhance

OFHEO’s role as safety and soundness regulator.

Introduction

On January 22, 2003, Freddie Mac announced that it would reaudit and restate

its financial statements for 2000 and 2001. The company also announced that its’

external auditor would delay certification of Freddie’s year-end 2002 financial statements. Five months later, on June 7, the board removed the company’s top three

officers. OFHEO, the SEC, and a U.S. Attorney all have ongoing investigations of

the company and its accounting practices. These extraordinary actions reflect the

culmination of developments over several years. Given our ongoing investigation, I

ask for the Committee’s understanding if I am restrained in my testimony, as facts

are still being verified and circumstances evaluated. I will begin by describing the

major developments in chronological order.

Lead-Up to FAS 133 Preparation and Implementation—1999

First, the sequence of events begins with the preparation, in 1999, for implementation of Financial Accounting Standards Board (FASB) Statement No. 133—Accounting for Derivative Instruments and Hedging Activities (FAS 133). FAS 133 is

not the only accounting standard involved in this matter, but it plays the most important role. FAS 133 establishes accounting and reporting standards for derivative

44

instruments, including certain derivative instruments embedded in other contracts,

(collectively referred to as derivatives) and for hedging activities.

FAS 133 requires an entity to recognize all derivatives as either assets or liabilities in the financial statements and reflect those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as: (a) a hedge

of the exposure to changes in the fair value of a recognized asset or liability or an

unrecognized firm commitment; (b) a hedge of the exposure to variable cashflows of

a forecasted transaction; or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-forsale security, or a foreign-currency-denominated forecasted transaction. The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.

Under FAS 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining

the ineffective aspect of the hedge. Those methods must be consistent with the entity’s approach to managing risk.

I would now like to turn to OFHEO’s examination strategy to cover FAS 133 preparation at the Enterprises in 1999. The routine 1999 examination work was conducted at the same time OFHEO’s examiners were expending considerable efforts

to ensure that both Enterprises were prepared for, and all essential systems across

the two companies would be fully compliant with Y2K goals. Because of the critical

nature of Y2K readiness, examiners conducted extensive testing and validation of

systems preparedness. Against this backdrop, the FAS 133 examination strategy required the examination team to maintain expertise and working knowledge of the

accounting standard and its potential effects on each Enterprise; evaluate and assess the Enterprises timeline for implementation; evaluate the strategy each Enterprise was pursuing for its implementation of the accounting pronouncement and

analyze the effects of FAS 133 on financial statements. In addition, our examiners

would continue to evaluate the external accountant’s position on the accounting policy guidance associated with implementing FAS 133; assess the systems enhancements to conduct hedging and financial reporting under FAS 133; and evaluate and

monitor implementation readiness and event management, including contingency

preparations for the transition.

In the second half of the year, FASB unexpectedly delayed the implementation

date of FAS 133, from January 1, 2000 to January 1, 2001, so that companies could

focus their attention on Y2K.

Transition Period to FAS 133 Readiness—2000

In 2000, OFHEO’s examiners assessed the development and implementation of

Enterprise plans with respect to several new significant accounting standards, including FAS 133. At the same time, they reviewed the effectiveness of Y2K efforts

and the effects on the financial safety and soundness of a 20 percent decline in the

volume of originations; an increase in the proportion of Enterprise purchases of single-family mortgages evaluated through automated underwriting systems; and the

increased use of sophisticated technology for risk management across the companies.

In evaluating preparations for the implementation of FAS 133, examiners were

actively evaluating: systems preparation, implementation strategies, impact analysis, documentation specifications, portfolio management strategies, and the approvals from management, the board and the internal and independent external accountants involving FAS 133 implementation. We recognized the substantial

progress that had been made on the preparations and the considerable analysis that

had been performed. Further, we noted the additional efforts that were underway

to deal with the remaining systems and documentation challenges associated with

implementing and operating with FAS 133.

In late 2000, the audit committee approved the Financial Reporting Controls Improvement Plan (FRCIP). The FRCIP was designed to address issues affecting financial accounting and financial reporting that had been identified by the company, its

independent auditors, and OFHEO. The goal of the FRCIP was to achieve the same

level of controls in the financial accounting and financial reporting area that were

present across the other areas of the company and in the operating business units.

OFHEO’s examiners evaluated the FRCIP and Freddie Mac’s progress in completing the FRCIP in a number of ways. In 2000, examiners evaluated and communicated with management about the FRCIP itself, ensuring if it was reasonably

designed to address the root causes of the identified weaknesses. Also, in 2000, examiners assessed the design of the tools both management and the board’s audit

committee intended to use to measure and report progress in implementing the

45

FRCIP. On a regular basis, examiners were assessing the progress toward completion of the FRCIP and communicating our assessments to the company.

In the fourth quarter of 2000 and the first quarter of 2001, Freddie Mac entered

into several transactions to minimize the impact of FAS 133. PwC later identified

these FAS 133 transition transactions as accounting issues needing correction before

the 2002 financial statements could be certified.

Implementation of FAS 133—First Quarter 2001

In 2001, OFHEO’s examiners continued their ongoing evaluation of FAS 133’s implementation and its impact on the Enterprise, with respect to business activities,

risk management strategies, and portfolio management. Among the variety of features our examiners were reviewing, were the operational aspects associated with

FAS 133 and the company’s quarterly closing practices. When reviewing the quarterly closings, we noted the sign-offs and notations of the company’s auditors. Our

review found no reservations or qualifications associated with Arthur Andersen’s

certification of the quarterly and year-end 2001 financial statements and the conformance of those financial statements and disclosures with GAAP.

FAS 133 was implemented in first quarter 2001. Arthur Andersen certified each

quarter’s financial statements under the new FAS 133 pronouncement as GAAP

compliant. At this same time, extensive interpretations continued to be produced on

FAS 133 by FASB.

While OFHEO was conducting its FAS 133-related examination activities, we

were also dedicating examiners to assess the impact of record levels of originations,

new corporate governance standards and record volumes of purchases, and

securitization on both Enterprises safety and soundness. OFHEO examiners were

also evaluating the timeliness and effectiveness of the Enterprises actions to meet

the final Risk-Based Capital Rule.

Need to Strengthen Expertise and Controls—2001

After preparing for FAS 133, the actual implementation of this accounting standard further highlighted aspects of Freddie Mac’s financial accounting and financial

reporting areas that needed strengthening. It became more apparent to OFHEO and

Freddie Mac that, while the overall control structure for the company was strong,

in the financial accounting and financial reporting area there was an apparent need

to strengthen expertise and reduce the reliance on manual systems. Strengthening

expertise and reducing the reliance on manual systems were important aspects of

the FRCIP introduced in 2000, and examiners continued in 2001 to evaluate the

progress against this remediation plan. We continued to press management to ensure progress continued in implementing the FRCIP and maintaining the plan’s implementation remained an important corporate priority.

OFHEO felt the control environment at that point in financial accounting and financial reporting was stable, but in need of strengthening. The FRCIP was designed

to address the identified weaknesses and to strengthen the control environment in

the financial control and financial reporting area to a level consistent with the control environments across the other parts of Freddie Mac. While there were weaknesses in the financial accounting and financial reporting area, the manual processes did mitigate those control weaknesses in the operating process and resulted

in Freddie Mac’s ability to produce reliable financial records. Upon completion of the

work to reengineer the financial accounting and financial reporting process, there

would be a more timely, efficient, and streamlined process that would not depend

upon manual systems to ensure the reliability of financial information.

In context, Freddie Mac maintained effective internal controls in its various business areas. The area covered by FRCIP was the financial accounting and financial

reporting area, which represents a subset within the larger finance area, and an

even smaller subset within the overall company.

OFHEO’s examiners continued in 2001 to evaluate progress on the FRCIP at least

quarterly by, for example, analyzing and testing the quarterly progress reports to

the audit committee, internal audit, senior management, and Arthur Andersen, and

evaluating the events reached or expected, major milestones, schedule overruns, and

the level of completion of each project. Examiners concluded that by mid-2001 approximately one-third of the FRCIP had been completed. As a result of a national

search, Freddie Mac brought in a new Senior Vice President—Corporate Controller,

charged with responsibility for the accounting and control function. This key milestone was achieved in October 2001, and by year-end 2001 Freddie Mac completed

Phase I of the FRCIP, which included reconciliations, and deployment of integrated

and automated cash management, bank account and transactional reconciliations

and billings/receivables functionalities. In 2002, OFHEO’s examiners continued their

ongoing assessments of progress under the FRCIP, and determined that the new acVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00049 Fmt 6633 Sfmt 6621 21517.TXT SBANK4 PsN: SBANK4
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countability model and Operation Risk Management Unit, when implemented,

would strengthen Freddie Mac’s financial accounting and reporting processes.

Also during this period, OFHEO was planning enhancements for its examination

activities. In 2000, I had meetings with the Chief Examiner, and we outlined plans

for strengthening OFHEO’s examination program. Among our discussions was an

idea to create an examination team dedicated to accounting matters. In January

2001, the Chief Examiner delivered a plan designed to enhance OFHEO’s examination program. A cornerstone of that plan was to more than double the size of the

examination staff, adding depth and additional specialized skill sets to deal with

complex issues associated involving the supervision of the Enterprises.

The plan to strengthen OFHEO’s examination program included the formation of

a group for specialized examination activities, including a team of accountants. After

receiving this plan in January 2001, I began advocating within the Administration

and with Congress the importance of OFHEO obtaining the resources to begin implementing this plan and enhancing our examination program. In the second-half

of 2002, we were able to start populating our team of accountants with skilled technicians who would be dedicated to accounting matters at the Enterprises.

New Outside Auditor—2001

Late in 2001, Arthur Andersen was under public scrutiny because of its role as

the audit firm of record in certain high-profile Federal investigations and bankruptcy filings. Given these developments in late 2001 with Arthur Andersen,

Freddie Mac’s Board of Directors and executive management deliberated whether

they should keep that firm or select a new independent accounting firm. Freddie

Mac solicited OFHEO’s views concerning the retention of Arthur Andersen. OFHEO

opined that given the circumstances, retention of the firm created a higher-risk situation for Freddie Mac.

The audit committee decided to change independent accountants and interviewed

two potential firms in the first quarter of 2002. The Committee decided to switch

to PwC for Freddie Mac’s independent public accountants for the year ending December 31, 2002. Freddie Mac made a public announcement of this decision on

March 6, 2002. The audit opinions of Arthur Andersen on the consolidated financial

statements of Freddie Mac for the fiscal years ending December 31, 2000 and 2001

did not contain any adverse opinion or disclaimer of opinion, nor were they qualified

or modified as to uncertainty, audit scope, or accounting principles. In separate

management letters, Arthur Andersen shared its concern with senior management

on a number of items that had also been independently noted by OFHEO.

Engagement of PwC—2002

OFHEO evaluated and tracked changes being made through its routine examination activities in 2002 regarding the engagement of PwC and the work of the audit

committee. PwC began its audit engagement immediately after being selected by the

audit committee. OFHEO examiners had an introductory meeting with PwC managers for the Freddie Mac audit on March 5, 2002. PwC was ratified as the independent public accountant at Freddie Mac’s May 2, 2002 Annual Shareholders

Meeting. In the course of its audit, PwC initiated a process of identifying various

accounting policies and accounting issues to discuss with Freddie Mac’s management. Both Freddie Mac management and PwC conveyed the nature of these discussions to the audit committee. In the normal course of business, PwC met with the

audit committee in executive session on these matters.

Additional Expertise Added at Freddie Mac—2002

Consistent with OFHEO’s concerns, some important staffing decisions in the finance area were announced at Freddie Mac during 2002, adding necessary expertise. In June, a new Senior Vice President for Operational Risk Oversight was hired.

On June 18, the board announced the creation of a new senior level executive position and national search, for an Executive Vice President of Finance, consistent with

the goals outlined in the FRCIP. The newly created position would be responsible

for the overall finance, accounting, corporate planning, tax, shareholder relations,

and market risk and operating risk oversight functions of the company. The CFO

and the Corporate Controller would continue in their respective roles and they

would report to the new Executive Vice President—when hired. Until the new position was filled, the Corporate Controller had a direct administrative reporting line

to the COO and a direct communication line with the audit committee, similar to

the CFO’s reporting line. The current EVP and CFO—Mr. Vaughn Clarke—no

longer had the Corporate Controller reporting through him, and notified the company of his intentions to leave Freddie Mac. On March 19, 2003, Freddie Mac announced that Mr. Martin Baumann had filled the newly created EVP of Finance

position.

47

ALLL Accounting Matter Identified—2002

OFHEO was actively involved in the discussions that were taking place between

PwC and Freddie Mac regarding the Allowance for Loan and Lease Losses (ALLL).

The ALLL was identified in July 2002 by PwC as a critical accounting matter that

needed to be resolved as they worked toward certifying Freddie Mac’s financial

statements.

A special audit committee meeting was held on July 16, 2002 where PwC raised

the ALLL issue for Freddie Mac—it was too conservative in its loss estimates and

coverage per PwC’s determination under GAAP. PwC felt this matter on the ALLL

needed to be resolved before Freddie Mac’s release of second quarter financial statements on July 23, 2002.

OFHEO and Freddie Mac representatives met on July 22, 2002 to gather information about the final size of the adjustments being made to Freddie Mac’s financial

statements. The adjustment was a $246 million reduction in the ALLL. On the same

day, the audit committee had a special meeting to review the final analysis and approve the adjustment for release to the public in the July 23, 2002 release of financial statements.

Accounting policies and issues continued to be worked on by PwC, management

and the board throughout 2002. Progress appeared on track for the certification of

fiscal year 2002 financial statements. As of fourth quarter 2002, the ALLL was the

only accounting issue that had risen to the level of PwC expressing reservations to

the audit committee relating to that firm’s ability to certify Freddie Mac’s statements and that had been resolved in July 2002. OFHEO continued to evaluate and

monitor the status of the accounting policies under discussion between PwC and

Freddie Mac during 2002, as well as the actions and decisionmaking by the audit

committee. Examiners continued in 2002 to evaluate progress on the FRCIP at least

quarterly. This included examiners testing selected work products and evaluating

project management and reporting.

Unresolved Accounting Matters under FAS 133—2003

PwC came to the Freddie Mac Board in mid-January 2003 and informed the audit

committee they would be meeting with representatives from PwC’s national office

about unresolved accounting policy matters, related to FAS 133 implementation. On

Monday, January 20, 2003, PwC notified the audit committee that they were uncomfortable with certain accounting treatments applied during the FAS 133 transition. Furthermore, until its concerns were resolved, it would not be able to certify

the company’s 2002 fiscal financial statements using the accounting policies from

prior periods, even though the policies had been approved by Arthur Andersen as

GAAP compliant. OFHEO was made aware of these developments on that day and

met with Freddie Mac officials the following day.

The nature of the major accounting issues identified through the restatement

process include:

1. The erroneous accounting treatment of the company’s Securities Sales

and Trading Group (SS&TG) as a third-party broker dealer;

2. Inadequate documentation and testing of certain derivative instruments

and their valuations accounted for as hedge instruments for accounting purposes;

3. The erroneous transfer of mortgage securities out of the ‘‘held-to-maturity’’ and trading accounts;

4. The treatment of mortgage sales transactions as financings;

5. Accounting for certain cash transactions used to manage interest rate

risk as if they were derivatives; and

6. Omitting the recognition of the guarantee fee and credit obligations embedded within sold PC’s.

These transactions are the subject of our investigation, and I will have more to

say about them in my final report.

Because Arthur Andersen was no longer an operating firm at this point, PwC

could not undertake a normal transition pursuant to the AICPA guidance for successor/predecessor accountants. Instead, PwC would have to undertake additional

substantive testing. The board of directors determined that PwC should conduct a

reaudit of the prior period financial statements.

OFHEO, PwC, and the audit committee evaluated the nature of the accounting

issues. Among the factors considered was the cumulative effect of the adjustments

flowing from the change in accounting treatments. The net cumulative effect of the

new accounting treatments was an increase to income in prior periods, thus increasing the amount of capital on a cumulative basis. This would also result in considerable volatility in those prior periods. Further, OFHEO, PwC, and the audit

48

committee considered the effects from the accounting policy changes for any potential effect on the fair value statements of Freddie Mac. All concluded there was no

meaningful impact on the fair value statements, which meant the underlying economics for Freddie Mac’s risk positions were materially unaffected by the timing

changes in recognizing income for the GAAP statements being restated.

Examiners were on-site at Freddie Mac gathering more information about the

issues and the action plan that were being formed to address the reaudit. Freddie

Mac announced the reaudit and the delay in 2002 certified financial statements on

January 22, 2003.

Based upon the reaudit of prior periods, Freddie Mac said it would be restating

2000 and 2001 annual results and quarterly financial results for 2001. Along with

delays in issuing certified 2002 financial results and prior period restatements,

there would be delays in issuing certified quarterly financial statements for the first

and second quarter of 2003. The timeline was to have the restatements done in approximately 6 months.

The restatement process has involved the reevaluation of over 100 accounting

policies, which resulted in the identification of approximately 20 major issues that

will affect the financial statements.

These accounting changes will result in about half of the company’s derivatives

being marked to market through current period earnings as opposed to being deferred and recorded into earnings over time. In addition, all mortgage securities will

be marked to market either through OCI or current period earnings. In addition,

previously off-balance sheet guarantee fees and obligations relating to approximately one-half of the guarantee business will now be recorded on balance sheet at

fair value, with changes reported in current period earnings. These changes will

most likely result in increased volatility and decreased future earnings.

Heightened Focus—January 2003 to Present

In mid-January 2003, it was clear that a forensic review of selected accounting

issues raised by PwC would be appropriate. The law firm of Baker Botts was retained by the audit committee to perform diagnostic and forensic work associated

with the restatement process. The scope of Baker Botts’ engagement is to conduct

a review of the facts and circumstances surrounding certain transactions and other

matters related to the restatement process. OFHEO’s plans were to monitor and

consider the work of Baker Botts, while concentrating the Agency’s efforts on the

reaudit and restatement process. When the restatement process neared its completion, OFHEO would consider the progress and adequacy of the counsel’s review and

determine whether the Agency would need to undertake its own forensic review.

At this point, OFHEO focused on its mission—safety and soundness—and emphasized to Freddie Mac the importance of properly concluding the reaudit and publishing certified financial statements. In addition, OFHEO concurred with the

board’s decision to engage outside counsel for forensic and related work.

OFHEO’s accounting team began continuous surveillance of the restatement

process on January 22, 2003, focusing on: The accounting issues surrounding the

transactions that triggered the reaudit; the accounting policies/issues under consideration—being changed or affirmed; the organization and staffing of the project; the

analysis of the cumulative effect of the restatement process; the preparation of adjustments; the methodology for establishing value estimates; the process for running

ledgers and analyzing results; the quality control process; the plan for rolling out

the revised financial statements; and the status of controls being embedded into the

new processes as they are being built. In addition to the ongoing work of the accounting team, there were periodic updates and evaluations on the restatement

process from January on.

February—In February, OFHEO continued its close evaluation of the restatement process. Specifically, OFHEO’s accounting team scrutinized the organizational

structure of the effort, the plan of action, and the resources and the timeline associated with the work on the restatement process.

March—OFHEO met with the board and its audit committee on March 6. In that

meeting, there was considerable discussion relating to the restatement process, the

reaudit, and OFHEO’s posture toward completing the restatement process. Also in

March, as noted earlier, Freddie Mac announced the hiring of Mr. Baumann as Executive Vice President for Finance. Mr. Baumann was given full responsibility for

the restatement process by the board of directors and for formulating a plan of action for the post-restatement environment. Mr. Baumann is reporting directly to the

board of directors until the restatement process is completed.

OFHEO remained engaged during the period the board considered a delay in the

release of first quarter financial results to coincide with the restated financials for

prior periods. On March 25, Freddie Mac announced the restatement process reVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00052 Fmt 6633 Sfmt 6621 21517.TXT SBANK4 PsN: SBANK4
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mained on track. The company’s expectation was still to have the restatement concluded as soon after the close of second quarter 2003 as practical—expecting to restate financials by mid-July 2003. Freddie Mac also notified the market they would

not be releasing first quarter financials, rather, they would provide operating statistics and risk measures. The decision to delay first quarter financials was to provide

those 2003 results consistent with the basis upon which the restated financials will

be presented. In the March 25 release, Freddie Mac also identified additional accounting issues.

April—In April, Freddie Mac was moving toward the final stages of a complete

review and affirmation of all the accounting policies. OFHEO continued to evaluate

the work being conducted and the progress against the established timeline. Some

additional accounting items were adding to the complexity of the task. Freddie Mac

brought in third-party vendors to expedite the process after PwC approved the use

of such vendors. On April 29, PwC informed the audit committee that they might

not be able to accept the representations of top management.

May—In May, OFHEO observed slippage in the restatement process against established time frames. PwC and Freddie Mac had more than 500 people working

on the process 6 days a week and this work had been continuous since January

2003. They were beginning to complete some of the adjustments. There was considerable work that needed to be done between production of statements and producing

the tables and disclosure to accompany those statements. On May 8, PwC informed

Senior Board members and counsel that PwC would not accept the representations

of Vaughn Clarke and David Glenn.

On May 13, the board’s Governance Committee at its weekly meeting approved

the Finance Function Governance Plan (FFGP) presented by Mr. Baumann. This

plan, superceding the FRCIP, addressed the considerable work that has been done

to reengineer the process and enhance the controls for financial accounting and financial reporting. This plan, some of which will take almost 2 years to complete,

is intended to build a finance environment incorporating a high level of professional

standards and compliance that delivers comprehensive and understandable financial

information. The objectives included addressing findings which had arisen during

the restatement process and the work of Baker Botts and PwC.

In late May, OFHEO again observed the challenges against achieving the timeline

with the additional accounting issues that were added in April. However, Freddie

Mac continued to work toward the mid-July target. There were no new issues since

April. Freddie Mac continued to work through all the adjustments and calculated

the valuation estimates for prior periods. Some opportunities to strengthen controls

noted during the restatement process continue being implemented by Freddie Mac.

On May 27, OFHEO was briefed on the Baker Botts work for the audit committee.

The briefing covered the scope of the project, the nature of their forensic work and

perspective on the status of their findings to date. In response to a direct question,

Baker Botts expressed no concerns regarding the management team of inappropriate or improper management behavior. Subsequent to this meeting, OFHEO

learned of very troubling information regarding the conduct and integrity of management in matters related to the restatement process, indicating the board’s counsel had not been fully forthcoming. This lack of candor contributed to my decision

on June 7 to initiate an OFHEO investigation.

Events of June 4 through June 7

Mr. Chairman, I will begin a discussion of the key events of June 4–7, that have

drawn so much attention. First, I would note that the Freddie Mac Board of Directors was holding a regularly scheduled meeting on Thursday, June 5 and Friday,

June 6.

On Wednesday, June 4, Mr. David Glenn met with the board’s outside law firm—

Baker Botts—and informed them that he had altered parts and had removed pages

from a document that had been requested by the firm. That evening, counsel from

Baker Botts informed the lead outside director of Mr. Glenn’s admission.

On Thursday, June 5, Freddie Mac’s Board was informed of Mr. Glenn’s admissions and determined that actions were required. The morning of June 5, OFHEO

was alerted that the board would have an urgent communication to discuss with us

when the board’s deliberations were concluded. the board’s deliberations continued

into Friday, June 6.

On Friday June 6, during the day, the board made decisions on the separation

from the firm of Brendsel, Glenn, and Clarke and on the appointment of O’Malley,

Parseghian, Petersen, and Baumann. The board communicated to OFHEO immediately on its actions regarding the management changes. Later that evening, I was

informed about the circumstances surrounding Mr. Glenn. I instructed board counVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00053 Fmt 6633 Sfmt 6621 21517.TXT SBANK4 PsN: SBANK4
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sel to appear at OFHEO’s offices on Saturday, June 7, to advise us on all the matters surrounding management changes.

On the morning of June 7, OFHEO senior staff and I met with representatives

of Freddie Mac’s Board to learn the details of recent events. I would note that much

of what was addressed that day was known to OFHEO and had been the subject

of the restatement. However, new issues relating to Mr. Glenn and the termination

and replacement of senior management were also presented; particularly the lack

of confidence in Mr. Glenn expressed a month earlier by PwC. I considered the information regarding Mr. Glenn a clear signal of a breakdown in the integrity of the

Freddie Mac’s control environment at the highest levels and sent a letter to the

board that day initiating an OFHEO investigation.

Following this meeting, as occurred after the meeting on May 27, additional matters came to light and, again, reflected a lack of candor that concerned me deeply.

In the June 7 letter, I formalized with the board certain actions with respect to

the restatement process. In addition, I tasked a special investigative team to explore

and review accounting practices relevant to the restatement process at Freddie Mac

and, in addition, management’s progress in implementing an action plan that

OFHEO directed the board to provide for the Agency’s formal approval. The investigative team has also undertaken an investigation of employee misconduct. OFHEO

is moving expeditiously on this review.

The Role of a Federal Financial Safety and Soundness Regulator

Having discussed our specific regulatory role over the restatement process at

Freddie Mac, I would now like to put it in a more general context. First the role

of a financial safety and soundness regulator and second, and more specifically, the

Agency’s regulatory approach in examining accounting practices and controls.

OFHEO uses a safety and soundness approach in supervising the Enterprises that

is analogous to the Federal Reserve System’s and the Office of the Comptroller of

the Currency’s approach to supervising large-and-complex banking organizations.

The foundation of these approaches is that the management of these firms should

be held responsible for monitoring and managing the institution’s exposure to risk.

By looking at the firm’s risk management procedures and internal controls, the safety and soundness regulator assesses whether the firm’s ability to manage risk

matches the level of risk it assumes. In addition, the supervisory process also reviews the firm’s performance in complying with the company’s own internal policies,

as well as other prescriptive requirements. In short, safety and soundness supervision is directed toward identifying material problems or emerging problems and

seeing they are appropriately corrected before the company’s financial solvency is

threatened.

During the past decade, financial safety and soundness regulators and OFHEO

have endeavored to continuously enhance the examination process to make it more

risk-focused and to make greater use of technological innovations. Increasingly, safety and soundness supervision stresses the need for financial firms to implement

sound risk management practices for: Active oversight of management by the board;

clearly defined policies, procedures, and authority; comprehensive risk measurement

and reporting systems; and adequate audits and systems of internal controls.

OFHEO’s supervisory activities are designed to assess the Enterprises’ risk profiles and require remedies where and when they are appropriate. They encompass

evaluations of each Enterprise’s asset quality, management of interest rate risk, liquidity management, capital adequacy, and their risk management strategies and

risk management practices—including their internal controls and governance.

Safety and soundness regulators do not attempt to prescribe ‘‘regulatory accounting principles’’ for financial reporting. In fact, when accounting principles were prescribed in the 1980’s by financial regulators, many of those standards were criticized

after numerous financial institutions failed. Congress subsequently expressed its desire for financial safety and soundness regulators to rely upon established accounting principles (GAAP) for financial reporting standards (Section 121 of FDICIA). In

OFHEO’s 1992 Act, Congress directed OFHEO to do the same, that is, to pursue

GAAP in their regulatory reporting requirements.

Safety and soundness regulators do not review accounting policies for conformance

with GAAP, nor do we certify that a company’s financial statements are consistent

with GAAP. We expect an independent auditor to certify that a company’s financial

statements are in conformance with GAAP. We review transactions to ensure that

they are consistent with sound risk management. The work of the independent auditor is to conduct its audit and report on the company’s annual financial statements.

The scope of the independent auditor’s engagement must be sufficient to permit the

auditing firm to determine and report upon whether the financial statements are

presented fairly and in accordance with GAAP.

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The internal and external auditors routinely work together in establishing the

scope and frequency of audits to be performed. The independent auditor reviews the

scope and adequacy of the internal auditing program.

Safety and soundness supervision does not replace an internal audit function for

the Enterprises’ Board of Directors. Internal audits are a governance/management

control question. That is, the board of directors and executive management need to

have the internal controls tested and assessed by units without business-line operating responsibilities, such as an internal audit group. Internal audit provides the

board and the CEO, along with other members of senior management, with assurances concerning the effectiveness of controls.

Safety and soundness regulators do not perform forensic work (investigative work

on what has occurred) unless a need arises. In fact, safety and soundness regulators

frequently cause the board of directors to engage forensic professionals to investigate irregularities and share the results of their findings with the regulator. Subsequent to the findings from the forensic work, the regulator holds the board accountable for ensuring there are appropriate remediation plans and action items to

address the issues that are identified.

OFHEO’s Approach to Examining Accounting Practices and

Controls Over Financial Reporting

The process of examining an Enterprise’s accounting practices and related internal controls for financial reporting begins with a thorough study of the strategies

and the techniques the board of directors has adopted to set the company’s course,

and to measure and evaluate management’s performance in implementing the

board’s strategies. This step includes, for example, an evaluation of the board’s committee structure, oversight practices and reporting conventions, and an assessment

of the effectiveness of the overall control framework at the board level. The examination process also includes a ‘‘mapping’’ of the corporate structure management

has adopted to facilitate the implementation of the board’s strategies and the

achievement of its objectives pertinent to financial reporting. The objective of the

mapping process is to establish a roadmap of management’s assigned responsibilities, duties, and functions that can then be used to identify key risk points in the

internal control framework for financial reporting that warrant targeted evaluation

and attention due to their potential impact on financial safety and soundness.

Having established an appropriate understanding of the overall control framework

and its risk points by, for example, reviewing relevant policies, procedures, systems,

tools, and management reporting, and by interviewing Enterprise management and

personnel, examiners then sample selected transactions in order to test whether the

framework actually functions as designed and intended. Depending on the nature

of the examiners’ focus, these sampling activities may include evaluations of the actions of a variety of different participants and their respective roles in the control

framework, including management, technical staff, internal auditors, and independent auditors. During the course of their evaluations, examiners apply evaluative standards that reflect the professional standards appropriate for the actions

under review, and reach conclusions that address the Enterprises’ financial safety

and soundness.

OFHEO’s approach to examining accounting practices and internal controls for financial reporting should be familiar to the Committee, given that our approach is

built on the same well-established concepts that form the core of applicable provisions of the Sarbanes-Oxley Act of 2002 and the SEC’s regulations implementing the

control-related provisions of that Act. Our examination approach also embraces

fundamental precepts found in widely-recognized control frameworks such as the Internal Control-Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (more familiarly known as ‘‘COSO’’), the

Guidance on Assessing Control published by the Canadian Institute of Chartered

Accountants, and the Turnbull Report published by the Institute of Chartered Accountants in England & Wales. Moreover, we regularly consider practices adopted

by other financial safety and soundness regulators, generally accepted auditing

standards, and control-related methodologies and standards propounded by professional associations such as the Institute of Internal Auditors and the American Institute of Certified Public Accountants, and we enhance our evaluative techniques

as necessary to maintain a position on the leading edge of this evolving field of expertise.

The Committee has requested information on OFHEO’s role with respect to

approving termination agreements for the executive officers of the Enterprises, including involvement in the recent termination agreements of Freddie Mac’s executive officers. In addition, you sought information on OFHEO’s corporate governance

rule. Details on both follow.

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Executive Compensation

OFHEO has broad authority to consider executive compensation, both as a specific

matter of excessive compensation as well as a factor in the operational integrity of

the Enterprises.

OFHEO draws authority from the explicit and implied authorities of its statute,

the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, PL

102–550, Title XIII; 106 Stat. 3672 (October 28, 1992). At the same time, other

OFHEO authorities are delineated in certain sections of the chartering acts for the

Enterprises.

Excessive Compensation. OFHEO is directed by statute to prohibit the payment

of ‘‘excessive compensation’’ to executive officers; 12 U.S.C. 4513(b)(8). The prohibition on excessive compensation is tied to compensation that is ‘‘. . .not reasonable

and comparable with compensation for employment in other similar businesses. . .;’’

12 U.S.C. 4518(a). At the same time, OFHEO may not set or prescribe or set a specific level or range of compensation for such executives; 12 U.S.C. 4518(b).

Termination Benefits. OFHEO has authority to review and provide approval for

‘‘termination benefits.’’ This authority is contained in the charter acts of the two Enterprises.

For example, in the Freddie Mac charter (Federal Home Loan Mortgage Corporation Act, 12 U.S.C. 1451 et seq.), Section 303(h)(2) provides that the Corporation

may not enter into any agreement or contract to provide money or other things of

current or potential value in connection with the termination of employment of any

executive officer unless the agreement or contract is approved in advance by

OFHEO; 12 U.S.C. 1452(h)(2). The statute provides for OFHEO to make such determination based on comparability of such agreements with officers at comparable

companies. The statute covers contracts entered after the date of enactment, but

provides that any ‘‘renegotiation, amendment, or change’’ after such date of enactment to any contract entered into before or after the date of enactment shall be considered entering into a new agreement or contract that OFHEO should review and

provide its opinion.

In regards to Freddie Mac, OFHEO has undertaken certain actions relating to executive compensation. Specifically, I wrote to the board of directors on June 7, 2003

indicating it must explain its rationale for any termination packages for the individuals leaving the firm, specifically for Brendsel, Glenn, and Clarke. Further, I directed the board to inform these individuals that their termination packages are

subject to OFHEO review and approval and, for any employee discharged for misconduct, that OFHEO could direct indemnification of Freddie Mac for losses incurred.

We have directed Freddie Mac not to transfer funds, stock, or options to these

three individuals and Freddie Mac is complying. OFHEO is reviewing now the termination packages for Brendsel, Glenn, and Clarke.

I want to reiterate what I noted regarding OFHEO’s authority in this area. First,

we review executive compensation as a stand-alone matter, that is: Is such compensation excessive? And, second, as we proceed with the investigation, we look to

the behavior of management and whether it comports with the standards of the corporation, violates any corporate governance rules or otherwise harms or threatens

the safety and soundness of the corporation. If so, OFHEO would consider actions

that would involve compensation, such as ordering restitution.

Corporate Governance

OFHEO has had in place for some time an active program of review for corporate

governance at the Enterprises. Corporate governance is considered to be a major

component of risk management and a fundamental ingredient in the safe and sound

operation of the firms. Corporate governance under the examination program is

composed of separate programs entitled Board Governance, Management Processes

Program, Audit Program, and Management Information Program.

While OFHEO has strong statutory support for its corporate governance regime,

in 2000, the Agency began a program of building up its regulatory infrastructure,

putting in place rules to support its various functions and to strengthen its legal

position. This program included a corporate governance rule. The rule generated a

great deal of interest and OFHEO issued a Final Rule on June 2, 2002, effective

on August 5, 2002.

The rule made clear that corporate governance is a key area of safety and soundness and it directed each of the Enterprises to elect a State law for the purposes

of adhering to a body of corporate law. Both have done so. The rule required the

companies to have committees and that they meet the highest applicable standards;

both have such committees. A quorum of the board is required to transact business

and no proxy voting is allowed; both have such policies. The rule required conflict

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of interest policies; both have such policies. The rule mandated that the board meet

its responsibilities and described the areas of key concern for Board oversight of senior management. Finally, the rule noted the authority of OFHEO to limit or restrict

indemnification of current or former board members as part of its safety and soundness authority.

OFHEO’s examination team has worked with the Enterprises to see that changes

that were required have been put in place and that the Enterprises continue to address other requirements, such as changes mandated in the Sarbanes-Oxley Act.

Legislative Enhancements

I would like to submit for the Committee’s consideration a series of legislative recommendations to add to OFHEO’s broad authorities and to fill in a number of gaps

between OFHEO’s authorities and those of other financial regulators.

Paramount among these is permanent funding for the Agency. Other financial

safety and soundness regulators are funded through assessments on the institutions

they regulate; so is OFHEO. Only OFHEO, however, must move through the annual

appropriations process. The budget process has had a limiting effect on the Agency’s

resources and may affect our ability to effectively address regulatory issues on a

timely basis.

OFHEO must have more flexibility to respond to important issues, such as

Freddie Mac’s restatement of income, without stretching thin our ability to continually monitor the significant credit and interest rate risks being managed by the

two Enterprises. The amount of resources needed to address the issues surrounding

Freddie Mac’s restatement is straining our resources. Permanent funding is needed

to ensure that OFHEO can continue to effectively regulate the Enterprises. I am

pleased that the Administration has endorsed this needed change.

The other recommendation I would like to highlight relates to charter compliance.

I believe that the regulatory responsibility for ensuring that the Enterprises remain

in compliance with their charters more properly resides with the safety and soundness regulator. Mission regulation would continue to reside in HUD in the form of

affordable housing goals and fair lending enforcement.

OFHEO has the authority and responsibility for taking an enforcement action

when an Enterprise violates any applicable law or regulation. In fact, under the current scheme, if HUD found that a new program was not permissible, HUD would

turn to OFHEO to take any necessary enforcement action. In addition, OFHEO

would take appropriate action if we independently determined that an Enterprise

was in clear violation of its charter. OFHEO should have full authority, including

in areas of ambiguity, for interpreting and enforcing charter compliance.

Without casting any doubt on HUD’s abilities, I simply believe that public policy

would be better served if OFHEO, with its active examination and oversight of the

Enterprises, had full responsibility for charter compliance.

The draft proposal, attached with a summary, strengthens OFHEO with explicit

receivership authority, removal authority, greater facility in hiring examiners, adds

criminal penalties for certain violations of law, provides independent litigation authority and addresses certain gaps in OFHEO’s enabling statute that have been addressed previously by regulation.

Notes on Recent Events and the OFHEO June 2003 Annual Report

to Congress

Turning now to the OFHEO Report to Congress, we reported that Freddie Mac’s

overall internal control framework, and the management of the internal control

framework, are effective. We stated, however, that Freddie Mac’s release of audited

financial statements was being delayed pending a reaudit of past financial statements, and that Freddie Mac had agreed that certain accounting treatments applied

in the past were incorrect. We informed Congress at the time, of our opinion regarding the reaudit. We further advised Congress that Freddie Mac’s Board of Directors

had undertaken efforts to enhance expertise and controls in the area of financial

accounting and operational control, that we had evaluated the board’s and management’s plans in that regard, and that we were satisfied that these actions were

appropriate steps to address the situation. In my view, these statements clearly indicate that, although the overall framework is effective, OFHEO is ensuring that

the board and management devote serious attention and remedial efforts to the area

of financial reporting and related controls. OFHEO’s activities in this regard are

highlighted in this testimony.

With regard to internal controls, our examination program is consistent with applicable professional standards in that it addresses each Enterprise’s overall internal control framework; that is, the framework that includes the following categories:

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porting; (3) compliance with applicable laws and regulations; (4) and safeguarding

the assets of the company. Consider that the term ‘‘internal control’’ encompasses

five interrelated components—the control environment; risk assessment activities;

control activities; information/communication; and monitoring. As you might imagine, companies as complex as Fannie Mae and Freddie Mac develop equally complex

internal control frameworks. These frameworks encompass hundreds, perhaps thousands, of separate controls, including approvals, authorizations, verifications, reconciliations, segregation of duties, systems access limitations, and a myriad of others. In short, the integrity of the overall internal control framework is determined

by considering the total picture, and when viewed in its entirety, a framework may

exceed safety and soundness standards even though there are observed weaknesses

or deficiencies in particular controls.

Examples of the application of this principle include practices adopted under

standards established by the American Institute of Certified Public Accountants,

and guidance provided by the SEC in recent rules implementing provisions in the

Sarbanes-Oxley Act that pertain to assessments of internal controls over financial

reporting. Specifically, it is common for an independent auditor to provide an unqualified opinion on management’s reports of financial condition even though the

auditor is aware of certain ‘‘reportable conditions.’’ In the vernacular of the independent auditor, a reportable condition is a significant deficiency in the design or

operation of the internal control structure that could adversely affect a company’s

ability to record, process, summarize, and report financial data consistent with the

assertions of management in the financial statements. The common practice is for

the auditor to communicate such deficiencies to management in the form of a management letter, while at the same time allowing its unqualified opinion to stand.

As a separate example, under SEC rules, significant deficiencies that do not rise to

the level of a material weakness do not preclude management from characterizing

its internal controls over financial reporting as ‘‘effective.’’ The SEC guidance prohibits management from deeming its controls effective if there are one or more

material weaknesses; however, the SEC also observes that a material weakness constitutes a greater deficiency than a significant deficiency. In sum, I believe the

standards we have applied in reaching our examination conclusions on internal controls are consistent with those established by both the AICPA and the SEC.

Before I move on, I would like to emphasize a point or two about information flow

and the environment that preceded the publication of our Annual Report to Congress. The results and conclusions of the 2002 annual examination were based on

the information gathered and evaluated during the course of our work during 2002.

That information was supplemented by information obtained by OFHEO during

2003, from early January up to the time of the publication of the Annual Report

to Congress. As I discussed earlier, OFHEO has devoted considerable effort and resources to this matter, and our efforts continue to yield new information. One

should also consider that the board of directors’ internal investigation is being conducted during 2003 as well, and that the board’s investigation may yield new information. In addition, the Committee is aware that I initiated OFHEO’s own special

examination on June 7, little more than 1 week before the statutory delivery date

for the Report to Congress; and it is possible that our special examination could give

rise to new findings as well. I raise these facts to emphasize that the date on which

the Report was due fell in the midst of a very fluid environment; nevertheless, I

believe that the examination results and conclusions expressed in the Report to

Congress regarding the overall internal control and framework at Freddie Mac are

appropriate. Certainly, we will have more to say about the controls over financial

reporting, improper earnings management, and corporate governance practices after

the special examination has concluded. I assure you that I will provide the Committee with a timely notification and description of any substantive changes in our

view of the internal control framework and corporate governance practices once I

have the benefit of the results under the various investigations currently underway.

Supplemental Appropriations

Finally, I would like to bring to the Committee’s attention an urgent funding matter. Earlier this week, I submitted an fiscal year 2003 supplemental funding request

of $4.5 million to the Senate and House Appropriations Committees.

The requested funds will support two critical objectives: First, the funds will support the on going special investigation of Freddie Mac. The investigation is already

well underway and is building on information gathered over the course of the restatement process. The requested resources are necessary to obtain contract services

for investigative support and forensic accounting experts. Second, OFHEO intends

to conduct a special accounting review of Fannie Mae. The special review would

independently evaluate the accounting policies at Fannie and examine whether

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their implementation is resulting in a high level of conformance to GAAP. While I

do not have a specific concern about Fannie Mae’s accounting practices, such a review would be most prudent under the circumstances.

OFHEO’s goal of concluding the investigation of Freddie Mac expeditiously is dependent on receiving these funds as soon as possible. I would like to ask for the

Committee’s support in obtaining the additional funds.

Conclusion

In summary, Mr. Chairman, is this a serious matter? Yes. Is there a crisis? No.

While challenges remain, Freddie Mac remains safe and sound. At the end of our

investigation, we will present all the facts, conclusions, and recommendations for

the Committee’s consideration. Mr. Chairman, thank you for the opportunity to testify. I would be pleased to answer any questions you or Committee Members may

have.

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING

FROM ARMANDO FALCON, JR.

Q.1. I would like to follow-up on my questions about the anonymous letters. Your staff briefed Committee staff and informed staff

that some anonymous letters were received and then investigated

by Baker Botts who dismissed the charges in the letters. Did the

charges in those letters have anything to do with what actually

happened at Freddie? What charges were made in the letters? Who

were the letters sent to? Is there any idea of where they came from,

a Freddie employee? An auditor?

A.1. The letters contain a series of charges which can be summarized as allegations of wrongdoing against Freddie Mac that they

overstated their 1999 earnings by several hundred million dollars;

that they commingled cash collateral in violation of security agreements and filed false or misleading financial and regulatory

reports; and that they made a billing error of approximately $6 million in the account of Bank of America.

The allegations contained in the letters are not directly related

to the accounting issues that have led to the company’s restatement. The letters were sent to Fannie Mae, and Fannie Mae delivered them to Freddie. Although the letters indicated OFHEO and

others were copied, we did not actually receive copies. The source

of the letters continues to be unknown, they are anonymous.

Q.2. Can the Committee receive a copy of the letters?

A.2. OFHEO obtained the letters pursuant to a subpoena and confidentiality agreement. We would like to discuss this with the Committee and try to find a way to satisfy the Committee’s request.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOLE

FROM ARMANDO FALCON, JR.

Q.1. Mr. Falcon, when were you informed of the Freddie Mac

Board’s decision to terminate the President and CEO, force the retirement of its CEO and force the resignation of its CFO? When

you were informed and what exactly did the board or its representative tell you? How did they describe the situation?

A.1. I was informed of the board’s decision to make the management changes on June 6, 2003. I was informed that the board had

just concluded its deliberations and decided that a change was necessary in light of issues raised by the restatement.

Q.2. Mr. Falcon, in your testimony you say that Baker Botts told

you of no management problem on May 27. Earlier in your testimony you state that on May 8 that PriceWaterhouseCoopers informed some Freddie Board Members that it ‘‘would not accept the

representations’’ of some employees. This appears to be a key development in the reaudit. When and how did you learn of these

PriceWaterhouseCoopers concerns? What did you do when you

heard of these concerns?

A.2. On May 8, 2003, PriceWaterhouseCoopers (PwC) communicated to Freddie Mac’s Board their unwillingness to accept the

representations about the company’s financial statements from Mr.

Glenn and Mr. Clarke. On May 27, OFHEO’s Chief Examiner was

briefed by Mr. Doty on the status and latest developments in his

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investigation. No mention was made of PwC’s lack of trust in the

two individuals, even when specifically asked if there was anything

else we should know about the restatement and investigation.

OFHEO learned of the communication between PwC and the

board in the June 7 meeting with Freddie Mac’s representatives

that I convened. I considered PwC’s concerns to be a very material

development. Learning about this material development almost 30

days after the information was communicated to the board concerned me deeply. The delay in learning this critical piece of information, coupled with other considerations, caused me to formalize

and expedite aspects of our ongoing supervision of Freddie Mac’s

reaudit and restatement process and independently investigate certain aspects of potential management conduct. The formalization of

our oversight activities and expediting our own independent evaluation of the factors causing the reaudit and restatement were reflected in my June 7 letter to Freddie Mac’s Board of Directors.

Q.3. Mr. Falcon, I am very interested in the fact that 3 days before

the board’s shakeup OFHEO had publicly approved of the management’s treatment of an earnings restatement that had been pending since January, stating ‘‘we remain satisfied that the board of

directors and executive management are taking the appropriate action.’’ How do you reconcile this with your letter that weekend

which stated that the management shake-up ‘‘only goes a part of

the way toward correcting serious problems’’ at Freddie Mac?

A.3. In the 2002 Annual Report to Congress, OFHEO included a

paragraph covering the Freddie Mac reaudit and restatement process. The paragraph summarized OFHEO’s assessment of Freddie

Mac’s efforts surrounding: The independent auditor’s decision to

delay its 2002 certification of financial statements, the board of director’s decision to have prior period statements reaudited and restate those earlier periods, and the remediation program to address

control matters in the financial accounting and operational control

area. OFHEO concluded and reported to Congress that Freddie

Mac’s Board and its management took appropriate action to address the delay in the 2002 certified financial statements.

When the independent auditor delayed an opinion on the 2002 financial statements. OFHEO’s focus was to ensure the company remained committed to getting the restatement process done well

and in a timely manner. In addition, we evaluated a May 2003

Board-approved plan to addresses financial accounting and operational control weaknesses that superceded the Financial Reporting

Controls Improvement Plan (FRCIP) approved by the board in

2000. Working to ensure that Freddie Mac’s reaudit and restatement process was done well and in a timely manner had been our

priority and remains a key concern as the safety and soundness

regulator.

Beginning June 4, there were two key developments that caused

me to send a letter on June 7 to the Freddie Mac Board of Director.

First, there was the action of a senior Freddie Mac official that led

to his termination, and triggered the board’s decision to force the

separation of two other senior executives on June 6. In tandem

with those decisions, the board installed a new executive management team to lead the firm. The second key development was that

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on June 7, I was presented with information suggesting there may

have been past management decisions that resulted in smoothing

the company’s earnings by delaying income into future periods.

Up until June 6, OFHEO had been emphasizing to the board and

its executive management the importance of getting the restatement process done well and in a timely manner. I decided to formally reemphasize this as a regulatory priority on June 7. Following the same rationale, I elevated OFHEO’s routine supervisory

efforts covering Freddie Mac’s remediation plan to address control

weaknesses in the financial accounting and operational control

areas. I wanted to ensure OFHEO’s supervisory priorities would remain a key focus of the new executive management team.

Distinct from the supervisory priorities involving the restatement

process and control weaknesses at Freddie Mac, learning about

management practices that may have been intended to manage

earnings and violations of the company’s code of conduct by a senior executive were troubling. These acts of misconduct by executive

managers represent a serious problem if supported through our investigation.

Q.4. Mr. Falcon, some have suggested that the safety and soundness responsibilities of OFHEO should be transferred to the Treasury Department. What are your views on this proposal?

A.4. First and foremost, effective safety and soundness oversight

requires the following three elements:

1. Independence from political influence;

2. Permanent finding outside the appropriations process; and

3. Full powers and authority to conduct oversight and take any necessary regulatory action.

With those fundamentals in place, OFHEO would be well-positioned for long-term success in either HUD or Treasury.

Q.5. Mr. Falcon, in your July 14 letter to the Senate Appropriations Committee. you indicated that OFHEO will now begin an

‘‘independent’’ review of Fannie Mae’s accounting practices. However, the OFHEO handbook includes a lengthy list of checks which

your examiners are to conduct precisely to review accounting and

audit quality. I know OFHEO is not supposed to be the GSE’s auditor, but your own handbook says that you were monitoring and ensuring appropriate accounting standards. Please comment on this

apparent contradiction and also explain why OFHEO is only now

undertaking an independent review of Fannie Mae? Please provide

this Committee with a detailed list of dates on which examiners reviewed Fannie Mae accounting practices, the nature of this review,

the manner in which it compares with that done by bank examiners, and the reasons why this review was not ‘‘independent.’’

A.5. There is no contradiction between the work outlined in my

July 14 letter and the routine supervisory work conducted by

OFHEO. The special review of Fannie Mae—which will be a comprehensive review of their accounting policies and whether their

implementation is resulting in a high level of conformance with

GAAP—is work that will be independent of the routine supervisory

activities at OFHEO. The work proposed in my July 14 letter requires a forensic accounting investigation to ascertain the intent

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behind the way Fannie Mae’s management applies GAAP.

OFHEO’s routine supervisory activities do not include forensic accounting techniques. Similar to the other financial safety and

soundness regulators, OFHEO does not regulate the accounting

used by the Enterprises. OFHEO does advocate the appropriate

application of GAAP by the Enterprises and the publication of accurate and meaningful financial disclosures. Like the depository

regulators, OFHEO regards reputable independent auditors to possess expertise in accounting. The independent auditor’s certification

of a company’s financial statements and disclosures is intended to

provide assurances that management has fairly presented the financial statements in accordance with GAAP. Considering the current environment, I want to expedite our special forensic review of

Fannie Mae’s application of GAAP accounting, to answer questions

that may be asked about Fannie Mae.

OFHEO’s approach to reviewing independent audits and financial reporting is analogous to the other safety and soundness regulators. Allow me to provide more contour for the nature and scope

of that approach. Over the years, there have been two forms of accounting principles that were used by financial firms for the preparation and reporting of financial condition and results. First, there

were the accounting principles being prescribed by the regulators.

During the 1980’s there were a number of regulatory accounting

principles (RAP) being prescribed. Many of these RAP standards

were roundly criticized after the failures of numerous depository institutions and Congress expressed its desire for financial safety and

soundness regulators to rely upon the established generally accepted accounting principles (GAAP) for financial reporting standards.

The second and more widely recognized accounting principles are

prescribed by GAAP, arguably a set of principles that are subject

to interpretation and can result in similar transactions receiving

different accounting treatments.

Investors and markets have learned to appreciate that GAAP is

not precise. The accounting principles prescribed through GAAP

were never meant to be rigid, but intended to allow for new business structures, as well as, new and innovative transactions.

Therefore, GAAP is flexible to allow for the adaptation to changing

circumstances, and not immune from debates in its application.

Section 121 of FDICIA directs the depository regulators to pursue GAAP in their regulatory reporting requirements. In OFHEO’s

1992 Act, the Congress directed OFHEO to pursue GAAP in its

regulatory activities.

Accounting standards are intended to provide the foundation for

credible financial statements and other disclosures that are the key

means for communicating a firm’s operating result and its overall

health, as well as making transparent the economic value of the

firm. In addition, accounting standards’ are intended to provide the

foundation for disclosing reliable information to the marketplace

which promotes enhanced market discipline. The foundation for

credible financial statements and disclosure has obvious implications for the supervisor in its oversight of the safety and soundness

of the financial firm.

Many of the accounting standards that have emerged in recent

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actions that FASB has prescribed. For instance, under FAS 133 the

application of GAAP for certain transactions may very likely not reflect the underlying economics of the transactions.

Fannie Mae and Freddie Mac, like other large financial firms are

required to engage an independent external auditor to audit their

financial statements and disclosures. There are several roles performed by the independent auditor, and key among these roles is

the performance of testing to conclude whether management has

fairly presented the financial statements in accordance with GAAP.

In that regard, the independent auditor provides a level of assurance that the financial statements are free of material

misstatements and renders a final opinion, which carries the accounting firm’s signature. That audit opinion falls into one of three

categories: clean, or ‘‘unqualified,’’ if the records amount to a fair

representation of the company’s underlying economic health;

‘‘qualified,’’ if there are exceptions to an otherwise fair representation of the financial statements; or a ‘‘disclaimer,’’ meaning the client’s recordkeeping is so inadequate that the auditor cannot even

render an opinion. For companies experiencing serious financial

difficulties, the independent auditor is also supposed to state

whether there is ‘‘substantial doubt’’ that the entity can continue

as a ‘‘going concern’’ for a reasonable period of time. Fannie Mae

has always received unqualified opinions on its financial statements from its independent auditors. Freddie Mac has also obtained unqualified opinions on its financial statements from its

independent auditors. The certification of Freddie Mac’s 2002 financial statements has been delayed by the firm’s new auditors

pending the reaudit and restatement of prior periods based upon

the new firm’s interpretation for the application of GAAP to certain

accounting transactions.

The importance of the independent auditor’s opinion that is rendered on a firm’s financial statements has been bolstered by court

cases that have established a public responsibility for the independent auditor which transcends any employment relationship

with the management and board of directors of the firm being audited. When the independent auditor certifies the public reports of

a company, their ultimate allegiance is to the corporation’s creditors, stockholders, and to the investing public.

Like the depository financial safety and soundness regulators,

OFHEO evaluates the work performed by the auditor and the independence of the auditor and the audit work. Through its supervisory programs, OFHEO has routinely considered the accounting

policies of the Enterprises and tested the accounting practices on

transactions. In our design, implementation and operation of the

risk-based capital test, OFHEO has considered the accounting policies and practices of each Enterprise. We are required to consider

the accounting treatments used by the Enterprises regularly in the

administration of the risk-based capital test, in addition to carefully considering changes or innovations in accounting for transactions. Through our examination program, we routinely conduct

transactional testing which includes a consideration of whether

transactions are being accounted for consistent with the approved

GAAP of the company. In 2002, with the addition of more resources

to our examination program, we added a team dedicated excluVerDate 11-MAY-2000 18:07 Jun 08, 2005 Jkt 000000 PO 00000 Frm 00095 Fmt 6633 Sfmt 6601 21517.TXT SBANK4 PsN: SBANK4
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sively to accounting issues. This dedicated accounting team is used

to augment routine examination testing that includes the consideration of accounting policies and practices. As well, this team of examiners is engaged with the Enterprises’ accountants discussing

and considering the proposed application of GAAP for new FASB

pronouncements. As part of the examination testing, the quarterly

closing and reporting processes are evaluated to determine if there

are procedures employed to achieve GAAP compliance and test to

see there are sign-offs on the financial statements by the independent auditors, and whether there are reservations noted by the

auditor.

Like the depository regulators, an effective audit program is key

in a quality risk management framework. We regularly evaluate

the quality of the audit programs, the appropriateness of the audit

work performed and the sufficiency of follow-up on audit findings

in our safety and soundness examinations. When there are deficiencies recognized in aspects of the internal or independent external audit programs, the regulator ensures there is remediation for

the deficiency. Generally, the examination activities covering the

audit program covers: A determination of independence, a determination of professional proficiency; a determination of the appropriateness of the scope of work; a testing and determination of the

completeness of audit work performed; an evaluation of management of the internal audit; a determination of the quality and sufficiency of follow-up and oversight by the board’s audit committee;

a determination of the appropriateness of the risk assessment process employed by auditors; and a determination of the auditors

involvement in new policies, procedures, or practices. For more contour on what examiners are evaluating for the audit programs at

the Enterprises, please refer to the attachment.

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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED

FROM ARMANDO FALCON, JR.

Q.1. Quoting from your June 15, 2003, Office of Federal Housing

Enterprise Oversight (OFHEO) Annual Report to Congress, ‘‘Message From the Director,’’ you wrote:

On the occasion of our 10th Anniversary, it is with great pride that I report to

Congress that the Office of Federal Housing Enterprise Oversight has developed

into the strong, capable, and innovative regulator that Congress envisioned when

it created the Agency only a decade ago. OFHEO today is actively and aggressively

fulfilling its mission of ensuring the safety and soundness of Fannie Mae and

Freddie Mac (the Enterprises).

the Enterprises have remained safe and sound through another year of exceptional growth in the housing sector of our economy. In a year when more and more

Americans have become homeowners, the public can take comfort in knowing that

OFHEO is on the job, doing its part to ensure the strength and vitality of the Nation’s housing finance system.

Later, on pages 37–38 in Chapter 4 of the report, when reporting

on the Freddie Mac Examination Results and Conclusions, the report states:

[Freddie Mac’s] audit functions are dependent and effective. The Internal and External Audit Functions have the appropriate independence. Auditors performing the

work possess appropriate professional proficiency. The scope of the audit work is appropriate, and the audit work is complete. The management of the Internal Audit

department is effective. Executive management and the board of directors are appropriately involved with and follow up’ on identified audit issues. The auditor’s risk

assessment process is effective. Internal Audit is appropriately involved in new

products and new initiatives.

If OFHEO is ‘‘actively and aggressively fulling its mission,’’ how

did such accounting inadequacy fail to be addressed in OFHEO’s

examination of Freddie Mac’s operations, especially since the implications of FAS 133 have been discussed and implemented since

1999? How can the public ‘‘take comfort in knowing that OFHEO

is on the job’’ if it fails to effectively oversee such problems in an

appropriate time frame? How can we be sure that another similar

problem at Freddie, or Fannie for that matter, is not brewing? Why

shouldn’t such problems be discovered, disclosed, and addressed in

real time in order for OFHEO to be an effective regulator that the

public can really trust?

A.1. To begin, the public can take comfort in the fact that OFHEO

has done its job because Freddie Mac’s safety and soundness has

not been called into question. The issues raised, while important,

have not been about Freddie Mac’s financial solvency. There are

two distinct issues under discussion. The first issue involves the

application of generally accepted accounting principles (GAAP) and

the second issue involves questionable motives behind certain management decisions made during Freddie Mac’s implementation of

FAS 133.

First, there is the issue of accounting adjustments involving

Freddie Mac’s restatement process and PwC’s delayed certification

of Freddie Mac’s 2002 financial statements. I take seriously the

fact that the restatement adjustments will be substantial. I also

take seriously the delay in 2002 certified financial statements. My

concern was the reason OFHEO stressed to Freddie Mac the importance of completing the restatement process as expeditiously as

possible and the equal importance of getting it done well. But, at

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ments contemplated, this remains an accounting issue, more specifically the timing of income recognition. There is not a question

of whether there will be billions of dollars more or less in income

earned by Freddie Mac over the life of the existing transactions.

Rather, the accounting issue involves the period in which those billions of dollars in income get recognized. In short, the fair value of

the firm is not materially affected by the adjustments. But the

GAAP reported net income in past and future time periods will

fluctuate based upon where the income adjustments are recorded.

Like the other financial safety and soundness regulators,

OFHEO does not regulate the form of accounting used by the Enterprises. OFHEO does, however, advocate the appropriate application of GAAP by the Enterprises and the publication of accurate

and meaningful financial disclosures. Like the depository safety

and soundness regulators, OFHEO regards reputable independent

auditors to possess expertise in accounting. Fannie Mae and

Freddie Mac like other large financial firms are required to engage

independent external auditors to audit their financial statements

and disclosures. A key role of the independent auditor is the performance of testing to conclude whether management has fairly

presented the financial statements in accordance with GAAP.

Freddie Mac obtained unqualified opinions through 2001 from its

prior independent auditor. The new independent auditor’s opinion

on the 2002 financial statements was delayed due to the application of GAAP to certain transactions. More specifically, PwC expressed reservations about the application of GAAP for selected

types of hedge accounting treatments due to the hedge documentation and the quarterly documentation of hedge effectiveness. While

PwC was not comfortable with the hedge documentation on record,

the prior auditor had been comfortable and signed-off on the accounting treatments and certified the 2001 financial statements.

Freddie Mac’s audit functions are independent. Independence has

been determined using the evaluative standards employed by

OFHEO which incorporate criteria outlined by recognized sources.

To determine the ‘‘independence’’ of the external auditor, examiners: (1) evaluate the ‘‘engagement’’ of the external audit firm to

determine that it is an arm’s-length transaction; (2) assess the access the external auditor has to the board (through the audit committee), including the frequency of meetings the external auditor

has with the audit committee in executive session with no operating management present; (3) evaluate the terms and conditions

of the ‘‘engagement,’’ and the policies and practices of the external

audit firm against the independence standards and guidelines of

the AICPA (American Institute of Certified Public Accountants),

the NYSE, and the SEC; (4) evaluate the nature and extent of

nonaudit services provided by the external audit firm; (5) evaluate

the expertise and staffing of the external auditor for the engagement; and (6) test the external auditors work papers to determine

if identified matters are appropriately communicated and recorded.

In addition to evaluating the independence of the external audit

function, examiners evaluate other factors in determining the adequacy and sufficiency of the external audit.

In my testimony and in the Annual Report, I noted that for several years OFHEO has been working with Freddie Mac to see the

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controls and expertise in the financial accounting and financial reporting areas are strengthened. While progress was noted, OFHEO

continues to work with Freddie Mac to see that expertise and controls in the financial accounting and financial reporting areas continue to improve.

Q.2. Could you describe in detail what expertise the staff of

OFHEO has in effectively evaluating and monitoring the various

complex financial instruments that Fannie and Freddie employ for

their respective operations on a regular basis? How does such expertise compare to your colleagues at the Treasury, the Federal Reserve, and private GSE analysts? Please explain in detail.

A.2. OFHEO has a talented staff of professionals with impressive

and varied backgrounds. Our staff is composed of experienced professionals and technicians with many years of experience in regulation, the capital markets, the mortgage markets, in investment

management, in financial analysis, in hedging, in financial engineering, in accounting, and in housing policy and research. Early

in my term as the Director, I sought to increase the funding for the

Agency to build the permanent staff and obtain the depth in

human resources and expertise needed to administer our regulatory program. We have made significant progress in obtaining the

staff and expertise to fulfill our mandate, and the multiyear plan

that I am implementing seeks to build even further the depth and

capacity in our personnel. However, there remains considerable

work for a lean staff of professionals to accomplish in our safety

and soundness oversight of these two companies.

OFHEO has deliberately hired seasoned professionals from numerous backgrounds. We have hired from within Government, from

the private sector, and from academia. From the Government

ranks, we have hired from the banking and thrift regulatory agencies (the Federal Reserve System, the Office of the Comptroller of

the Currency, the Office of Thrift Supervision, and the FDIC), from

the GAO, and other Federal Agencies. From the private sector, we

have hired from Wall Street firms, from commercial banking companies, from investment management firms, from consulting firms,

from technology companies, from accounting firms, from investments banks, and from law firms. From academia, we have hired

college professors and researchers. Through these three channels of

hiring we have assembled an experienced group of professionals

with a variety of technical, managerial, and policy-formulation

backgrounds.

Through the skills sets employed by OFHEO, we have excellent

knowledge of the mortgage and housing markets, the debt markets,

the Enterprises’ lines of business, investment management, hedging activities and techniques, the derivatives business, interest rate

risk management, credit risk management, counterparty risk management, liquidity management, accounting, econometrics, and the

legal frameworks for the Enterprises’ business activities.

OFHEO’s collective knowledge and understanding of Fannie Mae

and Freddie Mac is without a doubt much greater than that of any

other entity in the Government or private sector.

Q.3. I realize that Fannie and Freddie have voluntarily decided to

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spite being exempted from doing so by their charters. However, it

is also my understanding that they do not want to register their

debt securities. Would registration of the Enterprises’ debt securities assist you in being a more effective safety and soundness regulator? Please explain in detail why or why not.

A.3. the Enterprises’ disclosures related to their debt securities

serve an important function. The disclosures promote market understanding and confidence and result in greater Enterprise access

to the capital markets. Those disclosures are thus important to

safety and soundness and should be mandatory rather than voluntary. This is the more important consideration than the actual

act of registration. Accordingly, OFHEO has under consideration a

regulation that would mandate debt disclosures equal to those of

other publicly held companies.

Q.4. In your testimony, you recommend keeping OFHEO as a

quasi-independent regulator housed within HUD. Please describe

in detail how moving OFHEO and/or its oversight authority to the

Office of Thrift Supervision (OTS) or the Department of the Treasury would harm or help OFHEO’s ability to effectively regulate the

GSE’s.

A.4. First and foremost, effective safety and soundness oversight

requires the following three elements:

1. Independence from political influence;

2. Permanent finding outside the appropriations process; and

3. Full powers and authority to conduct oversight and take any necessary regulatory action.

With those fundamentals in place. OFHEO would be well-positioned for long-term success in either HUD or Treasury.

Q.5.a. In your testimony, you highlight OFHEO’s authority to review executive compensation packages to ensure they are not ‘‘excessive’’ as allowed in 12 U.S.C. 4518(a), which defines ‘‘excessive’’

compensation as such that is ‘‘. . .not reasonable and comparable

with compensation for employment in other similar businesses.’’

Please describe in detail how you interpret that definition of excessive compensation.

A.5.a. OFHEO carries out the statutory requirement to prohibit excessive compensation by comparing the compensation received by

senior executive officers at Fannie Mae and Freddie Mac including

all direct and indirect payment of benefits both cash and noncash,

granted to or for the benefit of the executive officer, to that received by executives for employment in other similar businesses.

In addition to its ongoing review, OFHEO periodically undertakes a study to compare compensation provided by each Enterprise to executive officers to that provided by similar businesses to

executive officers doing similar work. OFHEO retains an executive

compensation consultant to assist in conducting the comparability

studies. The comparator group for each Enterprise includes publicly held financial institutions or major financial services companies. The compensation policies of Fannie Mae and Freddie Mac

are compared to a group of similar businesses through the use of

proxy statements and survey data. OFHEO documents the compensation plans of Fannie Mae and Freddie Mac; conducts in-depth

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interviews with Fannie Mae and Freddie Mac executive officers

about the nature of their work and the compensation, received and

examines the reasonableness and competitiveness of the compensation packages at those firms, as well as the pay mix and the extent

to which compensation is performance-based. The comparability

studies update and complement the ongoing monitoring by OFHEO

of compensation actions taken by the Enterprises as well as compensation developments for executives at similar businesses.

Q.5.b. Based on what you know now, is the compensation for

former Freddie Mac CEO Brendsel, former COO Glenn, and former

CPO Clarke excessive? Please explain in detail. Have you reviewed

the compensation of current Freddie Mac executives? If so are they

excessive, according the above-mentioned definition? Please explain

in detail.

A.5.b. OFHEO now has a special investigation underway which

will address, among other matters, whether the compensation of

former and current executives was excessive under the circumstances.

Q.6.a. On July 23, 2003, Baker Botts, LLP released a report on its

investigations of Freddie Mac and how Freddie improperly used

various accounting techniques to smooth out earnings. In your testimony, you suggested that the Baker Botts, LLP investigators

were less than cooperative. Why was that the case? Please describe

in detail the extent of their lack of cooperation.

A.6.a. On May 8,2003, PriceWaterhouseCoopers (PwC) communicated to Freddie Mac’s Board their unwillingness to accept the

representations about the company’s financial statements from Mr.

Glenn and Mr. Clarke. On May 27, OFHEO’s Chief Examiner was

briefed by Mr. Doty on the status and latest developments in his

investigation. No mention was made about PwC’s lack of trust in

the two individuals, even when specifically asked if there was anything else we should know about the restatement and investigation.

OFHEO learned of the communication between PwC and the

board in the June 7 meeting with Freddie Mac’s representatives

that I convened. I considered this to be a material development.

Learning about this material development almost 30 days after the

information was communicated to the board concerned me deeply.

The delay in learning this critical piece of information coupled with

other considerations caused me to formalize and expedite aspects

of our ongoing supervision of Freddie Mac’s reaudit and restatement process and independently investigate certain aspects of

potential management conduct. The formalization of our oversight

activities and expediting our own independent evaluation of the

factors causing the reaudit and restatement were reflected in my

June 7 letter to Freddie Mac’s Board of Directors.

Q.6.b. Did OFHEO discover the various accounting techniques described in the report as being used by Freddie Mac to smooth out

earnings as a part of its ongoing examinations activities? Please explain in detail why or why not.

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A.6.b. OFHEO’s Special Investigation Unit is looking at these

issues; thus, our report will address them at completion of this investigation.

Q.6.c. The Baker Botts Report also names the current CEO, Gregory Parseghian, as being intimately involved in the various questionable transactions that prompted Freddie Mac’s Board of Directors to dismiss COO Glenn and accept the resignations of CEO

Brendsel and CFO Clarke. What role will OFHEO play in order to

determine the extent of Parseghian’s involvement? Please explain

in detail.

A.6.c. OFHEO’s Special Investigation Unit is looking at these

issues; thus, our report will address them at completion of this investigation.