U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2250 Mail: Stop SSOP, Washington, DC 20402–0001

89–960PDF 2003

FREDDIE MAC: ACCOUNTING STANDARDS ISSUES

RAISED IN THE DOTY REPORT

HEARING

BEFORE THE

SUBCOMMITTEE ON

COMMERCE, TRADE, AND CONSUMER PROTECTION

OF THE

COMMITTEE ON ENERGY AND

COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

SEPTEMBER 25, 2003

Serial No. 108–48

Printed for the use of the Committee on Energy and Commerce

(

Available via the World Wide Web: http://www.access.gpo.gov/congress/house

COMMITTEE ON ENERGY AND COMMERCE

W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

RICHARD BURR, North Carolina

Vice Chairman

ED WHITFIELD, Kentucky

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES W. ‘‘CHIP’’ PICKERING,

Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

ERNIE FLETCHER, Kentucky

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

JOHN D. DINGELL, Michigan

Ranking Member

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

TOM ALLEN, Maine

JIM DAVIS, Florida

JAN SCHAKOWSKY, Illinois

HILDA L. SOLIS, California

DAN R. BROUILLETTE, Staff Director

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION

CLIFF STEARNS, Florida, Chairman

FRED UPTON, Michigan

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

JOHN B. SHADEGG, Arizona

Vice Chairman

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

LEE TERRY, Nebraska

ERNIE FLETCHER, Kentucky

MIKE FERGUSON, New Jersey

DARRELL E. ISSA, California

C.L. ‘‘BUTCH’’ OTTER, Idaho

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

(Ex Officio)

JAN SCHAKOWSKY, Illinois

Ranking Member

HILDA L. SOLIS, California

EDWARD J. MARKEY, Massachusetts

EDOLPHUS TOWNS, New York

SHERROD BROWN, Ohio

JIM DAVIS, Florida

PETER DEUTSCH, Florida

BART STUPAK, Michigan

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

C O N T E N T S

Page

Testimony of:

Barratt, James W., Senior Managing Director, Forensic and Litigation

Advisory, FTI Consulting ............................................................................. 13

Doty, James R., Partner in Charge, Baker Botts, LLP ................................. 7

Lev, Baruch, Philips Bardes Professor of Accounting and Finance, Department of Accounting, Taxation and Business Law and Department

of Finance, Director, Vincent C. Ross Institute of Accounting Research,

Stern School of Business .............................................................................. 14

(III)

(1)

FREDDIE MAC: ACCOUNTING STANDARDS

ISSUES RAISED IN THE DOTY REPORT

THURSDAY, SEPTEMBER 25, 2003

HOUSE OF REPRESENTATIVES,

COMMITTEE ON ENERGY AND COMMERCE,

SUBCOMMITTEE ON COMMERCE, TRADE,

AND CONSUMER PROTECTION,

Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2322, Rayburn House Office Building, Hon Cliff Stearns (chairman)

presiding.

Members present: Representatives Stearns, Shimkus, Shadegg,

Radanovich, Bass, Bono, Terry, Otter, Schakowsky, Green, McCarthy, Strickland, and DeGette.

Staff present: David Cavicke, majority counsel; Ramsen

Betfarhad, majority counsel, Will Carty, legislative clerk; and

Consuela Washington, minority counsel.

Mr. STEARNS. Good morning everybody, and welcome to the Subcommittee on Commerce, Trade, and Consumer Protection of the

Committee on Energy and Commerce. Today we have a very important hearing. The first opportunity for Congress to hear the results

of an internal investigation at Freddie Mac regarding accounting

problems there. We are privileged to have Mr. Doty, partner at

Baker Botts who was in charge of this investigation that produced

this internal report.

I have had the opportunity to review the report and wish to compliment him on its thoroughness, rigor and objectivity. Members on

the Energy and Commerce Committee have had an opportunity in

recent years to examine a number of reports on internal investigations. The Doty report, in my view, is at the top of those reports

in its completeness and its ability to explain very complicated

transactions. Also accompanying Mr. Doty is Mr. James Barratt,

who led a team of forensic accountants who reviewed Freddie Mac’s

books. I also commend you for your work, and I hope Mr. Doty will

have the opportunity to identify the members of his team who I understand are accompanying him in this hearing.

Finally we have Professor Baruch Lev. Professor Lev has provided expert testimony to the Congress a number of times on very

complicated accounting matters. So we appreciate his help today.

I also would like to compliment Freddie Mac. They had cooperated

with our inquiry and provided to the committee information and

documents so we can have a better understanding about these

issues. There are two things for us to consider today, the first is

2

the report itself obviously and the second is what is permissible

under GAAP.

Although Freddie Mac, by its own admission, made serious accounting misstatements, had they structured some of these transactions differently, it is possible that GAAP would have permitted

the nondisclosure of the fair value of Freddie Mac’s derivative portfolio. For the benefit of taxpayers who implicitly guarantee

Freddie’s portfolio and investors, we need to ask if GAAP is adequate if it allows a company with $600 billion in mortgages and $1

trillion in derivatives not to have fair value disclosure of the bulk

of these assets. The report made a number of findings of great significance that we should consider.

Beginning in December, 2000, senior management of Freddie

Mac engaged in multiple complex transactions in order to hide the

increase in value in its derivatives portfolio. There was no economic

purpose to these transactions other than to simply hide income.

Freddie Mac incurred expenditures to hide income for accounting

purposes. These transactions included the so-called Giant. This

transaction involved shifting $30 billion of Freddie Mac securities

in which Freddie Mac had an unrealized loss to a third party. The

purpose of the Giant was to recognize a one time loss on selected

assets to offset real gains and then prevent the Giant from being

accounted for at fair value. Freddie Mac took on other actions to

hide the $1.5 billion gain in its derivatives portfolio. They included

changing the accounting methodology of options on swaps and a series of so-called J-Deals in the neighborhood of $700 million. Earnings management: The Doty report found that in 11 of 11 quarters

examined, senior management of Freddie Mac changed the stated

value of various reserve accounts in order to meet or exceed Wall

Street’s analysts public expectation of quarterly earnings.

The Doty report states ‘‘there was a longstanding practice at

Freddie Mac of making discretionary accounting judgments with a

view toward producing financial statements that more closely approximated analysts’ estimates. Those involved in the practice report that they believe they were free to do so under the GAAP so

long as the amounts involved were not quantitatively material.’’

This is on page 57 of the report.

So my colleagues, these are serious issues. We shall listen carefully to the testimony. We will continue to monitor the developments as they follow their restatement and we may have, of course,

additional hearings on this restatement. We are looking for a nonpartisan solution to the challenges of improving accounting standards. Congress is not the body to set accounting standards. I believe Congress should consider, though, in light of what is happening, appointing a Blue Ribbon Commission of experts to recommend improvements in our accounting standards today.

So I encourage both members—both parties to share their ideas

and we will work in a bipartisan manner to understand this and

to see how to improve it.

With that, my ranking member, Ms. Schakowsky.

Ms. SCHAKOWSKY. Thank you, Mr. Chairman, and I appreciate

especially your final words about the need on the part of the American public and the economy to work together in a bipartisan way

to seek solutions. This hearing on the Doty report and FASB’s acVerDate 11-MAY-2000 14:02 Dec 02, 2003 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 89960.TXT HCOM1 PsN: HCOM1
3

counting standards is a very important one, and Mr. Doty, your report provides a detailed account and analysis of Freddie Mac’s accounting scandal. The Doty report details how Freddie Mac manipulated its earnings reports to hide a $1.4 billion one-time increase

in earnings. This begs the question, why should—why would

Freddie Mac underreport its profits?

In other corporate scandals, companies inflated their earnings.

The answer is that Freddie Mac hid its profits to meet Wall Street

expectations and perpetrate the impression that Freddie Mac is a

stable profitable company that does not have volatile earnings.

Freddie Mac’s deception raises a series of questions about its corporate governance, internal controls and regulatory oversight. It

also raises the question about FASB’s accounting standards and

how they are manipulated in the marketplace. And today we will

focus on the accounting issues raised by the scandal.

Our subcommittee has an important responsibility to ensure that

all companies provide clear and accurate financial information to

the public. Without clear and accurate information, workers and investors are left to the whims of CEOs that may act irresponsibly.

Families and institutional investors alike cannot make sound investment decisions if they know only half the story. Our publicly

traded companies need to have clear, honest and accurate books.

This is especially true when it comes to Freddie Mac.

Freddie Mac is not just another company. It has a major impact

on the housing market and our capital markets. And this government-sponsored enterprise purchased $592 billion of mortgages in

2002. Freddie helped finance homes for nearly 2.5 million low and

moderate income families and families living in underserved areas

and provided home ownership opportunities for many families that

are traditionally shut out of the housing market. Freddie Mac’s financial health is also an important issue for taxpayers. There has

always been a general perception in the marketplace that Freddie

is too big to fail. Therefore for several reasons we need to make

sure that Freddie Mac is as transparent as possible.

That is why I support my colleague Mr. Markey’s effort to improve Freddie Mac’s transparency. In fact, Freddie’s decision to register its stock with the SEC in part led to Freddie Mac’s restatement of earnings. And I want to commend Mr. Markey for his leadership in this issue. And I am pleased to join him in his efforts.

I look forward to hearing from today’s witnesses. This is an important issue for our constituents and the U.S. Economy. Thank you,

Mr. Chairman.

Mr. STEARNS. Mr. Shadegg?

Mr. SHADEGG. I thank you, Mr. Chairman. I want to thank you

for holding this timely hearing on the accounting problems at

Freddie Mac. As we consider proposals to prevent the reoccurrence

of similar problems, it is vital to first gain an understanding of

what exactly went wrong. The witnesses at today’s hearing will

help tremendously in that task. As a result of these investigations,

there will be legislation to incorporate lessons learned from these

problems as well as other potential problems with these government sponsored entities.

I believe it is critical to keep two imperatives in mind as we craft

this legislation. First, we must ensure that the legislative response

4

is geared toward preventing the reoccurrence of similar problems.

Some may argue that the specific accounting problems identified in

the internal investigation by Baker Botts did not conceal problems

with the financial soundness of Freddie. I believe this argument

misses the point. The same attitude that gave rise to nonstandard

accounting to conceal news of unexpected profits from outside analysts could just as easily have led to the use of sham accounting

to hide news of significant losses.

To ensure that Freddie and Fannie remain financially sound, it

is critical that legislation be crafted in such a way to prevent the

reoccurrence of such inaccurate accounting and to give outside regulators and analysts a meaningful opportunity to identify a problem before it is out of control. Second, we must keep in mind the

law of unintended consequences. These two institutions play an important role in making home ownership attainable for millions of

Americans and improving liquidity in the mortgage market, and we

must ensure that legislation does not put these missions at risk.

At the same time, we must ask whether certain privileges enjoyed by Freddie and Fannie, which are not available to similar

companies—such as the exemption from reporting under the 1993

Act, are warranted or wise. Above all, we must insist on greater

transparency to allow outside experts, both regulators and market

analysts, to accurately monitor their financial health. I welcome

our panel and appreciate, Mr. Chairman, you holding this hearing.

Mr. STEARNS. I thank my colleague.

The gentleman from Texas, Mr. Green.

Mr. GREEN. Thank you, Mr. Chairman, and thank you for holding this follow-up hearing on the accounting practices of Freddie

Mac. Our last hearing occurred right before the Doty report was released, and even then we were pretty sure that the senior management at Freddie Mac was manipulating accounting standards to

manage the company’s earnings. Today we know that to be the

case, and I am pleased that we have Mr. Doty here to enlighten

us on the specifics of what went wrong with Freddie Mac.

Coming from Houston and having worked on this committee to

investigate the mismanagement at Enron, I find it ironic that we

are now examining a company that wanted to hide large earnings.

I think the folks at Enron would like to have that problem. I know

my constituents who lost their retirements or investments in Enron

would like to have that problem. At any rate, we now know that

Freddie Mac sought to hide $1.4 million gained in its derivative

portfolio. While this example of earnings mismanagement certainly

sticks out as a major reporting problem, we must also keep in mind

that the company consistently altered its earnings to meet Wall

Street expectations. In fact the report tells us that the Freddie Mac

managed earnings in each of the 11 quarters it studied. I can only

assume that managing earnings was standard operating procedure

at Freddie Mac. And I can’t help but question exactly how steady,

steady Freddie really is. The underlying question is how do these

revelations affect investors.

And I am sure that each of us in this room have constituents

who have called worried about their investments in Freddie Mac.

And the constituents I hear from all say they chose to invest in

Freddie Mac specifically because of its government sponsorship and

5

its reputation as a safe investment. In trying to maintain this reputation, however, I am afraid that Freddie Mac may have tarnished it.

So as we examine Freddie Mac as a case study on accounting

principles in general, I hope we can keep our investors in mind and

ensure that our work on this front ultimately increases transparency and accountability. And I thank the panel and the witnesses, Mr. Chairman. And I yield back my time.

Mr. STEARNS. I thank my colleague.

And if there is no further opening statements, all opening statements will be made part of the record. I will start with my questioning—we are going to have the opening statements first. A little

eager here. So we welcome—we welcome to have your opening

statement, gentleman from Nebraska.

Mr. TERRY. Waive the opening statement.

[Additional statements submitted for the record follow:]

PREPARED STATEMENT OF HON. BARBARA CUBIN, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF WYOMING

Thank you, Mr. Chairman, for holding another hearing on this issue. The situation before us is not simple and it is our responsibility to address it very deliberately, thoroughly and effectively.

It is an honor to have these witnesses here today. Thank you for joining us and

lending us your expertise and first-hand experience with accounting standards in

the examination of what has happened at Freddie Mac. It goes without saying that

your testimony will be tremendously valuable to the Committee, and play an important role in the future of corporate governance.

What has been demonstrated B or continues to come to light B is that while we

have boards and standards that govern corporate disclosure, it appears that even

by complying with these rules and regulations, there are still instances where shareholders and the general public have been kept in the dark about a company’s true

financial conditions. There is something very wrong here and it is our responsibility

to work to make it right.

Notwithstanding any criminal intent or action, it is clear that we must question

whether the underlying issue of regulatory power handed down by Congress and the

regulations that follow, must be revisited, reshaped and reformed, if not overhauled

completely. The daunting nature of even posing this question is an indication of the

task at hand.

While it is not something we can answer or accomplish in our hearing today, this

discussion will serve as an integral part of improving accounting standards and corporate governance. We must not get lost in the weeds of details, but maintain an

accurate overall picture of what is really going on here.

The jurisdiction of this subcommittee extends its reach to the examination of accounting standards, though it is important to note that the entire picture of what

has happened at Freddie Mac brings to light a myriad of issues that demand our

attention. There’s no question that this hearing will be another useful tool in our

work to realign and strengthen how the corporate world functions.

I thank the Chairman again and yield back the remainder of my time.

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, CHAIRMAN, COMMITTEE ON

ENERGY AND COMMERCE

I want to Commend Cliff Stearns for his leadership today in his pursuit of accounting questions raised by Freddie Mac. We have jurisdiction over accounting

standards, it is a difficult, technical area, but one of importance to investors and

taxpayers. We have seen much reform in the past two years resulting from problems

at Enron, Worldcom, Tyco and other names that are now household words. Accounting standards is an area that has not yet been reformed. It is one that we should

look at on a bipartisan basis.

I want to commend Freddie Mac. They have cooperated with our inquiry to date,

providing information and documents to both the majority and minority staff that

have enhanced our understanding of the accounting issues there.

6

I want to draw an important distinction: while I am sure Freddie Mac regrets

much of the conduct detailed in the Doty Report that we consider today, it is conduct of a lesser magnitude than we have examined in other areas. I believe that

Freddie Mac is not a criminal enterprise.

I also want to commend Jim Doty. I have reviewed your report. Like Chairman

Stearns, I have found it to be dispassionate, rigorous and fair. Today you will help

us understand what went on at Freddie Mac.

We are also joined today by and old friend, Baruch Lev. Professor Lev, we are

going to look to you and other experts to give us ideas on how FASB and accounting

standard setting can be improved.

There were some serious issues raised by the Doty Report.

1. To avoid realizing a one-time gain in its derivatives portfolio of $1.4 billion,

Freddie Mac manufactured a series of transactions to generate artificial losses.

Freddie Mac wished to hide this derivatives gain because it felt that it would get

no credit from Wall Street if it were a one-time event. Freddie planned, instead to

realize the gain over time. It also wished to avoid fair value accounting, which it

believed would make its earnings more volatile.

2. In each of eleven quarters examined in the Doty Report, Freddie Mac took steps

to alter its earnings to meet or exceed Wall Street Analysts expectations by one or

two cents per share. This effort to increase earnings was justified because the quarterly adjustments were in the $30-$50 million dollar range, which Freddie believed

was not material to its overall performance.

The Doty Report shows that senior management of Freddie Mac went to great

lengths to achieve this accounting chicanery. They spent millions of dollars on bogus

transactions that only served to move income from one quarter to another. As Professor Lev has pointed out, this is at best, wasteful of valuable economic resources

that could be better used in providing housing for Americans.

An equally important question is what is permissible under GAAP. Had these

transactions been structured differently, many would have been permissible.

FASB rules spend ten pages requiring firms to account for their derivatives at fair

value, then 790 pages providing exceptions that allow companies to avoid the rule

completely. Freddie Mac has $600 billion in home mortgages of our constituents and

$1 trillion in derivatives. It, and other entities like it, should provide fair value accounting of these assets.

We will be looking for ways to improve standard setting. I encourage all Members

to weigh in with ideas on how to achieve this goal.

PREPARED STATEMENT OF HON. HILDA L. SOLIS, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF CALIFORNIA

Mr. Chairman, thank you very much for holding this important hearing so that

we may hear testimony from today’s witnesses on the findings raised in the Doty

report.

At the outset, Mr. Chairman, I want to say that I’m troubled by the findings in

the Doty report which found significant and costly financial accounting practices at

Freddie Mac.

I must state for the record that I am against corporate mismanagement, and I

believe the steps that Freddie Mac has taken in recent months to rectify their poor

management issues are to be commended. We as members of Congress must not

allow these reported management irregularities at Freddie Mac to obscure the important role that housing GSEs play in making affordable mortgage lending available to communities across the United States. Housing GSEs were created to bring

low cost capital to the housing market, a congressionally-mandated obligation that,

in my experience, has done well.

We must not lose sight of the fact that Fannie Mae and Freddie Mac have harnessed their expertise in housing finance and greatly advanced access to low cost

capital to millions of low and moderate-income Americans.

In closing, I am eager to learn from the panelists about how these companies can

move forward into a new era of management and corporate accountability so that

they may continue to make lending more affordable to our constituents.

Mr. STEARNS. Mr. James Doty, partner in charge of Baker Botts,

LLP; Mr. James Barratt, senior managing director forensic and litigation advisory FTI consulting. And Professor Baruch Lev, Philips

Bardes professor of accounting and finance, department of accounting, taxation and business law and department of finance, director,

7

Vincent C. Ross institute of accounting research, Stern School of

Business.

Mr. Doty, we will start with you.

STATEMENTS OF JAMES R. DOTY, PARTNER IN CHARGE,

BAKER BOTTS, LLP; JAMES W. BARRATT, SENIOR MANAGING

DIRECTOR, FORENSIC AND LITIGATION ADVISORY, FTI CONSULTING; AND BARUCH LEV, PHILIPS BARDES PROFESSOR

OF ACCOUNTING AND FINANCE, DEPARTMENT OF ACCOUNTING, TAXATION AND BUSINESS LAW AND DEPARTMENT OF FINANCE, DIRECTOR, VINCENT C. ROSS INSTITUTE

OF ACCOUNTING RESEARCH, STERN SCHOOL OF BUSINESS

Mr. DOTY. Thank you, Chairman Stearns, Ranking Member

Schakowsky, members of the panel, for having us here and giving

us this opportunity. I do want to give full credit to the investigative

team who has accompanied me and who has helped me do this.

You have Sara Kropf, Arma Adams, Brett Scharback, Amy Gonce,

Mike Barta, Steve Richards, Brad Bennett. These are people who

spent a great deal of time digging out the facts of this situation.

And without them, Jim Barratt and I could not have done what we

have done.

I will take responsibility for the shortcomings of the report, but

I want to give credit for its strengths that have been kindly noted

here to this team. I also would like to inflict on the panel one historical anecdote, which my team may condemn me for, but there

was a very bad man in the 18 century named Taliran whose accomplishment was that he survived the French revolution. He was

asked in the middle of the terror whether the execution of a popular nobleman was a crime by the ruling regime. And Taliran responded quick as a whip as he wanted to do, well it was really

much worse than a crime, it was a blunder.

Now our values have changed since the 18th century, but what

we find ourselves doing in much of what we are seeing in corporate

America, I think both as lawyers and as legislators, is distinguishing between crimes and blunders and attempting to determine how to treat the blunders when they become very serious

threats to our economy and our financial disclosure system.

With that in mind, I think it is important to say at the outset

what the investigation did not find at Freddie Mac. There was no

indication that the company was creating fictitious profits. Nothing

we found called into question the fundamental safety and soundness of the company. While we found misapplications of accounting

principles, our investigation did not reveal rampant criminal conduct, misappropriation of covert funds for personal gain, or others

of the types of intentional wrongdoing that have characterized recent scandals.

Rather, we found a company that was focused on risk management, but responsive, probably too responsive to the market expectation of steady, nonvolatile earning growth. The market expectation was, at times, clearly at odds with the reality of the business

as the business had developed in the past decade. To remind the

committee, since 1989, the company has evolved from a quasi-governmental entity to a public company that is a major participant

in international capital markets. This period also marked a fundaVerDate 11-MAY-2000 14:02 Dec 02, 2003 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 89960.TXT HCOM1 PsN: HCOM1
8

mental shift in the company’s business as it retained more of the

purchased mortgages as long-term investments, this is the so-called

retained portfolio.

Many of the challenged transactions were the result of the tension of the changing business reality of managing that retained

portfolio and the determination of management to maintain the

image of steady Freddie by delivering quarterly and annual earnings expected by analysts. We will talk about these transactions,

but that tension is what you see in much of this story. Missing at

Freddie, missing at Freddie Mac was a sufficient boundary marked

by the company’s accounting professionals to discipline the goal of

steady Freddie and to ensure that capital market transactions and

reserve policies were accounted for properly. The accounting errors

that led to the restatements resulted, in large part, from inadequacies in corporate accounting, in responding to the accounting rules

applicable to derivative transactions, most notably SFAS 133 and

SFAS 125 and initiatives within corporate accounting with respect

to managing reserves.

The challenges faced by corporate accounting were exacerbated

by rapid growth in the company’s retained portfolio of mortgage

loans and the associated exposure to volatility in reported earnings.

However, the practices that enabled the company to report earnings smoothed to within to two to three cents per share of analysts

expectations involved reserve adjustments not simply capital market transactions. Combination of techniques.

It is important to note that notwithstanding the various accounting errors, we found nothing to suggest that the transactions at

issue had the effect of undermining the company’s risk management policies and practices. Indeed, it was the maintenance of the

risk management policies and the avoidance of changing the character of the portfolio that undermines the accounting treatment. As

discussed in the report, we did find problems. We found weaknesses in the company’s internal compliance and governance processes, disclosure practices that fell below the standards required of

a public company, weaknesses in corporate accounting that resulted in excessive reliance on independent auditors.

In many of the cases that Mr. Green and others are familiar

with, the company had excluded their independent auditors from

many of the planning of complex transactions that resulted in accounting error. This is a case that the company relied excessively

on independent auditing advice because it did not have in house

the capacity and the expertise to make these judgments. The role

of senior management is a focus of the report. Employees in F&I,

corporate accounting and other business units were expected by

senior management to take actions that would help achieve the

goal of steady nonvolatile earnings growth. The board of directors

was aware of the goal, but the flow of information was so controlled

by former management, that the accounting challenges involved in

executing those strategies was not fairly presented to the board.

Finally, even as the board and its audit committee members became increasingly concerned over the apparent length of depth and

expertise in corporate accounting, senior management failed to

take prompt corrective action demanded by the board, a failure

that had serious consequences. These governance problems are the

9

focus of a robust remediation effort now going forward at Freddie

Mac under the oversight of the board and the direction of the new

CFO. But that’s the governance side. I would like to take a bit of

time to talk about the underlying accounting issues that are of interest to this committee. There are three groups of rules that we

think that are within your purview and are clearly implicated in

the issues that you are concerned with. One is SFAS 135, Statement of Financial Accounting Standards 133. Our report describes

several transactions that were entered into in late 2000 and early

2001 in response to changes in accounting rules, most notably 133.

SFAS 133 required the company to record derivative instruments

on its balance sheet at fair market value, that is to say, marked

to market through earnings, through income. And that would have

commenced in January 1, 2001. SFAS 133 has been criticized as an

example of a rule based rather than principle based accounting

standard. The concern has been expressed that as such, SFAS 133

might encourage a check-the-box approach that eliminates judgment from application of the standard. It is, nevertheless, GAAP.

SFAS 133 was GAAP. Without commenting at this point on the action the company took in response, we note two findings that we

made.

First, the company believed that the transition to 133 marked to

market accounting to distort the financial condition of the company

by producing a one time gain for which the company would not receive credit from analysts and investors and by creating artificial

in their view artificial earnings volatility in future periods. Second,

in what we saw to be a common theme in many of these transactions, management believed that SFAS 133 should be transacted

around because it did not reflect the economic fundamentals of the

company’s business. The most instructive business was the Coupon

Tradeup Giant transaction, the CTUG, which involved a reclassification, portfolio assets with embedded losses from the health to

maturity account to the trading account and then reclassifying

those securities from trading back to available for sale.

And that would have resulted in losses going into the income

statement without avoiding the volatility in the future of appreciation of those assets. Now although the company and its independent auditors have now determined that that transaction was

not compliant with GAAP, it is, as was noted possible that some

of the transaction structure adjustments would have permitted it

to avoid failing under 125. But the important thing for the committee here is what was missing in this attempt was a real transfer

of risk and a real change in the beneficial ownership and the structure and character of securities held in the retained portfolio. It is

the tension that I was describing.

In other words the accounting transaction would have gone

through the 133, the SFAS 133 test, if it had met the test of SFAS

125, which required a real transfer and a beneficial ownership

change. And that did not happen because the persons managing

the retained portfolio were unwilling to compromise the quality,

the character and the structure of that portfolio merely to accommodate an accounting result.

So you had a tension within the company that results in as they

tried to back away from and avoid 133, they bumped into SFAS

10

125 and they did that because they did not engage in real risk

transfer. Again, they violated GAAP. SFAS 91 required the company to amortize the value of premiums and discounts over the estimated life of a mortgage pool. Mortgages are prepaid. Mortgages

carry penalties and premiums. The company is required to book a

catch up adjustment to income when those prepayments and discounts—when those premiums and discounts exceed the estimated

amortization rate or the estimated rate of prepayment and discount. The model that generates that range of value, if it is violated by actual experience, results in a charge to earnings.

The company again believed that this resulted in volatility in its

earnings and it responded by creating a band within which it

charged these adjustments to a reserve account. The reserve account is not permitted by GAAP. The reserve account was used to

smooth out the effect of prepayments and discounts in the mortgage pool. But worth noting for the committee, is that the use of

a nonGAAP reserve for this purpose was fully transparent to the

company’s then public accounting firm which tolerated the practice

as long as the amounts involved were not quantitatively material.

That is a second category of the problem we found.

A third category, which is encompassed within the report is

SFAS 5, which many of you know relates to the accounting for loss

contingencies. And it requires that a company’s reserves be based

on probable losses. As noted in our report in a number of instances,

the company made management adjustments to reserve accounts

and altered the models that supported reserve policy with a view

to presenting a steady nonvolatile pattern of earnings growth.

These reserve adjustments frequently were not supported by documentation in accordance with GAAP.

As such, the reserve policy reflected a purpose of moving earnings to within a penny of two of analysts’ estimates of earnings per

share rather than as a balanced assessment of the underlying experience and losses required by reserve policy. The foregoing summary is intended just to convey the three major areas of accounting

policy that are implicated by the transactions involved. There are

capital market transactions, reserve policy and management reserve adjustments. They were all three affected in violation of

GAAP. They were all three affected without adequate public disclosure. All three of them raised serious concerns for the company

that Freddie Mac is setting about attempting to fix. And with that,

I thank you for your attention and I would be happy to take your

questions when the other witnesses have testified.

[The prepared statement of James R. Doty follows:]

PREPARED STATEMENT OF JAMES R. DOTY

Chairman Stearns, Ranking Member Schakowsky and members of the Subcommittee: Thank you for inviting me to testify today concerning our investigation

of certain accounting matters for the Board of Directors of the Federal Home Loan

Mortgage Corporation (‘‘Freddie Mac’’ or the ‘‘Company’’). Details of the investigation and our conclusions are set forth in our Report dated July 22, 2003. I would

like to speak today to those findings and their implications for the significant work

of this Subcommittee and your ongoing concern with accounting standards.

I.

It is important at the outset to say what we did not find. There was no indication

that the Company was creating fictitious profits. Nothing we have found calls into

11

1The opinions expressed to us by the Company indicate that the referenced growth of the Retained Portfolio was one factor enabling Freddie Mac to perform its mission in furthering the

liquidity of the secondary mortgage market through crises such as the implosion of Long Term

Capital Management and other international financial crises of the 1990’s. 2These matters are now being investigated by the Securities and Exchange Commission, the

Department of Justice, and the Office of Federal Housing Enterprise Oversight and nothing in

this testimony is intended as a comment on those investigations. 3 CTUG, Swaptions Portfolio Valuation and J-Deals.

4Statement of Financial Accounting Standard No. 133 (‘‘SFAS 133’’), Accounting for Derivative

Instruments and Hedging Activities. The range of the accounting standards involved in the inContinued

question the fundamental financial safety and soundness of the Company. While we

found misapplications of accounting principles, our investigation did not reveal

rampant, criminal misconduct, misappropriation of corporate funds for personal

gain, or the other types of intentional wrongdoing that have characterized recent

scandals. Rather, our investigation found a company focused on risk management,

but responsive—perhaps overly so—to the market expectation of steady, nonvolatile

earnings growth. That market expectation was, at times, apparently at odds with

the reality of the business as it has developed over the past decade.

Since 1989, the Company has evolved from a quasi-governmental entity to a public company that is a major participant in international capital markets. This period

has also marked a fundamental shift in the Company’s business as it has retained

more of the purchased mortgage loans as investments (the ‘‘Retained Portfolio’’).1

Many of the challenged transactions were the result of the tension between this

changing business reality and the determination of senior management to maintain

the image of ‘‘Steady Freddie’’ by delivering the quarterly and annual earnings expected by analysts.2

Missing at Freddie Mac was a sufficient boundary, marked by the Company’s accounting professionals, to discipline the goal of ‘‘Steady Freddie’’ and to ensure that

capital market transactions and reserve policies were accounted for properly.

The accounting errors that led to the restatements resulted in large part from the

inadequacies of Corporate Accounting in responding to the accounting rules applicable to derivative transactions, most notably SFAS 133 and SFAS 125, and initiatives

within Corporate Accounting with respect to managing reserves. The challenges

faced by Corporate Accounting were exacerbated by rapid growth in the Company’s

Retained Portfolio of mortgage loans, and the associated exposure to volatility in reported earnings. However, the practices that enabled the Company to report earnings ‘‘smoothed’’ to within 2 cents to 3 cents per share of analysts’ expectations involved reserve adjustments, not simply capital market transactions.

It is also important to note that, notwithstanding the various accounting errors,

we found nothing to suggest that the transactions at issue had the effect of undermining the Company’s risk-management policies and practices. As discussed in our

Report, we did find problems: (i) weaknesses in the Company’s internal compliance

and governance processes; (ii) disclosure practices that fell below the standards required of a public company; and (iii) weaknesses in Corporate Accounting that resulted in excessive reliance on independent auditors with respect to accounting decisions and policies.

The role of senior management is a focus of the Report. Employees in F&I, Corporate Accounting and other business units were expected by senior management

to take actions that would help achieve the goal of steady, nonvolatile earnings

growth. The Board of Directors was aware of this goal but the flow of information

was so controlled by former management that the accounting challenges involved in

executing particular strategies were not fairly presented.

Finally, even as Board and Audit Committee members became increasingly concerned over the apparent lack of depth and expertise in Corporate Accounting, senior management failed to take the prompt corrective action demanded by the Board,

a failure that had serious consequences. These governance problems are the focus

of a robust remediation effort now going forward at Freddie Mac, under the oversight of the Board and the direction of the new CFO, Martin Baumann.

II.

Now, I shall turn to some of the underlying accounting issues that seem to me

most germane for the Subcommittee.

SFAS 133

Our Report describes several transactions 3 that were entered into in late 2000

and early 2001 in response to changes in accounting rules, most notably SFAS 133.4

12

vestigated transactions was not, of course, limited to SFAS 133, but included SFAS 125, SFAS

140, SFAS 107, SFAS 115, SFAS 91, SFAS 5, EITF 99-20 and EITF D-14. 5This gain would be measured by the difference between the previous, or carrying, value of

the derivative, and its fair value. 6 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

7Later in 2001, the Company entered into a series of transactions known as the ‘‘Linked

Swaps,’’ which had the effect of transferring approximately $420 million in operating earnings

into later years. The Linked Swaps, which were executed at the direction of senior management,

had minimal business justification other than the shifting of operating earnings. Linked Swaps

are also problematic in that they were designed to shift a non-GAAP metric, ‘‘operating earnings,’’ that senior management had identified as the key financial metric that the market should

refer as reflecting the true economics of the Company.

SFAS 133 required the Company to record derivative instruments on its balance

sheet at fair market value (i.e., marked-to-market through income) beginning January 1, 2001. SFAS 133 has been criticized as an example of a rule-based, rather

than principle-based, accounting standard. The concern has been expressed that, as

such, SFAS 133 might encourage a check-the-box approach that eliminates judgment from the application of the standard.

Without commenting further on the action the Company took in response, we note

two findings. First, the Company believed that the transition to SFAS 133 would

distort the financial condition of the Company by producing a one-time gain for

which the Company would not receive credit from analysts and investors, 5 and by

creating artificial earnings volatility in future periods (requiring that some derivatives be marked-to-market but not permitting similar treatment of the debt economically hedged by those derivatives). Second, in what we saw to be a common

theme in many of the transactions we investigated, management believed that

SFAS 133 should be ‘‘transacted around’’ because it did not reflect the economic fundamentals of the Company’s business.

The most instructive example of this response was the CTUG transaction, which

was intended to offset the one-time transition adjustment gain under SFAS 133 by

reclassifying certain portfolio assets with embedded losses from ‘‘held-to-maturity’’

to ‘‘trading’’ (producing a loss that would be reported in the transition adjustment

line on the Company’s income statement) and then reclassifying the securities from

‘‘trading’’ to ‘‘available-for-sale’’ (an asset classification that does not require markto-market accounting and so would not produce earnings volatility in the future).

Although the Company and its independent auditors have determined that the

transaction was not compliant with GAAP, it is possible that with certain adjustments to the transaction structure the Company would have satisfied GAAP. Specifically, the most serious GAAP problem with the CTUG arises not under SFAS

133, but under the transfer and control requirements of SFAS 125.6 These flaws

could have been addressed by transactional changes. SFAS 133, in paragraph 54,

invites reporting companies to attempt precisely what Freddie Mac attempted—to

transfer held-to-maturity derivatives into trading and thereby offset this one-time

gain with the embedded losses.

The Swaptions Portfolio Valuation and the J-Deals were similarly entered into in

order to avoid volatility in financial results.7 The J-Deals, if structured and executed

differently, could have achieved the Company’s intended results (consistent with

SFAS 125 and SFAS 115).

SFAS 91

As described in our Report, SFAS 91 required the Company first to amortize the

value of premiums and discounts over the estimated life of a mortgage pool, and

then to book ‘‘catch up’’ adjustments to the income statement when actual prepayments differed from estimates. Again, the Company believed that, as applied to it,

this accounting standard produced misleading results that tended to overstate the

volatility of the Company’s business. The Company responded by creating a ‘‘band,’’

and by booking the catch up adjustment (so long as it fell within this band) to a

special reserve account, rather than the income statement. On one occasion, the

Company also changed its assumptions about interest rate yield curves, again with

an eye toward reducing volatility in its reported financial statements.

Worth noting, however, is that the use of a non-GAAP reserve for this purpose

was fully transparent to the Company’s then-public accounting firm, which tolerated

the practice so long as the amounts involved were not quantitatively material.

SFAS 5

SFAS 5 provides that a company’s reserves be based on ‘‘probable’’ losses. As

noted in our Report, in a number of instances, the Company made ‘‘management

adjustments’’ to reserve accounts and altered the models that supported reserve polVerDate 11-MAY-2000 14:02 Dec 02, 2003 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6621 89960.TXT HCOM1 PsN: HCOM1
13

icy, with a view to presenting a steady, nonvolatile pattern of earnings growth.

These reserve adjustments frequently were not supported by documentation in accordance with GAAP. As such, the reserve policy reflected a purpose of moving earnings to within a penny or two of analysts’ estimates of earnings per share, rather

than a balanced assessment of the underlying probable losses.

The foregoing summary covers the three major areas of accounting policy implicated by the transactions investigated—capital market transactions, reserve policy

and management reserve adjustments.

Thank you again for the opportunity to appear; and I will be happy to take your

questions.

Mr. STEARNS. I thank the gentleman and Mr. Barratt.

STATEMENT OF JAMES W. BARRATT

Mr. BARRATT. Good morning. Chairman Stearns and members of

the subcommittee, thank you for the invitation to appear here

today. My name is James W. Barratt and I am a senior managing

director in the forensic and litigation advisory practice of FTI Consulting here in Washington, DC. I am a CPA and have over 19

years of experience in accounting, auditing and investigations, including several years as an accountant in the division of enforcement at the SEC. FTI consulting is a multi discipline consulting

firm with practices in the area of financial restructuring and litigation consulting.

In December 2002, James Doty of the law firm of Baker Botts

retained FTI to provide forensic accounting consulting services in

connection with the internal investigation requested by the audit

committee of the board of Freddie Mac. FTI possessed the forensic

accounting experience and the electronic evidence consulting resources to assist in conducting this investigation. Over the course

of several months, members of FTI and Baker Botts worked closely

together to conduct the internal investigation. The FTI forensic accounting teams performed analyses of various accounting and financial reporting issues related to derivative transactions and reserve accounts.

The FTI electronic evidence team supported the forensic accountants and the attorneys in the electronic evidence gathering and the

analysis. That process included the imaging of numerous hard

drives, obtaining stored e-mails and other data from network servers and identifying relevant documents through key word searches

and other techniques. On July 23, 2003, the report on the results

of the investigation was made to the board of directors of Freddie

Mac. As stated in the report, our purpose was to conduct a factfinding investigation. To that end FTI has assisted Baker Botts in

developing an understanding of the structure, execution and accounting implications of each of the specific transactions. Our purpose has not been to test whether the accounting was correct, because the company had already determined the accounting was in

error. I welcome the opportunity to assist the subcommittee in the

hearing today. Thank you.

[The prepared statement of James W. Barratt follows:]

PREPARED STATEMENT OF JAMES W. BARRATT, SENIOR MANAGING DIRECTOR,

FORENSIC AND LITIGATION ADVISORY PRACTICE, FTI CONSULTING

Chairman Stearns, Ranking Member Schakowsky and members of the Subcommittee:

Thank you for the invitation to appear here today.

14

My name is James W. Barratt and I am a Senior Managing Director in the Forensic and Litigation Advisory Practice of FTI Consulting (‘‘FTI’’) in Washington, DC.

I am a CPA and have over 19 years of combined accounting, auditing, and investigative experience including serving several years as an accountant in the Division of

Enforcement of the U.S. Securities and Exchange Commission.

FTI Consulting is a publicly traded, multi-disciplined consulting firm with leading

practices in the areas of financial restructuring and litigation consulting.

In December 2002, James Doty of the law firm of Baker Botts, L.L.P. (‘‘Baker

Botts’’) retained FTI to provide forensic accounting consulting services in connection

with an internal investigation requested by the Audit Committee of the Board of

Directors of Freddie Mac. FTI possessed the forensic accounting experience and electronic evidence consulting resources to assist in conducting the investigation.

Over the course of several months, members of FTI and Baker Botts worked closely together to conduct the internal investigation. The FTI forensic accounting teams

performed analyses of various accounting and financial reporting issues related to

complex derivative transactions and reserve accounts. The FTI electronic evidence

team supported the forensic accountants and the attorneys in the electronic evidence gathering and analysis process. That process included the imaging of numerous hard drives, obtaining and storing e-mails and other data from network servers,

and identifying relevant documents through keyword searches and other techniques.

On July 23, 2003, the Report on the results of this investigation into accounting

and financial reporting matters was made to the Board of Directors of Freddie Mac.

As stated in the Report, our purpose was to conduct a fact-finding investigation. To

that end, FTI has assisted Baker Botts in developing an understanding of the structure, execution, and accounting implications of each of the specific transactions. Our

purpose has not been to test whether the accounting was correct because the Company has already determined that the accounting was in error.

I welcome the opportunity to assist the Subcommittee in the hearing today.

Mr. STEARNS. I thank the gentleman. Professor Lev.

STATEMENT OF BARUCH LEV

Mr. LEV. Thank you for the opportunity to be here. I would like

to comment briefly on two subjects. One is on several important

issues that if I were writing this report I would have included them

in the report or emphasized them somewhat differently, although

I find the report outstanding. And the second issue is some serious

deficiencies in what is known as GAAP, generally accepted accounting principles that come to light once more in Freddie Mac.

So I start with my comments on the several issues in the report.

The first one, I call if it complies with GAAP, it is fine. I think the

attitude, Freddie Mac’s attitude at least at the time, is expressed

beautifully in footnote 67 of the report when they say Parseghian

has acknowledged that he was aware of the use of reserves to meet

earnings goals but understood these reserves are being managed

consistent with GAAP.

This means that you can manipulate because using reserves to

meet goals means manipulating your earnings simply. You can manipulate as long as it is consistent with GAAP. They also quote the

auditor, Arnall indicated to us Arthur Andersen viewed its role as

being focused on GAAP measure. And even the report itself is

somewhat GAAP centric, for example, they mention several times

that a major measure indicator operating income that was manipulated by Freddie Mac is not a GAAP measure as if that is a mitigating circumstance. Investors of course are not really concerned

whether financial information reports are consistent and comply

with GAAP. What they are concerned with is whether they comply

with reality. Whether earnings, asset liabilities that are reported

to them are truthful, that present reality.

15

Just to give you an example from buying a house which I did recently, you speak with the engineer and you ask the engineer about

foundations of the house and whether there are leakages, and suppose he or she tell you, well, the house meets the ordinance or the

regulation. Who cares about this? What you care is reality. And

that is the issue of GAAP or reality behind GAAP, which I would

if I wrote the report I would have emphasized more.

Second issue I call, what about investors? When you read the report and again it is an outstanding report, but when you read the

report you somehow get the impression that by the end of the day

no harm was done. I just quote one sentence. They say on page 31,

they say transactions discussed below didn’t compromise the company’s risk management strategy, will not have an apparent effect

on safety and soundness. Perhaps I am not sure about that, but

perhaps. But what about compromising investors. Information was

manipulated. Investors made decisions based on this information,

must have compromised their decision; must have compromised resource allocation in capital markets, which is a foundation of the

economy. Third issue is which is really related to some extent to

the one I just talked about is the social costs. Mr. Doty and rightfully so emphasized that they didn’t find any misappropriation of

funds, but huge amount of funds were misappropriated, perhaps

not by individuals but just by all the schemes that were done.

If you think about the scores of people that spend hours and

hours probably days and weeks of scheming and perpetrating these

things and then coming up with all kinds of mechanisms and financial instruments that were very costly, legal fees, transaction costs,

what about this misappropriation of funds. And probably the most

serious of all here is that a climate of manipulation and intrigue

must have permeated Freddie Mac. The report quotes, and again

it is a beautiful thing, they quote a trader speaking to another

trader and the trader says, what we do is basically book expense

now and get it back in 6 months. Almost like a joke. And he says

keep it under your hat. I don’t want to see expletive deleted

Bloomberg about this trade either.

How do you think a major company—I saw Freddie Mac ranked

among the 20 largest companies in the world in terms of assets—

how do you think the business of the company is conducted when

this kind of climate permeates there. And the last point on the report, I find it a little too forgiving. For example, the report says

Freddie Mac sought to avoid making any disclosure that would require subsequent explanation or lead investors to draw any conclusion other than the one management believed best reflected economics of company’s business. There is a very simple way if managers are convinced that a new accounting rule doesn’t reflect economics of the business, there is a very simple way or ways dealing

with it. Companies are doing it daily. One is to call a press conference or financial analyst conference and explain it to them, that

this is just a one time item and will never reoccur again.

And the second which lots of companies are again are to issue

pro forma earnings and to say these are GAAP earnings but they

don’t reflect reality. Here are the earnings that reflect reality and

that is the reasons why. You don’t resort to schemes or manipulations which of course you don’t disclose in order to somehow retain

16

the economics of the business. My second subject and again very

briefly is really the big picture, which Freddie Mac is only a small

part of the puzzle. And that is what comes to be known as GAAP,

generally accepted accounting principles.

All the scandals we had, starting recently, starting with Enron

and culminating now with Freddie Mac, they all expose fundamental deficiencies, fundamental weaknesses of the accounting system which now mushroomed to tens of thousands of pages of extremely detailed instructions of how to account and how to report

for every single transaction, which of course is a lost cause. It is

hopeless, because once the FASB after about 2 years of deliberation

comes out with new instructions, smart bankers, lawyers, accountants take about 10 minutes to transact around this, change the

contract and transact around it—the new rules and the report

gives great examples of how Freddie Mac did it and it is constantly

done. So this whole thing is really, really hopeless. But what is so

dangerous about an extremely complex system is that crooks thrive

in complex environment.

Crooks thrive in the tax system because it is so complex. Crooks

recently thrived in the worldwide Web because it is so complex.

And crooks definitely thrive in GAAP because it is so complex. Why

do they thrive? Because they have the most to gain. And they employ the best experts in doing so. So that is a major problem. Sarbanes-Oxley, I wrote in my report, they instruct the accounting regulators to study, move away from rule-based to principle-based.

There is some study by the FASB. I don’t see any real change in

this direction. And the second and last issue of major problem with

GAAP is the fundamental ability to manipulation. Non accountants

believe that accounting is about facts.

Accounting is about a few facts and a huge number of estimates,

judgments, even just sheer guesses. Just to give you one example.

One of the largest item in the income statement is pension expense

particularly for labor intensive companies. To estimate the pension

expense, you have to estimate the gain on your portfolio of pension

assets, the money that was put aside; the gain on this portfolio

next year.

Now who can estimate that what the stock market will do next

year. It is absurd. But this is a large part of the measurement of

income. What is really serious is that the huge amount of reserve

and accounting finances has shown two things: A, that managers

are managing, manipulating earnings on a very large scale, particularly by misusing these estimates because no one can order an

estimate; and second is that investors fall into the trap and pay for

it.

Just to give you an example how widespread this manipulation

is to give you a big picture. I just checked yesterday with First

Call, which is a service that tracks financial analysts’ forecast of

earnings and then the earnings reports by companies. I asked them

to give me information about Standard and Poor 500 companies.

These are the 500 largest companies in the United States, roughly,

70 to 75 percent of the whole U.S. Economy. 40 percent in the last

4 quarters, 40 percent of Standard and Poor 500 companies exactly

matched to the penny, to the penny analysts forecasts or beat by

a penny analysts forecast. I tell you, based on my experience in

17

business and accounting, that for a huge organization which is

spread worldwide with sometimes hundreds of thousands of employees, to meet by a penny an outside target without manipulation, it is an impossibility.

So this is the environment that you are dealing with. And we

really have to see the large picture here. I really urge you if I may

to do two things: A, come up with ways or generate ways to

strengthen the controls and the transparency of Freddie Mac, but

equally important, to start dealing with the big issue with the accounting system known as GAAP. Thank you.

[The prepared statement of Baruch Lev follows:]

PREPARED STATEMENT OF BARUCH LEV, PHILIP BARDES PROFESSOR OF ACCOUNTING

AND FINANCE, STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY.

My observations and comments concerning the July 22, 2003 report (Report) of

the board of Freddie Mac (hereafter the Company) prepared by Baker Botts L.L.P.

relate to two issues: (1) What, in my opinion, is missing from or not sufficiently emphasized in the report, and (2) the accounting regulatory environment, known as

GAAP (generally accepted accounting principles). I would like to state at the outset

that I find the Report thoughtful, insightful, and very well articulated.

I. MISSING FROM THE REPORT

1. If it complies with GAAP, it’s fine.

The attitude of the former management of Freddie Mac toward financial reporting

seems well represented by Mr. Parseghian (a former top executive): ‘‘Parseghian has

acknowledged that he was aware of the use of reserves to meet earnings goals, but

understood that these reserves were being managed consistent with GAAP.’’ (footnote

67). Thus, according to this view, financial information can be ‘‘managed’’ by elaborate devices aimed to make investors believe that the Company’s performance is different from reality (otherwise, why manage?), as long as the scheme is within the

wide latitude allowed by GAAP. This exclusive GAAP concern is also echoed by the

Company’s chief auditor: ‘‘Arnall indicated to us that Arthur Andersen viewed its

role as being focused on GAAP measures.’’ (p. 85). GAAP is also the standard against

which the Report evaluates the various schemes and transactions perpetrated by the

Company (e.g., ‘‘These errors appear to us to have been a good faith misapplication

of GAAP . . .’’ p. 53). Also, a closely-watched indicator which was manipulated by the

Company—operating earnings—is somewhat mitigated in the Report, because it’s a

‘‘non-GAAP metric.’’

For investors and other constituencies, GAAP compliance is of secondary importance. What these users of financial reports need is information that complies with

reality. They need to be assured that the financial reports portray a truthful and

unbiased picture of the Company’s real earnings, assets, and liabilities, rather than

that management’s practices conformed with GAAP, known for its wide latitude and

ease of manipulation.

The absence of a culture of honesty and integrity at the Company, manifested by

the extensive efforts to manage the information conveyed to investors, some in compliance with GAAP and others not, is not sufficiently condemned in the Report.

2. What about investors?

While detailing the extensive schemes of the Company to manipulate its financial

information, the Report does not elaborate on the damage inflicted on the information users. One, therefore, may get the impression that no serious harm was done.

Thus for example, the Report states (p. 31): ‘‘The transactions discussed below did

not compromise the Company’s risk management strategy... will not have an apparent effect on safety and soundness.’’ But what about compromising the multitude

of investors who relied on the ‘‘managed’’ information? Surely, the Company’s managers would not have resorted to such elaborate and costly schemes as described in

the Report, unless they believed that investors will react in an ‘‘undesired manner’’

to the truth. Tampering with information by a major player in capital markets such

as Freddie Mac adversely affects resource allocation in the economy. Not a small

matter.

18

3. The social cost of manipulation

Management and manipulation of financial information seriously damages investors and the resource allocation process of capital markets, and inflicts additional

costs on society at large. The Report details the extent of the Company’s schemes:

scores of high ranking employees from accounting, trade, legal, tax, shareholder relation and other departments were engage for considerable time periods in a socially

wasteful activity of managing information. This substantial time, effort and management attention should, of course, have been devoted to further the real objectives

of the Company.

In addition to efforts and time, substantial monetary resources (legal fees, transaction costs) were wasted in structuring deals and financial instruments which, according to the Report, had no real business purpose. All this is a dead weight loss

on society.

But, perhaps the most serious damage resulted from the climate of manipulation

and intrigue that must have permeated wide echelons of the Company, and even

spilled outside. Thus, for example, a Company’s trader speaking to a colleague explains that the reason for the trade is: ‘‘book expense now and get it back in six

months.’’ He advises the trader to ‘‘keep that under your hat.’’ And states: ‘‘I don’t

want to see any [expletive deleted] Bloomberg about this trade either.’’ (p. 75). One

can only speculate about the adverse impact of a social climate, where employees

are motivated to manage information (Dean’s performance evaluation, p. 45), on

Freddie Mac’s business activities and performance.

4. Report too forgiving

A theme that runs through the Report is that the Company’s management ‘‘just’’

wanted to portray reality. Apparently, no intention to deceive. Thus, the Report

says: ‘‘Freddie Mac sought to avoid making any disclosure that would require subsequent explanation or lead investors to draw any conclusion other than the one management believed best reflected the economics of the Company’s business.’’ (p. 53).

This is admirable, if not for the numerous, detailed descriptions in the Report of

different managerial objectives, such as to portray a steady growth of earnings; to

eliminated reported volatility; to meet analysts’ forecasts; to hide large gains until

‘‘needed’’ in the future, and so on. Obscuring earnings volatility, and making investors believe that the Company meets prescribed targets does not strike me as just

intended to reflect ‘‘the economics of the business.’’

II. GAAP DEFICIENCIES

In addition to exposing the reader to what transpired within Freddie Mac, the Report implies volumes about GAAP, the framework of accounting and reporting rules

governing public companies’ financial reporting. In particular, the Company’s nefarious activities shed light on two major GAAP deficiencies: extreme complexity, and

vulnerability to manipulations. These deficiencies were, of course, evident in the numerous corporate scandals that surfaced during the last three years, yet they did

not receive adequate attention by policymakers.

1. GAAP Complexity

The Report comments repeatedly on the complexity of GAAP, and in particular

the FASB statements on financial instruments—the trigger of much of the Company’s manipulations (e.g., ‘‘The errors... resulted in large part...from inadequacies

in responding to complex accounting rules . . .’’ p. V). GAAP developed over time to

become an incredibly detailed set of rules and instructions, stretched over tens of

thousands of pages, constantly changing in an attempt to prescribe the accounting

and reporting of every new event and business development. By its nature and the

long deliberation process, GAAP is always ‘‘behind events,’’ because once a new rule

emerges, business contracts are changed to ‘‘transact around’’ the rule. Freddie

Mac’s Report provides telling examples of financial instruments and deals structured and executed solely to thwart GAAP.

The extreme complexity, detail, and the constant change of GAAP have various

unintended consequences. One of the most serious is that the complexity gives significant advantage to those, like the Company, who intend to misuse the rules, because those people and entities have sufficient incentives to invest the time and

money required to comprehend GAAP. It is well known that crooks thrive in complex environments (e.g., the World Wide Web).

Sarbanes-Oxley attempted to deal with this issue by instructing accounting regulators to move away from rules-based and toward a principles-based accounting system. My impression is that such a move did not reach far. In fact, GAAP complexity

marches on.

19

2. Vulnerability to manipulation

Laymen are generally under the impression that accounting is all about facts.

Few things are farther from the truth. Accounting is about some facts, and a lot

of judgments, estimates, and outright guesses. The measurement processes underlying the determination of earnings and the valuation of asset is replete with estimates, such as the provisions for depreciation and amortization, bad debts, pension

expense, warranties, asset impairments, and so on. The current move of accounting

regulators toward ‘‘fair value accounting’’ enhances considerably the role of estimates in financial reports. Thus, the Report (p. 47) quotes from GAAP concerning

the fair value of financial instruments which affects both earnings and asset values:

‘‘If quoted market prices are not available, management’s best estimate of fair value

may be used . . .’’ The Report is explicit about how the Company’s management ‘‘best

estimated’’ fair values.

Extensive research has shown that accounting estimates are: (1) widely used by

mangers to manipulate financial reports, and (2) systematically deceive investors

and thwart resource allocation in capital markets. The reason: good, honest estimates cannot be regulated, or audited effectively, nor is it straightforward to prove

after the fact that an estimate, even widely far off the mark, was intentionally misleading.

One can get an idea about the current prevalence of earnings management by

large U.S. corporations, mostly by misusing estimates, from the startling data (obtained from Thomson’s First Call) that during the last four quarters, over 40% of

the S&P 500 companies met to the penny, or beat by a penny the consensus earnings forecasts by financial analysts. It is virtually impossible for a large, complex

business enterprise, operating in a volatile environment, to meet to the penny an

external earnings forecast, without some ‘‘management.’’

The vulnerability of GAAP to manipulation by misusing the multiple estimates

underlying accounting is amply demonstrated in the Report. This vulnerability, with

its adverse economic and social consequences has not received the required policymakers’ attention.

III. POSTSCRIPT

Freddie Mac adds to the variety of recent corporate scandals the case of a company that understated, rather than overstated its earnings. This, however, is not

a mitigating factor. Understated earnings today, are often used to overstate earnings tomorrow. The accounting manipulations described in the report are serious

and require remedial actions. But one should not lose sight of the bigger picture:

the events described in the Report point once more at fundamental vulnerabilities

of GAAP, which so far have not been adequately addressed.

Mr. STEARNS. Professor Lev, thank you.

At this point I will start to question. Professor Lev, you have

used the word manipulation, scheming, intrigue. So obviously you

would not agree with Mr. Doty’s analysis. This is simply blunders.

Mr. LEV. I will not call those ‘‘blunders.’’

Mr. STEARNS. Mr. Doty, in light of the fact that you have used

the word ‘‘manipulation,’’ manipulation does not imply a blunder.

And Mr. Lev, you are saying 40 percent of the Fortune 500 companies might be doing pretty much the same thing. Is that what you

are implying?

Mr. LEV. I think, of course, investigate it.

Mr. STEARNS. You are saying the probability of all of them coming in with one cent of the analysts’ prediction, 40 percent of the

Fortune 500 cannot be done. There is no probability they would

meet that.

Mr. LEV. Extremely low. I don’t want to instruct people how to

do these things, but they do really two things: They manage the

forecasts by continuously talking to analysts and gauging the forecast, and then they manage the earnings to meet the forecast. So

they come from two directions.

Mr. STEARNS. This committee has jurisdiction over FASB so we

are trying to understand how to reform and change GAAP. To do

20

this, let us take a real life example and I will start with Mr. Doty.

In reading through this report, this Giant transaction is perhaps

the most outstanding one. It occurred on a very large amount, $30

billion and the report said it occurred within several hours. So we

transferred $30 billion to create a net loss in several hours in a

buyback. Can you just maybe in very simple sentences tell us what

a Giant transaction is and is it used by all the other Fortune 500

companies, or is that only something Freddie Mac did?

Mr. DOTY. Mr. Chairman, we don’t know about——

Mr. STEARNS. This is not a customary thing. This is something

Freddie Mac created.

Mr. DOTY. Doing something which SFAS 133 invites. The new accounting rule invited companies—and I love this transaction, chairman, because it does illustrate the complexities that you are dealing with in your committee. The rule invited companies to avoid

the one-time marked to market spike in their reported earnings by

reclassification transactions. It was permitted to reclassify securities that were held in the health to maturity account, out of that

account to trading or available for sale.

This transaction was a reclassification of securities first from

health to maturity to trading, involved a sale to a third party, assemblage in a coupon Giant, transferred back to Freddie Mac, and

then a transferred into available for sale so that future appreciation would not affect earnings. It failed not because it was attempting something which was inconsistent with the purpose of 133, but

because the techniques of that elaborate transaction failed the

transfer of risk and the beneficial ownership and control provisions

of SFAS 125.

Mr. STEARNS. No real transfer of risk was the violation, but not

what they did.

Mr. DOTY. And that is because the division of the company owning the securities, F&I was not willing to undergo the change of the

security ownership positions that would have been needed to satisfy the accounting technique. They were insistent on keeping those

securities which they wanted in the portfolio. So you have, in effect, a tension within GAAP between rules, SFAS 133, which does

not presume that volatility is good and steady earnings are bad. It

is accounting neutral. But it creates problems for companies that

are trying to navigate that.

Mr. STEARNS. You would admit, though, to do a transaction of

that complexity required a lot of foresight and scheming and intrigue, manipulation. And the fact that no real risk—no real transfer of risk was involved, these folks knew that when they did it,

didn’t they?

Mr. DOTY. They did.

Mr. STEARNS. People who had that kind of knowledge to do that

kind of transaction surely understand risk and surely understand

that when you do that, you have to transfer that risk and that

wasn’t done. Mr. Lev, let me ask you, we are going to have a second round of questioning here, but how do you think GAAP should

be changed to stop something where people do this with no real

transfer of risk and for the average person to realize they are

transferring $30 billion over 2 hours just to create a bogus number

so they can get earnings in line with expectation of analysts?

21

And Mr. Doty mentioned that these people felt that the GAAP

did not reflect Freddie Mac’s business actions. They made that decision. So evidently accountants and business people can say to

themselves, you know, we are going to take this into our own hand,

it just doesn’t reflect real life, but we are going to do it and we are

going to do it this way. How can GAAP be changed to make this

more realistic or accurate?

Mr. LEV. That is really not a question that can be answered in

a few minutes. This is a huge system that was somehow——

Mr. STEARNS. Let me just help you. Would you take GAAP and

make it more like the European Union, principle based rather than

law based.

Mr. LEV. Yes. I will definitely make it much simpler than it is

now based on a few rules and objectives and supplement it with

rather than instructing people exactly how to account for everything as I said before, which is basically self-defeating, I would

supplement the relatively few rules and instructions with very detailed full disclosure, just tell the story and shift the emphasis to

the full disclosure. If Freddie Mac would have fully disclosed these

schemes, I have no doubt in my mind that they would not have entered into them in the first place if they knew that they had to

fully disclose this. That they bought this and sold this and parked

it 2 hours in between. Full disclosure which may take maybe 10,

15 more pages in the financial report, I think will do a lot of good.

The second thing that I do and this relates to the multitude of

estimates and judgments that go into it, I would cut many of them

because they don’t serve any purpose and they open the door for

the crooks. And I would and I already suggested it several times,

I would distinguish in the financial reports between facts and estimates, or as some people say, facts and fictions in this case. You

could have an income statement with rather than one column, you

will have two columns in this case. One will be facts—facts are

mostly cash-flow transactions. And then there are estimates.

So I don’t throw all the estimates out, but readers have an idea

about the vulnerability of the report, is it based—are earnings

based on 20 percent of estimates, 50 percent estimates, 80 percent

estimates? This I think will go a long way. But we also have to

think about substantive changes in the whole process that leads to

this mushrooming of rules and regulations.

Let me say one more thing, with your permission, because you

mentioned at the end of your question about management didn’t

believe that GAAP in this case portrayed reality. And we heard it

several times today that as opposed to Enron and others, they were

understating income, not overstating income as if this is a mitigating factor. Now I, of course, don’t know what the intention of

the former management was. I never spoke with any of them. But

I know from experience that most managers understate income in

several periods because they know that they need these reversed

to overstate income in the future.

This is the reason for understating income. It is a very sinister

thing. And it is not somehow a good thing to understate income.

By understating income, you create a reserve, 2 years, 3 years

down the road when earnings are really low you say, we have a reserve and we can use it. And of course, Freddie Mac used reserves

22

in this case. So what they did was not something which is, in my

opinion, somehow tame or even a good thing. It is no better than

overstating in my opinion.

Mr. STEARNS. Ms. Schakowsky.

Ms. SCHAKOWSKY. Professor Lev, I agree with your assessment,

but there have been times in the past when FASB tried to rebuild

it in a way that created transparency standards for accounting of

derivatives and it was met with strong opposition from powerful interest groups and Members of Congress and Federal Reserve

Chairman Alan Greenspan. And as a result of the opposition, SFAS

133 includes over 700 pages of exemptions. Do you think FASB

would encounter the same opposition if it tried to strengthen SFAS

133 and close the loopholes?

Mr. LEV. I really don’t know. Perhaps. Whenever you hit vested

interests, you encounter opposition. But I think if the major objective is toward implicit perhaps toward low burden, you will encounter less antagonism than they encounter now than just by piling

up statement after statement and rules after rules.

Ms. SCHAKOWSKY. So the decrease in the burden of all the rules

that exist right now might be incentive enough.

Mr. LEV. I don’t advocate to throw out the rules now. You know

this committee about a year ago, I suggested and the chairman

mentioned it today to set up a blue ribbon committee because

things are really involved in this case. Accounting is complex. Business becomes more and more complex. Crooks proliferate. So it is

not an easy thing to do, you know, just to sit here and give a few

suggestions. It has to be studied very carefully, but with an objective in mind. And in my mind, the main objective is simplify the

system as much as you can.

Ms. SCHAKOWSKY. Let me just state two more questions I have.

Mr. Doty, Professor Lev said that understating earnings was not

benign at all and that this is a serious problem and that we should

be concerned about. So that is one I want to ask. The other is because we are talking about Freddie Mac. We talked about its impact on capital markets, but is there something to worry about in

terms of housing markets, too, because that is, after all, what its

business is.

Mr. DOTY. Excellent questions. First, I don’t think anyone should

read the facts found about deferral of income as mitigating factors

or as vindication or any of that nature. That does affect the quality

of earnings. The missing piece here is that the SEC expects that

companies will discuss their critical accounting policies, disclose

transactions and accounting policies and estimates that affect the

quality of earnings. And I think its very clear that we fault Freddie

Mac for a failure to make transparency come about by explaining

how these transactions—and in the CTUG transactions, same was

true.

As to the tension between the housing markets, it is a point of

pride with many at Freddie Mac that the retained portfolio grew

because the company was buying mortgages and providing liquidity

of that market at the time of the collapse of long-term capital management and during the international debt crisis. There is an issue

for this honorable House and the Senate as to how you manage

that, but it is part of your accounting, I think responsibilities here

23

and the concern you are showing for accounting rules that you consider that one size may not fit all and there may be questions of

whether we want a system in which derivatives are counted for in

one manner in all cases.

Do we want a system in which if—in which the most conservative accounting is always opted for. Do we want a system in which

companies must include an operating earnings or a core earnings

comparison along with a GAAP-reported comparison. There are

many options before you and before FASB. And they are going to

be worked out I think in the arena of international accounting

standards and they will bear on how much latitude and how much

color or texture we want public companies to give to financial presentations and how consistent is that with the rigor and the accuracy that we require of GAAP. And I do not believe that that is a

question that is susceptible of a simple answer, but I think it is

commendable.

Ms. SCHAKOWSKY. I would ask you to comment on this notion

that true full disclosure would at the very least be very helpful,

even if we don’t throw out GAAP and move to principles, but this

notion of much clearer disclosure and much more complete disclosure.

Mr. DOTY. I think that is what the public wants and I think that

is what Professor Lev is alluding to. It has to do with the fact that

the amount of detail and the length and complexity of notes I think

is deterrent to some person’s feeling when they are reading financial statements. The Commission has, in the adoption of management discussion and analysis, attempted to deal with that, but it

seems to me the challenge is to create the understanding for what

the accounting—what the audit represents and what can be expected of an audit and what the accounting principles really show

without throwing out the level of detail and rigor that our current

system provides. Thank you.

Mr. STEARNS. Thank my colleague, Mr. Shadegg.

Mr. SHADEGG. Thank you, Mr. Chairman. I want to compliment

you on this panel. I think this has been one of the more informative discussions that I have heard in any congressional testimony

and I compliment you all for a very elucidating discussion. Professor Lev, I have to tell you I absolutely loved your example. I am

actually building a house right now and you are right. I don’t

whether it meets the building codes. I want to know if it is built

right, if it is sound and if it is going to stay up. And if the building

code is defective and the engineer says to me that it meets the code

but it is going to fall down next week because the code is defective,

it doesn’t mean a thing to me. So I loved that point.

The chairman has already asked the first question begged by

your testimony, which is what can we do for GAAP? And you explained that is difficult to answer. Though I understand that as a

general proposition, you would say eliminate some of the detail,

move toward principles and guidelines requiring full disclosure and

honest disclosure, and I gather more sunshine in terms of full reporting; is that correct?

Mr. LEV. Yeah. Definitely.

Mr. SHADEGG. I happen to be a lawyer and the code of ethics for

lawyers is, in many ways, susceptible of criticism as being too

24

vague because it requires you to do the right thing. Then somebody

gets the second guess whether it was the right thing. Yet, I think

your point about complexity being a haven for crooks is well taken.

The second question begged by your testimony is you said to

strengthen the controls and transparency over Freddie Mac itself.

Of those that have been discussed or of any others, do you have

specific recommendations?

Mr. LEV. I really didn’t investigate this issue carefully. People

are saying maybe should move to Treasury, but that is not an area

I feel competent.

Mr. SHADEGG. Okay, I understand that you don’t have an opinion

about that. Mr. Doty, I also appreciate your report and I think you

have done a great service with it and with your testimony as well.

Let me ask you, do you agree with Professor Lev with regard to

the idea of simplifying GAAP and requiring it to be more principled-based? And if so, is that a feasible challenge.

Mr. DOTY. I believe we are speaking, Mr. Shadegg, of ideals that

are very difficult to implement. And I think there would be harm

to the system if we allowed rigor in the requirement of conservatism in the application of principles to be thrown over in order to

get simplification. I don’t understand Professor Lev to be advocating that at all. I do think we have a third factor pressing on this

and that is international accounting standards, the listings that we

want to retain in this country and the view of some European

issuers that our accounting rules are already too burdensome. And

when we talk about principle-based accounting we mean more lenient presentation of deferral of earnings or concealment of reserve

policies. And then I realize no one on this panel and not Professor

Lev is advocating that.

So it seems to me the devil is, as always, is going to be in the

details, but that we should be able to accelerate the release of these

standards so that they are more timely to create an overarching

purpose for them that can be understood by laymen and others and

to implement the accounting with more transparency in the contextual disclosure, and I think that will go a long way.

Mr. SHADEGG. If there were a patina over GAAP, which said that

these rules apply to the extent that they fully disclose or more

carefully, more accurately reflect the true condition of the company,

would that be an improvement?

Mr. DOTY. I believe you have just described what would be set

forth as being the guiding principle of GAAP plus. When all of

these transactions were occurring, GAAP plus was not a household

word. It has become a household word, and I think people want it,

but I think what you are describing is intended to get us to GAAP

plus. Show us what the rules provide as a picture of the company,

but put in the context that avoids hiding behind the rules in order

not to tell people what this means for the company’s performance.

Mr. SHADEGG. I think you both clearly described that Freddie

Mac took the specific rules and used them to conceal information

rather than to disclose information that was important to investors

and analysts and that put us in the box.

Professor Lev?

Mr. LEV. I think an example that will help here to clarify the

point is differences between principles and rules. Let’s take FASB

25

133, the financial instrument thing. You can state an objective, you

can state the rules that financial instruments are assets and liabilities, they should be presented by the company at fair value or any

other value, and then let the company report, let the auditors be

responsible for the report, rather than the current situation in

which, in addition to this, there are hundreds, sometimes thousands of pages prescribing specific instruction for everything, for

every type of swap and for every type of option, for everything.

That is what I think is not only redundant, it is even dangerous.

The reason, if I can say one more sentence?

Mr. SHADEGG. Sure.

Mr. LEV. The reason, we have to understand the reason.

The reason why it mushroomed in the United States more than

other countries to this extent is that this is a litigious society. Both

corporations and accountants come daily to the FASB and they said

give us a rule. It is not that the FASB imposes rules. They ask for

the rules, because they somehow feel safer with a rule than just

in following or maybe not following the rule, as in this case, than

if there is some kind of a gray area and they have to take responsibility.

This thing has to be resisted, in my opinion.

Mr. SHADEGG. Thank you very much.

Mr. STEARNS. I think we will take one more set of questions, Ms.

DeGette, before we go.

Ms. DEGETTE. Thank you, Mr. Chairman, and I would like to

welcome the panel and ask unanimous consent to put my opening

statement in the record.

Mr. STEARNS. So ordered.

Ms. DEGETTE. Thank you, Mr. Chairman.

[The prepared statement of Hon. Diana DeGette follows:]

PREPARED STATEMENT OF HON. DIANA DEGETTE, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF COLORADO

Thank you, Mr. Chairman. Following the accounting scandals and subsequent investigations at Enron, WorldCom and Qwest, Congress passed important legislation

in the form of the Sarbanes Oxley Act, which helped to increase the transparency

in financial reporting and proved to be an important step in cracking down on the

financial engineering within Corporate America. Unfortunately, the recent revelation that Freddie Mac distorted or ‘‘smoothed’’ its earnings and blatantly disregarded accounting rules in order to bring profits in line with Wall Street estimates, proves that more must be done. Indeed, the very fact that Freddie Mac—

which is not only one of the largest financial institutions in the world, but also a

Government sponsored entity has been employing the same sort of fraudulent accounting practices that Enron used, demonstrates how systemic these crooked financial engineering practices are.

A little more than 18 months ago, this sub-committee convened to discuss accounting reform as it related to, what at the time, was unfolding to be the Enron

scandal. At that hearing, we highlighted that one of Enron’s failings was the fact

they engaged in highly volatile transactions without adequately disclosing the risk

involved. Enron turned out to be a major dealer in derivatives and employed several

engineering activities in order to keep their derivatives’ losses off of their financial

statements. Although this may be considered the most innocuous of Enron’s violations, it nevertheless brought into question whether there needs to be stricter accounting regulation regarding derivatives.

Freddie Mac, while certainly no Enron, nevertheless employed similar strategies

in order to avoid stating the accurate market value of their derivatives portfolio. In

fact, in June 2001, Freddie Mac engaged in several, extremely complex transactions

in order to avoid realizing a non-recurring gain of $1.4Bn from its hedging portfolio.

While unlike in the cases of Enron and Worldcom, Freddie Mac understated earnings in June 2001, instead of overstated them, the aim was nevertheless the same:

26

to manipulate profits to bring them in line with Wall Street expectations. However,

by avoiding a large one-time gain in June 2001, the Company was able to bleed in

the extra earnings over the next two years, overstating their profits during this time

period. In addition, Freddie Mac’s management further manipulated profits by artificially stating the value of various reserve accounts.

In the end, the effect was that Freddie Mac reversed engineered their earnings

to coincide with Wall Street’s expectations—a steady, but northern moving bottom

line. And once again, in the end, the end consumer, in this case the investor, turns

out to be the biggest victim. It is the public who lose out from the lack of transparency and from the gross disregard of accepted accounting principles—not only financially do the consumers lose, but once again their trust in a system that is supposed to contain safeguards to protect them has once again been rocked.

Of course, the blatant disregard for accounting rules exhibited by Freddie Mac

simply did not happen in isolation—it entailed cooperation on many levels: from the

management team to Freddie Mac’s internal corporate accountants to the Company’s external accounting firm, Arthur Andersen. Though it would be easy to presume that that the shady accounting practices at Freddie Mac have been eradicated

with the ousting of key members of the management team and the dissolution of

Arthur Anderson, it is nevertheless incumbent upon us to ensure that that we not

only trim the weed of a culture that embraces accounting negligence, but pull it up

from its very roots.

What potentially may be even more disturbing than Freddie Mac’s blatant manipulation of GAAP and consequent lying to investors, is that if the Company had

structured their transactions more cleverly, they could have still adhered to GAAP

while keeping the fair value of their hedge portfolio off of the books. Is it possible

that even after our dealings with Enron that we support an accounting system that

is so vulnerable so as to actually invite manipulation? Hopefully, this hearing will

bring us one step closer to understanding—and making—the necessary reforms that

must be made in the accounting system.

At one point, I was under the impression that accounting was a cut-and-dry practice—similar to math in the sense that there was one right answer. More and more,

however, I realize that many corporations treat accounting less like a science and

more like art—open to creative interpretation and manipulation. We must not allow

companies to employ fuzzy math or artful accounting in order to line their own

pockets.

It is imperative that we do what is in our power to streamline and correct our

current accounting system so that the accounting practices at the Enrons and the

WorldComs—and I am disheartened to say it, at the Freddie Macs of this world,

do not happen again.

Ms. DEGETTE. Mr. Doty, as I understand it, Freddic Mac manipulated its earnings for 11 consecutive quarters by engaging in complex derivative transactions and by artificially stating the reserve

accounts, which were in blatant disregard of SFAS 91. Is that an

accurate statement?

Mr. DOTY. It is certainly a statement that some may make.

They——

Ms. DEGETTE. Do you think it is inaccurate?

Mr. DOTY. They achieved—lawyers are prone to take striking

statements and reduce them to more banal statements, I guess.

We see it——

Ms. DEGETTE. Some lawyers at least.

Mr. DOTY. Well, the fact is that they did concoct capital market

transactions in order to defer earnings and to mitigate volatility.

The means whereby they fine-tuned the earnings to achieve the analyst expectation within two or three cents a share was largely the

reserve accounting in a few selected reserve funds.

Ms. DEGETTE. And they did this for 11 quarters, right?

Mr. DOTY. They did it and their auditors knew——

Ms. DEGETTE. For 11 quarters?

Mr. DOTY. Yes, and with full knowledge.

Ms. DEGETTE. So you wouldn’t really disagree with this statement?

27

Mr. DOTY. Well, I think we come down hard on the practice.

Ms. DEGETTE. Okay. Well, in your report you say these systematic efforts to change earnings to meet Wall Street’s expectations

were a blunder, right?

Mr. DOTY. No.

Ms. DEGETTE. No?

Mr. DOTY. We say that in many of the derivative transactions

they involve the unintentional misapplication of GAAP, a clear

misapplication of GAAP.

Ms. DEGETTE. Do you think it was intentional or unintentional?

Mr. DOTY. We believe that they thought they were complying

with GAAP. This is what a GAAP centric rules-based system can

produce.

Ms. DEGETTE. Professor Lev, do you believe that? Do you believe

they were complying with GAAP?

Mr. LEV. I really cannot read the minds of these people.

Ms. DEGETTE. Sure.

Mr. LEV. I didn’t speak with them. I don’t believe such elaborate

schemes over extended periods will be benign.

Ms. DEGETTE. See, I am also on the Oversight and Investigations

Subcommittee and we were the ones that did the investigation into

WorldCom and Enron and all of those evildoers, and they all said

the same thing. They all said, well, we thought we were complying

with the accounting standards when we concocted these elaborate

transactions, and I guess in my mind, as a lawyer, when I see

somebody over 11 consecutive quarters making these very elaborate—constructing these very elaborate transactions, I can only

come to the conclusions that they are using GAAP as a kind of

mantle to shield their actions.

Now, Professor Lev, you are nodding, I hope, in agreement.

Mr. LEV. In principle, I agree with you, yeah.

Ms. DEGETTE. Something else, I don’t have much time left, and

we have a vote on the floor. One of the issues that came out of the

corporate responsibility hearings that we had was the issue of

board accountability, and several of you have mentioned the concept of trying to have people have a conservative interpretation of

GAAP. I am wondering, Mr. Doty, in your report, you said that the

Board was aware of this ‘‘Steady Freddie’’ mentality, but because

the flow of information was so limited the Board did not fully understand what it complied.

Do you believe that Freddie Mac’s board from 2000 to 2002 neglected their fiduciary duty to protect shareholders by not probing

even more deeply into how this goal was being achieved?

Mr. DOTY. No, Congressman. I am burdened by the knowledge

that they tried very hard at the end of 2000, going into 2001 and

through 2001, to achieve greater control of the accounting function.

This was a very proactive board. It has been extremely proactive

since January, 2000.

Ms. DEGETTE. I bet they have.

Mr. DOTY. But at that time, at the time you are inquiring of,

they were expressing grave discontent with management for having

people in corporate accounting who they thought were not up to the

task.

Ms. DEGETTE. Well, if I could interrupt you.

28

Mr. DOTY. They were overseeing, they were not managing.

Ms. DEGETTE. We had the same problem, too, where the Board

was saying we have grave concerns but at the same time these

practices were going on.

I wonder if you have any thoughts as to how we can beef up information or the Board’s oversight responsibility so that these practices don’t continue to go on, even when board members are expressing concern.

Mr. DOTY. Well, I think you can look at what board members do.

Board members are going to be judged by the courts and by the

regulatory agencies as to whether they are actually going to be

doing things that deal with these problems. I think in the case of

the Freddie Mac board it will be seen that they did. They were

seeking to recruit and to obtain a chief financial accounting officer

who had real expertise. They were thwarted in that goal. They

sought to do something about errors in the accounting that they

began to perceive at the end of 2001. They were thwarted. They

called in management in the spring of 2002 and said, unless you

fix these problems immediately your pay is going to suffer. It is

probably the most immediate control a board of directors has over

management is to threaten their pay and the Freddie Mac board

was a bit ahead of their time in doing it.

Ms. DEGETTE. Thank you.

Mr. STEARNS. I thank my colleague.

We are going to take a temporary recess. We appreciate your patience. We are going to go take a vote and then we will reconvene.

[Brief recess.]

Mr. STEARNS. The subcommittee will come to order.

Mr. Barratt, we want to get you involved here, so we have got

some questions for you. Explain to us why companies would want

to change the characterization of assets from ‘‘held to maturity’’ to

‘‘available for sale,’’ and what are the implications for these

changes, and keep it simple for all of us, for sixth graders.

Mr. BARRATT. I will try. I think one way I think of it is you have

kind of three buckets, you have held to maturity, you have available for sale, and then you have trading, and depending on which

classification you get in, you get different accounting treatment. So

in this case held to maturity is carried on the books at amortized

cost. It is not subject to the fluctuations and market. It is not market to market, but the person who makes the decision of what goes

in each bucket, people could make different decisions on what goes

in the bucket, right?

Mr. STEARNS. Yes.

Mr. BARRATT. And there is another, FASB 115, that goes to that

classification. You have held to maturity, the literature says there

is a positive intent and the ability to hold it to maturity. So there

is a desire instead of just classifying it 1 day one way and then

another——

Mr. STEARNS. So it is pretty subjective?

Mr. BARRATT. Yes, and you can change it. Depending on a variety of circumstances, you may want to move it, but there is different treatment depending on what bucket you are in.

Mr. STEARNS. Hmm.

29

Mr. BARRATT. And available for sale when they mark to market,

that adjustment goes through the equity part of the balance sheet,

so there is not an income statement effect when there is changes

available for sale.

However, on trading, when it is mark to market, it hits the income statement and does affect your earnings and volatility.

Mr. STEARNS. Does FASB clearly point out what the requirements are in determining what goes in, for example, each of these

buckets, and so forth?

Mr. BARRATT. I think——

Mr. STEARNS. Or is it just all subjective?

Mr. BARRATT. SFAS 115 does a pretty good job in saying what

it takes to go into each bucket.

Mr. STEARNS. Okay. So should the characterization of an asset

determine its accounting treatment?

Let me say that again: Should the characterization of an asset

determine its accounting treatment?

Mr. BARRATT. I guess the example to answer that, if you didn’t

characterize these assets in one of these buckets or not?

Mr. STEARNS. Right.

Mr. BARRATT. That could create problems that you are alluding

to, that you could kind of move things around for your own purposes, so I think it is important that there is some characterization

and make them accountable to what the intent is with regard to

the securities.

Mr. STEARNS. Explain to us on the basis of your work some of

the steps companies take to avoid fair value accounting of derivatives?

Mr. BARRATT. Avoid fair value.

I guess to kind of mitigate the effect of the fair value in recognizing these gains there is a variety of things. In this case, for example, there is the swaption valuation change where you just have

a different valuation model to avoid some of that gain that comes

from fair value.

Another thing you can do is there is derivatives that are not in

a hedging relationship, are mark to market, through earnings, and

they affect the income statement. So to the extent you can pair up

those non-hedge derivatives in a hedging relationship, you can

avoid that income hit from fair value accounting.

Mr. STEARNS. Do you think that these actions to avoid fair value

accounting are socially useful? You might have to take off your forensic and litigation advisory cap to do this.

Mr. BARRATT. Mr. Doty may have an opinion on this.

Mr. DOTY. Socially useful.

I think, just to step back, I think SFAS 133, in its intention to

have fair value accounting, instead of just having historical costs

that might be on there or not even the balance sheet, it is a good

thing to have more relevant, more timely information available to

investors. So I think it is a desirable objective, but I think, as we

have learned today, that the rules that set out how you do that create some difficulty sometimes in achieving it.

Mr. STEARNS. So your answer to socially useful is, what, yes or

no?

30

Mr. DOTY. Well, to avoid fair value accounting I would say is not

socially useful.

Mr. STEARNS. Okay. Just for my colleagues and perhaps for the

panel, I asked to get the book on this FASB Statement 133, and

this is it, and, you know, there is a lot of appendix here, but you

can see that accounting for derivative instruments and hedging activities, this is the kind of document that people must understand,

comply with, and this one they try to manipulate. They have got

to understand how to manipulate, and there are things like how

should the basis of a hybrid instrument be allocated to the host

contract in the embedded derivative when separate accounting for

the embedded derivative is required by Statement 133. So the people who are involved here are obviously pretty smart and knowledgeable to be able to even get to the starting line in this thing.

So these are not people that are going to blunder so much as I

think work the system here, and for good or for bad, the GAAP is

allowing it.

So that is my 5 minutes.

Ms. McCarthy, would you like——

Ms. MCCARTHY. Mr. Chairman, thank you both for this hearing

and thank the witnesses for sharing their expertise with us.

The SEC report required by Sarbanes-Oxley concluded that the

principle only standards present enforcement difficulty. I know you

are aware of that. We have all seen issues and discussion of that

in the press, but they are concerned because they provide little

guidance or structure for exercising that judgment by preparers

and auditors, and this is of concern to me and I am sure other

members of the committee. They recommended something else they

called principle-based or objective-oriented standards which possess

the following characteristics, and I will share them with you, although I am sure you are familiar with them, that they be based

on an approved and consistently applied conceptual framework,

clearly state the accounting objective of the standard, provide sufficient detail and structure so that the standard can be

operationalized and applied on a consistent basis, minimize exceptions from the standard and avoid use of percentage tests, bright

lines, that allow financial engineers to achieve technical compliance

with the standards while evading the intent of the standards, and

I wondered, Professor Lev and Mr. Doty, if you would support such

a solution.

Professor Lev and then Mr. Doty.

Mr. LEV. Let me just say that I am not a great fan, personally,

of principles versus rules, particularly because I don’t know when

a principle ends and the rules starts. I mean, the thing is extremely vague.

What I was proposing, and it is in line with what you just read,

is really simplification, focus on a few governing objectives. You can

call them principles. Definitely avoid, and I must say the ridiculous

thing that was just quoted by the chairman from FASB 133, which

is so incredibly detailed, dealing with an instrument that maybe

even doesn’t exist anymore right now, because things change very

quickly, and then putting emphasis, as I said before, on full disclosure. I heard someone saying here during the intermission that no

31

one reads financial reports, and they definitely won’t read the full

disclosure.

This is absolutely wrong. My daughter is a financial analyst. She

reads financial reports of the companies that she follows, every single word, and what she doesn’t understand she pesters management in conference calls about that, so I don’t care whether 95 percent of investors don’t read financial reports.

Those that read determine the price and the volume, so I just

refuse to accept that the only way to go is just making the system

like the book that the chairman is now holding, which is only the

rules. Then you have thousands of pages of interpretations that follow this thing.

Ms. MCCARTHY. I thank you, Professor, and I do agree that rule

based standards only provide that vehicle for circumventing the

very intention of the standard that we want to have met.

Mr. Doty.

Mr. DOTY. Well, I think one comes away from this experience believing there is no substitute for good judgment properly applied.

One of the things, one of the transactions for which we fault

Freddie Mac was the employment of an account, a reserve account,

with the full knowledge of their independent auditors, their independent auditors, which was not maintained consistently with

GAAP, and they knew it was a non-GAAP account but it was allowed to be used for this purpose of earnings smoothing because

the amounts were not material. So it is an example of what you

were pointing to, Ms. McCarthy, of the use of a quantitative test

in a context in which the judgment should have been quite different from the quantitative test, and it is clearly the case that professionals have a duty, we do, as lawyers, accountants have, to use

judgment.

It seems to me that there is an historical sea change at work,

a cultures change within professions, and what we are seeing now

at Freddie Mac as they labor through their restatement is the

adoption of a new corporate culture that is quite different from the

one obtained before, and we would hope and I think we would expect it is going to be much more laden with correct judgment.

Ms. MCCARTHY. Thank you very much for your answers and

thank you, Mr. Chairman. I yield back.

Mr. STEARNS. I thank the gentlelady. I think we are ready to

conclude. Mr. Doty, I just have a few items.

Who were the counterparties in the Giant and the J deals? Can

you specifically tell us who they were?

Mr. DOTY. I can. We have not made a great deal of this in the

report because the transactions were initiated by Freddie Mac, but

Salomon Smith Barney was a counterparty chosen in the Cetaug

transaction and Morgan Stanley in the J deals.

Mr. STEARNS. It was just those two then?

Mr. DOTY. Yes.

Mr. STEARNS. Professor Lev, you have pointed out the two major

problems with GAAP, extreme complexity and vulnerability to manipulation.

I asked in my first series of questions what should be done. I

guess now I am asking you the problems of earning management

32

is widespread. I think that is what you are indicating in your testimony.

Could you take another shot at what should be done and maybe

I will ask the other folks too, and that will be our conclusion here.

Mr. LEV. In the case of earnings management?

Mr. STEARNS. Yeah.

Mr. LEV. I mean, in addition to all the things that——

Mr. STEARNS. Or is it benign?

Mr. LEV. It is definitely not benign.

Mr. STEARNS. Okay.

Mr. LEV. It is not benign because it affects market prices and the

decisions of people.

I mean, in addition to all the things, you know, strengthening

the board and auditors and so on and so on, it also behooves some

in the investment community to do something. They basically perpetrate the whole thing. Their complete focus on quarterly earnings

of companies motivate this kind of an earnings game, a much more

reasonable focus, rather than on quarterly earnings. If you think

about earnings of a company, quarterly earnings are almost completely meaningless. They are largely effected by random things,

transitory things.

If they would have focused more on long-term measures, like

three quarters, four quarters, and so on and so on, the whole game

would lose much of its power. Some leading companies—I don’t see

it mushrooming, but there was a beginning. Some leading companies announce in the wake of all the scandals, announce we are not

going to give any guidance about earnings or they took themselves

out of the earnings game.

I think only giant companies can afford at least at the beginning

to do such things, but this is really a difficult issue. It is so endemic to the investment process, this focus on everything shortterm.

Mr. STEARNS. Mr. Barratt.

Mr. BARRATT. My only thoughts there would be I think in some

cases adjustments were considered to be immaterial. They were so

small that either the auditor or the company didn’t necessarily consider it possibly the way they should.

I think Staff Accounting Bulletin 99 that SEC issued has got

some way to address that, and so the other point I would make is

I think now, in light of all, Sarbanes-Oxley and everything else

that is going on, I think auditors in companies will be looking at

all the adjustments that were going on, that were either proposed,

or not made and really I think drilled down to the point where it

is more difficult possibly to——

Mr. STEARNS. To do it.

Mr. BARRATT. To achieve that, yeah.

Mr. STEARNS. Mr. Doty.

Mr. DOTY. Three things, disclosure, better disclosure, and the

best disclosure, and I think if you do that I know of no area in our

national life in which disclosure hasn’t cured a great many problems.

Mr. STEARNS. Just bring some sunshine in?

Mr. DOTY. Yes.

33

Mr. STEARNS. Let me thank all of you for your testimony and

thank you for your patience and indulgence while we voted and

also thank Freddie Mac for their cooperation and directness here.

It has helped and I think jurisdiction of our committee is such that

we are trying to work on some kind of legislative initiative here,

dealing with FASB, and I think you have been very helpful, and

with that, the subcommittee is adjourned.

[Whereupon, at 11:50 a.m., the subcommittee was adjourned.]

Æ