Hearing of the Subcomm. on Commerce, Trade, and Consumer Protection of the House Comm. on Energy and Commerce-Freddie Mac's Accounting Restatement

Federal News Service January 28, 2004 Wednesday
Copyright 2004 Federal News Service, Inc.
Federal News Service

January 28, 2004 Wednesday

HEADLINE: HEARING OF THE SUBCOMMITTEE ON COMMERCE, TRADE AND CONSUMER PROTECTION OF THE HOUSE COMMITTEE ON ENERGY AND COMMERCE

SUBJECT: FREDDIE MAC'S ACCOUNTING RESTATEMENT: ARE ACCOUNTING STANDARDS WORKING?

CHAIRED BY: REPRESENTATIVE CLIFF STEARNS (R-FL)

WITNESSES PANEL I:

ARMANDO FALCON, JR., DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT;

ACCOMPANIED BY WANDA DELEO, CHIEF ACCOUNT, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT;

PANEL II:

MARTIN BAUMAN, CHIEF FINANCIAL OFFICER, FREDDIE MAC

LOCATION: 2322 RAYBURN HOUSE OFFICE BUILDING, WASHINGTON, D.C.

BODY:

REP. CLIFF STEARNS (R-FL): The hearing today will focus on two reports: the Supplemental Report to the Board of Directors of Freddie Mac, known as a supplement to the Doty Report and submitted to the board on November 18th 2003, and the Report of the Special Examination of Freddie Mac by the Office of Federal Housing Enterprise Oversight, or OFHEO, completed in December 2003. We have two witnesses here today, and I'd like to thank them for appearing before the committee to help us better understand what happened at Freddie Mac.

I would like to thank Armando Falcon, director of OFHEO, Freddie's regulator, for OFHEO's work on passing through the problems at Freddie that led to Freddie Mac's disregard of financial accounting standards. I would also like to thank Martin Bauman, CFO of Freddie Mac, for being here today.

At the last hearing we held on the accounting standards issues raised by the Doty Report, I complimented Mr. Doty on his thoroughness and objectivity with regard to the internal investigation and the report. While Mr. Doty is not appearing as a witness here today, I wish to acknowledge the supplemental report was produced with the same rigor as the initial report. It also will be a useful tool as guiding our review of accounting standards.

We will focus on three things today. First, the supplement to the Doty Report, second, the OFHEO Report, and finally on the implications of the content of these reports for fair disclosure under U.S. GAAP. The supplement to the Doty Report addresses issues that were known to require further inquiry at the time of release for the initial report. As with the transactions scrutinized in the final report, hiding income was a primary factor if not the sole motivation for several transactions investigated for the follow-up report. The supplement reveals further evidence of earnings management at Freddie Mac.

The OFHEO Report provides an overview of the culture at Freddie Mac that facilitated earnings management over 11 quarters. The report indicates that Freddie disregarded accounting rules, internal controls and disclosure standards to maintain a reputation for steady earnings. So I look forward to hearing from Mr. Bauman about what controls Freddie is putting into place to guard against improper accounting.

The third issue we need to look at today is what this information means for accounting standards. Although Freddie Mac made accounting misstatements, it is possible that if some of the transactions were structured more carefully, they would have been GAAP compliant. It is possible Freddie could have hidden billions of dollars on income in a way that complied with GAAP. I suggest this is not the fault-this is not the result we want from our United States accounting standards.

So-called mixed attribute accounting allows companies to decide whether financial assets were carried at current market price or at historic cost. Let me repeat that. Allows companies to decide whether financial assets are carried at current market price or at historic cost. Freddie shifted assets between categories to manipulate earnings without any change in the underlying economics of its performance. Now, taxpayers do not have the option of changing the characterization of assets to change the tax treatment. I think GAAP should not allow this either.

U.S. GAAP was once hailed as a premier accounting system, I believe GAAP is still a strong accounting system and I applaud FASB for all their efforts to shore up the system over the last two years. While I do not believe Congress is the appropriate body to set detailed accounting standards, I believe we as a committee of oversight over accounting standards setting, have a responsibility to ensure standards produced financial statements that are transparent and comprehensible. I encourage my colleagues to join me to produce legislation to reform GAAP. I look forward to a dialogue here today that will further these efforts.

And I thank you, and I ask the distinguished ranking member for her opening statement.

REP. JANICE D. SCHAKOWSKY (D-IL): Thank you, Chairman Stearns, for convening this important hearing to follow up on the accounting scandal at Freddie Mac.

I appreciate Mr. Falcon and-is it Falcon or Falcone? Well, what do you like?

Okay.

And accompanied by Mr. Leo this morning and Mr. Bauman's attendance today so that we can go over the Office of Federal Housing Enterprise Oversight's examination of just what went wrong at Freddie Mac and Freddie Mac's actual restatement of earnings.

According to OFHEO's report, Freddie Mac used a variety of accounting tricks to move gains and losses around to smooth out and meet earning expectations. Through their manipulations, steady Freddie seemed to live up to its name. However, as its restatement shows and we all know, the cumulative effect of their attempts was hiding $5 billion of volatility. Some have been lulled into a sort of complacence with the accounting scandal at Freddie Mac because they underreported their earnings.

It seemed that while their two earnings revealed some unsteadiness, what they were hiding was not so bad, they hid profits. But this reporting has been misleading as well. In 2001, Freddie's restatement reveals that they over reported their earnings by $989 million. Earnings for 2001 actually were about a billion dollars less than they reported, again that $5 billion was accumulative effect of their restatement.

My concerns today are not just with Freddie Mac, but also with the agency put in charge of their oversight. OFHEO's oversight was created in 1992 to ensure the safe and sound operations of Freddie Mac and Fannie May. However as OFHEO's report reveals a lot was happening at Freddie Mac under their oversight. Today we'll focus on the accounting issues that were raised by Freddie Mac, our subcommittee has the responsibility to ensure that all companies provide clear and accurate financial information to the public.

The scandal at Freddie Mac is a clear example of what can happen when corporate officers do not abide by the rules of clear and accurate accounting. All publicly traded companies need to have clear and accurate books. This is especially true for Freddie Mac. What happened at Freddie Mac has a major impact on the housing market. Freddie purchased almost $600 billion in mortgages in 2002. It also has helped finance homes for nearly 2.5 million low and moderate income families, and families in underserved areas.

It was able to do so, at least in part, because of the benefits and freedoms enjoyed and an established mission as a government sponsored enterprise. As we all know, with freedoms come responsibilities. While Freddie was trying to living up to their reputation, they were not living up to their responsibilities. As a GSC and as one of the largest players in the housing market, playing accounting games puts more than the corporation's financial standing at risk, it puts taxpayers and people's homes in jeopardy.

As I said before, Freddie Mac is not just another company. Therefore, we need to make sure that Freddie Mac is as transparent as possible. And while I applaud the work that OFHEO has done since the scandal has come to light, and appreciate Freddie's restatement of earnings, willingness to take steps toward remediation, we still have a long way to go. Freddie Mac needs to be registered with the SEC. And voluntary registration is taking too long and does not have the same power as mandated.

And that is why I support my colleagues' efforts, Congressman Shays and Markey, to require Freddie Mac to abide by the same rules of transparency available. Because of who you are and the place you have in making money available for homeownership, it is vital that Freddie Mac is held to at least the same standards as other publicly traded companies, if not higher.

I thank you, Mr. Chairman.

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REP. SCHAKOWSKY: Thank you, Mr. Chairman.

I appreciate your good questions, too. I was going to start really the same way. This is a scathing statement that you made. I mean, some of the language is pretty harsh in here. Rightfully so I think, but "obfuscate particular policies," "disdain for appropriate disclosure standards," "misled investors," "low regard for disclosure," "obsession with steady, stable growth and earnings at the expense of proper accounting policies and strong accounting controls," "weak or nonexistent accounting policies," and on and on. But it really led me to think really the same question. Since as I understand at OFHEO you employ, quote, "a full range of supervisory and enforcement tools, including examinations, capital standards and prompt corrective action procedures," is it simply just the lack of expertise? Or is it that in the past you have not been looking for the things, since safety and soundness wasn't of concern, that you weren't looking at all for the things that we have subsequently-you've-have been discovered?

MR. FALCON: This accounting misconduct is not something that we would-you have to review the financial transactions and how they apply GAAP to those transactions to be able to detect this type of conduct. And this conduct, by its very nature, isn't obvious or made plain to-whether the public, investors or regulators. You have to go in and try to find this type of misconduct. And without an accounting review by our agency on a regular basis we can't do that, which is why we're changing this part of our oversight program over these two enterprises. We will begin through use of our Office of Compliance, as well as an Office of Chief Accounting, begin to spot check and review the implementation of new accounting standards.

REP. SCHAKOWSKY: Now, if they were forced to register with the SEC, the SEC would do that kind of work. Is that correct? And let me just add, and do you support legislation that would require it, since they've been so lackadaisical and to date have not registered with the SEC?

MR. FALCON: I think it became very clear to us, Congresswoman, in the course of this investigation that a system of voluntary disclosure standards is not adequate, and so I do support the repeal of the company's '33 and '34 exemptions.

REP. SCHAKOWSKY: Freddie Mac has been fined $125 million. I want to ask you-I don't know the answer to this. Is this sufficient? I think what Americans are feeling right now is that some of these scandals go largely unpunished, that while there is a little burst of energy at first and "isn't this terrible" and a lot of finger pointing and wagging, that in the end it's, you know, maybe a slap on the wrist and that's about it. We have a particular responsibility here. You know, it's one thing to talk about Enron or some private-totally private company and "isn't this awful" and actually there should be more consequences. But still we, because it's a GSE, have particular responsibility. Is this sufficient so far in the way of a fine?

MR. FALCON: I think-you mentioned the adjectives that were in the report and my testimony about the type of conduct we discovered. I'm not pleased about that kind of conduct at all, any more than you are. As you pointed out, these are government sponsored enterprises. They live off of a public trust to fulfill their mission.

REP. SCHAKOWSKY: Exactly.

MR. FALCON: And if that public trust is violated then our housing finance system is at risk, which is why we are taking as strong an action as possible. I think the fine of $125 million was a very substantial fine, one of the largest ever imposed by a safety and soundness regulator for misconduct. Top management has been replaced. You will see over the course of the next year a turnover on the board, and we are implementing a very strong remedial plan for the company, including this week we'll decide whether or not the company should hold additional capital pending its compliance with the remediation plan.

REP. SCHAKOWSKY: I thank you.

And thank you, Mr. Chairman.

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REP. SCHAKOWSKY: Thank you, Mr. Chairman.

Mr. Falcon, in your statement you talk about executive compensation and I was wondering if-I was hoping and asking if we could get a copy of the OFHEO study of executive compensation of Freddie and Fannie which has been presented to the Financial Services Committee. I understand that Fannie Mae has retained the services of former Clinton prosecutor Ken Starr, who is reportedly trying to keep the Financial Services Committee from releasing that report. And so I am asking you if we can get a copy of that report for the record?

MR. FALCON: I'd be happy to provide it to you-to the committee, Congresswoman. The information was-the information on the salary and total benefits of the senior most individuals of the two companies, we provided it to the House Financial Services Committee with the understanding that it is confidential information, and I believe we can provide it to you as well.

REP. SCHAKOWSKY: I mean, to the extent that you say that compensation of senior executives contributed to the improper accounting and management practices of the enterprise, I would think that at the very least it should be provided to us. But also I would think that the public has a right to see that as well.

MR. FALCON: What that is referencing to is-their bonus was structured in a way that I think 40 to 60 percent of the bonuses were dependent upon achieving this earnings targets. That's what that is in reference to. But we'll certainly work to fulfill your request, Congresswoman.

REP. SCHAKOWSKY: And what is the rationale for it being confidential?

MR. FALCON: For part-the-only the information related to the top five individuals at the company are subject to the public disclosure standards, the same as for every corporation. This list went beyond the top five individuals and included compensation for individuals that are covered by our excessive compensation regulations. It's a list of approximately 20 or so individuals for each company.

REP. SCHAKOWSKY: Well, I think it is worth having a discussion about what portions, at the very least, of that should be made public. The issue is one I think that should be open to scrutiny by more than just members of the committee. But I thank you for your willingness to make it available to us.

REP. STEARNS: Would the gentlelady yield?

REP. SCHAKOWSKY: Yes.

REP. STEARNS: If you struck the names of those 20 individuals and released the information as to their programs and incentive without personal information, would that eliminate the concern of privacy and allow for more broad evaluation?

MR. FALCON: Possibly, Congressman. May I ask that counsels work with the committee on this issue?

REP. STEARNS: Would the gentlelady consider that acceptable as a starting point?

REP. SCHAKOWSKY: Well, as a starting point. But, you know, I still think that full disclosure is in order.

And let me ask you this: have the executive compensation practices changed at Freddie Mac since all of these problems have been revealed?

MR. FALCON: Yes, they have, Congresswoman. The emphasis on short-term earnings is no longer part of that compensation, the bonus structure, so they have worked to correct that problem.

REP. SCHAKOWSKY: Thank you. I look forward to seeing it.

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REP. SCHAKOWSKY: Thank you, Mr. Bauman. I appreciate the tough talk, and I'm serious about that, that an acknowledgement of the problems that were and a commitment to make the changes.

The one thing I noticed when you talked about what your responsibilities were for disclosure, you didn't mention timely.

And I'm concerned in your testimony when you said the objective of completing the process, that is voluntarily registering common stock with the SEC, ASAP, as soon as possible, as opposed to exactly when. Now, we know that-and you referred to-you reaffirmed the commitment that had been made in July of-you had made, yes, in July of 2003 in the restatement announcement and other public statements. So when is this exactly going to happen? I mean, Fannie Mae, even with their accounting problems, already did it last March. And I understand that it will be close to 2005 before you register.

MR. BAUMAN: Congresswoman, if I omitted timely in my questions to Chairman Stearns, that was an error. My oral statement did say that I'm committed to developing an exemplary finance function that produces accurate, timely, well-controlled and transparent financial reports. First thing Freddie Mac had to do was to complete the restatement of prior years, and as indicated in our restatement press release, the company made many accounting errors in the past. Correcting those errors means also correcting some financial infrastructure in the company to build accounting systems that are based on the right rules, not the wrong rules.

We're doing that right now as quickly as possible, have engaged-really all the major consulting firms are working with us in many ways to build that infrastructure as quickly as possible and as accurately and reliably as possible so we can get our financial statements current, timely and continue with the '34 Act registration process. I've met with the Securities and Exchange Commission already and they have agreed that as soon as we get our 2002 annual report issued --

REP. SCHAKOWSKY: Which is when?

MR. BAUMAN: -- which will be in February, our 2002 annual report, that the SEC is willing to reengage with us in discussing the registration process so we can begin a draft of the filing such that as soon as we become current in our financial reports that we could be registered with the SEC as promptly as possible.

REP. SCHAKOWSKY: And when is 2003 going to be done?

MR. BAUMAN: All right. We've stated that our objective is to release our 2003 results by June 30th, 2004. And as I indicated that's a function of building the accounting infrastructure that we need to ultimately get timely in the long term, as well as getting the results out the door.

REP. SCHAKOWSKY: Timely being six weeks after the quarter?

MR. BAUMAN: Approximately, in accordance with --

REP. SCHAKOWSKY: That's what the --

MR. BAUMAN: -- SEC guidelines, that's correct. That's approximately the timeframe.

REP. SCHAKOWSKY: Well, if you were registered with the SEC, it wouldn't be approximately, that would be what it is.

MR. BAUMAN: It's 45 days, the rules, and they're coming down to 35 days over the next year, correct.

REP. SCHAKOWSKY: Okay. The legislation that would remove the exemption, does Freddie Mac have a position on that legislation?

MR. BAUMAN: The '33 Act legislation on the registration of securities is really designed to help consumers, more so than to help Freddie Mac. It's very important that consumers getting mortgages are able to lock in an interest rate on their house. They're able to do that because of the way the mortgage market operates. Mortgage brokers are able to lock in interest rates for consumers because of the to be announced mortgage market that they can lock in the mortgage rates with a --

REP. SCHAKOWSKY: Do you support the legislation?

MR. BAUMAN: It would not be good for consumers. It would increase the cost of mortgages to homeowners, so we do not support it.

REP. SCHAKOWSKY: No, I would recommend that you rethink that position. I think that there are a lot of people out there that would feel a great deal more confidence if Freddie had to abide by the same rules as other corporations that already feel that how come there hasn't been this full disclosure while it's voluntary, and I think it would ultimately be in your interest to rethink your position on that legislation. Let me just ask you-no, I'm out of time. Thank you, Mr. Chairman.

REP. STEARNS: I thank you.

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