SPEAKERS CONTENTS INSERTS
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THE OFHEO REPORT:
ALLEGATIONS OF ACCOUNTING AND
MANAGEMENT FAILURE AT FANNIE MAE
Wednesday, October 6, 2004
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
and Government Sponsored Enterprises,
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:03 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard H. Baker [chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Shays, Gillmor, Bachus, Castle, Lucas of Oklahoma, Royce, Manzullo, Kelly, Ney, Fossella, Biggert, Miller of California, Toomey, Capito, Hart, Kennedy, Tiberi, Brown-Waite, Kanjorski, Sherman, Meeks, Inslee, Capuano, Ford, Hinojosa, Lucas of Kentucky, Crowley, Clay, McCarthy, Baca, Matheson, Lynch, Miller of North Carolina, Scott, and Velazquez.
Also present: Representatives Oxley (ex officio), Frank (ex officio), Watt, Waters, Davis of Alabama, Maloney, and Brown of Florida.
Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order.
The Capital Markets Subcommittee meets today for the purpose of receipt of a report from the Office of Federal Housing Enterprise Oversight.
It is indeed a very troubling report, but it is a report of extraordinary importance not only to those who wish to own a home, but also as to the taxpayers of this country who would pay the cost of the cleanup of an enterprise failure.
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Although not intended to fuel the effort to bring about regulatory reform, the analysis makes clear that more resources must be brought to bear to ensure the highest standards of conduct are not only required, but more importantly, they are actually met.
For the record, I am not pleased and certainly not happy about these revelations. I am saddened by the disclosures. In all my years of inquiry in this matter, I was only in pursuit of appropriate oversight. Never did I question whether the GSEs were professionally managed to the highest standards of business conduct. Now I do. The culture of mismanagement described in the report must be eliminated and assurances gained that the highest standards of conduct will be consistently practiced.
I know there will be those who will still cling to the belief that the issues raised are minor or that opinions may differ on technical accounting standards. Some may still think this is all a plot by the big banks to preserve market share. The content of this report, in my view, cannot be legitimately questioned. Utilizing the firm of Deloitte & Touche and the staff of OFHEO, the director's report is delivered after review of over 200,000 documents and e-mails, as well as hundreds of interviews and depositions of current and former staff of Fannie Mae.
The statement made in the first page of the executive summary unfortunately sums up our circumstance: ''The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of managerial supervision and the overall safety and soundness of the enterprise.'' This finding, in my judgment, makes committee action essential.
For the record, I should also note that the resistance the GSEs have expressed toward enhanced housing goals. In light of these revelations, their opposition now makes more sense than ever. Should the proposals considered in this committee focus clearly on the needs of first-time homebuyers actually become law, the enterprises would have to allocate resources to those goals at the expense of reduced earnings.
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A reduction in earnings would reduce the likelihood of paying out bonuses to executives. This same observation holds true as to the regulator's decision to increase capital, and Fannie's strong objections to such a requirement. We all know that the enterprise is thinly capitalized, but the potential effect of requiring a responsible capital level would adversely affect earnings per share, and consequently affect the bonus payments to executives.
I also wish to inform members of the committee of another troubling incident, which I now choose to make public. About a year ago, I corresponded with the director's office making inquiry about the levels of executive compensation at the enterprise for the top 20 executives. This is information that had not been made public previously.
In a matter of days, Fannie Mae had engaged the services of Mr. Ken Starr, legal counsel, for the purpose of informing my staff and committee council of the potential consequences of making that information public. It was made clear that civil legal actions would be filed, I presume against me, if the information were to be released.
At that time, I made the decision not to release the data since there was no clear relevance to the reform effort under way, not out of concern for any litigation that might be filed. The realization that the disclosure of this information was so sensitive to the enterprise never really fully impacted me until I read the director's report. Now I understand why the enterprise was so anxious not to have public disclosure of compensation, ironically of an entity that was created by the Congress and supported by the taxpayer.
Circumstances have now changed. As a direct result of the abhorrent accounting practices, executives have been able to award themselves bonuses I do not believe they earned and I do not believe they deserve. For that reason alone, disclosure of where the money went is highly appropriate.
At the conclusion of this hearing, I will release the compensation information obtained from OFHEO and further, I will forward a letter to the director requesting that all compensation information for both enterprises be provided to the committee for a period covering 10 years for all executives that shared in any bonus distributions. This is now essential, in that OFHEO has indicated that accounting manipulation has impacted the financials on more than one occasion, therefore placing the payment of bonuses in question.
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I find this very troublesome business. Much is at stake. The ability of this committee and this Congress to act will be called into question. Notwithstanding the ultimate outcome, the facts will remain and our duty will never be more clear.
Mr. Kanjorski?
[The prepared statement of Hon. Richard H. Baker can be found on page 146 in the appendix.]
Mr. KANJORSKI. Mr. Chairman, we meet today for what might well be our last hearing this year. At our first hearing in 2004, we reviewed the special examination of Freddie Mac by the Office of Federal Housing Enterprise Oversight. It therefore seems fitting that we will bookend our hearings this year with an evaluation of the findings to date of a similar examination of Fannie Mae's accounting policies and practices.
The recently released preliminary report by the Office of Federal Housing Enterprise Oversight includes a number of significant charges. The report concludes that Fannie Mae has failed to follow generally accepted accounting practices in two key areas. They are the accounting of derivatives contracts and the amortization of discounts, premiums and fees involved in the purchase of home mortgages.
The report also raises concerns about the company's organizational structure and its internal controls. These are serious matters that merit our careful attention because government-sponsored enterprises with their public responsibilities and private capital have, in my view, a special obligation to operate fairly, safely and soundly.
As we proceed today, I must urge my colleagues on both sides of the aisle to demonstrate patience and caution when approaching these matters. We should not leap to immediate conclusions. The report on Fannie Mae is preliminary. It is part of an ongoing process.
We should not overanalyze these findings because we do not have all of the information. Fannie Mae's board, as I understand, has already agreed to adopt a number of reforms based on this initial report and it may ultimately implement more. The Office of Federal Housing Enterprise Oversight continues to examine the company's books. The Securities and Exchange Commission, the arbiter of accounting standards for Fannie Mae, is now studying these matters. In short, we need to let this process work itself out.
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We should also refrain from hyping these initial findings in an effort to achieve some short-term gain. As we well know from past experiences, our actions and statements on Capitol Hill have the potential to rile the capital markets. They could also raise the price of homeownership. We should therefore practice caution, prudence and discretion.
My primary focus at today's hearing will be to determine whether the issues raised in the preliminary report constitute some form of systemic risk for Fannie Mae. I therefore intend to ask each of the witnesses their perceptions regarding this issue. I expect them each to offer me their candid assessments of these matters.
As we proceed today, I also suspect that some of my colleagues will return to the question of how best to modify the regulation of government-sponsored enterprises like Fannie Mae and Freddie Mac. As I said at our very first hearing on the oversight of government-sponsored enterprises in March 2000, ''We need to have strong, independent regulators that have the resources they need to get the job done.'' I can assure everyone involved in these debates that I continue to support strong, world-class and independent GSE regulation.
A strong world-class and independent regulator will protect the continued viability of our capital markets and promote confidence in Fannie Mae and Freddie Mac. It will also ensure taxpayers against systemic risk and expand housing opportunities for all Americans.
Like many of my colleagues, I was greatly disappointed last year when the Bush administration rejected our bipartisan efforts to create an independent regulator. Politics, in my view, should play no role in financial regulation. It is therefore my hope that when we revisit this issue in the 109th Congress, we will continue to remain resolute and unwavering in our bipartisan efforts to create a strong, independent and world-class regulator with the powers and resources it needs to get the job done.
In closing, Mr. Chairman, I commend you for your sustained leadership in these matters and for convening this timely hearing. The preliminary report by the Office of Federal Housing Enterprise Oversight and its agreement with Fannie Mae deserve careful review and public scrutiny. I consequently look forward to hearing from our witnesses today.
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[The prepared statement of Hon. Paul E. Kanjorski can be found on page 156 in the appendix.]
Chairman BAKER. I thank the gentleman for his statement.
Chairman Oxley?
Mr. OXLEY. Thank you, Chairman Baker, for holding this hearing on the recently released report from OFHEO's special examination of Fannie Mae. You have followed these issues closely and should be commended for your diligent oversight of the GSEs. It is my hope that this hearing will highlight the concerns raised in the OFHEO report and will help members get to the bottom of the accounting and corporate governance issues at Fannie Mae.
It is unfortunate that we are here today. After earnings smoothing at Freddie Mac was discovered, the public and the markets, and the members of the committee were assured that there were no similar issues at Fannie Mae. The findings in OFHEO's report, if accurate, are disturbing.
While we wait for OFHEO, and the Justice Department and the Securities and Exchange Commission to complete their respective tasks, the management and board of directors at Fannie Mae must take real steps to address the issues and continue to cooperate with regulators. The agreement between Fannie Mae and OFHEO is a beginning of that process, but I seriously doubt it can be the end.
Since the enactment of Sarbanes-Oxley 2 years ago, corporate financial statements have become more transparent and more reliable. There is no question in my mind that the act is at least partially responsible for this progress. The CEO and CFO certifications of financial statements have had a profound impact on the reporting process.
Other provisions are working, too, such as the Public Company Accounting Oversight Board's inspections regime, strengthened and independent audit committees, officer and director bars, the Fair Funds, expedited disclosures of insider transactions, and internal control requirements, to name just a few. That is not to say that we can legislate integrity in every case, but we do have a sensible framework of incentives and disincentives that will affect behavior.
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The OFHEO report raises serious questions about whether Fannie Mae has adequate internal control procedures, ultimately one of the core aspects of Sarbanes-Oxley. The multiple and conflicting duties of the chief financial officer, who we will hear from this morning, calls into question whether there is adequate separation between the risk-taking and control functions.
In my view, section 404 is one of the most important parts of the Sarbanes-Oxley Act. Internal control over financial reporting consists of company policies and procedures that are designed to provide reasonable assurance about the reliability of a company's financial reporting and the preparation of external financial statements in accordance with generally accepted accounting principles. Failure to comply with its requirements is not an insignificant matter. I am eager to hear from the company's senior management officials on their adherence to this critical provision.
Fannie Mae enjoys certain advantages in the marketplace not afforded to other financial companies in order to serve a public purpose. We have recently learned that the corporate structure may have fostered an atmosphere in which senior management may have had undue influence over accounting policies and procedures, and that corporate earnings and management compensation may have been manipulated.
OFHEO has worked hard in conducting reviews of the GSEs. Director Falcon and his staff have been diligent in trying to ensure that the GSEs receive the appropriate oversight. The findings of this report, if correct, reinforce arguments for the creation of a GSE regulator with the powers and authorities granted to other financial regulators and commensurate with the task of overseeing these large and complicated companies.
I was dismayed to learn that OFHEO was forced to resort to issuing subpoenas this past July in order to obtain cooperation with its investigation. It is my sense that if OFHEO had the tools possessed by other regulators, this investigation would not have reached the subpoena stage. If we had a GSE regulator with the powers and authority of a world-class regulator, it is possible that these problems at Fannie Mae would have been remedied earlier and today's hearing would not be necessary.
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The OFHEO report details problems ranging from possible earnings manipulation to management structures that may not have been in line with state-of-the-art corporate governance. I am very concerned about the possibility that Fannie Mae claims to have sound corporate governance standards, when in reality these standards are not in practice.
Fannie Mae's board did the right thing in entering into an agreement with OFHEO and beginning the process of remedying the problems highlighted in the report. The OFHEO report is not finished and it is my hope that Fannie Mae will cooperate with this investigation as well as the other investigations currently under way at the Securities and Exchange Commission and the Department of Justice. Furthermore, I hope that this situation does not develop into a war among accountants arguing technical points that do not put to rest the issues raised in the OFHEO report. We owe it to the housing market and to the financial markets to quickly resolve all of the accounting and governance uncertainties.
I want to welcome all the witnesses appearing before the subcommittee today. I look forward to your testimony.
I yield back.
[The prepared statement of Hon. Michael G. Oxley can be found on page 148 in the appendix.]
Chairman BAKER. Thank you, Mr. Chairman, for your interest and leadership in this matter.
Ranking Member Frank?
Mr. FRANK. Thank you, Mr. Chairman.
First, I want to address a little history here. The committee here was well on the way to adopting legislation that would have enhanced the regulatory structure for Fannie Mae and Freddie Mac. In the Senate, in fact, the committee actually voted out a bill. There was some disagreement between the parties over I think a relatively minor section over receivership. I think that could have been worked out.
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I believe we were well on the way, the chairman and I and the staffs, to putting together a bill that would have enhanced the regulator and could have passed. What stopped progress on a new bill was the Bush administration's determination to go beyond safety and soundness and into provisions that would have restricted the housing function.
What is powerful here are not Fannie Mae and Freddie Mac, but the interests of a majority of the members of this committee in housing at two levels. First of all, in housing in the conventional market, is very important, and the continuance of Fannie Mae and Freddie Mac are important to that. We also have a subset of issues involving affordable housing, and those are very important to many of us.
What derailed the legislation was an insistence by the Bush administration on going beyond safety and soundness and giving the regulators, for example, particular power to say, well, they are going beyond their charter in housing; they should not do these new products. There were specific issues here that transcended safety and soundness or went under it, but the administration was seeking powers that were not related to safety and soundness.
If they were to have dropped that, we would have a law already signed and in place, because on the question of safety and soundness regulation, there has not been a significant dispute.
I will give you an example of what concerns me in this regard. Many of us on this committee, contrary to what some people think, were very aggressive in pushing Fannie Mae to stay in the manufactured housing business in full fight when they were talking about retrenching, and that was bipartisan—the gentleman from Wisconsin, Mr. Green, myself and others, because you will not get the kind of homeownership we want at the right demographic.
As to safety and soundness, manufactured housing is an example. I do not expect Fannie Mae and Freddie Mac to make as much money as possible on every single entity. The attitude of OFHEO towards manufactured housing is an example of why I am concerned about making sure the regulator has safety and soundness powers, but not general powers. In manufactured housing, it was those of us on this committee, Democratic and Republican who care about housing who pushed Fannie Mae to stay in it.
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When I wrote to the secretary of HUD to ask him to join us, the answer was, several members did, he was much too busy for that, his scheduler told us, and we could go talk to the head of FHA. So that is the issue.
Finally, turning to this report, I have to say that I read the director's testimony and I will talk to him about it again, I regret what seems to me frankly almost boilerplate in his report that says at the end of every specific, and this could raise safety and soundness issues. It could, but nothing in here seems to me that it does.
To the extent that people played games to get bonuses, I am outraged. People making that much money, let me put it this way, at the level of compensation of the top officers of Fannie Mae, they should get bonuses if they rush into a burning building to rescue a kid, maybe a cat, but not for doing their job. I think it is unseemly of them to be getting bonuses in the first place for doing what they are getting paid very well to do.
To the extent that there was manipulation, that is very wrong and should be penalized. But I have seen nothing in here that suggests that the safety and soundness are at issue, and I think it serves us badly to raise safety and soundness as a kind of a general shibboleth, when it does not seem to be the issue.
Last point, and Fannie and Freddie are to some extent criticized from both ends. There was an article by Gretchen Morgenson in the New York Times on Sunday that said the problem is that they have done too much to bring housing to people who really cannot afford it and should not be given this chance to own the housing. Her article said the problem here has been they have overextended by lending money to people who were below the economic level that should be there.
On the other hand, they are criticized by the chairman of this subcommittee for not doing enough for lower-income people. Both obviously cannot be right. I think what we need to do is to go forward as we were ready to do with a tougher safety and soundness regulator, but in ways that do not impinge on Fannie's and Freddie's ability to do a better job than they have been doing with affordable housing and to continue to do the job they have been doing with regard to housing in general.
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Chairman BAKER. Mr. Shays?
Mr. SHAYS. Thank you.
I am new to this committee and I was absolutely shocked when we looked at Enron and WorldCom. The board of directors did not do their job. The management did not do its job. The employees did not speak out. The lawyers in the firm were facilitators. The rating agencies did not do their job. It scared the hell out of me, frankly.
We passed Sarbanes-Oxley, which was a very tough response to that. And then I realized that Fannie Mae and Freddie Mac would not even come under it. They were not under the 1934 Act. They were not under the 1933 Act. They play by their own rules, and I am tempted to ask how many people in this room are on the payroll of Fannie Mae, because what they do is they basically hire every lobbyist they can possibly hire. They hire some people to lobby and they hire some people not to lobby so that the opposition cannot hire them.
Fannie Mae has manipulated, in my judgment, OFHEO for years. For OFHEO to finally come out with a report as strong as it is tells me that has got to be the minimum, not the maximum. I congratulate OFHEO for finally stepping up to the plate and not being manipulated by the very organization they are supposed to regulate.
I hear these arguments that Fannie Mae and Freddie Mac are looking out for the interests of the homeowners, and they score worse in helping minorities than the private sector banks under the 1934 Act and the 1933 Act.
Fannie Mae and Freddie Mac are very generous to members of Congress and very generous to the organizations of caucuses in Congress. They do not have to disclose what they do. They do not have to play by the same rules. They are going to crash if this Congress does not wake up and do something about it.
I am absolutely shocked at the extraordinary tolerance that has taken place in this Congress. This is just the beginning of the story. What did OFHEO say? They said they have accounting methods and practices that did not comply with generally accepted accounting practices, employed an improper cookie jar reserve in its accounting system, deferred expenses to meet compensation targets, did not have proper corporate governance controls in place.
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We need to wake up and the sooner we do the better it will be for Fannie Mae and Freddie Mac and all their investors, and the better it will be for our government.
Chairman BAKER. The gentleman yields back.
Mr. Scott?
Mr. SCOTT. Thank you very much, Mr. Chairman.
This is indeed an important hearing. I am very much concerned about the direction that Fannie Mae is moving in. Fannie Mae does an extraordinarily important function in our society, unique among companies in terms of being a catalyst to increase homeownership among middle-income and lower-income individuals. So this is a very important hearing.
Last year, Freddie Mac, another corporation with similar duties, had one of the largest corporate financial restatement of earnings and saw the ouster of its top executives. Fannie Mae representatives assured us then, on this subcommittee, that their books were clean and that they should not be associated with Freddie Mac's problems.
Now, we are meeting to discuss OFHEO's report, which shows that Fannie Mae inappropriately reduced earnings volatility and provided management with the flexibility to determine the amount of income and expense recognized in any accounting period. In 1998, the management at Fannie Mae needed an earnings-per-share target of $3.23 in order to receive the maximum bonus for the company. Due to the accounting schemes used by Fannie Mae, the executives just hit the earnings-per-share mark and they earned bonuses totaling nearly $6 million.
I think the general issue before the public and people all across this country is simply, has the time come to decide if companies that violate public trust should continue to receive special treatment. I think the fundamental question here is, why the Fannie Mae board believed it was appropriate to link executive pay to earnings per share, and whether this compensation scheme resulted in inappropriate incentives for management.
Whether or not the reasons that the company altered earnings was to achieve bonuses is not yet known. The report is there and we have these hearings to get to the bottom of it. I submit to you that we must get to the bottom of it so that we can give Fannie Mae a clean bill of health. The Department of Justice has opened up a criminal investigation into the allegations of the report, and that investigation may clear up the intent.
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Congress should carefully review the OFHEO report because the special examination is continuing and ongoing. Questions have also been raised about OFHEO's ability itself.
Chairman BAKER. Can the gentleman quickly wrap up?
Mr. DAVIS.—to act on this report and the method by which the report was released.
I certainly look forward to the hearing from the panel's testimony on the OFHEO report and Fannie Mae's report to address the criticisms of its accounting practices.
Chairman BAKER. I thank the gentleman. The chair to the best of its ability will try to keep members' opening statements to the requested 5-minute statement length.
Mr. Castle?
Mr. CASTLE. Thank you, Mr. Chairman.
The issue before us is an important one today. I share the concerns of a lot of the other members who have spoken about it, a number of the issues that are before us. It is vast and it is disturbing and hopefully we can do something about it. Frankly, I think we should have done something about it before we started down this alley. Perhaps we can now.
I am going to keep my opening comments, Mr. Chairman, to one issue that concerns me, in what appears to be multiple interpretations of generally accepted accounting principles, GAAP. In February 2004, OFHEO hired Deloitte & Touche to examine the accounting policies of Fannie Mae.
Specifically, OFHEO's report finds fault with the company's accounting treatment of, one, the amortization of premiums, discounts and fees related to the purchase of mortgages and mortgage-backed assets, understatement of accounting financial standards, SFAS 91; and two, financial derivative contracts under SFAS 133. KPMG LLP, Fannie Mae's auditor, has stated it stands behind its audit work.
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Fannie Mae has also stated they believe they were following generally accepted accounting principles. I am concerned that two different auditors would have different interpretations of SFAS 91 and SFAS 133. Therefore, I have sent a letter to Robert Hertz, chairman of the Financial Accounting Standards Board, FASB, for their comments on SFAS 91 and 133, and whether these standards need to be readdressed to remove any gray areas that may exist.
If improper accounting has occurred, I question how these accounting practices were allowed to occur and what was management's knowledge of these actions. It bothers me greatly to hear the allegation that accounting tricks were used to meet specific earnings-per-share targets that resulted in vast amounts of executive compensation to be paid.
I thank all of our witnesses for appearing before us today and I hope we will have an exchange on the merits of what has occurred and what needs to occur in the future. I welcome the news that OFHEO and Fannie Mae have reached an agreement to address the improper accounting and internal controls within Fannie Mae. I strongly believe, however, that in light the likely reforms achieved in the passage of the Sarbanes-Oxley Act, we must again be prepared to act.
Mr. Chairman, I would ask unanimous consent to insert the text of my letter to Chairman Hertz for the record. With that unanimous consent, I will yield back the balance of my time.
Chairman BAKER. I thank the gentleman. Without objection, the letter will be included in the official record.
I am advised by staff that the opening statement period for members is 3 minutes, not 5 minutes.
Mr. Clay?
Mr. CLAY. Thank you, Mr. Chairman.
Mr. Chairman, we are rushing to judgment today. OFHEO has released a preliminary report which has not been proven, but leaked to the press. During the course of the examination, Fannie Mae was not given the chance to respond to OFHEO findings. Informal communications, which are at the core of the GSE's oversight statute, were essentially ignored. At least one former examiner of OFHEO questioned the political motivations behind OFHEO's rush to judgment.
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Mr. Chairman, we do not normally hold hearings on matters before other investigations are complete. Internal findings are normally discussed informally and remedies proposed. There are other stages of this process that take place before a judgment is rendered. Why circumvent the process? Why this hearing?
If I were a member of Fannie Mae's board, I would find the environment very intimidating. Mr. Chairman, why is Senator Shelby not holding a hearing on this preliminary report? After all, the Senate Banking Committee reported out legislation on the GSEs. Maybe this hearing agenda is about something more than the accounting procedures at Fannie Mae.
As you know, Fannie Mae recently entered into an agreement with OFHEO in which they focused on accounting, internal control, and capital. Fannie Mae has agreed to increase additional capital by 30 percent. I am not sure how the new requirement promotes affordable housing. Within 45 days OFHEO and Fannie Mae will implement additional internal controls. The Securities and Exchange Commission, as is intended, should be the final arbiter of GAAP. Why can't we let the SEC decide this issue? Why must we rush past them?
This hearing is about the political lynching of Franklin Raines. We have seen this happen too many times before. We are to go out of session and the deed is to be done before the election. Why can't we just say that this is the agenda? Let us debate that issue on its own merit. Better still, let due process take its course and let the chips then fall where they may. That is, unless this is truly a witch hunt.
We are having a trial by OFHEO leaks, trial by newspaper articles, and trial without due process. In this case, the Senate has it right.
Chairman BAKER. The gentleman yields back.
Mr. Royce?
[The prepared statement of Hon. Wm. Lacy Clay can be found on page 151 in the appendix.]
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Mr. ROYCE. Thank you, Mr. Chairman. I thank you for holding this hearing on the OFHEO report allegations of accounting and management failure at Fannie Mae, as it is called. I would like to commend you, Mr. Chairman, for your continued leadership on GSE oversight.
While there is no question as to where I stand on GSE issues generally, the fact of the matter is the GSEs have a special relationship to the government. After all, there are not many institutions that share common characteristics with Fannie Mae, such as a charter created by Congress, an exemption from local taxation, an exemption from certain SEC registration and fees, and an ability to borrow from the U.S. Treasury Department under certain circumstances.
With this in mind, I believe that Fannie Mae and GSEs in general have an important obligation to conduct operations to the highest standard. As a member of this oversight subcommittee, I expect Fannie Mae to be a role model to other businesses as it fulfills its federally mandated mission. Fannie Mae should be conducting operations in a safe and sound way. In my view, this should include strong internal controls in the risk management department, coupled with consistent and conservative applications of accounting rules.
With its newly released report, the Office of Federal Housing Enterprise Oversight has called into question many of Fannie Mae's risk-mitigating practices. This is very troubling to me and there is no doubt that OFHEO has placed the burden on Fannie Mae to answer these allegations. As OFHEO has leveled some very serious charges, I recognize that we do need to give Fannie Mae the opportunity to respond. This hearing is part of the process for this committee to learn more facts, and I appreciate the participation of all the witnesses today.
In addition to our important oversight role in this committee, I hope that we will move swiftly to create a new regulatory structure for Fannie Mae, for Freddie Mac and the Federal Home Loan banks. There is a very simple solution. Congress must create a new regulator with powers at least equal to those of other financial regulators such as the OCC or the Federal Reserve.
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I hope this committee will heed the advice of Chairman Greenspan and the entire Board of Governors, the Federal Reserve Staff, the U.S. Treasury Department, the OECD, the IMF and countless others who have urged Congress to act.
Now, on the approach that was rejected by the Bush administration and, by the way, was rejected by myself and many others on this committee. Why was that approach rejected by the Fed, by the Treasury? Because that legislation was not a true effort at reform as it failed to address several of the key issues that are essential to true reform of the regulatory regime of the housing GSEs.
Specifically, that non-reform effort would have created a regulator without the authority to raise capital standards, without the authority to place an ailing GSE into receivership, without the authority to oversee all aspects of a GSE's operations, leaving much of this oversight at HUD.
Chairman BAKER. Can the gentleman begin to wind up?
Mr. ROYCE. I will wind up right now by saying there is a difference of opinion on which approach to take if we really want a world-class regulator. I thank you again for the opportunity for this hearing and for us to hear from these witnesses today.
Chairman BAKER. I thank the gentleman.
Mr. Baca?
Mr. BACA. Thank you very much, Mr. Chairman and Ranking Members. Thank you for holding this hearing. I appreciate the opportunity to hear from witnesses about these very important issues.
These are very complex rules and it is possible that we are not going to see a resolution until the issue is decided by the SEC. As I understand it, there are three broad areas of inquiry involving accounting, internal control, and capital. I would simply say I am not going to pre-judge the issues, and that before any stones are cast, we should see that there is culpability. Judge not and not be judged.
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Our country is a country of laws, and there is a process that must be followed and respected. Make no mistake, we will follow this process wherever it may lead. At the end of the day, if anyone, and I stress anyone, has not respected the law they will face the consequences.
Mr. Chairman, I think it is important that in rushing to judgment that we not destroy an institution that is helpful in providing assistance for first-time homebuyers and minorities. Fannie Mae is an integral part of our economy and many of our constituents have been able to realize the American dream of homeownership due to its programs.
I am concerned that the regulators follow the procedure that exists for investigating potential concerns in a way that is consistent, and respectful of confidentiality and impartial. We need to follow proper procedures in handling audits before they go public. We should ensure that the process is fair. We should ensure that the process is fair in getting the facts. And that we engage in corrective action if there are any deficiencies.
Like most of us have been involved in nonprofit organizations where we had auditors that audited us. They come back with a report. They give an opportunity to make corrections if any are done. And all of us have been involved in nonprofit organizations and on boards of directors. We know the consequences if those procedures are not followed.
I think it is important that we keep the politics out of what should be and historically has been a nonpolitical process. It concerns me that OFHEO has been Fannie Mae's regulator since 1992. OFHEO has been its regulator since 1992, and all of a sudden issues are being raised. The regulators had an opportunity in the past to address any concerns.
So we need to ask: What, if anything, has changed? This is not about headhunting. It is about positive steps to correct any problems. I look forward to hearing the witnesses.
I yield back the balance of my time. Thank you very much, Mr. Chairman.
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Chairman BAKER. I thank the gentleman.
Mr. Ney?
Mr. NEY. Thank you, Mr. Chairman, and thank you for holding the hearing. I also want to thank, of course, the witnesses for appearing today. I look forward to hearing their testimony, as I know everybody does, so without objection I will submit all of my written statement for the record. I just have a couple of comments.
OFHEO's recent report on the activities of Fannie Mae asserts the company engaged in accounting practices that do not comply with the generally accepted practices. Of course, it is troublesome. In addition, the report raises concerns about deferred price adjustments, derivatives and hedging activities, internal control issues. I think the stopgap measure was a good thing to implement.
According to OFHEO and what we have read, they are serious and it raises concerns regarding the validity of previously reported financial results. OFHEO's findings to date are obviously very serious. Right now, if you would read the accounts in the papers, it looks like the management of Fannie Mae is basically looking at the fact of, in the media at least, of making them a poster child for regulatory reform.
It is important to keep in mind, though, that the examination is still in the process. So the newspapers and the way people are looking at it is one thing, and the reality of what we are going to find out today I think is important, and the process that OFHEO will finish is obviously important, and also the SEC is going to be the final arbiter of compliance with the general accounting practices, and has not yet, as I understand, offered its opinion on Fannie's accounting methods. So that is another part of this puzzle I think that will be out there for us to look at.
Of course, Fannie was chartered by Congress to create a secondary market and improve the function of home mortgage markets. I think that we can all agree that the United States mortgage and credit markets are the envy of the world. A strong, vibrant housing market is important to everybody.
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There can be no doubt that we have to take some steps to strengthen the GSEs by establishing a new world-class regulator. How we do that and who is to be that regulator, I do not know today. With the growing presence of GSEs in the capital markets and the possible risks they pose to the financial system, the cost of a safety and soundness regulator would be a prudent step. But I want to add the big ''however.'' That ''however'' is we have got to proceed in this endeavor with caution. It cannot be mixed with politics.
If we want to talk about politics or press reports or lobbyists, maybe we ought to do a bill to ban lobbyists, then we can have a rich Republican and a rich Democrat do the lobbying for everybody. We could call them the 527s of lobbying. So I think we take that kind of talk out of the process because any new regulatory structure has to recognize the importance of the GSEs to the secondary mortgage market.
Everyone agrees that strong regulatory oversight is critical to maintaining public confidence in this remarkable system. As I have said before, enhanced regulations for GSEs should not impede their ability to support affordable housing in America.
So I applaud the chairman for this hearing. I think we have to state a public policy as we go down this road and do what is right for the good of Americans, and to craft public policy that ensures safety and soundness, but let's not throw in this process the housing market to the wolves because that hurts the average American.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Ms. Inslee?
Mr. INSLEE. Thank you.
I just wanted to follow up. Our ranking member talked about, when you talk about evaluating this, we are looking at soundness. It made me sort of think of our obligation of buying a horse. You check its soundness. You check its teeth. You check it for hoof rot. That is an important part of this function here, to check on soundness of Fannie Mae.
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But the problem to date has been some folks do not want to check for soundness, check its teeth, check it for hoof rot. They want to hobble the horse when it comes to being a main stem of the housing supply in this country. Whatever comes of these hearings, I hope that we keep in mind those two different functions, that we ought to focus on soundness, but not allow this what may be, and I do not know yet because I think you should have the trial before the execution, but it may be very unfortunate things that occurred, to hobble this very, very important horse that is carrying the U.S. economy in residential homes in this country.
Thank you.
Chairman BAKER. I thank the gentleman.
Ms. Kelly?
Mr. KELLY. Thank you very much, Mr. Chairman.
I have no statement at this time. I look forward to these witnesses.
Chairman BAKER. Mr. Toomey?
Mr. TOOMEY. Thank you, Mr. Chairman. I want to congratulate you for your long work in this hearing and for holding the hearing today.
I just want to make one quick observation. Many folks have already observed that there are considerable complexities in the accounting issues that we are going to be addressing today. I think it is important to make sure we make it very clear up front, and not get bogged down in the complexities of some of this accounting because the dispute here that is alleged, I should say the allegation that is made by OFHEO, is not that there is a dispute over the interpretation of ambiguous and complex rules over which reasonable people could disagree, but rather the allegation is that there has been a pattern of invention of accounting policies and devices which systematically and intentionally misrepresent financial statements for the purpose of smoothing earnings and achieving maximum bonuses.
Now, if these allegations are true, they are obviously extremely disturbing and require I think major changes at Fannie Mae. That is what we are going to be talking about and hopefully shedding some light on today, not the arcane interpretation of accounting rules, but whether or not accounting rules were being set aside, and different policies were adopted for purposes for which they certainly should not have been.
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I think that is what we need to focus on, Mr. Chairman. I thank you for holding this hearing and I yield the balance of my time.
Chairman BAKER. I thank the gentleman.
Ms. McCarthy?
Mr. MCCARTHY. Thank you, Mr. Chairman.
I will hand in my statement. I certainly do appreciate hearing from the chairman and the ranking members, but we are into this hearing 45 minutes and we still have not heard from the witnesses, and I personally think that we should be talking to the witnesses, and then do our statements and ask questions.
With that, I yield back the balance of my time.
Chairman BAKER. I thank the gentlelady.
Mr. Bachus?
Mr. BACHUS. I thank the chairman.
First of all, chairman, there have been several remarks made that we would have addressed these issues had it not been for the Bush administration. It is my recollection that the Bush administration actually urged this committee and this Congress to take strong action and that at that time that was in the sort of post-Freddie Mac. At that time, many of the Democratic members accused the Bush administration of going on a witch hunt against Fannie Mae of saying that things were right at Fannie Mae, and that OFHEO was doing a wonderful job, and that there was sufficient regulation, that this was simply to accuse the Bush administration of wrong motives.
It was actually a combination of those in the Senate that did not want to take action, and members of this committee that disagreed with the Bush administration. One thing the Bush administration was concerned about is the new products that Fannie was offering, and they wanted Treasury to approve those new products. It is my recollection that the minority members almost to a person resisted those reforms.
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I do think, and I commend Mr. Frank. Mr. Frank actually had it right and more accurately when he said the Bush administration wanted to go further than this committee. I think that is absolutely true. And now all of a sudden, some of the things that the Bush administration wanted to do it seemed like they would have been very prudent things to have done.
So to try to, a month before an election, to try to somehow create a smokescreen that the Bush administration had done something wrong would be inaccurate and would not be factual. Of course, it probably is not surprising either.
We have before us today OFHEO, and Fannie Mae and their officers will be before us at a later date. My understanding of this hearing is we are to examine OFHEO and you are to testify as to the agreement that you have made with Fannie Mae as a result of your study of their accounting practices, and that in fact you found that they violated two important accounting rules.
My questions would be, all this stuff that you have discovered now, why wasn't it discovered 3 or 4 years ago, since you have been the regulators for years and years. Why is it suddenly coming to light?
Chairman BAKER. Could the gentleman begin to wrap up?
Mr. BACHUS. So I would simply say that I think there are some tough questions for Fannie Mae, but I think there are also some tough questions for OFHEO because I believe that if they have done these things and you were the regulators, you should have known before just the last few months. This should have come to light.
Thank you.
Chairman BAKER. The gentleman's time has expired.
Mr. Hinojosa?
Mr. HINOJOSA. Chairman Baker, over the last 4 years, the United States has suffered from immense job loss. We have suffered from an increase in the number of people living in poverty. We have witnessed an incredible and unsupportable switch from federal budget surplus to an ever-growing budget deficit.
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We have also experienced a tremendous increase in the national debt over the last 4 years. Overall, our economy has not been performing very well during this period, with oil prices exceeding $50 per barrel. In fact, to say that it has been underperforming would be an understatement.
However, there is one sector of our economy that has been performing well consistently, and that is the housing market. It has served as the foundation of the U.S. economy since the stock market declined many years ago. It is the one sector of our economy to which we need to pay the most attention at this time. We need to nurture it. We need to ensure that nothing we do here in Congress harms it.
At this point, I think we need to keep our powder dry until all the ongoing accounting and adequacy of its capital and the quality of management investigations are complete. Then we can see where everything stands once all the dust settles.
Having said that, Mr. Chairman and Congressman Kanjorski, I look forward to hearing the testimony of all of today's witnesses.
I yield back the remainder of my time.
Chairman BAKER. I thank the gentleman.
Ms. Brown-Waite?
Ms. BROWN-WAITE. Thank you very much, Mr. Chairman. Thank you for your leadership in providing this opportunity for the committee to address this important issue.
I would also like to thank our witnesses for coming to the committee this morning.
As Americans, we have heard in the past couple of years about the Enron scandal and other corporate examples of ''cooking the books.'' As members of Congress and members of this committee with oversight over the mortgage and housing industries, it is imperative that we ensure that companies with as much industry clout as Fannie Mae, are following generally accepted accounting principles, or GAAP.
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I was listening to Bloomberg the other day, yesterday as a matter of fact, and I heard how much your stock has also suffered. So there is obviously a rippling effect of this OFHEO report. However, that being said, as committee members we have to remember that the report released by OFHEO in September is early in its preliminary stages. I think that there are more accusations in this report than findings.
We certainly look forward to hearing how OFHEO completed this report. We have had some heartaches with corporate scandals in this country, but I do not think we should be jumping to conclusions. While we are ensuring that Fannie Mae is using honest GAAP-compliant principles, the committee also needs to be certain that we are giving Fannie Mae a fair chance to be heard.
Coming from Florida where our state was devastated by hurricanes and where a lot of rebuilding is going to take place, it is obviously important that we have the availability of the funding for home construction that Fannie Mae regularly participates in.
I look forward to hearing what our witnesses from Fannie Mae have to say, and I want to again thank you, Mr. Chairman.
I yield back the balance of my time.
Chairman BAKER. I thank the gentlelady.
Mr. Lucas of Kentucky?
Mr. LUCAS OF KENTUCKY. Mr. Chairman, I look forward to hearing from the witnesses.
Chairman BAKER. I thank the gentleman.
Mr. Lynch?
Mr. LYNCH. Thank you, Mr. Chairman.
I am going to be brief. The one thing I do not want to forget are the good things that Fannie Mae is doing. I hear Enron talked about here this morning. This is not Enron. This is not the Enron situation. These are clearly violations of accounting principles, but let's not go overboard and make this a criminal proceeding.
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I am very interested in hearing exactly what the differences in the accounting practices and how we can correct them. But this should not be a witch-hunt. This should not be a political exercise in punching people who have done a lot of good things in this country providing housing opportunities for a lot of people that need them. But clearly, we have to get our house in order here.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. Gillmor?
Mr. GILLMOR. I will enter my statement into the record. Thank you, Mr. Chairman.
Chairman BAKER. The member's statement and all members' statements will be made part of the official record.
Mr. Miller?
Mr. MILLER OF CALIFORNIA. Thank you. I would like to thank you, Mr. Chairman, for your continued commitment to ensuring the safety and soundness of the secondary market.
The question of impropriety has surfaced as a result of allegations of accounting irregularities at Fannie Mae has sent shock waves through the strong housing market. That market has kept this nation going in recent years. The United States housing market is the envy of the world. We enjoy the lowest interest rates and the highest homeownership of any developed nation in the world.
When Americans are homeowners, it spurs economic and community development and provides residents with a sense of pride in their community. Homeownership is the single largest creator of wealth for most Americans. For this reason, it is imperative that we work through this process to maintain a strong housing market.
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The GSEs have been at the forefront of creating affordable housing opportunities for American families. In my district, for example, Fannie Mae has created employer-assisted housing programs for the city of Boreas Police Department to allow police officers to live in the communities they serve. They also helped to finance affordable housing initiatives in Anaheim, California, and Anaheim is an extremely high-cost housing area.
Across the district, they have been able to offer innovative programs to allow those with blemished credit to afford the dream of homeownership, to help seniors convert the equity in their homes into cash to help them meet their needs, and to help families and individuals with special needs become homeowners.
All of this, in partnership with lenders, is intended to meet the ever-growing need of our communities. As we address deficiencies in GSE supervision, we must not lose sight of Congress' original goal in chartering GSEs. The mission of Fannie Mae and Freddie Mac is to provide stability and ongoing assistance to the secondary market for residential mortgages, and to provide access to credit and homeownership in the United States.
As we move forward to make much-needed regulatory reform to ensuring the safety and soundness of GSEs, Congress must be unwavering in our commitment to help Americans achieve the dream of homeownership and continue to ensure the accessibility of mortgage funds at the lowest cost. We must completely understand the implications of changes in the regulatory structure in meeting the goals of the charter, being careful not to inadvertently hinder the ability of GSEs to be innovative in meeting the needs of potential homebuyers.
I believe Congress has ample evidence that OFHEO may not have the experience necessary to appropriately regulate complex financial institutions such as Fannie Mae and Freddie Mac. OFHEO released annual reports that the internal and external audit functions at Fannie Mae exceeded safety and soundness standards and had the appropriate independence. How can we be confident in such findings when OFHEO is now issuing a report with very different troubling findings about the serious accounting irregularities at Fannie Mae?
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We must work to ensure a new regulatory regime under which investors in the market can be confident that these companies are sound and that their investment in America's housing markets are safe. While there is no question that regulatory change must be made to ensure that GSEs are held to the absolute highest standard of ethical conduct, I urge my colleagues to remain mindful that strong regulations provide a means to achieve our ultimate goal of expanding the supply of affordable housing credit across our nation.
Mr. Chairman, I again want to thank you for holding these hearings. The goal of these two companies is so critical to our economy. I look forward to working with you to ensure the appropriate regulatory reforms are made.
I yield back.
Chairman BAKER. I thank the gentleman.
Mr. Ford?
Mr. FORD. I am sorry. I do not have anything to say. I am a believer that when you hold hearings, you should let the witnesses talk.
So I welcome you all and look forward to hearing from you.
[The prepared statement of Harold E. Ford, Jr. can be found on page 152 in the appendix.]
Chairman BAKER. A commendable attitude.
We have two members who are not members of the subcommittee today, but who are members of Financial Services. I would like to recognize them at this time.
Ms. Waters?
Ms. WATERS. Thank you very much, Mr. Chairman. I would ask unanimous consent to make a brief opening statement.
Chairman BAKER. Without objection, please proceed.
Ms. WATERS. I appreciate the opportunity to be here today. I must share that I feel like I am in another round in the battle between FM Watch and the GSEs. FM Watch, financial institutions that decided a long time ago to wage a political war to reduce the GSEs' share of the mortgage market, and of course I must say, Mr. Chairman, led by you.
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OFHEO has gone from weak and ineffective to the extreme of accusing Fannie Mae now of questionable accounting practices in order to increase their bonuses. They have gone back to 1996. That is a serious allegation. I hope they are prepared to prove it. Obviously as we explore the safety and soundness issues that are the subject of this hearing, all of us on the Financial Services Committee must keep our eye on the housing mission of the GSEs, particularly the affordable housing mission that we have entrusted to Fannie Mae and Freddie Mac. As we proceed, it is critical that we ensure any action that we may consider not impair the housing mission of the GSEs.
Mr. Chairman, I note with interest that the 211-page OFHEO report from Mr. Dickerson to Director Falcon that we will explore in today's hearing still bears the following notation on each page: special examination of Fannie Mae, privileged and confidential disclosure, and/or duplication prohibited, even though the OFHEO report was posted on the OFHEO Web site and has been publicly available for almost two weeks.
Mr. Chairman, as I understand it, normally the examination and regulatory process is a confidential process where the regulator raises his concerns with the party being examined and the regulator gives that party a full opportunity to respond before determining whether regulatory action is required? I note that when Director Falcon's September 20 letter expressing concerns about Fannie Mae made the papers, the OFHEO report had just been completed. By September 22, the September 17 OFHEO report was publicly available, and by September 27, an agreement had been signed between Fannie Mae and OFHEO. It seems highly unlikely to me that the normal kind of regulatory dialogue could have occurred within this timeframe.
So I hope that the witnesses will address whether the regulatory process was proper, or whether there were public disclosures outside the normal process for reasons having nothing to do with safety and soundness. The September 7th OFHEO report is fairly characterized as a work in progress. As Mr. Dickerson notes in his transmittal memo to Director Falcon, it contains the findings to date of the special examination of Fannie Mae.
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The report raises a number of highly technical and arcane accounting issues, including issues concerning the treatment of derivatives. Some of these issues appear to be controversial, and may be disputed by Fannie Mae. These issues cannot be easily summarized and they may not lend themselves to a brief and simple response. I hope that we will have the patience to give these issues the time that they may require.
Mr. Chairman, to my knowledge, apart from a few brief press releases from Mr. Raines and Fannie Mae's independent director, Mrs. Ann Korologos announcing the intention of Fannie Mae to cooperate with the OFHEO investigation, and later announcing the September 27 agreement between OFHEO and Fannie Mae, there has been no in-depth public response by Fannie Mae to the substantive allegations contained in the OFHEO report.
This is the first chance that our committee and the public will have to hear Fannie Mae's response to these allegations, and it will be good to hear their side of the story. I am particularly concerned about the 30 percent capital set-aside or surplus requirement because that takes a lot of money out of the market for mortgages.
Thank you. I yield back the balance of my time.
Chairman BAKER. I thank the gentlelady.
Mr. Watt?
Mr. WATT. Thank you, Mr. Chairman.
I just want to express my thanks to the chairman for allowing members who are not part of the subcommittee to participate in the hearing.
I think members of the subcommittee have expressed in various ways a number of the concerns that I would have expressed had I been a member of the committee. At the end of the day, we want to make sure that Fannie and Freddie and whatever other institutions are available to encourage and support increased homeownership and housing in this country are made stronger and more vibrant.
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I also share a number of the process, due process and fairness concerns that have been raised by various members of the committee. So I am here to participate in this for those reasons, because I am a supporter of housing for American people and because I believe in fairness and process and due process, and not convicting somebody before the process runs its course.
I hope we will keep in mind both of those things, and I appreciate the chairman allowing us to participate. I yield back the balance of my time.
Chairman BAKER. I thank the gentleman.
If there are no further opening statement by members at this time, I would now proceed to recognize our first witness for the hearing today.
Mr. Armando Falcon is the director of the Office of Federal Housing Enterprise Oversight, who I understand today is accompanied by Ms. Wanda Deleo, chief accountant, and Mr. Christopher Dickerson, chief compliance examiner, Office of Federal Housing Enterprise Oversight.
Before I proceed, I am reminded, I have a statement of Mr. Roger Barnes, former manager of financial accounting, deferred assets in Fannie Mae's controller division, submitted to the committee and asked to be made part of the official record. If there is no objection, I now move to incorporate that into our hearing record.
[The prepared statement of Roger Barnes can be found on page 197 in the appendix.]
By prior agreement with Mr. Kanjorski, we have determined that given the gravity of the hearing content today, that all witnesses should be asked to testify under oath, given the fact that this is an investigative hearing.
Mr. Falcon, do you have any objection to testifying under oath?
Mr. FALCON. Not at all, Mr. Chairman.
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Chairman BAKER. It is my understanding that you are accompanied by staff. Will they be testifying and answering questions during the course of your testimony today?
Mr. FALCON. They will not have testimony, Mr. Chairman, but they will be available to the committee to answer any technical questions about the report.
Chairman BAKER. In that light, it would be my opinion and advisable, should we solicit information from them, that each of you take the oath. Do either of you have any objection to testifying under oath if required by the committee?
Ms. DELEO. No.
Mr. DICKERSON. No.
Chairman BAKER. If that is the case, I would ask that you now stand and raise your right hand and affirm the oath.
(WITNESSES SWORN)
Chairman BAKER. Thank you. Each of you is now considered to be under oath.
Mr. Falcon, I would recognize you. Given the importance of your report, we customarily limit our witnesses to 5 minutes in presentation. I would encourage you to summarize as best you can, but should you find the need to exceed 5 minutes, I am certain members of the committee would welcome a full and complete discourse from you on this matter.
Please proceed at your leisure.
STATEMENT OF HON. ARMANDO FALCON, DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT
Mr. FALCON. Thank you, Mr. Chairman, and thank you Ranking Members Kanjorski, Frank and Chairman Oxley, who was here earlier, for inviting me to testify about OFHEO's special examination of Fannie Mae. As always, my testimony reflects my own views and are not necessarily those of the secretary of HUD or the President.
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Before getting to my comments on the report, I would like to introduce two of my staff who you mentioned earlier. On my right is Chris Dickerson, OFHEO's chief compliance examiner and one of our derivatives experts. On my left is Ms. Wanda Deleo, our chief accountant. Both are leading the work of the special examination, and they are here to assist me in answering any technical questions the committee may have about the report.
In July of last year, I announced that OFHEO would conduct a special examination of Fannie Mae's accounting policies, internal controls and financial reporting. While the special examination continues, our safety and soundness mandate requires that when we find problems, we move quickly to remedy them, rather than wait until the entire examination is complete. The report represents our findings to date and it serves as the basis for the actions that we have taken.
The report raised such serious safety and soundness concerns that we brought them to the immediate attention of the board. To the board's credit, it became very engaged in the examination and moved quickly to reach an agreement with OFHEO on the plan of remediation. The agreement constitutes an important first step towards resolving OFHEO's concerns and ensuring safe and sound operations at the enterprise.
Let me now turn to the substance of the report. It documents Fannie Mae's pervasive and willful misapplication of generally accepted accounting principles, as well as critical operational deficiencies. The report's findings have implications in four areas of major concern to OFHEO: the validity of Fannie Mae's previously reported financial results; the adequacy of its regulatory capital; the quality of senior management's supervision of the enterprise; and Fannie Mae's overall safety and soundness.
The accounting violations cannot be dismissed as mere differences of opinion in accounting rules. Fannie Mae understood the rules and simply chose not to follow them. Fannie Mae's development of improper accounting policies and practices can be traced back to a corporate culture and operating conditions characterized by the following: a desire on the part of senior management to portray Fannie Mae as a consistent generator of stable and growing earnings; an ineffective process for developing accounting policies; an operating environment that tolerated weak or nonexistent internal controls; key person dependencies and poor segregation of duties; incomplete and ineffective reviews by the enterprise's office of auditing; an inordinate concentration of responsibility rested in the chief financial officer; and an executive compensation structure that rewarded senior management for meeting goals tied to earnings per share, a metric that can be and was subjected to senior management manipulation.
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The accounting problems at Fannie Mae that OFHEO has uncovered relate mainly to FAS 91 and FAS 133. Let me briefly describe each. FAS 91 governs the amortization of balances related to mortgages and mortgage-related securities. Management developed accounting policies and selected and applied accounting methods to improperly reduce earnings volatility related to amortization. Fannie Mae improperly delayed the recognition of income to create a cookie jar reserve that it could dip into whenever it best served the interests of senior management. Those interests included smoothing earnings and meeting earnings-per-share targets linked to executive bonuses.
An important example of how this worked took place in 1998. At that time, external events caused a plunge in interest rates, which in turn added to an acceleration of mortgage pre-payments. As a result, Fannie Mae faced a more rapid premium amortization in the enterprise's mortgage portfolio than expected. In December, management's own amortization models specified that $400 million in premium amortization expenses had to be recorded on Fannie Mae's books in 1998. However, management decided to record only $200 million of the $400 million that year.
Fannie Mae deferred the remaining $200 million to 1999 and recorded it incrementally throughout that year. KPMG, Fannie Mae's outside auditor, decided the enterprise's action on this matter as an ''audit difference,'' a term which means that KPMG disagreed with Fannie Mae's action. Had Fannie Mae taken the full $400 million charge in 1998, senior managers would have lost their eligibility for any bonuses. That is because incentive compensation depended on Fannie Mae realizing earnings-per-share targets.
As it happened, the earnings-per-share target which would secure senior management the maximum bonus could only be reached if Fannie Mae recorded no more than $200 million of the expenses in 1998.
The next year, Fannie Mae kicked off a challenge grant initiative which promised to reward management for doubling earnings in 5 years. To avoid facing amortization problems similar to those in 1998, senior management began a prolonged and concerted effort to develop policies for managing amortization. The goal was to gain earnings flexibility and the ability to minimize earnings volatility. In this regard, the 1998 violation was not a singular event. It represented a continuous effort to artificially guarantee success in meeting targets.
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Let me now turn to FAS 133 and hedge accounting. FAS 133 requires that derivatives be marked to market and that changes in fair value be included in earnings unless the derivative is designated as and qualifies for hedge accounting. We have found that Fannie Mae implemented FAS 133 in a manner that placed earnings volatility and maintaining the simplicity of operations above compliance with GAAP. These goals to an inordinate degree influenced the development of Fannie Mae's approach to hedge accounting.
The prerequisites for receiving hedge accounting treatment include effectiveness assessment, ineffectiveness measurement and proper hedge documentation. Because Fannie Mae has not met these critical requirements, it should not receive hedge accounting treatment for many of its derivatives. Instead, proper accounting for such derivatives requires that their fair value changes be recorded directly through earnings.
As a result of these issues and Fannie Mae's disregard for complying with FAS 133, we are concerned about the validity of the amounts Fannie Mae has reported in accumulated other comprehensive income, the earnings the enterprise has presented in prior quarters, and the adequacy of regulatory capital.
Let me state plainly that Fannie Mae's accounting was just wrong, and must be fixed properly. The stakes are too high to just forgive past sins. If any company, especially a government sponsored enterprise, is allowed to get away with this type of accounting misconduct, then no regulator can do its job and no investor is safe. A regulator and an investor must be able to trust the books and records of a company.
Regarding internal controls, OFHEO found that Fannie Mae maintained a deficient accounting policy development process, key person dependencies and poor segregation of duties, all of which contributed in important ways to the enterprise's problems. The details of these matters are addressed in the report.
As I mentioned earlier, we took prompt and appropriate action to address these serious problems. We entered into an agreement with the board requiring that Fannie Mae implement correct accounting treatments, hold the 30 percent capital surplus, recalculate prior period financial statements using correct accounting, appoint an independent chief risk officer, and put in place policies to ensure adherence to accounting rules and new internal controls.
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I would also like to remind the subcommittee that the special examination is continuing. If OFHEO discovers more problems, we will take further action.
Finally, I would like to thank the leadership of the full committee and the subcommittee for your support for our funding. The current continuing resolution has placed severe constraints on our ability to hire additional staff and employ outside experts for the continuation of the Fannie Mae examination. This could not come at a worse time for the agency, and it once again illustrates the need to remove OFHEO from the appropriations process.
Mr. Chairman and members of the subcommittee, I have tried to summarize the report as best I could. I would like to ask that it be placed into the record, and we are prepared to answer any questions that the subcommittee may have.
[The prepared statement of Hon. Armando Falcon can be found on page 160 in the appendix.]
Chairman BAKER. Your full testimony and the report content thereof will be included in the official record of the committee.
Mr. Falcon, did you find that management of Fannie Mae had adopted and implemented a strategy from a managerial perspective to steer accounting reports for two important goals. One is to present an image of very stable earnings to the broader market; and two, to manage EPS calculations to enable maximum bonus payments to be achieved for executives?
Mr. FALCON. Those are the findings contained in the report, Mr. Chairman.
Chairman BAKER. Did you find in at least one instance in 1998 that manipulation of accounting methods inconsistent with GAAP resulted in an EPS calculation which enabled the bonus payment to executives that they would not have been entitled to if accounting practices consistent with GAAP had been utilized?
Mr. FALCON. That is the situation we described in 1998, yes.
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Chairman BAKER. Is it correct that in reaching the earnings-per-share trigger of $3.23 that the calculation of 3.23 in carried to the math resulted in a calculation of 3.2309. Is that correct?
Mr. FALCON. Yes.
Chairman BAKER. Has it been established why the decision was made to defer $200 million of a $400 million unexpected expense was deferred from 1998 into 1999 and not any alternative amount?
Mr. FALCON. We have not received an adequate explanation as to why that was done. We do know that their external auditor disagreed with that action that was taken.
Chairman BAKER. Is it correct that in at least preliminary response that the modeling utilized by the enterprise was determined by management to be inaccurate and the feeling was expressed that the $400 million expense was actually overstated, and their view was that by deferring the $200 million it perhaps would more reflect economic reality?
Mr. FALCON. Their own internal modeling for amortization clearly demonstrated that they had to take this $400 million expense in 1998. It was their internal models that they were relying on for amortization expensing.
Chairman BAKER. But they believed that model to be accurate?
Mr. FALCON. Yes.
Chairman BAKER. Then there is no justification. My understanding was the $200 million had been deferred because a preliminary explanation is that the modeling was believed to be inaccurate and had overstated the expensing. More importantly, in the subsequent four quarters in 1999, the expensing did occur, acknowledging the value, and in fact did not the expensing require increases over the $200 million originally calculated?
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Mr. FALCON. Let me say something to that. I cannot speak to what the company believed as far as this amortization in 1998. I can say that we believe that it was not justified under generally accepted accounting principles, and that $400 million should have been recognized in 1998.
Chairman BAKER. Is it correct that there are, because many will allege or suspect to allege, that this was a one-time dispute over arcane accounting methodologies? Their outside audit, you indicated, agreed that the expense should not be deferred and should be taken in 1998. Is that correct?
Mr. FALCON. Yes.
Chairman BAKER. Isn't it correct that there were other accounting irregularities identified in other reporting years that placed the earnings calculation in question, and therefore the subsequent bonus calculations resulting from those earnings?
Mr. FALCON. I am sorry?
Chairman BAKER. Let me restate. Is it correct that you identified in the course of your examination other accounting irregularities and inconsistencies in other reporting years that placed the earnings for those years in question because of the accounting methodologies utilized, and therefore would result in placing the bonus payments made to executives in question?
Mr. FALCON. Yes.
Chairman BAKER. Going forward, I wish to reiterate that this is an interim report, not a final report. You engaged the services of Deloitte & Touche as an outside audit team to assist your staff in reaching these conclusions. In the course of that examination, you have reviewed, your staff, Deloitte & Touche, in excess of 200,000 documents and e-mails over the course of the past 8 months. In addition, hundreds of interviews and depositions taken.
This report should be understood as a first step, not a final step. As I understood in your opening statement, as you discover additional information that should be brought to the attention of the committee, you intend to do so. Is it appropriate or can you comment today on where your next focus of attention will take you within the enterprise's activities?
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Mr. FALCON. I think I cannot at this time, Mr. Chairman, but I can tell you that we do this as a two-step process here. The first step in this review on these issues was to identify whether or not——
Chairman BAKER. Let me do this, Mr. Falcon. I hate to cut you off, but my time has expired, and I am going to try to hold other members to be accountable. I have one wrap-up question that is important for me to ask.
Given the public statements to date by the executives and board members of Fannie, and the testimony I have reviewed that Fannie will proceed with today, in essence disputing all of your findings, placing your accounting judgment in question, the disputes with the opinion of your outside audit firm, the fact that you have had to request the issuance of subpoenas to get the enterprise to respond to your normal course of inquiry, do you believe the culture of mismanagement at Fannie Mae will change unless significant personnel alterations are required, as they were at Freddie Mac?
Mr. FALCON. This comes down to a question of whether or not we have sufficient confidence in management to promptly implement the remediation plan that will be required to put the company back fully on sound footing. The issues raised by our staff in this report certainly do cause doubts about whether or not there is sufficient confidence in management going forward, such that there should not be management changes at the top of the company.
We are currently considering that and we are having discussions with the board about the issue of management accountability and the confidence in current management.
Chairman BAKER. I regret our time is so limited.
Mr. Kanjorski?
Mr. KANJORSKI. Let me ask the first question right off. Is there a systemic risk problem at Fannie Mae, in your opinion, at this stage of the preliminary report that you have gone through?
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Mr. FALCON. I think that we have managed this process in a way such that there is not substantial risk of a systemic disruption. Through the actions we have taken, and through the board's prompt action in agreeing with us on remedial actions, we have precluded the possibility of systemic events.
Mr. KANJORSKI. So we can inform the investing public and others that hold securities of Fannie Mae, is there any reason in the world that they should worry about the value or the credibility of their securities?
Mr. FALCON. I am not quite comfortable talking about recommending whether or not an investor should or should not invest in this company.
Mr. KANJORSKI. I am not asking you to make a recommendation. Is there anything in your findings, in other words, as a result of the audit differences that are being attended to, and as a result of some of the accounting wrongs that may have been uncovered through your investigation, is there any reason to believe that there is a large loss of equity or a question of Fannie Mae remaining solvent?
Mr. FALCON. In the worst-case scenario, the company could be undercapitalized, below its minimum capital requirement, but not to the extent that the company would be insolvent.
Mr. KANJORSKI. Can you give us a maximum amount of undercapitalization that you may have discovered? In other, the need to infuse more capital, what would that amount be?
Mr. FALCON. Now that we have determined that the accounting policies of the company were not consistent with GAAP, the next step for us to take is to do an evaluation of the impact of these improper accounting practices on past financial statements, especially the impact of its large derivatives portfolio possibly not being eligible for hedging accounting treatment, which means the amounts in other comprehensive income would have to flow back into the balance sheets through earnings, and therefore be recognized.
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We will not know this until we go through all of the evaluation exercises. There are $12 billion in negative losses in OCI, and if all of that were forced to move over to earnings, the company could potentially take a hit of that much. But we do not know, congressman, how much, if any of that will move into the retained earnings portion of balance sheets until we have worked with the company to come to those determinations.
Mr. KANJORSKI. Making the worst-case scenario assumption, however, that does not constitute in your mind systemic risk? Is that correct?
Mr. FALCON. Yes. The solvency of this company is not threatened by the findings we have to date.
Mr. KANJORSKI. Okay. I want to move you along because I have a few questions.
I do not understand what you do as a regulator, but I assume you examine auditors' reports. Is that correct?
Mr. FALCON. Yes.
Mr. KANJORSKI. And I assume that audit differences, as you indicated, how they handle the $400 million or the $200 million, showed up in a finding by the auditor to the corporation that was a difference here of opinion and how this should be accounted for. Is that correct?
Mr. FALCON. What we do——
Mr. KANJORSKI. Not what you do. I want to know what papers you examine. What I am asking you is did you examine the audit report of 1998 and did there exist a finding indicating there was a difference between the auditor and the corporate leadership as to how this $400 million was accounted for?
Mr. FALCON. We were not aware of this audit difference until we began this accounting examination.
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Mr. KANJORSKI. Why were you not aware of it?
Mr. FALCON. We have not traditionally looked at the work of the external auditor to ensure that they were properly certifying that the company's financial statements were consistent with GAAP.
Mr. KANJORSKI. Do you mean the regulator does not get the outside audit report and examine it thoroughly before it passes, or examines anything else in a corporation? I would think that would be the first tool that you would look at.
Mr. FALCON. Let me ask our chief accountant about this question, Mr. Kanjorski.
Ms. DELEO. We are certainly taking that approach at this point.
Mr. KANJORSKI. I am not worried about 2004. I am asking about 1998. I am trying to get an essence of just what a regulator does. The only prior experience that I have had sitting on a board of a bank was that we would have external audits and at the conclusion there would be an exit meeting of all the differences or questions raised by the auditor that would be presented to the audit committee.
It just seems rudimentary that if you are going to spend hundreds of thousands or maybe millions of dollars to hire an auditor, that all of that is laid out in the findings and the differences, and that should be the first piece of paper the regulator picks up and looks at because a lot of work has been done and a very credible auditing company has made differences in findings. In 1998, if we had picked up the audit report by the external, outside auditor, was there a reflection of an audit difference in how that $400 million was handled?
Chairman BAKER. I would ask the gentleman that that be the last question on this round.
Please respond, sir.
Mr. FALCON. Yes. We look at this, Congressman, as a team effort. The safety and soundness of this company is dependent, yes, on us doing our job properly. It is dependent on management running the company properly, the board properly overseeing the company, and the external auditor doing its work to ensure that the financial statements are consistent with GAAP. We look at the financial statements and the work of the external auditor. I do not know where this audit difference was reflected.
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Mr. KANJORSKI. I just want to follow this line of questioning. You mean at this point in time you do not know whether or not that was openly displayed in the outside audit report?
Mr. FALCON. Let me ask Mr. Dickerson, please, Congressman, to address this.
Mr. DICKERSON. Congressman, we had testimony from the controller and the CFO that there was this $200 million audit difference between the firm and KPMG. We saw internal documents from the company that there was approximately a $400 million expense that was estimated.
Mr. KANJORSKI. And it was listed as an audit difference by the outside auditor in 1998.
Mr. DICKERSON. Right. And we learned that through testimony that we obtained from the CFO.
Mr. KANJORSKI. It took you 6 years and depositions to discover something that was on a concluded audit document as a finding?
Mr. FALCON. We need to go back and find out if this was included in any documents that were or should have been provided to the agency. If we find that this was something that was in some documents that we could have had access to, that we should have had access to, then it points out a need for us to strengthen our program.
I am not saying that the agency is completely without fault here. We have more resources now, with an accounting staff. We did not have an office of chief accountant until 2 years ago. Ms. Deleo has just joined the agency very recently. But in light of the Freddie Mac problems, I think it has highlighted a need for this regulator to get heavily involved in accounting issues because they do go to the heart of the safety and soundness of our work. If we cannot rely on the books and records of this company——
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Mr. KANJORSKI. Yes, but you do not read the books and records of this company as a regulator. It does not matter. It would just seem to me that this committee could call up and subpoena the outside audit report of 1998 and I will be shocked if a finding is not there mentioning this audit difference as to how the money was handled. It should have been the first day you arrive at the place, looking at the audit. You should know what happened.
I am just worried about, we are calling you a regulator and you are scaring hell out of me that you did not see that, and everybody should have been alerted to that that sits on a board, that you go through your audit findings. That is so axiomatic. I guess in law school we used to call that Horn book.
Chairman BAKER. The gentleman's time has really expired, if I may. I really want to try to hold members. We have much more to do today. Please help me here to get through this process.
Mr. Castle?
Mr. CASTLE. Thank you, Mr. Chairman. Even by Washington standards, this is an extraordinarily tangled web that we are dealing with here and a little bit hard to follow to a degree.
Fannie Mae clearly has some questions to answer here. I am worried that we have not given the regulators, OFHEO in this case, sufficient assets to move ahead with what they have to do in terms of their work. There are a lot of people hired on the outside to try to hold all this off. Frankly, I think we have a responsibility as a subcommittee and a committee right here to do everything we can to get to the bottom of all of this.
Let me just start with this, if I may, Director Falcon. And that is, as I understand it, you hired an outside auditor recently. Did you not hire an outside auditor prior to that time because of insufficient funds to do so?
Mr. FALCON. We have not hired an outside auditor to assist us prior to the initiation of this special accounting examination. That is right.
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Mr. CASTLE. Was it because you had insufficient funds to do so?
Mr. FALCON. We have been trying to. We have not undertaken a special accounting review like this prior to this point. We have not made the request, I guess, for the funds. But even if we saw the necessity for it, we would not have had the funds and we would have had to come to Congress for the additional funding.
Mr. CASTLE. Let me ask you another question. Can you tell me why, and I can only judge this through press statements of my own accord. KPMG is standing by the company's financial reports, even after your report, of course. Could this be another example of just a difference of opinion as to the application of GAAP, such as the one I understand you have with this company with regard to their manufactured housing loans? Or is it something else?
Mr. FALCON. We feel very strongly that these are black and white accounting issues. These are not issues of interpretation. They are not issues where reasonable people can disagree. We have taken prompt, strong action in trying to deal with this because we do think they were clear violations of accounting principles.
Mr. CASTLE. So i.e. KPMG then in standing by this is at fault in terms of the clear accounting principles which exist. Is that what your statement is basically?
Mr. FALCON. If they are standing behind this accounting treatment, then yes, they are wrong as well.
Mr. CASTLE. Do you have sufficient powers to carry out your responsibilities? I know there has been a lot of discussion about changing agencies and all the things that we should do, but I am worried about what you can do now in terms of cease and desist orders, other regulatory powers which you need, the funding which you need in order to carry out your responsibilities to make sure all this is handled correctly.
This is of overwhelming significance, and I think for you to be shortchanged in any of these categories would be a terrible error. Can you detail for us where there may be needs, or if there are not needs at all?
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Mr. FALCON. I think there are several key areas where we would like the same powers that are given to every other safety and soundness regulator. It begins with the authority to assess for budgetary needs outside the appropriations process, to have independent funding. It begins with flexibility in a variety of areas, including capital requirement setting. Every other regulator has that.
It includes issues like independent litigating authority, the ability to freeze the pay of any executives where we find potential wrongdoing. We recently had an opinion in district court saying that we do not have the same authority that other regulators have. So there are quite a few areas where we just need strengthening across the board, including general safety and soundness powers.
Mr. CASTLE. Changing the subject, I wrote down a couple of comments, and I do not know if I wrote them down correctly, of course. Correct me if you see otherwise, but that you made in your opening statement. You said that Fannie Mae understood the rules, but chose not to follow them.
Mr. FALCON. Yes.
Mr. CASTLE. What do you mean, Fannie Mae? Do you mean their board of directors, their officers? What do you mean by Fannie Mae in that circumstance? And are the rules that you are referring to accounting rules or something beyond anything that has been discussed here today?
Mr. FALCON. What we mean is, this is not a matter where the rules were too complex and the company did not understand them. It is not a matter where they made a good-faith effort to try to comply with the rules. They did not comply with rules that they clearly understood.
Mr. CASTLE. Accounting rules?
Mr. FALCON. Accounting rules.
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Mr. CASTLE. That they clearly understood. And when you say ''they,'' you are referring to whom?
Mr. FALCON. Those responsible in the company for setting accounting policy consistent with GAAP.
Mr. CASTLE. So it could be officers or it could be directors or a combination of the two or something of that nature?
Mr. FALCON. Yes.
Mr. CASTLE. Okay. And then you said it is just plain wrong and must be fixed and not overlooked. I assume that is just a follow-up to what you had said earlier in this particular area. When you say ''fixed,'' if a mistake was made, do you mean going back and just correcting the accounting principles? Or is there something further that needs to be done to so-called ''fix'' their problems?
Chairman BAKER. That would have to be the gentleman's last question.
Please respond, sir.
Mr. CASTLE. Thank you, Mr. Chairman.
Mr. FALCON. It means making sure that the proper accounting policies are put in place going forward. If there was an impact on their financial statements going backward, that it would mean that there would be a need to correct those financial statements going backwards. That is an issue that we are working with the SEC on.
Mr. CASTLE. Thank you, sir.
Chairman BAKER. I thank the gentleman.
Ranking Member Frank had to step out. Just for the committee's purpose, I have committed on his return to recognize him in the proper order for his questions.
Mr. Clay, you are up next.
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Mr. CLAY. Thank you, Mr. Chairman.
Mr. Falcon, when you and members of OFHEO's staff conducted interviews and received company documents, why was Fannie Mae not allowed to question their witnesses on the record?
Mr. FALCON. They were allowed to participate in those sessions. I am not aware if they requested such opportunity, but the interviews of their employees were held at our request in order to gather information about the company's accounting policies and practices and internal controls.
Mr. CLAY. Why were Fannie Mae officials not provided the opportunity to respond to findings or conclusions reached by OFHEO during the course of the examination?
Mr. FALCON. I think because we followed a regular order here. We followed an accepted practice of regulators. Faced with findings of significant accounting misconduct by senior management and dealing with a management that is resistant to regulation, that same management team responsible for this accounting misconduct, any regulator would have done what we did, take this directly to the board.
Mr. CLAY. Is this due process?
Mr. FALCON. This is safety and soundness regulation which requires prompt action to ensure that the company does not get into financial difficulties.
Mr. CLAY. Is this the way you have handled internal investigations in the past?
Mr. FALCON. Other than the Freddie Mac special accounting review, this is only the second special examination that we have conducted. On more routine matters like our ongoing annual risk-based examination of the enterprises, we do have that type of a give and take, but this was a different situation.
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Mr. CLAY. In May and June of 2003, OFHEO published its 2002 annual report giving both companies, Fannie Mae and Freddie Mac, more than satisfactory grades on accounting and internal controls. You and your agency were pretty embarrassed when issues were discovered at Freddie Mac. Were you so determined to not let this happen again even if it meant denying Fannie Mae fundamental fairness that is routinely provided to banks?
Mr. FALCON. No, congressman. I have testified before this committee before that I had no reason to believe that this company was engaged in any kind of accounting improprieties like Freddie Mac. But given the fact that questions were being raised about whether or not the same problems existed at Freddie Mac, I thought it appropriate to go in and take a look at Fannie Mae. So we did. I am as disappointed as I think you are that the company has engaged in this type of conduct. But the findings are what they are, and we have taken action.
Mr. CLAY. Let us go back to the process, then. Examiners discuss preliminary concerns and possible findings with regulated entities. Would it not have been fair to do this with Fannie Mae, to sit down and have a discussion with them?
Mr. FALCON. We did have a discussion, but it was with the board, congressman. Like I said, this was a situation where we have findings of serious accounting misconduct by management and we have that same management being resistant to our efforts to deal with these issues, noncompliance with our efforts to examine the company such that we had to go to the Justice Department and ask for a court enforcement of our subpoena. In such situations, any regulator would have gone directly to the board, brought the matter to the board's attention, and sought immediate action to ensure the safety and soundness of the company.
Mr. CLAY. You did not provide Fannie Mae with a draft examination report. Banks are given an opportunity to respond before finalizing an examination report or discussing matters with their company's board. Why not Fannie Mae in this instance?
Mr. FALCON. We do that. In the course of our normal examination of the company, we do that. But as I have said, this is a different situation.
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Mr. CLAY. And you claim that they were hostile to the examiners. In what way?
Mr. FALCON. They were resistant to compliance with our request for documents and we had difficulty in scheduling their employees for interviews. We eventually had to move to taking statements on the record, rather than having informal interviews of employees. We had to move to the issuance of administrative subpoenas. We had to ultimately try to get those subpoenas enforced in court.
Mr. CLAY. Don't you think that all interests are best served by ensuring that all relevant data is available to OFHEO and that there are no misunderstandings of relevant facts?
Mr. FALCON. I am sorry, Congressman. That all relevant data is available to——
Mr. CLAY. To your agency and there are no misunderstandings of relevant facts.
Mr. FALCON. Yes.
Chairman BAKER. That will need to be the gentleman's last question. His time has expired.
Mr. CLAY. Did he answer?
Chairman BAKER. He did respond, I believe ''yes.''
Mr. CLAY. Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Chairman Oxley?
Mr. OXLEY. Thank you, Mr. Chairman.
Director Falcon, 3 years ago our committee was heavily involved in the accounting scandals surrounding Enron and WorldCom and others. We saw, based on our hearings and evidence, manipulation of earnings, corporate governance failures, raiding of corporations by their executives in order to pad their own wallets.
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After reading your report, it seems that you are alleging many of the same problems now exist at Fannie Mae. As you know, the Sarbanes-Oxley Act was formulated to prevent future Enrons, but has been repeatedly criticized in some quarters as being too tough on corporations. Do you believe that Sarbanes-Oxley has been a useful tool in your investigation? And do you believe that Fannie Mae's executives were in violation of the Sarbanes-Oxley Act?
Mr. FALCON. I think it has been a very useful tool, Mr. Chairman, because the spirit of Sarbanes-Oxley is accountability, accountability of management and accountability of boards in corporate governance issues. Here we have a situation where because of the requirements of Sarbanes-Oxley, I think the board has stepped up to try to begin to fulfill its responsibilities. They have worked with us well in coming to an agreement. We are working on developing a good relationship going forward to address any future problems.
The provisions like certification certainly are beneficial. There is much at stake when an executive certifies compliance with the provisions of Sarbanes-Oxley. It has been a very useful tool for the agency, because we also have safety and soundness standards that our patterned off of Sarbanes-Oxley as well.
Mr. OXLEY. How does your job working with the regulated entity, that is Fannie Mae, and in the context of Sarbanes-Oxley regarding the SEC, explain to the committee a little bit about how, as a technical matter, that works?
Mr. FALCON. We are working with the SEC. Now that Fannie Mae is a registered company under the 1934 Act, they are covered by Sarbanes-Oxley. We are working with the SEC. We have shared with them all of our findings. We are sharing our documents with them, everything that they have requested. We have a shared interest here. Our interest is safety and soundness. The SEC's interest is investor protection. We are each working to make sure that our missions are fulfilled here. Sarbanes-Oxley has encouraged that kind of interagency cooperation between the safety and soundness regulator and the SEC to make sure that both interests are properly served.
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Mr. OXLEY. Director Falcon, Fannie Mae is one of the largest users of derivatives in the world. As such, Fannie Mae should be well versed with the rules related to FAS 91 and FAS 133. Is it your understanding that Fannie was aware of the fact that their accounting was not GAAP compliant, but they chose not to comply because, to do so, would be too burdensome and costly? Or is it your opinion that Fannie Mae made a material misapplication of the GAAP rules?
Mr. FALCON. I think it is both, Mr. Chairman. One, they wanted to maintain the accounting principles that they thought were best suited to the company. At the same time, they willfully did not apply accounting rules properly. This is an important point because it was not just a matter of these rules being too complex for this large, very sophisticated company. They understood the rules. They chose not to follow them.
These accounting principles have to mean something, Mr. Chairman, and they should apply to every company equally. No one gets special treatment. What we have done in this report is to highlight the issues of how the company has not complied with some very critical accounting rules. The company will not get special treatment from us. I do not think anyone should give it special treatment in making sure it complies with all accounting principles.
Mr. OXLEY. The Sarbanes-Oxley Act clearly spells that out. So you are saying that basically this was a selective effort on the part of Fannie to use accounting principles that would benefit them, as opposed to what we would consider to be generally accepted accounting principles as enunciated by the FASB and ultimately the rules set up by Sarbanes-Oxley and the SEC and the Public Company Accounting Oversight Board.
Mr. FALCON. That is right. They simply did not comply with GAAP because compliance with GAAP would have shown more volatility in their quarterly financial statements than they would have liked. So through the misapplication of GAAP, they were able to project an image of the company of smooth earnings, which conveys to the markets less risk than is actually there because of the volatility of strict compliance, of proper compliance with GAAP.
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Mr. OXLEY. Okay. So the issue is a selective interpretation of GAAP. I would assume that Fannie will come before the committee later today and argue that basically it was a difference of opinion over those issues, and that they were clearly compliant with the GAAP and that you had a different interpretation as to whether that was procedurally correct. How would you respond in advance to almost certainly they will be testifying to?
Mr. FALCON. It would not surprise me, Mr. Chairman, that that would be their position. We have found, not just our chief accountant and her staff, but also Deloitte & Touche, we have found that these are clear violations of generally accepted accounting principles. They are not situations where a company can say that they may have been aggressive; they may have been consistent in spirit. No, these were noncompliance with GAAP.
We would not have come to the very firm conclusions we did in this report and not have taken prompt corrective action were it not for the fact that these were clear violations of GAAP. If any company were allowed to engage in this type of accounting misconduct, then no investor could rely on the books and records of the companies and their financial statements.
Mr. OXLEY. This will be my last question, Mr. Chairman.
As you know, in Sarbanes-Oxley we specified that insider stock sales, instead of the traditional 40-days recording requirement, would now be made in real time, that is within 24 hours of that sale. Did your investigation look into insider, that is corporate executives, stock activities? If so, what did it tell you?
Mr. FALCON. We have been monitoring the sales of individuals within the company. We are just now beginning to shift our focus into other areas like that. Our first objective here was to assess compliance with GAAP in these two critical accounting areas, and now move to remedy those problems and get to valuation issues. But issues like the insider stock sales are something that we have been monitoring and perhaps we will come back and give you a report on that.
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Mr. OXLEY. It would seem to me at least that perhaps would be the SEC's role because the Act required them, the insiders who sell stock, to report that on the Web site at the SEC. And so, I would assume that at least the SEC would assume that particular role and that OFHEO would be secondary in that regard. Is that correct?
Mr. FALCON. Yes. They are publicly disclosed, and the SEC would have a role in that.
Mr. OXLEY. They would have the primary role, would they not, under the law?
Mr. FALCON. They would have a primary role, but safety and soundness requires that we also take action. There is some overlap. Safety and soundness requires that we also take action when we see violations. It is important that we do coordinate with the SEC in areas where there is overlap.
Mr. OXLEY. The purpose, of course, of the provision, as Chairman Baker knows and others on the committee, was to provide more transparency in real time because perhaps if we had that on the books during the Enron case, some of those insider sales would have put up a lot of red flags, particularly when the employees were locked down and not able to sell their shares. So that is why I wanted to bring that point up, the idea of the immediacy of it and the transparency of it hopefully, at least at some point, will provide some deterrent to that kind of behavior, including perhaps smoothing out earnings or making earnings look better than they really are.
With that, I yield back.
Chairman BAKER. I thank the chairman.
Mr. Scott?
Mr. SCOTT. Yes, thank you, Mr. Chairman.
Mr. Falcon, there have been some questions raised as to the timing of the release of your report. Could you describe the manner in which this report was released, the timing of it? Were there systematic leaks to the press? Were they internal? And the affected parties such as Fannie Mae were aware of your findings before they were released to the press?
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Mr. FALCON. We have kept a tight lid on this as we have gone through the process. The first communication we had about this report as we got to the end of it was on Friday, the day before we met with the board, I do not remember the exact date, congressman, but we did contact the company and asked that the board assemble itself so that we could present the report to the board.
We did not release the report to anyone prior to that date. The first time we released the report outside the agency was to the board at that date. We did have on the Friday before that Monday meeting, some conversations with other agencies just to make them aware of what we were finding and how we were going to proceed.
Then once we went to the board on Monday, the week progressed with discussions between us and the board about proper remedial action.
Mr. SCOTT. Let me ask you this, then, at what point did you release it to the press in that order of events? When exactly did you do that?
Mr. FALCON. We did that on Wednesday. I had a commitment to the board that we would not release the report as long as they objected, and we were in the process of working out the terms of this agreement to take care of remedial actions. On Wednesday, I had a meeting with a couple of the board members. They said that given the intense interest in this, they no longer had any objections, and given the fact that there was