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,
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.
Page 2 PREV PAGE TOP OF DOC 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.
Page 3 PREV PAGE TOP OF DOC 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.
Page 4 PREV PAGE TOP OF DOC 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.
[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.
Page 5 PREV PAGE TOP OF DOC 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.
Page 6 PREV PAGE TOP OF DOC [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.
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.
Page 7 PREV PAGE TOP OF DOC 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.
Page 8 PREV PAGE TOP OF DOC 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.
Page 9 PREV PAGE TOP OF DOC 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 bipartisanthe 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.
Page 10 PREV PAGE TOP OF DOC 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.
Page 11 PREV PAGE TOP OF DOC 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.
Page 12 PREV PAGE TOP OF DOC 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. 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.
Page 13 PREV PAGE TOP OF DOC 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. 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.
Page 14 PREV PAGE TOP OF DOC 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. 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.
Page 15 PREV PAGE TOP OF DOC 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.
[The prepared statement of Hon. Wm. Lacy Clay can be found on page 151 in the appendix.]
Page 16 PREV PAGE TOP OF DOC 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.
Page 17 PREV PAGE TOP OF DOC 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. 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.
Page 18 PREV PAGE TOP OF DOC 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.
Page 19 PREV PAGE TOP OF DOC Chairman BAKER. I thank the gentleman.
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.
Page 20 PREV PAGE TOP OF DOC 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.
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.
Page 21 PREV PAGE TOP OF DOC 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.
Chairman BAKER. I thank the gentleman.
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.
Page 22 PREV PAGE TOP OF DOC 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.
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. 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.
Page 23 PREV PAGE TOP OF DOC 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.
Chairman BAKER. The gentleman's time has expired.
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.
Page 24 PREV PAGE TOP OF DOC 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. 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.
Page 25 PREV PAGE TOP OF DOC 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. 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.
Page 26 PREV PAGE TOP OF DOC 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. 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 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.
Page 27 PREV PAGE TOP OF DOC 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?
Page 28 PREV PAGE TOP OF DOC 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. 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. 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.
Page 29 PREV PAGE TOP OF DOC 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.
Page 30 PREV PAGE TOP OF DOC 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. 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.
Page 31 PREV PAGE TOP OF DOC 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.
Page 32 PREV PAGE TOP OF DOC 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.
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.
Page 33 PREV PAGE TOP OF DOC 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.
Page 34 PREV PAGE TOP OF DOC 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.
Page 35 PREV PAGE TOP OF DOC 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.
Page 36 PREV PAGE TOP OF DOC 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.
Page 37 PREV PAGE TOP OF DOC 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?
Page 38 PREV PAGE TOP OF DOC 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?
Page 39 PREV PAGE TOP OF DOC 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. 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?
Page 40 PREV PAGE TOP OF DOC 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.
Page 41 PREV PAGE TOP OF DOC 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.
Page 42 PREV PAGE TOP OF DOC 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.
Page 43 PREV PAGE TOP OF DOC 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
Page 44 PREV PAGE TOP OF DOC 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. 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.
Page 45 PREV PAGE TOP OF DOC 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?
Page 46 PREV PAGE TOP OF DOC 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.
Page 47 PREV PAGE TOP OF DOC 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.
Page 48 PREV PAGE TOP OF DOC 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.
Page 49 PREV PAGE TOP OF DOC 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.
Page 50 PREV PAGE TOP OF DOC 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.
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.
Page 51 PREV PAGE TOP OF DOC 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.
Page 52 PREV PAGE TOP OF DOC 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.
Page 53 PREV PAGE TOP OF DOC 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.
Page 54 PREV PAGE TOP OF DOC 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. 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?
Page 55 PREV PAGE TOP OF DOC Mr. FALCON. We have kept a tight lid on this as we have gone through the process. The first communication we had about this report as we got to the end of it was on Friday, the day before we met with the board, I do not remember the exact date, congressman, but we did contact the company and asked that the board assemble itself so that we could present the report to the board.
We did not release the report to anyone prior to that date. The first time we released the report outside the agency was to the board at that date. We did have on the Friday before that Monday meeting, some conversations with other agencies just to make them aware of what we were finding and how we were going to proceed.
Then once we went to the board on Monday, the week progressed with discussions between us and the board about proper remedial action.
Mr. SCOTT. Let me ask you this, then, at what point did you release it to the press in that order of events? When exactly did you do that?
Mr. FALCON. We did that on Wednesday. I had a commitment to the board that we would not release the report as long as they objected, and we were in the process of working out the terms of this agreement to take care of remedial actions. On Wednesday, I had a meeting with a couple of the board members. They said that given the intense interest in this, they no longer had any objections, and given the fact that there was also some expression raised from members of Congress about go ahead and put the report out there, I exercised my judgment and said, okay, then we will go ahead and release the report.
Mr. SCOTT. Okay. Did you consult with the Securities and Exchange Commission or FASB prior to making the report's findings public, as to whether or not Fannie's accounting was consistent with GAAP?
Mr. FALCON. We spoke to the SEC about this on the Friday before we went to see the board. Prior to that time, we did not seek their opinion about this. Because we viewed these issues as clear violations and the company clearly understood these rules, we did not. If we felt that this involved a gray area and we needed some guidance about what the rules required and whether or not the company was meeting those rules, then we would have certainly sought guidance from the SEC.
Page 56 PREV PAGE TOP OF DOC Mr. SCOTT. Okay. Two little points here. How are the problems with accounting for derivatives at Fannie, how do they compare with what you have found with the examination of Freddie Mac? Are they the same? Same abuses?
Mr. FALCON. We have seen the same cultural issues. We have seen the same motivations in terms of smoothing earnings. Some role in compensation issues. So certainly much of that appears to be consistent between the two companies.
As far as the actual magnitude of any impact on the company's financial statements, I really do not have an answer for that until we complete this next phase of the process, which is to assess the impact on past financial statements.
Mr. SCOTT. Why do you think that Fannie Mae altered their earnings? What was the underlying purpose from your report?
Mr. FALCON. The primary rationale as we see it was a strong desire that the company had to present itself to the public and investors as a company which had very smooth and consistent and reliable earnings growth. The only way to do that was to develop these accounting practices which allowed them to smooth out the volatility which exists in this line of business.
Mr. SCOTT. Do you think that this activity was generated on the part of Fannie Mae so that they could increase their compensation package?
Chairman BAKER. That would need to be the gentleman's last question. His time has expired.
Please respond, sir.
Mr. FALCON. It certainly appears that way to us. Given this one instance in 1998 and given the fact that for the next 5 years bonuses were continually tied to earnings per share as a metric. That metric was being manipulated in order to create smooth earnings. It certainly appears that way to us.
Page 57 PREV PAGE TOP OF DOC Mr. SCOTT. Thank you very much, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. SHAYS. You are almost becoming a sympathetic figure, and your organization. I mean, you have issued a report and you are getting attacked on the report. You are being questioned why you did not do a better job sooner, and yet your organization has not been given the authority or the power by Congress to do the job it needs to do.
And frankly, I do think you needed to show a little more energy, which you are starting to do. I am seeing the result of that. When did you give them the report? When did you talk to them? Why didn't you find out sooner? Instead of having members of this Congress try to find out what the hell they did.
One of the things that I find somewhat astounding is, are you saying to this committee that you actually had to issue subpoenas against this organization or consider it or threaten it to get information you are entitled to get?
Mr. FALCON. We issued administrative subpoenas to get information that we needed for this special examination, yes.
Mr. SHAYS. Why would you have to issue administrative subpoenas? Why can't you just ask for it?
Mr. FALCON. We did initially, but we did not get sufficient compliance, certainly not timely compliance, partial compliance. Therefore, we felt the only way to solve that problem was to move toward administrative subpoenas.
Mr. SHAYS. So the bottom line is, not only have you found this company not in compliance, you are telling us they resisted in your initial efforts to find out what was going on. They resisted your efforts to do your job. Isn't that correct?
Mr. FALCON. That was our feeling and that is why we moved toward the more formal processes.
Page 58 PREV PAGE TOP OF DOC Mr. SHAYS. And you have stated to us that these findings are very serious, correct?
Mr. FALCON. Yes.
Mr. SHAYS. Are investors impacted? Isn't it possible that investors, based on reports, will have made decisions that were based on faulty information?
Mr. FALCON. Unfortunately, that very much is the case when you have financial statements issued under accounting practices that are not consistent with GAAP. GAAP is there to ensure consistency of reporting across quarters so that you have the ability to compare a company's performance from quarter to quarter. If you do not have correct compliance with GAAP, then you do not have that comparability from quarter to quarter and can judge a company's performance over time.
Through these catch-up provisions the company had under FAS 91, it allowed it to minimize earnings volatility and that comparability that investors need.
Mr. SHAYS. And didn't it also enable them to say they were a low-risk enterprise?
Mr. FALCON. The lack of volatility certainly conveyed that impression.
Mr. SHAYS. Now, having discovered what you have discovered without the cooperation of the organization, are they accepting your findings or resisting your findings?
Mr. FALCON. I feel like the board has been cooperative in working with us to address these findings.
Mr. SHAYS. Right. And they said that they will change their behavior, correct?
Mr. FALCON. They said they would change their behavior going forward. They are going to do the calculations for us going backwards so we can assess the magnitude of the incorrect accounting in prior periods.
Page 59 PREV PAGE TOP OF DOC Mr. SHAYS. What concerns me is, when Mr. Raines comes and testifies, he is not going to give us the feeling that he gets it. Why do you think that is the case?
Mr. FALCON. I cannot speculate on that. I just know that our findings, we feel very strongly about what we found. A lot of work has gone into this. It does not surprise me that the company would continue to stand behind its accounting, but the fact is it is wrong.
Mr. SHAYS. It is wrong, and there is not going to be any doubt about the fact that it is wrong. Now, their auditor was paid $3 million in a $1 trillion firm. Doesn't that raise some question about their capability, the auditor's capability to do the job, with a $1 trillion operation?
Mr. FALCON. We are now focusing more on the work of the external auditor. We have had concern about potentially excessive reliance by the external auditor on the internal audit function and internal policy-setting by the company, but that is something for further review now that we have completed this step in the process.
Mr. SHAYS. I congratulate you on the work you have done. I congratulate you for trying to protect the public. I congratulate you for showing courtesy to the company, meeting with them first before this report was issued. But the bottom line is, what really matters is what your report says and how they deal with it. I am somewhat appalled and maybe even a little shocked that you would have had to use subpoenas to get information to do your job. I thank you for going to that level to ensure that you could get your information.
Chairman BAKER. The gentleman's time has expired.
Ranking Member Frank?
Mr. FRANK. Thank you, Mr. Chairman.
Let me say, I was pleased and I understand what the gentleman said. I guess, if your feelings have been hurt. I am sorry. I did not think anybody here was of that sensitivity. I was pleased to join with the chairman in objecting to the appropriations committee to level-fund you going forward, but we thought that was the best thing we could do was to get you more money, and the chairman of the committee and I jointly protested the decision of the Appropriations Committee, but being in the minority we do not get to make those appropriations decisions, but we were certainly supportive of that.
Page 60 PREV PAGE TOP OF DOC I did have a couple of questions. This is important about how this was done, because I think there is a problem that a perception could be created before we can establish a reality that could be damaging. Now, you told the gentleman from Georgia how you went about telling people, et cetera. But there was a newspaper report over that weekend I think quoting the chairman of the subcommittee. He said he had been briefed on the content of the report. We on our side, on the Democratic side, heard nothing until we read about it in the paper. Was the chairman briefed and is it appropriate to brief one side and not tell the other?
Mr. FALCON. That would be certainly not appropriate and not consistent with the way I would like to deal with this committee, congressman. We did not brief any member of the committee. Unfortunately, the press just reported that inaccurately.
Mr. FRANK. Wait. Stop. The press mis-reported it. All right. Maybe that will make it into the reports of today's proceedings.
So the report that the chairman had been briefed was an error on the part of the press. He was not briefed.
Mr. FALCON. Yes.
Mr. FRANK. Okay.
Chairman BAKER. Would the gentleman yield? I just want to confirm. I do not know where the report generated. I was not either by SEC or OFHEO given any advance information.
Mr. FRANK. Okay. I appreciate that. I would just caution people, and we now have an agreement from all parties that the assertion that OFHEO had briefed the chairman of this committee was a mistake in the press. If that is the only mistake the press has made in this, that would be quite extraordinary.
Let me ask you, similar. There was one report in one newspaper that you had made a referral of a criminal matter to the Justice Department. Is that accurate?
Page 61 PREV PAGE TOP OF DOC Mr. FALCON. We have not made a formal criminal referral. All we have done is given a copy of the report to them.
Mr. FRANK. To everybody. So that means you have not made a criminal referral as that is defined.
Mr. FALCON. Right. We have not made a formal referral.
Mr. FRANK. Okay. That is another one again. I think the suggestion that there was a criminal referral is it seems to me quite misleading. I am glad we were able to clear that one up.
Now, on the question of the substance, Fannie Mae has agreed to a 30 percent increase in their capital. Is that correct, as a result of your conversations with them?
Mr. FALCON. Yes.
Mr. FRANK. How did you arrive at the decision to make it 30 percent? My understanding is, as I read this, the smoothing out of earnings, if that happened, to give people more pay is outrageous, but it does not seem to me to implicate in any way the safety and soundness. A smoothing out means up one and down another. It does not affect certainly the overall economic position.
Then the question is the derivatives and the hedge accounting. The potential misstatement there is I guess part of the reason that you asked for the 30 percent increase in capital because it might have been a misstatement.
But my understanding is you have come to no conclusion as to what the amount of a potential misstatement was. Is that correct?
Mr. FALCON. That is correct.
Mr. FRANK. Could it have been an under-estimate as well as an over-estimate?
Mr. FALCON. Potentially.
Page 62 PREV PAGE TOP OF DOC Mr. FRANK. So what we know is that you disagreed with the way they did them. I was struck, and I would ask unanimous consent to put in the record here a very interesting report, September 27th from Merrill Lynch, Thoughts on OFHEO's Special Examination of FNM.
They note, for instance, with regard to the derivative issue and the potential problem, the market value of these derivatives, just like that of straight fixed-rate debt, is how you correlate it with interest rates. When the rates fail, these derivatives show losses. When rates rise, they show gains. My understanding is rates are probably going to be going up in the next time period, so they are more likely to show gains than losses.
Since you have not been able to quantify this and in fact you are not clear whether this is going to be a gain or a loss, where did the request for a 30 percent increase in capital come from? How did you decide it had to be a 30 percent increase?
Mr. FALCON. It is because of the management and operations risk, as well as the uncertainty about their financials.
Mr. FRANK. But how did you calculate 30 percent? What were the figures?
Mr. FALCON. We took the 30 percent because the risk-based capital standard requires a 30 percent add-on for management and operations risk, but there is not that add-on in the minimum capital standard. We decided that given the weaknesses we found in internal controls, uncertainty of financial statements, we decided
Mr. FRANK. And the 30 percent, you said that is the requirement. That was a preexisting figure that you decided applied here?
Mr. FALCON. That is in the statute.
Mr. FRANK. Okay. Again, I think we ought to be clear. The decision to require a 30 percent increase in capital was not based at all on any calculation on the extent to which the capital might have been impaired, but was a borrowing from the statute or an application from the statute of what happens when you find management risk.
Page 63 PREV PAGE TOP OF DOC Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. ROYCE. Thank you, Mr. Chairman.
I would like to learn a little more about FAS 133. One of the things I want to know is whether Fannie Mae and Freddie Mac apply FAS 133 in a similar manner, or is one more conservative and more consistent than the other? Another question, as I understand it, FAS 133 went into effect in 2000 or 2001, and to qualify for hedge accounting your derivatives have to perfectly match what they are hedged against when they are booked, and you have to document that. If you do that, then you are allowed to use hedge accounting.
One of the questions I would have is, if they were not perfectly matching was it because in your findings, was it because Fannie Mae did not have the expertise or the ability to do that? Or did they and they simply decided not to for some reason? I was wondering why the auditor, KPMG, did not pick this up. This is not one of the examples that they originally cited, unless it is and I do not know it and you could let me know that.
The other question I have is, how material was this? How great were the irregularities? I know it says it has to perfectly match, but I do not know from your report the extent that this was off, and therefore requiring this long-haul accounting approach rather than the hedge accounting. Maybe you could help me out so I could better understand what is at issue here.
Mr. FALCON. Sure. On the technicalities of this 133, my chief accountant is much more qualified than I am, fortunately, to get into the details of that. She can address the difference between how Freddie Mac did it and how Fannie Mae did it.
Mr. ROYCE. Let us start with that, because I am interested if there is a considerable difference in approach. Let me just hear that out in terms of a more conservative or consistent approach by one of the GSEs over the other.
Page 64 PREV PAGE TOP OF DOC Ms. DELEO. Actually, before Freddie's restatement, the application of 133 between the two companies was substantially different. Of course now after the restatement, because of a number of things that happened during that process, they are different. You really cannot make that comparison.
Mr. ROYCE. You cannot make that comparison because they were applying a completely different approach in terms of how they were going to value the portfolio on the risk?
Ms. DELEO. I guess I would not say completely different, but substantially different.
Mr. ROYCE. Could you help me out and just indicate if initially one approach, in your view, was more conservative and more consistent than the other in terms of the two GSEs here?
Ms. DELEO. In both instances, there were misapplications. They were just mis-applied in different ways.
Mr. ROYCE. I see. Okay, well that answers my first question to some extent. Go ahead, Mr. Falcon.
Mr. FALCON. Mr. Dickerson, if you don't mind, would like to add to that, congressman.
Mr. DICKERSON. Freddie Mac had a program where they were applying their derivative hedges directly to the mortgages on their books. That was one difference. Fannie Mae has chosen to apply almost all of their derivatives to specific liabilities on their balance sheet. That is one big difference between Fannie and Freddie.
Mr. ROYCE. Okay. And let's go to the question of why the auditor, why KPMG did not pick this up. We are going back to the first year that they would have to comply. Did that auditor at the time feel they had complied with the standards that would allow hedge accounting? Or did they simply not test for that? Do we know? I would be interested in that.
Page 65 PREV PAGE TOP OF DOC Mr. FALCON. We are now looking into the determinations of KPMG on these matters. But let me make clear that the responsibility for compliance with accounting rules primarily rests with the company. It is not sufficient to simply say that the auditors signed off.
Mr. ROYCE. I understand that. I wonder, did the company at the time feel it was in compliance? I guess your argument would be, listen, if it has to match perfectly, then the company knew it was not matching perfectly by definition if they are using estimates. But I do not know the details here to know how far off they were. That is what I am trying to elicit, is a greater understanding of the specifics of this.
Ms. DELEO. Let me address that. Just backing up a second, let's talk about 133 because I think it will help in the context. One-thirty-three in principle is really a very simple pronouncement because it basically says you need to mark to market your derivatives. But it goes ahead to say that if you qualify for hedge accounting, and what we are looking at there is that you are going to go through and make an assessment test to see if the derivatives are highly effective. If they are highly effective, then you need to measure for ineffectiveness. So that is kind of the second step. If they are not highly effective, you cannot use hedge accounting.
Then in addition to that, there are some exceptions in 133, very rule-based and very specific, that say if you have matched terms, which they do not actually have, and there are very specific criteria that you must meet to do that, then in that case there is no ineffectiveness. They are perfectly effective if the terms are matched. So you would not have to do the assessment test and you would not have to measure ineffectiveness. That is the problem. It is that they moved to that last very specific area and they simply do not qualify under that.
Mr. ROYCE. One last question. Is that because they do not in your opinion have the ability or the expertise to do that?
Page 66 PREV PAGE TOP OF DOC Ms. DELEO. They fully understood the rules. That is not in doubt. Their systems are not capable at this point of doing what we are calling long-haul accounting, doing the assessment test and the measurement of ineffectiveness. They could have built systems to do that, but that was not done.
Mr. ROYCE. I see.
Chairman BAKER. The gentleman's time has expired.
Mr. ROYCE. This really has helped me understand.
Mr. Chairman, thank you.
Chairman BAKER. I thank the gentleman.
Mr. HINOJOSA. Thank you, Mr. Chairman.
Director Falcon, I understand that your report hinges on the accounting work of Deloitte & Touche. My question is, what was your cost to retain Deloitte & Touche for the 8-month period that you said they worked for you?
Mr. FALCON. Let me clarify, congressman. This work is and the judgments in it are the product of OFHEO. Deloitte assisted us in this work and they support the findings, they agree with the findings in this report as well, but this is the work and the judgments of OFHEO. They did assist us, but I do not want to pass anything off to them. This was our judgment.
Mr. HINOJOSA. So it was your judgment, and they have signed off on the OFHEO findings. Correct?
Mr. FALCON. Yes, congressman.
Mr. HINOJOSA. You also mentioned that you did not speak to nor review the working papers of KPMG accounting firm while preparing this report. It seems to me that it is less than clear, then, that Deloitte has signed off on your OFHEO findings.
Page 67 PREV PAGE TOP OF DOC Mr. FALCON. Deloitte fully supports the findings and conclusions of this report. They also view these accounting issues as very clear-cut violations and not matters of interpretation.
Mr. HINOJOSA. Aren't the views of the KPMG auditors critical to your report? They are a very reputable firm. They do the work for my company.
Mr. FALCON. They are reputable. KPMG may disagree with us, but it is not unlike Arthur Anderson. They supported everything Freddie Mac did until that got corrected.
Mr. HINOJOSA. I yield back the balance of my time.
Chairman BAKER. I thank the gentleman.
Mr. NEY. Thank you, Mr. Chairman.
Following a little bit in the line of the question the gentleman just asked, I think the one thing that has to be, from your opinion from what I have heard, it has to be pretty well-grounded would be the strength of the comment that OFHEO has made that the company willfully did misapply GAAP. Now, at the end of the day, the chairman of the SEC does make that call whether that statement will be accurate in his view. I am not saying your statement is necessarily inaccurate.
If that happens and the SEC says something, and I am not asking you to speculate on what they are going to say, but if that happens and you have said one thing and the SEC says another, is there any type of discussions? Do we have the mechanics in place in the law that allows discussions back and forth between OFHEO and SEC to say, wait a minute, we think this and SEC says that. I know the SEC is the final decision maker on it, but is there any mechanism in current law that would allow a debate or a point of view to be discussed in case there are two separate opinions?
Page 68 PREV PAGE TOP OF DOC Mr. FALCON. I think the way this would work is the SEC would determine what is appropriate for purposes of the disclosures that are filed as required by the SEC. We also rely on the financial statements of the company and its books and records in assessing the safety and soundness of the company and capital adequacy of the company.
If we see fit that the books and records are inaccurate and need to be changed for purposes of our capital requirements or for purposes of assessing their safety and soundness throughout our examination program, then we would take appropriate action utilizing our safety and soundness authority and they could do what they thought was appropriate for purposes of their disclosures that they require.
Mr. NEY. When you presented it to the Fannie Board, the fact that they willfully misapplied general accounting practice, one, what was the reaction, the statement made back to you by Fannie's board? Two, with the auditing firm, KPMG, what was their discussion with you, KPMG's, about their work papers or why they advised Fannie to do this?
Mr. FALCON. KPMG was not in the meeting with the board when we sat down with the board and presented our report to them. The board did hear the entire presentation. They were all present either in person or by telephone, and they have taken this matter very seriously. Like I said, to their credit they moved quickly to reach an agreement with us to assure that safety and soundness concerns were properly addressed.
Mr. NEY. If KPMG signed off on this and advised Fannie, and then if OFHEO has not had any discussion or your staff with KPMG as to why they advised Fannie, has Deloitte & Touche had a discussion or looked at the work papers as to why KPMG advised Fannie to do it this way?
Mr. FALCON. We are now beginning work on the process of assessing KPMG's work papers, having discussions with KPMG. In addition, just as we are bringing in the SEC into these matters surrounding financial disclosures and their adequacy, we are also speaking with the Public Company Accounting Oversight Board about the adequacy of the external auditor's work in this regard.
Page 69 PREV PAGE TOP OF DOC Mr. NEY. I just wondered on the process, and it was verging on the gentleman's question before, it seems that at some point in time Deloitte & Touche would have to have a conversation with KPMG to see why they would advise this, and look at their point of view because it is a pretty stern statement that it has been willfully misapplied. KPMG I would assume at some point in time, even though you are not to phase two of this, there would be discussions between auditing firms and yourselves to at least hear their point of view of why they would tell Fannie, yes, this is acceptable.
Mr. FALCON. We will have those discussions. Let me ask Mr. Dickerson to talk about it. He knows more about what happened in the past and what we will do going forward.
Mr. NEY. I know you are going to have those discussions, but Deloitte is sitting there in a way, saying yes, this is misapplied general accounting practices. I just want to understand why there was not a previous conversation to give them a comfort level of why, and before this whole report came out. That is one thing I would question.
Mr. FALCON. We at OFHEO have requested work papers from KPMG and have talked with their partners about getting those work papers. We have actually received some of those work papers and have reviewed ourselves, OFHEO examiners, some of the work papers in coming to the conclusions that are in our report. It is important to note that the report represents the views of OFHEO, so it is most important for the examiners at OFHEO and the office of the chief accountant to be comfortable with what KPMG has done.
Mr. NEY. Mr. Chairman, my time has expired. At some point in time down the road, I would like to get your opinion of what tools you would need if you were to become the regulator for the future.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Page 70 PREV PAGE TOP OF DOC Mr. Capuano?
Mr. CAPUANO. Thank you, Mr. Chairman.
I would like to ask just a few general questions about FAS 133, which obviously I am not terribly familiar with, a little bit, but not terribly familiar with. As I understand it, it is a relatively new regulation. Is that correct?
Mr. FALCON. It went into effect in 2001.
Mr. CAPUANO. So relatively new in these kinds of things. Am I right to understand that between the regulations and the guidelines and the rules relative to it, it comes to about 900 pages, give or take. Is that a fair estimate?
Mr. FALCON. Yes, Congressman.
Mr. CAPUANO. So it is a relatively new 900-page regulation.
In the normal course of events of any new accounting standards, any changes in GAAP, any changes in FAS or any of these things, am I right to understand, again, not just in banking or not just in GSEs or anyplace else, but in every day, including individuals and everything else, when something new like this comes out that is clearly long, clearly complicated, clearly important, and clearly has very important ramifications, isn't there a normal period of time in which the people who are affected by whatever the rule or regulation is, plus the auditors and the accountants who interpret it, isn't it a fairly common thing to have a period of time where people may interpret things differently, and the systems, through the industry, the regulators, the courts, the IRS, whoever it might be, the SEC, then over time tends to take different approaches to the same rule and regulation and say, well, wait a minute, we know you took different approaches, but this is not right and this is not right, and little by little they come to a consensus.
Is that not a normal situation?
Mr. FALCON. I think that grace period you are describing occurs prior to the effective date of the implementation of the rule. This rule did go through many years of discussion, many years of debate and analysis. It had a delayed effective date. Even after it was supposed to become effective, I think it was delayed for an additional year.
Page 71 PREV PAGE TOP OF DOC Mr. CAPUANO. I understand that. I understand how rules are made, but even after rules are made, are you telling me that in the normal course of events that every FAS, every GAAP rule is then implemented perfectly by everybody in lock-step with no disagreement, no discussion, no need to then clarify different things that happen in a 900-page report?
Mr. FALCON. The rules apply as of the effective date of the rule.
Mr. CAPUANO. I understand the rules apply, but how are they interpreted? You are telling me they are clear, concise and unequivocal on all counts every time there is a change in the FAS, every time there is a change in GAAP? I have to tell you, that is not my experience and I do not think that is the experience of any accountant or auditor in the country. It is not the experience of the IRS, the SEC or you.
So I understand how rules are made, but I also know that once rules are made there is still a period of time afterwards, not a set period of time, that different people read different things differently and interpret things differently with good will. So the thinking that somehow you set a rule and that is it, well, if that is the case we do not need courts. We do not need the IRS. We certainly do not need the tax court for any interpretations because we have thousands and thousands of tax rulings, and this is really just one implementation of it.
I would obviously disagree, or I am not sure that you answered the question, but clearly it takes time to work these things out.
I guess in the normal course of events, absent different issues, and not all the time, is it not a normal circumstance where many entities within the rules of GAAP, within the rules of various FAS's and other accounting procedures and tax procedures, try to on occasion smooth out earnings? Is that not something that happens here and there in the business world?
Mr. FALCON. If it happens, it is wrong. It is not proper to try to smooth out earnings by violating accounting rules.
Page 72 PREV PAGE TOP OF DOC Mr. CAPUANO. I did not say violate it. You did not hear the question. Within the rules of accounting, within the rules allowed by various regulators, there are times and certain situations that it is allowed.
Mr. FALCON. If it is within the rules of accounting, it is not improper.
Mr. CAPUANO. That is what I asked. So within the rules, the concept of smoothing out earnings in and of itself is not a violation, understanding fully well that there are times that it is wrong, there are times that it is not, and that is what the debate is about is whether these rules are right or wrong.
I also wonder, are you chasing KPMG at this point in time, or are you just kind of letting it float at the moment?
Mr. FALCON. No, we are starting, as we said, to obtain the work papers of KPMG and we will discuss with them their assessments.
Mr. CAPUANO. Okay. It strikes me again, and I know this is very complicated and I understand that, but if they had the opportunity to make these decisions, and what they did, as I understand it, and again correct me if I am wrong, is in their reports they simply cited it as an audit difference.
For those who do not understand, an audit difference does not stop the process. They could have said it was a material weakness. Nobody in their right mind wants a material weakness noted on their annual report, and hopefully even understaffed you would have found something that was cited as a material weakness in an annual report. They did not cite it as a material weakness. Am I wrong?
Mr. FALCON. No, it was just an audit difference.
Mr. CAPUANO. So then KPMG as an auditor has said, basically, look we do not necessarily agree, but it is a minor point. Here it is in the footnotes, and we will move on.
Page 73 PREV PAGE TOP OF DOC Chairman BAKER. This will have to be the gentleman's last question. His time has expired.
Mr. CAPUANO. Thank you, Mr. Chairman.
Again, I guess I will just finish by simply stating that clearly there are some serious questions. You have raised serious concerns, and if you turn out to be right, there will be some serious ramifications of it, but I still think that some of the concerns and some of the comments that have been made here today are kind of jumping the gun and putting the cart before the horse relative to allowing people to make a determination of what was right and what was wrong; what was willful and what was simply just a difference of opinion in the ordinary course of business.
Mr. TOOMEY. At this time the chair will recognize the gentlelady from New York.
Mr. KELLY. Thank you very much.
I appreciate the fact that you have delivered a partial report. It has been very interesting reading. One of the things I am troubled by and I see repeatedly in the report is that there are people carrying double roles within the structure of Fannie Mae. I understand that the OFHEO has been asking the chairman of the board and the CEO of both the GSEs to separate people into separate functions. For instance, Janet Honeywell, her job was forecasting as well as financial reporting.
There are numerous examples, starting on page 158, going on through, are people, first of all, who are not CPAs that were doing financial structuring and analysis. And secondly, they were auditing their own work essentially. My question to you is, Freddie Mac apparently has agreed to separate roles. Apparently, Fannie Mae has not. Are they in the process of working with you to try to do that? Can you talk to us about why you think this is a healthy thing to do? What is ongoing with regard to OFHEO working with Fannie Mae to make sure that there is a separation of duties?
Page 74 PREV PAGE TOP OF DOC Mr. FALCON. We do think it is important that key functions be separated so that there is not a conflict of interest or that someone with an incentive to meet some goals also has the ability to manage the accounting of those goals such that they are met.
So we have taken action, going to Freddie Mac to make sure there was proper separation of offices and functions and individual responsibilities. The board of Fannie Mae has agreed with us to create a separate chief risk officer. We found that the individual responsible for setting goals in this instance was also responsible for making sure that they were met.
We are looking at other issues as well. We have a pending corporate governance rule amendment which would separate the function of the chairman of the board and the chief executive officer. Freddie Mac has already agreed to do that, and once this rule is implemented it will also provide the same for Fannie Mae.
Mr. KELLY. I want to go back to page 160 of your report. I do not know how to pronounce Sam Rajappa. I do not know how to pronounce that last name.
Mr. FALCON. That would be Rajappa.
Mr. KELLY. It is Rajappa. Thank you. There is a statement in here by Tim Howard noting that Sam Rajappa reports directly to the chairman of the audit committee, but for the last I think year and a half, maybe 2 years, he has reported on a dotted line basis to me.
In reading your report, I could not quite figure out who had a straight firm line and who had a dotted line, because it looked to me like a lot of these things were being mixed responsibilities. Jeffrey Guliana had a dual responsibility. There is one name after another here where I do not see a solid structure, but rather an informal structure. I would like you to expand on what you have found with regard to this, because I am not sure exactly who was the person that was signing off on the bottom line here.
Page 75 PREV PAGE TOP OF DOC Mr. FALCON. That is a good question. We found that this was a big weakness in the way these accounting policies were being set. There was not a clear process in place. There were no accounting controls. There was not even adequate documentation about what the accounting policies were and the roles in formulating these accounting policies.
Let me ask Mr. Dickerson, who can speak very well to these internal control issues, to elaborate further.
Mr. DICKERSON. Right. We found, for example, in the amortization area that there was one individual who was in charge of the modeling and accounting for amortization. That is a weak segregation of duties. We found, you mentioned Ms. Pennewell, who was in charge of financial reporting and financial planning, so she had opportunities at least to help meet through accounting financial goals that her group had earlier set.
Mr. KELLY. Is there now in place a structure, because I understand from Mr. Falcon, from what he just said, that that structure has not really been changed much, and it is still unclear to me. Have you established with them now a clear line of who reports to whom?
Mr. FALCON. It will take a little time to fix all of these problems, to do the reorganization within the company and create the positions and select individuals for the positions. But this is something covered by the agreement with the board, and we are going to move as expeditiously as possible to get these fixes in place.
Mr. KELLY. Thank you.
Chairman BAKER. The gentlelady yields back.
Mr. LYNCH. Thank you, Mr. Chairman.
I was late in the hearing, but I do want to thank you for coming here today and helping the committee with its work. I know you have had a rough time with some of my colleagues, but I do not think there is anybody here that questions your good intentions to help us with this process. That is the position I take. You are good to do your work and we need you to do it really well, and I am sure that is going to happen.
Page 76 PREV PAGE TOP OF DOC However, this is the political side of the table, so some of us up here are going to twist and use your information to help us grind an axe with Fannie Mae or others, or to defend it as I will intend to do. But that is not to discount the good work that you are doing.
I do want to rebut a couple of things, and I want you to work with me here. I have heard Enron, Enron, Enron a bunch of times here. Quite frankly, the chairman of the subcommittee did a wonderful job in helping the committee with its work in that case, but even the chairman of the full committee has brought that specter to bear in comparing what has happened at Fannie Mae to Enron.
I just want to ask you, we had the Enron situation. We had a house of cards there, a financial house of cards where there was no strength to the underlying business. They had a very unsound business model. We had serious problems in the underlying business. Is that what you see here? Is that what you see here?
Mr. FALCON. The business model of the company remains sound.
Mr. LYNCH. Remains sound.
I do not have much time. That is just one thing I wanted to get out there.
Mr. FALCON. Okay.
Mr. LYNCH. We had 19 criminal indictments. We had 96 criminal charges. We had 78 fraud counts against the people who were running Enron. Is that what we have here? Or is it more in the line of noncompliance with accounting standards?
Mr. FALCON. We have deferred any opinions, resolutions of any criminal conduct to the Justice Department. We have referred to the corporate fraud task force our report. We are cooperating, giving information to the U.S. attorney upon request about anything we found and documents that we have about this. Beyond that, we are not forming judgments about the criminality of this, and we have not made any criminal referrals to the Justice Department.
Mr. LYNCH. Thank you. In terms of the gross manipulation that occurred in the California power market by Enron in which investors and employees lost their pensions and their life savings. Is that what we are looking at here or is it something different?
Page 77 PREV PAGE TOP OF DOC Mr. FALCON. I think until the entire review is over, I would withhold maybe broad categorical statements about this. Certainly, what we have found to date raises serious concerns with us about the company's proper accounting, as well as their internal controls, doubts about safety and soundness, prior financial statements. If we find that this type of conduct shows up in other areas that we have yet to begin to review, then it would become much more serious than even it is now.
Mr. LYNCH. So you are saying they could be defrauding the public and the investors and the employees just like Enron? Is that what you are saying, that this could be one of those cases?
Mr. FALCON. No. I do not know. I have no
Mr. LYNCH. You just said there was a sound business model here.
Mr. FALCON. Exactly, a sound economic business model. But as far as any criminal intent or any desire to break laws for some criminal purpose, I do not know. I cannot speak to that.
Mr. LYNCH. Okay. Thank you.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. TOOMEY. Thank you, Mr. Chairman.
What I would like to do is address this question of whether we are really talking about a difference of interpretations of ambiguous rules, or whether we have something that is really pretty objective. While this gets a little bit complicated, I think it is manageable, I hope within 5 minutes. Let me see if I can walk through what I understand to have gone wrong with respect to FAS 91. Tell me where I go wrong on this.
First of all, Fannie Mae buys assets that trade at premiums and discounts. Correct? Some of these assets have prepayment features.
Page 78 PREV PAGE TOP OF DOC Chairman BAKER. Mr. Toomey, I hate to interrupt your train, but I will let you re-start.
Just by way of announcement for members, I understand we will have a series of two votes. It would be the chair's intention upon recessing for those two votes that we would recess the committee for 30 minutes to give members and witnesses a chance to refresh themselves. That would mean we would return here, let's just say 1:30 p.m. We would proceed with Mr. Toomey's comments and questions, and then break at that point, just so all members are advised, 1:30 p.m.
If you would like, you can proceed now, or at your leisure; if you want to come back. Either way.
Mr. TOOMEY. I would like to proceed when we get back.
Chairman BAKER. Okay. Great. The committee will stand in recess until 1:30 p.m.
Chairman BAKER. At this time I would like to reconvene the hearing of the Capital Markets Subcommittee.
At the time the committee recessed, Mr. Toomey had been recognized to proceed, and at this time I recognize the gentleman for 5 minutes.
Mr. TOOMEY. Thank you, Mr. Chairman.
I would like to take up where we left off on this discussion about whether what we have seen with Fannie Mae has been a willful misrepresentation of certain income and expense accounts, or whether it is just the difference in interpretation of an inherently complex and ambiguous accounting laws.
It seems to me the allegations being made by OFHEO, which frankly seem very well substantiated, are very clear: It is the former. This is a willful, conscious misrepresentation.
Page 79 PREV PAGE TOP OF DOC And in fact, KPMG agrees with you and not with the company when they cite this irreconciled item. Is that correct?
Mr. FALCON. Yes, the $200 million
Mr. TOOMEY. The $200 millionnumber one, their auditors agree with you, not with the company, with respect to this treatment.
Now, I would like to get to the substance of what this treatment is about with regard to FAS 91.
As I understand itand please correct me when I go wrong heremy understanding is that when a financial services firm such as Fannie Mae buys assets at either premiums or discounts, some of which have prepayment features, they are required to amortize the premiums and the discounts over a projected life of the asset, which is determined in part by estimating prepayment rates and other things.
My question for you is: When those assumptions are made, the model is employed and an amortization schedule for premium or discount is arrived at, is that not a very precise figure?
Mr. FALCON. Yes.
Mr. TOOMEY. So it is not a range, it is not a ballpark, there is a number. And if you carry it out far enough it goes right to the penny. Is that correct?
Mr. FALCON. Yes, Congressman.
Mr. TOOMEY. And then my understanding further is that when the next quarter comes around, interest rates very often will be different than what was projected in the previous quarter, and that requires a reassessment.
And part of that reassessment is a very preciseit is a new number, and the company is required to catch up, if you will, on the previous errors that come to light, errors with respect to how reality differed from what was projected in the previous quarter. Is that correct?
Page 80 PREV PAGE TOP OF DOC Mr. FALCON. Yes. We are required to make those adjustments. I would not use the term ''catch up'' in the same sense that the company called what they were doing a catch-up.
Mr. TOOMEY. Okay, but they are required to make an adjustment, to affect the cumulative difference between what was projected and what in fact occurred in economic reality, and that, too, is a very precise number. Is that correct?
Mr. FALCON. Yes.
Mr. TOOMEY. And the rules, do they say that despite the fact that a precise number is calculated, you do not have to really use that number? Does FAS 91 give any discretion about what number you use?
Mr. FALCON. Let me ask our chief accountant.
Ms. DELEO. No.
Mr. TOOMEY. It does not. Does FAS 91 suggest that you can round this number to some degree?
Ms. DELEO. No.
Mr. TOOMEY. Okay, it does not allow that.
I am looking the testimony from Mr. Raines and from Mr. Howard, and it talks about how this estimation process is imprecise. In fact, it is not imprecise at all; it is very precise.
It is subject to future revision, but at the point in time in which it is calculated, it is perfectly precise. Is that correct?
Ms. DELEO. That is correct.
Mr. TOOMEY. The alleged imprecisions are used in Mr. Raines's testimony as a justification for creating a range. In fact, the range has nothing to do with this calculation. Or does it?
Page 81 PREV PAGE TOP OF DOC Ms. DELEO. No, the range does not have anything to do with it.
Mr. TOOMEY. The range was a perfectly arbitrary invention of the company, it seems to me. Is that your opinion?
Ms. DELEO. Correct.
Mr. TOOMEY. And the range of $100 million, plus or minus, from these adjustments is not even contemplated, much less allowed, under FAS 91, is it?
Ms. DELEO. There is nothing under FAS 91 that would allow for a range.
Mr. TOOMEY. So it is not as though there is a range that is allowed and there is a dispute over how much. There is no such concept.
But you make a further allegation, if I understand it correctly, which is that not only is it simply and very straightforwardly wrong to not report the full number precisely as calculated, which Fannie Mae has done, but that there was a policy within company systematically not to report the precise number, but rather to have this cushion that you describe as a cookie jar, which served the purpose of evening out income. Am I correct to understand that?
Ms. DELEO. You are correct.
Mr. TOOMEY. Some seem to suggest that this is not really material, you know, Fannie Mae is a big company, you know, it has got a lot of income. But this range that they created was $100 million. Right?
Ms. DELEO. Plus or minus 1 percent, but it basically rounds to $100 million.
Mr. TOOMEY. And it was not an effort to round this number; it was derived from a totally different set of calculations regarding totalmy time has expired. I just want to make the point.
A plus or minus variation here of $l00 million, what does Fannie Mae roughly earn in a quarter? What is the total income in a quarter?
Page 82 PREV PAGE TOP OF DOC Mr. DICKERSON. Probably in the neighborhood of a billion.
Mr. TOOMEY. About a billion.
Chairman BAKER. I would say $150 million, probably.
Mr. TOOMEY. So we are talking over 10 percent of the reported income in a given quarter.
Mr. DICKERSON. Actually it could work out larger than that.
Mr. TOOMEY. And it could work out larger than that.
So by virtue of the sheer magnitude, I do not understand how someone can say it is material.
But I would further argue that I am not sure the materiality applies as a concept when you are dealing with a systematic misrepresentation of the numbers. I do not think that is allowed regardless of how big the misrepresentations are. Is that correct?
Ms. DELEO. I would completely agree with that.
Chairman BAKER. Your time is expired. It has been most helpful. I appreciate your insights, Mr. Toomey.
Mr. MEEKS. Thanks, Mr. Chairman.
Let me make sureI think that it has put some things in context, especially with reference to some of the process.
I think it is a matter of fact, I think you would agree with me that plenty of people do not like Fannie Maes or Freddie Macs for that reason, their current status in the market. People wanted to change it.
Before your report came out there was talk from this committee and from others in the private company that one did not like the status that Fannie Mae had. You would agree with thatright?the status that Fannie Mae and Freddie Mac currently has in the market?
Page 83 PREV PAGE TOP OF DOC Mr. FALCON. No, Congressman, I do not support privatization of these companies.
Mr. MEEKS. I did not ask you that. I did not ask you whether you do or not.
I said I think that we could all agree that we know from either some of your prior testimony, there are individuals in some movements that have been afoot that did not like the status of Fannie Mae and Freddie Mac had within the market. You could agree with that.
Mr. FALCON. Only certain individuals
Mr. MEEKS. And is it also true that in fact you, when you came here previously to testify on other occasions, many individuals on this committee were very critical of you and challenged your ability to be able to relate to the largest financial entities in this country. Is that not correct?
Mr. FALCON. Yes, Congressman.
Mr. MEEKS. In fact, they were so upset with you at that particular time, there were bells put forward that indicated that they may need to create a new regulator for the GSEs. Is that not also correct?
Mr. FALCON. Yes.
Mr. MEEKS. And it is also true that this is a special examination, a special examination actually departed from what is standard financial institutional examination procedures. Is that not also correct?
Mr. FALCON. No.
Mr. MEEKS. This was not a special examination?
Mr. FALCON. Yes, it was a special examination, yes.
Mr. MEEKS. All right. And under ordinary procedures, would it not also be a situation whereas, you know, there were questions in regards to some of the regulations that you were overseeing that Fannie Mae, or whoever you are investigating, would have had the opportunity to address those issues prior to the issuance of the report.
Page 84 PREV PAGE TOP OF DOC Mr. FALCON. Any examination follows a pattern where if it is a normal examination, like our annual risk-based examination, there will be, depending on severity of the issues that are found, you could have, would have give and take between the management.
But this was a special examination, or it was situation where there were serious concerns raised about the conduct of management in this area of accounting and internal controls
Mr. MEEKS. And some of that is subjective. Because as we indicated, I think that when someone was talking before, the person that is clearly talking about FAS 133F and FAS 91, the ultimate determination is going to be made by the SEC, and there could be a question whether discretion, whether or notbecause we do not know, you know, it could be a difference of opinion between you and the SEC. We do not know that yet.
Right now what you are putting out is just more allegations.
And what I am talking about, when I start talking some irregularities, I am talking aboutwell, you know, even Senator Bond talked about the leaking of evidence or leaking of letters to the Wall Street Journal, other press. That is not standard. That does not happen under those circumstances. Is that a common procedure, to leak evidence and letters?
Mr. FALCON. Congressman, we did not release this report prior to the board agreeing with us that they did not have any objections to this report being put into the public domain. I received a letter from members of Congress in fact urging me to do so.
I had a commitment to the board not to release this report while we in these discussions. But once they no longer objected, I decided to do so.
Mr. MEEKS. But even before they objected, things were leaking out. And I do not know if Congress had ever asked for it, but things were leaking out beforeat one time and previously.
So it has not been the usual type of investigation here, with things leaking, to give a hint of something or other. It seems to me that it is just curious to me that this is happening.
Page 85 PREV PAGE TOP OF DOC Well, OFHEO itself was threatened with reference to being replaced by a regulatory agency.
But let me just go to someplace else, because you make strong allegations. And, you know, sometimes you throw things out there. I know, I used to be a prosecutor. And it is very dangerous. And you made some allegations, strong allegations, that, you know, I do not know where the evidenceI have not heard the evidence of it.
But, again, coming from the background that we are talking about, with reference to the pressure that was put on OFHEO by others and members of this committee about doing certain things, and all of a sudden I see this report coming out, I see things that are being leaked out.
And then you make some charges that a lot of this is being done because of executive bonuses. That is a very serious charge. And I don't know exactly how you back this up. Can you just tell me? How do you back this up?
Mr. FALCON. It is our judgment, based on the evidence we saw, that this company in 1998, in that instance, when you look at the circumstances, the company deferred this $200 million of expenses in disagreement with this external auditor, and the evidence seemed to us that it was in order to meet these compensation bonus targets.
Chairman BAKER. The gentleman's time is expired. Did you have a wrap-up?
I thank the gentleman.
Mr. BACHUS. Thank you.
Director, derivatives have been used to hedge risk and actually have been used successfully. In this case, you have talked about this particular derivative contract had not been approved for hedging. Is that right?
Page 86 PREV PAGE TOP OF DOC Mr. FALCON. Their derivatives portfolio, they were classifying all but about $43 million of the notional value of their derivatives portfolio as eligible for hedge-accounting treatment, which means any changes in market value would flow through other comprehensive income and not through the
Mr. BACHUS. To flow to the
Mr. FALCON. Yes.
Mr. BACHUS.to the underlining security of whatever it was hedged to, whatever the derivative was based on?
Mr. FALCON. Whatever change in value occurred in the derivative wouldn't flow through earnings to the balance sheet, but rather would go through other comprehensive income.
Mr. BACHUS. Okay. Did that affect Fannie Mae from a safety and soundness standpoint, in your opinion?
Mr. FALCON. I think, overall, everything we find in this report does raise concerns about the company's safety and soundness. We have found practices that are inconsistent with safety and soundness, practices about not complying with accounting rules, not having accurate financial disclosures, not having the appropriate internal controls.
The report has great detail, I believe, on the reasons why we have expressed concerns about the company's safety and soundness.
Mr. BACHUS. Just assuming that they had applied with the FAS 133 in their risk management, do you believe that Fannie overall has made the right economic and risk management decisions in terms of protecting its portfolio from market risk?
Mr. FALCON. They use their derivatives to hedge against the interest rate risk associated with this retained portfolio that they manage. And their use of these derivatives is proper to hedge risk. We are not questioning their use of derivatives to properly manage the interest rate risk that they face.
Page 87 PREV PAGE TOP OF DOC What we are seeing here is a lack of compliance with the accounting rules. We are also looking at other things related to this derivatives portfolio. This is just the beginning of what we have determined. These are our findings to date. And we will continue to look at issues raised.
They usetheir policy is to use derivatives only to hedge risk and not to speculate. That is also our safety and soundness standard.
Mr. BACHUS. How long
Mr. FALCON. But we are looking at it to make sure there weren't transactions that were inconsistent with that policy.
Mr. BACHUS. Okay. How longI mean, you have been critical of their internal controls and of some of their accounting practices. How long have these practices been going on and these lack of internal controls, in your opinion?
Mr. FALCON. The internal controlsI guess we found thatthe policies on FAS 91 date back to 1998 and on 133 date back to 2001. So certainly these weaknesses that allowed these improper accounting policies to be put in place certainly go back as far as that.
Mr. BACHUS. Now, you are examining them on a regular and constant basis, right?
Mr. FALCON. Yes.
Mr. BACHUS. Why did you just now discover those things? Why did it take this long?
Mr. FALCON. We look at many issues related to credit risk, interest rate risk, management and operations risk, a wide variety of areas of a company's risk profile.
This is an area where, very recently, as a result of the Freddie Mac accounting problems, we decided to go and take a very close, detailed look at Fannie Mae. We have not, prior to this point, conducted such an in-depth examination focused on one area of the company.
Page 88 PREV PAGE TOP OF DOC Our examination program assesses their risk and risk-management practices across a wide range of risk. Focusing in narrowly on this subject has uncovered problems that the broader review has not uncovered previously.
Mr. BACHUS. Okay. One final. Did you all consult withnow, KMPG was their outside auditor, right?
Mr. FALCON. Yes.
Mr. BACHUS. And Deloitte & Touche, you all used them to do your audit, right?
Mr. FALCON. Yes.
Mr. BACHUS. Is that right? Have you all consulted with KMPG about your findings?
Mr. FALCON. We have begun the process of obtaining KPMG's work papers, discussing this with KPMG. But we have not gone down a path of trying tomanagement and the company is ultimately responsible for ensuring that the company's policies and practices in the accounting area are consistent with GAAP.
Mr. BACHUS. But you were totally unaware that they were doing all this until just recently?
Mr. FALCON. We have not conducted an in-depth accounting exam like this previously.
Mr. BACHUS. Had you criticized their internal controls prior to this? You are their regulator, right? And internal controls would be a basic part offor instance, who signs off, who within the company signs off on these derivative contracts and their treatment? Had you questioned those in the past?
Mr. FALCON. I would have to go back and look at our previous examination reports. But if we did, in fact, identify these problems in the past, we hadn't conducted this type of an in-depth examination before.
Page 89 PREV PAGE TOP OF DOC Mr. BACHUS. You probably should have, right?
Mr. FALCON. I would have liked to have done it previously, yes, now that we know what we know.
Chairman BAKER. One more question, sir.
Mr. BACHUS. On September the 20th, you were meeting with the Fannie Mae board. You all were going to present to them your findings, is that correct?
Mr. FALCON. Yes.
Mr. BACHUS. And you had not made that known to the public at that time, had you?
Mr. FALCON. Right.
Mr. BACHUS. And I know everybody was waiting on that meeting. And then that morning I recall picking up The Wall Street Journal and seeing it pretty much laid out as to what you all's report was going to show in detail. That is a violation of your own rules, isn't it?
Mr. FALCON. Right. We did not authorizeI did not authorize the release of any information about what we were about to do at the board. All I can tell you is, the Friday before that Monday, we did bring some other federal agencies in the process in an effort at interagency cooperation to let them know what we had found and what we were about to do. Now, that Friday we had also had discussions with some board members, in order to get them to convene the meeting for Monday.
Mr. BACHUS. But somebody disclosed what was then nonpublic information. I know that is a violation of you all's guidelines and every agency's. I think your guideline 105 prohibits the disclosure of nonpublic information regarding a regulated entity and actually provides civil and criminal penalties. So somebody would have had to violate that guideline, would they not?
Page 90 PREV PAGE TOP OF DOC Mr. FALCON. If it was someone in the company, within the agency
Mr. BACHUS. Or in another agency, then they would have
Mr. FALCON. Well, our guideline only applies to us. If you are citing our guideline, it only applies to OFHEO and not
Mr. BACHUS. Have you done anything to identifyor, were you concerned about that, when you saw that that nonpublic information had been disclosed in violation of your own rules and regulations?
Mr. FALCON. I am always concerned about information that shows up in the public domain
Mr. BACHUS. Have you all tried to identify the individual or individuals who violated these rules?
Mr. FALCON. I am not sure, Congressman, what shows up in the newspaper, whether it is conjecture, speculation. There is an insatiable rumor mill that circulates around everything
Mr. BACHUS. Actually, it was specific in what they
Mr. FALCON. It is hard for me to discern what is speculation and what is based on a leak and what is based on some authorized release of information.
Mr. BACHUS. You saw that report. It was pretty apparent that they had to have inside information.
Mr. FALCON. I have seen speculation about what we might do for months and months now, based on what knowledge people had about what we did with Freddie Mac.
Mr. BACHUS. Okay.
Chairman BAKER. Mr. Bachus, you have used almost twice your time. You are, like, 5 minutes over.
Page 91 PREV PAGE TOP OF DOC Mr. BACHUS. I am sorry.
Mr. FRANK. And you are not going to get an answer, no matter how you ask, so you might as well move on.
Chairman BAKER. Let us see, Mr. Watt, I think you are next.
Ms. Waters is next?
Okay. Ms. Waters?
Ms. WATERS. Thank you very much, Mr. Baker.
Mr. Falcon, you have been before this committee before. And you were pretty much on the hot seat on more than one occasion, where you were accused of not doing a good job, not exercising your oversight responsibility, of being incompetent.
And I think a number of members you talk with following those hearings, where you not only ask for support but try to make the case why OFHEO should remain. Is that true?
Mr. FALCON. No, I have actually supported a regulator with all the authorities and powers and resources to do his job, even if it means abolishing my agency.
Ms. WATERS. Did you seek support for yourself and for your agency following the criticism that was reaped upon you in this committee? Did you talk to any members of Congress?
Mr. FALCON. Oh, yes, I have
Ms. WATERS. All right, thank you.
I would also like to know a little bit more about what has happened since the time that you came under such criticism and how you got to this point. You talked about when you first decided that you were going to do this investigation on Fannie Mae.
Did you at any time talk with any members of Congress during the time of this investigation about what you were doing, seek any advice, get any suggestions, any members or their staffs? You are under oath.
Page 92 PREV PAGE TOP OF DOC Mr. FALCON. I recall questions from various members of Congress in the Senate who
Ms. WATERS. Did you talk to any members of Congress or their staffs about this investigation, seeking advice, getting advice, accepting suggestions, hearing suggestions about this investigation?
Mr. FALCON. Asking advice aboutnot for the purposes of trying to get advice from a member of Congress about what we should look at
Ms. WATERS. So you did talk with some members of Congress or their staffs while you were in the process of this investigation. Is that correct?
Mr. FALCON. Yes.
Ms. WATERS. All right. Did any member of Congress or their staff offer support for OFHEO or you in exchange for suggestions or give you ideas about how you ought to approach this investigation?
Mr. FALCON. Absolutely not.
Ms. WATERS. Did you report to the chairman of this committee, this subcommittee, or the chairman of the overall committee or the ranking member of this committee at any time during this investigation about what you were doing?
Mr. FALCON. Absolutely not.
Ms. WATERS. Let me go one by one.
Did you, at any time, report to the chairman of this entire committee, Mr. Oxley, about what you were doing?
Mr. FALCON. About theno. But
Ms. WATERS. About the investigation, anything that you were doing or undertaking in the investigation.
Mr. FALCON. No.
Page 93 PREV PAGE TOP OF DOC Ms. WATERS. Did you, at any time, talk with Mr. Baker about whatever was going on in the investigation? Did you seek advice, did you get any advice, did you have any conversations with him about the investigation?
Mr. FALCON. I have not sought any advice, any guidance about how tofrom any member of Congress
Ms. WATERS. Did you talk with Mr. Baker
Mr. FALCON. No.
Ms. WATERS.about the investigation at any time or his staff?
Mr. FALCON. No. It would have been improper for me
Ms. WATERS. That is all I want to know. Did you talk with Mr. Baker or his staff at any time during this investigation in any shape, form or fashion, whether it was seeking advice, just hearing advice, advising about what you were doing? That is all I want to know. Did you? Yes or no?
Mr. FALCON. Let me answer the question. I did speak to several members of Congress about the investigation, about the need for funding for the investigation
Ms. WATERS. But I specifically asked about Mr. Baker at this point.
Mr. FALCON. Oh, Mr. Baker, yes, and other members of Congress
Ms. WATERS. All right. Thank you.
Mr. FALCON.including other senior members of the committee about the investigation and my need for resources to keep this thing going.
Mr. FRANK. Would the gentlewoman yield?
Page 94 PREV PAGE TOP OF DOC Ms. WATERS. Yes, I will yield to the gentleman from Massachusetts.
Mr. FRANK. I just want to make clear that I was never told or any way informed. My understanding was the Republican leadership was informed before this broke that this was about to break. But I want to make it clear: No one on the Democratic side received any notice. And I do believe there was, unfortunately, notice on the Republican side in advance.
Ms. WATERS. Taking back my time, this is not simply about notifying about this hearing. This is about what was going on in the investigation, how it was being approached, what was being done.
Were you talked to at any time?
Mr. FRANK. No. As I said, I didn't even get the notice that others got that it was happening, and so we had never heard anything.
Ms. WATERS. Okay. Then that is well made.
Now, did you discuss the 30 percent reserve with any members of Congress and get a suggestion about that amount prior to concluding that that was the amount that should be in reserve?
Mr. FALCON. No.
Ms. WATERS. Did you talk with any staff member?
Mr. FALCON. No.
Ms. WATERS. This, again, based on the questioning of Mr. Barney Frank, was an amount that you came up with but that amount was not based on any calculations, any research that would indicate that this would be the proper amount in reserve. You did not have any supporting documentation for that, is that correct?
Mr. FALCON. We arrived at the 30 percent requirement because we thought that was prudent from a safety and soundness standpoint, given the weaknesses in management and operations, given the uncertainties of the financial statements
Page 95 PREV PAGE TOP OF DOC Ms. WATERS. I am asking about your documentation. Did you pull it out of the thin air? Did you pull it out of air? Did you have some documentation? Did you have something to compare it with? How did you get the 30 percent?
Chairman BAKER. And that would need to be theif I may, that would need to be the lady's last series of questions.
If you would respond, because the gentlelady has exceeded her time significantly. Would you please respond to the gentlelady's question?
Mr. FALCON. Congresswoman, we basedI based that decision, using my judgment about what was appropriate, prudential in order to ensure the safety and soundness of this company. Given the uncertainties about their balance sheets, given the operational weaknesses, there was precedent for this with Freddie Mac, I took action that I thought was essential to make sure that this company, that its safety and soundness was ensured.
And we arrived at 30 percent because there is a 30 percent management and operations risk in the statute for risk-based capital, so we simply applied the same standard to the minimum capital.
Ms. WATERS. You had no documentation.
Thank you. I yield back the balance of my time.
Chairman BAKER. Mr. Watt?
Mr. WATT. Mr. Chairman, Mr. Davis from Alabama has a bill on the floor and I would like to defer to him, if it is okay.
Chairman BAKER. Oh, I am sorry, Mr. Manzullo, you have been patiently waiting.
I should go to Mr. Manzullo first, and then I will come back to Mr. Davis.
Mr. MANZULLO. Thank you.
I am reading page 11 about the actual amount of the bonuses.
Page 96 PREV PAGE TOP OF DOC Mr. Johnson got a $1.9 million bonus on a salary of $966,000; Mr. Raines, $1.1 million bonus on a $526,000 salary; Lawrence Small, $1.1 million on a salary of $783,000; Jamie Gorelick, $779,000 bonus on a salary of $567,000; Timothy Howard, $493,000 on a salary of $395,000; and Robert Levin, $493,000 bonus on a $395,000 salary.
These are annual bonuses. Is that not correct? Every year they have a bonus?
Mr. FALCON. Yes.
Mr. MANZULLO. And so this is what they make. This is just for 1998. Is that correct?
Mr. FALCON. That was the amount of the AIP award and bonus.
Mr. MANZULLO. What you see on page 11 is nothing less than staggering. Because you state that the earnings-per-share range, the minimum payout is $3.13, the maximum was $3.23, with a target of $3.18.
And just by happenstance, coincidence, you could almost say on your terms that for Fannie Mae to pay out the maximum amount in annual incentive payment awards in 1998, the earnings per share would have to be $3.23. It is below the $3.13 minimum payouts threshold, no bonus would occur.
And then you state, remarkably, the 1998 earnings-per-share number turned out to be $3.23 and nine mills, a result that Fannie Mae met the EPS maximum payout goal right down to the penny, and that if they had used the correct accounting practiceswhich you say in your testimony, accounting violations cannot be dismissed as mere differences of interpretation, Fannie Mae understood the rules and simply chose not to follow them, but if Fannie had followed the practices, there would not have been a bonus that year. Is that not correct?
Mr. FALCON. That is right, Congressman.
Mr. MANZULLO. Well, what are you saying here? Are you saying this is coincidence? Or did somebody cook the books to come up with $3.23 and nine mills so they got the maximum payment.
Page 97 PREV PAGE TOP OF DOC Mr. FALCON. I think what we are saying is, there are very strong appearances that the management did, in this instance, improperly defer $200 million of this $400 million expense to the next year for the purposes of achieving these bonus targets.
Mr. MANZULLO. So the main purpose was so they could get their bonuses. That is what you just said.
Mr. FALCON. Yes, in addition to the appearances of smoothing earnings.
Like I said, this was the beginning of the implementation of their catch-up in their FAS 91 accounting policies which allowed them to utilize this amount to project smooth earnings over time.
Mr. MANZULLO. I find this staggering. This is absolutely astonishing when the oversight organization says that Fannie Mae projected its earnings and did its accounting practices for the reason so that the executives could get the maximum amount of their bonus. That is your conclusion?
Mr. FALCON. That certainly how it appears to us, yes.
Mr. MANZULLO. And did you look at bonuses for any other years besides 1998?
Mr. FALCON. We have information about the bonuses for the yearsyes, and it actually included the information that was given to Chairman Baker.
Mr. MANZULLO. Can you tell us what the bonuses were for subsequent years to 1998?
Mr. FALCON. I believe for the top five individuals, it is a matter of public record because of the disclosures under the securities laws.
Mr. MANZULLO. Were they similar amounts, do you recall offhand?
Mr. FALCON. I believe they were similar, yes.
Page 98 PREV PAGE TOP OF DOC Mr. MANZULLO. Did your research, investigation, look at any other years besides 1998 to see if you came up with similar conclusions?
Mr. FALCON. We have not to date, I believe, found a transaction like the one in 1998, which was deferred to another year with the fact of resulting in full bonuses as opposed to no bonuses.
We have not yet found a similar type transaction in similar years, in subsequent years, but we certainly do see the fact that the policy of managing their earnings occurred over time at the same that their Challenge Grant Initiative was put forward.
Mr. MANZULLO. So this is all based upon the fact that you are paid according to theyou get your bonus according to the earnings per share, regardless how you get those.
Mr. FALCON. That is the metric that is contained in their compensation program.
Chairman BAKER. Mr. Manzullo, you have expired your time, but you have one wrap-up.
Mr. MANZULLO. I do have one final question that speaks for itself.
I believe on page 12 that says that if they had done the correct accounting method there would not have been a bonus that year.
Mr. FALCON. Yes, that is right.
Mr. MANZULLO. Thank you.
Chairman BAKER. I thank the gentlemen.
Mr. DAVIS. Thank you, Mr. Chairman.
Let me thank my friend from North Carolina for yielding.
Page 99 PREV PAGE TOP OF DOC Mr. Falcon, when Mr. Lynch was questioning you earlier, you said something that really caught my attention. You said that you wanted to avoid making any broad and categorical statements until the investigative process was complete.
Do you remember saying that?
Mr. FALCON. Yes.
Mr. DAVIS. That sounds like a good goal, and I think that is exactly the stance that one would want from someone in your position.
So in light of that, let me ask you about several observations that you have made and see if they meet the standard that you set out.
Mr. Manzullo asked you a number of questions and others have asked you questions about the motivation for the expenses, and you said fairly directly that you think that the motivation was to pave the way for bonuses, or to create an appearance of earnings to justify bonuses.
Is that not a pretty broad and categorical statement on your part?
Mr. FALCON. It is.
Mr. DAVIS. And second of allif I can continue, as my time is limitedyou made the observation or response to someone's questionswhere you were asked rather point blank: Would it be in the interest of Fannie Mae if there was a change in the management structure?
Do you recall those questions?
Mr. FALCON. Would it be in the interest
Mr. DAVIS. You asked if it would be in the interest of Fannie Mae if there were a change in the management structure.
Mr. FALCON. Yes, we had that.
Mr. DAVIS. And I think your answer was in the affirmative that it would be. Do you recall that?
Page 100 PREV PAGE TOP OF DOC Mr. FALCON. I think what I said was, we were going to assessthat the question before us was whether or not we had sufficient confidence in this management team going forward, trust that they could properly implement this plan of remediation and have the confidence of both us and the board going forward to properly run this company in compliance with all the rules and regulations.
Mr. DAVIS. You had various questions about the management structure.
Mr. FALCON. Yes, yes, I did.
Mr. DAVIS. Is that not a pretty broad and categorical statement to raise questions about the management structure?
Mr. FALCON. It is.
Mr. DAVIS. Furthermore, you make a pretty broad statement in your reportin fact, I think I am quoting from youthat there was a pervasive and willful misapplication of GAAP in two critical areas.
Is that a quotation from your report?
Mr. FALCON. Yes.
Mr. DAVIS. Is the reference to a pervasive and willful misapplication a pretty broad and categorical statement?
Mr. FALCON. It is, about these two accounting areas.
Mr. DAVIS. So let me put this in perspective, because I agree with your honesty in all four of those answers, those are very broad statements.
One of the things that has been raised by several of my colleagues on this side of the aisle has to do with: As I would characterize it, does OFHEO have the appropriate level of arms-length relationship that is needed with Fannie Mae?
Several of my colleagues have made the point, and I make the point to you now, that as I understand the mission of OFHEO, it is to be a regulator, it is to assess the safety and soundness of the institution that you are regulating.
Page 101 PREV PAGE TOP OF DOC The SEC has the responsibility of making judgments about whether accounting fraud occurred.
This body has the responsibility of making judgments about the proper policy course.
And the Justice Department has the responsibility of making proper judgments about whether a criminal act has happened.
Have I gotten the division of labor just about right, from what you know?
Mr. FALCON. There is some overlap
Mr. DAVIS. There is some overlap, but do I basically have it right?
Mr. FALCON. Yes.
Mr. DAVIS. A concern that I haveand I want to give you a chance to respond to itbut a concern that I have is you are making very specific, what you have correctly acknowledged, broad and categorical judgment about the management of this institution, about the willfulness of practices that may or may not be in controversy.
You have imputed various motives to the people running the organization.
You went to the board and put a 48-hour ultimatum on them without having any specific regulatory authority to put that kind of ultimatum on them.
That sounds like some kind of an invisible line has been crossed. That sounds to me as if you have gone from being a dispassionate regulator to someone who is very much involved and has a stake in this controversy.
And I will follow up on Ms. Waters's point because I think it is very well taken: Her observation is that the political context surrounding your investigation was that serious doubts were being raised about OFHEO.
In fact, frankly, doubts were raised about your leadership of OFHEO. And all of a sudden, the response to that is to produce an enormously critical report.
Page 102 PREV PAGE TOP OF DOC My concern is that OFHEO has jumped off the fencewhere it should be, if it is a dispassionate regulatorand has somehow gotten involved in the business of taking a side in this controversy.
Now, I will give you a chance to respond to that.
Mr. FALCON. Well, Congressman, I appreciate the time to respond.
The categorical statements that I was referencing to with Mr. Lynch was, he asked me to make a broad categorical statement as to whether or not we had Enron-like fraud going on with this company.
Mr. DAVIS. No, sir. You said that you had a problem with making broad and categorical statements. And your instinct is right.
The reasonand I will make this my last pointthe reason that you do not want to make broad and categorical statements I suspect is because the ultimate concern of OFHEO ought to be the safety and soundness of Fannie Mae.
Is it possible that by casting all of these dispersions and all of these doubts upon the board at Fannie Mae, and upon the structure of Fannie Mae, that you potentially are weakening this institution in the market, that you are potentially weakening the housing market in this country?
Are those possible consequences from the very broad and sweeping generalizations you have made about this institution?
Mr. FALCON. Well, first off, we may disagree on this, but it was not what I was telling the congressman about the type of categorical statements
Mr. DAVIS. No, please answer the last question that I asked you.
Chairman BAKER. And if you would, sir, begin to wrap up
Page 103 PREV PAGE TOP OF DOC Mr. DAVIS. I will, and then I will wrap up on just a point, but I do not want you to answer any question other than the one I just asked you, because our time is so limited.
Is it possible and is it a reasonably foreseeable consequence that these kinds of amputations, these kinds of insinuations about the board, could end and of themselves damage the safety and soundness of Fannie Mae by weakening its position in the market? Is that possible?
Mr. FALCON. Our actions are all designed for the safety and soundness of this
Mr. DAVIS. Is that possible?
Mr. FALCON. If we did our job properly perhaps, but we have not.
Congressman, let me just say, I understand your politics running all the issues.
Mr. DAVIS. No, I am just asking
Mr. FALCON. We are just trying to do our job as a regulator. You can question my motives, my judgment, even my qualifications
Mr. DAVIS. That is not the question I am asking.
With all due respect, Mr. Chairman, that is not the question I am asking.
Mr. FALCON.but that will not change the contents of this report.
Mr. DAVIS. Is it possible that the market standing of Fannie Mae could be weakened by your testimony?
Chairman BAKER. Please be responsive to him.
Mr. FALCON. It is possible. And if does
Page 104 PREV PAGE TOP OF DOC Mr. DAVIS. Thank you, you have answered my question.
Mr. FALCON.course of actions we have taken, it is because of what the company has done, as we have outlined in this report.
Chairman BAKER. The gentleman's time has expired.
Ms. Hart, did you now have questions? Ms. Hart?
Ms. HART. Thank you, Mr. Chairman.
We have been watching this drama play out a little bit. As you know, the committee has considered a number of different proposals that actually would change your position, as far as being the regulator for GSEs.
And one of the things that I know during this debate that you have been seekingand I think it is importantis to separate the roles of chairman of the board and CEO at both Fannie and Freddie. And I know that Freddie has agreed to do this, but from my understanding, up to this moment, Fannie Mae has not agreed to do this.
Can you tell us, first of all, as far as the agreement that you have with them goes, is there anything involving that in the agreement that you have with them and why you think that is important to have that separation happen?
Mr. FALCON. The agreement does not specifically cover the separation of the chair and CEO positions. It does require a review of the organizational structure to address issues of possible conflicts in different positions and functions.
We do have a corporate governance rule pending which would separate the position of chair and CEO. And we have proposed that and are moving toward a final rule on this because we found that, based on the situation at Freddie Mac, that this was just best corporate practice for these government-sponsored enterprises.
We found that the board could not properly fulfill its role as overseer over management as long as the CEO was also the chairman of the board of the company. And so, we entered an agreement with Freddie Mac, whereby they agreed to separate the positions.
Page 105 PREV PAGE TOP OF DOC And I must say that, to the board's credit, that didn't take much persuasion. I think they saw that this was appropriate in themselves. And so, they took this step. And with this corporate governance rule being in place, soon I hope, we will then require the same thing of Fannie Mae.
Our report on Freddie Mac certainly highlights the need for a government-sponsored enterprise which has imperfect market discipline to have a separation of these positions.
Ms. HART. If that is such an important point, why is your instruction in the agreement with Fannie so general?
Mr. FALCON. Well, because we intend to deal with this through our corporate governance regulation, while the overall issues about organizational structure get addressed by the board and us.
Ms. HART. Okay. I yield back. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Ms. Hart.
Mr. Watt, in the interim Mr. Crowley appeared, and he was ahead of you.
Mr. CROWLEY. Thank you, Mr. Chairman.
Thank you, Mr. Falcon, for being here today, and thank you all for testifying.
I just want to go back a little bit of ways in the hearing. I was in the back room prior to the break for votes when Mr. Shays was asking you a number of questions. And in response to a question from Mr. Shays, you suggested, at least as I interpreted it, that investors could be harmed by the actions taken by Fannie Mae.
Could you tell me where that is in your report? Do you have that in your report?
Page 106 PREV PAGE TOP OF DOC Mr. FALCON. I think potential harm exists because of inaccurate financial statements being issued by the company.
Mr. CROWLEY. Is that an observation of yours, or is that in the report itself?
Mr. FALCON. It is in the report.
Mr. CROWLEY. Where in the report is that?
Mr. FALCON. The fact that we think that the company has issued inaccurate financial statements as a result of these accounting practices? I would have to go through and find the exact
Mr. CROWLEY. If you don't mind, I would like to know, if you can. Maybe your staff can let my staff know where in the report that is.
Mr. FALCON. Absolutely.
Mr. CROWLEY. Just on Mr. Davis's line of questioning, which I thought was excellent, what effect do you think this report will have on the mortgage market?
Mr. FALCON. I think what we have seen to date is that the mortgage market has functioned well. There is continued liquidity being moved into the mortgage market. And despite Fannie Mae's problems, as found in this report, there haven't been any real disruptions in the mortgage market.
Mr. CROWLEY. Do you anticipate there will be any disruptions in the mortgage market because of this report?
Mr. FALCON. As long as the markets and the public see that we are working to take prompt corrective action
Mr. CROWLEY. Yes or no?
Mr. FALCON. No.
Mr. CROWLEY. No, you do not.
Page 107 PREV PAGE TOP OF DOC Do you believe that this report shows any evidence that Fannie Mae may be departing from its mission of increased homeownership through making homeownership more affordable in this country?
Mr. FALCON. The report did not address that point.
Mr. CROWLEY. For example, I know Mr. Raines has pledged to create 6 million new homeowners, including 1.8 million minority homeowners, by 2014. Do you believe this goal may be threatened now because of this report?
Mr. FALCON. I don't think
Mr. CROWLEY. I am going to ask Mr. Raines the same question, but
Mr. FALCON. As long as the company is maintaining its adequate capital, as long as we have taken proper steps, along with the cooperation of the company, I think we will minimize any damage to their ability to meet their affordable housing goals.
Mr. CROWLEY. Let me finallythank you. Let me finally ask you, while there are some things in this report that are damaging, in the text itself, it is the SEC, I believe, and not OFHEO that has the final say over whether or not Fannie Mae must restate past earnings. Is that correct?
Mr. FALCON. Yes. Ultimately the SEC has to decide whether their statements issued pursuant to laws were accurate.
Mr. CROWLEY. And some have argued to me that there is more than an even chance that the SEC may disagree with the most damaging allegations, such as accounting or derivatives and delayed recognition of expenses. Is that correct?
Mr. FALCON. I guess some have predicted that. I cannot speak to what others might predict. All I know is that we find these issues to be very clear violations of GAAP. And we feel confident that once the SEC takes an objective look at this, that they will come to the same conclusions that we have and that Deloitte & Touche has.
Page 108 PREV PAGE TOP OF DOC Mr. CROWLEY. Thank you.
Mr. FRANK. Would the gentleman yield to me?
Mr. CROWLEY. Yes, I will. I yield to the gentleman from Massachusetts.
Mr. FRANK. I thank the gentleman.
And I appreciate the answers, Mr. Falcon, you gave to Mr. Crowley. But it makes me even more disturbed that you, both in your written statement and again, sort of threw ''safety and soundness'' around almost like kind of boilerplate.
I think you just accurately answered the questions that, no, if everything works out as we expect it to, there are no threats, et cetera, thisyou seem to be saying, ''Well, these are in areas which could raise safety and soundness problems.'' I don't see anything in your report that raises safety and soundness problems. Your answers to Mr. Crowley certainly didn't indicate that there were.
How does this raise safety and soundness problems, other than the kind of, frankly, almost ritualistic saying, ''Well, these are areas where safety and soundness could be implicated presumably if it went far enough''?
But I think it is irresponsiblelet me be very clearon the basis of this report and what you have concluded so farI mean, we have earnings smoothed out. With regard to derivatives, you have told you me you cannot even say at this point whether they have under-reported or over-reported earnings.
How does this threaten the safety and soundness, what you have uncovered, of Fannie Mae?
Mr. FALCON. Just the very fact that we have serious doubts about the accuracy of the financial statements and their books and records, the very fact that we have identified very serious internal controls
Page 109 PREV PAGE TOP OF DOC Mr. FRANK. Well, let me ask a question. Does any accuracy threaten the safety and soundness? That is what bothers me. There is a quality and a quantity issue here.
There are inaccuracies that can be disturbing, and if they led to inappropriate compensation, I would be very unhappy. But the notion that any inaccuracy implicates safety and soundness, I think, based on what you have said here, where you cannot even concludeyou have said you cannot even quantify any potential amount of loss. To throw ''safety and soundness'' around in that thing I think really is, for a regulator, irresponsible.
Mr. FALCON. Well, I think internal controls are a very serious safety and soundness concern. A breakdown or a lack of internal controls
Mr. FRANK. Do you think the safety and soundness is at risk right now?
Chairman BAKER. Mr. Crowley, that will have to be your last question. If you can wrap up.
Mr. FRANK. He accepts that.
Mr. CROWLEY. That was my first question, as a matter of fact.
Mr. FRANK. Yes, I mean, you have just told Mr. Crowley it didn't implicate safety and soundness. Does it, your report, what you have reported?
Mr. FALCON. No, I think our report absolutely does implicate safety and soundness.
Mr. FRANK. Is the safety and soundness at risk now?
Mr. FALCON. Are they at risk of becoming insolvent right now? No. We have an agreement with the board in place that will address these problems, provide an adequate capital cushion. We think we
Mr. FRANK. That is the answer. The rest is just rhetoric.
Page 110 PREV PAGE TOP OF DOC Chairman BAKER. The gentleman's time is expired once over.
Mr. OSE. Thank you, Mr. Chairman. I yield 15 seconds to Mr. Shays. And I am counting.
Mr. SHAYS. Thank you.
I would just like to say to you, Mr. Falcon, what you have done is you have exposed illegal activity on the part of Fannie Mae, and you are being criticized for exposing it. If they have a safety and soundness problem, or if the markets are impacted, it will only be impacted based on what Fannie Mae did.
And I just want to congratulate you. You have more courage than I realized you had, because the messenger is being shot and not the person who did the wrongdoing. I have seen it here in this committee, and I am pretty outraged by what I am seeing.
Congratulations for what you have done.
Ms. WATERS. Would the gentleman yield?
Mr. OSE. Let me ask myit is my time.
Ms. WATERS. Would the gentleman yield?
Chairman BAKER. It is Mr. Ose's time, and I think he wants to reclaim it.
Mr. OSE. I do want to reclaim it.
Ms. WATERS. Oh, he is reclaiming his time?
Mr. OSE. Mr. Falcon, I follow this stuff very carefully because, having weathered the storm on the games-playing that took place in some of the energy companies, I am very, very sensitive to what might be occurring in the financial markets underpinning the housing market.
If I understand correctly, there are questions as to the validity of the numbers on an ongoing basis within the enterprise known as Fannie Mae.
Page 111 PREV PAGE TOP OF DOC Now, Fannie Mae's securities are held as tier-one capital by any number of additional institutions. My concern here is not so much the direct impact but perhaps the indirect impact that might manifest itself as a result of manipulation of earnings.
Could you speak to that issue? In other words, the secondary impact, if you will, outside of Fannie Mae, is that a possible consequence for banks holding Fannie Mae's securities as tier-one capital?
Mr. FALCON. The banks holdings in the debt of Fannie Maeif there is somemight have undue concentration in Fannie Mae debt as a percentage of the total capital, if the problems were not addressed quickly with Fannie Mae such that we remedied the concerns that we have found, I think the bank regulators might have some concern about the devaluation in what is being held as capital of some financial institutions.
Mr. OSE. This is exactly the point that I think OFHEO properly has made, is that this issue is not constrained to the enterprise we know as Fannie Mae. This issue goes beyond the enterprise we know as Fannie Mae. That is why it is so important that the numbers that Fannie Mae reports accurately reflect the enterprise's activity. If they do not reflect the enterprise's activity, there are significant adverse effects outside the enterprise that we would end up being called upon to deal with.
That is why I am, frankly, pleased to see you bring this to our attention. I am troubled by what I hear. I am looking forward to the witnesses that follow you. And I thank you for your work.
Chairman BAKER. Would the gentleman yield?
Mr. OSE. And I yield to the Chairman.
Chairman BAKER. I would just like to point out to the gentleman, there is approximately 8,400 insured federal depository institutions. Of that number, in excess of 3,000 institutions hold 100 percent, not 50, not 70, 100 percent or more of their required tier-one capital in GSE securities.
Page 112 PREV PAGE TOP OF DOC It is of extraordinary consequence we fully understand that the financials are indeed accurate, because an impairment in the issuance of debt, it would not require the insolvency of an enterprise, merely an impairment in the ability to issue debt. If the regulator increases capital requirements, where are they going to go to raise the capital?
So I think the gentleman has raised an excellent point I think heretofore has not been recognized. I thank him for yielding.
Mr. OSE. I yield back the balance of my time.
Chairman BAKER. Mr. Watt?
Mr. WATT. Thank you, Mr. Chairman. And again, thank the Chairman for allowing the nonmembers of the subcommittee to participate.
I think I may be the last questioner, so I want to try to follow up on a couple of things. Number one, Mr. Bachus, I believe it was, asked about the leak the morning of the day you met with the Fannie Mae board.
My question to you is, are you undertaking any internal investigation to determine whether that leak was inside your shop at present?
Mr. FALCON. I will.
Mr. WATT. Are you presently, or you are planning to in light of the comments that were raised today?
Mr. FALCON. Yes.
Mr. WATT. Okay.
Mr. FALCON. And I guess I would also ask
Mr. WATT. That is all I need to know.
Second, you made reference in response to questions that Ms. Waters asked to at least some conversations with members of Congress leading up to the time that you had the meeting with the board of Fannie Mae.
Page 113 PREV PAGE TOP OF DOC Would you be kind enough to provide to the chairman and the ranking member of this subcommittee a list of those contacts and the contents of those contacts? I don't expect you to have that with you today, but would you provide that to the chairman and ranking member?
Mr. FALCON. Sure, Congressman.
Mr. WATT. Okay. Now, let me kind of zero in on the bottom lines, as I have gathered them, and contrary to what Mr. Shays is saying, I am not second-guessing whatever conclusion the study. But I do have some problems with the timing of the release of this information.
Is it correct that you have not concluded whether the derivative conduct that you describe in your report either resulted in an overstatement or an understatement of Fannie Mae earnings?
Mr. FALCON. Right. The next step
Mr. WATT. Okay. Just, is that correct?
Mr. FALCON. Yes.
Mr. WATT. Okay. And, now, since we have separated out that, we don't know what the financial consequence of that is.
Let me go to the primary thing that I want to get at, and this is at the bottom of page three of your statement. Right near the next-to-the-last sentence there you say, ''Fannie Mae improperly delayed the recognition of income to create a 'cookie-jar' reserve that it could dip into whenever it best served the interest of senior management.''
Now, the word ''cookie-jar'' makes it sound pretty small, but in actuality, the specific incident you are talking about related to $400 million in 1998. Is that correct?
Mr. FALCON. Yes.
Mr. WATT. And what you are saying is that in 1998, Fannie Mae made a decision to recognize only $200 million of that and then amortized the rest of it over 1999. Is that the bottom line on what you are saying?
Page 114 PREV PAGE TOP OF DOC Mr. FALCON. Yes.
Mr. WATT. Now, is it also then true that for 1997 and prior years, there would have had to be an understatement of revenue or income for Fannie Mae in order for Fannie Mae to have been able to create this ''cookie jar''?
I mean, is that not what this means when you say they improperly delayed the recognition of income. Does that not mean that in some years to prior to 1998, they did not recognize income so they understated income. Is that not what that means?
Mr. FALCON. I do not believe so. I would like to have my chief accountant to explain to you, but I think it was just a function of
Mr. WATT. Yes, well, tell your chief accountant to tell me what this means.
Mr. DICKERSON. The ''cookie jar'' is really a Securities and Exchange Commission term of art for
Mr. WATT. I do not care about the term itself, but you cannot create a reserve in a cookie jar without having created some consequences to prior earnings. Is that correct, Ms. Deleo or whoever it is that is going to answer it?
Mr. DICKERSON. Congressman, our analysis and our special examination did not go back beyond
Mr. WATT. I understand that. That is not the question I am asking. But you cannot really determine whether there was an overstatement or an understatement of earnings over time at Fannie Mae without going back beyond 1998, can you?
If they were creating a reserve that was supposed to level out earnings, they had to understate at some point and overstate at some point. Is that not correct?
Mr. DICKERSON. Well, Congressman, our examination found that there was $400 million
Page 115 PREV PAGE TOP OF DOC Mr. WATT. I understand that. I have acknowledged that. I went through that in some detail and you went through it some detail.
The question I am asking is: In order to create the cookie jar reserve, would there not have had to be an understatement of income at some point just as there was an overstatement of income at some point?
Chairman BAKER. And someone please try to answer his question. The gentleman's time has expired.
Mr. WATT. I thought it was a pretty simple question myself.
Mr. DICKERSON. It was after this experience in 1998 that Fannie Mae implemented policies to create these cookie jar reserves beginning in 1999
Mr. WATT. How can you say that and you did not even look at 1997? You do not know whether the cookie jar was already there or not, do you?
Mr. DICKERSON. I cannot really speak to the years before 1998, sir.
Mr. FALCON. Congressman, I think what you are getting at is: Was this there in 1997 and they just carried it forward or something to that effect.
This $400 million showed up in 1998 as a result of the change in interest rates and the amortization
Mr. WATT. Well, what did they offset it against if there was not already a reserve? And how did they get the reserve if there was not already understated income at some point, or overstated income at some point?
I am just trying to figure outI mean, this is a balancing act, right? And the objective is to smooth out earnings. Is that not right?
Mr. FALCON. This came up as a result of a change in interest rates and a change in the amortization of the expenses related to the mortgages.
Page 116 PREV PAGE TOP OF DOC So it is not something that is necessarily what you are suggesting. It is more of a factor of the models showed that they
Mr. WATT. But is it necessarily what you are suggesting? That is the question.
Chairman BAKER. With that, the gentleman's time really has expired.
Mr. Director, would you care to respond to his last comment?
Mr. FALCON. No, Mr. Chairman.
Mr. FRANK. For something clear cut, that is pretty hard to explain.
Chairman BAKER. Mr. Director, on behalf of the committee I wish to express our appreciation for your courtesy with your appearance here today and for the work you do.
I know that, given the difficulty of this issue and strong opinions held by members from many perspectives, that the criticisms that you took today may be difficult for you and your staff to accept, given the length of time and the amount of effort you have put into production of this report.
I want to express our appreciation publicly for your effort, and be assured that our work going forward, like yours, will not stop with today's hearing.
Thank you very much, sir.
Mr. FALCON. Thank you.
Chairman BAKER. At this time I would like to ask our second panel participants to come forward, when it is possible.
At this time the committee welcomes our next two witnesses: Mr. Franklin D. Raines, chairman and chief executive officer of Annie Mae, and Mr. Timothy Howard, vice chairman and chief financial officer of Fannie Mae.
Page 117 PREV PAGE TOP OF DOC Gentlemen, by prior agreement with Mr. Kanjorski, it was determined that all witnesses appearing here today will testify under oath. Do either of you have any objection to testifying under oath?
Mr. RAINES. No, sir.
Mr. HOWARD. I do not.
Chairman BAKER. The chair also is required to advise you that the rules of the committee and of the House entitle you to be advised by counsel. Do you desire to be advised by counsel during your testimony today?
Mr. RAINES. No, sir.
Mr. HOWARD. Nor do I.
Chairman BAKER. In that event, let me ask you to rise and raise your right hand to affirm the oath.
Consider yourself sworn in, gentlemen. Thank you.
Mr. Raines, we would certainly proceed with your opening statement first. Your official statement of course will be made part of the record.
Normally we request that witnesses try to make their statement in 5 minutes. However, given the nature of the report in question and the importance to your organization, certainly we would want you to proceed as you deem appropriate.
Mr. RAINES. Well, thank you, Mr. Chairman.
STATEMENT OF FRANKLIN D. RAINES, CHAIRMAN AND CHIEF EXECUTIVE OFFICER, FANNIE MAE
Mr. RAINES. My name is Frank Raines. I am the son of Ida and Delano Raines. I grew up in Seattle, went to public school, graduated from college and law school. I am a brother, a husband, a father and friend.
Page 118 PREV PAGE TOP OF DOC For all but two of the last 25 years, I have been in the financial services business, and those 2 years I served our nation as the director of the Office of Management and Budget.
I am now the chairman and CEO of Fannie Mae. And Fannie Mae is the nation's largest source of funds for homeownership and rental housing for low-, moderate-and middle-income Americans.
We like to say we are in the American dream business.
I introduce myself in this way not because I am a stranger to this committee, but because I do not recognize the person, colleagues or company that someone described this morning.
But I nevertheless hope that I can make a contribution to a constructive dialogue this afternoon.
I do thank you, Chairman Baker, and I thank Ranking Member Kanjorski, and Chairman Oxley and Ranking Member Frank for the opportunity to be here.
We appreciate this opportunity to answer your questions about issues raised in the September of 2004 report by OFHEO of a special examination of Fannie Mae.
I would like to begin by noting that this is the first opportunity that Fannie Mae and its board are taking to respond in an official forum to the allegations set forth in the OFHEO exam report.
We take this report seriously.
Out of respect for the regulatory process and for OFHEO, we have sought with great diligence to follow an orderly process throughout the special examination, which is ongoing.
We have chosen not to respond ad hoc to questions about the exam report's content or conclusions. Instead, we will provide our responses in the appropriate forums, including through the boards independent review to the Securities and Exchange Commission and to the Congress.
Page 119 PREV PAGE TOP OF DOC So I appreciate that the committee has provided this forum today.
Some people have mistakenly concluded that the company's agreement with OFHEO constitutes an admission by the company to the findings and conclusions of the report.
Let me clarify that this is not the case. The agreement itself states that the company was not admitting or denying any wrongdoing as a result of signing the agreement.
Fannie Mae respects the role of OFHEO as our safety and soundness regulator. The strong oversight OFHEO provides is critical, given Fannie Mae's significant role in the U.S. housing finance system and the financial system as a whole.
In our view, from a decade of experience working with OFHEO, I believe that our overall safety and soundness regime makes Fannie Mae a better company.
OFHEO has more examiners per regulated company than any of the bank regulators.
OFHEO's risk-based capital standard is a model for financial institutions globally and goes farther than new risk-based capital models being proposed for financial institutions with more complex operations than Fannie Mae.
The best financial institutions will tell you the same thing. They welcome the exam process because it fosters cooperation in making the institution the best that it can be.
A confidential and cooperative examination process builds confidence, both the regulators confidence in the company, but also the company's confidence in its own safety and soundness.
Now, while this special examination unfortunately departed from standard financial institution examination procedures, our obligation remains the same: to make adjustments needed to respond to OFHEO's concerns, just as any financial institution would do with respect to its regulator.
That is why the company, led by our board, promptly entered in to a regulatory agreement with Director Falcon to make changes to our accounting, capital and internal controls and organization.
Page 120 PREV PAGE TOP OF DOC And let me thank our board members, particularly our presiding director, Ann Korologos, for their dedication and efforts on behalf of Fannie Mae in the past 16 days. Their diligence made it possible to quickly set forth an orderly process to resolve the concerns raised by the OFHEO report.
In conjunction with the agreement, the board's independent review committee has hired the law firm of Paul, Weiss, Rifkind, Wharton & Garrison to conduct an independent investigation, led by former Senator Warren Rudman, of all the allegations in the special examination report.
The issue of whether our implementation of FAS 91 and FAS 133 was consistent with generally accepted accounting principles remains with the SEC.
This agreement and these measures are important steps toward addressing the matters raised in the OFHEO report and a way to move forward. Adopting these measures will make Fannie Mae stronger and even better able to pursue our mission and the business that fuels our mission.
That mission, after all, is our central function. Congress chartered Fannie Mae to expand access to homeownership for low-and moderate-income Americans, and we are committed to that mission.
Earlier this year we announced the commitment to create 6 million first-time homebuyers, including 1.8 million minority first-time homebuyers, over the next decade, and to do our part to raise the minority homeownership rate to 55 percent and beyond.
By quickly reaching agreement with OFHEO where we could, we are able to maintain our mission focus.
For those that may be concerned that some of these steps, particularly the 30 percent capital surcharge, will constrain our mission activities, let me say this: Fannie Mae will do everything in our power to meet our commitments to expanding homeownership and affordable housing while also doing everything in our power to try to meet the requirements of the agreement.
Page 121 PREV PAGE TOP OF DOC Before I close, I would like to touch on the issues raised by the OFHEO report concerning our implementation of the accounting standards FAS 133 and FAS 91. These accounting standards are highly complex and require determinations over which experts often disagree.
First, the report alleges that in 1998 the company willfully violated GAAP in order to maximize executive bonuses. These are serious allegations. They concern events that occurred almost 6 years ago.
Importantly, I would note that the OFHEO report does not cite any documents or witnesses to support these allegations.
Upon reading of this allegation in the report, the company undertook to assemble the relevant facts. And we have learned of no facts and no other materials that support the allegation that the decision about the amount to book was related to bonuses.
Based on the facts as I understand them, the $240 million estimate was arrived at as part of an analysis conducted by our accounting and financial staff, independent of any considerations of compensation. Additionally, this analysis was documented at the time and was disclosed to and fully discussed with our independent auditor.
We intend to turn all of this factual information over to the independent committee of the board and its outside counsel for review.
Second, the report alleges that we misapplied GAAP with respect to two accounting standards, FAS 91 and FAS 133. We believe we applied those standards in accordance with GAAP, and our independent auditor, KPMG, reviewed our application of those standards and concurred.
Fannie Mae has previously issued and filed with the SEC financial statements that reflect the accounting and financial statement presentation that OFHEO has alleged to be inappropriate. Those financial statements were certified by me and by our chief financial office, Tim Howard, after a thorough process and audited by our independent auditor, KPMG.
Page 122 PREV PAGE TOP OF DOC Fannie Mae has not withdrawn those financial statements, and KPMG has not withdrawn its opinion that those financial statements were prepared consistent with GAAP in all material respects.
Rather, the issues that have been raised by OFHEO will be taken up directly with the staff of the SEC, which ultimately has the final authority over GAAP.
Our accounting staff has repeatedly determined that our policies and practices with regard to FAS 91 and 133 are reasonable and in accord with GAAP. And KPMG has issued unqualified opinions on our financial statements, and that remains their position today.
In fact, when I certify our financial statements, I certify that these documents fairly present, in all material respects, the financial condition, results of operations and cash flows of the company. That is a very serious statement, and I take it very seriously.
We engage in a rigorous due-diligence process before I ever put pen to paper and make that certification. I only certify after receiving assurance that I can say with confidence that our financial statements fairly present, in all material respects, the financial condition, results of operation and cash flows of the company.
Mr. Chairman, no one is more interested in a full and open examination of these issues than I am. I cherish this company. I believe in the mission that Congress challenged Fannie Mae to carry out. And I am inspired by the 5,000 women and men who come to work every day trying to help lenders help people get into homes.
Most of all, I believe that Fannie Mae's biggest challenge ahead is helping the financial system and mortgage industry to meet the growing and changing housing needs or our growing and changing nation.
This decade is expected to produce 30 million more Americans, who will create 13 million to 15 million new households. Minorities will represent 80 percent of that growth. And as a result, we estimate that 46 percent of future first-time homebuyers will be minorities and immigrants.
Page 123 PREV PAGE TOP OF DOC Serving their housing needs will require new ideas and innovations in mortgage financing. And we look forward to helping the industry with this challenge.
Given this public mission for which Congress created us and as an instrument of national housing policy, Fannie Mae expects and welcomes OFHEO's rigorous oversight to ensure that we are safe, sound, solid and stable for the long run. As I said the last time I appeared before this committee, strong oversight is in the best interest of Fannie Mae, our shareholders, financial markets and homeowners.
I want to make one thing very clear. I have always tried my best to ensure that our company does the right thing in the right way. And I believe to this day that we did.
If, however, after a thorough review of all the facts, it is determined that our company made significant mistakes, our board and our shareholders will hold me accountable. And I will hold myself accountable. That comes with being a CEO. I accepted that burden on the day I took the job, and I accept it today.
Thank you, Mr. Chairman and members of the committee. And I look forward to answering any questions that you may have.
[The prepared statement of Franklin D. Raines can be found on page 176 in the appendix.]
Chairman BAKER. Thank you, sir, for your statement.
Our next witness is Mr. Timothy Howard, vice chairman and chief financial officer of Fannie Mae.
Please proceed at your leisure, sir.
STATEMENT OF TIMOTHY HOWARD VICE CHAIRMAN AND CHIEF FINANCIAL OFFICER, FANNIE MAE
Mr. HOWARD. Good afternoon, Ranking Member Frank, Chairman
Page 124 PREV PAGE TOP OF DOC Chairman BAKER. Make sure that mic is on, or pull it a little closer. We can't hear you the way we should.
Mr. HOWARD. Is it on now?
Chairman BAKER. Yes, sir. Thank you.
Mr. HOWARD. Good morningor good afternoon, I should say. Thank you for inviting me to be here today.
I joined Fannie Mae in 1982 when the company was in the midst of a severe financial crisis brought on by flaws in its interest rate risk management. Under the leadership of David Maxwell, we were able to turn the company around and establish the solid financial footing that has enabled Fannie Mae to reliably provide hundreds of billions of dollars in affordable, fixed-rate mortgage financing to millions of low-, moderate-and middle-income Americans.
I consider it a privilege to have been able to devote the past 22 years of my career to this company and its mission. Throughout this time, I have tried my absolute best to do the right thing for the homebuyers Fannie Mae helps to serve, the employees I lead and the investors who have placed their trust in our company.
All of my judgments regarding accounting issues were made in openness and good faith, with the goal of providing investors with the most meaningful and understandable information possible.
When accounting issues arose, I worked with the head of my accounting policy group, who I know to be knowledgeable and highly respected in the industry. I also made certain that any accounting approaches we adopted were reviewed with our outside auditor.
I had a clear objective in guiding Fannie Mae's implementation of the two accounting standards that are at issue in the OFHEO report: FAS 133 and FAS 91. And that was to preserve the accuracy and utility to investors of our financial statements by reporting on what I honestly believed were the true economics of our business.
Page 125 PREV PAGE TOP OF DOC At all times, I believe that the accounting applications we adopted were within the boundaries defined by GAAP, as interpreted and understood by our accounting experts both inside and outside the company.
We filed financial statements with the SEC that were fully audited by KPMG, and as Frank said, Fannie Mae has not withdrawn these financial statements, and KPMG has not withdrawn its opinion that those financial statements were prepared consistent with GAAP in all material respects.
FAS 133 is widely considered to be the most complicated accounting standard ever issued. Its implementation had the potential to greatly reduce the clarity and utility of Fannie Mae's financial statements.
We recognized this challenge from the outset, but we did not attempt either to circumvent the standard or to violate GAAP to deal with it. Instead, we developed a separate earnings measure, core business earnings, to convey to investors our financial results in the absence of FAS 133.
FAS 91 requires that we estimate the average lives of the mortgages in our portfolio to determine the rates at which premiums or discounts on these mortgages should be amortized into our income statement.
By definition, this estimation process is imprecise. From the inception of FAS 91 in the late 1980s, we have used ranges to address this imprecision in estimating mortgage pre-payments. KPMG concurred with our use of a range.
Ultimately the SEC will resolve the issue as to whether our implementation of FAS 133 and FAS 91 is consistent with GAAP. This is entirely appropriate. And I look forward to receiving the results of their review.
It is important to note, however, that the matters to be reviewed relate to accounting judgments and not issues of risk management. Financially, Fannie Mae is as strong as ever, and our ability to carry out our mission remains intact.
Page 126 PREV PAGE TOP OF DOC I look forward to responding to your questions on these matters.
[The prepared statement of Timothy Howard can be found on page 169 in the appendix.]
Chairman BAKER. Thank you, sir.
Mr. Raines, prior to the decision being executed to defer the $200 million in expenses in the end of 1998 into the quarters of 1999, were you consulted or did you have knowledge of that proposed transaction?
Mr. RAINES. Mr. Chairman, first, let me be clear. There was no decision made to defer any expense from 1998 to 1999.
Secondand Mr. Howard can go into greater detail into how the process actually occursbut we did not make any deferral. I was part of a discussion, as I always am as the CEO, in our closing process in which the decisions made in our financial area with regard to the calculation of the catch-up provision was discussed. But the determination of that was made through our normal process of closing our books.
Chairman BAKER. So you did
Mr. RAINES. But Mr. Howard will be able to give you more detail.
Chairman BAKER. Sure. So that you were involved in a discussion about the amount of catch-up required. And your view is that was that a customary process, not a decision made with regard to this specific expensing item.
Mr. RAINES. That was a discussion that we would have at the end of each period, discussing a variety of issues related to closing the books of any given year.
Chairman BAKER. Were there any discussions related to the consequences of that expense treatment in relation to the EPS?
Mr. RAINES. No.
Page 127 PREV PAGE TOP OF DOC Chairman BAKER. When did you first realize that the earnings-per-share figure would be $3.23?
Mr. RAINES. The first time that I would know what the earnings figure would be is when our controller would have closed the books and done all of the analyses necessary to determine what the final results are and then that would be reported to me. That would be after any decision that was made with regard to the catch-up provision.
Chairman BAKER. Was there any discussion in which you participated relative to the determination of the catch-up amount?
Mr. RAINES. No, I did not participate in determining the amount of the catch-up. That was done, as I mentioned, within our financial function, which is their job.
Chairman BAKER. I know you are knowledgeable of the Fannie Mae's Challenge Grant InitiativeI believe that was something that was organized in your administration in 1999which initiated executive incentives for increased earnings.
Is it your view, or is it correct to assume that, including the $27 million of 1998 bonuses that were not part of the Challenge Grant Initiative, because it was implemented I understand in 1999, that went forward from 1999 to 2003, that the total amount of bonuses granted by Fannie to those entitled slightly in the excess of $245 million?
Mr. RAINES. Mr. Chairman, I do not understand what you just said. Let me explain to you why.
Chairman BAKER. I will clarify the question for you.
In 1998, the bonuses reported were $27 million. And I can give you the figure for each year.
In 2003, the total amount of bonuses was $65 million, the yearly aggregate, the amount of bonuses each year, per year, 1998 through 2003, and that comes out to be $245 million.
Page 128 PREV PAGE TOP OF DOC If you are not familiar with that number
Mr. RAINES. I did not understand what the question was.
Chairman BAKER. Did that help?
Mr. RAINES. You told me what the facts were about bonuses.
The Challenge Grant has nothing to do with bonuses. The Challenge Grant has absolutely nothing to do with bonuses.
Chairman BAKER. It does in a sense. Challenge Grants incentivizes executives to enhance the growth of the corporation's profitability, based on the corporation's profitability the EPS has calculated. The calculation of the EPS then determines whether the bonus trigger is hit.
Mr. RAINES. You just crossed the line again.
The Challenge Grant has to do with stock options. It has nothing to do with bonuses.
Stock options were granted to every Fannie Mae employee. Every employee of Fannie Mae was given a grant and would only vest if the company doubled its earnings over 5 years, and then it would vest over a delayed period if it did not.
So the Challenge Grants have nothing to do with bonuses.
Chairman BAKER. Well, let me clarify, then.
In 2002, Fannie Mae paid out a total of $51 million in bonuses of which $12.4 million was paid to the top executives.
I have a chart that is going up here now that shows total compensation.
Since we have talked about restricted stock awards, we have talked about stock options, and we have talked about bonuses, that chart characterizes what was awarded in 2002 based uponwhat? If it was not earnings per share, per stock options, if it was not earnings per share or restrict stock awards, am I misunderstanding that the bonuses were not calculated based upon the earnings-per-share number?
Page 129 PREV PAGE TOP OF DOC Mr. RAINES. Again, Mr. Chairman, I think you are mixing two or three things together.
Chairman BAKER. I may be, but let's go through the detail
Mr. RAINES. I would like to be helpful.
Chairman BAKER. I know.
Mr. RAINES. Let me try to answer the question
Chairman BAKER. I will give you the right question that I would like to have answered, if it is possible: Did the $3.23 earnings-per-share determination in 1998 trigger the payment of bonuses to executives?
Mr. RAINES. Yes.
Chairman BAKER. Thank you.
Does the earnings per share have any effect on any of the other benefits awarded that are displayed on this chart, either the restricted stock grants or the options?
Mr. RAINES. Well, Mr. Chairman, this is your chart. This is the first time I have seen your chart. It has information on this chart that was provided to our regulator as confidential information, that it was information that is protected, in our belief, by the laws of the United States.
But be that as it may, now that you have displayed it before the committee, if I can answer your question.
Chairman BAKER. Sure, but to answer your legal point, I have the absolute right to display it, despite Mr. Ken Starr's threats to the contrary, in the context of a committee hearing discussing the policy of Fannie Mae's compensation.
Mr. RAINES. Mr. Chairman, I am going to answer your question.
Chairman BAKER. Well, please proceed.
Page 130 PREV PAGE TOP OF DOC Mr. RAINES. I am just pointing out the legal status of this information.
If we go across your chart, salary has nothing to do with earnings per share. Salary is established at the beginning of the year.
Chairman BAKER. I understand that.
Mr. RAINES. The second line you have is bonus. Those, in all these yearsif I am correct, looking at this because it is very small typeis based on earnings per share, but not entirely.
Because individual employee bonuses also have a performance factor involved in them. And so the earnings that they would earn is not just based on EPS, but there are also on their performance.
Fringe benefits have no relationship at all.
Chairman BAKER. I was not raising that issue here.
Mr. FRANK. Mr. Chairman, are we all going to get this much time?
Chairman BAKER. I will be happy to cut him off if you would like for me to.
Mr. FRANK. I would like to go with the 5-minute rule.
Chairman BAKER. In order to move ahead, let me recognize Mr. Kanjorski.
Mr. BACHUS. Mr. Chairman, does he have a copy of this, other than reading off the chart?
Chairman BAKER. I have just recognized Mr. Kanjorski.
Mr. FRANK. I understand that. I wondered why Mr. Bachus was talking, then.
Page 131 PREV PAGE TOP OF DOC Mr. BACHUS. I understand, Mr. Chairman
Mr. FRANK. Well, Mr. Kanjorski has the floor. Let us go to Mr. Kanjorski.
Chairman BAKER. Mr. Kanjorski has the time. He does have the information that came from Fannie Mae.
Mr. BACHUS. I did not know if he had this table before
Mr. KANJORSKI. I do not have that chart. I think it is only on one side?
Chairman BAKER. Can we have it distributed?
It is being distributed now.
Mr. KANJORSKI. Well, shall I wait and hold my time so I would have the same information that the other side of the aisle has in their possession?
Chairman BAKER. Let me give you mine.
Mr. KANJORSKI. Well, thank you very much.
Mr. BACHUS. What I am saying is, do these two gentlemen have this
Mr. KANJORSKI. Do all the members on our side of the aisle have it?
Mr. BACHUS. He is indicating that he does not have it.
Chairman BAKER. Time out. Hold up.
Ms. WATERS. I have not seen it.
Chairman BAKER. Hold up one moment. We will make sure that staff distributes it to every member
Ms. WATERS. And to the panel.
Page 132 PREV PAGE TOP OF DOC Mr. KANJORSKI.reproduction costs of the committee, are we over the allotted budget amount?
Mr. FRANK. Mr. Chairman?
Ms. WATERS. Parliamentarian query: Is this illegal or is it legal? I mean, there was a legal question raised here. Is it illegal for us to have this information? Can we display or not?
Chairman BAKER. No, Ms. Waters, it is not illegal.
Mr. KANJORSKI. Not for us.
Chairman BAKER. Not in the course of the committee consideration. I would not have released it had it not been. I have had it for over a year.
Mr. FRANK. Mr. Chairman?
Chairman BAKER. Mr. Frank?
Mr. FRANK. I have another appointment, but if the gentleman from Pennsylvania wanted to study this, I would be glad to go now and have him go after.
Chairman BAKER. Would Mr. Kanjorski like to yield his time to Mr. Frank?
Mr. KANJORSKI. Actually, Mr. Frank, I am not going to use this at all. As a senior member of the committee, I am smart enough to
Mr. BACHUS. Mr. Chairman, I am just saying, I still do not think that the panelists have this table
Chairman BAKER. Your point is well taken, Mr. Bachus. It will be delivered. Thank you.
Mr. BACHUS. But as we question them, I just
Chairman BAKER. I said your point is well taken. It will be delivered. Thank you.
Page 133 PREV PAGE TOP OF DOC Mr. KANJORSKI. You mean there were not sufficient copies produced for the committee members.
Chairman BAKER. Let me put it this way: I wanted to make sure I released this information. I am accountable for its release, and I put it into the public forum pursuant to my rights as chairman, subject to a response from the regulator, and I wanted to make sure that I did not get criticized for leaks. And we had all these accusations that people got advanced information inappropriately before it was publicly released.
I have now publicly released it. I am accountable for that decision.
Ms. WATERS. Will the gentleman yield?
Chairman BAKER. And every member of the committee, everybody in the room has access to it.
Mr. KANJORSKI. Let me make a point, because I was very tough on the regulator, and I intend to be tough on Mr. Raines and Mr. Howard.
But, Mr. Chairman, may I point out that you obviously had to seek legal opinion as to whether or not you are violating the law by distributing this document.
And may I just say that opinion is opinion. You found a lawyer that gave you an opinion contrary to Mr. Kenneth Starr. And for the last time I recall, was not Mr. Kenneth Starr really most accomplished attorney in another proceeding
Mr. FRANK. If the gentleman would yield
Chairman BAKER. That is opinion.
Who is recognized? Mr. Kanjorski and Mr. Frank.
Mr. KANJORSKI. Mind if I take it now, Barney? Let me take the 5 minutes. Do I have 5 minutes?
Mr. FRANK. I have been trying to get to regular order. I am glad
Page 134 PREV PAGE TOP OF DOC Chairman BAKER. Thank you, Mr. Frank. Please keep your members in order, we will be fine.
Mr. KANJORSKI. Maybe this goes to Mr. Howard and not to Mr. Raines, but either one of you, feel free.
When Mr. Falcon was before us, the regulator, he talked about discovering for the first time the smoothing of earnings in 1998. And the transaction that he describes as a $400 million item that should have been in but it was reduced to $200 million, but that it was cited somewhere in an audit difference.
I wanted to find out whetherand that was done by your outside auditors, as I understand at that time were KPMG. Is that correct?
Mr. HOWARD. Yes, it is.
Mr. KANJORSKI. Am I being incorrect when I said to Mr. Falcon that that would have been a finding or a difference in the audit that had to be resolved at the exit audit with either the board or management?
Mr. HOWARD. Mr. Kanjorski, it typically would have been identified by the auditor and discussed with the audit committee, and it was.
Mr. KANJORSKI. Now, that document, although it was not the final audit, something appeared in the final audit that would have reflected that working document draft, that there were audit differences expressed by your account.
Mr. HOWARD. It was mentioned in the accountant's report.
Mr. KANJORSKI. In the final audit.
Mr. HOWARD. Yes.
Mr. KANJORSKI. And the final audit, it seems to me, in 1998, were not only an internal document for the corporation, but that was provided and should have been provided to all the shareholders if they wanted it. Is that correct?
Page 135 PREV PAGE TOP OF DOC Mr. HOWARD. It typically is summarized in our annual report. The audit itself is not provided to shareholders.
Mr. KANJORSKI. Is it a secret document and not allowed to be read or understood by the regulator?
Mr. HOWARD. Not to my knowledge.
Mr. KANJORSKI. I am trying to gather: What in the hell does the regulator do when they regulate only two entities, and the first document they start with is not the outside audit, and particularly go to audit differences? Is that not what they talked to you about?
The new auditor found some audit differences there, and we want to know how you played it and to pass on whether you did it in conformity with the regulator's position that you acted properly.
Mr. HOWARD. Well, Mr. Kanjorski, I did spend a full day being interviewed by the special committee. They had an opportunity to ask me about this incident. I believe I could have put it in context that would have made it more understandable to them. They did not ask me.
Mr. KANJORSKI. No, I am just trying to understand: What does the regulator do if he does not start out with audit differences?
Mr. HOWARD. I cannot answer that.
Mr. KANJORSKI. It seems to me
Mr. RAINES. The actual document you are referring to has been, in my understanding, provided to OFHEO. The working papers have already been provided to OFHEO.
Mr. KANJORSKI. But in 1998, did he have access to that document?
Mr. RAINES. Yes.
Page 136 PREV PAGE TOP OF DOC Mr. KANJORSKI. I am trying to figure out whether we really should get worried here and that we have not had close regulation, whether it is Fannie Mae or Freddie Mac, if they are not looking at some base document that would reflect audit differences from your outside auditor to see what adjustments were made and why, and then that being footnoted in the final audit report.
What happened here? Why 6 years went by and the regulator did not say, ''1998, there was a little dispute between the outside auditor and the inside auditors in regard to how we treat this $400 million, or $200 million, adjustment.''
Mr. HOWARD. Well, Mr. Kanjorski, I would say there was not even a little dispute. The outside auditor had recorded an audit difference similar to this each prior year on our treatment of this so-called catch up adjustment on FAS 91. This was not unusual, it was not new.
Mr. KANJORSKI. Well, what do we have to do, in terms of the committee, in authorizing a new regulator, or whatever powers we give a new regulator, so they do not come in here and say 6 months or 6 years later that there was this difference that supposedly then affects bonuses and compensation and all these things, but that they did not see it when it was about as clear as a battleship in the Potomac would be?
Mr. RAINES. Mr. Kanjorski, I am not sure there is anything that the Congress needs to do.
It is my belief, it is my understanding, that our examiners have had access to this information over all these years and simply have not made any comment about them.
So I do not think this is a matter of finding a secret document that have not seen before. I believe that the examiners had access to all
Mr. KANJORSKI. I am not suggesting that there was secrecy. I am just getting worried about how superficial was the regulatory authority on your institution and Freddie Mac if they miss something that would have jumped out, audit differences.
Page 137 PREV PAGE TOP OF DOC Here is your outside auditor saying that, and obviously the regulator did not look at it.
Mr. RAINES. I guess what I am saying is, I do not know that they missed it back 6 years ago. The question is: How is it being characterized? The characterization may have changed.
Mr. KANJORSKI. Let us go to that point.
From that time in 1998 until now, it is your testimony, as I understand it, that KPMG had worked out and resolved in their mind, giving a full opinion letter on the audit, how it was treated in 1998 and how prior to that and how subsequent to that, that type of an adjustment was treated.
Mr. RAINES. Yes. In fact, I can read to you what they said to our audit committee in 1999 regarding 1998.
They said: The principal area of estimates and judgments in Fannie Mae's financial statements, including the amortization of premium and discount, KPMG did not identify any areas within the financial statement that they believe include unreasonable estimates.
That is what they said to our audit committee regarding 1998, having made that audit exception.
Mr. KANJORSKI. Well, their new auditor went in this last year, and did he find or did they find an audit difference there that they did not agree with, the opinion of your auditor?
Mr. HOWARD. Mr. Kanjorski, let me add one additional fact, and that is, after 1998 we worked to develop a specific method that limited the amount of the catch-up adjustment that we could allow not be recorded in a given year.
Once we put in place that procedure, which was the end of the year 2000, KPMG no longer recorded any size catch-up adjustment as an audit difference, provided it remained within the range that was set by our policy.
Page 138 PREV PAGE TOP OF DOC Chairman BAKER. Now, if the gentleman has one more and then
Mr. KANJORSKI. Yes, I would like both of you to answer this question. It is a very simple question.
Is there anything of a systemic risk problem at Fannie Mae?
Mr. HOWARD. Absolutely not, in my judgment.
Mr. RAINES. No, sir. And the report doesn't indicate any, because all of our risk management practices are working very well and the company is very strong.
Mr. KANJORSKI. Thank you, Mr. Chair.
Chairman BAKER. Thank you, Mr. Kanjorski.
Mr. Shays, you are up.
Mr. SHAYS. I told your staff that I would like to listen to some of the questions before I begin mine.
Chairman BAKER. Mr. Royce?
Mr. ROYCE. Okay, thank you, Mr. Chairman.
In my opening statement, Mr. Howard, I said that, in my view, Fannie Mae has a moral obligation to conduct its operations to the highest standard of business practices. Do you agree with me on that?
Mr. HOWARD. Absolutely.
Mr. ROYCE. Well, the question I would like to ask is, has Fannie Mae acted in a way consistent with that belief? Does Fannie Mae have strong internal controls? Does Fannie Mae conservatively and consistently apply accounting rules?
Mr. HOWARD. I believe we do conservatively and consistently apply accounting rules. We exercise judgment in applying them to practical business situations, as is consistent with good accounting practice.
Page 139 PREV PAGE TOP OF DOC As far as the moral tone, I believe that we have an entirely honorable, decent staff, full of integrity, who have had a very difficult time in the past two weeks, seeing themselves characterized in a very unfavorable way.
Mr. ROYCE. I understand that. But there was an audit difference with your outside auditor
Mr. HOWARD. An audit difference is simply a notation. It is not a direction for us to change the way we account for the transaction in question. That is a fact.
Mr. ROYCE. Well, the question I have there is, when OFHEO began the process of going back through the booksand in my view, OFHEO obviously has not been a very effective regulator. If they were exercising proper oversight, this issue would have surfaced in a timely matter and we would not be dealing with it now.
Mr. HOWARD. I am sorry, which issue?
Mr. ROYCE. The FAS 133 issue.
The other question I wanted to ask you was along the lines of what I asked Director Falcon. To follow up on that question, how does Fannie Mae's application of FAS 133 compare to other major financial institutions? Did you apply the standard the same way?
Mr. HOWARD. Well, Congressman Royce, I believe we made one major step that is different from most institutions. And that is that we realized that in order to faithfully implement FAS 133 in a fashion that did not make our income statements harder for investors to interpret and while still permitting us to use the hedging techniques that enable us to manage our interest rate and other risks, we needed to develop a supplemental earnings measure that adjusted for the effects of FAS 133.
FAS 133 adds an element of fair value accounting to what otherwise is a historical cost-income statement. And mixing those two concepts makes an income statement unintelligible to investors. We did not want that. We did not want to stop hedging. And we did not intend to undertake sham transactions to smooth out the effects of FAS 133.
Page 140 PREV PAGE TOP OF DOC So we developed a supplemental earnings measure called core business earnings that we publish to this day. I do not know of another institution that has followed that lead.
Mr. ROYCE. Okay. I thank you, Mr. Howard.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. FRANK. Thank you, Mr. Chairman.
First, I have to say to Mr. Raines and Mr. Howard, if it wasand I take the chairman at his word; I do not believe you would have done anything illegalbut if there had been any questions, there shouldn't have been. I think it is perfectly appropriate for this to be public.
I am a strong supporter of Fannie Mae and Freddie Mac, but you are not simply another private corporation. There is a lot of government involvement. I think this is entirely appropriate.
And, Mr. Chairman, I would have maybe given it to them in advance.
And I did have one question. There is either a mistake here, or there are either two people in managed capital or there is one person in managed capital who is getting twice.
But other than that, I think, yes, it is entirely appropriate.
And let me add to this. This is not directly relevant, butand here I would say that this is a problem with regard to American corporations in general.
You gentlemen work very hard and you do good work, but I do not understand why in the world you need bonuses. At the level of compensation you get, we ought to be able to count on you to do your very best without any kind of incentive. And I would hope you would set a good example.
Page 141 PREV PAGE TOP OF DOC If your salary is too low, raise your salary. But I think incentive bonuses, particularly if they are connected to stock optionsand there is no evidence of it happening here, with regard to stock optionsbut with stock options, top executives are given a perverse incentive.
If either one of you runs into a building that is on fire and rescues a baby, get a bonus. But doing your job, not at all levelmy level, your levelI think that is a mistake. And to the extent that they are performance-related, we leave ourselves open.
If you want to comment on that at the end, you can do that, but I would just ask some questions now, because, to the extent that there was smoothing out that might have been affected by thiswell, let me ask, because that is the major question.
Was the fact that bonuses were somehow dependent on certain earnings a factor in the treatment of earnings? And if you did not mean it consciously, might it have affected you, do you think? Mr. Howard?
Mr. HOWARD. If you are referring to the incident reported in the OFHEO report for 1998, as Mr. Raines mentioned, we have been looking into that. And so far we have determined that the amount that was determined to be accurately recorded in 1998 was determined as a result of a process that was run in
Mr. FRANK. I am going to your motives. You both deny that trying to hit a certain amount so you could get your bonuses was a factor to any extent in your decisions? I think it is important to just ask you that question.
Mr. HOWARD. Yes, in coming up with that number, yes, we do not
Mr. RAINES. We both deny that.
Mr. FRANK. You both deny that?
Mr. HOWARD. Yes.
Page 142 PREV PAGE TOP OF DOC Mr. FRANK. Okay, I think it is important to get that.
Next question is, in your reading of theseand I will repeat what I said previously, that accounting for derivatives does seem to meand I know Mr. Falcon said, ''Well, it is very clear-cut,'' but as Mr. Watt asked Mr. Falcon and his two chief aides a fairly straightforward set of questions, it got less and less clear to me and it did not appear to them to be as clear-cut.
And I will say, my sense is accounting for derivatives ranges somewhere between alchemy and astrology. You are accused of being on the alchemy end.
And that as they have gone over it with you, have they pointed outand Mr. Falcon said no, but is there any decision, first of all, whether you are considered by them to be guilty on the whole now of under-reporting, of over-reporting? Do you know whether they think you over-reported or under-reported?
Mr. HOWARD. I do not.
Mr. RAINES. No, we can't tell from reading the report.
Mr. FRANK. So they have not even concluded whether you over-reported or under-reported.
I did notice the Merrill Lynch report said, given this category, that it was a situation of the sort where when interest rates rose, there would probably be gains, and when interest rates dropped, there would probably be losses.
Mr. Howard, is that accurate?
Mr. HOWARD. Well, there is a certain type of derivative that we use, which, when interest rates fall, it declines in value and, when interest rates rise, it rises in value.
Mr. FRANK. What percentage of the contested derivatives are in that category, do you know?
Page 143 PREV PAGE TOP OF DOC Mr. HOWARD. To be honest, Mr. Frank, I am not sure which derivative transactions
Mr. FRANK. Okay. To the extent that they are there, obviously we would expect there to be an increased rather than a decrease in the near term.
Mr. HOWARD. If interest rates rise.
Mr. FRANK. So, now, when you agreed with them to increase your capital by 30 percentI am going to ask you what your sense was. Mr. Falcon has acknowledged that since they had not come to any conclusion as to whether you had under-reported or over-reported, the 30 percent was certainly not based on any estimate of to what extent your capital might have been impaired.
In other words, there were no numbers there. It was simply that in the statute there is a 30 percent figure that is there, really, for somewhat other purposes, not for dealing with accounting for derivatives. And he borrowed it because it had some reality.
Did you get any indication why 30 percent was chosen other than that?
Mr. RAINES. To be clear, the agreement was negotiated by our board.
Mr. FRANK. Oh, okay. So we have to ask Ms. Korologos.
Mr. RAINES. And my understanding is this is the number that the director wanted.
Mr. FRANK. And as he said, it is not based on anywe have to be very clear. The 30 percent was not based on any analysis of inadequacy of capital. It was not based on any conclusion that the capital had been impaired.
Again, to the extent that there was inappropriate smoothing out, that is wrong, and it is being looked into. It should be corrected. But worst case, it does not seem to me that anything has been suggested that jeopardizes your going forward as a corporation.
Page 144 PREV PAGE TOP OF DOC Mr. Falcon disappointed me, as I told him, when he acknowledged to Mr. Watt and others, to me, that there was no threat to solvency, no remote threat to solvency that he talked about, but said somehow safety and soundness was implicated.
In their conversations with you, has anything been adduced to suggest that you are going to have to curtail, to some extent, your activities or that the investors are somehow at risk? Mr. Howard or Mr. Raines?
Mr. HOWARD. Not in conversation with me directly.
Mr. RAINES. No, sir. There have been no conversations that we were at risk, other than what is included in their report.
There is the issue of how we get to the 30 percent additional capital. And there obviously are some people who would prefer that we reduce what we do in the market
Mr. FRANK. Right. And that is my next question, which is, you know, HUDand I will finish in just
Chairman BAKER. I just want to keep regular order, as you suggested.
Mr. FRANK. I understand. I am just trying to keep up with you, Mr. Baker. You are my role model.
Chairman BAKER. Start earlier.
Mr. FRANK. Thank you.
We had HUD last year not exercise its right to increase your goals. As you know, HUD had the right, a year before, tolast year they could have promulgated an increase in your affordable housing goals that would have taken effect this year. They didn't do it. It was an oversight, according to the secretary; they forgot to do it.
Now they are talking about increasing. And I certainly want to see an increase in the amount of affordable housing. But obviously if your overall activity shrinks, we are in trouble because, if I am correct, your affordable housing goals are not absolute but they are percentages of your overall activity.
Page 145 PREV PAGE TOP OF DOC So the question is, what will the effect of the 30 percent additional capital be on your reaching an absolute amount, in terms of affordable housing?
Mr. RAINES. The answer is, we don't know yet. We have a 45-day period to come up with a capital plan, under the agreement, which we will do.
We don't have a lot of choices. As you know very well, you either can reduce the size of your activities or you can increase the amount of capital that you have. If we have to reduce the size of our activities, then the percentage made up of the affordable housing goals will go down because we will be doing less business.
Mr. FRANK. So that arbitrary 30 percent might result in a diminution in your affordable housing activity?
Mr. RAINES. Well, if the capital plan requires us to reduce our activities, yes, it would reduce the impact of the goals as a result of our having made those choices.
Mr. FRANK. Thank you, Mr. Chairman.
Chairman BAKER. Thank you, sir.
Mr. Shays, did you want to go now?
Mr. SHAYS. No.
Chairman BAKER. Mr. Ney?
Mr. NEY. Thank you, Mr. Chairman.
One of the issues I wanted to ask about is something I was asking OFHEO today. It is on the generally accepted accounting practices.
At the point in time, when they came in and said that there was a willful violation of the accepted accounting practices, I asked if in fact OFHEO had talked to the Fannie auditors and whether Deloitte & Touche, in fact, had talked to your auditors at that time, to see why those auditors recommended to you to use certain accounting practices.
Page 146 PREV PAGE TOP OF DOC And I just wondered if you had any comment on that, about should Deloitte & Touche sit down prior to this report, is what I guess I am getting at. And that was the plan made with OFHEO.
Mr. RAINES. Well, I believe that they should have sat down with the auditors and asked them what was their view on these issues, because our auditors have obviously been looking at these issues for many years and they have an opinion on public record as to how they have come out on that question.
So I believe that they should have sat down with them before coming to the conclusions that they have come to, because obviously KPMG has come to a different conclusion than OFHEO has.
I don't know what the positions of Deloitte & Touche are. The report doesn't tell us, and I think the director testified that the findings in the report were OFHEO's. So I can't comment on what the positions of Deloitte & Touche are on these issues. We know what KPMG's positions are on the issues.
Mr. NEY. I will speak for what OFHEO said today. If I recall correctly, OFHEO said that Deloitte & Touche concurred with OFHEO.
And my follow-up question was, did Deloitte & Touche at any point in time communicate with your auditors to see why? And I wondered if, at any point in time, if Deloitte & Touche concurred, had they at any point in time had any contact or working papers of your auditors?
Mr. RAINES. Not to my knowledge.
Mr. HOWARD. Nor to mine.
Mr. RAINES. Not to my knowledge that there has been any contact either by OFHEO or by Deloitte & Touche with KPMG to explore these issues.
Mr. NEY. Thank you, Mr. Chairman.
Page 147 PREV PAGE TOP OF DOC Chairman BAKER. I thank the gentleman.
Who is next?
Mr. SCOTT. Thank you, Mr. Chairman.
Mr. Raines and Mr. Howard, your accuser, OFHEO, has spent the better part of four hours this morning making some extraordinary accusations. And I want to make sure that you have ample opportunity to refute those accusations, a fair amount of which is this: that essentially you all cooked your books so that you could meet certain earnings targets so that you could get bonuses.
And the chairman has passed down this sheet, and one look at this sheet puts, in my estimation, some very strong, strong incentives.
I think we owe you the opportunity to make sure that you have the opportunity to refute that charge first.
And I know, Mr. Chairman, I have 5 minutes, if you will allow me to get that question out, then I have two more questions on the line of politics and process, but I want you to answer that charge because I think that is at the center of this hearing this morning.
Mr. RAINES. Well, thank you for that opportunity.
This is a very serious allegation, and I deny that occurred.
We have looked for the facts. There were no facts in the OFHEO report. None. Other than their calculation that said, ''Oh, there seems to be if we subtract one number from another you get this result.''
But we looked into the facts of what happened back 6 years ago, and we found no facts that would support the allegation that was included in the report.
Mr. SCOTT. Why, then, would OFHEO, in your opinion, make that charge?
Page 148 PREV PAGE TOP OF DOC Mr. RAINES. Well, Congressman, I do not know. This entire examination has been unusual. It has been the most unusual regulatory endeavor I have seen in the 30-some-odd years I have been in this city.
And I have never seen the case where a regulatory agency brought serious allegations against a company without asking the company for a response in advance.
So I do not know. This has been something that is inexplicable to me as to why they would follow this path. And I do not believe there has been an adequate explanation of why they followed this to this moment.
Mr. SCOTT. I asked your accuser this morning: When did they make this report public and when they did inform you of the report?
I would like to have your interpretation of those chain of events.
Were you made aware and briefed on this report by your oversight accuser prior to them making it public?
Mr. RAINES. Let me walk you through the entire sequence very quickly.
We began reading newspaper accounts that OFHEO was about to finish a report. I personally called the director to talk to him about him, to set up a meeting to talk about it.
I was unable to have a conversation with him about it or to have a meeting with him about it.
On Friday, at about 4 o'clock Eastern Time, members of our board were called and told that the director wanted them to assemble on Monday, to meet with OFHEO officials to hear about the report.
On Monday, four OFHEO officials came to Fannie Mae to brief our outside directors, and at that same time they handed to management a copy of the report.
Page 149 PREV PAGE TOP OF DOC They then proceeded to brief the board on Monday.
But as you know, much of the information about the report was not only in the political press, but also was in the financial press prior to that Monday.
Mr. SCOTT. Let me ask you: When did the board make the decision to link, and they did actually make the decision to link executive pay bonuses to earnings per share?
Mr. RAINES. Fannie Mae has linked bonuses to earnings per share for as long as I have been around the company. That goes back to 1991. Tim Howard has been there longer than I have.
Mr. HOWARD. I cannot recall a year in which they were not linked.
Mr. RAINES. And indeed, virtually every company of which I am aware links some part of their compensation to earnings per share. So this is not an unusual thing; this is one of the most common aspects of corporate
Mr. SCOTT. Well, the point I wanted to get on the record was: The linkage was made prior to you being chief executive officer.
Mr. RAINES. Absolutely, prior to my even being at the company.
Mr. SCOTT. So this was not done on your watch. It was done and it has been normal procedure to link
Mr. RAINES. Yes, sir.
Mr. SCOTT. Now, Mr. Howard, one point: You are the vice chairman of the board
Mr. HOWARD. Yes.
Mr. SCOTT.you are the chief financial officer
Mr. HOWARD. Correct.
Page 150 PREV PAGE TOP OF DOC Mr. SCOTT.you are the supervisory person over internal audit.
Mr. HOWARD. That is not correct. The internal auditor reports directly to the chairman of our audit committee. He has what is called a dotted-line relationship to me, which means I am his internal point of contact in the company.
Mr. SCOTT. Do you not approve his salary?
Mr. HOWARD. I do not. I make a recommendation on his salary to our senior management group, and his salary is determined collectively in consultation with the chairman of the audit committee.
Mr. SCOTT. But you do set the targets, financial targets, for the year, you said.
Mr. HOWARD. The financial targets are set collectively by the senior management team.
Mr. SCOTT. But you do have the authority to meet those targets.
Mr. HOWARD. No, I do not.
Mr. SCOTT. Oh, you do not. That is good to know, because there have been some reports that you did.
Mr. HOWARD. There have been lots of things that have been said incorrectly.
Mr. SCOTT. That is why I want to make sure that you have ample opportunity to refute. This is a very serious hearing.
I think the future, the jeopardy of Fannie Mae is at stake. And I want to make sure we give you ample opportunity to answer every one of these charges.
Mr. HOWARD. If I may take advantage of that opportunity and just be very clear in what we are saying, there is no linkage, to my knowledge, of compensation to the determination of what the catch-up charge would be in 1998.
Page 151 PREV PAGE TOP OF DOC We found no evidence of a linkage of that to compensation decisions for 1998.
Mr. SCOTT. Thank you.
I yield back the balance of my time, Mr. Chairman.
Chairman BAKER. I thank the gentleman.
Mr. OXLEY. Thank you, Mr. Chairman.
Mr. Raines, welcome back.
I am sorry if I am plodding over old ground, but I just got back in the committee room.
Mr. Raines, I wanted to ask you in regard to the Freddie Mac issue: You stated that Freddie Mac to make its GAAP earnings less while Fannie Maethis is your quotereported and explained the volatility. The OFHEO report finds that Fannie Mae misapplied GAAP, due to among other things, managements desire to portray Fannie Mae as a consistent generator of stable and growing earnings.
I guess the question occurs: What is the difference, in your case, between Freddie and Fannie in that regard?
Mr. RAINES. Mr. Chairman, they tried to get me with no chart. I had to have one. And this simply illustrates the major point.
That is our reported earnings. That is what we are accused of having made stable.
And if this was what we are trying to make stable, we did a very bad job of trying to stabilize our reported earnings.
And that is really the big difference between what Freddie Mac admitted they did and what we are accused of.
Page 152 PREV PAGE TOP OF DOC Freddie Mac was accused of trying to straighten out that orange line, and that they entered into transactions to straighten out the orange line. That is the GAAP earnings line.
And then they said, yes, that is what they did.
And what we did instead was, we have two ways of reporting the earnings. We simply report the volatility in GAAP, and we say,''Here's another way to calculate it in core. You the investor now have both ways to calculate it.''
So I am not exactly sure what is meant by the accusation that we were smoothing earnings, because FAS 133 is not even included in corethe impact on net income is not even included in core business earnings.
So that is why we have a little difficulty understanding what the accusation is.
But the difference between us and Freddie Mac is that OFHEO is saying we have misapplied accounting standards. They link us smoothing; we do not understand what that means.
Freddie Mac said they were trying to smooth.
Mr. HOWARD. Mr. Chairman, as you can see from the chart, even the core business earnings line is not particularly smooth in recent years. So whether it is GAAP, which we made no attempt to change with transactions that were not economic, or core business earnings, the allegations of transactions to smooth earnings, or accounting manipulations to smooth earnings does not appear to be substantiated by the actual earnings results.
Mr. OXLEY. Let me also ask both of you: On your Web site, you claim that the hedge accounting treatment for each individual transaction is determined and documented in writing before you enter into that transaction.
And furthermore, you say it cannot subsequently be changed.
Page 153 PREV PAGE TOP OF DOC The OHFEO report disagrees with that assessment, citing instances where there was no contemporaneous hedge documentation as well as instances where staff created hedge designations retroactively.
Do you disagree with those allegations?
And does FAS 133 not require full documentation for transactions
Mr. HOWARD. First of all, Chairman, there are two separate issues, which I will address separately.
The first set of documentation that you were referring to was documentation of hedge transaction types.
Before we can enter into any given hedge transaction type, we have a hedge policy developed that is worked out by our accounting policy group, that is within our controller's department, but independent of other groups.
So all they do is accounting policy. And that accounting policy is reviewed with the outside auditors.
So before we do a single individual transaction, we have an agreed-upon derivatives or hedging policy.
Now, where the difference of viewpoint in the OFHEO report arises is over agreement on whether individual transactions were documented sufficiently. We believe they were and therefore qualify for hedge accounting.
OFHEO, in certain instances, contends they were not and therefore these transactions may not qualify for hedge accounting.
Mr. OXLEY. Does the report cite specifics? And if so, are there disagreements on the specifics? Or is this a generalization?
Mr. HOWARD. The report cites specifics. I am not intimately familiar with those specifics since I do not deal with them at that level.
Page 154 PREV PAGE TOP OF DOC Mr. OXLEY. Mr. Raines, do you have any comments?
Mr. RAINES. Again, I do not know about the individual specifics in the report, but their general position is that our way of documenting, with the combination of contemporaneous paper documentation plus automated systems, they believe does not meet their test.
We believe it does meet the test of GAAP.
Mr. OXLEY. And finally, in my opening statement I talked quite a bit about the application of the Sarbanes-Oxley Act in this particular case.
You of course are a publicly traded company and are subject to the requirements of the act as well as regulations therein.
Is there anything in your estimation to give any indication that any of the provisions of the act or the subsequent regulations had been violated or ignored?
Mr. RAINES. No, sir, I do not know of any. In fact, I think the act has been very helpful to us, because one of the reasons that we have documentation on a lot of these things is because we are going through the process as required by the Sarbanes-Oxley Act. That is why we have, as I described in my written testimony, this entire process around certification so that we know exactly at the highest levels of the company what decisions were being made and by whom.
And also I can tell you, as a result of the Sarbanes-Oxley, I have made a campaign in our company to go around and tell people, ''If you think there is something wrong, raise your hand. Raise your hand, and it will be looked at that.''
That has been our policy and that continues to be our policy, and I have to say, the direct growth from the reforms that were brought in by Sarbanes-Oxley.
Mr. OXLEY. Thank you.
Thank you, Mr. Chairman.
Chairman BAKER. I thank the chairman.
Page 155 PREV PAGE TOP OF DOC Mr. Clay?
Mr. CLAY. Thank you, Mr. Chairman.
And thank you, Mr. Raines and Mr. Howard for being here.
Mr. Raines, in May of this year, Dow Jones International News reported that Senator Kit Bond, Republican from Missouri, was so critical of OFHEO's leaks to The Wall Street Journal that he asked HUD's inspector general to examine OFHEO's practice of handling confidential information with the media.
This morning I asked Mr. Falcon a question such as: Why did the examiners not discuss preliminary concerns of possible findings with Fannie Mae? Why was Fannie Mae not provided a draft report? And why did Fannie Mae not have the opportunity to respond to findings?
I question why the process for handling these findings was altered and done differently for Fannie Mae. I find this to be inconsistent and a rush to judgment.
In informal conversations with the executives from Wall Street and individual large brokerage houses, I get the feeling that the markets are not worried about the safety and soundness of Fannie Mae, as OFHEO says that it is. But of course, the markets are not political. I do not see due process being carried out with respect to Fannie Mae.
Do you have an opinion on this, Mr. Raines?
Mr. RAINES. Well, Mr. Clay, as I testified, you know, we are a regulated company. We recognize we are a regulated company, do everything we can to work cooperatively with our regulator. And we will continue to do that regardless of what has happened with regard to this special examination. They have a job to do and we have a job to do.
By the same token, I don't believe that because we are a cooperation that we are not due due process. And I think we have a long tradition in this country of providing due process even to people who have done the most heinous things. They have been accorded due process. And that is all we have really asked for thus far is give us the opportunity to state our case and let us take these issues to someone who can resolve them.
Page 156 PREV PAGE TOP OF DOC Now there have been many issues like this resolved by other regulators, banking regulators, without newspaper headlines. The issues that relate to FAS 91 and 133 we can discuss forever, but the SEC is going to decide.
And in my view, there is no reason the issues couldn't have just been taken directly to the SEC before any examination was completed and just ask them what is the answer. Then we wouldn't be having a debate here about, you know, whether or not the regulations embodied in this book are simple.
A regulation that has 172 interpretations that have come out since it waswe wouldn't be having that debate if we had done the simple step of going to the SEC, in which we would have joined in and said what is the answer? And then we would all know what to do going forward.
Mr. CLAY. I know that Fannie Mae has agreed to the increase in capital and how much in dollars is that increase?
Mr. RAINES. We don't have an exact estimate, but if you look back at the most recent periods it would require something in excess of $3 billion.
Mr. CLAY. Okay. I commend the company for this and for agreeing to other changes that will make for better transparency. Nevertheless, how would this almost $3 billion have been used were it not required for capital? I mean will the housing mission be affected adversely by this increase? And will it help the housing mission?
Mr. RAINES. Congressman, the honest answer is I don't know yet. We have 45 days to come up with a capital plan, but we don't have a lot of choices. And it could require us to reduce our activities because we have only 270 days to come up with the $3 billion. And that is just one of the issues we are going to have to struggle through.
So, it is possible it could require us to reduce our market activities to achieve the goal.
Page 157 PREV PAGE TOP OF DOC Mr. CLAY. I thank you for your response.
Mr. Chairman, that is all for me. I yield back the balance.
Chairman BAKER. I thank the gentleman.
Ms. KELLY. Thank you, Mr. Chairman.
I have very little time, Mr. Raines. And I would appreciate it if you could answer my questions within a yes, no format. I really appreciate the presence of both of you before the committee today.
Mr. Raines, which member of the executive management team is responsible for risk management, accounting, on-balance sheet mortgage portfolio, business planning, tax, investor relations and internal audit? Do you have one member who
Mr. RAINES. There is no one responsible for all those things unless you are thinking of me. But there is no one person responsible for all those things.
Ms. KELLY. Well in the OFHEO interview with Tim Howard he said he had those portfolios.
Are you aware that, as the director of financial accounting, Jeff Guliana has responsibility for modeling critical accounting estimates, as well as reporting and accounting for model results? Just give me a yes or a no please.
Mr. RAINES. I think the answer is yes.
Ms. KELLY. Thank you.
Are you also aware that a senior vice president for financial reporting and planning, Mrs. Janet Pennewell, is responsible for reporting net income, as well as forecasting what net income will be? I just need a yes or a no, sir, please.
Mr. RAINES. Ms. Kelly, sometimes when you phrase it in a way that is not exactly right giving you a yes or a no may be misleading to you. So
Page 158 PREV PAGE TOP OF DOC Ms. KELLY. Well, that is in the OFHEO report in that way. So, I just
Mr. RAINES. That may well be
Ms. KELLY. Is that true? I mean does this woman havedoes she report net income, as well as forecast what the net income will be? That is what I read in this report.
Mr. RAINES. If you put it that way, no.
Ms. KELLY. Okay.
Mr. RAINES. But, I was trying to be helpful, but if you put it that way, the answer is no.
Ms. KELLY. I am sorry. I have a bill on the floor and I have to get back over and I have to get through this because I really need answers to my questions.
Are you aware that a senior vice President for the operations risk, Sam Rajappa, was, and is still, apparently responsible for auditing his prior work as controller? Just a yes or a no, please, sir.
Mr. RAINES. No, he is not responsible for auditing his prior work as controller.
Ms. KELLY. Okay. That is, again, that was in his interview, that is apparently what he said he was doing in the OFHEO report. Mr. Rajappa says he was employed as Fannie Mae controller from 1994 to the end of 1998, which was the time period where earnings manipulations to trigger executive bonuses is alleged.
Were you aware that that arrangement was a clear contradiction of the IAA standards relative to the auditor independence? Did he assume that he was doing this and he wasn't?
Mr. HOWARD. I can actually help there. Mr. Rajappa was moved in as head of operations risk but the auditor at the time was a man named Jack Wassen. Mr. Wassen was the company's auditor. Mr. Wassen reported to Mr. Rajappa. So there was no violation of that standard at the time.
Page 159 PREV PAGE TOP OF DOC Ms. KELLY. Thank you.
Mr. HOWARD. You are welcome.
Ms. KELLY. According to, again, the OFHEO report, Mr. Rajappa reports to you, Mr. Howard, is that true?
Mr. HOWARD. I have been chief financial officer for 14 years. For the first
Ms. KELLY. Sir, I just need a yes or no answer.
Mr. HOWARD. No.
Ms. KELLY. He is not now or has he ever?
Mr. HOWARD. No, he reports to the chairman of the audit committee. He does not report to me.
Ms. KELLY. Okay. What about the members of the executive committee? Do you meet, and according to what the OFHEO interview shows, the executive team met to cooperatively set salary and bonus for Mr. Rajappa, as well as Mr. Rajappa being available to audit the executive team. That is what is in the report. I just need to know from either one of you a yes or a no.
Mr. RAINES. This is very hard to give yes or no answers to
Ms. KELLY. I understand that, sir
Mr. RAINES. But
Ms. KELLY.but I have a very limited time.
Mr. RAINES. I understand, but the implication of my giving you an answer that is incorrect is so great that I refuse to take the risk without telling you what the real answer is.
The answer is that the compensation for everybody in the company, including mine, is in part determined by our executive team. We have in process where lots of people are involved in setting the compensation. So, the answer is yes, but that is not an unusual thing.
Page 160 PREV PAGE TOP OF DOC Ms. KELLY. Okay.
Mr. Raines, as the CEO of a major company this committee and I believe the American people, investors, taxpayers and homebuyers, expect you both to know about these operations and to be so intricately involved in the decisions and processes of the company that questions like mine could be able to be answered with a quick yes or no. There needs to be bright lines for who is reporting to whom and who is doing what.
When I read this OFHEO report I did not see bright lines. If there are bright lines, sir, I would hope that perhaps you could get us a construct of exactly what they are. If they do not agree with OFHEO so be it. But it would be important for us to know how you have Fannie Mae structured because I believe quality and transparency is what the American people deserve.
Thank you. I yield back the balance of my time.
Chairman BAKER. I thank the gentlelady.
Mr. LYNCH. Thank you, Mr. Chairman.
Well, I don't have a bill on the floor and I have plenty of time. So, if either of you gentlemen would like to expand on the previous yes/no answers in any respect, feel free to do so right now. As someone who has grown up in public housing, I have a real investment in Fannie Mae's mission. And I see the good work that you do.
Let me justyou know, the previous speaker mentioned that she saw no bright lines in this OFHEO report. This is 200 pages. I just want to ask you again, just to be sure in my own mind, did OFHEO sit down with you and interview you, Mr. Raines or Mr. Howard in preparation of this, this examination of your corporation, of Fannie Mae?
Mr. RAINES. They did not interview me.
Page 161 PREV PAGE TOP OF DOC Mr. HOWARD. They did interview me on two occasions; one to discuss impairments on certain types of securities, and one was a more general interview.
Mr. LYNCH. Okay. And what about sitting down with your auditors, did they sit down with your auditors about this report?
Mr. HOWARD. Not to my knowledge.
Mr. RAINES. I do not believe that they have interviewed our auditors. But to be clear on your question, since they have done thefinished the report, they have not talked to us either about the content of the report.
Mr. LYNCH. Well it is not surprising then that there would be no bright lines in this and that some of these accounting rules are fairly complex and one would certainly understand how there might be differences of interpretations as you have pointed out.
In your own minds as the CFO and CEO, is this a usual relationship with a regulator that they would go around you and not sit down extensively with you to try to bring you into compliance with a GAAP that they thought you were in noncompliance with?
Mr. HOWARD. For me it is an unusual relationship.
Mr. RAINES. Congressman, I would agree that it is an unusual relationship. I did note in Director Falcon's testimony that he gave a reason why he felt the necessity to go around senior management he said was the lack of cooperation by senior management. And if I could address that issue, I would
Mr. LYNCH. I would like you to.
Mr. RAINES.be delighted.
We had our first meeting with OFHEO with regard to this special examination on January 7. Since that date we produced 427,466 pages of documents, in 67 different document productions and 14 different requests, answering 425 questions. We also provided 966,367 pages of e-mail and e-mail attachments.
Page 162 PREV PAGE TOP OF DOC We have even provided on three different occasions, our own consultant to go to OFHEO to help OFHEO with their technology in managing their searching of our e-mails. We had 100 people working for 4 days to respond to just one of their e-mail requests.
We have made Fannie Mae people available 47 times to be interviewed as part of this process. Now we provided to them the working papers of KPMG and quite a bit of other information.
I met with Director Falcon and told him, or informed him that if there were any problem with Fannie Mae's cooperation in this examination call me directly. And I have received no such call. Now, the most inflammatory statement I guess is the one that says that thethat our cooperation was so bad that it required subpoenas to be issued and then subsequently the Justice Department was called upon to perhaps enforce those subpoenas.
First, with regard to the issuance of subpoenas, my attorneys were told by OFHEO staff that the issuance of subpoenas was not related to a lack of cooperation but that they were doing this simply to get people on the record.
Secondly, with regard to the Justice Department, both in-house and outside counsel for Fannie Mae spoke to the Justice Department about OFHEO's referral to it regarding enforcement of one subpoena relating to e-mail and the Justice Department indicated that this was an issue that they expected to be worked out between OFHEO and Fannie Mae without any involvement of the Department or the courts.
So, with regard to our cooperation, I think it has been overwhelming. The subpoenas, as we were told, had nothing to do with lack of cooperation. And the Justice Department has indicated that they believe that this was an issue that could and should be resolved between OFHEO and Fannie Mae and it was resolved. All of the material requested by OFHEO has been provided to them.
Mr. LYNCH. Thank you. And thank you for clearing that up. Is there anything else you would want to add in terms of not a one-word answer, yes or no, but anything else that you feel that you need to clarify?
Page 163 PREV PAGE TOP OF DOC Mr. RAINES. There is one other point I would like to make, and it is an issue I think bears a broader discussion and that is the notion that in corporations there should be silos and that people should have one function, another function, and another function and they should never have any of these brought together. In fact, the practice of corporations is to bring together these things at a high level.
Mr. Howard is a vice chairman of Fannie Mae. He is one of the three most senior executives. So, of course he has many people who report to him. Otherwise, everyone would have to report to me and that wouldn't be a very functional organization.
So it is not unusual to have these reporting relationships. Indeed, there are many surveys that show that people bearing the CFO title quite often have risk management reporting to them, quite often have the balance sheet, the management reporting to them, quite often have internal audit reporting to them.
So, although it was characterized as being unusual, it is actually usual, and, in his role as the vice chairman, his duties are far beyond simply being the CFO, and it is quite appropriate that he have a large part of the company reporting to him.
Mr. LYNCH. Okay. Thank you, gentleman.
Thank you, Mr. Chairman.
Chairman BAKER. Mr. Toomey?
Mr. TOOMEY. Thank you, Mr. Chairman.
I would like to get to the specifics of one of the allegations with regards to FAS 91 in particular. As we all understand, FAS 91 deals with the methodology by which a firm is required to amortize premiums and discounts. In the case in question, I believe specifically the situation arises in which these premiums and discounts have to be amortized over securities that have prepayment features.
There are requirements under FAS 91, as I understand it, that you do the calculation, you then amortize a very precise amount quarterly over an assumed future remaining life of a given security, and then, when the next quarter comes around, you need to reanalyze this.
Page 164 PREV PAGE TOP OF DOC Interest rates very often will, in fact, be somewhat different than they were projected to be or assumed to be in the modeling in the previous quarter, and you then redo the amortization essentially.
You do this prospectively, but you also do it historically, so to speak, with an adjustment to the current quarter, which is intended to capture the cumulative historical difference between what was estimated in the past and what reality has shown.
My concern and my understanding and the testimony of OFHEO is that FAS 91 requires that you come up with a precise number and that number be entered in that given quarter, and my concern is that you developed a policy whereby you did not use that number. You created a considerable discretion, in fact, over what number you would use within a range.
I would like for you to explain to me where it is in FAS 91 that you are authorized to not use the number that the model comes up with and confirm, if you will, that it is, in fact, that methodology about which KPMG said they have an audit difference with Fannie Mae.
Mr. HOWARD. Mr. Toomey, I would be happy to address that.
In estimating the rate at which we amortize premiums and discounts, one has to make a number of assumptions on
Mr. TOOMEY. Understood.
Mr. HOWARD.interest rates and prepayment sensitivities. By making assumptions that are reasonable but different, one can come up with different sets of very precise numbers, and I understand you have to choose one, and we do that.
So, when interest rates change, we will by practice reflect that new estimate in the rate at which we amortize purchases at the premium going forward because those adjustments take place over time.
Where we have used in the past a range or a threshold to determine at what point we have sufficient certainty around the estimates that we are making between the numbers that we recorded historically and the numbers a new set of assumptions would indicate we should have recorded historically, we have, as a matter of policy, since FAS 91 was first implemented, had some latitude around zero, typically plus or minus $100 million, but more than that.
Page 165 PREV PAGE TOP OF DOC Mr. TOOMEY. My point is, does FAS 91 authorize that?
Mr. HOWARD. According to our accounting policy team and KPMG, it does. KPMG
Mr. TOOMEY. Then why does KPMG have a difference on that issue?
Mr. HOWARD. KPMG had a difference prior to 1998 because we did not have a defined policy in place that governed how much latitude we could havelet me finish, pleasebefore we made an automatic adjustment.
Once we put that policy in place and limited the amount or the size of that range, KPMG removed its audit difference, therefore confirming our view that the treatment of this estimate retroactivelynot prospectively, but retroactivelywas, indeed, consistent with GAAP, and this is something that the SEC will look at, and they will give us their view.
Mr. TOOMEY. Yes. Oh, they will. But you have not cited anything in FAS 91 that says you are allowed to use a number other than what your model comes up with.
The other thing that raises concern about this is the exchange in memos between yourself and others seems to suggest that there was a conscious ongoing effort to manage this amount. This is a large amount. $100 million on a quarterly report out of earnings of $1 billion or so, thereabouts, suggests a very substantial percentage of this.
Mr. HOWARD. Congressman, let me be very clear. My intent in getting involved in the development of the policy was to ensure that the numbers we were reporting to investors was as clear and as meaningful as they could possibly be.
I will give you an example of how I thought about this. For the five years from 1999 through last year, our net interest income averaged about $2 billion per quarter. Now investors are looking for changes in our net interest in come for evidence of how fast our business is growing.
A net interest income amount of $2 billion in one quarter, growing at 10 percent per year annualized, will be roughly $2.05 billion in a quarter. If we are growing at 15 percent annualized, it will be $2.075 billion. So the difference between 15 percent growth and 10 percent growth in a single quarter is $25 million.
Page 166 PREV PAGE TOP OF DOC If we adopt a policy that causes us to make these random adjustments based on our estimates of prepayments, collapsed over a number of years going back into a single quarter that is, say, $70 million, we have worsened the quality of our financial statements by adding a spurious numberthis is our view. I am not asking you to agree with itthat is bigger than the discernment investors are trying to achieve in looking at our quarter-to-quarter financials.
I made the judgment. Accounting does not only permit but also encourages practical applications and judgments in financial reporting. This, in my view, was a good judgment because it preserves the integrity and the quality of our published financial statements.
Mr. TOOMEY. Well, I see my time has expired. I have to say I am very skeptical about this methodology, in particular this catch-up mechanism, this range, using this discretion in terms of how much income you show, and it is such a substantial portion of total income.
Mr. HOWARD. It is not discretion. Let me be clear: It is not discretion.
Mr. TOOMEY. Well, the report quotes people in your firm who describe it as discretion.
Mr. HOWARD. For a small period of time historically, we had discretion. After the policy was locked in the middle of 2002, there has been no discretion from that point forward.
Mr. TOOMEY. Well, you are directly contradicting what some people from your firm are saying in the OFHEO report in terms of the discretion that remained after the policy was adopted.
Mr. HOWARD. After the policy was adopted in December 2000, in the middle of 2002, we eliminated any potential for discussion by changing the policy. So we now have an agreement with KPMG that we will use no additional discretion in doing the FAS 91 amortization post December of 2002, and that is a fact. OFHEO may not have picked that up.
Page 167 PREV PAGE TOP OF DOC Mr. TOOMEY. So, since 2002, you have ceased and desisted using this methodology that you used before.
Mr. HOWARD. What happens is when our catch-up adjustment is within the size limited by the guidelines, roughly plus or minus 1 percent on net interest income and 2 percent on guarantee fees, we do not make any adjustments at all. So that is not discretion.
When it is outside that, we book to the edge of the range and no further. That is not discretion either.
Mr. TOOMEY. And the establishment of the range, the methodology and the amounts of these ranges, these were all developed and established by you. This is not under the direction of FAS 91.
Mr. HOWARD. Well, by the company.
Mr. TOOMEY. By the company.
Mr. HOWARD. Yes, that is correct. They are consistent with FAS 91.
Mr. TOOMEY. Well, that is what we are going to find, the SEC's opinion on that.
Mr. HOWARD. You are absolutely right.
Mr. TOOMEY. Yes.
Chairman BAKER. I thank the gentleman.
Mr. BACA. Thank you very much, Mr. Chairman.
Let me ask this question of Mr. Raines or Mr. Howard, and either one of you can respond.
OFHEO has been the regulator since 1992. Is that correct?
Mr. HOWARD. Yes.
Page 168 PREV PAGE TOP OF DOC Mr. BACA. That is 12 years. During this 12 years, their responsibility is not only to audit you. Is that correct?
Mr. RAINES. Well, they examine us. They have an annual examination.
Mr. BACA. And during that examination, if they find any deficiencies, is it their responsibility to let you know of any deficiencies, methodologies or other that you are following that you should not be following? Is that correct?
Mr. RAINES. Yes, that would be their responsibility.
Mr. BACA. In this particular case, did they ever come back and tell you in terms of standard practices or procedures or deficiencies that you had to talk to either one of you two with regard to these issues?
Mr. RAINES. Yes, not until we saw the special examination report.
Mr. BACA. Isn't that a normal practice for any accounting firm or auditing firm, to basically sit down with the CEO or the chairman to discuss any deficiencies or procedures or process that they are not following? Is that normal standard?
Mr. RAINES. It is a standard, and we did sit down with them each year. In fact, their chief examiner met with our board and presented the results of their exam, and none of these issues were included in any of those exams over any of those years.
Mr. BACA. And in any of those years, did they ever sign off in terms of your methodology or procedures or methods that you used?
Mr. RAINES. Well, you might want to talk about the FAS 133 exam.
Mr. HOWARD. Yes. From what I can recall, when we implemented the process for FAS 133, along with the systems, OFHEO did do a review of those processes and systems and said that it met or exceeded safety and soundness standards.
Page 169 PREV PAGE TOP OF DOC Mr. BACA. That meant they had to have signed off, right? That said that you are following directions, and they did not come back and tell you that you needed to follow a different one or the methodology that you are using is now different. Is that correct?
Mr. HOWARD. I would not know how to characterize it. They would have to do the characterization. I can tell you what they did.
Mr. RAINES. But did they do it?
Mr. HOWARD. Did they?
Mr. RAINES. Did they come back and tell us to do something different?
Mr. HOWARD. No.
Mr. BACA. Okay. Thank you.
This morning, the regulators allegated that Fannie Mae did not respond to the initial request for information and that it had to issue a subpoena. Can you give us your version of the events leading to this release of the information?
Mr. RAINES. Congressman, we have been very responsive to OFHEO over this period, specifically relating to subpoenas. Our attorneys were told that the use of subpoenas did not relate to a lack of cooperation, but that this was because OFHEO wanted to move from informal interviews to having them on the record. That is what we were told at the time that the first subpoenas were issued because we said to them, you know, ''There is no need for this. We will produce the people, and we will produce the documents.'' They said they wanted to move
Mr. BACA. So you were willing to be cooperative with them and willing
Mr. RAINES. We were willing and we were cooperative providing hundreds of thousands of pages of material and almost a million pages of e-mail to them as the result of their requests.
Page 170 PREV PAGE TOP OF DOC Mr. BACA. Did OFHEO personally contact you regarding the preliminary findings, either one of you?
Mr. RAINES. No.
Mr. HOWARD. Not me.
Mr. BACA. It seems odd that they would not contact you. Yet, you know, they have gone to the media and they have gone everywhere else. But yet they should have followed, practiced standard procedures, which is a total violation.
Maybe we should have them on the audit out here versus you guys in terms of not following practice or not following the laws that are in place.
Where do you think the process will go from here?
Mr. RAINES. Congressman, this process has been so unusual, I cannot tell you. I can tell you what we are doing.
Our board has negotiated an agreement with OFHEO, which we are going to faithfully follow and put into effect within the timeframes as agreed to between the director and our board.
We are also going to be cooperating with the independent counsel that our board has appointed to look into all of these allegations and to see if we can find out what the facts are, and so we will cooperate with them.
We will be attempting to take the two big accounting issues, FAS 91 and FAS 133, directly to the SEC and ask them to give us resolution on those so we can see, and, if we are right, then we are right, and, if we are wrong, we will make whatever changes the SEC tells us to make, and we will also cooperate with any law enforcement agency that is attempting to look at these allegations.
They are very serious allegations, they have to be looked at, and I am delighted that today, for the first time, we are allowed to at least partially give our point of view. But, certainly, the independent counsel will be looking at every document and every person and doing a very thorough review, and we look forward to that.
Page 171 PREV PAGE TOP OF DOC Mr. BACA. Thank you.
I served on numerous boards, and, usually, when an audit is done by any accounting firm, they usually come up with the recommendations, the deficiencies, recommendations for improvements.
You usually give that nonprofit organization an opportunity to correct those deficiencies before any kind of action is taken, and I am just really appalled at the kind of action that has occurred out here without first discussing it with either one of you two in terms of any corrections or actions that need to be taken. If there was a difference in terms of methodology, accounting system, what needed to be done, it seems like they would have approached you.
So, hopefully, we will comply with both the laws that are in place right now in terms of standard practices that need to be done.
And, Mr. Chairman, I realize that my time has expired, but thank you very much.
Chairman BAKER. Mr. Bachus?
Mr. BACHUS. Thank you.
Chairman Raines, we are talking about these financial reporting issues in a lot of the discussion, whether, you know, you violated FASB rules or not, but did these issues, I mean, first, undermine your creditworthiness?
Mr. RAINES. Well, I have to say, Congressman, that since this report has come out, we have been put on credit watch, and one of our credit ratings was dropped, went down as a result of this report.
So a report like this from a regulator has serious consequences in the capital markets. You know, our stock price dropped by $14 billion as a result of this report coming out in the way it did.
Page 172 PREV PAGE TOP OF DOC So, yes, this report has a very, very big impact on how we do our business from our debt costs to our credit ratings to our stock price.
Mr. BACHUS. Okay, but you are not in jeopardy of meeting your ordinary course of business, your obligations and that?
Mr. RAINES. No, the fundamental economics of the company has not changed.
Mr. BACHUS. Okay.
Mr. RAINES. The company is in fine shape. The only thing that has changed is this report.
Mr. BACHUS. Yes, when creditworthiness changes, your credit rating changes, you are put on credit watch. Obviously, that has implications not only for the housing market, but for the general economy as a whole.
Mr. RAINES. Yes.
Mr. BACHUS. I think what we had discussed this morning is you heard Director Falcon say you all were uncooperative, but you have rebutted here pretty clearly, and, you know, so we have a difference of opinion on that.
The other thing, which a gentleman just mentioned, is he says he used best regulatory practices in this special investigation. You have been in government business for a long time. Is this normal? Is this the best practices for other government regulators? How would they have typically handled things as opposed to how OFHEO did?
Mr. RAINES. Well, Congressman, when I was in the government as the director of the Office of Management and Budget, one of my duties was to oversee regulatory matters throughout the federal government, and I have never seen a proceeding like this. In all of my time, I have never seen a proceeding like this.
The financial regulators are given special powers, very, very strong powers. They can put a financial company out of business if they choose to. And because they are given those special powers, they exercise them very carefully.
Page 173 PREV PAGE TOP OF DOC Quite typically, a financial regulator in this circumstance, taking everything OFHEO has said at face value, as being true, that financial regulatory would have managed this without one headline, and they would have done it entirely confidentially.
They would have resolved the issue, and, at the end, the resolution would have been announced, and this has happened many times. The Fed, the OCC, the OTS have had to do this with financial institutions.
So, if we take everything they said as being exactly right, I do not know of any financial regulator who would have done it this way. I have never heard of a special examination report being made public.
Mr. BACHUS. Well, it certainly has been on the public stage, the entire process.
CFO Howard, do you want to comment?
Mr. HOWARD. No.
Mr. BACHUS. Oh, okay. I am sorry.
Let me ask you this. You know, you all have basically said that most of what they have, I think, accused you all of doing you had not done or that they had not, at least before now, asked you to change your internal controls, very strange, and you are defending your practices, I think, by and large.
That being the case, why did you all enter into this September 27 agreement? I mean, you know, if they were not right, why would you have sort of consented to do what they asked you to do? And I know that you did not acknowledge any wrongdoing, but you took some pretty drastic measures, and one might say, ''Why would you have done that?''
Particularly, one thing you have done is you have agreed to this capital surplus of 30 percent of minimum capital reserve, which if followed could, you know, restrict your activities which could negatively impact the financial markets. So I would just say is there an explanation for that.
Page 174 PREV PAGE TOP OF DOC Mr. RAINES. Well, yes, there is. Our board gave tremendous consideration to this, and there are several points, I believe, that they wanted to make.
The first point was to acknowledge that we are a regulated company, and, if our regulator has concerns, whether we agree with them or not, they have to be taken quite seriously. So they wanted to demonstrate that on every issue they could agree to that they would reach an agreement.
Second is that the agreement preserves the issues on which we do not agree, and those are to go to the appropriate place.
Third is that we are mindful of the markets, and the idea that a company as large as we are would be seen to be having some kind of ongoing battle with their regulator struck us as to be contrary to our mission, and we did not want to take the risk of undermining our mission by appearing to be in an ongoing battle with our regulator.
So the board had to make a judgment. I know some people took that agreement as being an admission of guilt. I think it was a demonstration of leadership by our board that put our mission first as opposed to our reputations or our feelings or our gut, all those other things that they could have put first. They put the mission first, and I think that is admirable, and I applaud them for doing it.
As I mentioned before, financial regulators are very powerful entities. They can put you out of business, and so it is imperative for the board to ensure that we have a functioning relationship with our regulator on an ongoing basis.
Mr. BACHUS. Can I
Chairman BAKER. Can you wrap up? Yes, sir.
Mr. BACHUS. This is my final question. This will be for you, CFO Howard.
Can you outline for us the exact steps that must be followed under FAS 133 for a derivative contract to receive hedge treatment and also whether Fannie departed from common industry practice in establishing an effective hedge?
Page 175 PREV PAGE TOP OF DOC Mr. HOWARD. We, first of all, do not believe we did depart from practice, and, importantly, OFHEO has not contested the fact that the transactions that we have entered into are economically effective.
Mr. BACHUS. Right.
Mr. HOWARD. What they are talking about is whether we have met the criteria for hedge accounting. The requirements differ according to the nature of the transaction.
For the derivative transactions at issue, you must first identify the transaction as being a certain type of hedge, with documentation. We believe we have done that. OFHEO has raised some questions over technicalities around the documentation.
The second thing that has to happen, again, in types of transactions we have undertaken, is we need to have a high degree of effectiveness. It is called in the literature ''perfect effectiveness,'' which can be assumed. We have assumed perfect effectiveness on these hedges because, in our view, that we have buttressed by periodic testing, there is a very, very small amount of ineffectiveness.
Even though I recognize that minimal ineffectiveness and perfect effectiveness are not the same thing, our reading of the accounting literature, buttressed by KPMG notes it is making a practical application in a business context that is permissible, and that is what we have done.
Mr. BACHUS. Well, then it is my understanding that there is no question that any of these activities undermine the safety and soundness. In fact, some of them are prudent business practices except where they may have violated, you know, financial reporting standards.
Mr. HOWARD. And we do not think we have.
Mr. BACHUS. I think that is really the issue, not whether you have engaged in any dangerous
Page 176 PREV PAGE TOP OF DOC Mr. RAINES. Right. In fact, these hedges are all designed to reduce risk.
Mr. HOWARD. Exactly right.
Chairman BAKER. The gentleman's time has expired.
Mr. MEEKS. Thank you, Mr. Chairman.
Mr. Raines, Mr. Howard, this may come as a surprise to you, but some people just do not like Fannie Mae's current status in the market, and that is pre-this OFHEO's report, et cetera. In fact, this may be a surprise, that when OFHEO came hereand Mr. Falcononce before, many members of this Congress criticized them severely and threatened to put them out of business, in fact, wanted a new regulatory agency to come in.
You know, I understand your statements, Mr. Raines, about you do not understand certain things, but let me just let you in on a surprise. Some people do not want you in business. They do not like the success that you have accomplished by putting people with decent homes and roofs over their head. Some people just do not like that. And so that might be a surprise to you.
In fact, let me ask. Prior to this hearing that we had where OFHEO was threatened, had there been an occasion or any time before where OFHEO may have examined Fannie Mae and noted any irregularities or discrepancies in any kind of accounting standards?
And I wonder how did they work with you in the past before we had all of these secrets coming out that people do not like what you do?
Mr. RAINES. Well, prior to the issuance of this special examination report, all of our examinations from OFHEO found that we met or exceeded safety and soundness standards, and that is going back to when OFHEO first organized itself back in, I think, 1993.
Page 177 PREV PAGE TOP OF DOC So we had never, to my knowledge, had an outstanding issue with OFHEO on accounting, internal controls or any other issue. In the course of their examinations, they would make recommendations to us and, you know, we would adopt them. But we have never had an issue prior to this examination report.
Mr. MEEKS. Were you willing to make those? When OFHEO was making those recommendations, et cetera, in the past, would that have been shared with the press or members of Congress or put in the headlines of the newspapers? Has that ever happened before?
Mr. RAINES. No, the examination reports remain confidential until OFHEO makes an annual report to Congress, usually released in June, and then it is made available, but all of the examinations are held confidential, and, in fact, OFHEO has a regime for their regular examination function that holds these things confidential, and we have had very good experience with their regular examination process in that regard.
Mr. MEEKS. So this is a relatively new phenomenon that has taken place now as far as your relationship with your regulator.
Mr. RAINES. With regard to this special examination, this is very new.
Mr. MEEKS. I know that you have indicated in your testimony thus far that your board, I understand, had agreed to the 30 percent capital surplus because you want to show, you know, you are part of the market and that you are cooperating, et cetera.
But I am curious to know is there any other financial institution that does anything even close to 30 percent.
Mr. RAINES. As a mandated surplus? Well, Freddie Mac has a
Mr. MEEKS. Other than Freddie Mac.
Mr. RAINES. No, sir. I am not aware personally of a financial institution that is otherwise solvent that is required to have a mandatory surplus by their regulator, but that is not to say it does not exist. I am just not aware of it.
Page 178 PREV PAGE TOP OF DOC Mr. MEEKS. And, Mr. Howard, let me just ask you a question. This will be my last questionand I will yield back the balance of timebecause I am just trying to make sure that I understand.
According to OFHEO, Fannie Mae must supply FAS 91 by recognizing only $200 million against expenses for prepaid loans, instead of $400 million, and, of course, you state that Fannie Mae's treatment was correct and that KPMG agrees with you. Just explain to me why are you right and OFHEO wrong.
Mr. HOWARD. Prior to 1998, you know, any amount of this so-called catch-up adjustment, which, again, was the comparison we made after the fact between the amount that we had brought into income based on an old assumption of average life of the portfolioremember there are millions of loans in the portfolioand a new average life. That difference we had kept track of but never recorded in current period income. That was the catch-up adjustment.
In 1998, that dollar amount grew to a large size of expenseit was actually closer to $440 millionand we determined that some portion of that likely did represent a true economic cost. So we put together a group within the finance department of portfolio people and comptroller's people to come up with a method of determining the best amount to best reflect true economic substance.
The recommendation they made to me and to us as the senior management team was that $240 million was that right amount. So the remaining amount, which was not deferred because it was an amount that never was recorded on the books in previous yearsit was kept track of, and that was the audit differencethat turned out to be a judgment that ex-post proved to be correct because next year we did not have an audit difference that was expense. We had one that was income.
So the judgment in retrospect turned out to be correct. It was made as a part of a process that had integrity, and it was independent of any link to compensation.
Page 179 PREV PAGE TOP OF DOC Mr. MEEKS. Thank you.
Chairman BAKER. The gentleman's time has expired.
Mr. SHAYS. Thank you, Mr. Chairman.
Mr. Raines, I have a lot of respect for you. I think that you are one of the best budget directors. You are very articulate. I liked your opening statement, the buck stops with me. We do not hear that enough, and I thank you for that.
My problem with Fannie Mae is I feel it is a bully in the marketplace that exercises its incredible advantages and does not want to play by the same rules that everyone else plays by, and I think you know that is what I think.
I think that your not being under this 1933 Act and then voluntarily agreeing to be under the 1934 Securities Actvoluntarilyto me is a bit arrogant. I think you should be willing to be under those laws.
I think to suggest that you should have a weak regulator like OFHEO, and, when we wanted to strengthen it, you had objected to strengthening it, I have a problem with that.
So I am not surprised by what is happening right now.
When you say, ''Well, OFHEO never did this before, and we played by their rules,'' they were a very weak regulator.
I am not pleased to learn that you have given $245 million worth of bonuses in the last five years. That is aside from stock options. So I have a bit of a problem with that.
But I am particularly curious as to why OFHEO needed to have subpoenas in order for them to do their job. Why did they have to get subpoenas? So, if you would just tell me that, I would start off with my questions with that.
Mr. RAINES. Well, I will just answer your subpoena question.
Page 180 PREV PAGE TOP OF DOC Mr. SHAYS. Yes.
Mr. RAINES. There are a lot of other things there, but
Mr. SHAYS. I know that, but that is my time. You have had your time.
Mr. RAINES. With regard to the subpoenas, our lawyers were told by OFHEO staff that they were issuing subpoenas not because of any lack of cooperation by Fannie Mae, but because they wanted to move the interviews from being informal interviews to interviews on the record with someone there keeping a record of exactly what was told. That is what we were told contemporaneous with the issuance of the subpoenas.
Mr. SHAYS. Can I just say to you I am a little concerned with that answer because it seems to conflict with what we had been told. So I justand you are under oathwant to make sure.
Are you suggesting that there was no requirement whatsoever for them to get subpoenas, that you, as soon as they asked for this information, you, Fannie Mae, voluntarily provided this information? Is that your testimony?
Mr. RAINES. That is my testimony.
Mr. SHAYS. Is that your testimony, Mr. Howard, as well?
Mr. HOWARD. To the best of my recollection, yes.
Mr. SHAYS. Okay. To the best of your recollection. In other words, this information was asked for, and you voluntarily were going to provide it, but, instead, they said, ''Oh, by the way, we want to go and get subpoenas.''
Mr. RAINES. We were actually in the process. We had been doing this for quite a while. The special exam had been going on for a while before the first subpoena was ever issued. We had been providing thousands of documents, providing people, providing e-mails.
Page 181 PREV PAGE TOP OF DOC Mr. SHAYS. Okay. Did you provide the information they wanted, not what you wanted?
Mr. RAINES. Yes. We had provided every piece of information they wanted, and we told them they would get that with or without subpoenas.
Mr. SHAYS. Okay, but I think it is important to put on the record because the information is that they had to get subpoenas to get this information.
Mr. RAINES. Well, I have testified very clearly that that is inaccurate.
Mr. SHAYS. Okay. Let me ask you, besides the bonuses, you offer stock options as well?
Mr. RAINES. We are a shareholder-owned company, and we pay according to what our statute provides, which
Mr. SHAYS. Is that a yes?
Mr. RAINES. We pay comparably to other companies, and we use stock options among the various things in our executive compensation.
Mr. SHAYS. Do you dispute the amount of $245 million over the last five years as bonuses? That is a lot of money. It is a quarter of a billion dollars. Nodding the head does not get transcribed.
Mr. RAINES. Well, I have to go calculate the number. It is a number that is calculable, and I do not know what the number would be.
Mr. SHAYS. Do you think it is in the ballpark?
Mr. RAINES. It could be.
Mr. SHAYS. Yes.
Mr. RAINES. But you say it is a very large number. In the last five years, we have also probably had after-tax income of $30 billion. So our executive compensation
Page 182 PREV PAGE TOP OF DOC Mr. SHAYS. I know you are a very successful company.
Mr. RAINES.is a tiny, tiny percentage of our revenue, and it is a tiny percentage of our profit.
Mr. SHAYS. Why should banks have to set aside between 6 percent and 8 percent of their portfolio and you guys are in the range of about 3 percent?
Mr. RAINES. Banks should do that because they have much more risky portfolios. Banks are allowed to invest in a wide range of assets. We can only invest in single-family and multifamily homes.
Mr. SHAYS. So it is your testimony that you do not need to have more because you do not feel any of your investments potentially could go sour?
Mr. RAINES. If none of them would go south
Mr. SHAYS. No, you set aside a certain sum in case the market starts to go bad, and the residential marketplace is very volatile, and you have about 3 percent of your portfolio set aside. If a bank gets below 4 percent, they are in deep trouble. So I just want you to explain to me why I should be satisfied with 3 percent.
Mr. RAINES. Because banks do notthere are not any banks who only have multifamily and single-family loans. I think if you check, banks are now arguing that their capital for those loans should only be 2 percent or less. I mean, that is the argument they are making right here in Washington today, that these assets are so riskless that their capital for holding them should be under 2 percent.
Mr. SHAYS. Fine, but let me just ask you this question because OFHEO was asked this. Before OFHEO issued its report, did any of you speak to any people in the press or with any members of Congress about their report?
Mr. RAINES. We did not know anything about their report. We had never seen their report.
Page 183 PREV PAGE TOP OF DOC Mr. SHAYS. When did you see their report?
Mr. RAINES. We saw their report on Monday.
Mr. SHAYS. Did you know of the report? Did you know the contents of the report?
Mr. RAINES. No, we had no knowledge of the content of the report. In fact, I had been calling the director. I had a meeting scheduled with the director to discuss the progress on the special examination, which he canceled. I had three calls into him to discuss it because of the press reports that we had seen, and I never talked to him.
Mr. SHAYS. I thank the chairman. Just to verify, we are not playing a word game here of a draft of the report.
Mr. RAINES. The report was handed to management as OFHEO officials walked into a meeting with our board, literally handed to us as they walked in.
Mr. SHAYS. And you were not given a draft earlier or a working draft or anything like that?
Mr. RAINES. We saw nothing.
Mr. SHAYS. So the answer to your question is you never spoke to any member of Congress before this report was issued or the press about this report before it was issued?
Mr. RAINES. About the contents of the report?
Mr. SHAYS. About the report.
Mr. RAINES. Well, if we are going to be thiswe never saw the report!
Mr. SHAYS. I did not ask that. I want an answer to the question because I had been told that Fannie Mae had been speaking to reporters and press about this report before it was issued.
Page 184 PREV PAGE TOP OF DOC Mr. RAINES. About the content? Is that what you are asking? The contentare youI want to be very clear here.
Mr. SHAYS. Not the content. Just concerns that there was going to be a report that came out, et cetera, et cetera, et cetera, and
Mr. RAINES. We have talked about concerns. Yes, we have talked about concerns about the report that we had been reading about in the paper. Yes, indeed. The press was calling us. When they were reporting OFHEO is about to do a report, they asked us, ''What is your reaction?'' and we said, ''We do not know anything about that.''
Mr. SHAYS. And that is the extent of your contacts? You did not initiate any?
Mr. RAINES. Why don't you give me the example and then I can tell you what
Mr. SHAYS. No, no. I do not want to give an example. I do not want to give you an example. I want to know if you all affirmatively went out to the press to engage them in a dialogue about this report which you say you have not seen.
Chairman BAKER. And that will have to be the gentleman's last question because your time has expired.
Mr. SHAYS. The answer is a yes or no. Did either you or your organization do that?
Mr. RAINES. Look, I do not understand what you mean by engaged. No doubt
Mr. SHAYS. No, you do not want to answer the question.
Mr. RAINES. No doubt we talked to the press about the report we had not seen. No doubt that someone in Fannie Mae talked to the press about a report we had not seen because we were getting asked questions about a report we had not seen. Some questions indicated that they knew more than we did.
Page 185 PREV PAGE TOP OF DOC Mr. SHAYS. And the question I asked, though, which you could be responsive toand I would appreciate itis: Did you affirmatively interact with the press or actively contact the press about this report, not respond?
Chairman BAKER. And that is the gentleman's last question.
Mr. RAINES. I am not trying to be difficult.
Mr. SHAYS. The answer is a yes or no.
Mr. RAINES. I am not trying to be difficult, Congressman, but you are asking me the question, did we ever call a reporter and mention it? Probably, but not because we had seen the report.
Mr. SHAYS. Thank you. I hear you. I hear you.
Mr. RAINES. Okay.
Chairman BAKER. The gentleman's time has expired.
Ms. WATERS. Thank you very much.
I just wanted to clear up a little something here. I find the information about the bonuses very interesting, and I am sure that it will cause a lot of discussion, but that is not really why we are here today.
You raised a question earlier, Mr. Raines, about this being proprietary information. Do you still think that this is proprietary information that has been released, after you have seen what we have?
Mr. RAINES. My concern about proprietary information solely goes to not the five people at the top because our information is public, but we have people trying to recruit away our people every day. Every day, we have recruiters coming to Fannie Mae trying to recruit our people away.
This is a road map as to how to go about recruiting Fannie Mae employees. This is private information about people who are not public officials, who are not senior officials, and now this is being made public for reasons I do not understand.
Page 186 PREV PAGE TOP OF DOC Ms. WATERS. Well, the reason that I asked is that our chairman did indicate that he had a legal opinion. I do not have a copy of that legal opinion. I do not think there is anything in writing. I think that his conclusions were drawn based on some constitutional reference.
I just wanted to make sure that it is your understanding that it is proprietary information so that I can continue my follow-up and my investigation to find out whether or not proprietary information has been released. But you do think it is proprietary?
Mr. RAINES. My only goal here was to not waive any rights we have.
Ms. WATERS. All right.
Mr. RAINES. We continue to maintain whatever rights we have asserted. I did not want to waive that by sitting here and not saying something that was being revealed.
Ms. WATERS. Okay. That is fine. And I think I know what to do with that.
I know you have repeated this any number of times, but I think it is very important for you to repeat part of an answer that you had given earlier, relative to this business about subpoena and information from OFHEO about you had been forced somehow to answer questions.
Part of your information had to do with the Justice Department and the fact that they had been contacted. What was the Justice Department's response to OFHEO's request to be involved in this in some way?
Mr. RAINES. The Justice Department response was that they indicated that this was an issue that they expected to be worked out between Fannie Mae and OFHEO and that they did not believe that there was a need for any involvement of the department or the courts in working it out.
Page 187 PREV PAGE TOP OF DOC Ms. WATERS. Excuse me one second, my colleague, Mr. Shays? My colleague, Mr. Shays?
The question that you asked about whether or not they had been forced through a subpoena to cooperate or to answer questions, there was one portion of his answer that you were not privy to. You were not in the room. I just asked him to repeat it. You were being distracted. I would like to ask him to report that again.
The Justice Department had been contacted to ask to be involved in some way with this investigation. What did the Justice Department say, Mr. Raines?
Mr. RAINES. Let me read to you specifically so you have the statement that has been approved.
''Both in-house and outside counsel for Fannie Mae spoke to the Justice Department about OFHEO's referral to it regarding enforcement of one subpoena relating to e-mail, and the Justice Department indicated that this was an issue that they expected to be worked out between OFHEO and Fannie Mae without any involvement of the department or the courts.''
Ms. WATERS. Okay. Thank you very much.
I also would like to inquire
Mr. SHAYS. I do not know what that means. I do not know what the means, so if you would
Ms. WATERS. Okay. On my time now.
Mr. RAINES. I think what that means is
Ms. WATERS. Excuse me. This is my time. You may not answer him on my time. He can get some additional time.
Let me just ask you is it true that you absolutely had not seen this report until they came to the boardroom with the report.
Mr. RAINES. That is true. I did not see the report until they went into the boardroom, and they then handed a report with my name on it, an envelope with my name on it, saying, ''This is your copy of the report.''
Page 188 PREV PAGE TOP OF DOC Ms. WATERS. Were you ever told why it was important to come before the board with such haste? From the time the report supposedly was finalized and to the time that they came to the boardroom, did you ever hear why it was so important to get that board organized so that they could receive this report? Were you ever explained to why it happened that way?
Mr. RAINES. It was not explained to me. I can believe you are going to have our lead director testifying before you. She can also answer whether it was ever explained to her.
Ms. WATERS. Did you ever hear that the timing of the board meeting had anything to do with the fact that there was a desire to have this hearing prior to the recesscongressional recess? Did you ever hear any of that discussion?
Mr. RAINES. I did not hear that.
Ms. WATERS. All right. Finally, let me just ask you this.
Obviously, Fannie Mae is a very sophisticated organization with a lot of smart people doing big, big business, and it isI cannot understand why you would be involved in any activity that could easily be unveiled that was incorrect accounting practices or anything else with some kind of investigation. You have testified as to your accounting practices and your understanding of what is expected of you.
Finally, when Fannie Mac was investigated, did this raise some kind of red flag, and, even though you felt that what you were doing, you were doing it correctly, that you were on solid ground, did you say, ''Well, let us look at ours again, too, to see if there is anything here.'' I mean, I would have done that, and I want to know did you two did that?
Mr. RAINES. We did, indeed, do that. We engaged outside counsel, we engaged accounting, we looked at everything that was alleged about Freddie Mac to see did Fannie Mae have the same problems, and our conclusions were that we did not, and, to this day, no one has alleged that we had the same problems that Freddie Mac had. These issues that are in the OFHEO report are brand-new issues to Fannie Mae and they are new to our relationship with OFHEO.
Page 189 PREV PAGE TOP OF DOC Ms. WATERS. And, by the way, I am going to ask you something that you may not want to answer.
Since all of this has been made public, I read an editorial in The Wall Street Journal that talked about the fact that there had been an investigation and that editorial almost jumped to the conclusion that there must be something wrong, and, therefore, the investigation, even though there had not been a response, there must be something wrong, and even though they did not explore it fairly, they came to the conclusion that you would not be fit to be the treasurer of the United States of America.
What does the speculation about your being perhaps asked at some point in timeshould certain people win the presidency, what does that have to do with your work now have to do with whether or not you should be asked to be the treasurer of the United States of America. Have you heard that discussion at all?
Mr. RAINES. I have heard that discussion. As you know, I have been around this town a long time. It is very said. It is very sad to me if any consideration of politics goes into something like this. My service in the government, you know, has been, I think, service.
You know, I have never run for office, and I have never sought to be a political figure. You know, I have responded when a President of the United States has asked me to respond, and thatI have been asked twice and I have responded twice to that case.
More than me, my colleague, my former boss, Jim Johnson, has been brought into this, and let me say something about that directly. He, too, has been mentioned as a potential person to be in a future administration. We have done a look at the 1998 incident that has been alleged by OFHEO, and we have found no acts that would relate to Jim Johnson whatsoever.
Indeed, he was not the CEO when these decisions were made. I was. And so any implication that Jim Johnson had something to do with this is just totally without factual base. It shows what happens in these kinds of frenzies.
Page 190 PREV PAGE TOP OF DOC I have to tell you the thing that bothers me far more than this treasury thingfar moreis explaining to my kids. That is hard.
Ms. WATERS. Well, I
Mr. RAINES. It is hard when your daughter feels she needs to say to her dad, ''I support you.'' I am supposed to be supporting her. That is hard.
Ms. WATERS. Well, we are going to be out of here when we go on recess, and all of this talk is going to fester. You have not had an opportunity to respond.
You have not been questioned. You have not had an opportunity to explain. Most of the members up here on this panel do not understand accounting practices. They are learning a lot for the first time today.
What this could potentially do is in some way damage your reputation because these allegations are being made without your having an opportunity to respond.
Chairman BAKER. Ms. Waters, your time has long expired. Can you wrap up, please?
Ms. WATERS. Yes, I will wrap this up. What would you ask this committee to do in the interest of fairness that would in no way accept OFHEO without the opportunity for the kind of response that is always allowed in this kind of setting? What would you ask this committee to do?
Mr. RAINES. Ms. Waters, what I would ask the committee to do is to insist with all the agencies within your oversight they operate within
Chairman BAKER. Excuse me.
Ms. WATERS. I was trying to hear him.
Chairman BAKER. I thought your time had expired. Please proceed.
Ms. WATERS. Yes.
Page 191 PREV PAGE TOP OF DOC Mr. RAINES. What I would ask this committee to do is to insist for all the agencies within your oversight that they operate under the commonly accepted rules of due process and fair play. I would also like your support to get a resolution on these issues that the SEC would give us an answer.
You know, we did not come here to say today we are perfect or even that we know that we are right. We are simply saying we approach this with a businesslike approach, with honesty and integrity, and if we are wrong, we will make the changes. If we are right, you know, then we will go forward.
All we have asked is that the proper process be used. The answers will come out of the proper process. That is the only request that we are making, is that at least give us the minimal rights that we would expect to be given to any other company, to any individual, any organization.
Chairman BAKER. The gentlelady's time has long expired. We do have a number of other members wishing to be heard.
Mr. OSE. Thank you, Mr. Chairman.
Mr. Howard, am I correct in understanding you are the chief financial officer for Fannie Mae?
Mr. HOWARD. Yes, you are.
Mr. OSE. Am I correct in understanding that questions of how to treat income or expense at Fannie Maethat decision would at least go through your office?
Mr. HOWARD. It would typically be discussed with me, depending on the level of importance.
Mr. OSE. At what level of importance do issues come to your office for a final determination?
Page 192 PREV PAGE TOP OF DOC Mr. HOWARD. That determination is made by the people who bring them to me.
Mr. OSE. Is there typically a threshold dollar amount?
Mr. HOWARD. No. It is usually how unusual, new the issue is.
Mr. OSE. In terms of such unusual or new situations, are you the final arbiter of such decisions?
Mr. HOWARD. Again, it is situational. In some cases, it could be the chairman, whoever that may have been, it could be me.
Mr. OSE. Now I recognize that the report in question today covered a period prior to Sarbanes-Oxley being in effect.
Mr. HOWARD. Yes.
Mr. OSE. Is that your understanding also? So it predates our passage here on the Hill of that particular
Mr. HOWARD. Parts of it do. Yes, that is correct.
Mr. OSE. All right. Does the audit committee of the board of directors get involved in these questions?
Mr. HOWARD. Which questions?
Mr. OSE. Questions of a new or unusual set of circumstances having to do with how to treat income or expense.
Mr. HOWARD. Again, it would depend on the situation. Sometimes they are briefed on it. They are typically not consulted for a decision.
Mr. OSE. The audit committee is not consulted for a decision of any nature related to this kind of a situation? It is just given to them as a fait accompli?
Mr. HOWARD. It is. I am attempting to recall an instance where the audit committee may have been consulted in advance on a financial decision. I cannot recall one.
Page 193 PREV PAGE TOP OF DOC Mr. OSE. So, in effect, what you are saying is that the audit committee does not set the standards for the decisions. The recommendation is given to them and they will either say yea or nay?
Mr. HOWARD. Well, no, we typically do not even do that. We will report on the financial condition of the company, significant accounting issues. Anything that we think ought to be brought to their attention for review, we will bring to them.
They can comment on them, they can ask us to do things differently, but we do not ask them for a decision because they typically do not have the level of expertise to make decisions at that level of detail.
Mr. OSE. I just want to make sure I understand it. Implicit in your answer is that such decisions are therefore made at the management level, rather than the board level.
Mr. HOWARD. That is correct.
Mr. OSE. Okay. So the final arbiter for such decisions is your office?
Mr. HOWARD. It, again, depends on the decision. It could be the comptroller. It could be the level below the comptroller. It could even be at a level below that.
Mr. OSE. So the decisions may be made within perhaps the operating units of Fannie Mae.
Mr. HOWARD. Not accounting decisions. They would not be made within the operating units. Accounting policy decisions are made by the accounting policy person, transactional decisions that have accounting ramifications are made in the units, but the results are reviewed and assessed by people in the comptroller's department.
Mr. OSE. And then they are run past you as CFO for final sign-off or rejection.
Page 194 PREV PAGE TOP OF DOC Mr. HOWARD. It depends on the issue. Most of them do not come to me for that step.
Mr. OSE. Mr. Chairman, we may have the wrong guy here to ask these questions on the accounting rules or modifications.
I am curious whether or not you do play a role in making decisions as to what is or is not treated as an expense in one case or an income issue in another.
Mr. HOWARD. Typically not.
Mr. OSE. And you are also testifying that the audit committee of the board of directors is not involved in those decisions either.
Mr. HOWARD. Not asked to make them. Informed of them.
Mr. OSE. Now you are CFO. Am I correctly advised that you are CPA trained?
Mr. HOWARD. You are incorrectly advised. I am not a CPA.
Mr. OSE. You are not a CPA. Okay.
Let me ask a different set of questions, if I might. Actually, this goes to Mr. Raines. Prior to this hearing, did you or any of your agents or employers or counsel visit with any members of this subcommittee about the substance that we were going to discuss here?
Mr. RAINES. Yes.
Mr. OSE. Did you or any of your agents or employers or counsel provide questions to members of this subcommittee for the purpose of having those questions posed to witnesses during this hearing?
Mr. RAINES. I believe we talked to members about or staff about questions that they might want to pose, yes.
Mr. OSE. Okay. The only reason I ask that question is that Mr. Falcon, I think, was asked on the previous panel to provide to the committee a record of all such contacts that he may have had with the committee or his agents or employees. I am asking: Will you provide the committee a similar record of all such contacts to this committee regarding this hearing?
Page 195 PREV PAGE TOP OF DOC Mr. RAINES. My answer is I do not know. I mean, we will have to talk to our counsel and others.
Mr. Falcon is a government employee. He is running a government agency. There are laws that relate to the ability of a government employee to lobby the Congress, and I assume that that is what the inquiry was to Mr. Falcon.
We are not a government agency. We are not prohibited from lobbying the Congress, but I would certainly take under advisement your request, and we will get back with you with an answer.
Mr. OSE. I am going to take that as a no, Mr. Chairman. Thank you.
Mr. FRANK. Mr. Chairman?
Chairman BAKER. Yes, Mr. Frank?
Mr. FRANK. Mr. Chairman, we have a colleague now on the committee, the gentlewoman from Florida, Ms. Brown, who is very interested in this and a student of Fannie Mae and its activities, and I would ask unanimous consent that she be allowed to enter a statement into the record of this hearing.
Chairman BAKER. Without objection.
Mr. Davis, you are recognized.
Mr. DAVIS. Thank you, Mr. Chairman.
Mr. Raines, I had planned to go in a different direction, but I want to follow up on Mr. Ose's comments for a moment. You have been in D.C. for how many years as a
Mr. RAINES. I have lived here for about 20-some-odd years.
Mr. DAVIS. Okay. But in terms of your work at OMB and your work at Fannie Mae, you have been a part of the institutional layers in this town for a while, have you not?
Page 196 PREV PAGE TOP OF DOC Mr. RAINES. Yes, sir.
DAVIS; And you have seen your share of congressional hearings, I assume, over the course of time?
Mr. RAINES. Yes, sir.
Mr. DAVIS. Is it a fairly common practice, Mr. Raines, for almost every single entity that comes before this committee to have some consultation or talk with members of Congress or staffers before their folks testify?
Mr. RAINES. Yes, sir. I typically did that when I was in the government, and I have done it since I have been out of the government.
Mr. DAVIS. And that is not an unusual or insidious practice in any way?
Mr. RAINES. No way.
Mr. DAVIS. And just one final point on this: You were asked by Mr. Ose if you or Mr. Howard had talked to your attorneys. Are you aware from newspaper reports that there is a Department of Justice probe in this matter?
Mr. RAINES. I am aware of that from the newspapers.
Mr. DAVIS. And based on your professional experience, Mr. Raines, is it not commonplace that if someone is a potential subject even, much less a target, of a Justice Department probe that they would probably be out of their mind if they did not talk to a lawyer?
Mr. RAINES. Yes, sir. You are right.
Mr. DAVIS. And especially if you are about to give public testimony under oath, wouldn't the prudent thing be to talk to a lawyer?
Mr. RAINES. Yes, sir.
Mr. DAVIS. Okay. Let me move to a much more important set of questions. One of the things that OFHEO is criticizing, as you know, is the structure of management at Fannie Mae, and they are questioning the structure of responsibilities, and there is some argument that there should be a greater separation of certain job descriptions.
Page 197 PREV PAGE TOP OF DOC Mr. Howard, you understand that is one of the subjects here.
Mr. HOWARD. I do.
Mr. DAVIS. How long has OFHEO been in existence?
Mr. RAINES. The Congress created them in 1992. They actually, I think, came into existence in 1994.
Mr. DAVIS. Okay. The structure that they are questioning or raising issues abouthow long has it been in place at Fannie Mae?
Mr. RAINES. A version of the current structure has been in place since 1991 when I joined the company.
Mr. DAVIS. Okay. At any point prior to September of 2004 has OFHEO raised any questions about the structure or the alignment of job responsibilities at Fannie Mae?
And I will ask both of you that question.
Mr. RAINES. Not to my knowledge.
Mr. DAVIS. Mr. Howard?
Mr. HOWARD. Nor to mine.
Mr. DAVIS. And, as far as you know, has OFHEO been aware of that structure for the whole 12 years of its existence?
Mr. RAINES. Yes, sir.
Mr. HOWARD. It could have been.
Mr. DAVIS. And has OFHEO given you any explanation of why they did not raise questions in the previous 12 years?
Mr. RAINES. No.
Mr. HOWARD. No, sir.
Mr. DAVIS. Does it suggest to you the fact that if they did not raise questions in the previous 12 years, they probably did not think it was a matter worth questioning?
Page 198 PREV PAGE TOP OF DOC Mr. HOWARD. I do not know.
Mr. RAINES. That would be speculating. They asked us lots of questions over the period of time, and, as far as I know, this has not been an issue with them.
Mr. DAVIS. Neither of you was in the room when I had a chance to question Mr. Falcon earlier, but I want to ask you for a reaction to some observations that I made.
As I understand OFHEO, their task is to oversee the safety and soundness of Fannie Mae. Am I correct in that understanding?
Mr. RAINES. Yes.
Mr. HOWARD. Yes.
Mr. DAVIS. One of the concerns Ms. Waters has raised, that I have raised and other members of the committee have raised is that it appears that OFHEO has crossed some line into simply being a neutral and dispassionate analyst or neutral and dispassionate observer of what the institution does, to having a very strong set of opinions about the institution.
Is that the impression the both of you have?
Mr. RAINES. Congressman, I think that there has been an evolution in their thinking that they believe that they either have the authority to or have the need to be more directive as to how we carry out our responsibility.
Mr. DAVIS. Now, Mr. Raines, for the relationship to work shouldn't there be some arm's length between OFHEO and Fannie Mae?
Mr. RAINES. Yes, I believe we should run the company and they should examine the company.
Mr. DAVIS. Is that relationship or that desirable relationship undermine if OFHEO somehow becomes an advocate and if they appear to have developed their own agenda with respect to the future of Fannie Mae?
Page 199 PREV PAGE TOP OF DOC Mr. RAINES. Well, I think it does raise serious questions of who is ultimately responsible for the outcomes. I mean, if we are doing what they say then who is to be held accountable for what happens?
Mr. DAVIS. Okay. Let me ask you one final set of questions because our time is so limited. The ultimate mission of OFHEO is to preserve the safety and soundness, correct?
Are either of you concerned that by issuing a public condemnation of Fannie Mae and its practices, a public condemnation of the management structure, a public condemnation of its accounting in advance of the SEC doing it, are either of you concerned that that could somehow jeopardize Fannie Mae's status in the market and that that could, in its own right, have an impact on safety and soundness?
Mr. HOWARD. I am very concerned about that.
Mr. DAVIS. Could you elaborate on that, Mr. Howard, for a minute?
Mr. HOWARD. Certainly. The markets respond toas Mr. Raines mentioned earlier, regulators have enormous power and they are perceived by investors, particularly international investors, to have such power. And most regulators do not make pronouncements of the nature that we saw over the last two weeks without very serious convictions that those are true.
Mr. DAVIS. One final question, if the chair will indulge me just a few extra seconds, one of the things that we have heard about is the fact that OFHEO went to the board of directors and essentially put a 48-hour ultimatum in place.
Do you know of any authority that OFHEO has to give an ultimatum to the board of directors with its course of action? Is there any statutory authority for that?
Mr. RAINES. I don't know of any such authority, no.
Page 200 PREV PAGE TOP OF DOC Mr. DAVIS. And to your knowledge, did OFHEO give any explanation of why it was so time sensitive that the board of directors move forward?
Mr. RAINES. I believe what they said to the board was that they thought the matters were serious and they wanted to test the seriousness of the board in responding to the report.
Mr. DAVIS. Is it within OFHEO's charter to test the seriousness of the board of Fannie Mae? Is that written anywhere in their charter of their job description? That sounds like a fairly political purpose, doesn't it? Or a little bit of an agenda based purpose; we want to test the seriousness of the board.
Chairman BAKER. If you can, make that your last question because we do have others and we have another panel too.
Please respond if you choose.
Mr. RAINES. No, I am unaware of any specific statutory reference to that.
Chairman BAKER. The gentleman's time is expired.
Mr. CASTLE. Mr. Chairman, thank you very much.
I don't want to get into this, it is funny how you think you are going to ask one line of questions and then you hear something else and you immediately want to follow up on that.
I don't necessarily agree with Mr. Davis, for whom I have tremendous respect I might add, onor even the answers to some of that. I mean, it seems to me OFHEO has a real role in all of this and to me, I mean, I agree with you, Mr. Raines, in sort of the role of examining.
But I think when they examine and there is something that with which they don't agree I think they have some responsibility actually to make it public. I think you would agree with that. In fact, it shows in your testimony, your very good testimony, here today.
Page 201 PREV PAGE TOP OF DOC I mean I am one of those who worries about Fannie Mae. I think, you know, you have good people running it and that kind of thing, but, frankly, it is very large, some of the practices I think are a little marginal. I worry about this perception the Congress will back up whatever Fannie Mae does. I just think there are a lot of issues.
I think the regulatory issue is very important though. And somehow or another we have lighted a fire under OFHEO who I would have written off a year ago and all the sudden they got a tiger by the tail type thing. I don't know what is right or what is wrong. But, I just want to make sure that Fannie Mae is being run correctly because it is very, very important. And I worry about the safety and soundness of that.
But, on the other hand, hey look, we are all running for office right now. We are criticized daily by our opponents. So a little criticism can't be the end of the world. And perhaps if it is justifiable criticism and changes are made, perhaps that is positive. I look at your testimony
Mr. RAINES. Congressman, if you are being accused of committing a crime it is a little bit different.
Mr. CASTLE. Well, right. But, you know, I am notthe jury is out on all of this right now. But the whole point is that some review I think is essential.
For example, if you look at page two of your testimony you have made several changes as a result of what OFHEO has done, at least as I understand it. You go through the first, second or third and I don't need you to go through all the details, but you go through all the things that you have done, the building up the 30 percent capital surplus, the chief risk officer, et cetera, et cetera, some probably more important than others. And I couldn't begin to tell you, which you probably could.
But these are changes which you have pretty well agreed to, perhaps not totally willingly, but you have looked at it and you have made the decision that these are things you probably should do that would benefit you that you did not do of your own accord but you did because of the OFHEObecause OFHEO was involved or is that correct?
Page 202 PREV PAGE TOP OF DOC Mr. RAINES. Congressman, we don't look for things to disagree with OFHEO.
Mr. CASTLE. Right.
Mr. RAINES. Many of these things we would have been willing to do if OFHEO had approached us in a different way. So this isn't an issue of everything OFHEO says is wrong and everything we say is right.
Indeed, I think the fundamental flaw, if I could say what the fundamental flaw is in our relationship with OFHEO, it is not created by OFHEO. It is created by the fact that the OFHEO examination process does not have the same legal protection that the bank examination process has. And that has a negative effect on the entire relationship.
Bank examiners are not allowed to make public bank examinations, even if they are requested by a member of Congress.
Mr. CASTLE. I want to go to another line of questioning. I am not going to parse that or argue it too much, except to say that I think there are certain powers that OFHEO, perhaps, should have that they don't have and perhaps there are others that they have that they should not have.
I just think I want to get it straightened out. I mean, my sense is that you all have been sort of back and forth on whether there should be a successor to OFHEO or not. I hope that somehow or another when this is all said and done we can get this whole oversight, overview, examination, regulatory aspect of it correct.
Mr. RAINES. I agree.
Mr. CASTLE. Because I just think that is important for all of us. That is my goal and I hope we can get great cooperation on that.
Let me go on to this whole business of 98 because I don't totally understand it. But my understanding is when all this happened you were CEO, is that correct? Mr. Johnson moved on and you were CEO?
Page 203 PREV PAGE TOP OF DOC Mr. RAINES. I became CEO at the beginning of 1999.
Mr. CASTLE. 1999. So this happened at the end of 1998?
Mr. RAINES. No, it would have happened in 1999. The books are closed in January. So I would have been CEO.
Mr. CASTLE. Okay. Well, with respect tothis change really bothers me and I don't know if this is something that has been stated. There is no proof of it and I don't know whether it is correct or not, so this may even be hypothetical rather than practical. But, it concerns me that if, according to the report, and dug it out, and it was filed by OFHEO.
I am sorry, according to the testimony, which we had today by Mr. Falcon it basically states that the amortization models of management were $400 million, however management decided to record only $200 million that year and then spread the rest over the next year, which allowed bonuses to be paid.
My question is, is there any record of that or is that just something that happened? Did they look at minutes of meetings or e-mails or anything to make that determination?
I mean, that, frankly, does have overtones to it that we can speculate on how serious they might be. But I think we all would agree it would be pretty serious if, indeed, a decision was made to put extrato violate a standard accounting procedure and to put extra money into a different year to resolve theor to lessen the
Mr. RAINES. It is a very serious
Mr. CASTLE.keep the gains high the year before.
Mr. RAINES. It is a very serious allegation. The report states no facts. It doesn't cite one piece of paper. It doesn't cite one witness who says that that decision was tied to compensation.
As I mentioned earlier, we actually launched an effort, once we heard this allegation, we launched an effort to go and look at the facts. And if you look at the facts as to how this occurred we have found no facts that indicate that this decision was tied to compensation.
Page 204 PREV PAGE TOP OF DOC Mr. CASTLE. Did you find any factsI know my time is almost up and I have 15 second I have to yield to Mr. Shays. But did you find any facts that would indicate the decision is in violation of standard accounting procedures? That is what they are stating. That is a pretty serious allegation.
Mr. RAINES. No. We didn't find any of those facts either. Our auditors looked at the decision at the time.
Mr. CASTLE. Right.
Mr. RAINES. And they approved the financial statements and they reported to the audit committee that there were not estimates that they believed were unreasonable.
Mr. CASTLE. But KPMG apparently found an audit difference on this, as I understand it, a term which KPMG, this according to his testimony again, disagreed with Fannie Mae.
Mr. RAINES. There was an audit difference. This is what is called a subjective difference, which means that there are different ways to do it, but when it came to the board, and the boardand they would have to report to the board, were there any estimates by management that they felt were unreasonable, their answer was no.
Mr. CASTLE. So the decision was made, there was an adjustment made and then the question becomes is what was the behind that decision and whether or not it met good accounting practices or good corporate practices.
Mr. RAINES. And we looked at the contemporaneous records and you can see in the contemporaneous records, in fact, that the calculations that OFHEO is relying on were not possible because no one knew what the EPS number was on the date that this decisions appears to have been made. So this false precision of just getting there exactly was impossible to know because the books hadn't been completely closed for several more days.
Page 205 PREV PAGE TOP OF DOC So that is what I am saying. We have looked at the facts. There appeared not to be any facts to back this up. And if OFHEO has facts that back up, you know, we would be delighted to see them.
Chairman BAKER. The gentleman's time has expired.
Mr. CASTLE. I was supposed to give 15 seconds to Mr. Shays.
Chairman BAKER. Well, let me suggest this, I had one more question and I had not had an opportunity to speak to Mr. Howard, if everybody wants to take 2 minutes, let us constrain.
Mr. SHAYS. I wonder if I could go now because I have a
Chairman BAKER. We would be happy if you would leave now.
Mr. SHAYS. Would the gentleman yield?
Chairman BAKER. I am sorry, you want to say something first, I didn't understand your request. Yes, I would recognize the gentleman.
Mr. SHAYS. Thank you.
I just want to put on the record, Mr. Raines, that in communicating after your comment about the subpoenas to the office of compliance, they said they had requested thousands of documents and some of these documents simply were not coming. They got concerned about it. They particularly wanted e-mails. And only after they provided a subpoena request did the e-mails start flowing.
And in conversation with Justice they basically said Justice said it wasn't necessary because now the e-mails were flowing, which is not uncommon in Congress when we issue a subpoena. Sometimes the threat of the subpoena provides that information from flowing.
And I just want to also say that the reason why this information is public and you don't want it to be public now is they felt this was so serious that this information shouldn't be suppressed. And I happen to agree with them on that account as well.
Page 206 PREV PAGE TOP OF DOC Mr. RAINES. Well, if I might.
Mr. SHAYS. I thank the gentleman for yielding.
Mr. RAINES. If I might?
Mr. SHAYS. Sure.
Mr. RAINES. Fist of all, what I gave you was what the contemporaneous statement was, not what is being said today, but what was said at the time the subpoenas were issued.
Mr. SHAYS. Right. They didn't need it because you were now complying.
Mr. RAINES. No, at the time the subpoenas were issued, not the time they went to the Justice Department, the time the subpoenas were issued, they told us they were not doing it because we were not cooperating. So, that, I think, is a very important distinction.
Mr. SHAYS. They are saying that they were no longer necessary because after the subpoenas were provided that there started to be more information flowing, that is
Mr. RAINES. That is a Justice Department issue. That is not why they issued the subpoena in the first place. That is where
Mr. SHAYS. So there is a disagreement that we are going to have to nail down.
Mr. RAINES. Yes.
Mr. SHAYS. You have your opinion, they have their opinion.
Mr. RAINES. I think that is exactly right. But the second issue on why this was made public, the exact same kind of examinations go on with big banks, small banks, thrifts, without special examinations being published. So there are other ways to do this. This is an anomaly. OFHEO is the only financial regulator who does not have the
Page 207 PREV PAGE TOP OF DOC Mr. SHAYS. You are under the 1934 act.
Mr. RAINES. I am sorry?
Mr. SHAYS. You are under the 1934 act, public disclosure.
Mr. RAINES. No, their examination has nothing to do with the 34 act. It is solely to do with the banking laws. Under the banking laws, examinations are secret. And that helps the relationship between examiners and the bank because they can have very free flowing discussions. OFHEO doesn't have that. It is not their fault. They have very good examiners. We are not quibbling with that.
But the process is not a good process. We think the process that exists between examiners and the examinee is best referenced to looking at how the OCC has that work. And that is what we strive for. We are going to work with OFHEO to see if we can get there. But they do have this one disability that is not their fault, which is their examinations are going to be made public and that has a negative effect.
Mr. SHAYS. What I would like you to do, though, is work with Congress to get a stronger enforcement process. That is what I would like.
Chairman BAKER. Your time is expired, Mr. Shays.
Mr. Kanjorski, did you have a follow-up?
Mr. KANJORSKI. You know, a part of what we have to ultimately do is come up with a new regulatory scheme here. And I have been listening to this testimony and I was thinking since we have a regulator for two entities, you know, why can't we make an in-resident meat inspector, if you will, that is down at your place 24 hours a day or however necessary.
But when you have these exit strategies where something like an audit difference comes up, wouldn't it be more likely to end up without disputes or problems if the regulator sat in and knew what the issue was on the rulings so that they don't miss it?
Page 208 PREV PAGE TOP OF DOC Mr. RAINES. Congressman, we actually have 40 OFHEO examiners resident at Fannie Mae. And so we do have them in close proximity. And we do believe that our examiners are aware of the closing process and of the findings of our auditor. That has never been hidden from our examiners.
Our normal examining process, I believe, has worked well. Our only difference is how the special examination has worked. It is not about the normal examination process.
Mr. KANJORSKI. But why didn't somebody in the normal examination process be sitting in, to know what this audit difference was in 1990?
Mr. RAINES. My personal belief isand I will go checkmy personal belief is that our examiners were aware of this.
Mr. KANJORSKI. Well, you ought to examine your records and get the worksheets and see whethersomebody should have been there, to know that that was discussed, that the issue was resolved in one way or another and obviously acceptable to the regulator.
Mr. RAINES. And I will come back to you. I will check on that. But my belief is that our examiners had been well informed, and they have been very professional people. They have been aware of each and every one of these accounting decisions over the years, and they have exercised their judgment on them in that process.
So, we are notwe have no complaints about the normal examination process. We believe it has functioned. And they have hired people who examined other large financial institutions. They now have a new examiner in charge, who I just met with, and he has met with our senior management. And we are going to work with him to make sure we have the best possible examination relationship that exists.
Chairman BAKER. Mr. Castle, did you wish another 2 minutes?
Page 209 PREV PAGE TOP OF DOC Mr. CASTLE. I just have one comment, if I may, Mr. Raines. I heard you say earlier, based on this levelthe executive officer compensation chartthat it is the road path, that people will come and steal your employees.
I have seen the salaries. You don't have to worry about Congress coming up and stealing any of your employees.
Mr. RAINES. Having been a federal employee a couple of times
Mr. CASTLE. You know the problem.
Mr. RAINES. I know the problem. I know it well.
Chairman BAKER. Ms. Waters?
Ms. WATERS. SEC has been referenced any number of times here today. And I guess Mr. Falcon said that there were overlapping responsibilities.
What is SEC doing now? Have you been examined by SEC in the past, since 1998? What have they said about your accounting practices? What part of this have they overseen, examined, investigated since 1998, and what are they saying now?
Mr. RAINES. Well, the SEC has been enormously cooperative with us in our process of becoming a registrant. We are the largest business ever to become a new registrant with the SEC. They have never had an $800 or $900 billion entity do that.
They were very helpful in that process, in reviewing our initial documents and giving us feedback. So, they have bent over backwards to be helpful. I am enormously grateful to them for that.
They have also worked with us on sticky accounting issues. And we, like other companies, have presented accounting issues to them and asked them for a judgment as to what the appropriate accounting is and, again, they have been very responsive in giving us answers.
Page 210 PREV PAGE TOP OF DOC We, of course, have implemented the answers that they have given to us. So, we expect that the SEC will carry out their function here. They are busy; they have a lot of things to do. I don't know what their timetable may be
Ms. WATERS. Have they been in touch with you since this information became public?
Mr. RAINES. We have had contacts through counsel with the SEC Enforcement Division. But also we have had contact not through counselthrough business peopleand with other parts of the SEC. So we try to maintain good communications with them.
It is my desire nowas it would have been my desire before the report came outthat these accounting issues simply go to the body who can solve them. Then we will have the answer. We won't be having a debate about who is right and who is wrong.
There will be an answer and we will implement it and go forward.
Chairman BAKER. Gentlelady's time has expired. I only had one further request of you, Mr. Howard. In order to better understand your explanation and your responsibility with regards to the $200 million expensing issue of 1998, I would like to request a written response, which I will submit to you at a subsequent time.
The reason for asking the question in the hearing is that if your response would be pursuant to your oath taken during the course of the hearing, which would establish some important value to your written response.
The essence of the request will go to the manner in which the expense amount was determined, why the figure was arrived at, the chronology of that decision-making process, those who participated, if it did not rise to your level.
As you represented earlier in the hearing today, there are some financial decisions that come before you, some that do not. We need to know if it did not, to what level did it rise? Was this matter discussed among all executives? Did it go before the board for at least an announcement or some disclosure to the board?
Page 211 PREV PAGE TOP OF DOC Basically, a process by which we can be sure, as members of the committee, we have gotten complete and full explanations as to the elements that OFHEO has brought to our attention.
Please understand, in my capacity, I am presented with a very contentious and volatile report. If I were to have left Washington D.C. and gone home without addressing the elements of this report, I can only imagine the criticisms that would be leveled against this committee for its inaction.
Should the interim report plead OFHEO to take the next step and issue some other yet unknown criticism, it certainly would leave this Congress in a very untenable position as the entity responsible not only for the creation of OFHEO but for creation of Fannie itself.
I certainly hope that the future does not bring ill-advised consequences to the institution, its ability to extend credit to prospective homeowners or, even worse, to have consequences for taxpayers.
My role is to examine, thoroughly examine, and I hope to spring to speedy resolution all of these matters. I have no interest in, nor motivation, to bring any adverse consequence to the enterprise or to Freddie Mac and, I will continue, however, to be the arm's length examiner of enterprise conduct that we appear, in your view, not to have with OFHEO.
With that disclosure and no further comment, thank you. And this panel is dismissed.
If our witness for our third panel is able to make it to the desk, we would invite her to do so now.
Thank you very much for your participation.
Welcome the presiding director of the board of directors of Fannie Mae, the honorable Ann McLaughlin Korologos. Is that correct?
Ms. KOROLOGOS. That is right, sir.
Page 212 PREV PAGE TOP OF DOC Chairman BAKER. It was previously determined by mutual discussion that all those who would testify before the committee in this proceeding would be asked to take the oath. Do you have any objection to being sworn in?
Ms. KOROLOGOS. I do not.
Chairman BAKER. If you would not, do you seek the advice of counsel during your testimony?
Ms. KOROLOGOS. I do not.
Chairman BAKER. If you would not mind rising and raising your right hand, I will administer the oath.
Thank you very much. Please be seated. Consider yourself sworn in and under oath.
As we have extended to all other witnesses in the course of the morning and afternoon, we request that the presentation, if possible, be limited to 5 minutes. Given the gravity of the issue before the committee, however, we would certainly extend any courtesy to you to proceed at your discretion.
Your official testimony will be made part of the record. Please proceed.
STATEMENT OF HON. ANN MCLAUGHLIN KOROLOGOS, PRESIDING DIRECTOR, BOARD OF DIRECTORS, FANNIE MAE
Ms. KOROLOGOS. Thank you, Mr. Chairman, and I hope I can keep more or less to the 5 minutes. I know it has been a long day, but I appreciate the opportunity to be here.
I would like to thank Chairman Oxley, Ranking Member Frank, Chairman Baker, of course Ranking Member Kanjorski and members of the Subcommittee.
My name is Ann Korologos and I am the presiding director of Fannie Mae's board of directors. I also currently serve as chair of the Nominating and Corporate Governance Committee and on the board's Compensation Committee.
Page 213 PREV PAGE TOP OF DOC I am a shareholder-elected, independent director. I have served in three Cabinet departments, including as secretary of labor under President Ronald Reagan, and I headed the Presidential Commission on Aviation Security and Terrorism, specifically investigating the bombing of Pan American Airways flight number 103.
The board of Fannie Mae appreciates this committee's oversight of the company, of the board and of our regulator. And I welcome the opportunity to speak on behalf of the board about OFHEO's report to date on its special examination.
The board takes the issues raised by the OFHEO report very seriously. We are here to do the right thing. By that I mean: to OFHEO, the SEC and Congress, and to do so in a way that protects the shareholders and restores the public's confidence.
In this way, the company can continue to fulfill its critical housing mission: to use the financial flexibility of a private company to pursue the societal goals of increased homeownership.
As directors, we must meet our fiduciary duties of loyalty, care and good faith. We do not take these responsibilities lightly. These duties have meaning. They require us to gather the facts, conduct an objective investigation and render judgment based on the facts.
We must look at the issues in the report deeply, thoughtfully and carefully, using whatever resources are necessary. And we will be held accountable for how we meet our responsibility.
The board, with independent counsel and independent accountant, will investigate the issues in the report, and we will work expeditiously. So I thank you for this opportunity to speak on behalf of the board. We were moving fast before this hearing, and I can share with you that we now are continuing to do so, and we now know where we are going.
The board has participated through our audit committee, in following the company's response to the examination since it began over a year ago. We have received regular reports from the audit committee on the examination's progress, as best it could be understood.
Page 214 PREV PAGE TOP OF DOC On Friday afternoon, September 17, Director Falcon contacted me to say that OFHEO wished to share its findings to date with the outside directors of the board. I convened a meeting of the board for the next business day, which was Monday, September 20.
Every nonmanagement director attended in person or by telephone. On that day, we received the written report and OFHEO's senior staff made a presentation to the nonmanagement directors and the company's outside counsel.
The staff also gave us a letter from the director and a draft agreement, to be signed within 2 days, outlining actions to be taken. In addition, the board was informed by management, after that meeting, that they had received a call from the SEC that these issues would be a part of an informal inquiry by that regulator.
The board immediately began a series of meetings and discussions with OFHEO over the week of September 20. I think I either spoke or met with Director Falcon every day that week. I assured Director Falcon that the board and the company would work cooperatively with OFHEO and that we would address all their concerns.
I also expressed the boards hope that our work together would build a constructive relationship based on mutual respect and trust going forward. I told him, however, that the board could not, consistent with its fiduciary responsibilities, sign a document in 48 hours.
On Tuesday, September 21, I advised the director that the board had authorized the hiring of independent counsel, former Senator Warren Rudman, and his law firm, Paul, Weiss, Rifkind, Wharton & Garrison LLP, subject to OFHEO approval, to address the questions raised by the OFHEO report.
I also advised the director that we would provide to him, the next day, a draft work plan based on the actions required by OFHEO's agreement. On Wednesday, Pat Swygert, a fellow board member and President of Howard University, and I met with the director and his senior staff at OFHEO offices.
Page 215 PREV PAGE TOP OF DOC We provided the draft work plan that was approved by the board and, because so much of the report had been leaked to the press by that time, I also advised the director that the company did not object to OFHEO's public release of the report.
After reviewing the draft work plan, Director Falcon told me later that evening that he thought the plan was substantive and addressed each of the areas of concern raised by the report. I have attached to my written statement a copy of this draft work plan.
On Thursday, in a conversation with OFHEO's general counsel, however, it became clear that OFHEO wanted a written agreement to be signed by the board.
Therefore, at my direction, on behalf of the board the company's counsel began meeting with OFHEO staff to reach such an agreement. Discussion continued throughout the weekend, and after additional board meetings, we and OFHEO announced the September 27 agreement.
With the agreement completed, the thorough process to address OFHEO's report is underway. Importantly, management has pledged its cooperation to the board in effort and we will hold them accountable to that pledge.
The details of the agreement are well known. The company will move immediately to begin making a number of changes including a capital surplus plan, accounting policy modifications, internal control enhancements and other changes.
The board's independent counsel, Senator Warren Rudman and his law firm were approved by OFHEO yesterday. Senator Rudman will hire independent accountants, also subject to OFHEO approval.
Senator Rudman's work will also be reported to the SEC. We expect Senator Rudman to conduct his review as described in our agreement with OFHEO and to report his findings to the board, OFHEO, and the SEC
The company and its outside auditors have a disagreement with OFHEO about some aspects of the implementation of FAS 91 and FAS 133. The agreement establishes a process going forward to resolve these issues.
Page 216 PREV PAGE TOP OF DOC This board believes in accountability and objectivity. We will not prejudge the outcome of this process, and I respectfully ask you not to prejudge it, as well. We vigorously share your concerns and want to get to the bottom of this.
We believe that we have built a sturdy, corporate governance structure to be prepared for any challenge this organization may face. How this board and the company handle themselves when things go wrong is the ultimate character test.
We have benchmarked our governance against other companies. Our nonmanagement directors meet as a group, without management, every time the full board meets, and often in between. These are candid, probing discussions.
Our standards for director independence more than meet those of the New York Stock Exchange. Mr. Chairman, I would be remiss not to comment on the article which questions the board's independence in today's paper.
Two years ago, we applied the New York Stock Exchange standards for director independence enhanced for our board's accountability. We worked with our outside governance counsel, Gibson, Dunn & Crutcher.
We developed a director questionnaire and a process for matching directors' nonprofit and business connections with corporate or foundation contributions or business relationships.
For example, for a business relationship, a director is considered not independent under these guidelines. We take a five-year look back versus a three-year look back under the New York Stock Exchange rules.
On an annual basis, an excess 2 percent of consolidated gross revenues or $1 million, whichever is greater, would determine independence. And for charitable organizations on an annual basis, a $100,000 or 5 percent of gross revenues of the charity or the non for profit, whichever is less.
Page 217 PREV PAGE TOP OF DOC The New York Stock Exchange permits charitable contributions of any size and only requires disclosure of donations in excess of $1 million or 2 percent of the director's charities gross revenues.
In addition, no direct compensation other than director pay is permitted under our guidelines although the New York Stock Exchange permits directors to receive up to $100,000 per year in other pay before they are no longer independent.
In addition, one director has a personal business relationship issue, and that was brought to our attention some months ago, and a decision on independence will be made at our October Governance Committee meeting.
We have, therefore, regardless of reports in the press, I think, applied both the spirit and the fact of the criteria for independence and that that is put forth in the New York Stock Exchange guidelines.
If the New York Stock Exchange, governance watchdogs or anyone else wants to change those guidelines, you can be assured that we would change ours and meet those requirements. I thought I might offer to submit, for the record, the board guidelines so that you would have them with this testimony.
If I may speak personally for a moment, I have known some of you over the years from my experiences in both public service and the private sector. And I think you know my commitment to ensuring that our laws are upheld and the institutions of our economy maintain the highest levels of integrity.
There is only one way I know how to deal with such a difficult situation: to speak the truth, to find the facts without bias, to base judgments on those facts, and then to act without hesitation. We must do the right think carefully and deliberately. We must not rush to judgment or take actions in haste today that we will have to correct tomorrow.
I will commit to you that the board is determined to follow a process that will inspire confidence and restore public trust.
Page 218 PREV PAGE TOP OF DOC Thank you, Mr. Chairman.
[The prepared statement of Hon. Ann McLaughlin Korologos can be found on page 171 in the appendix.]
Chairman BAKER. Thank you very much for your statement. Let me quickly say that I have no question either about your service as a board member nor any of the independent board members.
Ms. KOROLOGOS. Thank you, Senator.
Chairman BAKER. I do think, as you have stated, today's problems present a challenge that will require decisive action based on full knowledge and confirmation of all the facts.
What is problematic in the current environment is that, as Mr. Raines was before the committee for some time this afternoon, on a number of occasions in response to various questions, he would state the report cites no facts, speaking to OFHEO's report.
I find that troublesome with regard to coming to an agreement that is in everyone's best interest. I will be the first to say that no report is probably 100 percent accurate. But I would also quickly observe that few reports are 100 percent incorrect.
I note that the board took rather quick and decisive action in reaching this first agreement, which would seem to indicate to me that there were some reasons the board came to a conclusion that it was appropriate to enter into that agreement.
Do you believe that OFHEO is a competent regulator?
Ms. KOROLOGOS. I don't know that I am equipped to make that judgment. I had the opportunity to meet with the director about 8 months ago as chairman of the governance committee, which turned out to be fortuitous. So, when I received the call, I knew the director.
Generally speaking, boards don't involve themselves in this detail with the regulator, frankly, at least not in the companies I am involved in. More so, in financial, I can't make that judgment.
Page 219 PREV PAGE TOP OF DOC Chairman BAKER. Okay. Do you believe, knowing what you know now from the substance of the report made available to you, that the board has been advised sufficiently, frequently enough, and to sufficient detail to have made appropriate judgment in the matters of concern in the OFHEO report?
Ms. KOROLOGOS. Do you mean with regard to the agreement or generally speaking
Chairman BAKER. Generally speaking in your capacity as an individual board member, do you feel you have been given sufficient information about the business judgments made by management of the corporation today?
Ms. KOROLOGOS. I would say that the report raises issues that clearly are serious. That is why, again, with OFHEO's encouragement, through their agreement, we have retained independent investigators, both on the accounting side and, as you know, for some of these other issues.
So I don't want to prejudge anything by answering your question.
Chairman BAKER. And, my next question is not to lead you to a statement that would be interpreted incorrectly.
I have read accounts from various independent board members at different times making the statement that they have full confidence in the judgments made by, and fully support the current management. As you outlined, going forward, we need to know all the facts, follow all of those facts to their end conclusion.
As you encouraged the committee and others not to jump to any presumptions before that process is finished, I would hold that door open both ways; that we not rise to the defense of all parties until we have come to a judgment as to everyone's involvement, if there is found to be a substantive accounting problem that was inconsistent with GAAP that led either to shareholder value being depleted or reports to the markets of incorrect financials.
Page 220 PREV PAGE TOP OF DOC I think it was clear from the testimony of Mr. Howard and Mr. Raines. They first don't see a factual basis for the allegations that have been made by OFHEO but, secondly, can't make full judgment about the accusations until they have more information.
Is it your view that the board, going forward, will reserve judgment in all these matters whether it be positive or negative?
Ms. KOROLOGOS. I think so, completely. I will say that they have in the past and, if I might commentsince I am one of the people who were quoted in the pressI think this is a good forum to develop that because I wholeheartedly agree with you. My statement asked that none of us prejudge, of course, and we should be objective, and this board can be objective and is objective.
When I called Frank Raines, the Chairman of the company, to tell him I had received a call at 4 o'clock on Friday from the director, his first response when I said I would convene a meeting was, ''How can I help?'' That is a first-class CEO.
Consistently, over these weeks, management has asked, ''How can we help?'' That is the spirit of cooperation that we have with management in order to achieve all that we want to achieve. That does not detract from our objectivity.
Many of us on the board have been there long enough to have worked with management over many issues on a great company achieving its mission. So, in that spirit, yes, certainly, we have experiences.
I don't think that is mutually exclusive from the job that we have laid out, and I commit to you our objectivity, our unbiased tenacity to go forward and find out, if you will, the other side of this report and see where it comes out.
Chairman BAKER. Well at least an exploration of all the allegations OFHEO makes should be thoroughly vetted and conclusions reached. I hope that the findings are not as severe as OFHEO has represented them to be, but we all have a duty to find out.
Page 221 PREV PAGE TOP OF DOC Ms. KOROLOGOS. Absolutely.
Chairman BAKER. And I thank you for that.
Mr. KANJORSKI. Madam Secretary, am I correct that you have been on the board at Fannie Mae for 14 years?
Ms. KOROLOGOS. Oh, you are making me older than I am.
Mr. KANJORSKI. Eleven years.
Ms. KOROLOGOS. Ten years; just 11 this year, so 10 and a half.
Mr. KANJORSKI. So you predate Mr. Raines tenure.
Ms. KOROLOGOS. I do, sir.
Mr. KANJORSKI. And you predate one of the issues that we have had the regulator testify about today, the FASB 91 audit difference that was reported in 1998. First of all, I would like to test your memory.
Do you have any recollection at any time of your auditors, management or the regulator talking to you or other members of the board about this handling of the $400 million or $200 million in 1998 that has been the object of one of the charges made by the regulator?
Ms. KOROLOGOS. I don't have a recollection. I presume it would come through an Audit Committee report, and I can't promise you that something was said but I don't remember anything being said; no.
Mr. KANJORSKI. I know very little about how regulators operate and even less about how many analysts they have at your agency. Mr. Raines tells me they have 40 in-house meat inspectors. Pretty broad exposure.
Do you, in the last several weeks, in meeting with the auditor and getting their report and meeting among the board with your various experts that you have retained now, do you have a sense as to whether or not there is a systemic risk problem at Fannie Mae?
Page 222 PREV PAGE TOP OF DOC Ms. KOROLOGOS. I do not believe there is a systemic risk problem at Fannie Mae nor have I been in any gatherings that would lead me to believe that. I certainly would not have signed on behalf of the company, the agreement, if I didn't take into consideration the impact of the agreement, as well, and also the capital plan that is being developed and the likes.
So, no, I don't. I haven't heard that and I don't feel that.
Mr. KANJORSKI. Very good. One of the things that amazes me is the regulator, in testimony earlier today, indicated, of course, that OFHEO has been auditing or regulating since 1991. And it is in 1998, one of the audits obviously had a finding that was an audit difference as to how to handle this particular transaction.
I was just struck why they didn't pick that problem up in 1998 or 1999 or any subsequent year that they had to deal with that audit report; that is, that the regulator didn't pick it up. It seems to me almost the first area that you would begin to do your regulation, is to look at the outside audit report.
Has that struck you at all as being peculiar?
Ms. KOROLOGOS. I have to say I only learned that from these hearings today. It strikes me the way it strikes you, sir. I would think that would be certainly a first stop; maybe not the last stop, but a first stop for a regulator.
Mr. KANJORSKI. One of the things that we have been struggling with over the last year and a half is to create an independent, world-class regulator for Freddie and Fannie. We thought we were going to come close to success not too long ago but, for reasons that are in the atmosphere in Washington, that didn't occur.
But, invariably, as a result of this investigation and the Freddie Mac investigation and the testimony we received from the regulator this morning, I am absolutely thoroughly convinced that we have to do something to create a stronger, more independent, world-class regulator; other than that, Mr. Baker and myself are going to be remiss in carrying out our responsibility.
Page 223 PREV PAGE TOP OF DOC But in starting that process, I am just at a loss as to how something could happen in 1998 and be listed as a finding in an audit report, and the regulator didn't ask anybody about it or get any information about it or resolve the application of GAAP rules to that particular finding.
It just blows my mind, and $200 or $400 million is a significant amount of money, even in a huge institution like Fannie Mae.
So, I am not sure that this was a wasted hearing from any standpoint, because we heard, for the first time, really, that process that the regulator has gone through. And I am not casting aspersion to this point on Mr. Falcon because he was not there, as I understand it, in 1998. He came subsequently.
But, apparently, we have done one poor job as federal regulators, particularly of these two institutions. If nothing else, we should get that straightened out. There has been a lot of press, a lot of it bad, and as all of us know, it had some impact on the stock of Fannie Mae.
Do you feel there is any reason, in your role on the board, that going forth from this hearing, both the investing public and the purchasers of your obligations should have any fear at all as to the security and the position of Fannie Mae, that their investments are secure?
Ms. KOROLOGOS. I don't feel so. I feel that the agreement that we signed puts us on a very acceptable path to giving strength and clarity and openness to the issues that have been raised. I think that should be, I hope, assuring to the public. That is part of what I think our responsibility is; to the publicall the public, employees, investors, shareholders, the like.
Mr. KANJORSKI. Well, my sense of youI should disclose for the record, we had the occasion to meet yesterdayI can't remember ever being more impressed even though we do differ politically. But with your basic competency and capacity, you certainly have won my faith that you are going to do a job and how you have gone about it really impresses me.
Page 224 PREV PAGE TOP OF DOC I want to join my colleague, Mr. Baker. This is not the happiest role we have to play, as members of Congress. But quite frankly, the testimony of yourself today and the CEO, Mr. Raines, and Mr. Howard, the CFO, and even the regulator gave me a little bit more confidence that we are not dealing with something that is dangerous here to the public or is terribly disastrous to Fannie Mae.
But it is good that we get it over with and if you keep the captain of that ship, you are going to let me sleep a lot better. Thank you.
Ms. KOROLOGOS. Thank you, sir.
Chairman BAKER. The gentleman yields back.
Mr. SCOTT. Thank you very much, Mr. Chairman. I wanted to go back to a line of questioning I started with Mr. Raines, which I think gets to the fundamental problem that has been brought before this committee, and that is that your board made the decision to tie the compensation bonuses to earnings per share.
Can you comment on that? I think it is very important that I reaffirm Mr. Raines's comment that this preceded him because I think there are several things that I am very concerned about. One is the credibility of Mr. Raines, who runs that department, which means the credibility of Fannie Mae.
This serves a very, very important constituency for all of us across the country who are concerned about making sure we have adequate housing, affordable housing for all income levels.
But I would like to find out why that board felt it believed that it was appropriate to link executive compensation to earnings per share, and whether or not this move, this compensation scheme, resulted in inappropriate incentives for management?
I think that unless we can clear that and try to get some common ground on that issue, especially as I mentioned, with the chart that Mr. Baker has provided this committeewhich I am sure we are not the only ones who are going to see that chartit is going to show some stark comparisons between what actual salary was and what those bonuses were.
Page 225 PREV PAGE TOP OF DOC So, there is certainly meat for incentives here. I think this might be something we want to share. Could you give me your comments on why this, you felt, was appropriate?
Ms. KOROLOGOS. I would be happy to. Again, I have only been on the board since 1994 but, in both my experience at Fannie Mae and many other corporate boardsin some case, where I am also on comp committeesearnings per share was a very acceptable incentive, if you will.
Generally combined with others, different companies did it different ways. So you are not talking about a company that was the only one. I wanted to make that clear.
Why was that? Well, in the late 1980s, early 1990s, the acceptable philosophy for compensation besides always, in some way being performance based, was to tie management to the shareholder, and earnings per share was one way to do that. Likewise, options, which we saw become out of favor and the like. In a way, I would think we would all take comfort.
At Fannie Mae, it is a much more, even transparent process than at other companies precisely because we are a GSE. Unlike other public companies, the amount our executives make is somewhat dictated by law, and the law states that OFHEO is required to ensure that Fannie Mae's compensation programs are reasonable and comparable with compensation for employment in similar industries.
We use the comparability test of looking at peer companies and the like and structuring not only the earnings-per-share measurement, but in other aspects as well, both tangible and intangible performance measures and the like.
So you generally have salary, you have bonus, you have long term, you have short term kind of incentives. So you try and strike a balance between financial and nonfinancial measures.
Earnings per share, for purposes of this report, seem to have jumped out and your question is quite a legitimate one. I would only say that it is becoming, in recent years because of incentives leading, in some companies, to behavior that wasn't intended to re-look at compensation. And there are a lot of different mixes going on.
Page 226 PREV PAGE TOP OF DOC Mr. SCOTT. You have seen the report that was presented before the committee
Ms. KOROLOGOS. I actually did not see the paper that was handed out yet. No, I have not.
Mr. SCOTT. But you are familiar with the bonus and the structure and the comparison of base
Ms. KOROLOGOS. Yes, very much so.
Mr. SCOTT. Do you stand by that? Do you feel that
Ms. KOROLOGOS. I stand by what we did; yes, I certainly do, and I think that I have found, again, my experience on a number of other boards; it is always a work in progress. We use outside consultants as well, is what I wanted to assure you.
So this is not something we plucked out of the air and allowed to hang out there to be abused in any way, shape or form.
Mr. SCOTT. Well I think this is very important to get on the record because, as I said earlier, there have been some very strong accusations made against Fannie Mae, and I want to make sure you have a chance to respond to that.
If I may continue, in view of that, what changes, if any, in corporate governance and some of these compensation policies that the board is considering to address in relationship to the issues that have been raised by this report and, again, I too question the timing of it and I think there probably are some motivations there.
People say politics isn't a part in that, but you really can't take politics out of politics. I believe really, as a result of today's hearings, that politics has certainly manifested in what we have here.
But, having said all of that, OFHEO has given a report. Are you going to make any changes in the way you operate and, if so, in governance and in compensation, as a result of this board and some of the issues that it has pointed out?
Page 227 PREV PAGE TOP OF DOC It runs the gamut of misapplied accounting rules, has kind of stabilized the earnings, the inadequacy of the regulatory capital, the deferred expenses. It just seems to me, do you take this report, just say there is nothing here, or do you take it and say here is what we are going to do to try to fix this situation.
Do you give this report credibility?
Chairman BAKER. And, Mr. Scott, that will have to be your last question because you are well over time.
Ms. KOROLOGOS. Let me assure you, I thinktwo significant things, perhaps. One, the agreement we signed itself permits usI think there are 32 or 33 issues thereworking with Senator Warren Rudman and the accounting people that he will bring, to do a very deep dive, if you will, and look very carefully at all of those issues, some of which may result in change, some may not. I can't prejudge that.
So, that is the route for the report itself, in terms of taking it serious, following all of the issues, both through the agreement and the report itself.
Secondly, you ask if there will be changes in governance. In terms of the company's governance and its organization, that is a part of the agreement, and that will be addressed accordingly.
In terms of corporate board governance, I said in my statement, and I really do believebut I am open always to best practices and we follow these issues religiouslythat we are at a point, because of good governance, that we are able to, one, get us this far to keep some stability and calm to a process that I think is very important, to exercise our fiduciary responsibilities in a thoughtful and informed way, and organized ourselves previously to be able to participate in the various teams that are going to be created to fulfill our obligations under the agreement.
One board member has particular expertise in capital markets and the like; Don Marron, formerly of Payne Webber, he will be a very good team person. Another woman, Leslie Rahl, on the board, is a derivatives expert; let her work on those issues.
Page 228 PREV PAGE TOP OF DOC So, we are organizing ourselves with our expertise. So, I think that is the corporate board governance piece. Whether changes come for board governance from the report, I don't see that right now but I am open to it, but I don't see that.
I think the third issue on compensation, however, obviously we welcome any findings from the independent investigation that address some of the allegations in that area.
As a member of the Comp Committee, we have been addressing, as we look again, at comparables, at best practices, at the structure of compensation, at those in our industry, how to base the bonus plan on more than just earnings per share such as risk and mission factors.
That is going to be forthcoming. So, that is a piece of work that has already been going on but it has been going on because of the marketplace, if you will, in executive compensation.
Chairman BAKER. The gentleman's time has expired. Ms. Waters?
Ms. WATERS. Thank you very much. Would you please give me the correct pronunciation of your name?
Ms. KOROLOGOS. I would be happy to. It is all O's, and it is Ko-ro-lo-gos.
Ms. WATERS. Ms. Korologos. I would like to thank you for coming here today.
I don't know how long you have been here but you may know by now that some of the questions that I raised to Mr. Falcon question the motive of the director as it relates to this so-called investigation.
And I know sometimes that is not a nice thing to do, but I know a lot of history about this ongoing political battle between FM Watch and the GSEs and some of our members' role in all of that.
Page 229 PREV PAGE TOP OF DOC I also know about the criticisms that were launched at OFHEO and its past oversight or lack of the GSEs. So I have a historical reference for many of the questions that I have asked and some of the accusations that I have may have made.
Having said all of that, you entered into an agreement with OFHEO without having a response from your organization. And it appears that you entered into an agreement because you wanted to show that you were cooperative, that you were not resisting criticism, that if there were problems you wanted to solve them.
It seems to me that is what you did, and you made that decision knowing that some people would not understand that this was not an admission of any kind of guilt or anything else. But I think it is very important for that to be restated time and time that, out of the spirit of cooperation, you entered into this agreement.
Now, I have looked at some aspects of this agreement as represented to us today. And what it appears is that you have entered into agreement that you could easily enter into because, as far as I am concerned, what is being asked of you is not that difficult to begin with, and it may not require you to do any changes at all. You may be correct in some of the things that you are doing.
I don't see any timeframe or time guidelines on any of these points made in the agreement that you should have something done by a certain date, even though we are led to believe this was an emergency.
The board had to be convened right away because these serious accounting problems had been identified and unless you do something right away, the safety and soundness of this organization was at great risk.
But even when I look at the number one recommendationimplement correct accounting treatments that will bring the enterprise into compliance with SFAS 91 and SFAS 133it didn't say do this in 30 days, in 60 days, in 90 days.
Page 230 PREV PAGE TOP OF DOC It just puts it out there but nobody saysunless it is someplace elsehow the agreement will be made as to what the correct accounting treatments are based on the fact that there are some disagreements, perhaps, about the implementation of SFAS 91 and 133. That is one example.
This other requirementprotect its existing capital surplus and move to a targeted capital surplus equal to 30 percent of its required minimum capitalthere is no emergency relative to this requirement.
It didn't say that if you don't do this in 30 days, 60 days, 90 days, something terrible is going to befall this agency. It didn't say that we have come up with this percentage because this is what we have examined, this is what we have looked at and this is the conclusion that we have come to based on these facts.
And, of course, in the spirit of cooperation, you could agree to that, because even though it potentially takes capital away from being involved in some of these good things that you may be doing, it doesn't really admit that something is wrong with the surplus of the minimum capital requirements that you have nowthe 18 percent or whatever that is.
So, as I go down each one of these, some of them look a little weak, they look like little smoking mirrors to say that I did an investigation and so now I want you to undertake a top to bottom review of your staff structure.
Duh, I mean, I think this is what you do all the time. And as has been indicated, that even in the ongoing meetings that you have, where people can raise questions, et cetera, et cetera, you are doing this all the time.
So, having said that, would you confirm for me, your understanding of why you entered into this agreement and whether or not you believe that this means that you immediately make great big changes because you were doing something wrong.
Or is this just an agreement to say, ''Okay. You want us to look at this? We will be happy to look at it. We believe that we are right and we believe that in the final analysis, we will be proven right.''
Page 231 PREV PAGE TOP OF DOC Explain to us where you are coming from.
Ms. KOROLOGOS. I will.
Chairman BAKER. And that would be the gentlelady's question because her time has expired now. We would be pleased to hear your response.
Ms. KOROLOGOS. Thank you, Mr. Chairman. Yes, it was a very difficult, important period for the board to be presented with an agreement and then, uncertain at the time, the importance of the agreement, per say, because to sign it in 48 hours would not have been possible responsibly.
When, however, we presented, based on the agreement, a work plan, I was able to spend the days with management and say, ''What can be done? Let us break this apart and see what can be done on the issues that were raised in the report.''
And it really came in sort of three chunks. There were the accounting issues and, clearly as you heard in testimony today, the SEC has a serious role there. There were the capital issues, if you will and the capital plan.
Well that, again, we could bring the best brains together and the talent and work with OFHEO and determine that. And then, I guess you might say, we had also the organizational issues and throughout, we had some very serious allegations that could be addressed by an investigator that OFHEO encouraged us to have.
So, as we broke it apart, we were able to develop a work plan. Having done that that gave us some background, when I understood from the director, or from counsel, they still wanted an agreement and they wanted it really before Monday, the 27th.
I think, in part, from what they told me in preparation for the quarterly letter that they issue regarding our safety and soundness. So that became an issue within the timeframe for this agreement.
The counsels worked together with the board and with me, particularly, on the elements of the agreement. And various changes were made to your point, to make acceptable. There was no way we were going to sign an agreement we couldn't deliver on, number one.
Page 232 PREV PAGE TOP OF DOC And, number two, we were very eager to get this process going so we could give answers to the public, to our investors, to our shareholders, to the housing community. We had already seen an economic impact because of the swirl and the fire storm we are in.
But how can we stay thoughtful, see through the process of developing an agreement that, one, was responsible, that would further clarify, explain, investigate, in an open way, the issues that had been raisedthey were seriousand, at the same time, to your point on timing, not commit to something we couldn't achieve.
You will notice in the agreementyou are rightthere are various timeframes, but not necessarily a timeline for delivery. There are 15 days to give the comprehensive plan and seek approval or disapproval of OFHEO.
There are 45 days to have a counsel working for us and conduct reviews. There is a compliance committee requirement and the like. So, there were different timeframes, all of which, in many cases, require OFHEO to approve or disapprove.
My hope is that we will be able to work with OFHEO so their approvals will come in a timely way, too. I think that is an important part of keeping going. We will be developing a tracking system to monitor implementation and our progress.
Now, let me say that it is in our interest to be on two paths here. One is to implement the agreement, the investigation and do so expeditiously because we want to put all of this behind. If there are changes to make, we are happy to make them. If they are allegations that are proven, we need to deal with it.
At the same time, the other track we are on is to run the business. The most important thing we do in this very vibrant, wonderful company with a fabulous public mission is to keep the business going.
So, the more these issues hang around, if you will, I think is irresponsible for the board not to set our own timelines and make sure we can reach them.
Page 233 PREV PAGE TOP OF DOC That is my best answer to why we did the agreement, what kind of appropriate pressure, if you will, we will keep on the process and the special committee that we created to work on this to oversee it.
The individuals within the company we are selecting to help us there is to keep this moving because we really want to put it behind us. But we want to benefit from the process and do it. As I keep saying, we want to do it right the first time and we want to do it thoughtfully.
So, we are notI frankly don't want to come back before this committee or our shareholders or our employees and say, ''Oh gosh, we didn't do a good job. We have got to redo it.'' Let us do it right the first time and I think the process we set up will do that.
So, the timelines that will be developed to implementI am sure there will be some give and take, and that is appropriate with the regulator, and what they think we can do in a certain timeframe and what we think we can do.
I would expect in the spirit of cooperation we will work out that tracking system and those timelines together.
Chairman BAKER. Let me thank you, Ms. Korologos, for your appearance here today and your testimony and also give you an assurance.
Despite the view that the work in the committee may be political in its nature, Mr. Kanjorski and I work very closely together. Our work, especially in this arena, has been bipartisan. We both share the view that strong regulatory capacity is absolutely essential. And we will work as a partner in this process to assist the board in achieving the desired end result.
This does not mean it will be easy or that everyone will always agree on all perspectives. But the public discussion is a good thing, and bring it to speedy resolution is even more important. I think by making the appropriate assurances of good faith on all sides, that we can do something good for homeownership as well as ensuring taxpayers they have no potential liabilities in these matters.
Page 234 PREV PAGE TOP OF DOC Again, I thank you. I will ask unanimous consent to make a part of the official record, the addendum and reports that you cited in your testimony.
I have documents that were forwarded from OFHEO, the OFHEO report itself, the blue book, and the letter of transmittal of November 12, 2003, to me, of the chart. And I think that is all of the remaining items that need to be officially made part of the record without objection.
And let me express to all participants and my faithful comrades who stayed until 6:11 this evening. Thanks for your good work.
Our meeting stands adjourned.
Ms. WATERS. Thank you very much, Mr. Chairman. And may II don't know if I need unanimous consent request to make a request of you relative to our future work.
I don't know if you plan on having more hearings anytime soon, but my request would be that the responses that will be given by Fannie Mae to this investigation be put together, prepared in whatever fashion they are going to be and that we use those same responses if we are going to have another hearing.
My suggestion is that we not have a hearing until that is done so that we are all working from the same information.
Chairman BAKER. By way of disclosure for all interested stakeholders, it would be my intent, at this time, to discuss probably over the recess, regulatory reform. I don't know whether there would be a proposal introduced for discussion purposes, but it is not likely, in my view, that this committee would reconvene its work until the next Congress.
With the hope, I thinkthe long hope for expectation that this Congress will leave town this weekend. If that, in fact, is the case, there would not be the prospect of an additional hearing.
Page 235 PREV PAGE TOP OF DOC However, to acknowledge the gentlelady's point, at such time as a hearing notice would be issued, I can assure you that any information the enterprise would choose to make part of that hearing process, we would certainly welcome. I would formally ask the chair of the independent board members on any report she would choose to provide to the committee, we would be happy to receive.
And likewise, I am sure; there will be work of independent members during the course of the recess to get us fully prepared to consider whatever ramifications there are from the pending study or regulatory reform or any other issue a member might choose to bring before the committee.
Ms. WATERS. Am I to understand that the Chairman is saying that you possibly will be working on regulatory reform based on the book that has been done by OHFEO already?
Chairman BAKER. No. My view is I have been working on regulatory reform all my life. That effort would just continue into early next year. As you know, we had a proposal in this committee which was very close to being adopted and for whatever reason, did not get adopted.
The Senate has moved the proposal out of Senate Banking Committee, which is now pending. It would be my hope that givenlet me take the side of the discussion from those who have been critical of Mr. Falcon and OFHEO.
For those, it would appear it would be likely that you would support a different regulatory structure. For those of us who feel that enhanced oversight is good from a taxpayer perspective, they would support a new regulatory structure.
I don't know anybody today on the committee who expressed objection to the discussion of and passage of a new regulatory structure. So, given that, I think it is our duty to take that up early next year, and in the intervening months, anyone who has suggestions or recommendations, they should be made known and we can take them into consideration.
Page 236 PREV PAGE TOP OF DOC Ms. WATERS. If I may, Mr. Chairman, I certainly agree that you have been working on regulatory reform for a long time and that the question of whether or not OFHEO was competent to do this certainly has been discussed in this committee.
And some of us, who may have, at one time, supported OFHEO, may be with you on your proposed changes. And what you would like to do with the Treasury Department, I don't know.
But my real question is whether or not you anticipate working on regulatory reform that will respond to some of these allegations that have been surfaced by OFHEO, in the absence of the response that I think we just desperately need to have from Fannie Mae and they have not had the opportunity to present?
That is my question.
Chairman BAKER. I don't see further action by this committee until additional information is provided from both perspectives. I think OFHEO would want the opportunity to respond to the testimony today from Fannie Mae, and it is evident that Fannie Mae would choose to give us more informationthe board members as wellas to their findings and factual determinations of the OFHEO allegations.
So, I think both sides are going to be providing members with a lot of information. I am trying to say to the gentlelady, we won't act until there is something that validates acting.
In the interim, we should be working on our regulatory proposal to bring ultimate closure to this whole chapter.
Ms. WATERS. I think I understand that Mr. Chairman. I guess just to wrap this up, what I am really getting at is in the regulatory reform that you have been working on for a long time, we can reasonably anticipate what some of that is all about.
But what I am not certain about is whether or not in that regulatory reform I would look in there and see specific references to this recent OFHEO investigation as it relates to accounting practices that are yet undecided.
Page 237 PREV PAGE TOP OF DOC Chairman BAKER. That level of analysis would be relegated to the new regulator. I do not see the committee getting engaged in anything other than the principles of oversight. And as I have long said, an independent regulator properly funded with the real authority to assess the enterprise's safety and soundness.
That is it. It has always been the principles. And nothing beyond that need be in legislation, and I think there are any number of proposals I have had in prior sessions, which describe in generality what we would be considering, and those have no reference to the OFHEO analysis of today.
Ms. WATERS. Thank you.
Chairman BAKER. Mr. Scott?
Mr. SCOTT. So, Mr. Chairman, just to make sure we are clear, there will be no movement whatsoever on any regulatory reform until we have this rebuttal process from both OFHEO and Fannie Mae to today's hearings.
Chairman BAKER. Not exactly. What I said was there will be no further action by this committee on this subject matter until conditions warrant action by this subcommittee.
Assume, for the moment, if you wish to pursue this discussion that OFHEO comes back with another troubling report in the next 2 days or the next 2 months. Certainly, the committee would want to receive that report and discuss the findings.
I am not suggesting, however, we would move on a legislative proposal in the next 5 days. There is certainly not time to do so. It would likely be early next year; a reform proposal introduced, would go through due process, all members would be heard, and certainly the enterprises and all those who have a stake in this matter would be given ample opportunity to voice their opinion.
I don't know exactly the sensitivity that you and the gentlelady are addressing. There is not going to be anything introduced tomorrow that takes page 46 of this report and makes it a new regulation. If that is what you are after.
Page 238 PREV PAGE TOP OF DOC Mr. SCOTT. You mentioned in the event that there may be another report, is there any indication or evidence on your part that OFHEO is contemplating or putting forward another report?
Chairman BAKER. Oh, no. Let me make it clear one more time. I have no information that any other member does not have. I have had no phone calls from anybody. I asked the director in the public view today, ''Mr. Director, what is your next step,'' hoping that that would send the signal that whatever he told me, he was going to tell you.
Mr. SCOTT. Right.
Chairman BAKER. That is all I know.
Mr. SCOTT. All right.
Chairman BAKER. And when I know more, I will be happy to share it and, in the meantime, I hope I don't see you all until January.
Mr. SCOTT. Thank you.
Chairman BAKER. If there is no further business for this committee, we stand adjourned.
[Whereupon, at 6:19 p.m., the subcommittee was adjourned.]