LIST OF FIGURES AND TABLES Figure 1. Spread Between Yields of 10-Year Agency and Treasury Debt..... Figure 3. Volatility of a 3 X 10 Swaption....... Figure 4. Volatility of a 3 X 10 Swaption 23 30 Figure 5. 3-Month LIBOR and 10-Year Swap Rates.. Figure 6. Federal Funds Target Rate...... Table 1. Freddie Mac Rebalancing Activity, Fourth Quarter 2000.. Table 2. Breakdown of Estimated Freddie Mac Excess 2001 Earnings Per Share (June 30, 2001)...... Table 3. Freddie Mac Loan Loss Reserve and Net Losses. Table 4. Corporate Bonus Plan Funding History.. 1998-2001 Performance Years.... Table 5. Summary of Bonus Payouts of Senior Freddie Mac Officers, Table 6. Earnings Per Share in the Informal Scoring Process.. Table 7. Freddie Mac Derivatives Counterparties.. Table 8. Linked and Leveraged Swaps..... Table 9. Counterparties to Other Transactions.. 31 34 39 39 38 40 53 62 63 65 75 77 82 EXECUTIVE SUMMARY In the early 1990s, Freddie Mac promoted itself to investors as "Steady Freddie,” a company of strong and steady growth in profits. During that period the company developed a corporate culture that placed a very high priority on meeting those expectations, including, when necessary, using means that failed to meet its obligations to investors, regulators and the public. The company employed a variety of techniques ranging from improper reserve accounts to complex derivative transactions to push earnings into future periods and meet earnings expectations. Freddie Mac cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth. The conduct and intentions of the Enterprise were hidden and were revealed only by a chain of events that began when Freddie Mac changed auditors in 2002. This report describes the circumstances leading to Freddie Mac's $5 billion restatement and makes recommendations on corrective and preventative measures. Corporate Culture and "Tone at the Top" The corporate culture fostered by that "tone at the top" resulted in intense and sometimes improper efforts by the Enterprise to manage its reported earnings. Beginning in the early 1990s, Freddie Mac promoted expectations of steady, rapid growth in profits. A corporate culture evolved that placed a very high priority on meeting the earnings estimates of Wall Street analysts but neglected key elements of the infrastructure of the Enterprise needed to support growth. The senior management of Freddie Mac placed an inordinate emphasis on meeting stock analyst expectations regarding non-volatile earnings growth. The corporate culture fostered by that "tone at the top" resulted in intense and sometimes improper efforts by the Enterprise to manage its reported earnings, compromised the integrity of many employees, and limited the effectiveness of its internal control structure. Freddie Mac created and maintained reserve accounts that did not comply with GAAP and entered into transactions with little or no economic substance, all for the express purposes of obtaining accounting results that would support the goal of reporting steady earnings growth and meeting analyst expectations. i A tension developed between the more bureaucratic elements of Freddie Mac responsible for supporting and reporting transactions and the "financial engineers" who designed products and strategies to achieve corporate earnings goals. Compounding that problem, the Enterprise managed General and Administrative expenses to a rigid guideline, regardless of the level of profits. The preoccupation of management with adhering to the expense limits resulted in an insufficient allocation of resources-both dollars and staffing-to divisions responsible for accounting, financial reporting, and internal controls. The lack of attention by senior management and the Board of Directors to those functions resulted in transactions not being recorded in financial statements in accordance with GAAP. Finally, senior management and the Board failed to establish and maintain adequate internal control systems. The culture of Freddie Mac even allowed certain persons and business units to change or avoid established written policies and controls, in part because management of operations risk was not a priority. Improper Management of Earnings By 1999 Freddie Mac had established a practice of engaging in transactions for the express purpose of managing its reported earnings and other measures of financial performance included in the financial statements of the Enterprise. Freddie Mac used several strategies to shift earnings into future reporting periods, reflecting the proclivity of management to increase operations risk in the quest for more stable earnings. Although some of the most egregious examples relate to the desire of management to address earnings volatility challenges associated with the implementation of Statement of Financial Accounting Standards 133 (FAS 133), there were numerous other instances when Freddie Mac management engineered transactions with little or no economic substance to obtain specific accounting results: Management executed several interest rate swap transactions that moved $400 million in operating earnings from 2001 to later years. Those transactions had virtually no other purpose than management of earnings specifically, making operational results appear to be less volatile than they were. • Management created an essentially fictional transaction with a Freddie Mac adopted, and then quickly reversed, a dubious change in its methodology for valuing swaptions. That change had the effect of reducing the value of the derivatives portfolio of the Enterprise by $730 million. On at least one occasion, a transaction was entered into at the instruction of management for the purpose of disguising the effective notional amount of the Freddie Mac derivatives portfolio and thereby allay the concerns of an investor. From 1998 to 2002, management purposefully kept loan loss reserves at an unusually high level by using aggressive assumptions, even though actual and foreseeable credit losses were rapidly declining. Both management and the Board of Directors were aware that the Securities and Exchange Commission had criticized that practice as an inappropriate form of earnings management. Freddie Mac used another, non-GAAP reserve to dampen earnings fluctuations occasioned by unpredictable premium amortization caused by changing mortgage prepayment speeds. Management changed key assumptions in the calculation of the reserve when necessary to achieve a desired earnings result. It is clear that management went to extraordinary lengths to transact around FAS 133 and to push the edge of the GAAP envelope. One could reasonably ask if communicating the true nature of the transition gain in the derivatives portfolio of Freddie Mac to equity investors would have been more difficult than disguising the amount of that gain. Senior Freddie Mac management failed to disclose to the public information that would have revealed more fully the nature of transactions undertaken to manage earnings and the intent to do so. Such disclosure would have called into question the accounting treatment of the transactions adopted by Freddie Mac. iii Incentives Created by Executive Compensation The compensation of senior executives of Freddie Mac, particularly compensation tied to earnings per share, contributed to the improper accounting and management practices of the Enterprise. The size of the bonus pool for senior executives was tied, in part, to meeting or exceeding annual specified earnings per share targets. It was not tied directly to meeting earnings forecasts of analysts but actions to shift earnings from one quarter to future periods helped ensure that earnings per share goals, and consequently the bonuses based upon them, would be achieved in the future. Freddie Mac used a corporate scorecard involving a formulaic approach to setting the size of the corporate bonus pool. Achieving earnings per share targets played a substantial role in the formula but former CEO Leland Brendsel and former COO David Glenn also exercised considerable discretion over the outcome. The informal process by which Mr. Brendsel and Mr. Glenn revised the scorecard results, and therefore the amount of funds available for individual bonuses, reinforced in the minds of managers and other employees the importance of achieving earnings per share targets. Weak Accounting, Auditing and Internal Controls The management of a corporation is responsible for maintaining a control environment that will, among other things, accurately record transactions to provide for published financial statements that are consistent with the true financial condition of the firm. In that regard, the obsession of Freddie Mac with steady, stable growth in earnings was at the expense of proper accounting policies and strong accounting controls. Weaknesses in the staffing, skills, and resources in the Corporate Accounting Department of the Enterprise led to weak or nonexistent accounting policies, an over reliance on the external auditor, weak accounting controls, and an over reliance on manual systems. Given the size of the company and the role in the housing finance and capital markets, those weaknesses effectively increased the systemic risk posed by the Enterprise. The deficiencies of the company resulted in improper accounting of many complicated transactions in which the Enterprise engaged during the period of the |