FREDDIE MAC'S ACCOUNTING RESTATEMENT: ARE ACCOUNTING STANDARDS WORKING? MONDAY, JANUARY 28, 2004 HOUSE OF REPRESENTATIVES SUBCOMMITTEE ON COMMERCE, TRADE, The subcommittee met, pursuant to notice, at 10 a.m., in room 2322, Rayburn House Office Building, Hon. Cliff Stearns (chairman) presiding. Members present: Representatives Stearns, Shimkus, Shadegg, Ferguson, Issa, Otter, Schakowsky, Solis, Markey, McCarthy, and Strickland. Staff present: Brian McCullough, majority counsel; David Cavicke, majority counsel; Arturo Silva, deputy communications director; William Carty, legislative clerk; and Consuela Washington, minority counsel. Mr. STEARNS. Good morning. The subcommittee will come to order. My colleagues, this is the third hearing we have held in the subcommittee on accounting issues raised by Freddie Mac. The hearing today will focus on two reports: the supplemental report to the Board of Directors of Freddie Mac known as the supplement to the Doty report and submitted to the Board on November 18, 2003; and the report of the special examination of Freddie Mac by the Office of Federal Housing Enterprise Oversight, OFHEO, completed in December 2003. We have two witnesses here today and I'd like to thank them for appearing before the committee to help us better understand what happened at Freddie Mac. I would like to thank Armando Falcon, Director of OFHEO, Freddie's regulator for OFHEO's work on parsing through the problems at Freddie that led to Freddie Mac's disregard of financial accounting standards. I would also like to thank Martin Baumann, CFO of Freddie Mac for being here today. At the last hearing, we held on the accounting standards issued raised by the Doty report, I complimented Mr. Doty on his thoroughness and objectivity with regard to the internal investigation and the report. Although Mr. Doty is not appearing as witness here today, I wish to acknowledge the supplemental report was produced with the same rigor as the initial report. It also will be a useful tool as guiding our review of accounting standards. (1) We'll focus on three things today. First, the supplement to the Doty report; second, the OFHEO report; and finally, on the implications of the contents of these reports for fair disclosure under U.S. GAAP. The supplement to the Doty report addresses issues that were known to require further inquiry at the time of release for the initial report. As with the transactions scrutinized in the final report, hiding income was a primary factor, if not the sole motivation for several transactions investigated for the follow-up report. The supplement reveals further evidence of earnings management at Freddie Mac. The OFHEO report provides an overview of the culture at Freddie Mac that facilitated earnings management over 11 quarters. The report indicates that Freddie disregarded accounting rules, internal controls, and disclosure standards to maintain a reputation for steady earnings. So I look forward to hearing from Mr. Baumann about what controls Freddie is putting into place to guard against improper accounting. The third issue we need to look at today is what this information means for accounting standards. Although Freddie Mac may have made accounting misstatements, it is possible that if some of the transactions were structured more carefully they would have been GAAP compliant. It is possible Freddie could have hidden billions of dollars of income in a way that complied with GAAP. I suggest this is not the result we want from our United States accounting standards. So called "mixed attribute" accounting allows companies to decide whether financial assets are carried at current market price or at historic costs. Let me repeat. Allows companies to decide whether financial assets are carried at current market price or at historic costs. Freddie Mac shifted assets between categories to manipulate earnings without any change in the underlying economics of its performance. Now taxpayers do not have the option of changing the characterization of assets to change the tax treatment. I think GAAP should not allow this either. U.S. GAAP was once hailed as a premiere accounting system. I believe GAAP is still a strong accounting system and I applaud FASB for all their efforts to shore up the system over the last 2 years. While I do not believe Congress is the appropriate body to set detailed accounting standards, I believe we as a committee of oversight over accounting standards setting have a responsibility to ensure standards produce financial statements that are transparent and comprehensible. I encourage my colleagues to join me to produce legislation to reform GAAP. I look forward to a dialog here today that will further these efforts and I thank you. I ask the distinguished Ranking Member for her opening statement. Ms. SCHAKOWSKY. Thank you, Chairman Stearns, for convening this important hearing to follow up on the accounting scandal at Freddie Mac. I appreciate, Mr. Falcon, and accompanied by Ms. DeLeo this morning and Mr. Baumann's attendance today so that we can go over the Office of Federal Housing Enterprise oversight examination of just what went wrong at Freddie Mac and Freddie Mac's actual restatement of earnings. According to OFHEO's report, Freddie Mac used a variety of accounting tricks to move gains and losses around to smooth out and meet earning expectations. Through their manipulations, steady Freddie seemed to live up to its name. However, as its restatement shows, and we all know, the cumulative effect of their attempts was the hiding of $5 billion of volatility. Some have been lulled into a sort of complacence with the accounting scandal at Freddie Mac because they under reported their earnings. It seemed that while their true earnings revealed some unsteadiness, what they were hiding was not so bad. They hid profits. But this reporting has been misleading as well. In 2001, Freddie's restatement_reveals that they over reported their earnings by $989 million. Earnings for 2001 actually were about $1 billion less than they reported. Again, that $5 billion was accumulative effect of their restatement. My concerns today are not just with Freddie Mac but also with the agency put in charge of their oversight. OFHEO's oversight was created in 1992 to ensure the safe and sound operations of Freddie Mac and Fannie Mae. However, as OFHEO's report reveals, a lot was happening at Freddie Mac under their oversight. Today, we'll focus on the accounting issues that were raised by Freddie Mac. Our subcommittee has the responsibility to ensure that all companies provide clear and accurate financial information to the public. The scandal at Freddie Mac is a clear example of what can happen when corporate officers do not abide by the rules of clear and accurate accounting. All publicly traded companies need to have clear and accurate books. This is especially true for Freddie Mac. What happens at Freddie Mac has a major impact on the housing markets. Freddie purchased almost $600 billion in mortgages in 2002. It also has helped finance homes for nearly 2.5 million low and moderate income families and families living in under served areas. It was able to do so at least in part because of the benefits and freedoms enjoyed in an established mission as a government-sponsored enterprise. As we all know, with freedoms come responsibilities. While Freddie was trying to live up to their reputation, they were not living up to their responsibilities. As a GSE and as one of the largest players in the housing market, playing accounting games puts more than the corporation's financial standing at risk. It puts taxpayers and people's homes in jeopardy. As I said before, Freddie Mac is not just another company. Therefore, we need to make sure that Freddie Mac is as transparent as possible and while I applaud the work that OFHEO has done since the scandal has come to light, and appreciate Freddie's restatement of earnings, willingness to take steps toward remediation, we still have a long way to go. Freddie Mac needs to be registered with the SEC and voluntary registration is taking too long and does not have the same power as mandated. And that is why I support my colleagues' efforts, Congressmen Shays and Markey, to require Freddie Mac to abide by the same rules of transparency available. Because of who you are and place you have in making money available for home ownership, it is vital that Freddie Mac is held to at least the same standards as other publicly traded companies, if not higher. I thank you, Mr. Chairman. Mr. STEARNS. I thank my colleague. Mr. Shimkus. Mr. SHIMKUS. Thank you, Mr. Chairman. It's an important hearing and it's good to be back and addressing these concerns. I will be brief. In the committee summary, obviously we're here to review Freddie Mac's announced restated financial cumulative net income increase by $5 billion regulatory per capita increase by $5.2 billion; stockholders equity increased by $6.7 billion. These are obviously restated numbers. In OFHEO's report under the executive summary, it talks about the corporate culture fostered by the tone at the top resulting in intense and sometimes improper efforts by the enterprise to manage its reported earnings. And in another article in The New York Times dated 30 November, the headline "Hiding Profits is Just Deceitful." We're even more involved because this is a government-sponsored enterprise. There is connection to us because of that privilege and I think the public is just getting tired of whether it's a for profit entity or a government-sponsored entity of leadership at the top rigging the books for purposes that are as The New York Times says is deceitful. And so you're here to help us sort through really the blow by blow of where we're at. Then we do need to look with my colleagues in how bills should be written and drafted, laws should be passed to bring some more accountability. The public is just tired and we should not claim and go after one sector of the corporate world while another one goes unscathed for what we would define as improper activity. So Mr. Chairman, I think it's an important hearing. Thanks for calling it and I yield back the balance of my time. [The prepared statement of Hon. John Shimkus follows:] PREPARED STATEMENT OF HON. JOHN SHIMKUS, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS Good Morning. Mr. Chairman, thank you for holding this hearing to provide a forum for Freddie Mac to restate their financial reports. This hearing marks the third time in the last 7 months that this Subcommittee has investigated the accounting practices of Freddie Mac. I should hope that this hearing will finally produce an answer to what we have been looking for—the accurate depiction of Freddie Mac's suspicious transactions. The fact that Freddie Mac, a government sponsored enterprise, had to make major revisions to the past three years accounting records only adds fuel to the flame in this era of corporate distrust. And even these records may not be correct, as Freddie Mac will not be issuing its 2002 annual report until June of 2004-over a year later than normal. I am interested to hear from our panel of witnesses and learn more about the measures that have taken place to correct the improper reporting by this enterprise. I'm also anxious to hear how Freddie Mac plans to avoid this type of situation in the future and comply with the basic accounting standards they have discarded in the past. Thank you Mr. Chairman, and I yield back the remainder of my time. Mr. STEARNS. I thank my colleague. The gentleman from Massachusetts. Mr. MARKEY. Thank you, Mr. Chairman, and thank you so much for having this hearing. It is very timely, very important because Congress did establish Freddie and its sister company, Fannie Mae, to link Wall Street financing to the goal of promoting home ownership throughout Main Street America. In order to advance this objective, Congress has allowed these two companies many regulatory benefits, such as exemption from State taxes, a line of credit at the United States Treasury, an exemption from the registration, financial reporting requirements of the Federal securities laws. But while Freddie and Fannie might be "government-sponsored enterprises," they are also private investor-owned corporations. As such, they have responsibilities to their shareholders, including the responsibility to provide full and complete disclosures regarding their financial and operating condition and to obtain audited financial statements that comply with generally accepted accounting principles. In other words, both of these institutions do a wonderful job in creating more housing in the United States. No one is going to debate that. But many of those very same families then invest their own money into the shares of those companies thinking that it must be a very good company. The government sponsors it. But it isn't required to provide all the same information that other corporations in America are. The transparency is not there, so that investors can make the right decision. And that's why Christopher Shays and I introduced legislation to provide that accurate disclosure and accounting practices at these companies. Today, we're going to hear from Freddie Mac's principal regulator, the Office of Federal Housing Enterprise Oversight about the results of its investigation into accounting irregularities at Freddie Mac. OFHEO's December 2003 report on its special examination of Freddie Mac raises a number of very disturbing issues that I look forward to hearing about today. The OFHEO report describes a corporate culture that "casts aside accounting rules, internal controls, disclosure standards and the public trust in the pursuit of steady earnings growth." It details instances in which Freddie Mac "knowingly circumvented prevailing public disclosure standards in order to obfuscate particular policies and specific capital market and accounting transactions" and it finds "a disdain for appropriate disclosure standards" that misled investors, ordinary Americans, putting their money into these companies and undermined market awareness of the true financial condition of the enterprise. In my view, these findings only serve to underscore the failure of voluntary disclosure to serve the needs of American investors and of our financial markets. In the aftermath of this accounting scandal, it is time for Freddie Mac's new leadership to change course and embrace legislation through repeal of its special exemption from the Securities and Exchange Commission registration and reporting requirements. There is no single step that Freddie Mac could take that would do more to signal to investors that the corporate culture at the company has changed. There is no single step that the Congress could undertake which would better protect investors from a repetition of the type of accounting problems that we have seen at Freddie Mac. |