Mr. Chairman, again, I want to thank you so much for having this very important hearing.

Mr. STEARNS. I thank my colleague. The gentleman from Idaho. Mr. OTTER. I have nothing.

Mr. STEARNS. Mr. Shadegg, I'm sorry, the gentleman from Ari

zona.

Mr. SHADEGG. Thank you very much, Mr. Chairman, for holding this hearing. Since our last hearing on this issue on September 25, the restatement by Freddie Mac of its 2002 financial information, coupled with the release of the reports by Baker Botts and OFHEO weren't another look at the accounting problems which beset Freddie Mac.

I am pleased that we have such knowledgeable witnesses present and was interested to read in their testimony not only the description of what went wrong, but also the steps that Freddie Mac can and in some instances is taking to correct the situation which gave rise to the accounting problems.

I am also encouraged that Freddie Mac has appointed a chief compliance officer to ensure that at least one key employee in the company has legal and regulatory compliance as his primary function. Important as such structural improvements are, however, they pale in comparison to the need to instill in all employees, managers and board members, the understanding that accounting standards are not a performance metric to be manipulated or worked around, but rather a gauge which must be kept accurate. At the hearing last September, I made the point that accurate accounting could best be encouraged through the establishment of guidelines, rather than overly formulaic rules which can be avoided on technicalities. I'm building a home right now and there are certain building codes which it must comply with. Obviously, it's important to comply with those codes, but it's more important that the home actually be well constructed and that it will last for decades and so complying with the code isn't the issue, building a sound home is, in fact, the issue.

I was interested to see that in the testimony of Mr. Falcon, he bolstered my position. He notes that "to maintain Freddie Mac's image as a smooth and steady earning machine, it is now clear that management went to extraordinary lengths to transact around FAS 133 and at times failed to comply with GAAP." He also discusses the culture of deception which existed among some members of Freddie Mac's management team and their willingness to disguise earnings.

In the next few weeks we will consider legislation to institute certain reforms to Freddie Mac and other government-sponsored enterprises. It is my hope that this legislation will be structured to not only ensure greater compliance with technical accounting standards, but will result in greater attention to the spirit of accurate reporting without which the standards themselves are meaningless.

I thank you, Mr. Chairman, again for this hearing and look forward to the testimony of our witnesses.

Mr. STEARNS. I thank the gentleman. Good morning, Ms. Solis, you're welcome. You can take your time and we welcome your opening statement if you have one?

Ms. SOLIS. I'd like to submit my statement for the record, thank you.

Mr. STEARNS. By unanimous consent, so ordered.

[The prepared statement of Hon. Hilda L. Solis follows:

PREPARED STATEMENT OF HON. HILDA L. SOLIS, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA

Thank you, Mr. Chairman, for calling this hearing today. I'm pleased that this Subcommittee is continuing to examine the problems uncovered at Freddie Mac last year, as well as the state of accounting standards in general.

I share the concern held by many of my colleagues on this panel about the lack of transparency in corporate accounting. I believe it is critical that companies provide thorough and accurate information about their financial status to the public. We should not leave investors in the dark, defenseless against sloppy accounting by corporate managers.

Holding corporations accountable is especially important for government- sponsored entities such as Freddie Mac. We all know that Freddie Mac, along with Fannie Mae, is crucial to the housing market. This is especially true in districts such as mine in Los Angeles County, which is home to many low to moderate income families, the majority of whom are Latino and Asian. I hope that as we continue to evaluate this issue, we will keep these consumers-and all taxpayers-in mind.

It is in the best interest of our constituents to have a viable, secondary housing market. Improving transparency and disclosure requirements will help accomplish this goal.

I want to thank the witnesses for joining us today. I look forward to their testimony.

Thank you.

[Additional statement submitted for the record follows:]

PREPARED STATEMENT OF HON. W.J. “BILLY" TAUZIN, CHAIRMAN, COMMITTEE ON ENERGY AND COMMERCE

This is the third hearing Chairman Stearns has held on accounting problems at Freddie Mac. I commend Chairman Stearns for his dogged pursuit of the technical issues associated with accounting questions.

The most important lesson_we have leaned from this inquiry is that GAAP Accounting Standards as set by FASB leave much to be desired. Although Freddie Mac violated GAAP by hiding billions of dollars in earnings, had they done their accounting more carefully, some of those transactions would have been permissible.

So called "mixed-attribute accounting" allows some financial firms to vary the accounting treatment of an asset by characterizing the asset as "available for sale" or "held for investment". By manipulating these categories, some financial firms can alter their accounting by billions of dollars without any regard to economic reality. This anomaly should change. FASB should be encouraged to adopt a rule correcting this.

We know from the corporate scandals that have surfaced in the past two years that it is difficult to regulate fraud. However, lost in some of the particular cases is why no one discovered the truth earlier. Are accounting standards so complex that virtually anything can be hidden or are they so complex that no one is smart enough to understand the financial statements? Simply stating that accounting standards should be simpler sounds great, but will it benefit anyone if the information is meaningless?

I commend Chairman Stearns for his attention to these questions and hope that the Subcommittee will continue this inquiry in this Congress.

Mr. STEARNS. Mr. Falcon, I think we're taken care of all our opening statements, so we welcome you this morning, for your opening statement.

STATEMENT OF HON. ARMANDO FALCON, JR., DIRECTOR, OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT Mr. FALCON. Thank you, Mr. Chairman, Ranking Member Schakowsky, I apologize for the error in my written testimony

about the misnomer, and members of the subcommittee. Let me introduce to my left, Ms. Wanda DeLeo, who is the Chief Accountant at OFHEO. Í asked her to join me up here to assist me in answering any detailed questions about accounting matters at Freddie Mac.

I appreciate the opportunity to discuss with you OFHEO's report of the special examination of Freddie Mac. My written testimony discusses the key findings and conclusions of the report, focusing largely on accounting and earnings management issues. I request that the committee include it, as well as the full text of the report in the record.

Mr. STEARNS. By unanimous consent, so ordered.

Mr. FALCON. Thank you. A year ago, Freddie Mac announced that completion of its 2002 financial audit would be delayed and that earlier periods would be re-audited and restated. They switched external auditors from Arthur Anderson to Price WaterhouseCoopers. That triggered an assessment of Freddie Mac's accounting policies and practices.

On June 7, as this re-audit was underway, Freddie Mac announced the abrupt departure of three of its principal officers. At the same time, I ordered a special examination of the circumstances that led to the restatement and management changes. Although some aspects of the special examination are not yet complete, the bulk of the work was finished this past fall. OFHEO issued a report of the examination containing the findings and conclusions along with appropriate recommendations in December.

Let me now turn to the major findings of the special examination. The report of the special examination of Freddie Mac reveals how Freddie Mac manipulated its reported earnings and disclosed other financial information in a misleading way in 1999 through 2002. The report provides a chronology of relevant events, reviews the strategies that Freddie Mac employed to manipulate earnings and indicates that the Board was made aware of transactions whose sole purpose was to shift income.

The report also shows how the executive compensation program of Freddie Mac, particularly the compensation tied to earnings per share, influenced accounting and management practices during that period.

On January 1, 2001, Freddie Mac, along with other financial institutions, was required to implement FAS 133, “Accounting for Derivative Instruments and Hedging Activities." In addition to their many operational challenges, FAS 133 was problematic to Freddie Mac with respect to its goal of steady earnings growth. Specifically, FAS 133 required management to record a transition adjustment based upon any embedded gain or loss in its derivatives portfolio upon adoption of the standard.

Freddie Mac's derivatives portfolio, in particular, its portfolio of interest-rate swaptions, had substantial gains that had to be recognized on the transition date. Management sought to minimize this transition adjustment, in part to minimize the appearance of volatility on its balance sheet, as well as to shift derivative gains into future periods and recognize them gradually into income.

To maintain Freddie Mac's image as a smooth and steady earnings machine, never perturbed by changes in interest rates, mort

gage volumes, or other economic factors, it is now clear that management went to extraordinary lengths to transact around FAS 133, and at times failed to comply with GAAP. One example of this was the "Coupon Trade-Up Giant" transaction, referred to in our report as a "CTUG."

The purpose of the CTUG transaction was to move securities with embedded losses from the held-to-maturity portfolio to the trading portfolio and then into the available for sale portfolio. Management wanted the benefit of having its securities in a trading account but only for enough time to realize a loss and offset its derivative gains.

The CTUG transaction was a transaction with little or no economic substance that Freddie Mac manufactured in order to obtain a particular accounting result. Indeed, the economic aspects of the deal were negative when one considers the operational hazards created by the transaction which compounded Freddie Mac's accounting and control weaknesses.

The report of special examination also detailed the use of a dubious method by Freddie Mac to value its swaptions portfolio in a way that minimized its derivatives gain. The report describes how the head of Freddie Mac's Market Risk Oversight unit worked with Freddie Mac's derivatives desk to reverse-engineer a lower value for its swaptions portfolio. The revised swaption valuation method contributed to a $730 million misstatement of the 2001 financial results of Freddie Mac.

This is illustrative of the culture at Freddie Mac at that time and highlights the willingness of all levels of management to disguise earnings.

The FAS 133 transition was not the only episode of improper earnings management activities. In January 2001, the shape of the yield curve began to change dramatically in favor of Freddie Mac which resulted in the windfall of net interest income for the enterprise. In order to shift some of this windfall from 2001 into the future, management executed the first of several interest rate swap transactions that were referred to in the report as linked swaps. Each pair of swaps substantially offset each other and was virtually riskless for Freddie Mac and their counterparts. The link swaps moved approximately $450 million in operating earnings from 2001 into future years.

The compensation of senior executives of Freddie Mac, particularly compensation tied to earnings per share also contributed to the improper accounting and management practices of the enterprise. The size of the bonus pool for senior executives was linked, in part, to meeting or exceeding annual specified earnings per share targets. While not tied directly to smoothing earnings growth, actions shifting 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.

In some instances, Freddie Mac knowingly circumvented prevailing public disclosure standards in order to conceal particular policies and specific capital market and accounting transactions. A disdain for appropriate disclosure standards, despite oft-stated management assertions to the contrary, misled investors and un

dermined market awareness of the true financial condition of the enterprise.

Within Freddie Mac, no one took responsibility for public disclosures. Failure to assign responsibility and accountability for disclosure to an internal division contributed directly to inaccurate corporate and financial reporting. Such a lack of assigned responsibility reflected the low regard executive management held for that function.

For the most part, the same long-tenured shareholder-elected directors oversaw the same CEO, COO, and General Counsel of Freddie Mac from 1990 to 2003. The non-executive directors became complacent and allowed past performance of those officers to color their oversight. The oversight exercised by the Board might have been more vigorous if there had been a regular turnover of shareholder-elected directors or if directors had not expected to continue to serve on the board until the mandatory retirement age or beyond.

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.

A thorough review and update of accounting policies had not occurred in over 12 years. Freddie Mac's accounting errors during this time period were pervasive and persistent occurring in more than 30 different accounting issue groups. The weaknesses in accounting policies created an environment that allowed for and even encouraged transacting around GAAP. These weaknesses also encouraged an over reliance on Arthur Andersen, the external auditor. Arthur Andersen was soon in a position of auditing its own work.

Freddie Mac, as part of the restatement process has reviewed over 150 accounting policies. Senior management and the board did not establish and retain a strong internal control system. Therefore, they could not provide reasonable assurance that transactions were recorded as necessary to permit preparation of the financial statements in accordance with GAAP. As a direct result of management and the board not addressing these weaknesses in a timely fashion, Freddie Mac went 10 months without audited financial statements for 2002; was forced to re-audit and restate both 2000 and 2001 financial statements and will not be able to provide investors with quarterly information until at least mid-2004.

An internal audit report dated December 1996 reported that controls over the derivatives execution, administration, and accounting processes require improvement and that further deterioration in controls could affect the reliability of financial reporting. Neither management, internal audit or the external auditor addressed these weaknesses during the next 7 years.