• The Board issued Statement 133 in June 1998.11 As issued, Statement 133 was effective for all fiscal quarters of all fiscal years beginning after June 15, 1999, with earlier application encouraged.

• Following the issuance of Statement 133, some enterprises and auditors expressed concern about certain challenges they faced in applying Statement 133. Those challenges included organization-wide educational efforts and information system modifications that were made more difficult by the modifications and testing of systems to ensure their proper operation in the year 2000.

• On May 20, 1999, the Board issued an Exposure Draft that proposed deferring the effective date of Statement 133 for one year. 12 The Board received 77 letters of comment from respondents.

• In June 1999, the Board issued Statement of Financial Accounting Standards No. 137, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133 ("Statement 137").13 Statement 137 deferred the effective date of Statement 133 to all fiscal quarters of all fiscal years beginning after June 15, 2000.

WHAT ARE SOME OF THE KEY REQUIREMENTS OF STATEMENT 133? 14

Statement 133 requires that an enterprise report all of its derivatives as either assets or liabilities on the face of its financial statements and measure those instruments at their fair value.

Statement 133 also generally requires that any changes in the fair value of derivatives (gains or losses) be reported in the enterprise's earnings in the period of the change. If, however, certain conditions are met, an enterprise may specifically designate a derivative as a hedge of a related item and receive special accounting for the combination of the derivative and the related item in a manner that matches or offsets the earnings effect.

Hedge accounting is a special accounting practice that reflects an entity's intended strategy between two separate transactions. Rather than applying the applicable standards to each component of the strategy, hedge accounting allows the entity to recognize the gains or losses_on_the_derivative in the same period as the income statement effect of the hedged item. Entities engaged in risk management activities desire hedge accounting so that the income statement reflects the effect of their hedging strategies in the same period as the item being hedged. Because hedge accounting defers recognition of gains and losses on derivatives, numerous conditions must be met at the outset of the transaction and over the life of the transaction; these are called hedge criteria. The criteria differ, depending on the nature of the risk being hedged.

In general, a derivative may be specifically designated (1) as a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment or (2) as a hedge of the exposure to variable cash flows of a forecasted transaction. The accounting for changes in the fair value (gains or losses) of the derivative differs depending on that designation.

For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss on the derivative is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. An example of a fair value hedge is the use of an interest rate swap to change the interest rate risk on a fixed-rate bond from fixed to floating. In a perfect hedge, hedge accounting will show net interest expense at the new floating rate. However, if the hedge is not perfect, the differences are required to be reported in earnings and, thus, are transparent to investors.

For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the gain or loss on the derivative is initially deferred in other comprehensive income (which is a balance sheet account) to the extent that the hedge is effective; the gain or loss is subsequently reclassified into earnings in the period that the related forecasted transaction affects earnings. An example of a cash flow hedge is the use of an interest rate swap to change the risk profile on a floating-rate loan-the swap serves to lock

11 See Attachment 3 for News Release, "FASB Derivatives Statement Now Available" (June 16, 1998).

12 FASB Exposure Draft, Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133 (May 20, 1999).

13 See Attachment 3 for News Release, "FASB Delays Implementation Date for Derivatives and Hedging Standard" (July 7, 1999).

14 See Attachment 4 for a summary of the requirements of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (June 1998).

in the cash flows associated with the transaction. In a perfect hedge, hedge accounting will show net interest income at the new fixed rate. To the extent that the swap is not effective in offsetting the cash flows on the loan, any ineffectiveness is reported in earnings immediately and separately disclosed. Several other disclosures are required to help investors understand how and when the deferred amount will be reclassified into earnings.

An enterprise that elects to apply special hedge accounting is required to identify and document at the inception of the hedge (1) the specific item(s) that are being hedged and the entity's risk management strategy, (2) the method it will use for assessing the effectiveness of the hedging derivative, and (3) the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

HOW HAS THE FASB RESPONDED TO REQUESTS FOR ADDITIONAL GUIDANCE AND IMPROVEMENTS TO STATEMENT 133?

Implementation Guidance

At the time Statement 133 was issued in June 1998, the Board was aware of the complexities associated with transactions involving derivatives and their prevalent use as hedging instruments. Because of that, even before Statement 133 was issued, the Board established a Derivatives Implementation Group ("DIG") of outside experts to assist the FASB in answering questions that companies might face as they began implementing the Statement. 15

The responsibilities of the DIG were to identify practice issues that arose from applying the requirements of Statement 133 and to advise the FASB on how to resolve those issues. Public meetings of the DIG were held bimonthly during 1998, 1999, and 2000. The DIG identified and assisted the FASB in resolving more than 150 discrete issues relating to the implementation of Statement 133.

In 2001, as the number of new implementation questions diminished, the responsibility for addressing Statement 133 implementation issues was transferred from the DIG to the FASB's Emerging Issues Task Force.16

Amendments

Prior to Statement 133 becoming effective in July 2000, the FASB received numerous requests from enterprises and auditors to amend that Statement. The requests focused mainly on guidance related to specific issues that, if amended, would ease implementation difficulties. In analyzing those requests, the Board did not discover any new significant information suggesting that the framework of Statement 133 was inappropriate or that major changes should be made.

In June 2000, in response to the requests, the FASB issued Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities ("Statement 138"), amending certain provisions of Statement 133.17 In general, Statement 138 (1) expands the scope of certain transactions that are excluded from the requirements of Statement 133, (2) broadens the criteria that permit enterprises to qualify for special hedge accounting, and (3) clarifies certain provisions based on the recommendations of the DIG.

More recently, in April 2003, the Board issued Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“Statement 149").18 Statement 149 amends Statement 133 largely to revise and further clarify the scope of Statement 133 and codify several issues that were identified and resolved as part of the DIG process.

Consistent with the FASB's mission and Rules of Procedure, the FASB stands ready to consider any additional implementation issues or proposed improvements to the accounting for derivatives and hedging activities.

Thank you, Mr. Chairman. I would be happy to respond to any questions. [The attachments are retained in subcommittee files.]

Mr. STEARNS. I thank the gentlelady.

Mr. Baumann, we welcome your testimony.

15 See Attachment 3 for News Release, "FASB Appoints Task Force to Aid with Implementation Issues on Derivatives" (February 5, 1998) and Attachment 5 for a description of the Derivatives Implementation Group and a list of its members.

16 See Attachment 1 for a description of the Emerging Issues Task Force.

17 See Attachment 3 for News Release, "FASB Issues Amendment to Derivatives Standard" (June 15, 2000).

18 See Attachment 3 for News Release, "FASB Issues Standard That Amends and Clarifies Accounting Guidance on Derivatives" (April 30, 2003).

STATEMENT OF MARTIN F. BAUMANN

Mr. BAUMANN. Chairman Stearns and Ranking Member Schakowsky, thank you for inviting me today to discuss financial accounting standards for derivatives.

My name is Martin F. Baumann. For more than 30 years, I worked at PricewaterhouseCoopers, where I was a partner, Global Banking Leader, and Deputy Chairman of the World Financial Services Practice. I have also been privileged to chair and serve on numerous accounting industry committees that prepared guidance on financial and accounting and reporting issues. In April of this year, I joined Freddie Mac as Executive Vice President of Finance. Mr. Chairman, I applaud you for holding today's hearing, and for the subcommittee's long-standing commitment to improving accounting standards. I particularly want to commend you, Mr. Chairman, for your draft bill that addresses the important issues of principles-based and fair value accounting.

Before I begin, I would like to say a few words about recent events at Freddie Mac. Freddie Mac is undergoing the process of restating prior years' financial results. We candidly laid out the details of the restatement in a recent news release, which is attached to my testimony. Our intensive restatement process is expected to be concluded at the end of this third quarter. We have a comprehensive and aggressive remediation program in place which we have reviewed in detail with our primary regulator, OFHEO. Because the restatement is underway and the reasons giving rise to the restatement are the subject of Federal investigations. I am sure you can understand why I cannot comment further at this time on the restatement.

I also want to mention that, as previously announced, the outside directors of Freddie Mac's board have retained the firm of Baker Botts to review the facts and circumstances relating to certain accounting errors identified during the restatement process. I understand that the Baker Botts report may be completed and released by Freddie Mac's Board to the public very shortly, possibly as early

as tomorrow.

The comprehensive nature of our restatement gives rise to two questions I would like to address. First, let me stress that Freddie Mac is unquestionably safe and sound. Our expertise in interest rate and credit risk management is widely recognized, and we consistently exceed our statutory and risk-based capital requirements. The restatement will result in significantly higher retained earnings and an increase in our regulatory capital.

Second, Freddie Mac will fulfill its commitments to register with the Securities and Exchange Commission. Following completion of our restatement, we will proceed expeditiously to resume our Form 10 registration process with the SEC.

On the subject of financial accounting standards, let me start with a clear an unequivocal statement. GAAP is the basis and touchstone for our financial reporting. My observations today on GAAP are offered as part of a healthy public dialog and in no way imply less than complete support for the standard-setting process and our commitment to fully comply with GAAP standards.

Freddie Mac fully supports the FASB's ongoing projects to increase the use within GAAP of fair value based measures for finan

cial instruments. In fact, we have found that fair value measures are of increasing importance to investors and other market players. While we already provide a fair value balance sheet on an annual basis, Freddie Mac is now preparing to become one of the first financial institutions to provide investors with a fair value balance sheet on a quarterly basis. This will provide investors with an additional measurement tool along with our GAAP financial statements.

In discussing Financial Accounting Standard 133, my written testimony goes into some detail. Let me summarize by saying that while the derivatives we use are unquestionably economically effective in managing our interest rate risk, the accounting standards that apply to such derivatives go only part of the way to providing a full fair value presentation in GAAP reporting. This is because investment securities and derivatives are accounted for at fair value, but debt obligations are not. This presents a challenge for financial reporting because the two techniques we use to manage interest rate risk have highly similar economic results, yet the GAAP accounting treatment between them is quite different.

Let me conclude by saying a few words about a principles-based accounting framework. I believe such an approach holds the potential to improve financial reporting. Achieving its promise, however, will require rigorous oversight from Congress, regulatory and selfregulatory organizations. The challenges are significant, but the opportunity to improve investor understanding makes pursuit of principles-based accounting worthwhile.

Mr. Chairman, Freddie Mac is pleased to work with you toward meeting the highest standards of financial transparency and accountability. Thank you again for the opportunity to appear today. [The prepared statement of Martin F. Baumann follows:]

PREPARED STATEMENT OF MARTIN F. BAUMANN, EXECUTIVE VICE PRESIDENT FINANCE AND CHIEF FINANCIAL OFFICER, FREDDIE MAC

Thank you, Chairman Stearns. Good afternoon. It's a pleasure to be here today. My name is Martin F. Baumann.

For more than 30 years, I worked at PricewaterhouseCoopers, where I was a partner, deputy chairman of the World Financial Services Practice, and the Global Banking Leader. Most of my career at PricewaterhouseCoopers was spent within its Financial Services Group, where I was responsible for certifying the financial statements for some of the largest U.S. and international banking, insurance, and other financial services clients.

During my career I also have been privileged to chair and serve on a number of accounting industry committees and task forces that prepared standards and guidance on various financial accounting and reporting issues. May I say that I am delighted to be on the same panel today as Leslie Seidman, with whom I have worked on critical banking industry matters.

In April of this year, joined Freddie Mac, where I currently serve as Executive Vice President and Chief Financial Officer.

Mr. Chairman, I applaud the subcommittee for holding today's hearing, the fifth hearing since 2001 that has focused on financial accounting standards. The importance of transparent accounting and reporting standards is clear to everyone. I commend the subcommittee for laying before the public the importance of financial accounting standards before those issues hit the front pages. Mr. Chairman, I also want to state my support for the thrust of your effort to move GAAP toward a principles-based framework.

RESTATEMENT OF PRIOR YEAR FINANCIAL RESULTS

Before I talk about the issue that prompts today's hearing, let me say a few words about recent events at Freddie Mac. As you know, Freddie Mac is undergoing the

process of restating its prior year financial results. This restatement will affect the corporation's financial statements for 2002, 2001 and 2000. Freddie Mac's financial results for periods prior to 2000 will also be affected by the restatement. The impact of these corrections for periods prior to 2000 will be reflected as an adjustment to the beginning balance of retained earnings as of January 1, 2000.

Freddie Mac issued a progress update on its restatement on June 25, 2003. As we stated in that release, the information we disclosed "reflects poorly on Freddie Mac's past accounting, control and disclosure practices." A copy of that press release is attached to my statement. As you'll see from it, while Freddie Mac is now in the process of correcting accounting errors, it remains an extremely safe and sound financial institution.

The accounting corrections fall primarily into five categories. The four major categories are: security classification; accounting for derivative instruments; asset transfers and securitizations; and valuations of financial instruments. A fifth category includes numerous other accounting policies, practices and entries that, individually and in the aggregate, will have a smaller impact on cumulative retained earnings than the four other categories.

As we have disclosed to the public, this intensive process is ongoing and expected to be completed by the end of this third quarter. In the meantime, the reasons giving rise to the restatement are under investigation by the Securities and Exchange Commission, the Office of Federal Housing Oversight, and the Justice Department. In view of these pending investigations, I am sure you can understand why I cannot comment at this time on the details of these matters. It is our understanding with the Chairman that the hearing today is not about these matters, but rather about the more general policy issues raised by such accounting standards as FAS 133 relating to financial derivatives. I am delighted to be here on that basis to address the Subcommittee's questions.

In addition, as previously announced in our June 25 press release, the outside directors of Freddie Mac's Board retained the firm of Baker Botts, LLP to review the facts and circumstances relating to certain of the principal accounting errors identified during the restatement process. As previously announced, it is expected that the report of Board Counsel will be completed and that the Board will determine to release it to the public shortly.

FREDDIE MAC'S COMMITMENT TO DISCLOSURE

It is important to point out that Freddie Mac's new management took the initiative to candidly lay out these errors. We said at the time that the new management team and our Board of Directors is "determined to set high standards for candor and transparency in our financial reporting." In fact, I believe that taking the initiative to release this information is tangible evidence of the type of transparency and candor that Freddie Mac is working to create.

On the point of disclosure, Freddie Mac agrees with Undersecretary of the Treasury Peter R. Fisher, who in a speech last November talked about the importance of improving the quality of information that investors receive. In that speech, he said: .investors have a fundamental right to see the companies in which they invest through the eyes of management." Freddie Mac is determined to meet this standard.

Freddie Mac is continuing to work closely with its independent auditor and other advisors to complete the labor-intensive restatement as quickly as possible without sacrificing accuracy. We are working toward completing the process and releasing results during this third quarter of 2003. At the same time, we are aggressively addressing the factors that contributed to the restatement. We know how to fix these shortcomings and we will. We will emerge stronger than ever, with significantly improved accounting and disclosure practices that will meet the highest standards. We have a comprehensive and aggressive remediation program in place, which we call our Finance Function Governance Project, led by me and reporting to the Governance Committee of our Board of Directors. This program is designed to ensure that we have the highest level of accounting expertise, compliance with GAAP and regulatory reporting, and fully accurate, timely, and transparent financial reporting. We have reviewed the plan in detail with our primary regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) and will be providing them with regular updates.

FREDDIE MAC IS SAFE AND SOUND

The comprehensive nature of our restatement process has raised some questions I'd like to squarely address.