Freddie Mac is unquestionably safe and sound. As we have stated previously, we expect the restatement to result in significantly higher retained earnings. Commensurately, we expect an increase in our regulatory capital.

Freddie Mac is subject to strong capital requirements, which we consistently meet. Our regulatory capital requirements incorporate two different measures. One is a traditional, or minimum capital requirement. The other is a risk-based capital stress test that requires Freddie Mac to hold capital sufficient to survive 10 years of severe economic conditions.

The stress test results released by OFHEO have consistently shown that Freddie Mac has held substantially more capital than would be necessary to survive such extreme conditions. In line with this, on June 30, 2003, OFHEO classified Freddie Mac as adequately capitalized, OFHEO's highest rating.

Freddie Mac's business fundamentals are as strong as ever. As a result of our disciplined approach to the investment business, we expect a material increase in the fair value of shareholder equity in our fair value balance sheet as of year-end 2002 versus year-end 2001, in spite of a record low interest rate environment. We continue to attract funds from around the world to support homeownership in America. The recent pricing of our 2-year and 10-year debt issuances was extremely well received despite market volatility.

Freddie Mac will fulfill its commitment to register with the Securities and Exchange Commission. Freddie Mac is fully committed to completing the process of voluntarily registering its common stock with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Last summer we voluntarily agreed to submit to the full panoply of the periodic financial disclosure reporting requirements that apply to registrants. We are enthusiastically, unequivocally, and irrevocably committed to completing this process, as our President and CEO, Greg Parseghian, said in a letter last week to Treasury Secretary John Snow, which is also attached.

Following completion of our restatement and re-audit, we will proceed expeditiously to resume our Form 10 registration process with the SEC. Voluntary Exchange Act registration will place our financial disclosures under the direct oversight of the SEC, thereby ensuring that our disclosures meet the standards of an SEC registrant. This is another part of our commitment to transparency in financial reporting.

Freddie Mac uses derivatives to manage risk, not speculate. Derivatives are a key tool used by Freddie Mac to manage the risk inherent in long-term fixedrate prepayable mortgages, the mortgage of choice for most Americans. Chairman Alan Greenspan of the Federal Reserve Board, has praised the use of derivatives by Freddie Mac and Fannie Mae numerous times.

Through the use of derivatives and other asset-liability management strategies, Freddie Mac and other mortgage investors manage and reduce the interest rate risk inherent in owning consumer-prepayable mortgages. They do so by transferring some of the risk to high-quality third parties that are willing and able to assume and manage that risk. To say it another way: We use derivatives to hedge existing exposures-we do not use derivatives to speculate.

The accounting issues related to derivatives identified by Freddie Mac do not diminish or change the economic effectiveness of those derivatives. The restatement has no adverse impact whatsoever on the economic or fair value results we achieve through derivative instruments, which continue to prove very effective in managing risks. Our monthly disclosures around our interest rate risk levels and our forthcoming disclosure regarding the full fair value of Freddie Mac's balance sheet provide ample evidence that our derivatives usage is keeping low risk and not adversely affecting fair value.

Because our restatement is still underway, I cannot comment further at this time on specific accounting issues discussed in our June 25 press release. However, I would be pleased to meet with you again, or answer any written questions you might have after we have published our press release announcing the restatement results.

DISCUSSION OF ACCOUNTING ISSUES RELATED TO TODAY'S HEARING

Today I would like to address three matters related to U.S. generally accepted accounting principles, or GAAP, and the relevant accounting issues that this subcommittee has shown so much leadership in raising and addressing. First, I will discuss the increasingly important role that fair value measurement is having for purposes of GAAP financial reporting and disclosure. Second, I will discuss how Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Financial Instruments and Hedging Activities," as amended, or SFAS No. 133, applies fair

value measurement concepts but still leaves a mixed measurement model for financial reporting. I will close with some thoughts concerning the conceptual framework used to craft new standards: Should they be principles-based or rules-based?

Before I begin, let me make a clear and unequivocal statement: GAAP is the basis and the touchstone for all financial reporting. For Freddie Mac, we are entirely committed to using GAAP as the primary basis for our on-going communications with our shareholders and other interested parties. Any observations regarding how GAAP works should be understood as offered as part of a healthy public dialogue regarding how to improve GAAP and in no way implies anything less than our wholehearted support for those responsible for standard setting and commitment to comply fully with all applicable GAAP standards.

FAIR VALUE AND GAAP

Freddie Mac fully supports the FASB's ongoing projects to increase the use within GAAP of fair value-based measures for financial instruments. Over the years, the FASB has made significant progress towards this objective. I agree with the FASB Chairman Robert Herz' statement that “...I think it's hard to argue with the conceptual merits of fair value as the most relevant measurement attribute. Certainly, to those who say that accounting should better reflect true economic substance, fair value, rather than historical cost, would generally seem to be the better measure." Freddie Mac's support of fair value concepts is mindful of the views of a number of important capital markets participants. For example, the Bond Market Association, the International Swaps Dealers Association and the Securities Industry Association have expressed support for fair value measurement concepts in a March 2002 report, stating: "[S]ince fair value reflects current market conditions, it provides comparability of the value of financial instruments bought at different times. In addition, financial disclosures that use fair value provide investors with insight into prevailing market values, further helping to ensure the usefulness of financial reports."2

For its part, Freddie Mac understands that fair value measures are of increasing interest and importance to our investors. Our new management team is committed to providing investors with the information they need to understand how we view and manage the business, so that investors can value our business fairly and accurately. To that end, we announced in our June 25th press release that we will begin releasing quarterly fair value balances sheets in addition to our GAAP-based financial statements and related tables. Freddie Mac already provides a fair value balance sheet on an annual basis as part of our consolidated notes to financial statements, in accordance with SFAS 107. We are now preparing to become one of the first financial institutions to provide investors with a full fair value balance sheet on a quarterly basis, which will show mark-to-market gains and losses on our business and provide investors with an additional measurement tool along with our GAAP financial statements.

SFAS 133 AND APPLICATION OF FAIR VALUE MEASURES TO FINANCIAL INSTRUMENTS

Let me now turn to a discussion of SFAS 133 and its application of fair value measures to derivative financial instruments. As an introductory matter, let me underscore that Freddie Mac applies risk-management strategies with strict discipline. We use derivatives to reduce interest-rate risks that any mortgage investor faces. Our use of derivatives demonstrates our commitment to dispersing economic risks. We do not use derivatives to speculate or make bets on the direction of interest rates. To do so would be contrary to our risk management disciplines and to our statutory mission to provide liquidity to the mortgage market at all times. Prudent use of derivative instruments is essential to our ability to manage interest-rate risk in a wide variety of market scenarios and thus to fulfill the mission that Congress has directed to accomplish.

While the derivatives we use are unquestionably economically effective in reducing and dispersing our interest-rate risk, the accounting standards that currently apply to such derivatives only go part of the way to providing a full fair value presentation in GAAP reporting. This is because while investment securities and derivatives are accounted for at fair value, debt obligations are not. Allow me to provide

"Meeting the Challenges of Financial Reporting in an Era of Change," Address of Robert H. Herz, AICPA 2002 National Conference on Current SEC Developments.

2 Explanation and Benefits of Fair Value Accounting, prepared by The Bond Market Association, International Swaps & Derivatives Association, Securities Industry Association, March 26, 2002.

a simplified example drawn from our own experience that describes how investors manage interest-rate risk.

When a mortgage investor purchases standard single-family mortgages, it faces the risk that the homeowners on these mortgages will exercise the option to prepay their mortgages in a low interest-rate environment. For mortgage investors that finance their investment activities by issuing debt, these prepayments could leave the investor at risk, because the investor would be forced to re-invest prepaid mortgage proceeds in lower yielding assets, creating a potential future shortfall on the amount the investor owes on the debt used to fund the original mortgages. For this reason, prudent investors find ways to manage the prepayment risk associated with residential mortgages and mortgage securities.

A mortgage investor can finance its mortgage purchases using two techniques to manage this interest-rate, or prepayment, risk. One way is to issue debt with a call option embedded in it-so called "callable debt"-which gives the investor a right of prepayment similar to the one that borrowers have on their mortgages, thus eliminating most prepayment risk. The second technique for the investor is to issue non-callable debt while at the same time purchasing stand-alone options that accomplish the same financial result as the callable debt-making the investor whole in the event interest rates result in mortgage prepayments. These stand-alone options (for example, interest-rate swaps or "swaptions") are referred to as "derivative" financial instruments. In both funding techniques, the resulting interest-rate risk economics are the same. When Freddie Mac invests in mortgages, we choose between these two basic risk management techniques to achieve the lowest cost, because that translates to lower mortgage costs for consumers and sound economics for our business operation.

Here's the challenge in our financial reporting in this area: While these two techniques have highly similar economic results, the GAAP accounting treatment between them is quite different. Whether callable or non-callable, the debt that a mortgage investor issues will be reflected in financial statements on the basis of its historical cost, without regard to market value changes that might occur with respect to such debt over a period of time. But with respect to derivative financial instruments, SFAS 133 provides for the change in market value of such instruments to be directly reflected in financial statements from period-to-period.

Please understand that I support fair value measures with respect to derivative instruments. The crux of our challenge is that GAAP policies today provide for different measures of economically similar transactions requiring fair value treatment for derivatives used with non-callable debt but requiring historic cost treatment for callable debt. In other words, current GAAP policies could be characterized as being in a transitional stage from historic cost to fair value measures. This mixed measurement model creates a challenge for all reporting companies in clearly explaining both the accounting results and the underlying economic results for transactions involving derivative instruments. It is absolutely essential that the management of these companies make every effort to provide transparent, informative and candid financial reporting to their investors. Freddie Mac is committed to that objective.

TOWARD PRINCIPLES-BASED ACCOUNTING

SFAS No. 133 is a rule-based standard attempting to establish guidelines for an industry that is growing in complexity and size each day. SFAS 133 is extremely detailed and highly prescriptive. While I agree with the underlying principle of this standard, which requires the recording of derivative instruments at fair value, a legitimate question can be asked as to whether companies, investors and practitioners might benefit from an approach that promised to reduce the enormous complexity in the rule's application. The Securities and Exchange Commission and the FASB, among others, have been studying the potential efficacy of adopting a U.S. financial reporting system based on principle-based standards.3 Proponents of principlesbased accounting in the United States envision that it would result in a fundamental shift away from the very detailed, rule-based standards, like SFAS 133, to standards under which companies and their auditors would determine appropriate accounting policies based on the economic substance of the transaction rather than its form. This is the framework on which many international accounting standards are based.

3 Speech by Cynthia A. Glassman, U.S. Securities and Exchange Commission, 23rd Annual Ray Garrett Jr. Corporate Goverance and Securities Law Institute Northwestern University School of Law, Chicago, IL, April 10, 2003.

I believe that a principles-based accounting framework holds the potential to improve the representational faithfulness of financial reporting under U.S. GAAP. This is because a principles-based approach would ensure that all reporting companies meet the substance and not just the form of accounting rules. However, for such an approach to work, policymakers, including the Congress, would be well advised to focus on a number of questions. First, would there be a strong enough framework of oversight to guide the application of fundamental principles and ensure consistency? A principles-based framework could emphasize the judgment of company managers and accounting professionals. Second, clear, consistent and, let me emphasize-readily comparable disclosures could be essential to ensure that a principlesbased approach would provide clear disclosures with the proper level of information for investors.

Principles-based accounting holds enormous promise, but achieving its promise will require foresight from Congress and rigorous oversight from regulatory and selfregulatory organizations. The challenges are significant, but the opportunity to improve investor understanding makes pursuit of these challenges worthwhile.

CONCLUSION

Mr. Chairman, let me applaud you for holding this hearing to again focus on such important issues related to transparent accounting standards.

Mr. STEARNS. Thank you, Mr. Baumann.
Mr. Wallison.

STATEMENT OF PETER J. WALLISON

Mr. WALLISON. Thank you, Mr. Chairman. Thank you for inviting me to testify this afternoon on the subject of Fannie Mae and Freddie Mac. My testimony will focus on the efficacy of accounting in general, not specifically on FAS 133, and I ask that my written testimony be included with the committee's record.

Mr. STEARNS. By unanimous consent, so ordered.
Mr. WALLISON. Thank you, sir.

Accounting issues have dominated the news about Fannie and Freddie recently, for good reason. A failure or serious financial crisis at either of these companies could cause major losses to the government, to the taxpayers, and to the economy as a whole. This is not an enviable position for this country to be in, and it does not have to be so, but that is where we are today.

The concern about Freddie Mac's accounting is a reminder that we are relying on only two safeguards to protect our economy against a serious problem-accurate accounting and good regulation. The events of Freddie raise questions about both.

What exactly Freddie's management did is really irrelevant. The important point is that its management made serious misjudgments that were not reversed by its auditors, or caught by its regulator. What this shows is that in relying, as we do, on accounting and regulation, we are placing a lot of weight on two very thin reads.

Unfortunately, many people have the impression that accounting is some kind of exact science, that the numbers are all there and just have to be added up. This is not the case. Under Generally Accepted Accounting Principles, known as GAAP, there is a great deal of room for management judgment, and these judgments can radically change the financial statements. Let me give you an example.

On September 13, 2002, Fannie Mae transferred $135 billion of securities from the balance sheet classification "Held to maturity" to the classification "Available for sale." On that date, the market

value of these securities was higher than what Fannie had paid for them. By reclassifying these securities as Available For Sale, Fannie was able to carry them at their higher market value rather than at their cost. The effect of this was to add a significant amount to Fannie's shareholder equity. Thus, a technical management decision which had no effect on economic reality, made Fannie's balance sheet look healthier on September 14 than it looked on September 12.

This is what I mean when I say that we are relying on a weak read when we rely on a company's financial statements to alert us to impending problems.

The subject of the hearing today, FAS 133 and accounting for derivatives, only further complicates things and puts more opportunities for window-dressing into management's hands.

What about regulation? Again, in my view, a weak read. It appears that OFHEO, Freddie's regulator, was not aware of the scope of the company's financial problems. This should not surprise us. The managements of regulated companies frequently will not tell their regulator about problems until these have gotten completely out of hand. Before that, the hope is to work out the problem before the regulator finds out. Once the regulator knows, everybody knows. Exactly this seems to have happened in Freddie's case.

Again, the point is not this particular case, it is importance is that it should alert us to the fact that reliance on regulation to protect us against financial disaster is often, very often, misplaced.

Why is it especially important in this case to worry about accounting and regulation? Because the housing market is unique. It is at once the largest part of our economy, and it is dominated by two companies. In most other areas of the economy, there are a lot of companies. If one fails, as Enron failed, for example, the market sector carries on virtually unaffected. The housing market is not like that. If Fannie or Freddie fails or has a serious financial crisis, we can have systemic effects on our whole economy. Thus, although we could withstand some bad accounting and some regulatory failure in many other areas of the economy, we cannot risk this here. Since accounting and regulation are such thin reads, the real question for Congress is whether the benefits provided by Fannie Mae and Freddie Mac outweigh their cost and the risk they create. In my prepared testimony, I argue that Fannie and Freddie create enormous risk for the economy and the taxpayers, but provide no significant benefits to homeowners or to the housing market generally. They do not make homes appreciably more affordable, do not contribute significantly to home ownership in the United States, and appear to discriminate against minority or low-income borrowers.

Under these circumstances, the best course for Congress would be to eliminate the risks they pose by cutting their links to government. Although I favor complete privatization, if Congress is not prepared to do this at this point, there is a less dramatic way substantially to reduce their risks. Congress should prohibit Fannie and Freddie from buying back their mortgage-backed securities or accumulating substantial portfolios of mortgages.

Most of the limited benefits that Fannie and Freddie provide to the mortgage market comes from the issuance of their mortgage