accounting staff and experience caused key-person dependencies in crucial control areas. Simply stated, the quality and quantity of accounting expertise was too weak to assure proper accounting of the increasingly complicated transactions and strategies being pursued by Freddie Mac. From 1993 through 1996, the first four years of rapid retained portfolio growth, management actually reduced accounting and reporting personnel by nearly 20 percent. As described in a memorandum by Lisa Roberts, staffing remained a problem in subsequent years: 26 During the past five years (with the exception of 2002), management Freddie Mac also failed to provide adequate funding for accounting systems. For example, in 1996 Corporate Accounting still managed the entire portfolio accounting process on Excel spreadsheets. That system was improved slightly in 1997, but repeated requests for a more robust Treasury accounting system were denied until 2000.28 Accounting needs were regularly given a low priority in allocating the limited amounts that Freddie Mac was willing to devote to general and administrative expenses." 29 relative to Fannie Mae why did accounting have to take the short end? it was always viewed as a second-class citizen. 26 OFHEO Interview, Gregory Reynolds, October 2, 2003, pp. 142-143. 27 Memorandum to Cindy Gertz, from Lisa Roberts, April 16, 2003, OF 1401526. 28 Memorandum to Files, "Issues History," Gregory Reynolds, October 2, 2003, pp. 88-90, GR1-89. 29 Memorandum from former Chief Financial Officer, John Gibbons, to Leland Brendsel, October 7, 1999, "All of these departures reflected frustration with systems development at Freddie Mac, and, in particular, the judgment that developing finance systems was not valued in the corporation. This is a situation, which puts critical corporate processes at risk and reflects, I believe, a distorted view of how systems development and infrastructure support the corporation's success.' " See also, OFHEO Interview, Gregory Reynolds, October 2, 2003, p. 135, GRI-71. Q: That developing these financial systems was not sufficiently valued at the corporation? Failure to Manage Operations Risk 30 Another significant aspect of the corporate culture of Freddie Mac is a narrow definition of operations risk and a related neglect of operations risk management. The Basel Committee on Bank Supervision defines operations risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." That definition is broad enough to encompass the risk of loss from failures to maintain appropriate accounting policies, practices, and controls or financial reporting controls, as may result from inadequate staffing and resources in those areas. During the period covered by the restatement, Freddie Mac did not define operations risk that broadly. Management viewed operations risk as the potential for losses due to technology-related failures-for example, the losses that would be incurred if firewalls at file servers were breached, the Enterprise was not Y2K ready, or a disgruntled employee sabotaged an internal computer system. Freddie Mac failed to view operations risk as including failure to maintain or comply with written accounting and financial disclosure policies, procedures, and controls. Illustrative of that narrow definition of operations risk and of the implications of that view for operations risk management oversight at Freddie Mac, is a presentation entitled "Risk Management, Controls and Oversight," presented to the Board of Directors of the Enterprise on March 1, 2002. That document lists and defines the four primary business risks facing Freddie Mac: Credit, Market/Interest, Operations, and Financial Reporting and Disclosure Risks. Operations risk is defined as “the risk of loss due to an interruption of critical business operations or processes, inadequate resources, capacity or capital, inefficiencies or inadequate controls over the delivery of products or services.” 9931 A: Developing financial systems ... that applies not just to the financial systems, but, Within the corporate culture of Freddie Mac, the financial functions were the second- 30 Basel Committee on Banking Supervision, Sound Principles for Management and Supervision of 31 The document provides an extensive, multi-page review of the Freddie Mac oversight process for credit and market risk. There is no discussion of operations risk oversight. There is a section on the role of Internal Audit as an independent reviewer of risk relative to the other units in the organization. Later in the document, a table shows the internal review process at Freddie Mac for the four primary risks. The Credit Risk Oversight business unit is listed as providing an internal review of credit risk, the Market Risk Oversight business unit is listed as responsible for internal review of interest rate and market risk, and the Corporate Controller is listed as responsible for the internal review of financial reporting and disclosure risk. The chart lists "none" for internal review of operations risk.32 Internal Audit is listed as an external reviewer of each of those risk areas. The presentation concludes: While our control framework is sound, implementation of several aspects 33 The special examination does not agree with that conclusion. As discussed in detail in Chapters V and VII, significant weaknesses existed in the Internal Audit function of Freddie Mac and in the ways in which senior management and the Board responded to weaknesses identified by the General Auditor. Those weaknesses existed, in part, because the culture of the Enterprise had a narrow view of operations risk and saw no need to implement a broad framework for monitoring and managing that risk. The absence of such a framework contributed, in part, to decisions by senior management to execute transactions that were intended to manage reported earnings, had little or no effect on interest rate risk, and increased operations risk. 34 It was not until mid-2002 that Freddie Mac began to make controlling operations risk a corporate goal. Management created an Operating Risk Management Forum, which first met April 16, 2002, to parallel its existing Market Risk and Credit Risk 34 The members of the Operating Risk Forum included: David Glenn, Gregory Parseghian, Paul Peterson, Adrian Corbirre, Maud Mater, Michael Hager and William Ledman. OFHEO Interview, Edmond Sannini, August 1, 2003, pp. 31-32. Forums. On May 1, 2002, in a major reorganization two months after the Board of Directors presentation, Freddie Mac created the Control and Operating Risk Division. That reorganization consolidated in one division responsibility for establishing and maintaining an internal control structure over business risk, operations, and financial reporting, compliance with laws, regulations and other legal requirements; and safeguarding of Freddie Mac assets. The division is now responsible for Operating Risk Oversight, Financial Information Technology (financial reporting application systems), and Financial Reporting. 35 35 Q4-2002 Internal Control Assessment Update - Control and Operating Risk Division, 2002, OF 1303861 - OF 1303865. 36 The term "earnings management" came into widespread use among accountants, lawyers, and others following a now famous September 1998 speech by the then Securities and Exchange Commission Chairman, Arthur Levitt The term is perhaps unfortunate, in that almost all business activity is designed to enhance earnings, and the essence of good corporate management is maximizing profit (earnings) for shareholders. As used in this report, it means inappropriate manipulation of reported accounting results through various devices. This chapter reviews how Freddie Mac manipulated its reported earnings and disclosed other financial information in a misleading way in 1999 through 2002. The chapter provides a chronology of relevant events, reviews the strategies that the Enterprise employed to manipulate earnings, and indicates that the Board was made aware of transactions whose sole purpose was to shift income. The chapter also examines how the executive compensation program of Freddie Mac, particularly compensation tied to earnings per share, influenced accounting and management practices at the Enterprise during the period. The special examination concludes that excessive attention and dedication of corporate resources of a government-sponsored enterprise to management of earnings for the purpose of meeting securities market expectations, without an additional, overriding business purpose, is an unsafe and unsound practice. Strategies Employed by Freddie Mac As discussed in Chapter II, in the period covered by the special examination, senior management at Freddie Mac placed an inordinate emphasis on achieving steady, stable growth in earnings per share. The Enterprise used a number of strategies in an effort to shift earnings among quarters and years so as to achieve that objective. A useful way to 36 Arthur Levitt, "The Numbers Game,” Address, the NYU Center for Law and Business, September 29, 1998. |