reporting directly to the CEO, with explicit responsibility for operations risk, as well as credit and market risk. In addition, Freddie Mac's central audit department needs to be strengthened so that it can play a more effective role.

To address accounting weaknesses, the report recommends that OFHEO consider and require the exchange of external audit firms. Freddie Mac needs to establish and maintain superior accounting controls and prevent underreliance on its external auditor. It should also document the legitimate business purpose of every significant business transaction.

To address inappropriate management incentives, the report recommended that Freddie Mac refocus its compensation program more on long-term goals, not on short-term earnings.

Until remediation efforts have taken full effect, Freddie Mac remains exposed to substantial management and operations risk. The report recommends that OFHEO consider addressing this concern by requiring Freddie Mac to hold significant regulatory capital surpluses, at least until it can produce timely and GAAP-consistent financial reports.

Finally, the Board recommends that OFHEO take three additional steps. First, OFHEO should implement regulations that provide for mandatory disclosure similar to that required of SEC-registered companies if Congress does not repeal the exemptions of the enterprises from securities laws. Second, OFHEO should expand its capacity to investigate and detect misconduct by including more substantive tests of internal control frameworks at the enterprises, including procedures to identify pressures to commit fraud and opportunities to carry it out. Third, OFHEO should conduct a special examination of the accounting practices of Freddie Mac.

Mr. Chairman, I want to inform you not just about the report, but also of actions OFHEO has taken prior and subsequent to the report. OFHEO directed the holding of termination benefits of senior management pending our review.

OFHEŎ directed that the current CEO and general counsel be replaced.

OFHEO entered into a consent order with the company's former COO, David Glenn, and secured both his cooperation in our investigation and a strong civil money penalty.

OFHEO entered into a consent order with the company, securing a significant money penalty, and imposing a plan of remedial action on the company that requires issues identified by our investigation be addressed.

Finally, OFHEO is pursuing legal actions requiring the termination for cause of the company's former CEO and CFO.

I have undertaken actions at OFHEO as well. Our examination force is being strengthened. The new Office of Chief Accountant will elevate our work in the important field of corporate accounting and reporting, and a new office of compliance will expand our capacity to conduct in-depth reviews of enterprise activities and better ensure their compliance with laws and regulations.

I would like to close my testimony with an urgent appeal to the committee for assistance in obtaining our 2004 budget. Once again, severe constraints have been placed on our operations. The shortterm continuing resolution we are operating under prevents us

from hiring the additional examiners and analysts we need to strengthen our oversight. In addition, we are unable to hire the help we need to conduct our review of Fannie Mae. If the long term is enacted which freezes our budget at 2003 levels, we will need to scale back oversight at a time when greater oversight has never been more urgent.

I urge the committee to help OFHEO to get the resources its needs as soon as possible.

Thank you, Mr. Chairman, and I would be happy to answer any questions the committee may have.

Chairman BAKER. Thank you, Mr. Falcon.

[The prepared statement of Hon. Armando Falcon Jr. can be found on page 61 in the appendix.]

Chairman BAKER. As I understand it, there were 16 different recommendations that were made as a result of your analysis, and I think it should be clear that, given the circumstances in which you addressed the significant attention given to this staff by this matter, there is no one better poised to make recommendations for reform than your office.

What troubles me is they are, frankly, recommendations; that it is up to the enterprise to determine which, if any, it chooses to implement.

One that I find extremely important, OFHEO should require Freddie to hold in a capital surplus limiting growth until they produce timely and certified statements. It appears that at least June of this year would be the soonest it might occur, and, as in the past, that date has the potential to slip.

Do you have the authority to mandate additional capital at this time?

Mr. FALCON. Let me be clear about these recommendations. I may not have been earlier, Mr. Chairman. These recommendations were produced by my staff to myself, and these are recommendations that I will decide whether or not they get implemented, not the enterprise, and I have taken them under consideration, and I agree with all of these recommendations.

Chairman BAKER. Well, in light of that determination, do you believe you have the authority to implement number 5?

Mr. FALCON. Yes.

Chairman BAKER. In light of your prior statement this morning, wherein you indicate if appropriations are not adjusted immediately, you will enter into a period of time in which there is great market uncertainty, great congressional uncertainty, about the ultimate resolution of these matters, why would we not move forward on the great majority or all of these recommendations, particularly in light of your inability to move forward on the forensic accounting analysis of conduct at Fannie Mae?

Mr. FALCON. It is my intent, Mr. Chairman, to move forward on these recommendations. Some will be implemented pursuant to an amendment to our corporate governance regulations, which we are currently drafting. Some of them will be fulfilled through action taken by the company, through working with the company to see them implemented, and others we are working to develop right

now.

The one of specific interest to you on the capital surplus, I expect by the end of next week we will have developed a plan which would implement that provision.

Chairman BAKER. Well, given where we are and the uncertainty of what may be further determined as to the actual accounting conduct, no one hopes for any more bad news, but, in light of the fact we do not now know that the Agency may face budgetary limitations on its ability to pursue further examination at great detail, I would strongly recommend or encourage that action be taken as timely as possible, rather than waiting on the enterprise to certify its financials.

Do you have the authority to separate the functions of the CEO from the Chairman, or is that an enterprise determination?

Mr. FALCON. No, that is something we do have the authority to do, Mr. Chairman.

Chairman BAKER. Is there any item on your 16 elements that you feel you are constrained at this time to act on without proper authority to act, or all of these, without reciting them all, or is it in the posture of being reviewed by you at this time and determinations being made as to whether they will be required?

Mr. FALCON. I believe we have the authority to implement all of the recommendations that are included in this report. Now, whether or not any of our actions are challenged by one or more of the enterprises remains to be seen.

Chairman BAKER. And explain for me what that would mean procedurally should someone at the Freddie Mac Board adopt a resolution saying, we do not want to do "X." what are their rights under the current structure, and what would be your ability to impose it under objection?

Mr. FALCON. Well, we would follow the normal procedures act of promulgating regulation and finalizing regulation. Once the regulation is final, they would certainly be free to challenge it in court. Chairman BAKER. Back at the beginning of this, when Mr. Brendsel's departure occurred, there was an announcement of a severance package that amounted to almost $40 million that was going to be granted without adequate determination of his participation in the accounting manipulations. I wrote at that time and asked that you take whatever action might be permissible under law to preclude the granting of that bonus until such time as final determinations of fault had been made. It is my understanding that that is now in some state of legal discussion.

It triggered a similar question that we wrote a letter in December to your office asking, first, do you review and approve—and I understand that you do review and approve-compensation and severance terms for both enterprises-for executives at both enterprises? We were informed that, perhaps, by the middle of January we might receive an answer to our request for an analysis of the Fannie Mae severance packages, and to date we have not yet received it. Can you give me an idea as to when we might receive that information as well?

Mr. FALCON. Let me I believe is that the request where we may have partially fulfilled the request, but there is still a portion that is outstanding, Mr. Chairman?

Chairman BAKER. There was a request relative to salaries and compensation and a second part relative to severance, and you have provided the compensation information, but we have not yet received the severance information.

Mr. FALCON. Let me look into that and make every effort to try to get that to you by the end of the week.

Chairman BAKER. Terrific, because the principal concern there was we had clearly identified wrongdoing, and it appears-not factually known-that the executive may have had some responsibility for that wrongdoing. And to allow someone to profit as a result of those actions is highly inappropriate.

Before we would enter into-and I am not alleging any improper or inappropriate conduct of Fannie Mae, but I think we should know and have in advance the disclosure of those terms and to ensure that you as a regulator have the ability to stop, withhold, and ensure that the taxpayer interest is protected before determinations are made about someone's ability to mismanage numbers and be rewarded financially.

I have exceeded my time. I will be back.

Mr. Kanjorski.

Mr. KANJORSKI. Maybe next year, Mr. Chairman.

Mr. Director, I listened with great interest in your report, and let me see if I understood you correctly.

First and foremost, it was not your Agency that discovered the misstatement. The misstatement or the the realization of the misstatement came about because sometime in 2002, an accounting firm was changed, and, in the process of that change, the second accounting firm picked up the restatement; is that correct? Mr. FALCON. That is correct, Congressman.

Mr. KANJORSKI. That is very disturbing to me, because listening to some of your recommendations, I was trying to interpose myself as Director of Freddie Mac, and I was trying to figure out if the regulator did not pick up this manipulation that had been occurring for years, and only a new accounting firm picked it up, how would you expect a Director to have either access to the information necessary to discover this occurrence or to have the expertise necessary to pick up that?

Mr. FALCON. I think what we expect of the Board is that they ensure that there are adequate accounting controls and internal controls relating to the accounting function, such that

Mr. KANJORSKI. They did. They hired one of the best accounting firms in the country.

Mr. FALCON. Right; but this conduct occurred prior to the hiring of PricewaterhouseCoopers. This conduct occurred when Arthur Andersen was their external auditor, and it had occurred at a time when their internal audit function was very weak, and the external auditor was serving in essence as the internal auditor for the company as well. So you really had an internal auditor auditing their own work.

Mr. KANJORSKI. And I understand that, but how would you expect a member of the Board of Directors to know whether or not the internal auditing function is reliable? How would you know that? I mean, I have sat on Boards, and I rely on what the certified accountant firm says the condition of the company is, what the re

port back of the executive management-high executive management firm reports to the Board. How would I be expected to know whether or not there is compliance, whether there is stretching or smoothing of earnings, whether it is driven in 2004, for whatever reason?

In this instance, you suspect it is driven for remuneration under the contract, the employment contract, to the high management? I am just a little worried about that, because, one, we have spent, obviously, millions of dollars to have a regulator, and the regulator-I am not attacking you, at all, you have done a great job, but it shows the need for regulation at these large entities is so great from a standpoint of understanding what is going on that it is obviously not clear to most people that you would pick up an irregularity like this, and yet that irregularity can be horrendous in cost to the company and to the taxpayer ultimately.

I do not know what we do about it, short of having maybe dual auditing, or someone came up with the idea in the past a change of auditors periodically, because if we had not had a change of auditors here, they would still be doing what they were doing, and you would not have picked it up. The regulator for the government would not have picked it up.

Mr. FALCON. Right. The nature of the conduct that we found with the company was, by its nature, hidden and not transparent to regulators and to-fully to the Board as well.

The Board was aware of weaknesses in the accounting function of the company, and, in fact, a plan was developed to try to improve the accounting function at the company, but that was not adequate to what was ultimately needed at the company. This was an area-as far as OFHEO's standpoint goes, this involved accounting transactions, the accounting for transactions which were designed to shift earnings into future periods.

Now, the role of a safety and soundness regulator is not to, on the secondary level, certify the work of the auditor. No safety and soundness regulator is equipped to do that, but I do not think that is adequate in the future.

What we are going to work on going forward through the creation of an office of a chief accountant is to look at expertise where we can look at more closely the work of a company to implement new accounting standards, the work of a company to account for certain novel or unique transactions which might be questionable. We have to do what has not been done by the safety and soundness regulators. That is what I think is necessary going forward.

Mr. KANJORSKI. The only thing I am trying to relate to you is I do not have a high degree of confidence at this point that we are any more prepared to meet a challenge of this nature in another entity; that we would either discover it, that we have the tools to handle it, that we have the transparency within the company to pick it up. And it is all nice and good to say, well, Directors are going to have to be more cautious and more responsible.

I do not know what you do as a Director. If your top manager is lying to you, if your auditors are lying to you, and if the government regulator that regulates you cannot pick it up, how do you expect the Director to pick it up? Short of camping on the site and