shadowing the operations of the company, I do not know how you do it.

The other thing I am interested in here: Did you find that this was purely a profit-driven vehicle for top management to get a better return on their bonus programs or whatever it was?

Mr. FALCON. That was part of the cause of the problems in the company. It was not the only reason for the actions in the company.

The company very much wanted to try to show steady earnings growth, and because of market conditions in early 2001, they reaped a windfall in net income at the company. The result was they sought to shift that money around. In addition, they had to try to shift income around that was the result of

Mr. KANJORSKI. Right, I understand what they did, but do you feel you have gotten to the motive? Was the motive for self-reward under the schemes of the bonuses or payment system of management, or was there some other scheme?

I am sort of hurt to think that some of these fellows would have subjected this company's reputation and assets to extraordinary losses. I mean, the way I am running in my mind, this is probably a cost of over a billion dollars to this company, and certainly they did not get that kind of a package return from their-as a motive from their salary situations. So it seems the expense to the company far exceeds the benefits, the package benefits, these people received, so I am looking for some other motive that was there.

Mr. FALCON. And I think it is addressed in the chapter in our book which talks about the tone at the top. The company took great pride in meeting the expectations of analysts; hence, the nickname Steady Freddie. And ultimately it engaged in whatever means were necessary to continue to meet those expectations of investors.

Mr. KANJORSKI. I am sorry to be so long. I am shadowing the Chairman, however.

You found some difficulty with the counterparties in the derivatives, and, as I understand it in prior discussions with you, you do not necessarily know whether or not-how far your authority allows you to reach into determining whether the counterparties are sufficient to honor the commitments they make in derivatives. And of course that is vitally important as to whether there is any validity or value in the derivatives.

If you have a fake counterparty or a less than adequate counterparty, you have nothing, and it seems to me when we are dealing in the hundreds of billions of dollars, some people say trillions of dollars, of derivatives today, particularly with these GSES, what scope of a program do you have to authorize or to ask Congress to authorize you with greater authority to get into the review, oversight and understanding of the effectiveness of counterparties in these transactions, derivative transactions, or does not that scare you?

It scares the hell out of me. I do not sleep very well. If these folks are doing what they did in Enron and manipulating what they did here, now they are playing a sissy game. They ought to be out playing with derivatives and setting off false counterparties, and they could be ripping off tens of hundreds of billions of dollars. What is your feeling of that?

Mr. FALCON. We are currently looking at the role of counterparties in the Freddie Mac situation, trying to discover whether improper conduct was engaged in by facilitating some of the key transactions the company used to shift earnings. We have not concluded that review yet.

Ultimately our authority-we do not have direct authority over these counterparties; however, we do have authority over the two companies we regulate, and if we thought their entering into transactions with certain counterparties was an unsafe and unsound practice, we could take steps to limit their business dealings with those counterparties.

Mr. KANJORSKI. Do you examine or have the authority to examine the financial statements of counterparties?

Mr. FALCON. No, we do not.

Mr. KANJORSKI. So you have no idea whether they are strong counterparties or effective and well-asseted counterparties, do you? Mr. FALCON. We do look at the counterparty's credit rating.

Mr. KANJORSKI. That is the whole point. You are relying on secondary, and whoever did the credit rating is probably relying on their oversight by a government regulator. There is sort of a tendency for everybody to think the other guy is making the examination, the study, or the determination; in fact, nobody is, and it could just as easily be a very similar transaction to Enron. A very bright financial fellow could structure counterparties that are straw counterparties, that have absolutely no value out there, and yet are handling these multi-billion-dollar transactions, with the assistance in a way of internal management, because they have a goal to affect their income stream as a result of success, but, in fact, the counterparty would be interested in eluding the operation, getting paid for something that they are not putting value up for. Chairman BAKER. Mr. Kanjorski, if I might, the recommendation number 11 is Freddie should document legitimate business purpose for every significant derivative transaction, so the regulators have identified that as an area of concern. I am very anxious to see if they have the ability to enforce that.

Mr. KANJORSKI. Right.

Chairman BAKER. I thank the gentleman.

Mr. Shays.

Mr. SHAYS. Thank you. I have questions, but I would like to follow other Members and hear what they have to ask.

Chairman BAKER. Mr. Ryun.

Mrs. Biggert?

Mrs. BIGGERT. Thank you, Mr. Chairman, Director Falcon.

Going back to the Board of Directors, just for clarification, the Board is made up of Directors who are shareholder-elected, and then there is also the Presidential-appointed Directors?

Mr. FALCON. Yes, Congresswoman. There are five of them for each company.

Mrs. BIGGERT. Five?

Mr. FALCON. Five.

Mrs. BIGGERT. And in your statement you say the shareholderelected Directors, I assume, are going to stay until they reach 65 or even beyond?

What is the average a Director has been a shareholder?

Mr. FALCON. The average tenure of a Director for Freddie Mac? Mrs. BIGGERT. Mm-hmm.

Mr. FALCON. I believe it is probably over 10 years.

Mrs. BIGGERT. Okay. And then you say that, conversely, the service of the Presidential Directors is-averages just over 14 months, or was your statement that that is when they become effective?

Mr. FALCON. That is their average tenure on the Board. Their terms are for 1-year appointments, and some of them are reappointed, but the average tenure of a Director is 14 months.

Mrs. BIGGERT. Right. So do you think if they are serving as a Presidential appointment, if the tenure was longer, that maybe they would have been more effective, and maybe they would have been able to participate to something that was going on, misconduct?

Mr. FALCON. I think they could be more effective on the Board if they were allowed a longer term on the Board. However, my preferred approach is, I think, corporate governance would be better enhanced if shareholders were allowed to elect all Directors of the Board, rather than 13 of the 18 Board members.

Mrs. BIGGERT. Do you have any background in why there were Presidential appointments made, the reasoning for it?

Mr. FALCON. Just the nature of these being government-sponsored enterprises and the charters. That was part of the originalI believe it was one of the original charter provisions of both companies.

Mrs. BIGGERT. So there would be more oversight if there were just the shareholders?

Mr. FALCON. I believe shareholders would have a larger voice in the company if they elected the members of the Board, as opposed to just a portion of the Board members.

Mrs. BIGGERT. Okay. One of the something that companieswhen there is rapid growth, that is often seen as a stress on the institution, and we have seen dramatic growth in the operations of Freddie Mac over the last several years. Did not this growth as much as 30 percent raise concerns at OFHEO?

Mr. FALCON. Much of the growth has come in the form of the retained portfolio, which, over the last 10 years, I think, has grown maybe 7-maybe 700-fold. They began their retaining portfolio operations with well less than $100 million, and I think they were at a 600- or $700 million enterprise, depending on what you are talking about.

That reflects a shift in the company's business strategy. As they became more of a portfolio lender, they began to take on credit risk associated with guaranteed mortgages, but the growth presented a new risk, which was market risk, which was part of holding these portfolios.

Mrs. BIGGERT. So that does not raise any red flag with OFHEO to investigate or ask for an examination?

Mr. FALCON. It does mean that the company has to devote appropriate resources to making sure they adequately understand and manage the risk associated with holding those large retained portfolios.

Up to this point we have seen them manage the risk associated with those portfolios in a very prudent manner, so we do watch the

growth rate carefully. As long as they are able to manage the growth, we haven't seen the need to step in and slow down the growth.

Mrs. BIGGERT. So there is nothing that you would want to change in that which you think, maybe looking back, that you should have?

Mr. FALCON. No, Congresswoman.

Mrs. BIGGERT. All right. So do you know whether the enterprise or their auditors conducted their own stress test?

Mr. FALCON. They did maintain their own stress test while we were in the process of developing our stress test. I believe they have discontinued the use of those stress tests; in fact, I think it was one of their voluntary steps they had taken internally at the companies, but with OFHEO's stress test now fully implemented, I do not know if they continued to use their internal stress test. Mrs. BIGGERT. So did you review their data that they had accomplished?

Mr. FALCON. We are familiar with the operations of the stress test they were running during this interim period, but we do run our own stress test, based on the data submitted by the enterprises to OFHEO, and I believe the stress test is a very robust gauge of risk, and it ties capital very closely to risk.

Mrs. BIGGERT. Thank you very much.

Thank you, Mr. Chairman.

Chairman BAKER. Thank you, Mrs. Biggert.
Mr. Scott?

Mr. SCOTT. Thank you, Mr. Chairman.

Mr. Falcon, let me ask you about the culture at Freddie Mac. Do you think there is a permissive corporate culture that neglected accounting and oversight and focused on the wrong incentives for executive pay there?

Mr. FALCON. I do, Congressman.

Mr. SCOTT. Have you seen any improvement in that culture at Freddie Mac?

Mr. FALCON. I have. Since the time that new management has been brought in, including the new Chairman of the Board of the company, the company has done a lot of good work in trying to implement a remediation plan, as well as steps to bring about a new corporate culture within the company, so I think they have done a lot of good work.

I think, since the events of that transpired in the past year, the Board has been very active in fulfilling its responsibilities, so I think companies also cooperated very well with OFHEO. So I think as a general matter the company has done a lot to resolve a lot of these problems.

Mr. SCOTT. Is there anything particular that you could put your finger on that might have caused this permissive culture there?

Mr. FALCON. It was the result of senior management at the very top focusing first and foremost on the desire to try to meet the earnings expectations of the investment community; and it meant trying to smooth out any spikes in income, whether they be down or up. In this case, it was upward spikes in income that were shifted into future periods. I think the company became overly concerned with the fact that if there was a spike that went up very

high that the analyst community might then expect the raise their expectations for the company. So the desire was to try to meet expectations but not by too much, not exceed them by too much.

Mr. SCOTT. Now, you say that until-you stated that until Freddie Mac fully complies with remediation, it remains exposed to substantial management and operation risk. Will OFHEO require Freddie Mac to hold significant capital surpluses?

Mr. FALCON. Well, as I have said, they have made good progress in turning around the corporate culture at the company and focusing on the highest standards. There remains much to be done. The company still has a ways to go before it can produce timely quarterly financial statements. The requirements of our consent order will need time to get fully implemented, and there are several very senior management positions that remain to be filled. So there is still much to be done at the company. In the meantime, these remediation efforts that are required in our consent order with the company will work to address shortcomings in the accounting area, in the internal controls area. However, in the interim, I think it is an appropriate for the company to hold additional capital until all of these corrective actions have taken full effect; and that is what we will address by the end of next week.

Mr. SCOTT. Okay. Well one final question, Mr. Chairman, if I could. The examination report recommended that OFHEO conduct a special examination of the accounting practices of Fannie Mae. On January 2nd, the Wall Street Journal stated that Fannie Mae has lost so much capital in the past 3 years that its capital is now below OFHEO's required minimum. Are you aware of that article? Mr. FALCON. I am aware of the issue that you raise. I don't think it is comparing the same thing though.

Mr. SCOTT. What is your opinion on this?

Mr. FALCON. May I? I think the focus there has been on capital as reflected in fair value statements, as opposed to capital as calculated in our core capital standard. Our core capital standard is similar to that of every other safety and soundness regulator and is consistent with GAAP.

What a fair value statement does is try to market all the assets and liabilities of the company; and, in this case, that capital as reflected in fair value statements is lower than the capital as we calculated for core capital and minimum capital purposes. However, while fair value statements are useful indicators of the company's current liquidation value, it does not reflect-it has some limitations. It does not reflect the ongoing concern value of a company. So that is the difference between the two standards, Congressman. Mr. SCOTT. Thank you.

That is all my questions, Mr. Chairman.

Chairman BAKER. I thank you, Mr. Scott.

Mr. Shadegg, do you have questions? Mr. Bachus?
Mr. BACHUS. I thank the Chairman.

Director Falcon, as I recall, it was January when Freddie Mac made the announcement that it planned to restate its earnings. Then in June they announced the departures of Mr. Glenn and Mr. Clark and Mr. Brendsel, and it was at that time or the next day or two that you formed a special investigative unit to investigate.