131 The Standard Reports to the Investment Committee for September 7, 2001, which Mr. Parseghian presented, noted that certain items offset favorable short-term debt costs in 2001, including "using swaps to transfer NII to 2002 and beyond.' Mr. Parseghian told OFHEO staff that he sought to include more quantitative detail about the swaps in his Investment Committee report, but the detail was removed at the behest of senior management present at the dry run, a group that included Leland Brendsel, then-General Counsel Maud Mater, and David Glenn. 132 However, the Investment Committee may have been told more. Notes taken from a breakfast review of the September 7th board committee meetings by the assistant to Mr. Glenn include the following for the Investment Committee: "derivatives position trillion, to back load income. $400b to shifting income."133 Ultimately, management did not unwind the swaps until they had already moved large amounts of operating earnings. That earnings movement began late in the third quarter of 2001, a time many Americans will always associate with attacks on the World Trade Center and the Pentagon. In view of those events, the Earnings Release of Freddie Mac for that quarter reminded investors that, despite those tragic events, investors could count on a steady stream of earnings: "We are all saddened by the terrible events of September 11," said Leland A New External Auditor As 2001 was winding down, headlines appeared about Enron, the once highly regarded energy company in Houston, Texas. Previously a mundane distributor of natural gas, 130 Handwritten notes from Board of Directors meeting, September 7, 2001, OF 1625371. 131 Investment Committee Standard Reports, p. 4, OF 5021913. 132 OFHEO Interview, Gregory Parseghian, v.1, August 4, 2003, pp. 122-133. 133 Journal excerpt, Bob Ryan, September 11, 2001, OF 2010250. 134 Freddie Mac Third Quarter 2001 Earnings Release, October 17, 2001. Enron later seemed to make spectacular profits on trading energy derivatives and bandwidth futures. However, stories were emerging about the management of Enron, who allegedly engaged in transactions to create nonexistent profits and enrich themselves. That cast the external auditors of Enron, Arthur Andersen, in an extremely unfavorable light. The firm fired David Duncan, the lead partner for Enron, in January 2002, after alleging that he ordered the destruction of documents upon learning of a government investigation. The situation could not have come at a worse time for Arthur Andersen, soon after high-profile restatements at Waste Management, for which the SEC ordered Arthur Andersen to pay $7 million for "improper professional conduct,” and Sunbeam, which resulted in Andersen paying $110 million to settle shareholder lawsuits." 135 Given the unfavorable publicity engulfing Arthur Andersen, companies using the audit firm had to rethink their relationship with them. Freddie Mac had been an Arthur Andersen client since the early 1970s and relied on the firm to an unusual degree. However, the Audit Committee of the Board of the Enterprise decided, at a January 2002 meeting, that it was time to move on. In describing that meeting, Ronald Poe, a member of the Audit Committee, said the committee believed "that Arthur Andersen as a firm with its involvement in Enron was headed down a rocky road and that we should probably get out in front of the curve in terms of replacing Arthur Andersen. We then called Leland in and directed Leland to begin a process for replacement of Arthur Andersen 9,136 The diary of David Glenn indicates that he had considerable angst concerning the possibility of switching to a new auditor. For example, Mr. Glenn wrote in a January 27, 2002, entry that Andersen "signs off on mk to mkt, FAS 133, operating earnings. Andersen people play key role in getting work done." In a memo to Mr. Brendsel of January 30, 2002, Mr. Glenn expressed other concerns about the decision to hire a new auditor, writing that "I find it difficult to understand how such an important issue could 137 135 See, "Enron: After the Collapse," http://www.pbs.org/newshour/bb/business/enron/player6.html. 136 OFHEO Interview, Ronald Poe, September 16, 2003, p. 137 Diary excerpt, David Glenn, January 27, 2002, DG 0015. 48. 138 have been made without my knowledge or involvement.” It appears that Mr. Glenn later took steps to keep Arthur Andersen a viable candidate to remain as external auditor, as documents from his office indicate that Freddie Mac formed a Management Selection Committee to interview candidate firms for the external audit engagement. In a presentation document titled “Auditor Selection: Process and Recommendation," the Management Selection Committee recommended that the Audit Committee meet and interview both PricewaterhouseCoopers and Arthur Andersen. One of the selection criteria listed in the document is called "Transition Risk." For that criterion, the Management Selection Committee gave Arthur Andersen good marks: "No transition risk if AA is retained for 2002 audit. Due to lack of tenure of key FM financial managers, AA knowledge of policy and process is critical to FM's financial reporting process." In an earlier draft, that committee recommended the reappointment of Arthur Andersen and noted that a transition of auditors "presents significant risks" including "the possibility of restatements." " 139 ,,140 Despite the views of management, the Audit Committee decided to hire PricewaterhouseCoopers. The PricewaterhouseCoopers engagement commenced in March 2002, and the new auditors soon raised issues regarding the size of the loan loss reserve, requiring management to reduce the reserve by $250 million. PricewaterhouseCoopers later discovered other problems relating to transactions surrounding the FAS 133 transition, including the CTUG transactions and the change in the method for valuing swaptions. After Freddie Mac hired the law firm of Baker Botts to investigate allegations in "whistleblower" letters, PricewaterhouseCoopers relayed those issues to Baker Botts. The firm investigated them and found numerous problems relating to specific transactions as well as a culture of earnings management at the Enterprise. The continuing emergence of issues ultimately led to the decision by PricewaterhouseCoopers in January 2003 that a reaudit of the financial statements of Freddie Mac for 2000 and 2001 was necessary. 138 Memorandum to Leland Brendsel, “Audit Issues," David Glenn, January 30, 2002, ODG 0003983. Auditor Selection: Process and Recommendation, February 25, 2002, FM C0003298. 139 140 Auditor Selection: Process and Recommendation (Draft), February 24, 2002, ODG 0005127. Loan Loss Reserves and Earnings Management Senior management kept the loan loss reserve of Freddie Mac at an unusually high level relative to actual and projected losses from 1998 to 2002, a period when earnings at the Enterprise were growing rapidly. Senior management justified the high reserve levels by citing the need to protect against large and unexpected credit losses, such as those that actually occurred in 1990. While such losses are possible, management could not support that they were probable, which is a key requirement of FAS 5, Accounting for Contingencies. The failure of Freddie Mac to reduce the loan loss reserve in recent years stemmed in part from past experience. In 1990, the Enterprise had incurred large loan losses in its multifamily mortgage portfolio. Those losses required Freddie Mac to increase its loan loss reserve by $100 million. The size of that loan loss provision embarrassed management at that time, particularly because the Enterprise had only recently become a public company. In later years, the loan loss reserve grew larger, but in 1998, losses started declining rapidly, as shown in Table 3. "141 Current and former employees, as well as Board members, have said that the loan loss reserve was kept at a high level because of the conservative credit culture of Freddie Mac, rather than it being a "cookie jar" to manage earnings. For example, former Controller Gregory Reynolds recalled that "Russ Palmer [a former Chairman of the Audit Committee] specifically said... I don't want to see this number going down." Mr. Reynolds also said that "the view that we should be conservative was a view that was held by the CEO, COO, and CFO, in addition to the Audit Committee." Lynne Oliver of Corporate Accounting also noted that Mr. Palmer “was very risk-averse and asked why they [Corporate Accounting] were not increasing reserves.' The current Audit Committee Chairman of Freddie Mac, Thomas Jones, expressed similar sentiments when he told OFHEO staff "that strong financial companies want to maintain conservative 143 » 142 143 Memorandum prepared by Baker Botts, Re: Lynne Oliver Interview, February 10, 2003, OF 2000451. reserve levels, and this was a company that had a not too distant history of not having adequate loan loss reserves.' "144 Although the conservative preferences of Freddie Mac management and the Board with respect to loan loss reserves are not inherently problematic, the assumptions and techniques used to determine the size of the loan loss reserve of the Enterprise were not well supported. Freddie Mac set the size of the reserve high enough to absorb a loss that forecasting models and other methodologies indicated was very unlikely. That approach is inappropriate given that FAS 5 specifically requires that the reserve only be established to cover losses that are probable, not just possible. The Audit Committee was aware of the low probability that the full reserve would be needed. The "Key Financial Reporting Estimates" presented to the committee on March 2, 2001 included a comment that “(the) most probable case anticipates a mild slow down in the economy" but that "the current reserve balance is well in excess of the most |