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payers against systemic risk and expand opportunities for all Americans.
Today more than 68 percent of Americans own the homes in which they live. Government-sponsored enterprises have contributed greatly to this accomplishment. Because our housing marketplace is one of the most important sectors in our persistently struggling economy, we must also tread carefully in our forthcoming debates over any legislation to modify the regulation of GSEs.
In closing, Mr. Chairman, I commend you for your sustained leadership in these matters and for convening this timely hearing.
[The prepared statement of Hon. Paul E. Kanjorski can be found on page 51 in the appendix.)
Chairman BAKER. Mr. Shays?
Mr. Chairman, Fannie Mae and Freddie Mac constitute the twentieth and fortieth largest institutions on the New York Stock Exchange and the second and fourth largest financial institutions. They play an extraordinary role, they are vital to our economy, they are vital to housing, but they play by different rules, and when you play by different rules, you have to have greater oversight, not lesser oversight, and, frankly, we have had both. They do not have to conform to the 1993 act-excuse me, the 1933 act. They do not have to conform to the 1934 act.
When we put them under the 1934 act voluntarily is when the problems of Freddie Mac became apparent. It just seems to me is an indication that we should get these very excellent companies under the same rules and make sure that they have a regulator that is going to do the job necessary.
I think OFHEO has done an excellent job in this report. It is just too bad we haven't seen this kind of effort earlier.
Thank you, Mr. Chairman.
Mrs. MCCARTHY. Thank you, Mr. Chairman. I will wait until their testimony. Thank you.
Chairman BAKER. Thank you.
Mr. OXLEY. Thank you, Mr. Chairman, and I want to thank you for convening the hearing today on the recent report issued by the Office of Federal Housing Oversight-Enterprise Oversight. This report details the causes of Freddie Mac's restatement and management reorganization that followed, and this is a comprehensive report that highlights many of the concerns we have heard about the operations and the oversight of the GSEs.
As a result of this investigation, OFHEO and Freddie Mac have entered into a consent agreement which Freddie Mac agreed to pay $125 million in fines and made several significant changes to its corporate governance.
I appreciate all the hard work that Director Falcon and his staff has done on this report. Freddie Mac currently has debts outstanding in the trillions of dollars. There is no doubt that this company is critical to the housing market. Freddie supplies liquidity to institutions so they can provide loans to consumers seeking to purchase homes; however, with this important mission comes an equally important mandate to protect the taxpayers and to be honest with investors. As the OFHEO report demonstrates, Freddie Mac's senior management misled its investors, its Board of Directors and the U.S. taxpayers.
I am encouraged by the remediation efforts underway at Freddie. Mr. Baumann and his team have worked hard at difficult times to formulate a plan to return Freddie Mac to financial stability, and they should be commended for that. I believe with continued diligence and real reforms, confidence can be restored in the operation of this important company.
Director Falcon has presented an in-depth review of Freddie Mac, but the question remains where was OFHEO when these important trades were taking place? This investigation was not commenced when Freddie Mac announced its restatement; rather it began after the Chairman and CEO along with two other senior executives were released from the company. In fact, if Arthur Andersen had not been removed as the auditor for Freddie Mac, there would be no guarantee that the improper trading practices would not still be going on today.
I believe that OFHEO is underfunded and lacks many of the necessary powers to adequately oversee Freddie and Fannie. I support additional funding for OFHEO so it can fully examine the GSES and hire a sufficient number of examiners to monitor these financial institutions.
The report we consider today makes several important recommendations for changes both at Freddie and at OFHEO. These recommendations are well thought out, and many of them should be implemented.
I look forward to the testimony of Director Falcon and Mr. Baumann. I hope this hearing will shed some light on what went wrong with Freddie Mac, what steps are being taken to remedy the situation, as well as what changes should be made to ensure that both Freddie Mac and Fannie Mae are properly regulated.
Mr. Chairman, I want to personally commend you for your steadfast interest in this issue going back years, and there is no question that, had you not been a bulldog in pursuing some of these issues, many of these would have not come to light. We would not be on the—really on the cusp of some major reforms with the GSEs, and had it not been for you, this would not have happened, and I appreciate the opportunity to be here, and I yield back.
Chairman BAKER. Thank you, Mr. Chairman, for your kind words.
[The prepared statement of Michael G. Oxley can be found on page 46 in the appendix.]
Chairman BAKER. Mrs. Biggert.
Chairman BAKER. Mr. Ney submits a statement for the record. Without objection, it is adopted.
[The prepared statement of Hon. Robert W. Ney can be found on page 52 in the appendix.)
Chairman BAKER. Ms. Harris, do you have a statement?
Ms. HARRIS. Thank you, Mr. Chairman, and thank you for having this hearing today. I want to express my appreciation for your willingness to conduct these hearings concerning the special report of Freddie Mac.
I also want to thank Mr. Falcon of OFHEO and Mr. Baumann of Freddie Mac for their insights and willingness to testify before this committee.
Freddie Mac has taken encouraging organizational steps to improve their internal controls and to reform their corporate climate. Likewise, the OFHEO has drafted 16 carefully developed recommendations.
The vitality of the housing market and the importance of accurate corporate reporting are beyond dispute. Our Nation's economy requires beds to thrive. A healthy housing industry has helped buoy us, while other sectors of our economy have struggled. At the same time our consumer confidence levels have remained incredibly resilient, reaching levels typically associated with economic expansion. The result is a real growth rate in 2003, which is 4.4 percent up from 2.8 percent in 2002.
We must continue pursuing policies that support economic growth. MIT economist Lester Thurow_argues that scandal always follows boom in capitalism. Ironically, Freddie Mac was still booming when the accounting irregularities were discovered, making this a truly unique situation requiring special attention.
I am sincerely interested in the measures that would restore public confidence while maintaining a strong housing industry, and I look forward to your comments.
Chairman BAKER. Thank you, Ms. Harris.
With that, I would like to welcome back, who is certainly no stranger to the committee room, the Director of the Federal Office of OFHEO, Mr. Falcon. Thank you very much for being here today. STATEMENT OF ARMANDO FALCON, DIRECTOR, OFFICE OF
FEDERAL HOUSING ENTERPRISE OVERSIGHT Mr. FALCON. I am pleased to be here. Thank you, Mr. Chairman. I am pleased to be here.
Mr. Chairman, Ranking Member Kanjorski, Chairman Oxley and members of the subcommittee, I appreciate the opportunity to discuss with you OFHEO's report of the special examination of Freddie Mac. My prepared testimony will summarize the key findings and conclusions, and I request the committee include it, as well as the full special examination report, in the record.
Chairman BAKER. Without objection.
Mr. FALCON. My testimony expresses my own views and not necessarily those of the President or the Secretary of Housing and Urban Development.
A year ago tomorrow, Freddie Mac announced that completion of its 2002 financial audit would be delayed and that earlier periods would be reaudited. A switch to internal auditors from Arthur Andersen to PricewaterhouseCoopers had triggered a reevaluation of Freddie Mac's accounting policies, especially those relating to hedge accounting treatments for derivatives occasioned by implementation of FAS 133.
However, the reaudit and restatement process itself raised questions beyond merely the choice of accounting policies. On June 7, as Freddie Mac announced the abrupt departure of three of its principal officers, I ordered a special examination of the conditions that led to the accounting failures and management changes. Although some aspects of the special examination are not yet complete, the bulk of the work was finished this past fall. OFHEO issued a report of the examination, containing the findings and conclusions along with the appropriate recommendations, which the committee received in December.
Since the early 1990s, Freddie Mac promoted itself to investors as Steady Freddie, a company strong in profits, and developed a corporate culture that placed a very high priority on achieving such results. The examination showed that, to do so, Freddie Mac used means that failed to meet its obligations to investors, regulators, and the public. The company employed a variety of techniques ranging from improper reserve accounts to complex derivative transactions to push earnings into future periods and meet earnings expectations. Freddie Mac cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth. The conduct and intentions of the enterprise were hidden and were revealed only by a change of events that began when Freddie Mac changed auditors in 2002.
I will now summarize the areas covered in our report. First, the improper management of earnings. By 1999, Freddie Mac had established a practice of engaging in transactions for the express pur
a pose of managing its reported earnings. Freddie Mac used several strategies to shift earnings into future reporting periods, reflecting the proclivity of management to increase operations risk in the quest for more stable earnings. Although some of the most egregious examples relate to earnings volatility challenges associated with the implementation of FAS 133, there were numerous other instances when Freddie Mac management engineered transactions with little or no economic substance to obtain specific accounting results.
Second, the incentives created by executive compensation. The compensation of senior executives of Freddie Mac, particularly compensation tied to earnings per share, also contributed to the improper accounting and management practices of the enterprise. The size of the bonus pool for senior executives was tied in part to meeting or exceeding annual earnings per share targets. While not tied directly to smoothing earnings growth, actions shifting earnings from one quarter to future periods helped to ensure that earnings per share goals, and consequently the bonuses tied to them, would be achieved in the future.
Third, weak accounting, auditing, and internal controls. The management of any corporation, especially a government-sponsored one, is responsible for maintaining a control environment that will accurately record transactions to provide for publicly financial statements that are consistent with the true financial condition of the firm. In that regard, the obsession of Freddie Mac with steady, stable growth and earnings was at the expense of
proper account ing policies and strong accounting controls. Weaknesses in the staffing skills and resources in the corporate accounting department led to weak or nonexistent accounting policies and overreliance on the external auditor, weak accounting controls and an overreliance on manual systems. Given the size of the company and its role in the housing finance and capital markets, those weaknesses effectively increased the systemic risk posed by the enterprise.
Fourth, disclosure. In some instances, Freddie Mac normally circumvented prevailing public disclosure patterns in order to obfuscate specific market accounting transactions. A disdain for appropriate disclosure standards, despite all stated management assertions to the contrary, missed investors and undermined market awareness of the true financial condition of the enterprise.
Within Freddie Mac, no one took responsibility for public disclosures. Failure to assign responsibility and accountability for disclosure to an internal division contributed directly to inaccurate corporate and financial reporting. Such lack of assigned responsibility reflected a low regard that executive management had for that function.
Fifth, the Board of Directors. For the most part, the same longtenured, shareholder-elected Directors oversaw the same CEO, COO, and general counsel of Freddie Mac from 1990 to 2003. The nonexecutive Directors allowed the past performance of those officers to color their oversight.
Directors should have asked more questions, pressed harder for resolution of issues, and not automatically accepted the rationale of management for the length of time needed to address identified weaknesses and problems. The oversight exercised by the Board might have been more vigorous if there had been a regular turnover or shareholder-elected Directors, or if Directors had not expected to serve on the Board until mandatory retirement age or beyond. Conversely, the service periods of Presidentially-appointed Directors are far too short, averaging just over 14 months, for them to play a meaningful role on the Board.
Based on these findings, the examination report recommended that OFHEO and Freddie Mac take a broad range of actions. As a general matter, the report concluded that OFHEO must ensure that Freddie Mac has established an adequate remediation plan and is allocating the necessary resources to establish a new corporate culture that rewards integrity and the acceptance of responsibility and that penalizes failure to meet appropriate standards of conduct.
The report also detailed a number of specific actions. To improve the effectiveness of the Board of Directors, Freddie Mac should separate the functions of the chief executive officer and the Chairman of the Board, impose strict term limits on Directors, and require the Board meet more frequently.
To address Freddie Mac's general neglect of operations risks and compliance issues, the report recommends that Freddie Mac establish a formal compliance program and a position of chief risk officer