VIII. RECOMMENDED ACTIONS...... 163 General Recommendations........... 163 1. Freddie Mac Should Separate the Functions of the CEO and the Chairman of the Board....... 164 2. Freddie Mac Should Develop Financial Incentives for Employees Based on Long-Term Goals, not Short-Term Earnings..... 164 3. OFHEO Should Establish a Regulatory System of Mandatory Disclosures the Enterprises or Their Securities Exemptions Should be Repealed.... 164 4. OFHEO Should Consider Requiring a Periodic Change of the External Auditors at the Enterprises, Not Just a Change in Engagement Partner..... 165 5. OFHEO Should Require Freddie Mac to Hold a Capital Surplus and Should Consider Limiting the Growth of the Retained Portfolio Until Freddie Mac Produces Timely and Certified Financial Statements... 165 6. OFHEO Should Establish a "Materiality" Standard for the Provision of Sufficient Information to the Board of Directors.... 166 7. Freddie Mac Should Impose Strict Term Limits on the Members of the Board of Directors... 166 8. OFHEO Should Ensure that the Board Becomes More Actively Involved in Oversight of the Enterprise........ 166 9. Freddie Mac Should Establish a Formal Compliance Program.... 167 10. Freddie Mac Should Establish the Position of Chief Risk Officer..... 168 11. Freddie Mac Should Document the Legitimate Business Purpose of Every Significant Derivative Transaction..... 168 12. Freddie Mac Should Establish and Maintain Superior Accounting Controls....... 169 13. Freddie Mac Should Prevent Undue Reliance on the External Auditor......... 169 14. Freddie Mac Should Strengthen and Clarify the Role of the Internal Audit Department... 170 15. OFHEO Should Expand Its Capacity to Detect and Investigate Misconduct....... 170 16. OFHEO Should Conduct a Special Examination of the Accounting Practices of Fannie Mae... 171 LIST OF FIGURES AND TABLES Figure 1. Spread Between Yields of 10-Year Agency and Treasury Debt... Figure 3. Volatility of a 3 X 10 Swaption....... Figure 4. Volatility of a 3 X 10 Swaption Figure 5. 3-Month LIBOR and 10-Year Swap Rates. Figure 6. Federal Funds Target Rate....... Table 1. Freddie Mac Rebalancing Activity, Fourth Quarter 2000........ Table 2. Breakdown of Estimated Freddie Mac Excess 2001 Earnings Per Share (June 30, 2001)....... Table 3. Freddie Mac Loan Loss Reserve and Net Losses.. Table 4. Corporate Bonus Plan Funding History.......... Table 5. Summary of Bonus Payouts of Senior Freddie Mac Officers, 1998-2001 Performance Years..... Table 6. Earnings Per Share in the Informal Scoring Process... Table 7. Freddie Mac Derivatives Counterparties....... Table 8. Linked and Leveraged Swaps....... Table 9. Counterparties to Other Transactions..... EXECUTIVE SUMMARY In the early 1990s, Freddie Mac promoted itself to investors as "Steady Freddie,” a company of strong and steady growth in profits. During that period the company developed a corporate culture that placed a very high priority on meeting those expectations, including, when necessary, using 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 chain of events that began when Freddie Mac changed auditors in 2002. This report describes the circumstances leading to Freddie Mac's $5 billion restatement and makes recommendations on corrective and preventative measures. Corporate Culture and “Tone at the Top" The corporate culture fostered by that “tone at the top” resulted in intense and sometimes improper efforts by the Enterprise to manage its reported earnings. Beginning in the early 1990s, Freddie Mac promoted expectations of steady, rapid growth in profits. A corporate culture evolved that placed a very high priority on meeting the earnings estimates of Wall Street analysts but neglected key elements of the infrastructure of the Enterprise needed to support growth. The senior management of Freddie Mac placed an inordinate emphasis on meeting stock analyst expectations regarding non-volatile earnings growth. The corporate culture fostered by that "tone at the top" resulted in intense and sometimes improper efforts by the Enterprise to manage its reported earnings, compromised the integrity of many employees, and limited the effectiveness of its internal control structure. Freddie Mac created and maintained reserve accounts that did not comply with GAAP and entered into transactions with little or no economic substance, all for the express purposes of obtaining accounting results that would support the goal of reporting steady earnings growth and meeting analyst expectations. Weaknesses in the Internal Audit Function... Reliance on External Auditor for Basic Accounting Functions and Decisions... Derivatives Execution, Administration, and Accounting.. Trades with Blaylock & Partners and with Salomon Smith Barney........ Lack of Responsibility Regarding Financial Information.... 96 102 104 105 107 109 112 113 115 Failure of Non-Executive Directors to Make Adequate Inquiries 143 Failure of Non-Executive Board Members to Secure Adequate Information......... 145 149 Complacency of Non-Executive Board Members.. 153 Failure to Ensure the Hiring of Qualified Executives for Key Positions... 156 159 VIII. RECOMMENDED ACTIONS........ 163 General Recommendations............. 163 1. Freddie Mac Should Separate the Functions of the CEO and the Chairman of the Board... 164 2. Freddie Mac Should Develop Financial Incentives for Employees Based on Long-Term Goals, not Short-Term Earnings...... 164 3. OFHEO Should Establish a Regulatory System of Mandatory Disclosures the Enterprises or Their Securities Exemptions Should be Repealed...... 164 ................ 4. OFHEO Should Consider Requiring a Periodic Change of the External Auditors at the Enterprises, Not Just a Change in Engagement Partner..... 165 5. OFHEO Should Require Freddie Mac to Hold a Capital Surplus and Should Consider Limiting the Growth of the Retained Portfolio Until Freddie Mac Produces Timely and Certified Financial Statements... 165 6. OFHEO Should Establish a "Materiality" Standard for the Provision of Sufficient Information to the Board of Directors...... 166 7. Freddie Mac Should Impose Strict Term Limits on the Members of the Board of Directors..... 166 8. OFHEO Should Ensure that the Board Becomes More Actively Involved in Oversight of the Enterprise...... 166 9. Freddie Mac Should Establish a Formal Compliance Program...... 167 10. Freddie Mac Should Establish the Position of Chief Risk Officer......... 168 11. Freddie Mac Should Document the Legitimate Business Purpose of Every Significant Derivative Transaction... 168 12. Freddie Mac Should Establish and Maintain Superior Accounting Controls....... 169 13. Freddie Mac Should Prevent Undue Reliance on the External Auditor.......................... 169 14. Freddie Mac Should Strengthen and Clarify the Role of the Internal Audit Department..... ............. 15. OFHEO Should Expand Its Capacity to Detect and Investigate Misconduct................. 16. OFHEO Should Conduct a Special Examination of the Accounting Practices of Fannie Mae.......... ................ 170 170 171 |