management, or otherwise failed in its duty to follow up on matters brought to its attention.

Recommended Actions

Freddie Mac should implement a comprehensive, Enterprise-wide initiative to establish a proper "tone at the top" and develop a corporate culture that rewards integrity and the acceptance of responsibility and individual accountability, and that penalizes failure to adhere to legal and regulatory requirements or professional standards of appropriate conduct. Furthermore, safe and sound operations require that Freddie Mac prudently plan for any future growth. Such planning includes taking steps to attract and retain personnel with the skills necessary to manage the growing risks associated with future growth. The Enterprise should have a plan for managing future growth. That plan should include provisions that specifically address anticipated problems that may arise as a result of growth and pay particular attention to anticipated staffing and systems needs to address those problems.

The experience of Freddie Mac shows that the management of the Enterprise must dedicate itself to managing operations risk as effectively as possible. Freddie Mac is under a statutory mandate to operate in a safe and sound manner, which includes having systems and management structures in place to ensure that operations risk receives the same attention as credit and interest rate risks. An inadequate provision of resources to compliance and internal controls is an unsafe and unsound practice. Specifically, the reliance of the Enterprise on manual processes to “work around” inadequately integrated information systems is a significant source of operations risk that Freddie Mac must resolve expeditiously.

OFHEO must ensure that the management of Freddie Mac has established an adequate remediation plan and is allocating the necessary resources to ensure that all of the remedial recommendations are promptly implemented. OFHEO should also take steps to ensure that the following recommendations are implemented:

1. Freddie Mac Should Separate the Functions of the CEO and the Chairman of the Board

2. Freddie Mac Should Develop Financial Incentives for Employees Based
on Long-Term Goals, not Short-Term Earnings

3. OFHEO Should Establish a Regulatory System of Mandatory Disclosures
for the Enterprises or Their Securities Exemptions Should be Repealed
4. OFHEO Should Consider Requiring a Periodic Change of the External
Auditors at the Enterprises, Not Just a Change in Engagement Partner
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

6. OFHEO Should Establish a "Materiality" Standard for the Provision of
Sufficient Information to the Board of Directors

7. Freddie Mac Should Impose Strict Term Limits on the Members of the Board of Directors

8. OFHEO Should Ensure that the Board Becomes More Actively Involved

in Oversight of the Enterprise

9. Freddie Mac Should Establish a Formal Compliance Program

10. Freddie Mac Should Establish the Position of Chief Risk Officer

11. Freddie Mac Should Document the Legitimate Business Purpose of Every Significant Derivative Transaction

12. Freddie Mac Should Establish and Maintain Superior Accounting Controls

13. Freddie Mac Should Prevent Undue Reliance on the External Auditor

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

1. INTRODUCTION

On January 22, 2003, Freddie Mac announced that the Enterprise would restate its financial results for 2002, 2001, and possibly 2000. That restatement occurred on November 21, 2003. The restatement resulted from the evaluation by management— conducted in conjunction with the external auditor of Freddie Mac, PricewaterhouseCoopers of certain accounting policies previously used by management and approved by the previous external auditor of the Enterprise, Arthur Andersen. Those issues involved primarily the hedge accounting treatment of certain transactions, including those occasioned by the implementation of Statement of Financial Accounting Standards (FAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. The restatement resulted in a cumulative increase in retained earnings of $5 billion and in regulatory core capital of $5.2 billion.

On June 7, 2003, Armando Falcon, the Director of the Office of Federal Housing Enterprise Oversight (OFHEO), ordered a special examination to be conducted into the events leading to the public announcement on June 9, 2003, of the termination, resignation, and retirement of three principal executive officers of Freddie Mac. On that date, the Enterprise announced the retirement of former Board Chairman and Chief Executive Officer Leland Brendsel, the termination of former President and Chief Operating Officer David Glenn, and the resignation of former Executive Vice President-Chief Financial Officer Vaughn Clarke. The special examination was ordered to expand and supplement an ongoing OFHEO examination of the financial condition of the Enterprise and the decision of Freddie Mac to restate its financial reports for 2000, 2001, and 2002.

Over the months during which OFHEO was conducting its examination of the restatement process, the agency became increasingly concerned about facts that came to light regarding weaknesses in controls and personnel in accounting areas and about the disclosure of misconduct on the part of Freddie Mac employees. The Director concluded that the initiative of the Enterprise in removing three members of the management team only went part of the way toward correcting serious problems with management practices

and controls. The special examination was tasked with reviewing those events leading to the restatement that revealed deficiencies in accounting practices and controls as well as employee misconduct discovered by Freddie Mac on or before June 4, 2003. The Director instructed the special examination to make recommendations to him as to additional steps that needed to be taken to help ensure the continuing safe and sound operations of the Enterprise.

By letter dated June 7, 2003, Director Falcon instructed the Board of Directors of Freddie Mac to provide its full cooperation with the special examination and to make available to the special examination all communications to the Board and management regarding deficiencies in accounting practices or its investigation of employee misconduct. The Director also instructed the Board to provide an explanation of its rationale for the compensation packages the Enterprise proposed for the three individuals in light of the circumstances surrounding their departures. That compensation is subject to the approval of OFHEO.

Director Falcon also informed the Board of Directors that, in the case of personnel terminated for misconduct, OFHEO would object to any re-employment of these individuals, and that OFHEO may hold them liable for indemnification to Freddie Mac for losses that may have resulted from their conduct.

Finally, the Director instructed the Board to provide to OFHEO, for review and approval, plans to address reform of Board oversight of the supervision of accounting practices by management; personnel and systems changes; plans for implementing accounting services quality controls; and a program for routine communications by the Board with OFHEO on the progress of the plan of remediation.

The special examination reviewed documents generated by the operations of Freddie Mac or obtained by OFHEO over ten years in the course of its regular examination process. Documents, including emails and audio tapes, were produced by the Enterprise pursuant to OFHEO subpoena. OFHEO also obtained, pursuant to subpoena, testimony under oath from numerous employees and members of the Board of

Directors of Freddie Mac. OFHEO is cooperating with the Securities and Exchange Commission and the Office of the United States Attorney for the Eastern District of Virginia.

During the months of August and September 2003, the special examination provided recommendations to the Director for action concerning members of the current management of Freddie Mac and the former management of the Enterprise. Certain information provided to the Director has been excluded from this report to ensure the continuing integrity of the examination and regulatory processes. This report presents the conclusions and recommendations of the special examination.