[Senate Hearing 109-1057]
[From the U.S. Government Printing Office]



                                                       S. Hrg. 109-1057
 
       THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF FANNIE MAE

=======================================================================


                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             SECOND SESSION

                                   ON

THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF THE WIDESPREAD PROBLEMS 
                         PRESENT AT FANNIE MAE

                               __________

                             JUNE 15, 2006

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html



                  U.S. GOVERNMENT PRINTING OFFICE
45-576                    WASHINGTON : 2009
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing 
Office  Internet: bookstore.gov Phone: toll free (866) 512-1800 
Fax: (202) 512-2104  Mail: Stop IDCC, Washington, DC 20402-0001



            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                         Mark Oesterle, Counsel

                 Peggy Kuhn, Senior Financial Economist

           Mark A. Calabria, Senior Professional Staff Member

                 Dean V. Shahinian, Democratic Counsel

             Jonathan Miller, Democratic Professional Staff

                 Lynsey Graham Rea, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)



                            C O N T E N T S

                              ----------                              

                        THURSDAY, JUNE 15, 2006

                                                                   Page

Opening statement of Chairman Shelby.............................     1
    Prepared statement...........................................    71

Opening statements, comments, or prepared statements of:
    Senator Dodd.................................................     3
    Senator Bennett..............................................     4
    Senator Sarbanes.............................................     4
    Senator Allard...............................................     5
    Senator Reed.................................................     6
    Senator Hagel................................................     7
    Senator Stabenow.............................................     8
    Senator Sununu...............................................     9
    Senator Dole.................................................    11
        Prepared statement.......................................    72
    Senator Martinez.............................................    12
    Senator Carper...............................................    27
    Senator Schumer..............................................    31

                               WITNESSES

James B. Lockhart III, Acting Director, Office of Federal Housing
  Enterprise Oversight...........................................    13
    Prepared statement...........................................    72
    Response to written questions of:
        Senator Hagel............................................    89
        Senator Crapo............................................    96
        Senator Martinez.........................................    97
Christopher Cox, Chairman, Securities and Exchange Commission....    15
    Prepared statement...........................................    77
    Response to written questions of:
        Senator Hagel............................................   101
        Senator Martinez.........................................   104
Stephen B. Ashley, Chairman of the Board of Directors, Fannie Mae    38
    Prepared statement...........................................    79
    Response to written questions of:
        Senator Hagel............................................   109
        Senator Martinez.........................................   113
Daniel H. Mudd, President and CEO, Fannie Mae....................    40
    Prepared statement...........................................    81
    Response to written questions of:
        Senator Hagel............................................   117
        Senator Crapo............................................   123
        Senator Martinez.........................................   131

                                 (iii)


       THE OFHEO REPORT OF THE SPECIAL EXAMINATION OF FANNIE MAE

                              ----------                              


                        THURSDAY, JUNE 15, 2006

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met, pursuant to notice, at 10:33 a.m., in 
room SD-538, Dirksen Senate Office Building, Senator Richard 
Shelby (Chairman of the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The Committee will come to order.
    This morning, the Committee will conduct an oversight 
hearing on OFHEO's report on the special examination of Fannie 
Mae. The report provides an unfortunately familiar story of a 
company plagued by fraudulent accounting practices, inadequate 
internal controls, and failed corporate governance.
    OFHEO's report provides great detail on the widespread 
problems present at Fannie Mae. Congress, as we all know, 
chartered Fannie Mae to serve an important public purpose: that 
is, to build a strong and vibrant secondary market to 
strengthen our nation's housing finance system. In the hundreds 
of pages of OFHEO's report, we do not read about the noble 
mission of making homeownership possible for more Americans. 
OFHEO's report clearly proves that Fannie Mae has lost focus on 
its mission. It appears that their primary business mission 
was, in fact, to engage in earnings management in order to 
yield maximum possible executive compensation.
    This is a company whose management developed an obsession 
with achieving performance targets, with little else seeming of 
consequence. In fact, so great was this obsession that the head 
of the Office of Auditing, ostensibly charged with ensuring 
accurate financial reports, was instead preaching Chairman 
Raines' goal of doubling earnings per share, telling his staff 
that they must have $6.46 branded in their brains, $6.46 
branded in their brains. That even the audit staff was so 
compromised, one can only conclude that greed served as the 
sole force driving management's behavior.
    It is also clear that more than one check on corporate 
misbehavior failed. The lack of attention and investment by the 
company in systems, internal controls, and risk management 
should be an embarrassment to this company, including the Board 
of Directors. The report also calls into question the role of 
the external auditor and the independence of the internal audit 
process.
    The themes of this report should certainly resound in the 
ears of the Committee Members. This is certainly not the first 
time that we have heard of them. The overstatement of earnings, 
the lack of transparency, the inattention of the Board of 
Directors, and the near-record settlement with the Securities 
and Exchange Commission would pose a threat to the viability of 
many a private corporation.
    Yet, there is one very tangible difference in the Fannie 
Mae story, and this difference is critical to our consideration 
of any regulatory reform proposals. Unlike other companies, 
which were felled by corporate misdeeds, Fannie Mae continues 
to operate in the capital markets as if nothing has happened. 
Wall Street analysts have not clamored to downgrade Fannie Mae 
debt, and the company continues to issue significant volumes of 
debt that domestic and international investors remain eager to 
buy and to hold.
    These market conditions should make clear to the Congress 
that market discipline plays little if any role in policing 
Fannie Mae and by extension Freddie Mac. Because of the 
perception that these entities are implicitly backed by the 
Government, it is clear that we cannot count on the normal 
private market mechanism to temper the risk taking behavior of 
the GSEs. The GSEs' creditors have little incentive to pay 
attention until the point where irreparable harm has occurred, 
corrections are impossible, and the thin levels of capital have 
evaporated.
    In other cases where the behavior of companies such as 
Enron, WorldCom, and others were egregious, this Committee 
acted to change the ground rules. We took vigorous action to 
protect the investors from similar behaviors in the future. The 
question now is how do we go about doing this for the GSEs? We 
must be mindful of the fact that these companies do not operate 
under the same set of rules that apply to other private 
companies. Thus, part of our regulatory effort must address the 
fact that market discipline is not present. For this reason, we 
must be sure that the regulator has the necessary authority and 
guidance from Congress to ensure that the GSEs stay focused on 
their mission, while minimizing their ability to take advantage 
of their special status by abusing their charter.
    For our first panel today, we welcome two distinguished 
witnesses: Mr. James Lockhart, Acting Director of the Office of 
Federal Housing Enterprise Oversight, which we call OFHEO; and 
Mr. Christopher Cox, Chairman of the Securities and Exchange 
Commission. For our second panel, the Committee will hear from 
Mr. Daniel Mudd, Chief Executive Officer, Fannie Mae; and Mr. 
Stephen Ashley, Chairman of the Board of Directors of Fannie 
Mae.
    I thank all of you for being here today to discuss some of 
these disturbing findings recently released by OFHEO. The 
Committee did invite two additional witnesses for the hearing 
this morning. We extended an invitation to Mr. Franklin Raines, 
the former Chief Executive Officer and Chairman of the Board of 
Fannie Mae. On the advice of his counsel, he has chosen not to 
appear, and I would like to include the response we received 
from his attorney in the record this morning.
    The Committee also believes that it would be useful to hear 
from other members of the Board of Directors. OFHEO's report 
highlights the failure of the Audit and Governance and 
Compensation Committee of the Board of Directors. We did invite 
Mr. Thomas Gerrity, who headed the Audit Committee for a number 
of years, but he had a prior commitment and could not attend 
today.
    We believe that it will be necessary to hear additional 
views from the Board members and perhaps from other entities, 
such as S&P, who rated Fannie Mae so highly on corporate 
governance less than 2 years ago. We will schedule this hearing 
as expeditiously as possible, and without objection, the letter 
from Franklin Raines' attorney, Mr. Kevin M. Downey's letter to 
me as Chairman of the Banking Committee advising that Mr. 
Raines would not testify will be made part of the record.
    Senator Sarbanes. Mr. Chairman----
    Chairman Shelby. You want to defer to Dodd?
    OK; Senator Dodd.

             STATEMENT OF SENATOR CHRISTOPHER DODD

    Senator Dodd. Well, thank you, Mr. Chairman, and I thank my 
colleague from Maryland. I will be very, very brief in these 
opening comments.
    First of all, thank you, Mr. Chairman for holding these 
hearings and the timeliness of them as well and for our 
witnesses who will be testifying before us this morning. The 
abusive practices detailed in this nearly 350-page report are 
both disturbing and incredibly disappointing, to put it mildly. 
It is difficult to completely absorb the significant accounting 
irregularities, the pattern of earnings management, and the 
clear intent of enriching certain employees, widespread 
corporate governance failures, and the total failure of both 
internal controls and external oversight.
    I view the measures taken by OFHEO in ensuring capital 
adequacy and safety and soundness of Fannie Mae to be wholly 
appropriate, and I commend the staff of OFHEO and you, Mr. 
Lockhart, for the work done by you and the people who worked 
with you on this effort. It is extremely important. I would 
also like to commend Chairman Cox, Christopher Cox, and his 
staff for their contributions to this effort as well, and we 
are anxious to hear your thoughts this morning.
    In the consent decree, OFHEO and the SEC have provided a 
very clear set of directions to Fannie Mae and its Board to 
change the way that they do business, and it is my hope that 
these changes have already begun. And I probably should have 
said this at the outset, Mr. Chairman. I think we want to keep 
the distinction between the underlying purpose originally 
intended for these GSEs and the tremendous contribution they 
make to a very critical component of our economy, and that is 
in housing: the fact that 70 percent of adult Americans today 
own their own home, in no small measure, it is due to the work 
supported by these GSEs.
    But confusing purpose with practices here, and what is at 
stake is the very point I just made: that if these GSEs do not 
start operating correctly, we may see the loss of this critical 
component to our economy. I am very worried about that. I know 
there are others who frankly have an underlying problem with 
the whole notion of Fannie Mae and Freddie Mac. I do not. I 
have deep concerns about what has occurred here, but I would 
hope in our analysis of this, we do not destroy critical 
components of the housing industry as a result of our efforts 
here to clean up a very, very big and sloppy mess, to put it 
mildly.
    So to you, Mr. Lockhart, and your staff, I commend you 
immensely, but I hope, Mr. Chairman, in the process of working 
through this, we do not destroy the critical component that 
these GSEs can play in such a vital piece of our economy.
    Chairman Shelby. Senator Bennett.

              STATEMENT OF SENATOR ROBERT BENNETT

    Senator Bennett. Thank you very much, Mr. Chairman.
    I appreciate the comments of my friend from Connecticut and 
generally agree with what he has said here. We have a common 
friend, long-time Washington observer who has said Congress, 
whenever faced with a crisis, has one of two responses: do 
nothing or overreact. And in this case, we seem to be headed 
toward doing both. I think we do need a strong regulator. I do 
think we need a piece of legislation, but I think we do need 
also to be careful that we do not overreact.
    I know the press particularly keeps saying this is another 
Enron, which it clearly is not. Fannie Mae has taken its lumps. 
Fannie Mae is paying a very large fine. Fannie Mae is under a 
very, very strong microscope, which it needs to be. But it is 
still operating, which Enron was unable to do. It has not 
closed its doors. No criminal charges have been filed against 
its people as happened almost immediately after Enron, and let 
us understand, as Senator Dodd has said, it and Freddie Mac 
play a very significant role in the housing market. So let us 
not do nothing, and at the same time, let us not overreact.
    Senator Dodd. Well said.
    Chairman Shelby. Senator Sarbanes.

               STATEMENT OF SENATOR PAUL SARBANES

    Senator Sarbanes. Well, thank you very much, Mr. Chairman.
    The report of the special examination of Fannie Mae issued 
by OFHEO documents a number of very serious problems at Fannie 
Mae. I will not enumerate them. In fact, Mr. Chairman, you have 
done so to some extent in your opening statement. But the 
report underscores clearly the necessity of maintaining, 
documenting, and being held accountable for strong and 
effective internal controls and other financial and risk 
management systems.
    As the Chairman of the SEC, a former colleague of ours in 
the Congress, Chairman Cox, said in announcing the $400 million 
settlement with Fannie Mae, the accounting and fraud charges 
that the SEC is filing against Fannie Mae reflect the failure 
by Fannie Mae to maintain the kinds of internal controls that 
could have prevented what, in all likelihood, will be one of 
the largest restatements in American corporate history.
    The professional staff at OFHEO have worked hard over the 
last 3 years to complete this thorough examination and to reach 
a consent order with Fannie Mae. Likewise, the staff at the SEC 
have made a very significant contribution to the resolution of 
this matter, and I want to thank all of them for their work. In 
the consent order, OFHEO has required the Board of Directors 
and senior management to take steps to improve corporate 
governance at Fannie Mae by requiring that the Board put in 
place policies and procedures to ensure appropriate oversight.
    Among the mandates in the agreement are requirements that 
Fannie Mae maintain a chief risk officer responsible for 
directing the organization to oversee risk management 
throughout the company; maintain an independent internal 
auditor and require the auditor to report directly to the Audit 
Committee; maintain procedures directing the Chief Compliance 
Officer to report any information relating to possible 
misconduct directly to the Board of Directors in a timely 
fashion; maintain at least one Board member with sufficient 
technical expertise to fully understand the implications of 
accounting policies through financial statements; and 
presenting proposals for enhanced public disclosures of its 
performance and risk measures.
    The governance requirements contained in the consent order 
are the result of ongoing oversight by OFHEO. It is imperative 
that the leadership at Fannie Mae implement these 
recommendations as quickly and thoroughly as possible, so the 
company can turn its full attention to meeting its mission of 
supporting the housing market and affordable housing in the 
United States.
    By all evaluations, we have a financing system for the 
housing market that is sort of envied across the world in terms 
of what it has been able to accomplish, and we need to keep 
that, I think, constantly in mind. The GSEs play an important 
role in supporting the housing market and in helping us to 
obtain affordable housing. They have a very important public 
mission with respect to housing.
    This public mission places upon them an obligation to meet 
high standards of corporate behavior, both with regard to their 
corporate governance and their business practices. Our 
objective must be to ensure that these standards are met so 
that the GSEs can meet their public mandate with respect to the 
nation's housing.
    Mr. Chairman, I look forward to the hearing.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I would like to join my 
colleagues in thanking you for holding this very important 
hearing. And like my colleagues, I was disappointed to learn 
that Fannie Mae manipulated the books so that executives could 
collect their multimillion dollar bonuses.
    OFHEO's report laid out a shocking and disturbing picture 
of irresponsible behavior. Both Congress and the public are 
very concerned about the fact that a company with Government 
ties, the sort of organization that should be of the very 
highest ethics, perpetrated such a scheme. OFHEO's report 
demonstrates that we need strong, fundamental reform of GSE 
oversight, and we need it quickly.
    I know that some disagree with the approach we took in 
Chairman Shelby's bill. Personally, I think it was the right 
approach and that the report demonstrates the need for the 
strongest possible reform. As to those who disagree, I think 
they should make their case on the Senate floor. If they can 
make their case, we will be able to pass amendments. If they do 
not, then, they will not. Either way, we need to stop delaying.
    Clearly, the status quo of accounting manipulation or 
simply an environment in which it was able to happen is the 
most unacceptable of all circumstances. I would also strongly 
encourage the Securities and Exchange Commission and the 
Justice Department to closely examine the circumstances 
revealed by OFHEO's report to determine if it is appropriate to 
bring criminal charges against those involved.
    A failure of confidence in the stability and reliability of 
Fannie Mae could have dire consequences for a large sector of 
our economy. Just as we pursue wrongdoing in the private 
sector, it is even more important that we enforce responsible 
standards of Government-Sponsored Enterprises such as Fannie 
Mae. I look forward to hearing from our witnesses. Their 
testimony will be helpful as we continue our efforts to ensure 
this sort of thing can never happen again.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Reed.

                 STATEMENT OF SENATOR JACK REED

    Senator Reed. Well, thank you very much, Mr. Chairman.
    We are here this morning to hear about the results of 
OFHEO's special examination of Fannie Mae. This report relates 
more of the details of the accounting scandal at Fannie Mae, 
describes how accounting transgressions, including inaccurate 
report of amortizations, a lack of documentation for account 
entries, and debt repurchasing to ensure earnings per share in 
subsequent years were used to create an appearance of an almost 
risk-free corporation with steadily increasing earnings year 
after year.
    This report also sheds light on how many individuals and 
entities look the other way or simply fail to scrutinize 
Fannie's troubling course and confirms to me that Fannie was in 
need of stronger oversight, not only by its regulator but also 
by its Board, which is why this Committee has had hearing after 
hearing on what we can do to strengthen regulation and how to 
create a world-class regulator for Fannie and Freddie and the 
Federal Home Loan Banks.
    This report confirms what we already know: that OFHEO or a 
newly created GSE regulator must have the funding, authority, 
and independence it needs to make sure that the GSEs are safe 
and sound and not posing unacceptable risks to the American 
taxpayers. At the same time, we need to make sure that any new 
regulatory setup enhances the GSEs' mission of making housing 
more affordable for millions of middle and lower income 
Americans.
    At a time when housing is becoming less affordable, when 
homes are doubling in price every 6 years and incomes are 
increasing by a mere 1 percent per year, Fannie's mission is of 
paramount importance. Through a unique public-private 
partnership, Fannie Mae and Freddie Mac have succeeded in 
creating a considerable mortgage market in the United States. 
They have succeeded in facilitating the emergence of one of the 
highest homeownership rates in the world, and they have 
succeeded in allowing millions of Americans to own affordable 
homes.
    In fact, Fannie and Freddie can do more, a lot more toward 
this mission. I have offered and if given the opportunity will 
offer again an amendment to the GSE reform bill that would 
improve and clarify Fannie's affordable housing goals. This 
amendment would also require Fannie and Freddie to create an 
affordable housing fund for underserved housing markets in our 
country.
    Thanks in large part to OFHEO's oversight and the consent 
decree reached with Fannie, I am hopeful that Fannie Mae is 
returning to safe and sound business practices; that it is 
reconciling with the failures of its past; and that it is 
reemerging with a focus on its mission of affordable housing. I 
hope that the accounting failures at Freddie and Fannie Mae do 
not cause us to lose sight of the overall success of the GSEs' 
mission.
    I look forward to the hearing and the testimony and thank 
you again, Mr. Chairman.
    Chairman Shelby. Senator Hagel.

                STATEMENT OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you.
    Mr. Chairman, what we are dealing with is an astounding, an 
astounding failure of management and Board responsibility, 
driven clearly by self-interest and greed. And when we 
reference this issue in the context of the best we can say is 
it is no Enron, now, that is a hell of a high standard.
    [Laughter.]
    Senator Hagel. This issue needs to be dealt with, and just 
as the distinguished Senior Senator from Colorado noted, it 
needs to come to the floor of the Senate. And I hope the 
Majority and Minority Leader of the Senate or their staff are 
taking note of this hearing this morning and the testimony that 
will be presented, and I hope the Majority Leader and the 
Minority Leader get some sense of urgency and understanding 
what is involved here.
    There is a story in the Wall Street Journal today that 
talks about the $11 billion in losses on derivatives that were 
deferred, hidden, mismanaged. You talk about not another Enron, 
I suppose; we are not there yet. We do not know. Chairman 
Greenspan and others who have served this country rather 
responsibly, Senator Bunning's notations notwithstanding.
    [Laughter.]
    Senator Hagel. In all due respect to the distinguished 
Senator from Kentucky, we have been warned, this Committee has 
been warned time after time, year after year, about the 
systemic failure that is at risk here.
    And my goodness: when will the Congress act? When will we 
find the courage to deal with this? I understand the 
significance of what these GSEs have meant for our housing 
industry; of course, that is the point, that is exactly the 
point, that we do not want to risk that. They have done 
incredibly good work for millions of Americans, and we are, 
just as the distinguished Senator from Connecticut noted, we 
are at risk in seeing that come unwound, and we may see, if we 
do not deal with this in a responsible way this year, that the 
future of GSEs is maybe over.
    And I do not believe I overstate that. I, like any Senator, 
any elected official can say what we want. We have no 
responsibility for anything. But the fact is that when you are 
dealing with this massive amount of fraud and mismanagement, 
something has to be done. And if we do nothing else around 
here, if we are elected to do nothing else, this is certainly 
something that would come within the purview of why we are 
here.
    And I hope that with these hearings this morning and the 
more information that will be presented that the Majority 
Leader of the U.S. Senate, the Minority Leader of the U.S. 
Senate will understand the severity and the need to act on 
this, and this bill that we have produced in this Committee 
will be brought to the floor of the Senate and will be voted on 
this year. We will have a conference committee; we will have a 
resolution of this and put this fiasco behind us and solid, 
responsible management back on track for not only the citizens 
of this country and the taxpayers but for the housing industry.
    Mr. Chairman, I look forward to our witnesses. Thank you.
    Chairman Shelby. Senator Stabenow.

              STATEMENT OF SENATOR DEBBIE STABENOW

    Senator Stabenow. Well, thank you, Mr. Chairman, and thank 
you to Mr. Lockhart and OFHEO and all of the work that has been 
done, and Chairman Cox, it is good to see both of you.
    I think the challenge for us on this Committee is to not 
only to be able to understand that your report and the 
agreement and so on allows us to know what has happened, and 
the fact of the matter is there have been serious problems, 
serious issues, and Fannie Mae, Freddie Mac, our whole GSE 
system has an obligation to hold to the highest possible 
standards of corporate conduct.
    But we also have a challenge in making sure we do not throw 
the baby out with the bath water, and I think that is what 
other colleagues have said, and I certainly agree with Senator 
Bennett, Senator Dodd, and others who have spoken about that 
balance that we really have to find, to act but not to 
overreact. And that is my concern as we move through this.
    And as we look at this, I feel compelled to say that when 
Fannie Mae was set up in February 1938, it was set up to do 
exactly what they have done: to help families own a home, to be 
able to help families have the American dream. And to quote 
President Eisenhower back in 1954, he said this has been one of 
our major legislative goals. It will raise the housing 
standards of our people, help our communities, improve older 
neighborhoods, and strengthen our mortgage credit.
    So despite--and in no way am I an apologist for what has 
happened, and there is no question that we have to focus on a 
strong regulator and on GSE reform, but I hope that we will 
also understand that the commitment to homeownership and the 
impact on Americans has been significant over the years. And 
more recently, I am very concerned about what has been 
happening as it relates to our country. There have been 
numerous warnings that a housing slowdown is on the horizon.
    In fact, the most recent CPI numbers indicate that another 
increase in interest rates is just around the corner. This will 
put even more pressure on family budgets which are already 
squeezed, certainly in my State and other States as it relates 
to exporting of our jobs and increased health care costs and 
energy costs, and I am very concerned that families who cannot 
afford the rate increases may find themselves without a Fannie 
Mae or Freddie Mac to turn to in order to keep their homes if 
we are not careful.
    So, Mr. Chairman, I would just hope--I am interested in 
hearing about the changes that have already been made by Fannie 
Mae, changes that need to be made as well as a focus on their 
core mission, which has not changed, and I hope we will not 
take actions that will force them to change, because the 
families in this country right now need this opportunity as 
much as they ever have.
    Thank you.
    Chairman Shelby. Thank you.
    Senator Sununu.

                STATEMENT OF SENATOR JOHN SUNUNU

    Senator Sununu. Thank you, Mr. Chairman.
    We certainly welcome the witnesses, and I do not have 
prepared testimony, but I want to respond to a few of the 
points that have been made. First, with regard to overreaction: 
I am pleased to say this is one case where I think that it 
cannot be argued, and it cannot be argued effectively because 
this process did not begin 6 months ago or a year ago or 2 
years ago.
    This process of crafting legislation began 3 years ago, 
before anyone was talking about crisis or Enrons or anything 
else, when a few of us recognized that perhaps because we had 
worked on housing issues in the past or worked with OFHEO in 
the past on regulation that we just needed a stronger, better, 
more effective regulator with more staff, with more money, with 
better supervisory powers commensurate with those in other 
areas of the financial service industry.
    So 3 years ago, Senator Dole, Senator Hagel, and I 
introduced legislation that contains most of the key core 
elements of the bill that this Committee has recently been 
discussing, and it has certainly changed since then. The fact 
is it has been a 3-year process, listening to those who would 
be affected by the legislation, listening to housing advocates, 
listening to other Members of the Committee. The Chairman, the 
Ranking Member, and their staff had a lot of suggestions in 
this legislation, and it has changed a good deal over those 3 
years.
    But the suggestion that we should all be concerned about 
overreacting I think is an argument for more delay, and I think 
it should be avoided. I think we should be serious and honest 
about our work, serious and honest about the amount of work 
that has already gone into this product, and we should be 
realistic about the importance of moving forward with 
legislation that has been very thoroughly discussed and vetted. 
And we may agree about or disagree with certain technical 
aspects of the legislation, but it has been well worked through 
the legislative process.
    We would have completed this much earlier, at a much 
different time, and in an atmosphere that did not carry the 
suggestion of crisis if it had not been for the stonewalling of 
the GSEs and the stonewalling of their allies 3 years ago, 2 
years ago, and 1\1/2\ years ago. I think recently, the work of 
the Committee has been substantive, and we have made good 
progress. But if you go back in the record to 2 or 3 years ago, 
there was nothing but stonewalling on the part of the GSEs and 
their allies.
    Second, concerns about the value of the GSEs, their housing 
mission, and the housing market: this is an issue on which all 
of us agree. And that agreement is not verified by what we 
happen to say here in front of the Committee. It is verified 
and validated in the legislation itself. The legislation does 
not change the charter or the mission of the GSEs one whit. It 
does not restrict it; it does not reduce it; it does not modify 
it. That charter and that mission, to provide liquidity in the 
secondary mortgage markets is affirmed, in fact, affirmed and 
reaffirmed throughout the legislation.
    And perhaps the one area where we might make modification 
is in the important area that Senator Reed mentions, which is 
to expand that mission and charter where affordable housing is 
concerned, and I think that is an area where we have got a 
great deal of agreement, and we are going to end up. This 
legislation, I think, will and should end up with a provision 
very similar to what has been proposed by Senator Reed.
    So to continually assert that we are concerned that we will 
hurt their mission or hurt their charter suggests that you have 
not read the legislation or that you are questioning the 
motives of all of the staff members and Democrats and 
Republicans who have worked on the legislation, and I think 
that is wrong, because we have reaffirmed the mission and 
reaffirmed the charter, and it is just simply wrong to set up a 
choice, that we have a choice between good regulation or a 
strong housing market. That is just simply wrong.
    There is nothing in the provisions, the restrictions on 
portfolios or guidelines for the portfolios, enforcement or 
flexibility of the regulator to set capital limits, none of 
that affects or undermines the mission and the charter of the 
GSEs.
    Third, the concern that this is not an Enron. I think 
Senator Hagel made a very fair point. There are differences, 
but as I read a suggestion that was made in a newspaper 
yesterday, perhaps the biggest difference at the moment is that 
the guys at Enron have been convicted. What we have here is a 
situation where there were $11 billion in intentional earnings 
misstatements that were designed to affect the stock price, 
affect bonuses, and, in effect, mislead shareholders and 
investors, all done at an entity where we all agree there is an 
implicit taxpayer guarantee. The implication is that taxpayers 
are on the hook.
    So in terms of the concerns or the fears or the potential 
impact on the taxpayer, it is fair to argue that this is 
perhaps more significant or more grave than Enron. I think to a 
certain extent, we should step back from the rhetoric here, but 
we should recognize that this is very, very serious. People 
intentionally misstate earnings, manipulate earnings to mislead 
shareholders in a way that affects their own compensation and 
in a way that is arrogant and unethical and illegal, we have a 
problem, and it is magnified, not minimized but magnified by 
the nature of these institutions.
    I put those concerns out to try to address some of the 
points that we have made. I think we have very good legislation 
here. It has been worked thoroughly; includes suggestions from 
both sides of the aisle. Everyone understands that the 
technical details of some of these provisions, whether they are 
the precise powers having to do with capital standards or 
portfolio limits or the exact details of the affordable housing 
piece will be worked out in conference. But it is a serious 
mistake to continue to delay of this legislation at a time when 
the need for it, both from the perspective of the capital 
markets and the taxpayers, is greater than ever.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Dole.

              STATEMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. I want to thank you, Chairman Shelby, for 
holding today's hearing regarding the OFHEO report. This report 
not only confirms my deep concerns about Fannie Mae; it 
demonstrates that the GSEs' actions were far worse than I could 
have imagined.
    Nearly 3 years ago, as we have heard, after it was revealed 
that Freddie Mac had misstated its earnings, Senators Hagel, 
Sununu, and I introduced legislation to strengthen the 
regulation of the GSEs. And Fannie and Freddie responded, 
dispatching an army of lobbyists to Capitol Hill and spending 
tens of millions of dollars to oppose our bill. In 2004, their 
lobbying tab totaled $26 million and just last year, more than 
$24 million. At times, it has truly felt like David and 
Goliath.
    No one has better described Fannie's mindset than the 
current CEO, who, in an internal memorandum of November 2004, 
asserted, and I quote, the old political reality was that we 
always won. We took no prisoners. And we faced little organized 
political opposition, end of quote.
    Even today, after all that we now know about Fannie and 
Freddie, the GSEs' influence on the Hill remains strong. But we 
in Congress must stand up to any political influence the GSEs 
continue to wield. The facts speak for themselves: on May 23, 
the Securities and Exchange Commission concluded that, and I 
quote, between 1998 and 2004, Fannie Mae engaged in a financial 
fraud involving multiple violations of Generally Accepted 
Accounting Principles in connection with the preparation of its 
annual and quarterly financial statements. The SEC went on to 
explain that these violations had the effect, among other 
things, of falsely portraying stable earnings growth and 
reduced income statement volatility, and for the year ended 
1998, of maximizing bonuses and achieving forecasted earnings, 
end of quote.
    Some had earlier claimed that Fannie and Freddie's problems 
were an understandable misapplication of complicated, obscure 
accounting rules. We now know that this was not the case; that, 
in fact, Fannie and Freddie were committing fraud for many 
years, in part driven by certain executives' personal greed.
    There can no longer be any doubt about what we must do here 
in the Congress. Fannie Mae and Freddie Mac need strong 
regulation to ensure that fraud and manipulation in their 
accounting practices have been forever banished from these 
institutions, and we need it now. This report represents a 
clarion call for the swift consideration and passage of 
legislation to create a new, independent regulator of these 
enterprises. This new regulator should have the ability to 
limit the sizable portfolios of Fannie and Freddie, thereby 
redirecting the GSEs to their original mission and preventing 
them from engaging in activities that could undermine their 
safety and soundness or place them at systemic risk.
    I thank both OFHEO and the SEC for their tenacious and 
diligent work on this issue. Director Lockhart, your report 
provides a complete and detailed expose, not only of the many 
complex transactions that underlay the problems at Fannie Mae 
but also of the broader culture of venality that developed at 
the GSEs. I thank you and the other witnesses for joining us 
here today.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Martinez.

               STATEMENT OF SENATOR MEL MARTINEZ

    Senator Martinez. Mr. Chairman, thank you very much for 
holding this very important hearing on this very, very timely 
topic. I would like to make my prepared remarks a part of the 
record, but I really think----
    Chairman Shelby. Without objection, it shall be made a part 
of the record.
    Senator Martinez [continuing]. ----I should just speak 
about a little bit of the history of this.
    And let me say that some years ago, not too many years ago, 
around 3 years ago, I guess, when my colleagues introduced a 
bill, I was sitting at the table testifying. It was as a result 
of some concerns that I had had and others in the current 
administration had had about the GSEs. And the concerns were 
greatly about the size of the GSEs, the implied guarantee, the 
fact that the taxpayers were on the hook, and they continued to 
grow exponentially, and also a concern that OFHEO was an 
inadequate regulator. Part of the GSE oversight was at HUD. 
OFHEO was under HUD but not really a part of HUD, and in fact, 
if you were to have wanted to design a regulatory scheme, which 
is still in effect today, by the way, that was fairly 
ineffectual, you would have designed exactly what was in place.
    Now, as was just mentioned by Senator Dole, in fact, this 
was something of this culture of arrogance and disdain for 
regulation that permeated Fannie Mae. It was a culture that 
basically said we do not have to be normal, as noted by Mr. 
Mudd in his memo to Raines. We can write or have written rules 
that work for us, and that worked for a long time, and unless 
we pass this legislation, unless it comes to the floor and 
becomes law, that is still what is happening today.
    But now, our concerns brought by my testimony and this bill 
that has been referenced was because we were concerned. But we 
had no idea what really was transpiring, what really was going 
on. We had no idea that the executives of Fannie Mae had given 
themselves, through manipulation of the stock price, bonuses 
and compensation in excess of $200 million. How many homes 
could Habitat for Humanity build if you were to give them a 
donation of $200 million? This was the compensation that was 
given to about four or five of the chief executives at this 
entity. One of them is the CEO today.
    So what I would suggest is that there is great urgency, and 
I would not fear overreaction. I would fear underreacting to 
what is, in fact, a crisis for America's taxpayers who are on 
the hook. I want to commend Mr. Lockhart, but also, I want to 
commend Armando Falcon, who was the head of OFHEO during the 
period of time when these initial reports were made with little 
staff and very little resources, because OFHEO was 
systematically starved from resources by the lobbying power of 
Fannie Mae for years to make it an incapable regulator, to keep 
it understaffed and undermanned so they could not do the job 
right, just like they, themselves kept their own financial 
staffs understaffed and their own financial system antiquated 
and complicated that they would turn up all of a sudden with a 
problem of $11 billion in magnitude.
    When we talk about these not being an Enron, it may not be 
an Enron, but you know what it is? It is a WorldCom. WorldCom 
was a scandal of $11 billion. This happens to be $11 billion. 
The only difference between WorldCom and this, in addition to 
the fact that, you know, as Senator Sununu said, some people 
are in jail and others are not, is the fact that this 
particular company, this particular entity, was chartered to 
help America's poor find a place to live, and for that, the 
American taxpayer said we will be on the hook. There is an 
implicit guarantee; it is not a specific guarantee, but one 
that I know everyone around this table would know if these 
entities were to fail, the taxpayers of America would be on the 
hook.
    So, Mr. Chairman, I am very much one of those who believes 
that we have to get this legislation through; that we have to 
ask the hard questions of current Fannie executives as well as 
the Board, and that we must give OFHEO the necessary powers so 
that they can be the regulator that we all believe they should 
be.
    I look forward to the witnesses and thank you for the 
hearing.
    Chairman Shelby. Thank you.
    Mr. Lockhart, Mr. Cox, we welcome you again. Both of you 
have been here and will probably be here many times.
    We will start with you, Mr. Lockhart.
    Senator Bennett. Mr. Chairman?
    Chairman Shelby. Yes.
    Senator Bennett. Could I just make one quick sentence?
    Chairman Shelby. Sure, Senator Bennett.
    Senator Bennett. I would remind my colleagues I voted for 
the bill.
    [Laughter.]
    Senator Bennett. Thank you.
    Chairman Shelby. Mr. Lockhart.

              STATEMENT OF JAMES B. LOCKHART III,

                        ACTING DIRECTOR,

         OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

    Mr. Lockhart. Good morning, Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Committee. Thank you for the 
opportunity to discuss the findings of our Special Examination 
of Fannie Mae and the settlement agreement. It is a pleasure to 
be here with Chairman Cox, as the investigation and settlement 
agreements are excellent examples of government agencies 
working well together.
    Before starting, I would like to mention that OFHEO will 
submit later today our Report to Congress on the 2005 
examinations of Fannie Mae and Freddie Mac, which reinforces 
the message that significant remedial actions are still needed 
at both enterprises. As Government-Sponsored Enterprises, they 
have unique positions among American corporations and an 
extremely important mission: facilitating the growth of 
affordable housing in the United States. Franklin Raines and 
his previous management team violated that trust.
    By encouraging rapid growth unconstrained by proper 
internal controls, risk management, and accounting systems, 
they did serious harm to Fannie Mae while enriching themselves 
through manipulating earnings per share. The result was an 
estimated $10.6 billion of overstated profits, well over a $1 
billion in expenses to fix the problems, and ill-gotten bonuses 
in the hundreds of millions of dollars.
    The report details an unethical, take no prisoners, 
corporate culture where the ends justified the means. The image 
of Fannie Mae as one of the lowest risk and ``best in class'' 
institutions was a facade. Senior executives were managing 
Fannie Mae in an ``unsafe and unsound manner.''
    As you see in the chart, in order to receive maximum 
bonuses, senior executives hit earnings per share targets with 
uncanny precision by deliberately and systematically using 
inappropriate accounting and improper earnings management. 
Chairman Raines' 6-year compensation exceeded $90 million, of 
which $52 million was directly tied to achieving earnings per 
share targets. The inappropriate ``tone at the top'' spread. 
Incredibly, the Internal Auditor told his staff when discussing 
Raines' goal of doubling EPS that they had a moral obligation 
to ``help him'' and to help make ``tangible contributions to 
Frank's goals.''
    Fannie Mae used a four-step approach to manipulating 
earnings: first, to prevent large, unpredictable earnings 
fluctuation, Fannie Mae implemented investment, derivatives, 
and other accounting standards to reduce volatility, and they 
did that while ignoring GAAP. Second, they went to 
extraordinary lengths to avoid recording losses on assets whose 
values had declined. Third, management then manipulated 
earnings to hit specific targets, using cookie jar reserves, 
income shifting transactions, and debt repurchases. And fourth, 
the report details the conscious decisions to use outdated 
accounting systems and to create a weak internal control 
environment which made it harder to uncover that manipulation.
    The company's internal and external auditors failed to 
properly confirm compliance with GAAP, and even when KPMG 
became aware of the non-GAAP accounting practices, they 
continued to issue unqualified opinions. The last line of 
defense, the Board of Directors, failed to be sufficiently 
informed and independent. Their oversight failings meant that 
they did not discover, let alone correct, the multitude of 
unsafe and unsound practices, even after Fannie Mae's problems 
became apparent.
    The Board approved bonus plans focused on managing earnings 
rather than risk. In 2002, Fannie Mae incurred billions of 
dollars in economic losses from interest rate risks. The 
operational risk losses were among the largest ever incurred. 
The settlement agreement has nearly 60 provisions designed to 
repair the damage and to prevent reocurrence.
    Fannie Mae agreed to undertake a comprehensive reform 
program aimed at really top to bottom changes, including its 
Board of Directors, internal audit, risk management, 
compliance, internal controls, accounting systems, and external 
relations. Fannie Mae agreed to review current and former 
employees for remedial actions. Fannie Mae agreed to pay a $400 
million penalty, and Fannie Mae agreed to freeze the growth of 
its portfolio mortgage assets.
    The need for a settlement agreement full of so many 
remedial actions exemplifies why the report recommends 
strengthening OFHEO's regulatory process and supporting 
legislation to strengthen our safety and soundness powers. It 
is difficult to say whether the proposed legislation would have 
totally prevented the mismanagement, but I believe with the 
proposed legislation and proper staffing levels, OFHEO could 
have uncovered the problems well before such serious damage was 
done.
    Thank you. I would be pleased to answer questions.
    Chairman Shelby. Chairman Cox.

                 STATEMENT OF CHRISTOPHER COX,

                           CHAIRMAN,

               SECURITIES AND EXCHANGE COMMISSION

    Mr. Cox. Thank you, Chairman Shelby, Ranking Member 
Sarbanes, Members of the Committee. It is a pleasure, likewise, 
for me to be here. I appreciate the invitation but particularly 
to be here with Director Lockhart. His team at OFHEO has done, 
as you know, an outstanding job, and the Securities and 
Exchange Commission has very much appreciated the opportunity 
to work with them.
    I would like to testify to the Securities and Exchange 
Commission's own recent enforcement action against Fannie Mae. 
I know that this Committee has spent a great deal of time 
examining the issues surrounding Government-Sponsored 
Enterprises, and I appreciate the opportunity to bring our 
point of view to the table. Since my written testimony contains 
many of the details of the accounting violations that our 
enforcement action was based upon, I would like to ask your 
permission to summarize that part of my testimony and then turn 
to----
    Chairman Shelby. Proceed.
    Mr. Cox [continuing]. ----important disclosure issues that 
I believe may be of interest to the Committee.
    On May 23, the Commission and the Office of Federal Housing 
Enterprise Oversight----
    Chairman Shelby. Chairman Cox, could you bring the 
microphone just a little closer to you, please?
    Mr. Cox. On May 23, our Commission and the Office of 
Federal Housing Enterprise Oversight jointly announced 
settlements with Fannie Mae for accounting fraud. The 
Commission's action alleges that Fannie misstated its financial 
reports from at least 1998 through 2004. In settling these 
charges, as Director Lockhart mentioned, Fannie Mae has agreed 
to pay civil penalties totaling $400 million. The lion's share 
of these penalties will be returned to defrauded shareholders 
through our Fair Fund program.
    Both Director Lockhart and I agree that a penalty of this 
size represents a meaningful sanction that is necessary to 
address the egregiousness of Fannie Mae's conduct. In addition 
to the $400 million in penalties, Fannie Mae will be 
permanently enjoined from future violations of the anti-fraud 
provisions of the Federal securities laws. It will also be 
subject to a permanent injunction against violations of the 
reporting, books and records, and internal control provisions 
of the Federal securities laws.
    The significance of the corporate failings at Fannie Mae 
cannot be overstated. The company has estimated its 
restatements for 2003 and 2002 and for the first two quarters 
of 2004 will result in at least an $11 billion reduction of 
previously reported net income. This will be one of the largest 
restatements in American corporate history.
    Fannie Mae's size and status make it a financial giant, but 
despite its prominent position in our financial marketplace, 
the company's internal controls were wholly inadequate for the 
size, complexity, and sophistication of Fannie Mae's business. 
Its failure in key areas highlights the critical need for 
senior management to constantly reassess the adequacy of 
internal controls as the business matures. That kind of 
attention to internal controls is necessary for the good of the 
business, for the protection of investors, and for the health 
of our capital markets.
    Fannie Mae is a clear example that neglecting internal 
controls can be devastating for a company and for its 
investors. We are considering our investigation of the 
individuals and entities whose actions and inactions led to 
this result. The public should have full confidence that we 
will vigorously pursue those individuals who have violated the 
Federal securities laws.
    Until the investigation is complete, I cannot comment 
further on the alleged conduct of particular individuals or the 
specifics of the investigation, but I would like to address 
several important and closely related disclosure issues. Fannie 
Mae's settlement of accounting fraud charges raises a very 
significant policy issue that I know has been carefully 
considered by Members of this Committee: Should the Congress 
require mandatory registration and periodic reporting under the 
Exchange Act by Fannie Mae as well as Freddie Mac and the 
Federal Home Loan Banks?
    As you know, the securities issued by Fannie Mae are exempt 
securities under current laws issued by the SEC. But there is 
no question that the word ``Government'' in Government-
Sponsored Enterprise leaves many members of the investing 
public with the mistaken impression that GSEs' securities are 
backed by the full faith and credit of the U.S. Government, 
when in fact, there is no such guarantee.
    So we have a situation in which GSEs sell securities to the 
public. They have public investors, and they do not have the 
full faith and credit of the U.S. Government backing their 
securities, yet they are not required to comply with the 
disclosure rules under the Federal securities laws which exist 
for the protection of investors. That is why, going back at 
least as far as 1992, the Securities and Exchange Commission 
has consistently urged that GSEs should comply with the 
disclosure requirements of the Federal securities laws.
    In July 2002, Fannie Mae announced that it would 
voluntarily register its common stock with the SEC under 
Section 12(g) of the Exchange Act. The registration of its 
common stock became effective on March 31, 2003, and Fannie 
subsequently began filing periodic reports with the SEC; but, 
after that, many of Fannie Mae's periodic disclosures have been 
late, incomplete, or not filed at all. Most notably, as of 
today, Fannie has not filed an annual report, its 10-K, for 
either 2004 or 2005, and it has not filed its quarterly report 
on form 10-Q for any of the preceding seven quarters.
    I have no doubt that our recent enforcement action has 
focused the attention of Fannie Mae's management on improving 
its disclosure to investors. At the same time, there can be no 
question that, in the future, Fannie Mae would be far more 
likely to maintain consistent compliance with our disclosure 
regime if the Congress were to terminate its special status of 
voluntary registration and reporting and make its registration 
and reporting mandatory. That is a far better way to protect 
investors.
    I know that this Committee is considering legislation that 
would require compliance with the Exchange Act reporting 
requirements by Fannie Mae, Freddie Mac, and the Federal Home 
Loan Banks. I commend you for your attention to this issue and 
encourage your consideration of this legislation. We stand 
ready to support you in these efforts, and the Securities and 
Exchange Commission is prepared to enforce mandatory compliance 
should you choose to change the requirements for these 
Government-Sponsored Enterprises.
    I also wanted to bring the Committee up-to-date on a 
related issue involving the New York Stock Exchange's listing 
requirements. The NYSE rules authorize suspension and delisting 
when a listed company fails to file its annual report with the 
SEC in a timely manner. As you know, because of Fannie Mae's 
failure to file its 2004 and 2005 annual reports, the NYSE 
amended its general delisting rules to provide a unique 
exception for Fannie Mae, even though it is not explicitly 
phrased in these terms.
    Since the NYSE put this new rule in place, questions have 
been raised about whether the exemption is appropriate. As I 
testified before this Committee in April, the exemption needs 
to be considered in light of the unusual circumstances not only 
of Fannie Mae's voluntary transition to Exchange Act financial 
reporting compliance but also its requirements for a massive 
restatement.
    As I testified then, however, this exemption must be 
temporary and only for the purpose of allowing Fannie Mae to 
come into initial compliance with Exchange Act reporting. To 
respond to concerns that this exception might become a 
permanent rather than a temporary policy, I want to inform the 
Committee that we have encouraged the New York Stock Exchange 
to amend its rule to put an expiration date on this exception. 
That way, Fannie Mae and its investors will understand that we 
expect Fannie, like any other listed company, to remain in full 
compliance with NYSE listing standards.
    The Commission's action against Fannie Mae, our support for 
mandatory GSE registration and reporting under the Exchange 
Act, and our support for an expiration date on Fannie's unique 
exception under the NYSE's listing rules are all animated by 
the same principle: that investors are best served by applying 
the Federal securities laws in an evenhanded manner to all 
companies participating in the public markets.
    Thank you again, Mr. Chairman, for giving me the 
opportunity to testify today, and I am pleased to respond to 
any questions the Committee might have.
    Chairman Shelby. I will start with you, Mr. Cox, but I will 
address it to both of you.
    With most private companies, we rely on market participants 
to raise questions and send alarms when numbers for a company 
do not look right. Likewise, we anticipate that most private 
companies cannot remain unscathed in debt markets or in 
dealings with their customers when scandal taints that company. 
But with reference to Fannie Mae, at least one analyst 
indicates that he places, and I quote, very little risk on 
delisting and expects a lot of regulatory forbearance, end 
quote.
    Chairman Cox, given that the GSEs have an advantage that 
other private companies do not, how can we tailor a regulatory 
structure to pick up where market discipline might leave off?
    Mr. Cox. Mr. Chairman, these GSEs have been around for 
awhile. We have a lot of experience with their strengths and 
now their weaknesses. I think what we want to do is attract all 
of the strength and support that market discipline can provide. 
After all, these are public entities that are taking capital 
from the public.
    I would commend you for the focus that you have on 
strengthening the regulatory side. I think we also need to 
strengthen the market side. The regime that we administer at 
the Securities and Exchange Commission is in the main a 
disclosure regime, and so great emphasis needs to be placed on 
getting out good, high quality information about these 
enterprises to the public. We have failed in that respect, I 
think it is very, very clear with Fannie; and, if we are to get 
on the right track, we need to make sure that normal market 
disciplines apply in the future.
    Chairman Shelby. Mr. Lockhart, do you have anything to add?
    Mr. Lockhart. The only point that I would add is if these 
companies were not Government-Sponsored Enterprises, the end 
might be significantly different than it is today. If it had 
been a financial institution, they would have lost their debt 
ratings and that would have been unfortunate.
    Chairman Shelby. Chairman Cox, some people have questioned 
whether any real harm has resulted from Fannie Mae's conduct. 
We hear this. If one buys into this argument, it would suggest 
that under certain circumstances, some amount of fraud is 
acceptable, even fraud that results in a $400 settlement with 
the Securities and Exchange Commission. You are the Chairman of 
the SEC. Is there some level of fraud that is acceptable in 
corporate America?
    Mr. Cox. Our job at the Securities and Exchange Commission 
is to police the markets against fraud.
    Chairman Shelby. All fraud, right?
    Mr. Cox. Of course, of course, and I think it is not so 
much a matter of accepting an argument in this case as it is 
noticing that what is attempting to pass for an argument is an 
egregious misstatement of fact. There was harm. It is 
objectively measured. Investors paid for $11 billion in 
earnings that were not there. A company with $47.5 billion in 
market capitalization chartered by the Congress, a private 
company with a public mission, as it calls itself, was for a 
period of several years raising capital on the basis of 
financial statements that were the result of fraud. Its senior 
management was manipulating earnings and did so to enrich 
themselves.
    The harm to investors is both direct and measurable. The 
stock price of Fannie Mae fell from over $75 to very recently 
under $49. As Director Lockhart has pointed out, they have 
spent over $1 billion thus far just trying to fix some of these 
problems. That is investors' money.
    The harm to the markets, the diminution in confidence, is 
broad and immeasurable. Perhaps, as Senator Sununu pointed out, 
the gravest potential harm would be to the taxpayers if Fannie 
Mae were to fail, because Fannie has long traded on the mirage 
of the full faith and credit of the Federal Government backing 
those securities when, in fact, no such guarantee exists.
    Chairman Shelby. Mr. Lockhart, some other people would 
contend that Fannie Mae's improper accounting and earnings 
management never represented a risk to the safety and soundness 
of Fannie Mae itself or the financial markets. I personally 
believe it has simply been a matter of luck. It is clear that a 
great deal of management's focus was on earnings targets and 
not much else. I also believe that it was simply fortunate that 
we learned of the fraudulent practices at Fannie Mae before 
more serious safety and soundness issues arose.
    How would it be possible that fraudulent accounting and a 
lack of internal controls would not pose a threat to safety and 
soundness for any financial company?
    Mr. Lockhart. It would be impossible.
    Chairman Shelby. It would be impossible. Thank you.
    Chairman Cox, corporate governance. In January of 2003--I 
believe it was January 2003--Standard and Poors, S&P, assigned 
the company a corporate, that is, the company, Fannie Mae, a 
corporate governance score of 9, when 10 was the highest 
possible score. S&P said then that Fannie, quote, is not only 
demonstrating its own strong governance practices, but it is 
also showing leadership in the United States with regard to 
providing greater openness and disclosure about its corporate 
governance standards, end quote.
    The company received the highest possible score in the 
areas of board structure and processes and financial 
disclosure. Fannie was the only company among S&P's first 10 
clients to make its corporate governance grade public. It also 
paid, of course, for this rating. In retrospect, Mr. Lockhart, 
Mr. Cox and Lockhart, in retrospect, what do you make of this 
sterling review by SEC? Chairman Cox, obviously, they were way 
off the mark.
    Mr. Cox. I think that, when we answer that question in 
retrospect, it is very easy to see that the rating was not 
deserved. I think S&P, were they to be able to write their 
report in the light of what we all know today, under no 
circumstances would issue it. So I think what we have 
highlighted here are some of the inherent inadequacies of 
fortune telling when it comes to the job that these rating 
agencies have. I think the same can be true with respect to the 
financials of Fannie. I mean, obviously, anybody who was 
evaluating them on the basis of those financial statements had 
to contend with the fact that we now know that, to a certain 
extent, they were fraudulent.
    Chairman Shelby. Mr. Lockhart, do you have any comment?
    Mr. Lockhart. Well, I agree on the S&P report. Obviously, 
they were wrong, and it probably should have been a 0 or a 1, 
as it turned out. But there were some obvious things that were 
there; for instance, the Chairman and the CEO was the same 
person, and we made sure that that is not going to happen in 
the future with these two entities, and there is a lot of 
corporate governance in the settlement agreement, as you know, 
that we did with both Freddie and Fannie, and we are going to 
stay on top of it.
    Chairman Shelby. Thank you.
    Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    Mr. Lockhart, this Committee has reported out your 
nomination, as you know, unanimously, and it is pending over on 
the Senate calendar now and presumably will be taken up in the 
very near future. Now, you have been the acting director at 
OFHEO now for 2 months or so?
    Mr. Lockhart. About one and a half.
    Senator Sarbanes. One and a half months. What is your sense 
of how on top of this situation OFHEO is?
    Mr. Lockhart. At the moment, I have been very pleased with 
the team. Many of them have been hired since the problems 
occurred 3 or 4 years ago. We built up--we have probably 
doubled the staff since then. We have hired a lot of 
experienced bank examiners. We have two teams now and they are 
in Fannie and Freddie every day looking at the issues.
    So I have been pleased that we have been making some good 
progress, but also, I have to tell you I am convinced that we 
do not have all the tools we need, and that is one of the 
reasons we are obviously supporting the legislation.
    Senator Sarbanes. Well, we are trying to sort out those 
tools here in the Committee when we considered it, and in fact, 
I think there was a unanimous position with respect to many of 
the tools that have been suggested being provided to OFHEO. 
There are some differences that remain. Many of us think an 
affordable housing provision is extremely important. That is 
not in the Committee-reported bill, and then, there are some 
questions about portfolio limitations which raise important 
issues. I wanted to ask you about that.
    As I understand it, the consent decree that was arrived at 
with Fannie Mae freezes the portfolios at the end of the year 
2005 level. Is that correct?
    Mr. Lockhart. That is correct.
    Senator Sarbanes. And then provides that this growth 
limitation shall expire when the Director determines that it is 
appropriate to let them grow again, based on information 
regarding capital, market liquidity issues, housing goals, risk 
management improvements, outside auditor's opinion that Fannie 
Mae's consolidated financial statements present fairly in all 
material respects the financial condition of the company, 
receipt of an unqualified opinion from an outside audit firm 
that Fannie Mae internal controls are effective pursuant to 
Section 404 of the Sarbanes-Oxley Act.
    Now, I take it from this language, and the agreement also 
says that you will allow Fannie to grow even ahead of meeting 
those conditions a moderate amount per annum; I take it an 
adjustment as inflation goes or something of that sort?
    Mr. Lockhart. No, what it says is that they can come 
forward with a plan in 60 days, and we will look at it. But 
again, it is at the discretion of the Director whether we agree 
to the plan. There is no automatic acceleration.
    And I want to put in context why we put that limit in. This 
company has serious internal controls, risk management, and 
operational risk problems, as well as accounting systems 
problems, and we felt it was just imprudent to let it continue 
to grow until it has fixed those problems.
    Senator Sarbanes. Yes, I understand that, and it seems to 
me a fairly prudent and rational thing to do. But the point is 
that these controls, as I understand it, are to stay in place 
until such time as you are convinced that the company can grow 
in a safe and sound manner, as demonstrated by the fact that it 
is well enough capitalized, is meeting its legal obligations 
with regard to its housing goals, and can demonstrate and 
document that the company is being run in a safe and sound 
manner, is that correct?
    Mr. Lockhart. That is correct, sir.
    Senator Sarbanes. Now, I also wanted to ask you about, in 
this effort to sort of see how we are doing and where we are 
getting, whether things are under control and so forth and so 
on; the report notes that Fannie's strategy was to match 
between 50 and 60 percent of the optionality of its mortgage 
assets with comparable options on the liability side.
    This indicates that the company was taking on a lot of 
interest rate risk, which was reflected in some significant 
increases in Fannie's duration gap, which reached as high as 14 
months at one point.
    Mr. Lockhart. Right.
    Senator Sarbanes. Can you tell us, without revealing 
confidential information, whether or not Fannie is more closely 
matching now its assets with its liabilities? I have heard 
reports that the duration gap now, like Freddie's, where I do 
not think this was really any significant issue at Freddie, is 
now between 0 and 2 months; is that correct?
    Mr. Lockhart. That is correct, Senator. They have narrowed 
the duration gap significantly since then.
    Senator Sarbanes. And this is a matter, I take it, you all 
are following very closely.
    Mr. Lockhart. We get weekly capital reports from the 
company. As I said, we have examiners in there every day, and 
we are following it very closely. We are also looking at the 
hedging activity on the optionality as well.
    Senator Sarbanes. What is your view of how well they are 
moving and how quickly on putting into place a system of 
internal controls? I mean, the report says that they were 
grossly inadequate; in fact, contravened supervisory standards, 
and I know a great deal of focus has been placed on that. What 
progress is being made in that regard?
    Mr. Lockhart. Certainly, some progress was being made in 
both companies, but they have a very, very long way to go; a 
couple of years, really, 3 years, and as you will see in the 
report that we are putting out today, the annual report where 
we do the report of the examinations of the two companies, we 
do show there are a lot of issues these companies have to face, 
in the controls, accounting, risk management, human resources, 
getting the people there. They have a whole series of issues, 
and it is going to take several years to correct.
    Senator Sarbanes. What are they falling short in doing in 
terms of moving on this front? I mean, obviously, you need, 
like Chairman Cox--I forget where he was--recently gave the 
speech in which he emphasized the importance of an effective 
system of internal controls, not just in this instance but for 
all companies. What more, if anything, can be done to get 
there, or is it just it cannot be done overnight, and it is a 
time problem we have to work through?
    Mr. Lockhart. A lot has to be done. As Chairman Cox 
mentioned, neither of these companies are timely reporting at 
this point, so they are not getting their accounts out. From 
the internal controls standpoint, they are not even close to 
conforming with Sarbanes-Oxley at this point. Again, it is 
going to take several years to get there. They have lots of 
consultants. They have a lot of people and a lot of manpower 
devoted to these issues, but these companies were so poorly run 
that it is going to take many years to fix.
    Senator Sarbanes. Meanwhile, I presume OFHEO is monitoring 
that situation very closely. You now have your people sort of 
in the company day by day; is that right?
    Mr. Lockhart. We have people in the company day by day, our 
examination teams, and I can tell you that we have meetings at 
all levels with those companies on a very regular basis. But we 
are still, I have to tell you, occasionally finding problems; 
i.e., there are still control problems that we are discovering 
even in the last several weeks.
    Senator Sarbanes. Mr. Chairman, I see my time has expired. 
Thank you very much.
    Chairman Shelby. Thank you.
    Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Mr. Lockhart, does the consent decree deal at all with 
compensation methodology?
    Mr. Lockhart. Well, we have the powers to review the 
compensation of executives.
    Senator Sununu. But as part of the agreement, were there 
any limitations or restrictions placed on compensation policy?
    Mr. Lockhart. We will review any changes, and we have told 
them, and they have agreed, that they have to change from the 
EPS-only bonus plan to one that covers a lot more areas.
    Senator Sununu. Are there any members of the executive team 
today that are compensated in any part based on earnings per 
share or stock price?
    Mr. Lockhart. Last year, there were no bonuses paid at the 
company. This year, I am not sure what the plan is, because I 
have not seen it yet, but I assume from what they have told me 
that there may be some EPS, but it will be a much smaller part.
    Senator Sununu. We have heard testimony here before this 
Committee, and it has been presented in other Committees as 
well by the past Fed Chairman and others in the regulatory 
environment that the powers proposed in the legislation 
addressing the guidelines for the GSE portfolios would not have 
any negative effect on their mission; specifically, the Fed 
provided material to this Committee showing that the size of 
the portfolios had no impact on availability of 30-year 
mortgages, on mortgage rates, or in the area of providing a 
critical buffer in cases of financial crises.
    Do you agree with that assessment that has been made by the 
Federal Reserve?
    Mr. Lockhart. I generally agree. I have not looked through 
all the details, but yes, I do. You have to think of these 
companies as really two lines of business. One is packaging 
mortgages and securitizing them, and that, under the 
legislation, would continue to grow, and one is just really a 
substitute for the other: buying the mortgages and keeping them 
or just buying them and securitizing them. So certainly, if 
they continue to securitize mortgages, they will support the 
housing market.
    Senator Sununu. Chairman Cox, in your testimony, you talked 
about the stock exchange rules, the New York Stock Exchange 
rules regarding delisting. You note that you have encouraged 
the New York Stock Exchange to amend its rule to put an 
expiration date on the exception it has provided to Fannie Mae 
regarding delisting procedures.
    What is the mechanism for that encouragement? Has there 
been any formal communication or formal request from the SEC to 
the NYSE to establish a fixed duration, an expiration
    Mr. Cox. Yes; the communications between the SEC and the 
NYSE are taking place at the professional staff level. In 
addition, Chairman Thain and I have had these discussions 
directly.
    Senator Sununu. What specific duration do you recommend 
that they impose on the exception?
    Mr. Cox. Our discussions are general at this point. What we 
have agreed is that while we are not trying in any way to 
precipitate or force delisting, we want to be sure that both 
Fannie and its shareholders understand that there are 
consequences for failure, and we want to provide every 
encouragement to get Fannie into a position where it can be 
Exchange Act compliant and thus compliant with the NYSE listing 
standards that apply to every other listed company.
    So we will move forward on this as quickly as we can. I 
have been having these discussions as well with other 
Commissioners, and we will report back in real time.
    Senator Sununu. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Reed.
    Senator Reed. Well, thank you very much, Mr. Chairman.
    Mr. Lockhart, I think that the issue that is dividing the 
Committee in terms of the language of the bill turns on this 
notion of systemic risk. Operational risk, I think we 
understand. That is essentially the focus of this hearing, 
whether the organization is run well, whether the Audit 
Committee operates, whether the outside auditors are there, and 
I presume, based on your agreement with the company, that you 
have essentially at least established in your mind that this 
operational risk issue has been handled effectively at this 
point; is that fair to say?
    Mr. Lockhart. No, I would not say that. They have not 
handled the operational risk yet. They are putting plans in 
place to handle it. I do not think, for instance, that they 
actually have a good operational risk capital model at the 
moment, and they certainly are not complying with Sarbanes-
Oxley; they are not there.
    Senator Reed. But you are confident that given the 
framework that you have established, that you will be able, 
through your regulatory authority, to achieve that? Are you 
that confident?
    Mr. Lockhart. I am hopeful, yes.
    Senator Reed. Now, the other risk that they run constantly 
is interest rate risk. And that goes to their hedging 
activities, et cetera. You are looking into that, too, and you 
have provided for that?
    Mr. Lockhart. We certainly look at their market risk, their 
interest rate risk, yes, and their credit risk also.
    Senator Reed. And their asset risk also?
    Mr. Lockhart. Yes, that is credit risk basically.
    Senator Reed. Now, we are in this category of systemic 
risk. Assuming you have covered all of these other risks, what 
do you mean by systemic risk? And I ask the question because I 
think it is the question that might divide us.
    Mr. Lockhart. Well, I think systemic risk is a very big 
issue for these two companies, primarily because they are so 
large, and they represent such a large portion of the financial 
markets in this country and the housing markets.
    There is no doubt in my mind that these companies are 
highly leveraged and more highly leveraged, potentially, than 
any other financial institution in this country. They have $1.5 
trillion of debt outstanding, and they have used that debt to 
buy $1.4 trillion of assets. To hedge those assets, they have 
$1.3 trillion of derivatives, and on top of that, they have 
$2.6 trillion in guarantees. And that is all built on a 
combined capital of only $75 billion.
    This is a very large exposure, built on a very small 
capital base. And so, a systemic risk means what happens if 
there is a problem in the financial markets, and could these 
companies cause such a problem? We are certainly very hopeful 
that they will not, but I do not think we necessarily have all 
the protections built in at this point.
    Senator Reed. And correct me if I am wrong, but my numbers 
suggest that in terms of their retained portfolio, it is about 
14 percent of the overall market, which is not trivial, but 
that leaves 86 percent of the market controlled by hundreds of 
other entities, some regulated, most regulated, and some, 
presumably, not regulated. So I think in this regard, there is 
also a systemic risk on the other side, outside of this 
company, which is regulated presumably by the Fed and by 
others.
    Mr. Lockhart. This is a concentrated risk. These two 
companies represent 40 percent of the mortgage market in this 
country. The 15 percent that you mentioned is on mortgages that 
they own and about 26 percent on the guarantees. So that is a 
very, very large exposure. Systemic risk can potentially be on 
both.
    Senator Reed. Absolutely. But the focus, I think, of this 
legislation is on their retained portfolio; is that correct?
    Mr. Lockhart. Right, and one of the reasons is because not 
only is it a retained portfolio; there are the derivatives that 
go with it.
    Senator Reed. Yes.
    Mr. Lockhart. So it is a double exposure, if you will.
    Senator Reed. But I think, just trying to think clearly, 
and I think when we talk about the systemic risk, and this is a 
serious topic, obviously, but I think we have to be very 
careful. On the other side, the mortgage-backed security side, 
where they do have 26 percent of the market, you seem to be 
less concerned about that in terms of systemic risk; is that--
--
    Mr. Lockhart. We are less concerned about that, but you 
have to look at the whole ball of wax, if you will, and I think 
there is more risk on the portfolio side, and as you know, the 
portfolios have tripled in market share in the last 15 years; 
in fact, at the peak in 2003, it was quadruple the market 
share. They were up at about 20 percent. I think that is a 
serious issue that should be addressed by Congress and the 
regulator.
    Senator Reed. Well, I guess, I think it is a serious issue. 
But typically, the way we have addressed this issue with 
respect to the Federal Reserve is to give them the tools with 
respect to the safety and soundness issue, raising capital, et 
cetera. I do not think we have given them a category of 
systemic risk which they can sort of improvise or, you know, 
innovate in terms of regulation.
    I say this not suggesting it might not be appropriate, but 
I do not think we have yet understood precisely what tools you 
want, precisely what the risks are. In fact, the systemic risks 
posed to many companies is a huge deficit by the Federal 
Government and the interest rate policy by the Federal Reserve. 
That is pretty systemic, but I suspect you are not asking for 
that authority.
    Mr. Lockhart. What we are asking for--and I think the 
Senate bill covers a lot of the issues, as does the House 
bill--are stronger safety and soundness; obviously, we need 
that. We need stronger capital powers, part of which could 
address systemic risk, and we need to look at these portfolios 
to see if they need to be as large as they are.
    Senator Reed. Do you think the Federal Reserve needs those 
same powers when it looks at the portfolios of Citigroup and 
Bank of America and others?
    Mr. Lockhart. I think that they can control the growth of 
those companies. In fact, in the case of Citigroup, I think 
they were told not to grow awhile ago.
    Senator Reed. But that is based upon, and I do not want to 
belabor this, it is based on the existing powers. Here is where 
I think the dilemma is: I do not think there is a big debate 
about giving you the financial powers that the Fed has, that 
the OCC has with respect to national banks and others. It is 
just what do you mean by this systemic risk? Is this an 
undefined term which you will make of it is what you want to? 
And I think that is the real issue, a substantive issue, a 
principal issue that we have to sort out amongst ourselves, and 
we need more guidance from you.
    And my time has expired.
    Chairman Shelby. Thank you, Senator Reed.
    Senator Dole.
    Senator Dole. Chairman Cox, you stated that Fannie Mae 
would be far more likely to maintain consistent compliance with 
our disclosure regime if the Congress were to terminate its 
special status of voluntary registration and reporting and make 
its registration and reporting mandatory. Does this mean that 
the SEC now supports full GSE compliance with the 1933 and 1934 
securities acts, and if not, why not, and what provisions are 
you suggesting should apply?
    Mr. Cox. I focused in my testimony, and indeed, the SEC has 
focused in more than a decade-long look at this issue, on the 
Exchange Act reporting obligations rather than the 1933 Act. 
They are essentially the same kind of information, and what we 
are concerned about is getting that information to the 
marketplace. I think there is an additional layer of issues 
that you might want to consider as you consider application of 
the 1933 Act: specifically, what effect, if any, would that 
have on costs? And would that, in turn, translate into directly 
or indirectly higher mortgage costs?
    If the cost-benefit tradeoff is determined to work 
satisfactorily, then, there is certainly no conceptual reason 
that the 1933 act requirements as well as the 1934 Act 
requirements should not be applied. And I would point out that, 
if currently Fannie were subject to the 1933 Act, it would not 
be able to issue any securities, because one of the 
requirements is that you be current in your 1934 Act reporting 
requirements, which, of course, they are not.
    Senator Dole. As you have said, in all likelihood, this 
will be one of the largest restatements in American corporate 
history. Given that fact, how can the New York Stock Exchange, 
how can the SEC permit the stock of Fannie Mae to be traded 
without additional disclaimers or warnings to investors that 
there are still no current financials for this company?
    Mr. Cox. Well, I think that those have to be and are being 
transmitted. There have been several 8-K filings by Fannie. One 
of the things that we want to be sure of and that the NYSE 
clearly wishes to be sure of is that that kind of current 
information is being provided to the marketplace. It is 
entirely because of the unique circumstance by which Fannie, 
starting in 2002, determined voluntarily to subject itself to 
these requirements that we find ourselves in this unusual spot.
    But, as I mentioned, I think it is very important that we 
focus on the ``why.'' And the reason that the New York Stock 
Exchange has amended its listing standards with respect to 
Fannie is so that we can get them into compliance, so that they 
could make the transition to both registration and reporting 
under Section 12 of the Exchange Act.
    It is a little bit of jargon, but the purpose of that is to 
protect investors. I mean, there are shareholders whose 
interests are paramount, and we want to be sure that they have 
liquidity, they have a place to trade, that we do not drive up 
their cost, and so on. And so, to the maximum extent possible 
in protecting their interests, we want to get the show on the 
road; get Fannie compliant.
    Senator Dole. Thank you.
    On page 5 of your written statement, you note that Fannie 
Mae did not have adequate systems or personnel in place to 
comply with FAS 133. Yet Congress, investors, and American 
taxpayers were told repeatedly that Fannie Mae had world-class 
controls and disclosure. Was that assertion based on ignorance, 
or was it a blatant lie? I do not know which is worse, but both 
scenarios are outrageous.
    Mr. Cox. Well, I think we were ignorant, the public, 
investors, the market, because some people were intentionally 
manipulating Fannie's earnings, both with respect to FAS 133, 
as you mentioned, and also FAS 91.
    Senator Dole. Let me direct this question to both of you: 
Do either of you believe that there should be a moratorium on 
all new GSE initiatives unless or until the GSEs, their 
external auditors, the SEC, and OFHEO agree that the GSEs have 
resolved their serious problems?
    Mr. Lockhart. From my view, I am not sure a moratorium is 
needed, but I think that managements need to concentrate on the 
issues you just mentioned. Developing new products at this 
point when they are stretched for manpower, new products that 
would require new systems, new risk management, and everything 
to go with it, when they are telling us that they cannot really 
fix the problems for several years just does not make sense to 
me at this point.
    Senator Dole. Chairman Cox.
    Mr. Cox. I concur. The focus, of course, of the SEC right 
now is our ongoing investigation of individuals and 
organizations who have contributed to the problems we have 
already uncovered with the respect to the question you and I 
were just discussing about getting them current in their 
registration reporting obligations under the Exchange Act. It 
would be awfully nice to have these restatements accomplished, 
to get them current, to give shareholders the comfort that they 
are meeting the listing standards of the New York Stock 
Exchange and to do first things first.
    Senator Dole. Thank you, Mr. Chairman. I think my time has 
expired.
    Chairman Shelby. Senator Carper.

               STATEMENT OF SENATOR THOMAS CARPER

    Senator Carper. Thanks, Mr. Chairman. I apologize for not 
being able to be here to hear your statements. Gentlemen, we 
thank you for joining us today. We have just concluded our 
markup of the Chemical Security bill that Chairman Cox and I 
were talking about and reported it out unanimously, if you can 
believe that.
    Mr. Cox. Congratulations.
    Senator Carper. One of my disappointments as a Member of 
this Committee is that we were unable to pass something out 
with bipartisan support with respect to GSE regulation. The 
bill that is now languishing before the Senate is one that I 
hope we can come back to, take it up, and find common ground 
amongst ourselves. And I believe your testimony and that which 
will follow will be helpful toward that end.
    Senator Dole has asked you a question that I was going to 
ask, but I want to follow up a little bit with respect to 
registration with the SEC. And I just wanted to ask you, 
Chairman Cox, if you will, to just further explain the costs to 
the GSEs for compliance and what effect, if any, that might 
have on the GSEs' ability to comply with their mission.
    Mr. Cox. It has been asserted by some that there would be 
material incremental costs. I cannot tell you today that I 
believe that to be true, but I think it is appropriate for 
Congress to weigh the costs and benefits, and the SEC, and our 
professional staff, including our economists, would be very 
happy to cooperate with you in that endeavor.
    Senator Carper. Thanks.
    Mr. Lockhart, if I could direct a question to you: you may 
have already been asked this question. If you have, I 
apologize. I am going to ask it again.
    When you look at the changes that have been made at Fannie 
Mae, and we will just stick with Fannie Mae, but if you look at 
the changes that have been made there over the last year, would 
you handicap those which you find favor in and those which you 
find still fall a bit short of what is needed?
    Mr. Lockhart. I would say they have made progress, but it 
is disappointingly slow, and I would say the same thing about 
Freddie Mac. The Chairman of Freddie Mac was quoted this week 
saying the company is materially different than Fannie Mae. If 
you read the report we are putting out today, these two 
companies are still very far away from really being where they 
should be. And I think that an important part of their mission 
is they are supposed to be these world class companies that 
they claim to be to fulfill this mission of affordable housing, 
and they are not there yet, not even close.
    Senator Carper. The two issues, as I am sure you already 
discussed it, that kept us apart when we reported a bill out of 
Committee were the provisions dealing with affordable housing 
and the issues that relate to the portfolio, what can be in the 
portfolio, the size of the portfolio, the growth of the 
portfolio.
    Would you just, in layman's terms, both of you, just 
explain--Chairman Cox, you are really good at this, as I have 
noted before, just in layman's terms, what concerns should we 
bring to our final negotiations, which hopefully will get us a 
resolution and able to move a bill? With respect to the 
portfolio, what especially should we focus on trying to 
address?
    Mr. Cox. Well, both with respect to the affordable housing 
piece and the limitations on the portfolio, I think it is 
slightly outside or at least slightly tangential to our main 
focus at the Commission. What we would like to see, and I would 
hope that we can keep our eye on this ball, too, is that Fannie 
would become a normal, in this sense, private issuer of 
securities to the public that reports under the Exchange Act 
requirements.
    And, if that were accomplished, and if, in consequence, it 
met the NYSE local listing standards, then, I think it would be 
a much more salutary discipline on Fannie by the markets based 
on genuine information. The next order of concern at the SEC, 
as Senator Sarbanes has mentioned several times, is internal 
controls. I know this is an issue to Director Lockhart as well, 
so focus on both the way that Fannie and the GSEs are devoted 
to their missions and on the way the regulator has an 
opportunity to discipline that. I think it is of vital 
importance.
    Senator Carper. Mr. Lockhart, can you just briefly respond 
to my question?
    Mr. Lockhart. I think some of the key issues are the 
systemic risk that we were talking about with Senator Reed and 
the operational risk inherent in those portfolios, not only 
from the investments they are making but from the derivatives 
that help support those portfolios. That has to be a major 
concern.
    We also, in limiting the portfolios, have to look at what 
is in the portfolios. And to the extent that they are taking 
more risk, we are going to have to look very hard at that as 
well. It is the size that is a systemic risk issue, as well as 
the operational market and credit risk issues in those 
portfolios.
    Senator Carper. My time has expired. Thanks very much.
    Chairman Shelby. Senator Bennett.
    Senator Bennett. Thank you, Mr. Chairman. I apologize for 
having to leave and just catching the tail end of Mr. 
Lockhart's comment.
    I think you may have covered the issue that I want to talk 
about. Assuming that we get the kind of world class regulator 
that we are hoping for as the result of legislation, would you 
feel comfortable with the regulator having the authority to 
deal with the portfolio issue rather than having Congress 
mandate any aspect of it?
    Mr. Lockhart. It would be very helpful for Congress to give 
us guidance, and that is what the Senate bill does, gives some 
guidance to the regulator. The regulator does need flexibility. 
I think there are two ways to go about this, and we may have to 
look at both. One is guidance on portfolio limits, and the 
other is risk-based capital and minimum capital requirements. 
As I said earlier, I believe we have to look seriously at risk-
based capital rules and the minimum capital rules, because I am 
not sure that these companies are as well capitalized as they 
should be going forward.
    Senator Bennett. Well, I am a little reluctant about the 
Congressional guidance. Guidance is a very vague word. And I 
think there are two aspects to this, and give me your reaction. 
One is the safety and soundness of Fannie Mae and Freddie Mac. 
The other is the systemic risk arising from their laying off 
the risk through hedges and derivatives. I think the regulator 
has to look at both. As I understand it, the House bill is 
almost exclusively the safety and soundness of Fannie and 
Freddie; is that correct?
    Mr. Lockhart. It is almost exclusively, although they do 
ask us to do a study, and they mention systemic risk as one of 
the things we are supposed to be looking at.
    Senator Bennett. OK, if we write it into the law, the 
standards that might apply in 2006 could turn out in the fast-
changing financial services world to be inappropriate as early 
as 2009 or 2010. Guidance is one thing; specificity is another. 
Do you have any views as to where the guidance ought to be that 
would give the regulator the maximum flexibility to respond if 
there were changes in the derivatives market that we cannot 
conceive of now but that could have significant bearing on the 
way the portfolio is managed?
    Mr. Lockhart. Guidance can be part of legislation, as it is 
in the Senate bill. Certainly, there needs to be that 
flexibility going forward. We do not want to have to come back 
to Congress every year to get a fix. I agree with you entirely 
there.
    Senator Bennett. That is my concern.
    Mr. Lockhart. And one of my concerns when I was at PBGC, 
for example, you do not get a chance to have major legislation 
every year in this country.
    Senator Bennett. Yes.
    Mr. Lockhart. At PBGC, I fought 3 or 4 years. Senator Dole 
remembers this well as my boss: and we finally got legislation, 
but it did not go far enough. One of the important things we 
want to do here is to make sure that we go far enough at this 
point but also give the regulator the powers to make changes.
    Senator Bennett. We are having this hearing as if the bill 
were still before us, and of course, it is not. The bill has 
passed out of Committee. So these are just discussions that 
would inform the debate on the floor.
    Let me ask one question just for my own information. You 
spoke of tremendous earnings being restructured, the earnings 
restatement. Are there any earnings that will be put into 
future quarters that were brought into previous quarters in an 
effort to make the earnings look good when, in fact, they 
should have been delayed to some future time?
    Mr. Lockhart. I am not sure about that, because we have not 
gotten all the details. There were some financial transactions 
that did move earnings out to the future, and I assume they 
will be restated. We may have actually passed that time by now.
    Senator Bennett. Yes.
    Mr. Lockhart. Basically, I would assume that there will be 
some ups and downs, yes.
    Senator Bennett. That is a question probably I ought to ask 
Mr. Mudd.
    Mr. Lockhart. Right.
    Senator Bennett. Because if, in fact, there are substantial 
earnings yet to come in future quarters, that might explain why 
the stock market has not reacted as strongly. If all of the 
money was completely lost and would never, ever be seen again, 
that is one thing, but if some of it is going to be seen future 
down----
    Mr. Lockhart. You can ask that of CEO Mudd. But I think the 
issue is, when they correct the accounting, that those 
transactions will disappear, basically, because they were not 
GAAP-compliant, and when they make them GAAP-compliant, they 
will put the earnings back where they are supposed to be.
    Senator Bennett. Yes, but the thing I am trying to find out 
is were there earnings? If they were improperly allocated or 
improperly apportioned, obviously, that is not GAAP-compliant, 
and obviously, that falls under the----
    Mr. Lockhart. As I understand it, that $11 billion 
restatement is a net number.
    Senator Bennett. Is a net number; OK, that is what I was 
trying to find out.
    Mr. Lockhart. And the future earnings will be depending on 
what they do in the future, basically.
    Senator Bennett. Yes, OK.
    Mr. Lockhart. Because they are going to be keeping their 
books by GAAP and, now, they have lost most of their hedge 
accounting, so we will see a relatively volatile set of 
earnings in these companies.
    Senator Bennett. I see; but that is the point I had not had 
before: the $11 billion is a net number.
    Mr. Lockhart. That is my understanding, yes, Senator.
    Senator Bennett. I see.
    OK; thank you, Mr. Chairman.
    Chairman Shelby. Senator Schumer.

            STATEMENT OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman, and thank you, 
witnesses.
    I have some real concerns here. Obviously, there have been 
some misdeeds at Fannie and Freddie. I think a lot of people 
are being opportunistic, taking those and then throwing out the 
baby with the bath water, saying let us dramatically 
restructure Fannie Mae and Freddie Mac when that is not what is 
called for as a result of what has happened here. First, I want 
to ask you, Mr. Lockhart: the new administration at Fannie and 
Freddie have taken some real reforms, including the $400 
million settlement. Do you think what they have done is good, 
and do you think it is adequate?
    Mr. Lockhart. The steps they are taking have been good, but 
they are not adequate yet. As I said before, it is going to 
take several years to be SEC-compliant and certainly to meet 
our----
    Senator Schumer. But what more should they be doing now? It 
will take years, but that is because of what happened in the 
past. What more should the new management at Fannie and Freddie 
be doing that they are not doing now, or at Fannie, anyway, 
that they are not doing now?
    Mr. Lockhart. They need to continue to work on internal 
controls, risk management, accounting systems, recruiting 
people, and reviewing the people that they have. There is a 
whole series of actions that we have set out in the agreement.
    Senator Schumer. But are they not in the process of doing 
all of those?
    Mr. Lockhart. They are in the process of doing it.
    Senator Schumer. Do you think they are doing it too slowly?
    Mr. Lockhart. They are doing it slowly. Whether it is too 
slowly, I am not sure, because of the resources available.
    Senator Schumer. OK, I am a little concerned, also, at the 
independence of you and the regulator. There seems to be this 
coordinated effort to go after Fannie and Freddie. On the same 
day that Treasury announces it is going to try to do what 
cannot be accomplished legislatively, Secretary Jackson 
announces HUD's intention to initiate a review of Fannie and 
Freddie's holdings. Have you had conversations with the 
administration, with the Treasury, the White House, or the 
Federal Reserve, about the Senate GSE bill?
    Mr. Lockhart. I have had conversations, obviously, when 
they were looking at appointing me to the job.
    Senator Schumer. And what did you say? Did you say you 
supported it?
    Mr. Lockhart. I said at that point, I did not know enough 
to say I supported it, but I certainly support the principles 
of a stronger regulator.
    Senator Schumer. Well, that, we agree with, but let us go 
to that issue of, you know, the problems that are here, the 
accounting problems and others, I do not think you are going to 
have any dispute. But then, there is, again, the idea to 
dismantle or greatly diminish Fannie and Freddie at a time when 
we are having a tougher time for middle class people to find 
housing. So I want to ask you about systemic risk, which is a 
different issue.
    Mr. Lockhart. Can I just say about dismantling----
    Senator Schumer. Yes.
    Mr. Lockhart. Because I would not have taken this job if it 
was a dismantling job. To me, it is a rebuilding job, and that 
is what needs to be done.
    Senator Schumer. Well, do you not think that if you greatly 
limit portfolios, if you put in pretty strong portfolio limits, 
it will greatly limit what Fannie and Freddie can do in the 
future compared to what they do now?
    Mr. Lockhart. It will change what they do, but I do not 
think it is going to greatly limit them because as I said 
earlier, they do continue to have the power to securitize 
mortgages. They package them up and sell them to the 
marketplace. In fact, that is their bigger business. And 
really, what happens is they are either going to issue 
securitized mortgages or debt and buy mortgages. And to the 
investor, they can make the choice of which they want, and at 
the moment----
    Senator Schumer. Let me ask you this: have you had specific 
conversations with Treasury, White House, Federal Reserve about 
systemic risk?
    Mr. Lockhart. I have had conversations again about systemic 
risk prior to my appointment with now Fed Governor----
    Senator Schumer. How did you define to them, how do you 
define today what systemic risk is, and do you think Fannie and 
Freddie in their present status contribute or possibly create 
systemic risk?
    Mr. Lockhart. I do believe that they create systemic risk. 
OFHEO put out a report three or 4 years ago that gave some 
scenarios of how that could be created.
    Senator Schumer. How do you define it?
    Mr. Lockhart. I define systemic risk as actions by these 
companies that they could cause a major problem in the economy.
    Senator Schumer. OK, it says here, page 21 of the report to 
Congress, based on OFHEO's examination activities to date, it 
is the overall conclusion of OFHEO that Fannie Mae has strong 
asset quality and prudential credit risk management policies. 
Do you agree with that?
    Mr. Lockhart. Yes.
    Senator Schumer. So how is the systemic risk--let me just 
ask----
    Mr. Lockhart. They have market and credit risk capabilities 
that are reasonably strong. They do need to be improved in 
several areas. Their operational risk is not acceptable at this 
point.
    Senator Schumer. Their----
    Mr. Lockhart. Operational risk management.
    Senator Schumer. Let me ask you this: basically, the 
systemic risk argument says something terrible can happen, and 
they have so much that you better be careful. How is it 
different than the systemic risk that any private institution 
has, CitiGroup, I do not know, some of the others which are 
immense as well? Is there any difference?
    Mr. Lockhart. There is some difference, because first of 
all, this is a very concentrated risk. Citigroup is a very 
diversified financial institution. This is all concentrated, 
really, in one market. And they have a tremendous market share, 
40 percent.
    Senator Schumer. Is it not stable market than many of the 
other markets the financial institutions are in?
    Mr. Lockhart. Housing goes up and down. Interest rates go 
up and down, and they are two of the real drivers here. As I 
was saying earlier, you are going to see these companies have a 
lot more volatility in the future----
    Senator Schumer. But generally the----
    Mr. Lockhart. It is not totally stable.
    Senator Schumer. But generally, the market there is 
regarded as one of the more stable risks by investment grade, 
by interest rates, by everything else.
    Mr. Lockhart. If you are referring to the credit quality of 
the borrowers and the asset coverage----
    Senator Schumer. Yes.
    Mr. Lockhart [continuing]. ----that is more stable than 
some of the other investments. But one of the things that has 
happened in this market from time to time is they have done 
transactions that create risk.
    Senator Schumer. And so could a private institution.
    Mr. Lockhart. Private institutions have, yes.
    Senator Schumer. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Martinez.
    Senator Martinez. Thank you, Mr. Chairman.
    Let me back up a moment for the benefit of those who might 
have missed part of the hearing. But when we talk about 
misdeeds, we are really talking about accounting fraud, is that 
not, Mr. Cox, your testimony, that what we had here was 
accounting fraud?
    Mr. Cox. That is certainly the basis for what the SEC 
charged Fannie with.
    Senator Martinez. Now, and the magnitude of the misdeeds 
which are accounting fraud was $11 billion. That is the 
magnitude of the restatement, correct?
    Mr. Cox. That is, I believe, the lower bound of the 
estimate. We do not know yet what the real number will be.
    Senator Martinez. But that will be the bottom of it? It 
could be higher?
    Mr. Cox. That is right.
    Senator Martinez. Which puts it at about the same level as 
WorldCom if we were to compare.
    Now, also, we have talked about new management. Mr. 
Lockhart, I want to ask you about that, because it really is of 
great concern to me about where we are on that issue. In fact, 
the CEO is not new to Fannie Mae, correct?
    Mr. Lockhart. That is correct.
    Senator Martinez. One of the concerns that I have is 
whether, in fact, the manipulation of the numbers, the 
manipulation of earnings which is part of what this accounting 
fraud is about triggered certain bonuses to members of an elite 
group of executives, correct?
    Mr. Lockhart. That is correct.
    Senator Martinez. My understanding from your report is that 
Mr. Mudd, the current CEO, benefited to the tune of $13 million 
to $14 million in these bonuses.
    Mr. Lockhart. Yes, he did. I think it was actually $15 
million.
    Senator Martinez. $15 million?
    Mr. Lockhart. $15 million out of $26 million.
    Senator Martinez. His compensation over a 5-year period was 
$26 million, of which $15 million of those were triggered 
precisely by the very earnings that were tilted through 
accounting fraud in part to stabilize the earnings and in part 
to benefit the executives with these outlandish bonuses.
    Mr. Lockhart. To me, it is not just accounting fraud. This 
is mismanagement of the company. And I am not referring 
necessarily to the present management, but I am talking about 
the management during this period. It is more than just 
accounting fraud. They underinvested in systems; they tried to 
do a series of activities to weaken the agency, as you know, 
and so, it is much more than just accounting fraud in my mind.
    Senator Martinez. When we talk about your recommendations 
or the actions you have suggested, and I know Chairman Cox, 
perhaps you cannot comment on this, but I am anxious to know 
whether, in fact, there will be an opportunity for a recovery 
to the investors of these bonuses which may have been as a 
result of accounting fraud, and if it is not appropriate to 
answer at this time, I would be happy to wait until another 
point to hear the answer.
    Mr. Cox. Well, I think I can state in the very abstract 
that disgorgement is always a remedy that is available. Since 
we are in the midst of an investigation right now, I cannot 
fast forward to what might be the result.
    Senator Martinez. Do you have an estimate, Chairman Cox, of 
the loss to shareholders created by the accounting fraud that 
is documented in the OFHEO report?
    Mr. Cox. Well, certainly, there is a market measure. On the 
basis of the change in share price--the share price was over 
$75 a share. Now, it is below $49 as of about June 7, I think, 
the last figure I have in my head.
    Chairman Shelby. How many billions of dollars roughly, just 
calculate--
    Mr. Lockhart. It is about a billion shares, so that is 
about $25 billion, $25 billion to $30 billion.
    Chairman Shelby. $25 billion.
    Senator Martinez. So that is about $25 billion in magnitude 
in terms of what it represents to the investors, and this is to 
folks who just, in good faith, believing the numbers, believing 
the reports, bought the stock. Now, you know, we went back and 
forth here on risk, and my understanding of the systemic risk 
that this company undertakes, one of the things that makes them 
different from a private company is the fact that they have 
this implicit guarantee from the Federal Government.
    Mr. Lockhart. That is correct; they do have the implicit 
guarantee, and that is one of the reasons that these companies 
are still standing. As I said earlier, they would have probably 
lost their credit rating if they were a normal company. And 
that has been very helpful to keep supporting the housing 
market, which we all agree is an extremely important mission of 
these companies.
    Senator Martinez. Which is, at the end of the day, what 
they are chartered to do, support the housing market and to try 
to help first-time homebuyers and, you know, bring affordable 
housing to the marketplace. There are other parts of OFHEO's 
and HUD's analysis, more HUD analysis of these GSEs which would 
suggest that they trail, they lag behind the market in terms of 
providing assistance or mortgage assistance to low and moderate 
income homeowners, first time home buyers. Are you familiar 
with that as well?
    Mr. Lockhart. I have heard that, but I have not gotten into 
the details.
    Senator Martinez. You ought to take a look. It is there.
    Mr. Lockhart. I will.
    Senator Martinez. Mr. Chairman, my time has expired. Thank 
you very much.
    Chairman Shelby. We have two votes on the floor. We have 
one now in the second warning. We are going to take about a 20-
minute recess. So the Committee is in recess.
    [Recess.]
    Chairman Shelby. The Committee will come back to order.
    Senator Hagel.
    Senator Hagel. Mr. Chairman, thank you.
    Gentlemen, I very much appreciate you indulging our 
Committee and in particular giving me an opportunity to get 
back, and thank you. I know Chairman Cox is well aware of these 
kinds of procedures, votes and all that go with it, so thank 
you very much, and I do not have a great number of questions, 
and the ones that I do, in the interests of time, Mr. Chairman, 
I will submit for the record, but I do appreciate the 
opportunity to ask a couple of questions.
    Mr. Lockhart, I apologize also, since I had to go manage 
one of the amendments on the floor, and I may be covering 
ground here that others have asked. So if that is the case, 
just tell me, and we will move on to something else. Thank you. 
Mr. Lockhart, given the level of fraud and mismanagement 
outlined in your recent OFHEO report on Fannie and previous 
report on Freddie, how concerned is OFHEO about the ability of 
the GSEs, Fannie and Freddie, to manage the $1.5 trillion 
portfolios they have?
    Mr. Lockhart. OFHEO is concerned about the management of 
both GSEs. The internal controls are not there. Risk management 
is not there. Accounting systems are not there. We did put a 
freeze on Fannie Mae for that very reason and are not allowing 
them to grow their portfolios from year-end levels. We are in 
discussions with Freddie Mac at the moment on that same issue.
    Senator Hagel. Obviously, if we can pass new regulation 
reform legislation which would give OFHEO additional authority, 
additional resources, I assume that would be significantly 
important, in fact, to address the concern that you have, the 
authority. And if you could just develop that in a brief way, 
how critical is that authority? And by the way, you know where 
the two bills are, the bill that we passed out of this 
Committee plus what the House has done. If you do not think 
that authority is sufficient, I would like to hear that as 
well.
    Mr. Lockhart. Both bills go a long way to where we need to 
get to on the safety and soundness issue. There is just no 
doubt about it: we need more authority and a whole series of 
things that the bills do cover. In particular, capital 
authority, receivership authority, and we need more budget 
flexibility. On the issue of portfolio limits, the Senate bill 
does give better guidance of where they want to be, and that is 
helpful.
    And there may be pieces in both bills; I believe the House 
bill has better language on disgorgement, for instance. 
Basically, legislation is what we need. We need to strengthen 
this agency. We need to be a much stronger safety and soundness 
regulator.
    Senator Hagel. Thank you. As you know, the OFHEO report 
states, and I will quote from the report, quote, by 
deliberately and intentionally manipulating accounting to hit 
earnings targets, Fannie's senior management maximized the 
bonuses and other executive compensation that they received at 
the expense of the shareholders. That, end of quote, comes from 
your report.
    Can you tell the Committee, were any members of the Fannie 
Board aware of this accounting manipulation? Or how many were 
at least aware generally, or how many knew anything about it? 
How many tangentially had some sense of what was going on?
    Mr. Lockhart. I am not sure that we were able to show that 
any Board member really knew, and that is the fault of the 
Board, because their job is to be informed of what is going on 
in the company, and they were too passive. I say any Board 
member; obviously, the Chairman of the Board, Raines, was 
aware, and the other management members of the Board were 
aware. I am talking about the outside Board members.
    Senator Hagel. And what are we going to do to address that? 
Because we all understand that that is a primary, certainly a 
basic fiduciary responsibility of Boards of Directors. Do we 
need new authorities? Do we need a new Board? Do we need new 
management? What do we do?
    Mr. Lockhart. In part of our various settlement agreements, 
we put in a whole series of rules for the Board, and they are 
starting to make some of those changes. One of the things we 
did was to separate the CEO and the Chairman job. We are 
strengthening the Board committees. They have, I think, four or 
five new Board members and a new member of one of the key 
committees, the new chair of the Audit Committee, which we 
really applaud.
    So they are making progress, and you will hear from 
Chairman Ashley later, and he will tell you that they are 
making progress in the Board. I believe they are, but they may 
have to go farther. As you know, we have asked the Board to 
look at the Board members and the management team that are 
still in place to see if there need to be any additional 
changes.
    Senator Hagel. How many members of management are still at 
Fannie who benefited from these bonuses and executive 
compensation during the period of your investigation?
    Mr. Lockhart. I cannot give you an exact number, but I 
would guess it is probably over 10 still.
    Senator Hagel. Still there at Fannie Mae, OK.
    Mr. Lockhart. Right.
    Senator Hagel. OK, regarding the lobbying efforts that we 
have heard a great deal about, which your report focuses on 
with some detail; in fact, again, I will just quote something 
very quickly, and then I am going to ask you a question about 
it from your report: Fannie Mae lobbyists worked to ensure that 
the agency, OFHEO, was poorly funded and used longstanding 
relationships with Congressional staff to interfere with 
OFHEO's special examination of Fannie Mae, end of quote.
    The Fannie Mae lobbying effort to generate the HUD 
Inspector General's fourth investigation of OFHEO and all the 
other pieces that you addressed, did you direct your attention 
to, or do you know who, in fact, directed Fannie Mae lobbyists 
in this regard, members of management there at Fannie Mae?
    Mr. Lockhart. The lobbyists reported to very senior 
managers, and as I understand it, they were certainly in 
contact with the chief executive officer. This was a 
longstanding tradition at the company, as we have already heard 
several times today. They were extremely active in lobbying 
Congress and spent an awful lot of money at it.
    Senator Hagel. So does that then imply, or are you then 
saying it was directed out of the CEO's office? My question 
would then be was that Mr. Raines? What role did Mr. Mudd have 
in this, who, of course, is now the CEO but at the time was the 
chief operating officer. So what did the investigation develop 
in the way of who was direction----
    Mr. Lockhart. This is an area I have not paid as much 
attention to. One of the things that we did in our consent 
decree was we told them to relook at this whole group and do a 
study of how it is being organized. Mr. Donilon, who sat over 
this group, as I understand it, was the corporate secretary, 
and he was in contact with the senior management and Chairman 
Raines, on what was going on. This whole organization was 
extremely active at trying to prevent OFHEO from doing its job. 
And that is the unfortunate truth.
    Senator Hagel. Well, that is a rather significant statement 
that you have just made, because you have, starting with Mr. 
Mudd, who is still there, who is managing, as the CEO, this 
organization, so if, in fact, he was involved in doing what you 
had just stated the institution, the enterprise as a whole, 
that is a pretty disturbing point.
    I intend to ask Mr. Mudd, when he is up here in a few 
minutes, what role he played, but you, being the director of 
the regulatory agency that made this examination and came up 
with this report, I would ask that this Committee then be 
informed, as you have noted, further developing more 
information and a report on this.
    Mr. Lockhart. We will. I can tell you that he has made some 
significant changes in this group. Maybe more need to be made, 
but they are certainly a lot less active than they were, and he 
has promised me that they will continue to be that way.
    Senator Hagel. Well, and I appreciate that, but again, I 
will ask him the question, because if he was party to directing 
efforts, significant multimillion dollar efforts to undermine 
the institution's regulator, which we found out from your 
report they were doing, but, if it is that great, they, and I 
think this Committee and I certainly would like to know who, 
especially because they all benefited rather significantly from 
undermining the interest of the American people and the 
American taxpayer by their conduct and behavior and 
mismanagement.
    As the Chairman of the SEC noted in a more private setting 
and as was brought out in this hearing this morning, there 
would be probably some indictments in a private corporation. 
There may be indictments yet. But in the interests of time, Mr. 
Chairman, I very much appreciate both what you and Chairman Cox 
are doing at your agencies. They are important, you know that, 
at an important time, and I appreciate again your generous 
efforts to accommodate my schedule. Thank you.
    Mr. Chairman, thank you.
    Chairman Shelby. Gentlemen, we appreciate your appearance 
today and your contribution to good corporate governance and to 
the GSEs.
    Mr. Cox. Thank you, Mr. Chairman.
    Mr. Lockhart. Thank you, Mr. Chairman.
    Chairman Shelby. We are going to call up our second panel 
now: Mr. Daniel Mudd, President and Chief Executive Officer of 
Fannie Mae, and Mr. Stephen Ashley, Chairman of the Board of 
Directors of Fannie Mae.
    Mr. Mudd, Mr. Ashley, your written testimony will be made 
part of the hearing record of the Banking Committee. We will 
first call on you, Mr. Mudd, for any opening statement you want 
to make.
    Mr. Mudd. Yes, sir, if I might, Mr. Chairman, defer to my 
Chairman, Mr. Ashley, to open and follow him briefly.
    Chairman Shelby. That is OK. If you want to do that, that 
is OK with us.
    Mr. Ashley, then.

                STATEMENT OF STEPHEN B. ASHLEY,

              CHAIRMAN OF THE BOARD OF DIRECTORS,

                           FANNIE MAE

    Mr. Ashley. Thank you, Mr. Chairman, Senator Sarbanes, 
Members of the Committee, my name is Steve Ashley. I have been 
in the mortgage business for over 40 years, and the last time I 
had the privilege of testifying before this Committee was when 
I served as President of the Mortgage Bankers Association of 
America.
    Eighteen months ago, I was asked to become the independent 
chairman of the Fannie Mae Board of Directors, and I appreciate 
the opportunity to appear before the Committee today. The 
Fannie Mae of 1998 to 2004 portrayed in the final OFHEO report 
of its special examination is a far different company than was 
portrayed to the Fannie Mae Board by departed management, our 
former external auditor, and annual regular examination 
reports. I would like to comment briefly on the Board and the 
company's response to the OFHEO special examination of Fannie 
Mae and the changes we have made and are continuing to make to 
address the problems identified.
    On September 20, 2004, when we received OFHEO's interim 
report, we acted immediately to examine and respond to its 
findings. Within a week of receiving the report, we reached an 
agreement on a process to resolve the issues raised by the 
report. We pledged to work cooperatively with OFHEO, and we 
began supervising the work of fixing the company. Also in 
September 2004, the Special Review Committee of the Board 
initiated an independent review of the issues raised in the 
OFHEO report and other matters relating to the company's 
accounting, governance, structure, and internal controls.
    To conduct the review, the Committee engaged former Senator 
Warren Rudman and his law firm of Paul Weiss, which retained 
the services of a forensic accounting firm. The Board directed 
that the work of Paul Weiss be transparent to OFHEO, the SEC, 
and the Department of Justice during the entire period of 
review.
    In October 2004, the Board established an ongoing 
Compliance Committee. And by the end of 2004, working with 
OFHEO, we had taken action to replace our outside auditor, 
launch our restatement, and replace our chief executive officer 
and chief financial officer. Since September 27, 2004, the full 
Board has met 43 times; Board committees have met 146 times.
    Since January 1, 2005, I have met directly with the 
director or acting director of OFHEO 17 times. As independent 
chairman of Fannie Mae, I typically spend 2 to 3 days a week at 
the company providing direct oversight. Working with OFHEO, we 
also agreed to take steps to further strengthen the company's 
corporate governance. Let me describe some of these and other 
changes the Board has made.
    We separated the roles of the chief executive officer and 
the chairman of the Board. Five of the 12 nonmanagement members 
are new since 2004, and the newest member, Dennis Beresford, is 
a former chairman of the Financial Accounting Standards Board 
and is serving as chairman of the Audit Committee. All five of 
the new Board members are independent of management. We 
eliminated two seats held by management, retaining just one, to 
increase the proportion of independent Board members. In 
addition, in accordance with our corporate policy and OFHEO's 
corporate governance rules on length of service, another Board 
member, Ann Korologos, will be leaving the Board effective July 
31. As lead director and chairman of the Governance Committee 
in 2004, she felt it was her duty to remain on the Board an 
extra 2 years to see us through the investigative phase, which 
is now complete.
    To ensure accountability and the timely flow of 
information, we established reporting lines to the Board for 
the positions of chief audit executive, chief compliance and 
ethics officer, and chief risk officer. During this period, the 
Board exercised one of its paramount functions: to select and 
review the performance of the CEO of the company. We made a 
change in leadership at Fannie Mae when we appointed Dan Mudd 
as interim CEO on December 21, 2004.
    We directed Mr. Mudd to begin working with the Board and 
with OFHEO to implement our regulatory agreements, carry out 
other necessary and appropriate changes to the company, and put 
Fannie Mae on the right track. More specifically, we made clear 
that his duties included the following: restoring the company's 
capital; restating Fannie Mae's financial results; building a 
new management team, particularly in the areas of finance, 
accounting, and audit; rebuilding relationships with 
regulators, customers, and stakeholders; garnering credibility 
with the investment community; boosting the company's 
investments in our financial systems and internal controls; and 
rebuilding the company's culture.
    In June 2005, the Board selected Dan Mudd as permanent 
president and CEO of Fannie Mae, after consultation with OFHEO 
and a very thorough review by Senator Rudman. As interim CEO, 
Mr. Mudd demonstrated an ability to lead a large financial 
institution through a major and challenging transition, 
including the ability to reach out and rebuild confidence with 
our regulators, Congress, and others. He demonstrated his 
capacity for the job by doing the job.
    On May 23 of this year, the company took a big step forward 
when we reached settlements with the Securities and Exchange 
Commission and OFHEO. The settlement with OFHEO addresses the 
recommendations found in the OFHEO final report. The Board is 
committed to ensuring full and total compliance with these 
agreements.
    Mr. Chairman, I can report to this Committee that there is 
a strong determination on the part of the Board, management, 
and the employees for Fannie Mae to grow into a different 
company than it was from 1998 to 2004, and that changes have 
been made up, down, and across the organization. At the same 
time, the Board understands that Fannie Mae still has much more 
to do, and working with our regulators and with this Committee 
and the counterpart committees in the House, we intend to hold 
ourselves and the management team accountable for the changes 
to be made.
    I welcome this chance to report to you, and I am happy to 
answer any questions.
    Chairman Shelby. Mr. Mudd, do you have a statement?

                  STATEMENT OF DANIEL H. MUDD,

                       PRESIDENT AND CEO,

                           FANNIE MAE

    Mr. Mudd. Yes, thank you, Mr. Chairman, Senator Sarbanes, 
and Members of the Committee. I appreciate this opportunity to 
appear before you today, and to update you on the progress that 
we have made at Fannie Mae since I began in the role as chief 
executive officer in December 2004.
    It is clear from the Rudman report, from the OFHEO report, 
that Fannie Mae got a lot of things wrong from 1998 to 2004. 
Bad decisions about accounting and many other matters let a lot 
of people down and in so doing broke a public trust. We have 
learned some painful lessons about getting things right and 
about hubris and about humility, and we have made changes. We 
are making progress. But we have much more to do, and I am 
determined to do it.
    We began with a plan to fix the company on December 31, 
2004, the day that I was appointed as interim CEO. We set out 
to restore our capital, restate our prior financial statements, 
rebuild our relationships with our regulators, partners, 
stakeholders, and Members of Congress to manage our business 
and recenter our company on serving the families who need 
affordable housing, armor-plate our financial controls, and 
finally, to fix our corporate culture, which the OFHEO report 
makes clear led to a lot of our problems.
    I have heard your comments today, and I have heard, 
certainly, many more comments in private. The days of the 
arrogant, defiant, ``my way'' Fannie Mae had to end. We have 
begun to build a Fannie Mae that listens better, that welcomes 
accountability, that works with our regulators and with 
Congress and serves the market by putting our mission to serve 
housing first.
    Let me describe briefly some of the tangible steps we have 
taken starting with the people. First, we have established a 
new senior management team to provide the leadership, the 
talent, and the ethical standards worthy of our role and our 
mission. We have a new chief financial officer; we have a new 
comptroller; a new chief audit executive; a new chief of 
accounting policy; a new general counsel; a new chief risk 
officer; and a new head of corporate strategy.
    Second, in cooperation and consultation with OFHEO, we are 
fundamentally reorganizing the company to ensure that strong 
checks and balances are in place. We have separated the 
portfolio business from the chief financial officer's 
responsibility. We have reorganized the finance function and 
brought in entirely new leadership from outside the company. We 
are reorganizing and strengthening internal audit.
    We have also replaced our outside auditor with Deloitte and 
Touche, which is conducting a comprehensive re-audit of the 
entire company. They have over 300 auditors onsite as I speak 
at Fannie Mae. We are making further key organizational 
changes, which include establishing a new and separate 
compliance and ethics organization. We have written and 
publicly pledged ourselves to a standard of ethical, honest, 
and transparent conduct. We have established a new chief risk 
organization with an independent and comprehensive view of all 
of the risks the company is taking. We have disbanded the so-
called Law and Policy Division.
    Third, we have restored and maintained our capital 
adequacy. We now have roughly $39 billion of capital in 
reserve, and our ratio of capital to assets is higher than it 
has ever been in our history.
    Fourth, we are paying people to do the job, not to hit 
targets. We have adopted a new executive compensation structure 
with broad performance goals.
    Fifth, we are making steady progress on completing our 
financial restatement, which will be done by the end of 2006. 
We have already completed the restatement of significant 
portions of our balance sheet and developed the systems to 
support and control our business. We are in the process of 
putting in place systems and controls to ensure that we are 
GAAP and Sarbanes-Oxley compliant. There is absolutely no 
routine or process or control anywhere in the company that is 
beyond the scope of overhaul and improvement to the highest 
standard. We can get this done. Our overarching goal is to get 
it done once, to get it done right, and to make sure the 
investments occur so that this will never happen again.
    Mr. Chairman, I would also like to reiterate a commitment 
that I made to the Committee last April, which is that Fannie 
Mae will work cooperatively with Congress to put legislation 
for GSE regulation in place. We do want a bill. In particular, 
we continue to support legislation to create a strong, well 
funded regulator that would oversee both the safety and 
soundness and the mission attainment of the enterprises.
    With respect to how we engage Congress, that is part of the 
new Fannie Mae as well. I hope that you have seen a new tone 
and manner of quiet, fact-based engagement from us. Where we 
disagree, I hope we disagree respectfully. You have my pledge 
to do all I can to move this process forward.
    Mr. Chairman, from the day I was appointed to lead Fannie 
Mae, we have been moving forward aggressively to identify the 
problems identified by OFHEO. The question may be: Why is this 
worth doing? The reason this company exists is because of our 
housing and liquidity mission, with the goal of putting people 
into homes. In the last 18 months, we have purchased or 
guaranteed more than 4 million home loans. We have helped to 
create 136,000 more minority homeowners and serve 600,000 
moderate- and low-income families. We have helped provide 
financing to build, rehab, or finance over half a million units 
of affordable rental housing. Nearly two-thirds of our overall 
business serves one or more of our HUD affordable housing 
goals. And, we are investing literally billions of dollars in 
the Gulf Coast region to help finance and rebuild the homes and 
communities there.
    During the past 18 months, we attracted more than $21 
billion of overseas investment to provide liquidity here in the 
U.S. housing market. And, this year, we are providing roughly 
half a trillion dollars to finance homes for 3 million 
Americans, 25 percent of them African-American, Hispanic, and/
or first-time homebuyers; all of them Americans looking to own 
or rent a home and become part of a community.
    I know that you are counting on us to fulfill our mission 
and to help us serve this growing Nation and its growing 
housing needs. I believe that is what makes this worth doing. 
Mr. Chairman, the company is changing and will continue to 
change thanks to these lessons we have been given to learn. My 
obligation and my pledge to you in Congress is to move forward 
and to get this right, to build a Fannie Mae that is truly able 
to serve affordable housing in America.
    Thank you for the opportunity, and we look forward to your 
questions.
    Chairman Shelby. Mr. Ashley, you and Mr. Mudd both referred 
to the Rudman Report. How much did that cost Fannie Mae to get 
Mr. Rudman's law firm to do that inside?
    Mr. Ashley. Mr. Chairman, the last number that I heard on 
the total investigation, which would include the costs of not 
only the work of the Paul Weiss team but also the forensic 
accounting team that was engaged plus search firms that were 
engaged----
    Chairman Shelby. Sure.
    Mr. Ashley [continuing]. ----was around $70 million.
    Chairman Shelby. $70 million. And, of course, there was a 
lot of difference between the Rudman report and the OFHEO/SEC 
report.
    Mr. Mudd, you wanted to work with us on legislation. When 
are you going to start, because I see no evidence of that 
myself in the last 6 months?
    Mr. Mudd. Senator, I hope we have been----
    Chairman Shelby. And I would like for you to.
    Mr. Mudd. Yes, sir, we are available any time, 24 by 7.
    Chairman Shelby. We are, too, but we have not seen any 
evidence of any change in tone that you talked about.
    Mr. Mudd. Well, Senator, I apologize for that, and if there 
is anything that we have missed, I would be happy to address 
it. Believe me, I believe it is in the interest of the 
enterprises to have a strong, credible, well funded regulator 
that has all the normal bank-like authorities that any 
regulator that we are familiar with would have, and if there is 
anything I can do to support that, I will.
    Chairman Shelby. We are going to give you an opportunity, 
and we hope you do it.
    Mr. Mudd, in your testimony, you suggested that Fannie Mae 
got a lot of things wrong from 1998 to 2004: bad decisions 
about accounting and many other matters that let a lot of 
people down and in so doing broke a public trust. Those are 
your words. Mr. Mudd, by bad decisions about accounting, I am 
assuming you are referring to the accounting fraud that Fannie 
Mae was found to have engaged in and was penalized by the SEC. 
Is that what you are talking about?
    Mr. Mudd. That is part of it, Senator. I think the 
routines, the processes, the controls, the investments that we 
had in place were clearly inadequate. But I actually paint the 
picture a little bit broader than that and talked in my 
statement about the culture, about the focus, and other areas 
that we are focusing on to try to get it right.
    Chairman Shelby. You are not suggesting, though, here in 
your words, I hope, that they were just bad decisions, not 
fraud, are they? The SEC has said that you all were guilty of 
fraud. You agreed to pay $400 million. You are not trying to 
minimize that here at this hearing, are you?
    Mr. Mudd. No, sir, we have reached a settlement on all 
those matters with the SEC.
    Chairman Shelby. I am just using your words.
    Mr. Mudd. And we certainly do not disagree----
    Chairman Shelby. I am just quoting your own words.
    Would you agree that fraud is a little more serious and 
much more significant than just, quote, your words, letting 
people down and breaking the public trust?
    Mr. Mudd. Yes, sir, I would.
    Chairman Shelby. Mr. Ashley, where does the buck stop? For 
example, the SEC and OFHEO said, quote, that an extensive 
financial fraud--extensive financial fraud--was committed at 
Fannie Mae. But, of course, corporations are abstract entities 
that cannot commit fraud in a sense; somebody does it. Mr. Mudd 
and Mr. Ashley, both: Who are the individuals primarily 
responsible for the extensive financial fraud at Fannie Mae 
that SEC Chairman Cox talked about?
    Mr. Mudd. Senator, there are processes in place going on 
right now at the SEC and at the Department of Justice.
    Chairman Shelby. Sure.
    Mr. Mudd. We are cooperating with all those. That is 
ultimately their determination, but I assure you----
    Chairman Shelby. We know it is under investigation still.
    Mr. Mudd. Yes, sir.
    Chairman Shelby. Mr. Ashley, during the time addressed in 
the special exam that we have talked about here, it would be 
helpful for the Committee and for the record if you could give 
us a basic understanding of how the Board, which you have been 
a member of before you were chairman, operated in providing 
oversight of Fannie Mae's management; for example, perhaps you 
can outline for the Committee what typically happened at a 
Board meeting, such as did the Board typically hear 
presentations from Fannie Mae staff other than senior 
management? Did the Board ask questions--you were a member of 
the Board--regarding these briefings? And were Board members 
encouraged to raise agenda items for the next Board meeting? 
Was the company's relationship with OFHEO ever discussed at 
these meetings?
    Mr. Ashley. Mr. Chairman, typically, Fannie Mae's Board 
meetings, which would be calendared seven to eight times a 
year, now eight times a year, would be 2 day meetings, with 1 
day devoted to committee meetings. The Board functioned through 
the traditional governance committee meetings: Audit; 
Compensation; Governance, Assets, and Liability, which is now 
renamed the Risk Policy Committee; Housing and Community 
Development.
    Those meetings would contain presentations and discussion 
from management within the jurisdiction that those committees 
had. During the Board meeting, the committee chairs would 
report on the work of the committees. In addition, there would 
be regular reports from various members of management--not 
simply the CEO--including, perhaps, in-depth items, such as 
financial reports and so forth.
    Chairman Shelby. Mr. Mudd, the House testimony on initial 
findings, on October 6, 2004, Mr. Raines and Mr. Howard gave 
testimony to the House Subcommittee denying OFHEO's preliminary 
report on Fannie's accounting and culture. Did you disagree 
with any of their comments? Did any of their comments strike 
you as untrue, inappropriate, misleading? Did you communicate, 
if so, your views to anyone either inside the company, to the 
Board, or anyone else?
    Mr. Mudd. Senator, I----
    Chairman Shelby. Did those comments bother you? You were 
inside the company then.
    Mr. Mudd. Yes, sir; I was not involved in the preparation 
for those comments, nor did I hear them at the time. Clearly--
--
    Chairman Shelby. But you are aware of what was said.
    Mr. Mudd. Yes, sir.
    Chairman Shelby. You have reviewed it since.
    Mr. Mudd. And as I have worked through----
    Chairman Shelby. Do those comments bother you?
    Mr. Mudd. Yes, sir, they do.
    Chairman Shelby. Did they bother you when you first learned 
about them?
    Mr. Mudd. Senator, I would say that they bothered me. As I 
came into this job and had to work through what the actual 
facts were and had to get to the bottom of where the financial 
issues were, the sheer scope of the financial accounting 
matters that we had to address and the depth of the issues in 
terms of our Financial Accounting Department, our Controls 
Department, and the environment there over that period of time 
when I saw what the issues looked like on the ground, did 
increasingly bother me.
    Chairman Shelby. Mr. Mudd, there are people who question 
you are the appropriate person to head Fannie Mae. We know you 
are the CEO, and you were elected by the Board. Given your role 
in senior management at the time in question we are talking 
about here, as chief operating officer of the company during 
this time, how is it that you were not aware of any of these 
practices?
    Did you ever question how it was possible that the company 
that you were the chief operating officer of then could achieve 
such stable earnings in light of the business model being 
pursued and the accounting required under FAS 133? And if so, 
to whom did you raise these questions if you were troubled by 
them, and what efforts did you undertake to further examine 
them and to remedy them.
    Mr. Mudd. Yes, sir. It is a tough question, Senator.
    Chairman Shelby. That is part of our job up here. You know 
that.
    Mr. Mudd. It is one that I think about an awful lot myself. 
And since the time I came into the interim job here, I have 
been----
    Chairman Shelby. No, I am referring back to when you were 
the chief operating officer.
    Mr. Mudd. Yes, sir, yes, sir, and I just wanted to give you 
a bit of background.
    Chairman Shelby. OK.
    Mr. Mudd. Five years worth of my e-mails, my appointments, 
my letters, the meetings that I had, and the documents that I 
saw were fully reviewed by both OFHEO transparently and in the 
Rudman report.
    Chairman Shelby. That is not what I am asking you. When you 
were the chief operating officer, were you aware of what was 
going on in the company? You should have been.
    Mr. Mudd. Yes, sir.
    Chairman Shelby. And if so, I am not asking you about your 
e-mails and OFHEO now; I am asking you specifically, were you 
aware of this if you were--and you were the chief operating 
officer before you were promoted to be the CEO.
    Mr. Mudd. Yes, sir. In my role as chief operating officer, 
my responsibilities were principally dealing with the customers 
and dealing with the systems technology. I would say that as 
the issues unfolded, there was no moment where someone was hit 
by lightning on the road to Damascus and saw everything for 
what it was as a piece. Rather, I would answer your question by 
saying----
    Chairman Shelby. If you were not hit by lightning on the 
road to Damascus, was the sky lit up for you where you could 
see a little better?
    Mr. Mudd. I would say the clouds gathered, the lightning 
began to strike, and things got worse from there, Senator.
    Chairman Shelby. Did it take a lightning strike to wake you 
up, and you were the chief operating officer?
    Mr. Mudd. No, sir, it took understanding a train of events 
and a series of issues that enabled the Board, management, 
those that are there now, independent auditors, and OFHEO who 
you heard from earlier today, to take all of those pieces and 
put them together to understand the full scope of where things 
had been. I would not suggest to you that any one single piece 
of information or evidence brought all that to light at once.
    Chairman Shelby. Were you ever deeply troubled where you 
could not sleep at night? I mean, you are the chief operating 
officer, and you have got to, in the culture, know what is 
going on. And if you did not know what is going on, you know, 
what is your job?
    Mr. Mudd. Yes, Senator, my job was focused on the customers 
and on the technology systems. I was not responsible for 
financial accounting. I was not responsible for the mortgage 
portfolio. I was not responsible for internal audit, and I was 
as shocked as anyone in the company or anyone in Congress or 
anyone in the market when these issues were uncovered and came 
to light.
    Chairman Shelby. Senator Sarbanes, thanks for your 
indulgence.
    Senator Sarbanes. Thanks, Mr. Chairman.
    Mr. Ashley, in light of these questions, I would be 
interested in understanding the Board process that led to Mr. 
Mudd now assuming the CEO position at Fannie Mae.
    Mr. Ashley. Yes, sir, I am happy to go through that. 
Clearly, in December 2004, when it became obvious to the Board 
that Messrs. Raines and Howard could no longer lead the 
company, we reached out to Dan to serve as an interim CEO and 
President.
    Soon thereafter, right around the first of 2005, the Board 
created a Search Committee, which was chaired by Director Ann 
Korologos, engaged in a very thorough, nationwide, and very 
competitive search. The search was pretty well discussed in the 
media with some names at the time. That search went through 
until the latter part of April 2005. During this time period, I 
was serving as independent chair, nonmanagement chair, and Mr. 
Mudd was serving as an interim CEO.
    Senator Sarbanes. When did you become the interim chair?
    Mr. Ashley. I never served as an interim chair, Senator. I 
was elected chair of the Board on the 21st or 22nd of December 
2004, as a nonexecutive chair, I think is the terminology.
    Senator Sarbanes. Previously, had the chair and the 
executive been combined in one position?
    Mr. Ashley. Yes, sir, that is correct.
    As we moved through the spring of 2005, it became clear 
that Mr. Mudd was doing a very good job, and indeed, I would 
say an excellent job of moving the company from where it had 
been, starting the process of change in culture that was 
necessary, developing a new organization for the company, 
weeding through people, terminating people, and then, most 
importantly, starting the process of recruiting individuals of 
excellent talent and new to the company beginning first in the 
finance area and the comptroller's area.
    When it became clear that Mr. Mudd was going to be a 
finalist--not necessarily the finalist, and, indeed, at that 
point in time, he was not the finalist--I approached Senator 
Rudman as well and had discussions with the then-director of 
OFHEO as to was there anything in their knowledge, their 
background, that would suggest that the Board should not move 
forward considering Mr. Mudd as a finalist. Senator Rudman's 
team spent approximately 2 to 3 weeks doing very in-depth 
reviews. I believe that these were the things that Mr. Mudd was 
referencing earlier in his response to Chairman Shelby's 
question. They did a very detailed review of every aspect of 
Mr. Mudd's work at the company, seeking to discover whether he 
was in any way implicated in any of the wrongdoing that had 
been identified in the interim report of examination from OFHEO 
that was given to us in September 2004.
    Senator Rudman's investigation was thorough. He met with 
the Search Committee and then later with the full Board 
discussing the results of his investigation, and at that point 
in time, the Board felt that there was no reason why Mr. Mudd 
should not be considered for the CEO position, and indeed, we 
did elect him as President and CEO, I believe, in 2005.
    Senator Sarbanes. Now, if I heard you correctly, you said 
just a moment or two ago not only that you took this up with 
Rudman but with the Director of OFHEO.
    Mr. Ashley. I had discussions with the director of OFHEO, 
yes, Senator.
    Senator Sarbanes. Is that Mr. Falcon at the time?
    Mr. Ashley. That would have been Mr. Falcon.
    Senator Sarbanes. And what was the gist of those 
discussions?
    Mr. Ashley. My recollection, Senator, is that I had one 
discussion where I outlined that Mr. Mudd was going to be 
considered as one of two finalists. I asked whether there was 
any reason that we should not consider him, because if there 
was, I wanted to be sure that that was clear to the committee 
and the Board at that time. He asked for some time to do 
whatever work he needed to do and to check, I am sure, with 
colleagues at OFHEO.
    At a subsequent point in time, I cannot remember exactly 
what the time lapse was, we had another discussion, and he 
indicated that, in his view, there was no reason that we could 
not go further considering Mr. Mudd for this position.
    Senator Sarbanes. Has the Board reexamined this question in 
light of the recent OFHEO report?
    Mr. Ashley. Senator, we have, and when the OFHEO report was 
ready several weeks ago, approximately a week before it was 
released, it was made available to a small group under 
confidentiality for fact checking. At that time, it became 
certainly obvious to those reading the report that Mr. Mudd was 
named a number of times in this report, and therefore, I felt 
that the Board had to examine those findings and discuss them 
thoroughly.
    The Board did so. We asked Senator Rudman to read the 
report, to come back to us and to address questions as to 
whether there were new findings, whether there were new 
material findings, and whether there was anything on what we 
had previously known of Dan's involvement that had turned up in 
the Rudman Report that was new or different or that would cause 
Senator Rudman or his team to change their opinion and their 
recommendation to the Board that they had made in the spring of 
2005.
    He reported that there was not any reason that they would 
change their opinion on that. The Board read the report, 
examined every notation that was made in the report regarding 
Mr. Mudd, discussed it. We met in an executive session. We had 
the benefit of counsel. The Board did not take action until 
after full discussion with and without Senator Rudman and in 
all cases without Mr. Mudd. We discussed further, and then, on 
the morning that the OFHEO report was released, we expressed 
our confidence in Mr. Mudd to continue in service as CEO of 
Fannie Mae.
    Senator Sarbanes. Well, my time is up. If I could just put 
one more question, the report of OFHEO on the special 
examination of Freddie Mac, not Fannie Mae now, but Freddie 
Mac, which came earlier, said 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. And 
they go on then to discuss this.
    Now, it sounds very familiar as we look through the report 
of the special examination of Fannie Mae. I would put it to 
both of you: did you read the Freddie Mac report, and did it 
register on you in terms of, well, you know, what are we doing 
here, here being at Fannie Mae? Did anyone pick up on that, 
both in management and on the Board? So I put the question to 
both of you.
    Mr. Ashley. Senator, I will respond.
    Senator Sarbanes. And I apologize to my colleagues.
    Chairman Shelby. That is all right.
    Mr. Ashley. I will respond as to the involvement of the 
Board and the discussion of the Board around the Freddie Mac 
report.
    Certainly, the Board was well aware of the issues that had 
surfaced at Freddie Mac. They had been publicized; copies of 
the executive summary of the report were distributed to the 
Board. I believe that there was discussion in the Audit 
Committee with KPMG, Fannie Mae's auditors. There was clearly 
discussion at several Board meetings during that early time 
period about whether Fannie Mae had any of these problems. 
Questions were addressed to CEO Raines and CFO Howard in the 
Board meetings.
    The Board received complete and full assurance from both 
executives every time the issue was discussed that Fannie Mae 
did not have those problems. At the same time, the Audit 
Committee was receiving assurances from KPMG that that indeed 
was the case.
    Mr. Mudd. Nothing to add, Senator, other than that the same 
level of reading and review was done across management, but, 
broadly, the process and the conclusions followed Mr. Ashley's 
comments.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Bennett.
    Senator Bennett. Thank you very much, Mr. Chairman.
    I would like to follow up on the questions that I asked the 
Director of OFHEO with respect to the earnings. I am not quite 
clear, and I am not quite sure of his answer. It is my 
understanding that one of the problems was that the earnings 
were placed in the wrong quarter or the wrong fiscal reporting 
period in an effort to make that period look better and that in 
the restructuring and restating, the earnings are not going to 
go away. They are going to reappear in another financial 
reporting period.
    Now, he said that the $11 billion figure was a net figure 
and that they all went away. So I am confused: the newspaper 
reports led me to believe one thing; his statement was the 
other. Given the degree of analysis that you have made of all 
of those earnings, I think you probably are in a better 
position to answer that question. I do not know if you heard my 
question to the Director, but could you respond to that area, 
either one of you?
    Mr. Mudd. I would be happy to, Senator.
    The restatement goes back for the years 2001 to 2004, and 
those amounts of earnings recognition will be retimed. 
Approximately $11 billion, actually somewhat less than that, 
was overstated in the prior periods. Those periods will be 
corrected, and, by and large, there will be some fine-tuning 
differences with respect to where some securities are priced in 
the market and so forth; but, as a broad theme, your assumption 
in your question is correct: those amounts will then flow back 
into future periods as the restatement is completed.
    Senator Bennett. Do you have a dollar figure on what the 
net really is, then? Because from what you have just said, the 
net was not the $11 billion that he was quoting.
    Mr. Mudd. No, sir. To use parallel terms, the gross amount 
potentially under restatement is slightly under $11 billion, 
but exactly how those specific amounts apply from period to 
period is exactly what we are determining----
    Senator Bennett. I see.
    Mr. Mudd [continuing]. ----in the process of the 
restatement, and I will not be able to give you that answer 
until the restatement is completed this year.
    Senator Bennett. What would you be surprised if it were 
more than? That is an unfair question, but just ball park. Do 
you think that half of the $11 billion will show up in some 
future statements?
    Chairman Shelby. This is pure speculation, is it not, Mr. 
Mudd?
    Mr. Mudd. Senator, I would not--we have made significant 
progress on the restatement. We have now been through all of 
the policies that apply, understand where there were 
misapplications of GAAP, and understand how each of those 
securities were priced during that period under the relevant 
accounting rules that were applied. We have rewritten the 
systems to do that. We have completed the process of restating 
significant portions of that, and small adjustments aside, the 
overwhelming proportion of the balance of that flows back in.
    Senator Bennett. OK, so it would be more than half of the 
$11 billion will flow back in at some future time?
    Mr. Mudd. Yes, sir, well more than half.
    Senator Bennett. All right, thank you. I appreciate that 
clarification.
    Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel.
    Senator Hagel. Thank you.
    Let me stay on that point for a moment, because I am a 
little lost in this conversation. I take a pretty simple view 
of all this, Mr. Mudd. Dishonesty is dishonesty, whether it is 
$11 billion or $5 billion. Do you agree with that, Mr. Mudd?
    Mr. Mudd. Yes, sir, I do.
    Senator Hagel. So intentional, fraudulent behavior, 
intentionally misstating anything is irrelevant, it seems to 
me, as to the numbers. Do you agree with that or not agree with 
that?
    Mr. Mudd. I do agree with that, Senator.
    Senator Hagel. Let us just get the record straight on this: 
whether it is $11 billion or $6 billion, if fraud was 
committed, it was committed, and that is what the OFHEO report 
says.
    Chairman Shelby. That is also what the SEC said.
    Senator Bennett. And I am not suggesting that there is not 
fraud. I am just wanting to know the financial condition of the 
company, and the financial condition of the company is affected 
enormously.
    Senator Hagel. Senator, the financial condition of any 
company reflects on the culture and the management and the 
honesty and the ethics of a company.
    Senator Bennett. I agree.
    Chairman Shelby. That is right.
    Senator Martinez. The fact is they do not know the 
financial condition of the company and have not known it for 
years.
    Senator Hagel. That is the other element. We do not know. 
And what is interesting, Senator, is we keep finding out more 
and more.
    Now let me, if I might, get on to some other questions. 
Thank you for clearing that up, Mr. Mudd. I will have some 
questions for you in a moment.
    Mr. Chairman, how long have you been on the Board?
    Mr. Ashley. Senator, I have been on the Board since May 
1995.
    Senator Hagel. You have been there quite awhile.
    Mr. Ashley. It seems like a long time, yes, Senator.
    Senator Hagel. So you have seen an awful lot.
    Mr. Ashley. I have seen a lot in the last 2 years that I 
never expected to see, Senator.
    Senator Hagel. Well, apparently, there was a lot you did 
not see.
    Mr. Ashley. Senator, I share your concern and your sense 
of, I think, righteous outrage on this.
    Senator Hagel. Oh, do not give me any righteous outrage, 
Mr. Ashley. This is not about righteous outrage. It is about 
fraudulent conduct in the interests of those who were managing 
an institution with their own greed and their own self 
interest. So this is not righteous outrage. That is for the 
confessional or for your spiritual advisor, Mr. Ashley.
    You have a fiduciary responsibility, and I think you 
failed, and the entire Board failed, and according to the 
reports, it is pretty clear that you failed. Now, can you sit 
there and tell this Committee that you knew nothing about what 
was going on? Because to hear the two of you talk or somebody 
else, the chief operating officer said he was not aware of much 
of this, which we will get to the chief operating officer in a 
moment.
    But you seem that you do not know anything about what 
happened, what was developing, the lobbying, the money, the 
compensation. You have seen the compensation here that Mr. Mudd 
received as well as Mr. Raines and a number of others here. 
Now, you are a man of great experience and depth in this 
business. Was that strange to you at all that was going on, no 
questions asked?
    Mr. Ashley. Senator, I have worked 40 years in the mortgage 
banking business, and I have had a great passion for this 
business. And I cannot express to you the deep disappointment 
and anger that I as a member of the Board, and I know this is 
shared by my colleagues on the Board, feel at this moment in 
time when a company and a management and people that we put our 
trust in was broken, not just broken, but shattered.
    And the fact that the Board trusted Frank Raines and Tim 
Howard I think is reasonable for any Board to be able to trust 
their management. To the point that they do not trust that 
management, they should remove that management.
    Senator Hagel. What about Mr. Mudd? Was Mr. Mudd exempt 
from this? He was chief operating officer according to the 
records here.
    Mr. Ashley. Senator, I think in my response, I believe, to 
Senator Sarbanes' question, I explained the process that the 
Board went through to affirm the trust and to be sure that we 
could place trust in Mr. Mudd going forward in his leadership, 
in his judgment, in his management decisions.
    Senator Hagel. Well, I do not know how much you read of any 
of these reports. The question was asked by Mr. Sarbanes a few 
minutes ago. But let me just respond to this comment about Mr. 
Mudd. This comes from the OFHEO report. There are a number of 
indications of Mr. Mudd's awareness of what was going on. This 
one, in particular, is an e-mail that Mr. Mudd wrote in 2003. 
It is in the OFHEO report; quote, Mr. Mudd says in the e-mail, 
I spoke to a Treasury Department official. He had agreed to 
talk to the SEC on what to do if OFHEO was not falling in line. 
Already, another Treasury official had already bent his ear 
about OFHEO obstructionism--OFHEO obstructionism--promised me 
he would check in to see where things were and would call the 
SEC when we needed to, end of quote.
    Now, this is an e-mail from Mr. Mudd, chief operating 
officer, who does not know anything about what is going on, nor 
do you as a member of the Board. So how do you respond to that 
when you say that you were offended by Mr. Raines and Howard 
and others who just bamboozled you all, because you really did 
not know what was going on?
    Mr. Ashley. Senator, the e-mail in question, I believe, and 
Mr. Mudd can explain it in more detail, I believe related to a 
call that was made at the time the company was seeking SEC 
registration.
    Senator Hagel. What do you know about the lobbying efforts? 
Did Mr. Mudd have anything to do with that? Did you have 
anything to do with that? How many Board members had contracts 
who did lobbying on behalf of the institution? Do you know 
anything about those things?
    Mr. Ashley. Senator, I was----
    Senator Hagel. Does Mr. Mudd know anything about those 
things?
    Mr. Ashley. I think Mr. Mudd can respond to that. I was not 
engaged in lobbying activities on behalf of the company. There 
is one Board member, which is, this is public information, 
where there is a contract, a consulting contract with his firm.
    Senator Hagel. Is this still active?
    Mr. Ashley. It is still active.
    Senator Hagel. You do not find any conflict with that?
    Mr. Ashley. He is not an independent director under the 
Board's independence guidelines. The director in question 
provides good counsel to the Board and to myself.
    Senator Hagel. So you have a Board member who is 
compensated, I understand; is that right?
    Mr. Ashley. He is.
    Senator Hagel. Then, in addition to that compensation, that 
Board member is hired as a lobbyist.
    Mr. Ashley. His firm is hired as a lobbying consultant to 
the company.
    Senator Hagel. And you find nothing irregular about that?
    Mr. Ashley. Certainly in the standards of independence and 
governance going forward, I would choose to see every director, 
other than the single management director, be completely 
independent in every way, shape, and form, and this Board is 
moving in that direction.
    Senator Hagel. What is the answer? I did not get your 
answer, the answer to my question.
    Mr. Ashley. Senator----
    Senator Hagel. Do you find nothing inappropriate about that 
relationship?
    Mr. Ashley. Senator, the relationship has been handled 
appropriately during the period that that conflict has existed 
since that director has been on the Board. My further response 
is that the rules of governance that I see for this company 
going forward would dictate that every nonmanagement director 
be independent in the fullest sense of the word.
    Senator Hagel. So what is your answer? You find nothing 
inappropriate with that kind of----
    Mr. Ashley. The relationship has been handled 
appropriately, Senator.
    Senator Hagel. So it is not inappropriate to have a member 
of the Board who is not part of management but have his firm 
being paid contractually for lobbying efforts and also a member 
of the Board of Directors.
    Mr. Ashley. The issue, really, for governance is whether 
that matter has been appropriately disclosed and the 
relationship is handled appropriately. I feel very strongly 
that there should be no conflicts with Board members going 
forward.
    Senator Hagel. You obviously do not think that is a 
conflict.
    Mr. Ashley. Senator, at the present time, this relationship 
is handled within the rules of the road.
    Senator Hagel. That is not my question, and you know it, 
Mr. Ashley. Mr. Ashley, part of the problem we have, you have, 
your institution has, is because you do not give straight 
answers. This is not complicated. Now, I do not know, maybe 
because you have been on the Board too long, but I do just find 
it astounding that neither of you really know anything that has 
been going on.
    Now, Mr. Mudd, I am going to read something here: Regulator 
says Mudd knew of misdeeds. This is from the May 24, 2006, 
story by Terence O'Hara, Washington Post, and it says this: 
Fannie Mae Chief Executive Daniel H. Mudd was aware as early as 
the fall of 2003 of serious allegations of accounting misdeeds 
and failed to pass key information on to the company's Board of 
Directors according to Fannie Mae's Federal regulator. In the 
first detailed account of Mudd's involvement in the management 
lapses at the mortgage giant, the Office of Federal Housing 
Enterprise Oversight also cited an instance in which Mudd asked 
a Treasury Department official to intervene on the company's 
behalf to rein in OFHEO during its examination of Fannie Mae's 
accounting practices, and I am sure you have read it, and it 
goes further.
    Would you care to respond to that, Mr. Mudd?
    Mr. Mudd. I would.
    Senator Hagel. Inaccurate, wrong, right?
    Mr. Mudd. Well, Senator, the Post itself corrected that 
headline the next day.
    Senator Hagel. I am not talking about the headline. I am 
talking about what it says, the story. Was the story 
inaccurate?
    Mr. Mudd. Senator, I was never aware of any misdeed, any 
mischaracterization, any intentional violation of accounting 
rules. Looking back, are there things that I regret? 
Absolutely.
    Senator Hagel. Did you benefit from the $6.46 obsession? Do 
you know what I am talking about? Let me refresh your memory. 
In the same year--this is from the OFHEO report--Sampath 
Rajappa, Fannie's senior vice president for operations, risk, 
and head of internal audit told Fannie's Internal Audit Group, 
quote, you must be obsessed, he says to all of you, on $6.46. 
After all, thanks to Frank, we all have a lot of money riding 
on it. Remember, now, Frank has given us an opportunity to earn 
not just our salaries, benefits, raises, employee stock 
purchase programs, but substantially over that if we make 
$6.46, end of quote.
    You recall, I suspect, maybe you do not; maybe you do not 
know this either. The final EPS number for 2003 was $7.29, 
which triggered the bonuses. Now, I am sure you remember 
bonuses and what everybody got. Now, this report from OFHEO 
cites a number of you which did pretty well. And according to 
this, if this is accurate, your compensation over that period, 
those last 4 years that we had the investigation, 2000 through 
2003, is $26,306,057; is that accurate?
    Mr. Mudd. Yes, as reported, Senator.
    Senator Hagel. So you did not really have much to win or 
lose, obviously, on any of the fraudulent behavior that was 
going on in the $6.46 memo. Let me ask, did you ever see that 
memo?
    Mr. Mudd. Senator, there is no place for fraud or cheating 
or misuse of rules in any company that I work for. And as I 
stated in the prior question, I did not participate in any of 
that; I was not aware of that; I did not go to any meeting 
where any of that was discussed. I think the attitude is 
inappropriate. I think it is inappropriate in the company. I 
think it is inappropriate for an independent auditor to be 
saying anything at all like that. I reject those comments. We 
have changed it entirely.
    Senator Hagel. Did you see the memo?
    Mr. Mudd. I did not see the memo, and I did not hear the 
speech.
    Senator Hagel. Well, this memo had wide circulation.
    Mr. Mudd. I am sorry; I have seen it since the time. I 
thought you meant in the actual timeframe it was given; I am 
sorry.
    Senator Hagel. No, I am asking in the actual timeframe.
    Mr. Mudd. No, I did not.
    Senator Hagel. You did not see it. You must be one of the 
only senior members who did not see it, because according to 
the OFHEO report, this was given wide circulation, and the 
chief operating officer did not see it.
    Mr. Mudd. Sir, if you are referring to Mr. Rajappa's 
comments about the $6.46----
    Senator Hagel. Yes, sir.
    Mr. Mudd [continuing]. ----my understanding, having read 
through the report, is that that was a speech that he gave to 
his own group of employees, and not being one, I was not 
present there.
    Senator Hagel. Just for the record, Mr. Raines, in that 
period, it was actually a 6-year period, he comes out according 
to the compensation, according to the OFHEO report, over $90 
million; Mr. Howard comes out with $30 million; Jamie Gorelick, 
for a 4-year period, comes out with about $27 million. You are 
right in there at over $26 million. We have Mr. Levin at $26 
million. So there was a rather significant interest, I suspect, 
by senior management to reflect those numbers that Frank stated 
for everyone. And the Board knew nothing about any of this; is 
that correct, Mr. Ashley?
    Mr. Ashley. Did the Board know anything about Mr. 
Rajappa's----
    Senator Hagel. No, no, no. The Board knew nothing about any 
of this $6.46, not necessarily the memo but the target numbers 
that would incentivize management to get all the stock deals, 
the bonuses, the compensation? The Board knew nothing about any 
of that?
    Mr. Ashley. The Board would have received periodic updates 
on earnings throughout the year and forecasted earnings to year 
end as any Board, I would hope, would receive that information.
    Senator Hagel. Thank you.
    Mr. Chairman, I have gone over my time.
    Chairman Shelby. No, you take time, whatever you need.
    Senator Hagel. Thank you. Another point here.
    [Laughter.]
    Senator Hagel. This is a memo as well from independent 
analysis, and it quotes you, Mr. Mudd, and this is a memo that 
evidently, you wrote in 2000. And it says this: we also need to 
continue to focus on our 2003 challenge. We still have a gap of 
nearly $375 million in pre-tax income. I know that the numbers 
in our third quarter forecasts around our big bets are still 
being refined as we iron out the issues and that those revenue 
numbers may well change. It is clear that these new products 
may not be sufficient to get us to our $6.46 goal. And we as a 
company must be looking hard at what it will take to make it. 
Now, this is from OFHEO report, page 78.
    According to the report, you wrote that memo.
    Mr. Mudd. Yes, sir, that is true. All companies that I am 
familiar with in my time have budgets, have targets for 
revenues and expenses, have compensation plans that have 
targets in them. Part of my responsibilities were to manage 
those P&Ls for the businesses that I was running. And I spent 
most of my time doing that. Never at any point would I sanction 
any departure from the rules in order to hit those targets. 
Part of managing a business is to try to attain the results 
that the organization has set out for, and that was my focus, 
Senator.
    Senator Hagel. I see. I find it interesting, because in 
response to the Rajappa memo, you acted like you were not aware 
of this target number, this $6.46.
    Mr. Mudd. No, sir; no, sir, if I conveyed that impression, 
I did not mean it. I was aware of the target number.
    Senator Hagel. But you were not aware of the memo.
    Mr. Mudd. I was not aware of Mr. Rajappa's speech to his 
own group of employees.
    Senator Hagel. All right; well, I think I received what I 
needed.
    Let me ask one last question. I have a number of questions 
for the record that we will submit. Mr. Mudd, in light of all 
of this, I mean, first, are you thinking seriously about giving 
any of this money to charity that you received through all the 
fraudulent misrepresentations? And am astounded that you would 
even stay with this institution. Have you thought about 
resigning?
    Mr. Mudd. Senator, I have thought about an awful lot of 
things. I did not like the old Fannie Mae any more than I 
understand from your emotions and words about this that you 
liked the old Fannie Mae. And I thought about leaving the old 
Fannie Mae a lot of times, and I did not, because I am not a 
quitter. I stayed around. If the standard is now, if you quit, 
you get off scot free, and if you stay around, and you try to 
fix it, you are a bad guy, Senator, I cannot do anything about 
that standard.
    Senator Hagel. What is your compensation now?
    Mr. Mudd. I am focused on getting the problems fixed and 
getting this organization to where it needs to be.
    Senator Hagel. Thank you. What is your compensation now?
    Mr. Mudd. I think the last year, the number was around $8 
million, including salary, bonus, and long-term.
    Senator Hagel. What about this year?
    Mr. Mudd. I do not know what the targets are. I would be 
happy to send----
    Senator Hagel. Well, $8 million is not a bad number. I can 
see why you would also want to stay around for that incentive. 
I mean, that is not altogether something that I suspect is not 
part of your consideration. Mr. Chairman, I appreciate----
    Chairman Shelby. Thank you, Senator.
    Senator Hagel [continuing]. ----the indulgence of the 
Committee, and I will submit some questions for the record. 
Thank you very much.
    Chairman Shelby. Thank you.
    Senator Carper.
    Senator Carper. Mr. Mudd, Mr. Ashley, I would like to try 
to refocus the questioning a little bit if I might.
    One of my disappointments in serving on this Committee in 
the last 5 years was our inability to find common ground to 
develop consensus on how best to regulate GSEs going forward. 
We had a vote here right along party lines. We sent a bill to 
the floor which is not going to see, frankly, in my view, the 
light of day until we can bridge our differences in two 
critical areas. One of those is affordable housing, and second 
is the issue of portfolios, what should be in the portfolio, 
how large should the portfolio be, how quickly can it grow?
    I have observed and had an opportunity to discuss with a 
number of my colleagues on both sides of the aisle here in this 
committee; we have discussed these two issues, with the real 
focus on the affordable housing position. Over in the Federal 
Home Loan Bank, they have an Affordable Housing Program where 
they are required by law to set aside, I think, 10 percent of 
their net income into an affordable housing fund. Those numbers 
go to the States and are divided up, distributed, and mingled 
with State monies, local monies, nonprofit monies, for profit 
housing dollars in order to create affordable housing for the 
residents of probably all 50 States.
    I sensed in recent weeks, maybe last couple of months, a 
growing consensus on this Committee that we should put in the 
final bill that we take up for debate and hopefully pass in the 
Senate this year an affordable housing provision. Senator Reed 
has worked hard on it; I know others have as well.
    Would you take just a minute or two, Mr. Mudd, and talk 
with us to share your counsel and your views on what makes 
sense with respect to an affordable housing provision; maybe 
looking at the Home Loan Bank; is the model a good model or a 
bad one? Looking at the House bill as either a good model or 
bad bill, and tell us in your own view what we should keep in 
mind as we attempt to craft our own provision on the floor.
    Mr. Mudd. I will do my best, Senator.
    I think that the housing goals are an important and an 
intimate part of what we do, and I support them fully. Over the 
years, the administration of the housing goals has been on the 
HUD side, and the safety and soundness administration has been 
on the OFHEO side. So the counsel, I guess, that I would have 
on that is that both pieces of legislation, as I understand 
them, are correct in contemplating a single regulator. I think 
it is important to have a single regulator, because in one 
place, you can balance out the safety and soundness goals with 
the mission goals and see the whole thing of a piece. So I 
think the regulator having a broad view of everything that goes 
on in the enterprise is certainly an important thing.
    The goal structure that we have right now was originally a 
set of goals expressed as a percentage of business. There is 
now a set of subgoals in place that represent a percentage of 
business for purchase money mortgages, really, first-time 
homebuyers, principally. And the idea that has been discussed 
in the course of the legislation is an affordable housing fund.
    I think all those are eminently good ideas, and my only 
encouragement would be that they be considered all of a piece, 
all of a piece together so that all of our activities are 
pointed in the right direction, and it is the direction that 
Congress and the administrative agencies want us to go in.
    Senator Carper. By the way, the Federal Home Loan Banks, as 
I recall, under the law, they have a requirement to set aside 
10 percent of their net income into an affordable housing fund. 
I am not sure what the approach is in the House, but I think it 
is similar to that. In conversations I have had with one of our 
Republican colleagues, we have talked about establishing an 
affordable housing fund, and instead of having some percentage 
of net income, to have a transaction fee that would be related 
to the magnitude of, I guess, the bonds that are underwritten 
and securitized.
    Any comment on which of those may be more appropriate?
    Mr. Mudd. Just a couple of thoughts. As I understand the 
Home Loan Bank program, as it exists, there are no percentage 
of business goals. So that is really their one focus in terms 
of the affordable housing piece of it. So again, if we, per the 
discussion earlier, considered all of those of a piece, I think 
that would be a good idea.
    Second, the Federal Home Loan Banks have in place the 
apparatus, really, to dispense those monies in the form of 
grants. We could do it. We could build out the infrastructure, 
but my encouragement would be that instead of the focus on 
grantmaking, per se, which is not something we do, that it be 
focused on the type of activities that the GSEs are already 
into, which are funding loans and making investments in the 
areas that need it most.
    Senator Carper. All right, one other question, if I may: 
The other critical issue that has divided us, I believe, deals 
with portfolios: what is in a portfolio, how large, how quickly 
can it grow. And I am not sure that all of us have a very good 
understanding of the nature of your portfolios, what is 
included, to what extent the assets in your portfolio help 
support housing authorities, like our State housing authority 
in Delaware or municipal housing authorities and those, frankly 
of other States as well.
    Just take a couple of minutes, if you will; give us a 
primer, just lay out for us the nature of the assets that 
comprise your portfolio, how those assets maybe relate to your 
mission, and any concerns that you might want to share with us 
with regard to limitations that could be imposed on those 
portfolio, maybe that should or should not in your view.
    Mr. Mudd. Yes, sir, it is a great question. I will try to 
start.
    We have two lines of business: a guarantee business, which 
provides guarantees on mortgage-backed securities held by 
others and a portfolio business which are investments on our 
own balance sheet. That portfolio is approximately $722 billion 
as we speak today.
    Contrary to some of the thoughts, there is nothing in that 
portfolio that is not related to housing or finance or 
mortgages but for a small component, I think about 7 percent, 
that is a liquidity fund per an agreement we have with the 
Treasury Department to ensure that we have nonmortgage 
liquidity in the event of some dislocation in the mortgage 
market.
    So within the portfolio, what we hold are 50 percent 
conventional, conforming mortgage-backed securities, the 
principal business that we are in. We hold 35 percent whole 
loans, so there are mortgage loans that, instead of being 
packaged already into a mortgage-backed security, exist each 
unto themselves, and about 14 percent municipal securities, 
sub-prime securities, Alt-A securities, mortgage revenue bonds 
and so forth. And, we have, in addition to that, a Low-Income 
Housing Tax Credit portfolio and a fund investment, a set of 
funds in specific projects in communities all across the United 
States.
    Those are the activities that are really encompassed on the 
balance sheet of Fannie Mae. They are all housing related. As 
some of the Senators have indicated, the portfolio is the first 
business that we were in. That was the business that we were 
first put in business to pursue. And the idea was that that 
portfolio would be used to provide liquidity into the secondary 
market for mortgages, so that there is a steady supply of funds 
into the mortgage market so that in the event of a dislocation, 
a Katrina, a 9/11, or those types of things, there is still a 
steady flow of funds there. That kind of gives some confidence 
to the mortgage market.
    We have this liquidity mission, and we have an 
affordability mission. My own view, Senator, is that those two 
things are pretty intimately linked, and they are pretty 
intimately linked into the overall structure of the mortgage 
market in the United States. And, I would just add a point, 
which is that I do not think it should be an unrestricted 
portfolio, and that is reflected in the sanctions imposed by 
OFHEO in the course of this settlement agreement, in which they 
said you have got some issues; hold the portfolio flat; fix the 
issues, and when we are comfortable with it, you can move 
again.
    Those are normal, bank-like regulatory authorities that 
exist in a lot of institutions. I am not uncomfortable with 
that, but I also do not know what the future might bring. And 
there is a provision in the discussions with OFHEO that if 
there is one of those dislocations, we would obviously 
immediately be in touch with OFHEO to make sure we could 
respond and continue to serve that liquidity mission.
    Senator Carper. Thanks.
    Mr. Chairman, thank you for being generous with this time. 
I just want to say in conclusion, we should be able to work 
this out, and you are----
    Chairman Shelby. You are talking about the legislation now.
    Senator Carper. Yes, yes, and you are as gifted as any 
Chairman I have ever worked with. And you have got willing 
people on this side and I know with my colleagues on the other 
side. We ought to be able to work this out, and these are the 
two critical points. And I would just offer whatever help and 
service that I can be in trying to get us to develop a 
consensus. I want to do that. I would like to see us have a 
strong regulator. We need to regulate these folks, and we can 
certainly do better. And those are the two points that are 
holding us apart. And we have got to be smart enough to figure 
out how to find common ground there. I think we can.
    Chairman Shelby. We are also going to need the help of 
Fannie Mae. Mr. Mudd knows that. And I hope we will get it, but 
we have not gotten it thus far.
    Senator Martinez.
    Senator Martinez. Thank you, Mr. Chairman.
    Mr. Ashley, does the Board currently have a Compensation 
Committee?
    Mr. Ashley. The Board does have a Compensation Committee, 
Senator.
    Senator Martinez. I am astounded that, given the level of 
scrutiny under which this company is today--we can talk about 
the past, but I am talking about today, now, that Mr. Mudd's 
compensation is, as he revealed a moment ago, $8 million last 
year, and I do not even know what it will be this year. But is 
your Compensation Committee comfortable with that level of 
compensation? And are they still derived from the same types of 
schemes as was in the past, the way in which compensation was 
derived?
    Mr. Ashley. I will answer the second part of your question 
first. No. Mr. Mudd and all other executive compensation is not 
derived on the same formulaic basis that it was previously 
where the bonuses were tied singularly to an achievement of an 
EPS target. There are multiple factors currently that go into 
evaluating the bonus levels, which are decided by essentially 
each committee of the Board that has oversight for that 
particular function of the organization, and then, those flow 
into the Compensation Committee for composite review, and 
ultimately, the entire Board is engaged in the discussion. It 
is a fulsome process. It is not tied to EPS; certainly today 
not at all, because we do not have earnings.
    Now, to the first part of your question, Senator, the 
approach that this company, first of all, is chartered, but 
second must undertake is competitive compensation for those 
skill sets that we must have in the company. And those come 
primarily from the financial services sector, so this company 
is competing with the 20 or so major financial services 
companies in the country. So competitiveness is one factor. 
There is a second factor that must be brought in given the 
charter status that this company has and the mission status, 
and that is appropriateness.
    Senator Martinez. How much is the compensation for the CEO 
of Freddie?
    Mr. Ashley. I do not know. We would be glad to supply that 
for you.
    Senator Martinez. I can find it, but you do not know.
    Mr. Ashley. I do not know.
    Senator Martinez. But you believe it to be comparable?
    Mr. Ashley. I actually believe it to be in excess of Mr. 
Mudd's. Those comparabilities were examined by the Comp 
Committee at the beginning of the year when Mr. Mudd's salary 
was established.
    Senator Martinez. What is the Board doing about the 
compensation that was paid in bonuses as a result of what has 
now been acknowledged, and I presume you would agree, was 
through fraudulent accounting practices? Let me clarify that. 
Would you agree that the accounting precisely were fraudulent 
in nature as alleged in the report by OFHEO?
    Mr. Ashley. Senator, that is a very difficult question for 
me to answer, because there are legal proceedings around this. 
I, speaking individually, have a great deal of discomfort with 
what was done. There is a process in place----
    Chairman Shelby. Senator, could you yield just a second?
    Senator Martinez. Yes, sir.
    Chairman Shelby. You have great discomfort, and you entered 
into an agreement to pay a $400 million fine, you, as the 
Chairman of the Board of Fannie Mae and so forth; excuse me, 
but that is troubling to this Senator.
    Mr. Ashley. Senator, I wish I could speak as affirmatively 
as I feel inside.
    Chairman Shelby. OK.
    Mr. Ashley. My lawyers are tugging at my coattails.
    Chairman Shelby. OK, the Senator has the time.
    Senator Martinez. Given that there is obviously a problem 
with the prior compensation and the scheme by which it was 
derived, and whether we would call it fraud, I mean, I can be 
freer; I can understand the constraints under which you may be 
testifying, would it be appropriate for the Board to take 
action to receive or to obtain a payback, a repayment, to ask 
these folks who obtained these very large bonuses for payback 
for the benefit of the investors, to help pay the fine, to 
restore the faith in the company, to restore the trust of the 
public, because it is a Government-Sponsored Enterprise, 
because the mission is to provide housing for the least of our 
people, for all of those reasons?
    Mr. Ashley. I agree with all of those reasons. Let me tell 
you the process that the Board has in place. First of all, 
there is no reward of any form for those who have committed 
fraud. Let us be very clear on that. The Board is working with 
the SEC, with the DOJ, with OFHEO, and there are ongoing 
investigations of the individuals at this point in time, which 
is one of the constraining factors that I am speaking under 
here.
    The Board will be informed by those investigations, and I 
have said several times publicly that every option is available 
to the Board when we are informed by those investigations and 
in consultation with counsel. And that is a process that must 
play out. I would like to be able to sit here today and tell 
you it was concluded and give you finality to it. It is not, 
but it will be.
    Senator Martinez. In terms of your current CEO, Mr. Mudd, 
and his current role and the appropriateness of his current 
role, he was the COO, chief operating officer previously. You 
can say to this Committee that your Board is comfortable that 
this is the best person to lead Fannie Mae at this point in 
history, at that point in time, given the prior participation 
in the company at a time that seemed to have been so troubled 
in management as well as in other activities?
    Mr. Ashley. Senator, I can.
    Senator Martinez. OK, now, Mr. Mudd, and you and I have 
talked a number of times, and I appreciate the candor with 
which you have dealt with me, and I appreciate that greatly. 
And I do not find this comfortable, because I like you.
    One of the things that has come to light is your commentary 
to Mr. Raines in November of 2004, which states in part, and I 
only have part of this memo; I hope it is not out of context: 
the old political reality was that we always win; we took no 
prisoners; and we face little organized political opposition. 
We used to, by virtue of our peculiarity, be able to write or 
have written rules that worked for us. We now operate in a 
world where we will have to be normal.
    That culture, that type of environment, you are the COO, 
you are being compensated, as has been stated, in very 
substantial amounts, including bonuses of about $15 million 
over the period of those several years. And what I would ask is 
a question that often arises in these types of situations: Mr. 
Mudd, what did you know about the practices at the company that 
you were the COO of, and when did you know it?
    Mr. Mudd. Thank you, Senator.
    I indicated in the earlier question, my knowledge of the 
issues, the challenges, the problems, the misdeeds unfolded 
over a period of time, and what I would ask your indulgence to 
do is, because I think it is responsive to your question, is to 
give you the context that might not have existed in that memo. 
Because, in fact, what I was doing then in the prior regime was 
encouraging the company to change.
    Senator Martinez. I will allow you to do that, and I am 
delighted for you to do it.
    Mr. Mudd. Yes, sir.
    Senator Martinez. When you talk in this memo, you are 
talking about we. We always won. We took no prisoners. We faced 
little organized political opposition. We used to, by virtue of 
our peculiarity, be able to write or have written rules that 
worked for us, and we now operate in a world where we will have 
to be normal.
    Mr. Mudd. Yes, sir.
    Senator Martinez. You are including yourself as part of 
that culture. And I understand that perhaps what you were doing 
here is signaling that there needed to be a change, and you 
were a change agent, and in that regard, I compliment you. But 
I also wonder what did you know, and when did you know it? And 
I will be glad to hear your memo, but I would like an answer to 
that question: when did you know of what was happening at 
Fannie Mae that we all today find so troubling?
    Mr. Mudd. Senator, I became aware of the problem in its 
full manifestation the day that you did, the day that the SEC 
announcement was made. I was shocked and stunned by that. I 
understood that there were issues in the culture. I understood 
that there were management issues along the way. I understood 
that we did not quite have all the skills we needed in all the 
areas we needed to to keep up with the increasing cycle of new 
accounting standards that need to be implemented.
    But never, never, never, did I have any indication that 
that would lead to the type of problems that have now come to 
light. And so, my whole focus now is on getting those fixed. I 
was never aware of any misdeed, any intentional misapplication 
of any accounting procedure, any fraud, any cheating; none of 
those activities. My own focus was on getting things done 
right.
    The sentence immediately after the one that you cite in the 
memo was: the new reality--because there are approximately 10 
or 12 paragraphs that are missing between those two lines that 
you have quoted--was the new reality is that 4 years of 
continuous fighting has worn out even our friends. We no longer 
get the benefit of the doubt. The fight has resulted in 
relationships that are worse than they were when we started, 
and the new reality is that legislation can happen without our 
acquiescence. Finally, all this action has supported our idea, 
our brand of affordable homeownership, with a political brand, 
just as feared. We were lightly regulated for a long time. Now, 
we have the SEC, OFHEO, other governmental bodies essentially 
telling us for the areas in their purview how to operate. We 
will have to, and have started to, forge a new constructive 
relationship with OFHEO.
    That is the type of thing that I was writing back in those 
days, Senator. I did not always win.
    Senator Martinez. When was that memo? November of 2004?
    Mr. Mudd. Yes, sir.
    Senator Martinez. OK, I would like to have that memo, Mr. 
Chairman, attached as part of the record. I think it would be 
helpful for us to have the entirety of that.
    Chairman Shelby. Will you furnish a copy of that for the 
record?
    Mr. Mudd. Yes, I will, sir.
    Chairman Shelby. That will be made part of the hearing 
record without objection.
    Senator Martinez. So what you are saying, basically, is 
that when you wrote that memo, was that prior to the SEC 
report?
    Mr. Mudd. Yes, it was.
    Senator Martinez. So at that point, at some point prior to 
the SEC report, you had knowledge that all was not well at 
Disneyland, right?
    Mr. Mudd. I had knowledge that we were not--that we did not 
have the culture that we needed; we did not have the financial 
skills that we needed; and we needed to get them in place 
quickly, remembering that----
    Senator Martinez. That is prior to the SEC report.
    Mr. Mudd. Yes, sir, that was.
    Senator Martinez. Let me ask you this: did you know, or did 
it occur to you that--you were the COO--that the Audit 
Department was concerned with their own compensation, with EPS 
as an obvious conflict of interest? I mean, would it not be a 
little troubling to suggest that the Auditing Department's 
compensation to the members of the Auditing Department was 
going to be dependent on the EPS of the company, and what could 
an Audit Department do to impact the EPS other than cook the 
books?
    Mr. Mudd. Senator, that is deeply troubling to me. I do not 
think that is the way an audit staff should be compensated or 
focused, and I have changed that since I took this job. The 
audit team is----
    Senator Martinez. Did you know about that before then? When 
you were the chief operating officer, did you know that the 
Auditing Department's compensation was derived from the EPS?
    Mr. Mudd. Senator, the compensation of the entire company 
at that time was derived in some measure off of the ultimate 
financial results of the company.
    Senator Martinez. So you were, as COO, aware that your 
Audit Department's compensation depended on the EPS of the 
company.
    Mr. Mudd. Yes, that is true. And that was also the 
understanding that I had in other prior companies that I had 
worked for.
    Senator Martinez. The Audit Department is special, is it 
not?
    Mr. Mudd. Yes, it is.
    Senator Martinez. Is it not the arbiter, is that not the 
one that sets the books is the one that the investors rely 
upon? I mean, you are a publicly traded company.
    Mr. Mudd. It is a very important function. It is a very 
important check. It is very important for it to be independent 
and report directly to the Board, as it does now. It is very 
important that all of its compensation, any of its compensation 
really be aligned toward telling the truth, not toward being 
aligned with the result of the company.
    Senator Martinez. But you knew of it then, and you did not 
do anything to seek to change that at that time.
    Mr. Mudd. I knew that their compensation was aligned with 
the rest of the company.
    Senator Martinez. Which depended on the EPS.
    Mr. Mudd. Ultimately, it did depend on the results of the 
company, and those results were expressed in EPS, yes, sir.
    Senator Martinez. As a member of the Board, sir, did you 
know that?
    Mr. Ashley. Senator, the fact that all employees of Fannie 
Mae shared in one way or another in an EPS target was known to 
the Board. I would point out that during the 1990s and the 
early part of the decade of 2000 that this was an accepted and 
indeed promulgated form of compensation, in addition to base 
compensation, that most of corporate America, publicly owned 
corporate America, engaged in in one form or another. The 
purpose was to align the management of the company with the 
interests of the shareholders. Fannie Mae----
    Senator Martinez. The Audit Department is not part of 
management.
    Mr. Ashley. No, I quite agree.
    Senator Martinez. That goes well below management, does it 
not?
    Mr. Ashley. I quite agree with your point on this.
    Senator Martinez. My question is: did the Board know that 
at the time, and were there any bells that went off? Did you 
have any concerns about the obvious conflict of interest?
    Mr. Ashley. I do not recall any discussion in the Board 
about the Audit Committee compensation. It may have taken place 
in the Audit Committee, per se, which would have been the 
proper venue for it.
    Senator Martinez. Let me just ask one last question, Mr. 
Chairman.
    Chairman Shelby. You go ahead. It is important.
    Senator Martinez. Mr. Mudd, as we go forward, we have a 
bill pending. Three years ago, some of us were working, I as 
the HUD Secretary and others of this Committee to get a bill 
done. You and I have discussed before the fact that your 
predecessor, Mr. Raines, told me that he would be favorable to 
that bill. He then proceeded to scuttle it, to come over here 
and lobby against it and send the very vast array of lobbyists 
at the disposal of Fannie Mae to do just that. Do you employ as 
many lobbyists today as you did then? Friendly question; I know 
the answer.
    Mr. Mudd. I am sorry?
    Senator Martinez. Is that a friendly question? I know the 
answer.
    Mr. Mudd. The answer would be no, we do not, sir.
    Senator Martinez. You have told me that you want a 
regulatory bill that would help your company; I believe it 
would help your share price to have a good, strong regulator in 
place as soon as possible; is that correct?
    Mr. Mudd. Yes, sir, I agree with you on that.
    Senator Martinez. Why can we not get complete support for 
our bill, including portfolio limits? I mean, should your 
portfolio limitations--be obvious that you need them, that you 
must have them, that the risk is too great, that the taxpayers 
bear that risk? Can we not persuade you to support the bill 
currently on the floor so that we can move forward, give you a 
strong regulator, fulfill the promise that Raines made to me 
some time ago that he did not fulfill but that I believe is so 
apparent a need of this company to have a strong regulator in 
place, even if you have to swallow hard about the portfolio 
limits? Because maybe the times are such that you have just got 
to operate differently. Maybe there is a new normal. Maybe you 
cannot make your own rules. Maybe you cannot set your own 
standards. Maybe you cannot continue to operate with a weak 
regulator. Maybe this needs to be part of the new culture and 
go ahead and endorse this bill and not continue to fight the 
portfolio limits aspect of this bill, because you still do have 
friends.
    Mr. Mudd. Senator, thank you for the question and the 
sentiments.
    I would like there to be a bill. As far as I know, the 
discussions have not included a change in our mission, and as I 
understand it and as I interpret it, our charter is still for 
us to provide liquidity in the secondary market for mortgages.
    There are other companies I am sure that the Committee is 
familiar with that have many different divisions and many 
different operations. We only have two lines of business: our 
guarantee business and our portfolio. And, my own perspective, 
as much as I enjoy being here today, I have no vote in the 
process, my own perspective is that it is very important to 
understand that those two businesses operate together in order 
for us to perform our mission.
    And if, through the legislative process, Congress still 
wants us to accomplish the same mission, I have got those two 
tools to do it, and I think it would be much more difficult for 
me to represent to you that I could do that if I had fewer 
tools to accomplish it, sir.
    Senator Martinez. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Hagel, but then, I have got a few 
questions after you.
    Senator Hagel. Thank you. I just have a couple of follow-up 
questions to Senator Martinez's line of questioning on lobbying 
expenses. If I understood that exchange, Mr. Mudd, in your 
answer to Senator Martinez as to less lobbyists employed today, 
is that what you said? What did you say?
    Mr. Mudd. Do you want me to elaborate?
    Senator Hagel. I do not want you to elaborate. Say again 
what you said to Senator Martinez.
    Senator Martinez. I believe he said they had fewer 
lobbyists.
    Senator Hagel. Is that what you said?
    Mr. Mudd. Yes, sir.
    Senator Hagel. Well, I have before me information that 
says, in fact, your lobbying expenses have increased every 
year. Is that not right or----
    Mr. Mudd. Senator, having looked at this, the way that the 
formula works----
    Senator Hagel. What formula?
    Mr. Mudd. There is a formula under which we report our 
lobbying expenses to Congress and so forth. And what we have 
done is stopped using outside lobbyists, by and large, to carry 
any water for us but rather to, in order to pursue the type of 
constructive engagement on this that I think is most 
appropriate, have folks in the company who are in management, 
who are familiar with these issues, visit with Members of 
Congress or with others in order to explain the very types of 
questions we are talking about today.
    As I understand the way that the formulation works, the 
amount of time, for example, that anyone would spend doing that 
is divided across your base of expenses, and that becomes 
effectively attributable lobbying expense. We are spending less 
on outsiders carrying any water for us. We are having more 
folks come up and explain where we are. But that results in the 
number being larger than it would be otherwise.
    Senator Hagel. But that does not exactly square with your 
answer to Senator Martinez. According to that formula or 
whatever formula you use, and I would like for the record to 
show, and you can get more information on that, as to who is 
lobbying from your organization and how you are compensating 
them and how much money, regardless of the formula, then, what 
you are telling me is that there is more lobbying going on. Or 
you are paying your people inside more than you were paying 
outside people.
    Mr. Mudd. No, sir.
    Senator Hagel. Why is the number up? Regardless of the 
formula----
    Mr. Mudd. It is expressed as a percentage of our expenses.
    Senator Hagel. I am not talking about percentages. I am 
talking about raw numbers. 2005 is what I have before me right 
now: $10,080,000; 2004, $8,790,000; 2003, $8,700,000; 2002, 
$7,500,000. These are dollar numbers; not percentage numbers, 
they are dollar numbers. So again, explain to me your answer to 
Senator Martinez. You are spending more on lobbying according 
to the reports.
    Mr. Mudd. Those numbers, Senator, are expressed as a 
percentage of time spent against the total expense for 
lobbying. Therefore, because our expenses have gone up due to 
the restatement and due to other reasons, the factor against 
which we are multiplying it to produce that has gone up. The 
amount of time, the number of firms that are involved in this--
--
    Senator Hagel. That does not make any sense.
    Chairman Shelby. That is not the question he is asking you.
    Senator Hagel. That is not the question I am asking anyway.
    Senator Martinez. How much are you paying for lobbyists? 
Are you paying more money out for lobbyists? Do you have more 
lobbyists? Do you have fewer lobbyists?
    Senator Hagel. Obviously, he is paying more.
    Senator Martinez. That is part of the culture that we are 
talking about fixing that your memo--you know, we need to have 
confidence that this is in fact changing.
    Mr. Mudd. In terms of the number of individuals inside the 
company that are working on that, fewer. In terms of the number 
of outside firms that are working on that, fewer. In terms of 
the number of management individuals that have spent time on 
the Hill talking about these issues, explaining these issues, 
those are counted in the equation, Senator. That is all.
    Senator Hagel. Go ahead.
    Senator Martinez. So you come to the Hill to meet with a 
Member of Congress.
    Mr. Mudd. Yes, sir.
    Senator Martinez. Somehow or other, your time allocation to 
that is made as part of your lobbying expenses.
    Mr. Mudd. Yes, sir. That is my understanding.
    Senator Hagel. I would like to see those numbers, and I 
would like to see those records and how you keep those records, 
if you will provide all that for these years, these last 4 
years for the Committee, and how much out of your salary--your 
compensation last year was $8 million, you said; is that right? 
$8 million was what your compensation was last year? Total 
compensation.
    Mr. Mudd. I can get you the exact numbers in terms of 
reporting.
    Senator Hagel. Well, you used the term $8 million a few 
minutes ago.
    Senator Martinez. W-2.
    Senator Hagel. Well, then, I would like to see how much of 
that $8 million is allocated to lobbying for you, and I would 
like to see that breakdown, as you have just said that you have 
fewer lobbyists, outside lobbyists, more internal people doing 
the work.
    Now, let me ask both of you a question, since you seem not 
to have good memories on these things. In April of 2004, Fannie 
ran a very significant series of television ads attacking GSE 
reform the week before a Senate Banking Committee markup on GSE 
reform. Now, obviously, each of you were at Fannie in 2004; 
each of you were there in fairly responsible positions. You 
just happened to see the ads? Did you know about the ads? How 
did the lobbying work? You were chief operating officer, Mr. 
Mudd. What did you know about ads, how much money they were 
spending, and the content of the ad?
    I remember at the hearing, as Chairman Shelby, I suspect, 
recalls, I was astounded that a GSE, a Government-Sponsored 
Enterprise, was running television ads against the oversight 
Committee that chartered it, the Congress. I was astounded by 
that. Now, what did you know about that?
    Mr. Mudd. I had a general awareness that those ads were 
running, Senator, and when this came on my watch, we have 
essentially stopped any advertising like that, because I agree 
with you.
    Chairman Shelby. So this was advertising, you call it, not 
lobbying.
    Senator Hagel. Yes.
    Chairman Shelby. Although, the end result is lobbying. Is 
that how you attribute it in your accounting? Was it attributed 
to advertising by Fannie Mae rather than lobbying?
    Mr. Mudd. I am sorry, Senator, I was just trying to respond 
to Senator Hagel's question.
    Chairman Shelby. Well let me ask you, if Senator Hagel will 
permit me.
    Senator Hagel. Yes, Mr. Chairman.
    Chairman Shelby. All these TV ads that you were running 
that he is referring to, did you deem that advertising rather 
than part of your lobbying shop, although the end result, it 
was lobbying against our legislation?
    Mr. Mudd. I can go back and look at----
    Chairman Shelby. We would be interested in that.
    Mr. Mudd [continuing]. ----what the reporting was at that 
time to understand it. It was up through a different division, 
so I was not familiar with it at the time.
    Chairman Shelby. It is a lot of money, though.
    Mr. Mudd. But I would be happy to provide for the Senators 
how that was characterized.
    Chairman Shelby. If you would do that for the record along 
with the others.
    Thank you, Senator Hagel.
    Senator Hagel. Yes, Mr. Chairman, thank you.
    Did the Board have any idea of what was going on? Or the 
overall numbers, since you have been on the Board, for example, 
Mr. Ashley, the numbers I have, Fannie has spent a lot of money 
on lobbying. Did the Board know anything about expenditures? I 
mean, we are getting into tens of millions of dollars is where 
we have been since 1998, about $61 million, according to the 
report spent on lobbying. Did the Board know about this?
    Mr. Ashley. The details of the lobbying expenses were not 
known to the Board, Senator.
    Senator Hagel. Not even the numbers? You had no idea that 
$60 million was being spent over that period of time?
    Mr. Ashley. I was unaware of these numbers until I became 
nonexecutive chair.
    Senator Hagel. Do you think the Audit Committee of the 
Board knew anything about it?
    Mr. Ashley. If they did, I am not aware, Senator. I do not 
recall this ever being reported out as a numerical number to 
the Board.
    Senator Hagel. I will have additional questions for the 
record. Thank you.
    Chairman Shelby. Mr. Ashley, you were a member of the Board 
of Directors of Fannie Mae from 1995; is that correct?
    Mr. Ashley. That is correct, Mr. Chairman.
    Chairman Shelby. And you are still a member, and you are 
Chairman of the Board now.
    Mr. Ashley. That is correct, Mr. Chairman.
    Chairman Shelby. There is no break in that service for 11 
years?
    Mr. Ashley. There is not, Mr. Chairman.
    Chairman Shelby. Did you have an Audit Committee at Fannie 
Mae?
    Mr. Ashley. Yes, sir.
    Chairman Shelby. On the Board of Directors, an Audit 
Committee?
    Mr. Ashley. That is right, sir.
    Chairman Shelby. Were you ever on that Audit Committee?
    Mr. Ashley. I was on that Audit Committee for a very brief 
time----
    Chairman Shelby. When was this?
    Mr. Ashley [continuing]. ----at the end of 2004, for about 
2 months at the end of 2004.
    Chairman Shelby. Oh, that is interesting. You were there 
for 2 months. Were you chairman of the Auditing Committee?
    Mr. Ashley. No, sir, I was never chairman.
    Chairman Shelby. Who was chairman of the Audit Committee?
    Mr. Ashley. At that time, Mr. Gerrity was chairman of the 
Audit Committee.
    Chairman Shelby. And who was the Chairman before that time?
    Mr. Ashley. I would have to verify this. I believe it was 
Mr. Mai.
    Chairman Shelby. Mister who?
    Mr. Ashley. Mai, M-A-I.
    Chairman Shelby. OK, how many members of the Board of 
Directors of Fannie Mae were on the Audit Committee of the 
Board of Directors?
    Mr. Ashley. It would have varied over that time; anywhere, 
usually, from three to perhaps four or five members.
    Chairman Shelby. Did you ever interact with these members 
before you went on as a member of the----
    Mr. Ashley. The chair of the Audit Committee reported 
regularly at each Board meeting following an Audit Committee 
meeting or an audit call.
    Chairman Shelby. Did you ever ask questions of the Audit 
Committee as a member of the Board of Directors?
    Mr. Ashley. There were regular interchanges between all 
members of the Board and in response to the report of the Audit 
Committee chair to the Board.
    Chairman Shelby. Were there any questions asked about 
questionable accounting practiced during that time?
    Mr. Ashley. Yes, sir; as the Freddie Mac issues became 
known, this was clearly a matter of discussion within the 
Board, and the Audit Committee chair was asked and reported on 
what KPMG had indicated to the Audit Committee.
    Chairman Shelby. Was Mr. Raines part of the Audit Committee 
when he was Chairman of the Board?
    Mr. Ashley. Mr. Raines would not have been a member of the 
Audit Committee as a member of management.
    Chairman Shelby. Was Mr. Mudd ever a part of the Audit 
Committee?
    Mr. Ashley. The same answer, Senator.
    Chairman Shelby. OK, all of that is troubling to me.
    Senator Carper.
    Senator Carper. Thanks, Mr. Chairman.
    As we wind up here, I want to come back and focus on a path 
forward and focus a bit less on the sins of Fannie Mae and 
those who ran this enterprise in recent years. I have asked 
Fannie Mae to provide certain information to my office that we 
think will be helpful in crafting a legislative language with 
respect to portfolio limits.
    Mr. Chairman, I will just say in my own State, I used to be 
Governor there, as you know, and made housing, especially 
homeownership, a big priority. And one of the things that I 
want to make sure that we do going forward is we address 
portfolio limits and what can go into a portfolio. I want to 
make sure that we do not somehow disadvantage our own housing 
authorities, whether they are State housing authorities or 
local municipal housing authorities in their ability to meet 
their missions of providing affordable housing.
    I have said to Fannie Mae, it would be interesting to know 
how the assets in Fannie Mae's portfolios relate to the 
affordable housing missions of our housing authorities. I have 
asked for that information. They provided it for my State, and 
they are beginning to provide it for the other States.
    I suspect I am not the only Member of this Committee that 
has asked Fannie Mae to provide information that might be 
helpful in enabling us to craft compromises in these two major 
areas: portfolios and affordable housing fund. Can you give us 
an example of any other requests for information that you have 
received, that you are mindful of from any of us, that you have 
provided a response for or maybe that you have not?
    Mr. Mudd. Senator, as far as I know, we are relatively up 
to date on any requests for information from Congress. There 
has been, I think appropriately, an interest both in the 
activities of the company as they relate broadly to providing 
mortgage financing in each of the States as well as with 
respect to specific investment projects on a community by 
community basis. Any of that information that the Senators 
would like to see that is relevant to their States, we will 
provide.
    Others have requested information in terms of our financial 
position and our capital related to the $39 billion in capital 
that we have related to the ongoing progress that we are making 
on the completion of the restatement related to how 
increasingly firm our understanding of how we are going to get 
that work done and when it is going to be done.
    And for those and any other requests, we would be 
delighted, because my general view has been that the more 
information we can provide in terms of what we actually do, 
provided that we are doing it appropriately with the right set 
of controls and the right safety and soundness approach, the 
more we will be in the right space in terms of both our 
business and our mission.
    Senator Carper. In my time here in the Senate, from time to 
time, I have colleagues who say to me work with me on a 
particular issue. And what they really mean is accept my 
proposal. And I heard my friend Senator Martinez essentially 
say well, why do you not just embrace the language in the 
Senate Banking Committee bill as it pertains to portfolio 
limits?
    And, you know, if this were a House Banking Committee, and 
the Chairman here and I used to serve on the House Banking 
Committee, my suspicion is that the House Banking Committee, if 
you were sitting before them, might say, well, why do you not 
just embrace our proposals with respect to portfolio limits and 
frankly with an affordable housing fund? And I do not know that 
it is appropriate for you to embrace either of these proposals.
    Our responsibility, in my judgment, is to use you as a 
resource, to use the lessons that you have learned and we have 
learned through the misbehavior of those that you have worked 
with and to figure out what is the right thing to do going 
forward.
    You can provide a great service for us in helping to 
address, I think, particularly these two issues. I do not think 
it is appropriate for us to say you should embrace either the 
language that is in our bill or, frankly, the language that is 
in the House bill but to give us the best advice and counsel 
from what you have learned and some hard lessons and to enable 
us to craft a better course going forward.
    And I would close, Mr. Chairman, simply by stating what I 
have stated before: we ought to be able to work this out. The 
taxpayers of this country expect that from us. The folks who 
depend on these folks at Fannie Mae and Freddie Mac doing their 
job, they are depending on us as well. And I pledge to work 
with you to help us find that common ground.
    Chairman Shelby. Mr. Mudd, you said you were going to work 
with us. I assume Mr. Ashley as the Chairman is going to, too, 
but that will be soon tested in the next several weeks. You 
talked about this as a new Fannie Mae. We are going to see, 
because if you want to help us bring forth a substantive, 
meaningful bill, you are going to have that chance. We will 
have to wait and see.
    Thank you for your testimony. The Committee is adjourned.
    [Whereupon, at 3:02 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
            PREPARED STATEMENT OF CHAIRMAN RICHARD C. SHELBY

        Letter Received from Kevin M. Downey to Chairman Shelby


                                 ______
                                 
              PREPARED STATEMENT OF SENATOR ELIZABETH DOLE
    I want to thank you, Chairman Shelby, for holding today's hearing 
regarding the OFHEO Report of the Special Examination of Fannie Mae. 
This report not only confirms my deep concerns about Fannie Mae--it 
demonstrates that the GSE's actions were far worse than I could have 
imagined.
    Nearly 3 years ago, as we've heard, after it was revealed that 
Freddie Mac had misstated its earnings, Senators Hagel, Sununu and I 
introduced legislation to strengthen the regulation of the GSE's. And 
Fannie and Freddie responded, dispatching an army of lobbyists to 
Capitol Hill and spending tens of millions of dollars to oppose our 
bill. In 2004, their lobbying tab totaled $26 million--and just last 
year, more than $24 million. At times it has truly felt like David and 
Goliath! No one has better described Fannie's mindset than the current 
CEO, who in an internal memorandum of November 2004 asserted, and I 
quote: ``the old political reality was that we always won, we took no 
prisoners, and we faced little organized political opposition.'' End of 
quote. Even today, after all that we now know about Fannie and Freddie, 
the GSEs' influence on the Hill remains strong. But we in Congress must 
stand up to any political influence the GSEs continue to wield. The 
facts speak for themselves: On May 23 the Securities and Exchange 
Commission concluded that, and I quote, ``between 1998 and 2004, Fannie 
Mae engaged in a financial fraud involving multiple violations of 
Generally Accepted Accounting Principles in connection with the 
preparation of its annual and quarterly financial statements.'' The SEC 
went on to explain that, ``these violations had the effect, among other 
things, of falsely portraying stable earnings growth and reduced income 
statement volatility, and--for [the] year-ended 1998--of maximizing 
bonuses and achieving forecasted earnings'' end of quote. Some had 
earlier claimed that Fannie and Freddie's problems were an 
understandable misapplication of complicated, obscure accounting rules. 
We now know that this was not the case--that in fact Fannie and Freddie 
were committing fraud . . . for many years . . . in part driven by 
certain executives' personal greed. There can no longer be any doubt 
about what we must do here in Congress--Fannie Mae and Freddie Mac need 
strong regulation, to ensure that fraud and manipulation in their 
accounting practices have been forever banished from these 
institutions. This report represents a clarion call . . . for the swift 
consideration and passage of legislation to create a new, independent 
regulator of these enterprises. This new regulator should have the 
authority to limit the sizable portfolios of both Fannie and Freddie, 
thereby redirecting the GSEs to their original mission and preventing 
them from engaging in activities that could undermine their safety and 
soundness, or place them in systemic risk
    I thank both OFHEO and the SEC for their tenacious and diligent 
work on this issue. Director Lockhart, your report provides a detailed 
and complete expose, not only of the many complex transactions that 
underlay the problems at Fannie Mae, but also of the broader culture of 
venality that developed at the GSEs. I thank you and the other 
witnesses for joining us here today.
                                 ______
                                 
              PREPARED STATEMENT OF JAMES B. LOCKHART III
                            Acting Director,
             Office of Federal Housing Enterprise Oversight
                             June 15, 2006
    Good morning. Chairman Shelby, Ranking Member Sarbanes and members 
of the Committee, thank you for the opportunity to discuss the findings 
of our Special Examination of the Federal National Mortgage 
Association, better known as Fannie Mae. I will also discuss the 
settlement agreements reached by the OFHEO and the Securities and 
Exchange Commission (SEC) with Fannie Mae. My testimony reflects my 
views and not necessarily those of the President or the Secretary of 
Housing and Urban Development.
    It is a pleasure to be here with Chairman Christopher Cox as the 
investigation and settlement agreements are excellent examples of 
government agencies working together. Before turning to a detailed 
discussion of the Special Examination and settlement, I would also note 
that later today OFHEO will submit its 2006 Report to Congress on the 
Examinations for both Enterprises pursuant to its statutory mandate.
    As a Government Sponsored Enterprise (GSE), Fannie Mae has a 
special position among American corporations and an extremely important 
mission--facilitating the growth of affordable housing in the United 
States. Despite its recent downsizing, Fannie Mae remains one of the 
largest financial institutions in the United States. As a GSE, Fannie 
Mae has a special mandate and position of public trust. The previous 
management team, led by Chairman and Chief Executive Officer (CEO) 
Franklin Raines, violated that trust. By encouraging rapid growth, 
unconstrained by proper internal controls, risk management and other 
systems, they did serious harm to Fannie Mae while enriching themselves 
through earnings manipulation.
    Let me provide a brief history about OFHEO's Special Examination. 
Despite Fannie Mae's protests, in July 2003, OFHEO informed this 
committee that it intended to conduct a special accounting review of 
Fannie Mae to evaluate whether it complied with Generally Accepted 
Accounting Principles or GAAP.
    In September 2004, OFHEO issued an interim report that detailed 
serious problems relating to Fannie Mae's accounting. Importantly, 
OFHEO found that Fannie Mae did not comply with GAAP for FAS 91, which 
deals with amortization of loan fees, premiums and discounts, and FAS 
133, which covers derivatives and hedge accounting. The SEC concurred 
with OFHEO's findings and ordered Fannie Mae to restate its financial 
statements filed with the Commission.
    Since then, OFHEO and the Board of Directors of Fannie Mae have 
entered into three agreements requiring remedial steps. The last 
agreement was signed on May 23, 2006.
    The OFHEO report details an arrogant and unethical corporate 
culture. Perhaps the best written record of this culture is a memo from 
the Chief Operating Officer to the CEO 2 months after OFHEO's interim 
report. He was discussing the need to change and wrote: ``The old 
political reality was that we always won, we took no prisoners . . . '' 
and he added, ``we used to . . . be able to write, or have written 
rules that worked for us.''
    Fannie Mae's management directed employees to manipulate accounting 
and earnings to trigger maximum bonuses for senior executives from 1998 
to 2003. The image of Fannie Mae as one of the lowest-risk and ``best 
in class'' institutions was a facade. The examination found an 
environment where the ends justified the means
    Senior Fannie Mae executives were precisely managing earnings per 
share (EPS) to the one-hundredth of a penny to maximize their bonuses 
while neglecting investments in systems, internal controls, and risk 
management. The combination of earnings manipulation, mismanagement, 
and unconstrained growth resulted in an estimated $10.6 billion of 
overstated profits, well over a billion dollars in expenses to fix the 
problems, and ill-gotten bonuses in the hundreds of millions of 
dollars. Senior executives were flat-out wrong, or, to use the proper 
regulatory phrase, were managing Fannie Mae in an ``unsafe and 
unsound'' manner. Senior management manipulated accounting; reaped 
maximum, undeserved bonuses; and prevented the rest of the world from 
knowing about it. They co-opted their internal auditors and other 
managers. They stonewalled OFHEO.
    The Board of Directors, the last line of defense, failed to be 
sufficiently informed and independent. Their oversight failings meant 
that they did not discover, let alone correct, the unsafe and unsound 
practices at Fannie Mae, even after the Freddie Mac problems became 
apparent.
Management Manipulated Earnings
    During the period covered by our report, Fannie Mae reported 
extremely smooth profit growth and hit EPS targets with uncanny 
precision each quarter. By deliberately and intentionally manipulating 
accounting, senior management maximized their bonuses and other 
compensation, which came at the expense of shareholders. In 1998, 
management should have recognized significant losses from the 
amortization of premiums and the impairment of guaranty-fee buy-ups, 
but much of the actual loss was deferred so that management could meet 
bonus targets, as well as the expectations of analysts. In other years, 
such as 2001, when very low short-term rates resulted in higher-than-
forecasted earnings, management engaged in various manipulations, 
including debt repurchases and structured transactions with no 
legitimate business purpose, to save earnings for a rainy day. For 
example, the total compensation of former Chairman and CEO Frank Raines 
exceeded $90 million from 1998 through 2003. Of that amount, more than 
$52 million was directly tied to achieving EPS targets.
    Senior executives at Fannie Mae consistently reminded managers and 
other employees of their personal stake in meeting EPS targets. Indeed, 
the head of the Office of Auditing told his staff, in reference to 
Chairman Raines' goal of doubling earnings per share from $3.23 to 
$6.46 by 2003, that they must have ``$6.46 branded in their brains.'' 
That statement implies a blatant conflict of interest for an internal 
auditor.
    Now, I want to spend a few minutes briefly describing the 
accounting tools that management used to achieve their desired earnings 
targets and the control environment--or lack thereof.
Specific Accounting and Earnings Management Issues
    In brief, the extreme predictability of the financial results 
reported by Fannie Mae from 1998 through 2003, and the ability to hit 
EPS targets precisely each quarter, were illusions deliberately and 
systematically created by management. The real question is how was 
management able to accomplish this when their business is volatile by 
nature and accounting was moving toward measuring and reporting assets 
and liabilities at fair value.
    First, they had to assure that large unpredictable changes in fair 
value were not recognized. FAS 115, Accounting for Certain Investment 
in Debt and Equity Securities and FAS 133, Accounting for Derivative 
Instruments and Hedging Activities are examples of accounting 
standards, if implemented properly, that would have recognized and 
recorded earnings volatility. Faced with that outcome, Fannie Mae chose 
to implement these and other accounting standards in a fashion that 
reduced volatility while ignoring the fact that these practices did not 
comport with GAAP.
    During this same period, Fannie Mae management went to 
extraordinary lengths to avoid recording GAAP-required impairment 
losses on assets whose values had declined. Examples of such assets are 
manufactured-housing and aircraft-lease-backed securities, interest-
only securities, and ``buy-ups.'' Not only did they not record these 
losses but the report details the extraordinary measures management 
took to keep this information off the books and out of the view of 
their external auditor and regulatory bodies.
    By utilizing the above strategies, management was able to keep 
earnings within a predictable range, placing management in a position 
to employ several techniques to manipulate and manage earnings more 
directly, including the use of cookie-jar reserves, income shifting 
transactions and inappropriate debt repurchases.
    The natural question at this juncture is where were the internal 
controls that should have prevented this type of behavior and where 
were the internal and external auditors? The report details the 
conscious decision made by management to use existing systems even when 
proper implementation of new accounting pronouncements and rapid growth 
necessitated the need for new systems. It also discusses the weak 
internal control environment that management created or allowed to 
exist. In fact, this underinvestment in internal controls, accounting 
systems, risk management, and staff helped them to manage earnings as 
it made it much easier to hide improper actions that smoothed earnings.
    The report also discusses the serious failures in the Office of 
Auditing. Internal Audit failed to properly confirm compliance with 
GAAP as specified in its audit objectives or to consistently audit 
critical accounting policies, practices, and estimates in a timely way. 
When Internal Audit did find shortcomings they were not adequately 
addressed or communicated. Internal Audit failed to perform its primary 
task and issued misleading reports about its work. Finally, it failed 
to exercise due professional care in investigating allegations of 
accounting improprieties raised by two employees in the Office of the 
Controller.
    Similarly, external audits performed by KPMG failed to include an 
adequate review of Fannie Mae's significant accounting policies for 
GAAP compliance. KPMG was aware of the non-GAAP provisions of Fannie 
Mae's FAS 91 policy as well as the non-GAAP practices the Enterprise 
was using in the application of FAS 133. That notwithstanding, KPMG 
issued unqualified opinions on Fannie Mae's financial statements for 
the years in question when these statements included significant 
departures from GAAP. Last, the external auditor performed a cursory 
review, at best, of the allegations of fraud raised by Roger Barnes. 
The procedures performed by the external auditor were not sufficient to 
make a determination regarding the propriety of the internal 
investigation performed by Fannie Mae or to evaluate the Enterprise's 
conclusions regarding Mr. Barnes' assertions.
The Role of the Board
    The Board-approved executive compensation program at Fannie Mae 
sent senior executives the message to focus on increasing earnings 
rather than controlling risk. Indeed, during much of the period covered 
by the report, Fannie Mae took significant amounts of interest rate 
risk and, when interest rates fell in 2002, incurred billions of 
dollars in economic losses, despite the smooth reported earnings. 
Fannie Mae also had significant operational risk exposures.
    The report also provides some insight on matters of corporate 
governance that gave rise to many of these problems. For example, the 
Special Examination found that the Board of Directors of Fannie Mae 
contributed to the Enterprise's problems by failing to be sufficiently 
informed and failing to act independently of its chairman, Frank 
Raines, and other senior executives. The Board failed to exercise the 
requisite oversight over the Enterprise's operations, and failed to 
discover or ensure the correction of a wide variety of unsafe and 
unsound practices. These failures occurred even after serious 
accounting and earnings management problems at Freddie Mac became 
widely known.
    In particular, the Audit Committee did not provide adequate 
oversight of the internal audit function, and did not monitor the 
development and implementation of critical accounting policies. These 
failures resulted from the Committee's own neglecting to develop the 
specialized financial knowledge necessary for its oversight 
responsibilities. The Audit Committee also failed to initiate an 
independent investigation of Roger Barnes' whistleblower claims of 
accounting irregularities when they arose.
    The failure of the Audit Committee was compounded by failures of 
the Compensation Committee. The primary role of this committee is to 
ensure that senior management is properly compensated for its role in 
directing the affairs of the Enterprise. Nevertheless, the Compensation 
Committee approved a compensation structure based on a single measure 
that was easily manipulated by management. The Compensation Committee 
also did not monitor the executive compensation system for signs of 
abuse by senior management.
Recommendations
    Based on the report's findings, staff made specific recommendations 
to me, as Acting Director, to enhance the safety and soundness of 
Fannie Mae. I have accepted all of the recommendations. Several of them 
were directed to OFHEO, including:

    OFHEO needs to continue to strengthen and expand its 
        regulatory infrastructure and regular examination programs.
    Matters identified for remediation by Fannie Mae should be 
        considered for Freddie Mac.
    OFHEO should continue to support legislation to provide the 
        powers essential to meeting its mission of assuring safe and 
        sound operations at Fannie Mae and Freddie Mac.

    However, the majority of these recommendations are directed at 
Fannie Mae and I am pleased to say they have all been incorporated into 
the agreement that was signed on May 23, 2006.
Settlement
    OFHEO reached a settlement with Fannie Mae to address the various 
problems found in the course of the Special Examination. The settlement 
represents a step toward correcting a dangerous course that had been 
followed by one of the largest financial institutions in the United 
States. Unprincipled corporate behavior and inadequate controls simply 
will not be tolerated. The settlement addresses both specific 
misconduct and weaknesses as well as the overall culture that permitted 
such misconduct and mismanagement to occur.
    I am pleased that the settlement reached by OFHEO could be 
concluded at the time the Report of the Special Examination was 
released and in close consultation and cooperation with the SEC. 
Chairman Cox said at the OFHEO press conference, ``Fraudulent financial 
reporting directly undermines the fairness of our capital markets, and 
the very purpose of those markets to allocate capital to its best 
uses.''
    The key components of the agreement, that contains nearly 60 
remedial provisions, include:

    OFHEO directed Fannie Mae to pay a $400 million penalty to 
        the government. This level of penalty signals that unsafe and 
        unsound conditions cannot be tolerated at firms that have a 
        public mission and enjoy public benefits.
    OFHEO directed that Fannie Mae freeze the growth of its 
        portfolio mortgage assets to the level of December 31, 2005. 
        OFHEO's action is based on the ongoing internal controls, risk 
        management and accounting deficiencies and the need for the 
        Enterprise to provide OFHEO an acceptable business plan for 
        managing its market activities. Sole discretion lies with the 
        Director of OFHEO to modify or lift the limits based on his 
        assessment of plans and progress. The preexisting surplus 
        capital requirements and capital planning along with limits on 
        corporate actions such as dividend payments remain in effect.
    Fannie Mae must strengthen its Board of Directors 
        procedures to enhance Board oversight of Fannie Mae's 
        management and the Enterprise must create new Board committees 
        to address new legal and reporting obligations and must demand 
        and receive improved reporting to the Board by management.
    Fannie Mae must make a major investment in internal 
        controls. From a clear policy on the role of outside 
        consultants to external testing of controls and greater 
        emphasis on operational risk to simple, prudent controls for 
        ledger entries, the Enterprise must address its control 
        environment that suffered under prior management. The external 
        relations program must be reviewed and internal controls 
        created as well.
    Fannie Mae must remediate its accounting structures, 
        personnel, and reports to management and the Board. Accounting 
        staff must be skilled and adequately funded and significant 
        transactions must be flagged and detailed for the Board.
    Fannie Mae is undertaking a review of current and separated 
        employees who are mentioned in our report for remedial actions; 
        additional employees discovered during this review may be 
        subject to sanction. This review is underway and OFHEO monitors 
        the Enterprise's progress. If the Enterprise does not or cannot 
        proceed, then OFHEO will proceed against individuals under the 
        authority it possesses. Chairman Cox indicated that the SEC is 
        undertaking its own review for possible action against 
        personnel involved in matters within its jurisdiction.
    Fannie Mae must establish succession plans; comprehensive 
        budget, staffing, and training plans for individual offices; 
        and must continue to work with OFHEO on its determinations 
        regarding appointments to senior offices. Fannie Mae is 
        directed to put in place qualified individuals with appropriate 
        skills and adequate resources, and to provide a strong training 
        program that includes training on the code of conduct and law 
        compliance.
    Fannie Mae must assure that compensation programs are not 
        tied solely to EPS measures.

    The emphasis on specific reforms is coupled with requirements to 
alter tone and culture. These are critical to any company. Be it direct 
action or the failure to correct behavior--that is, be it intentional 
policy or a policy of neglect--the key to most corporate failures is 
tone at the top. OFHEO's settlement seeks to remedy both the conduct 
and the culture that permitted that conduct at Fannie Mae.
    Finally, let me note that the remedial steps undertaken by OFHEO 
underscore the need for legislation. If the agency had sufficient 
budget authority to enhance its staff, more robust legal authority over 
individuals and those affiliated with the Enterprise, other powers 
similar to those of other financial regulators including receivership, 
flexible capital standards, new product and growth controls, and more 
streamlined enforcement authorities, then there is a strong possibility 
OFHEO could have prevented the many unsafe and unsound practices cited 
in our report rather than seeking to remedy them through settlements. 
Clear and explicit authorities aimed at remediation will have a 
beneficial effect in prevention of unsafe practices. OFHEO clearly 
needs legislation to make this a reality. That concludes my prepared 
remarks. 


                                 ______
                                 
                 PREPARED STATEMENT OF CHRISTOPHER COX
                               Chairman,
                U.S. Securities and Exchange Commission
                             June 15, 2006
    Chairman Shelby, Ranking Member Sarbanes, and Members of the 
Committee:
    Thank you for giving me the opportunity to be here today to testify 
about the Securities and Exchange Commission's recent enforcement 
action against the Federal National Mortgage Association (``Fannie 
Mae''). Under Chairman Shelby's leadership, this Committee has spent a 
great deal of time and effort examining the issues surrounding 
Government-Sponsored Enterprises and I appreciate the opportunity to 
appear before you this morning on behalf of the Commission.
SEC Enforcement Action Against Fannie Mae
    On May 23rd, the Commission and the Office of Federal Housing 
Enterprise Oversight jointly announced settlements with Fannie Mae for 
accounting fraud. The settlements require the company to pay a penalty 
of $400 million. This is a meaningful penalty designed to deter future 
misconduct. Moreover, as a result of the Fair Fund provisions of the 
Sarbanes-Oxley Act, most of the penalty will likely be used to 
compensate defrauded investors. Both Director Lockhart and I agree that 
a penalty of this size represents a meaningful sanction that is 
necessary to address the egregiousness of Fannie Mae's conduct. 
Fraudulent financial reporting directly undermines the fairness of our 
capital markets, and the very purpose of those markets to allocate 
capital to its best uses.
    By interfering with the full and fair disclosure that underpins our 
markets, fraudulent financial reporting cheats investors of their 
savings. That is why the extensive financial fraud that you will hear 
described today required such an emphatic deterrent response.
    The Commission's action alleges that Fannie Mae misstated its 
financial statements from at least 1998 through 2004. In settling these 
charges, Fannie Mae has agreed to pay $400 million, the lion's share of 
which will be paid to the Commission, who will in turn return it to 
defrauded shareholders through our Fair Fund program. Fannie Mae also 
agreed to be permanently enjoined from future violations of the anti-
fraud, reporting, books and records, and internal control provisions of 
the Federal securities laws.
    The significance of the corporate failings at Fannie Mae cannot be 
overstated. The company has said that it estimates the restatement of 
its financial statements for the years ended December 31, 2003, and 
2002, and for the quarters ended June 30, 2004, and March 31, 2004, 
will result in at least an $11 billion reduction of previously reported 
net income. In all likelihood this will be one of the largest 
restatements in American corporate history.
    Fannie Mae's size and status make it a financial giant. Yet despite 
its prominent position in the financial marketplace the company's 
internal controls were wholly inadequate in light of the size, 
complexity, and sophistication of Fannie Mae's business. Its failure in 
key areas highlights the critical need for senior management to 
constantly assess internal controls as their business grows. Such an 
investment is necessary for the good of the business, for the 
protection of shareholders, and for the health of our capital markets. 
Fannie Mae is a clear example that neglecting internal controls can be 
devastating for a company and its investors.
    The Commission's complaint lays out in detail the many accounting 
failures that occurred at Fannie Mae from books and records violations 
to fraud. The complaint also describes the corporate culture at Fannie 
Mae that emphasized stable earnings growth and reduced income statement 
volatility that was the backdrop for the fraud. As a result of this 
conduct, the company's financial results were smoothed through 
misapplications of Generally Accepted Accounting Principles, or GAAP.
    Two accounting principles are critical to Fannie Mae's business: 
accounting for nonrefundable fees and costs associated with loans, 
known as Financial Accounting Standard 91, or FAS 91, and accounting 
for derivative instruments and hedge activities, known as FAS 133.
    In connection with FAS 91, the Commission's allegations contained 
two key components. First, at the end of 1998, senior management 
intentionally manipulated earnings in order to obtain the highest 
available bonus payout. Senior management of the company determined 
that certain expenses would not be booked even though GAAP required 
they be recorded. At the same time, senior management engaged in a 
series of additional inappropriate adjustments to the company's income 
statement so that the company hit the earnings per share target 
necessary to trigger maximum management bonuses.
    Second, under FAS 91, companies are required to recognize loan 
fees, premiums and discounts as an adjustment over the life of the 
applicable loans. For groups of similar loans, a company can use 
estimates of prepayments to calculate the effective interest rate of 
the loans and determine the portion of such fees and related items to 
be recognized in the income statement. If actual prepayments differ 
from estimates, or estimates change, the net investment in the loans 
must be adjusted with an offsetting entry to the income statement. From 
before 2000 through 2004, Fannie Mae improperly used a threshold to 
determine when certain of these adjustments would be recorded to its 
income statement. If the amount to be recorded did not exceed the 
company-calculated threshold, Fannie Mae did not record it. This 
practice was an improper departure from GAAP and had the effect of 
reducing earnings volatility.
    In connection with FAS 133, without proper basis in the relevant 
accounting literature, Fannie Mae sought to fit the vast majority of 
its transactions into a simplified method of applying hedge accounting 
that assumed no ineffectiveness in the hedge relationship. By assuming 
no ineffectiveness, Fannie Mae avoided measuring and recording in its 
income statement the difference between the change in value of its 
derivatives and the change in value of the items being hedged by the 
derivatives.
    The transactions in question simply did not qualify for such 
treatment under FAS 133. One reason Fannie Mae adopted this approach 
was that it did not have adequate systems or personnel in place to 
comply with FAS 133's provisions--in particular, with provisions that 
require periodic assessment of effectiveness and measurement of 
ineffectiveness. Had Fannie Mae applied such provisions, it would have 
resulted in income statement volatility that senior management of the 
company wanted to avoid. Most of Fannie Mae's anticipated restatement 
of at least an $11 billion reduction of previously reported net income 
is a result of its improper hedge accounting.
    The Commission continues its investigation regarding the 
individuals and entities whose actions and inactions have led to this 
result. The public should have full confidence that we will vigorously 
pursue those individuals who have violated the Federal securities laws. 
Until the investigation is complete, I cannot comment further on the 
alleged conduct of particular individuals or the specific stage of the 
investigation.
Improved Disclosure to Fannie Investors
    Fannie Mae's settlement of accounting fraud charges raises another 
very significant policy issue, one that has been carefully considered 
by members of this Committee: whether to require mandatory registration 
and periodic reporting under the Exchange Act by Fannie Mae, Freddie 
Mac, and the Federal Home Loan Banks.
    As you well know, the securities issued by Fannie Mae are ``exempt 
securities'' under current laws administered by the SEC. However, there 
is no question that the word ``Government'' in ``Government-Sponsored 
Enterprises'' leaves many members of the investing public with the 
mistaken impression that GSE securities are backed by the full faith 
and credit of the U.S. Government, when in fact there is no such 
guarantee.
    For this reason, the Commission--going at least as far back as 
1992--has consistently advocated the view that, because GSEs sell 
securities to the public, have public investors, and do not have the 
``full faith and credit'' government backing of government securities, 
GSE disclosures should comply with the disclosure requirements of the 
Federal securities laws.
    In July 2002, Fannie Mae took a step forward by announcing that it 
would voluntarily register its common stock with the SEC under Section 
12(g) of the Exchange Act. The registration of its common stock became 
effective on March 31, 2003, and Fannie Mae subsequently began filing 
periodic reports with the SEC. Unfortunately, many of Fannie Mae's 
periodic disclosures have been late or incomplete. Most notably, Fannie 
has to date not filed an annual report (10-K) for either 2004 or 2005, 
and has not filed quarterly reports (10-Q) in any of the preceding 
seven quarters.
    While our recent enforcement action has assuredly focused the 
attention of Fannie Mae's management on improving its disclosure to 
investors, there is no question that, in the future, Fannie Mae would 
be far more likely to maintain consistent compliance with our 
disclosure regime if the Congress were to terminate its special status 
of voluntary registration and reporting, and make its registration and 
reporting mandatory. That, in my view, is a far better way to protect 
investors.
    I know this Committee is considering legislation that would require 
compliance with the Exchange Act periodic reporting requirements by 
Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. I commend you 
for your attention to this issue, and encourage your consideration of 
this legislation. As I mentioned, the Commission has historically been 
in strong support of mandatory compliance by the GSEs with these 
disclosure requirements. We stand ready to support you in these 
efforts, and will be prepared to enforce mandatory compliance, should 
you choose to change the requirements for these Government-Sponsored 
Enterprises.
    I also wanted to bring the Committee up to date on a related issue 
of the New York Stock Exchange's rules, which authorize suspension and 
delisting when a listed company fails to file its annual report with 
the SEC in a timely manner. As you know, because of Fannie Mae's 
failure to file its 2004 and 2005 annual reports on time, the NYSE 
amended its general delisting rules to provide a unique exemption for 
Fannie Mae, though it is not specifically phrased in those terms.
    Since NYSE put this new rule in place, questions have been raised 
about whether this exemption is appropriate. As I testified before this 
Committee on April 25, 2006, the exemption needs to be considered in 
light of the unusual circumstances not only of Fannie Mae's voluntary 
transition to Exchange Act financial reporting compliance, but also its 
massive restatement. I also expressed my view that this exemption must 
be temporary, only for the purpose of allowing Fannie Mae to come into 
initial compliance with Exchange Act reporting. To respond to concerns 
that this exception might become a permanent, rather than temporary, 
policy, I want to inform the Committee that we have encouraged the NYSE 
to amend its rule to put an expiration date on this exception, so that 
Fannie Mae--and its investors--understand that we expect Fannie Mae, 
like any other listed company, to remain in full compliance with NYSE's 
listing standards.
    In conclusion, the Commission's action against Fannie Mae and its 
position on the appropriate treatment of Government-Sponsored 
Enterprises under the Exchange Act's periodic reporting regime are 
animated by the same principle--that investors are best served by 
applying the Federal securities laws in an even-handed and judicious 
manner to all companies participating in the public markets.
    Thank you again for giving me the opportunity to be here today. I 
am pleased to try to respond to any questions you may have.
                                 ______
                                 
                PREPARED STATEMENT OF STEPHEN B. ASHLEY
                  Chairman of the Board of Directors,
                               Fannie Mae
                             June 15, 2006
    Mr. Chairman, Senator Sarbanes, and Members of the Committee. My 
name is Stephen B. Ashley. I have been in the mortgage business for 
over 40 years, and the last time I had the privilege of testifying 
before this Committee was when I served as President of the Mortgage 
Bankers Association of America. I appreciate the opportunity to appear 
before the Committee today.
    Eighteen months ago, I was asked to become independent Chairman of 
the Fannie Mae Board of Directors, whose job it is to protect the 
interests of shareholders and stakeholders by holding management 
accountable, putting in place the proper corporate governance, and 
ensuring that the company is operated in a safe and sound manner.
    The Fannie Mae of 1998-2004 portrayed in the final OFHEO report of 
its special examination is a far different company than was portrayed 
to the Fannie Mae Board by departed management, our former external 
auditor, and annual regular examination reports. I would like to 
comment briefly on the Board and the company's response to the OFHEO 
special examination of Fannie Mae and the changes we have made and are 
continuing to make to address the problems identified.
    On September 20, 2004, when we received OFHEO's interim report, we 
acted immediately to examine and respond to its findings. Within a week 
of receiving the report, we reached an agreement on a process to 
resolve the issues raised by the report, we pledged to work 
cooperatively with OFHEO, and we began supervising the work of fixing 
the company.
    Also in September 2004, the Special Review Committee of the Board 
initiated an independent review of the issues raised in the OFHEO 
report and other matters relating to the company's accounting, 
governance, structure, and internal controls. To conduct the review, 
the Committee engaged former Senator Warren Rudman and his law firm of 
Paul, Weiss, which retained the services of a forensic accounting firm. 
The Board directed that the work of Paul, Weiss be transparent to 
OFHEO, the SEC and the Department of Justice through the entire period 
of the review.
    In October 2004, the Board established an ongoing Compliance 
Committee to ensure that the company fulfilled its agreement with OFHEO 
and all the company's legal and regulatory obligations.
    By the end of 2004, working with OFHEO, we had taken action to 
replace our outside auditor; launch our restatement; and replace our 
Chief Executive Officer and Chief Financial Officer. Since September 
27, 2004, the full Board has met 43 times; Board Committees have met 
146 times. Since January 1, 2005, I have met directly with the Director 
or Acting Director of OFHEO 17 times. As independent Chairman of Fannie 
Mae, I typically spend 2 to 3 days a week at the company, providing 
direct oversight.
    In March, 2005, the Board also entered into a supplemental 
agreement with OFHEO to enhance Fannie Mae's internal financial 
controls and accounting policies and practices to ensure they conform 
to GAAP, disclosure and other regulatory standards.
    We also agreed to take steps to further strengthen the company's 
corporate governance. Let me describe some of these and other changes 
the Board has made:

    We separated the roles of the chief executive officer and 
        the chairman of the board, as it was essential to establish the 
        appropriate governance and oversight of management, assuring 
        all parties that we were progressing on our agreed upon goals.
    Five of the 12 nonmanagement members are new since 2004, 
        and the newest member, Dennis Beresford, is a former chairman 
        of the Financial Accounting Standards Board and will serve as 
        chairman of the Audit Committee. All five of the new Board 
        members are independent of management. We eliminated two of the 
        seats held by management, retaining just one, to increase the 
        proportion of independent board members.
    In addition, in accordance with our corporate policy and 
        OFHEO's corporate governance rules on length of service, 
        another Board member, Ann Korologos, will be leaving the Board 
        effective July 31. As lead director and chairman of the 
        Governance Committee in 2004, she felt it was her duty to 
        remain on the Board an extra 2 years to see us through the 
        investigative phase, which is now complete.
    To ensure accountability and the timely flow of 
        information, we established reporting lines to the Board for 
        the positions of Chief Audit Executive, Chief Compliance and 
        Ethics Officer, and Chief Risk Officer.
    To improve our relationship with our regulators and to hear 
        about any problems directly, I and other members of the Board 
        have established regular interactions with OFHEO.

    During this period the Board exercised one of its paramount 
functions: to select and review the performance of the CEO of the 
company. We made a change in leadership at Fannie Mae when we appointed 
Dan Mudd as interim CEO of Fannie Mae on December 21, 2004.
    We directed Mr. Mudd to begin working with the Board and OFHEO to 
implement our regulatory agreements, carry out other necessary and 
appropriate changes to the company, and put Fannie Mae on a new track.
    More specifically, we made clear that his duties included the 
following:

    Restoring the company's capital;
    Restating Fannie Mae's financial results;
    Building a new management team, particularly in the areas 
        of finance, accounting, and audit;
    Rebuilding relationships with regulators, customers, and 
        stakeholders;
    Garnering credibility with the investment community, both 
        the debt and equity markets;
    Boosting the company's investments in our financial systems 
        and internal controls; and
    Rebuilding the company's culture on a foundation of 
        service, respect, and openness.

    In June 2005, the Board selected Dan Mudd as permanent President 
and CEO of Fannie Mae, after an extensive, competitive nationwide 
search and careful and deliberate consideration, including consultation 
with OFHEO and a very thorough review by Senator Rudman. As interim 
CEO, Mr. Mudd demonstrated an ability to lead a large financial 
institution through a major and challenging transition, including the 
ability to reach out and rebuild confidence with our regulators, 
Congress and others. He demonstrated his capacity for the job by doing 
the job.
    On May 23 of this year, the company took a big step forward when we 
reached settlements with the Securities and Exchange Commission and 
OFHEO. The settlement with OFHEO addresses the recommendations found in 
the OFHEO final report. The Board is committed to ensuring full and 
total compliance with these agreements.
     Mr. Chairman, I can report to this Committee that there is a 
strong determination--on the part of the Board, management, and 
employees--for Fannie Mae to grow into a very different company than it 
was from 1998 to 2004, and that changes have been made up, down and 
across the organization. At the same time, the Board understands that 
Fannie Mae has much more to do, and working with our regulators and 
with this Committee and the counterpart committees in the House, we 
intend to hold ourselves and the management team accountable for the 
changes that need to be made.
    I welcome this chance to report to you and to answer any questions 
you have.
                                 ______
                                 
                  PREPARED STATEMENT OF DANIEL H. MUDD
                           President and CEO,
                               Fannie Mae
                             June 15, 2006
    Mr. Chairman, Senator Sarbanes, and members of the Committee. My 
name is Daniel H. Mudd, and I appreciate the opportunity to appear 
before you today to update you on the progress we have made at Fannie 
Mae, where I have served as Chief Executive Officer since December 
2004.
    The final OFHEO report, and the special investigation by former 
Senator Warren Rudman and the law firm of Paul, Weiss for our Board of 
Directors, have provided a detailed picture of the failings at Fannie 
Mae during the years 1998 through 2004.
    I appreciate the opportunity to comment on that period, and I would 
like to report on what we have done to overhaul the company since the 
start of 2005, and also respond to your questions.
    It is clear from the reports that Fannie Mae got a lot of things 
wrong from 1998 to 2004. Bad decisions about accounting and many other 
matters let a lot of people down, and in doing so, broke a public 
trust. We have learned some painful lessons about getting things right, 
and about hubris and humility.
    We have made changes. We are making progress. And we have much more 
to do. I am determined to do it.
    We began with a plan to fix the company on December 21, 2004, the 
day I was appointed as Fannie Mae's interim CEO. We set out to: Restore 
our capital; restate our prior financial statements; rebuild 
relationships with our regulators, partners, stakeholders, and 
Congress; manage our business; recenter the company on serving families 
who need affordable housing; armor-plate our financial controls; and 
finally, fix our corporate culture, which the OFHEO report makes clear 
led to a lot of our problems.
    I have heard your comments today, and I have heard many more in 
private. The days of arrogant, defiant, ``my way'' Fannie Mae had to 
end. We have begun to build a Fannie Mae that listens better, welcomes 
accountability, works with our regulators and with Congress, and serves 
the market by putting our mission to serve housing first.
    Let me describe some of the tangible steps we're taking, starting 
with the people.
    First, we have established a new senior management team to provide 
the leadership, talent and ethical standards worthy of our role and 
mission.
    Of the 55 members of the company's senior-most management, 75 
percent are new or in different positions and a third are entirely new 
to the company, especially in the critical finance, accounting, and 
risk areas.
    We have a new Chief Financial Officer, we have a new Controller, a 
new Chief Audit Executive, a new Chief of Accounting Policy, we have a 
new General Counsel, a new Chief Risk Officer, and a new head of 
Corporate Strategy. These leaders join us from important roles in major 
financial institutions, large corporations, and highly regarded firms.
    Second, in cooperation and consultation with OFHEO, we are 
fundamentally reorganizing the company to ensure that strong checks and 
balances are in place. For example:

    To ensure appropriate segregation of duties, we have 
        separated the portfolio business from the CFO's 
        responsibilities.
    Under the new CFO, we have reorganized the Finance function 
        and brought in entirely new leadership from outside the 
        company.
    We are reorganizing and strengthening Internal Audit, and 
        the new Chief Audit Executive has a direct and independent line 
        to the Board's Audit Committee.

    We have also replaced our outside auditor with Deloitte and Touche, 
which is conducting a comprehensive re-audit of the entire company. 
Deloitte, which formerly provided advice to OFHEO when several of the 
accounting problems were first identified, has over 300 auditors onsite 
at Fannie Mae.
    We are making further key organizational changes, which include:

    Establishing a new and separate Compliance and Ethics 
        Organization to provide a robust compliance and internal 
        investigation function, led by a senior executive, with a 
        reporting line to the Board. We have written and pledged 
        ourselves to a standard of ethical, honest, and transparent 
        conduct inside and outside the company.
    Establishing a new Risk Organization with an independent 
        and comprehensive view of all the risks the company is taking, 
        and again, with a reporting line to the Board. We have 
        recruited and hired a senior executive from JP Morgan Chase to 
        lead this function.
    Disbanding the so-called Law and Policy division so that 
        each function reports directly and separately to me. These are 
        staff functions that exist to support our business and our 
        mission--not a center of command and control.

    Third, we have restored and maintained our capital adequacy, 
including the 30-percent surplus mandated in our agreement with OFHEO 
and supervised by their examiners. We now have roughly $39 billion 
dollars of capital in reserve; our ratio of capital to assets is higher 
than it has ever been in our history.
    Fourth, we are paying people to do the job--not to hit targets. We 
have adopted a new executive compensation structure with broad 
performance goals that include achieving affordable housing mission 
goals, improving our culture, complying with regulatory standards, and 
delivering shareholder value.
    Fifth, we are making steady progress on completing our financial 
restatement, which will be done by the end of 2006.
    We have put over 1,000 full-time and 2,500 contract employees on 
the job and invested over $800 million, a large part of that on new 
systems. We have completed an exhaustive review of our accounting 
policies and practices to determine their consistency with Generally 
Accepted Accounting Principles.
    We have completed the restatement of several, significant portions 
of our balance sheet, and developed systems to support and control our 
business. We are in the process of putting in place systems and 
controls to ensure we are GAAP and Sarbanes-Oxley compliant. There is 
absolutely no routine, process, or control anywhere in the company that 
is beyond the scope of overhaul and improvement to the highest 
standard. We have over 150 projects underway and 200 associates working 
on this alone. We can get this done--our overarching goal is to get it 
done right the first time, and to make the investments to ensure this 
never happens again.
    Mr. Chairman, I would like to reiterate a commitment I made in my 
testimony last April, that Fannie Mae will work cooperatively to 
support the efforts of Congress to pass legislation to strengthen GSE 
regulation.
    In particular, we continue to support legislation to create a 
strong, well-funded regulator that would oversee both the safety and 
soundness and the housing mission of the enterprises.
    We believe the regulator should have bank-like regulatory powers, 
including the authority to reduce on-balance sheet activities, based on 
safety and soundness. We also support housing goals, and an affordable 
housing fund, that strengthen our affordable housing mission and our 
role in the U.S. housing economy.
    With respect to how we engage with Congress--that is part of the 
new Fannie Mae as well. I hope you have seen a new tone and manner of 
quiet, fact-based engagement from us. Where we disagree, we do so 
respectfully. You have my pledge to do all we can to help move this 
process forward.
    Mr. Chairman, from the day I was appointed to lead Fannie Mae, we 
have been moving forward aggressively to fix the problems OFHEO has 
cited. The question may be, why is this worth doing? The reason this 
company exists is because of our housing and liquidity mission to help 
put people into homes.
    Indeed, in these past 18 months:

    We have purchased or guaranteed more than four million home 
        loans.
    We helped to create 136,000 more minority homeowners and 
        serve 600,000 low- and moderate-income families overall.
    We helped provide financing to build, rehab or refinance 
        600,000 units of affordable rental housing.
    Nearly two-thirds of our overall business serves one or 
        more of our HUD affordable housing goals.
    We are investing literally billions of dollars in the Gulf 
        Coast region to help finance and rebuild homes and communities 
        there.
    We attracted more than $21 billion of overseas investment 
        to provide liquidity to the U.S. housing finance market.
    Most important, we are providing what we estimate is 
        roughly half a trillion dollars this year to finance homes for 
        three million Americans, 25 percent of them African-American, 
        Hispanic, and/or first-time home buyers.

    I know that you are counting on us to fulfill our mission, and help 
to serve this growing Nation and its growing housing needs. That is 
what makes this worth doing.
    Mr. Chairman, this company is changing and will continue to change 
thanks to the lessons we have been given to learn. My obligation and 
pledge to you, the Congress, and the market we serve is to get this 
right and move forward. We are building a new Fannie Mae that is able 
to truly serve affordable housing in America.
    I thank you for the opportunity to appear before you today. I look 
forward to your questions.

Addendum

                   Memo to Frank Raines from Dan Mudd














                                 ______
                                 

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM JAMES B. 
                          LOCKHART III

Q.1. Former Federal Reserve Chairman Greenspan and Treasury 
Secretary Snow testified before this Committee about the need 
for GSE reform and specifically warned about the systemic risks 
posed by the GSEs' large portfolios that stand at about $1.5 
trillion.
    Given the level of fraud and mismanagement outlined in the 
recent OFHEO report on Fannie and a previous report on Freddie, 
how concerned are you about the ability of the GSEs to manage 
these large portfolios?
    The Senate Banking Committee passed a GSE reform bill last 
July that gives the GSE regulator the ability to limit the 
portfolios based on their systemic risk and anchor them to 
their mission. Former OFHEO Director Armando Falcon recently 
wrote an op-ed arguing that this is critical authority the new 
regulator must have.
    In your opinion, how critical is this authority?

A.1. First, as OFHEO's special examination reports on the two 
Enterprises and our most recent regular annual examination 
reports in our 2006 Report to Congress have made clear, both 
Enterprises have had and continue to face major controls and 
systems problems, areas critical to managing their very large 
asset portfolios. They each have literally years of work ahead 
of them to expand, strengthen, and rebuild the infrastructure 
they must have. Even after the Enterprises rectify their 
current unsatisfactory conditions, operational risks associated 
with their asset portfolios promise to remain considerable 
because of the size of the portfolios and the complexities of 
managing the interest rate risks involved.
    Second, the interest rate and operational risks to the 
Enterprises created by the portfolios are accompanied by 
significant systemic risks affecting others. The Enterprises' 
size and importance to mortgage markets means that their 
problems could become broad housing finance issues. Their 
interdependencies with other institutions that hold their debt 
securities or are derivatives counterparties mean that that 
their problems could become broad financial market issues. 
Their high leverage and the lack of market discipline on their 
debt yields make their mortgage holdings more precarious than 
for less leveraged firms subject to normal market discipline. 
In view of these risks, I think it is critical that the new 
regulator Congress creates for the Enterprises should receive 
guidance from Congress on what assets can be held by the 
Enterprises and the authority to set limits based on safety and 
soundness and systemic risk.
    Reducing the portfolios will not, as some have claimed, 
cause mortgage market turmoil while just transferring the 
systemic risk elsewhere. Over the past 2 years, the 
Enterprises' agency mortgage-backed securities (MBS) portfolios 
shrank by more than $280 billion without market disruption. In 
many cases, investors replace Fannie Mae and Freddie Mac direct 
debt with higher yield MBS guaranteed by them. The new 
investors will generally be less leveraged than the Enterprises 
and often better able to take the risk of long-term mortgage 
assets, which might lessen the need to utilize the derivative 
markets, as well.

Q.2. The OFHEO report states that ``by deliberately and 
intentionally manipulating accounting to hit earnings targets, 
[Fannie's] senior management maximized the bonuses and other 
executive compensation they received, at the expense of 
shareholders.''
    Specifically, which senior management benefited from these 
bonuses? How much did they make? Is OFHEO going to ask that 
this money be returned?
    Who specifically directed the accounting manipulation? Who 
was aware of it? What was the specific role of then Chief 
Operating Officer Daniel Mudd, former Chief Executive Officer 
Franklin Raines and former Chief Financial Officer Timothy 
Howard?

A.2. As described in Chapter V of our report, Fannie Mae 
employees at and above the level of Director (here, Director 
being a managerial level below Vice President, not a member of 
the Board) participated in the Annual Incentive Plan (AIP), 
which was directly tied to growth in earnings per share (EPS). 
For the years 1998-2001, the range of funding of the AIP bonus 
was 50 percent of a target amount for minimum corporate EPS 
achievement to 150 percent of a target amount for maximum 
achievement. Beginning in 2002, the Board tightened the funding 
range to 75 percent for minimum achievement of EPS goals and 
125 percent for maximum achievement. By 2002, AIP bonus award 
eligibility included the Chief Executive Officer (CEO), two 
Vice-Chairs, six Executive Vice Presidents, 35 Senior Vice 
Presidents, 117 Vice Presidents, and 495 Directors.
    In addition to AIP, senior executives benefited from the 
Performance Share Plan (PSP), which included financial goals 
tied directly to EPS on a rolling 3-year basis. On top of this, 
virtually all employees were awarded ``EPS Challenge Grants,'' 
the award of which was based upon doubling EPS from $3.23 at 
the end of 1998 to $6.46 at the end of 2003.
    Shown below is a table from our report showing the 
compensation of the five highest-paid Fannie Mae executives 
from 1998 through 2003. Note that the compensation shown for 
bonus, PSP, and the EPS Grants was directly tied to EPS goals.


    In the consent order executed by Fannie Mae and accepted by 
the Director of OFHEO on May 23, 2006, the Enterprise agreed to 
conduct reviews of current employees, as well as Board members, 
mentioned in the OFHEO report. The report based on this review 
will include the Enterprise's plans to seek restitution, 
disgorgement, or other remedies to recover funds from 
individuals. OFHEO will review this report and take enforcement 
actions, if necessary, with respect to these matters. As part 
of the consent order, Fannie Mae has agreed to review the 
possibility of pursuing former executives to disgorge their 
bonuses.
    The Report of the Special Examination of Fannie Mae cites 
instances where management directed accounting decisions that 
did not comply with GAAP and that allowed management to 
maximize their bonus compensation. For example, in January 
1999, Chairman and CEO Franklin Raines approved a 
recommendation made by the Chief Financial Officer (CFO) (Tim 
Howard) and the Controller (Leanne Spencer) to defer the 
recognition of $200 million in amortization expense. This 
deferral, along with other accounting decisions made at that 
time relating to provisions for loan losses and the recognition 
of low-income housing tax credits, allowed management to meet 
the EPS threshold for maximum bonuses.
    In addition to Fannie Mae management, personnel from KPMG, 
including Julie Theobald, Ken Russell, and Eric Smith, were 
aware in January 1999 that amortization expense was understated 
by about $200 million. KPMG posted an audit difference for that 
amount, but then waived it, stating that it was immaterial. 
However, the expense deferral was material, as it allowed 
management to meet its 1998 earnings targets and achieve 
maximum AIP bonus payouts.
    Ms. Theobald told OFHEO examiners that the $200 million 
expense deferral was disclosed to Audit Committee Chair Thomas 
Gerrity, but this was done in early February 1999--more than 2 
weeks after Fannie Mae's mid-January public release of its 1998 
earnings. The appropriate time for KPMG to advise Gerrity about 
the expense deferral would have been before the 1998 earnings 
release.
    The desire to minimize earnings volatility was well known 
throughout the ranks of senior management. For example, in a 
November 4, 2001, memorandum from Ms. Spencer to Mr. Raines 
entitled ``Update on Earnings,'' Ms. Spencer provided 
information on earnings management and ``smoothing ideas.'' Ms. 
Spencer also described to Mr. Raines plans to ``pull the 
earnings down'' to $6.30 EPS in the following year (2002), with 
an indication that CFO Howard had asked the Senior Vice 
President for Portfolio Strategy, Peter Niculescu, for ideas on 
how to accomplish that. In part, this strategy to push earnings 
out of 2002 to future periods was accomplished through the use 
of income-shifting REMICs, which had no substantive economic 
purpose, but which altered the recognition of book income, 
allowing management to smooth earnings. This strategy to shift 
income was presented in a November 2001 Quarterly Business 
Review, which was attended by Messrs. Raines, Mudd, and Howard, 
among others.
    The process used by Fannie Mae for amortizing deferred 
premiums and discounts relating to mortgages and MBS was a key 
component of the earnings management process. Had management 
complied with SFAS 91, which prescribes the rules for these 
activities, Fannie Mae would have recognized significantly more 
earnings volatility than they actually did. A former employee 
of Fannie Mae, Roger Barnes, alerted management to significant 
accounting and control problems relating to amortization, 
including Messrs. Raines and Howard, as well as the head of the 
Office of Auditing (Sam Rajappa) and management in the 
Controller's Office, including Leanne Spencer, Janet Pennewell, 
and Mary Lewers. Problems with Fannie Mae's amortization 
accounting were also raised by Michelle Skinner in an informal 
employee meeting chaired by Daniel Mudd, who was then Chief 
Operating Officer. As the OFHEO Report describes, Mr. Mudd 
failed to adequately follow-up on the concerns raised by Ms. 
Skinner.

Q.3. The OFHEO report states that Fannie Mae lobbyists ``worked 
to ensure that the agency (OFHEO) was poorly funded'' and 
``used longstanding relationships with Congressional staff . . 
. to interfere with OFHEO's special examination'' of Fannie 
Mae.
    Specifically, explain this in more detail. How did Fannie 
lobbyists interfere with your investigation?
    Please comment on Fannie's lobbying effort to generate the 
HUD Inspector General's fourth investigation of OFHEO.
    Who specifically directed Fannie Mae lobbyists to do this? 
Who specifically was aware of this? What was the role of Mudd, 
Raines, and Howard?
    Your report states the Board was notified by a Fannie 
employee of the HUD Inspector General's results. What was the 
Board's role in all of this? Were they aware of what was going 
on? Why were they notified?

A.3. The aggressive policy of Fannie Mae toward its regulator 
was, in part, developed by its Government and Industry 
Relations unit, which was led by Thomas Donilon and involved 
Government and Industry Relations employees, William Maloni and 
Duane Duncan, during the period reviewed for the Special 
Examination. What began as aggressive lobbying later became a 
systematic attempt to undermine the work of the Special 
Examination. This strategy manifested itself in several ways:

  1.  Working with Senate Appropriations staff, Fannie Mae 
        sought to attack former OFHEO Director Falcon and the 
        agency through the generation of a Department of 
        Housing and Urban Development (HUD) Inspector General 
        (IG) examination investigating travel and employee 
        salaries in the OFHEO legislative/external office. An 
        e-mail from Duane Duncan to Donilon dated October 27, 
        2002, describes these efforts. It is noteworthy that 
        OFHEO was not asked for this information directly. 
        Evidence discovered during the exam shows a company 
        policy of generating HUD IG investigations, with the 
        implication of possible wrongdoing, in an effort to 
        undermine the reputation and credibility of the agency.
  2.  Documentary evidence demonstrates continuous efforts 
        between Fannie Mae and congressional staff to establish 
        percentage guidelines to govern agency use of 
        appropriated funds, which was seen as a way to divert 
        funds from the Special Examination.
  3.  Working with staff of the VA-HUD Subcommittee of the 
        Appropriations Committee of the U.S. Senate, Fannie Mae 
        was able to get language inserted into an 
        appropriations bill that would have withheld $10 
        million from OFHEO appropriations until a new director 
        was appointed to replace Armando Falcon, who, as the 
        Director of OFHEO, initiated the Special Examination of 
        Fannie Mae.
  4.  A fourth effort, resulting from extensive interaction 
        between a Fannie Mae lobbyist and congressional staff, 
        was the initiation of a HUD IG examination to determine 
        if OFHEO was spending an appropriate percentage of its 
        budget on examinations. The HUD IG concluded that OFHEO 
        met the appropriate requirements and was comparable to 
        other Federal financial regulators in its allocation of 
        funds and staff. However, key OFHEO resources were 
        diverted for almost 10 months while complying with the 
        requirements of the examination.
  5.  Again, working with congressional staff, Fannie Mae 
        lobbyists succeeded in initiating another HUD IG 
        examination (the ``fourth'') to investigate whether the 
        leadership of OFHEO had, as part of their personal 
        political agenda, overstated accounting problems of 
        Fannie Mae. In sworn testimony, Duane Duncan, head of 
        Government and Industry Relations at Fannie Mae, 
        admitted that Fannie Mae had initiated the HUD IG 
        examination in an effort order to discredit the 
        findings of the Special Examination and the agency.

    In a sworn interview with OFHEO examiners, Duane Duncan 
testified that it was the desire of Fannie Mae senior 
management that the report of the HUD IG's fourth investigation 
to discredit the agency and Special Examination be made public. 
Mr. Duncan received direction from his superiors during 
meetings of the External Affairs Committee, which met each 
Monday. Franklin Raines, Thomas Donilon, Timothy Howard, and 
sometimes Daniel Mudd attended those meetings, with Mr. Raines 
and Mr. Donilon deciding what positions Fannie Mae would take 
on any given issue. Mr. Duncan implemented the decisions made 
at those meetings. Mr. Duncan also met with Mr. Donilon at the 
end of each workday in order for Mr. Donilon to manage the 
implementation of the decisions.
    The management of Fannie Mae wanted the report of the HUD 
IG's investigation published, even though it was nonpublic and 
legally restricted information. Accordingly, the Enterprise 
began a campaign to enlist support for the release of the 
report. Fannie Mae eventually succeeded in getting the document 
published on a congressional Web site for 1 hour, during which 
time management downloaded the report for further 
dissemination, including to its Board of Directors, analysts, 
and congressional staff. Thus, management succeeded in its 
efforts to distract attention from its multi-billion dollar 
accounting errors by creating a large volume of publicity about 
OFHEO.
    In an interview with lawyers from Paul, Weiss (counsel to 
the Board of Directors), Ken Duberstein, a director on the 
Board of Fannie Mae, said that he recalled Mr. Raines saying 
that the HUD IG report would undermine OFHEO and that Mr. 
Raines could obtain an early release copy of the report. 
According to Mr. Duberstein, he told Mr. Raines that such an 
approach could backfire and that Mr. Raines should stay away 
from any such approaches.

Q.4. The OFHEO report states that the:

        Board contributed to those problems by failing to be 
        sufficiently informed and to act independently of its 
        chairman, Franklin Raines, and other senior executives; 
        by failing to exercise the requisite oversight over the 
        Enterprise's operations; and by failing to discover or 
        ensure the correction of a wide variety of unsafe and 
        unsound practices.

        The Board's failures continued in the wake of 
        revelations of accounting problems and improper 
        earnings management at Freddie Mac and other high 
        profile firms, the initiation of OFHEO's special 
        examination, and credible allegations of improper 
        earnings management made by an employee of the 
        Enterprise's Office of the Controller.

    Can you give specific examples of the Board's failures? 
Explain also the ``credible allegations of improper earnings 
management'' made by a Fannie employee.

A.4. The Fannie Mae Board of Directors failed in numerous ways 
that put the safety and soundness of the Enterprise at risk. 
Among other things, the Board:

    Failed to stay informed about Fannie Mae corporate 
        strategy, major plans of action, and risk policy;
    Approved an executive compensation program that 
        created incentives to manipulate earnings;
    Failed to provide delegations of authority to 
        management that reflected the current size and 
        complexity of the Enterprise;
    Failed to ensure the effective operation of its own 
        Audit and Compensation Committees;
    Failed to act as a check on the authority of 
        Chairman and CEO Franklin Raines;
    Failed to initiate an independent inquiry into 
        Fannie Mae's accounting following the announcement of 
        Freddie Mac's restatement and subsequent investigation; 
        and
    Failed to properly look into the allegations of 
        Roger Barnes.

    In August 2003, Roger Barnes, a former Manager in Fannie 
Mae's Controllers' Office, approached the Office of Auditing to 
raise concerns regarding Fannie Mae's accounting practices 
related to SFAS 91. By that time, the Baker Botts report had 
been released detailing accounting manipulations at Freddie 
Mac. OFHEO had also announced plans to commence a special 
investigation of Fannie Mae's accounting practices. Against 
that backdrop, Mr. Barnes questioned the propriety of 
amortization accounting, and asserted his belief that 
amortization amounts recorded in the financial statements were 
manipulated in order for them to ``agree'' with forecasted 
amortization expenses. Such actions would constitute 
inappropriate earnings management. The Office of Auditing was 
responsible for investigating those allegations. In the 
September 2004 Report of Findings to Date, Special Examination 
of Fannie Mae, OFHEO found that the Office conducted a hurried 
investigation into Mr. Barnes' allegations that culminated in 
the head of the Office of Auditing certifying GAAP compliance 
to the Board of Directors.
    Fannie Mae rushed into a severance agreement with Mr. 
Barnes on November 3, 2003. Given its responsibilities for 
regulatory compliance and investigation of complaints related 
to accounting, internal controls, and auditing matters, the 
Audit Committee was required to ensure a timely, thorough, and 
independent investigation into Mr. Barnes' allegations. The 
allegations, and subsequent settlement agreement, should have 
raised the concern of every member of the Audit Committee, 
especially when considered against the background of the 
recently released Baker Botts report on Freddie Mac's internal 
investigation and the initiation of the OFHEO Special 
Examination.
    The Audit Committee failed to make further inquiries or 
convene a special investigation after being informed at the 
November 17, 2003, Audit Committee meeting that Fannie Mae had 
reached a settlement with Mr. Barnes. The news of the 
settlement was received by the Audit Committee just 3 days 
after the Committee had been convened in order to discuss 
certification of the third quarter financial statements. Fannie 
Mae settled the case before bringing the matter to the Audit 
Committee and elected to postpone discussion of the matter 
until after the financial statements had been certified. Given 
that OFHEO had just announced a Special Examination of Fannie 
Mae's accounting practices, the allegations made by Mr. Barnes 
warranted further investigation. At a minimum, the Audit 
Committee had an obligation to ensure that the matter be 
disclosed to OFHEO. Instead, the matter was ignored until 
February 2004, when it was reviewed as part of the Special 
Examination.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM JAMES B. 
                          LOCKHART III

Q.1. Fannie Mae signed a consent agreement on May 23, 2006, 
with the Office of Federal Housing Enterprise Oversight 
agreeing to cap its retained mortgage related portfolio to $727 
billion, its level on December 31, 2005.
    Using Fannie Mae's $727 billion portfolio as a model, what 
would Fannie Mae's portfolio size be with the limits of S. 190? 
Please include an explanation of the assumptions that you used 
to arrive at this number?

A.1. S. 190 would restrict mortgage and mortgage securities to 
those held for the purpose of securitization, those that are 
not readily securitized, and those held solely for the purpose 
of supporting the guarantee business. More than half of Fannie 
Mae's mortgage asset portfolio at the end of last year 
comprised securities already guaranteed by Fannie Mae, or by 
Freddie Mac or Ginnie Mae. Those would not generally be 
permitted. The remaining $355 billion is roughly divided 
between private label MBS (11 percent) and whole mortgages (35 
percent), and a large portion do not qualify under HUD's rules 
as supporting affordable housing. More work would be necessary 
to determine how much would be permitted under S. 190, but a 
strict reading of the language might qualify only a small 
portion.

Q.2. What are the public policy benefits and risks of the two 
different portfolio sizes?

A.2. Enterprise asset portfolios can contribute to the 
availability of funding for affordable housing and to the 
stability and liquidity of the secondary market for mortgages 
and the market for mortgage securities. These benefits, 
however, could still be achieved with much smaller portfolios, 
while risks would be greatly reduced.
    The major portion of the Enterprises' public policy 
benefits stem from their guarantee business. By guaranteeing 
securities backed by pools of mortgages, they make use of their 
GSE status to make mortgage investments more desirable to a 
wider range of investors. That lowers mortgage interest rates 
on conforming loans, with estimates of the effects ranging from 
2 to 25 basis points. Purchasing mortgage securities for their 
asset portfolios has little effect, in general, because it 
simply substitutes one type of debt for another, with 
Enterprise borrowings replacing mortgages and MBS. This is 
especially true when an Enterprise acquires mortgage securities 
already guaranteed by an Enterprise. Much the same is true when 
an Enterprise buys and holds mortgage loans that it could 
easily securitize. However, the Enterprises also buy mortgages 
and hold them for a short time while they are securitizing 
them.
    Assessing the effects of the remainder is more complex 
because Enterprise acquisition of these assets not only 
withdraws them from the debt market, but it also replaces them 
with Enterprise debt. This category includes Enterprise 
purchases of private label securities backed by subprime loans, 
manufactured housing, and municipal revenue bonds. The 
magnitude of benefits for loans in these categories is 
uncertain, as is the extent to which they could be maintained 
if the Enterprises did not retain the securities on their 
balance sheets, but instead guaranteed the securities and 
resold them. As for stability and liquidity, an active trading 
capability coupled with a small inventory of securities backed 
by the ability to expand rapidly to cope with market liquidity 
emergencies should serve those purposes.
    While the benefits of the Enterprises' large asset 
portfolios are limited, the risks are quite significant. 
Mortgages, especially fixed-rate mortgages, have complex and 
difficult to anticipate payment patterns requiring extensive 
hedging activities. The interest rate risk in its portfolio 
caused massive losses to Fannie Mae in the early 1980s and more 
recently in 2002, and the operational risk in their portfolios 
has caused serious problems for both Enterprises in recent 
years. Because of their size and importance to housing finance 
markets, counterparties, and holders of their securities; and 
because of their high leverage ratios, the lack of market 
discipline, and lack of bankruptcy or receivership provisions, 
these institutions also entail significant systemic risk that 
stems to a large degree from their asset portfolios. Weighing 
the benefits and the risks, it seems clear that Enterprise 
mortgage portfolios should be much smaller without affecting 
their missions of affordable housing, stability, and liquidity.
                                ------                                


  RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM JAMES 
                        B. LOCKHART III

Q.1. In your testimony today you stated that the OFHEO report 
details an arrogant and unethical corporate culture at Fannie 
Mae from 1998 to 2004. You also stated that, ``perhaps the best 
written record of this culture is a memo from the Chief 
Operating Officer Dan Mudd to the CEO 2 months after OFHEO's 
interim report.'' In that memo Mr. Mudd was discussing the need 
to change and wrote:

        The old political reality was that we always won, we 
        took no prisoners, and we faced little organized 
        political opposition . . . We used to, by virtue of our 
        peculiarity, be able to write, or have written, rules 
        that worked for us. We now operate in a world where we 
        will have to be `normal.'

    Given your selections of this memo as the best example of 
what went wrong at Fannie Mae, to what degree was Dan Mudd 
responsible for what happened at Fannie Mae? How should he be 
held accountable?

A.1. Mr. Mudd was Chief Operating Officer at Fannie Mae from 
February 2000 through December 2004, when he was elevated to 
CEO upon the resignation of Mr. Raines. Mr. Mudd, in addition 
to broad responsibilities for ensuring that Fannie Mae had an 
adequate operating infrastructure, also had responsibilities to 
monitor the profit and loss statements of the business units 
reporting to him. We now know through the Special Examination 
that the accounting policies used by these business units were 
seriously deficient, particularly as they relate to the 
impairment of mortgage assets. The finite insurance 
transactions discussed in our report, which involved little or 
no transfer of risk, affected business units reporting to Mr. 
Mudd. Mr. Mudd also chaired Quarterly Business Review meetings, 
during which senior executives sometimes presented strategies 
relating to income shifting.
    Given these circumstances, plus the problems noted in our 
report regarding the lack of appropriate action by Mr. Mudd 
when accounting concerns were raised to him by Michelle 
Skinner, we think it is appropriate for the Board to include 
Mr. Mudd in its review of current employees with respect to 
possible disgorgement of compensation. OFHEO will assess the 
results of the Board's review upon completion.

Q.2. How confident are you with Fannie (and Freddie's) most 
current financial reporting? When will each company complete 
their accounting restatements?

A.2. OFHEO is not satisfied with the Enterprises' current 
reporting given the control weaknesses that have been found to 
date. Both companies are devoting significant resources to 
improve their financial reporting capabilities and they are 
making progress toward having audited financial statements. 
Much work and testing remains to be done.
    OFHEO and the Enterprises' external auditors are engaged 
and are carefully monitoring the remediation of the financial 
reporting process. Both Enterprises are implementing major new 
systems and processes to facilitate more timely and accurate 
financial reporting. OFHEO must remain vigilant as the 
introduction of new systems, processes and personnel can 
initially increase the risk of operational errors.
    Currently Freddie Mac has completed its financial 
restatement, however they have not yet returned to timely 
financial reporting. Their objective is to return to quarterly 
reporting with the release of full-year 2006 financial results. 
After that, they will begin the process of registering their 
common stock with the SEC. Fannie Mae is still in the process 
of completing its financial restatement for the years 2002-
2004, and they expect to be complete by the end of 2006.

Q.3. Fannie is required to continue maintaining a 30 percent 
capital surplus, as part of its capital restoration plan. Under 
what conditions may you decide that this requirement should be 
modified or expire?

A.3. The 30 percent capital surplus is required due to 
operational weaknesses at Fannie Mae, including accounting and 
internal control deficiencies. Until such weaknesses are 
demonstratively corrected to OFHEO's satisfaction, and assuming 
no other safety and soundness issues emerge, the surplus will 
stay in place. OFHEO evaluates capital on an ongoing basis, 
assessing existing and emerging issues, to determine the 
adequacy of Fannie Mae's capital. At this time, it is therefore 
not possible to predict when the capital surplus requirement 
may be modified. As you know, the pending legislation gives 
OFHEO more flexibility in setting both minimum capital and 
risk-based capital requirements. Operational risk will be a 
component of each.

Q.4. Fannie Mae is required to report to you whether any former 
officers should be terminated. What action could OFHEO take 
against these individuals.

A.4. Fannie Mae must report to OFHEO whether the company will 
seek damages or other remedies against former officers. If the 
company fails to taken action, OFHEO has available, under a 2-
year statute of limitations, the ability to seek restitution, 
disgorgement, or reimbursement of such individuals as well as 
civil money penalties that could exceed any actual damages. As 
noted in comments transmitted to the Banking Committee on the 
legislation, the procedures for (and, thereby, the 
effectiveness of) OFHEO's current remedies would be improved by 
the pending legislation.

Q.5. Freddie Mac has announced that its accounting restatement 
will be further delayed. What is the status of Freddie Mac's 
compliance with its written agreement with OFHEO and the 
company's outlook from your standpoint?

A.5. As noted previously, Freddie Mac now has completed its 
financial restatement, but is not yet a timely filer of 
financial statements. The Enterprise is currently in compliance 
with the Agreement, and they continue to work to improve their 
governance and operational issues. Specific plans has been 
executed by the Enterprise but it may take several years to 
implement them.

Q.6. The Chairman of the Board and CEO positions, held jointly 
by Franklin Raines, have been separated and Chairman Stephen 
Ashley appears to have cast the nonexecutive chairman roll as 
an independent check on the CEO. What are the benefits of those 
changes in structure and practices and what is your assessment 
of Ashley's performance?

A.6. OFHEO determined that in the instance of both Fannie Mae 
and Freddie Mac the position of Chairman of the Board and CEO 
should be separated. This has been effectuated with Fannie Mae 
and we are working with Freddie Mac to do the same. Such 
separation of positions has been adopted by a growing number of 
public companies. The Enterprises hold unique positions, 
including a public mission, and the need for Board oversight of 
that mission is enhanced with separation of the two positions. 
Further, where both companies need to focus their energies on 
remediation--a primary responsibility of management--the 
separation permits a more efficient use of personnel.

Q.7. The report states ``the goal of senior management was 
straightforward: to force OFHEO to rely on the Enterprise for 
information and expertise to such a degree that Fannie Mae 
would essentially regulate itself.'' Would you agree that 
Fannie Mae sought to oversee OFHEO, instead of the other way 
around?

A.7. As a matter of corporate policy, Fannie Mae sought to 
circumvent, constrain, and undercut OFHEO. Some of the 
techniques used by Fannie Mae included personal attacks on the 
competence, integrity, and motivation of officers at the 
agency, limiting the budget of the agency through the 
appropriations process, and creating conflicts with other 
independent and executive branch regulatory agencies. Further, 
after the initiation of the Special Examination, Fannie Mae 
undertook a concerted effort to limit and interfere with the 
examination by working with legislators and their staff to 
generate repeated IG investigations. This was done in order to 
divert agency resources and attention away from the Special 
Examination, to disparage the agency and its officers, and to 
restrict the use of appropriated funds.

Q.8. Were efforts to generate interagency conflict, between 
OFHEO and HUD, SEC, OMB, and others, made at Fannie Mae's 
highest levels, and if so by whom?

A.8. The practice of opposing, circumscribing, and constraining 
its regulator became a firmly established practice at Fannie 
Mae. One method Fannie Mae employed to accomplish this involved 
creating conflict between OFHEO and other agencies whenever 
OFHEO attempted to craft regulations or take other regulatory 
actions. For example, correspondence between Fannie Mae's 
outside counsel (WilmerHale) and Ann Kappler, who was Fannie 
Mae's General Counsel at the time, reveal efforts to contact 
the Secretary of HUD and the HUD General Counsel in order to 
convince them of a ``legal flaw'' in the then-proposed OFHEO 
risk-based capital rule, which then would provide justification 
to ``kick the legal issue to Justice for resolution.'' This 
would allow the dispute to be seen as one between OFHEO and 
another regulatory agency, not between Fannie Mae and its 
regulator.
    Other correspondence reveal efforts on the part of Fannie 
Mae to scuttle OFHEO's then-proposed corporate governance 
regulations by supporting arguments that the SEC and the Stock 
Exchanges--not OFHEO--had the legal authority to do rulemaking 
in this area. Further, when the OFHEO Special Examination of 
Fannie Mae commenced, correspondence describes a call to the 
General Counsel of the SEC from Fannie Mae's General Counsel, 
who stated that ``We do not believe that OFHEO has authority to 
opine on GAAP, or to order us to restate our financial 
statements. We would like to reach an understanding with the 
Commission on this matter.''

Q.9. It is my understanding that the size and aggressiveness of 
the company's lobbying and grass roots activities have been 
substantially reduced. Can you give me more specifics about in-
house and external activities in terms of personnel, costs, and 
approach?

A.9. Fannie Mae, in the consent order issued by OFHEO, is 
required to conduct a review of and develop enhanced internal 
controls for the operation of the Government and Industry 
Relations office. The purpose is to have adequate supervision 
in place to assure control by the Enterprise of this operation 
such that the mission and positions taken by the Enterprise are 
subject to control and review. As part of the review, we will 
secure information on expenses, broadly defined, as well as 
costs and controls.

Q.10. Did you evaluate the role of Fannie Mae's Community 
Business Centers, formerly known as Partnership Offices, in 
community or political activities?

A.10. Fannie Mae CEO Daniel Mudd announced changes to the 
partnership offices and changes to the name, mission, and role 
in political matters. OFHEO will be examining these functions 
and will be able to provide additional information. By way of 
background, I would note the following points.
    Although an evaluation of the Partnership Offices was not a 
primary focus of the Special Examination, many of the documents 
that we reviewed indicate that a primary factor in deciding 
where Partnership Offices would be located was the perceived 
need to build relationships with key Members of Congress. Rob 
Levin, currently Executive Vice President and Chief Business 
Officer of Fannie Mae, testified to the nature of so-called 
``affinity'' contacts in particular Partnership Offices, and 
that Fannie Mae staff would be ``aware of '' relationships with 
Members of Congress and other government officials when making 
decisions regarding Partnership Offices.
                                ------                                


RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM CHRISTOPHER 
                              COX

Q.1. In your testimony, you note that you have encouraged the 
New York Stock Exchange (NYSE) to amend its rule, which 
exempted Fannie Mae from having to delist from the NYSE, by 
putting an expiration date on this exemption.
    Can you comment as to specifically when this expiration 
date is? What is the status and timetable of Fannie's 
restatement and registration with the SEC? When will Fannie be 
in total compliance with its financial disclosure?
    Just to be clear, my understanding is that if Fannie does 
not meet any part of this timetable, then the SEC will ensure 
that the listing rules are enforced and no further special 
exemptions are granted. Is this correct?
    For that matter, what is the status of Freddie's 
registration? When will Freddie be in total compliance with its 
financial disclosures?

A.1. On January 30, 2007, Commission staff, acting pursuant to 
delegated authority, approved a proposed rule change (attached 
and available at: http://www.scc.uovlrulcs/sro/nvsc/2007/34-
55198.pdf) by the NYSE to eliminate a provision of NYSE Rule 
802.01E, which operated to permit Fannie Mae to continue 
listing on the NYSE even though it was more than 12 months late 
in filing its annual report. Under the NYSE's rule change, the 
Exchange's discretion to allow a company to continue listing 
that is more than 12 months late shall expire on December 31, 
2007. The NYSE's rule change also provides that if prior to 
December 31, 2007, the Exchange had determined to continue 
listing a company that was more than 12 months late pursuant to 
that provision of Rule 802.01E, and that company fails to file 
its late annual report by December 31, 2007, suspension and 
delisting procedures will commence in accordance with the 
NYSE's Listed Company Manual.
    Fannie Mae filed its 2004 Annual Report on Form 10-K with 
the Commission on December 6, 2006. The filing provides 
consolidated financial statements for 2004, and a restatement 
of previously issued financial information for years 2002, 
2003, and the first two quarters of 2004.
    Although Freddie Mac agreed to voluntarily register under 
the Exchange Act, it has not yet formally filed a registration 
statement with the Commission. Freddie Mac has stated it 
intends to complete the Exchange Act registration process when 
it completes its restatement and audit of its financial 
statements.
    Freddie Mac has publicly indicated its accounting and 
disclosure practices are the subject of a pending investigation 
by the Commission's Enforcement Division.

Q.2. In your testimony, you note that ``the Commission--going 
at least as far back as 1992--has consistently advocated the 
view that, because GSEs sell securities to the public, have 
public investors, and do not have the `full faith and credit' 
government backing of government securities, GSE disclosures 
should comply with the disclosure requirements of the Federal 
securities laws.''
    In your opinion, should Fannie and Freddie be required to 
register their debt and mortgage backed securities with the SEC 
(not just their common stock) as well? Why should Fannie and 
Freddie get a free pass when other companies don't? What's 
wrong with more disclosure?
    Wouldn't this requirement send a clear message to the 
markets that GSE debt is not backed by the full faith and 
credit of the Federal Government? Wouldn't this be good public 
policy for the American taxpayer?

A.2. The Commission participated with the Department of 
Treasury and the Board of Governors of the Federal Reserve 
System in a 1992 Joint Report on the Government Securities 
Market (1992 Report) that addressed these issues, among other 
things.\1\
---------------------------------------------------------------------------
    \1\ Department of the Treasury, Securities and Exchange Commission, 
Board of Governors of the Federal Reserve System, Joint Report on the 
Government Securities Market, January 1992.
---------------------------------------------------------------------------
    As an introductory matter, please note that the two Federal 
securities laws that are relevant to the question--the 
Securities Exchange Act of 1934 and the Securities Act of 
1933--have very different, though related, purposes.

    The Exchange Act requires registration of various 
        categories of public securities. Exchange Act 
        registration results in ongoing periodic reporting of 
        detailed narrative and financial disclosure regarding 
        the corporation. This corporate information is the 
        information on which the Commission and staff have 
        focused in urging disclosure by GSEs. Registration 
        under the Exchange Act also subjects reporting 
        companies to the provisions of the Sarbanes-Oxley Act 
        applicable to Issuers.
    The Securities Act requires registration of 
        transactions, namely public offerings of securities. In 
        addition to information about the securities being 
        offered, registration under the Securities Act requires 
        disclosure of essentially the same corporate 
        information as is required under the Exchange Act. 
        Commission staff review of Securities Act registration 
        statements may affect the timing of securities 
        offerings and other registered transactions.

    The 1992 Report did not recommend removal of the exemption 
from the Securities Act for the offer and sale of mortgage-
backed and related securities of Fannie Mae and Freddie Mac as 
it is not clear what impact registration and reporting of 
mortgage-backed offerings might have had on the secondary 
mortgage market.
    In 2002, staff of the Commission, Department of Treasury, 
and OFHEO conducted a joint study of disclosure regarding 
mortgage-backed securities with a view to ensuring that 
investors in mortgage-backed securities are provided with the 
information that they should have.\2\ The report, which was 
issued in January 2003 concluded that some additional 
disclosures would be both useful and feasible in the mortgage-
backed securities market. Each of Fannie Mae and Freddie Mac 
has implemented these new disclosures.
---------------------------------------------------------------------------
    \2\ Department of Treasury, Office of Federal Housing Enterprise 
Oversight, Securities and Exchange Commission, Staff Report: Enhancing 
Disclosure in the Mortgage-Backed Securities Market, January 2003.
---------------------------------------------------------------------------
    Consideration of Securities Act registration of the GSE's 
mortgage-backed and related securities raises a very 
significant and unique complexity, as discussed in the January 
2003 report, due to the fact that a substantial portion, 
recently a majority, of the GSE's mortgage backed securities 
have been issued in the so-called ``To Be Announced,'' or 
``TBA,'' market. We understand that the TBA market is 
significant, as it is used to set or ``lock in'' mortgage rates 
in the U.S. housing market. Transactions in this market involve 
forward sales of pools of mortgages that are not yet identified 
and, in most cases, are not yet in existence. Because actual 
pools are not established at the time of the transactions, 
there can be no disclosure of pool characteristics beyond the 
TBA standards already available to the market. Therefore, the 
registration of offers and sale of mortgage-backed securities 
would necessitate a consideration of the impact of such 
registration on TBA transactions.
    Finally, the matter of requiring the registration of Fannie 
Mae's and Freddie Mac's mortgage-backed and related securities 
should be considered in light of that registration's likely 
impact on other GSEs that are exempt from the Federal 
securities laws. For example, the Federal Home Loan Bank 
System, which was created prior to enactment of the Securities 
Act or creation of the Securities and Exchange Commission in 
1934, is comprised of twelve banks that are GSEs and operate 
independently. The Federal Home Loan Bank System, through the 
Office of Finance, is one of the largest issuers of debt 
securities in the world and the Federal Home Loan Banks compete 
with Fannie Mae and Freddie Mac for debt investors. While the 
Finance Board adopted a rule requiring Exchange Act 
registration of the common stock of each Bank and almost all of 
the Banks have now completed that registration, the Banks 
continue to be exempt from the Securities Act and the other 
Federal securities laws.
                                ------                                


    RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM 
                        CHRISTOPHER COX

Q.1. What is your estimate of the loss to shareholders created 
by the accounting scandal documented in the OFHEO Report? Some 
estimates are that there have been $1.3 billion in expenses 
related to correcting the accounting fraud not to mention the 
billions in market losses?

A.1. The Commission's Office of Economic Analysis (OEA) 
estimates that the fraud at Fannie Mae caused its common stock 
to be overvalued by an amount ranging from $12.5 billion to 
$16.5 billion. This estimate is based on OEA's determination 
that Fannie Mae's stock declined by about 25 percent as the 
news of the fraud became public over the course of more than a 
year. As news of the fraud became public, the market realized 
that not only was Fannie Mae very different from what it 
represented itself to be, but also that Fannie would have to 
spend a considerable amount correcting the accounting fraud. 
Thus the $12.5 to $16.5 billion figure includes the market's 
expectation of the cost of correcting the accounting fraud at 
the time it was revealed.
    Shareholders who bought their stock after the fraud began 
and held onto it as the fraud was revealed very likely lost 
money as the stock fell. Because Fannie Mae's stock was heavily 
traded during the lengthy period of the fraud, it would have 
been extremely difficult to calculate such trading losses with 
precision, and doing so would have consumed extraordinary 
resources.
    Instead, the Commission's OEA staff examined Fannie Mae's 
offerings of securities during the fraud period to determine 
whether Fannie Mae derived an improper benefit from its 
financial fraud. OEA determined that the prices of the debt 
securities sold by Fannie during the fraud period were not 
inflated. However, OEA found that the fraud nevertheless 
benefited Fannie Mae by allowing it to meet its minimum capital 
requirements with less capital than was required under 
Generally Accepted Accounting Principles and applicable law. 
This improper benefit allowed Fannie Mae to operate on a larger 
scale than it was entitled to operate, allowing it to generate 
larger profits than it was entitled to generate.

Q.2. How did you determine the $350 million fine for Fannie 
Mae, and do you believe that figure even approaches full 
restitution for shareholders?

A.2. In determining the fine in the Fannie Mae case, the 
Commission applied the principles set forth in its statement on 
financial penalties issued in January 2006. That statement sets 
forth nine factors that the staff should consider in evaluating 
the appropriateness of financial penalties.
    In applying these factors, the Commission consults with, 
among others, the professional staff in its Office of Economic 
Analysis (OEA). OEA is particularly helpful in determining 
whether the corporation derived a direct benefit as a result of 
the violation, which is one of the primary factors in the 
Commission's penalties statement.
    In this case, OEA determined that, but for the fraud, 
Fannie Mae would not have met the minimum capital requirements 
set for it by its primary regulator, the Office of Federal 
Housing Enterprise Oversight. In other words, the fraudulent 
accounting allowed Fannie Mae to operate on a larger scale--and 
therefore to earn larger profits--than it would have been able 
to do if it had complied with Generally Accepted Accounting 
Principles and applicable law. Using a conservative analysis, 
OEA determined that Fannie Mae's misconduct allowed it to 
derive an overall illicit benefit that was likely at least $400 
million.
    Based on this analysis of benefit, the other factors in the 
Commission's penalties statement, and the $50 million penalty 
imposed by OFHEO, the Commission decided that a $350 million 
penalty in its action was appropriate even though this amount 
is likely far less than full restitution, which is measured by 
the actual losses incurred by investors as a result of Fannie 
Mae's fraud. Restitution historically has been awarded in 
criminal securities cases, not in civil or administrative ones. 
As the Committee knows, the Commission's jurisdiction is civil 
and administrative; consequently, restitution is not a measure 
of relief that the Commission has won in cases like this one. 
Nonetheless, the Commission, in doing what it can to provide 
financial relief to investors, always strives to secure maximum 
disgorgement and legally appropriate penalties in its cases, 
including the case against Fannie Mae.

Addendum

            Securities and Exchange Commission Rule Changes









                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM STEPHEN B. 
                             ASHLEY

Q.1. The OFHEO report states that Fannie lobbyists ``used their 
longstanding relationships . . . to interfere with OFHEO's 
special examination'' of Fannie Mae. The Rudman report states 
that Fannie had ``a reputation for lecturing lawmakers'' and 
``a sophisticated lobbying organization that was known to be 
aggressive.'' In July 2004, Fannie ran television 
advertisements that were critical of GSE regulatory reform 
efforts the week before a Senate Banking Committee mark-up. 
Both of you were at Fannie when this occurred. Were the costs 
of these television advertisements reported in your lobbying 
disclosure expenses? How does lobbying further your statutory 
housing mission? Is it appropriate for a congressionally 
chartered institution to use funds earned under the benefit of 
its GSE status to lobby against congressional efforts to 
strengthen that institution's oversight? Has FASB looked at any 
additional studies to see whether this might be a possibility?

A.1. The 2004 advertising referred to was included in the total 
reportable lobbying expenses under Fannie Mae's 2004 Lobbying 
Disclosure Act (LDA) report. The company has not undertaken any 
advocacy advertising since 2004.
    Fannie Mae's management and board have made repairing our 
working relationships with our regulators and Congress, and 
establishing a new tone and manner in the way we communicate 
with policymakers, customers, and partners top corporate 
priorities. The company has reduced its lobbying operation 
significantly since 2004, and we remain committed to reversing 
the sometimes heavy-handed nature in which the company engaged 
with policymakers in the past.
    We believe it is very important that the company maintain 
an appropriate, professional, and responsive relationship with 
the regulators who oversee our business and with Congress, 
which chartered us to fulfill our housing mission.
    Fannie Mae communicates with government officials at all 
levels to provide information about the company and its role in 
the secondary mortgage market. Communication between government 
officials and Fannie Mae facilitates the exchange of important 
information and ideas on a variety of topics including 
mortgages, affordable housing, and capital markets. The 
company's government relations activities comply with 
applicable disclosure regulations.
    Fannie Mae continues to support passage of legislation to 
create a strong, well-funded regulator that would oversee the 
safety and soundness and the housing mission of the 
enterprises, and the company's government relations staff 
provides information to policymakers as appropriate with 
regards to this effort.
    We are unaware of any studies by the Financial Accounting 
Standards Board (FASB) about this matter.

Q.2. How many outside lobbyists and consultants does Fannie Mae 
have a contract with? What is the total number from 1998-2006? 
What was the total amount of money paid to these individuals 
for consulting and/or lobbying services for each of these 
years? How much of that money was ultimately reported under the 
lobbying disclosure act?

A.2. Currently, Fannie Mae has 19 external lobbying firms that 
are expected to file Federal LDA reports identifying Fannie Mae 
as a client for the semiannual period January to June 2006.
    From 1998 to 2005, the total number of firms that reported 
lobbying activities identifying Fannie Mae as a client and were 
registered lobbyists under the LDA ranged from 11 to 24 firms 
per year. The number of lobbying firms by year is provided 
below:


------------------------------------------------------------------------
  1998      1999      2000     2001     2002     2003     2004     2005
------------------------------------------------------------------------
    11        16        14       19       24       22       23       23
------------------------------------------------------------------------


    The total amount of retainers and expenses paid by Fannie 
Mae to these firms by year is identified below. A number of the 
firms were law firms that, in addition to providing lobbying 
services, also provided legal services to Fannie Mae on matters 
unrelated to lobbying (such as litigation, real estate, and 
securities disclosure). The costs for all of these services is 
included.


----------------------------------------------------------------------------------------------------------------
     1998           1999          2000          2001          2002          2003          2004          2005
----------------------------------------------------------------------------------------------------------------
    $2.09M         $3.45M        $3.41M        $5.56M        $7.94M       $11.67M        $7.36M        $4.67M
----------------------------------------------------------------------------------------------------------------


    The total amount of lobbying income related to lobbying 
activities on behalf of Fannie Mae reported by these lobbying 
firms on LDA reports is as follows:


----------------------------------------------------------------------------------------------------------------
     1998           1999          2000          2001          2002          2003          2004          2005
----------------------------------------------------------------------------------------------------------------
    $1.00M         $1.69M        $2.03M        $2.49M        $2.79M        $2.32M        $2.95M        $2.16M
----------------------------------------------------------------------------------------------------------------


    As allowed by the LDA, Fannie Mae has always used the tax 
method to report its lobbying expenses; the company is required 
to make a good faith estimate of lobbying expenses that are 
nondeductible.
    To derive this estimate, Fannie Mae uses the ``ratio 
method'' whereby a corporation multiplies its total costs of 
operations by a fraction. The numerator of the fraction is the 
number of hours employees spent on lobbying activities, and the 
denominator is the total work hours of all the company's 
employees on all company activities.
    The corporation adds the result of this calculation to its 
third party lobbying costs (such as amounts paid to outside 
lobbying firms, dues, legal fees associated with lobbying, 
etc.) to determine its total lobbying expenses.
    As noted, this method of calculating a company's lobbying 
expenditures is heavily impacted by the corporation's overall 
costs. Accordingly, despite a reduction in the amount paid to 
outside lobbying firms, Fannie Mae's overall lobbying costs as 
reported in its 2005 LDA filing grew, mostly due to the 
significant increase in the company's overall operating costs 
that year, which in 2005 were related to the company's 
restatement.
    Accordingly, Fannie Mae reported the following total 
lobbying expenditures through the company's LDA filings:


----------------------------------------------------------------------------------------------------------------
     1998           1999          2000          2001          2002          2003          2004          2005
----------------------------------------------------------------------------------------------------------------
    $5.55M         $7.01M         $7.0M        $6.57M        $7.59M         $8.7M        $8.79M       $10.08M
----------------------------------------------------------------------------------------------------------------


Q.3. The OFHEO report states that the ``Board contributed to 
those problems by failing to be sufficiently informed and to 
act independently of its chairman, Franklin Raines, and other 
senior executives; by failing to exercise the requisite 
oversight over the Enterprise's operations; and by failing to 
discover or ensure the correction of a wide variety of unsafe 
and unsound practices.''
    It further reads ``the members of the Board were all 
knowledgeable and qualified individuals, fully capable of 
understanding the business and corporate governance duties with 
which they were charged.''
    ``The Board's failures continued in the wake of revelations 
of accounting problems and improper earnings management at 
Freddie Mac and other high profile firms, the initiation of 
OFHEO's special examination, and credible allegations of 
improper earnings management made by an employee of the 
Enterprise's Office of the Controller.''

A.3. As I testified, the Fannie Mae of 1998-2004 portrayed in 
the final OFHEO report of its special examination is a far 
different company than was portrayed to the Fannie Mae Board by 
departed management, our former external auditor, and annual 
regular examination reports.
    I agree that Fannie Mae's board was composed of capable and 
qualified directors who in my perception were concerned with 
the strength of the Enterprise and its important mission. 
During the years examined in the OFHEO report, I believed the 
board came prepared for our meetings, asked the right 
questions, and appeared to be actively engaged in their duties 
of oversight. It was not my impression at the time that my 
colleagues on the board lacked independence from Mr. Raines or 
other senior executives. As a result of the investigations by 
both Senator Rudman and OFHEO, however, I have learned of a 
number of matters that I did not know at the time and that, in 
hindsight, I would have wanted to know as a member of the 
board.
    Following the issuance of OFHEO's report on its special 
examination of Freddie Mac, the board asked Fannie Mae's senior 
management and its outside auditors whether the issues 
identified in that report were also issues at Fannie Mae. The 
board as a whole received reports from different members of 
senior management on several separate occasions in response to 
these questions. In addition, the Audit Committee of the board 
received its own detailed presentation on these issues from 
senior management and the outside auditors. Throughout these 
presentations, we were assured that the problems identified at 
Freddie Mac were not present at Fannie Mae.
    In addition, it is my understanding that management 
informed the Audit Committee about accounting allegations made 
by Roger Barnes and that the allegations had been investigated. 
I also understand that the committee was told that Mr. Barnes 
had agreed that appropriate action had been taken in response 
to his concerns.
    The board has learned a lot of lessons, and we have worked 
to apply what we have learned. As I testified, since the 
initial OFHEO special examination report of September 2004, the 
board has continued to make significant changes to its 
composition, structure, and relationship to management:

    We separated the roles of the Chief Executive 
        Officer and the Chairman of the Board, as it was 
        essential to establish the appropriate governance and 
        oversight of management, assuring all parties that we 
        were progressing on our agreed-upon goals.
    Five of the 12 nonmanagement members are new since 
        2004, and the newest member, Dennis Beresford, is a 
        former chairman of the FASB and serves as chair of the 
        Audit Committee. All five of the new board members are 
        independent of management. We eliminated two of the 
        seats held by management, retaining just one, to 
        increase the proportion of independent board members. 
        In accordance with our corporate policy and OFHEO's 
        corporate governance rules on length of service, 
        another board member, Ann Korologos, will be leaving 
        the board effective July 31, 2006.
    To ensure accountability and the timely flow of 
        information, we established reporting lines to the 
        board for the positions of Chief Audit Executive, Chief 
        Compliance and Ethics Officer, and Chief Risk Officer.
    To improve our relationship with our regulators and 
        to hear about any problems directly, I and other 
        members of the board have established regular 
        interactions with OFHEO.

Q.4. The OFHEO report states that Fannie Mae lobbyists ``worked 
to insure that the agency (OFHEO) was poorly funded'' and 
``used longstanding relationships with Congressional staff . . 
. to interfere with OFHEO's special examination'' of Fannie 
Mae.
    What is your knowledge of this? Were you aware of this 
lobbying effort? If you were aware of it why didn't you stop 
it?
    The OFHEO report states the Board was notified of the HUD 
Inspector General's results. Mr. Ashley, the report also states 
(on page 276) you were notified about the results in 2004. Why 
were you notified about the results. Do you encourage this type 
of behavior at Fannie? If not, what did you do to specifically 
discourage it?

A.4. Throughout the course of the special examination the board 
directed the company to cooperate fully with OFHEO. We received 
periodic reports about the company's responses and were 
repeatedly assured that the company was cooperating and would 
continue to cooperate fully. Throughout this period, I never 
saw or heard anything that suggested that the company was 
attempting to obstruct OFHEO's special examination through 
lobbying efforts or otherwise.
    As for the HUD Inspector General's (IG) review of OFHEO, I 
recall learning the results of the review at the time they were 
reported in the press in November 2004. As noted in the OFHEO 
report (p. 276, fn. 165) I was also sent an e-mail from a 
Fannie Mae officer summarizing the press reporting on the 
topic. Keeping myself informed of the results of such a review 
of the company's regulator was fully consistent with my 
obligations as a board member.
    At no time was I ever informed that the IG's review of 
OFHEO was part of any effort by Fannie Mae to obstruct OFHEO's 
special examination of Fannie Mae. As I previously testified, 
management and the board have made establishing a new tone, 
manner, and approach in the way we interact with regulators and 
policymakers a top corporate priority.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM STEPHEN 
                           B. ASHLEY

Q.1. Acting Director Lockhart has noted that Dan Mudd's memo 
where Mr. Mudd stated:

        The old political reality was that we always won, we 
        took no prisoners, and we faced little organized 
        political opposition . . . We used to, by virtue of our 
        peculiarity, be able to write, or have written, rules 
        that worked for us. We now operate in a world where we 
        will have to be `normal' is the best written record of 
        the arrogant and unethical corporate culture at Fannie 
        Mae from 1998 to 2004.

    Given such an assessment, why do you feel that Dan Mudd is 
the best man to lead Fannie Mae into the future?

A.1. I will elaborate further about our comprehensive review of 
Dan in the context of our agreement with OFHEO in response to a 
subsequent question.
    As I testified, the board selected Dan Mudd as President 
and CEO of Fannie Mae in June 2005 after an extensive, 
competitive nationwide search and careful and deliberate 
consideration, including consultation with OFHEO and a targeted 
review by Senator Rudman. As interim CEO, Dan demonstrated an 
ability to lead a large financial institution through a major 
and challenging transition, including the ability to reach out 
and rebuild confidence with our regulators, Congress, and 
others. He demonstrated his capacity for the job by doing the 
job and he retains the confidence of the board. Since taking 
the helm, I believe Dan has effected positive changes in the 
culture of Fannie Mae. He has met our expectations. We chose 
him for his excellence in critical areas, and he has justified 
our choice.
    With regard to Dan's memorandum, I accept what he has 
explained in answering these questions from the Committee:

        As discussed during my June 15, 2006, testimony, the 
        thrust of my November 16, 2004, memorandum was in no 
        way an endorsement of the preexisting tone and attitude 
        at Fannie Mae. The purpose of the memorandum was to 
        reject the preexisting tone and attitude and encourage 
        the company to change. A central theme of the 
        memorandum was the importance of improving our 
        relationships with OFHEO and our other regulators, 
        including the SEC. My memorandum was attempting to 
        provide a `wake up call' that change was necessary to 
        meet the challenges of the more competitive and 
        evolving financial markets.

        For much of its life span, Fannie Mae had a practically 
        unique position in American financial markets. This 
        `peculiarity' meant that rules had to be created to 
        address aspects of Fannie Mae's business that were 
        different from other financial institutions. Thus, as 
        my memorandum noted, we `faced little organized 
        political opposition' during that era. However, as the 
        financial markets have become more sophisticated and 
        competitive, Fannie Mae became less unique and there 
        was less need for Fannie Mae-specific rules. My 
        memorandum does not indicate that the `old political 
        reality' from the bygone era was appropriate. Nor did I 
        suggest or condone any effort to eliminate political 
        opposition. There are and will be strongly opposing 
        views about the financial markets and Fannie Mae's role 
        in that arena. Fannie Mae recognizes that robust debate 
        in this area is appropriate and healthy.

        I strongly believe that a properly functioning, 
        professional relationship with our regulators is in the 
        best interest of our company and the housing markets, 
        and I have made it a top priority since becoming CEO to 
        repair and strengthen those relationships. I have also 
        made it clear from day one that the approach, tone and 
        manner with which we engage policymakers has needed to 
        change, and I hope we have made significant strides in 
        this regard.

Q.2. Responsibility for overseeing operational risk was 
primarily given to Frank Raines, but was then handed to Dan 
Mudd, Fannie's current CEO. What was Mudd's role as COO and to 
what degree was he responsible for what happened at Fannie Mae? 
How should he be held accountable?

A.2. When he was Chief Operating Officer, Dan Mudd's 
responsibilities primarily were dealing with Fannie Mae's 
customers and with the systems technology, and employees in 
those areas reported to him. While reporting structures changed 
from time to time at Fannie Mae during my tenure on the board, 
by 2003 all credit and risk personnel, including the Senior 
Vice President for Operations and Risk, reported to the Chief 
Financial Officer. Dan also did not oversee financial 
accounting, the mortgage portfolio, or internal audit.
    As I testified, the board selected Dan Mudd as President 
and CEO of Fannie Mae in June 2005 after an extensive, 
competitive nationwide search and careful and deliberate 
consideration, including consultation with OFHEO and a targeted 
review by Senator Rudman. Indeed, when it was clear that Dan 
was going to be a finalist for the position, I approached 
Senator Rudman, and had discussions with the then-director of 
OFHEO, as to whether there was anything in their knowledge that 
would suggest that the board should not move forward in 
considering Dan as a finalist. Senator Rudman's team spent 
about 2 to 3 weeks doing very in-depth reviews of Dan's work at 
the company, examining whether he was in any way implicated in 
any of the wrongdoing that had been identified in the September 
2004 OFHEO report. Senator Rudman's investigation was thorough. 
He met with the board's search committee and then later with 
the full board to discuss the results of his investigation. At 
that point, the board felt there was no reason why Dan should 
not be considered for the CEO position, and we subsequently 
appointed him CEO.
    Then, a week before OFHEO released its final special 
examination report in May of this year, a draft was made 
available to a small group under confidentiality for fact 
checking. At that time, we learned Dan was named several times 
in the report. Therefore, I felt that the board had to examine 
those findings and discuss them thoroughly, and did so. We 
asked Senator Rudman to read the report, to come back to us and 
address questions as to whether there were any new or different 
material findings that would cause the Senator and his team to 
change their opinion and their previous recommendation to the 
board regarding Dan's service as CEO. Senator Rudman reported 
that there was not any reason to change his opinion.
    The board continues to have full confidence in Dan Mudd as 
CEO of Fannie Mae.
    Under Fannie Mae's May 23, 2006, settlement agreement with 
OFHEO, the board of directors appointed a special committee of 
four independent board members (three of whom have joined the 
company subsequent to the end of 2004) which is conducting the 
personnel review prescribed by the agreement, including ``plans 
to seek restitution, disgorgement, or other remedies to recover 
funds from individuals.'' Mr. Mudd has stated publicly that he 
will abide by the decisions of the committee with regard to 
this matter.

Q.3. Fannie Mae senior executives omitted critical information 
to the Board leaving directors with a false sense of 
reassurance. Management is at fault, but what role should the 
board have played and why did they just accept and not question 
what management presented? The OFHEO report holds the Board 
more responsible than the Rudman report did, why is that?

A.3. The board of directors of every public company is 
responsible to act diligently, independently and on an informed 
basis in its oversight of the management of the corporation. In 
my view, Fannie Mae's board of directors discharged these 
responsibilities even though, in hindsight, information has 
come to light that was not made known to the board of directors 
at the time. As I discussed in responding to a question from 
Senator Hagel, in my opinion, the members of Fannie Mae's Board 
of Directors were well-qualified for their position, 
thoughtful, informed and engaged in the interactions that I 
observed with the management of the company.
    As I testified, the Fannie Mae of 1998-2004 portrayed in 
the final OFHEO report of its special examination is a far 
different company than was portrayed to the Fannie Mae board by 
departed management, our former external auditor, and annual 
regular examination reports. During the years examined in the 
OFHEO report, I believed the board came prepared for our 
meetings, asked the right questions, and appeared to be 
actively engaged in their duties of oversight. It was not my 
impression at the time that my colleagues on the board lacked 
independence from Mr. Raines or other senior executives. As a 
result of the investigations by both Senator Rudman and OFHEO, 
however, I have learned of a number of matters that I did not 
know at the time and that, in hindsight, I would have wanted to 
know as a member of the board.
    We learned a lot of lessons, and have worked hard to apply 
what we have learned. As I testified, since the initial OFHEO 
special examination report of September 2004, the board has 
continued to make significant changes to its composition, 
structure, and relationship to management:

    We separated the roles of the Chief Executive 
        Officer and the Chairman of the Board, as it was 
        essential to establish the appropriate governance and 
        oversight of management, assuring all parties that we 
        were progressing on our agreed-upon goals.
    Five of the 12 nonmanagement members are new since 
        2004, and the newest member, Dennis Beresford, is a 
        former chairman of the FASB and serves as chair of the 
        Audit Committee. All five of the new board members are 
        independent of management. We eliminated two of the 
        seats held by management, retaining just one, to 
        increase the proportion of independent board members. 
        In accordance with our corporate policy and OFHEO's 
        corporate governance rules on length of service, 
        another board member, Ann Korologos, will be leaving 
        the board effective July 31, 2006.
    To ensure accountability and the timely flow of 
        information, we established reporting lines to the 
        board for the positions of Chief Audit Executive, Chief 
        Compliance and Ethics Officer, and Chief Risk Officer.
    To improve our relationship with our regulators and 
        to hear about any problems directly, I and other 
        members of the board have established regular 
        interactions with OFHEO.

    As for the question why the OFHEO report holds the board 
more responsible than did Senator Rudman's report, I 
respectfully wish to defer to the authors of those reports. But 
I emphasize that the board takes the findings of both of those 
reports seriously, and we are committed to addressing the 
issues therein.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM DANIEL H. 
                              MUDD

Q.1. Mr. Mudd, in your testimony, you noted that ``Fannie Mae 
will work cooperatively to support the efforts of Congress to 
pass legislation to strengthen GSE regulation.'' Senators 
Sununu, Dole, and I have been circulating a letter to Chairman 
Shelby and Majority Leader Frist expressing the need to pass 
effective GSE reform this year and urging Senate leadership to 
bring 8.190 to the floor where the full Senate can debate the 
merits of the bill. To date, we have 26 Senators on the letter 
and the list is growing. Do you support the merits of this 
letter?

A.1. As I testified in my opening statement before the 
Committee in June, our position remains the same as when I 
testified in April 2005. While it would be inappropriate for 
Fannie Mae to comment on how or when the Senate should take up 
this debate, I can assure you that we will continue to work 
cooperatively to support the efforts of Congress to pass 
legislation to strengthen GSE regulation. In particular, we 
continue to support legislation:

    To create a single independent, well-funded 
        regulator with oversight for safety and soundness and 
        mission;
    To provide the regulator with strong bank-like 
        regulatory powers over capital, activities, 
        supervision, and prompt corrective action;
    To provide the regulator with bank-like authority 
        to reduce on-balance sheet activities, based on safety 
        and soundness; and
    To provide a structure for housing goals that 
        includes an affordable housing fund that strengthens 
        our housing and liquidity mission.

Q.2. According to the OFHEO report, you wrote in an e-mail in 
2003:

        I spoke to [a Treasury Department official], he had 
        agreed to talk to [the SEC] on `what to do if OFHEO was 
        not falling in line' already ([another Treasury 
        official] had already bent his ear about OFHEO 
        obstructionism) . . . promised me he'd check in to see 
        where things were and would call [the SEC] when needed.

    Can you respond to this? How does this fit in with your 
calls to change the tone of Fannie Mae?

A.2. The e-mail related to a call I made to a Treasury official 
during the time Fannie Mae was seeking and preparing for our 
voluntary registration with the SEC, an effort I supported to 
improve Fannie Mae's transparency and bring the company into 
line with other large public financial institutions. As the 
date approached for the filing of our first Form 10-K with the 
SEC, we learned that OFHEO disagreed with Treasury and the SEC 
about some aspects of the registration process. I called the 
Treasury official for guidance and clarification of the 
positions of the three agencies, solely with respect to 
interagency disagreements regarding the registration process.
    I want to emphasize that I did not make the call to 
generate conflict or to interfere, in any way, with OFHEO 
regulation of Fannie Mae. I meant the call as a good-faith 
attempt to obtain guidance about our regulatory obligations as 
we expanded Fannie Mae's financial reporting through SEC 
registration.
    As for Fannie Mae's tone and manner, I could not agree with 
you more--as I testified, the days of the arrogant, defiant, 
``my way'' Fannie Mae had to end. As CEO, I have explicitly 
made building stronger, cooperative relationships with our 
regulators and Congress, and changing our culture to one of 
service and humility, among our top corporate priorities. We 
have made many changes, and we are committed to making more.

Q.3. The OFHEO report states that ``by deliberately and 
intentionally manipulating accounting to hit earnings targets, 
(Fannie's) senior management maximized the bonuses and other 
executive compensation they received, at the expense of 
shareholders.'' You received a total of $26.3 million in 
executive compensation from Fannie between 2000-2004. Do you 
plan to return any of it? What is your total compensation for 
2005 and 2006?

A.3. Under Fannie Mae's settlement agreement with OFHEO, the 
board of directors has appointed a special committee of four 
independent board members (three of whom joined the company 
subsequent to the end of 2004), which is conducting the 
personnel review prescribed by the agreement, including ``plans 
to seek restitution, disgorgement, or other remedies to recover 
funds from individuals.'' I have stated publicly that I will 
abide by the decisions of the committee with regard to this 
matter.
    Prior to being named the company's President and CEO on 
June 1, 2005, I earned a base salary of $850,000. Upon being 
named President and CEO, my base salary rose to $950,000 for 
the remainder of the year. I also received a cash bonus of 
$2,591,875 for the 2005 performance year, and was granted 
restricted shares of company stock valued at $8,000,000, 
subject to a vesting period of 4 years.
    My annual salary for 2006 remains at $950,000. My 2006 
annual cash bonus award target is 275 percent of my annual base 
salary. Decisions on additional compensation provisions for 
2006 are at the discretion of the company's board of directors 
and have not been determined.

Q.4. The OFHEO [report] states that

        In 2003, three Fannie Mae employees expressed serious 
        concerns about the Enterprise's accounting. Roger 
        Barnes, then a manager in the Office of the Controller, 
        made allegations about Fannie Mae's accounting for 
        deferred price adjustments under FAS 91 to Sampath 
        Rajappa, Senior Vice President for Operations Risk, who 
        then reported those concerns promptly to Ann Kappler, 
        Senior Vice President and General Counsel.

        Another employee in Securities Accounting also 
        expressed concerns about amortization accounting to 
        Chief Operating Officer Daniel Mudd, and a third 
        employee echoed those concerns. Ms. Kappler and Mr. 
        Mudd initiated flawed investigations into those 
        allegations and concerns. When those investigations 
        were completed, Ms. Kappler made statements about the 
        issues raised and their disposition--in one case, to 
        the Audit Committee of the Board of Directors--that 
        were false and misleading.

    Can you respond to this? When did you become aware of 
Fannie's accounting problems? What were your responsibilities 
as Chief Operating Officer? Which employees reported to you? 
Did the Senior Vice President for Operations and Risk report to 
you?

A.4. While I carried the title of Chief Operating Officer 
(COO), my responsibilities, as assigned by the Chainnan and CEO 
at the time, primarily were working with Fannie Mae's customers 
and dealing with the systems, technology, and employees in 
those areas that reported to me. While reporting structures 
changed from time to time at Fannie Mae during my tenure as 
COO, by 2003 all credit and risk personnel, including the 
Senior Vice President for Operations Risk, who ran internal 
audit, reported directly or indirectly to the Chief Financial 
Officer. I also did not oversee financial accounting or the 
mortgage portfolio.
    I first learned that OFHEO had concluded that certain 
aspects of Fannie Mae's accounting were wrong upon release of 
the September 2004 OFHEO report. Like a lot of people, I was 
stunned.
    As CEO, my number-one priority has been to get our 
accounting right and fix our systems, internal controls, 
organization, and other issues as we complete our restatement 
by the end of this year.
    The Securities Accounting employee cited in the OFHEO 
report, Michelle Skinner, raised a question about accounting 
during an open-forum, town hall-style meeting I held with 
employees on a regular basis, which the company called an 
``unplugged'' meeting. For unplugged meetings, employees were 
invited to ask questions on any type of issue or concern--
ranging from complicated business and work issues, to the food 
served in the cafeteria, and the coverage limits of the dental 
plan. In the September 9, 2003, session, Ms. Skinner asked a 
complex accounting question. Because I am not a trained 
accountant and do not have expertise in the field, and because 
the financial accounting function did not report to me during 
my service as COO, I could not answer her question on the spot. 
So I invited Ms. Skinner to send an e-mail to me explaining her 
concerns in greater detail.
    When I received her e-mail, I asked my assistant--a former 
securities lawyer--to ensure answers were provided in response 
to Ms. Skinner's questions. The matter was referred to Internal 
Audit, the General Counsel, and the Controller's Office. By 
late September, Internal Audit provided to me its assurance 
that issues raised by Ms. Skinner were being handled by the 
company in a manner consistent with GAAP. I was also told that 
our external auditor, KPMG, reviewed these issues and found the 
treatment acceptable.
    At my direction, a November 17, 2003, tutorial session was 
organized to address the questions that had been raised by Ms. 
Skinner in greater depth and in an open dialog with interested 
employees. It is my understanding that Ms. Skinner and Mr. 
Anthony Lloyd (the ``third employee'' referenced in the 
question) stated that they were satisfied with the response and 
that their concerns had been addressed. At the time, I believed 
that the issues were being thoroughly reviewed and that a full 
and accurate response was provided by offices and individuals 
experienced and knowledgeable in the area. At all times, I 
tried to address Ms. Skinner's inquiry openly and thoroughly.

Q.5. The OFHEO report states Fannie's ``corporate culture was 
intensively focused on attaining Earning Per Share (EPS) 
goals'' and ``senior management provided an incentive to 
employees to double EPS to $6.46 by year-end 2003.''
    In the same year, Sampath Rajappa, Fannie's Senior Vice 
President for Operations Risk and head of Internal Audit told 
Fannie's internal audit group: ``you must be obsessed on $6.46. 
After all, thanks to Frank [Raines], we all have a lot of money 
riding on it . . . Remember, Frank has given us an opportunity 
to earn not just our salaries, benefits, raises, ESPP [Employee 
Stock Purchase Program] but substantially over that if we make 
$6.46.'' The final EPS number for 2003 was $7.29 which 
triggered the bonuses.
    Is this the right message to be sending to your company's 
internal audit group?
    According to the OFHEO report, meeting this goal--and 
triggering the option grants and bonuses--was a primary goal of 
senior management. In a 2000 memo, you wrote:

        We also need to continue to focus on our 2003 challenge 
        . . . we still have a gap of nearly $375 million in 
        pre-tax income . . . ! know that the numbers in our Q3 
        forecast around our `big bets' are still being refined 
        as we iron out the issues--and that those revenue 
        numbers may well change. It is clear that these new 
        products may not be sufficient to get us to our $6.46 
        goal--and we as a company must be looking hard at what 
        it will take to make it.

    When did you become aware of this EPS incentive plan? Were 
you aware that this incentive plan was extended to internal 
audit employees? Who reviewed these targets? Did you have the 
ability to review these targets? Can you also provide the 
Banking Committee a copy of this memo?

A.5. As I testified, I was not aware of Mr. Rajappa's speech at 
the time, and it is deeply troubling to me. I don't think 
that's the way that an audit staff should be focused, and I and 
the board have made a priority of changing that since I took 
the job of CEO. As I also testified, I believe it's very 
important that the audit staff be independent and report 
directly to the board, and that its compensation be independent 
of the company's financial results.
    With these principles in mind the board and management have 
completely overhauled the internal audit function to ensure it 
is the corporate guardian it is supposed to be. The Chief Audit 
Executive is a new external hire who reports directly to the 
Audit Committee of the board of directors with a dotted line 
reporting to the CEO. This position has increased direct 
interactions with, and enhanced detailed reporting to, the 
board's Audit Committee and its chair (who is a new Fannie Mae 
board member, Dennis Beresford, a former chair of the Financial 
Accounting Standards Board). The Internal Audit function also 
has undergone a comprehensive organizational and process 
redesign, including new structure, staffing levels, skill 
assessments, audit planning processes, execution, and 
reporting. The company has also replaced its outside auditor 
with Deloitte and Touche, LLP, which formerly provided advice 
to OFHEO when several of the accounting problems were first 
identified and is now conducting a comprehensive re-audit of 
the entire company with more than 300 auditors onsite at Fannie 
Mae.
    As Fannie Mae Chairman, Steve Ashley, said during his 
testimony:

        During the 1990s and the early part of the decade of 
        2000 this was an accepted and indeed promulgated form 
        of compensation in addition to base compensation that 
        most of corporate America publicly owned corporate 
        America--engaged in one Finn or another. The purpose 
        was to align the management of the company with the 
        interests of the shareholders.

    I was aware of the EPS goal when I arrived at Fannie Mae in 
2000 because the company announced it broadly--publicly and 
internally--when it was launched in 1999, and it remained a 
corporate financial stretch goal through 2003. The incentive 
was available to all full-time employees of the company. And as 
I noted in my appearance before the committee, this was a 
compensation structure similar to other companies that I had 
worked for previously and which I thought appropriate in those 
circumstances.
    The company has now adopted a new executive compensation 
structure with broad performance goals that include achieving 
affordable housing mission goals, improving our culture, 
complying with regulatory standards, and delivering shareholder 
value. In addition, Fannie Mae's Consent Order with OFHEO 
explicitly requires the board to ensure that our compensation 
practices ``include financial and nonfinancial metrics and 
shall not be tied exclusively to earning per share'' and that 
``compensation metrics for the internal auditor, chief 
compliance officer, controller, and such others, as determined 
in consultation with OFHEO, be appropriate to their roles and 
do not create a conflict of interest.''
    Regarding my memorandum of October 12, 2000, as I 
testified, all companies that I'm familiar with have budgets 
with targets for revenues and expenses, and compensation plans 
that have targets in them. Part of my responsibilities as COO 
was to review the profits and losses of that part of the 
business I was running and to try to attain the goals set by 
the organization. Never at any point would I sanction any 
departure from the rules in order to hit EPS targets.
    In response to your request, my memorandum is being 
provided to the Committee as an attachment to these responses.

Addendum

                        Memorandum from Dan Mudd





                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DANIEL H. 
                              MUDD

Q.1. Fannie Mae signed a consent agreement on May 23, 2006, 
with the Office of Federal Housing Enterprise Oversight 
agreeing to cap its retained mortgage related portfolio to $727 
billion, its level on December 31, 2005. Using Fannie Mae's 
$727 billion portfolio as a model, what would Fannie Mae's 
portfolio size be with the limits of S. 190? Please include an 
explanation of the assumptions that you used to arrive at this 
number?

A.1. Under S. 190, the size of Fannie Mae's portfolio would be 
the sum of the seven permissible assets listed in the bill. 
While several of these asset definitions could be subject to 
some interpretation (e.g., ``mortgages and mortgage-backed 
securities for the purpose of securitization'' and a ``limited 
inventory of mortgages solely for the purpose of supporting the 
guarantee business''), in our analysis a literal reading of the 
bill would lead to a reduction in the size of our portfolio to 
a range of $10 billion to $100 billion.
    We summarize below our best estimates of the projected size 
of Fannie Mae's portfolio under the provisions of S. 190, 
broken down into the seven permissible asset categories listed 
in the bill. We note, where appropriate, any assumptions we 
make concerning the bill's provisions and/or future conditions 
and behavior in the housing, secondary mortgage, and capital 
markets.



  1.  Mortgages and mortgage-backed securities for the purpose 
        of securitization: $2-20 billion. We assume this 
        category would consist of whole loans purchased from 
        lenders that are in the process of conversion into 
        mortgage-backed securities (MBS) and eventual sale. 
        These loans may need to be held on the balance sheet to 
        optimize security sales. Loans or packages of loans 
        from disparate lenders, delivery mechanisms, or 
        delivery months may need to be aggregated over some 
        period of time to achieve the best available price in 
        the securities market.

  2.  Mortgages acquired to meet affordable housing goals, if 
        such assets are not readily securitizable: $2-20 
        billion. Currently, Fannie Mae holds approximately $250 
        billion of mortgage loans on our balance sheet. A 
        literal reading of the phrase ``if such assets are not 
        readily securitizable'' would preclude us from holding 
        almost all of these loans, whether or not they qualify 
        as affordable housing loans, since almost all loans are 
        readily securitizable at some price. Of the loans on 
        our balance sheet, more than 90 percent could be 
        securitized by lenders through programs currently 
        offered by Fannie Mae. In general, loans acquired and 
        held on our balance sheet tend to meet our affordable 
        housing goals criteria at a greater rate than loans 
        placed in MBS. For example, of loans acquired on our 
        balance sheet in 2005, 61 percent met our low and 
        moderate-income affordable goal (compared to 46 percent 
        of loans in MBS), 35 percent met our special-affordable 
        goal (compared to 18 percent of loans in MBS), and 40 
        percent met our underserved goal (compared to 37 
        percent of loans in MBS).

  3.  A limited inventory of mortgages solely for the purpose 
        of supporting the guarantee business: $2-50 billion. We 
        interpret this category to include only those mortgage 
        holdings that directly and solely support the guarantee 
        business. We include loans and securities that we may 
        need to purchase from lenders as a means of retaining 
        or improving the guarantee business with those lenders. 
        We specifically did not include MBS holdings that 
        provide liquidity support and thus, improve the price 
        performance of MBS securities.

  4.  Real estate acquired through foreclosure: $2-5 billion. 
        We base this estimate on our recent holdings of this 
        asset class. We assume these holdings would grow 
        somewhat as the credit guarantee business grows, but 
        would not exceed $5 billion in scale (absent any 
        significant rise in the rate of foreclosures).

  5.  and 7. Cash and liquid investments: $1-3 billion.

  6.  Real estate, intellectual property fixtures, and 
        equipment for use in the business operations of the 
        enterprise: $1-2 billion.

    Based on our reading, S. 190 would bar the GSEs from 
investing in almost all instances in MBS. This prohibition 
would encompass MBS backed by loans to finance affordable 
housing for low- and moderate-income families, very low-income 
families, or underserved communities. The prohibition would 
also apply if the GSEs' investment in MBS promoted the 
liquidity of loans, especially fixed-rate loans, for middle-
class homebuyers.
    The Charter Act assigns important obligations to Fannie 
Mae, including obligations to:

    Provide stability in the secondary market for 
        residential mortgages;
    Provide ongoing assistance to the secondary market 
        for residential mortgages; and
    Promote access to mortgage credit throughout the 
        Nation . . . by increasing the liquidity of mortgage 
        investments and improving the distribution of 
        investment capital available for residential mortgage 
        financing.

    Currently, in meeting our Charter Act obligations, Fannie 
Mae fulfills a broader role than we could under the list of 
permissible investments in the bill. Consequently, the company 
has a much larger loan portfolio ($731 billion at the end of 
June 2006) than would be the case if S. 190 were enacted. Thus, 
we believe the bill would require the company to liquidate 
approximately $600 billion to $700 billion in assets.

Q.2. What are the public policy benefits and risks of the two 
different portfolio sizes?

A.2. As Fannie Mae testified before the Committee in April 
2005, we believe that our mortgage portfolio--our original line 
of business since 1938--fosters liquidity and affordability in 
the U.S. mortgage market, especially in times of economic 
distress or market disruption. Unlike any other investor in 
U.S. mortgages, the GSEs are required by law to operate in all 
50 states, under all economic conditions. This helps ensure the 
availability of mortgage capital through good times and bad.
    We believe that mandating a large reduction in the size of 
our portfolio could make it difficult for the GSEs to help 
provide these benefits for low-, moderate-, and middle income 
homeowners and renters currently served by the U.S. mortgage 
market. We also believe the risks that have been suggested 
about the current GSE portfolios would be effectively addressed 
by granting a new GSE regulator with bank-like powers to ensure 
the safety and soundness of the GSEs' operations.
    As we have previously testified, we believe the GSEs' 
current portfolio business provides several important public 
policy benefits for housing.
    First, the GSEs' current portfolios increase the stability 
of the U.S. housing sector.
    Today, the U.S. housing finance system draws funds from the 
entire U.S. and global capital markets (including banks, Wall 
Street, pension funds, foreign central banks, and others) 
through the sale of GSE debt instruments. This vastly improves 
on the system it replaced, which drew funds almost entirely 
from U.S. bank deposits. It also is considered improbable that 
myriad small financial companies and mortgage bankers could 
access the international capital markets with the efficiency 
and scale that are hallmarks of the GSEs' role. Under the 
former system, Americans' ability to get a mortgage at 
reasonable rates and terms was heavily dependent on the state 
of the overall U.S. economy. Housing in general, including 
builders and the housing trades, was subject to a series of 
boom-bust cycles that often amplified economic cycles in the 
broader economy.
    The capital markets funding system, backed by the GSEs' 
portfolios, has smoothed out chronic boom-bust housing cycles. 
Housing has gone from a source of general economic instability 
and disruption to a stabilizer, and even a driver, of economic 
growth. The GSEs, both in their guarantee and portfolio roles, 
play a central role in this capital markets model and, in fact, 
there has been a pronounced reduction in housing cycle 
volatility that correlates closely with the growth of the GSEs' 
portfolios over the course of the 1990s.
    Susan Wachter, Professor of Real Estate and Finance at the 
University of Pennsylvania's Wharton School, testified last 
year before the Senate Banking Committee that:

        The role of mortgage market access to global capital 
        markets as an automatic stabilizer for the U.S. economy 
        is demonstrated by the strength of the housing sector 
        and its role in moving the economy out of the 2001 
        recession. Access to international capital markets 
        during a period of low and falling interest rates and 
        possible deflation has resulted in additional consumer 
        spending which has supported the U.S. economy. This 
        benefit that the GSEs and secondary markets provide the 
        American consumer is a major contributory factor to the 
        strength of America's economy today and to the long-run 
        stability of America's economy going forward. [Emphasis 
        added]

    Second, the GSEs' current portfolios increase the liquidity 
and affordability of U.S. mortgages.
    The GSE portfolio purchases increase the demand for U.S. 
mortgages and mortgage backed securities, thus making them more 
tradable (i.e., liquid) and putting downward pressure on the 
interest rates charged to homeowners. They do so in several 
ways.
    By issuing debt to purchase mortgages, the GSEs draw in 
hundreds of billions of dollars from investors at home and 
abroad to expand the availability and lower the cost of 
mortgage capital. For example, Fannie Mae's senior, long-term 
Benchmark Securities outstanding represented 42 percent of our 
total long-term debt outstanding as of the end of the second 
quarter of 2006, and we know that over the last eight and a 
half years, international investors purchased approximately 
one-third of those Benchmark issuances in aggregate, or $160 
billion. Smaller U.S. banks (e.g., community banks, 
agricultural banks, commercial lenders ) are also substantial 
investors in GSE debt, demonstrating a strong preference for 
investing in GSE debt versus MBS issued by the GSEs. It is not 
at all clear that these investors would place their money in 
the U.S. housing market without the predictability and 
convenience provided by GSE debt issuances.
    In addition, by investing in their own mortgage-backed 
securities, the GSEs create a ``backstop bid'' which acts as a 
safety net and is relied upon by other investors. A number of 
securities dealers have acknowledged the stabilizing force of 
the GSE backstop bid. Lehman Brothers, for example, has stated 
that ``weakening of the backstop bid from the agencies . . . 
increases the risk in owning mortgages from a liquidity 
standpoint.''\1\
---------------------------------------------------------------------------
    \1\ Lehman Brothers, Mortgage Strategy Weekly, MBS and ABS 
Research,4-25-2005, p.  3.
---------------------------------------------------------------------------
    Substantially restricting the GSEs' portfolios effectively 
would eliminate the backstop bid and make mortgages less liquid 
and less attractive investments. This could cause other 
investors to withdraw from the mortgage market. One respected 
Wall Street analyst described the process involved as follows:

        The mortgage-backed securities market is a multi-
        trillion dollar market. For the last 10 years they have 
        relied quite heavily on the idea that there is a 
        backstop bid from Fannie and Freddie when spreads widen 
        out. Without that backstop bid, it just simply makes 
        sense to most people on Wall Street that that's going 
        to add volatility and some spread widening to the 
        mortgage markets. It's very difficult to see how 
        lenders can absorb those extra costs, and so you would 
        have to assume some are going to get passed on to 
        homeowners in some size or fashion.\2\
---------------------------------------------------------------------------
    \2\ Jim Vogel, FTN Financial, Memphis, Tennessee quoted on 
Bloomberg, August 1, 2005.

    In short, the Fannie Mae and Freddie Mac portfolios, 
combined, finance approximately one and a half trillion dollars 
of U.S. conforming mortgages. Removing the GSE investment 
demand from the market would tend to decrease the availability 
of mortgage financing and increase its cost.
    Third, the GSEs' current portfolio operations provide key 
support for the 30-year fixed rate mortgage, with a prepayment 
option, a home loan that distinguishes our system from most 
others in the world.
    By creating two companies that invest only in residential 
mortgages, Congress laid the foundation for the 30-year fixed-
rate pre-payable mortgage, which is an important tool for 
wealth creation, stabilizing communities and neighborhoods, and 
allowing low- and middle-income homeowners to manage their 
other financial obligations without having to worry about their 
mortgage costs changing.
    While no one can state with certainty the full impacts of 
portfolio restrictions on the availability of the 30-year 
fixed-rate mortgage, there is a real-world laboratory that 
shows what the market might be like without the GSEs. This is 
the jumbo market, which the GSEs are, by law, prohibited from 
participating in. There, one finds a marked difference in the 
incidence of fixed-rate mortgages. In 2005, the percent of 
mortgages used to purchase homes that were fixed rate was 74 
percent in the conforming market compared to only 35 percent in 
the jumbo market.
    The GSEs' portfolio operations in the conforming market 
appear to be a big factor in explaining this discrepancy. It is 
well recognized that ARMs tend to have higher credit risk than 
fixed-rate mortgages. Therefore, the absence of a GSE guarantee 
on a jumbo mortgage should, if anything, drive the market 
toward a higher supply of fixed-rate loans in the jumbo market 
than in the conforming market. That the opposite occurs 
suggests that it is the GSEs' willingness to invest in fixed-
rate conforming mortgages through portfolio operations (rather 
than their guarantee of such mortgages) that is the driving 
force behind the much greater frequency of fixed-rate mortgages 
in the conforming market.
    Fourth, the GSEs' current mortgage portfolios allow the 
companies to play a shock-absorbing function for the finance 
system during times of potential difficulty, such as the debt 
crisis of 1998.
    The GSEs' experience in mortgage trading operations and the 
willingness of a broad array of investors to invest in GSE 
bonds gives the companies an ability to act quickly to buy 
mortgages in times of crisis, supporting the liquidity of the 
broader mortgage market.
    For example, in an independent study, economists Joe Peek 
and James A. Wilcox asked, ``How can GSEs stabilize mortgage 
flows?'' and wrote:

        First, they may directly increase mortgage flows during 
        recessions by purchasing whole mortgages and mortgage-
        backed securities to at least partially offset the 
        procyclicality of supplies by others . . .

        Thus, when housing-related GSEs increase their supplies 
        of mortgage activities in response to financial 
        disruptions, they serve as shock absorbers that lessen 
        the fall-off in the supplies of home mortgages . . .

        Having increased during (the comparison period 
        associated with) each recession, intermediation by 
        Fannie Mae and Freddie Mac combined was countercyclical 
        . . . [T]he behavior of the other participants in the 
        mortgage market was procyc1ical . . .

        During periods of international financial crises or of 
        domestic economic stress . . . GSEs may be particularly 
        well suited to facilitating mortgage flows. So long as 
        there are such crises and stresses, GSEs may be 
        particularly effective in stabilizing mortgage markets 
        and moderating business cycles.\3\ [Emphasis added]
---------------------------------------------------------------------------
    \3\ Peek, Joe, University of Kentucky and James A. Wilcox, Haas 
School of Business, UC Berkeley, Secondary Mortgage Markets, GSEs, and 
the Changing Cyclicality of Mortgage Flows, Ed. Andrew H. Chen. 
Research in Finance 20, January 2003, various pages. For online copy, 
follow link from http://207.36.165.114/Denver/Papers/
DenverProgram818.htm

    Severely restricting the size of the GSEs' mortgage 
portfolios would reduce their capacity to serve this 
stabilizing role. The GSEs' charter obligations to increase 
liquidity and to bring stability to the market in periods of 
stress are complementary activities. In order to be able to 
fulfill the role of mortgage market stabilizers in times of 
market distress, a GSE must have established, during normal 
times, a liquid market for its securities, rather than relying 
upon untried securities.
    In addition, the GSEs have to maintain systems 
infrastructure, a network of broker/dealers and a cadre of 
experienced staff in order to be able to conduct stabilizing 
operations during periods of turmoil.
    In conclusion, the current GSE portfolios provide 
substantial liquidity and affordability benefits to the U.S. 
mortgage market and the homeowners and consumers that are 
served by that market. Restricting the GSEs to the list of 
investments permitted in S. 190 could make it difficult or 
impossible for the GSEs to help provide these benefits, 
especially during cycles when other investors shy away from 
mortgages. Finally, as we have previously stated, we believe 
that any risks posed by the current system would be effectively 
addressed through ensuring that the GSE regulator has bank-like 
powers to ensure the safety and soundness of the GSE 
operations.

Q.3. It has come to my attention that HUD Secretary Jackson 
plans to review the nonmortgages that Fannie currently holds, 
in keeping with its government charter to maintain proper 
safety and soundness levels. Could you please comment on what 
nonmortgage financial products Fannie currently holds, and also 
give your thoughts on the soundness of those products?

A.3. Fannie Mae's nonmortgage assets fall into three 
categories:

    First: The company maintains a Liquid Investment Portfolio 
(LIP) consisting of money market and fixed-income assets with 
high credit quality. The purpose of the LIP is two-fold: (1) to 
reduce risk by providing a pool of nonmortgage investments to 
ensure the company could meet all of its obligations if it did 
not have access to the debt markets for as long as 3 months; 
and (2) to provide for the temporary investment of excess 
capital. The LIP is one major component of the company's 
contingent liquidity program, as detailed in a September 2005 
agreement with OFHEO. We report on our nonmortgage asset 
holdings to HUD every quarter, and OFHEO regularly reviews our 
liquidity plan.
    The LIP consists of money market instruments, asset-backed 
notes, corporate debt, and bank deposits. By corporate policy 
this portfolio is restricted in the type of assets it is 
allowed to hold as well as the overall credit quality, 
maturity, and duration of those assets. The average credit 
rating of the LIP is in the AA category. The size of the LIP 
varies due to changing liquidity and capital management 
requirements. Again, the express requirement is that Fannie Mae 
maintains this portfolio of nonmortgage assets in order to 
ensure the safety and soundness of our overall financial 
activities.

    Second: Low Income Housing Tax Credits (LIHTC)--In addition 
to providing mortgage financing to multifamily housing, Fannie 
Mae also works with nonprofit and for-profit housing sponsors 
to increase the availability of funds to affordable multifamily 
housing by making equity investments in properties that qualify 
for Federal LIHTC.
    Congress created LIHTC in 1986. The credit generates about 
$8 billion of private investment each year to produce more than 
125,000 affordable apartments for low income families and the 
elderly.
    Properties developed under LIHTC target residents who earn 
60 percent or less of the area's median income. In a 1997 
study, the General Accounting Office found that average Housing 
Credit apartment renters earn only 37 percent of area median 
income. Many earn less than 30 percent.
    Fannie Mae's participation in the LIHTC market provides 
day-in day-out liquidity to this important affordable housing 
market. Fannie Mae's LIHTC investments span all parts of the 
country and all types of properties that have received an 
allocation of the tax credit.
    Fannie Mae's credit performance from its LIHTC portfolio 
has been very strong. Total losses on the total book over the 
17 years of LIHTC investment activity equal approximately one-
tenth of a percent.

    Third: In addition to the LIP and LIHTC assets described 
above, as of June 30, 2006, Fannie Mae holds approximately $5 
billion of other nonmortgage assets (.6 percent of our total 
assets). There are four types of investments in this category: 
(1) Debt and equity investments entered into through activities 
of the American Communities Fund (ACF), $2.4 billion; (2) 
Market-rate equity investments, $0.4 billion; (3) Tax-
advantaged investments in synthetic fuels and wind energy, $7.0 
million; and (4) Corporate-owned life insurance, $2.0 billion. 
These are described below:

    ACF Investments--ACF provides various types of 
        financing to help meet community development needs, 
        including: predevelopment loans to nonprofit 
        developers, participations in acquisition, development 
        and construction financing, and construction lines of 
        credit or letters of credit. As an equity investor, 
        Fannie Mae acts as a limited partner or nonmanaging 
        member of a limited liability corporation (LLC) that 
        invests in real estate operating properties, mezzanine 
        loans, and historic tax credits. Fannie Mae either 
        invests directly in a property or through a fund that 
        holds direct investments. Fannie Mae also has 
        investments in common or preferred shares of community 
        development financial institutions (CDFIs).
    Market-rate Equity Investments--These investments 
        comprise limited partner or LLC member equity interests 
        in direct or fund investments in rehabilitation 
        properties.
    Investments in Synfuels and Wind Energy--Between 
        1998 and 2000, Fannie Mae invested in limited 
        partnerships that acquired and operated plants that 
        produce synthetic fuel from coal and wind energy plants 
        designed to produce electricity. The investment in 
        plants that produce energy from nonconventional sources 
        qualifies for tax credits under the Internal Revenue 
        Code.
    Corporate Owned Life Insurance--As is typical in 
        major corporations, Fannie Mae has purchased corporate-
        owned life insurance (COLI) that covers the lives of 
        certain directors and officers. This insurance provides 
        a benefit to the company in the event of the death of a 
        key employee, which reduces the costs associated with 
        the related loss of talent, expertise, and knowledge. 
        The company also uses these investments as a means of 
        funding deferred compensation and supplemental 
        retirement programs.
                                ------                                


 RESPONSE TO WRITTEN QUESTIONS OF SENATOR MARTINEZ FROM DANIEL 
                            H. MUDD

Q.1. The OFHEO Report on pp. 269-271 asserts that you missed an 
opportunity to recognize that there were similarities between 
Freddie Mac and Fannie Mae's situation. Can you explain why you 
didn't refer the complaints by Michelle Skinner (which were 
confirmed by the Head of the Office of Auditing, Sampath 
Rajappa) to the Board Audit Committee?

A.1. The Securities Accounting employee cited in the OFHEO 
report, Michelle Skinner, raised the question about accounting 
during an open-forum, town hall-style meeting I held with 
employees on a regular basis, which the company called an 
``unplugged'' meeting. In the unplugged meetings, employees are 
invited to ask questions on any type of issue or concern-
ranging from complicated business and work issues to the food 
served in the cafeteria and the limits of coverage under the 
dental plan. In the September 9, 2003, session, Ms. Skinner 
asked a complex accounting question. Because I am not a trained 
accountant and do not have expertise in the field and because 
the financial accounting function did not report to me during 
my service as COO, I could not answer her question on the spot. 
So I invited Ms. Skinner to send an e-mail to me explaining her 
concerns in greater detail.
    When I received her e-mail, I asked my assistant--a former 
securities lawyer--to ensure answers were provided in response 
to Ms. Skinner's questions. The matter was referred to Internal 
Audit, the General Counsel and the Controller's Office. By late 
September, Internal Audit provided to me its assurance that 
issues raised by Ms. Skinner were being handled by the company 
in a manner consistent with GAAP. I was also told that our 
external auditor, KPMG, reviewed these issues and found the 
treatment acceptable.
    At my direction, a November 17, 2003, tutorial session was 
organized to address the questions that had been raised by Ms. 
Skinner in greater depth and in an open dialog with interested 
employees. It is my understanding that Ms. Skinner and Mr. 
Anthony Lloyd (another employee who shared similar concerns) 
stated that they were satisfied with the response and that 
their concerns had been addressed. At the time, I believed that 
the issues were being thoroughly reviewed and that a full and 
accurate response was provided by offices and individuals 
experienced and knowledgeable in the area. At all times, I 
tried to address Ms. Skinner's inquiry openly and thoroughly.

Q.2. Based on the OFHEO report (p. 34) you were describing 
needed changes and you stated:

        The old political reality was that we always won, we 
        took no prisoners, and we faced little organized 
        political opposition . . . We used to, by virtue of our 
        peculiarity, be able to write, or have written, rules 
        that worked for us. We now operate in a world where we 
        will have to be `normal.'

    Can you explain to me what you were trying to say in that 
memo? If you were simply operating Fannie Mae pursuant to its 
government charter and playing by the rules why would you have 
needed (in the past) to eliminate any political opposition and 
I am assuming you meant both Congress and more specifically 
OFHEO?

A.2. As discussed during my June 15, 2006, testimony, the 
thrust of my November 16, 2004, memorandum was in no way an 
endorsement of the preexisting tone and attitude at Fannie Mae. 
The purpose of the memorandum was to reject the preexisting 
tone and attitude and encourage the company to change. A 
central theme of the memorandum was the importance of improving 
our relationships with OFHEO and our other regulators, 
including the SEC. My memorandum was attempting to provide a 
``wake-up call'' that change was necessary to meet the 
challenges of the more competitive and evolving financial 
markets.
    For much of its life span, Fannie Mae had a practically 
unique position in American financial markets. This 
``peculiarity'' meant that rules had to be created to address 
aspects of Fannie Mae's business that were different from other 
financial institutions. Thus, as my memorandum noted, we 
``faced little organized political opposition'' during that 
era. However, as the financial markets have become more 
sophisticated and competitive, Fannie Mae became less unique 
and there was less need for Fannie Mae-specific rules. My 
memorandum does not indicate that the ``old political reality'' 
from the bygone era was appropriate. Nor did I suggest or 
condone any effort to eliminate political opposition. There 
are, and will be, strongly opposing views about the financial 
markets and Fannie Mae's role in that arena. Fannie Mae 
recognizes that robust debate in this area is appropriate and 
healthy.
    I strongly believe that a properly functioning, 
professional relationship with our regulators is in the best 
interest of our company and the housing markets, and I have 
made it a top priority since becoming CEO to repair and 
strengthen those relationships. I have also made it clear from 
day one that the approach, tone, and manner with which we 
engage policymakers has needed to change, and I hope we have 
made significant strides in this regard.

Q.3. It appears that on page 37 of the OFHEO Report we have 
evidence of what used to be the case at Fannie Mae (e-mail 
dated January 13, 2003). Can you explain what you meant by 
``what to do if OFHEO was not falling in line?''

A.3. The e-mail related to a call I made to a Treasury official 
during the time Fannie Mae was seeking and preparing for our 
voluntary registration with the SEC--an effort I supported to 
improve Fannie Mae's transparency and bring the company into 
line with other large public financial institutions. As the 
date approached for the filing of our first Form 10-K with the 
SEC, we learned that OFHEO disagreed with Treasury and the SEC 
about some aspects of the registration process. I called the 
Treasury official for guidance and clarification of the 
positions of the three agencies, solely with respect to 
interagency disagreements regarding the registration process.
    I want to emphasize that I did not make the call to 
generate conflict or to interfere, in any way, with OFHEO 
regulation of Fannie Mae. I meant the call as a good-faith 
attempt to obtain guidance about our regulatory obligations as 
we expanded Fannie Mae's financial reporting through SEC 
registration.

Q.4. I'd like an explanation of your reasoning for not 
procuring more resources for the Auditing Department. Based on 
the e-mail referenced on by footnote 82 on p. 206, I assume you 
were aware, or at least should have been aware, that audits 
were being postponed or canceled. How do you explain your 
oversight of this issue given that you were growing your 
business during these years, not to mention the new compliance 
requirements from Sarbanes-Oxley (2002)?

A.4. That particular e-mail reflects the regular adjustment 
process that the Audit Department would undertake mid-year in 
its audit plans. The e-mail specifically indicates that the 
original plans were being adjusted due to the Audit 
Department's focus on Sarbanes-Oxley and the OFHEO Special Exam 
during 2004. At this time (August 2004), the Audit Department 
did not report to me; I was provided this e-mail as a courtesy 
so that I would be generally informed of the Audit Department's 
plans for the rest of 2004. The e-mail did not state that the 
Audit Department wanted or needed additional staff, but rather 
explained that Sarbanes-Oxley requirements and the OFHEO 
Special Exam (which began in 2003) had caused adjustments in 
the work done by the Audit Department. It made sense to me then 
that the Audit Department should be focused on those issues. 
Indeed, it was publicly reported that many American 
corporations were reevaluating resources and plans in light of 
the advent of Sarbanes-Oxley. In addition, at the time I 
believed that the Audit Committee and the CFO (which both had 
oversight responsibility for the Audit Department) were 
properly monitoring the Audit Department's needs and taking any 
appropriate steps, when needed, to provide additional resources 
to the Audit Department.

Q.5. Did it not occur to you that to connect the compensation 
of the Auditing Dept with EPS was an obvious conflict of 
interest? What could the auditing department possibly do to 
help meet the EPS of $6.46?

A.5. As I stated in my appearance before the committee, I agree 
that the Audit function is a very important function and a very 
important check that requires independence. It is critical that 
its compensation be independent of the company's financial 
results.
    As Fannie Mae Chairman, Steve Ashley, said during his 
testimony, ``during the 1990s and the early part of the decade 
of 2000 this was an accepted and indeed promulgated form of 
compensation in addition to base compensation that most of 
corporate America--publicly owned corporate America--engaged in 
one form or another. The purpose was to align the management of 
the company with the interests of the shareholders.''
    The EPS goal was announced broadly--publicly and 
internally--when it was launched in 1999, and it remained a 
corporate financial stretch goal through 2003. The incentive 
was available to all full-time employees. And as I noted in my 
appearance before the committee, this was a compensation 
structure similar to other companies that I had worked for 
previously and which I thought was appropriate in those 
circumstances.
    Fannie Mae has now adopted a new executive compensation 
structure with broad performance goals that include achieving 
affordable housing mission goals, improving our culture, 
complying with regulatory standards, and delivering shareholder 
value. In addition, Fannie Mae's Consent Order with OFHEO 
explicitly requires the board to ensure that our compensation 
practices ``include financial and nonfinancial metrics and 
shall not be tied exclusively to earning per share'' and that 
``compensation metrics for the internal auditor, chief 
compliance officer, controller, and such others, as determined 
in consultation with OFHEO, be appropriate to their roles and 
do not create a conflict of interest.''
    To ensure proper oversight moving forward, the board and 
management have completely overhauled the internal audit 
function to ensure it is the corporate guardian it is supposed 
to be. The Chief Audit Executive is a new external hire who 
reports directly to the Audit Committee of the board of 
directors with a dotted line reporting to the CEO. This 
position has increased direct interactions with, and enhanced 
detailed reporting to, the board's Audit Committee and its 
chair (who is a new Fannie Mae board member, Dennis Beresford, 
a former chair of the Financial Accounting Standards Board). 
The Internal Audit function also has undergone a comprehensive 
organizational and process redesign, including new structure, 
staffing levels, skill assessments, audit planning processes, 
execution, and reporting. The company has also replaced its 
outside auditor with Deloitte and Touche, LLP, which formerly 
provided advice to OFHEO when several of the accounting 
problems were first identified and is now conducting a 
comprehensive re-audit of the entire company with more than 300 
auditors onsite at Fannie Mae.

Q.6. Next, I would like to discuss your e-mail/memo regarding 
restricting Board access to management. In your e-mail which 
begins on the bottom of page 271 of the Report, you appear to 
infer that in restricting the Board's access to management 
(essentially giving CEO /Chairman Raines sole discretion in 
what is communicated to the Board) is a ``best in class'' 
principle for corporate governance. Do you still believe that?

A.6. The e-mail you ask about addressed unique circumstances 
specific to the employee who received it, our former SVP for 
Human Resources, Kathy Gallo. I did not intend this 
communication to limit employee access to the board or its 
committees in general.
    Here are the circumstances behind the e-mail. In 2003, Ms. 
Gallo told me she had received direction on specific issues 
from a board committee chair, Ann Mulcahy. When I discussed the 
matter with Ms. Mulcahy, she informed me that the Committee in 
fact had not provided any such direction to Ms. Gallo. At Ms. 
Mulcahy's direction, I sent Ms. Gallo an e-mail--addressed to 
her alone (with certain appropriate people copied)--directing 
her to use regular channels of communication with the board and 
its committees to ensure a clear record of board and committee 
decisions. This guidance to Ms. Gallo did not limit or affect 
any board member's ability to seek information from any Fannie 
Mae employee. As indicated by the limited distribution of the 
e-mail, I intended it solely to address the situation that 
arose concerning Ms. Gallo. In addition, the channel of 
communication (the Office of the Corporate Secretary) 
identified in the e-mail to Ms. Gallo did not give Mr. Raines 
sole discretion over the information communicated to the board.
    I believe in the principle that the board should have full 
and unfettered access to management and employees. Many of the 
organizational, structural and reporting changes Fannie Mae has 
made since I became CEO--within the company and with the board, 
and to fulfill our regulatory agreements and otherwise--are 
designed to ensure this access.

Q.7. Hedge accounting is of great importance to Fannie Mae 
because of its large derivative portfolio used to hedge 
interest rate risk associated with its debt issuances. The SEC 
announced in December 2004 that Fannie Mae's hedge accounting 
policies and procedures did not comply with GAAP (FAS 133). 
Would you explain FAS 133, the differences between the short-
cut and long-haul methods of hedge accounting and their 
implications, particularly the potential earnings volatility, 
and why Fannie Mae did not comply?

A.7. Fannie Mae uses interest rate derivative instruments to 
manage and reduce the interest rate risk that, for all mortgage 
investors, is inherent in holding mortgage assets, particularly 
fixed-rate loans, which are our specialty. These derivatives, 
in essence, help us to match the duration of our liabilities 
(the debt we issue to purchase mortgages) with the duration of 
the mortgage assets we purchase.
    FAS 133, Accounting for Derivative Instruments and Hedging 
Activities requires that derivatives be carried on financial 
statements at fair value with changes in fair value (mark) 
included in earnings unless the company applies hedge 
accounting. Thus, without applying hedge accounting, the fair 
value mark on the derivative is included in earnings without an 
offsetting mark related to the hedge item.
    As I currently understand it, the so-called ``short-cut'' 
method is a provision in FAS 133 that allows for an assumption 
that the gain or loss on the derivative instrument will exactly 
offset the gain or loss on the hedged item. This method 
significantly simplifies the computations necessary to make the 
accounting entries because it does not require the periodic 
calculation of how well changes in the fair value of the 
derivative mirror changes in the fair value of the hedged item. 
Thus, under the short-cut method, no amount of ineffectiveness 
is included in earnings during the life of the hedge 
relationship. Companies may only apply the short-cut method if 
the critical terms of the derivatives precisely match the 
critical terms of the hedged item.
    In contrast, the long-haul method requires quarterly 
calculations of the ``effectiveness'' of each hedging 
relationship. To the extent the change in fair value of the 
derivative is not offset by the change in the fair value of the 
hedged item, ``ineffectiveness'' results. Any amount of 
ineffectiveness is included in earnings in the period in which 
it occurs. As it has been explained to me, Fannie Mae applied 
the short-cut method to its hedging relationships under the 
belief that it had met the requirements of the standard. The 
SEC determined in December 2004 that this application of FAS 
133 was not appropriate.

Q.8. Do you believe that Fannie Mae did not engage in innocuous 
practical interpretations or modest deviations from a strict 
reading of FAS 133, but the company clearly departed from FAS 
133 requirements?

A.8. As it has been explained to me, Fannie Mae applied a 
short-cut method to its hedging relationships under the belief 
that it had met the requirements of the standard. The 
requirements of FAS 133 have challenged many companies, 
resulting in a large number of restatements. Prior to SEC 
pronouncements, the company believed that its interpretation of 
FAS 133 was reasonable. It has now been determined that these 
interpretations were not appropriate under the short-cut 
method.

Q.9. Mr. Raines committed to double Fannie Mae's EPS in 5 
years. This strategy meant aggressively expanding the credit 
guarantee and portfolio investment business, with the latter 
offering the better prospect for growing earnings. Would you 
explain the interest rate risk taken and how the asset duration 
gap changed? Why should the board have recognized the 
inconsistency between reporting stable EPS growth and taking 
significant interest rate risk and implementing FAS 133 
properly?

A.9. Interest rate risk is the risk of loss to future earnings 
or long-term value that may result from changes in interest 
rates. Fannie Mae's principal source of interest rate risk 
stems from holding mortgages that homeowners may prepay at any 
time without penalty. The so-called ``borrower's option'' is a 
fundamental underpinning of the U.S. system and is made 
possible by the GSEs' liquidity function. The cash-flows from 
mortgage assets are highly sensitive to changes in interest 
rates because of the borrower's option, exposing the company to 
interest rate risk because the cash-flows of mortgage assets 
and the liabilities that fund them are not perfectly matched 
through time and across all possible interest rate scenarios. 
As interest rates decrease, borrowers are more likely to 
refinance fixed-rate mortgages, resulting in increased 
prepayments and mortgage cash-flows that are received earlier 
than expected. Conversely, an increase in interest rates may 
result in slower than expected prepayments and mortgage cash-
flows that are received later than expected.
    The company assesses exposure to changes in interest rates 
using a diverse set of analyses and measures, including the 
duration gap. The duration gap is the difference between the 
estimated durations of portfolio assets and liabilities. 
Duration gap summarizes the extent to which estimated cash-
flows for assets and liabilities are matched, on average, over 
time and across interest rate scenarios. A positive duration 
gap signals a greater exposure to rising interest rates because 
it indicates that the duration of assets exceeds the duration 
of liabilities. A negative duration gap signals a greater 
exposure to declining interest rates because the duration of 
the company's assets is less than the duration of its 
liabilities. It should be noted that the duration gap reflects 
the mortgage portfolio at a point in time and not projected 
future business activity. Since October 2000, the company has 
publicly disclosed its duration gap on a monthly basis.
    Prior to 2003, the company maintained a preferred range for 
its duration gap of plus or minus 6 months. From 1992 to 2002, 
the company's duration gap was wider than plus or minus 6 
months approximately one-third of the time. The company's 
duration gap experienced a negative shift during 2002 primarily 
as a result of a significant decline in interest rates that 
resulted in a surge in mortgage refinancing activity. The 
significant increase in expected mortgage prepayments caused 
the durations of the company's mortgages to shorten by more 
than the duration of the company's debt. The company's duration 
gap peaked at minus 14 months in August 2002 before narrowing 
to minus 5 months by the end of the year. The reduction in the 
duration gap was accomplished primarily through portfolio 
rebalancing action taken by the company. For all of 2002, the 
company's duration gap was wider than plus or minus 6 months in 
3 months of the year, slightly less than the company's 
historical average of approximately one-third of the time.
    Beginning in 2003, the company has followed a risk 
discipline that requires a duration gap of plus or minus 6 
months substantially all of the time. To maintain the duration 
gap within this tighter risk tolerance, the company began 
taking rebalancing actions earlier and with more frequency than 
it previously had. The company's monthly duration gap has been 
within the range of plus or minus 6 months in every month since 
October 2002, and has been within a range of plus or minus 1 
month in every month since October 2004.
    Fannie Mae's financial results as measured under generally 
accepted accounting principles (GAAP) do not capture the full 
impact of changes in the fair value of our mortgage assets or 
our debt. Hence, changes in fair value of the mortgage assets 
or debt due to changes in interest rates are only recognized in 
earnings when realized through assets sales or debt 
repurchases. Conversely, GAAP requires derivatives to be 
measured at fair value with changes in fair value recorded 
through earnings unless a qualifying hedge accounting 
relationship has been established. As a result of this GAAP 
mismatch, without hedge accounting, even if the duration gap is 
managed to zero, earnings and EPS volatility will result from 
the changes in the fair value of derivatives. It is equally 
possible that a financial institution exposed to interest rate 
risk from a significant duration gap could expect little short-
term GAAP earnings and EPS volatility because their derivatives 
have been appropriately designated in hedging relationships.

Q.10. Fannie Mae buys derivative instruments that will offset 
the impact of interest rate movements on the company's debt 
obligations and thereby maintain its spread. The notional 
amount of their derivative portfolio passed the $1 trillion 
mark in 2003. Their menu of hedge transactions has increased to 
approximately 70 different combinations of debt and 
derivatives. Fannie Mae's debt is sold primarily to purchase 
mortgages and mortgage-backed securities (MBS) to hold in 
portfolio. What is your view of the risk and complexity 
involved in managing this retained portfolio? The retained 
portfolio is considerably more profitable than guaranteeing 
MBS. Is this an example of the earnings at any cost culture at 
the company? What, if any, correlation is there between the 
size of the portfolio and the company's achievement of its 
mission?

A.10. Fannie Mae is one of many large U.S. financial 
institutions, including large federally insured commercial 
banks--that have and manage a retained portfolio of residential 
mortgages. Fannie Mae's portfolio holds only about 7 percent of 
the $10 trillion mortgage debt outstanding assets, and the 
retained portfolios of some of the largest banks are growing, 
with one beginning to rival the size of Fannie Mae's (Bank of 
America's is nearly $500 billion).
    All mortgage investors face similar risks and complexities 
of managing their mortgage portfolios. Fannie Mae differs from 
most other mortgage investors in two major ways. First, unlike 
most of these other mortgage investors, Fannie Mae invests 
exclusively in residential mortgages--among the safest assets 
in the world--which allows us to focus on managing their risks, 
making it less complex for us than managing the range of assets 
that others do. Second, Fannie Mae's ability to raise capital 
by issuing debt securities in various and variable durations 
gives us the ability to match our funding with the mortgages we 
purchase and hold, and thus better manage the risks 
effectively.
    Regardless of our profitability, Fannie Mae has managed a 
retained mortgage portfolio since our inception in 1938 for a 
critical reason: to achieve our chartered purpose of providing 
liquidity to the housing finance system by raising capital 
globally and domestically, and purchasing mortgage assets, 
providing lenders with a steady supply of funds, at favorable 
rates and terms, in all markets across the Nation under all 
economic conditions. Indeed, as a result of their charters, the 
GSEs are the only mortgage investors that are required to be in 
all markets at all times, even when banks and other investors 
pull away.
    The 70 different combinations of debt and derivatives cited 
in the question refers to the accounting classifications Fannie 
Mae had historically used in linking its derivatives to 
specific debt issues or anticipated debt issues. The types of 
derivatives used fall into only four classes: (1) interest rate 
swaps; (2) interest rate swaptions; (3) interest rate caps; and 
(4) foreign currency swaps. Interest rate swaps are among the 
most liquid derivative instruments in the market, and are used 
to manage the duration of the portfolio. Swaptions and caps are 
used to manage the prepayment or convexity risk of mortgages we 
own. The smallest group of derivatives we use are foreign 
currency hedges which basically swap all debt we issue 
denominated in foreign currency into U.S. dollars.
    It also should be noted that the mortgage portfolio is not 
always our most profitable business, nor is it ``considerably 
more profitable than guaranteeing MBS.'' Any of our businesses, 
like those in other institutions, may be more or less 
profitable at a given time.

Q.11. The company claimed its hedges exactly matched its risk 
exposure in the portfolio when it did not. Critics focus on the 
extent of interest rate and prepayment risk, but shouldn't the 
risk involved in accounting for the derivatives and hedging be 
a major concern?

A.11. Fannie Mae uses interest rate derivative instruments to 
adjust the duration of our debt to manage the interest rate 
exposures of our mortgage related assets. The reasons why we 
enter into derivatives--to allow us to manage our interest rate 
exposures--is unaffected by the accounting.
    As with any complex accounting standard, and particularly 
in the case of FAS 133, subjective judgments and 
interpretations are required that create risk that there could 
be differing interpretations. Many of the most complex 
interpretations of FAS 133 relate to hedge accounting. Given 
the challenges presented by the hedge accounting requirements, 
Fannie Mae is not currently applying hedge accounting.
    Fannie Mae's financial results as measured under generally 
accepted accounting principles (GAAP) do not capture the full 
impact of the changes in the fair value of our mortgage assets 
or our debt. Hence, changes in fair value of mortgage assets or 
debt due to changes in interest rates are only recognized in 
earnings when realized through assets sales or debt 
repurchases. Conversely, GAAP requires derivatives to be 
measured at fair value with changes in fair value recorded 
through earnings unless a qualifying hedge accounting 
relationship has been established. As a result of this GAAP 
mismatch, without hedge accounting, even if the duration gap is 
managed to zero, earnings and EPS volatility will result from 
the changes in the fair value of derivatives. It is equally 
possible that a financial institution exposed to interest rate 
risk from a significant duration gap could expect little short-
term GAAP earnings and EPS volatility because their derivatives 
have been appropriately designated in hedging relationships. 
That said, our number-one corporate priority is to complete the 
restatement under this, and other accounting standards, and we 
are leaving no stone unturned to do the job right.

Q.12. The controller's office lacked adequate staffing and 
systems, as well as sufficient accounting and financial 
reporting expertise for a company as complex as Fannie Mae. The 
Controller, at one time, was not a certified public accountant. 
What, if any, active support did this office receive from 
senior management, especially following the company's voluntary 
SEC registration and what steps has current management taken?

A.12. Overall, the company has established a new management 
team, particularly in the critical control functions, including 
finance, accounting, audit, and risk to provide the leadership, 
experience, talent, and ethical standards necessary for a 
company with the scope of Fannie Mae. In cooperation and 
consultation with our regulator, we are fundamentally 
reorganizing the company to ensure that strong checks and 
balances are in place. The standard the company has put forth 
during the transformation in this regard is straightforward--
the average businessperson should be able to look at the 
organization chart and understand key roles and 
responsibilities and identify clear checks and balances.
    The company has a new Chief Financial Officer, a new Chief 
Risk Officer, a new Chief Audit Executive, a new Senior Vice 
President for Accounting Policy, and a new Controller. As part 
of the Controller's department, we have bolstered the staffing 
considerably with 17 officers working in this area compared to 
five previously. Accounting policy, accounting application and 
budgeting are all separate now, with each group headed by new 
senior leadership from Big Four accounting firms or major 
corporations and eight of the staff, including the Controller 
himself, are certified public accountants.
    The company has taken other concrete steps in this regard:

    The CFO, Robert Blakely, who headed up the 
        restatement at MCI, does not run a business--he is 
        focused solely on Finance.
    To ensure proper oversight, we have reorganized and 
        strengthened Internal Audit, and the new Chief Audit 
        Executive has a direct and independent reporting line 
        to the board's Audit Committee. The board's Audit 
        Committee is now chaired by Dennis Beresford, a former 
        member of FASB who joined the board this year.
    The company has replaced its outside auditor with 
        Deloitte and Touche, which formerly provided advice to 
        OFHEO when several of the accounting problems were 
        first identified and is now conducting a comprehensive 
        re-audit of the entire company with more than 300 
        auditors onsite at Fannie Mae.
    To integrate strong risk management into the 
        accounting, controls, and audit areas and throughout 
        the entire enterprise, the company has put in a place a 
        strong risk management function headed by Chief Risk 
        Officer Enrico Dallavecchia. Mr. Dallavecchia had been 
        with JP Morgan Chase as head of market risk management, 
        and he comes to the company with almost 20 years of 
        experience in banking and risk management.
    As part of the company's restatement and 
        remediation efforts, Fannie Mae has invested hundreds 
        of millions of dollars in new systems to ensure that 
        the company's technologies in this area will meet high 
        standards, ensure proper controls, and fully support 
        the accurate and transparent financial reporting 
        required of an SEC registrant.

Q.13. The head of internal audit did not have training or 
experience as an auditor. Internal audit had to clear 
communications with the board's audit committee through senior 
management and told the committee that Fannie Mae's accounting 
complied with GAAP, when it actually audited only for 
compliance with the company's policies interpreting GAAP. What 
steps have been taken to reorganize the internal audit 
function?

A.13. Management and the board's Audit Committee appointed a 
new Chief Audit Executive, Jean Hinrichs, from outside the 
company who reports directly to the Audit Committee with a 
dotted line to the CEO. The Chief Audit Executive has over 25 
years of internal audit and risk management experience. She has 
increased direct interactions with the board's Audit Committee 
and its chairman, and enhanced detailed reporting to the 
committee monthly. The Internal Audit function has implemented 
a comprehensive organizational and process redesign, including 
a new structure, staffing levels, skill assessments, audit 
planning processes, execution, and reporting.
    As part of the organizational restructure, the Internal 
Audit department has three new vice presidents who have an 
average of 23 years of experience in audit and risk management 
with top-tier financial institutions and public accounting 
firms. As a result of targeted recruiting and training, the 
Internal Audit department has 20 certified public accountants 
and 70 percent of the department has an auditing, accounting or 
technology professional certification.

Q.14. Fannie Mae voluntarily registered its stock with the SEC; 
as a result, the enterprise was required to comply with 
Sarbanes-Oxley, effective in 2004. The OFHEO Report states: 
``Although the Office of Auditing lacked the requisite 
knowledge, skills, and resources, Fannie Mae delegated to the 
Office the responsibility of building and maintaining the SOX 
404 compliance system.'' This addition to existing duties was 
``overwhelming.'' How has this affected the company's SOX 
compliance?

A.14. The Internal Audit department had project oversight for 
the company's efforts to develop and assess internal control 
over financial reporting in 2004 pursuant to Section 404 of the 
Sarbanes-Oxley Act and related rules of the SEC. The department 
coordinated with KPMG, the company's independent auditor at the 
time. Upon announcement of the restatement and senior 
management changes, the company engaged PricewaterhouseCoopers 
LLP (PwC) to assist with SOX 404 compliance efforts. The 
company also engaged Deloitte and Touche LLP as its new 
independent auditor.
    With the assistance of PwC, we have been assessing the 
effectiveness of our internal control over financial reporting 
that existed as of December 31, 2004, and as of December 31, 
2005. To date, we have identified control deficiencies in a 
number of areas, including: financial systems and other 
information technology systems; entity-level controls relating 
to risk oversight, staffing and expertise of the internal audit 
and accounting departments, and documentation of policies and 
procedures; design and application of accounting policies; the 
valuation of our assets and liabilities; and financial 
reporting processes. We expect to conclude that many of these 
identified deficiencies are either material weaknesses or 
significant deficiencies that in the aggregate constitute 
material weaknesses. We also may uncover additional 
deficiencies as this assessment process continues.
    Management has taken a number of steps since December 2004 
to address control deficiencies, including completely 
reorganizing the company's finance area and hiring a new Chief 
Financial Officer, a new Controller, a new Chief Audit 
Executive and several other new accounting officers, 
reorganizing the company's risk management and corporate 
compliance functions and appointing a new Chief Risk Officer 
and a new Chief Compliance and Ethics Officer.
    Our report on internal control over financial reporting in 
our Annual Report on Form 10-K for both 2004 and 2005 will 
conclude that our internal control over fmancia1 reporting was 
ineffective due to the presence of material weaknesses. Our 
reports for 2004 and 2005 will identify material weaknesses and 
address our plans for remediation. We believe that Deloitte and 
Touche will not be able to issue opinions on the effectiveness 
of our internal control over financial reporting as of December 
31, 2004, or on management's assessment of the effectiveness of 
our internal control over financial reporting as of December 
31, 2004, but will be able to issue these opinions in 
connection with our internal control over financial reporting 
as of December 31, 2005.

Q.15. It is my understanding that the size and aggressiveness 
of the company's lobbying and grass roots activities have been 
substantially reduced. Can you give me more specifics about in-
house and external activities in terms of personnel, costs, and 
approach?

A.15. Management and the board have made establishing a new 
tone, manner, and approach in the way we communicate with 
policymakers a top corporate priority. Specific actions taken 
include:

    The company discontinued retainers with six outside 
        lobbying firms since the end of 2004, though 
        contractual obligations required additional retainer 
        payments to some firms in the first quarter of 2005.
    The company discontinued all advocacy advertising.
    The total operating expenses for the internal 
        Government and Industry Relations Department decreased 
        by 21 percent from 2004 to 2005.
    Fannie Mae continues to reduce its external 
        lobbying costs, and remains committed to its overall 
        objective of cutting external lobbying retainers by 
        one-third from previous levels.
    The company discontinued its regional public 
        affairs director positions, and has restructured its 
        Community Business Centers to focus on supporting local 
        business objectives.