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