 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
|
Prepared Witness Testimony The House Committee on Energy and Commerce
Freddie Mac: Accounting Standards Issues Raised in the Doty Report.
Subcommittee on Commerce, Trade, and Consumer Protection
Mr. James R. Doty
Chairman Stearns, Ranking Member Schakowsky and members of the Subcommittee: Thank you for inviting me to testify today concerning our investigation of certain accounting matters for the Board of Directors of the Federal Home Loan Mortgage Corporation ("Freddie Mac" or the "Company").Details of the investigation and our conclusions are set forth in our Report dated July 22, 2003.I would like to speak today to those findings and their implications for the significant work of this Subcommittee and your ongoing concern with accounting standards. I. It is important at the outset to say what we did not find.There was no indication that the Company was creating fictitious profits.Nothing we have found calls into question the fundamental financial safety and soundness of the Company.While we found misapplications of accounting principles, our investigation did not reveal rampant, criminal misconduct, misappropriation of corporate funds for personal gain, or the other types of intentional wrongdoing that have characterized recent scandals.Rather, our investigation found a company focused on risk management, but responsive - perhaps overly so - to the market expectation of steady, nonvolatile earnings growth.That market expectation was, at times, apparently at odds with the reality of the business as it has developed over the past decade. Since 1989, the Company has evolved from a quasi-governmental entity to a public company that is a major participant in international capital markets.This period has also marked a fundamental shift in the Company's business as it has retained more of the purchased mortgage loans as investments (the "Retained Portfolio").[1]Many of the challenged transactions were the result of the tension between this changing business reality and the determination of senior management to maintain the image of "Steady Freddie" by delivering the quarterly and annual earnings expected by analysts.[2] Missing at Freddie Mac was a sufficient boundary, marked by the Company's accounting professionals, to discipline the goal of "Steady Freddie" and to ensure that capital market transactions and reserve policies were accounted for properly. The accounting errors that led to the restatements resulted in large part from the inadequacies of Corporate Accounting in responding to the accounting rules applicable to derivative transactions, most notably SFAS 133 and SFAS 125, and initiatives within Corporate Accounting with respect to managing reserves.The challenges faced by Corporate Accounting were exacerbated by rapid growth in the Company's Retained Portfolio of mortgage loans, and the associated exposure to volatility in reported earnings.However, the practices that enabled the Company to report earnings "smoothed" to within 2¢ to 3¢ per share of analysts' expectations involved reserve adjustments, not simply capital market transactions. It is also important to note that, notwithstanding the various accounting errors, we found nothing to suggest that the transactions at issue had the effect of undermining the Company's risk-management policies and practices.As discussed in our Report, we did find problems: (i) weaknesses in the Company's internal compliance and governance processes; (ii) disclosure practices that fell below the standards required of a public company; and (iii) weaknesses in Corporate Accounting that resulted in excessive reliance on independent auditors with respect to accounting decisions and policies. The role of senior management is a focus of the Report.Employees in F&I, Corporate Accounting and other business units were expected by senior management to take actions that would help achieve the goal of steady, nonvolatile earnings growth.The Board of Directors was aware of this goal but the flow of information was so controlled by former management that the accounting challenges involved in executing particular strategies were not fairly presented. Finally, even as Board and Audit Committee members became increasingly concerned over the apparent lack of depth and expertise in Corporate Accounting, senior management failed to take the prompt corrective action demanded by the Board, a failure that had serious consequences.These governance problems are the focus of a robust remediation effort now going forward at Freddie Mac, under the oversight of the Board and the direction of the new CFO, Martin Baumann. II. Now, I shall turn to some of the underlying accounting issues that seem to me most germane for the Subcommittee. SFAS 133 Our Report describes several transactions[3] that were entered into in late 2000 and early 2001 in response to changes in accounting rules, most notably SFAS 133.[4] SFAS 133 required the Company to record derivative instruments on its balance sheet at fair market value (i.e., marked-to-market through income) beginning January 1, 2001.SFAS 133 has been criticized as an example of a rule-based, rather than principle-based, accounting standard.The concern has been expressed that, as such, SFAS 133 might encourage a check-the-box approach that eliminates judgment from the application of the standard. Without commenting further on the action the Company took in response, we note two findings.First, the Company believed that the transition to SFAS 133 would distort the financial condition of the Company by producing a one-time gain for which the Company would not receive credit from analysts and investors,[5] and by creating artificial earnings volatility in future periods (requiring that some derivatives be marked-to-market but not permitting similar treatment of the debt economically hedged by those derivatives).Second, in what we saw to be a common theme in many of the transactions we investigated, management believed that SFAS 133 should be "transacted around" because it did not reflect the economic fundamentals of the Company's business. The most instructive example of this response was the CTUG transaction, which was intended to offset the one-time transition adjustment gain under SFAS 133 by reclassifying certain portfolio assets with embedded losses from "held-to-maturity" to "trading" (producing a loss that would be reported in the transition adjustment line on the Company's income statement) and then reclassifying the securities from "trading" to "available-for-sale" (an asset classification that does not require mark-to-market accounting and so would not produce earnings volatility in the future). Although the Company and its independent auditors have determined that the transaction was not compliant with GAAP, it is possible that with certain adjustments to the transaction structure the Company would have satisfied GAAP.Specifically, the most serious GAAP problem with the CTUG arises not under SFAS 133, but under the transfer and control requirements of SFAS 125.[6]These flaws could have been addressed by transactional changes.SFAS 133, in paragraph 54, invites reporting companies to attempt precisely what Freddie Mac attempted - to transfer held-to-maturity derivatives into trading and thereby offset this one-time gain with the embedded losses. The Swaptions Portfolio Valuation and the J-Deals were similarly entered into in order to avoid volatility in financial results.[7]The J-Deals, if structured and executed differently, could have achieved the Company's intended results (consistent with SFAS 125 and SFAS 115). SFAS 91 As described in our Report, SFAS 91 required the Company first to amortize the value of premiums and discounts over the estimated life of a mortgage pool, and then to book "catch up" adjustments to the income statement when actual prepayments differed from estimates.Again, the Company believed that, as applied to it, this accounting standard produced misleading results that tended to overstate the volatility of the Company's business.The Company responded by creating a "band," and by booking the catch up adjustment (so long as it fell within this band) to a special reserve account, rather than the income statement.On one occasion, the Company also changed its assumptions about interest rate yield curves, again with an eye toward reducing volatility in its reported financial statements. Worth noting, however, is that the use of a non-GAAP reserve for this purpose was fully transparent to the Company's then-public accounting firm, which tolerated the practice so long as the amounts involved were not quantitatively material. SFAS 5 SFAS 5 provides that a company's reserves be based on "probable" losses.As noted in our Report, in a number of instances, the Company made "management adjustments" to reserve accounts and altered the models that supported reserve policy, with a view to presenting a steady, nonvolatile pattern of earnings growth.These reserve adjustments frequently were not supported by documentation in accordance with GAAP.As such, the reserve policy reflected a purpose of moving earnings to within a penny or two of analysts' estimates of earnings per share, rather than a balanced assessment of the underlying probable losses. III. The foregoing summary covers the three major areas of accounting policy implicated by the transactions investigated - capital market transactions, reserve policy and management reserve adjustments. Thank you again for the opportunity to appear; and I will be happy to take your questions. [1] The opinions expressed to us by the Company indicate that the referenced growth of the Retained Portfolio was one factor enabling Freddie Mac to perform its mission in furthering the liquidity of the secondary mortgage market through crises such as the implosion of Long Term Capital Management and other international financial crises of the 1990's. [2] These matters are now being investigated by the Securities and Exchange Commission, the Department of Justice, and the Office of Federal Housing Enterprise Oversight and nothing in this testimony is intended as a comment on those investigations. [3] CTUG, Swaptions Portfolio Valuation and J-Deals. [4] Statement of Financial Accounting Standard No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities. The range of the accounting standards involved in the investigated transactions was not, of course, limited to SFAS 133, but included SFAS 125, SFAS 140, SFAS 107, SFAS 115, SFAS 91, SFAS 5, EITF 99-20 and EITF D-14. [5] This gain would be measured by the difference between the previous, or carrying, value of the derivative, and its fair value. [6] Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities [7] Later in 2001, the Company entered into a series of transactions known as the "Linked Swaps," which had the effect of transferring approximately $420 million in operating earnings into later years. The Linked Swaps, which were executed at the direction of senior management, had minimal business justification other than the shifting of operating earnings. Linked Swaps are also problematic in that they were designed to shift a non-GAAP metric, "operating earnings," that senior management had identified as the key financial metric that the market should refer as reflecting the true economics of the Company.
|
|||||||||||
|
