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
September 25, 2003

 

Prepared Statement of The Honorable Cliff Stearns

Today we have an important hearing: The first opportunity for Congress to hear the results of the internal investigation at Freddie Mac regarding accounting problems there.

We are privileged to have Mr. Jim Doty, Partner at Baker Botts who was in change of the investigation that produced the internal report. I have reviewed the Report and wish to compliment Mr. Doty on its thoroughness, rigor and objectivity. Members on the Energy and Commerce Committee have had the opportunity in recent years to examine a number of reports on internal investigations. The Doty Report, in my view, is at the top of those reports in its completeness and its ability to explain complicated transactions and accounting.

Accompanying Mr. Doty is Mr. James Barratt who led a team of forensic accountants who reviewed Freddie Mac's books. I commend you for your work. I hope Mr. Doty will have the opportunity to identify the members of his team who I understand are accompanying him today.

Finally we are joined by Professor Baruch Lev. Professor Lev has provided expert testimony to the Congress a number of times on complicated accounting matters.

I would also like to complement Freddie Mac. They have cooperated with our inquiry and provided to the Committee information and documents so we can have a better understanding of these issues.

There are two things for us to consider today: The first is the Doty Report itself.

The second is what is permissible under GAAP. Although Freddie Mac by its own admission made serious accounting misstatements, had they structured some of these transactions differently, it is possible that GAAP would have permitted the non-disclosure of the fair value of Freddie's derivatives portfolio. For the benefit of taxpayers who implicitly guarantee Freddie's portfolio and investors, we need to ask is GAAP adequate if it allows a Company with $600 billion in mortgages and $1 trillion in derivatives not to have fair value disclosure of the bulk of those assets?

The Doty Report made a number of findings of great significance that we should consider:

• Beginning in December 2000 senior management of Freddie Mac engaged in multiple complex transactions in order to hide the increase in value in its derivatives portfolio.
• There was no economic purpose to these transactions other than hiding income. Freddie incurred expenditures to hide income for accounting purposes.
• These transactions included the so-called "Giant." This transaction involved shifting $30 billion of Freddie Mac securities (in which Freddie Mac had an unrealized loss) to a third party. · The purpose of the Giant was to recognize a one-time loss on selected assets to offset real gains and then prevent the Giant from being accounted for at fair value.
• Freddie Mac took other actions to hide the $1.5 billion gain in its derivatives portfolio They in included changing the accounting methodology of options on swaps, and a series of so-called "J-Deals" in the neighborhood of $700 million.
• Earnings Management: The Doty Report found that in eleven of eleven quarters examined. Senior management of Freddie Mac changed the stated value of various reserve accounts in order to meet or exceed Wall Street analyst's public expectations of quarterly earnings.
• The Doty Report states "[T]here was a long-standing practice at Freddie Mac of making discretionary accounting judgments with a view towards producing financial statements that more closely approximated analysts' estimates. Those involved in the practice report that they believed they were free to do so under GAAP so long as the amounts involved were not quantitatively material." (Doty Report pg. 57).

These are serious issues. I encourage Members to listen closely to today's testimony. We will continue to monitor developments at Freddie Mac, and following their restatement, may have an additional hearing on that restatement.

We are looking for non-partisan solutions to the challenge of improving accounting standards. Congress is not the body to set accounting standards. I believe Congress should consider appointing a Blue Ribbon Commission of experts to recommend improvements to accounting standards. I encourage Members of both parties to share ideas with us in this effort.

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