Case: A Connecticut Yankee in Fannie Mae’s Court
By Gaylen K. Bunker
It was Wednesday, October 6th, 2004 and Christopher Shays, member of the United States House of Representatives from Connecticut was about to enter the large room where the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, of the Financial Services Committee was to hold a hearing to review a report from The Office of Federal Housing Enterprise Oversight (OFHEO) regarding allegations of “Accounting and Management Failure” at The Federal National Mortgage Association, commonly known as Fannie Mae.1
Shays commented to the Chairman of the Subcommittee, Richard Baker from Louisiana, “It was interesting that two members of the larger Financial Services Committee; Michael G. Oxley, Republican from Ohio and Barney Frank, Democrat from Massachusetts had asked to be a part of the hearing.”
“They are both very concerned about the Future of Fannie Mae and its mission.” Baker responded.
History of Fannie Mae
Fannie Mae was established in 1932 as a mechanism to provide home mortgages to the poor. It was added to the Federal Home Mortgage association, a government agency in the wake of the Great Depression in 1938, as part of Franklin Delano Roosevelt’s New Deal in order to facilitate liquidity within the mortgage market. In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity from the annual balance sheet of the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Governmental National Mortgage Association (Ginnie Mae).
In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient secondary mortgage market. Since the creation of the GSEs, there has been debate surrounding their role in the mortgage market, their relationship with the government, and whether or not they are indeed necessary. Fannie Mae, as well as Ginnie Mae and later Freddie Mac, have played an integral part in the development of the most successful mortgage market in the world which has allowed U.S. citizens to benefit from one of the highest home ownership percentages in the world.
In 1999, Fannie Mae came under pressure from the Clinton administration to expand mortgage loans to low and moderate income borrowers. At the same time, institutions in the primary mortgage market pressed Fannie Mae to ease credit requirements on the mortgages it was willing to purchase, enabling them to make loans to subprime borrowers at interest rates higher than conventional loans. Shareholders also pressured Fannie Mae to maintain its record profits.
In 2000, due to a re-assessment of the housing market by HUD, anti-predatory lending rules were put into place that disallowed risky, high-cost loans from being credited toward affordable housing goals. In 2004, these rules were dropped and high-risk loans were again counted toward affordable housing goals.2
http://en.wikipedia.org/wiki/Fannie_Mae
Subprime Loan
A loan to a borrower with poor credit, income or assets that are hard to document, or other circumstances that would hinder loans from more orthodox sources.
http://www.nmhschool.org/tthornton/asia_rising/AsiaRisingTerms.php
After everyone was seated Chairman Baker called the hearing to order and announced: “The Capital Markets Subcommittee meets today for the purpose of receipt of a report from the Office of Federal Housing Enterprise Oversight. It is indeed a very troubling report, but it is a report of extraordinary importance not only to those who wish to own a home, but also as to the taxpayers of this country who would pay the cost of the cleanup of an enterprise failure.”
Office of Federal Housing Enterprise Oversight (OFHEO)
The Office of Federal Housing Enterprise Oversight (OFHEO) was an agency within the Department of Housing and Urban Development. It was charged with ensuring the capital adequacy and financial safety and soundness of two government sponsored enterprises – the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). It was established by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
http://en.wikipedia.org/wiki/Office_of_Federal_Housing_Enterprise_Oversight
Shays pulled out of his file a copy of the letter OFHEO had sent to Fannie Mae’s board on the previous September 20 that was subsequently released to the press and glanced over it:
September 20, 2004
Board of Directors
Fannie Mae
3900 Wisconsin Avenue
Washington DC 20016-2892
Dear Board Members:
As you are aware the Office of Federal Housing Enterprise Oversight is conducting a special examination of Fannie Mae’s accounting policies, internal controls, and financial reporting processes. I am transmitting to you a report I have received on our findings to date. The findings raise such serious safety and soundness concerns that immediate action is warranted, rather than waiting until the completion of the full special examination.
The report concludes that “the matters detailed in this report are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise.”
More specifically, the report documents how Fannie Mae 1) Applied accounting methods and practices that do not comply with GAAP in accounting for the enterprise’s derivatives transactions and hedging activities, 2) employed an improper “cookie jar” reserve in accounting for amortization of deferred price adjustments under GAAP, 3) tolerated internal control deficiencies, 4) in at least one instance deferred expenses apparently to achieve bonus compensation targets, and 5) maintained a corporate culture that emphasized stable earnings at the expense of accurate financial disclosures.
These findings cannot be explained as mere differences in interpretation of accounting principles, but clear instances in which management sought to misapply and ignore accounting principles for the purpose of meeting investment analyst expectations; reducing volatility in reported earnings; and enabling fragmented processes and systems, and an ineffective controls environment to exist.
As I stated earlier, these findings warrant immediate remedial action. I have enclosed an agreement for your review and consent that includes the minimum steps that need to be taken to address the safety and soundness problem we have identified to date. Included are corrective actions related to accounting policies and practices, capital adequacy, internal controls, segregation of duties, and further reviews. In addition, we must consider the accountability of management and whether we have sufficient confidence in management to fully implement these corrective measures and bring about broad cultural and operational changes in the areas of concern. The analysis and finding of this report make it difficult to assert such confidence.
We will be available to answer any questions you may have following today’s briefing on the report. I am prepared to work with you to resolve this matter in an orderly manner. However, you must realize I am prepared to act if the Board does not.
Sincerely
Armando Falcon, Jr.
Shay’s mind was brought back to the moment as he heard Chair Baker continue: “Although not intended to fuel the effort to bring about regulatory reform, the analysis makes clear that more resources must be brought to bear to ensure the highest standards of conduct are not only required, but more importantly, they are actually met.
“For the record, I am not pleased and certainly not happy about these revelations. I am saddened by the disclosures. In all my years of inquiry in this matter, I was only in pursuit of appropriate oversight. Never did I question whether the GSEs were professionally managed to the highest standards of business conduct. Now I do. The culture of mismanagement described in the report must be eliminated and assurances gained that the highest standards of conduct will be
consistently practiced.
“I know there will be those who will still cling to the belief that the issues raised are minor or that opinions may differ on technical accounting standards. Some may still think this is all a plot by the big banks to preserve market share. The content of this report, in my view, cannot be legitimately questioned. Utilizing the firm of Deloitte & Touche and the staff of OFHEO, the director's report is delivered after review of over 200,000 documents and e-mails, as well as hundreds of interviews and depositions of current and former staff of Fannie Mae.
“The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of managerial supervision and the overall safety and soundness of the enterprise.'' This finding, in my judgment, makes committee action essential.
“For the record, I should also note that the resistance the GSEs have expressed toward enhanced housing goals. In light of these revelations, their opposition now makes more sense than ever. Should the proposals considered in this committee focus clearly on the needs of first-time homebuyers actually become law, the enterprises would have to allocate resources to those
goals at the expense of reduced earnings.
“A reduction in earnings would reduce the likelihood of paying out bonuses to executives. This same observation holds true as to the regulator's decision to increase capital, and Fannie's strong objections to such a requirement. We all know that the enterprise is thinly capitalized, but the potential effect of requiring a responsible capital level would adversely affect earnings per share, and consequently affect the bonus payments to executives.
“I also wish to inform members of the committee of another troubling incident, which I now choose to make public. About a year ago, I corresponded with the director's office making inquiry about the levels of executive compensation at the enterprise for the top 20 executives. This is information that had not been made public previously.
“At the conclusion of this hearing, I will release the compensation information obtained from OFHEO and further, I will forward a letter to the director requesting that all compensation information for both enterprises be provided to the committee for a period covering 10 years for all executives that shared in any bonus distributions. This is now essential, in that OFHEO has indicated that accounting manipulation has impacted the financials on more than one occasion, therefore placing the payment of bonuses in question.
“I find this very troublesome business. Much is at stake. The ability of this committee and this Congress to act will be called into question. Notwithstanding the ultimate outcome, the facts will remain and our duty will never be more clear.
It was then time for opening comments and before any testimony had been given, twenty members of the committee made their five minute preliminary statements. Shays took out a note pad to jot relevant statements from the various speakers.
Paul E. Kanjorski, (Dem---Pennsylvania) Our actions and statements could rile the capital markets and raise the price of homeownership. We should therefore practice caution, prudence and discretion.
Mike Oxley, (Rep---Ohio) This report could reinforce arguments for the creation of a GSE regulator with the powers and authorities granted to other financial regulators.
Barney Frank, (Dem---Massachusetts) The Bush administration was going beyond safety and soundness and said Fannie Mae should not do these new products. We need to go forward in ways that do not impinge on affordable housing and housing in general.
Christopher Shays then had his opportunity for an opening comment: “We passed Sarbanes-Oxley, which was a very tough response to [Enron]. And then I realized that Fannie Mae and Freddie Mac would not even come under it. They were not under the 1934 Act. They were not under the 1933 Act. They play by their own rules, and I am tempted to ask how many people in this room are on the payroll of Fannie Mae, because what they do is they basically hire every lobbyist they can possibly hire. They hire some people to lobby and they hire some people not to lobby so that the opposition cannot hire them.
“Fannie Mae has manipulated, in my judgment, OFHEO for years. For OFHEO to finally come out with a report as strong as it is tells me that has got to be the minimum, not the maximum. I congratulate OFHEO for finally stepping up to the plate and not being manipulated by the very organization they are supposed to regulate.
“I hear these arguments that Fannie Mae and Freddie Mac are looking out for the interests of the homeowners, and they score worse in helping minorities than the private sector banks under the 1934 Act and the 1933 Act.
“Fannie Mae and Freddie Mac are very generous to members of Congress and very generous to the organizations of caucuses in Congress. They do not have to disclose what they do. They do not have to play by the same rules. They are going to crash if this Congress does not wake up and do something about it.
“I am absolutely shocked at the extraordinary tolerance that has taken place in this Congress. This is just the beginning of the story. What did OFHEO say? They said they have accounting methods and practices that did not comply with generally accepted accounting practices, employed an improper cookie jar reserve in its accounting system, deferred expenses to meet compensation targets, did not have proper corporate governance controls in place.
“We need to wake up and the sooner we do the better it will be for Fannie Mae and Freddie Mac and all their investors, and the better it will be for our government.”
Shays relinquished his time and continued taking notes.
David Scott, (Dem---Georgia) Why did Fannie Mae link executive pay to earnings per share, and did this compensation scheme result in inappropriate incentives for management.
Michael N. Castle, (Rep---Delaware) One issue that concerns me [is] multiple interpretations of generally accepted accounting principles, GAAP.
Wm. Lacy Clay, (Dem---Missouri) OFHEO released a preliminary report which not proven, was leaked to the press. This hearing is the political lynching of Franklin Raines. Let due process take its course and let the chips then fall where they may. That is, unless this is truly a witch hunt.”
Edward R. Royce, (Rep---California) Congress must create a new regulator with powers at least equal to those of other financial regulators such as the OCC or the Federal Reserve.
Joe Baca, (Dem---California) I think it is important that we not destroy an institution that is helpful in providing assistance for first-time homebuyers and minorities; an integral part of our economy.
Robert W. Ney, (Rep---Ohio) Enhanced regulations for GSEs should not impede their ability to support affordable housing in America.”
Jay Inslee, (Dem---Washington) Some folks want to hobble the horse when it comes to being a main stream of the housing supply in this country.
Patrick J. Toomey, (Rep---Pennsylvania) There has been a pattern to systematically and intentionally misrepresenting financial statements to smoothing earnings and achieving maximum bonuses.
Carolyn McCarthy, (Dem---New York) Offered little that was new.
Spencer Bachus, (Rep---Alabama) The Bush administration was concerned about the new products that Fannie was offering, and the minority members almost to a person resisted those reforms.
Ruben Hinojosa, (Dem---Texas) Over the last 4 years, the United States has suffered from job loss, poverty, budget deficits, national debt, and high oil prices. Housing has served as the U.S. economy engine. We need to ensure that nothing we do here in Congress harms it.
Ginny Brown-Waite, (Rep---Florida) There are more accusations in this report than findings. It is important that we have funding for home construction that Fannie Mae regularly participates in.
Stephen J. Lynch, (Dem---Massachusetts) We should not forget the good things Fannie Mae is doing. These are violations of accounting principles, let's not make this a criminal proceeding.
Gary G. Miller, (Rep---California) Housing has kept this nation going in recent years. Homeownership spurs economic and community development, provides residents with a sense of pride in their community and the single largest creator of wealth for most Americans. Regulatory change must ensure the high standards of ethical conduct and remain a means to achieve our ultimate goal of expanding the supply of affordable housing.
Maxine Waters, (Dem---California) It is critical that we ensure any action that we may consider not impair the housing mission of the GSEs.
Melvin L. Watt, (Dem---North Carolina) We want to make sure that Fannie and Freddie encourage and support of increased homeownership and housing in this country is made stronger and more vibrant.
Shays reflected on all the issues that seemed to be the central focus of the various members of Congress.
Affordable housing versus regulatory interference
Constituent pressure versus governmental oversight
The importance of accounting rules and transparency
Executives decisions versus auditor interpretations
Damaging the engine that is driving the economy
Armando Falcon
It was then time for the first witness to testify. Armando Falcon, Director of the Office of Federal Housing Enterprise Oversight gave his opening remarks, that pretty much followed what Shay had read in his letter to the board. More specificity was offered in addition to a recounting of Fannie Mae’s board moving quickly to remedy issues that had been raised in the letter to them. Following Mr. Falcon’s statement questions came from the committee and Shay made the following summary notes:
Chairman Baker: “Mr. Falcon, did you find that management of Fannie Mae had adopted and implemented a strategy from a managerial perspective to steer accounting reports for two important goals. One is to present an image of very stable earnings to the broader market; and two, to manage EPS calculations to enable maximum bonus payments to be achieved for executives?”
Mr. Falcon. “Yes.”
Mr. Kanjorski: “Making the worst-case scenario assumption, however, that does not constitute in your mind systemic risk? Is that correct?”
Mr. Falcon. Yes. The solvency of this company is not threatened by the findings we have to date.
Mr. Castle: “You said that Fannie Mae understood the rules, but chose not to follow them.”
Mr. Falcon. Yes. They did not comply with rules that they clearly understood.
Mr. Clay: “And you claim that they were hostile to the examiners. In what way?
Mr. Falcon. They were resistant to compliance with our request for documents and we had difficulty in scheduling their employees for interviews. We eventually had to move to taking statements on the record, rather than having informal interviews of employees. We had to move to the issuance of administrative subpoenas. We had to ultimately try to get those subpoenas enforced in court.
Chairman Oxley: “Fannie Mae is one of the largest users of derivatives in the world. As such, Fannie Mae should be well versed with the rules related to FAS 91 and FAS 133. Is it your understanding that Fannie was aware of the fact that their accounting was not GAAP compliant, but they chose not to comply because, to do so, would be too burdensome and costly? Or is it your opinion that Fannie Mae made a material misapplication of the GAAP rules?
Mr. Falcon. “They understood the rules. They chose not to follow them.”
Mr. Scott: “Mr. Scott. Okay. Two little points here. How are the problems with accounting for derivatives at Fannie, how do they compare with what you have found with the examination of Freddie Mac? Are they the same? Same abuses?”
Mr. Falcon. We have seen the same cultural issues. We have seen the same motivations in terms of smoothing earnings. Some role in compensation issues. So certainly much of that appears to be consistent between the two companies.
Mr. Shays: “One of the things that I find somewhat astounding is, are you saying to this committee that you actually had to issue subpoenas against this organization or consider it or threaten it to get information you are entitled to get?”
Mr. Falcon. We issued administrative subpoenas to get information that we needed for this special examination, yes.
Mr. Frank: “Now, on the question of the substance, Fannie Mae has agreed to a 30 percent increase in their capital. Is that correct, as a result of your conversations with them?”
Mr. Falcon. Yes.
Mr. Royce: “I would like to learn a little more about FAS 133. I am trying to elicit, is a greater understanding of the specifics of this.”
Ms. Deleo [Falcon’s assistant]. One-thirty-three in principle is really a very simple pronouncement because it basically says you need to mark to market your derivatives. But it goes ahead to say that if you qualify for hedge accounting, and what we are looking at there is that you are going to go through and make an assessment test to see if the derivatives are highly effective. If they are highly effective, then you need to measure for ineffectiveness. So that is kind of the second step. If they are not highly effective, you cannot use hedge accounting.
Then in addition to that, there are some exceptions in 133, very rule-based and very specific, that say if you have matched terms, which they do not actually have, and there are very specific criteria that you must meet to do that, then in that case there is no ineffectiveness. They are perfectly effective if the terms are matched. So you would not have to do the assessment test and you would not have to measure ineffectiveness. That is the problem. It is that they moved to that last very specific area and they simply do not qualify under that.
Mr. Hinojosa: “You also mentioned that you did not speak to nor review the working papers of [Fannie Mae’s external auditor] KPMG accounting firm while preparing this report. It seems to me that it is less than clear, then, that Deloitte has signed off on your OFHEO findings.”
Mr. Falcon. “Deloitte fully supports the findings and conclusions of this report. They also view these accounting issues as very clear-cut violations and not matters of interpretation.”
Mr. Ney: “I know the SEC is the final decision maker on it, but is there any mechanism in current law that would allow a debate or a point of view to be discussed in case there are two separate opinions?”
Mr. Falcon. “The SEC would determine what is appropriate for purposes of the disclosures that are filed as required by the SEC. We rely on the financial statements of the company and its books and records in assessing the safety and soundness of the company and capital adequacy of the company.”
Mr. Capuano: “Is it not a normal circumstance where many entities within the rules of GAAP, within the rules of various FAS's and other accounting procedures and tax procedures, try to on occasion smooth out earnings? Is that not something that happens here and there in the business world?”
Mr. Falcon. “If it happens, it is wrong.”
Mr. Kelly: “My question to you is, Freddie Mac apparently has agreed to separate roles. Apparently, Fannie Mae has not. Are they in the process of working with you to try to do that? Can you talk to us about why you think this is a healthy thing to do? What is ongoing with regard to OFHEO working with Fannie Mae to make sure that there is a separation of duties?”
Mr. Falcon. We do think it is important that key functions be separated so that there is not a conflict of interest or that someone with an incentive to meet some goals also has the ability to manage the accounting of those goals such that they are met.
Mr. Lynch: “I just want to ask you, we had the Enron situation. We had a house of cards there, a financial house of cards where there was no strength to the underlying business. They had a very unsound business model. We had serious problems in the underlying business. Is that what you see here? Is that what you see here?
Mr. Falcon. The business model of the company remains sound.
Mr. Toomey: “If I understand it correctly, which is that not only is it simply and very straight forwardly wrong to not report the full number precisely as calculated, which Fannie Mae has done, but that there was a policy within company systematically not to report the precise number, but rather to have this cushion that you describe as a cookie jar, which served the purpose of evening out income. Am I correct to understand that?”
Ms. Deleo (Wanda Deleo, Chief Accountant, OFHEO): “You are correct.”
Mr. Meeks: “Before your report came out there was talk from this committee and from others in the private company that one did not like the status that Fannie Mae had. You would agree with that--right?--the status that Fannie Mae and Freddie Mac currently has in the market?
Mr. Falcon. “No, Congressman, I do not support privatization of these companies.”
Mr. Bachus: “Derivatives have been used to hedge risk and actually have been used successfully. In this case, you have talked about this particular derivative contract had not been approved for hedging. Is that right? Did that affect Fannie Mae from a safety and soundness standpoint, in your opinion?”
Mr. Falcon. Yes. Whatever change in value occurred in the derivative would go through other comprehensive income. I think, overall, everything we find in this report does raise concerns about the company's safety and soundness. We have found practices that are inconsistent with safety and soundness, practices about not complying with accounting rules, not having accurate financial disclosures, not having the appropriate internal controls.
Ms. Waters: “Now, did you discuss the 30 percent reserve with any members of Congress and get a suggestion about that amount prior to concluding that that was the amount that should be in reserve?”
Mr. Falcon. No. We arrived at the 30 percent requirement because we thought that was prudent from a safety and soundness standpoint, given the weaknesses in management and operations, given the uncertainties of the financial statements----
Mr. Manzullo: “Mr. Johnson got a $1.9 million bonus on a salary of $966,000; Mr. Raines, $1.1 million bonus on a $526,000 salary; Lawrence Small, $1.1 million on a salary of $783,000; Jamie Gorelick, $779,000 bonus on a salary of $567,000; Timothy Howard, $493,000 on a salary of $395,000; and Robert Levin, $493,000 bonus on a $395,000 salary. And just by happenstance, coincidence, you could almost say on your terms that for Fannie Mae to pay out the maximum amount in annual incentive payment awards in 1998, the earnings per share would have to be $3.23. It is below the $3.13 minimum payouts threshold, no bonus would occur. Are you saying this is coincidence? Or did somebody cook the books to come up with $3.23 and nine mills so they got the maximum payment.
Mr. Falcon. What we are saying is, there are very strong appearances that the management improperly defer $200 million of this $400 million expense to [1999] for the purposes of achieving bonus targets, in addition to the appearances of smoothing earnings.
Mr. Davis: “Is it possible that by casting all of these dispersions and all of these doubts upon the board at Fannie Mae, and upon the structure of Fannie Mae, that you potentially are weakening this institution in the market, that you are potentially weakening the housing market in this country?”
Ms. Hart: “And one of the things that I know during this debate that you have been seeking--and I think it is important--is to separate the roles of chairman of the board and CEO at both Fannie and Freddie. And I know that Freddie has agreed to do this, but from my understanding, up to this moment, Fannie Mae has not agreed to do this. Why you think that is important to have that separation happen?”
Mr. Falcon. “We have proposed that and found that this was just best corporate practice for these government-sponsored enterprises. We found that the board could not properly fulfill its role as overseer over management as long as the CEO was also the chairman of the board of the company.”
Mr. Crowley: “Do you believe that this report shows any evidence that Fannie Mae may be departing from its mission of increased homeownership through making homeownership more affordable in this country? Mr. Raines has pledged to create 6 million new homeowners, including 1.8 million minority homeowners, by 2014. Do you believe this goal may be threatened now because of this report?”
Mr. Falcon. As long as the company is maintaining its adequate capital, as long as we have taken proper steps, along with the cooperation of the company, I think we will minimize any damage to their ability to meet their affordable housing goals.
Mr. Frank: “There are inaccuracies that can be disturbing, and if they led to inappropriate compensation, I would be very unhappy. But the notion that any inaccuracy implicates safety and soundness, I think, based on what you have said here, where you cannot even conclude--you have said you cannot even quantify any potential amount of loss. To throw ``safety and soundness'' around in that thing I think really is, for a regulator, irresponsible.”
Mr. Falcon. “I think internal controls are a very serious safety and soundness concern. Are they at risk of becoming insolvent right now? No. We have an agreement with the board in place that will address these problems, provide an adequate capital cushion.”
Mr. Shays Interjected: “I would just like to say to you, Mr. Falcon, what you have done is you have exposed illegal activity on the part of Fannie Mae, and you are being criticized for exposing it. If they have a safety and soundness problem, or if the markets are impacted, it will only be impacted based on what Fannie Mae did. And I just want to congratulate you. You have more courage than I realized you had, because the messenger is being shot and not the person who did the wrongdoing. I have seen it here in this committee, and I am pretty outraged by what I am seeing. Congratulations for what you have done.”
Mr. Ose: “I follow this stuff very carefully because, having weathered the storm on the games-playing that took place in some of the energy companies, I am very, very sensitive to what might be occurring in the financial markets underpinning the housing market. If I understand correctly, there are questions as to the validity of the numbers on an ongoing basis within the enterprise known as Fannie Mae. Now, Fannie Mae's securities are held as tier-one capital by any number of additional institutions. My concern here is not so much the direct impact but perhaps the indirect impact that might manifest itself as a result of manipulation of earnings.”
Mr. Falcon. “The banks holdings in the debt of Fannie Mae--if there is some--might have undue concentration in Fannie Mae debt as a percentage of the total capital, if the problems were not addressed quickly with Fannie Mae such that we remedied the concerns that we have found, I think the bank regulators might have some concern about the devaluation in what is being held as capital of some financial institutions.”
Chairman Baker concluded: “I would just like to point out to the gentleman, there is approximately 8,400 insured federal depository institutions. Of that number, in excess of 3,000 institutions hold 100 percent, not 50, not 70, 100 percent or more of their required tier-one capital in GSE securities. It is of extraordinary consequence we fully understand that the financials are indeed accurate, because an impairment in the issuance of debt, it would not require the insolvency of an enterprise, merely an impairment in the ability to issue debt. If the regulator increases capital requirements, where are they going to go to raise the capital? So I think the gentleman has raised an excellent point I think heretofore has not been recognized. I thank him for yielding.”
“At this time the committee welcomes our next two witnesses: Mr. Franklin D. Raines, chairman and chief executive officer of Fannie Mae, and Mr. Timothy Howard, vice chairman and chief financial officer of Fannie Mae.”
Franklin D. Raines Statement:
I am now the chairman and CEO of Fannie Mae. And Fannie Mae is the nation's largest source of funds for homeownership and rental housing for low-, moderate-and middle-income Americans. We like to say we are in the American dream business.
The issue of whether our implementation of FAS 91 and FAS 133 was consistent with generally accepted accounting principles remains with the SEC.
Congress chartered Fannie Mae to expand access to homeownership for low-and moderate-income Americans, and we are committed to that mission. Earlier this year we announced the commitment to create 6 million first-time homebuyers, including 1.8 million minority first-time homebuyers, over the next decade, and to do our part to raise the minority homeownership rate to 55 percent and beyond.
By quickly reaching agreement with OFHEO where we could, we are able to maintain our mission focus. For those that may be concerned that some of these steps, particularly the 30 percent capital surcharge, will constrain our mission activities, let me say this: Fannie Mae will do everything in our power to meet our commitments to expanding homeownership and affordable housing while also doing everything in our power to try to meet the requirements of the agreement.
Before I close, I would like to touch on the issues raised by the OFHEO report concerning our implementation of the accounting standards FAS 133 and FAS 91. These accounting standards are highly complex and require determinations over which experts often disagree.
First, the report alleges that in 1998 the company willfully violated GAAP in order to maximize executive bonuses. These are serious allegations. They concern events that occurred almost 6 years ago. Importantly, I would note that the OFHEO report does not cite any documents or witnesses to support these allegations.
Upon reading of this allegation in the report, the company undertook to assemble the relevant facts. And we have learned of no facts and no other materials that support the allegation that the decision about the amount to book was related to bonuses.
Based on the facts as I understand them, the $240 million estimate was arrived at as part of an analysis conducted by our accounting and financial staff, independent of any considerations of compensation. Additionally, this analysis was documented at the time and was disclosed to and fully discussed with our independent auditor.
We intend to turn all of this factual information over to the independent committee of the board and its outside counsel for review.
Second, the report alleges that we misapplied GAAP with respect to two accounting standards, FAS 91 and FAS 133. We believe we applied those standards in accordance with GAAP, and our independent auditor, KPMG, reviewed our application of those standards and concurred.
Fannie Mae has previously issued and filed with the SEC financial statements that reflect the accounting and financial statement presentation that OFHEO has alleged to be inappropriate. Those financial statements were certified by me and by our chief financial office, Tim Howard, after a thorough process and audited by our independent auditor, KPMG.
Fannie Mae has not withdrawn those financial statements, and KPMG has not withdrawn its opinion that those financial statements were prepared consistent with GAAP in all material respects.
Rather, the issues that have been raised by OFHEO will be taken up directly with the staff of the SEC, which ultimately has the final authority over GAAP.
Our accounting staff has repeatedly determined that our policies and practices with regard to FAS 91 and 133 are reasonable and in accord with GAAP. And KPMG has issued unqualified opinions on our financial statements, and that remains their position today.
In fact, when I certify our financial statements, I certify that these documents fairly present, in all material respects, the financial condition, results of operations and cash flows of the company. That is a very serious statement, and I take it very seriously.
We engage in a rigorous due-diligence process before I ever put pen to paper and make that certification. I only certify after receiving assurance that I can say with confidence that our financial statements fairly present, in all material respects, the financial condition, results of operation and cash flows of the company.
Mr. Chairman, no one is more interested in a full and open examination of these issues than I am. I cherish this company. I believe in the mission that Congress challenged Fannie Mae to carry out. And I am inspired by the 5,000 women and men who come to work every day trying to help lenders help people get into homes.
Most of all, I believe that Fannie Mae's biggest challenge ahead is helping the financial system and mortgage industry to meet the growing and changing housing needs or our growing and changing nation.
This decade is expected to produce 30 million more Americans, who will create 13 million to 15 million new households. Minorities will represent 80 percent of that growth. And as a result, we estimate that 46 percent of future first-time homebuyers will be minorities and immigrants.
Serving their housing needs will require new ideas and innovations in mortgage financing. And we look forward to helping the industry with this challenge.
Given this public mission for which Congress created us and as an instrument of national housing policy, Fannie Mae expects and welcomes OFHEO's rigorous oversight to ensure that we are safe, sound, solid and stable for the long run. As I said the last time I appeared before this committee, strong oversight is in the best interest of Fannie Mae, our shareholders, financial markets and homeowners.
I want to make one thing very clear. I have always tried my best to ensure that our company does the right thing in the right way. And I believe to this day that we did.
If, however, after a thorough review of all the facts, it is determined that our company made significant mistakes, our board and our shareholders will hold me accountable. And I will hold myself accountable. That comes with being a CEO. I accepted that burden on the day I took the job, and I accept it today.
Following Mr. Raines statement Timothy Howard, Vice Chairman and Chief Financial Officer for Fannie Mae made a statement. He ended his statement with: “It is important to note, however, that the matters to be reviewed relate to accounting judgments and not issues of risk management. Financially, Fannie Mae is as strong as ever, and our ability to carry out our mission remains intact.”
Representative Shays contemplated the two very different views presented by Falcon and Raines. Who was right? As he sat wondering Chairman Baker began the questioning of Mr. Raines. Suddenly, Shays was jolted back to reality by Baker.
Chairman Baker: “…bonuses in excess of $245 million. In 1998, the bonuses reported were $27 million. In 2003, the total amount of bonuses was $65 million, the yearly aggregate, the amount of bonuses each year, per year, 1998 through 2003, and that comes out to be $245 million.
Mr. Raines. “The Challenge Grant has nothing to do with bonuses. The Challenge Grant has absolutely nothing to do with bonuses.”
Chairman Baker: “It does in a sense. Challenge Grants incentivizes executives to enhance the growth of the corporation's profitability, based on the corporation's profitability the EPS has calculated. The calculation of the EPS then determines whether the bonus trigger is hit.
Mr. Raines. You just crossed the line again. The Challenge Grant has to do with stock options. It has nothing to do with bonuses. Stock options were granted to every Fannie Mae employee. Every employee of Fannie Mae was given a grant and would only vest if the company doubled its earnings over 5 years, and then it would vest over a delayed period if it did not. So the Challenge Grants have nothing to do with bonuses. Again, Mr. Chairman, I think you are mixing two or three things together.
Ms. Waters: “Parliamentarian query: Is this illegal or is it legal? Is it illegal for us to have this information? Can we display or not?”
Chairman Baker: “No, Ms. Waters, it is not illegal. I have had it for over a year. I wanted to make sure I released this information. I am accountable for its release, and I put it into the public forum pursuant to my rights as chairman, subject to a response from the regulator, and I wanted to make sure that I did not get criticized for leaks. And we had all these accusations that people got advanced information inappropriately before it was publicly released. I have now publicly released it. I am accountable for that decision.
A couple more congressional representatives asked questions of Mr. Raines, who answered them appropriately and then it was time for Barney Frank who focused on one key question.
Mr. Frank: “So the question is, what will the effect of the 30 percent additional capital be on your reaching an absolute amount, in terms of affordable housing? That arbitrary 30 percent might result in a diminution in your affordable housing activity?
Mr. Raines. “Well, if the capital plan requires us to reduce our activities, yes, it would reduce the impact of the goals as a result of our having made those choices.”
Mr. Clay: “I know that Fannie Mae has agreed to the increase in capital and how much in dollars is that increase?”
Mr. Raines. “We don't have an exact estimate, but if you look back at the most recent periods it would require something in excess of $3 billion.”
Ms. Kelly: “What about the members of the executive committee? Do you meet, and according to what the OFHEO interview shows, the executive team met to cooperatively set salary and bonus?”
Mr. Raines. “The answer is that the compensation for everybody in the company, including mine, is in part determined by our executive team. We have in process where lots of people are involved in setting the compensation. So, the answer is yes, but that is not an unusual thing.
Mr. Lynch: “In your own minds as the CFO and CEO, is this a usual relationship with a regulator that they would go around you and not sit down extensively with you to try to bring you into compliance with a GAAP that they thought you were in noncompliance with?”
Mr. Raines: Congressman, I would agree that it is an unusual relationship. I did note in Director Falcon's testimony that he gave a reason why he felt the necessity to go around senior management he said was the lack of cooperation by senior management. With regard to our cooperation, I think it has been overwhelming. The subpoenas, as we were told, had nothing to do with lack of cooperation. And the Justice Department has indicated that they believe that this was an issue that could and should be resolved between OFHEO and Fannie Mae and it was resolved. All of the material requested by OFHEO has been provided to them.
Mr. Baca: “It seems odd that they would not contact you. Yet, you know, they have gone to the media and they have gone everywhere else. But yet they should have followed, practiced standard procedures, which is a total violation. Where do you think the process will go from here?”
Mr. Raines. Congressman, this process has been so unusual, I cannot tell you. I can tell you what we are doing. Our board has negotiated an agreement with OFHEO, which we are going to faithfully follow and put into effect within the timeframes as agreed to between the director and our board. We are also going to be cooperating with the independent counsel that our board has appointed to look into all of these allegations and to see if we can find out what the facts are, and so we will cooperate with them. We will be attempting to take the two big accounting issues, FAS 91 and FAS 133, directly to the SEC and ask them to give us resolution on those so we can see, and, if we are right, then we are right, and, if we are wrong, we will make whatever changes the SEC tells us to make, and we will also cooperate with any law enforcement agency that is attempting to look at these allegations.
Mr. Bachus: “We are talking about these financial reporting issues in a lot of the discussion, whether, you know, you violated FASB rules or not, but did these issues undermine your creditworthiness?”
Mr. Raines. Well, I have to say, Congressman, that since this report has come out, we have been put on credit watch, and one of our credit ratings was dropped, went down as a result of this report. So a report like this from a regulator has serious consequences in the capital markets. You know, our stock price dropped by $14 billion as a result of this report coming out in the way it did. So, yes, this report has a very, very big impact on how we do our business from our debt costs to our credit ratings to our stock price.
Mr. Meeks: “You know, I understand your statements, Mr. Raines, about you do not understand certain things, but let me just let you in on a surprise. Some people do not want you in business. They do not like the success that you have accomplished by putting people with decent homes and roofs over their head. Some people just do not like that. And so that might be a surprise to you.”
Mr. Raines. Well, prior to the issuance of this special examination report, all of our examinations from OFHEO found that we met or exceeded safety and soundness standards, and that is going back to when OFHEO first organized itself back in, I think, 1993.
So we had never, to my knowledge, had an outstanding issue with OFHEO on accounting, internal controls or any other issue. In the course of their examinations, they would make recommendations to us and, you know, we would adopt them. But we have never had an issue prior to this examination report.
Mr. Howard. Prior to 1998, you know, any amount of this so-called catch-up adjustment, which, again, was the comparison we made after the fact between the amount that we had brought into income based on an old assumption of average life of the portfolio--remember there are millions of loans in the portfolio--and a new average life. That difference we had kept track of but never recorded in current period income. That was the catch-up adjustment.
In 1998, that dollar amount grew to a large size of expense--it was actually closer to $440 million--and we
determined that some portion of that likely did represent a true economic cost. So we put together a group within the
finance department of portfolio people and comptroller's people to come up with a method of determining the best amount to best reflect true economic substance.
The recommendation they made to me and to us as the senior management team was that $240 million was that right amount. So the remaining amount, which was not deferred because it was an amount that never was recorded on the books in previous years--it was kept track of, and that was the audit difference--that turned out to be a judgment that ex-post proved to be correct because next year we did not have an audit difference that was expense. We had one that was income.
So the judgment in retrospect turned out to be correct. It was made as a part of a process that had integrity, and it was independent of any link to compensation.
Mr. Shays: “Why should banks have to set aside between 6 percent and 8 percent of their portfolio and you guys are in the range of about 3 percent?”
Mr. Raines. Banks should do that because they have much more risky portfolios. Banks are allowed to invest in a wide range of assets. We can only invest in single-family and multifamily homes.
Mr. Ose: “Mr. Falcon was asked, on the previous panel, to provide to the committee a record of all contacts that he may have had with the committee or his agents or employees. I am asking: Will you provide the committee a similar record of all such contacts to this committee regarding this hearing?”
Mr. Raines. “My answer is I do not know. I mean, we will have to talk to our counsel and others. Mr. Falcon is a government employee. He is running a government agency. There are laws that relate to the ability of a government employee to lobby the Congress, and I assume that that is what the inquiry was to Mr. Falcon. We are not a government agency. We are not prohibited from lobbying the Congress, but I would certainly take under advisement your request, and we will get back with you with an answer.”
Mr. Davis: “Is it a fairly common practice, Mr. Raines, for almost every single entity that comes before this committee to have some consultation or talk with members of Congress or staffers before their folks testify?”
Mr. Raines. Yes, sir. I typically did that when I was in the government, and I have done it since I have been out of the government.
Mr. Castle: “I am one of those who worries about Fannie Mae. I think, you know, you have good people running it and that kind of thing, but, frankly, it is very large, some of the practices I think are a little marginal. I worry about this perception the Congress will back up whatever Fannie Mae does. I just think there are a lot of issues. I think the regulatory issue is very important though. I just want to make sure that Fannie Mae is being run correctly because it is very, very important. And I worry about the safety and soundness of that. We are all running for office right now. We are criticized daily by our opponents. So a little criticism can't be the end of the world. And perhaps if it is justifiable criticism and changes are made, perhaps that is positive.”
Mr. Raines. Many of these things we would have been willing to do if OFHEO had approached us in a different way. So this isn't an issue of everything OFHEO says is wrong and everything we say is right. I think the fundamental flaw is created by the fact that the OFHEO examination process does not have the same legal protection that the bank examination process has. And that has a negative effect on the entire relationship.
Chairman Baker concluded the questioning of Fannie Mae’s officers and stated: “I certainly hope that the future does not bring ill-advised consequences to the institution, its ability to extend credit to prospective homeowners or, even worse, to have consequences for taxpayers.”
Ann McLaughlin Korologos Statement
My name is Ann Korologos and I am the presiding director of Fannie Mae's board of directors. I also currently serve as chair of the Nominating and Corporate Governance Committee and on the board's Compensation Committee.
I am a shareholder-elected, independent director. The board of Fannie Mae appreciates this committee's oversight of the company, of the board and of our regulator. And I welcome the opportunity to speak on behalf of the board about OFHEO's report to date on its special examination.
The board takes the issues raised by the OFHEO report very seriously. We are here to do the right thing. By that I mean: to OFHEO, the SEC and Congress, and to do so in a way that protects the shareholders and restores the public's confidence.
The board, with independent counsel and independent accountant, will investigate the issues in the report, and we will work expeditiously. So I thank you for this opportunity to speak on behalf of the board. We were moving fast before this hearing, and I can share with you that we now are continuing to do so, and we now know where we are going.
The board has participated through our audit committee, in following the company's response to the examination since it began over a year ago. We have received regular reports from the audit committee on the examination's progress, as best it could be understood.
On Friday afternoon, September 17, Director Falcon contacted me to say that OFHEO wished to share its findings to date with the outside directors of the board. I convened a meeting of the board for the next business day, which was Monday, September 20.
Every non-management director attended in person or by telephone. On that day, we received the written report and OFHEO's senior staff made a presentation to the non-management directors and the company's outside counsel.
The staff also gave us a letter from the director and a draft agreement, to be signed within 2 days, outlining actions to be taken. In addition, the board was informed by management, after that meeting, that they had received a call from the SEC that these issues would be a part of an informal inquiry by that regulator.
The board immediately began a series of meetings and discussions with OFHEO over the week of September 20. I think I either spoke or met with Director Falcon every day that week. I assured Director Falcon that the board and the company would work cooperatively with OFHEO and that we would address all their concerns.
I also expressed the boards hope that our work together would build a constructive relationship based on mutual respect and trust going forward. I told him, however, that the board could not, consistent with its fiduciary responsibilities, sign a document in 48 hours.
On Tuesday, September 21, I advised the director that the board had authorized the hiring of independent counsel, former Senator Warren Rudman, and his law firm, Paul, Weiss, Rifkind, Wharton & Garrison LLP, subject to OFHEO approval, to address the questions raised by the OFHEO report.
I also advised the director that we would provide to him, the next day, a draft work plan based on the actions required by OFHEO's agreement. On Wednesday, Pat Swygert, a fellow board member and President of Howard University, and I met with the director and his senior staff at OFHEO offices.
We provided the draft work plan that was approved by the board and, because so much of the report had been leaked to the press by that time, I also advised the director that the company did not object to OFHEO's public release of the report.
After reviewing the draft work plan, Director Falcon told me later that evening that he thought the plan was substantive and addressed each of the areas of concern raised by the report. I have attached to my written statement a copy of this draft work plan.
On Thursday, in a conversation with OFHEO's general counsel, however, it became clear that OFHEO wanted a written agreement to be signed by the board.
Therefore, at my direction, on behalf of the board the company's counsel began meeting with OFHEO staff to reach such an agreement. Discussion continued throughout the weekend, and after additional board meetings, we and OFHEO announced the September 27 agreement.
With the agreement completed, the thorough process to address OFHEO's report is underway. Importantly, management has pledged its cooperation to the board in effort and we will hold them accountable to that pledge.
The details of the agreement are well known. The company will move immediately to begin making a number of changes including a capital surplus plan, accounting policy modifications, internal control enhancements and other changes.
The board's independent counsel, Senator Warren Rudman and his law firm were approved by OFHEO yesterday. Senator Rudman will hire independent accountants, also subject to OFHEO approval.
Senator Rudman's work will also be reported to the SEC. We expect Senator Rudman to conduct his review as described in our agreement with OFHEO and to report his findings to the board, OFHEO, and the SEC
The company and its outside auditors have a disagreement with OFHEO about some aspects of the implementation of FAS 91 and FAS 133. The agreement establishes a process going forward to resolve these issues.
This board believes in accountability and objectivity. We will not prejudge the outcome of this process, and I respectfully ask you not to prejudge it, as well. We vigorously share your concerns and want to get to the bottom of this.
If I may speak personally for a moment, I have known some of you over the years from my experiences in both public service and the private sector. And I think you know my commitment to ensuring that our laws are upheld and the institutions of our economy maintain the highest levels of integrity.
There is only one way I know how to deal with such a difficult situation: to speak the truth, to find the facts without bias, to base judgments on those facts, and then to act without hesitation. We must do the right thing carefully and deliberately. We must not rush to judgment or take actions in haste today that we will have to correct tomorrow.
I will commit to you that the board is determined to follow a process that will inspire confidence and restore public trust.
Chairman Baker: “I note that the board took rather quick and decisive action in reaching this first agreement, which would seem to indicate to me that there were some reasons the board came to a conclusion that it was appropriate to enter into that agreement.
Various congressmen weighed in on Ms Korologos’ statement and then Ms. Waters asked:
Ms. Waters: ”Would you confirm for me, your understanding of why you entered into this agreement and whether or not you believe that this means that you immediately make great big changes because you were doing something wrong. Or is this just an agreement to say, ``Okay. You want us to look at this? We will be happy to look at it. We believe that we are right and we believe that in the final analysis, we will be proven right.''
Ms. Korologos. “[We said] What can be done? Let us break this apart and see what can be done on the issues that were raised in the report.” And it really came in sort of three chunks. There were the accounting issues and, clearly as you heard in testimony today, the SEC has a serious role there. There were the capital issues, if you will and the capital plan. There was no way we were going to sign an agreement we couldn't deliver on, number one. And, number two, we were very eager to get this process going so we could give answers to the public, to our investors, to our shareholders, to the housing community. We had already seen an economic impact because of the swirl and the fire storm we are in. So, the more these issues hang around, if you will, I think is irresponsible for the board not to set our own timelines and make sure we can reach them.
Chairman Baker. Let me thank you, Ms. Korologos, for your appearance here today and your testimony and also give you an assurance. I don't see further action by this committee until additional information is provided from both perspectives. I think OFHEO would want the opportunity to respond to the testimony today from Fannie Mae, and it is evident that Fannie Mae would choose to give us more information--the board members as well--as to their findings and factual determinations of the OFHEO allegations. So, I think both sides are going to be providing members with a lot of information. I am trying to say we won't act until there is something that validates acting. If there is no further business for this committee, we stand adjourned.
[Whereupon, at 6:19 p.m., the subcommittee was adjourned.]
3 comments:
I need some cliff notes... lol
http://www.youtube.com/watch?v=_MGT_cSi7Rs&feature=related
Um, wow.
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