Report of the Special Examination of  Freddie Mac  December 2003 TABLE OF CONTENTS EXECUTIVE SUMMARY………………………………………….......... i Corporate Culture and “Tone at the Top”………………………………………………... i Improper Management of Earnings………………………………………………………. ii Incentives Created by Executive Compensation…………………………………………. iv Weak Accounting, Auditing and Internal Controls……………………………………..... iv Inadequate Disclosure……………………………………………………………………. v Board of Directors………………………………………………………………………... vi Recommended Actions…………………………………………………………………... vii I. INTRODUCTION……………………………………………………….. 1 II. CORPORATE CULTURE AND “TONE AT THE TOP”………....... 4 The Culture of “Steady Freddie”……………………………………………………........ 4 The Tone at the Top and Earnings Management……………………………………........ 7 Failure to Allocate Adequate Resources to Accounting and Infrastructure……………… 13 Failure to Manage Operations Risk………………………………………………….…… 15 III. IMPROPER MANAGEMENT OF EARNINGS……………………. 18 Strategies Employed by Freddie Mac………………………………………………….. 18 June 1999………………………………………………………………………… 19 The Year 2000 …………………...……………..................................................... 22 The FAS 133 Transition………………………………………………………..... 25 Changing Swaption Values………………………………………….................... 29 Problems with Coupon Trade-Up Giants (CTUGs)… ………………………….. 35 Positive Carry…………………………………………………………………..... 37 “Managing the Time Pattern of Net Interest Income Recognition”……………... 41 Changing Metrics……………………………………..……………………......... 43 Lowering the Bar………………………………………………………………… 45 A New External Auditor………………………………………………………… 49 Loan Loss Reserves and Earnings Management…………………………………………. 52 FAS 91 and the Improper Management of Earnings. ……………………………………. 55 The Aftermath……………………………………………………………………………. 58 The Role of the Executive Compensation Program of Freddie Mac……………..……… 60 Corporate Performance and Executive Compensation…………………………... 60 Earnings Per Share (EPS) Targets: A Key Scorecard Factor …………………... 61 The “Informal Process” of Determining Bonus Pools: The Role of Glenn and Brendsel…………………………………………………………………………. 64 Executive Performance Reviews and Improper Management of Earnings…….. 66 The Effect on Compensation of the Achievement of Earnings Targets………… 68 “Tone at the Top,” Earnings Per Share Growth, and Employee Performance…... 69 Executive Compensation and Earnings Management…………………………... 71 IV. COUNTERPARTIES…………………………………………............... 74 The Linked Swaps……………………………………………………………................... 76 Coupon Trade-Up Giants (CTUGs) ……………………………………………………... 80 The Blaylock Transactions…………………………………………………….................. 81 Other Counterparties…………………………………………………………................... 82 V. ACCOUNTING AND AUDITING…………………………………..…. 83 Weaknesses in Accounting………………………………………………………………. 84 Inadequate Accounting Personnel and Expertise……………………………….. 84 Out-of-Date or Nonexistent Accounting Policies………………………………. 91 Reliance on External Auditor for Basic Accounting Functions and Decisions… 96 Lack of Accounting Controls ……………………………………………….….. 102 Derivatives Execution, Administration, and Accounting…………………… 104 Guaranteed Mortgage Securities Reconciliation…………………………… 105 Trades with Blaylock & Partners and with Salomon Smith Barney………... 107 Inadequate Implementation of the Financial Reporting Controls Improvement Plan…………………………………………………………... 109 Weaknesses in the Internal Audit Function………………………………………………. 112 Lack of Responsibility Regarding Financial Information………………………. 113 Inadequate Follow-Up of Identified Deficiencies………………………………. 115 Internal Audit Control Weakness Timeline…………………………………….. 117 Ineffective Communication to the Board and Senior Management…………….. 118 VI. DISCLOSURE…………………………………………………………. 122 Disclosures Required by the SEC…………………………………………………..……. 123 Materiality………………………………………………………………………………... 124 A Culture of Minimal Disclosure………………………………………………………… 133 The Failure of the Internal Controls of Freddie Mac…………………………………….. 137 VII. THE BOARD OF DIRECTORS…………………………………….. 143 Failure of Non-Executive Directors to Make Adequate Inquiries ………………………. 143 Failure of Non-Executive Board Members to Secure Adequate Information……………. 145 Limited Time for Board Discussion …………………………………………………… 149 Complacency of Non-Executive Board Members……………………………………….. 153 Failure to Ensure the Hiring of Qualified Executives for Key Positions………………… 156 Failure to Hold Management Accountable…...……..………..………………..………… 159 VIII. RECOMMENDED ACTIONS……………………………………... 163 General Recommendations………………………………………………………………. 163 1. Freddie Mac Should Separate the Functions of the CEO and the Chairman of the Board………………………………………………………………………...………. 164 2. Freddie Mac Should Develop Financial Incentives for Employees Based on Long-Term Goals, not Short-Term Earnings……………………………………….. 164 3. OFHEO Should Establish a Regulatory System of Mandatory Disclosures the Enterprises or Their Securities Exemptions Should be Repealed……..……………. 164 4. OFHEO Should Consider Requiring a Periodic Change of the External Auditors at the Enterprises, Not Just a Change in Engagement Partner……………………… 165 5. OFHEO Should Require Freddie Mac to Hold a Capital Surplus and Should Consider Limiting the Growth of the Retained Portfolio Until Freddie Mac Produces Timely and Certified Financial Statements………………………………. 165 6. OFHEO Should Establish a “Materiality” Standard for the Provision of Sufficient Information to the Board of Directors……………………………..…….. 166 7. Freddie Mac Should Impose Strict Term Limits on the Members of the Board of Directors………………………………………………………………………........... 166 8. OFHEO Should Ensure that the Board Becomes More Actively Involved in Oversight of the Enterprise…………………………….............................................. 166 9. Freddie Mac Should Establish a Formal Compliance Program………………....... 167 10. Freddie Mac Should Establish the Position of Chief Risk Officer…………........ 168 11. Freddie Mac Should Document the Legitimate Business Purpose of Every Significant Derivative Transaction………………………...………………………… 168 12. Freddie Mac Should Establish and Maintain Superior Accounting Controls….... 169 13. Freddie Mac Should Prevent Undue Reliance on the External Auditor……….... 169 14. Freddie Mac Should Strengthen and Clarify the Role of the Internal Audit Department………………………………………………………………………….. 170 15. OFHEO Should Expand Its Capacity to Detect and Investigate Misconduct….... 170 16. OFHEO Should Conduct a Special Examination of the Accounting Practices of Fannie Mae…………………………………………...…………………………........ 171 LIST OF FIGURES AND TABLES Figure 1. Spread Between Yields of 10-Year Agency and Treasury Debt………………. 23 Figure 2. Average Interest Rate on 30-Year Fixed-Rate Mortgages…………………….. 30 Figure 3. Volatility of a 3 X 10 Swaption………………………………………..………. 31 Figure 4. Volatility of a 3 X 10 Swaption ……………………………………………….. 34 Figure 5. 3-Month LIBOR and 10-Year Swap Rates. …………………………………... 39 Figure 6. Federal Funds Target Rate…………………………...………………………… 39 Table 1. Freddie Mac Rebalancing Activity, Fourth Quarter 2000……………………… 38 Table 2. Breakdown of Estimated Freddie Mac Excess 2001 Earnings Per Share (June 30, 2001)………………………………………………………………………….. 40 Table 3. Freddie Mac Loan Loss Reserve and Net Losses………………………………. 53 Table 4. Corporate Bonus Plan Funding History……………………………………..… 62 Table 5. Summary of Bonus Payouts of Senior Freddie Mac Officers, 1998-2001 Performance Years…………………………………..……………………… 63 Table 6. Earnings Per Share in the Informal Scoring Process…………………………… 65 Table 7. Freddie Mac Derivatives Counterparties…………………………..…………… 75 Table 8. Linked and Leveraged Swaps…………...………………………………..…… 77 Table 9. Counterparties to Other Transactions…………...…………………………..… 82 EXECUTIVE SUMMARY In the early 1990s, Freddie Mac promoted itself to investors as “Steady Freddie,” a company of strong and steady growth in profits. During that period the company developed a corporate culture that placed a very high priority on meeting those expectations, including, when necessary, using means that failed to meet its obligations to investors, regulators and the public. The company employed a variety of techniques ranging from improper reserve accounts to complex derivative transactions to push earnings into future periods and meet earnings expectations. Freddie Mac cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth. The conduct and intentions of the Enterprise were hidden and were revealed only by a chain of events that began when Freddie Mac changed auditors in 2002. This report describes the circumstances leading to Freddie Mac’s $5 billion restatement and makes recommendations on corrective and preventative measures. Corporate Culture and “Tone at the Top” 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. Beginning in the early 1990s, Freddie Mac promoted expectations of steady, rapid growth in profits. A corporate culture evolved that placed a very high priority on meeting the earnings estimates of Wall Street analysts but neglected key elements of the infrastructure of the Enterprise needed to support growth. The senior management of Freddie Mac placed an inordinate emphasis on meeting stock analyst expectations regarding non-volatile earnings growth. 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, compromised the integrity of many employees, and limited the effectiveness of its internal control structure. Freddie Mac created and maintained reserve accounts that did not comply with GAAP and entered into transactions with little or no economic substance, all for the express purposes of obtaining accounting results that would support the goal of reporting steady earnings growth and meeting analyst expectations. i A tension developed between the more bureaucratic elements of Freddie Mac responsible for supporting and reporting transactions and the “financial engineers” who designed products and strategies to achieve corporate earnings goals. Compounding that problem, the Enterprise managed General and Administrative expenses to a rigid guideline, regardless of the level of profits. The preoccupation of management with adhering to the expense limits resulted in an insufficient allocation of resources—both dollars and staffing—to divisions responsible for accounting, financial reporting, and internal controls. The lack of attention by senior management and the Board of Directors to those functions resulted in transactions not being recorded in financial statements in accordance with GAAP. Finally, senior management and the Board failed to establish and maintain adequate internal control systems. The culture of Freddie Mac even allowed certain persons and business units to change or avoid established written policies and controls, in part because management of operations risk was not a priority. Improper Management of Earnings By 1999 Freddie Mac had established a practice of engaging in transactions for the express purpose of managing its reported earnings and other measures of financial performance included in the financial statements of the Enterprise. Freddie Mac used several strategies to shift earnings into future reporting periods, reflecting the proclivity of management to increase operations risk in the quest for more stable earnings. Although some of the most egregious examples relate to the desire of management to address earnings volatility challenges associated with the implementation of Statement of Financial Accounting Standards 133 (FAS 133), there were numerous other instances when Freddie Mac management engineered transactions with little or no economic substance to obtain specific accounting results: • Management executed several interest rate swap transactions that moved $400 million in operating earnings from 2001 to later years. Those transactions had virtually no other purpose than management of earnings —specifically, making operational results appear to be less volatile than they were. ii • Management created an essentially fictional transaction with a securities firm to move approximately $30 billion of mortgage assets from a trading account to an available-for-sale account. Other than to reduce potential earnings volatility, the transaction had no other meaningful purpose. • Freddie Mac adopted, and then quickly reversed, a dubious change in its methodology for valuing swaptions. That change had the effect of reducing the value of the derivatives portfolio of the Enterprise by $730 million. • On at least one occasion, a transaction was entered into at the instruction of management for the purpose of disguising the effective notional amount of the Freddie Mac derivatives portfolio and thereby allay the concerns of an investor. • From 1998 to 2002, management purposefully kept loan loss reserves at an unusually high level by using aggressive assumptions, even though actual and foreseeable credit losses were rapidly declining. Both management and the Board of Directors were aware that the Securities and Exchange Commission had criticized that practice as an inappropriate form of earnings management. • Freddie Mac used another, non-GAAP reserve to dampen earnings fluctuations occasioned by unpredictable premium amortization caused by changing mortgage prepayment speeds. Management changed key assumptions in the calculation of the reserve when necessary to achieve a desired earnings result. It is clear that management went to extraordinary lengths to transact around FAS 133 and to push the edge of the GAAP envelope. One could reasonably ask if communicating the true nature of the transition gain in the derivatives portfolio of Freddie Mac to equity investors would have been more difficult than disguising the amount of that gain. Senior Freddie Mac management failed to disclose to the public information that would have revealed more fully the nature of transactions undertaken to manage earnings and the intent to do so. Such disclosure would have called into question the accounting treatment of the transactions adopted by Freddie Mac. iii Incentives Created by Executive Compensation The compensation of senior executives of Freddie Mac, particularly compensation tied to earnings per share, contributed to the improper accounting and management practices of the Enterprise. The size of the bonus pool for senior executives was tied, in part, to meeting or exceeding annual specified earnings per share targets. It was not tied directly to meeting earnings forecasts of analysts but actions to shift earnings from one quarter to future periods helped ensure that earnings per share goals, and consequently the bonuses based upon them, would be achieved in the future. Freddie Mac used a corporate scorecard involving a formulaic approach to setting the size of the corporate bonus pool. Achieving earnings per share targets played a substantial role in the formula but former CEO Leland Brendsel and former COO David Glenn also exercised considerable discretion over the outcome. The informal process by which Mr. Brendsel and Mr. Glenn revised the scorecard results, and therefore the amount of funds available for individual bonuses, reinforced in the minds of managers and other employees the importance of achieving earnings per share targets. Weak Accounting, Auditing and Internal Controls The management of a corporation is responsible for maintaining a control environment that will, among other things, accurately record transactions to provide for published financial statements that are consistent with the true financial condition of the firm. In that regard, the obsession of Freddie Mac with steady, stable growth in earnings was at the expense of proper accounting policies and strong accounting controls. Weaknesses in the staffing, skills, and resources in the Corporate Accounting Department of the Enterprise led to weak or nonexistent accounting policies, an over reliance on the external auditor, weak accounting controls, and an over reliance on manual systems. Given the size of the company and the role in the housing finance and capital markets, those weaknesses effectively increased the systemic risk posed by the Enterprise. The deficiencies of the company resulted in improper accounting of many complicated transactions in which the Enterprise engaged during the period of the iv restatement. Although management developed plans to address identified weaknesses, those plans were neither well conceived nor fully implemented. For most of the period in question the Chief Financial Officer and the Controller of Freddie Mac promoted an attitude that the Enterprise should transact around GAAP because, they believed, financial statements prepared in accordance with GAAP would not reflect the true economics of the business of Freddie Mac. In that regard, the attention of the CFO and the Controller on meeting senior management desires and analyst expectations at the expense of accounting policies of high quality and strong accounting controls led to aggressive accounting and ultimately led to the restatement of years of incorrectly reported and misleading financial results. The Internal Audit Department of Freddie Mac did not accept responsibility for the reliability and integrity of the financial information of the Enterprise, did not follow- up effectively on identified deficiencies, and did not communicate effectively with management and the Board. In combination, the weaknesses in Corporate Accounting and Internal Audit meant that there were weak points at each major control juncture at Freddie Mac. Management and the Board failed to meet their responsibilities for adopting sound accounting policies and establishing and maintaining a strong internal control system to assure that financial statements were prepared in accordance with GAAP. The Board operated under the misconception that as long as the external auditor signed off on an accounting policy or a process, its responsibilities and those of management were fulfilled. Inadequate Disclosure In some instances, Freddie Mac knowingly circumvented prevailing public disclosure standards in order to obfuscate particular policies and specific capital market and accounting transactions. A disdain for appropriate disclosure standards, despite oft-stated management assertions to the contrary, misled investors and undermined market awareness of the true financial condition of the Enterprise. Overly general disclosures v