7
Caught in Freddie Mac’s Perfect Storm
Mr. Biggs says any concerns about Mr. Jones—who he says has a “very high sense of rectitude”—would be “a good example of the death of common sense.”
—JON E. HILSENRATH AND JOANN S. LUBLIN, Wall Street Journal, June 25, 2003
Corporate boards are a world unto themselves. And they are often about personal relationships—friendship, intersecting careers, social circles—connecting a company’s top executives to the people serving on the board. A recurring tension in American capitalism flows from this intersection: Just how effective is the board in influencing and overseeing what the company’s management does? There’s a natural tendency for top management to want board members they feel will be sympathetic toward them, and for board members to operate with a Golden Rule mentality: “I will treat management the same way I would like to be treated at my corporation, by my own board.”
In 1997 I joined the board of directors of Freddie Mac, also known as the Federal Home Loan Mortgage Corporation, the second-largest financier of mortgages in America. It was an extracurricular activity, outside my duties at Citigroup, and it paid a couple of hundred thousand dollars annually and entailed eight two-day meetings per year, and the requisite preparation work for those meetings. My primary interest in service on the board of directors was that it afforded me additional insight into mortgage risk analytics. Top executives tend to serve on corporate boards for several reasons—the prestige of advising and shepherding an important company, networking, the pay, and the chance to acquire skills and knowledge that might be called upon in their own career. But their main duty is to put their expertise and guidance into service for the company’s shareholders.
Freddie Mac was led by a South Dakotan named Leland Brendsel, its CEO, who had been with the company since 1982. He had a Ph.D. in economics and had served first as Freddie Mac’s chief financial officer before becoming CEO in 1985 and chairman of the board in 1989, when it went public. He’d overseen the organization’s growth from a small player in the mortgage market to an entity that had a major role in improving access to mortgages and financing homes for some 30 million Americans. Freddie Mac’s president was David Glenn, a Mormon from the Midwest who’d joined the company as chief financial officer in 1987 and been named president in 1990. The chief financial officer was Vaughn Clarke. There were eight independent outside directors on the board, and we each served as well on two or three of five board committees.
Beginning in 2001, Wall Street and large swaths of corporate America were overcome by wave after wave of financial scandal. Scandal became the drumbeat of the financial news, and as the stories accumulated, they created a widespread public impression of pervasive corporate malfeasance. Increasingly, the financial press and the SEC alike were becoming exuberantly pros-ecutorial. (To give a sense of the prevailing atmosphere, this book’s appendix lists two hundred Wall Street Journal articles regarding fraud and illegality at major American corporations between February 2001 and December 2004.) Just as the scandals were building steam, I was appointed chairman of the audit committee of Freddie Mac’s board of directors in 2001.
Then, in 2002, Enron collapsed. In March, the U.S. Justice Department charged Enron’s auditor, the Arthur Andersen accounting firm, with obstruction of justice over the destruction of documents related to its Enron audit. Arthur Andersen just happened to be Freddie Mac’s auditor as well. An article in the New York Times on March 14, 2002, “Audit Firms Await Fallout and Windfall,” by Jonathan D. Glater, was prescient in some of its observations on the possible consequences of an Andersen collapse:
If Arthur Andersen cannot find a savior, some of America’s biggest companies will be thrust into a period of uncertainty as they scramble to find someone else to bless their books … If Andersen’s efforts to find a merger partner fail, and that seems likely, more client defections are expected … For companies, switching auditors is neither simple nor cheap, accountants said, and where problems arise, it is usually soon after such a change is made. Filings with the Securities and Exchange Commission could run late, depressing share prices. In addition, accountants said, companies may find that a new auditor has a different approach to handling certain transactions … complicating matters, accountants said, is the scarcity of expertise within firms. The partners with the most experience may already be taken, and accountants who are less familiar with the client’s industry are more likely to make mistakes. That could have an effect on financial disclosures.
A core component of corporate finance is based on one simple idea: borrow money at one rate and lend or invest that same money at a higher rate to make a profit. When the scale of that simple idea is expanded, and when questions of timing, uncertainty, and regulations make things more complex, the opportunities for great profit, and great risk, grow. One of the most important but high-risk audit areas at Freddie Mac was the “retained portfolio” of mortgage-backed securities, which were held on Freddie Mac’s balance sheet instead of being sold into the secondary market to third-party investors such as pension funds and insurance companies. In essence, Freddie Mac issued corporate bonds to raise funds and used the funds to purchase consumer and commercial mortgages originated by commercial banks, savings and loan banks, and mortgage companies. Freddie Mac’s core business was to charge a “guarantee fee” for guaranteeing the purchased mortgages against default, bundle the mortgages into new “mortgage-backed securities” (MBS), and sell those to investors such as pension funds, insurance companies, and fixed-income-bond mutual funds. But Freddie Mac’s retained portfolio was an increasingly important source of profits because Freddie could borrow at very low interest rates because of its implied backing by the U.S. government, and capture the “interest rate spread” if it used those borrowed funds to purchase and retain mortgages paying higher interest rates than the bonds issued by Freddie Mac. This maneuver required sophisticated management of the underlying “interest rate risk” to maintain targeted spreads between Freddie Mac’s cost of borrowed funds versus the interest rate yield on the purchased mortgages, and the “duration risk” resulting from the possibility that borrowers could prepay the underlying mortgages (by selling or refinancing the mortgaged property). If the underlying mortgages were prepaid prior to maturity, it created a mismatch between the maturities and associated interest expense of debt securities issued by Freddie Mac versus the maturities and associated interest income of the purchased mortgages—which went away if the mortgages were prepaid.
While straightforward in concept, this “interest rate and duration risk management” was enormously complex when implemented at Freddie Mac’s scale of several hundred billion dollars in retained portfolio comprising millions of specific, unique mortgages and MBS securities and hundreds of billions of dollars in outstanding Freddie Mac bond obligations spread across thousands of unique specific debt offerings. In practice, Freddie Mac executed “portfolio-hedging” strategies to achieve and maintain targeted retained portfolio interest rate and maturity/duration risk characteristics. The Freddie Mac team that managed this process was led by senior vice president Greg Parseghian, and was regarded highly on Wall Street and among sophisticated investors as one of the best in U.S. capital markets.
An extraordinarily complex new accounting standard, FAS 133 Accounting for Derivative Securities, went into effect on January 1, 2001. At several hundred pages in length, it governed accounting for derivative securities and prescribed rules governing portfolio-hedging activities. Freddie Mac’s implementation of FAS 133 in 2001 was advised by Arthur Andersen, and the related 2001 quarterly accounting and financial statement reviews and 2001 annual audit were also conducted by Arthur Andersen. We on the audit committee were assured by Andersen that the company had done a good job implementing FAS 133.
But by early 2002, after the 2001 audit had been completed, we could see that Arthur Andersen might not survive the Enron scandal. For Freddie Mac to wait and monitor Andersen’s situation would be highly risky, because we might become trapped later in 2002 with a last-minute need to replace Andersen for the 2002 audit. In that scenario, our choice of audit firms might be severely curtailed; the best firms might not have the manpower to undertake a major new client so late in the 2002 accounting period. With those considerations in mind, we triggered a search for a new independent auditor and retained PricewaterhouseCoopers (PwC) for the 2002 audit. When Andersen collapsed shortly after being convicted on one felony count in June 2002, our decision to switch to PwC was proved correct, while at the same time the switch in auditors led, almost inevitably, to differing accounting interpretations between the two firms. Further complicating the situation was that Arthur Andersen had been Freddie Mac’s only independent auditor since 1970, the year Freddie Mac was founded. Freddie Mac’s accounting department had zero experience in audit firm transitions.
We didn’t have to wait long for the first problem to arise. In the third quarter of 2002, PwC representatives informed the audit committee that they had serious concerns regarding our FAS 133 implementation. According to PwC, Freddie Mac had continued to use some overall portfolio-hedging techniques and had failed to adequately link each derivative security intended for hedging to a specific underlying retained portfolio security, which was the object of hedging. If PwC’s concerns were correct, it meant that our retained portfolio might not qualify for “hedged portfolio accounting” and would have to be classified as “marked to market” and reported in Freddie Mac’s quarterly financial statements at current market values. Since the retained portfolio market values would fluctuate with interest rate movements and changes in credit market conditions, this would introduce into Freddie Mac’s financial statements enormous volatility from quarter to quarter on net income and shareholders’ equity.
The second problem developed in December 2002, a day after our board meeting. Someone inside the company had sent two anonymous whistle-blower letters to the SEC and the Office of Federal Housing Enterprise Oversight (OFHEO), Freddie Mac’s federal regulator, alleging that management had engaged in improper earnings management transactions and committed accounting errors in 1999 and 2000. Leland Brendsel phoned to tell me. I called an emergency audit committee meeting, at which we accepted management’s recommendation to engage the law firm of Baker Botts LLP to conduct an independent investigation, led by partner James Doty, who had served as a general counsel to the SEC from 1990 to 1992 and therefore had firsthand knowledge of the point of view from the other side of the table. In reports dated May 1, July 22, and November 13, 2003, Baker Botts reported its findings: the allegations in the anonymous letters were false in most material respects, but, during its investigation, the firm had identified additional accounting transactions that raised questions and required further inquiry. PwC and Baker Botts eventually named eight specific transactions or accounting policies that might go beyond issues of simple accounting error.
These events caused PwC to insist on a re-audit of Freddie Mac’s 2001 and 2000 financial statements rather than relying on the Arthur Andersen audits of those years. This in turn meant that Freddie Mac could not issue 2002 financial statements until the re-audit was completed, because a baseline of audited 2000 and 2001 financials was necessary for the multiyear 2000–2002 comparative financial statements. In January 2003, Freddie Mac announced publicly that it was conducting a re-audit of 2000 and 2001 financial statements, that it would be restating results to reflect higher earnings from derivatives that should have been recognized in prior years, and that the re-audit and restatement were expected to be completed by the end of the second quarter 2003. Freddie Mac, a major publicly traded corporation and one of the largest debt securities issuers in the global capital markets, was now crippled by being unable to issue timely current financial statements.
I knew that these developments might place Freddie Mac’s audit committee in the regulatory bull’s-eye. Outside legal counsel warned us it was likely that the SEC was looking for opportunities to prosecute a public company audit committee to make an example for independent director accountability and culpability. As audit committee chairman, I knew this meant that I was probably going to be the Freddie Mac director most directly targeted by the regulators.
The core underlying problem, it seemed to me, was that Freddie Mac’s senior management for many years had focused primarily on hiring top-tier executive talent in those business areas that were regarded as mission critical to the company’s success—interest rate and duration risk management, credit risk management, single-family mortgage origination, and multifamily mortgage origination. Unfortunately, senior management hadn’t devoted a complementary focus to recruiting top talent in “back office” functions such as accounting, internal controls, and financial reporting—maybe because Freddie Mac had historically been technically exempt from SEC registration, and because the company had operated on a much simpler business model for most of its history. When Freddie Mac adopted a more complex business model in the mid-1990s by beginning to grow the retained mortgage portfolio aggressively, the complexity of the related accounting and financial reporting increased dramatically.
In addition, FAS 133 in 2001 had triggered a geometric increase in the complexity of accounting and controls and financial reporting, for which the company was not well prepared. For several years, Freddie Mac’s audit committee had been pushing senior management to strengthen the company’s capabilities in these functions, and under my leadership the audit committee insisted on tying 25 percent of senior management bonuses to successful execution of a Financial Reporting Controls Improvement Plan. But I knew we would likely receive little sympathy from the regulators.
In April 2003 Baker Botts reported to the audit committee that six of the eight questionable transactions or accounting policies involved the “unintentional misapplication of generally accepted accounting principles (GAAP) based at least in part on the advice and concurrence of Arthur Andersen.” One of the issues involved a known departure from GAAP, which management and Arthur Andersen deemed immaterial. And one transaction involved a deliberate effort to smooth “operating earnings,” a non-GAAP metric, which had little practical effect on the company’s GAAP earnings.
Also, by April 2003 it was apparent that the time and management talent required to fix the accounting and reporting problems and complete a restatement was going to be much greater than management’s estimates. I was surprised when Leland Brendsel asked to visit me at my office in New York to discuss his plans and personal commitment to fix the problems. He sat across from me at my desk. “I’m sorry this stuff is happening, Tom,” he said. “I promise I’ll get this fixed.”
I told him, “I’m glad you’re sorry, Leland, but with all due respect, I’m not sure you’re the guy to fix the problem. The audit committee has been warning you for years and you haven’t fixed it, and now we’re in this mess. In my view, it’s unpardonable for a company of Freddie Mac’s stature not to have audited financial statements that investors can rely on. You had your chance, but in this league, you don’t get second chances.”
He looked surprised at the candor and severity of my assessment. He said, “I am the right person to fix it.”
I shrugged. “Fine, but I’m just being honest with you. I’ve lost confidence in your leadership and you won’t get my vote.”
Leland said that he couldn’t accept my assessment of the situation, that I was wrong. I told him that I understood his point of view. “I think we should simply agree to disagree,” I said.
In June 2003, when Baker Botts was nearly finished with its investigation, the law firm discovered that the president of Freddie Mac, David Glenn, had altered his personal diary to obscure his role in approving some of the questionable transactions. I was shocked by this new evidence of evasion and concealment. You never know, I thought, how a person is going to react in the face of immense pressure. I could almost imagine how the scenario had unfolded. Someone was being questioned about the implementation of various accounting transactions and was asked for a specific date on which the topic had been discussed in a meeting. That person may have mentioned, off handedly, that David Glenn was in the habit of keeping careful notes at meetings, that he kept a business diary: “I can’t remember exactly what day it was, but you should check David’s diary. He would know.” The note in question might not have revealed any obvious misdeed at all, but in a panic, or perhaps from an impulse to be less than completely candid with the investigators, the president had torn it from the diary.
His decision should have been, of course, to go to the investigator, Doty, at the outset, give him the diary, and say, “I don’t know if this will come to your attention or not, but I was in various meetings and I’ve got some entries here which can help explain my thoughts.” His decision should have been to control the story and get out in front of it. In that way, you’re saying, in effect, “I want to help the investigation and I have nothing to hide.” He didn’t make that decision.
The board understood that the removal of the diary pages could be construed as an intentional effort to impede a board investigation. It required a strong response. The board decided to terminate Glenn and requested the resignations of Brendsel and Vaughn Clarke, the CFO, too, on the basis of developments in the burgeoning accounting scandal.
We also promoted Greg Parseghian to president and chief executive officer, and elected Shaun O’Malley (retired chairman of PwC) as nonexecutive chairman. Our rationale was that Parseghian’s exceptional understanding of the risk characteristics of mortgage-backed securities portfolios, and his strong reputation in capital markets, would keep investors confident in the business side of Freddie Mac, while O’Malley would focus on managing the accounting and regulatory storm. It was a smart decision which unfortunately was undermined when OFHEO, the company’s federal regulator, ordered Freddie Mac to replace Parseghian on August 22, 2003, claiming that his investment group had been involved in some of the questionable accounting transactions. We on the board felt that Parseghian’s team had constructed transactions at the direction of the company’s president and was not responsible for the accounting or financial reporting of those transactions.
I had taken Greg Parseghian aside at the board dinner the evening before we promoted him to CEO and implored him to think carefully before letting us go down that path. I told him, “Greg, you’re the only one who knows in your heart the extent of your involvement in these questionable transactions, but it is certain to be discovered and brought into the light. If you’ve done anything questionable you will not survive as CEO, so it’s better to face that now and not let the board take you there. You don’t have to answer me now. You should think about this overnight and let me know tomorrow morning before the board meeting.”
“Sure, I’ll think about it overnight, but I’m okay,” he said. He hadn’t to his knowledge done anything inappropriate, he told me, or that could impugn his credibility or impair his effectiveness as CEO. He said that, after all, he’d always relied on the directions of the president and the CEO, and on the accounting personnel and Arthur Andersen for vetting the accounting treatment of transactions. The next morning Greg told me that he was comfortable moving forward, and I was a strong advocate for electing him CEO.
Freddie Mac finally completed the PwC re-audit and in November 2003 issued its audited financial statements for 2000, 2001, and 2002. The board recruited an outsider, Richard Syron, former head of the American Stock Exchange, to be Parseghian’s successor as CEO in December 2003.
Baker Botts’s final report to Freddie Mac’s board summarized the problem not as an abuse of authority for personal gain but instead “serious failures by senior management to discharge responsibilities entrusted to and placed upon them by the Board.”
On June 25, 2003, the Wall Street Journal ran a story headlined “Freddie Mac Board Played Key Role in Executive’s Ouster” that raised questions regarding my independence as a Freddie Mac director, since Freddie was a large client of Citigroup, while at the same time pointing out that most major financial institutions in the country also had dealings with Freddie Mac and that our vote to fire the company’s three top managers showed an independence and toughness unusual in corporate governance. I was gratified to read statements about me that were included in the article, among them this: “David Palombi, spokesman for Freddie Mac, noted that Mr. Jones’ role as audit committee chairman isn’t in violation of any current rules of the NYSE, adding that the board was aware of the proposed rules and would address them at an appropriate time. Mr. Palombi added, ‘Anybody who knows Tom Jones knows his independence, integrity and judgment are beyond question.’”
I was subpoenaed to testify by both the SEC and OFHEO. The interrogators at both depositions focused on my personal role in setting audit committee agendas and in linking senior management incentive compensation to effective execution of the Financial Reporting Controls Improvement Plan. They also wanted to probe my knowledge of the accounting issues at stake and the board’s role in overseeing or advising management. Both depositions also sought to learn how much I understood about the relevant accounting standards, and the board of directors’ role and responsibilities in ensuring that those standards were implemented correctly.
My OFHEO deposition was on August 12, 2003, at the OFHEO offices in Washington, D.C., starting at 10:00 in the morning. Hostile and accusa-tory, the questioning made it clear to me that regulators were “scalp hunting,” looking for an opportunity to bring charges against prominent business executives.
I testified that the audit committee was the driving force behind creating the Financial Reporting Controls Improvement Plan in late 2001 after the company encountered a problem reconciling guaranteed mortgage securities accounts. I further testified that the audit committee was the driving force insisting on rigorous definition and controls with regard to calculating and reporting Freddie Mac’s new non-GAAP financial reporting metric, called “operating earnings.” I described the role and functions of internal audit and the duties and responsibilities of board members and audit committee members, and the role of the audit committee with regard to financial statement disclosures. I described my understanding of the breakdowns that led to the restatement and re-audit of Freddie Mac’s 2000 and 2001 financial statements. I described the economic purposes of debt repurchase transactions and explained why they did not constitute earnings management. I described my understanding of the GAAP standard for loan loss reserves, and why Freddie Mac’s reserves were positioned appropriately at the conservative end of the allowable range of loss estimates. And I discussed various conversations I’d had with former CEO Leland Brendsel and CEO-designate Greg Parseghian.
It was clear to me that the OFHEO and SEC interrogators did not like me, and there was significant tension in the room throughout both depositions. The regulators were probably accustomed to investigatory targets who were deferential, conciliatory, and anxious to avoid conflict—but I exhibited none of those characteristics. I refused to yield any ground on any question that implied wrongdoing by Freddie Mac’s board or audit committee.
What follows is an excerpt from my OFHEO testimony. I am being grilled about various accounting transactions and estimates and financial statement disclosures. You will see from the nature of the questioning that the government investigators are focused on finding malfeasance at the board level. I was able to provide a clear and detailed explanation of the board’s actions.
OFHEO: Have you heard the term “earnings management”?
JONES: Yes, I have.
OFHEO: In what context have you heard that term?
JONES: Lots of newspaper articles and SEC pronouncements. It’s been an issue in the Doty investigation. It was implied within the whistle blower letter.
OFHEO: Mr. Jones, the court reporter has handed you Exhibit 9. It’s another presentation. It bears the name John Gibbons, Board of Directors Meeting, June 4, 1999. It is entitled “Financial Review and Outlook.” If you could look at the second page entitled “Overview,” and if you look at the second diamond on that page it’s entitled “Financial Prospects.” Look at the second indentation there which reads “NII [net interest income] is surging and we are undertaking transactions to smooth the time pattern of 1999–2000.” Do you see that statement?
JONES: Yes, I do.
OFHEO: Did that statement give you any concern in or around 1999?
JONES: Not especially, because the question is what’s the nature of the transactions that were planned to undertake, and how appropriate are they and are they in accordance with GAAP.
OFHEO: Do you recall questions of that nature being asked of Mr. Gibbons who apparently made this presentation?
JONES: Of course. I remember items like this being discussed, and the typical technique that was used was debt repurchases because you usually record an accounting loss on the repurchase of the debt. That takes down the current year income, and it’s made up as increased earnings emerge over time due to lower interest expense within the reduced debt portfolio. That was never a type of transaction that was ever suggested or identified as being inappropriate. It was fully disclosed in the financial statements, and usually discussed within the earnings press release itself. There was nothing hidden or misleading.
OFHEO: What’s the economic reason behind a debt repurchase as you understand it? What’s the business purpose, as opposed to the accounting impact coming from the debt repurchase. It has some effect, if I understood your answer, on undertaking transactions to smooth the time pattern of NII over 1999–2000. What is the economic purpose behind the transaction besides the accounting purpose?
JONES: When you run a large portfolio of securities, you do purchase and sale transactions all of the time in terms of whether there are advantageous pricing opportunities in the market. Prices go up and down on a daily basis, and so the economic advantage is within being able to get attractive pricing on the securities purchases or sales. Sometimes a company will buy and sell its own securities just to make sure there’s an active market in those securities. There can be an economic purpose to a company that there’s a certain level of trading volume, because it’s a more attractive investment instrument to other investors when they see significant trading volumes which imply efficient pricing. It all depends on the company’s particular economic situation, its strategy, trading volumes in the securities, and how efficiently the securities are priced. There can be many economic implications.
OFHEO: Do you know whether that particular one that you just referenced was engaged in by Freddie Mac?
JONES: Which particular one? I mentioned several.
OFHEO: Engaging in transactions of buying and selling its own stock?
JONES: We’re not talking about stock. We’re talking about debt securities.
OFHEO: Sorry, debt securities.
JONES: Yes, Freddie Mac does a lot of buying and selling its own debt securities.
OFHEO: In order to create a market or activity in the market, which I thought was what you said the purpose was?
JONES: When this crisis broke and our agency debt securities spreads started to widen against Treasuries, management came to the board and said we should step into the market and show support for our own securities so the pricing doesn’t collapse. So yes, we agreed to step up and support our own debt securities. That’s not earnings manipulation. That’s trying to support the efficiency of the pricing of our securities in the market, and trying to ensure that there was sufficient liquidity for other investors to sell without driving prices down to fire sale levels. There is nothing inappropriate about that at all.
OFHEO: Now one of the things that I heard you say earlier, Mr. Jones, was that the company formed a task force to prepare itself for the implementation of FAS 133. Is that correct?
JONES: Yes.
OFHEO: One of the things that was considered, was it not, was reporting not only GAAP earnings but also generating a new type of reporting metric, isn’t that right, called operating earnings?
OFHEO: Who was responsible for that idea, if you know?
JONES: My impression was that the primary champion was [president] David Glenn. I don’t know who he assigned to the working team to actually come up with the calculations and the design, but in board meetings the most outspoken proponent of that being one of the strategies was David Glenn.
OFHEO: Do you recall what he said as to why he advocated reporting on this basis as well as GAAP reporting, this basis being operating earnings reporting?
JONES: Primarily that the volatility of the financial statements was inevitably going to be greater under FAS 133, and not reflective of the underlying economics of the company, as I described to you earlier regarding marking to market on derivative hedges in different time frames than the realization of values on underlying hedged securities. So to make sure that investors could understand what the company thought its underlying economics really were we needed to create a measuring technique to communicate the economics.
OFHEO: And that was in contemplation that the measuring technique of marked to market for these derivatives required by FAS 133 would not present a true picture?
JONES: That is correct. It would be a distortion.
OFHEO: When Mr. Glenn advocated for presenting this other presentation of the company’s financials, this operating earnings, do you remember how the board reacted?
JONES: We thought it sounded reasonable. After all, the GAAP financials were still there and it’s not uncommon to see companies in different industries develop a non-GAAP measure because of what they feel are the unique characteristics of the particular company or the particular industry. That’s not an uncommon phenomenon.
OFHEO: Is it correct to say—I think I got your answer with respect to the board’s reaction. Was your reaction the same, that this would be an appropriate technique to employ, this use of operating earnings?
JONES: Yes, it sounded reasonable to me.
OFHEO: Sometime later, if I understood your earlier answer, you developed some concerns about the use of this non-GAAP metric to report the company’s financials. Is that right?
OFHEO: How did those concerns surface with you over time, from the time you first heard about using this technique as opposed to the time when you had these concerns?
JONES: I believe the company first started using operating earnings at the beginning of 2001, and then as that year evolved I thought I was hearing slightly different nuances in terms of how management was describing operating earnings. I thought I was hearing slightly different nuances, and it made me feel that we needed to pin this down. We needed to make sure that we were reporting something that is defined rigorously, and calculated consistently, and reported consistently. The fact that it’s an alternative reporting metric doesn’t mean that you can just do whatever you want to do with it.
OFHEO: It keeps changing along the way, is what I’m hearing.
JONES: I wasn’t sure what I was hearing, and so I started asking questions, asking for a written definition of operating earnings. Then I made it an issue that I thought PwC ought to opine on operating earnings as they did on GAAP. PwC said they could not opine on a non-GAAP measure, but they could perhaps do some agreed procedures. But to do agreed procedures, PwC required an appropriate audit trail regarding the definition, the calculations and measurements, and controls regarding data accuracy.
OFHEO: This was in 2002 that you were having these discussions with PwC, is that right?
JONES: Yes, that’s correct. As we started to prepare for the 2002 audit with PwC there was discussion of having some audit procedures to give the audit committee some assurance regarding operating earnings. That’s when PwC’s feedback was there had to be documentation of the definition, and documentation of the calculation, and control processes in terms of the data that was being fed into the calculations. It reached a stage where I think it was third or fourth quarter of 2002, the audit committee said that we would not agree to disclosure of operating earnings in the quarterly earnings press release if there was not a definition and calculation and data verification satisfactory to PwC. A lot of that wasn’t in place.
OFHEO: With respect to reserves, you talked about reserves earlier. Do you understand what the GAAP standard is for the creation of reserves?
JONES: I think it’s changed over time. I would paraphrase it as saying that it’s an event that is probable of occurring and reasonably estimable. That is the general standard behind creating a reserve—the degree of probability of loss occurrence, and the degree of reasonability of the loss estimation.
OFHEO: So probable of occurring and reasonable of estimating? Did I understand those to be the two elements?
JONES: Yes. That’s my understanding of the key elements.
OFHEO: With respect to the maintenance of reserves at the company, and here I’m talking about the loan loss reserve, wasn’t it brought to the board’s attention that it instead made its loan loss reserves on a much more conservative basis, if that’s the right terminology. Instead of most probable or probable of occurring, that they took the most adverse consequence and used that as a measure for probability of occurring?
JONES: Yes. At least I clearly understood that.
OFHEO: What was your reaction with your understanding of what the basis is for reserve, probable or most probable of occurring as opposed to the most adverse circumstances, as to why the company was permitted to engage in that?
JONES: My personal view is that strong financial companies want to maintain conservative reserve levels, and this was a company that had a not too distant history of not having adequate loan loss reserves.
OFHEO: When was that?
JONES: In the early nineties, I believe 1990 or 1991. An extra charge in excess of $100 million was taken through the P&L [profit and loss statement] because of inadequate reserves in the S&L [savings & loan] crisis. I personally had the experience in my earlier career at TIAA-CREF, which was one of the largest mortgage lenders in the country, of seeing a real estate implosion which caused the bankruptcy of many S&L’s, and I had seen the “Texas loss scenario” firsthand in terms of how adverse mortgage and real estate loss experience can be. I had seen triple-A rated financial institutions downgraded to junk status because they underestimated the severity of mortgage and real estate loss cycles, and so to me first class financial institutions appropriately want to be at the very conservative end of the reserve spectrum. The fact that Freddie Mac had gone through a number of years without its reserves being really stressed was to me reflective of nothing other than the fact that we hadn’t had an economic recession recently. We were in a prolonged period of economic growth, so what does that prove? The fact that the reserves aren’t stressed when the economy is strong doesn’t tell you what’s going to happen when the next recession comes. So, my personal view was to stay on the conservative end of the spectrum and see how the reserves behaved when they were stressed in the next recession, and then be in position to make a better judgment. Let’s see how the reserves behave through a full economic cycle. Let’s not just watch what they’re doing during the economic growth phase. Let’s see the reserve levels through a full cycle of growth and recession, and then we can make an informed judgment with regard to whether we’re in the right position.
OFHEO: Was it your understanding then based on your understanding of what GAAP required with respect to the maintenance of a reserve and the amount of that reserve, that using the most adverse consequences was appropriate under GAAP?
JONES: Rob Arnall [the Arthur Andersen engagement partner] was there in the audit committee meetings when this was discussed. Clearly, he was opining to us that the financial statements were in accordance with GAAP. The loan loss reserve was the largest reserve on the balance sheet. Every quarter when we had the sensitive estimates and judgments report, the loan loss reserve was the biggest number in the report and Rob Arnall was sitting right there. It was clear to us that we were on the conservative end of the spectrum. Never was it indicated that we were not in compliance with GAAP.
OFHEO: In connection with concerns expressed by the SEC about earnings management and use of cookie jar reserves, did the intersection of maintaining reserves at such a conservative level, even with Mr. Arnall’s blessing, did the board ever discuss maintaining reserves at that level in connection with the SEC’s concerns about cookie jar reserves?
JONES: It was a non sequitur because it’s not like we were taking the reserve level up and down in order to either reduce earnings or increase earnings. They were maintained at a high level, period. Flat, at the peak, through the period. So it wasn’t like the reserve level was being manipulated in order to achieve a P&L impact. The reserves were kept at a high level purely for the balance sheet protection.
The OFHEO and the SEC did ultimately bring civil fraud charges against Freddie Mac’s chief executive officer, president, chief financial officer, and several other executives, but no charges were filed against any Freddie Mac board member. My deposition testimony made it clear that the audit committee had very credible rationales for all its decisions and actions. In that context, I think my testimony was successful. I believe that my stout defense of the audit committee in both depositions was a key element in this outcome.
On September 7, 2007, the SEC issued a press release titled “Freddie Mac, Four Former Executives Settle SEC Action Relating to Multi-Billion Dollar Accounting Fraud.” It read in part:
The Securities and Exchange Commission today charged the Federal Home Loan Mortgage Corporation (Freddie Mac) with securities fraud in connection with improper earnings management beginning as early as 1998 and lasting into 2002. To settle the SEC charges, Freddie Mac agreed to pay a $50 million penalty, which is expected to be distributed to injured investors through a Fair Fund.
The SEC’s complaint alleges that Freddie Mac engaged in a fraudulent scheme that deceived investors about its true performance, profitability, and growth trends. According to the complaint, Freddie Mac misreported its net income in 2000, 2001, and 2002 by 30.5 per cent, 23.9 percent, and 42.9 percent, respectively. Furthermore, Freddie Mac’s senior management exerted consistent pressure to have the company report smooth and dependable earnings growth in order to present investors with the image of a company that would continue to generate predictable and growing earnings.
The charged former Freddie Mac executives are David W. Glenn (president, chief operating officer, and vice chairman of the board); Vaughn A. Clarke (chief financial officer); and former senior vice presidents Robert C. Dean and Nazir G. Dossani.
According to the Commission’s complaint, Freddie Mac’s violations were a direct result of a corporate culture that placed great emphasis on steady earnings, and a senior management that fostered a corporate image that was touted as “Steady Freddie” to the marketplace. Among the violations alleged in the complaint is the use of certain transactions to nullify the transitional effects of the company’s implementation of accounting standard SFAS 133 (which relates to accounting for derivative instruments and hedging activities); the improper change in valuing the company’s “swaptions” portfolio at year-end 2000; the improper use of derivatives to shift earnings between periods; the improper use of a reserve in connection with the company’s application of SFAS 91 (which relates to accounting for loan origination costs); the use of certain transactions to nullify the effects of an accounting pronouncement known as Emerging Issues Task Force Issue 99–20; and the maintenance and reporting of a reserve for losses on loans materially in excess of probable losses. A similar settlement was announced on November 7, 2007, with regard to the civil fraud charges OFHEO brought against Freddie Mac CEO Leland Brendsel, who agreed to pay $16.4 million.
For me, the primary impact of this Freddie Mac saga was as an enormous drain of time for special board meetings, meetings with Freddie Mac legal counsel, and meetings with my personal legal counsel to prepare for the OFHEO and SEC depositions. It was a distraction from my responsibilities at Citigroup. There were also newly proposed New York Stock Exchange and SEC rules on director independence which, if implemented, might create an appearance of conflict with Citigroup’s ongoing business relationships with companies whose boards I served on. The risks and potential negatives of my Freddie Mac board membership had tilted to the point where they outweighed the positives, so I resigned in 2004.
Ironically, in 2008 Freddie Mac had inadequate mortgage loan loss reserves to weather that year’s global financial crisis. It was consequently taken into receivership by the U.S. government. Just four years earlier, the SEC and the OFHEO had charged Freddie Mac with civil fraud and fined it for “maintenance and reporting of a reserve for losses on loans materially in excess of probable losses.”
It was also ironic that Greg Parseghian’s exceptional understanding of mortgage-backed securities, and his exceptional skills in managing MBS portfolio risk characteristics, were precisely what Freddie Mac most needed when the U.S. mortgage crisis exploded in 2008. Freddie Mac was more vulnerable to the mortgage crisis because its most talented mortgage portfolio management executives had been driven out of the company by the OFHEO and the SEC.