the Application of Federal Securities Law Disclosure and Reporting Requirements to Fannie Mae, Freddie Mac and the Federal Home Loan Banks
Alan L. Beller
Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
Before the Committee on Banking, Housing, and Urban Affairs, United States Senate
April 21, 2005
Chairman Shelby, Ranking Member Sarbanes, and Members of the Committee:
I am pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission regarding the application of disclosure and reporting requirements of the federal securities laws to Fannie Mae, Freddie Mac and the Federal Home Loan Banks. These Government-Sponsored Entities (GSEs) issue debt securities to the public. In addition Fannie Mae and Freddie Mac have publicly held common stock and also issue preferred stock and guaranteed mortgage-backed securities to the public. All of these entities and their securities are exempt from the registration and disclosure provisions of the federal securities laws. None of the debt securities issued by any of these GSEs is backed by the full faith and credit of the United States.
Commission’s Historical Views on GSE Disclosure
Since at least 1992, the Commission has expressed the view that, because the GSEs, most prominently Fannie Mae and Freddie Mac, but also including the Federal Home Loan Banks, sell securities to the public and have public investors, and do not have the “full faith and credit” government backing of government securities, their disclosures should comply with the disclosure requirements of the federal securities laws. The Commission participated with the Department of Treasury and the Board of Governors of the Federal Reserve System in a 1992 Joint Report on the Government Securities Market (“1992 Report”) that addressed these issues, among other things.1 Mandatory compliance by the GSEs with these disclosure requirements and the federal securities laws is the objective. The disclosure quality that we seek for the GSEs can only result from becoming subject to the SEC’s reporting system. The disclosure quality results not only from our disclosure rules but also the Commission’s and our administration of these rules, including our review and comment processes and our enforcement program.
The 1992 Report addressed registration, and indeed registration of a class of securities under the Exchange Act would result in mandatory compliance. Indeed all of the GSEs are now subject to regulations that essentially mandate Exchange Act registration. Achieving mandatory compliance is our ultimate objective.
Preliminary Discussion of Registration
For purposes of today’s subject, two of the federal securities laws are relevant – the Securities Act of 1933 (“Securities Act”)2 and the Securities Exchange Act of 1934 (“Exchange Act”)3. The Exchange Act requires, or allows for, registration by issuers of classes of their securities. Registration under the Exchange Act results in reporting requirements providing for disclosure of detailed information relating principally to the issuer. Under the Exchange Act and the Commission’s rules, required information includes financial statements, management’s discussion and analysis, description of business, information regarding directors and management and compensation, information regarding related party transactions and other information.4 In addition, the Commission recently adopted revised requirements under the Exchange Act providing more timely current disclosure of unquestionably material events regarding issuers consistent with Section 409 of Sarbanes-Oxley.5 All of this corporate information is the information on which the Commission and staff have focused in urging disclosure by GSEs. Registration under the Exchange Act also subjects reporting companies to the provisions of the Sarbanes-Oxley Act applicable to issuers.6 These provisions include CEO and CFO certification requirements, internal control requirements, prohibition on loans to insiders, restrictions on the use of proforma or non-GAAP measures and enhanced disclosure requirements, for example regarding off-balance sheet transactions.
The Securities Act, by contrast to the Exchange Act, requires registration by issuers of transactions, namely public offerings by issuers of their securities. One result of registration under the Securities Act is required disclosure of essentially the same corporate information as is required for reporting companies under the Exchange Act. Another result of registration under the Securities Act is required disclosure regarding the securities being offered.7 Finally, because the Securities Act registers securities offerings, review by the Commission staff of Securities Act registration statements can directly affect the timing of those transactions. Should Congress require Securities Act registration of securities offerings by the GSEs, we believe that with adequate rule-making authority we could address any logistical or other issues that might result. As discussed below, it may be appropriate in connection with requiring registration of offerings of mortgage-backed securities, especially in the forward or to-be-announced market, to consider the impact of registration on the mortgage market.
Fannie Mae and Freddie Mac
On July 12, 2002, Fannie Mae and Freddie Mac announced that each would voluntarily register its common stock under the Exchange Act and thus become subject to Commission reporting requirements. This decision took the form of a public announcement, along with press releases issued by each company. Fannie Mae’s registration statement under the Exchange Act was declared effective on March 31, 2003. Freddie Mac has stated it intends to complete the Exchange Act registration process when it completes its restatement and audit of its financial statements.
The proxy and insider transaction reporting requirements of the Exchange Act (Sections 14(a) and 16(a)) by their terms specifically apply only to nonexempt equity securities. The classes of common stock of Fannie Mae and Freddie Mac remain exempt securities even if registered under the Exchange Act and thus not subject to either section. In order to obtain the disclosure that would be required by officers and directors of the companies under the insider transaction reporting requirements of the Exchange Act and compliance by the companies with the Commission’s proxy rules, the Office of Federal Housing Enterprise Oversight (OFHEO) adopted rules effective April 30, 2003 requiring the officers and directors of Fannie Mae and Freddie Mac to file with the Commission all reports and forms that would be required by Section 16(a) and requiring the companies to file with the Commission all reports required pursuant to Section 14(a) .
As noted, Fannie Mae has registered its common stock under the Exchange Act. Fannie Mae is now fully subject to the Commission’s disclosure rules and the requirements of the Sarbanes-Oxley Act. Fannie Mae’s last periodic filing with the Commission was its Form 10-Q for the quarter ended June 30, 2004, which was filed on August 9, 2004. Since that time Fannie Mae has failed to file when due a quarterly report for the quarter ended September 30, 2004 and an annual report for the year ended December 31, 2004. Fannie Mae has made a number of Form 8-K current report filings.
During 2004, OFHEO announced that it reviewed several of Fannie Mae's accounting practices, focusing on the implications of those practices on the adequacy of Fannie Mae's regulatory capital, the quality of its management, and the overall safety and soundness of the enterprise. OFHEO issued a preliminary report of its findings on September 17, 2004. Subsequently, Fannie Mae sought guidance from the Commission’s accounting staff regarding certain accounting matters. At the request of Fannie Mae, the accounting staff at the Commission reviewed Fannie Mae’s accounting practices for deferred purchase price adjustments and for derivatives and hedging activities with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" (Statement No. 91), and Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement No. 133).
In the statement announcing the results of that review, the accounting staff noted, although it is unusual for the accounting staff to provide such guidance while there are pending investigations by the Commission and other agencies, Fannie Mae requested our guidance because, in its view, these accounting issues have received extraordinary public attention and resulted in the mortgage and capital markets experiencing uncertainty. Fannie Mae did not ask the accounting staff to express any views on factual matters or matters that require factual development and, in providing the requested guidance, the staff did not express any such views. The staff's guidance was based solely on information voluntarily provided by Fannie Mae and OFHEO.
The staff’s review summarized that during the period under review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133. The staff advised Fannie Mae that, to be consistent with Statement Nos. 91 and 133 and to provide investors with appropriate information, Fannie Mae should:
- Restate its financial statements filed with the Commission to eliminate the use of hedge accounting.
- Evaluate the accounting under Statement No. 91 and restate its financial statements filed with the Commission if the amounts required for correction are material.
- Re-evaluate the information prepared under GAAP and non-GAAP information that Fannie Mae previously provided to investors, particularly in view of the decision that hedge accounting is not appropriate.
As noted above, Fannie Mae has filed a number of Form 8-K current reports with the Commission. Those reports disclose, among other things, delays in filing the periodic reports noted above and Fannie Mae’s determination that its interim and audited financial statements for the periods from January 2001 through the second quarter of 2004 must be restated and should no longer be relied upon and that it will restate its financial results to comply with the staff’s determination. Fannie Mae has disclosed that the Commission is investigating certain issues associated with Fannie Mae's accounting and disclosure practices. I and others at the Commission appreciate the Committee's recognition of the non-public nature of the Commission's active investigation.
Mortgage-backed Securities. Our attention to date in seeking disclosure by the GSEs that meets our requirements has focused on corporate information. It has been our priority that investors who purchase and sell stock or “straight” debt (i.e. non-mortgage-backed debt) of the GSEs are entitled to the corporate information required to be disclosed under the Exchange Act. While Fannie Mae and Freddie Mac continue to be exempt from the requirements to register the offer and sale of securities under the Securities Act of 1933, the information about the corporation that would be required to be disclosed in a prospectus contained in a registration statement under the Securities Act is the same as what Fannie Mae is, and Freddie Mac will be, required to provide as a result of their voluntary registration under the Exchange Act.
Registration of securities transactions by Fannie Mae and Freddie Mac under the Securities Act, especially offerings of their mortgage-backed and other mortgage-related securities, requires consideration of factors not present with the more easily accomplished registration under the Exchange Act. The Commission did not recommend in the 1992 Report removing the exemption from the federal securities laws for the offer and sale of mortgage-backed and mortgage-related securities of Fannie Mae and Freddie Mac. While we seek to achieve the benefits for investors of registration under the securities laws, we recognize that these other factors need to be examined.
First, as noted above, the review process of the Division of Corporation Finance of registration statements of transactions under the Securities Act means that the timing of transactions could be affected. This is not the case as a result of Exchange Act registration, which requires the filing of periodic and current reports with company information rather than filings tied to the timing of offerings.
Second, because Fannie Mae’s and Freddie Mac’s mortgage-backed and other mortgage-related securities are backed by their respective guarantees, important information in analyzing these securities as a credit matter includes their financial and other corporate information. Exchange Act filings would contain this information without regard to Securities Act registration.
As to other information regarding mortgage-backed and related securities, in late 2002, staff of the Commission, Department of Treasury and OFHEO conducted a joint study of disclosure regarding mortgage-backed securities with a view to ensure that investors in mortgage-backed securities are provided with the information that they should have. The task force issued a report in January 2003.8 The report notes that market participants found the mortgage-backed securities market extremely efficient. The report concluded that some additional disclosures would be both useful and feasible in the mortgage-backed securities market. Both Fannie Mae and Freddie Mac have implemented these new disclosures.
Finally, registration of offerings of the GSE’s mortgage-backed and related securities under the Securities Act may raise another significant and uniquely complex factor – the impact on the mortgage market – that should be considered. In particular, a substantial portion, and recently a majority, of the GSE’s mortgage-backed securities have been sold into the so-called “To Be Announced,” or TBA, market. These transactions involve forward sales of mortgage-backed securities comprised of pools of mortgages not yet identified and in many, if not most, cases not yet in existence. The parameters that the securities and the mortgages in the pools must meet are set forth in standards established for the TBA market by market participants and discussed in the January 2003 report. Because actual mortgage pools are not established at the time of the forward sale transactions, there can be disclosure of expected material portfolio characteristics meeting these standards used in the TBA market, including ranges of pool elements, but disclosure of specific mortgage pool characteristics at the time of registration or commencement of offerings is not possible. The TBA standards that the mortgage pools must meet are already available to the market.
In addition, we understand that the TBA market is used to set or “lock in” mortgage rates in the U.S. housing market. A decision to require registration under the Securities Act of offers and sale of mortgage-backed securities should properly take into account whether, and if so, how such registration might impact the mortgage market and the operation of the TBA market. Similar considerations formed at least a portion of the background for the conclusion expressed in the 1992 Report. The Commission has never addressed the impact of Securities Act registration on the mortgage market.
It should be noted that the Commission recently adopted new rules to address comprehensively the registration, disclosure and reporting requirements for asset-backed securities, including mortgage-backed securities, under the Securities Act and the Exchange Act.9 Fannie Mae and Freddie Mac will not be subject to these new rules; compliance with the new rules is required for other public issuers of asset-backed securities, including mortgage-backed securities, for offerings commencing after December 31, 2005. Offerings covered by the regulations would include those involving forward sales of mortgage-backed securities by private registrants.
Federal Home Loan Banks
The Federal Home Loan Bank System was created prior to enactment of the Securities Act and the Exchange Act and the creation of the Securities and Exchange Commission in 1934. The system was created in 1932 to restore confidence to the nation’s financial institutions and improve the supply of funds to local lenders.10 The system is comprised of twelve banks. The Federal Home Loan Bank System through the Office of Finance is one of the largest issuers of debt securities in the world with $816.2 billion outstanding as of June 30, 2004. We believe that the holders of debt issued by the Office of Finance, for which the twelve Banks are jointly and severally liable, are entitled to the same type of information that is provided to investors in other public debt securities. Our interest is in assuring that public investors in this debt are provided with sufficient information when they are making their investment decisions.
The Federal Home Loan Banks are also exempt from the federal securities laws. The Banks prepare financial statements based on regulations of the Federal Housing Finance Board, which refer to Commission disclosure regulations. However, the staff of the Commission does not review these financial statements or any other disclosure documents of the Banks. The Banks are also not subject to the provisions of Sarbanes-Oxley Act of 2002 applicable to issuers, as discussed above. However, the Banks are subject to general antifraud restrictions prohibiting false or misleading statements of material facts or the omission of material facts necessary to make the statements made, in light of the circumstances under which they are made, not misleading. The Finance Board promulgated a rule requiring filing of registration statements under the Exchange Act by the Banks with the Commission by June 30, 2005 and effectiveness of those registration statements by August 29, 2005. We are concerned that there may be timing issues with some of the Banks complying with the deadlines in the Finance Board registration rule given where they are currently in the process. We are committed to acting in a timely manner, but time to receive and review submissions is becoming short, and we need to have adequate time to review the submissions.
The Banks, although federally chartered entities, have many of the same disclosure issues as any financial institution whose securities are issued to, and held by, the public. Consolidated obligations for which each Bank is either primarily or secondarily obligated are sold to the public in underwritten offerings. As discussed above, we believe investors in those debt securities are entitled to the same type of information as that provided by other issuers of public debt. As also discussed above, we further believe that the Commission’s detailed disclosure rules and filing requirements and the staff review and comment process provide the best framework for disclosing information to which investors are entitled.
Because the debt of the Banks does not carry the full faith and credit backing of the United States and investors in the Banks’ debt must therefore look only to the Banks for repayment of the debt, disclosures by the Banks should give the holders of its debt a materially complete and accurate picture of the Banks’ financial and operational situation to evaluate an investment. As is the case with Fannie Mae and Freddie Mac, the focus for disclosure has been the corporate disclosure required for a reporting company that registers under the Exchange Act. Registration of offers and sales of securities under the Securities Act has not been the focus and is not the subject of the Finance Board rule. In particular, as with Fannie Mae and Freddie Mac, corporate disclosure that would result from Exchange Act registration is the same as would be required as a result of Securities Act registration.
Because of the structure of the Federal Home Loan Bank System, including the Office of Finance, however, there are some issues that may be unique to the Banks. Prior to the Banks’ submission of filings, staff of the Commission met with members and staff of the Federal Housing Finance Board, representatives of the Banks and a group of directors of certain Banks, in each case at their request, to discuss the issues that registration under the Exchange Act may raise.
Very early in our discussions with all of these parties, we sought to clearly and carefully address concerns raised by the Banks about whether registration would require the structure of the system to change. The Commission has no regulatory interest in changing the structure of the system. Registration under the Exchange Act of each of the twelve Banks would not alter the structure of the Federal Home Loan Bank System. In addition, insofar as registration of a class of each Bank’s securities under the Exchange Act is being considered, there would be no impact on the timing or other aspects of offering transactions as a result of registration.
Because our focus on disclosure relates to the debt issued by the Banks and not to their common stock, we had initially considered, with the Finance Board and the Banks, the possibility of the Banks registering a class of debt securities. Under the Exchange Act the corporate disclosure required of a company is the same whether the security registered is debt or common stock. However, registration of equity could implicate additional requirements for the Banks, such as the proxy rules. Therefore we suggested the Banks register a class of debt securities. In our discussions with the Banks each Bank expressed a preference for registering a class of its stock, if any security was to be registered under the Exchange Act and that is what is required under the Finance Board rule. Because the corporate disclosure is the same, this is acceptable to us. We have also been working with the Banks to determine what requirements, such as the proxy rules, the Banks should not have to comply with because the publicly held securities that implicate registration and disclosure issues are their debt securities. This will result in the same disclosure as would be the case for corporate issuers whose only public securities are debt securities. We continue to believe that the most appropriate and flexible way to address these issues is at the Commission.
Our preliminary discussions with the Banks and the Finance Board also address three accounting related issues. Those issues include: the accounting treatment of the payment to REFCORP, the role of the combined financial statements of the twelve Banks, the accounting classification of redeemable capital stock, and the accounting treatment related to the joint and several nature of the Banks’ obligations:
- The Financial Institutions Reform, Recovery and Enforcement Act of 198911 obligated the Banks to make an annual $300 million payment to the US Treasury until 2030 for the partial payment of interest on bonds issued by the Resolution Funding Corporation, or REFCORP. The Gramm-Leach Bliley Act12 in 1999 changed how REFCORP payments are calculated and due. Each Bank is now obligated to pay 20 percent of earnings annually until these amounts for the whole system are equivalent to a $300 million annual annuity with a final maturity date of April 15, 2030. The Banks view the REFCORP payments as similar to a tax and accordingly, no obligation for future payments is recorded on their balance sheets. The Commission staff has indicated to the Banks that we would not object to this current presentation of the treatment of REFCORP payments.
- The Gramm-Leach-Bliley Act required each of the Banks to create a new capital structure. That Act allows each Bank to create two classes of stock, one with a redemption period of six months and the other with a redemption period of five years. The Banks are in the process of implementing their new capital plans. Because the stock will be redeemable, the issue arose as to whether the stock could be included as permanent equity on the financial statements of the Banks. Because all of the stock of each of the banks is “putable,” the Commission staff will not object if it is not separated from the equity section of the balance sheet. This would be similar to the treatment of the equity for co-ops currently registered under the Exchange Act. The face of the financial statements would need to indicate the stock is “putable” and the notes to the financial statements would include disclosure on how the puts work and on how much of the stock is in excess of the amount required to be held by member banks which is generally based on the member bank’s activity.
- The staff has also had discussions with the Banks regarding the appropriate treatment of the joint and several nature of the Consolidated Obligations. We have indicated to the Banks that we do not object to each Bank reflecting on the face of its balance sheet as long-term indebtedness only the amount of Consolidated Obligations for which that Bank has received proceeds and is therefore viewed by the Banks as primarily liable. The Banks would also disclose the total amount of outstanding obligations. The Commission staff has also indicated to the Banks that we do not object to their accounting treatment for the contingent liability related to each Bank’s guarantee of the remainder of the outstanding Consolidated Obligations for which it is not primarily liable.
In addition, we held preliminary discussions with the Banks and the Finance Board regarding the combined financials statements prepared by the Office of Finance. Each Bank is a separate corporation with its own management, employees, and board of directors. The Office of Finance, which is an agent for the Banks, prepares combined financial statements of the twelve Banks for public distribution but is not a separate entity or issuer. The financial statements are not consolidated because there are separate and distinct stockholder groups for each Bank with no common management or ownership at the system level.
Under the new requirements, the individual Banks will be registering with the Commission. Because of the structure of the system, there is no issuer tied to the combined statements to register under the Exchange Act. We believe, however, there are policy reasons for us to have an opportunity to review and comment on the combined financial statements that are distributed to investors. Under Finance Board regulations, the Board determines whether the combined financials statements comply with their requirements.13 We have been working on an arrangement with the Finance Board so that their review would give the Commission staff the opportunity to review the combined financial statements and provide the Finance Board comments, if any. None of the Banks would have additional responsibility for the combined financial statements as a result of registration under the Exchange Act or our proposed arrangement with the Finance Board regarding the combined statements. If the system structure were changed and the Consolidated Obligations were issued by a separate entity or issuer, it would seem appropriate for that entity to also register with the Commission and its financial statements comply with GAAP.
All twelve of the Home Loan Banks have submitted to the staff initial draft registration statements. The first Bank to submit an initial draft did so in May 2004; the last two were submitted last month. The staff has commented on all of the filings. As of April 15th, fewer than half of the Banks have submitted amendments in response to the staff’s comments. The staff and the Banks are continuing to go through the comment process. As is typically the case in the registration review process, accounting and related issues require the most attention. The Office of Finance announced on March 31, 2005 that three Banks have not yet completed their 2004 annual audit. The Office of Finance announced last week, on April 15th, that the status of the audited financial statements of those three Banks remained unchanged and that it will delay publication of the Federal Home Loan Banks 2004 Combined Financial Report and Combined Quarterly Financial Report for the nine months ended September 30, 2004. The Office of Finance stated that its decision was due to the ongoing reviews of accounting matters being considered by the Banks in preparation for SEC registration.
The individual and institutional investors who hold debt securities of the Banks depend for repayment on the Banks and not a government guarantee. We believe that applying the Commission’s disclosure requirements and processes is the preferred method of helping to ensure that these investors receive the materially accurate and complete disclosure they deserve. We believe that the Commission’s detailed disclosure rules and filing requirements, and our staff review and comment process, provide the best framework for disclosing that information. We have a long history of reviewing the disclosure of companies in many diverse industries, and we regularly review the complex debt and equity structures of these companies. We have not initiated any process to seek registration by the Federal Home Loan Banks, but we do believe that our rules and registration would provide the desired result. Registration would also apply the requirements of Sarbanes-Oxley to the Banks. Our staff is working hard to achieve that result with maximum protection for investors and maximum efficiency for all registrants consistent with our mission to protect investors.
1 Department of the Treasury, Securities and Exchange Commission, Board of Governors of the Federal Reserve System, Joint Report on the Government Securities Market, January 1992.
2 15 U.S.C. § 77a et. seq.
3 15 U.S.C. §78a et. seq.
4 See generally Regulation S-X, 17 C.F.R. 210 and Regulation S-K 17 C.F.R. 229.
5 See Release 34-49424 (March 16, 2004) and 17 C.F.R. 249.308.
6 Pub. L. 107-204 (2002) 116 Stat. 745 (2002).
7 Registration of sales under the Securities Act also results in an automatic requirement to file Exchange Act reports for at least some period of time.
8 Department of Treasury, Office of Federal Housing Enterprise Oversight, Securities and Exchange Commission, Staff Report: Enhancing Disclosure in the Mortgage-Backed Securities Market, January 2003.
9 See Release 33-8518 (Dec. 22, 2004).
10 Federal Home Loan Bank Act, Pub. L. No. 72-304, 47 Stat. 725 (1932)
11 Pub. L. No. 103-73 (1989).
12 Pub. L. No. 106-102 (1999).
13 12 C.F.R. 985.6(b).