Mistakes were made -- lots of them. Management controls were weak, disclosures were misleading, and accounting in many cases was flat-out wrong. Despite all that, the company's future is rosy. That was the message from Freddie Mac (FRE ) on June 25, when it announced that an upcoming restatement could total $4.5 billion. "The company remains safe and sound," Freddie Mac Chairman Shaun F. O'Malley declared.
The market, too, focused on the good news: The restatement, expected in September, will boost Freddie's past earnings and increase surplus capital. That raises the possibility of bigger dividend payouts or even a share repurchase to reward stockholders. Freddie's shares rose 1.6%, to $50.83.
But no matter how hard Freddie tries to spin billion-dollar accounting errors, the housing-finance agency's admissions are fueling critics. Freddie made so many mistakes in applying derivative accounting rules that "a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges," the company said. And while Freddie Mac will correct financial statements back to 2000, the errors date from the mid-'90s, says new Chief Financial Officer Martin F. Baumann.
Not everyone is as sanguine as the stock market, however. What, for instance, would have happened had Freddie bet the wrong way on interest-rate movements, or if banks, fearing further problems, refused to buy its debt? Freddie's problems reveal just how little is known about its inner workings -- and highlight the risks should the markets lose confidence in its ability to manage its huge derivatives portfolio."Even if they're not trying to cook their books," says Michigan State University accounting professor Thomas J. Linsmeier, Freddie's mistakes show that "there could be a systemic problem requiring a taxpayer bailout."
That's exactly why a small but vocal group of banks, politicians, and academics for years have argued that Freddie and its larger cousin, Fannie Mae (FNM ), be subject to tougher regulation, including Securities & Exchange Commission oversight. Now, Freddie's revelations will make it harder -- though not impossible -- for either of the two government-sponsored enterprises to block reforms. They have also raised anew the question of whether these giants should be split up or even privatized.
Freddie and Fannie are crucial cogs in the housing market because they buy mortgages from commercial banks and other lenders and resell them to investors as mortgage-backed securities. That frees lenders to lend again. And thanks to the three-year-old housing boom, Fannie and Freddie now carry an astronomical $1.6 trillion in assets on their balance sheets, up from $962 billion in 1999. But as Freddie has shown, what lies behind those numbers is often a mystery.
The reason, in a word, is derivatives. The root of Freddie's problems can be found in a dense document called Statement of Financial Accounting Standards 133, which determines accounting rules when derivatives are used as hedges. The rules require companies to assign current market values to the interest-rate swaps, options, and other derivatives they hold and to reflect any changes in their value on the balance sheet. FAS 133 also contains a sweetener: Companies can offset any gains (or losses) on an asset with a similar loss (or gain) on the derivative used as a hedge. And here's the real grabber: Any changes in a derivative's value can be recognized over the life of the hedge, allowing companies to avoid the volatility that market-value accounting creates.
The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up.
The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.
Freddie, it turns out, had sought to lock in favorable spreads between the lower interest rate it pays to holders of its debt and the higher rate it gets for the home mortgages in its portfolio. Typically, financial institutions lock in such spreads with standard interest-rate swaps. But in an attempt to lower hedging costs, Freddie used Treasury securities instead of swaps. At the end of 2002, Freddie held some $16 billion in Treasuries on its books as debt hedges.
The net effect was the same -- holding Treasuries can protect against interest-rate changes as well as an interest-rate swap. There the similarities end. Because Treasuries are cash instruments, they aren't eligible for hedge accounting under FAS 133. So by designating Treasuries as derivatives and accounting for them as hedges, Freddie violated FAS 133 and now must reverse that treatment by recognizing gains in past years. Although Freddie at the time tried to document the transactions as true hedges, and even got Andersen's O.K., Baumann says: "The accounting was wrong. It just didn't qualify" for hedge treatment.
Once the new auditors dove deeper, they found a disturbing pattern: Most of the derivatives were incorrectly accounted for. Another big error concerns what are called "held-to-maturity," or HTM, securities. Freddie's portfolio includes $260 billion worth of mortgage securities that it classifies as HTM. As long as companies promise not to sell such securities before they mature, they can record them on the balance sheet at their original cost instead of revaluing them each quarter.
But Freddie used some of its HTM securities as collateral for short-term borrowings. It later repurchased the securities, and in doing so, tried to classify the sale and repurchase as a simple repurchase. But once sold, HTM securities do not qualify for hedge accounting. By selling a portion of the HTM portfolio, Freddie tainted its entire $260 billion portfolio. That means Freddie must record any value changes on more than 100,000 securities in either the income statement or shareholders' equity.
Freddie's board and new management team -- besides O'Malley and Baumann, it includes former Chief Investment Officer Gregory J. Parseghian as CEO and President -- have vowed to put the books in order. They are adding to Freddie's accounting staff and increasing the level of internal oversight. Executives overseeing risk-management functions now report directly to Baumann.
But that won't be enough to mollify critics. Longtime Fannie and Freddie foe Representative Richard H. Baker (R-La.) on June 24 unveiled a measure to move their regulator, the Office of Federal Housing Enterprise Oversight, from the Housing & Urban Development Dept. to the Treasury Dept. and to expand its powers. Treasury Secretary John W. Snow refuses to comment on any specific proposal, but he may be warming to the idea. "[We want] a regime of greater transparency so the investment community will know what's going on," says Snow. Freddie's effort to come clean may be just the start of hard times ahead for the GSEs.
By Paula Dwyer, with Rich Miller, in Washington