Freddie Mac Scandal

Executive Summary
Originally known as the Federal Home Loan Mortgage Corporation, Freddie Mac was
chartered by Congress in 1970 as a private company with a public mission to
stabilize the nation's mortgage markets and widen opportunities for home
ownership and affordable rental housing. Freddie Mac (and its sister institution
Fannie Mae) was set up based on the idea that neither government nor private
banking interests could address the nation's housing finance needs. The company's
charter established a board comprising 18 members - thirteen elected by
shareholders and five appointed by the President of the United States.
Freddie Mac is a Government-Sponsored Enterprise (GSE), that is, a business entity
that has a distinct relationship with the government. GSEs usually enjoy special
perks and privileges that other businesses do not receive. Freddie Mac, for example,
is exempt from state and local taxes. Neither is it subject to standard disclosure
rules imposed on other financial institutions. It is rated by credit rating agencies
such as Moody's. GSEs such as Freddie Mac are among the world's largest securities
issuers.
Introduction
It is not possible to ascertain if its reported earnings before 2000 are correct
because securities rules stipulate that when a company restates its earnings it has
to go back only three years. Freddie Mac's accounting problems were different from
those at scandal-ridden companies such as Enron and WorldCom because it was not
a case of outright looting of the company by its executives. Nevertheless, they did
break the law and their activities constituted a fundamental breach of business
ethics. The company said that it had manipulated its earnings to meet Wall Street's
desired objective of steady earnings growth. To that end, it succeeded in doing so
and in keeping its stock prices high, it has not hurt investors thus far. But as one of
the four largest financial institutions in the U.S., its financial problems could create a
"systemic risk" - the risk that a problem in one area, in this case the housing
market, could spread and have serious adverse effects on the economy as a whole.
The savings and loan crisis of the 1980s illustrated the riskiness of the mortgage
market. If interest rates rise, financial institutions may find that their cost of funds
exceeds their income for long-term, fixed-rate mortgages. If rates fall, homeowners
refinance their mortgage and reduce income streams to institutions, which must still
pay off debt previously issued at higher interest rates. Protection from interest rate
risk is critical to soundness of the GSEs, and it appears that strategies to avoid, or
hedge risk were partly responsible for Freddies recent accounting problem.
Also at issue are oversight and regulation. The companies accounting misdeeds
were revealed just days after the federal regulator responsible for its financial

oversight gave it a clean bill of health. In addition, it has not met its specific public
interest mission, which is to enhance opportunities for home ownership and
affordable rental housing for low-income and minority populations.
Presentation of Data
A December 2003 report by the Federal Reserve Board finds that Freddie like Fannie
benefits from its government connection far more than homeowners do. In addition
to being exempt from state and local taxes and a credit line of $2.25 billion from the
federal government (the Treasury Department is authorized by Congress to buy
$2.25 billion of its securities in case of a default), the Congressional Budget Office
estimates that Freddie's federal subsidies are valued at more than $10 billion.
Rather than boosting homeownership, the federal subsidies help the company's
shareholders because it increases the company's earnings.
The implicit guarantee of its credit line from the federal government allows it to
borrow at interest rates by about half a percentage point lower than comparable
borrowers. By comparison, the average mortgage rate is reduced by less than a
tenth of a percentage point. This amounts to a savings of $87 a year for a typical
homeowner. The company's net income for 2002 was $10.1 billion (data for 2003 is
not available). Former CEO and Chairman Leland Brendselwas awarded a cash
bonus of $2.1 million, in addition to his salary of $1.1 million before being ousted
last year. Bonuses for Top executives for 2001, the year the company inflated its
profits, were based on corporate performance.
Analysis
In December 2003 Freddie Mac, the federally chartered mortgage financing giant,
agreed to pay a civil penalty of $125 million and implement measures to correct its
accounting and governance problems as part of a consent order with a federal
regulator. The company faced a criminal investigation by the Justice Department
and a civil inquiry by the Securities and Exchange Commission. When the
company's problems imploded earlier, the McLean, Virginia-based firm declared that
its accounting errors were different from those plaguing corporate America during
that year. Rather than inflating its earnings, the company had understated its
profits. But when the company restated its financial statements of November 2003,
it disclosed that its cumulative earnings for the years 2000-2002 were higher than
what it had reported originally, and it had inflated its earnings for 2001 by nearly $1
billion. According to Standard & Poor's, "news of the one year of inflated earnings
adversely changes the character of the accounting controversy because it reflects
an even more volatile true earnings profile."
The Federal Reserve study also said that the complex accounting methods used by
the company are hard to understand. Such questionable methods are a risk for
taxpayers who would be expected to bail out the firm with its billions of dollars in
loans and debts if it had financial problems.

A company spokesman called the study "an interesting but fundamentally flawed
academic exercise," while a senior vice president said that the findings were "highly
theoretical and bear no resemblance to the reality experienced in the housing
industry and capital markets every day."
Conclusion
It is clear that oversight of the company was completely inadequate at all levels.
The OFHEO failed in its responsibility to ensure its safety and soundness. HUD
allowed it to stray from its fundamental mission of expanding home ownership and
affordable housing. The company's board, as the OFHEO report points out, was
complacent and failed to exercise adequate oversight.
But that does not justify calls for privatization of Freddie Mac and elimination of its
core public mission of providing affordable housing for low-income and minority
populations. Current proposals to create a more effective and independent
regulatory agency could work if they don't become a victim of inter-agency battles.
GSEs like Freddie Mac should have the same disclosure rules that apply to other
financial institutions. When oversight of an institution as important as Freddie Mac
falls on one of the smallest federal regulatory agencies, the public has reasons to be
worried. At the same time, the company needs to do more than just step up it
political lobbying expenditures and fulfill its obligation of expanding opportunities
for home ownership and affordable rental housing.
Recommendation
Some of the recommendations in the agency's report -- which Mr. Falcon, the
director, said he might or might not impose on the company -- are more severe. The
report proposes increasing the amount of capital that the company must retain and
limiting how much its portfolio of mortgages may grow. Finally, the report
recommends that the regulatory agency examine the accounting practices of
Fannie Mae; the agency has already received bids on that project, Mr. Falcon
said.(Source: www.nytimes.com)
References
Market Place; Freddie Mac Gets Penalty And Rebuke Over Scandal by JONATHAN D.
GLATER
Published: December 11, 2003
www.nytimes.com
Corporate Research E-Letter No. 43
THE SCANDAL IN HOME MORTGAGE FINANCING: A LOOK AT FREDDIE MAC by
Mafruza Khan
Published: January 2004
www.corp-research.org