Cracks in the Foundation
Scandal at Freddie Mac could toughen controls on the mortgage giants
Does this sound familiar? A much-admired corporate giant with impenetrable finances makes a cryptic announcement of accounting irregularities and sends its top executives packing (some with multimillion-dollar payouts). Criminal and securities investigations are launched, and Congress plans a hearing.
So far, recent corporate scandal history isn't repeating itself. After last week's announcement, mortgage giant Freddie Mac didn't collapse into an Enron-like dust heap. While its stock fell 16 percent on the news, the underlying business of providing cash for home loans sailed on smoothly. The owner or guarantor of 1 out of every 6 mortgages in the United States managed to keep buying and selling its mortgage-backed securities. Indeed, mortgage rates continued to fall, as they have all year.
But if investors and lenders weren't alarmed, federal officials and taxpayer groups were. The market calm belies a storm on Capitol Hill, where proponents of stricter regulation for Freddie and its bigger sister, Fannie Mae, seized upon the latest news to sound the alarm about what they perceive as a loosely regulated financial marketplace where trillions of dollars change hands. "People are scared there is more yet to come," says Rep. Richard Baker, a Louisiana Republican, chairman of the House subcommittee on capital markets. "If there is an unwinding of Freddie Mac, the potential liabilities are enormous." Baker, who plans hearings on the matter, says the newly raised fears have opened a window of opportunity to push through stricter federal oversight.
What set off the alarm bells was Freddie Mac's announcement that longtime CEO Leland Brendsel and Chief Financial Officer Vaughn Clarke had resigned, while Chief Operating Officer David Glenn had been fired for refusing to turn over notes potentially relevant to an internal investigation into the company's finances. Freddie Mac installed its chief investment officer, Gregory Parseghian, a financial executive with little political experience, to run the company.
The reason for the concern in Washington, if not so much in the financial markets, is the belief that were anything to happen to the two mortgage giants and other quasi-governmental companies that sell securities, the government would step in to bail them out. Even though every Freddie Mac bond contains a clear warning that it does not have government backing, investors stubbornly believe otherwise. The reason: Both Freddie (originally the Federal Home Loan Mortgage Corp.) and Fannie were chartered by Congress to reduce homeowners' borrowing costs by buying mortgages from banks, thus freeing up more cash to lend to other home buyers. Traders feel "the feds would never allow things to really get bad," says Marilyn Cohen, president of bond specialist Envision Capital Management.
And the risk is clearly substantial. Freddie Mac owns or guarantees $1.3 trillion worth of mortgages and has hedged against interest-rate and repayment risk by investing millions of dollars more in intricate financial instruments known as derivatives. Fannie Mae, which has been considered the more aggressive of the two, owns or backs nearly $2 trillion in loans.
"Smoothing." Freddie Mac's troubles date back to January, when the company announced that its new accounting firm, PricewaterhouseCoopers, believed that its prior accountant, Arthur Andersen of Enron fame, had misclassified some of its derivatives. As a result, the company said it would restate earnings for the past several years. Investors shrugged off the announcement because Freddie Mac said the move would actually result in higher profits. Enron and WorldCom, of course, had done just the opposite--inflated their profits to keep their stock prices high.
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