Cracks in the Foundation
Scandal at Freddie Mac could toughen controls on the mortgage giants
Low-balling profits is a technique that has been used (though generally denied) to achieve the art of earnings "smoothing." Throughout the 1990s, many companies, including the bluest of the blue chips, occasionally set aside a little extra profit in good quarters so they could goose earnings in troubled periods. That kept reported profits steadily marching upward. But in the new, zero-tolerance investing era, even well-intentioned smoothing has become suspect.
Another reason investors hadn't been concerned about the earlier announcements was that Freddie Mac continued to receive widespread praise as one of the best-managed and most-admired companies in America. On June 4--just days before the management shake-up began--Freddie Mac's regulator, the Office of Federal Housing Enterprise Oversight, praised the company's management. "Management effectively conveys an appropriate message of integrity and ethical values," OFHEO reported to Congress.
After learning of the accounting problems, the regulator insisted that Freddie Mac was financially secure but hinted at more bad news to come. "Serious problems," such as lack of accounting controls and expertise, remained, said director Armando Falcon. He sent in auditors to check the restatement and investigate alleged employee misconduct. And he demanded that Freddie Mac hold off on any severance payments to the executives. (Brendsel's contract, for example, promised him $3.2 million in salary and bonus and more than $21 million in options. Glenn was denied severance but could cash in $6 million worth of options. Clarke's contract was not made public.)
New probes. Now, regulators are all over the Virginia company. The Securities and Exchange Commission has launched a probe, formally beginning what had been an informal investigation. The U.S. attorney in Northern Virginia has opened a criminal probe. And Representative Baker, a longtime critic of the mortgage giants, plans to release reform legislation late this week. Last week's surprises prove OFHEO "is underfunded and undermanned," he adds.
But even Baker concedes that cracking down on the quasi-governmental companies will be tough. Fannie Mae and Freddie Mac have managed to maintain special governmental treatment--unlike private financial services companies, they don't have to pay state income taxes and don't have to register their bond issues with the SEC--through intense lobbying, large campaign donations, and the perception they are vital to homeownership. The two enterprises are among the biggest donors of "soft money" to the political parties. Freddie Mac doled out $4 million last year, while Fannie handed out $1.8 million, according to a list compiled by the Center for Responsive Politics. And they spend millions more on high-powered lobbyists. In 2000, Freddie Mac spent $5.1 million on outside lobbyists, while Fannie Mae spent $7 million.
Both companies say they will oppose any moves that threaten to increase the cost of mortgages for America's home buyers. "Congress put in place our exemptions to help keep homeownership affordable," says Freddie Mac spokesman Douglas Robinson. "Anything that alters that model has to be examined very closely."
No doubt, with so many government officials now looking into Freddie Mac, everything will come under close scrutiny. But the odds are long that those examinations will result in anything more than minor reforms. Despite the urging of luminaries such as Alan Greenspan that Freddie Mac and Fannie Mae should operate without government support, there is no sign Congress is worried enough yet to cut them off altogether. Freddie Mac's fate is likely to bear little resemblance to that of Enron.
Freddie Mac's Role in Home Financing
Once a home buyer takes out a mortgage, the lending institution can sell the loan to Freddie Mac, which repackages many of these loans into bundles of mortgage-backed securities. These are then sold to investors, and the proceeds are used to buy more mortgages. This helps keep the mortgage market liquid. Freddie makes its money from fees for packaging the loans and from mortgages it retains.
VALUE OF MORTGAGE PORTFOLIO $1.3 TRILLION
SHARE OF MORTGAGE MARKET 14 pct.
With Paul J. Lim and Jodie Kirschner
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