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.
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
This story appears in the June 23, 2003 print edition of U.S. News & World Report.