Accounting and Management Problems at Freddie Mac

Accounting and Management Problems at Freddie Mac

Order Code RS21567
Updated November 7, 2007
Accounting and Management Problems
at Freddie Mac
Mark Jickling
Specialist in Financial Economics
Government and Finance Division
Summary
For most of 2003, Freddie Mac, one of the two government-sponsored enterprises
(GSEs) that dominate the secondary market for home mortgages, was embroiled in a
controversy over improper accounting methods. The company announced in January
of that year that a major revision of past financial statements was underway. The
restatement was issued on November 21, 2003. Net income for 2002 and earlier years
was revised upward by $5.0 billion. Freddie Mac has admitted that some of its
accounting policies were selected in order to produce a steady stream of earnings, and
that numerous transactions were undertaken for the sole purpose of “smoothing out”
reported earnings. These accounting problems led to the replacement of Freddie’s top
executives, payment of $125 million in fines, and $410 million to settle an investor
lawsuit. On November 6, 2007, former CEO Leland Brendsel settled charges by paying
a $2.5 million fine and returning $10.5 million in salary and bonuses to Freddie Mac.
In March 2007, the company resumed timely annual reporting by filing its 2006 annual
report. It expects to resume timely quarterly filings by the end of 2007 and, after that,
to register its stock with the Securities and Exchange Commission.
This report will no longer be updated.
Freddie Mac, one of the two government-sponsored enterprises (GSEs) that
dominate the secondary market for home mortgages, announced in January 2003 that its
financial reports for the past three years would have to be restated. The reaction was
mild; the markets assumed that interpretations of complex accounting rules were at issue
rather than fundamental economic problems at Freddie Mac. On June 9, 2003, without
providing any new information about the nature of the accounting issues, Freddie
dismissed its top three executives, including CEO Leland Brendsel. This action raised the
specter of an Enron-like financial scandal, and Freddie’s stock price plunged by nearly
20%. A subsequent report to Freddie’s board of directors found that accounting controls
had been weak and that certain accounting decisions and market transactions had been
implemented to “smooth out,” or reduce volatility in reported earnings. On August 21,
2003, the Office of Federal Housing Enterprise Oversight (OFHEO) recommended that

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Freddie’s replacement CEO be fired, on the grounds that he had been involved in the
accounting problems. Greg Parseghian was removed by Freddie’s board, and was replaced
in December 2003 by Richard F. Syron.
On November 21, 2003, the restatement of past accounting results was released,1 as
summarized in the table below. It is noteworthy that while the net effect of the restatement
was to increase reported earnings, restated net income for 2001 was almost $1 billion less
than originally reported. Freddie Mac notes that the restatement shows “significantly
greater volatility than previously reported.”
Table 1. Restated Financial Results for the Three Years Ended
December 31, 2002
(in millions)
Net Income
Regulatory Core Capital
Stockholders’ Equity
As
As
As
Year
Previously
As
Previously
As
Previously
As
Ended
Reported Restated Change Reported Restated Change Reported Restated Change
December
31, 2000
$2,547
$3,666 $1,119
$14,380 $16,273 $1,893
$14,837 $17,357 $2,520
December
31, 2001
$4,147
$3,158
($989)
$19,336 $20,181
$845
$15,373 $19,624 $4,251
December
31, 2002
$5,764
$10,090 $4,326
$23,792 $28,990 $5,198
$24,629 $31,330 $6,701
Source: Freddie Mac press release, November 21, 2003.
The restatement does not end the company’s accounting uncertainties. Freddie Mac,
which is exempt from the registration and disclosure requirements that apply to other
companies that sell stock to the public, committed itself in 2002 to voluntary compliance
with Securities and Exchange Commission (SEC) disclosure standards. In its restatement,
Freddie announced that it would begin voluntary SEC reporting “as soon as possible after
the company’s return to timely reporting.” This has not happened yet, but the current
projection is to begin filing timely quarterly reports by the end of 2007. Freddie filed its
2006 annual report on March 23, 2007, in timely fashion.
Background
Freddie Mac is a GSE that plays an important role in the secondary mortgage market.
Like Fannie Mae,2 its rival GSE, Freddie buys mortgages from lenders and repackages
them in the form of securities, which it may hold or sell to public investors. Freddie
finances its purchases of mortgage loans by selling bonds: either bonds backed by its own
financial resources (called “straight debt”), or mortgage-backed securities, where interest
1 See [http://www.freddiemac.com/news/archives/investors/2003/restatement_112103.html].
2 Freddie Mac was formally chartered as the Federal Home Loan Mortgage Corporation, and
Fannie Mae as the Federal National Mortgage Association. The abbreviated forms are now the
official corporate names.

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and principal payments made by homeowners are passed through to holders of the bonds.
As GSEs, Fannie and Freddie are exempt from state and local taxes, from certain
regulatory requirements, and have a line of credit with the U.S. Treasury. Their most
significant advantage, however, is what is called the implicit guarantee — although the
bonds they sell are not formally backed by the full faith and credit of the U.S. government,
market participants behave as though they are. Because the markets do not believe that
the Treasury would allow Fannie or Freddie to default, the GSEs are able to sell bonds at
lower interest rates than other financial institutions.
More than 60% of all single family mortgage debt has been sold in the secondary
market, or “securitized.” As the leading players in this market, the housing GSEs
represent an extraordinary concentration of financial risk. Because there is a strong public
interest in ensuring that Freddie and Fannie remain financially strong, Congress in 1992
created OFHEO, a safety and soundness regulator dedicated exclusively to these two
institutions.
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 from long-term, fixed-rate mortgages. If rates fall, homeowners
refinance their mortgages 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 the soundness of the GSEs, and it appears that strategies to avoid, or “hedge,”
risk were partly responsible for Freddie’s recent accounting problems.
Freddie Mac’s Accounting Problems
Appendix II to Freddie Mac’s November 21, 2003, restatement discusses the
accounting errors that made revision necessary. The basic factors underlying the
accounting errors were “lack of sufficient accounting expertise and internal control and
management weaknesses....” In addition, certain transactions and accounting policies
were implemented to achieve steady growth in reported earnings. The two accounting
policies that appear to have been most important in this regard — yielding 88% of the
upward revision in pre-tax net income — are the classification of securities and
accounting for derivatives instruments.3 How these issues affect net earnings is discussed
below.
Between 2000 and 2003, interest rates fell dramatically — mortgage rates from over
8% to as low as 5.2%. The fall in rates had two major impacts on Freddie Mac’s financial
statements. Both Freddie’s bond portfolio and the derivatives contracts Freddie had
purchased to hedge the risk of falling interest rates4 increased sharply in value. Under
3 Appendix II, p. 2. Available online at [http://www.freddiemac.com/news/archives/investors/
2003/restatement_112103.html].
4 Derivatives are financial instruments whose value is linked to changes in some price or variable,
in this case interest rates. To hedge against falling rates, Freddie purchased interest rate swaps
in which Freddie agreed to pay floating-rate interest to the swap dealer, while the swap dealer
agreed to pay Freddie a fixed rate of interest. (The size of the payments is calculated by
reference to a notional principal amount that does not actually change hands.) As rates fell,
(continued...)

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generally accepted accounting principles (GAAP), these gains in asset value should have
been reported as current income. However, Freddie chose accounting treatments for these
asset gains that deferred recognition of income until later years, thus “smoothing out” the
effects of falling interest rates. The restatement of earnings is based upon Freddie’s and
its new auditor’s decision that these accounting policies were incorrect.
Much of Freddie’s bond portfolio was held in an accounting category called “held
to maturity” (HTM). This meant that the bonds would not be sold, and that therefore day-
to-day fluctuations in their market value were irrelevant; all that mattered was the amount
of principal and interest payments, which was fixed and known in advance. These bonds
were carried on Freddie’s balance sheet at historical cost, which meant that increases in
the bonds’ market value (as interest rates fell after 2000) were essentially ignored, and did
not appear as current earnings. However, during the 2000-2002 period, some of the bonds
classified as HTM were sold. As a result, the restatement reclassifies much of the entire
bond portfolio as “available for sale” (AFS), and changes in market value are recognized.
Gains in the bonds’ value over the period appear in the restated earnings as either current
earnings or stockholders’ equity.5
Derivatives accounting is governed by FAS 133 of the Financial Accounting
Standards Board (FASB). Under FAS 133, the fair value of all financial derivatives must
be calculated (“marked-to-market”) at the end of each accounting period. Changes in fair
value from the previous accounting period must be reported as current income, unless the
derivatives are used for hedging. If a derivative is used to hedge an asset, the value of that
asset — the hedged item — will move in the opposite direction to the derivative’s value.
Thus, a fall in the price of the hedged asset will be offset by a gain in the derivative (or
vice versa). Under FAS 133, the firm can recognize as earnings both the change in the
derivative’s value and the offsetting change in the hedged item’s. If the gains and losses
are closely correlated, the net effect on reported earnings will be very small or zero.
There is another form of hedge accounting under FAS 133, covering derivatives held
to hedge a future transaction or cash flow. Since the hedged item in this case does not yet
exist, it cannot be marked to market and used to offset gains in the derivative’s fair value.
However, FAS 133 allows the gain or loss in a derivative used to hedge a future event to
be assigned to comprehensive income, a subcategory of stockholders’ equity. When the
future transaction or cash flow occurs, the derivative is marked to market and changes in
fair value are recognized as current income, but presumably gains or losses in the
derivative will be offset by the hedged item.
Either form of hedge accounting has the effect of reducing the impact of changes in
derivatives’ fair value on current earnings and the bottom line. To qualify for this
accounting treatment, however, FASB requires that there be a close relationship between
changes in the value of the derivative and the hedged item. Derivatives that do not meet
FASB’s hedge test are considered speculative trading instruments, and changes in fair
value from period to period must be recognized and reported as current earnings.
4 (...continued)
Freddie’s floating rate obligation diminished, while it continued to receive the fixed payment.
5 Stockholders’ equity is separate from current earnings; it represents the proprietary interests of
the owners (stockholders) of a corporation, or the going-concern value of assets over liabilities.

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Freddie Mac, like most U.S. corporations that use derivatives, states in its annual
reports that it does not use derivatives for speculative purposes. In its restatement,
however, Freddie concludes that most of its derivatives in 2001 and 2002 did not qualify
as accounting hedges. This means that, from a GAAP perspective, these were speculative
positions. Recognition of fair value gains and losses in derivatives positions resulted in
an upward revision of pre-tax net earnings by $5.0 billion.
Based on the November 21, 2003 restatement, the accounting treatments of
derivatives and bond portfolios were the major factors in the restatement. In both cases,
the drop in interest rates to 1950s levels produced unexpected windfall gains in the value
of financial instruments. Freddie chose not to recognize these gains to avoid creating an
impression of earnings volatility, knowing that these gains would be reversed if the trend
in interest rates turned upwards. According to the June 25 statement, accounting policies
were designed “with a view to their effect on earnings in the context of Freddie Mac’s
goal of achieving steady earnings growth.” In other words, Freddie sought to “smooth
out” reported earnings and reduce volatility by deferring to future years earnings that
should have been recognized under GAAP as current income.
An internal report to Freddie’s board of directors issued in July 2003 provides further
detail on specific transactions designed to defer earnings and produce the desired
accounting results.6 The report concludes that these transactions, and the accompanying
accounting policies, indicated serious deficiencies in Freddie Mac’s internal controls,
disclosure practices, and in the governance policy of former management. The report
notes, however, that these transactions do not appear to have been made “at the expense
of the company’s risk management policies and practices.”7 In the November 21, 2003
restatement, Freddie Mac stated that it “accepts” the report’s conclusions.
In November 2005, Freddie announced that its reported income for the first half of
2005 would have to be restated and reduced by about $200 million, because of problems
in a “legacy” computer system.
The June 25, 2003, release noted several actions taken to fix weaknesses in
accounting and management controls. These include the expansion of senior accounting
staff, creation of an operating risk oversight unit, and strengthening the review of
accounting and other critical business operations. In conjunction with OFHEO, Freddie
has embarked on a “comprehensive remediation program,” to effect “broad changes in the
finance function.”
In 2006, Freddie reported that its remediation effort had proved to be much more
difficult and complex than expected. Among the areas where work continued were
mitigation of identified material weaknesses and significant deficiencies, strengthening
of the financial close process, implementing critical systems initiatives, and completion
of a review of the company’s system of internal controls related to the processing and
recording of the company’s financial transactions. In March 2007, the company filed its
6 Baker Botts L.L.P., Report to the Board of Directors of the Federal Home Loan Mortgage
Corporation: Internal Investigation of Certain Accounting Matters , December 10, 2002 - July
21, 2003, 107 p.
7 Ibid., p. iii.

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2006 annual report and thus resumed timely annual reporting. Timely quarterly reporting
was expected to resume by the end of 2007.
Freddie Mac’s Management and Regulatory Problems
The “smoothing out” of reported earnings through questionable interpretations of
GAAP is normally regarded as a violation of accounting rules. The SEC’s view is that
if a firm deals in volatile financial instruments, that volatility should be fully reflected on
its accounting statements. In August 2004, Freddie announced that an SEC investigation
was continuing, involving possible violations of regulations involving fraud, deceptive
practices, and insider trading.
In December 2003, OFHEO settled its investigation with a consent agreement.
Freddie admitted to no wrongdoing, but agreed to pay a $125 million fine. In April 2006,
Freddie paid $410 million to settle a class action suit brought by pension funds and other
investors as a result of stock losses stemming from the scandal.
In September 2005, Freddie agreed to help federal investigators pursue former CEO
Leland Breindsel and former CFO Vaughn Clarke, who were forced out in 2003. Freddie
also agreed to seek recovery of their severance pay and stock awards, which totaled tens
of millions of dollars, if the regulators determine that misconduct was involved in the
accounting scandal. Clarke and David Glenn, the former chairman, settled OFHEO
charges by paying fines of $125,000. In November 2007, OFHEO announced a
settlement with Brendsel: he agreed to pay a $2.5 fine to the government and to return to
Freddie Mac $10.5 million in salary and bonuses.
There have been proposals to reform regulation of the housing GSEs. Two bills in
the 110th Congress — H.R. 1427 (passed by the House on May 22, 2007) and S. 1100 —
propose to restructure GSE regulation.8 The bills would replace OFHEO with an
independent agency with authority over Fannie, Freddie, and the Federal Home Loan
Banks. They would enhance the safety and soundness tools available to the GSE
regulator by giving it more flexibility to establish and enforce risk management,
operational, and capital standards, and authority to put a GSE into receivership, if
necessary.
The accounting scandal at Freddie Mac was followed by a similar scandal at Fannie
Mae in 2005. Given the importance of Fannie and Freddie to housing finance and the
financial system at large, these deficiencies in accounting are troubling. If Freddie’s
management cut corners with accounting rules to conceal an inconvenient excess of
earnings, how might it respond to a shortfall in earnings that presaged serious trouble in
the company? An announcement that either Fannie or Freddie faced unexpected and
undisclosed problems could trigger wide instability in debt markets. The size of the
housing GSEs and the volume of their debt securities held by other financial institutions
make management and regulatory reform important public policy issues.
8 For a summary of the provisions of these bills, see CRS Report RL33940, H.R. 1427 and S.
1100: Reforming the Regulation of Government-Sponsored Enterprises, by Mark Jickling,
Edward Vincent Murphy, and N. Eric Weiss.