[A-List] Report Says Freddie Mac Misled Investors

["Gary Santos" <evs@xxxxxxxxxxxx>]

Report Says Freddie Mac Misled Investors
By ALEX BERENSON
http://www.nytimes.com/2003/07/24/business/24MAC.html?th

reddie Mac, the big mortgage financier, has used a grab bag of accounting
techniques to mislead investors about its results since 2000, according to a
report released yesterday by the company. Gregory Parseghian, the new chief
executive, knew of some of the tactics, which reduced reported profits, the
report said.

Freddie Mac, which for most of the last few years has faced the uncommon problem
of having profits that substantially exceeded forecasts, did not want to deviate
too much from those expectations, the report said. So it used techniques to make
its main business of insuring and buying mortgages seem less profitable and to
create a reserve of earnings for later years.

The 107-page report, prepared by outside investigators for Freddie Mac's board,
underscores the complexity of the accounting used by Freddie Mac to present its
results. It also underlines how easily financial companies like Freddie Mac can
manipulate their reports to investors.

Last month, Freddie Mac said it had understated its pretax profits by as much as
$6.9 billion in 2002 and previous years as a result of serious accounting
problems, and the company ousted its three top executives.

The report also offers more evidence of what regulators and many investors say
is a culture of earnings management in corporate America. Like many other big
publicly traded companies, Freddie Mac put a premium on meeting analysts'
forecasts of its profits and providing consistent growth in reported earnings.

Paul Miller, senior analyst at Friedman, Billings, Ramsey, a regional brokerage
firm in Virginia, said he and other analysts had too often taken on faith the
earnings reports of Freddie Mac and other big financial companies.

"There's always been these companies, there's this black box in there, and you
ask about their numbers, and they tell you what they want you to hear and you go
back and write a report," Mr. Miller said. "When you get very, very straight
earnings streams - the economics of the business don't operate that smoothly."

Mr. Miller also said he did not know if Mr. Parseghian could survive as the
company's chief executive. At one point, Mr. Parseghian told another senior
official at Freddie Mac that he "needs help in earnings management," according
to the report.

In a conference call yesterday, Mr. Miller said that Freddie Mac's chairman,
Shaun F. O'Malley, appeared to be trying to blame the former management. "The
company would like to think it's settled," he said. "Investors, they haven't
quite bought into it yet."

Mr. O'Malley said yesterday that the board had confidence in Mr. Parseghian.
"Greg is a person of considerable talent, deep expertise and unquestioned
integrity," he said.

With more than $600 billion in assets, Freddie Mac is the fourth-largest
financial institution in the United States. It is owned by investors but has a
government charter to make housing more affordable by increasing the pool of
capital available for mortgages. It owns or insures some 19 percent of all home
mortgages.

For now, the problems at Freddie Mac have not had a broad impact on financial
markets or the housing market, one of the few strong sectors in a struggling
United States economy. Shares in Freddie Mac rose 60 cents yesterday, to $51.69,
although they are down 13.7 percent since June 6, shortly before the company
announced the firing of David W. Glenn, its president, and the resignations of
Leland C. Brendsel, its chairman, and Vaughn Clarke, its chief financial
officer. Freddie Mac's bonds have held their value since the announcement,
dropping only slightly compared with Treasury bonds.

But the scope of the problems at Freddie Mac, and assertions by some
institutional investors that its larger corporate cousin, Fannie Mae, has had
multibillion-dollar losses that have been obscured by complex accounting, have
caused critics of the companies to complain that they are taking on too much
risk without enough government oversight.

The companies and the government both say that the debt is not guaranteed by
taxpayers, but because of the two lenders' government sponsorship, many bond
investors think that Washington would ultimately step in to repay them if the
companies ran into financial trouble.

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Such a guarantee could one day prove very costly to taxpayers, especially
because both companies have about $50 in debt for every $1 in equity, giving
them very little cushion against unexpected problems, the critics say.

James Bianco, president of Bianco Research, said: "At the end of the day, a lot
of people think that this is all about nothing because if the company isn't able
to pay me back, the government will anyway. We don't let Citigroup or J. P.
Morgan Chase or Goldman, Sachs come to the bond markets and borrow to infinity
without looking at the financial statements. But we certainly seem to with these
guys."

The report released yesterday was prepared over the last seven months by the law
firm Baker Botts for Freddie Mac's board. In December, the board's audit
committee hired Baker Botts after the company received two anonymous letters
saying it had misstated its 1999 results and committed other wrongdoing. Baker
Botts determined that the accusations in the letters were largely wrong, the
report said.

But in the course of its investigation of the letters, Baker Botts discovered
other possible problems with the company's accounting policies. At the same
time, PricewaterhouseCoopers, which Freddie Mac had hired in March 2002 to
replace Arthur Andersen as its auditor, discovered problems in the company's
books. As a result, Baker Botts broadened its investigation, according to the
report.

James Doty, a lawyer in the firm's Washington office and the former general
counsel of the Securities and Exchange Commission, led the inquiry. The board
set no limits on the investigation's time or cost and directed all its employees
to cooperate with the investigation, Mr. Doty said.

Besides using accounting techniques to create a reserve of earnings for future
years, the report asserts, the company tried to conceal the impact of the
techniques when it was forced to discuss them with the board and investors.

Further, the report says, Freddie Mac's accounting controls were weak for a
company of its size, and the company discouraged employees from admitting or
discussing accounting errors.

The techniques themselves fell into several categories, according to the report.
Late in 2000, the company found itself with a large one-time gain because of an
accounting change mandated by the Financial Accounting Standards Board.

Instead of reporting the gain to investors, the company sought ways to defer it
over time. Senior managers, including Mr. Parseghian, approved a strategy that
included selling and repurchasing some bonds in its portfolio, a transaction
that had no economic effect but created a one-time loss to offset the gain. Over
time, the loss would be reversed into the company's income, according to the
report. The company intended the transaction to comply with standard accounting
rules, but it did not, according to the report.

In another effort to hide its one-time gain in 2000, the company stopped using
market prices for some of the derivatives in its portfolio, according to the
report, which called the decision "results-oriented, reverse engineered, and
opportunistic."


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