Freddie Mac said yesterday that it had understated its earnings by nearly $5 billion over more than three years, ending an 11-month review of the company’s accounting that led to resignations by prominent executives and concerns by regulators and lawmakers.
The size of the restatement announced by the company, which is the nation’s second-largest buyer of home mortgages after its corporate sibling, Fannie Mae, is at the high end of the range it announced in June. Executives at Freddie Mac warned of increased volatility in reported earnings in the future as a result of correct application of current accounting rules, causing some to question the volatility of Fannie Mae’s earnings as well.
Former executives apparently manipulated Freddie Mac’s earnings in an effort to meet investors’ expectations.
The size of the restatement also prompted some lawmakers and regulators to raise anew their concerns about how Freddie Mac is regulated and to call for more stringent oversight.
”In the face of the latest incarnation of the company’s restatement, it’s absolutely astonishing that Congress has yet to step in and rein in this financial behemoth,” Representative Christopher Shays, Republican of Connecticut, said in a statement yesterday. ”Freddie Mac is the fourth-largest financial firm in the country. It obviously can’t add or subtract, yet it has the chutzpah to dictate what laws it will comply with, and it continues to tell Congress and the White House what type of regulation is acceptable to it.”
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Armando Falcon Jr., who heads Freddie Mac’s primary regulator, the Office of Federal Housing Enterprise Oversight, emphasized that his agency’s investigation of Freddie Mac’s accounting was continuing and noted that the company had a long way to go. ”More remains to be done by Freddie Mac,” he said.
Executives at the company said yesterday that though they hoped the long-awaited announcement was the end of a difficult period in the company’s history, much work remained. Martin F. Baumann, Freddie Mac’s chief financial officer, told investors on a conference call yesterday that the company would try to complete its quarterly and annual results for 2003 by June 30, 2004, and to resume more timely quarterly reporting thereafter.
”Today’s release represents a significant step in our progress toward financial reporting that is complete, accurate and well controlled,” Mr. Baumann said.
Shares of Freddie Mac rose 3 cents yesterday, to $55.67, after the company released the revised numbers. Since Freddie Mac announced in January that it would restate earnings to correct improper accounting for previous years, the company has replaced several top executives and has endured months of scrutiny from the news media and harsh questioning from lawmakers and regulators. One executive, David W. Glenn, its former president, agreed last month to pay a $125,000 fine and to assist in the regulatory investigation.
The company’s current chief executive, Gregory J. Parseghian, will step down once Freddie Mac’s board picks a successor. Shaun F. O’Malley, the chairman, said that a chief would probably be named by the end of the year. Regulators pressed the board to replace Mr. Parseghian after a report by an outside law firm investigating Freddie Mac’s accounting determined that he played a role in some of the transactions that later came under accounting scrutiny; Mr. Parseghian had replaced Leland C. Brendsel, who resigned in June.
The details of the accounting at Freddie Mac offer a glimpse into the difficult issues facing executives confronted with complex reporting requirements and pressed to meet goals of smooth earnings growth. The restated financial statements show that the company did not simply understate net income consistently; it fluctuated sharply from quarter to quarter.
For example, according to its restatement, Freddie Mac lost $111 million in the first quarter of 2001 rather than earning nearly $1 billion as it reported. It earned more than $2 billion, or double what it reported, in the third quarter of that year; and in the third quarter of 2002, it earned more than $5 billion — over $4 billion more than the company reported at the time.
On the call with investors yesterday, Freddie Mac executives warned that the restated results showed greater volatility because new rules under generally accepted accounting principles, or GAAP, affected how the effect of fluctuating interest rates must be reported.
”There will also be significant volatility in its GAAP results in the future,” Mr. Baumann, the chief financial officer, said.
On a pretax basis, the company understated net income by a total of $7.6 billion. The largest single component, nearly $5 billion, was a result of improper accounting for investments in derivatives, Mr. Baumann said. The second-largest piece, about $1.7 billion, was a result of improper classification of securities held by the company.
Because Freddie Mac did not correctly account for derivatives transactions intended to hedge against changes in interest rates, the transactions had to be revalued quarterly at their market price, or ”marked to market,” and included on Freddie Mac’s income statement. The value of those transactions changed, while the value of the underlying asset that created the interest rate risk — for example, a bundle of mortgages kept on the company’s balance sheet — did not.
As interest rates fell in 2002, the value of derivatives investments used to manage the risk of falling rates that were not in proper hedging relationships increased by $5.9 billion, Mr. Baumann said.
”That creates the volatility,” Mr. Baumann said. He added that the volatility was not related to increased riskiness of the company’s financial position but was a function of accounting rules correctly applied. ”There’s the business, fair value and then there’s GAAP,” and investors need to consider all three, Mr. Baumann said.
Determining what volatility is cause for concern will be difficult, though, said Bert Ely, a a consultant and a critic of both Fannie Mae and Freddie Mac. ”How much of it is artificial volatility due to accounting rules and how much of it is honest-to-God volatility?” he asked. ”It’s going to make it difficult for people to draw these numbers apart.”
Stockholders’ equity in Freddie Mac rose by $6.7 billion after the restatement, largely as a result of retained earnings that had been understated.
A supplemental report by Baker Botts, the law firm hired by Freddie Mac’s board to investigate the accounting, also provided more support for earlier findings that former top executives were aware of some of the transactions used to smooth earnings improperly. Most of the executives named in the report are no longer at the company.
Based on additional investigation, the firm found, ”The picture that emerges from the documents involves the awareness of the C.E.O., C.O.O. and C.F.O. of the use of accounting to achieve the desired financial results.”
The documents reviewed by Baker Botts have also been turned over to regulators, the firm noted.
