In the most detailed look yet at the accounting scandal plaguing Freddie Mac, a board-ordered investigative report says former top executives violated accounting rules and withheld information from the board of directors in an effort to present a pattern of steady earnings growth.
”This is a painful day for Freddie Mac,” chairman Shaun O’Malley said Wednesday. ”In the simplest terms, the findings reflect poorly on the past accounting, controls and disclosure practices used by Freddie Mac.” He said the housing finance giant will address the problems and make sure they never happen again.
The 107-page report by the Baker Botts law firm reveals how Freddie Mac’s top executives used complex accounting practices to manipulate earnings despite regulatory oversight and independent board members. Unlike other recent accounting scandals, in which companies inflated their earnings, Freddie Mac was deferring income to smooth out its earnings from quarter to quarter.
The report disclosed new information about the circumstances preceding the departures of Freddie Mac’s chief executive, president and chief financial officer in June. It says former CEO Leland Brendsel and president David Glenn directly participated in accounting and investment decisions designed to manipulate how the company reported profits and, investigators say, senior management kept the board and shareholders in the dark about controversial practices sometimes at odds with the company’s own auditors.
Lawyers make clear that Freddie Mac’s failures were not ”of rampant criminal misconduct, or abuse of authority for personal gain,” but the inability of management to appropriately contend with the mortgage giant’s unexpected financial riches.
Perhaps the report’s biggest surprise is that it places new CEO Gregory Parseghian, recently promoted from the jobs of chief investment officer and senior vice president, at the center of many of the former management’s controversial practices. Parseghian approved and participated in many discredited decisions.
But he was not responsible for the company’s accounting and disclosure, the report concluded. Parseghian relied on advice he received from the internal accountants and outside auditors at Arthur Andersen, said James Doty, the Baker Botts lawyer who led the investigation.
That doesn’t satisfy everyone. ”This seriously raises questions about Parseghian,” says Bert Ely, head of Ely & Co., a financial consulting firm in Alexandria, Va. ”There is an element of whitewash in the report.”
Investigators also carefully raise doubts about the truthfulness of some of Brendsel’s and Glenn’s statements to them about the company’s finances, saying, ”The weight of the evidence, particularly the statements of (other) employees, is to the contrary.”
The accounting scandal at Freddie Mac has reverberated on Wall Street and Capitol Hill. The government-chartered, private mortgage corporation is a political powerhouse and an investment colossus in the global market for mortgage-backed securities. Together, Freddie Mac and Fannie Mae the other leading government-chartered mortgage investor hold $1.4 trillion in assets and own or guarantee 45% of U.S. mortgage debt.
The company’s stock has been battered, falling from a year-to-date high of $64.78 in January to close at $51.69 Wednesday.
The report by law firm Baker Botts revealed that Freddie Mac’s problems began with two anonymous letters alleging accounting, reporting and internal control irregularities. They were sent by fax in December to Fannie Mae, which forwarded the letters to Brendsel.
The report said the allegations proved to be largely false. But in the course of that probe, investigators uncovered accounting errors that led to the announcement on Jan. 22 that Freddie Mac’s 2002, 2001 and 2000 results would be restated. Freddie Mac has said 2000-2002 earnings were understated by $1.5 billion to $4.5 billion. O’Malley said it hopes to announce restated earnings by Oct. 31.
For years, Freddie Mac was known as ”Steady Freddie,” a reference to a policy of conservative management articulated by Brendsel and enforced with Glenn’s help. The staff was well aware of the mandate to maintain Steady Freddie’s reputation, and that ultimately led to the accounting problems, the internal report said.
As Freddie Mac’s size and profitability grew in the trillion-dollar mortgage finance boom that accompanied falling interest rates, the company engaged in increasingly intricate and often improper investment and accounting practices.
Among the report’s revelations:
Freddie Mac devised questionable investment and trading strategies to book hundreds of millions of dollars in paper losses while deferring gains into future reporting periods. In some cases, Freddie Mac essentially swapped identical assets, accounting for a transaction as a sale by relinquishing control of the underlying security ”for a couple of hours,” the lawyers say.
Another dubious practice related to the timing of donations the company made to its charity, the Freddie Mac Foundation. Lawyers say management earmarked $9.6 million for the foundation in 1999 in a move timed to bring the company’s financial statement ”more closely in line” with analysts’ estimates that year.
Management misinformed and ignored its own board of directors as part of its well-established practice of providing incomplete or misleading financial information both internally and externally. ”The information flow to the board was tightly scripted and controlled,” the report says, adding that the disclosures ”fell below the standards required” of a stockholder-owned company.
The accounting team was ”anemic for an institution of its size,” the lawyers say. Freddie Mac’s CFO and controller were not certified public accountants from late 2000 to late 2001, and its accounting personnel ”lacked the expertise” to understand the intricate decisions being made, the lawyers say. To compensate, Arthur Andersen partners took over much of the accounting work, blurring the line between the roles of in-house and independent auditors at a shareholder-owned company.
During that period, Freddie Mac engaged in one of its biggest, and now discredited, ”earnings management” strategies.
In that instance, Freddie Mac deferred about $420 million in operating earnings from the third and fourth quarters of 2001 into future years under a complicated investment strategy known as ”linked swaps,” the lawyers say.
Freddie Mac documentation shows Parseghian was closely involved in this controversial accounting practice, which Arthur Andersen subsequently demanded be halted.
Under the ”linked swaps” strategy, Freddie Mac executed eight sets of paired trades in which it exchanged rights to interest-rate income streams with an unnamed trading partner. The way the trades were structured, Freddie Mac immediately began paying its partner but deferred its own income streams.
Lawyers quote one of Freddie Mac’s investment traders, Sean Flanagan, as saying in a taped telephone call the idea was to ”book expense now and get it back in six months.”
Arthur Andersen audit partner Rob Arnall says the transactions were ”barely” consistent with accounting standards but told Glenn not to engage in further transactions of that type. The missing pages from Glenn’s diaries relate to this meeting with the Andersen partner, the lawyers say. The lawyers say Glenn briefed Brendsel about the auditor’s concerns, but neither man took action. Details of the transaction were withheld from the board.
The investigators conclude Freddie Mac ”management could have terminated the trades but failed to do so until virtually the entire desired accounting effect” that is, deferred profit ”was achieved. And Brendsel, Glenn and (former CFO Vaughn) Clarke all assumed a posture of ‘deniability.’ ”
Freddie Mac’s problems are not behind it. It still faces a criminal probe, shareholder lawsuits and formal investigations by the Securities and Exchange Commission and its regulator, the Office of Federal Housing Enterprise Oversight.
The revelations also have sparked congressional hearings and calls for increased oversight of Freddie Mac and Fannie Mae.
Some analysts credit Freddie Mac’s board with conducting a thorough internal investigation.
”I think it’s the beginning of the end of the controversy,” said Paul Miller, an analyst at Friedman Billings Ramsey.
”But I don’t think it’s the end, by any means.”