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Why Freddie's Mess Matters


On June 9, Freddie Mac revealed one of the biggest corporate scandals of the year. The mortgage-finance giant fired President David W. Glenn for allegedly failing to cooperate with outside lawyers hired to probe its accounting. Freddie's CEO and CFO were also forced to resign. Now, the U.S. Attorney in Northern Virginia has launched a criminal probe, the Securities & Exchange Commission a civil investigation, and Congress a probe into why Freddie's regulator was asleep at the wheel.

The big worry is that Freddie's problems could turn out to be so severe that they rock the mortgage markets and snuff out the huge refinancing boom that is keeping consumers -- and the economy -- afloat. Freddie is huge in mortgages: Last year, it bought $642 billion worth of them, a quarter of all issues. In January, it disclosed that its new auditors found mistakes in its accounting for derivative contracts and said it would restate up to three years of results.

As yet, there's no indication its problems run deeper. But if, for example, it has mishandled its complex portfolio of mortgages, borrowing, and derivatives, the outcome could be far worse. Federal Reserve policy makers have fretted in the past that Freddie's size poses a risk to the financial system, raising comparisons to the Long-Term Capital Management debacle in 1998.

What is Freddie and what does it do?

The Federal Home Loan Mortgage Corp. (its official title) buys mortgages from banks after they've lent to homeowners, allowing the banks to make more loans. Though investor-owned and publicly traded, it's a so-called Government Sponsored Entity with a charter from Congress to make money available to home buyers.

How does Freddie operate?

It packages the mortgages it buys, guarantees them, and then either keeps them as investments or sells them to the likes of pension funds. Freddie and its rival GSE, Fannie Mae, together hold about 19% of the $7 trillion in residential mortgages outstanding. Freddie makes money from fees and from buying, selling, and holding mortgages.

How does Freddie finance all those mortgages?

It has $24 billion in capital and borrows huge amounts in the bond markets -- $643 billion by the end of 2002. It typically pays 30 to 40 hundredths of a percentage point less than a bank would because its GSE status gives an implicit government guarantee on its debts. Freddie uses derivatives to hedge against sudden moves in interest rates which can wreck the value of its portfolio or raise its cost of borrowing.

So what exactly is Freddie accused of?

The biggest issue is an apparently big understatement of its past earnings. The company says the errors result from differences between it and its new auditors over the interpretation of complex accounting rules for derivatives. In the worst case, there could have been a "cookie jar" of profits that could be used to hide big losses in the future. Either way, Freddie's preferred accounting made its quarterly earnings look steadier and less susceptible to interest-rate moves, thereby lowering the rates it has to pay and plumping its stock price.

How far will the scandal go?

That's the big question. Glenn's firing, for allegedly destroying pages of a personal diary the lawyers wanted to read, has the markets wondering whether Freddie's derivatives portfolio is in trouble. If that turns out to be the case, Freddie might have to make forced sales of assets and reduce the amount of its lending -- either of which could push up the cost of mortgages. In a nightmare scenario, Freddie might have to be bailed out, or, like Long-Term Capital, taken over by creditors at the Fed's instigation.

So how worried should we be?

There's no evidence so far that Freddie has mismanaged its derivatives or that its portfolio is on the ropes. Its new CEO, Gregory J. Parseghian, a Wall Street derivatives whiz hired in 1996 as chief investment officer, is making reassuring noises. He told investors on June 9 that Freddie doesn't make bets on future moves in interest rates and ensures that its assets and liabilities -- the mortgages it holds and the money it owes -- are in close alignment. That means their payments are timed within one month of one another, and mature within one month of one another. So far, Wall Street has given Parseghian the benefit of the doubt, only modestly raising the yield on Freddie's debt by 9 basis points.

Do Freddie's problems reveal anything about Fannie Mae?

Freddie has long presented itself as more cautious than Fannie. To boost earnings, Fannie lets its assets and liabilities get as much as six months out of alignment, vs. the one month for Freddie. Fannie officials say they are in control of their risks and don't speculate with derivatives.

Absent a complete meltdown, is there anything to worry about?

Yes. Freddie's borrowing costs could go higher if bond investors can't stomach the higher volatility of its earnings. In that case, Freddie wouldn't be able to provide as much mortgage money as cheaply as the past. Mortgage rates would rise and nibble at home prices, though it is impossible to say by how much. In fact, Freddie may have already started a long-term downsizing: On June 11, Freddie announced it would buy back $10 billion of its debt early, effectively trimming the scale of its operations. Freddie says the buyback is routine.

And what would that mean for the average homeowner's mortgage?

Existing mortgages would be harder to refinance with new money and rates might edge up. Whether the difference would be noticeable depends on how much Freddie shrinks.

Is there any other fallout?

This is red meat to Washington lobbyists for private finance companies. They have long complained that Freddie and Fannie have unfair advantages as GSEs. Apart from having access to cheaper borrowing, they're not covered by SEC disclosure rules for publicly traded companies. Though both the House and Senate are expected to hold hearings, legislation is unlikely unless Freddie's problems turn out to be more serious than initially reported. One bill requiring the companies to register their mortgage-backed securities with the SEC has yet to gain traction.

What should Washington do?

Strengthen Freddie's slothful regulator, the Office of Federal Housing Enterprise Oversight, which is part of HUD. It didn't swing into action until it was alerted to Glenn's alleged misconduct after June 5. Some critics want to hand jurisdiction to the Treasury Dept., but it would be quicker for the White House to put a financial expert in charge of OFHEO. In fact, it is expected to nominate Mark Brickell, a former managing director at J.P. Morgan Chase (JPM) Co.'s derivatives group. By David Henry in New York and Laura Cohn in Washington


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