Markets weather storm over Freddie Mac accounting mess

News

Credit markets have remained largely unfazed by the recent furore over accounting irregularities at the US government-sponsored mortgage agency Freddie Mac, one of the world’s largest bond issuers.

Freddie Mac’s announcement of abrupt changes in its senior management has helped allay the unease that surrounded the agency in January, when it announced that it was reviewing its earnings for the past three years. Any damage caused by the announcement, say analysts, has been done to the agency’s political capital rather than fostering any real concerns about Freddie Mac’s credit quality.

One mortgage-backed securities analyst at a major US bank says: “While there is always an element of suspicion that deeper problems may emerge, the Street knows Freddie too well to be unduly concerned.”

At the heart of the investigation into Freddie Mac’s book-keeping is the agency’s accounting of derivatives contracts used to hedge interest rate risk. The revised accounts may restate Freddie Mac’s earnings for 2000–2002 by as much as $4.5 billion more than was originally disclosed, a move that could reduce net income during the next few years.

However, analysts say that the restatements will not alter the true value of the company nor its credit rating, and the accounting problems do not appear to be unduly sinister. One New York-based analyst says: “The new accounting standards for derivatives are horribly flawed: the whole market is struggling to get this right, not just Freddie.”

And according to another New York-based analyst: “The accounting issue has partly emerged because Freddie changed auditors in March 2002. Their former auditors Andersen had one way of approaching the derivatives contracts, and PricewaterhouseCoopers has another.”

More recent concerns have centred on the circumstances surrounding the dismissal of David Glenn, Freddie Mac’s former president and chief operating officer. According to the agency, Glenn was sacked over “serious questions as to the timeliness and completeness of his cooperation and candour with the audit committee.” However, the company claims that no new accounting issues have been raised by the dismissal.

And analysts expressed unanimous confidence in the new management team, and in CEO Greg Parseghian in particular, who has been making special efforts to reassure the investor community. “The new management team of Freddie Mac is determined to set high standards of candour and transparency in our financial reporting. Our investors and the public should expect and demand nothing less,” he says.

Investor confidence has also received a boost from Freddie Mac’s $9.8 billion bond buy-back in the US markets, and a buy-back of €2.06 billion in Europe. One analyst at a US bank says: “This level of support for their debt sends a strong signal to the market – Freddie is determined to reverse any unjustified cheapening of their bonds and to protect their funding costs for future issues.”

Freddie Mac and its larger relative, Fannie Mae, buy mortgages from lenders and refinance themselves in the capital markets by issuing bonds, or by repackaging mortgages into guaranteed securities which are then traded on the market.

Freddie and Fannie now own or guarantee almost half of all mortgages in America, and over the past five years, their combined investment portfolio has doubled to over $1 trillion.

Given Fannie and Freddie’s substantial portfolio and their central role in the US housing sector, it is perhaps no surprise that the political reaction to Freddie’s accounting problems has been to demand increased disclosure and greater regulation of the government-sponsored enterprises.

Recent proposals tabled by Congressman Richard Baker even call for the abolition of the current regulator, the Office of Federal Housing and Enterprise Oversight, to be replaced with a more powerful body.

However, while analysts say they would be concerned by any regulatory changes that might constrain Freddie Mac’s risk appetite, any changes in regulation are unlikely to be extreme. The most likely scenario is an increase in the budget of the existing regulator, and a move by Freddie to follow Fannie Mae’s decision to report to the SEC.

One analyst at a major US bank says: “The mortgage agencies have an enormously powerful political lobby amongst the Democrats, and entrenched support in the financial community, mainly because the banks earn massive underwriting fees for dealing with the enormous volumes of agency issuance. This support means that regulatory changes are unlikely to be far-reaching.”

Kathy Shanley, an analyst at independent research provider GimmeCredit, says: “Nothing has occurred in the past month to change our view that Freddie Mac will continue to benefit from the halo of implied government support.”