Market Place; Freddie Mac Gets

Penalty And Rebuke Over Scandal

By JONATHAN D. GLATERDEC. 11, 2003
Correction Appended
Federal regulators released a scathing report Wednesday on the corporate
culture that fostered improper accounting at Freddie Mac, the same day that
they announced that the company had agreed to pay a $125 million penalty and
to take measures to prevent future misconduct.
The settlement and the report may help Freddie Mac, the nation's secondlargest buyer of home mortgages behind its corporate sibling, Fannie Mae, to
recover from an accounting scandal that surfaced early this year. But some of
the report's recommendations suggest that regulators may impose new
restrictions on the company. They also suggest that regulators will now shift
their focus to the Wall Street firms that engaged in certain transactions with the
company and to accounting at Fannie Mae.
The report by the Office of Federal Housing Enterprise Oversight does not shed
much new light on the transactions at the center of the improper accounting,
which sought to smooth out earnings volatility, but it is much harsher than
previous reports in its assessment of Freddie Mac's executives and board
members.
''Freddie Mac cast aside accounting rules, internal controls, disclosure
standards, and the public trust in the pursuit of steady earnings growth,'' the
report states.
In addition, it says, ''senior management and the board failed to establish and
maintain adequate internal control systems.''
Freddie Mac reported its revised earnings last month, disclosing that it had
understated net income by nearly $5 billion over more than three years. Many
of the transactions that were accounted for improperly, including swaps and
reserves for loan losses, were described in a preliminary report to the board by
an outside law firm and in a supplemental report released with the restatement.
Some lawmakers greeted the report as further evidence of the need for an
overhaul of the regulation of government-sponsored entities, including Freddie
Mac and Fannie Mae.
''The information in Ofheo's report clearly confirms that there were serious
accounting, disclosure and management issues that led to Freddie Mac's

earnings restatement,'' Senator Richard C. Shelby of Alabama, chairman of the

Senate Banking Committee, said in a statement. ''It also serves to underscore
the deficiencies of Ofheo as a regulator, in that Ofheo never detected the
breakdown in the accounting and audit function at Freddie Mac. The Banking
Committee will continue to consider legislative reform for the G.S.E.'s to ensure
that they have a strong and credible regulator.''
Armando Falcon Jr., director for the regulatory agency, said that the report and
the settlement with Freddie Mac were proof of the agency's readiness to take
tough action when necessary. ''Freddie Mac lives on a public trust that should
never be violated,'' Mr. Falcon told reporters Wednesday. Such violations must
be addressed promptly when discovered, he added. ''Today's action indicates
that we will do so.''
Freddie Mac executives declined to comment on the report, but the company
said in a statement: ''The report is not part of the consent order, and Freddie
Mac did not consent to any part of the report. The report represents Ofheo's
interpretation of the facts, and Freddie Mac had no opportunity to provide
input into the text of the report. There are characterizations, findings and
conclusions in the report with which the company strongly disagrees.''
Shares of the company closed at $54.25, up 25 cents. Bert Ely, a banking analyst
in Alexandria, Va., noted that there was no way to determine the effect on
earnings of the fine to be paid by the company, which has not reported financial
results for any period of 2003. ''We didn't know what this year's earnings were
going to look like anyway,'' Mr. Ely said.
Under the terms of the settlement, in addition to the $125 million fine, Freddie
Mac's board is required to review and as necessary revise its bylaws and the
frequency of its meetings, along with the company's codes of conduct. The
board is also required to determine whether to impose limits on the terms of its
members. The company, in turn, is required to report on its internal controls
and on plans for strengthening its internal audit function. The company is
required to separate the jobs of chief executive and chairman.
Some of the recommendations in the agency's report -- which Mr. Falcon, the
director, said he might or might not impose on the company -- are more severe.
The report proposes increasing the amount of capital that the company must
retain and limiting how much its portfolio of mortgages may grow. Finally, the
report recommends that the regulatory agency examine the accounting
practices of Fannie Mae; the agency has already received bids on that project,
Mr. Falcon said.
The agency is also continuing its investigation into investment firms that
participated in the transactions that were accounted for improperly, according
to the report. Those firms are J.P. Morgan Chase, Credit Suisse First Boston,
Citigroup, Goldman Sachs and about 20 others.

Mr. Falcon distinguished his agency's report from the one written by Baker
Botts, the law firm hired by the board. ''The difference between our report and
that one is, we made an effort not to look just at the transactions,'' he said,
adding: ''We did our interviews pursuant to subpoenas. We looked at a host of
information that wasn't available to Baker Botts.''
The report, based on a review of documents, e-mail messages, audiotapes and
interviews, is critical of Freddie Mac's accounting practices and traces the
problems to the mid-1990's, even before the period covered by the company's
restatement.
The report repeatedly cites three former senior executives -- Leland C.
Brendsel, the former chief executive; David W. Glenn, the former chief
operating officer; and Vaughn A. Clark, the former chief financial officer -- for
creating a ''tone at the top'' that encouraged manipulation of earnings to meet
the expectations of Wall Street analysts and investors. Executives had an
incentive, in the form of larger bonuses, to try to meet earnings expectations,
the report states.
Gregory J. Parseghian, who succeeded Mr. Brendsel as chief executive in June,
is also criticized for his involvement in a series of transactions begun in 2001
that were also intended to smooth earnings. Mr. Parseghian will be succeeded
by Richard F. Syron, a former president of the American Stock Exchange,
Freddie Mac announced on Sunday.
According to the report, ''Although Mr. Parseghian admitted that the business
purpose of the linked swaps was marginal relative to their income effects, there
is no evidence that he or his staff checked with Arthur Andersen before
executing the swaps and there is no written evidence that corporate accounting
provided approval.''
Andersen was Freddie Mac's former auditor; its current auditor is
PricewaterhouseCoopers. In his diaries, which were reviewed by regulators, Mr.
Glenn expressed concern about the switch, warning of ''transition risk'' like ''the
possibility of restatements'' if a new auditor were appointed.
Andersen, which no longer audits public companies, comes in for its share of
criticism as well, for not correcting improper accounting and for not addressing
its own potential conflicts of interest.
Perhaps most telling, though, are the sections of the report dealing with the
company's board. The report strongly suggests that the board knew about the
efforts to smooth earnings. A presentation in June 1999 to the board by the
chief financial officer at the time, John Gibbons, informed members twice that
the company was ''undertaking transactions to smooth the time pattern of net
interest income.''

The notes of one director at that meeting, George D. Gould, suggest that he
understood exactly what was being presented and was most worried about
whether the smoothing would be apparent to others. Rather than worrying
about what the Securities and Exchange Commission's view might be, the
report states, Mr. Gould ''questioned 'how transparent smoothing of growth
would be to others.'''
After the board meeting, ''management carefully reviewed the board's minutes
to ensure that there were no references to earnings management,'' the report
continues.
The board also did not investigate potential weaknesses of the company's
accounting functions, the report states, although there were warning signs that
the accounting staff was inadequate to its task in areas like financing,
experience and manpower, the agency's investigation found.
According to the report, ''The special examination is led to the conclusion that
the board of directors of Freddie Mac played no meaningful role in the
oversight of the critically important area of accounting policies and practices, as
required by law and regulation.''
Correction: December 12, 2003, Friday An article in Business Day yesterday
about a report by federal regulators on improper accounting at Freddie Mac
included a Wall Street firm erroneously among those linked to improper
transactions. While J. P. Morgan Chase participated in deals with Freddie
Mac, the report did not say those transactions were part of the improper
accounting.