Corporate Research E-Letter No. 43, January 2004
THE SCANDAL IN HOME MORTGAGE FINANCING: A LOOK AT FREDDIE MAC
by Mafruza Khan
In December 2003 Freddie Mac, the federally chartered mortgage financing giant, agreed to pay a civil penalty of $125 million and implement measures to correct its accounting and governance problems as part of a consent order with a federal regulator. The company is currently facing a criminal investigation by the Justice Department and a civil inquiry by the Securities and Exchange Commission. When the company's problems imploded earlier in the year, the McLean, Virginia-based firm declared that its accounting errors were different from those plaguing corporate America these days. Rather than inflating its earnings, the company had understated its profits. But when the company restated its financial statements last November, it disclosed that its cumulative earnings for the years 2000-2002 were higher than what it had reported originally, and it had inflated its earnings for 2001 by nearly $1 billion. According to Standard & Poor's, "news of the one year of inflated earnings adversely changes the character of the accounting controversy because it reflects an even more volatile true earnings profile."
It is not possible to ascertain if its reported earnings before 2000 are correct because securities rules stipulate that when a company restates its earnings it has to go back only three years. Freddie Mac's accounting problems were different from those at scandal-ridden companies such as Enron and WorldCom because it was not a case of outright looting of the company by its executives. Nevertheless, they did break the law and their activities constituted a fundamental breach of business ethics. The company said that it had manipulated its earnings to meet Wall Street's desired objective of steady earnings growth. To that end, it succeeded in doing so and in keeping its stock prices high, it has not hurt investors thus far. But as one of the four largest financial institutions in the U.S., its financial problems could create a "systemic risk" - the risk that a problem in one area, in this case the housing market, could spread and have serious adverse effects on the economy as a whole.
Also at issue are oversight and regulation. The companies accounting misdeeds were revealed just days after the federal regulator responsible for its financial oversight gave it a clean bill of health. In addition, it has not met its specific public interest mission, which is to enhance opportunities for home ownership and affordable rental housing for low-income and minority populations.
WHO IS FREDDIE?
Originally known as the Federal Home Loan Mortgage Corporation, Freddie Mac was chartered by Congress in 1970 as a private company with a public mission to stabilize the nation's mortgage markets and widen opportunities for home ownership and affordable rental housing. Freddie Mac (and its sister institution Fannie Mae) was set up based on the idea that neither government nor private banking interests could address the nation's housing finance needs. The company's charter established a board comprising 18 members - thirteen elected by shareholders and five appointed by the President of the United States.
Freddie Mac is a Government-Sponsored Enterprise (GSE), that is, a business entity that has a distinct relationship with the government. GSEs usually enjoy special perks and privileges that other businesses do not receive. Freddie Mac, for example, is exempt from state and local taxes. Neither is it subject to standard disclosure rules imposed on other financial institutions. It is rated by credit rating agencies such as Moody's. GSEs such as Freddie Mac are among the world's largest securities issuers.
Freddie Mac is one of the biggest buyers of home mortgages in the U.S and is a publicly traded company. It buys mortgages from mortgage lenders, such as commercial banks and other financial institutions, repackages them as (mortgage-backed and debt) securities, which are then purchased by investors. Mortgage-backed securities are more liquid than individual mortgages. Institutions like Freddie Mac make their profits from the difference between the cost of its debts and the return on its mortgage holdings. Their role is to serve as a secondary market conduit between mortgage lenders and investors. Mortgage lenders use the proceeds from selling loans to Freddie Mac to fund new mortgages. In this way, Freddie Mac replenishes and increases the supply of funds available for homebuyers and apartment owners from mortgage lenders. About fifty percent of all new single-family home mortgages today are sold to secondary market conduits.
INTENDED GOALS AND ACTUAL OUTCOMES:
THE FEDERAL RESERVE BOARD STUDY
A December 2003 report by the Federal Reserve Board finds that Freddie like Fannie benefits from its government connection far more than homeowners do. In addition to being exempt from state and local taxes and a credit line of $2.25 billion from the federal government (the Treasury Department is authorized by Congress to buy $2.25 billion of its securities in case of a default), the Congressional Budget Office estimates that Freddie's federal subsidies are valued at more than $10 billion. Rather than boosting homeownership, the federal subsidies help the company's shareholders because it increases the company's earnings.
The implicit guarantee of its credit line from the federal government allows it to borrow at interest rates by about half a percentage point lower than comparable borrowers. By comparison, the average mortgage rate is reduced by less than a tenth of a percentage point. This amounts to a savings of $87 a year for a typical homeowner. The company's net income for 2002 was $10.1 billion (data for 2003 is not available). Former CEO and Chairman Leland Brendsel was awarded a cash bonus of $2.1 million, in addition to his salary of $1.1 million before being ousted last year. Bonuses for Top executives for 2001, the year the company inflated its profits, were based on corporate performance.
The Federal Reserve study also says that the complex accounting methods used by the company are hard to understand. Such questionable methods are a risk for taxpayers who would be expected to bail out the firm with its billions of dollars in loans and debts if it had financial problems.
A company spokesman called the study "an interesting but fundamentally flawed academic exercise," while a senior vice president said that the findings were "highly theoretical and bear no resemblance to the reality experienced in the housing industry and capital markets every day."
(LACK OF) CARE FOR FREDDIE: OVERSIGHT AND REGULATION
The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 created Freddie Mac's regulatory oversight structure related to two functions - its housing mission and its overall viability ("safety and soundness"). Its housing mission is overseen by the U.S Department of Housing and Urban Development (HUD), which also sets its affordable housing goals. Safety and soundness is regulated by the Office of Federal Housing Enterprise Oversight (OFHEO), which is located within HUD but operates independently.
As part of its housing mission, Freddie Mac is required to make 50 percent of its loans for affordable housing - 30 percent for underserved rural or urban areas and 20 percent for low-income families. But for years HUD has allowed it to invest primarily in the more profitable business of middle class home mortgages and shortchange its stated affordable housing goals. HUD is expected to complete a draft of regulations that would expand the organization's affordable housing goals later this month.
Following its accounting and disclosure problems, the OFHEO has come under fire for failing to monitor Freddie adequately. Assistant Treasury Secretary Wayne Abernathy has called it a "crippled agency." The Bush Administration and Congress have been debating for months about how best to regulate the company. The Administration has proposed creating a new regulatory body under the Treasury Department. But Democratic senators charge that the company's accounting problems are being used to curtail its mission and take away HUD's oversight. Such fears don't seem unfounded. In a recent speech, Gregory Mankiw, chairman of the President's Council of Economic Advisors reportedly said, "All indications are that if the housing GSEs were to lose some of their implicit subsidy, private financial institutions would eagerly step in."
Conservative think tanks like the American Enterprise Institute have been promoting full privatization as the solution for Freddie Mac's problems. As one AEI fellow has said, "The only effective way to protect the economy and the taxpayers is to separate the GSEs from the government - to privatize them fully by cutting their government links and their special privileges." The conservative analysis is that it is not possible for a single company like Freddie Mac to serve a dual mission of maximizing profits for shareholders and providing affordable housing for underserved communities. As a fully privatized entity its only goal would be to meet its obligations to its shareholder.
The conservatives say that if affordable housing is a desirable goal it should be pursued by a government agency. The only compromise they will consider is one in which Freddie Mac contributes a relatively small percentage of its profits to affordable housing in place of the current requirement of allocating 50 percent of its loans. A coalition of private mortgage lending institutions, FM Watch, whose members include J.P. Morgan Chase and Bank of America, have also been rallying for further privatization of the GSEs.
In December the OFHEO issued a report that provided details about the company's inappropriate conduct and improper management of earnings. The agency's actions against the company have included freezing the compensation packages of former and present executives, ousting the former CEO and the general counsel, imposing a civil money penalty on the former vice chairman and starting the process of terminating the former CEO and the CFO for cause.
IN THE PUBLIC EYE - FREDDIE'S RESPONSE
So far, the company's response to its critics seems to be pumped-up public relations efforts.
According to Political Money Line, a group that tracks federal lobbying expenditures, Freddie Mac was one of the Top 10 spenders among all companies in 2003. It was the first financial firm in many years to rank as one of the Top ten. According to a company spokesperson, "The large increase (you saw) in 2003 was due to the need to communicate and inform Congress of the very complex issues related to the earnings restatement. In the early years, we had very low lobbying expenses compared to similar companies of our size." The company gave $2.3 million to Republicans and $1.7 million to Democrats in soft money contributions during the 2002 election cycle.
According to the company's website, its board of directors created a governance committee in 2002 to address corporate governance matters, including development of corporate governance guidelines. It has also said that it intends to separate the positions of Chairman and CEO by 2006. In November 2003, following its accounting scandals, it announced that it had retained the services of Professor Charles Elson, a recognized expert in the field, "to strengthen the company's corporate governance practices, policies, and guidelines."
THE RESPONSE FROM CONGRESS
Congress for the most part is sidestepping the privatization issue and focusing on oversight and regulation as the way to set Freddie Mac back on track. There is broad agreement that oversight should be removed from the OFHEO and that regulatory independence should be established. Proposals include creating a new regulatory agency with a three-member board. One would be responsible for ensuring the organization's safety and soundness; another would monitor compliance with its congressional mandates to promote affordable housing, while a chairman would oversee both issues. Some favor one official from HUD and one from Treasury, with an independent chairman.
Attempts to pass legislation on GSE regulation failed last fall because of the Treasury Department's insistence on playing a lead role as a GSE regulatory agency and gaining new product (i.e., new types of securities) approval authority.
CONCLUSION
It is clear that oversight of the company was completely inadequate at all levels. The OFHEO failed in its responsibility to ensure its safety and soundness. HUD allowed it to stray from its fundamental mission of expanding home ownership and affordable housing. The company's board, as the OFHEO report points out, was complacent and failed to exercise adequate oversight.
But that does not justify calls for privatization of Freddie Mac and elimination of its core public mission of providing affordable housing for low-income and minority populations. Current proposals to create a more effective and independent regulatory agency could work if they don't become a victim of inter-agency battles. GSEs like Freddie Mac should have the same disclosure rules that apply to other financial institutions. When oversight of an institution as important as Freddie Mac falls on one of the smallest federal regulatory agencies, the public has reasons to be worried. At the same time, the company needs to do more than just step up it political lobbying expenditures and fulfill its obligation of expanding opportunities for home ownership and affordable rental housing.