"As the American Dream Grows, So Do We," asserts a recent
advertising slogan of Fannie Mae, America's leading buyer and seller
of home mortgages. Fannie and her smaller sibling, Freddie Mac, buy
mortgages from lenders and resell them at a profit. These transactions
provide the mortgage market with the liquidity that made it possible
for 43 million low and middle income families to become homeowners.
Congress sponsored Fannie and Freddie in 1938 and 1970, respectively,
as buyers for home mortgages. Together, they issued close to $3,000,000,
000,000 (i.e., 3 trillion) in debt and produced $80 billion in annual
revenues. Shareholder-owned Fannie and Freddie have long annoyed their
private competitors because the two get better terms when they borrow,
due to an implicit government guarantee that they would be bailed out
if they failed. Both are also exempt from federal and state taxes and
have a $2.25 billion line of government credit.
Freddie Mac should be able to share Fannie's pride in helping America
grow but an embarrassing accounting scandal is tarnishing its hitherto
relatively unblemished image. After Freddie had fired its scandal-ridden
auditing firm, Arthur Anderson, its new auditor, PricewaterhouseCoopers,
questioned the propriety of the company's accounting for its complex
trading in futures, also called derivatives trading. Since the Feds'
disclosure requirements for Fannie and Freddie are insufficient, investors
could not possibly know what went wrong.
Freddie's board became concerned when three years of financial results
had to be restated and still remained uncertain. Chairman Leland Brendsel,
moreover, failed to cooperate with an internal investigation and admitted
that he had altered and removed pages from a notebook that contained
handwritten observations made at company meetings.
Under pressure, Brendsel quickly retired, while CEO David Glenn was
dismissed, and CFO Vaughn Clarke resigned. That prompted Federal prosecutors
to begin investigating Freddie's operations for criminal wrongdoing.
As yet, nobody has been indicted, but the public at long last learned
more about the shenanigans possible in insufficiently transparent financial
institutions.
Because Chairman Brendsel retired, he was entitled to collect stock
options and shares worth $21.1 million, $3.2 million in salary and bonus
pay over the next two years, as well as health insurance and life insurance
for the next five years. Since CEO Glenn was fired, he cannot collect
all of his options and shares but will keep over $6 million. We don't
know CFO Clarke's compensation package because, for whatever reason,
the Feds require Freddie to disclose only the compensation of the five
highest-paid employees.
In their eagerness to produce bigger profits, Freddie's executives traded
billions of dollars in highly volatiles derivatives, an unnecessary
practice that put large amounts of mortgage funds in jeopardy. Warren
Buffet, the successful Chairman of Berkshire Hathaway, also known as
'the Oracle of Omaha', has characterized derivatives as "ticking
time bombs" and "financial weapons of mass destruction."
In the week after Freddie's three top executives left, the company's
shareholders lost a stunning $6.5 billion. Yet, neither the Securities
and Exchange Commission, nor the Attorney General, nor the obscure Office
of Federal Housing Enterprise Oversight have so far helped investors
find out how much damage the alleged irregularities caused. Why Congress
allows these two semi-governmental businesses to make political campaign
contributions is another mystery.
Since 1990, Fannie's and Freddie's managements have endeared themselves
to their political friends with $ 8.4 million in gifts. The recipients
of those favors will not be easily persuaded to tighten the rules under
which the two companies are supposed to operate. Yet, as a Wall Street
newsletter suggested, Freddie in particular "ought to be given
less rope to hang itself and others."
To mollify the millions of Americans in the mortgage market, Freddie
Mac announced that the revisions of its accounting for the last three
years will probably show a large understatement of earnings, and that
"cumulative increases related to the account will have offsetting
effects in future periods." Since this implies lower earnings expectations,
I would advise you, dear reader, to stay away from investing in Freddie
Mac, at least for now.