-->Fannie, Freddie Feel the Heat
By Matthew Goldstein
Senior Writer
9/24/2004 1:59 PM EDT

Mortgage finance giants Freddie Mac (FRE:NYSE) and Fannie Mae (FNM:NYSE) keep throwing out red meat for their critics to devour like a pack of ravenous lions.

An accounting scandal has been swirling around Fannie's top brass following the release of a report criticizing its bookkeeping. But not to be left out, Freddie on Friday reminded investors that it has an accounting mess of its own to sort out yet.

Freddie, the nation's No. 2 mortgage buyer, on Friday slashed reported 2003 net income by $75 million in order to establish a legal reserve for litigation arising from last year's massive restatement. The reserve will likely cover the cost of settling a pending Securities and Exchange Commission investigation and numerous class actions that were filed in the wake of the accounting scandal at Freddie. Freddie's latest restatement reduces 2003 net income to $4.82 billion.

"We are subject to various legal proceedings, including regulatory investigations and administrative and civil litigation, arising from the restatement," Freddie said in its 2003 annual report."We believe that a loss in connection with the proceedings... is probable and currently estimate the range of minimum loss to be from $75 million to $100 million."

Those numbers would add to the $125 million Freddie has already paid to the Office of Federal Housing and Enterprise Oversight. The McLean, Va., company paid that fine to settle allegations it played games with derivatives accounting in a bid to manage earnings and smooth out quarter-to-quarter profit volatility. The company's restatement totaled $5 billion over a period of years.

Derivatives are sophisticated financial instruments that Fannie and Freddie rely on to hedge their exposure to interest rate fluctuations, which can wreak havoc on the value of their mortgage-related investments. The accounting treatment for derivatives is complicated. But regulators charge it can be abused by managers looking to delay the recognition of gains and losses in order to manage earnings.

This week, similar accounting tricks came to light at Fannie as OFEHO released the findings of an eight-month investigation into the bookkeeping at the nation's biggest mortgage buyer. The regulator alleges that Fannie engaged in the same kind of abusive earnings management as Freddie. The report sparked a fierce selloff in shares at both companies, emboldening their many critics and leading observers to predict a top-level management shake-up at Fannie.

On Friday, the selling in shares of both companies continued. In morning trading, Fannie was down $2.10, or 3%, to $65, while Freddie dropped 33 cents to $64.


Cliff Walk?
Rocky times for Fannie, Freddie



With the accounting crisis just beginning at Fannie, there's much speculation that OFEHO will move, just as it did at Freddie, to oust the firm's management. There's a sense on Wall Street that Franklin Raines' days may be numbered as Fannie chairman and chief executive.

Fueling speculation that Fannie's directors may turn on Raines, the board on Thursday amended top execs' contracts to make it easier to withhold compensation should they be fired for cause. The board took the action after OFEHO Director Armando Falcon sent a letter to the Fannie directors warning them he is prepared to take action if they don't move swiftly in addressing the problems his agency has uncovered.

But it's not just OFEHO that Fannie and Freddie have to worry about. The latest accounting revelations are breathing new life into calls on Capitol Hill for greater control over the financial firms, which were established by the federal government to spur home ownership by guaranteeing mortgages and making a secondary market for mortgage bonds.

The critics, contending the mortgage giants have taken on too much debt and risk, want the businesses reined in. Some also maintain OFEHO has proven itself an ineffective regulator, noting that it began to crack down on Fannie and Freddie only in the face of political pressure.
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