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 second-largest 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.”