FREDDIE MAC SCANDAL (2003)

NATIONAL UNIVERSITY
Sampaloc, Manila

College of Business and Accountancy

FREDDIE MAC SCANDAL (2003)

Submitted by:

Avellaneda, Neil Bryan V. (Team Leader)

Gangan, Glaiza Marie B.
Suarez, Angelica I.

Submitted to:

Prof. Avillardo V. Clarin

Date of Submission:

January 7, 2020

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I. EXECUTIVE/MANAGEMENT SUMMARY

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 was
created by Congress to make mortgages affordable and pump cash into the market by buying
blocks of home loans from lenders and bundling them into securities for sale to investors
worldwide.

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

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home mortgages today are sold to secondary market conduits.

But from 2000 to 2002, Freddie Mac understating their earning by around $5 billion
(refer to Appendix I). Some insider trading cases are revealed. For most of 2003, Freddie
Mac, one of the two government-sponsored enterprises (GSEs) that dominate the secondary
market for home mortgages, was embroiled in a controversy over improper accounting
methods. The company announced in January of that year that a major revision of past
financial statements was underway. The restatement was issued on November 21, 2003. Net
income for 2002 and earlier years was revised upward by $5.0 billion. Freddie Mac has
admitted that some of its accounting policies were selected in order to produce a steady
stream of earnings, and that numerous transactions were undertaken for the sole purpose of
“smoothing out”reported earnings.

Freddie Mac fined $50 million by the U.S. Securities and Exchange Commission.
Understating earnings effect the economy by misallocation of resources. Insider trading is
another consequence of understating earnings, which make the market thinks the company
has a lower income and seems uninteresting for the market. The insider taking advantage of
this false information illegally. Another consequence is the market may misestimate the risk
of the company. The four executives who conceived and executed this fraud were also
punished. Their fines ranged from $65,000 to $250,000. They paid out disgorgement amounts
that ranged from $29,227 to $150,000. They also paid $410 million to settle an investor
lawsuit. On November 6, 2007, former CEO Leland Brendsel settled charges by paying
a $2.5 million fine and returning $10.5 million in salary and bonuses to Freddie Mac.
In March 2007, the company resumed timely annual reporting by filing its 2006 annual
report. It expects to resume timely quarterly filings by the end of 2007 and, after that,
to register its stock with the Securities and Exchange Commission. In a lawsuit filed in
federal court in Washington, the SEC said Freddie Mac "engaged in a fraudulent scheme that
deceived investors about its true performance, profitability and growth trends.”

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II. STATEMENT OF THE PROBLEM

a. Misstating the financial statements to make future results be more attrective to investors,
deceiving investors about its true performance, profitability and growth trends, misreporting
its true income.

The basic factors underlying the accounting errors were “lack of sufficient
accounting expertise and internal control, and management weaknesses” Freddie Mac
understated its earnings by $5 Billion U.S. dollars in order to meet WallStreet desired
objectives of steady earnings growth. This misdeed came to light when Freddie Mac restated
its financial statement in November 2003, the company’s comulative earning for the years of
2000-2002 were higher than what it had been reported originally and that its earning for 2001
was inflated by nearly $1 Billion andfor 2000-2002 the earning is understated by $6 Billion.
The one year of inflated earnings adversely changes the character of accounting controversy
because it reflects an even more changeable true earnings profile that shows Freddie Mac has
really manipulated its earnings.

The intention of Freddie Mac is to hide their earning from their risky volatile investment.
Their main priority is to take care of the public interest, but what the have doing all the while,
is to cater their shareholders needs. The company’s accounting policies and publicdisclosure
shared the common purpose of reinforcing investor’s perceptions of the dependability and
quality of company’s earnings and earnings potential. The purpose for them thus is to
understate their earning to hide the results that they have earned from these investments so
that they could continue with these risky strategies, while still being able to portray their
“STEADY Freddie” image to the public.

b. Understating the financial statement by $5 Billion with the intent of decreasing the price of
the company in the stock market to benefit the top management by taking advantage of the
situation illegally (insider trading).

The top executives of the company having access and control to the confidential
informations could take advantage on this situation illegally. They who know the real
condition of the company could buy the company’s stocks as much as possible since the price
has been dropped to its lowest level. They do not have to be worried because they could put
the right report any time they want and then the price of the company’s stock will rise again.
This is usually called by insider trading and is a high level crime.
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III. ALTERNATIVE COURSES OF ACTION

Freddie Mac did the unlawful act was made possible due to the fact that the organization
is a Government Sponsored Entity (GSE) and this allowed Freddie Mac certain privileges
such as minimal disclosure, and accounting standards being regulated less regularly. The root
of Freddie Mac’s problem can be found in the Statement of the Financial Accounting
Standards (FAS) 133. The rules require companies to assign current market values to the
interest derivatives they hold and to reflect any changes in their value on their balance sheet.
Companies thus can offset any gains or losses on an asset with a similar loss or gain on the
derivatives used as a hedge. Precisely Freddie Mac took advantage of this loophole in hedge
accounting to amortize gain and thus smooth company earning, effectively boosting investor
confidence as well as to avoid unwanted attention from government regulators who might
point to volatility.

One of the core problems was Freddie Mac’s lack of attention to the staffing, skill set and
resources it set to its accounting policies. The policies were clearly weak or non-existent.
There were apparent deficiencies in internal controls, processes would provide reasonable
assurance and assist in compliance testing; such measure would have surely provided a
safeguard against error in financial reporting.

The regulator, OFHEO, is responsible to ensure the safe and sound operation of Freddie
Mac. OFHEO have a full range of supervisory and enforcement tools including examination
and prompt corrective actions suggesting that perhaps, they should have detected the
misstatement earlier. OFHEO should have a responsibility to properly plan, perform and
evaluate situation to have reasonable expectation of detecting discrepancies.

Also, what could have done to avoid this is to have a better internal controls and a team of
adequately organized board of directors, the accounting process can be better enhanced with
two groups of auditors, an internal one as well as an outsourced auditing firm. By doing so,
both group of auditors can verify the figures or the financial statements of Freddie Mac to
ensure the authenticity of the numbers. Also, it is imperative the Freddie Mac resolves the
constant conflicting of interest between prioritizing of maximizing profits for the
shareholders and fulfilling their mission of being a company with the aim to provide
affordable housing for the people.

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IV. 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

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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 its political lobbying expenditures and fulfill its obligation
of expanding opportunities for home ownership and affordable rental housing.

Freddie Mac did the unlawful act was made possible due to the fact that the
organization is a Government Sponsored Entity (GSE) and this allowed Freddie Mac certain
privileges such as minimal disclosure, and accounting standards being regulated less
regularly. The root of Freddie Mac’s problem can be found in the Statement of the Financial
Accounting Standards (FAS) 133. The rules require companies to assign current market
values to the interest derivatives they hold and to reflect any changes in their value on their
balance sheet. Companies thus can offset any gains or losses on an asset with a similar loss or
gain on the derivatives used as a hedge. Precisely Freddie Mac took advantage of this
loophole in hedge accounting to amortize gain and thus smooth company earning, effectively
boosting investor confidence as well as to avoid unwanted attention from government
regulators who might point to volatility.

The treasurer should be responsible for the treasury risk management. 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. Protection from interest rate risk is critical
to soundness of the GSEs, and it appears that strategies to avoid, or “hedge” risk were partly
responsible for Freddie’s recent accounting problem. The treasury staff can create risk
management strategies and implement hedging tactics to mitigate the company’s risk.

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It is essential to have a broad set of controls that help to make sure that transactions
are correct, given that the large amount of cash involved in many transactions. Anyone
concluding a deal never controls or accounts for the resulting cash flows if the duties are
segregated properly among the staffs of treasury department.

Treasury has the purpose of matching actual transactions against the company
procedures and policies. An adverse audit that often reports, leads to procedural changes that
keep same problems from arising in the future, even though these audits find problems only
after they have occurred.

To reduce accounting fraud, a firm penalty has to be done to each of the suspects that
have done this crime earlier as an example to other companies and their board that this kind
of crime is unacceptable in the economy and business. The four executives who involved in
the crime, was given punishment by paying a certain amount of money to the SEC. They are
former president and chief operating officer David Glenn, ex-chief financial officer Vaughn
Clarke, and former senior vice presidents Robert Dean and Nazir Dossani. David Glenn,
fined $ 250.000 in civil fine, and $ 150.000 in restitution. The ex-chief financial officer
Vaughn Clarke, fined $ 29.227. The former senior vice presidents Robert Dean, fined $
34.658 in restitution.

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V. REFERENCES

Glater, J.D. (2003, December 11). Market Place; Freddie Mac Gets Penalty and Rebuke
Over Scandal. Retrieved from www.nytimes.com

Khan, M. (2004, January). The Scandal in Home Mortgage Financing: A look at Freddie
Mac. Corporate Research E-Letter No. 43. Retrieved from www.corp-research.org

Edward, J. (2007). Freddie Mac’s Scandal and the SEC’s Judgment, Smart Pros.
Retrieved from http://accounting.smartpros.com/x59491.xml

Unknown Author. (2003). Freddie Mac Outlines Details of Earnings Manipulation,

Accounting Web. Retrieved from http://www.accountingweb.com/topic/freddie-
mac-outlines-details-earnings-manipulation

Unknown Author. (2012). Freddie Mac Fraud, Slide Share. Retrieved from
http://www.slideshare.net/acw007/freddie-mac-fraud

Jickling, M. (2007, November 7). Accounting and Management Problems at Freddie Mac.
Retrieved from
www.everycrsreport.com/files/20071107_RS21567_66a525b32d2ab5712ff40b4d
3c3e82ac0fa398e3.pdf

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VI. APPENDICES

APPENDIX I:
On November 21, 2003, the restatement of past accounting results was released, as
summarized in the table below. It is noteworthy that while the net effect of the restatement
was to increase reported earnings, restated net income for 2001 was almost $1 billion less
than originally reported. Freddie Mac notes that the restatement shows “significantly greater
volatility than previously reported.”

Table 1. Restated Financial Results for the Three Years Ended December 31, 2002

(in millions)

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