Impact of fiscal shakeup at mortgage-finance firm

Removal of officials at Freddie Mac unnerves financial markets, homeowners.

When Congress sought to end accounting irregularities, few thought that the spotlight might fall on a company that was chartered by Congress itself and provides a service that touches millions of Americans.

But, now the klieg lights are on Freddie Mac, which purchases mortgages from home lenders so they can make new loans. On Monday, the company released its top three officials after questions arose over its earnings statements for the past two years. Congressmen are calling for hearings. And the financial markets are hoping the mess gets straightened out soon because many financial institutions own billions of dollars in stock and debt issued by Freddie Mac.

"This is not a pretty or welcome sight," says Marilyn Cohen, president of Envision Capital Management, a Los Angeles bond manager. "We thought we were at the tail end of the accounting shenanigans and corporate malfeasance."

If any of the charges turn out to be true, it will be even more surprising because Freddie Mac is considered a conservative and well-run company that does not cut corners. "I am incredulous," says Larry Platt, a mortgage banking partner at Kirkpatrick & Lockhart, a Washington law firm.

The hubbub comes at a time when the housing industry is one of the few bright spots of US economy. Low interest rates have prompted millions of Americans to either buy houses or refinance their current homes. And, Freddie Mac and Fannie Mae - which together guarantee or supply about one-third of all mortgages - have been big players in that growth. Freddie Mac, with $722 billion in assets, is now the nation's fourth largest financial institution. "They are a pillar of the housing market," says Scott Jacobson, director of research at Jefferies & Co., an investment bank.

SO FAR, the turmoil has not had any immediate impact on consumers' ability to finance mortgages.

Even before the latest headlines, the company and Fannie Mae - which helps low and moderate income home buyers - were under scrutiny by Congress. "Over the last few years there has been a debate over whether their obligations are backed by the full faith and credit of the United States," says Mr. Jacobson.

Some in Congress have also been after the company to register their mortgage securities with the Securities and Exchange Commission. Rep. Christopher Shays (R) of Connecticut and Rep. Edward Markey (D) of Massachusetts sponsored a bill in May that would require such quasi-public companies to register with the SEC and comply with the nation's securities laws. On Monday, the two representatives said this incident proved their bill was needed.

The Office of Federal Housing Enterprise Oversight (FHEO), which oversees Freddie Mac and its kin, has appointed special investigators to review Freddie Mac's accounting. According to published reports, the special audit team are citing "employee misconduct" and "management misjudgments." One issue was the refusal of the former president David Glenn to turn over a diary that includes notes from recent meetings.

"I guess the real questions are how long have they known about these problems and what took so long to do the house cleaning," says Ms. Cohen.

Jacobson says that accounting is extremely complex and includes lots of assumptions. For example, many mortgages are for 30-year terms. But, because interest rates change, individuals often prepay their mortgages and refinance with a lower rate.

To try to protect themselves from such uncertainty, many financial institutions turn to something called "derivatives." These are securities whose prices are based on another underlying investment, such as futures and options.

"I imagine that many of the assets and liabilities on the balance sheet are intangibles, such as derivatives that are very hard to value," says Mr. Platt. "Reasonable people can differ and what some might call misdeeds, others might call incorrect assumptions and that is what the review process is all about."

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