Freddie Mac continues to be put through the wringer after a high-profile accounting scandal forced the company to restate earnings for the last three years and led to the ousting of three top-level executives.

Most recently, the House Subcommittee on Capital Markets, chaired by Rep. Richard Baker (R-La.), has entered the fray as it met on Capitol Hill last week to discuss increased regulation for the nation's second-largest mortgage financier. Baker, a longtime critic of Fannie Mae and Freddie Mac, introduced a bill that would revamp oversight of the two government-sponsored companies, which together make up 40% of the U.S. home mortgage market.

Under the terms of the proposed legislation, the government would abolish their current regulator, the Office of Federal Housing Enterprise Oversight, and transfer supervision duties to the Office of Thrift Supervision, which would then be renamed the Office of Housing Finance Supervision. "The OFHEO has been somewhat toothless, historically," said Chris Neuharth, who manages fixed-income at U.S. Bancorp Piper Jaffray.

"These housing GSEs [government-sponsored enterprises] are too important and have too great a role in financial markets for Congress not to make sure adequate and effective oversight is in place to protect investors, homebuyers and taxpayers from missteps like this ever happening again," Baker said in a statement.

The move comes on the heels of an internal investigation of the company's books that revealed back in January irregularities tied to its employment of derivative contracts. Last Thursday, Freddie Mac indicated that it would restate earnings for the past three years $1.5 billion to $4.5 billion, which will hurt future earnings. Freddie Mac previously said that it posted a net profit of $5.8 billion in 2002 and $4.2 billion in 2001.

Earlier this month, the McLean, Va.-based company fired its President David Glenn for not being forthcoming enough in his cooperation with the board's audit committee. Not so coincidentally, the company announced the resignations of Chief Executive Officer Leland Brendsel and CFO Vaughn Clarke. The company's stock responded negatively as expected, plummeting nearly 16% on the day of the announcement. The shakeup in management prompted regulators to launch a formal investigation into the way Freddie conducts derivative accounting. The company's newly appointed CEO, Greg Parseghian, has maintained that no crimes have been committed at the firm. Otherwise, the company has been pretty tightlipped regarding the restatements

"You have to view this as tempering their balance sheet growth a little bit," Neuharth said. "It might manifest itself in just a little less demand for mortgage-backed securities, at least in the short run."

Investors are considerably rankled by the timing of the adjustment and lack of transparency after enduring a series of egregious scandals that include the collapse of Enron and WorldCom.

Selling Out

While the issue is definitely a cause for concern, some in the investment community say the issue is being blown out of proportion. The response to the news from the mutual fund industry was a "knee-jerk reaction," according to Fred Siegel, author of Investing for Cowards and president of The Siegel Group, a New Orleans, La., investment advisory firm with $1.2 billion under management. "Clearly, there was selling on part of their portfolios," he said. "I don't think anyone got rid of all their shares, but they pared them down a bit"

He called it a conditioned response of sorts in that potential accounting impropriety at any company right now will trigger a "sell first, ask questions later" mentality. Indeed, although the stock plunged 16% in the first trading day following the announcement, Siegel believes that was an overreaction by the market because most of the company's audit is already complete and it has not made any other restatements. In fact, the stock was down only 4% at deadline since the news broke, opening at $48.47 last Wednesday.

The difference between this accounting blunder and previous ones is that the board of directors took the initiative in cleaning up its mess, Siegel said. That shows at least some good faith that the company is serious about keeping its books clean, he said.

Furthermore, the company is adjusting its earnings to reflect higher earnings as opposed to most instances where companies inflate their profits. Siegel believes that when the dust finally settles, it will not be as big of a deal as the headlines have portrayed. He does think that the oversight board "dropped the ball" but says that this is a very unique and complex situation.

Freddie Mac is publicly held but has a mandate from Congress to allow as many people as possible to own homes. The government backs the mortgages, so if a person doesn't pay them, Freddie can foreclose on the house. Both Fannie and Freddie are vital cogs as far as the housing industry is concerned because there is a lot of money being circulated that banks don't mind lending. If they lend it according to the rules governing Freddie Mac, they can sell it to the government and get their money. Essentially, they are no-risk loans for the bank. Siegel currently has no positions in the stock but admitted that he will be monitoring it closely. "Right now is a good time to buy Freddie Mac," he said. "I think the stock is oversold."

Ed Walczak, manager of the Varnoble US Value Fund and an adherent to Warren Buffett's investment philosophy, was much more demonstrative in his endorsement of Freddie, saying he has been adding shares to his portfolio since news of the shakeup hit the Street.

"We haven't backed off on Freddie. In fact, we've increased our exposure," he said. Both Freddie and Fannie are among his top holdings, with each accounting for 7.5% of total assets under management. And once his clients were done purchasing, he bought some shares for himself.

"There's been an amazing amount of superficial, hyperbolic reporting in the press," Walczak said, referring to accusations that Freddie Mac was trying to smooth its quarterly earnings or classify interest rate bets as hedges. Due to the complexity of derivatives, it remains unclear what exactly went wrong at Freddie. "We only have 85% of the facts," he added.

In terms of regulatory action, Walczak said he would be very surprised to see anything onerous or detrimental to Freddie shareholders come to pass. Still, he said that it's possible that the two mortgage financiers could get a new regulator. As an equity holder, he wouldn't object to having a stronger regulator. "Let them take off their underpants and stand nude before the world," he said.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.