Freddie Mac: The Accounting Scandal

This article focuses on the Freddie Mac scam that took place in the year 2003. The article articulates the general description about Freddie Mac and further goes on to discuss the nuances of the fraud that took place in the company and shook its investors overnight.
Estimated Reading Time: 7 minutes

About Freddie Mac

The Federal Home Loan Mortgage Corporation, also known as Freddie Mac is a company which is headquartered in Virginia and is a public government sponsored company. The company was incorporated in the year 1970 to enhance the secondary market for mortgages in the U.S. The company was established with the aim to increase the home ownership and affordable rental housing. The board established through the company’s charter comprised of 18 directors out of which thirteen were elected by the shareholders whereas the rest of them were elected by the President of the country. These initiatives by the Government resulted in increased ownership in the country but it had repercussions too that overshadowed the benefits of such an arrangement. The company became one of the greatest securities issuers in the world.

Freddie Mac Scam is different from any other scam

The scandal that took place in this company is said to be different from other corporate scandals and frauds like Enron and WorldCom, as in the present case, the company’s top executives did not commit fraud or were involved in fraudulent activities. Notwithstanding this, the company still breached the laws and broke the business ethics which should be complied under all circumstances. The company also failed to meet its public objective that is to bestow the opportunities of owning their own houses and rental houses to people, at affordable and lower rates. The company stood as one of the four largest financial institutions and therefore it was anticipated that the company’s financial status would result into systemic problems for the country. The company’s accounting system was also seen as a defect and it was considered very complex to understand. Another major issue is that the company’s accounting misdeeds came to light days after it was granted a clean chit by the federal regulator who was responsible for its financial outlook.

Read about Enron Scam, the biggest scam in history of America

The GSE Status

The company has the status of Government Sponsored Enterprise (hereinafter referred as ‘GSE status’) which enabled it to be subjected to a lot of exemptions and benefits like the company did not have to pay local and state taxes. It also has distinct relationship and entity with that of government. The companies under this status are also not subject to standard disclosures that generally other financial institutions are. The company is the biggest mortgage country in the country and it buys mortgage from the commercial banks and financial institutions and convert it into securities which are further purchased by investors.[1] Such companies make profits through the difference obtained between mortgage holdings and cost of its debt. They act as secondary market conduit between the mortgage lenders and investors.

Goals and Actual Outcomes of the Company

The scandal came into light with the wake of Enron scandal which resulted in ousting of Arthur Anderson. The auditors then discovered that the company’s accounts have also been manipulated and therefore the whole issue came to light.The company intended to work for the benefits of public and render them housing and rental facilities but looking at the acts and functions of the company the image depicted is very distinct from its goals and agenda it was incorporated in the first place. A report by Federal Reserve Bank in December 2003 states that the company is far more benefitted than home owners or homebuyers. Freddie’s federal subsidies were valued at 10 billion dollars. These subsidiaries help the company to aid its shareholders financially instead of endowing benefits to the homebuyers as it increases the company’s earning as well. The salaries of the top executives of the company were though dependent on their corporate performances but they were usually paid well and further the report pointed out that the company had complex methods of accounting which is hard to understand.

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Working and Functioning of the Company

The company had majorly two functions i.e. its housing mission and its overall viability.[2] The housing mission in overlooked by the U.S. Department of Housing Land and Development (hereinafter referred as ‘HUD’) which is responsible for maintaining affordable prices of housing facilities. Further the other function is overlooked by the Office of Federal Housing Enterprise Oversight (hereinafter referred as ‘OFHEO’) which is a subordinate part of the HUD but generally operates independently. The Housing Mission dictates that the company shall provide 50 percent of loans for affordable housing, 30 percent of loans for undeserved rural and urban areas and the remaining 20 percent shall be provided for low-income families.But the company has failed to comply with this scheme and is for years had been engaged in providing loans to the middle class which was more profitable for the company and ignored the mission of providing affordable housing to people. Following such acts and work culture, the OFHEO issued a report which unveiled the company’s inappropriate management of earnings and improper conduct in doing business. The agency with intention to meet the goals of providing affordable housing has terminated the services of company’s CEO and other top executives. It further imposed a civil money penalty on the Vice chairman and other top executives of the company.

The Accounting Fraud

The company in the year 2003 disclosed the fact that for past 2-3 years viz. from 2000 to 2002 the company had overstated its profit by 5 billion dollars and they admitted that this was done to meet the expectations of Wall street. The major reason behind the accounting scandal was believed to be the lack of accounting expertise and internal control and smooth functioning of management.[3]Between 2000 to 2003 the company faced a major problem as the interest rates went low from around 8 percent to 5.2 percent. The company’s bond portfolio and derivative contracts which company brought for the purpose of hedging the risk of decreasing interest rates, went high. In accordance to the Generally Accepted Accounting Principles (hereinafter referred as ‘GAAP’) the gains in assets values shall be treated as current income which the company failed to do and which further resulted in levelling the results of decreasing interest rates. Furthermore, coming to the bond portfolio, the company mentioned it in the historical cost and therefore only the principle payment along with interest payment was material. This arrangement showed no change or fluctuations and was not mentioned under current earnings.

Followed Legal Actions Post Scandal

A law suit was filed by Securities Exchange Commission (hereinafter referred as ‘SEC’) which stated that the company had deceived the investors by not disclosing the true picture of the company and engaged in fraudulent activities which further deceived the investors about the actual performance of the company. The company had to pay an amount of 125 million dollars penalty in order to settle civil securities fraud charges imposed by federal regulators in an accounting lapse of four years.[4] Apart from this, the former top executives of the company viz. the President of the company, former chief financial officer, and two former senior vice presidents, settled negligent conduct charges by paying an amount of 515,000 dollars in civil fines.[5]It was further decided that the amount of penalty shall be utilized for the purpose of making good the loss incurred by shareholders.

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Steps Taken by the Company and the Government

After the accounting fraud was unfolded the company established a committee of Corporate Governance in order to make sure that the accounting standards and guidelines relating to corporate governance are necessary while undertaking business transactions. The company also further stated that it intends to separate the positions of CEO and chairman by 2006. Further, with the intention to strengthen company’s corporate governance policies, guidelines and practices, the company retained the services of Mr. Charles Elson.

The Parliament also took initiative to mark a change in the current law and policies. Parliament enacted two bills viz.H.R. 1427 and S. 1100 which proposed to amend the structure of GSE Regulations. The bills also replace OFHEO with an independent agency for the regulation of such financial institutions.

Conclusion

The article clearly showcases that the company failed to perform its functions at all the levels. Firstly, HUD let the company deviate from its actual mission of providing affordable housing to people and secondly, OFHEO failed to ensure that the safety and soundness of the company. The fact that the company was treated as “instrumentalities” of the federal government in the country along with some public listed companies played a major role in commission of such fraud. The companies shall now be brought at par with other financial institutions and publicly traded corporates. Also, steps shall be taken whereby they shall be made to give necessary disclosures of the transactions undertaken by them and this shall further bring more transparency in the system and shall lower the risk of happening of such an event in future. The company shall also be directed to provide information about the debts of the company and actual profits and losses of the companies. The article focused on the scandals in various aspects and the scandal depicts that it has become necessary to formulate a system which is transparent and accountable to the official bodies.

Read about Enron Scam, the biggest scam in history of America


[1]Mafruza Khan, The Scandal In Home Mortgage Financing: A Look At Freddie Mac,https://www.corp-research.org/e-letter/scandal-home-mortgage-financing

[2]Mafruza Khan, The Scandal In Home Mortgage Financing: A Look At Freddie Mac,https://www.corp-research.org/e-letter/scandal-home-mortgage-financing

[3] Mark Jickling, Accounting and Management Problems at Freddie Mac, CRS report for Congress, https://www.everycrsreport.com/files/20071107_RS21567_66a525b32d2ab5712ff40b4d3c3e82ac0fa398e3.pdf

[4] Freddie Mac settles accounting  fraud charges, NBC News, http://www.nbcnews.com/id/21027918/ns/business-us_business/t/freddie-mac-settles-accounting-fraud-charges/#.XSLU9egzbcc

[5]Freddie Mac settles accounting  fraud charges, NBC News, http://www.nbcnews.com/id/21027918/ns/business-us_business/t/freddie-mac-settles-accounting-fraud-charges/#.XSLU9egzbcc

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