Freddie Mac Ousts Top Officials As Regulators Prepare Inquiries

Freddie Mac, one of the nation's two huge government-sponsored mortgage-finance companies, shoved aside three of its top executives, questioned the "cooperation and candor" of its chief operating officer and reiterated plans to restate three years' worth of financial results.

The surprising developments prompted investors to sell Freddie Mac debt and purchase U.S. Treasury bonds. It also fanned the embers of a controversy over how adequately Freddie Mac and its sibling, Fannie Mae, are regulated. The market impact was muted, however, in part because Freddie said the restatement would make its profits and capital bigger than previously reported, not smaller.

Still, the moves raise questions about Freddie's ability to continue to fuel the rapid growth of the mortgage-finance market, which has been an important force in keeping the housing market strong during an otherwise weak economy.

Freddie Mac said Monday that its board asked its longtime chairman and chief executive, Leland Brendsel, 61 years old, to step aside. The president and chief operating officer, David Glenn, 60, was fired outright, and Chief Financial Officer Vaughn Clarke, 48, was pressured to resign.

Monday's action was a clear sign that the board has lost faith in Mr. Brendsel's ability to manage a company that has become so large and complex that it may need a new, more sophisticated generation of managers to steer it into the future. It is the nation's fourth-largest financial company, with assets of $722 billion at the end of 2002.

Freddie Mac and Fannie Mae are in the business of funding mortgages for home buyers. The two financial giants purchase home mortgages, thereby freeing lenders to make new home loans. The increasingly complex business compels the companies to use a bewildering array of derivatives and other hedging instruments to manage the immense risk that goes along with building up massive mortgage portfolios.

The company's regulator, the Office of Federal Housing Enterprise Oversight, said it has appointed a special investigative team to review Freddie Mac's accounting, citing "management misjudgments" and "employee misconduct." Separately, the Securities and Exchange Commission is also looking into Freddie Mac's accounting to see whether the company violated any securities laws, according to people familiar with the matter.

After more than a decade of torrid growth, Freddie Mac and Fannie Mae between them own or guarantee more than a third of all U.S. residential mortgages. They are credited with helping make mortgages affordable and available regardless of local financial conditions, in contrast to when savings and loan institutions dominated. But this means the mortgage market is more vulnerable to anything that raises Freddie's or Fannie's borrowing costs or impairs their ability to purchase mortgages.

If the new disclosures fray investor confidence and eventually impair Freddie's ability to borrow at a reasonable cost, that could undermine the mortgage and housing markets, which have underpinned what little growth the economy now enjoys.

Federal Reserve officials including Chairman Alan Greenspan have long worried that investors may be complacent about the risk of owning Fannie Mae and Freddie Mac securities because they assume the federal government won't let them fail. A related concern is that some shock might impair their ability to fund their huge operations and that any problem at one could ricochet through the markets via their extensive trading relationships with Wall Street.

Federal Reserve Bank of St. Louis President William Poole warned in a speech earlier this year that the agencies were vulnerable to an unexpected shock, adding that "the enormous scale of liabilities could create a massive problem in the credit markets" if one of them fell under a cloud. "A corporate-governance issue would not have been widely predicted," St. Louis Fed research director Robert Rasche noted Monday.

Monday, Treasury bonds rose and their yields fell as investors, rattled by Freddie's disclosures, sought safety (see article¹). The spread between yields on bonds issued by Freddie and those on Treasurys widened by about six hundredths of a percentage. The Treasurys-Fannie Mae spread also widened but not as much. However, other than the stock price, there was no sign of serious selling. Freddie successfully issued some short-term paper.

One issue the SEC is investigating is whether Freddie Mac, which first announced plans to restate some past earnings in January, deferred gains to future quarters in a bid to keep its revenue and earnings growth steady, people familiar with the matter said. Such a maneuver, sometimes known as "cookie jar" accounting, has been used by companies that are experiencing strong earnings but want to defer gains to a later date, when earnings may be weak. The SEC has been trying to crack down on companies that use such techniques. It settled cases with Microsoft Corp. and Xerox Corp., which were accused of setting up improper reserves.

Freddie Mac officials have said they weren't trying to smooth out earnings and that they believed they were following generally accepted accounting practices at the time.

In one sign that the board doesn't believe the accounting problems run deep, it moved swiftly to tap internal candidates to replace the departing executives. The board chose Gregory J. Parseghian, 42, formerly the company's chief investment officer, who was extremely popular on Wall Street, as the company's new chief executive officer and president. For chief operating officer, it tapped Paul T. Peterson, 53, who previously headed the company's single-family-housing division. The new chief financial officer is Martin F. Baumann, 55, previously an executive vice president for finance.

Tensions within the company began building earlier this year, when it announced that it would be restating its earnings for 2000, 2001 and 2002 after its new accountant, PricewaterhouseCoopers, raised questions about how the company and its previous accountant, Arthur Andersen, had handled accounting for some hedging transactions. Although Freddie Mac officials assured investors that the restatements would actually boost earnings, the restatement, which focused on complex issues related to the way the company classified some hedges and assets, was a major public embarrassment for the company. It also seriously upset board members, who were angered that the company would run into problems at a time of intense scrutiny of corporate-governance standards.

Matters grew more tense last Thursday, when the board gathered at Freddie Mac's McLean, Va., headquarters for two days of regularly scheduled quarterly meetings. During those meetings, a committee set up by the board to investigate the earnings restatement reported that Mr. Glenn had failed to cooperate fully with a request to hand over diaries he had compiled during recent meetings. According to company officials, Mr. Glenn had long had a practice of taking notes during meetings, in some cases adding details about why particular decisions were made. But when he handed over the notes, some had been altered and some pages were missing, the company said.

Company officials said they are unsure what the missing material included, but they added that the notes didn't include actual financial records. As a result, they said they don't believe that the missing notes pointed to additional, as-yet-undiscovered accounting problems. The officials said they were unsure why Mr. Glenn didn't fully cooperate. Freddie Mac didn't make any of the departed executives available for comment.

Even so, the board's displeasure over Mr. Glenn's failure to cooperate was so great that it unanimously decided to move forward with previously discussed plans to make changes in the company's senior management, according to board Chairman Shaun F. O'Malley. "The board was very upset" by the problems with Mr. Glenn, Mr. O'Malley said. "It felt it had to act decisively to enable the company to move ahead."

While the market was nervously digesting the news, Standard & Poor's Ratings Service reaffirmed Freddie Mac's ratings, casting doubt on critics who hinted at deeper problems for Freddie Mac. "Based on discussions with Freddie Mac, the reaudit will still result in material upward revisions of operating earnings and capital," said S&P analyst Victoria Wagner.

Indeed, the controversy may pass with no sustained impact on Freddie or the mortgage market, much as happened when Fannie roiled the market last fall by disclosing a sizable mismatch between its assets and liabilities. Indeed, even after widening Monday, the spread between yields on Freddie Mac bonds and Treasurys is still relatively narrow.

Nonetheless, the latest disclosures at Freddie Mac could lead lawmakers to consider legislative changes that previously would have been unthinkable because of Freddie Mac's and Fannie Mae's sizable political clout.

One idea would require fuller public disclosure of their finances. Unlike other publicly traded companies, Freddie and Fannie aren't required by law to comply with all SEC disclosure rules. Under pressure from critics, they've recently agreed to file annual reports and register their shares. But they continue to resist formal registration of the mortgage-backed securities that are their financial bread-and-butter.

Rep. Edward J. Markey, a Massachusetts Democrat who has co-sponsored legislation to require such disclosure, Monday demanded an immediate investigation as well as hearings by a House subcommittee.

Another idea that could pick up steam would be to beef up the regulation of such government-sponsored enterprises, perhaps by moving OFHEO into the Treasury Department from the Department of Housing and Urban Development -- an idea some Treasury officials have sympathized with in the past, though it isn't official policy. Treasury was told of Freddie's moves over the weekend and is monitoring developments, but has no other comment, an official there said.

Although OFHEO has taken steps to strengthen its oversight of Fannie and Freddie in recent years, it has long been the butt of jokes in Washington, where critics view the agency as underfunded and lacking the will to crack down on either of the two companies. Indeed, the decade-old agency didn't take its first regulatory action against Fannie or Freddie until last year, and it didn't know about the latest issues with Mr. Glenn until it was informed of them by the company.

An OFHEO spokeswoman said its staff has been "intimately involved" in the continuing restatement process since January.

Freddie Mac has endured heavy criticism in recent years as it, like Fannie Mae, grew rapidly and took on more risk. Mr. Brendsel was widely credited on Wall Street with helping engineer that rapid growth, which propelled Freddie Mac from a sleepy company with less than $10 billion in assets in the early 1980s into a financial powerhouse with more than $700 billion in assets today. Along the way, its portfolio of mortgages swelled to $583 billion at the end of last year from $22 billion in 1990.

The announcement Monday was all the more surprising given that investors have long believed Freddie Mac was the more conservatively managed of the two government-sponsored mortgage companies, and the one least prone to surprising revelations or risk issues. Indeed, investors have historically paid more attention to Fannie Mae, in part because it operates with a higher profile in Washington.

The latest problems revolved around two seemingly innocuous -- and somewhat arcane -- steps the company took while working with its previous auditor, Arthur Andersen. In one case, the company treated a certain hedging transaction as if it were a derivative, which is a financial contract derived from an underlying security, commodity, interest rate or currency; it later determined it shouldn't have done so. In the other case, the company "reclassified" some assets as "available for sale," which it also later found to be incorrect.

Because of the way accounting rules are written, the net effect of both moves was to allow the company to book certain gains in the future rather than all at once, which reduced the company's reported earnings in the short run.

Fannie Mae said it doesn't have any similar accounting issues. Spokesman Chuck Greener suggested that Fannie doesn't require additional oversight because it recently began filing quarterly statements with the SEC.

The SEC is also probing Freddie Mac to see whether Messrs. Brendsel and Clarke violated a provision of the Sarbanes-Oxley law that requires executives to certify that their financial statements are true, according to people familiar with the matter. Last August, Messrs. Brendsel and Clarke filed a signed certification with the SEC attesting to the accuracy of Freddie Mac's financial statements. Under Sarbanes-Oxley, the SEC could bring civil charges against the executives if those financial statements weren't accurate.

A spokesman for the SEC declined to comment.

In a letter to Freddie Mac, OFHEO director Armando Falcon also demanded an explanation of the board's termination packages for the three executives, "in light of the circumstances surrounding their departure." The regulator asserts that any termination packages are subject to its approval.

Some experts said they doubt that OFHEO has much real authority to overturn compensation arrangements. But in a telephone interview, Mr. Falcon insisted that the regulator has clear powers to block excessive termination payments. "Whatever they're leaving with we have to approve," he said.

By one measure, Mr. Brendsel was the most highly compensated of all mortgage executives in the U.S. in 2001, the latest year available, according to information compiled by Inside Mortgage Finance. Mr. Brendsel made $8.3 million in total compensation, including $1.13 million in base salary -- also the highest among top mortgage executives -- as well as $2.1 million in bonuses and $4.7 million in restricted stock awards. Mr. Glenn made $5.3 million in total compensation in 2002, including an $850,000 base salary.

By comparison, Franklin Raines, chairman of the larger Fannie Mae Corp., got $6.9 million in total compensation, including a $992,000 base salary. Washington Mutual CEO Kerry Killinger got $6.41 million in total compensation, including $1 million in base pay. If stock options are included, however, several of those executives were better compensated than Mr. Brendsel, including Mr. Raines.

Because its recent public disclosures have been delayed due to the accounting flap, Freddie Mac hasn't disclosed more recent compensation details, including any special severance packages. Monday, officials provided few details, except to say that Mr. Glenn would receive health and retirement benefits, but no severance package. Mr. Brendsel would receive benefits provided by his contract, but also would receive no severance, the spokesman added. But he said that "should not be taken negatively" in Mr. Brendsel's case. Freddie Mac wouldn't comment at all on Mr. Clarke's situation.

Write to Patrick Barta at patrick.barta@wsj.com⁶, Greg Ip at greg.ip@wsj.com⁷ and John D. McKinnon at john.mckinnon@wsj.com⁸

Updated June 10, 2003 9:17 a.m.