Fannie, Freddie Feel the Heat

Mortgage finance giants Freddie Mac (FRE) and Fannie Mae (FNM) keep throwing out red meat for their critics to devour like a pack of ravenous lions.

An accounting scandal has been swirling around Fannie's top brass following the release of a report criticizing its bookkeeping. But not to be left out, Freddie on Friday reminded investors that it has an accounting mess of its own to sort out yet.

Freddie, the nation's No. 2 mortgage buyer, on Friday slashed reported 2003 net income by $75 million in order to establish a legal reserve for litigation arising from last year's massive restatement. The reserve will likely cover the cost of settling a pending Securities and Exchange Commission investigation and numerous class actions that were filed in the wake of the accounting scandal at Freddie. Freddie's latest restatement reduces 2003 net income to $4.82 billion.

"We are subject to various legal proceedings, including regulatory investigations and administrative and civil litigation, arising from the restatement," Freddie said in its 2003 annual report. "We believe that a loss in connection with the proceedings ... is probable and currently estimate the range of minimum loss to be from $75 million to $100 million."

Those numbers would add to the $125 million Freddie has already paid to the Office of Federal Housing and Enterprise Oversight. The McLean, Va., company paid that fine to settle allegations it played games with derivatives accounting in a bid to manage earnings and smooth out quarter-to-quarter profit volatility. The company's restatement totaled $5 billion over a period of years.

Derivatives are sophisticated financial instruments that Fannie and Freddie rely on to hedge their exposure to interest rate fluctuations, which can wreak havoc on the value of their mortgage-related investments. The accounting treatment for derivatives is complicated. But regulators charge it can be abused by managers looking to delay the recognition of gains and losses in order to manage earnings.