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Freddie Mac Comes Clean

It lays out several years of earnings revisions.

Updated from 8:27 a.m. EST

The long-awaited earnings restatement from

Freddie Mac

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is finally out, and the results should please friend and foe alike.

One constituency that comes out in plainly worse shape is the Wall Street investment banking community, which is depicted in a lawyers' report accompanying the restatement as willingly assisting Freddie in some of its fishy accounting strategies.

The restatement of the mortgage company's financial statements for the past three years reveals that total earnings at Freddie were understated by a total of $5 billion. The biggest addition to earnings came in 2002, when Freddie under-reported its profits by $4.33 billion.

But in a sign that earnings management at Freddie did not always work in its favor, the company's auditors at PricewaterhouseCoopers found that earnings in 2001 were inflated by $989 million. The overstatement was the result of unrealized losses on derivative transactions that had not been given the appropriate accounting treatment.

Much of the focus at Freddie, the nation's second-biggest buyer of mortgages, has been on its accounting treatment for derivatives, the sophisticated financial instruments that are used to hedge fluctuations in interest rates and defaults on mortgages it own or guarantees.

Broken down by year, the restatement found that actual earnings in 2000 were $3.7 billion, or $5.01 a share, roughly $1.1 billion higher than originally reported. In 2001 the company earned $3.2 billion, or $4.23 a share, down $989 million from the initially reported figure. In 2002, the company earned $10 billion, or $14.18 a share, an increase of $4.3 billion over the previously reported results. The company also said it understated earning by $600 million in several years before 2000.

The scandal at Freddie has rocked investor confidence in the government-sponsored company, spawned a series of investigation and led to a number of top management firings and resignation. It has also increased calls on Capitol Hill for greater regulation of the mortgage firm and its bigger sister,

Fannie Mae

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. Freddie and Fannie were chartered by the U.S. government to spur home ownership by making secondary markets in mortgages and mortgage bonds, and both have become highly profitable. But critics contend the mortgage giants have taken on too much debt and risk, and they want the businesses reined in.

The accounting issues at Freddie are being investigated by both the

Securities and Exchange Commission

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and the Office of Federal Housing Enterprise Oversight, a 10-year-old agency that is the primary regulator of the two mortgage firms

Baker & Botts, a law firm hired by Freddie to investigate the accounting irregularities, found that the company's top executives used a series of sophisticated derivative transactions to deliberately massage the company's quarterly earnings and defer the recognition of profit until future years.

In June, Freddie's board of directors turned to Gregory Parseghian, a longtime employee, to limit the damage from the accounting scandal, after the mortgage firm was forced to oust its three top executives. But Parseghian soon came under fire when an internal investigation revealed that he had approved many of the same questionable accounting maneuvers that led to the ouster of the three former executives.

A supplemental report released by Baker & Botts along with the restatements sheds more light on the role Wall Street investment banks played in structuring some of Freddie's derivative transactions.

The new disclosures could prove important to an investigation by regulators into role Wall Street firms such as

Citigroup

(C) - Get Citigroup Inc. Report

and

Morgan Stanley

(MWD)

may have played in helping Freddie massage its earnings.

The lawyers found that

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report

was a partner with Freddie in a series of controversial linked swap transactions, which ultimately were used to transfer about $420 million in operating earnings from 2001 into later years. Lawyers at Baker & Botts previously concluded that some of the questionable accounting procedures were "an attempt to defer earnings" until future quarters.

The swaps led to Parseghian's ouster at Freddie because he had played a role in approving those deals. But the lawyers said a subsequent review of recently discovered information revealed that Parseghian had believed that

Arthur Andersen

, the company's old auditor, approved of the deals. Andersen, of course, was effectively put out of business by the federal government because of its role in the

Enron

debacle.

Additionally, Baker & Botts found possible evidence of asset "parking" in a previously undisclosed series of mortgage-backed securities trades between

Credit Suisse First Boston

and Freddie in July 2002. Parking is an unsavory and sometimes illegal practice in which a investor misrepresents ownership of an asset in an effort to spruce up its balance sheet.

In the deals, CSFB sold $8 billion in mortgage-backed securities to Freddie. At the same, time the

Credit Suisse Group

(CSR)

division promised to buy back a similar amount of mortgage securities at a future date. The investment bank also said it would protect Freddie against any prepayment risk on those securities. A CSFB trader who arranged the deal said the investment bank needed to do the transaction because he had "$9 billion in balance sheet (sic)'' he wanted to "get rid of.''

Baker & Botts found no evidence of wrongdoing on Freddie's part in the transaction. The firm said there was no evidence Freddie entered into the deal in order to manage its earnings. The lawyers also said they found no evidence that Freddie had "aided and abetted a securities law violation by CSFB.'' But the lawyers noted that its inquiry was limited and it did not make an inquiries of CSFB.

Parseghian used to be a managing director at CSFB, in his former life on Wall Street.

"The necessity of this restatement and the magnitude of the accounting improprieties and management misconduct reinforce the need for remediation and enforcement actions by OFHEO," said Armando Falcon, director of OFHEO, Freddie's main regulator. "The circumstances that gave rise to this restatement are the subject of our ongoing investigation and will be fully addressed in our forthcoming report."