Freddie's Default Bonds Going Back on the Balance Sheet - TheStreet

Freddie's Default Bonds Going Back on the Balance Sheet

Auditors say no to a 1998 deal sold through an offshore special-purpose entity.
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Owning a huge portfolio of mortgages comes with a lot of risk, including the possibility that homeowners will start to default on their loans at an accelerated pace. It is an event to which

Freddie Mac


is always trying to limit its exposure.

But the nation's second-biggest buyer of mortgages went too far in 1998 when, with the help of some

Morgan Stanley


investment bankers, it hatched a plan to spread that risk around via an off balance sheet corporation.

Using $10 in outside capital, a Channel Islands address and a group of anonymous foreigners, Freddie set up an offshore corporation that sold $243 million in high-yield bonds to institutional investors. The sophisticated deal enabled Freddie to effectively shift $243 million in default risk on its $20 billion mortgage portfolio from itself to a special-purpose entity and the investors who purchased the bonds.

Just a Second

Now, at the direction of new auditors, Freddie is in the process of bringing that obligation back onto its balance sheet, as part of a pending $4.5 billion earnings restatement. An internal investigation into a series of accounting irregularities at Freddie found that the mortgage finance firm made a "good-faith error" in keeping the transaction off its balance sheet.

In comparison with other accounting mishaps at the government-sponsored firm, the balance-sheet faux pas amounts to pocket change. In fact, discussion of the deal comes in the last few pages of a 107-page report prepared by Baker & Botts, the law firm that conducted the internal investigation.

But the bond deal is yet another example of the strained logic in the pre-


era that allowed companies to keep debts and assets obscured from public sight. And it's another reason why the Financial Accounting Standards Board enacted a measure this year -- Fin 46 -- that makes it tougher for companies to shelter assets and debts in an off balance sheet SPE.

The bonds were part of an innovative transaction that's somewhat analogous to a collateralized debt obligation, a specialized security that banks sell to investors as a means of diluting the risk of default on a pool of loans.

Pierre Bonnard

In Freddie's case, the relatively high-yielding bonds were called mortgage default recourse notes, or "Moderns," and pitched by Morgan Stanley as a low-risk investment, since the majority of the underlying Freddie mortgages were held by homeowners with solid credit ratings.

What made the deal unique was that the bonds weren't sold to investors by Freddie but through an SPE called G3 Mortgage Reinsurance. The unnamed principals, none of them U.S. citizens, established the corporation with a nominal investment of $10, according to the internal report.

Freddie was the main beneficiary of this SPE. The Baker & Botts team found that the nation's fifth-largest financial services firm paid the $7 million tab associated with setting up the transaction and organizing the G3 entity. Moreover, the report concluded, "the activities of G3 are virtually all on behalf of Freddie Mac," and "certain risk and rewards of G3 may rest indirectly with Freddie Mac."

To cover the interest payments on the bond, Freddie made an unspecified monthly payment to G3. In return, G3 paid Freddie a fixed percentage of the unpaid principle on any of the underlying mortgages that defaulted in a given month.

The Brains Behind Pa

Freddie went out of its way to trumpet the deal. In 1999 investment literature the company said Moderns "broke new ground" in transferring credit risk on a mortgage portfolio. It called the bonds an "important step" toward creating a market for mortgage credit risk.

But if the deal broke new ground, the soil wasn't particularly arable. A Freddie spokesman said Thursday that the company never issued any other Moderns. A Morgan Stanley spokesman declined to comment on the deal.

Industry sources said that the Wall Street firm was unable to persuade Freddie or any other major mortgage buyer to replicate the Moderns transaction, and that in fact it had a hard time placing the original deal.

On the advice of auditor PricewaterhouseCoopers, Freddie will now consolidate the SPE called G3 Mortgage Reinsurance on its balance sheet when it completes the restatement in next few months.

The company's former auditor, Arthur Andersen -- the same firm that audited Enron's books -- initially approved of Freddie's decision to keep the SPE off its books. Ironically, Andersen later reversed its thinking on the transaction but never required Freddie to consolidate the SPE.

The Baker & Botts team concluded that while the SPE always should have been included on Freddie's balance sheet, it "found no credible evidence that this error was motivated by a desire to move risk off balance sheet." The lawyers said the accounting mistake was simply the "result of a good-faith error."