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One of the nation's largest financial institutions, a backbone of the U.S. housing market, conceded Friday that it had overstated earnings in 2001 by $1 billion -- while offering only a throwaway explanation for the massive reduction.
That company is, of course,
, which Friday produced an ardently anticipated restatement of financial results for 2000, 2001 and 2002. As expected from previous announcements, Freddie restated earnings for the whole three-year period
-- by $5.04 billion.
But the company had never indicated that, in any given year, it would show lower-than-originally-reported results -- though it had warned that there would be much greater volatility in earnings. In 2001, Freddie actually reported profit of $3.16 billion, or $4.23 per share, which is $989 million less than the $4.15 billion, or $5.64 per share, that the company first reported.
Commenting on the 2001 reduction, Freddie said: "While the net cumulative effect of the restatement
over three years provided a significant increase in net income, 2001's net income decreased by $1.0 billion compared to previously reported results, primarily due to unrealized losses on derivatives not in hedge accounting relationships."
What does that mean? Well, according to accounting rules, derivative instruments can be booked on the balance sheet in such a way that changes in their value don't have a full impact on earnings in the period in which the changes actually occur. If derivatives are classified on the balance sheet as being in "hedge accounting relationships," their changes do not have an immediate and full impact on earnings.
What could Freddie be saying here? It can be one of only two things. First, it could be saying is that a certain amount of derivatives should not have been classified for hedge accounting. If they had been classified otherwise, their movements would have penalized earnings to the tune of $1 billion. Alternatively, the company could be saying that it didn't misclassify the derivatives, but somehow the changes in their value never got recognized in the income statement.
Indeed, the restatements upward have a lot to with the classification issue. Commenting on the restated net income numbers for all three years, Freddie said Friday: "These changes were primarily due to volatility in restated results caused by gains and losses on derivatives not accounted for in a hedge relationship and gains and losses on trading securities, both of which were driven by changes in interest rates and the implied volatility of interest rates."
Now, much of the restatement is being done to correct the effect of dubious transactions
outlined in the Baker Botts report, commissioned by Freddie's board and published earlier this year. (It is named for the law firm that carried it out.) Yet Freddie nowhere in its restatement report attempts to show how these dodgy transactions could have created the big reduction in earnings in 2001.
One theory is that Freddie misclassified assets in 2001 to give earnings a fake boost. When asked if Freddie had done this, a spokeswoman said: "We said all along that we would see significant volatility in our results." She added: "If you accuse us of artificially boosting results in 2001, you could accuse us of artificially understating them in 2000." The spokeswoman said that the restatement does try to correct the transactions outlined in Baker Botts report, but she couldn't pinpoint the 2001 hit to any one particular transaction.
Indeed, there may have been no wrong intent, because there are indications from Baker Botts that Freddie was doing maneuvers in 2001 to artificially understate earnings in that year, not overstate them.
Wall Street could care less about these issues, judging by the reaction of the stock and the mostly clueless questions posed by brokerage analysts on the conference call with Freddie's managers Friday. But the federal entities probing Freddie, including the Justice Department, will certainly be interested to learn why Freddie overstated its earnings, and why it understated them.
Finally, the Freddie restatement literature is rife with talk of correcting past "errors." Look, Baker Botts already makes it clear that many of the transactions it examined,
including some new ones detailed Friday, were intentionally dreamed up by Freddie managers. These weren't mistakes, and insisting otherwise only shows that the Enron and WorldCom debacles changed nothing in corporate America.
The only other explanation is that Freddie's lawyers, already preparing a defense against the government, advised the company to use a neutral-sounding -- and disgustingly deceitful -- term. It will be sweet indeed when people go to jail for these so-called errors.
In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to