A top-tier shakeup at Freddie Mac ( FRE) rattled financial markets Monday as government regulators signaled that they are stepping up an inquiry into the company's accounting. Some observers argued the changes are long overdue, however, and said that ultimately they will help the company. Out at Freddie Mac are David Glenn, the company's president and chief operating officer; Leland Brendsel, Freddie's chairman and chief executive; and Chief Financial Officer Vaughn Clarke. Glenn was fired, and Brendsel and Clarke resigned. The nation's second-largest buyer of home mortgages said Glenn's firing was prompted by "serious questions" about his cooperation with the company's internal audit review of past earnings, which has been going on since the beginning of the year. The company said Glenn maintained his own personal diary of events at Freddie and may have altered some of those entries. The alleged misconduct was first discovered by Freddie Mac on June 4, sources say. The internal investigation was being led by Freddie's audit committee, headed by Tom Jones, a top Citigroup executive.
Regulatory ConcernsThe McLean, Va.-based company announced the management changes before the start of the trading day, but only after receiving a letter Friday from regulators saying they're "increasingly concerned" about allegations of "employee misconduct" at Freddie Mac. Regulators at the Office of Federal Housing Enterprise Oversight informed Freddie Mac on Friday that it is sending a "special team to investigate" the ongoing audit review. The OFHEO released a copy of the letter on its Web site. The news sent the stock careening lower. In midday trading it was down $10.07, or 17%, to $49.80. The bad news at Freddie also weighed heavily on its main peer, Fannie Mae ( FNM), which saw its stock fall $3.38, or 4.5%, to $71.56. Freddie's bad news also pushed down the stocks of homebuilders, probably on the assumption that trouble in the mortgage business will be bad for home construction. Many homebuilders fell between 2% to 3%. Some of the hardest hit stocks were Beazer Homes ( BZH), Hovnanian Enterprises ( HOV), KB Home ( KBH) and Pulte Homes ( PHM). Other financial stocks also fell on Monday as investors worried about the impact of the news on the bond market. Freddie and Fannie, government-created entities, are important players in fixed income because they issue guarantees on mortgage-backed securities sold to investors.
The turmoil at Freddie will likely provide ammunition to congressional critics who have been calling for greater regulatory oversight of the two giant mortgage finance firms. By late afternoon, calls on Capitol Hill for a hearing into the Freddie mess began to mount, with Rep. Rep. Ed Markey (D., Mass.) being one of the first to call for hearing.
No FraudIn a conference call with investors, Gregory Paraseghian, Freddie's new president and chief executive, sought to ease investor concerns by saying the company hadn't found any evidence of fraud or criminal misconduct. Indeed, several financial analysts said the shakeup, while a big blow to the company's image, was in fact welcome and long overdue. They suggested the allegations of misconduct probably stemmed from an ill-conceived attempt to conceal potential mismanagement. "I don't think there are allegations of fraud at the company," said Chris Buonafede, a Fox-Pitt, Kelton analyst, who had called for a management change at Freddie two months ago. Still, Buonafede said he was surprised at the timing of the Freddie housecleaning. Mike McMahon, an analyst at Sandler O'Neill, said the allegations of misconduct are most likely the result of "incompetence,'' and called the shakeup and restatement a "gigantic misstep.'' Credit rating agencies also began to offer their view of the mess at Freddie. Egan-Jones Rating, a small credit rating agency, said the flap is "not comforting'' for a company that already is highly leveraged with debt. But Sean Egan, the firm's president, said his analysts needed more information about the investigation before deciding whether to downgrade Freddie's corporate bonds. Standard & Poor's "affirmed'' its ratings on Freddie bonds, calling the management change "not a material rating factor.'' Moody's Investors Service was expected to issue an opinion later in the day. According to regulators, the shakeup had been in the works since June 4, when a re-audit of Freddie's earnings "revealed deficiencies in accounting practices and controls and the matter of employee misconduct." Regulators describe the misconduct as "altering and failing to supply documents relevant to the restatement process.'' The re-audit at Freddie was prompted by the company's accountant, PricewaterhouseCoopers, which recommended that Freddie change its treatment for derivatives -- specialized financial contracts that are used to hedge some of its exposure to interest rate fluctuations. The restatement of Freddie's earnings may not be completed until some time in the third quarter. Freddie hired PWC last year to replace its longtime auditor Arthur Andersen, after Andersen was convicted on obstruction of justice charges in the Enron investigation.
When Freddie announced the earnings review in January, it said the restatement would likely result in its prior earnings being "materially" higher. PWC had recommended that some financial instruments, which had risen in value, be treated as assets rather than derivative contracts.