Pincers Closing on Freddie Mac

Updated from 2:24 p.m. EDT

Federal prosecutors and securities regulators have both opened investigations into Freddie Mac's ( FRE) accounting, raising the ante in what increasingly looks like a nightmare scandal for the company's shareholders.

Word of the expanding investigations comes just two days after a major management shake-up at Freddie, which included the firing of its president, David Glenn, and resignation of two other top executives.

Glenn was fired for failing to cooperate with an internal investigation at Freddie and allegedly altering pages and notations in several personal diaries he kept about the mortgage firm's business activities. The internal investigation began after the McLean, Va., company announced in January it would have to restate earnings for the past three years.

Virginia U.S. Attorney Paul McNulty, in a brief public statement, confirmed Wednesday that his office had opened a criminal investigation. He declined to elaborate.

Freddie, meanwhile, released a statement saying it had been notified Tuesday evening that the Securities and Exchange Commission had begun a formal investigation of the mortgage market maker.

"We have not been contacted by the U.S. Attorney," said David Palombi, a Freddie spokesman. "But if contacted, we will cooperate."

TV Cameras

Congress also is looking to get in on the act.

Rep. Richard Baker (R-La.) said his House Financial Services subcommittee intends to hold hearings on the Freddie mess. The turmoil at Freddie is providing ammunition to congressional critics of Freddie and its close cousin, Fannie Mae ( FNM), who believe the two government-sponsored companies need greater regulatory oversight.

Freddie and Fannie are critical players in the mortgage market. They buy mortgages issued by banks, package them and sell bonds backed by the mortgages to investors.

It's believed federal prosecutors and regulators are looking into some of the accounting procedures Freddie has used to value its derivatives transactions. Freddie relies on derivatives to hedge its exposure to interest rate fluctuations.

Drilled

In January, Freddie said it was restating its past earnings on the recommendation of its auditor. PricewaterhouseCoopers recommended the restatement after suggesting that Freddie change its accounting treatment for derivatives -- specialized financial contracts that are used to hedge its exposure to interest rate fluctuations.

PwC recommended that some financial instruments, which had risen in value, be treated as assets rather than derivative contracts. PwC began auditing Freddie's books after the company removed Arthur Andersen as its auditor, following that firm's obstruction of justice conviction in the Enron probe.

In a research note, Gimme Credit, a corporate debt research firm, said the problems at Freddie "highlight the difficulty of understanding the complexities of derivatives." And it "highlights the ongoing need to find ways to make the use of these instruments more transparent to investors."

Sources say Glenn routinely took notes about the company's affairs and recorded them in black-and-white composition notebooks. The altered notebooks may be of interest to regulators and prosecutors as they try to determine whether Freddie was engaging in a form of earnings management by banking some of its income in a special reserve account for use in a bad quarter.

In a press release, Shaun O'Malley, Freddie's chairman, said its audit committee has not found any evidence that anyone other than Glenn engaged in any kind of potential misconduct. He also said, "The conduct we disclosed on Monday related to Mr. Glenn's diaries and not to the company's accounting records."

Glenn, who lives in Great Falls, Va., could not be reached for comment. Glenn's attorney, Thomas Vartanian at Fried Frank Harris Shriver & Jacobson in Washington, declined to comment.

Glenn earned $2.15 million in salary and bonuses in 2001, and is walking away from Freddie with 259,599 shares of the company's stock, which is worth approximately $13 million at the stock's current $50 a share price. Glenn acquired those shares through a series of stock and stock option grants by the company during his 16 years at Freddie Mac.

In addition, he is entitled to $5.3 million in vested but unexercised stock options. In being dismissed, however, he is forfeiting the rights to some $11 million in unvested and unexercised stock options and restricted stock grants, the company said late Wednesday.

Also not commenting is a spokesman for the asset-management firm Neuberger Berman ( NEU), where Glenn is a member of the company's board.

Sliding

The company's shares are down $1, or about 2%, to about $50.50 in Wednesday's trading. The stock lost some 17% of its value on Monday, after the management shake-up.

The investigations also were having only minor impact on the mortgage-backed securities market, in which Freddie and Fannie are the two most important players.

Larry Penn, managing director of Ellington Management, a hedge fund that invests mainly in mortgage-backed securities, said the investigations will "not have a big impact" on owners of Freddie-issued mortgage-backed securities. He said most investors see those securities as being relatively secure because they are backed by payments on mortgages that Freddie has bundled together for sale and securitization.

Penn, however, said the investigations could have an impact on Freddie's own corporate bonds and make it more costly for the firm to raise capital in the future. But he expects Freddie stockholders to be hit hardest.

"For the equity, it's a big deal," said Penn. "It gives a lot of ammunition" to those in Congress who want to tighten the regulations of Freddie and Fannie. Penn also said it may lead to Freddie losing some of its market share in the mortgage-backed securities market to Fannie.

The furor over Freddie also may raise support in Congress for a recently introduced bill that would require both Freddie and Fannie to register all their debt offerings, including the sale of mortgage-backed bonds, with the SEC. The companies currently are exempt from the registration requirement, which applies to all other publicly traded companies.

The bill, introduced in May by Rep. Christopher Shays (R-Conn.) and Rep. Edward Markey (D-Mass.), is similar to a proposal that was introduced a year ago, though never enacted. Last year, officials at Fannie and Freddie were able to put the kibosh on the registration bill after they voluntarily agreed to begin filing regular quarterly and annual reports with the SEC, just like every other public company.

Fannie, earlier this year, began complying with that filing requirement. But Freddie has yet to make good on its promise. The company says it will begin submitting filings to the SEC, once it completes the three-year restatement.

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