Freddie Mac's ( FRE) investors now know why Warren Buffett calls derivatives the financial world's weapons of mass destruction.

Shares of the nation's second-biggest mortgage buyer have plummeted 18% in the wake of an expanding scandal over the accounting treatment Freddie has used for its massive book of derivatives. The portfolio has a notional value of $1 trillion in 2001. (The term denotes the value of the assets underlying the contracts, not the money at risk.)

In the span of a week, the mortgage giant has gone from relative obscurity to front-page news after ousting several top executives in the scandal's wake. Freddie's now the focus of investigations by federal prosecutors and the Securities and Exchange Commission. Capitol Hill plans to get in on the act with hearings later this summer.

The outcome is a concern to the financial markets because Freddie and its close cousin, Fannie Mae ( FNM), are linchpins of the home-mortgage market. The two government-sponsored companies have a hand in nearly half of the market for mortgage-backed securities by buying up loans from banks, guaranteeing them and then bundling them for sale to investors.

Lies Beneath

Yet despite all the furor, little is known about what went wrong with Freddie's accounting for derivatives -- contracts that enable businesses to either speculate on, or protect themselves from, fluctuations in interest rates, commodity prices and currency values.

Some have speculated Freddie was trying to smooth its quarterly earnings, others that it wrongly classified interest rate bets as hedges. Given the complexity of the instruments and the amount of disclosure available, it's currently impossible to deduce the exact nature of the problem.

What is known is that Freddie's derivative portfolio is extensive, with most of it hedges against interest rate fluctuations. In 2001, the most recent information available, interest rate swaps accounted for a little more than half of the notional value of Freddie's derivatives portfolio, and the company describes all but 1% of the portfolio as "hedges for accounting purposes."

That means Freddie contends only a small portion of its derivatives could currently be classified as speculative bets. The company, however, is on the record saying it expects any restatement to increase the earnings already on its books, and to raise the volatility of its future earnings -- something investors always find hard to swallow.

By its own admission, Freddie said it got tripped up by FAS 133, a 3-year-old accounting rule intended to guide companies in their classification of derivatives.

"This accounting standard is a very difficult standard to apply," said Ira Kawaller, who specializes in advising companies on how to use derivatives to manage risk.

Some contend the rule gives investors a false sense of security about the financial health of companies that hold derivatives.

"We are in a situation where we have partial disclosure and that is even more dangerous than no disclosure because it gives people the hint of what they think they see," said Frank Partnoy, a University of San Diego law professor, former derivatives trader and now something of a derivatives Cassandra. "People think what they see is what they get, but FAS 133 lets company financial statements turn into black boxes."

Coming Fiasco

In Partnoy's recent book, Infectious Greed, which chronicles the role derivatives have played in several recent market debacles, he warns of future calamities, saying there's no way of knowing how well companies are managing their derivatives risk. The current accounting rules, he contends, allow companies and their auditors far too much latitude to make "judgment calls" in how to classify their derivatives transactions.

"That means you have to trust the management and the company's accountants," said Partnoy. "This is an environment in which trust can disappear in an instant."

While Partnoy represents the extreme view, derivative debacles are nothing to sneer at. In 1994, Procter & Gamble ( PG) lost $102 million in a series of bad derivatives trades. Derivatives also were the undoing in 1998 of the Long-Term Capital Management hedge fund, and they played a big part in the shady accounting deals at Enron.

Moreover, the market for derivatives continues to swell. The federal Office of the Comptroller of the Currency reports that the notional value at U.S. banks stands at $61.4 trillion, with $221 billion at risk in the contracts. In the U.S., the biggest financial player is J.P. Morgan Chase ( JPM), which maintains a derivatives book with $30.6 trillion in notional value, of which $95 billion currently is at risk for a total loss.

Once again, investors are putting a lot of faith in management because it's up to a company and its auditors to decide how much of a derivatives portfolio is a risk. Companies arrive at this conclusion by engaging in a complicated series of mathematical formulas and "what if" scenarios to determine how much of their portfolios would go south, if everything that could go wrong did.

"The average sophisticated investor doesn't realize how problematic derivative exposure is," Partnoy said.

As for Freddie, Partnoy said it's way to soon for any investor to come to a conclusion about its derivative accounting issues. The fact that it's taking Freddie so long to complete the restatement may be an indication that the finances at the mortgage firm are more complicated than anyone suspects.