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.
"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."
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.