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.
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.