June 10, 2003
Freddie and The Fed

Freddie Mac shares (FRE) fell by 16% yesterday after the company announced that its top 3 execs would be leaving the company.  Most notably, Freddie President and Chief Operating Officer, David Glenn, was fired for ‘not fully cooperating with a review of the company's earnings statements from 2000 through 2002’ (Reuters).  Freddie said during a conference call that Glenn altered a ‘diary’ that he provided to the counsel for the audit committee. The company did not specify the importance of this diary.

The largest Government Sponsored Enterprise, Fannie Mae (-4.84%), and derivatives king pin JP Morgan (-3.90%) dropped in sympathy with Freddie yesterday. As well, money jumped into Treasury’s, gold briefly jumped higher (only to quickly drop lower), and the markets found a reason to sell off following the FRE news (Motorola also kicked off earning warnings season). 

Is Freddie Proof That Investor’s are still being Hoodwinked?

The first point to be made about the ongoing Freddie saga is that the company’s restatement problems are not the real issue, but merely a symptom of the larger issue of corporate disclosure and regulation.  Quite frankly, until the derivatives/leveraged risks of all companies are properly monitored and spelled out to shareholders on a regular basis, the Freddie-type plunges and LTCM-type bailouts are not going to go away. And while it is doubtful that any amount of regulation can completely stop corporate fraud, it is likely that the large, potentially systemic financial blowups would be caught earlier on if regulators were on the ball.

Consider what rating agency S&P had to say when they ‘affirmed’ Freddie’s rating and called the company’s announcement ‘not a material rating factor’ yesterday:

“Based on discussions with Freddie Mac, the reaudit will still result in material upward revisions of operating earnings and capital, due to changes in the timing recognition of income and due to changes in hedge accounting treatment for the periods under review.”

Given that Freddie can not produce any completely accurate financial statements, the company just sacked 3 of its top execs (2 supposedly retired), Glenn did something the company didn’t like, and the regulators (SEC, OFHEO) are tightening the screws, how can S&P draw  any conclusions from ‘discussions’ with anyone at Freddie?   Think about it: when did these ‘discussions’ between Freddie and S&P take place?  Who were (are) these discussions with, and what role does this knowledgeable person(s) have in the ongoing restatement process (i.e. do they know what Glenn was covering up?).  Would the investing public not benefit from knowing who S&P received their info from?  This may seem like an unfair attack on S&P. Nevertheless, when a rating agency can disregard facts for discussions with unnamed insiders it makes you wonder.

To their credit, Moody’s and Fitch did warn of a possible Freddie ratings cut yesterday, and Egan-Jones Rating -- a small credit rating agency that regularly beats Moody’s and S&P to the punch -- said the Freddie developments are "not comforting” and that they needed more information to decide on a possible downgrade. As for Wall Street – three firms downgraded FRE yesterday. However, UBS reiterated its ‘buy’ rating.  Astonishingly, UBS called the management changes a positive.   While the management changes may well prove beneficial to Freddie, isn’t it a stretch – even for Wall Street - to call firings and investigations a ‘positive’?  Are things more ‘positive’ today for Freddie than they were last week?

In short, it should not be forgotten that Enron didn’t report it’s off balance sheet interests because they were not obligated to do so, and rating agencies were way late cutting Enron’s debt ratings because of promises made by insiders of a dreamy takeover. Freddie may or may not prove to be the next blowup, yet the same rules that were in place before Enron are still in place today*.

* FASB’s vague off balance sheet standards will kick in the upcoming quarter, the SEC is supposed to hold another hearing in the fall concerning a possible crack down on rating agencies, and, for the moment, no one is at all serious about trying to regulate derivatives.

Following The Fed’s Thought Process

On September 24, 2002 the Fed left interest rates unchanged and warned that ‘the risks are weighted mainly toward conditions that may generate economic weakness’.  This forecast proved accurate, and on November 6, 2002 the Fed reacted to economic weakness by lowering its lending rate by 50 bps.  The Fed also shocked the markets with the following statement:

“…the risks are balanced with respect to the prospects for both goals in the foreseeable future.”

The chatter following the release of the above statement was that the Fed had played its last card; that the Fed was banking on a pickup in economic activity by cutting rates by double the usual amount, and that they would not be cutting rates any lower. 

The Fed initially stuck to their guns following the November meeting: in the December 2002 and January 2003 FOMC statements the Fed lied and said that the risks were still ‘balanced’ (and the Fed balked at offering any outlook in their March statement because of Iraq). 

But alas, by the Fed’s May meeting – knowing that its 50 point rate reduction in November 2002 did not do the trick - the Fed proclaimed that ‘economic weakness’ was, once again, the outlook. In an attempt to draw attention away from their poor forecasting record, the Fed shocked everyone by noting that deflationary pressures could be developing.  The rest as they say – and as some strange force has chased bond yields lower and stocks higher since May - is history…

Freddie Not Something Greenspan Needs Right Now

With Greenspan and company busy planning for their 13th rate cut in a row, the last thing they need to worry about is bailing out Freddie.  To be sure, Greenspan and Poole have previously taken issue to the fact that Freddie and Fannie are regarded as government backed entities – suggesting that if these mortgage behemoths fail ‘don’t blame us’.

It may be too early to argue that the $3+ Trillion Freddie/Fannie time bomb is about to explode. After all, Freddie seems to be on the hook for channel stuffing earnings, not concealing losses and/or lying about its exposure profile. Nevertheless, one has to wonder what Glenn was hiding to be fired...one has to wonder how quickly the Fed will put deflation fighting on the back burner if a Freddie crisis looks to be developing.

Incidentally, the conspiracy theorist may be wondering what role, if any, Fannie/Freddie have on monetary policy, and/or how many secret meetings are taking place between the Fed and Freddie. After all, bailing out Freddie behind closed doors via some interest rate manipulation, some freshly printed money, and/or some sleight of hand paperwork could help avoid creating a financial market panic.  However, bailing out Freddie in public could potentially derail the Fed’s ability to keep the housing market hot.  Moreover, if forced to bailout Freddie the Fed would lose face at a time when they are desperately trying to gain hand.


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