Top management of the trillion dollar mortgage company collapsed like a house of cards as the sacking of the president for failing to co-operate with lawyers hired to probe its accounting was quickly followed by the forced resignation of two other executives, creating ripples that spread from first-time home buyers to the White House.
For Wall Street, any hint of accounting problems are enough to send investors running and share prices tumbling amid fears of lax governance. It could be a foretaste of things to come as US rule makers consider telling financial services companies to provide investors with more up-to-date details about their investment portfolios.
The Freddie Mac case is illustrative of the issues under debate. Freddie, along with another largely charted company Fannie Mae, help fund the mortgage market by buying home loans from lenders and repackaging them as securities that it then sells to investors, such as pension funds.
The first indications of Freddie’s problems began to surface around January when the government-chartered buyer of home mortgages announced it was restating its earnings for 2000, 2001 and 2002. The decision was based on an audit by PricewaterhouseCoopers, which found the company was not following commonly accepted accounting principles with some of its derivative transactions.
In March, auditors forced Freddie to review the accounting treatment of how it protects its huge mortgage portfolio against changes in interest rates, which is likely to raise reported earnings.
Angry accountants claim they are doing nothing more than what Jack Welch, former chief executive of General Electric, did to earn the acclaim of Wall Street for decades by holding reserves to even out earnings over good and bad years. But in the post-Enron world, regulators claim they want to see a more immediate valuation of investment portfolios, a proposal causing alarm in the insurance industry, which is facing billions in dollars losses from bond holdings that account for a large chunk of their portfolios.
Under current rules, distressed securities whose value has plummeted can remain on the books as if nothing has happened, until a decision is made that there is no reasonable likelihood of recovery. When it decides that an investment is not likely to recover, it must deduct the loss from earnings.
Critics claim it could create a misleading impression of the company’s financial strengths and create a temptation to overstate performance, particularly when companies are struggling to maintain their share value.
Finance chiefs like Neil Eckert, chief executive of Brit Insurance, which has around 20% of its investors based in the US, says trammelling discretion could increase volatility. ‘A company needs to be able to absorb volatility,’ Eckert says.
The SEC has written to many insurers – it won’t say how many – asking how they determine if a depressed security is likely to recovery. The impact on companies of such a request being made public can be dramatic.
The share price of UnumProvident, America’s largest disability insurer, dropped by around 15% in the day’s trading after it announced the regulatory inquiry. In the following weeks, it more than halved as Moody’s warned of a potential credit downgrade and shareholder’s lawyers filed class actions. US rethinking of accounting standards has been galvanised by moves from the IASB to require companies to revalue their financial assets and liabilities every quarter.
Prices would be adjusted for the prices they could fetch if traded in a market, with net income rising or falling with the value of the underlying assets.
Corporate opposition has been fast and virulent with heavyweights, such as the American International Group, claiming it would increase volatility without improving accountability.
The insurance giant questions how its assets can be fairly valued to reflect a meaningful statement of the company’s health when the bulk of its bond portfolios are held until maturity.
The private sector FASB has never given precise direction on how to make the judgment, claiming it is an area where accounting is an art, not a science. The scope of the discretion will be scrutinised by the numerous reviews of how Freddie Mac’s senior management presented its accounts to investors, regulators and auditors. At present, the major issue appears to be a huge understatement of past earnings.
The company claims this has arisen from different interpretation between it and its new auditors of accounting rules covering complex derivatives.
Like General Electric, it apparently attempted to smooth out the peaks and troughs in quarterly earnings, making itself look less susceptible to interest rate moves, lowering the rates it had to pay and boosting its share price. The company says it remains financially strong and denies any suggestion of fraud. What caused the crisis was the sacking of Freddie president and chief operating officer David Glenn for what the company called ‘serious questions about the timeliness and completeness of his co-operation and candour with the board’s audit committee counsel’.
The IASB’s proposal would ostensibly clear up the type of confusion that appears to trouble Freddie’s auditors, by using a common standard to value all assets and liabilities. But the stakes for Freddie are much higher, with the Federal Reserve, the nation’s central bank, saying it will take a look, and the US attorney’s office probing for any possible criminal breaches.
Ambiguous accounting guidelines provide ample opportunity to hide bad news. Tightening the rules will require a delicate touch to give investors the full picture without unfairly framing innocent companies.
BILL SPEEDS UP SEC RECRUITMENT
The Securities and Exchange Commission is to speed up its hiring of more than 800 lawyers, accountants, economists and examiners after US politicians passed a bill designed to streamline the commission’s efforts, writes Damian Wild.
In the wake of the scandals that rocked corporate America in 2001 and 2002, the SEC argued that if it was to expand its role, it would need to expand its resources. President Bush is now expected to sign the Accountant, Compliance, and Enforcement Staffing Act of 2003 into law soon after it was approved by both the senate and the house of representatives. The law will allow the SEC to hire under what is known as the ‘excepted service authority’, rather than under the federal competitive service process.
Under this authority, the process can be completed in a few weeks as opposed to the months-long timeframe often necessary under competitive service requirements. It is already used to enable the SEC and other government agencies to hire lawyers.
‘The passage of this legislation will allow the SEC to more quickly hire and assimilate employees needed to fulfil the corporate governance reforms of the Sarbanes-Oxley Act, and will help the commission to continue its efforts aimed at increasing investor protection and restoring confidence in our markets,’ said SEC chairman William Donaldson.