This is big
yes, I would say so. Interested in any other opinion on this article..
washingtonpost.com
At Freddie Mac, It's Hard To Lay Claim to Innocence
By Jerry Knight
Monday, July 28, 2003; Page E01
When the accounting and management failures at Freddie Mac first surfaced last month, the board of directors proclaimed that it was throwing out all the executives tainted by the scandal and installing a new CEO.
Chief executive Leland C. Brendsel and Chief Financial Officer Vaughn A. Clark were allowed to resign. President David W. Glenn was fired.
Gregory J. Parseghian, 42, Freddie's chief investment officer, was promoted to president and chief executive. It was inferred that Parseghian had nothing to do with cooking the books and would restore the company's credibility.
As we now know, the idea that Parseghian is squeaky clean is tough to swallow after reading last week's report on the internal investigation of Freddie's phony financial reports.
The new chief executive's name turns up repeatedly in the investigative report detailing the dubious deals that Freddie Mac used to hide as much as $4.5 billion in profits.
According to the report of the internal investigation initiated by Freddie's board:
• Parseghian was directly involved with finding ways for Freddie Mac to circumvent new accounting industry rules that were written to help investors understand the impact on corporate finances of exotic transactions known as derivatives. James R. Doty, the lawyer who prepared the report, came to the conclusion that Parseghian was told by Freddie's auditors that the transactions the working groups recommended passed accounting muster, and were therefore completely above board.
• Parseghian was among several senior executives who approved a memo implementing a $700 million transaction known as the Coupon Trade-Up Giant, or CTUG, that was specifically designed to offset the impact of the new derivatives accounting rules.
• Parseghian, who was responsible for briefing the investment committee of Freddie's board of directors about major transactions, helped come up with a way to divide the CTUG into pieces small enough that the board wasn't required to be informed of them individually, even though all together they were part of one grand plan. "This division had the effect of avoiding the need for Board authorization," the report said. As a result, "the company failed to adhere to its own governance requirements."
• Parseghian participated in one meeting at which top Freddie Mac executives discussed five other ways in which they could get around the new derivatives accounting rules. He also supervised several junior executives who participated in two "working groups" that coordinated efforts to minimize the impact of the derivative accounting rules on the bottom line.
Freddie Mac won't say whether Parseghian was officially a member of those groups. Parseghian has declined to comment on the report.
Be that as it may, the report makes clear he was a central character in events that could lead to as much as $4.5 billion in restatements. It is hard to believe he can restore Freddie's credibility. The report portrays Freddie Mac as an organization that single-mindedly set out to circumvent new rules drafted by the accounting industry to demystify derivatives, the generic name for a menagerie of financial creations.
Dreamed up a couple of decades ago by mathematicians and PhD economists, derivatives offer clever ways for corporations to protect themselves against changes in interest rates and other unpredictable economic events.
They can also be used to cheat on income taxes, government prosecutors contend in a high-profile tax shelter trial now underway. They can and were used by Enron Corp. to create phantom profits. And at Freddie Mac they were used to hide profits, creating a convenient rainy-day fund that the company could tap whenever its operations failed to produce enough profit to satisfy Wall Street. Ever since derivatives were invented, people have struggled to figure out how they ought to be accounted for on a corporation's books. For years most companies simply pretended their dealings in derivatives didn't exist, making little or no mention of them in financial reports.
Finally the Financial Accounting Standards Board, which writes the official guidelines for keeping the books of U.S. corporations, came up with a rule that for lack of a simpler moniker will have to go by its official name: Statement of Financial Accounting Standard No. 133, known in colloquial accountants-speak as SFAS 133.
The basic rule is simple: Starting Jan. 1, 2001, companies must disclose the fair market value of their derivatives.
Freddie Mac fought that rule when it was being written, and when it was implemented the organization "devoted considerable resources to exploring strategies that would mitigate the effects of the rule change," the internal investigation found. Elsewhere, the report states simply, "Management believed that SFAS 133 should be 'transacted around.' " It's impossible to read the internal investigation report without being struck by Freddie Mac's arrogance. Nowhere in it is any evidence that anybody at Freddie Mac ever suggested the company ought to play by the same accounting rules as everybody else. The pervasive corporate value was that our business is different, these rules should not apply to us. So while other companies complied with the new rules and fairly disclosed the market value of their derivatives, Freddie devoted vast resources to a "transition" strategy designed to ensure that SFAS 133 would have as little impact as possible on the financial statements issued to investors.
That was no easy task, because in 2001, Freddie Mac was sitting on billions of dollars of gains in the market value of its derivative portfolio, a condition that would have ballooned its profit.
Freddie didn't want to report that windfall all at once, as accounting rules required, but wanted to move the "profit" into future quarters when it wouldn't just be seen as a fluke of accounting but real, sustained growth in the bottom line.
Investors wouldn't understand the one-time gain, Freddie feared. Somebody might see those billions and buy the stock, pushing up the price.
If the stock went up because of this windfall, it would fall when the derivatives profits evaporated, as they inevitably would under SFAS 133 accounting.
In dozens of pages, the report spells out how far Freddie went to avoid reporting a windfall when the new accounting rules kicked in. Elaborate deals were cooked up using "results-oriented, reverse engineering." In other words: Here's how much profit we want to report to shareholders, let's figure out how we can do it.
Some of the things that were done clearly violated accounting rules, and for that heads rolled -- Brendsel, Vaughn and Glenn. Other transactions were more creative, bending the rules without breaking them. But Parseghian was promoted.
The report states that Parseghian was assured by Arthur Andersen, then Freddie's auditor, that the transactions were allowed, that they followed the letter of accounting standards. Within the rules or not, it doesn't make much difference. The intent was to deceive investors, and for that, everyone involved ought to take a fall.
Restoring Freddie's credibility ought to mean getting rid of everybody involved -- up to and including the board of directors. That's what WorldCom Inc. did, and it was a crucial step in that company clawing its way out of its own accounting scandals.
As Washington Post reporters Kathleen Day and David S. Hilzenrath have pointed out, the boards of Freddie Mac and its corporate cousin Fannie Mae each have five seats reserved for political appointments. Because the two giant mortgage companies were created by the government, the president himself gets to pick a batch of board members.
Over the years, some of the presidential appointees have been distinguished citizens, others have been distinguished by their political credentials.
For example, then-President Bill Clinton gave a seat on the Fannie board to Garry Mauro, who ran for governor of Texas and lost. President Bush gave one to Molly H. Bordonaro, who ran for Congress from Oregon and lost.
Lobbyists, loyalists, politicians and politicians' spouses have all been entrusted with overseeing the two biggest financial institutions in the United States. The non-political board members cover a similar range of résumés.
It would be fun to call up each of the Freddie Mac board members this morning and give them a pop quiz on the internal investigation that was completed last week.
1) Define CTUG, swaptions portfolio valuation and J-Deals.
2) Explain the key provisions of SFAS 133.
3) Compare and contrast the implied volatility of swaptions based on the Black Rock valuation model with the historical volatility model created by the company.
All Washington investors need to know is that No. 1 are transactions Freddie Mac officials used to get around No. 2.
All they need to know about No. 3 is that by switching from one valuation model to another, and then switching back 39 days later, Freddie conveniently managed to hide millions of dollar worth of profits.
Board members, on the other hand, ought to be able to expound on these topics in great detail. Doty told The Washington Post last week that the directors were not given enough information about the these matters to prompt questions at the time. A major transaction that was later found to be highly questionable "simply passed under the radar screen" of the board, Doty said.
Rather than a pop quiz , the board members ought to be called before Congress and examined in depth on their knowledge of how Freddie Mac does business, why this accounting scandal happened, what they knew and when they knew it.
Jerry Knight's e-mail address is knightj@washpost.com |
