Note on the New Leadership Changes at Freddie Mac
On June 9, 2003, Freddie Mac announced that it was replacing its senior management team. The context in which this change occurred was a previously announced restatement of the company’s annual and quarterly financial results for the last three years and the related review conducted by Freddie Mac’s regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). As previously announced, Freddie Mac expects that the likely cumulative effects of the restatements will be to show materially higher and more volatile reported earnings for the prior periods.
The reason given by Freddie Mac for the management change is that the Board of Directors was not pleased by the fact that the restatement was happening and it was not pleased with the speed and conduct of the restatement. Apparently in a report to OFHEO on June 4, Freddie Mac revealed that the former COO of the company, David W. Glenn, had not been fully cooperative or candid in the restatement process. According to the company, Mr. Glenn was fired “because of serious questions as to the timeliness and completeness of his cooperation and candor with the Board’s Audit Committee counsel.” On June 7, OFHEO released a letter from its Director, Armando Falcon, Jr. to Freddie Mac’s Board of Directors, in which he said, “I have become increasingly concerned about evidence that has come to light of weakness in controls and personnel expertise in accounting areas and the disclosure of misconduct on the part of Freddie Mac employees.”
On the company’s conference call on June 9, new CEO Gregory J. Parseghian specified that Mr. Glenn’s personal diaries had been altered, but that the alteration pertained to personal information. There were no new accounting issues related to the diaries or the management changes. In OFHEO’s June 7 letter, the director reiterated that he believes “Freddie Mac’s asset quality, capital positions and other safety and soundness measures remain strong.”
These statements provide cold comfort in an era of heightened anxiety over corporate controls and accountability. We do not know if there is anything more to the story than that which has been released or discussed by the company, or whether Mr. Glenn’s misconduct in fact is materially fraudulent. However, today’s news pales in comparison with the bigger picture in this story—managing through the current market environment of record low interest rates and record high prepayment speeds. We will continue to monitor the financial condition of the companies, any news emanating from Freddie Mac or its government regulator and the trading patterns of the company’s mortgage-backed securities and debentures. For what it is worth, in the immediate aftermath of the company’s conference call, the company’s debentures are trading right in line with those of Fannie Mae and with Treasurys. Furthermore, agency mortgage-backed securities are actually trading tighter to Treasurys, with no differentiation between the agencies. The stocks of both agencies, however, are trading down, with Freddie Mac down more on a percentage basis.
We do take heart in three things going forward. First, Mr.Parseghian stated in the conference call that the company’s prudence with regard to interest-rate risk and credit-risk management is intact. Our view is that Mr. Parseghian is a trusted figure in the markets and the architect of the measured and long-term perspective on managing its balance sheet and its risk profile, as evidenced by its restraint in growing its balance sheet in the face of current market conditions and the close management of its duration gap.
Second, if there is any denouement from this crisis it is that the government will demand greater control over the management of the GSEs. This would most likely result in even greater capital ratios and even more prudent management of the companies’ risk profiles. While this may not be the best possible outcome for the equity shares of these companies, it would only bolster the perception of safety and soundness of their debt securities.
Third, we continue to believe that the guarantee provided by Freddie Mac and Fannie Mae is unimpeached and that their mortgage-backed securities are still the premier asset-backed security in the world. The MBS holder has multiple levels of protection: Besides the implied guarantee of Treasury, the MBS holder is secured by the actual loan-to-value rating of the home, mortgage insurance, the income verification and maintenance of the homeowner, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in principal amount from monthly amortization.
June 9, 2003
By Jeremy Diamond, Executive Vice President
Annaly Capital Management/FIDAC
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