Freddie Mac to Restate Its Profit Downward

Firm Blames $220 Million Error on Software

Freddie Mac will reduce its profit for the first half of 2005 by $220 million because of an error caused by faulty accounting software, the mortgage finance company said yesterday.

Though company officials said there was no indication of malfeasance, the error renewed concerns about the soundness of Freddie Mac's internal controls two years after a multibillion-dollar accounting scandal.

Having restated $5 billion in previously reported earnings in 2003, in recent months Freddie Mac was beginning to put its accounting troubles behind and had begun taking market share away from rival Fannie Mae, which is still recovering from its own accounting problems.

The newly disclosed error caught investors by surprise, particularly "given that Freddie had progressed much further in its accounting cleanup," said Robert Lacoursiere, an analyst with Banc of America Securities. More troubling was the fact that the accounting involved was basic. "If they have these types of problems, how have they managed everything else?" Lacoursiere said.

Freddie Mac officials emphasized, however, that the mistake represented only 1 percent of the $36.1 billion in capital on hand as of June 30, and the news had little effect on the company's stock price. Freddie Mac shares closed at $60.68 yesterday, down about 1 percent.

The error stems from a flaw in the accounting program Freddie Mac has used since 2001. In a recent review of the company's accounting system, Freddie Mac employees realized the software was routinely overstating the amount of interest that the housing finance company earned from certain types of mortgage-backed securities that it bought for investment purposes, spokesman Michael Cosgrove said.

The mistake totaled $220 million and to account for that, Freddie Mac decreased the profit it reported for the first half of 2005 to $1.4 billion from $1.6 billion.

The error may also delay by a few months Freddie Mac's plans to register its stock with the Securities and Exchange Commission, Cosgrove said.

Company officials tried to reassure investors yesterday, saying they would step up their review of accounting systems to root out any similar glitches.

Freddie Mac officials said efforts to complete accurate financial reports for 2005 will be finished by no later than the end of March, instead of January. But the error is likely to interfere with previously announced plans to buy back stock. "We've made enormous strides in fixing our financial infrastructure but . . . the effort is not yet complete," Martin F. Baumann, Freddie Mac's chief financial officer, said in a news release. "When we found this error, we corrected it immediately."

Cosgrove said the mistake was not caught earlier because, until recently, Freddie had not been buying the types of securities, backed by adjustable-rate mortgages, that the software apparently mishandled. Over the past year, the company has increased its holdings of such securities by 35 percent, to $236 billion from $175 billion.

As the company shifted to those types of investments, the mistake grew larger and more noticeable. According to a company news release, about $51 million of the error occurred in the second quarter of this year.

Critics of Freddie Mac and Fannie Mae have long argued that the companies' investment holdings are so large that mistakes would be magnified, possibly upsetting global financial markets.

Lynn E. Turner, a former chief accountant for the Securities and Exchange Commission, said this error indicates the company did not adequately test its accounting systems when they were first installed. He said, contrary to management's argument, the amount involved is significant.

"What they're saying is, 'We just aren't worried about an error until it reaches $220 million.' By then the number is so big it impacts shareholders," Turner said.