Attempting to Heal a Fractured Mortgage Market
Freddie's Woes Run Deep, Report Says

By David S. Hilzenrath
Washington Post Staff Writer
Wednesday, April 16, 2008; D01

A federal regulator said yesterday that it has "significant supervisory concerns" about the conditions of Fannie Mae and Freddie Mac, two government-sponsored housing finance companies that own or guarantee trillions of dollars of mortgages.

Both companies have suffered financially from the meltdown in the housing market and remain vulnerable to further declines, but Freddie Mac's problems run deeper, the regulator said.

Freddie Mac still has some ineffective internal controls, has invested in poorly underwritten loans and lacks "sufficient executive management depth," the Office of Federal Housing Enterprise Oversight said in an annual report to Congress.

The regulator also raised questions about accounting decisions Freddie Mac made last year, saying they need further review. Those issues include Freddie Mac's approach to calculating the amount of money it should hold in reserve and other accounting choices that enabled the company to report a one-time gain of about $1 billion.

Under an accounting rule, Freddie Mac was able to book income from changes in the value of securities it held and was able to choose which securities to use that way, presenting the opportunity to cherry-pick.

In an interview, OFHEO Director James B. Lockhart III said the agency was not challenging the accounting judgments Freddie Mac has already made but will be monitoring its approach going forward "to make sure there's a logical and ongoing methodology."

The Securities and Exchange Commission may look at the accounting issues as Freddie Mac seeks to register with the SEC this year, Lockhart said.

At the end of last year, Fannie Mae and Freddie Mac had $4.8 billion and $15 billion of paper losses, respectively, that they had not counted against earnings, OFHEO said. The deferred losses involve what the companies regard as temporary declines in the value of mortgage-related investments, but determining whether the losses are permanent and therefore must be counted against earnings is a judgment call, OFHEO said.

"This is raising a yellow flag," Lockhart said. "Obviously, if we had a major issue with any of these they would have made a change," he said.

The regulator's assessment came several years after twin accounting scandals prompted Fannie Mae and Freddie Mac to replace their top managers and begin overhauling the systems they use to track finances.

The government has been counting on Fannie Mae and Freddie Mac to help prop up the troubled mortgage market, and toward that end OFHEO last month agreed to let them operate with thinner financial cushions. In announcing the decision, OFHEO emphasized the progress both companies had made in recovering from the accounting scandals.

In the report released yesterday, OFHEO gave Fannie Mae more credit than Freddie Mac. Fannie Mae's internal controls range "from satisfactory to adequate," the regulator said.

Nonetheless, many of Fannie Mae's controls "remain manually intensive," increasing the potential for error, OFHEO said.

Chartered by the government to keep mortgage money flowing, Fannie Mae and Freddie Mac package mortgages into securities for sale to investors, promising to make the payments if the borrowers default. That frees lenders to make new loans. Fannie Mae and Freddie Mac also invest in mortgages directly.

The companies were responsible for about 75 percent of the mortgage-backed securities issued in the last three months of 2007.

Investors generally assume that the government would bail out the companies if necessary. Such a scenario, though unlikely, could hurt the government's credit rating, which in turn could make it costlier for the government to support annual budget deficits, the Standard & Poor's debt-rating agency reported Monday.

Both companies are reeling from the bursting of the housing bubble. They lost a combined $6 billion in the fourth quarter of 2007 as Fannie Mae reported its first annual loss since 1985 and Freddie Mac reported its first annual loss.

In a letter to congressional overseers, Lockhart yesterday repeated his longstanding plea for Congress to give regulators more power over Fannie Mae and Freddie Mac.

The two companies declined to answer questions about specific findings in OFHEO's report.

"We are pleased that OFHEO acknowledged our successful return to timely financial reporting and our effective management of interest rate and liquidity risks," Freddie Mac spokeswoman Sharon J. McHale said in an e-mail. "Our management team will continue to work closely with OFHEO to implement recommendations, further enhance controls and responsibly inject needed capital into the housing market."

Fannie Mae spokesman Brian Faith said his company "will continue working closely with OFHEO."

Freddie Mac's financial problems stem partly from a "strategic decision" to buy and guarantee higher-risk loans issued over the past two years, including mortgages with limited or no documentation and loans with low down payments, OFHEO said.

Freddie Mac must improve its planning and forecasting to ensure that it maintains sufficient capital, and its information systems have not kept pace with growing challenges, OFHEO said.

"Concerted efforts by the Board and management will be necessary to improve financial performance, mitigate credit weaknesses and complete the internal controls remediation effort," OFHEO said.