Outrage of the Week: Freddie's Curious Accounting

As anxiety over Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) keeps the financial sector in a panic, the hunt for those responsible is bound to gear up in the next few weeks.

As with past meltdowns, many deserve a share of the blame. Homeowners took on the risk, banks provided means for that risk, Freddie and Fannie had government backing to accept and insure the risk ... the debate could run in circles for days. As fellow Fool Anand Chokkavelu pointed out yesterday, Freddie and Fannie were, after all, just doing their job of providing liquidity to the mortgage market. No single group deserves all the blame here.

But if you've just gotta have something to scold, here's one no-no worth wagging your finger at.

Accounting gone wild
Freddie Mac's most recent quarterly earnings showed a net loss of $151 million, which easily beat analyst expectations. Not too bad, all things considered.

On the earnings conference call that day, Freddie Chairman and CEO Dick Syron explained the better-than-expected results: 

Our results reflect a balance of three factors: one, growing revenues based on increasing volumes, two, changes in our accounting that more closely align with the underlying performance of our business and three, worsening credit conditions.

Whoa, whoa, whoa ... time out!
Here's a good rule of thumb: Whenever management mentions anything along the lines of "changes in accounting to better reflect our business," and "worsening credit conditions" in the same sentence, your "shady" radar should start blaring at you.

Digging a little deeper, analysts estimated that those accounting changes Syron mentioned reduced Freddie's credit-related charges by at least $2.6 billion. The two rules he referred to give Freddie the privilege to:

  • Estimate the value of some assets using its own models.
  • Pick and choose certain assets to measure with its own models.

Without getting too deep into specifics, here's an overview of the accounting rules mentioned: So-called "Level 3" assets are so illiquid that market prices don't provide an adequate valuation. Without the market quoting a price, the only reasonable way to value the assets is with an internal model.

That's not entirely outrageous. However, Freddie's Level 3 assets rose by $120 billion during the quarter, as the company apparently chose to reclassify its entire asset-backed securities portfolio into Level 3. That gave Freddie a lot more flexibility to use its own models to price some of its most troubled holdings. In addition, the second rule allowed Freddie to use similar methods to value other assets that would otherwise have been ineligible for the treatment Level 3 assets get.

I think you can see the absurd conflict here: The more assets you can value with your own models, the more you can tell investors what they want to hear, and the happier everyone is.

If only it were that easy...
None of this seems to be illegal, and as far we know, Freddie didn't break any rules. But you don't need to be Warren Buffett to realize the move wasn't exactly an exercise in transparency.

If investors didn't get the clue back then, they probably get it by now. Since that fateful announcement back in May, both Fannie and Freddie have coughed up the majority of their share prices.

This is delicate stuff we're dealing with
Giving a company the right to pick and choose what assets it wants to value on its own isn't too far from leaving a kid in a candy store and saying "Only take what you think is responsible." Given the option, of course Freddie will try to assign its assets the highest values.

Thornburg Mortgage (NYSE: TMA  ) and MBIA tried to weasel their way out of marking assets to market levels -- neither made it very far. On the other side of the battle, companies like Citigroup (NYSE: C  ) , UBS (NYSE: UBS  ) , Merrill Lynch (NYSE: MER  ) , and AIG (NYSE: AIG  ) have almost certainly been forced to take writedowns that didn't accurately reflect the true value of the securities.

What's the solution to these accounting shenanigans? I don't have an answer. Nobody does, really. Assets are worth what someone else will pay for them -- no more, no less. When you can't find someone immediately willing to pay for them, their value becomes dicey. And when you're given the freedom to pick and choose how and when assets get valued -- as Freddie Mac was -- the whole thing becomes a lesson in sketchynomics.

Digging into the accounting games Freddie played two months before shares went into freefall outraged me the most this week. Anything outraging you? Feel free to chime in using the comment box below. We'd love to hear from you.

For related Foolishness:

Fool contributor Morgan Housel moved his losing stocks into an imaginary Level 3 zone, but he doesn't feel any richer. He doesn't own shares in any of the shares mentioned in this article, either. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always on the level.


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  • Report this Comment On July 21, 2008, at 9:34 PM, Ishortyou wrote:

    Well it looks like that those CDOs-ABS-SIVs need to be traded in an open market just like a common stock with a bid and a ask price, with that there will be less uncertainties about their price and with that the accounting should be more transparent.

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