probable case.'

,,145

Similarly, the same report presented to the committee on September 7, 2001, notes that "the current reserve balance continues to be in excess of

the most probable case" and that "we are adequately reserved even if a more significant economic downturn were to occur."

146

The maintenance of an unnecessarily high loan loss reserve has the appearance of creating a "cookie jar” that can be used to suppress or support earnings when convenient. There is some evidence that the loan loss reserve of Freddie Mac was so used, although the reserve consistently grew at a slow rate between 1998 and 2001. Suggestive notes from an April 1, 1998 meeting in the office of Mr. Brendsel indicate that "JG [then-CFO John Gibbons] to determine whether to reduce the first quarter loan loss provision from $75 million to $60-65 million to maintain a flat earnings stream. However, actual and

"147

probable future losses were declining sharply at the same time, so while the reduction in the provision was convenient, its timing appears appropriate. In an interview Deputy Controller Lisa Roberts recalled that, three years later, then-CFO Vaughan Clarke attempted to get Corporate Accounting to raise the reserve by $5 million to narrow the gap between preliminary earnings results and the expectations of stock analysts.'

148

149

In the fall of 2001, Freddie Mac hired Edmond Sannini as its new Controller. Not long after starting that job, Mr. Sannini expressed concern at the level of the loan loss reserve, "not so much the absolute level but at least the documentation that we had to support that did not seem to be commensurate that I would have expected to have.” The new auditors from PricewaterhouseCoopers started their engagement in March 2002, and Mr. Sannini told Messrs. Clarke and Glenn that "I thought that [PricewaterhouseCoopers] would come in, would be taking a hard look at our loan loss reserve based upon our documentation that we had."150 Sometime in the second quarter of 2002, said Mr. Sannini, it became clear "that it was broader than a documentation

145 Key Financial Reporting Estimates, Audit Committee, March 2, 2001, OF 2011150.

146 Key Financial Reporting Estimates, Audit Committee, September 7, 2001, OF 2011178.

147

Meeting Preparation and Feedback Form, Office of the President, April 1, 1998, LD ODG 0005980. 148 OFHEO Interview, Lisa Roberts, August 6, 2003, p. 62.

149

150

1950

OFHEO Interview, Edmond Sannini, August 1, 2003, p. 53.

Id., p. 55.

issue, that the levels that we were reserving to were most likely not probable and estimatable...."151

Ultimately, Freddie Mac made a $250 million reduction in the loan loss reserve, booking the entire amount in the third quarter of 2002. That reduction in the loan loss reserve increased earnings, but was largely offset in the fourth quarter of that year by a $225 million cash contribution by the Enterprise to the Freddie Mac Foundation and the corporate giving program of Freddie Mac. 152

FAS 91 and the Improper Management of Earnings

153

As noted in Chapter II, the use of inappropriate accounting strategies to dampen earnings volatility began well before the reaudit and restatement period. In 1994, Freddie Mac management created a reserve account to cushion against the fluctuations caused by the unpredictable amortization of premiums (or accretion of discounts) resulting from changing mortgage prepayment speeds. That amortization is required by FAS 91," which, among other things, requires that purchase premiums and discounts on loans (including debt securities) be recognized as an adjustment of yield, generally by the interest method based on the contractual terms of the loan. The debt securities the Enterprise owns are primarily mortgage-backed securities, which means that management must re-cast continually the amortization of premiums and discounts based on the prepayment speeds of the underlying mortgages. In a volatile interest rate environment, prepayment speeds can change rapidly, thus leading to changes in mortgage premium amortization and making net interest income volatile and difficult to forecast.

The creation of the FAS 91 reserve by Freddie Mac was itself an act of earnings management. Management created the reserve to offset a $200 million windfall gain from an unexpected tax event. The reserve was presented quarterly to the Audit Committee of the Board in a report of "Key Financial Reporting Estimates." A reserve

151 Id., p. 58.

154

152 Freddie Mac Fourth Quarter 2002 Earnings Release, January 27, 2003.

153 Financial Accounting Standards Board (FASB) 1986, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." Statement of Financial Accounting Standards, No. 91, Norwalk, CT: FASB.

154 Memorandum prepared by Baker Botts Re: Jeff Harris Interview, February 24, 2003, OF 2000327.

account to protect against potential changes arising from FAS 91 is not permitted by GAAP. There is no evidence that the Board was ever told that the reserve was a departure from GAAP, but there is also no evidence that the Board ever questioned if it was permitted by GAAP. Management used the reserve to absorb "catch-up" amortization when actual mortgage prepayments differed significantly from those previously forecasted, specifically one or two standard deviations away from a base-case interest rate forecast. The reserve peaked at $216 million in the fourth quarter of 1999, which was approximately 5.4 percent of net income.' When the reserve was depleted in the second quarter of 2001, management established a narrower range for catch-up amortization of plus or minus $25 million; any amortization outside of that range had to be recorded as income or expense. Getting the amortization numbers to fall within the range was sometimes an all-night process; according to one employee, it was "classic" for Freddie Mac to "play with the numbers until they got the right one."

155

156

Some of the problems relating to FAS 91 amortization relate to an outdated "amortization engine" used by Corporate Accounting to determine the correct amount of premium and fee amortization in a given reporting period. That amortization engine is inadequate for a company with a balance sheet as large as that of Freddie Mac, particularly since most of the assets of the Enterprise are mortgages whose prepayments are sometimes difficult to forecast.157 Difficulties in computing premium and fee amortization may have played a role in the decision to create an amortization reserve, but the reserve was also useful to management for earnings management purposes, and management made the Board aware of that. For example, a presentation by management to the Investment Committee in June 1999 states that “analyzing the adequacy of reserves (amortization and loan loss)" is among the "strategies we are investigating for improving the time pattern of NII between 1999 and 2000."158

155 Memorandum from Mary Beth Perdue to the Files, "Amortization Reserve," Attachment A, February 20, 2003, OF 2012954.

156 Memorandum prepared by Baker Botts, Re: Luis Betancourt Interview, February 6, 2003, OF 2000084

OF 2000085.

157 Internal notes prepared by OFHEO, Re: John Woods Interview, July 25, 2003.

158

Presentation to the Investment Committee of the Board of Directors of Freddie Mac, “Multi-Year Net Interest Income Planning," June 4, 1999, OF 5001460A.

Management used various interest rate and yield curve assumptions to determine amortization amounts. At various times management used a forward yield curve159, a 60

160

162

161

day average yield curve,' and a flat yield curve.' The multiple interest-rate methodologies used by management to estimate amortization at various points in time violated the consistency principle of GAAP." One example of management changing its interest-rate assumptions to obtain a more desirable earnings number occurred in the first quarter of 2002. Because the yield curve was steep at that time, as it had been in 2001, and because management had pushed forward operating earnings from 2001 into 2002 with linked swaps, earnings for the first quarter of 2002 were on a pace to come in significantly above forecasted results. The FAS 91 amortization component of net interest income was highly sensitive to assumptions regarding future interest rates, and the choice of the yield curve used was a critical one. Management decided to use a flat yield curve for the first quarter of 2002, which resulted in a $141 million difference relative to using a forward curve.

Freddie Mac employees in Corporate Accounting justified their use of the flat yield curve in part on the basis of conversations with PricewaterhouseCoopers in early 2002. Stephen Bledsoe, who headed the Net Interest Margin group in Corporate Accounting at the time, said that his understanding of the amortization process at that time was that it was reasonable to use a number of different interest rate forecast assumptions, including a flat or constant yield curve. He said that belief was based upon a conversation that he had with PricewaterhouseCoopers. However, partners from PricewaterhouseCoopers working on the Freddie Mac engagement later said that they were asked by Freddie Mac staff in a meeting in 2002 if there were companies that used a flat yield curve in their valuation processes. The partners answered that they were aware

159 The forward curve is an interest rate curve derived point by point from the traditional yield curve. The forward curve shows the implied forward interest rate for each period covered by the yield curve.

160

Memorandum from Stephen Bledsoe to the Files, "Use of average rates in asset amortization process," June 28, 2002, OF 2012955.

161 What has been described as a “flat yield curve" in other reports describing the Freddie Mac SFAS 91 process was actually the spot rate curve for a particular date, which would generally appear flatter than a forward yield curve.

162 Financial Accounting Standards Board (FASB) 1980, "Qualitative Characteristics of Accounting Information." Statement of Financial Accounting Concepts No. 2, paragraph 120. Norwalk, CT: FASB.

that some companies used a flat yield curve, but those companies had different businesses than Freddie Mac, and the purposes of the valuations were different as well.

The key problems with the FAS 91 reserve are 1) the use of a reserve account that was not compliant with GAAP; 2) the use of that account to reduce earnings volatility; 3) changing a key assumption used in the calculation of the reserve to achieve a desired earnings result; and 4) failing to disclose that a non-GAAP reserve account was being maintained and that a key assumption in the calculation of the reserve had been changed. Those problems resulted from weaknesses in the accounting policies, accounting controls, and disclosure policies of the Enterprise.

The Aftermath

Many of the transactions described above did not survive under the scrutiny of the reaudit of Freddie Mac. As the Enterprise dissolved many of its earnings management strategies in 2003, there were cascading effects throughout its financial statements, since those strategies were interconnected. The unwinding of the CTUGS, for example, killed the viability of the Embedded PC Option (EPCO) hedging strategy, a complex and operationally challenging attempt to reduce earnings volatility resulting from FAS 133. EPCO used combinations of interest rate swaps, swaptions, and other derivatives to hedge prepayment options embedded in the retained mortgage portfolio of Freddie Mac. Management developed EPCO in order to record fair value gains and losses for its embedded PC options' 163 that could then be used to offset fair value changes in the derivatives portfolio of the Enterprise. For EPCO to work, the hedged securities must be designated as available-for-sale, because investments classified as held-to-maturity or trading are ineligible for FAS 133 treatment. Thus, when management unwound the CTUGS and transferred its available-for-sale securities back to the trading account, those securities could no longer be included in the EPCO strategy. The "linked swaps" were also connected with EPCO, as they were used in EPCO hedge relationships in order to receive favorable accounting treatment. 164 Additionally, management identified other errors in measuring the effectiveness of the hedge relationships under EPCO and

163 "PC option" refers to the prepayment options in Freddie Mac PCs.

164 Memorandum from Thomas Stuber to the Files, "EPCO Hedge Strategy," May 16, 2003, OF 1707016.