Risk at Freddie Mac

By J. Duffie, Erin Yurday
2004 | Case No. F270
Freddie Mac, a government-sponsored enterprise (GSE) chartered by Congress in 1970, was one of the U.S. housing market’s largest supporters. At year-end 2003, Freddie Mac’s total mortgage portfolio reached a total principal of $1.4 trillion. The U.S. Government did not explicitly back Freddie Mac, which was a stockholder-owned organization, but investors were said to perceive some degree of implicit government backing. After its success in the 1990s, Freddie Mac made maintaining steady earnings growth in the mid-teens an explicit goal. A key to achieving steady earnings growth was interest rate risk management, since Freddie Mac earned much of its money by managing the difference between interest income on its mortgage and MBS assets and the associated funding costs. To smooth earnings in a changing interest rate environment, Freddie Mac prided itself on modeling, measuring, and managing credit and interest rate risk. Significant resources were devoted to developing sophisticated, quantitative risk modeling and solutions. Interest rate risk was reduced largely through the use of interest rate swaps and swaptions. The motivation to smooth earnings was inherent in Freddie Mac’s culture and caused business problems: The operations (e.g., accounting, audit, etc.) of the organization were not well supported, executive compensation was tied to meeting earnings estimates, and employees involved in developing creative accounting solutions to manage earnings were thought of as “first-class citizens.” On January 22, 2003, Freddie Mac announced it would restate earnings for 2002, 2001, and possibly 2000. The following June, OFHEO (Office of Federal Housing Enterprise Oversight), Freddie Mac’s regulator, began an examination of Freddie Mac’s culture and the events leading up to the restatement. OFHEO determined that Freddie Mac had neglected operations risk management when managing interest rate risk and earnings, leaving room for accounting and disclosure issues. Investors and regulators were taking a hard look at Freddie Mac. How should investors view the events leading up to the $5 billion restatement and Freddie Mac’s management of interest rate risk and operations risk?
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