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Freddie Mac's Scandal

November 2007- -The financial reporting lies in the statements of Federal Home Loan Mortgage
Corporation (Freddie Mac) came to light in 2003. The Securities and Exchange Commission recently
issued a litigation release that attempts to put the affair behind us. Unfortunately, the SEC still cannot
meet its goal of meting out punishment against the bad guys and only the bad guys.


The SEC issued Litigation Release No. 20304 on Sept. 27. The SEC alleges that the corporation
engaged in an accounting fraud from 2000 to 2002. The manipulation of earnings occurred by incorrectly
accounting for various derivative instruments of the firm as well as manipulating the accounting for loan
origination costs and reserves for losses. Freddie Mac will pay a $50 million fine. The four executives
who conceived and executed this fraud were also punished. Their fines ranged from $65,000 to $250,000;
they paid out disgorgement amounts that ranged from $29,227 to $150,000. More details are laid out in
the SEC complaint in this matter.
The fascinating thing about this accounting scandal is that it involved the understating of net income. In
particular, the SEC contrasts the reported income with the restated net income (in billions of dollars):
Year Reported Net Income Restated Net Income Difference
2000 $2.547 $3.666 $ 1.119
2001 4.147 3.158 (0.989)
2002 5.764 10.090 4.326
This fraud creates three problems for investors and creditors:
The first consequence of the fraud is that it misleads capital providers with respect to the firm; the
investment community will not think it as deserving as other organizations. The economy suffers a
misallocation of resources.
The second consequence of the fraud is that it supplies the corporate executives with incentives to engage
in insider trading. The market thinks the business entity has the lower income and may bid down the stock
price and the bond prices. The managers who are partaking in the fraud know that the earnings stream is
actually higher and can profit from this knowledge illegally.
The third consequence is that the market may misestimate the risk of the corporation and, in this case, that
seems to provide the motivation for the accounting fraud. Corporate managers wanted to portray a picture
of a steady, reliable company that was ever growing in resources and income. That picture was phony
inasmuch as the true income stream is far more volatile than the reported earnings would indicate.