Posted on 16-6-2003

Unreal Estate
By ROGER FRANKLIN, 14 June03

Enron, WorldCom, the bent analysts at Citi all have ruffled markets and
depressed the Dow. But a catastrophic wipeout? It didn't happen.

Let's hope the attitude lingers, because it may come in handy over the
months to come, given last week's news of a growing scandal at a
Government-backed outfit that goes by the name Freddie Mac. That's the cute
moniker of the Federal Home Loan Mortgage Corporation, which has indirectly
financed some 30 million American homes. That's one in six, and the sum
involved runs to around US$6.5 trillion. Yes, trillions.

The way it works, or should work, is this: Freddie draws on a pool of
discounted, Government-backed financing to buy mortgages from the banks
that issued them. This covers the banks' liabilities and re-injects the
cash they need to continue lending. Freddie then recoups its own costs by
selling bonds against the income those mortgages generate every month as
home owners pay them off. As investments go, it's as sexy as tap water,
which is why so many prudent Americans sock a solid portion of their
retirement savings into Freddie's public offerings: no big surprises, no
great risk. At least that is what everyone has believed.

On Monday, however, investors learned that things aren't quite so simple.
That was when Freddie's three top executives were ousted in the wake of an
ongoing audit by PriceWaterhouseCooper, which last year replaced the
defunct Arthur Andersen. Andersen, you may recall, was the bean-counter
whose willingness to turn a blind eye to Enron's depredations paved the way
for the world's biggest corporate collapse. It now appears Andersen applied
the same loose standards to its reviews of Freddie's books. PriceWaterhouse
says published earnings for the past three years have been incorrect, as
the investigation focuses on Freddie's attempts to inoculate itself against
interest-rate fluctuations by assembling a portfolio of derivatives.

This is where things get a little more anxious, if only because of
derivatives' role in some spectacular financial train wrecks. Orange County
in California went broke when its treasurer made the wrong bets, and Long
Term Capital Management imploded with a thud that could have vapourised all
of US$1 trillion if the feds had not rounded up a posse of banks to bail
out the bankrupt fund. Happily - and it's the only good news so far - the
most recent audits concluded that, unlike Enron, Freddie had understated
its earnings. That helps to explain why its stock sank only 19 per cent in
the four days after the head-loppings - a drop, incidentally, that might
have been much worse if Freddie and its sister, Fannie Mae (a privately
financed home loan funding guarantor which operates under a congressional
charter), had not immediately spent US$12 billion buying up their own shares.

So what's the cause for concern? There's a bunch of them, starting with the
fact that Freddie's chief financial officer shredded a pile of records
before being escorted out of the office in disgrace. According to some, he
fiddled the numbers so that Freddie's future growth would look much better
when judged against the artificially depressed numbers allegedly concocted
with Andersen's assistance. Next, there is the shock of learning that
Enron-style shenanigans, complete with off-the-books borrowing, have been
going on at a Government-backed institution. To investors, it's been like
discovering that a revered grandma was selling sin to sailors on the sly.

Then there are the echoes of Wall St's other recent scandals involving
duplicitous research. Of the five big brokerage houses that give favourable
ratings to Freddie's stock, four earn big money underwriting its bond
offerings. The bona fides of those opinions would be easier to accept if
rival outfits with no investment banking interests had not been downgrading
their own projections last week.

Finally, there are those derivatives, which once represented a sober US$72
billion slice of Freddie's balance sheet, but now account for an
intemperate US$1.2 trillion. And that's why, if Americans were in the mood
to worry, the incidence of sleeplessness would be soaring. If those
derivatives were to go sour, Freddie's financial foundation would crumble,
as Federal Reserve chairman Alan Greenspan noted when he observed that
Freddie and the even larger Fannie have the potential to prompt a systemic
economic collapse.

How so? It's quite simple: consumer spending has sustained the economy ever
since the shock of September 11, and much of that buying binge has been
fuelled by home owners refinancing their mortgages at the current low
rates. Most have added a little mad money to the total drawn against the
equity in their homes and then headed for the mall. If Freddie's woes
ripple through the mortgage market, banks will become less able and willing
to lend, liquidity dries up, the superheated property market tanks, and
millions of home owners see their paper wealth incinerated.

No one is saying that scenario will unfold. But the fact is, it could. Just
as well Americans have learned not to worry.