Can Mr. Fix-it repair Freddie Mac?

by Jack Milligan
For Virginia Business
September 2005

Before heading off to Boston College and later Tufts University, where he earned a doctorate in economics, Richard F. Syron worked for a while as an auto mechanic. Although he later went on to become president of the Federal Reserve Bank of Boston — and since January 2004, CEO at McLean-based Federal Home Loan Mortgage Corp. — the experience of fixing cars became a metaphor of sorts for his career.

“I’ve evolved into something I would describe as a financial mechanic,” he says. “I’m interested in things that need some work. I like to get in there and make it work right.”

He’s certainly at the right place. For the last two and a half years, Freddie Mac has struggled to recover from an embarrassing accounting scandal that turned off investors and put some members of Congress — which created the company to help promote home ownership in the U.S. — in a retributive mood. Syron’s challenge since taking over has been to restore Freddie Mac’s credibility, in Washington and on Wall Street.

In theory, Syron says this repair job is pretty simple. “Set timetables [for what needs to be fixed] and meet them.” His most significant accomplishment to date is bulldozing his way through a massive restatement of three years’ worth of earnings, which had been deliberately understated when the mortgage finance company’s previous management tried to tame its inherently volatile earnings. Freddie Mac expects to resume regular financial reports later this month when it releases results for the first two quarters of 2005. “The

y had a Herculean task of getting their financials together, and they’re doing it according to their timetable,” says Michael McMahon, an analyst at investment banking firm Sandler O’Neill & Partners in New York.

Syron may eventually win back the respect of Wall Street and all-important institutional investors. Whether he can win over Congress, though, is another matter entirely, particularly since Syron’s old boss, Federal Reserve Chairman Alan Greenspan, has warned repeatedly that Freddie’s and sibling Fannie Mae’s $1.5 trillion portfolios of mortgage loans and mortgage-backed securities (Freddie’s share is $665 billion) pose a systemic risk to the U.S. economy should the companies get into trouble and have to dump large quantities of securities on the market.

In testimony before the Senate Banking Committee last July, Greenspan disputed the notion that accumulation of vast portfolios at Freddie and Fannie actually makes more mortgage funds available to home buyers. “That is not adding liquidity to the housing market nor, in our judgment, is it assisting the market generally,” he says. “And in addition, because [managing a large investment portfolio] is a highly sophisticated operation and because it requires sophisticated hedging of interest-rate risk, it is imparting a significant risk to the American financial system.”

Congress and the Bush Administration are locked in a highly political struggle over the future of Freddie and Fannie — which has experienced its own accounting scandal. A tough Senate bill supported by the White House would greatly restrict the size of their enormous investment portfolios (which represent nearly a quarter of the home–mortgage market), defusing a time bomb buried in the nation’s economy or interfering with Freddie and Fannie’s core mission to promote home ownership in America, depending on your political persuasion.

Whether the House — which has passed a much less restrictive measure — and the Senate can reconcile their differences remains to be seen. It’s possible that Congress may fail to pass a bill reregulating Freddie and Fannie this year — the second year in a row it has been unable to reach a political consensus. But that’s not necessarily good news for either company since it’s still unclear whether Congress will drastically alter their business models. And if there’s one thing Wall Street doesn’t like, it’s uncertainty.

The inability of Congress to pass a bill has been a drag on Freddie Mac’s stock, notes Syron. The stock price has stayed in the mid- to low $60s since hitting $74 in late December. “Markets abhor uncertainty, and I think there’s a discount in the stock from not knowing what’s going to happen,” he says. “Whether the legislation is positive or negative, it would provide a degree of clarity,” adds Moshe Orenbuch, an analyst with Credit Suisse First Boston in New York.

Freddie Mac, which has assets of $26.7 billion, is Virginia’s second-largest financial institution after McLean-based Capital One Financial Corp. Freddie Mac was created by an act of Congress in 1970 to compete with Washing-ton-based Fannie Mae, which Congress had established in 1938 as part of the New Deal. Today, both companies promote home ownership by bringing liquidity to the mortgage market. They do this by purchasing home loans from lenders. These loans then are packaged into mortgage-backed securities and sold to institutional investors. Freddie and Fannie also hold billions of dollars of loans in their investment portfolios.

Commercial banks, which must hold a certain amount of capital on their balance sheets as a buffer against loan losses, have come to dominate the mortgage market in recent years — and every time they sell a mortgage to Freddie and Fannie, it frees up capital to make another loan.

Known as government-sponsored enterprises — or GSEs — Freddie and Fannie are publicly owned but exempt from oversight by the Securities and Exchange Commission. They are also exempt from paying state and local taxes, and can issue debt more cheaply than their competitors — chiefly Wall Street investment banks — because they have the implied backing of the federal government.

Freddie Mac’s troubles surfaced in January 2003 with an announcement that it had misapplied various accounting standards in an effort to smooth out its inherently volatile earnings stream. Investors dislike earnings volatility almost as much as they hate political uncertainty. A portfolio of mortgage loans and mortgage-based securities is highly sensitive to changes in interest rates, and the resulting changes in market values must be recorded every quarter — which can make a company’s net income go up and down like a yo-yo. Before the smoke had cleared, two successive CEOs had been fired, and the company had been extensively examined by its regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO.

Syron came to Freddie Mac from Thermo Electron Corp., a technology company headquartered in Philadelphia, where he had been CEO and later chairman. Before that, he served as chairman and CEO of the American Stock Exchange. Syron was joined in September 2004 by Eugene M. McQuade, whom Syron had gotten to know when he ran the Boston Fed and McQuade worked at Boston-based FleetBoston Financial Corp., first as chief financial officer and later as president and CEO. Current plans call for Syron to serve as CEO through 2007, then turn that position over to McQuade and remain on the board as chairman.

Both men are highly respected in the world of banking and finance, and they have provided Freddie Mac with something it really needs — squeaky-clean reputations. “The new management team has credibility — they imported that credibility,” says McMahon, who found Freddie Mac’s previous management team to be “very insular and difficult to deal with.”

But imported credibility will only take Syron so far, and he must be able to show Wall Street and the powers that be in Washington that things are being done differently. Putting the company back on a regular reporting schedule — and keeping it there — will certainly help. Wall Street will be waiting to see if Freddie Mac delivers this month with its first half 2005 results.

Syron also is in the midst of a thorough overhaul of Freddie Mac’s internal controls and accounting system — a process that probably won’t be completed until sometime next year. He has pledged that Freddie Mac will register its stock with the SEC next year as well — which should strengthen investor confidence since it will have to comply with the agency’s tough disclosure requirements. Lastly, Syron placed four new independent members on a board of directors that failed to make sure that accounting policies were being applied properly.

Orenbuch at Credit Suisse likes Syron’s balance of public and private sector experience. “He can speak to regulators and legislators in their own language,” he says. But whether anyone in Washington will listen to him is still an open question.

Noted consultant Bert Ely, president of Alexandria-based Ely & Co., argues that Freddie and Fannie no longer require the implied backing of the federal government to provide liquidity to the mortgage market. “I’m for anything that forces them towards privatization,” he says. Stripped of their funding and tax advantages, the two GSEs would probably end up smaller and therefore less of an economic threat if either one should ever go belly up.

Thus far, at least, Congress is not considering anything quite as drastic as privatization. A House bill passed in May would give OFHEO stronger enforcement powers over Freddie and Fannie, including limited authority to shrink the size of their investment portfolios. A proposed Senate bill, reported out of committee in July that has garnered the support of Treasury Secretary John W. Snow, would give OFHEO considerably more discretion to force the GSEs to reduce the size of their portfolios.

Syron takes exception to Greenspan’s argument that Freddie’s and Fannie’s huge portfolios pose a systemic risk to the U.S. economy. Reducing those portfolios would probably shift many of those holdings to the GSEs’ chief rivals — large U.S. banks that are FDIC-insured — which would still threaten the economy. “The risk has to go in one place or another,” he says. And since banks generally do not hold on to their fixed-rate mortgages because they carry a significant interest-rate risk, a dramatic reduction in the ability of Freddie and Fannie to buy these loans could lead to a sharp drop in the availability of the 30-year fixed-rate mortgage. And as Syron is quick to point out, there isn’t another country in the world where fixed-rate mortgages are more available than in the U.S. — a factor that he attributes to the presence of Freddie and Fannie.

Syron’s position draws support throughout the industry. Although he stops short of saying there shouldn’t be any portfolio restrictions, Kurt Pfotenhauer, senior vice president for government affairs at the Mortgage Bankers Association — the mortgage industry’s largest trade group — mostly agrees with Syron. “Should they have unlimited ability to grow those portfolios as large as they can?” he asks. “I don’t think a reasonable person can say that. But the fact that they can issue debt and carry a portfolio is clearly important for the market.”

With a Supreme Court nomination on the table and other pressing issues, its appears that Congress may fail to pass a GSE reform bill for the second year in a row. “There’s a growing chance that there will not be a bill this year,” says Ely, who has followed the legislative process closely. And that’s not necessarily in Freddie Mac’s best interests since it leaves a dark cloud over the company’s future. “They need a bill to put things to rest,” he says.