Last Wednesday, Freddie Mac hosted a conference call updating the status of its previously announced re-audit. On the call, the GSE's new management admitted that some accounting policies used in the past were implemented in the context of Freddie's goal to achieve steady earnings growth and that some of the agency's disclosure processes actually fell short of standards that would have been required of Freddie if it were a Securities and Exchange Commission registrant.

It was also revealed in the call that the cumulative impact of the restatement will likely increase retained earnings as of year-end 2002 by a range of $1.5 billion to $4.5 billion.

In its commentary after the conference call, Merrill Lynch analysts said that, although earlier briefings by Freddie's management had suggested that current income had been understated, presumably to smooth out future earnings, the breadth and scale of revisions are actually not a surprise. Merrill also said that the new management seems to be taking appropriate steps to regain credibility. However, investors will no doubt require a clearer understanding of these new policies and procedures before they gain comfort.

Meanwhile, last Tuesday U.S. Rep. Richard Baker (R-La.) announced his intention to introduce a bill to create a new government regulator for Freddie and its rival Fannie Mae that has increased funds and more powers. This announcement came a day before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises held a hearing called "GSE Oversight: The Need for Reform and Modernization." In this hearing, none of the GSEs were invited to testify, and there were no representatives from the Office of Housing Enterprise Oversight (OFHEO), which regulates both Freddie and Fannie.

In light of these recent events, Merrill said that regulatory as well as headline risk would certainly increase in the near term. "GSE topics likely to stay in the headlines in coming months will revolve around supervision, financial disclosures, derivative accounting and capital issues," wrote analysts. However, Merrill also emphasized that, ultimately, any move to strengthen disclosure and supervision should actually serve as a long-term positive for GSE debt holders.

In terms of the mortgage-backed market, analysts said that the issues raised against Freddie do not really affect MBS on fundamentals. However, some foreign investors, because of a lack of understanding of the U.S. system, now prefer Ginnie Maes. These investors are shying away from the headline risk involving both GSEs and believe that Ginnies are a better alternative. This is despite the fact that Ginnies have become more expensive relative to their conventional counterparts in the last couple of weeks due to the lack of headline risk and the limited supply in the sector.

MBS analysts do not think that the negative sentiment against GSE debt is well founded. The former management's misstatement of Freddie's quarterly earnings in respect to the timing of recognition of revenue does not fundamentally change the credit quality of Freddie, they believe. Aside from this, analysts also said that Congressman Baker's bill would probably not be passed this year without President George W. Bush's endorsement. These headline risks would likely be negative for Freddie and Fannie stock, but not for their debt, said analysts.

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