UNEDITED

The stock market demonstrated dynamics of a vulnerable speculative Bubble this week. Volatility was extraordinary, especially in the more speculative areas of the marketplace. For the week, the Dow gained 2% and the S&P500 added 1%. The Transports jumped 2.5%, increasing y-t-d gains to 29%. The Utilities were about unchanged. The Morgan Stanley Cyclical index added 2.5% (up 43% y-t-d) and the Morgan Stanley Consumer index increased 1%. The leading S&P groups were Steel, Movies & Entertainment, and Automobile Manufacturers. The broader market was exceptionally volatile, but ended the week with strong gains. For the week, the small cap Russell 2000 added 1.5% (y-t-d up 43%) and the S&P400 Mid-cap index rose 1%. The NASDAQ100 added 1%, increasing 2003 gains to 44%. The Morgan Stanley High Tech and Semiconductor indices were about unchanged. The Street.com Internet index increased 1.5% and the NASDAQ Telecom index added 1%. The Biotechs were little changed for the week. Financial stocks rose, with the Broker/Dealer and Bank indices up about 1%. Although bullion gained $2.50 to $408.85, the HUI gold index sank 6%.

Rather than being bothered by the sinking dollar or surging commodity prices, the Credit market ended a volatile week comfortable that the Fed remains on hold for a considerable period. As such, the yield curve steepened this week, as 2-year Treasury yields declined 6 basis points (to 1.81%) while long-bond yields rose 3 basis points (5.09%). The implied yield on December 2004 Eurodollars sank 12.5 basis points to 2.225%, the lowest since October 3. Five-year Treasury yields declined 2 basis points to 3.19%. Ten-year yields added 1 basis point to 4.24%. Benchmark Fannie Mae mortgage-backed yields increased 4 basis points. Spreads on Fannie's 4 3/8% 2013 note narrowed 1 to 36 and Freddie 4 ½ 2013 note narrowed 1 to 35. Corporate spreads generally widened slightly, although remaining a near 5-year lows. The 10-year dollar swap spread declined 1.5 to 36.75, the narrowest since mid-July.

It was another strong week of debt issuance. Investment grade issuers included Wyeth $3 billion (up from $2.5 bn), International Paper $1 billion, Procter & Gamble $700 million, Bunge Finance $500 million, Diageo Finance $500 million, Raytheon $500 million, Harrahs $500 million, Pricoa Global Fund $500 million, SBA Telecom $400 million, MDC Holdings $350 million, Cleveland Electric $300 million, Southern Cal Gas $250 million, Virginia Elect & Power $225 million, Caterpillar Finance $200 million, Wisconsin Public Service $125 million, RLI $100 million, and Washington REIT $100 million.

Junk bond funds received inflows of $384.5 million, the sixth straight week of positive flows. The extraordinary list of debt issues - imparting little impact on interest rates or spreads - is testament to the truly incredible amount of liquidity sloshing around the system. This week's junk issuers included Ship Finance International $580 million, Granite Broadcasting $405 million, Couche-Tard $350 million, Valeant Pharmaceuticals $$300 million, Sensus Metering $275 million, Young Broadcasting $230 million, United Agric Products $225 million, Bombardier $200 million, Vaisystems $200 million, Simons $200 million, Hanover Compress $200 million, WMC Finance $200 million, Kraton Polymers $200 million, Land O Lakes $175 million, Great Lakes Dredge&Dock $175 million, Mariner Health $175 million, Equinox Holdings $160 million, Tenneco Automotive $125 million, FPL Energy Wind Funding $125 million, Blue Ridge Paper $125 million, Semco Energy $50 million, and Pathmark Stores $50 million. Foreign dollar junk issuers included Tele Norte $300 million, Axtel $175 million, and Embratel $275 million.

New converts included: Sepracor $600 million, Emulex $450 million, Apogent Tech $300 million, Centerpoint Energy $225 million, Serena Software $220 million, Akamai Tech $175 million, Hanover Compress $144 million, Magnum Hunter $100 million, and Affymetrix $100 million.

Another strong week of sales pushed asset-backed security (ABS) issuance to a new yearly record. Total y-t-d issuance of $431.8 billion is running 19% above last year's record pace. By collateral type, Auto loan ABS is running down 14% at $14.4 billion and Credit card ABS is down almost 9% at $47.3 billion. Home Equity loan ABS, however, is running up almost 59% to $179 billion.

Commodities Watch:

December 11 - Dow Jones: "Imported oil will account for half of China's oil consumption by 2007 from little over 30% now due to low-level domestic oil production, a recent study by the Chinese Communication Ministry said Thursday, Kyodo news service reported. The official Xinhua News Agency, citing the study, said China's oil production has increased only 1.7% a year on average in recent years is projected to boost the nation's dependence on imported oil to more than half of its oil consumption by 2007..."

December 11 - Bloomberg: "The U.S. left its estimate for the soybean surplus before next year's harvest unchanged at 125 million bushels, the lowest since 1977..."

The CRB index jumped 2% this week, with 2-week gains of 5%. The CRB today closed at the highest level since April of 1996 and is up 44% from the lows of October 2001. Today saw $33 crude (strong global demand and a possibly intransigent OPEC) and $7 natural gas (cold weather and depleting inventories). According to Bloomberg, natural gas has surpassed $7 "for just the third time in the 13-year history of the Nymex contract," with 2-week gains of about 45%. With energy prices on the rise, the Goldman Sachs Commodity Index surged 5% this week, increasing two-week gains to 9%. Gold ended at a 7-year high, copper at a 6-year high, soybeans at 6-year highs and platinum at a 23-year high.

Dollar Watch:

The widely anticipated dollar rally will have to wait for at least another week. The dollar index dropped another 1% this week to the lowest level since the first week of 1997. It was interesting to listen to "Kudlie and Cramie" passionately beg Secretary Snow to intervene in the markets to support the dollar ("knock the heads" of the speculators). First of all, it will likely require a determined concerted intervention by global central bankers to even begin to turn the tide. And perhaps the Europeans are in no mood to participate, especially after watching the incredible financial resources expended by the Japanese (with ominously limited impact). Moreover, Messrs. Kudlow and Cramer should be careful for what they wish for: An unsuccessful major intervention would illuminate the Treasury's weak hand and likely precipitate a less orderly dollar decline.

As you read through this week's "watches," please take note that the dollar is at 6 to 7-year lows, gold prices at 6 to 7 year highs, commodity indexes at 6 to 7 year highs, Chinese inflation at 6 to 7 year highs, and even Japanese business confidence at 6 to 7 year highs. While inflationary manifestations are unbalanced, diverse and foolhardy, it is increasingly difficult to argue that an historic global reflation is not having a major impact. And it is also worth noting that the authorities in Washington, Beijing, and Tokyo (and, to a seemingly lesser extent, Frankfurt) have their individual motivations for perpetuating the current inflation. It has been a long time since inflation enjoyed such widespread adulation.

Global Reflation Watch:

December 12 - Bloomberg: "Japan's large manufacturers are the most optimistic in 6 1/2 years and plan to increase capital spending as accelerating global economic growth boosts demand for their cars, DVDs and mobile phones. Sentiment rose to 11 points this quarter from 1 point in the third quarter, the Bank of Japan's Tankan survey showed in Tokyo." The Tankan index is up 29 points in six months and 49 points from a year earlier. November corporate bankruptcies were down 22% from the year ago level.

December 8 - Bloomberg: "U.K. house price growth accelerated in October, the Office of Deputy Prime Minister John Prescott said, adding to the case for another interest rate increase as early as next month."

December 11 - Bloomberg: "French and German inflation accelerated in November, confirming the European Central Bank's view that consumer prices will rise faster than it had previously estimated. The French inflation rate, measured by European Union methods, rose to 2.5 percent from 2.3 percent in October, Paris-based national statistics office Insee said. Inflation in Germany speeded up to 1.3 percent from 1.1 percent..."

December 11 - Bloomberg: "Russian industrial production rose by 7.2 percent in November, Interfax reported, citing the State Statistics Committee. Industrial output increased by 6.8 percent in the first 11 months of the year, almost twice as fast as the 3.7 percent annual growth in the same period of 2002..."

December 8 - Bloomberg: "Taiwan's exports rose in November at their fastest pace in nine months, climbing to a record as electronics makers shipped more components to factories in China, and laptop computers and flat-panel displays to Europe. Exports rose 16 percent from a year earlier to $13.8 billion... Taiwan's sales to China and Hong Kong rose 33 percent in November to $5.1 billion..."

December 11 - Bloomberg: "India's economy may expand 6.7 percent in 2003, the Asian Development Bank said, raising its growth forecast for Asia's No. 3 economy from 6.3 percent. 'India is entering the upswing of a business cycle, implying an expected growth rate of around 7 percent or more during the next few years,' said Sudipto Mundle, chief economist for India at the Manila-based lender."

December 9 - Bloomberg: "Malaysia's economy will grow 4.9 percent this year, after exports rebounded and factories boosted production to meet overseas demand, the Malaysian Institute of Economic Research (MIER) said, raising its forecast from 4.3 percent. MIER...also raised its 2004 growth forecast to 5.7 percent from 5.4 percent."

December 9 - Bloomberg: "Thai consumer confidence rose to a record in November on optimism that rising exports and consumer consumption will boost economic growth, a survey showed."

December 8 - Bloomberg: "Turkey's industrial production jumped a larger-than-expected 12.3 percent in October from the same month last year, on surging exports and a pickup in domestic demand."

China Watch:

December 10 - Financial Times: "Investors have applied for nearly US$30bn worth of shares in China Life, 10 times the amount to be offered in next week's listing, in the latest sign of strong appetite for initial public offerings from Chinese companies."

December 10 - Financial Times: "In 1793 Lord Macartney, King George III's ambassador, led a 700-strong delegation to seek trade privileges from Qianlong, the fourth emperor of the Qing dynasty. Now, 210 years later, the traveling diplomats of the modern business world - investment bankers - are retracing his steps to curry favour with the current generation of Chinese leaders. In recent weeks Beijing has witnessed a glut of limousine motorcades as the heads of the big Wall Street investment houses made pilgrimages to the Chinese capital."

December 10 - Financial Times: "China looks increasingly under siege as it fights pressure to revalue its currency. Exporters are bringing back ever bigger dollar receipts and banks, according to the Bank of International Settlements, are repatriating funds and seeing more domestic deposits. The build-up of pressures is evident in gently rising prices and annualized money supply growth running at about 21 per cent. Now one of China's favourite tools to stem the tide - short-term bills used to sterilize foreign exchange intervention - appears to have been blunted. China, given it inflexibility on currency revaluation and interest rates, has relied heavily on sterilization bills, issuing some Rmb600bn worth since April. But buyers, deterred by the modest yields on offer, are shunning the paper. Other measures to control the money supply have had mixed success."

December 10 - Bloomberg: "China's money supply grew faster than the central bank's targeted rate for an 11th straight month in November, which may prompt the authorities to take additional action to curb lending in coming months. M2, the broadest measure of money supply rose 20.4 percent from a year earlier to 21.6 trillion yuan ($2.6 trillion), after climbing 21 percent in October, the People's Bank of China said."

December 12 - Bloomberg: "China's consumer prices rose 3 percent in November from a year ago, the fastest rate of inflation in 6 1/2 years, after wheat and soybean shortages drove food prices higher. The biggest increase since April 1997 followed a 1.8 percent climb in October... Food costs, which account for about a third of the index, rose 8.1 percent."

December 9 - Bloomberg: "China's exports grew by more than a third for a second straight month in November as companies such as Huawei Technologies Co., the nation's top maker of phone equipment, won more orders from abroad. Overseas sales rose 34 percent from a year earlier after gaining 37 percent in October, while the growth in imports slowed to 29 percent from 40 percent..." "China's exports rose 32.9 percent in the first 11 months of this year and its imports rose 39.1 percent, Liu Wenjie, vice minister of customs, told reporters in Beijing. That left a trade surplus for the period of $19.7 billion, he said. China's exports totaled $293.7 billion in the first 11 months of 2002 and its imports were $266.5 billion, the government reported a year ago."

December 10 - Bloomberg: "China's factory production grew in November at its fastest pace in nine months, surging as overseas companies move factories there to take advantage of wages less than one-twentieth those in the U.S. Production rose 18 percent from a year earlier to 397 billion yuan ($48 billion)..."

December 11 - Bloomberg: "China's economy will probably grow more than 10 percent in the second half of 2003 as its industrial sector expands to meet rising demand at home and abroad, Standard & Poor's said."

Domestic Credit Inflation Watch:

December 8 - MarketNews (Gary Rosenberger): "Businesses renewing their health benefit plans for next year should run into more double-digit increases and workers will likely assume a bigger chunk of the cost of those policies, say health insurance executives. Health insurers say the average rise in premiums dropped a couple of percentage points from a year ago. But the increases remain substantial -- in the low to mid teens -- even after plans are redesigned to reduce benefits... Regina Nethery, vice president of investor relations for Humana Inc., estimates commercial premiums for Humana customers will be in the range of 11% to 13% higher for 2004..."

December 12 - Bloomberg: "Texas's sales tax collections, the largest revenue source for the second most-populous U.S. state, have risen for the past three months as retail sales growth returned to levels before Sept. 11 2001. November sales tax revenue rose 4.3 percent to $1.36 billion in November, compared with the same period a year earlier, the fastest growth rate since August 2001."

December 11 - Dow Jones (Michael Derby): "The head of the world's biggest bond fund says it's time to start investing as if inflation were right around the corner. Bill Gross, managing director of PIMCO, which controls around $350 billion in fixed-income investments, told investors in his December research note that their investments should likely be moving away from things like stocks and bonds to holdings such as commodities and one of his old favorites, Treasury inflation-indexed bonds... To profit in this environment where prices are likely to start rising, Gross said he's advocating investment in commodities and 'tangible assets,' foreign currencies, real estate, inflation-indexed Treasury securities, and global bonds and foreign currency equities."

The Office of the Comptroller of the Currency released third quarter derivatives data today. For the quarter, total notional derivative positions expanded at an 8% annualized rate to $67.1 Trillion. Total positions were up 26% from a year earlier. By type, Interest Rate derivatives expanded at a 9% rate during the quarter (up 28% y-o-y) to $58.3 Trillion. Currency derivatives declined at a 10% rate during the quarter (up 18% y-o-y) to $6.9 Trillion. Credit derivatives increased at a 33% rate during the quarter (up 52% y-o-y) to $869 billion. By Product, Swaps increased at a 33% rate during the quarter (up 39% y-o-y) to $41.2 Trillion. By institution, JPMorganChase's total derivative positions expanded at an 18% rate during the quarter (up 26% y-o-y) to $34.2 Trillion. BofA's positions were about unchanged during the quarter (up 17% y-o-y) to $13.8 Trillion, while Citigroup positions actually declined at an 8% rate during the period (up 16% y-o-y) to $10.8 Trillion.

Economy Watch:

December 11 - MarketNews (Gary Rosenberger): "Imports surged to monumental proportions in October and continued to inundate U.S. shores through most of November, while exports maintained their grinding pace of recovery, say cargo and port executives."

University of Michigan Consumer Confidence surprised on the downside, with the early December reading giving back all of November's 4 point gain. Producer Prices declined 0.3% during November, with a year-over-year increase of 3.4%. MarketNews' Denny Gulino noted that "November's 4.3% increase in core crude materials prices (was) the strongest since June 1978..." Small business optimism as measured by the National Federation of Independent Business increased 1.3 points in November to the highest reading since at least 1986. The Mortgage Bankers Association reported third quarter commercial mortgage lending of $29.686 billion, up 45% y-o-y.

The stubborn Trade Deficit increased marginally to $41.8 billion during October, up almost 19% from one year ago. Year-over-year, Goods Imports were up a notable 11.1% to $108.8 billion, while Goods Exports rose 7.1% to $61.36 billion. In nominal dollars, Goods Imports were up $10.8 billion from a year ago, compared to Goods Exports that increased $4.1 billion. By category, Capital Goods Imports were up 14.0% y-o-y, Consumer Goods 13.8%, Automotive 7.9% and Industrial Supplies 9.3%. These large and broad-based increases lead me to question the governments 2.1% y-o-y increase in the Import Price Index. All the same, Goods Exports would need to rise 73% to match Imports.

November retail sales were up a stronger-than-expected 0.9%. Retail and Food Service Sales were up 6.9% y-o-y (steepest November y-o-y sales increase since 1999, according to Moody's John Lonski). Retail ex-autos were up 6.5% y-o-y. Electronic Stores sales were up 14.3% y-o-y, Building Materials 11.0%, Auto dealerships 8.5% and Bars and Restaurants 9.5%.

Also according to Moody's, third quarter corporate revenues were up 8.4% y-o-y, which will likely and not coincidently be close to total non-financial Credit growth during the period. November Import Prices were up a stronger-than-expected 0.4%. By category, Fuels and Lubricants were up 12.0% y-o-y, Building Materials 12.8%, Unfinished Metals 6.3%, Agricultural 3.7%, and Industrial Supplies ex petroleum up 6.4%. Capital Goods Import Prices were down 0.9% y-o-y.

Freddie Mac posted 30-year fixed mortgage rates declined 14 basis point this week to 5.88%. Fifteen-year fixed rates declined 12 basis points to 5.24%. One-year adjustable-rate mortgages could be had at 3.77%, unchanged for three weeks. The Mortgage Bankers Association application index dropped to the lowest level since June of 2002. Purchase Applications declined 9% for the week, while remaining 12% above the year ago level. Purchase application dollar volume was up 23.7% y-o-y. Adjustable-rate mortgages accounted for 29% of total applications, with an average loan amount of $281,800. Adjustable-rate mortgages were less than 14% of the total at the beginning of July.

Countrywide Financial Average Daily Fundings declined 5% from October to $1.479 billion. And with Non-purchase/Refi fundings down 49% y-o-y, Total Fundings for the month were down 33% to $38.8 billion. At the same time, Purchase fundings were up 27% y-o-y to $9.85 billion. November Home Equity fundings were up 52% y-o-y to $1.6 billion, while Subprime fundings were up 97% to $2.0 billion. "Adjustable-rate loan production of $8.5 billion accounted for 38 percent of monthly fundings, an increase of 125 percent over the prior year period... Total assets at Countrywide Bank...rose 4 percent over the prior month to $18 billion."

Washington Mutual disappointed The Street with lower guidance. It should come as no surprise that mortgage origination volumes have slumped dramatically over the past few months. This has clearly negative implications for the rapidly-expanding Washington Mutual and scores of other institutions making easy money from the refi boom. Yet we must be mindful that with near record home sales at record prices, along with record home equity borrowings, total mortgage Credit continues to grow at a very brisk pace.

Fannie Mae today raised their estimates for both 2003 and 2004 total home sales. Fannie now expects 7.09 million sales this year, 8.4% above 2002's record. Fannie expects sales to moderate somewhat next year to 6.73 million.

After two months of the fiscal year, total federal government receipts are up 3.9% from the comparable period last year. Total spending is running up 2.5%, with a total deficit of almost $113 billion. An Administration official this week forecasted a fiscal deficit in the "$500 billion range."

Last week's 28,674 bankruptcies were down about 3% from the comparable week one year ago.

Total Bank Credit declined $25.4 billion. Securities holdings added $7.3 billion, while Loans & Leases sank $32.6 billion. Commercial & Industrial loans declined $6.0 billion and Real Estate loans were about unchanged. Consumer loans declined $1.3 billion and Security loans dropped $18.2 billion. Elsewhere, Commercial Paper declined $3.8 billion. Non-financial CP dipped $1.0 billion and Financial CP declined $2.8 billion.

Broad money supply (M3) declined $11 billion. Demand and Checkable Deposits dropped $11.4 billion. Savings Deposits increased $13.7 billion, and Small Denominated Deposits dipped $0.6 billion. Retail Money Fund deposits declined $5.5 billion. Institutional Money Fund deposits sank $18.0 billion. Large Denominated Deposits added $7.6 billion. Repurchase Agreements dipped $1.3 billion and Eurodollar deposits declined $1.1 billion.

Foreign (Custody) Holdings of U.S. Debt, Agencies increased $8.0 billion last week, with six-week gains of $49 billion. Custody Holdings are up almost $210 billion, or 25%, from a year earlier.

Fraud at Freddie:

I have erred by trying to give Freddie Mac the benefit of the doubt. There are today complexities and the generally poor state of derivative accounting that financial institutions must deal with (including the implementation of FAS 133, accounting for derivative contracts). Freddie has also been operating in an extraordinary interest rate environment. In the back of my mind, I presumed that Freddie's management had likely been forced into using questionable accounting to counterbalance imperfect and confused accounting regulations that, if used as prescribed, would have misrepresented the true economic situation of the company. What they did was clearly wrong, but I have hesitated to think of it in terms of a malicious fraud. I have been wrong.

The 185 page report released Wednesday by the Office of Federal Housing Enterprise Oversight (OFHEO) paints a rather clear picture: Freddie Mac top management, over a number of years, had orchestrated an increasingly sophisticated fraud. They not only flagrantly disregarded accounting rules and moved repeatedly to deceive the public; there was a clear effort to undermine the quality and effectiveness of the entire accounting function throughout the organization. The long-term interests of the taxpayer and marketplace were jeopardized. Arthur Anderson was complicit and negligent, as was the Board of Directors (disregarding clear red flags, while pressing for stronger earnings growth.).

After reading through the report, I am left with the uncomfortable feeling that had interest rates risen meaningfully (rather than dropping to 40 year lows), Freddie would have had the clear potential to make the Enron debacle look insignificant in comparison. But the Fed pushed rates down, essentially turning Fraud at Freddie moot to the marketplace - for now.

Ironically, if it were not for the collapse of Enron it is quite likely that The Fraud at Freddie would have continued to this day. Arthur Anderson had been Freddie's "auditor" since the seventies and played an instrumental role in the accounting fraud. It was not until PriceWaterhouse arrived to replace a failing Anderson that the scheme began to unravel.

And perhaps the years of conscious neglect, general incompetence, and outright negligence throughout the accounting and reporting functions were, indeed, in stark contrast to adroit and diligent risk management at Freddie Mac. Seems like quite a stretch, knowing what we know today. I will definitely no longer give the company the benefit of the doubt. At the minimum, I will assume that Freddie is more financially vulnerable, with some potentially serious holes in its risk management strategies and implementation. I will also give some credence to the minority view that perhaps the Fed is sticking with short-term rates to protect the financially fragile GSEs. And, importantly, we haven't heard the last from OFHEO's Director, Mr. Falcon. His organization is in a continuing examination of the role played by the Wall Street firms and appears poised to take a much closer look at Fannie. He is even threatening to limit Freddie's retained portfolio growth and requiring additional capital until the mess is resolved. As a regulatory body - with congress incapable of surmounting the powerful GSE lobby - Mr. Falcon and OFHEO have an exciting new lease on life. Perhaps they will even develop the teeth that a disgraceful Washington has never allowed them to grow.

The Fraud at Freddie is certainly another clear indictment of Wall Street. It still amazes me that there has been so little backlash, despite the instrumental role The Street played in a series of major frauds including the hideous Enron affair. But, then again, contemporary finance has Wall Street in firm control of the purse strings, as well as the power center for sustaining the revered financial and economic Bubbles. The Wall Street/"beltway" partnership is stronger than ever; The Street has never seen itself as more bulletproof.

The markets were completely disinterested in this week's OFHEO revelations that the large Wall Street firms aided and abetted Freddie's fraudulent activities. All the same, OFHEO specifically named Morgan Stanley, UBS Warburg, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Salomon Smith Barney as counterparties to derivative trades transacted specifically to misrepresent and deceive. These firms made millions from fraudulent transactions involving little if any financial risk.

Regrettably, I do not have the time to do this lengthy document justice. Hopefully some extractions and brief comments will shed light as to the nature of the Fraud at Freddie. I encourage readers to peruse the document available at www.ofheo.com.

"In the early 1990's, Freddie Mac promoted itself to investors as "Steady Freddie," a company of strong and steady growth in profits. During that period the company developed a corporate culture that placed a very high priority on meeting those expectations, including, when necessary, using means that failed to meet its obligations to investors, regulators and the public. The company employed a variety of techniques ranging from improper reserve accounts to complex derivative transactions to push earnings into future periods and meet earnings expectations. Freddie cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth."

"Leland Brendsel (former CEO and Chairman) told interviewers acting on behalf of the Board of Directors that Freddie Mac adopted the goal of steady earnings growth in the early 1990s after some investors, including Berkshire Hathaway, told management that the Enterprise needed to communicate clear and simple messages that the public could easily understand. Fifteen to sixteen percent earnings growth was the simple message that management began to propagate. According to Mr. Brendsel, that goal was fairly easy when Freddie Mac was primarily a securitizer of mortgages. However, as the retained mortgage portfolio of the Enterprise grew and its earnings became more sensitive to interest rates, steady mid-teens growth became a more challenging goal." (page 21)

"Simply stated, the quality and quantity of accounting expertise was too weak to assure proper accounting of the increasingly complicated transactions and strategies being pursued by Freddie Mac. From 1993 through 1996, the first four years of rapid retained portfolio growth, management actually reduced accounting and reporting personnel by nearly 20 percent... in 1996 Corporate Accounting still managed the entire portfolio accounting process on Excel spreadsheets. That system was improved slightly in 1997, but repeated requests for a more robust Treasury accounting system were denied until 2000." (page 14) "Senior management and the Board of Freddie Mac failed to provide adequate resources to the corporate accounting function, even though they were continuously informed of those weaknesses..." (page 85) "...Freddie Mac senior management and the Board were quite aware that the skills and systems in Corporate Accounting were challenged and that the derivatives group lacked sufficient knowledge and training." "The information obtained during the special (OFHEO) examination indicates that a thorough review and update of accounting policies had not occurred at Freddie Mac in over twelve years." (page 91) "The weaknesses in accounting policies at Freddie Mac created an environment that allowed for and even encouraged transacting around GAAP. The resulting accounting errors committed were pervasive and persistent." (page 92) "In 2001, Arthur Anderson received $1 million for its audit work and $3.7 million for its consulting fees..." (page 97)

"David Glenn (former president and vice chairman) recounted an 'ugly' meeting that took place in the fall of 2000 between himself, Bob Ryan (assistant to Mr. Glenn), and Messrs. Dossani (Sr. V.P.) and Parseghian (exec V.P. and chief investment officer, later to briefly become President and CEO). At that meeting, the group discussed potential difficulties in continuing to meet the publicly stated goal of mid-teens earning growth without changes to the risk management practices of the Enterprise. According to Mr. Glenn, at that meeting and other meetings that followed, management consciously decided to change its risk profile and take more convexity risk - that is, speculate on interest rates - in order to maintain mid-teens earnings growth." (page 44)

"Management executed several interest rate swap transactions that moved $400 million in operating earnings from 2001 to later years. Those transactions had virtually no other purpose than management of earnings - specifically, making operational results appear to be less volatile than they were."

"Management created an essentially fictional transaction with a securities firm to move approximately $30 billion of mortgage assets from a trading account to an available-for-sale account... Freddie adopted, and then quickly reversed, a dubious change in its methodology for valuing swaptions. That change had the effect of reducing the value of the derivatives portfolio...by $730 million. On at least one occasion, a ('earnings management swaps') transaction was entered into (with Goldman Sachs) at the instruction of management for the purpose of disguising the effective notional amount of the Freddie Mac derivatives portfolio and thereby allay the concerns of an investor... Pressure to sustain earnings growth may have provided the impetus for a program to change the 'geography' of income. That program including selling of short-dated options to shift unrealized gains from the swaptions portfolio of Freddie Mac to its net interest income account...there was no disclosure of the short-dated options portfolio in the Annual Report..."

"In 1994, Freddie Mac management created a reserve account to cushion against the fluctuations caused by the unpredictable amortization of premiums resulting from changing mortgage prepayment speeds... Getting the amortization numbers to fall within the range was sometimes an all-night process; according to one employee, it was 'classic' for Freddie Mac to 'play with the numbers until they got the right one.'" (page 56)

"On November 22, 2000, CFO Vaughn Clark met with employees from Corporate Accounting and Funding & Investment to minimize the FAS 133 transition gain. The agenda identified their strategic objective: 'Recognize book losses in 1Q01 that offset the FAS 133 transition gain AND replace lost earnings in subsequent periods. The plan anticipated an exchange of $10 to 15 billion of PCs (MBS) with embedded losses in the retained portfolio for either a REMIC (real estate mortgage investment conduit) or a Giant (MBS) security... That memo outlined nine steps that would need to be executed in order to effectively recognize a loss on the 'sale' of the securities and then bring the same securities back to the portfolio... The problem for Freddie remained, however, that leaving the securities in the trading account would subject the Enterprise to significant exposure to earnings volatility... To eliminate that risk, the PCs were to be transferred to a counterparty - Salomon Smith Barney - and swapped for a Giant security... (held by Salomon 'with virtually no risk' 'only for a few hours' for a fee of between $4.7 and $18.8 million)"

"Numerous financial institutions, including some of the largest investment banks on Wall Street, were counterparties to transactions initiated by Freddie Mac in order to shift and smooth the reported earnings of the Enterprise. Those transactions had little legitimate business purpose and were structured to achieve a certain accounting result and to mislead investors about the finances of Freddie. OFHEO has not concluded its investigation of the role of the counterparties in those improper transactions. The agency is reviewing whether the counterparties met their obligation to ensure that they were not part of a scheme to mislead investors and whether they encouraged improper conduct in any way. In addition, OFHEO will examine the willingness of the counterparties to accommodate Freddie Mac in order to maintain other profitable business relationships."

"There is evidence to date that one or more of the counterparties to the transactions that Freddie Mac undertook to manage earnings may not have acted properly... In at least one instance, a trader at a counterparty - Morgan Stanley - suggested to Freddie Mac a plausible-sounding business purpose for a pair of linked swaps that were executed for the sole purpose of moving large amounts of operating income into the future. Given that many of the deals generated substantial commissions with minimal risk, the counterparties may have had a strong disincentive to inquire about the actual purpose of the transaction." (page 74/75)

"Trades between Freddie Mac and Blaylock & Partners and between the Enterprise and Salomon Smith Barney raise serious questions about the quality of internal controls at Freddie Mac." (page 107)

"The deliberate disdain of Freddie Mac for appropriate disclosure standards in the face of its asserted compliance with best practices misled investors and constituted conduct that undermined market awareness of the true financial condition of the Enterprise." (page 123)

"On November 21, 2003, Freddie Mac announced the results of its ($6.5 billion) restatement and its need to delay publication of its audited financial statements for 2003. That delay is due to the need to correct many problems described in this report related to weak accounting functions and a poor internal control environment. Undoubtedly, the desire to manage earnings played a major role in the creation of those problems, as the focus of senior management and the Board of Directors was more on the growth of earnings and the share price rather than best practices in accounting, controls, and operating infrastructure. Thomas Jones, Chairman of the audit committee, recalled expressing his views to Leland Brendsel in March 2003: 'Leland, with all due respect, in my view you've put the company in a very difficult situation. You've effectively lost control of our accounting and financial reporting status and we're now sitting in a situation where we don't have audited financial statements in the market and we're one of the most critical financial entities in the capital markets. In my view it is unpardonable to not have audited financial statements that investors can rely upon and in my view in this league you don't get second chances. You've been paid a lot of money to do this job and to me it's unacceptable that we don't have audited financial statements that investors can rely upon.' The intense efforts to manage reported earnings at Freddie Mac drained the skills of many of the most talented employees of the Enterprise. Those efforts compromised the integrity of many employees and damaged the effectiveness of the internal control structure at Freddie Mac. The quest to manage earnings eventually led to the termination of the most senior executives of the Enterprise, and resulted in one of the largest restatements in U.S. corporate history." (page 59)

I'll wrap this up with a conversation OFHEO documented in its report between a Freddie Mac employee and a Morgan Stanley derivative trader executing one of the sham derivative transactions:

Mr. Lavelle (Morgan Stanley): "We've been trained whenever people come in and start doing this kind of stuff, we've gotta ask why. Like not why, but like, everything's yeah. I don't want to be taken off in handcuffs here for doing something that's not kosher."

Mr. Powers (Freddie Mac): "How much are you making off this trade? (laughs)"

Mr. Lavelle (Morgan Stanley): "I don't know."

Mr. Powers (Freddie Mac): "You haven't even looked at it. (laughs)"

Mr. Lavelle (Morgan Stanley): "I'm just...You know what I'm saying...I mean, I don't mind if there's an accounting reason for you to do this and it makes you guys money. That's fine. You know, we're ok with it."

Mr. Powers (Freddie Mac): "That's where we are. We have an accounting reason for doing it. And, um, we're basically...we're offsetting some...

Mr. Lavelle (Morgan Stanley): "I mean you could tell me there's some asset liability reasons for you to be doing this, and I'm ok with that."

Mr. Powers (Freddie Mac): "I think that's a much as I'd...I don't want to tell you..."

Mr. Lavelle (Morgan Stanley): "I don't want to be taken into a courtroom, though, Ray, is what I'm saying, okay?"

Mr. Powers (Freddie Mac): "Yeah...No, no, no. This is not... This is basically an asset liability, cash flow management issue."

Mr. Lavelle (Morgan Stanley): "Okay, I'm with you."

Mr. Powers (Freddie Mac): "The thing is...because of the shape of the curve, um the geography of our carry in terms of the calendar gets screwed up. So all of a sudden, we have an uneven carry picture to manage and we strive for stability..."

Mr. Lavelle (Morgan Stanley): "If that's what you want to do, I'm, we're ok with that and we're happy to do it with you, so we can do a lot of this if you want."