Congress created Freddie Mac and his sister Fannie Mae to assist the mortgage market so as to make homes more affordable to the American people. They have done this, but in the process have grown into leviathans. Recently, the accounting by Freddie Mac has come under attack. While the details remain sketchy, it appears that the managers at Freddie misaccounted for its usage of derivatives. With the help of its new auditors, Freddie Mac announced that it will restate earnings because Treasury securities were considered derivate instruments when they should not have been.
  
The stock market has been swift to react, dropping around 16 percent. Declines have also occurred in the bond market. These are curious reactions because any restatement will increase past earnings and decrease future earnings. If past earnings improvements signaled anything positive, wouldn’t the market value those increases? If we believe in the time value of money, aren’t earnings today more valuable than earnings in the future? The answer to this riddle rests in understanding the fact that investors and creditors aren’t sure they can trust the managers at Freddie. (Which, of course, is why the board of directors had to fire the top three executives at the organization.) The increased financial reporting risk—the risk of not knowing how credible the financial statements are—requires an increase to the corporation’s cost of capital.
 
When financial institutions grant loans, they determine the interest rate based on the real interest rate, the expected inflation rate, and the risk that the loan applicant will not repay the loan in part or in whole. The real interest rate equals the interest rate that would exist in a world without inflation and for a party without credit risk. Inflation, by definition, means that future dollars are weaker than current dollars. Creditors protect themselves by increasing interest rates to offset the problem of inflation. They also are concerned about the credit risk of the loan applicant, and protect themselves here too by adding to the interest rate an amount that is the function of the borrower’s ability to repay the loan.
 
In the same way corporate creditors protect themselves from mendacious managers who might exaggerate things in the financial reports or might leave some things out. This financial reporting risk premium that is added to the interest rate covers potential investment losses because of lies, damned lies, and accounting lies. The problem, of course, is that the cost of debt and the cost of equity go up, so consequently the prices of bonds and stocks drop. The bottom line is that prevarication destroys some of the value of the firm.
 
Investors and creditors at Freddie Mac have paid a large price for managerial indiscretion. Perhaps if financial executives would learn and appreciate the fact that lying lowers the prices of bonds and stocks because of the increased financial reporting risk premium, they might grasp the fact that telling the truth is actually good for you.
 
Thanks, Mom.