1. Describe and evaluate New Century’s business model?
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New Century Financial Corporation, headed by founders Brad Morrice, Edward Gotschall, andRobert, was a firm which specialized in subprime mortgages. The company originated, sold, andserviced subprime home mortgage loans. New Century was structured as a real estate investment trust (REIT) and was composed of two operating divisions. The Wholesale Loan Division, known as New Century Mortgage Corporation, comprised 85% of the firm’s loan originations, while the Retail Mortgage Loan Division operated under Home123 Corporation. New Century Mortgage Corporation operated in 33 locations throughout 19 different states and relied heavily on independent mortgage brokers to identify potential borrowers and assist them through the loan process until the loans were closed by New Century. This division also purchased funded loans from other lenders and expedited the loan underwriting process through its web-based system known as FastQual. The Retail division was composed of 235 sales offices throughout 35 states, a call center, and a web site. This division was aggressive in its approach to seek out potential borrowers and close loans earning it the nickname “CloseMore University.” The company typically originated loans and used short-term loans to fund new mortgages until they were sold within 30 to 90 days of origination. New Century’s income was generated from the difference between the lending rate and rate at which the loans could be sold or financed and from servicing loans. Loans were sold either as whole loan sales where mortgages were pooled together and sold to investors or as securitizations structured as sales. The company also carried securitizations structured as financing as assets on their books and used the bonds to finance the securitized loans as liabilities, thereby generating income based on the difference between interest received from borrowers and interest paid to bondholders.
2. What were the primary risks faced by New Century?
New Century’s business model enabled the firm to grow rapidly from 2001 through 2006 as access to capital markets expanded and regulations were relaxed. Loan securitization allowed lenders to spread credit risk over a larger number of investors creating an environment where companies like New Century could lend to subprime borrowers at higher rates while financing their operations with the lower interest rates provided by the highly liquid mortgage-backed securities (MBS) markets. These factors fueled the company’s growth, but caused the firm to be highly sensitive to risks of increasing interest rates, declining home sales, and default by less creditworthy borrowers. New Century’s aggressive strategies in pursuing subprime borrowers resulted in increased risk of asset Additionally, the short-term credit the company obtained in order to finance loan origination was contingent on New Century meeting certain debt covenants and financial ratios. Increases in interest rates or regulations or the inability to move new loans off its balance sheet could cause the company to be unable to obtain financing to continue funding loans. Likewise, a decrease in the difference between the interest rate at which it could borrow and the interest rate at which new loans could be closed, would affect income and may result in noncompliance with net income requirements or debt-ratios imposed by New Finally, the loans which New Century sold were pooled together.
The investment banks which purchased the loans would perform a due diligence review on only 25 percent of the pool before negotiating the composition and price of the mortgage pool. A “kick-out” clause was included to allow for buyers to reject part of the loan pool for defects such as faulty documentation, appraisals, or underwriting issues. The buyers could also require New Century to repurchase loans which experienced early payment default (EPD). As such, the company was exposed to risks related to internal controls in monitoring loan processing, underwriting, and closing which could cause a substantial loss in income due to increased kick-outs and repurchased loans. Further aggravating these risks were the
company’s aggressive tactics in pursuing and closing subprime borrowers such as offering loans requiring only stated income and assets as opposed to full documentation loans.
3. What were New Century’s critical performance variables? How well was New Century performing with respect to these critical performance variables? New Century Financial had performance variables that critically affected its business and led to it’s eventual bankruptcy filing. These included liquidity, default rate, and forms of The overall rate of default is critical because of its compounding increase in liabilities with a decrease in assets. A default rate higher than the historic rate would adversely affect the valuation of many assets in the firm’s financial statements. It is also tied to the demand for mortgage backed securities, increased default reduces the demand for subprime securitization, thus reducing New Century Financial’s source of income at a time of increasing obligations.
4. What were the reporting errors identified by the bankruptcy examiner?
The bankruptcy examiner noted several inconsistencies with US GAAP. These included errors in calculating the loan repurchase reserve, the lower-of-cost-or-market (LCM) valuation of loans held for sale, and the residual interest valuation. Additionally, the methodology used for the allowance for loan losses (ALL) was known by management to be defective as the company’s models used poor predictors of future performance to determine the level of reserve needed. In calculating the repurchase reserve, New Century obtained historic averages and applied those percentages to loans sold in the last three months as EPD was defined as payment default occurring in the first three payments. However, since the repurchases were being processed by several different departments within the company depending on the cause of the repurchase, there was a backlog in obtaining the data in a timely manner. As loan repurchases became more frequent, the company continued using stale data causing the reserve calculation to In addition, the company was not properly applying LCM valuation as stated in its own company policy. Instead of pooling similar loans to determine to conduct LCM analysis, the firm was performing the analysis on the disaggregated loans and then grouping the loans together to conduct valuation on the group as a whole.
This method resulted in gains from one loan group offsetting the losses in another causing the LCM valuation to be significantly flawed. The residual interest valuation methods used were also flawed as the company was using discount rates which were lower than those used by others in the industry to compute residual interest. New Century disregarded numerous warnings from their auditors, KPMG, regarding the low discount rates and failed to provide documentation to justify or support the valuation methodology used. Furthermore, prepayment rates and loss rates were estimated using historical data related to activity occurring years prior without adjusting for changing market conditions which resulted in an overvaluation of residual interest. While the examiner did not consider the issues in the ALL calculation to be material, this issue merits attention because the company had been very aggressive in closing loans, many of which were risky stated income and assets loans to subprime borrowers. New Century management was aware that their ALL was flawed, although they believed that they were over-reserved and not under-reserved. As with their other accounting estimates, the company failed to provide adequate documentation to support assumptions and knowingly relied on poor predictors, stale data, and defective models.
5. Why did New Century fail?
New Century grew rapidly through the late 1990s and early 2000s, however its business model was not sustainable for the long term. The company relied heavily on subprime borrowers and offered them a range of risky loan options. Those subprime loans were pooled together and securitized in effort to reduce the riskiness of the loan pools. However, as high risk borrowers found themselves unable to make payments on their loans, a cooling real estate market and increase in interest rates left subprime mortgagors without little options to get out their loans Aside from those challenges which were shared by all competitors in the industry at the time, New Century also had several internal weaknesses. The company was strongly focused on sales and loan production, but failed to adequately monitor and control loan quality. Internal controls were poor and the audit committee did not sufficiently perform its duties to oversee the internal audit department and address operational risks. Internal auditors identified several issues regarding loans quality, closings, and servicing, however internal controls over financial reporting were overlooked. Adding to the company’s gross lack of controls, was the absence of a stated company accounting policy. The examiner pointed out that merely having a policy in place to address the accounting methodology and estimates would have greatly affected the company’s ability to apply appropriate accounting treatment consistent US GAAP.