New Century Case Analysis
New Century Case Analysis
1. What appeared to be New Century’s strategic objectives? Describe and evaluate the business model the company had adopted to achieve these objectives.
New Century Financial Corporation was founded in 1995 went public in 1996 and was also listed on NASDAQ. New Century’s primary goal was to originate and sell subprime mortgages. The main activities of the company included generating, retaining, selling, and servicing home mortgage loans for subprime borrowers who couldn’t get finance from other sources. By 2006 New Century expanded its product range to include fixed-rate mortgages, adjustable rate mortgages (ARMs), hybrid mortgages, and interest-only (IO) mortgages. The products were from the two Company’s divisions of Wholesale Loan Division and Retail Mortgage Loan Division, which was different in terms of sales channel (indirect and direct). The corporation employed almost 1,000 account executives & 50,000independent mortgage brokers within its Wholesale Loan Division and it operated 235 sales offices within Retail Mortgage Loan Division.
It was able to generate significant sales volume and achieve tremendous growth with CAGR of 70%percent from 2000- 2004 due to its ability to respond to increasing demand on such loans. Despite increasing competition in the subprime market, the Company still held strong position due to its low cost loan originators. Their major strategic objectives were to consistently achieve strong performance both in TRS and REIT. Their key focus was to lower cost and increase productivity. They did this by broadening the mortgage products and services through appropriate delivery channels as mentioned above and by improving Product mix to optimize execution. Below are the major operations of New Century financial Corporation. Whole loan sales:
New Century sold mortgages in loan pools to investors such as Goldman Sachs, JP Morgan Chase, etc at a premium value above the par because of high interest rates paid by its mortgagors. It should also repurchase the loans if there was any early payment defaults.
Securitization structured as sales:
New Century sod loans through a SPE for the purpose of securitization. New Century also provided credit enhancement by providing additional collateral above the principal value of the securitization. The expected cash flows from this over collateralization should be reported as revenues in the income statement. Securitization structured as financing:
New Century retained a part of securities backed by the securitized loans labelled “mortgage loans held for investment” (LFHI) as an asset on the balance sheet and bonds used to finance them as liabilities. It received interests from the mortgagor and paid out the interest to the bond holders. Lower of Cost or market (LCM) valuation of loans held for sale: All loans apart from LFHI and repurchased loans were classified as loans held for sale. Accounting rules required that the loans held for sale were reported at LCM.
2. What were the primary risks that New Century faces?
New Century had been growing with significantly very high speed. Company’s zeal for increased sales and profits added to the fact that the company was unable to appropriately implement mechanism of underwriting and monitoring loan quality. Thus, overall insignificant attention to effective operations imposed other principal business risk that included improperly handled or evaluated poor underwriting standards for mortgage loan borrowers, poor monitoring of loan quality, as well as improper accounting policies applied with no conformance to GAAP. Due to inappropriate underwriting standards that were a result of insufficient attention to risks of borrowers’ default, New Century Financial was unable to provide proper loan quality. The major factor in poor monitoring of the loans quality was the fact that the company did not worry about the borrowers’ ability to repay the loans as long as the company could sell the mortgages to investors.
Despite the fact that internal audit committee found and reported high risks problems that could affect sales of the loans and increasing loan originations that were at unacceptable levels´ as early as late 2004, senior management did not devote particular attention to loan quality until fourth quarter of financial year 2006.Furthermore, senior management did not approve the plan to monitor and identify underwriters who approved defective loans. On the contrary, a firm belief existed in the company that external auditors showed their unmistakable disdain for New Century Financial even when loan quality issues were revealed. As audit examiner stated ³Senior Management may have abdicated its responsibility to manage the day-to-day affairs´ particularly with respect to its failure to address kick-outs. Although New Century Financial business risks involved a great portion of internal mistakes, external factors such as Federal Reserve’s monetary policy played a significant role in deterioration of business opportunities for the New Century Financial Corporation.
The baseline interest rates were increased sharply in 2006 from 1.5 % to more than 5 %. Although such a hike in the interest rates had been forecasted and anticipated since2003, the New Century Financial did consider the flagship of tightening monetary policy. The increase in interest rate affected New Century Financial in the way that the company’s assets became riskier and more prone to financial distress. Increased exposure of New Century Financial Corporation’s assets to the risks endangered NCF assets to the effects of real price decreases. Since New Century Financial had issued many loans based on the fixed interest rate, while had been financing its investment and inventories using variable rate debt, the 2004interest rate increase had an effect of tremendous magnitude on the NCF’s assets.
The rough explanation of the effect is the current free rate for New Century’s assets increased sharply from 1.5 % to 5.5 %. There was an estimate that due to the hike in interest rate and, thus, in current risk-free rate, the value of the NCF’s assets dropped by approximately 11.3 %.Since short-term debt was little affected, the direct effect of monetary policy was reduced equity and increased debt-to-equity ratio of New Century Financial by roughly 30 percent from 6.5 to 8.5.The hikes in the interest rate and negative sensitivity of income to them were explicitly acknowledged by New Century Financial Corporation in their 10K-Form filing in2004. The company acknowledged that interest income to interest expense ration had dropped dramatically from 3.02 in 2003 to 2.45 in 2004, and 1.78 in 2005. Despite that New Century Financial attempted to hedge some of its interest rate exposure by the use of derivative contracts like interest rate caps contracts and Euro-Dollar futures, theses were very limited in size to respond to the hike of interest rate.
Although New Century Financial Corporation’s adjustable rate mortgages were somewhat immune to the threats imposed by interest rate risk, these mortgages became more exposed to the risk of borrower default on mortgage. It is assumed that since monthly payments on adjustable rate mortgage were a high fraction of borrowers’ income, increase in interest rate would make the loans unaffordable to them. Thus, the borrowers had two options to choose from ± either to refinance their mortgage with a loan at a lower interest and use capital gains on lower interest rates or to default on the mortgage in case real estate market does not provide any capital gain to lower interest payments. Nevertheless, New Century Financial was able to delay the negative impact of the increased rate on its adjustable rate mortgages for one year by issuing hybrid adjustable rate mortgages, which came with a two-year of payments based on the fixed interest rate.
The Federal Reserve’s monetary y policy of increasing interest rate not only put the risk on assets of the New Century Financial Corporations, but also raised concerns about the sustainability of the company’s business in general. In this regard, the increase in interest rate made the monthly payments on mortgages bigger, which made borrowing less attractive to consumers and potential customers of New Century Financial. Furthermore, the company was very sensitive to the increase in interest rate since a big part of New Century’s operations was company’s involvement and helping fixed-rate mortgage holders in refinancing their loans at a lower rate. Due to the fact that in 2004 it was almost impossible to refinance at a lower interest rate, the demand for refinancing sharply decreased putting the sustainability of New Century’s business at risk. Increase in interest rate impacted real estate market in the way that borrowers could not afford loans at lower interest rates as their home equity had already been substantially reduced by increased face value of their debts.
The fact that home equity had been reduced by2004 exposed not only homes of borrowers to risk but also New Century’s assets to the negative shock to housing prices. If housing prices continued upward trend, it would be possible for borrowers to refinance their existing mortgages. However, borrowers were constrained to default as there was no appreciation in house price. Thus, it became clear that adjustable rate mortgages in the New Century Financial Corporation’s portfolio were strongly ties to the real estate market trends and real estate prices.
According to examiner’s report the primary risks to New Century’s business included1) credit risk involving mortgage loan borrowers; 2) marketing risk involving changes in interest rates, housing values, warehouse lenders’ willingness to finance New Century’s mortgage lending operations, and secondary market investors’ appetites for whole loan sales and securitization offered by the Corporation; and 3) operational risks involving the Company’s ability to purchase or originate, and to sell or securitize, mortgage loans and to account for those transactions and properly reserve against risks relating to those transactions in an efficient and accurate manner. 3. What were the company’s critical performance variables? How well was the company performing with respect to these critical performance variables?
New Century is an REIT firm which involved in financing Real Estate Projects. It was involved in originating, retaining, selling and servicing home mortgages for subprime borrowers. The New Century Financial Corporation was restructured into a Real Estate Investment Trust (REIT) and began trading in NYSE in the year 2004. The Company has 2 loan divisions namely the Wholesale Loan Division which accounted for 85% of the company’s loans. This division employs around 1000 account executives and about 50000 mortgage brokers.
This division also purchases funded loans from other lenders. Retail Mortgages is driven by sheer volumes and not in terms of quality. This is achieved by fierce loan drives forcing to be termed as “Close More University” * In 2001, firm’s loan originations and purchases exceeded $6.2 billion and continued to grow at a fast pace reaching $56 million in 2005. The Adjustable Rate Mortgages accounted for around 81.7% of the Total mortgages showed a steady decline during the years 2004 to 2006 especially the medium term loans reduced from 54.4% in 2004 to 20.2% in 2006. This in turn impacts the ability of the firm to handle the pressure due to fluctuating interest rates.
* In terms of the firm’s performance in Markets, Share price skyrocketed to $63.91 in 2004 backed by volume growth in subprime loans from $202 billion to $401 billion. This can be attributed to automation of the loan processing especially the due diligence leading to irregularities in the credit ratings assigned to borrowers. This lead to the Average FICO Score for the Company’s portfolio to be steadily below 640 (2004:627; 2005:634:2006:634) which is the minimum level fixed by Fannie Mae and Feddie Mac . This increases the portfolio being highly risky which in turn makes the company really shaky in terms of its financial position.
* The Loan quality issues were clearly highlighted during the investigation by regulators post their Chapter 11 bankruptcy filing.
* Warehouse lenders who were supporting New Century in loan originations while the earlier loans were being sold, with a lot of covenants in terms of debt ratio and be subject to margin calls and financial statements adhering to GAAP. Credit line provided by Warehouse lenders were subject to a lot of scrutiny when those firms which were considered too big to fail were in the verge of bankruptcy.
* New Century depended on Securitization of loans from 30 to 90 days of origination which increased dramatically from 0% in 2001 to around 25% of the total loan sales in 2004 to sustain the cash flows. This depends on the difference between the lending rate and the rate at which the firm could either sell or borrow to finance future lending activities. This increases the riskiness of the firm when compared to the wholesale loans as we need to provide underwriting to the securities to ensure decent credit ratings.
* The Whole loan sales to Investors like financial institutions like Goldman Sachs who review the pools to negotiate the price and sometimes due to faulty documentation of the loans which was securitized and rejects the loan package termed as Kick out.
* Early Payment defaults which accounted for the 90% of repurchase due to the first payment defaults. The Early payment default which is a Loan quality indicator increased from 4.38% in 2003 to 11.96% in 2006 indicating the inefficiencies in due diligence in granting loans.
* Repurchase Reserve which is constituted by Premium Recapture, Interest Recapture and Future Loss Severity is pretty less. Premium Recapture is the premium over par the New Century received which needs to be returned in the event of default, the firm needs to account for it as a part of the Repurchase reserve. Interest Recapture is the amount of interest the investor should have received but did not because the mortgagor failed to make loan payments. This increase in the repurchase reserve indicates that the loan quality and the performance of the firm deteriorate in terms of its assets performance.
* Repurchase Reserve estimate was calculated based on the historical data where the whole loan sales $10.7 billion and a repurchase estimate of around $70.6 million and an allowance of $7.0 million in 2005. The Repurchase reserves exceeded the estimate and the actual Repurchase reserves was around $421 million in 2006 indicating misstatements and poor performance in terms of loan quality and reserve allocation.
* Premium Recapture was higher than industry average in terms of asset performance in terms of loans.
* This poor performance in terms of poor EPS going to the extent of negative EPS in 2000 although there is increase in sales indicating that volume growth from around $500 million to $2000 million and not the quality of earnings. This is reflected in the interest expense from $367.1 million in 2004 to $988.1 million in 2005.
* The Mortgage held for sale at lower cost of market from $3922.9 million in 2004 to $7825.2 million in 2005 indicating the quality of assets held by the firm in terms of loans.
* The need for issuance of Convertible Senior Notes indicating that the need for credibility over notes the drop from 204.9 in 2003 to 5.4 in 2004 indicating the drop in the performance of the firm in terms of credit rating. This affects the market for the firm wile issuing Convertible senior notes indicated by the liabilities from Convertible senior notes which are pretty high due to the high coupons which implies the poor credit rating for the firm.
4. What were the primary reporting items within New Century’s financial statements? Using the bank examiner’s report, what were the key reporting errors identified?
Accounting Policies at New Century Financial considered reporting in two divisions of Wholesale Loan and Retail Mortgage Loan as well as securitizing mortgage based loans on their balance sheet as mortgage-based securities. The practices to finance mortgage loans included so-call warehouse loans´ that were made by using short-term credits from other financial institutions to provide liquidity for continuing loan originations. To sustain credibility with warehouse creditors, New Century financial had to maintain certain level of liquidity and debt ratios as well as to provide financial statements for the lenders review and consideration in timely manner in conformance to the Generally Accepted Accounting Principles (GAAP). The New Century Financial accounting policies for recognizing revenues were based on the difference between lending interest rate to the mortgagors and the rate the company was able either to sell the mortgage loans to investors or finance them by short-term credits. Other income and revenues were also derived from servicing the loans, which New Century sold or securitized.
Accounting policies of New Century Financial required that loans held for sales rather investment were reported at the lower of cost or fair market value (LCM) as of the balance sheet date. The amount by which the original cost exceeded the fair value was to be recorded as a valuation allowance, changes in which were to be included as part of the net income for the period on accrual basis.
Primary Financial Reporting Items
There were various types of improper accounting practices identified by the examiner to be not in conformity with GAAP. These included:
* Improper calculating repurchases reserves: Repurchase reserves at New Century Financial were calculated based on historical repurchase data of successful loan sales. However, New Century Financial did not have the reliable data repurchases since repurchase claims were handled by a number of different departments..
* Improper lower of cost or market (LCM) valuation of loans held for sale: The general industry practice for LCM valuation of loans held for sale was that the loans were grouped and monitored by categories ± performing or non- performing loans. Such practice allowed the mortgage firms to properly execute valuation as well as monitor loan performance. However, New Century Financial Corporation joined both categories of performing and non- performing loans into one group, which resulted in discrepancies in actual net income of the company as New Century loans held for sale were over-valued and non-performing loans were not written down in timely manner.
* Improper residual interest valuation that led to material misstatements in the financial statements for 2005 and 2006: Residual interest rate was calculated based on internally developed Excel-based valuation model. However, the major issue was a significant lack of documentation on how the models for residual interest valuation worked and how the model assumptions were approved by the senior management.
* Improper record and statement of the allowance for loan losses
* Inadequate LCM valuation allowance
* Inadequate valuation of residual interest resulted in an overstatement of earnings in 2005 and 2006
According to banker’s examiner report, the key errors identified were as follows:
“Go to Auditor”
The banker examiner document alleged that KPMG had failed to perform its New Century engagements with “in accordance with the professional standards”. The examiner’s specific allegations included charges that 2005 New Century audit was improperly studded and the independence of certain KPMG auditors may have been impaired. The examiner also mainted that KPMG failed to adequately consider serious internal control problems evident in its accounting and financial reporting system and failed to properly audit the company’s critically important loan repurchase loss reserve.
Inadequate consideration of Internal control problems
The banker’s examiner challenged KPMG’s conclusion that the company’s internal control over financial reporting were ineffective during 2004 and 2005. The examiner pointed out that throughout its existence it did not have an “effective mechanism for tracking, processing, and handling repurchase claims”. The weak internal control prevented the company from determining the magnitude of the loan purchases requests at that point.
Failure to properly audit New Century’s Loan repurchases Loss reserve
The Bankruptcy examiner criticized KPMG for not insisting that New Century use a longer than 90-day “window” in computing the loan repurchase loss reserve. However, a KMPG suggested that policy was reasonable. Examiner contested the assertion that KPMG has reviews the log of loan repurchase requests, since that accounting record indicated that loans were being reacquired by New Centuryas long as three years after the date they were sold. He also uncovered evidence suggesting that a new century executive has informed a KPMG auditor that a significant number of loans older than 90 days were being repurchased by the company.
5. Why did New Century fail?
The collapse of New Century Financial was triggered by a large number of defaults on the mortgages. These defaults originated and a weakening real estate market. New Century ran out of money as these mortgages defaulted and it was forced to repurchase these mortgages under its sales agreements.
Some of the causes were:
Early Payment Defaults
In hindsight, New Century’s lending standards and practices were clearly inadequate, as signaled by the steep rise in early payment defaults.
When a lender sells a mortgage it originates to investors it will often sign a re-purchase agreement to entice buyers. If the borrower defaults within the first few months the investor can go back to the lender and force them to buy the mortgage back.
These early payment defaults were a major factor in the company’s collapse as it effectively ran out of money after being forced to buy back more mortgages than it could afford.
Tied to the early payment defaults is New Century’s use of leverage. Mortgages are a complex and difficult asset to manage because they are subject to both interest rate and credit risk. New Century was highly leveraged controlling more than $25 billion in assets with little more than $2 billion in equity, leaving little margin for error. As the market value of its mortgage assets deteriorated, shareholder equity evaporated.
Lack of Funds
The Company’s business model was to originate mortgages, bundle them together and then sell them to investors. This allowed New Century to keep the mortgages off the books and free up capital to continue to originate more mortgages. This works fine as long as you have minimal early defaults.
But as we know, New Century was suffering through a large number of early payment defaults. As these defaults started to pile up, the company’s available capital dried up. New Century could initially repurchase the mortgages with its capital and the capital it had available through its credit lines as well as the money it could raise through the sale of the real estate.
In the end, the defaults continued to increase to the point that New Century simply ran out of money and no one was willing to lend it more.
University/College: University of California
Type of paper: Thesis/Dissertation Chapter
Date: 23 November 2016
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