New Century Financial Corporation Case Study

New Century Financial Corporation Case Study

A. What primary business risks did NCF face?

New Century Financial Corporation (New Century) was one of the largest subprime loan originators in the U.S. New Century originated, retained, sold and serviced home mortgage loans mainly designed for subprime borrowers, whose credit score of 620 or below. After going public and being listed on NASDAQ, the value of New Century continued to grow at a fast pace, reaching $56 billion in 2005, according to the Harvard Business School's case study. By late 2005, several analysts recognized difficulties in the subprime market but believed New Century was safe. According to Michael Missal's final report, one analyst said "Based on available data, New Century is one of the lowest cost originators in the space which is a good sign for their long mortgage banking profitability." The company's profitability was backed up early in 2006 by another analyst backed up again. An analyst expressed surprise that "despite the company's aggressive growth, we have found little evidence of deterioration in underwriting and New Century's credit trends remain above industry averages." However, in 2007, 80% of U.S. subprime mortgages were adjustable-rate mortgages, according to the statement of senator Dodd. When the price of houses declined after the second quarter of 2006, it became more difficult to refinance because adjustable-rate mortgages raised interest rates higher, mortgage delinquencies soared. New Century Financial Corporation found out there was misstatement on its financial statement on 2006 which leaded to find out there were another severe misstatement on 2005 and severe dysfunctional internal control over the company.

The second risk the company faces is improper accounting practices not in conformity with GAAP. On the repurchase reserve, residual interest in off-balance-sheet securitizations, loans held for sale, and allowance for loan losses, these four are the major accounting practices lead the company to collapse.

B. What were the primary financial reporting items in NCF's financial statements related to these risks?

There were four financial reporting items in New Century related to risks explained above: Whole loan sales, Securitizations structured as sales, Securitizations structured as financing and Lower of cost or market valuation of loans held for sale. According to the Harvard Business School case study, errors on these items resulted in an overstatement of earnings before income taxes of $263 million over the seven quarters from Q1 2005 to Q3 2006. Of this, the amount pertaining to fiscal year 2005, the last audited financial statement, was $63.6 million, compared with total reported earnings before income taxes of $443.4 million for that year.

First, whole loan sales - New Century sold mortgages in loan pools at a premium to investment banks such as Goldman Sachs, JP Morgan Chase, Lehman Bros., and Morgan Stanley. On purchase agreements with these investment banks, the company required to repurchase if a borrowers failed to complete any of the first three loan payments (Early Payment Defaults). The value of these repurchased loans was reduced and New Century resold them at discounted price. Between 2003 and 2006, the percentage of Early Payment Defaults was increased from 4.38% to 11.96%. Loan sale premiums dropped from 4.18% to 1.59%. Kick-out loans were $5.1 billion and loans sold at a discount increase from $247 million to $916 million.

Second, in securitizations structured as sales, New Century sold loans to a special purpose entity trust which was created for securitization. SPE trust then sold securities to investors. New Century provided credit enhancement by providing additional collateral above the aggregate principal value of the securitization, in case the loans in the securitization pool failed to generate the expected cash flows. Therefore, the lowest tranches in the securitization pool and the first risk of loss belonged to New Century. New Century was eligible to receive payments from the OC loans after payment of principal, interest, servicing fees, and other trust expenses. The expected cash flow and net interest receivable on these OC loans constituted New Century's "residual interest" in the securitization. New Century sometimes securitized and sold the expected cash flows from the OC loans as Net Interest Margin Securities but would retain a residual interest in the NIMS pool; this formed part of the residual interest asset on its balance sheet.

Third, Securitizations structured as financing - With securitizations structured as financings, New Century retained the securities backed by the securitized loans labeled "mortgage loans held for investment" (LFHI) as assets on its balance sheet and the bonds used to finance them as liabilities. The company received interest from the mortgagor (recorded as interest income) and paid out interest to the bondholders (recorded) as interest expense. It created an Allowance for Loan Losses (ALL)--a reserve to provide for losses on loans held for investment. New Century estimated ALL monthly by calculating the potential for losses in the LHFI account over the next 18 months, based on projected loss rates, prepayment rates, and interest rates. Provisions for losses were expensed, and actual losses were charged to the allowance account.

In addition, All loans that New Century did not classify as "mortgage loans held for investments," including repurchased loans that it intended to sell, were classified as "loans held for sale." Accounting rules required that loans held for sale were reported at the LCM (lower of cost or fair market value) 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 on the balance sheet. Changes in the valuation allowance were to be included as part of net income of the period in which the change occurred (Statement of Financial Accounting Standards No. 65).

C. What accounting requirements and practices were relevant to these risks and reporting items?

First of all, Whole sale loans: Accounting rules required companies to establish loss reserves for repurchases of loans. The loss reserves had to cover

* Premium recapture - the amount of the premium over par the company received when it sold the loan and was required to return in the event of a default.

* Interest recapture - the amount of interest the investor should have received but did not because the mortgagor failed to make loan payments. New Century needed to pay the loan purchaser for the interest the purchaser did not receive.

* Future loss