New Century Financial Essay

1. Describe and evaluate hot vitamin Cs business model? naked Century monetary Corporation, headed by founders Brad Morrice, Edward Gotsch tout ensemble, andRobert, was a riotous which specialized in subprime mortgages. The company originated, interchange, andserviced subprime home mortgage lends. New Century was structured as a substantial estate investmenttrust (REIT) and was composed of two operating divisions. The Wholesale Loan Division,known as New Century Mortgage Corporation, comprised 85% of the firms loan originations,while the Retail Mortgage Loan Division operated under Home123 Corporation.New Century Mortgage Corporation operated in 33 locations passim 19 different statesand relied heavily on independent mortgage brokers to identify potential borrowers and assistthem through the loan process until the loans were closed by New Century. This division alsopurchased funded loans from other lenders and expedited the loan underwriting process throughits web-based syst em known as FastQual. The Retail division was composed of 235 sales officesthroughout 35 states, a call center, and a web site. This division was aggressive in its approach toseek 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 mortgagesuntil they were sold within 30 to 90 days of origination. New Centurys income was generatedfrom the difference between the bestow rate and rate at which the loans could be sold orfinanced and from servicing loans. Loans were sold either as whole loan sales where mortgageswere pooled together and sold to investors or as securitizations structured as sales. The companyalso carried securitizations structured as financing as assets on their books and used the bondsto finance the securitized loans as liabilities, thereby generating income based on the differencebetween pursuance received from borrowers and interest paid to bondholders.2. Wha t were the primary attempts faced by New Century?New Centurys business model enabled the firm to grow rapidly from 2001 through 2006as access to capital markets expanded and regulations were relaxed. Loan securitizationallowed lenders to spread credit stake over a larger number of investors creating anenvironment where companies like New Century could lend to subprime borrowers athigher grade while financing their trading operations with the lower interest rates provided bythe highly liquid mortgage-backed securities (MBS) markets. These factors fueled thecompanys growth, scarcely caused the firm to be highly sensitive to risks of increase interestrates, declining home sales, and default by less creditworthy borrowers. New Centurysaggressive strategies in pursuing subprime borrowers resulted in increased risk of assetAdditionally, the short-term credit the company obtained in order to finance loanorigination was contingent on New Century meeting plastered debt covenants and fi nancialratios. Increases in interest rates or regulations or the inability to move new loans off itsbalance sheet could cause the company to be unable to obtain financing to continue fundingloans. Likewise, a decrease in the difference between the interest rate at which it couldborrow and the interest rate at which new loans could be closed, would affect income andmay result in noncompliance with net income requirements or debt-ratios imposed by NewFinally, the loans which New Century sold were pooled together.The investment bankswhich purchased the loans would perform a due diligence review on only 25 percent ofthe pool before negotiating the fundamental law and price of the mortgage pool. A kick-outclause was included to allow for buyers to reject part of the loan pool for defects such asfaulty living, appraisals, or underwriting issues. The buyers could also require NewCentury to repurchase loans which experienced early payment default (EPD). As such, thecompany was exposed to risks re tardyd to internal controls in monitor loan processing,underwriting, and closing which could cause a substantial loss in income due to increasedkick-outs and repurchased loans. Further aggravating these risks were thecompanysaggressive play in pursuing and closing subprime borrowers such as offering loansrequiring only stated income and assets as opposed to full documentation loans.3. What were New Centurys critical performance variables? How well was NewCentury performing with respect to these critical performance variables?New Century Financial had performance variables that critically moved(p) its businessand led to its eventual bankruptcy filing. These included liquidity, default rate, and forms ofThe overall rate of default is critical because of its compounding increase in liabilities witha decrease in assets. A default rate higher than the historic rate would adversely affect the valuation of some(prenominal) assets in the firms financial statements. It is also ti ed to the demand formortgage backed securities, increased default reduces the demand for subprime securitization,thus reducing New Century Financials 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 includederrors in cypher the loan repurchase reserve, the lower-of-cost-or-market (LCM) valuationof loans held for sale, and the remnant interest valuation. Additionally, the modeology usedfor the allowance for loan losses (ALL) was known by management to be defective as thecompanys models used poor predictors of future performance to determine the level of reserveneeded. In calculating the repurchase reserve, New Century obtained historic averages andapplied those percentages to loans sold in the last three months as EPD was defined as paymentdefault occurring in the first three payments. However, since the repurchases were beingprocess ed by several different surgical incisions within the company depending on the cause of therepurchase, there was a backlog in obtaining the data in a timely manner. As loan repurchasesbecame more frequent, the company continued using stale data causing the reserve computation toIn addition, the company was not properly applying LCM valuation as stated in its owncompany policy. Instead of pooling similar loans to determine to pass on LCM analysis, the firmwas performing the analysis on the disaggregated loans and then grouping the loans togetherto conduct valuation on the group as a whole.This method resulted in gains from one loangroup 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 usingdiscount rates which were lower than those used by others in the industry to compute residualinterest. New Century disregarded numerous warnings from their auditors, KPMG, regardin gthe low discount rates and failed to provide documentation to justify or support the valuationmethodology used. Furthermore, prepayment rates and loss rates were estimated using historicaldata related to activity occurring years prior without adjusting for changing market conditionswhich resulted in an overvaluation of residual interest. plot of land the examiner did not consider the issues in the ALL calculation to be material, thisissue merits attention because the company had been very aggressive in closing loans, manyof which were risky stated income and assets loans to subprime borrowers. New Centurymanagement was aware that their ALL was flawed, although they believed that they wereover-reserved and not under-reserved. As with their other accounting estimates, the companyfailed to provide adequate documentation to support assumptions and knowingly relied on poorpredictors, stale data, and defective models.5. Why did New Century fail?New Century grew rapidly through the late 1 990s and early 2000s, however its businessmodel was not sustainable for the long term. The company relied heavily on subprime borrowersand offered them a range of risky loan options. Those subprime loans were pooled together andsecuritized in effort to reduce the riskiness of the loan pools. However, as high risk borrowersfound themselves unable to make payments on their loans, a alter real estate market andincrease in interest rates left subprime mortgagors without little options to get out their loansAside from those challenges which were shared by all competitors in the industry at thetime, New Century also had several internal weaknesses. The company was strongly focusedon sales and loan production, but failed to adequately monitor and control loan quality. Internalcontrols were poor and the audit committee did not sufficiently perform its duties to overseethe internal audit department and address operational risks. Internal auditors identified severalissues regarding loans qua lity, closings, and servicing, however internal controls over financialreporting were overlooked. Adding to the companys gross lack of controls, was the absence seizureof a stated company accounting policy. The examiner pointed out that merely having a policyin place to address the accounting methodology and estimates would apply greatly affected thecompanys ability to apply appropriate accounting treatment consistent US GAAP.