New Century Financial Corporation

Case Study

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ContentsCompany Overview...............................................................................................................................3

External Analysis – Industry...................................................................................................................4

Internal Analysis....................................................................................................................................6

Management, Board of Directors, Audit............................................................................................6

Applicable Financial Accounting Standards – FAS 5 and FAS 140......................................................6

Key Internal Accounting Controls......................................................................................................7

Primary Business Risks.......................................................................................................................8

Accounting Requirements and Practices Relevant to the Business Risks and Reporting Items.......12

Primary Financial Reporting Items Related to the Business Risks and NCF Financial Reporting

Errors...............................................................................................................................................13

Reasons Why Accounting Failures Went Undetected for so long despite Changes in Governance in the post-Sarbanes-Oxley Act Era.....................................................................................................15

Accounting controls that could have prevented or detected errors................................................16

Concluding Notes................................................................................................................................18

References...........................................................................................................................................19

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Company OverviewNew Century Financial Corporation was founded in 1995 by Robert Cole, Brad

Morrice, and Edward Gotschall. The Company went public in 1996 and was listed on

NASDAQ. New Century Financial Corporation operated within the U.S. Subprime Mortgage

Industry. The primary activities for the Company included originating, retaining, selling, and

servicing home mortgage loans designed for subprime borrowers, who were not eligible to

apply for prime mortgage loans. By the year 2006 New Century Financial Corporation

expanded its product range to include fixed-rate mortgages, adjustable rate mortgages

(ARMs), hybrid mortgages, and interest-only (IO) mortgages. The New Century products

were from the two Company’s divisions of Wholesale Loan Division and Retail Mortgage

Loan Division, which differed in terms of sales channel (indirect and direct). The New

Century Financial Corporations employed almost 1,000 account executives and 50,000

independent mortgage brokers in 19 states within its Wholesale Loan Division whereas it

operated 235 sales offices within Retail Mortgage Loan Division in 35 states.

New Century Financial Corporation was able to generate significant sales and income

and reach substantial growth with compounded annual return of 70 percent from 2000

through 2004 due to its capacity to respond to increasing demand on subprime mortgage

loans. Despite increasing competitive pressure in the subprime market, the Company still

held strong market positions due to its low cost loan originators. However, despite the

aggressive growth, in 2006 New Century Financial Corporations was put under concern due

to its loan quality, deteriorations in underwriting standards, and earnings quality.

In 2007 New Century Financial Corporation recognized deteriorations in underwriting

and calculating loan purchases and announced a restatement of the financial performance for

the previous year. The accounting deteriorations and delinquencies resulted in the liquidity

crisis faced in March 2007 and filing Chapter 11 Bankruptcy in April 2007.

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External Analysis – IndustryAlthough in early 1990s subprime mortgages were only a small pie in the US

mortgage industry, subprime grew extensively by 216 percent from 2001 through 2006 to

account for 20 percent of all mortgage originations (Figure 1).

Figure 1. Growth in U.S Subprime Mortgages (2001-2006).

Source: Cited in Palepu et al. “New century Financial Corporation,” Harvard Business School, October 14, 2009, p. 13. (Source: Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual, Top Subprime Mortgage Market Players & Key Data (2006).

Subprime mortgages were given as loans to individuals whose risk profile did not

allow them to qualify for a prime mortgage loan. Although subprime borrowers due to their

higher default risk had to pay 200 to 300 basis points more over prime rates, they eagerly

used subprime mortgages to finance home purchases or to re-finance already existing

mortgages.

The factors that encouraged the extensive growth of the subprime mortgage industry

included access to capital markets through loan securitization – pooling and reselling loans to

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investors; increased liquidity in the market for mortgage-backed securities; removal of

interest-rate caps in 1980s; low interest rates in 2000s; rising house value; proliferation of

non-traditional mortgages, etc.

The value chain of subprime industry involved a number of participating parties that

included borrowers, mortgage brokers, lenders who were represented by banks, credit unions,

mortgage companies, rating agencies, investors, and US Federal Reserve. The main actors

and their role in the value chain of the US subprime industry are reflected in the Figure 2.

Figure 2. U.S Subprime Mortgage Industry Value Chain

Source: Bartels J. C. “Sub-Prime Crisis Revisited – ‘Value Chain’ to Financial Meltdown,” Business Information Industry Association, October 3, 2008, p. 2.

The major lines of businesses for subprime mortgage lending firms included loan

origination, loan securitization or sale, and loan servicing. Loan origination business line

covered activities associated with processing loan applications, funding mortgage loans based

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on underwriting standards of lending firm, and selling mortgage loans to investors or

securitizing the loans on the firm’s balance sheet as mortgage-based securities (MBS). Loan

servicing business line involved activities associated with payment collection from borrowers

and making payments to loan holders and investors, as well as making payments on real

estate taxes and insurance.

Despite phenomenal growth in the subprime loans, the industry was not adequately

equipped to face the increase in interest rates and decrease in home prices in 2006 intimidated

the investors’ willingness to securitize mortgage-based loans, which led to the sharp decrease

in liquidity and resulted in the collapse of the industry in 2007.

Internal Analysis

Management, Board of Directors, AuditAs of March 2007, the Board of Directors of the New Century Financial Corporation

consisted of the three founders – Robert Cole the chairman and chief executive officer, Brad

Morrice, vice chairman and chief operating officer, and Edward Gotschall and vice

chairman–finance, – and eight other independent directors. The Board of Directors consisted

of seven committees that included audit, compensation, executive, finance, governance and

nominating, public and community affairs, and stock options.

Applicable Financial Accounting Standards – FAS 5 and FAS 140Financial Accounting standards developed and enacted by FASB guide the reporting

of companies. FAS 140 requires from originators and transferors of loan assets to recognize

all assets obtained and liabilities incurred upon completion of financial assets transfer.

Liabilities involve expenses and losses that are estimated to be incurred in relation to the

repurchase of earlier sold loans. In the FAS 140 in the paragraph 55 it is stated: “The

transferor initially measures those assets and liabilities at fair value on the date of the change

(circumstances under which the transferor such as New Century would be required to regain

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of the sold loans), as if the transferor purchased the assets and assumed the liabilities on that

date” (FAS 140). However, it was not assumed at New Century that some of the loans the

Corporation had sold would need to be repurchased. Despite the fact that New Century

management knew and acknowledged that some of its loans would be the subject to

borrowers’ default and would need to be repurchased, New Century calculated a repurchase

reserve that satisfied “probable” and “estimable” conditions. These conditions are provided

by the FAS 5 as follows:

“Information available prior to issuance of the financial statements indicates that it is

probable that an asset had been impaired or a liability had been incurred at the date of the

financial statements. It is implicit in this condition that it must be probable that one or more

future events will occur confirming the fact of the loss” (FAS 5).

Loss contingencies as well as claims existing as of the date of the New Century

financial statements report were sometimes misevaluated in terms that New Century applied

historical data rather than actual for preparing estimated financial statements.

Key Internal Accounting ControlsInternal audit control was performed by the audit committee that consisted of four

members – Marilyn Alexander, a certified public accountant (CPA) and an MBA from

Wharton; Donald Lange, president and CEO of Pacific Financial Services, a mortgage

banking company and a former president of the Mortgage Bankers Association of America;

Richard Zona, former vice chairman and CFO of U.S. Bancorp and former partner of Ernst

and Young; and Michael Sachs, chair of the audit committee, who was a CPA and an attorney

(Palepu et al. 2009, p. 6). The members of the audit committee were considered to be

financial experts as per SEC requirements. The New Century Financial audit committee met

to review audit function reports and provide financial information for external audit control.

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External Audit for New Century Financial had been performed by KPMG from 1995

until April 2007 when KPMG resigned due to restatement of accounting policies and

financial statements for 2006 that were announced by New Century Financial in March 2007.

Sometimes New Century Financial rendered expert advice during quarterly reviews and

annual audits from engagement teams that included specialists from within KPMG as well as

from other partners such as the Structured Finance Group who had substantial experience in

auditing mortgage companies.

Primary Business RisksNew Century Financial Corporation had been developing and growing with

significantly high speed. Since the company had the primary goal of originating and selling

more mortgages, the aggressive manner of making more loans at disastrous levels resulted in

the failure of New Century Financial Corporation to support the rapid growth the company

had had for the decade after its inception. 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

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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 “Senior Management

may have abdicated its responsibility to manage the day-to-day affairs” particularly with

respect to its failure to address kick-outs” (Missal 2007).

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 percent to more than 5

percent. Although such a hike in the interest rates had been forecasted and anticipated since

2003, 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 2004

interest 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 percent to 5.5 percent. 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

percent (Landier et al. 2010, p. 12). Since short-term debt was little affected, the direct effect

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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 in

2004. 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 (Landier et al. 2010, p.13).

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

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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 by

2004 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 included

1) 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 (Bankruptcy Examiner’s Final report, p. 72). Despite the

fact that all these risks were disclosed in the Company’s Form 10-K for 2005, the New

Century Financial Corporation did not address them appropriately which led to its

bankruptcy.

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Accounting Requirements and Practices Relevant to the Business Risks and Reporting Items

The major ways for New Century Financial to originate and finance loans were whole

loan sales, securitization structured as sales – loans held for sale, and securitization structured

as financing – loans held for investment (see Figure 3). While whole sale loans were directly

auctioned to investors, securitization structures as sale were actually securitization by New

Century Financial itself and securitization structured as financing remained on the NCF’s

balance sheet being financed through collateralized bond issues.

Figure 3. New Century Financial origination by categories of revenue

Source: Cited in Palepu et al. “New century Financial Corporation,” Harvard Business School, October 14, 2009, p. 13. (Source: Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual, Top Subprime Mortgage Market Players & Key Data (2006).

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

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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 Related to the Business Risks and NCF Financial Reporting Errors

The business risks of inappropriate underwriting loans and monitoring loan quality

resulted in accounting practices that were non-conformant to the US Generally Accepted

Accounting Principle. There were seven types of improper accounting practices identified by

the examiner to be not in conformity with GAAP. These included:

Improper calculating repurchases reserves (see Figure4). 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. Decentralization of repurchases combined with

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inadequate control systems resulted in sufficient backlogs in repurchase

reserves.

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 overvalued

and non-performing loans were not written down in timely manner.

Figure 4. New Century’s Repurchase Reserve Calculation Methodology

Source: Cited in Palepu et al. “New century Financial Corporation,” Harvard Business School, October 14, 2009, p. 24 (Source: Bankruptcy Examiner’s Final Report, p.184).

Improper residual interest valuation that led to material misstatements in the

financial statements for 2005 and 2006. Residual interest rate was calculated

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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 (Figure 5).

Figure 5. Estimated Impact of Misstatements on Earnings ($ millions, except for EPS)

Source: Cited in Palepu et al. “New century Financial Corporation,” Harvard Business School, October 14, 2009, p. 23 (Source: Bankruptcy Examiner’s Final Report, pp. 383 and 386).

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Reasons Why Accounting Failures Went Undetected for so long despite Changes in Governance in the post-Sarbanes-Oxley Act Era

Inadequate underwriting standards, improper monitoring of loan quality and senior

management’s negligence of GAAP and ethical valuation of mortgages resulted in the late

indication of critical loan and quality issues as well as collapse of the company.

The negligence and inadequate attention of senior management to the risks discussed

above proved the unchecked dominance of the business procedures in the company; the

strained relationship between the board of directors and senior management; problems when

following only industry practices rather than evaluating and developing practices that would

take in consideration other economic and business factors; failure to analyze enterprise risk

and implement proper risk management; limited focus of the audit committee and internal

audit department. All these factors added to the collapse of the company. However, if the

senior management and board of directors were able to address these issues and deal with

them in a timely manner, the negative sensitivity and negative shock to the Federal Reserve’s

monetary policy could have been substantially reduced.

Senior management and internal audit committee had to assume critical role in

promoting the accuracy and integrity of accounting, financial reporting and operational

processes. Had the audit committee of New Century Financial paid sufficient attention to the

practices applied in the company, the better would be chances to predict and face the issues in

an appropriate manner.

Accounting controls that could have prevented or detected errorsThe errors could have been detected and prevented on early stage if there were

sufficient internal control over auditing and financial reporting standards. Thus New Century

Among these controls would be internal control over financial reporting as well as effective

auditing design that derive from Generally Accepted Auditing Standards when applied

appropriately.

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There are ten Generally Accepted Auditing Standards in the United States which

cover general standards, standards of fieldwork and standards of reporting. General auditing

standards emphasize auditor’s obligation to 1) have adequate technical training and

proficiency to perform the audit, 2) maintain independence (in fact and appearance) in mental

attitude in all matters related to the audit, and 3) exercise due professional care during the

performance of the audit and the preparation of the report. Standards of fieldwork oblige

auditors to 1) plan the work adequately and supervise any assistants properly; 2) obtain a

sufficient understanding of the entity and its environment, including its internal control, to

assess the risk of material misstatement of the financial statements whether due to error or

fraud, and to design the nature, timing, and extent of further audit procedures; and 3) obtain

sufficient appropriate audit evidence by performing audit procedures to afford a reasonable

basis for an opinion regarding the financial statements under audit. The standards of reporting

require auditors to 1) state in the auditor's report whether the financial statements are

presented in accordance with generally accepted accounting principles; 2) identify in the

auditor's report those circumstances in which such principles have not been consistently

observed in the current period in relation to the preceding period; 3) determine and state

reasonable adequacy of informative disclosure of financial performance; and 4) express an

opinion regarding the financial statements, taken as a whole, or state that an opinion cannot

be expressed, in the auditor's report.

Although to the major points these standards were performed by the outside auditors

from KPMG, the outside auditors could have been more asserting in persuading the

management and the Board of the company to provide higher level of internal control over

auditing and reporting standards. Internal controls that would have prevented the errors at

New Century Financial include an effective framework that would have incorporated

processes designed to assure that transactions were booked properly initially and found their

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way to the proper place on the Corporation’s financial statements. Despite the fact that most

of the transactions were recorded properly, the evaluation of appropriateness of their records

was not performed. Furthermore, internal controls of the New Century Financial were a

subject to bias since the internal auditors did not show and employ appropriate level id

independence over auditing and financial reporting.

Generally it is managerial bodies and specifically top management and principal

financial officers who have responsibility to design and implement the Company’s system for

internal control over financial reporting. However, both the Company’s management and the

Board failed to provide that system was implemented in an appropriate manner.

Concluding NotesSince a drastic rise in interest rate in 2004 destroyed a large fraction of New

Century’s net present value, the company immediately modified its business model. Although

New Century Financial Corporation introduced a new, more price sensitive product: the

interest-only loan, it changed its customer base, selling this new product to more credit-

worthy, wealthier households, whose repayment decisions were more sensitive to real estate

prices. New Century Financial also changed the geography of its operations to sell more and

more of new loans in cities where real estate prices correlated with company’s legacy assets.

Despite the fact that this new business strategy was consistent with that of a financially

distressed company that started taking long bets on its own survival, it was undertaken too

late to save the company from bankruptcy.

As Missal and Richman assert: “To maximize their effectiveness, audit committees

and internal audit departments need to be independent, active, skeptical and through. If not,

they can give a false sense of comfort and may miss the opportunity to address an issue

before it becomes problematic. Given the importance that audit committees and internal audit

departments play in the corporate governance of every company, boards of directors need to

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ensure that they are fulfilling completely their responsibilities.” Namely the “if not” scenario

was the case in the New Century Financial Corporation which led to the company’s filing

bankruptcy report in the final outcome.

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ReferencesBartels J. C (2008). Sub-Prime Crisis Revisited – ‘Value Chain’ to Financial Meltdown. Business Information Industry Association, October 3, 2008. Retrieved 5 April 2011 from <http://www.biia.com/library/Sub-prime%20crisis%20revisited%20-%20Value%20Chain%20to%20Financial%20Meltdown.pdf>.

Financial Accounting Standard 5. Available online at <http://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820910926&blobheader=application%2Fpdf>.

Financial Accounting Standard 140. Available online at <http://www.gasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blobwhere=1175820919404&blobheader=application%2Fpdf>.

Landier A, Sraer D, Thesmar D. Going for broke: New Century Financial Corporation, 2004-2006. Retrieved 5 April 2011 from <http://www.princeton.edu/~dsraer/NC_v14.pdf>.

New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008.

New Century TRS Holdings, Inc., Interim Report of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), November 21, 2007.

Palepu et al. (2009). New century Financial Corporation. Harvard Business School, October 14, 2009.