New Century Financial Corporation

Lin Yu

Jingjing Zhao

New Century Financial Corporation

Background of New Century

New Century Financial Corporation, a public trade company located in California, was founded by Brad Morrice, Edward Gotschall, and Robert Cole in 1995.  Only five years later, the company squeezed into the top-10 subprime originators in the United State. In year 2005, New Century became the second largest subprime originator, just followed by Ameriquest Mortgage.  The company originated, retained, sold and serviced home mortgage loans designed for subprime borrowers, and it operated two divisions: The Whole Loan Division and the Retail Mortgage Loan Division.

In 1997, after originated over $350 million in loans in its first full year of operation, New Century went public and was listed on NASDAQ. In early 2005, the company had become one of the largest subprime loan originators in the US.

However, in February 2007, New Century announced that it had to restates its financial result for the first three quarters of fiscal year 2006 because of the errors in the accounting.  As a result of these accounting problems, the company suffered a liquidity crisis. On March 8, 2007, the company stopped accepting new loan applications because the financial backers are rejected to provide access to financing. On April 2, 2007, the New Century Financial Corporation went bankruptcy.

Business Model of New Century

New Century operated in more than forty subsidiaries in two areas: 1) secondary market operations. 2) loan origination operations. The company financed its loan production by selling the whole loan and securitizations originated in the secondary market. By selling the loan, New Century could identify upfront gains on sale to enhance its net earnings, whereas, by holding the loans to maturity, the company could just identify the interest income spread at the maturity. This permitted the company to preserve the mortgages from the books and make capital available to continue to originate more mortgages.

New Century’s Bankruptcy Process

Although New Century had a good performance during 2001-2005, with loan originations rising more than 5 times from $120 billion to around $625 billion, the company seems to die at the beginning of 2007 because of the material accounting errors followed by severe liquidity problems. Due to these accounting errors, the company showed a positive and increasing earning in 2005 and the first quarter of 2006 in line with analysts’ earnings expectations. However, this let New Century became more conventional about its assumptions underlying its retained interests and repurchase obligations, because the company would have reported only a small increase in net earnings during that period.

After its restatement announcement, New Century was imposed to cease new loan originations for the two reasons: 1) credit providers rejected to spread the financing agreements to finance new loan origination and, meanwhile, ask New Century to repurchase all outstanding mortgage loans and to pay large margin calls.  2) New Century was forbidden by some states to originate further loans because of violation of applicable state law.

The prohibition of continuing operating in some states, the severe liquidity, and the damage to its reputation force the company to ruin. Before the bankruptcy, New Century’s stock price were trading at less than 1$, which was more than 30$ two months before.

Problems within New Century

1. Strained relationship between senior management and the board

Boards questioned whether management provided them with full disclosure, whether management judgments had been appropriate, and even whether management “manipulated earnings”.

1. Incompetence and irresponsibility of Senior Management

Senior Management not only pay much attention to the problems and risks that New Century have, but also not take actions to solve these risks and problems. For example, after early increasing of repurchase claims, payment default, and kick-outs, senior management paid little attention than appropriate, because they consider these problems were industrywide problems

1. Lack of standard for loan quality in operation.

New Century paid little attention to enhancing the loan quality. Some at New Century measured loan quality by whether the loan could be sold, not whether it was likely that the borrower would meet his or her obligation. This standard exacerbated the problems for the company when the mortgage market deteriorated.

1. Failure to Analyze Enterprise Risk Management

Despite that the senior management was aware that there were gaps in the company’s risk-management practices, New Century failed to follow this approach

1. Little Focus of the Audit Committee and the Internal Audit Department

The audit committee and internal audit department did not pay attention to the certain issues of crucial importance to the company. Moreover, audit committee did not focus on the loan quality and operational issues.