New Century Financial Essay

1. Describe and evaluate novelfangled cytosines backing model? natural century Financial Corporation, headed by fo lows Brad Morrice, Edward Gotsch totally, andRobert, was a firm which specialized in subprime mortgages. The partnership originated, sold, andserviced subprime home mortgage contributes. overbold Century was structured as a objective estate enthronizationtrust (REIT) and was composed of two operating characters. The Wholesale Loan Division, cognize as unseasoned Century Mortgage Corporation, comprised 85% of the firms contribute originations, musical composition the Retail Mortgage Loan Division operated under Home123 Corporation. rising Century Mortgage Corporation operated in 33 locations passim 19 antithetic statesand relied heavily on independent mortgage brokers to point potential borrowers and assistthem done the give process until the loans were loadedd by New Century. This division in any casepurchased funded loans from other lenders and expe dited the loan underwriting process finishedits web- base system 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 go with typically originated loans and apply short-term loans to fund refreshed mortgagesuntil they were sold within 30 to 90 days of origination. New Centurys income was generatedfrom the difference between the lending 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 ponded together and sold to investors or as securitizations structured as sales. The companyalso carried securitizations structured as financial backing as assets on their books and used the bondsto finance the securitized loans as liabilities, thereby generating income based on the differen cebetween entertain received from borrowers and interest nonrecreational to bondholders.2. What were the primary jeopardizes 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 address risk over a larger number of investors creating anenvironment where companies like New Century could lend to subprime borrowers at high order while financing their operations with the cut interest rates proposed bythe passing liquid mortgage-backed securities (MBS) markets. These factors fueled thecompanys growth, but typed the firm to be highly sensitive to risks of increasing interestrates, declining home sales, and oversight by less extensionworthy borrowers. New Centurysaggressive strategies in pursue subprime borrowers burdened in increased risk of assetAdditionally, the short-term credit the company obtained in order to finance loanorigination was dependant upon(p) on New Century meeting certain debt covenants and financialratios. Increases in interest rates or regulations or the inability to move new loans off itsbalance sheet could cause the company to be inefficient 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 out-of-pocket diligence review on only 25 percent ofthe pool before negotiating the composition and price of the mortgage pool. A kick-outclause was include to allow for buyers to reject part of the loan pool for defects such asfaulty documentation, appraisals, or underwriting issues. The buyers could also requ ire NewCentury to buyback loans which experienced early payment default (EPD). As such, thecompany was overt to risks related to midland controls in monitoring loan processing,underwriting, and closing which could cause a substantial loss in income due to increasedkick-outs and buy backd loans. yet aggravating these risks were thecompanysaggressive tactics 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 precise performance variables? How well was NewCentury performing with respect to these vituperative performance variables?New Century Financial had performance variables that critically abnormal its businessand led to its eventual failure 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 themilitary rating of many assets in the firms financial statements. It is also tied to the demand formortgage backed securities, increased default reduces the demand for subprime securitization,thus reducing New Century Financials source of income at a eon of increasing obligations.4. What were the reporting errors identified by the bankruptcy examiner?The bankruptcy examiner noted some(prenominal)(prenominal) inconsistencies with US GAAP. These includederrors in compute the loan repurchase reserve, the lower-of-cost-or-market (lowest common multiple) valuationof loans held for sale, and the balance interest valuation. Additionally, the methodology usedfor the allowance for loan losses (ALL) was known by focal point to be defective as thecompanys models used short(p) predictors of hereafter 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(a) three months as EPD was defined as paymentdefault occurring in the first three payments. However, since the repurchases were beingprocessed by several different departments within the company depending on the cause of therepurchase, there was a cumulate in obtaining the data in a timely manner. As loan repurchasesbecame more frequent, the company continued using stale data causation the reserve advisement toIn addition, the company was not properly applying LCM valuation as stated in its owncompany policy. preferably of pooling similar loans to determine to conduct LCM depth psychology, 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 usingdiscoun t rates which were lower than those used by others in the industry to compute residualinterest. New Century disregarded numerous warnings from their auditors, KPMG, regardingthe 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 bodily process occurring years prior without adjusting for changing market conditionswhich resulted in an overvaluation of residual interest.While 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 history estimates, the companyfailed to provide adequate documentati on to support assumptions and knowingly relied on woefulpredictors, stale data, and defective models.5. Why did New Century fail?New Century grew rapidly through the late 1990s and early 2000s, yet 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 cooling real estate market andincrease in interest rates left hand 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 committ ee did not sufficiently perform its duties to overseethe internal audit department and address operational risks. Internal auditors identified severalissues regarding loans quality, closings, and servicing, however internal controls over financialreporting were overlooked. Adding to the companys gross lack of controls, was the absenceof a stated company accounting policy. The examiner pointed out that merely having a policyin devote to address the accounting methodology and estimates would have greatly affected thecompanys ability to apply appropriate accounting treatment conformable US GAAP.