Case Study on "Financial Risk Management"

Quoted Instructions for "Financial Risk Management" Assignment:

Instructions:

Focus on NCFʼs O&Dsʼ fido duties ***** loyalty, due care, good faith and candid disclosure; underwriting policies, if any; sub-prime risk management controls; issues relating to kickouts, EPDs and FPDs; NCFʼs exposure to operating risks including technology, systems (including internal controls), and personnel; repurchase reserve risk management including interest recapture risk; any problems relating to residual interests, OBS policies; any substantive accounting issues; failure of the outside auditors; and maybe any management shortcomings.

1. Strategic objectives? Their business model to achieve objectives?

2. Principal risks?

3. Performance variables, metrics? Did they performan in line with metrics?

4. Key reporting items in NCF*****s financials? Examiner*****s take on possible reporting errors?

5. Why did NCF fail?

6.Was the Board paying attention? Where*****d they come up short in their duties?

7.Any other stuff? Financing strategy? Liquidity risks sorta like LTCM?

Only include this source article:

I. INTRODUCTION AND EXECUTIVE SUMMARY

On February 7, 2007, New Century Financial Corporation (*****"New Century,*****" or the *****"Company*****") announced the need to restate its financial statements for the first three quarters of 2006. At the time, New Century was the second largest originator of subprime residential mortgage loans, which are loans made to borrowers who represent a high level of credit risk. The Company had grown at an incredible pace since inception, from originating $357 million in mortgage loans in its first year of operation in I996 to approximately $60 billion in 2006. New Century*****'s equity securities were traded on the New York Stock Exchange (*****"NYSE*****"), the Company had a market capitalization of over $1 billion in February 2007, and it had credit facilities of $17.4 billion to finance its activities. New Century reported net earnings of $411 million for 2005 and $276 million for the nine months ended September 30, 2006.

The February 7, 2007 news that New Century needed to restate its 2006 interim financial statements caused a dramatic and swift descent of the Company. Immediately following the announcement, New Century*****'s stock price dropped precipitously, and the Company disclosed on March 2, 2007 that it would not file its 2006 Annual Report on time. This revelation and other developments prompted increased margin calls by the Company*****'s lenders, accompanied by their refusal to provide further financing. As a result of these financial pressures, New Century stopped accepting loan applications on March 8, 2007, and the NYSE delisted the Company*****'s securities on March 13, 2007. On April 2, 2007, New Century and many of its affiliates (collectively the *****"Debtors*****") filed for bankruptcy protection. KPMG LLP (*****"KPMG*****") resigned as the independent auditor for New Century on April 27, 2007, and the Company announced on May 24, 2007 that its financial statements for the year ended December 31, 2005 also should no longer be relied upon.

On June I, 2007, this Court issued an order directing the United States Trustee for Region 3 (*****"U.S. Trustee*****") to appoint an Examiner to, among other things, *****"investigate any and all accounting and financial statement irregularities, errors or misstatements*****" and *****"to prepare a report within 90 days of the date of appointment, unless such time shall be extended by the Court.*****" On June 5, 2007, the U.S. Trustee appointed Michael J. Missal as Examiner and that appointment was approved by this Court on June 7, 2007. On November 21, 2007, the Examiner filed his First Interim Report related to the possible post-petition unauthorized use of cash collateral by New Century. The Court subsequently extended the date to file this Final Report unti! Febroary 29, 2008.

The Examiner has completed his investigation and files this Final Report. The Examiner recognizes that the subprime mortgage market collapsed with great speed and unprecedented severity, resulting in all of the largest subprime lenders either ceasing operations or being absorbed by larger financial institutions. Taking these events into consideration and attempting to avoid inappropriate hindsight, the Examiner concludes that New Century engaged in a number of significant improper and improdent practices related to its loan originations, operations, accounting and financial reporting processes. KPMO contributed to certain of these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitating the Company*****'s departures from applicable accounting standards.

The June I Order required the Examiner to identify any potential claims that the Debtors*****' estates may have arising out of any improper conduct. The Examiner believes that at least several causes of action may be available to the estates. First, the estates may be able to assert causes of action against KPMO for professional negligence and negligent misrepresentation based on KPMG*****'s breach of its professional standard of care in carrying out its audit and reviews of the Company*****'s financial statements and its related systems of internal controls. Second, the estates may be able to assert causes of action against some former Officers of New Century to recover certain of the bonuses paid to them in 2005 and 2006 that were tied, directly or indirectly, to New Century*****'s incorrect financial statements. These causes of action could seek millions ofdollars in recoveries.

New Century*****'s Officers and Directors owed the Company fiduciary duties ofloyalty, due care, good faith and candid disclosure. The Examiner has assessed the conduct of certain former Officers and current and former Directors to determine whether their actions or inactions may give rise to potential causes of action on behalf of the estates. Breach of fiduciary duty claims against officers and directors have strong defenses to overcome, particularly the business judgment rule and statutory or other limitations. Accordingly, the Examiner has not included a detailed discussion ofsuch potential claims. Nonetheless, because questions may be raised about the conduct and level of care exhibited by the former Officers and current or former Directors, some potential areas ofconcern are outlined in this Final Report.

All of New Century*****'s revenues, assets and operations were directly affected by the Company*****'s subprime lending policies and practices. It is therefore pertinent to New Century*****'s accounting and financial reporting processes to examine issues related to the Company*****'s loan originations.

*****¢ New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy. Loan originations rose dramatically in recent years, from approximately $14 billion in 2002 to approximately $60 billion in 2006. The Loan Production Department was the dominant force within the Company and trained mortgage brokers to originate New Century loans in the aptly named *****"CioseMore University.*****" Although a primary goal of any mortgage banking company is to make more loans, New Century did so in an aggressive manner that elevated the risks to dangerous and ultimately fatal levels.

*****¢ The increasingly risky nature o f New Century*****'s loan originations created a ticking time bomb that detonated in 2007. Subprime loans can be appropriate for a large number of borrowers. New Century, however, layered the risks of loan products upon the risks of loose underwriting standards in its loan originations to high risk borrowers. For example, more than 70% of the loans originated by the Company had low initial *****"teaser rates*****" that were highly likely to increase significantly over time. A senior New Century officer noted in 2004 that borrowers would experience *****"sticker shock*****" after the teaser rates expired. More than 40% of the loans originated by New Century were underwritten on a stated income basis. These loans are sometimes referred to as *****"liars*****' loans*****" because borrowers are not required to provide verification of claimed income, leading a New Century employee to tell certain members of Senior Management in 2004 that *****"we are unable to actually determine the borrowers*****' ability to afford a loan.*****" Another common loan product offered by New Century that had a high degree of risk was the *****"80120*****" loan, which involved two separate loans for the same transaction: a first lien mortgage loan with an 80% loan to value ratio and a second lien loan with a 20% loan to value ratio, resulting in a combined financing of 100% of the value of the mortgaged property. One Senior Officer o f New Century noted in early 2006 that the performance o f these 80/20 loans in 2005 was *****"horrendous.*****"

*****¢ New Century also made frequent exceptions to its underwriting guidelines for borrowers who might not otherwise qualify for a particular loan. A Senior Officer of New Century warned in 2004 that the *****"number one issue is exceptions to guidelines.*****" Moreover, many of the appraisals used to value the homes that secured the mortgages had deficiencies. Of the New Century loans rejected by investors, issues with appraisals were the cause of more than 25% of these *****"kickouts.*****"

*****¢ Senior Management turned a blind eye to the increasing risks of New Century*****'s loan originations and did not take appropriate steps to manage those risks. New Century*****'s former Chief Credit Officer noted in 2004 that the Company had *****"no standard for loan quality.*****" Instead of focusing on whether borrowers could meet their obligations under the terms of the mortgages, a number of members of the Board of Directors and Senior Management told the Examiner that their predominant standard for loan quality was whether the loans New Century originated could be initially sold or securitized in the secondary market. This attitude resulted in an increasing probability that New Century would have to repurchase billions of dollars of the riskier loans because of significant defaults or loan defects, particularly if market conditions changed. Some New Century employees recognized the increased perils of these mortgage products and lending practices starting no later than 2004, and recommended changes to manage and minimize risk. These recommendations, however, were either largely rejected or ignored by Senior Management, until market forces drove changes to the Company*****'s practices in the second half of 2006. By that time, however, billions of dollars of dubious mortgages were either held by New Century on its balance sheet or injected into the markets.

*****¢ Senior Management was aware of an alarming and steady increase in early payment defaults (*****"EPD*****") on loans originated by New Century, beginning no later than mid- 2004. The surge in real estate prices slowed and then began to decrease, and interest rates started to rise. The changing market conditions exacerbated the risks embedded in New Century*****'s products, yet Senior Management continued to feed eagerly the wave of investor demands without anticipating the inevitable requirement to repurchase an increasing number of bad loans. Unfortunately, this wave turned into a tsunami of impaired and defaulted mortgages. New Century was not able to survive and investors suffered mammoth losses.

*****¢ Senior Management similarly gave inadequate attention to the increasing amounts of investor *****"kickouts.*****" Many loans were rejected for reasons that should have been relatively easy to fix, such as missing documentation from newly funded loan files. Indeed, one former New Century manager recognized that *****"if we could just cure the no brainer type items l list below we would serve ourselves well.*****" The problem was not cured and kickout rates increased over time. Between 2004 and the end of 2006, investors rejected approximately $800 million in loans simply due to missing documentation, and billions of dollars of loans for other reasons. Investor kickouts resulted in millions of dollars in additional expenses for New Century to correct and maintain these loans, wasting New Century*****'s assets and further impairing liquidity.

*****¢ New Century also did not invest in the necessary technologies, systems or personnel to meet its growing business and expanding challenges. Many of the Company*****'s failures can be traced at least in part to these inadequacies.

*****¢ New Century*****'s Senior Management did not set an appropriate *****"tone at the top.*****" Many former New Century employees rationalized the Company*****'s actions with the belief that the Company was conducting business in the same manner or even better than its competitors. The Examiner did not review the practices of other similarly situated companies, but even if New Century*****'s practices were not outside the norm of its industry, this would not absolve anyone from failing to follow applicable accounting rules, legal standards or prudent business practices.

*****¢ New Century engaged in at least seven wide-ranging improper accounting practices in 2005 and 2006, most of which were not in conformance with generally accepted accounting principles (*****"GAAP*****"). As a whole, these practices resulted in material misstatements of the Company*****'s consolidated financial statements for at least the fiscal year ended December·31, 2005 and the first three quarters of 2006. The Examiner did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation, although its accounting irregularities almost always resulted in increased earnings. Ironically, New Century branded itself as a *****"New Shade of Blue Chip,*****" a marketing campaign which claimed that the Company would outperform its competitors by showing strong results achieved with *****"integrity.*****" It is now clear that the New Century did not achieve its financial results with *****"integrity.*****"

*****¢ New Century disclosed on February 7, 2007 that it had not been accounting properly for the reserve for losses associated with the repurchase of loans previously sold to investors. The Examiner*****'s investigation determined that New Century calculated the repurchase reserve incorrectly by not accounting for the growing backlog of repurchase claims relating to older loan sales and by excluding interest that needed to be paid to investors (*****"Interest Recapture*****") at the time ofloan repurchase. Specifically, New Century did not include the back- log of outstanding repurchase claims in any of its repurchase reserve calculations and excluded

Interest Recapture from the repurchase reserve calculation for 2005 and the first two quarters of 2006. The Examiner further determined that New Century reduced its repurchase reserve calculation in 2006, at a time when the Company was being flooded with repurchase claims from investors, by excluding two other critical components. In the second quarter of 2006, New Century removed a loss severity component on the existing inventory of loans already repurchased and included in the Loans Held for Sale (*****"LHFS*****") account. The Company then also removed loss severity on estimated future repurchases in the third quarter of2006. These critical omissions and changes were a violation of GAAP and materially understated the repurchase reserve by at least $104.8 million by the third quarter of 2006. New Century also failed to apply appropriately lower of cost or market (*****"LOCOM*****") accounting in valuing LHFS. By the third quarter of 2006, the LHFS account was overstated on New Century*****'s financial statements by at least $85.8 million.

*****¢ Several interviewees claimed that KPMG actually recommended the improper changes to the repurchase reserve calculation that were made in the second and third quarters of 2006. Although KPMG denied recommending any changes, it acknowledged discussing the issues with New Century at around the time they were made, and its workpapers document the changes. The workpapers further reflect that KPMG evaluated and approved the third quarter change. New Century is ultimately responsible for the accuracy of its financial statements, but KPMG bears responsibility, at a minimum, for suggesting accounting changes in the second and third quarters of 2006 that were inconsistent with GAAP and for failing to detect the material understatements of the repurchase reserve and the LOCOM valuation account. Further, members of the Accounting Department and KPMG should have advised the Audit Committee of these material changes to its repurchase reserve calculation, particularly since the Audit Committee specifically inquired about the adequacy o f the repurchase reserve during these time periods.

*****¢ New Century failed to value properly residual interests that the Company held in off-balance sheet securitizations, which represented hundreds of millions of dollars on its balance sheet. Residual interests were New Century*****'s rights to remaining cash flow or other assets from pools of mortgage loans the Company had securitized. New Century used flawed models to value those residual interests. The Board of Directors, Senior Management and KPMG paid close attention to the valuation of residual interests and knew that New Century was using more aggressive assumptions, including low discount rates, in the valuation models than those of its competitors.

*****¢ If New Century had used a more appropriate discount rate to compute the present value of future cash flows, the residual interest valuations would have been reduced by at least $14.8 million as of December 31, 2005. Other flawed assumptions resulted in the further overstatement of residual interest valuations by at least another $27.5 million as of December 31, 2005. The Examiner finds that KPMG improperly acquiesced in New Century*****'s reliance upon aggressive or stale assumptions in its residual interest valuation models. The Examiner further finds that KPMG failed to insist that New Century cure significant internal control deficiencies with respect to the valuation of residual interests, such as the absence of documentation describing how the residual interest valuation models worked and how the assumptions used in the models were established, revised or approved.

*****¢ The Examiner identified five other problematic accounting issues in 2005 and 2006 related to: (i) its allowance for loan losses (*****"ALL*****") with respect to loans it held for investment; (ii) its mortgage servicing rights (*****"MSR*****"); (iii) its deferral and amortization of loan origination fees and costs; (iv) its hedge accounting; and (v) the $77.7 million of goodwill that New Century recorded in connection with its acquisition of the loan origination platform of the prime mortgage retail division of RBC Mortgage Company. While problems associated with these accounting issues were not of the same financial magnitude as New Century*****'s errors with regard to its repurchase reserve calculations and its valuation of residual interests, they shared some disturbing characteristics that revealed flaws in New Century*****'s accounting and financial reporting processes.

*****¢ The problematic themes these accounting tssues shared included accounting practices and/or methodologies that were inconsistent with GAAP or otherwise subject to criticism by KPMG; not documenting key assumptions underlying New Century*****'s accounting; using discount rates in key areas of accounting that were low when compared to discount rates used by peer firms or the rates used internally by the Company when developing New Century*****'s business plans; and dismissing or minimizing the significance of New Century*****'s accounting errors or departures from prescribed accounting practices on grounds that they were *****"immaterial,*****" even in the absence of documented support for these conclusions.

*****¢ As a consequence of these accounting failures, New Century understated its repurchase reserve by as much as I000% in the third quarter of 2006, reported a profit of $63.5 million in the third quarter of 2006 when it should have reported a Joss, met analysts*****' earnings expectations for 2005 and the first quarter of 2006 when it should have announced earnings below expectations, and reported an increase in earnings per share (*****"EPS*****") of 8% for the second quarter of2006 as compared to the same quarter of2005, when it should have reported at least a 40% decline in EPS. Senior Management benefited from these errors as the three founders (Robert Cote, Edward Gotschall and Brad Morrice) received financial performance bonuses in 2005 that were at least 300% more than they should have been. Other Officers received financial performance bonuses that were approximately 130% to 270% higher than appropriate.

*****¢ KPMG contributed to these failings in critical ways. Among other inadequacies, KPMG failed to question or test certain important assumptions in a rigorous manner. The KPMG engagement team acquiesced in New Century*****'s departures from prescribed accounting methodologies and often resisted or ignored valid recollUIJendations from specialists within KPMG. At times, the engagement team acted more as advocates for New Century, even when its practices were questioned by KPMG specialists who had greater knowledge of relevant accounting guidelines and industry practice. When one KPMG specialist persisted in objecting to a particular accounting practice on the eve of the Company*****'s 2005 Form 10-K filing -- an objection that was well-founded and later led to a change in the Company*****'s practice -- the lead KPMG engagement partner told him in an e-mail: *****"I am very disappointed we are still discussing this. As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off.*****"

*****¢ Other conduct by KPMG was equally troubling and puzzling. KPMG signed off on a New Century repurchase reserve based on the estimate that the Company would need to repurchase approximately $70 million of the loans sold in the fourth quarter of 2005. At the same time, KPMG*****'s workpapers showed that the number of loans that New Century was going to need to purchase was approximately $140 million, not $70 million. KPMG had no explanation for this large discrepancy. Whether careless or intentional, KPMG*****'s error contributed to a significant understatement of the repurchase reserve.

*****¢ New Century made a number of false and misleading statements in its public filings, press releases and other communications. For example, New Century disclosed in its Form 10-K for 2005 and Forms 10-Q for 2006 that the Company *****"occasionally*****" may repurchase loans beyond the 90-day period after the loans were initially sold. These statements were misleading at best, as New Century knew it had a large and growing backlog of repurchase claims more than 90 days old, an important metric for those analyzing the Company*****'s financial statements. The Examiner did not review all of New Century*****'s public statements, but identified certain problematic statements in connection with the analysis o f other issues.

*****¢ There was an unhealthy friction between the Board of Directors and Senior Management at a time when the business challenges would have greatly benefited from a strong collaborative relationship. An effective working relationship between a company*****'s Board and Senior Management requires mutual respect and a healthy tension. However, this was not the situation at New Century in at least 2005 and 2006. In fact, a number of Board members were openly disdainful of certain members of Senior Management and challenged their integrity and competence. One former Director questioned whether *****"Management has been providing the board with full disclosure and whether Management judgments have been appropriate.*****" That same Director further *****"seriously questioned*****" in 2005 whether *****"Management has been manipulating earnings.*****" Members of Senior Management believed that some Board members were misguided and involved in issues outside their authority. This tension inhibited an open flow o f information between the Board and Senior Management and restricted the ability o f New Century to react nimbly and effectively to the rapidly deteriorating subprime market.

*****¢ New Century failed to have an effective system of internal controls. An effective system of internal controls is critical for any public company as it is required by law and promotes accurate reporting, effective operations and compliance with applicable laws and regulations. Nonetheless, New Century had a number of deficiencies in its system of internal controls, including not tracking the growing backlog o f repurchase requests related to older loans sold to investors, not remediating certain control deficiencies identified in earlier audits and not having proper documentation for key financial processes. These inadequacies contributed to many of the accounting and financial reporting deficiencies identified in this Final Report. KPMG was also to blame as it did not uncover significant internal control deficiencies.

*****¢ While New Century had an active Audit Committee, it failed to focus on certain issues of crucial importance to the Company, such as loan quality issues in 2004 and 2005, ensuring a sustained analysis by Management of entity-wide risk, key operational risks and proper supervision of New Century*****'s Internal Audit Department. Audit Committees are a vital corporate governance gatekeeper and play an important role in assuring the accuracy and integrity of a company*****'s accounting and financial reporting processes. Had the Audit Committee addressed these issues more effectively and with more urgency, some of the accounting and operational failures may have been avoided.

*****¢ New Century*****'s Internal Audit Department was also deficient in a number of ways, including not giving adequate attention to kickouts and repurchase claims, and not thoroughly assessing corporate or operational risks. Because New Century was in an industry with extremely high risks, a strong Internal Audit Department was that much more crucial. Unfortunately, New Century*****'s Internal Audit Department was not as strong a corporate governance mechanism as was needed.

The demise of New Century was an early contributor to the subprime market meltdown. The fallout from this market catastrophe has been massive and unprecedented. Global equity markets were rocked, credit markets tightened, recession fears spread and losses are in the hundreds of billions of dollars and growing. While these consequences are not the result of the activities of just one company, the lessons to be learned from New Century*****'s failures will hopefully strengthen and improve future activities within the mortgage and financial services industries.