Case Study: Financial Risk Management

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Financial Risk Management

Even at the best of economic times, the mortgage market tends to be a risky one. For a company offering loans at sub-prime rates, this is particularly the case. Before the collapse of the mortgage market, companies such as New Century took advantage of several financial factors to focus its strategic objectives, including the aggressive financial expansion of the company. This is what led to its ultimate downfall, like so many of its kind when the housing market collapsed, and more repurchase requests arose than could be returned by the company.

New Century's initial business objective was the aggressive increase of its loan originations. As part of its marketing strategy, it claimed to be a "New Shade of Blue Chip," which would achieve strong results with "integrity." Ultimately, this proved not to be the case.

The company's business strategy was pursued to such an extent that the company displayed little regard for the risks associated. This resulted in a rapid rise of loan originations between 2002 to 2006, from about $14 billion to about $60 billion. This was as a result of work conducted by the Loans Production Department with brokers specifically trained to originate loans for the company. The aggressive manner in which the company pursued its goals led to its ultimate downfall.

It must be emphasized that increasing loans should be the goal of any mortgage company; however, the single-minded way in which New Century did so, without any regard for mitigating potential risks, created ultimately unacceptable danger. The final result of this strategy came in 2007, when the risky nature of its business strategy finally came to light in its assertion of the need for restating its financials.

The primary difficulty for New Century was not the nature of its business; subprime loans can be appropriate in certain circumstances, and for a large number of borrowers. The difficulty for New Century, again, was the way in which it provided these loans. Primarily, the problem lay in the loose underwriting and accounting standards the company maintained for the purpose of ever increasing its loan rates.

Specifically, one of these standards was the more than 70% of the loans the Company originated that had low initial rates to gain high risk clients. These initial "teaser rates" were likely to increase dramatically later, when the promotion period expired. Another related factor was more than 40% of New Century's loans were originated and underwritten on the basis of a stated income, for which clients were not require to provide any verification. This created a situation in which employees of the company could not determine the ability of the client to afford the loan.

Another highly risky loan product was the so-called 80/20 loans, which provided two separate loans for the same transaction; where the first lien mortgage loan provided an 80% loan to value ratio, while the second provided 20%, which added to 100% of the property value. Despite the historical underperformance of this type of loan, the company continued to offer them.

A further factor was that New Century made frequent exceptions to its underwriting guidelines, particularly for borrowers who would not qualify for particular loans. Already in 2004, this was identified as a "number one issue" in the rocky finances of the company.

The main risk that could be identified was therefore the fact that clients would potentially and ultimately be unable to repay the loans at the interest rates that would later arise. When these loans were offered for repurchase, another potential risk was the company's inability to finance such as repurchase.

New Century also incurred a risk by not investing in the technology or personnel necessary to meet the growing demands of the business. While not completely to blame for the downfall of the company, it was a definite risk factor for New Century's operations. Such personnel and technologies might have identified and predicted the demise of the company before its actual occurrence, with the possibility of saving what was left to potentially make a new start. Failing this, however, the company's demise was complete.

Although sufficient evidence was not found to conclude that the company was engaged in specific earnings management or manipulation, it was indeed found that the company engaged in improper accounting practices during 2005 and 2006. Most of the company's accounting practices, in fact, did not conform to generally accepted accounting principles, also known as GAAP. To quantify, the company's accounting blunders were at least seven in number, and resulted in material misstatements of consolidated financial statements.

Specifically, it was found that the company had calculated the repurchase reserve incorrectly by not accounting for a backlog of repurchase claims and by disregarding investment interest that would need to be repaid when the loan was repurchased. In addition, two other critical components were excluded with the Company was inebriated with repurchase claims during 2006. The company removed a loss severity component on the existing loan inventory that has been repurchased, and also removed a loss severity on future repurchases as estimated in the third quarter of 2006. This resulted in a material understatement of the Company's repurchase reserve by at least $104.8 million by the second half of 2006. In addition, the result of omitting to appropriately apply lower of cost or market (LOCOM) account in the valuation of LHFS was an overstatement of this account by at least $85.8 million.

As New Century's accounting partner, it was also found that KPMG was at least partially responsible for the results of faulty accounting at New Century. Indeed, the company recommended the improper changes in terms of the repurchase reserve calculation during the second and third quarters of 2006. KPMG also did not detect to the material understatements on New Century's accounts, and should bear responsibility for this oversight as well. Both the Accounting Department and KPMG had a responsibility to advise the Audit Committee of the changes to the repurchase reserve calculation.

Ironically, it was unnecessary for New Century to create its unviable position. Improvements would have already been possible if a more appropriate discount rate had been used to compute the present value of future cash flows. If these discount rates were used, the residual interest values would have been reduced significantly, by at least $14,8 million. Another shortcoming on both the part of New Century and KPMG was that they did not work together to remedy internal control deficiencies in terms of residual interest valuations.

A further five accounting issues were found, which were related to: the company's allowance for loan losses; its mortgage servicing rights, the deferral of loan origination fees and costs; the company's hedge accounting; and the amount of goodwill it recorded in term so fits acquisition of the loan origination platform.

Along with the other accounting deficiencies the company incurred, these created not only a lack of integrity, but a lack of sustainable practice as well. In combination, the demise of the company as a result of accounting mismanagement is a dual disaster for the company, as it has faltered not only financially, but also ethically.

In terms of the company's competitive peers, New Century has also not adhered to the common practice at any given time. Indeed, its discount rates were significantly lower than those offered by peer firms. Furthermore, the accounting errors were dismissed as insignificant, when in fact they were not, even while no documentation was offered in support of any such claims.

When the numbers are quantified, New Century's understated repurchase reserve was as low as 1,000% below its actual value. As a result, it reported a profit of as much as $63,5 million, when in fact a loss was experienced. Further repercussions included that the company reported an increase of earnings per share when a decline of at least 40% was in fact more realistic. Another result was that financial performance bonuses were paid that were 300% more than they should have been.

According to the report, KPMG is far from flawless in this outcome. It failed to question and test important assumptions with appropriate rigor, for example. There was no question regarding prior knowledge on the part of either company, since KPMG specialists have made recommendations to remedy the oversights. There appears, however, to have been some conflict between KPMG specialists and the teams working directly with New Century. Whereas specialists appear to have had a good concept of the shortcomings of the company's accounting shortcomings, the professionals working directly with New Century appear to have complied with the mismanagement practices, hence revealing a fundamental lack of ethical consistency with in KPMG.

This is not to say that New Century was entirely consistent either. However, those who should have overseen and terminated the shortcomings did not. While New Century made false and misleading statements in its public filings and in other communications to the public, Senior Management simply turned a blind eye. The Chief Credit Officer, for example, noted that there was no standard for loan quality, which was… [END OF PREVIEW]

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