Professional Documents
Culture Documents
Case Study
Name
Professor’s/Instructor’s Name
Course
Date
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Contents
Company 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 Overview
New 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
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.
Although 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
Source: Cited in Palepu et al. “New century Financial Corporation,” Harvard Business
School, October 14, 2009, p. 13. (Source: Inside Mortgage Finance, The 2007
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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
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
interest-rate caps in 1980s; low interest rates in 2000s; rising house value; proliferation of
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.
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
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
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
Internal Analysis
Management, Board of Directors, Audit
As 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
Financial 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
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
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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
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.
Internal 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
New 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
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
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loan originations that were at “unacceptable levels” as early as late 2004, senior management
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
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
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
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percent (Landier et al. 2010, p. 12). Since short-term debt was little affected, the direct effect
of monetary policy was reduced equity and increased debt-to-equity ratio of New Century
The hikes in the interest rate and negative sensitivity of income to them were
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
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
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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
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
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
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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.
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
Century Financial itself and securitization structured as financing remained on the NCF’s
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).
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
included so-call “warehouse loans” that were made by using short-term credits from other
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
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
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
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
Accounting Principle. There were seven types of improper accounting practices identified by
of successful loan sales. However, New Century Financial did not have the
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
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
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).
financial statements for 2005 and 2006. Residual interest rate was calculated
major issue was a significant lack of documentation on how the models for
residual interest valuation worked and how the model assumptions were
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).
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
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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
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.
The 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.
There are ten Generally Accepted Auditing Standards in the United States which
cover general standards, standards of fieldwork and standards of reporting. General auditing
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
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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
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
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
opinion regarding the financial statements, taken as a whole, or state that an opinion cannot
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
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
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
Concluding Notes
Since 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
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
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
References
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.