New_Century_Financial_Corporation

9-109-034REV:OCTOBER14,2009________________________________________________________________________________________________________________ProfessorsKrishnaPalepuandSurajSrinivasanandSeniorResearcherAldoSesia,Jr.oftheGlobalResearchGrouppreparedthiscase.Thiscasewasdevelopedfrompublishedsources.HBScasesaredevelopedsolelyasthebasisforclassdiscussion.Casesarenotintendedtoserveasendorsements,sourcesofprimarydata,orillustrationsofeffectiveorineffectivemanagement.Copyright©2008,2009PresidentandFellowsofHarvardCollege.Toordercopiesorrequestpermissiontoreproducematerials,call1-800-545-7685,writeHarvardBusinessSchoolPublishing,Boston,MA02163,orgoto’sloanoriginationscreatedatickingtimebombthatdetonatedin2007.—BankruptcyExaminer’sFinalReport,February29,2008Inearly2005,NewCenturyFinancialCorporation(NewCentury)wasflyinghigh.Thecompany,founded10yearsearlier,hadbecomeoneofthelargestsubprimeloanoriginatorsintheU.S.Itsstockpricewastradingathistoricalhighs,andearningspersharefor2004were80%higherthanin2002.Yetbarely15monthslater,NewCenturywasinaliquiditycrisis.InNovember2006,TajBindrabecamethenewCFOatNewCentury;onemonthlater,hestartedaskingquestionsaboutthecompany’smortgageloanrepurchasereserves.InFebruary2007,thecompanyannouncedthatitneededtorestateitsfinancialresultsforthefirstthreequartersoffiscalyear2006becauseofaccountingerrorsrelatedtoitsmortgageloanrepurchaseobligations.1ThenewsdroveNewCentury’slenderstoinitiatemargincallsandrefusetoprovideanynewfinancing.InMarch,managementannouncedthatthecompanyhadstoppedtakingmortgageloanapplicationsandwouldnotfileits2006annualreportontime.OnApril2,2007,NewCenturyfiledforChapter11bankruptcyprotection.U.S.SubprimeMortgageIndustry—Early1990sto2008Intheearly1990s,subprimemortgageswereasmallpercentageofthetotalnumberandvalueofmortgagesoriginatedintheU.S.Butby2005subprimemortgagelendinghadbecomea$625billionindustry,accountingfor20%ofallmortgageoriginations.2Inthenewmillenniumalone,subprimemortgageoriginationsgrew216%from2001to2006(seeExhibit1).Whilethereweredifferentdefinitionsofasubprimemortgage,itwasgenerallyconsideredaloantoanindividualwithaFICOacreditscoreof620orbelow;inotherwords,toapersonwhoseriskprofiledidnotqualifyforaprimemortgage.Typically,subprimeborrowers,becausetheywereathigherriskofdefault,paid200to300aFICOwasanacronymfortheFairIsaacCorporation,whichcreatedthescoringsystemtomeasureanindividual’screditworthiness.FICOscoresrangedfrom300to850.ThisdocumentisauthorizedforusebyFeifeichen,from8/27/2013to12/27/2013,inthecourse:FIN501:EthicsinFinancialMarkets-Wegener(Fall2013),DePaulUniversity.Anyunauthorizeduseorreproductionofthisdocumentisstrictlyprohibited.109-034NewCenturyFinancialCorporation2basispointsboverprimeratesandhigherup-frontoriginationfees.3Subprimemortgagesincludedloanstopurchasehomesandtorefinancepre-existingmortgages.cThesubprimeindustry’sgrowthwasdrivenbyanincreaseinaccesstocapitalmarketsthroughloansecuritization—thepoolingandresellingofloanstoinvestors—inthe1990sandearly2000s.Securitizationofloansbackedbyrealassetssuchasautomobilesandhomesexperiencedsignificantgrowth,sincetheseassetswerehomogenousandcreditriskwasspreadoveralargenumberofindividuals(andwasthusdiversifiable).Withgrowthinaliquidmarketformortgage-backedsecurities,mortgageoriginatorscouldselltheloans,transferthecreditrisktootherinvestors,andgainliquiditytooriginatemoreloans.Otherfactorsalsooiledtheindustry’sgrowth.Legislationinthe1980sremovedinterest-ratecaps,whichmeantthatlenderscouldchargehigherratesformortgageandhomeequityloansand,therefore,lendtoborrowerswithhigherriskprofiles.TheTaxReformActof1986preventedindividualsfromdeductinginteresttheypaidonconsumerloansbutallowedthemtodeductinteresttheypaidonloanssecuredbytheirhomesandasecondresidence.Lowinterestrates,risinghousevalues,andaproliferationofnontraditionalmortgages(e.g.,hybridmortgageswheretheborrowerpaidafixedrateforthefirstfewyearsandthenavariableratefortheremainderoftheloan’smaturity)alsohastenedtheindustry’sgrowth.By1997subprimemortgageoriginationsconstitutedabout$125billion,or15%,ofthe$859billionmortgageoriginationsintheU.S.TheindustryhitabumpduringtheRussiandebtcrisisof1998.Theflighttohigher-qualitycreditbydebtinvestorsreduceddemandforsubprimemortgagesecuritizations,creatingliquidityproblemsforsubprimemortgageoriginators.Thisslowedindustrygrowth;somesubprimelenderswentbankruptandthesurvivingfirmsfocusedmoreoncreditquality.However,damagewaslimited,inpartbecausetheincreaseinhomepricesinthelate1990slimiteddefaultsbyborrowers,reducinglossesforinvestors.Between2001and2003,subprimemortgageoriginationswereonlyaround8%ofallresidentialmortgageoriginations.By2003,a