New Century Financial Bankruptcy Examiner Issues Report On What Went Wrong

In what will likely be a blueprint for an amended complaint in the securities fraud class action pending in federal court in California, the examiner appointed by the United States Trustee in New Century's bankruptcy case pending in a Delaware bankruptcy court issued an extensive 581-page report (part one, here; part two, here) detailing the findings of his investigation into what caused New Century's bankruptcy and potential causes of action the estate might have as a result of the conduct that led to the bankruptcy. Our summary of the California judge's dismissal of the initial complaint in the New Century securities class action is available here.

The Rise and Fall of New Century

The story of New Century parallels the story of the boom and bust of the subprime mortgage market. As set forth in the report, New Century was the second largest originator of subprime residential mortgage loans prior to its collapse in the wake of an announced restatement of its financials in February 2007.

Like the subprime mortgage market in general, New Century had grown exponentially in ten years – in 1996 it originated $357 million in loans, growing to over $60 billion in 2006. The report notes that New Century had a "brazen obsession with increasing loan originations," specifically noting that loan originations increased five-fold from 2002 to 2006 ($14 billion to $60 billion).

In order to increase the loan originations, New Century took on riskier loans which, according to the report, "created a ticking time bomb that detonated in 2007." For example, over 70% of New Century's loans were adjustable rate mortgages with low "teaser rates" that increased substantially after the initial period (usually two to three years). Over 40% of the loans were "stated income loans" which did not require verification of the borrower's income (often referred to as "liar loans" because of the propensity for fraud). New Century also relaxed underwriting standards, accepting loans for 100% of the value of the property and utilizing flawed or fraudulent appraisals.

Senior management and the New Century board did not act to limit these risky practices, instead focusing on whether the loans New Century was originating could be sold into the secondary market and securitized. This set up the eventuality that New Century would have to repurchase billions of dollars in "a tsunami of impaired and defaulted mortgages." (p. 4.)

According to the report, New Century appeared to be profitable and had a strong balance sheet during the boom period only because New Century engaged in "seven wide-ranging improper accounting practices," the primary one being its failure to set up appropriate reserves for its repurchase obligations. Without the proper reserves, New Century's financial health was overstated during the boom period and deteriorated virtually instantaneously upon the "tsunami" of defaulted mortgages and repurchase demands.

The examiner concluded that New Century understated its repurchase reserve by 1000% in the third quarter of 2006 and reported increasing profits during 2005 and 2006, when it should have been reporting declining profitability, and a loss by the third quarter of 2006 (when it reported over $60 million in profits).

The Blame Game

The examiner concluded that there was enough blame to go around. It cited the lack of focus by senior management, the board, and the company's audit committee on the risky nature of New Century's loans. It noted that several board members questioned whether senior management was providing the board with full disclosure of the material facts related to the financial health of the company.

The examiner held the company's auditor, KPMG, responsible for failing to stop, and even facilitating, the alleged improper accounting practices. While acknowledging the benefit of hindsight, the examiner concluded that "New Century engaged in a number of improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes. KPMG 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 generally accepted accounting practices." (p. 2)

The examiner ultimately concluded that the New Century bankruptcy estate had multiple potential claims against both the officers and directors of New Century for corporate waste and breach of fiduciary duty and against KPMG for negligence and accounting malpractice.

KPMG denied any wrongdoing in the wake of the report, and a spokesman stated (quoted in this article): "We strongly disagree with the report's conclusions concerning KPMG. We believe that an objective review of the facts and circumstances will affirm our position."

Implications of the Report

As mentioned at the outset of this post, the examiner's report will no doubt give fodder for the securities class action plaintiffs' amended complaint. In fact, the report expressly states that "New Century made a number of false and misleading statements in its public filings, press releases and other communications." (p. 8) It is likely that KPMG will get swept into the securities class action, as well as any actions by the bankruptcy estate.

The examiner's report may also slow down any move to relaxing the accounting standards (see Financial Week article) for mark-to-market and "fair value" accounting under FAS 140 for mortgage lenders (requiring companies' repurchase reserves to be set at fair value at the time of sale of the loan into the secondary market) and FASB 157 for valuing balance sheet assets (described in a previous post here).