The subprime meltdown has collapsed hedge funds and bankrupted several mortgage lenders. One of the biggest implosions was New Century Financial, which was once the second-largest originator of subprime mortgages in the United States.
From a high of nearly $64 per share in December of 2004 as traded on the New York Stock Exchange, New Century plunged to trade at $0.10 per share on the pink sheets in 2007. Investors lost billions. In this article, we will look at the company's quick rise and its even quicker downfall. Find out how it happened and who - if anyone - is to blame. (For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)
Rise of a Mortgage Juggernaut
New Century Financial was founded in 1995 by three mortgage veterans Bob Cole, Brad Morrice and Ed Gotschall. The company made its first loan in 1996 and went public one year later. By 1998, the company had grown to 1,151 employees, had 111 offices, originated $2 billion in mortgages and made $17.7 million in net profit.
All this earned New Century the 1998 Ernst & Young Entrepreneur of the Year Award for financial services for Orange County, California.
In 2000, New Century originated $4.2 billion in mortgages, and its momentum seemed nearly unstoppable. Here are a few of the highlights of New Century's rapid growth.
2002 - Added to the Nasdaq Financial-100 Index
- 2003 - Ranks twelfth on Fortune Magazine's list of "Fortune's 100 Fastest Growing Companies"
- 2004 - Converts to a real estate investment trust; listed on the NYSE; originates $42.2 billion in mortgages
- 2005 - Ranks third on the Wall Street Journal "Top Guns" list of best performing companies; originates a record $56.1 billion in mortgages.
- 2006 - Ranks second nationally in subprime mortgage origination volume
"We've achieved a lot in our first 10 years, but as I like to say, for New Century the best is yet to come!" Brad Morrice, vice chairman, president and chief operating officer, said on the company's website.
The Wild West of Mortgage Lending
New Century Financial was a star in the booming mortgage business of the late 1990s and 2000s. It made its money by concentrating on a then underserved section of the mortgage market: subprime borrowers. (To learn more, see Subprime Is Often Subpar.)
New Century's approach to the mortgage market was made clear in its March 2006 10-K filing, in which it stated that "[New Century Financial lends] to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers."
During this time, interest rates reached all-time lows. New types of mortgages were introduced to borrowers, which allowed for interest-only payments and deferred interest. Mortgage companies were rolling out proprietary automated-underwriting systems that allowed for quick, analytical underwriting decisions.
Borrowers were constantly willing to take on the risk of higher mortgage payments and a flat or rising mortgage balance because the ability to refinance down the road seemed certain. Housing prices continued to climb.
Wall Street and big investors were willing to take on risk that seemed quantifiable and diversified in exotic mortgage-backed security (MBS), asset-backed security (ABS) and collateralized debt obligation (CDO) structures.
Everybody was making money and virtually everyone was happy. As in most bubbles, the belief by most was that the good times were sure to go on forever. And New Century was on the leading edge.
The Worst Was Yet to Come
While New Century Financial rocketed from small beginnings into one of the largest players in the mortgage market, the extreme events of 2006/2007 in the mortgage and credit markets would lead to the company's downfall. (For an overview of the subprime crisis, see The Fuel That Fed The Subprime Meltdown.)
June 2004 - The Federal Reserve raises the fed funds rate, a benchmark for other short-term interest rates used to calculate the interest rates on adjustable-rate mortgages. This increase in short-term interest rates means that people resetting adjustable-rate mortgages are subject to substantial increases in their monthly payments. In effect, it cuts the legs out from under the housing market. (To learn more, see Why Housing Bubbles Pop.)
First quarter 2006 - The rapid pace of home price appreciation ends. However, New Century and the mortgage industry in general continues to originate subprime loans under the previously valid assumption that subprime borrowers will be able to refinance out of adjustable-rate mortgages. Wall Street continues to churn out subprime MBS, ABS, and CDOs that are easily sold to investors.
- Fourth quarter 2006 - Things begin to fall apart. The assumptions used in automated credit underwriting engines are proved to be invalid as the percentage of subprime loans in default begins to rise. Investor appetite for subprime securities dries up. Loan repurchase requirements for New Century and other subprime originators increases as early payment defaults rise. This is because mortgages sold into the secondary market frequently have clauses stating the mortgage must be repurchased if it goes into default within a certain period of time.
- February 2007 - Several large mortgage lenders run into problems, beginning with HSBC's well-publicized exit from the business at a $10.6 billion loss. Creditors quit lending short-term money - the lifeline of non-bank mortgage companies - to mortgage companies. Without the ability to borrow money, and with loan repurchases increasing, the party comes to an abrupt end for many subprime lenders.
March 8, 2007 - New Century stops accepting new loan applications. It announces margin calls to its lenders of $150 million.
March 12, 2007 - The company's shares lose 90% of their value and its $1.5 billion market capitalization is wiped out. Trading in the New Century Financial is halted on the NYSE.
- April 2, 2007 - New Century Financial files for Chapter 11 bankruptcy and lays off 3,200 people (54% of its workforce).
Analysis of New Century's Demise
The collapse of New Century Financial was precipitated by a large number of defaults on the mortgages that it originated and a weakening real estate market. As these mortgages defaulted and New Century was forced to repurchase these mortgages under its sales agreements, and it simply ran out of money.
At the time of bankruptcy, the company said its lenders could demand loan repayments of nearly $8.5 billion, a sum it had no way of repaying.
Below we dig a little deeper into the causes.
Early Payment Defaults
In hindsight, New Century's lending standards and practices were clearly inadequate, as signaled by the steep rise in early payment defaults.
When a lender sells a mortgage it originates to investors it will often sign a re-purchase agreement to entice buyers. If the borrower defaults within the first few months the investor can go back to the lender and force them to buy the mortgage back. (To learn more about the secondary mortgage market, see Behind The Scenes Of Your Mortgage.)
These early payment defaults were a major factor in the company's collapse as it effectively ran out of money after being forced to buy back more mortgages than it could afford.
Tied to the early payment defaults is New Century's use of leverage. Mortgages are a complex and difficult asset to manage because they are subject to both interest rate and credit risk. New Century was highly leveraged controlling more than $25 billion in assets with little more than $2 billion in equity, leaving little margin for error. As the market value of its mortgage assets deteriorated, shareholder equity evaporated. (To learn more, read Why Leveraged Investments Sink And How They Can Recover.)
Lack of Funds
The company's business model was to originate mortgages, bundle them together and then sell them to investors. This allowed New Century to keep the mortgages off the books and free up capital to continue to originate more mortgages. This works fine as long as you have minimal early defaults.
But as we know, New Century was suffering through a large number of early payment defaults. As these defaults started to pile up, the company's available capital dried up. New Century could initially repurchase the mortgages with its capital and the capital it had available through its credit lines as well as the money it could raise through the sale of the real estate.
In the end, the defaults continued to increase to the point that New Century simply ran out of money and no one was willing to lend it more. (For detailed analysis of the subprime meltdown as a whole, see Who Is To Blame For The Subprime Crisis.)
Ultimately, New Century Financial is to blame for its own bankruptcy. The company rode a wave in the mortgage business without adequate fraud prevention controls and credit underwriting standards in place. When short-term interest rates rose from historical lows, home prices stagnated and then fell. Investors became more risk averse, the mortgage wave crashed and New Century went under.To learn about another subprime casualty, read Dissecting The Bear Stearns Hedge Fund Collapse.