Nearly one-half of recent mortgage foreclosure victims obtained their loans from socalled subprime lenders that became dominant forces within the mortgage industry during the past two decades. The largest of those lenders were Countrywide, HSBC, New Century Financial Corporation (New Century), and Wells Fargo, but more than a dozen other large companies provided loans to borrowers with suspect credit histories.
The implosion of the lucrative but high-risk subprime sector of the mortgage industry in 2007 and 2008 ignited the financial panic in the United States that quickly engulfed the global economy.
The origins of the subprime mortgage debacle in the United States can be traced to the collapse of New Century, the nation’s second largest subprime lender. New Century was founded in 1995 by three friends who had previously worked together at a mortgage banking company. New Century, which was based in Irvine, California, grew dramatically over its brief existence. In 1996, New Century reported total revenues of $14.5 million and total assets of $4.4 million. Nine years later, the company reported total revenues of $2.4 billion and total assets of $26 billion.

During the heyday of subprime mortgage lending in 2005 and 2006, New Century funded $200 million of new mortgage loans on a typical business day. In early February 2007, just a few months after company executives insisted that New Century was financially strong, those same executives unsettled Wall Street when they revealed that the company would be restating previously released financial statements as a result of the misapplication of generally accepted accounting principles (GAAP).
Two months later, New Century declared bankruptcy. A court-appointed bankruptcy examiner summarized the far-reaching implications that New Century's downfall had for the global economy:
The increasingly risky nature of New Century's loan originations created a ticking time bomb that detonated in 2007. . . . The demise of New Century was an early contributor to the subprime market meltdown. The fallout from this market catastrophe has been massive and unprecedented. Global equity markets were rocked, credit markets tightened, recession fears spread, and losses are in the hundreds of billions of dollars and growing.¹
In fact, New Century would be just the first of many high-profile companies brought down by the turmoil in the mortgage industry. Other longtime stalwarts of the nation's financial services industries that fell victim to that turmoil included Bear Stearns, Lehman Brothers, and Merrill Lynch.
In September 2008, the federal government assumed control of the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Company (FHLMC), two "government-sponsored" but publicly owned companies better known as Fannie Mae and Freddie Mac, respectively. At the time, the two organizations owned or guaranteed nearly one-half of the approximately $12 trillion of home mortgages in the United States. For decades, the federal government had used Fannie Mae and Freddie Mac to create an orderly and liquid market for homeowner mortgages, but the enormous losses each suffered in 2007 and 2008 undercut that role and forced the U.S. Department of the Treasury to take over their operations.
Angry investors lashed out at a wide range of parties who they believed bore some measure of responsibility for the massive financial crisis. Those parties included the major subprime mortgage lenders in the United States, such as New Century, and the politicians, regulatory authorities, ratings agencies, and independent auditors who had failed to prevent or rein in the imprudent business practices of those lending institutions.
Only a few years removed from the sweeping reforms prompted by the Enron and WorldCom scandals, the accounting profession was once again forced to defend itself from a wide range of angry and often self-righteous critics. Among these critics was the New York Times. The prominent newspaper castigated the auditors of subprime lenders for stamping those institutions' financial statements with the accounting profession's equivalent of the Good Housekeeping Seal of Approval. "While accounting firms don't exert legal or regulatory authority over their clients, they do bestow seals of approval, the way rating agencies do. People in the financial industry, as well as investors, have reason to believe that a green light from an auditor means that a company's accounting practices have passed muster."²

The following section of this case provides a historical overview of subprime mortgage lending in the United States. Next, the history and operations of New Century  Financial Corporation are reviewed with a particular focus on the company’s major role in the subprime mortgage fiasco. The case then examines the criticism of KPMG,  New Century’s longtime independent audit firm, by the federal bankruptcy examiner  appointed to investigate the company’s sudden collapse in early 2007.

Questions
1. KPMG served as the independent audit firm of several of the largest subprime mortgage lenders. Identify the advantages and disadvantages of a heavy concentration of audit clients in one industry or subindustry.
2. As noted in the case, there was an almost complete turnover of the staff assigned to the New Century audit engagement team from 2004 to 2005. What quality control mechanisms should accounting firms have in such circumstances to ensure that a high-quality audit is performed?
3. Section 404 of the Sarbanes-Oxley Act requires auditors of a public company to analyze and report on the effectiveness of the client's internal controls over financial reporting. Describe the responsibilities that auditors of public companies have to discover and report 

(a) Significant deficiencies in internal controls and

(b) Material weaknesses in internal controls. Include a definition of each item in your answer. Under what condition or conditions can auditors issue an unqualified or clean opinion on the effectiveness of a client's internal controls over financial reporting?
4. One of New Century's most important accounts was its loan repurchase loss reserve. Each accounting period, New Century was required to estimate the ending balance of that account. What approaches or strategies should auditors apply when auditing important "accounting estimates"?
5. New Century's bankruptcy examiner charged that KPMG did not comply with applicable "professional standards" while auditing the company. List specific auditing standards or principles that you believe KPMG may have violated on its New Century engagements. Briefly defend each item you list.
6. Mortgage-backed securities (MBS) produced by New Century and other major subprime lenders were a focal point of attention during the 2008 financial crisis. Many parties maintain that the mark-to-market rule for investments in securities such as MBS contributed significantly to that crisis and that the rule should be modified, suspended, or even eliminated. Briefly summarize the principal arguments of those parties opposed to the mark-to-market rule. Do you believe that those arguments are legitimate? Why or why not?
7. Identify what you consider to be the three most important "take-aways" or learning points in this case. Rank these items in order of importance (highest to lowest). Justify or defend each of your choices.