New Century

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Discuss the story of Countrywide, an organization that was also a big player in the subprime market. How does Countrywide compare to New Century, particularly in time frame and facts. Describe your thoughts on why one company had a ?happy ending? and the other did not.

Advanced Auditing Summer 2017 New Century Lecture Notes NOTE: When answering the questions in the test on New Century, the information contained in the readings that have been assigned for New Century control; that is, if anything I say during this lecture or anything contained in these lecture notes conflicts with what you encounter in the readings assigned for this case, you should rely on the readings when answering the test questions. (The reason for this statement is simple: For the lecture, I will sometimes draw on sources that are not listed in the reading list for this topic; I have found that dates, names, and dollar amounts can vary among media sources. Therefore, to increase the likelihood that you do well on the tests, I will confine answers to those found in the reading material, including the text, assigned for this case.) I. Background - This case is about greed, misstatement of financial statements, insufficient disclosure, and auditor negligence. To understand this case, we must first look at the subprime mortgage crisis as it existed as little as a few years ago. a. Sub-prime mortgage crisis How did the sub-prime mortgage crisis come about? The sub-prime mortgage crisis was born as a result of a decade-long housing boom fueled by low interest rates and excess liquidity. During these 'boom' years, mortgage brokers, enticed by the lure of big commissions, talked buyers with poor credit into accepting housing mortgages with little or no down payment and without credit checks and proper tax documentation (often referred to as \"liars' loans\" because self-reported income was relied upon to determine the size of the loan to grant). The term \"sub-prime lending\" (also referred to as near-prime, non-prime, and second-chance lending) refers to making loans to people who may have difficulty maintaining the repayment schedule. Before the year 2000, an individual would get a mortgage loan from a bank (at times, a broker would connect the individual wanting a mortgage with a banker). The bank would then service the loan for the rest of the loan life. In other words, the bank shouldered the risk of default. Generally, the demand was for low risk investments that paid a nice return, such as home mortgage loans. However, such investment options were not easy to find. 1 As a result of a demand for investment vehicles, a great amount of money was invested in the U.S. mortgage market by means of securitization. Here's how it works: An individual gets a mortgage loan from an originator. The mortgage is then sold to a bank which, in turn, sells the mortgage to an investment firm on Wall Street. The Wall Street firm collects thousands of mortgages, which represents thousands of mortgage checks (income) every month, and creates a Mortgage Backed Security (like a bond), made up of these cash inflows. The Wall Street firm then sells shares of these cash inflows to investors. To create these Mortgage Backed Securities, banks and financial institutions often repackaged (i.e., \"bundled\") these debts with other high-risk debts and some prime mortgages (to reduce, somewhat, the risk, thereby making the bundle look more attractive) and sold them to worldwide investors. These mortgage backed securities were sometimes known as CDOs or \"collateralized debt obligations.\" These bundled sub-prime mortgages were traditionally isolated from, and sold in a separate market from purely prime loans. These \"bundles\" of mixed (prime and sub-prime) mortgages were asset-backed securities so the 'probable' rate of return looked superb (since sub-prime lenders pay higher premiums, and the loans were secured against saleable real-estate, theoretically the investment \"could not fail\"). Many borrowers could make the payments during the years of low interest, but eventually these borrowers began to default in large numbers. The demand for those Mortgage Backed Securities increased so much that more mortgages had to be created. The standards used to determine whether a mortgage applicant qualified for a mortgage were lowered to fulfill the demand for these mortgages. By 2003, almost anyone who wanted a mortgage got one. Examples of ways standards were lowered: 1. Creation of the stated income, verified assets (SIVA) loan. Applicants didn't have to prove their income anymore; they just needed to "state" it and show that they had money in the bank. 2. Creation of the no income, verified assets (NIVA) loan. The lender no longer needed to know about the applicants' income; applicants merely had to show that they had some money in their bank accounts. 3. Creation of the no income, no assets (NINA) loan (sometimes referred to as a Ninja loan). Not only did applicants not have to show that they had income, they also did not have to show that they had any money in the bank. All that was required was a credit score. In addition, a new type of loan, the Adjustable-Rate Mortgage (ARM) loan was created. These ARMs typically allowed mortgage holders to pay a low rate of 2 interest for the first 2-3 years, after which the interest rate was adjusted to the market rate every six to twelve months. (For example, a 2/28 loan is one for which the low, introductory interest rate is paid for two years and for the remaining 28 years, the rate periodically is adjusted to market.) Approximately 90% of home mortgage loans taken out in 2006 were ARMs and an estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. These loans, usually adjustable rate mortgages (ARMs), were known as sub-prime mortgages. They typically cost two or three points above those with less-risky credit reports and carry interest rate structures with low 'teaser rates' for the first couple of years, followed by much higher rates. With potential annual adjustments of 2% or more, this reset or jump in rates frequently resulted in eventually raising the borrower's monthly payment by as much as 100% and increasing the loan payment to more than the borrower could handle. Example: A $500,000 loan at a 4% interest rate for 30 years results in a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a monthly payment of $4,220. A 6% increase in the rate caused slightly more than a 75% increase in the payment. The total cost of the above loan at 4% is $864,000, while the higher rate of 10% results in a lifetime cost of $1,367,280. If sub-prime borrowers could refinance, they could lower their payment assuming interest rates for their risk category is sufficiently lower than the adjusted rate of 10% (and after considering refinancing charges). After 2007, many homeowners could not afford to refinance. A special type of ARM is the interest-only ARM, which allows the homeowner to pay just the interest (not principal) during an initial period and yet another type of ARM is the "payment option" ARM loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out \"payment option\" ARM loans, which meant they could choose to make payments so low that their mortgage balances rose every month. But these subprime ARM loans were even made to people with credit scores high enough to qualify for conventional mortgages with better terms (these increased from 41% in 2000 to 61% by 2006) partly because they were quickly approved and because these borrowers were acquiring second homes and other properties as investments. In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARM's even to those with credit ratings that merited a conforming (i.e., non-subprime) loan. 3 Many mortgage holders who were granted these loans could not afford the mortgage payments because a. Their household income was not high enough to make the mortgage payments after the ARM rates increased, b. Poor credit counseling, c. Predatory lending, d. Speculation, e. Consumer overconfidence (thought could refinance mortgage). (Many of the homeowners who took out ARMs believed they could re-finance later and escape the onerous effects of the high rates of interest they would pay when their rates were adjusted upwards. When they tried to re-finance, they found they had negative equity in the real estate they wanted to re-finance so they were unable to re-finance because they had insufficient collateral. Thus, they had to pay the higher rate of interest.) Why would originators lower their criteria for lending money so much? Originators didn't service these mortgages like they did years ago so they didn't care whether they were risky and whether the borrower would ever pay them back because they had sold the mortgages to Wall Street investment firms. However, some originators (like New Century and Countrywide) had a contingent liability to repurchase loans on which the mortgagees defaulted. Why would Wall Street investment firms buy them? They could represent them to U.S. and global investors as low risk investments. But why would any investor consider mortgage backed securities low risk investments? Because the credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, gave most of the Mortgage Backed Securities a AAA rating, the rating given to the safest investments, e.g., U.S. government bonds. But why would credit rating agencies give an AAA rating to these Mortgage Backed Securities? The credit rating agencies used the wrong data to estimate the risk. They used historical rates of default to rate the securities. However, the current situation was different: Because of the lower qualification standards, new mortgages were given to people who would never have qualified for them before and, of course, these persons were more likely to default on their mortgages. It was now easier to get a home loan, so more people qualified. This increased the demand for housing which, in turn, drove up housing prices. 4 The increased prices also attracted investors who were looking to buy houses as an investment so that they could sell it later to make a profit. This, too, increased the demand for housing and increased real estate prices. Because of the fair value of real estate kept increasing, the consequences from all the "bad" loans given to people who could not afford them were delayed. Whenever people experienced difficulties making their mortgage payments, they could easily take another loan against the value of their house, because now it was worth more. The sub-prime mortgage market continued without serious repercussions as long as housing continued to increase in value and interest rates didn't go up. Meanwhile, the homeowners continued to incur more debt until it reached a level of $700 billion or 5% of the US GDP (gross domestic product) in 2004. As sub-prime mortgages began to reset and resulted in foreclosure, housing prices also declined. Because of the way these loans and CDOs were globally distributed, it affected the entire economy. Keep in mind that a single CDO package might contain as many as 100 sub-prime mortgage loans. The fallout from the sub-prime mortgages has affected the housing market, financial markets, the entire US economy, and the global economy. The sub-prime crisis escalated in June 2007 when two Bear Stearns hedge funds collapsed. This had a rapid effect on other parts of the financial markets worldwide and negatively affected the money market sector that is critically important to banking and financial operations. Basically, homeowners went into more debt (by taking out home equity lines of credit) in order to pay off their debts. In contrast to the rising house prices (which rose by 124% between 1997 and 2006), the average household income didn't increase so mortgage holders could not afford their mortgage payments and they began to default on their mortgages. At this point, the housing market began to unravel. The number of people who defaulted on their mortgages increased which, in turn, increased the number of houses on the market. The oversupply of houses and lack of buyers caused housing prices to plummet until they hit a low in 2008. The Wall Street firms no longer wanted to buy Mortgage Backed Securities. Mortgage companies, which had previously sold the high-risk loans, began to go out of business. 5 Because of the glut of housing in the market, the fair values of real estate declined beneath their mortgage principals (\"negative equity\" or being \"underwater\"). Homeowners could no longer borrow additional money using the equity in their houses as collateral. Consequently, the Mortgage Backed Securities lost value because the underlying assets (the mortgages) lost value. Investors lost money. Financial institutions, such as Countrywide and New Century, did not maintain adequate reserves to protect against default and so were unprepared for the amounts that they eventually were required to pay. Auditors did not exercise due professional care in auditing the adequacy of these reserves. Unfortunately, the reserves were inadequate, and thus the financial statements were not prepared in accordance with GAAP. b. New Century i. Founded in 1995 by three persons who had previously worked for Option One Mortgage. ii. New Century Financial Corporation was a real estate investment trust (REIT) that originated mortgage loans in the US through its operating subsidiaries, New Century Mortgage Corporation and Home123 Corporation.1 iii. New Century used \"master repurchase agreements\" and its own working capital to fund origination and purchase of mortgage loans and to hold these loans for sale or securitization. These \"Master Repurchase Agreements\" provided that New Century would sell mortgage loans to a \"repurchase counterparty\" and commit to repurchase these loans on a specific date for the same price paid, plus a fee2 for the time value of money (called a \"price differential\"). For mortgage loans of lesser quality (or if market conditions deteriorated), the repurchase counterparties would sometimes pay less than the principal amount of the mortgage loan and New Century would finance a portion of the principal amount of the loans with its own working capital (called a \"haircut\"). 1 There were two divisions: Wholesale and retail. The wholesale division was operated by New Century Mortgage Corporation and originated and purchased mortgage loans through a network of independent mortgage brokers and correspondent lenders. At December 31, 2006, this wholesale division had approved 57,000 independent mortgage brokers and operated through 34 regional centers in 20 states and employed approximately 1,087 account executives. In 2006, it was responsible for 85% of the mortgage loans originated by New Century. The retail division, operated by Home123 Corporation, originated mortgage loans through direct contact with consumers at 262 branch offices and through referrals from third parties such as builders and realtors. It employed 1,702 loan officers. 2 This fee was partly based on the LIBOR (London Interbank Offered Rate). 6 IF the person owing the mortgage defaulted, the repurchase counterparties had a right to accelerate New Century's obligation to repurchase the loan. If New Century failed to repurchase the loan, the repurchase counterparties could take action that effectively eliminated New Century's right to repurchase the loan (so it would not have this asset to resell) and, furthermore, if New Century's obligation was not satisfied by the repurchase counterparties' actions, New Century was liable for any deficiency. Wholesale loan sales and securitizations: Most of New Century's sales of mortgage loans were in the secondary market by means of wholesale loan sales or by securitizations. a. Wholesale loans sales: New Century would sell a group of mortgage loans to a financial institution that would either hold the loans as an investment or pool the loans (with loans bought from other originators) for subsequent securitizations. b. Securitizations: New Century would sell a group of loans to a trust for cash and a residual interest in the trust. The loan sale agreements used by New Century usually provided that New Century would repurchase or substitute a loan IF a. The borrower defaulted on a payment shortly after the loan was sold, or b. New Century did not live up to a representation or warranty it made in the loan sale agreement. iv. It contracted with Bob Vila3 to be its advertising spokesman for several years and became the Official Mortgage Company of NASCAR and sponsored a couple of cars, including the Chip Ganassi Racing team. v. On January 1, 2007, New Century was the second-largest sub-prime mortgage lender (the first was Countrywide) in the United States and had approximately 7,200 full-time employees and a market capitalization of $1.75 billion. Two months later, in March 2007, its market capitalization value of its stock was less than $55 million.4 vi. On February 7, 2007, New Century announced that its financial statements for the quarters ended March 31, June 30, and September 30, 2006 were not in compliance with GAAP and would be restated. It also announced that it expected to report a 4th quarter loss and a loss for all of 2006. 3 Bob Vila starred in the do-it-yourself styled television series \"This Old House\" from 1979 until 1989 and in other home repair and renovation shows. 4 This is a 97% loss of market capitalization: ($1.75B - $55M)/$1.75B = 0.96857 7 This announcement spurred a flurry of securities class action lawsuits alleging that New Century had violated federal securities laws by issuing false and misleading financial statements (like the insufficiency of loan loss reserves) and failure to disclose material facts about New Century which resulted in the artificial inflation of the market price of its stock. vii. On March 9, 2007, New Century Financial Corporation reported that it had failed to meet certain minimum financial targets required by its warehouse lenders and disclosed that it was the subject of a federal criminal investigation. New Century Financial Corporation further indicated that it did not have the cash to pay creditors who were demanding their money. viii. On March 13, 2007, the New York Stock Exchange issued a press release in which it stated that it would delist New Century's common and preferred stock. ix. On March 20, 2007, New Century Financial Corporation said that it could no longer sell mortgage loans to Fannie Mae or act as the primary servicer of mortgage loans for the government sponsored enterprise. New Century Financial Corporation said that on March 14, 2007 it had been notified that Fannie Mae had terminated a mortgage selling and servicing contract with it citing alleged breaches of that contract and others. These announcements exacerbated an already precarious liquidity crisis for New Century as a result of the termination of funding for loans originated by New Century and the replacement of New Century as servicer for the mortgage loans (for which it received fees). New Century's inability to originate loans and meet its obligations to repurchase loans that fell beneath a predetermined benchmark5 led to the filing of bankruptcy. x. On April 2, 2007, New Century Financial Corporation and its related entities filed for bankruptcy under Chapter 11. New Century Financial Corporation listed liabilities of more than $100 million. It also announced that the employment of about 3,200 people, more than half the workforce, would be terminated. xi. On May 25, 2007, it filed its form 8-K, a day after stating that it had "...probably overstated 2005 earnings." xii. On March 26, 2008, an unsealed report (of 551 pages) by bankruptcy court examiner Michael J. Missal outlined a number of "significant improper and imprudent practices related to its loan originations, 52 If the market value of the loans times an \"advance rate\" was less than the repurchase obligations owed by New Century, the Repurchase Counterparties were entitled to make a margin call. This margin call could be satisfied by a cash payment made by New Century or by delivering additional mortgage loans. [This information is from footnote 8 in the bankruptcy court file called \"Opinion on Confirmation.\"] 8 operations, accounting and financial reporting processes," and accused auditor KPMG with helping the company conceal the problems during 2005 and 2006. xiii. On December 7, 2009, Federal regulators sued three former officers of New Century Financial Corp., accusing them of misleading the company's investors about the company's prospects. xiv. Summary: What did New Century do wrong? 1. Insufficient loan loss reserves: When reserves are established or increased, net income is decreased; if reserves are too low, net income is too high. Loan loss Loan loss reserves XX,XXX XX,XXX GAAP requires sufficient loan loss reserves based on the matching principle (by the use of estimates) and conservatism. 2. Lack of disclosure to directors and investors: According to an SEC complaint, New Century \"...failed to disclose important negative information, including dramatic increases in early loan defaults, loan repurchases, and pending loan repurchase requests.\" 3. Misleading information released by management to conceal its poor performance: According to an SEC complaint (see SEC Release 2009-258), \"...New Century disclosures generally sought to assure investors that its business was not at risk and was performing better than its peers.\" The combination of these wrongs caused the market price of the stock to be artificially high. Investors bought and sold based on this price and thus were harmed. If we analyze this fraud in terms of the fraud triangle, we have Opportunity: Management had the advantage of information asymmetry so it could easily withhold information from directors and investors and even misstate information since the directors and investors were not privy to this information. Pressure: The real estate market was in decline and management was under pressure to avoid any decreases in market price of the stock. Rationalization: (1) \"I'm entitled to the lifestyle that I've been enjoying for years.\" (2) \"I'm providing jobs for thousands of account executives and other support staff; if I don't prop up the market price, they'll lose their jobs.\" 9 II. Auditor Shortcomings a. The lawsuit filing by the New Century Liquidating Trust against KPMG alleged that KPMG performed \"...reckless and grossly negligent audits...\" and said that the result of KPMG's failure to function as the \"public's watchdog\" was \"catastrophic\". b. This suit alleged that KPMG was not independent: i. When the specialists within KPMG tried to point out financial misstatements, they were silenced by an audit partner so that KPMG's business relationship with New Century (especially as to fees earned) would be protected. ii. It issued its audit opinion before the audit was completed (it had not received information it needed on the loan losses). c. This suit also alleged that KPMG was grossly negligent: i. KPMG failed to detect material misstatements, including New Century's loan repurchase liability and its residual interest in the loans it securitized (which should have increased its loan loss reserves and thus decreased its income). ii. KPMG should have known that New Century's assumption that all repurchases would occur within 90 days was wrong and thus that its loan loss reserve calculation was flawed. iii. KPMG advised the client to remove, contrary to GAAP, a component (e.g., \"inventory severity\"; see Appendix A) from the loan loss reserve calculation. This removal resulted in an even lower balance of loan loss reserve and a less conservative recognition of loan loss expense. iv. KPMG issued an unqualified opinion on financial statements when, in fact, it knew these financial statements were not in accordance with GAAP.6 v. KPMG did not conduct, in accordance with AS no. 5 an adequate audit of the effectiveness of internal controls over financial reporting and report on significant deficiencies and material weaknesses in controls in 2005 and 2006 (See Appendix B for definitions of material weaknesses and significant deficiencies). 1. a failure to develop and document effective policies and procedures for performing estimates requiring the exercise of judgment, including the repurchase reserve and the valuation of residual interests; 2. a failure to establish safeguards and controls to prevent the revision of or deviation from accounting policies and related assumptions without adequate supervision and review; 3. a failure to establish safeguards and controls to insure the remediation of identified internal control deficiencies; 6 An \"unqualified opinion\" is now referred to as an \"unmodified opinion\" See AU-C 700, Forming an Opinion and Reportingon Financial Statements, at http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C00700.pdf. 10 d. 4. a failure to establish safeguards and controls to identify and process efficiently repurchase requests; and 5. a failure to establish safeguards and controls to ensure that the repurchase reserve estimation process accounted for all outstanding repurchase requests. KPMG was alleged to have not exercised due professional care. i. It accepted David Kenneally's word for the appropriateness of reserves without collecting adequate corroborating evidence. III. Update a. On July 31, 2010, the Los Angeles Times reported that a settlement had been reached between the SEC, three officers and the directors of New Century. The settlement bars them from serving as directors of public companies for five years, and levies fines and profit-disgorgement on the three officers. i. The corporate officers involved were Brad Morrice (a co-founder; now partner at Chadamor Corporation (dba Southwest Wholesale Nursery)), Patti M. Dodge (a CPA, a vice-president, and CFO; now a teacher at Esqueda Elementary School in Santa Ana, California) and David N. Kenneally (controller who had a difficult personality, reminiscent of Bernie Ebbers; now an independent consultant in Orange County, California). ii. The disbarred directors were co-founder Robert K. Cole, the estate of co-founder Edward Gotschall, Fredrick J. Forster, Michael M. Sachs, Harold A. Black, Donald E. Lange, Terrence P. Sandvik, Richard A. Zona, Marilyn A. Alexander, David Einhorn and William J. Popejoy. b. As of March 25, 2013, the bankruptcy of New Century had not been finalized (see New Bankruptcy Opinion, 2013). IV. Related case: Countrywide Financial Corp. a. Also involved in the sub-prime mortgage lending crisis b. Also audited by KPMG c. Not likely to file bankruptcy, acquired by Bank of America, because of reputation and political factors but one commentator has offered 3 reasons for bankruptcy: i. Countrywide is a separate legal entity from B of A and this could limit the potential damage to B of A. ii. Bad mortgages are all Countrywide's fault (86% of B of A's mortgages that are 60 days or more behind were originated by Countrywide). iii. Bankruptcy might be the cheapest option because it could cost B of A less than buying back the mortgage securities (WSJ, 2010). d. In 2012, one source stated that \"Bank of America has drastically scaled back its mortgage business after taking billions of dollars of losses from its Countrywide purchase.\" (Rothacker, 2012). It announced, in September 2011, a planned layoff of 30,000 employees in order to reduce costs and increase stock price (Kim, 2011; Bharatwaj, 2013). It laid off 3,500 employees in late 2011 (Reuters, 2011), 16,000 in 2012 (Hobson, 2012), and continued to lay off 11 employees throughout 2013 (for example, see Anderson (2013), McQueen (2013), and USCorpLayoffs (2013)). Appendix A Inventory Severity \"Inventory severity\" is one of two components of \"loss severity\" (the other component is \"Future loss severity.\" Inventory severity is the loss severity on loans already purchased. Loss severity is the difference between two factors: (a) The loan's unpaid principal balance that New Century had to pay to the repurchase party, and (b) The loan's fair value. Thus, when the loan's fair value is less than the unpaid principal balance, a loss exists. (For more information on inventory severity, see SEC Complaint, 2009) Appendix B Material Weaknesses and Significant Deficiencies Significant deficiency: A deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of a registrant's financial reporting. Material weakness: A deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis. Note: There is a reasonable possibility of an event, as used in this standard, when the likelihood of the event is either "reasonably possible" or "probable," as those terms are used in Financial Accounting Standards Board Statement No. 5, Accounting for Contingencies ("FAS 5"). Source: Auditing Standard No. 5, An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements 12 References Anderson, M. March 7, 2013. Bank of America plans mortgage assistance layoffs. Sacramento Business Journal. http://www.bizjournals.com/sacramentoews/2013/03/07/bank-of-americarancho-cordova-layoffs.html [Accessed: June 5, 2013] Bharatwaj, S. May 2, 2013. Bank Layoffs Continue to Mount. 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December 7, 2009. Securities and Exchange Commission, Plaintiff v. Brad A. Morrice, Patti M. Dodge, and Donald N. Kenneally, Defendants. http://www.sec.gov/litigation/complaints/2009/comp21327.pdf [Accessed: June 10, 2013] Sub-prime Mortgage Crises. 2011. Wikipedia. http://en.wikipedia.org/wiki/Subprime_mortgage_crisis [Accessed: May 31, 2011] USCorpLayoffs. April 4, 2013. 1789 Bank of America employees in New York and New Jersey to be laid off by May 31, 2013. http://uscorplayoffs.blogspot.com/2013/04/1789-bank-ofamerica-employees-in-new.html#!/2013/04/1789-bank-of-america-employees-in-new.html [Accessed: June 5, 2013] WSJ. November 2, 2010. Could BofA push Countywide into bankruptcy? http://blogs.wsj.com/deals/2010/11/02/could-bofa-push-countrywide-into-bankruptcy/ [Accessed: May 31, 2011] 14