Refer to Theory in Practice vignette 1.3, concerning the bankruptcy of New Century Financial. New Century had securitized and transferred to investors (i.e., derecognized) many (but not all) of its subprime mortgages, treating the transfers as sales. However, as the 2007-2008 market meltdowns developed, it was forced to repurchase many of these mortgages. Its provisions for credit losses on repurchases proved to be woefully inadequate. The company quickly ran out of cash.

Required

a . Why would a company such as New Century retain an interest in some of the mortgages it originated, rather than selling all of them on to investors via securitization?

b. Why would the company commit to repurchasing delinquent mortgages?

c. Suppose that the derecognition provisions of IFRS 9 and the disclosure provisions of IFRS 7 and 12, outlined in Section 7.8, were in effect from 1995, the date New Century was formed. Could New Century's filing for bankruptcy protection have been avoided? Discuss.

Theory in Practice 1.3

New Century Financial Corp. il lustrates the serious consequences that can result from lack of conservatism. Formed in 1995, New Century became the second-largest sub-prime mortgage lender in the United States. Its lending was in large part based on automated credit-granting programs, and reflected a belief that house prices would continue to rise. Many of these mortgages were securitized and transferred to investors. New Century accounted for these transfers as sales, thereby derecognizing them from its balance sheet. Gross profit was then the difference between the sales revenue received from investors and the cost of the mortgages transferred. Of course, reported earnings should allow for credit losses, since New Century committed to buy back mortgages that became troubled within one year after transfer.

In addition, New Century would retain some portions of the securitized mortgage pools (called retained interests), from which it would receive future cash flows. Also, the transfer agreements included the right to service the mortgages, for which New Century charged a fee. The retained interests and servicing rights assets were valued at current value, based on their discounted expected future cash flows. Thus, revenue from retained interests was recognized when the decision to retain was made, and servicing revenue was recognized at the time of mortgage transfer. These policies required numerous estimates and management judgments, especially for retained interests (since no secondary market exists for these assets). These policies contrasted with a more conservative policy of recognizing revenues as cash flows from retained interests were received and servicing responsibilities rendered.

However, through error or design, New Century seriously underestimated the extent of its mortgage buybacks and resulting credit losses. Of $40 billion of mortgages granted in the first three quarters of 2006, it provided only $13.9 million for repurchases. As the number of subprime mortgages in default increased greatly in the fourth quarter of 2006, New Century should have revalued its retained interests, and increased its provision for buybacks. As concerns grew, the company was soon unable to borrow money to finance buybacks. In February 2007, New Century announced that it would restate net income for the first three quarters of 2006 to substantially lower amounts, and would delay filing its 2006 annual report. In March 2007, it announced that it would no longer accept new mortgage applications. Its shares lost 90 percent of their value, and the company was delisted from the New York Stock Exchange. In 2007, it filed for bankruptcy protection.

New Century's auditor (KPMG) was drawn into the lawsuits that followed. In 2009, financial media reported a lawsuit of $1 billion, claiming that the auditor had allowed the serious understatement of provisions for buybacks. KPMG denied that it was responsible, claiming that the provisions were deemed adequate at the time, and blaming New Century's failure on the market meltdowns of 2007-2008. Later in 2009 the SEC filed civil fraud charges against three former executives of New Century, seeking damages and return of bonuses. Several other lawsuits followed. In 2010, financial media reported final settlement of a class action lawsuit that included a payment of over $65 million by former company officers and directors, and a payment of $44.75 million by auditor KPMG.