1. Identify the risks in New Century’s balance sheet.
2. On September 30, 2005, New Century had $ 14 billion of mortgage loans held for investment, offset by $ 13.9 billion of financing on mortgage loans held for investment. Did classifying these securitizations as mortgage loans held for investment, rather than as sales, provide more information to investors, less information to investors, or about the same amount of information to investors? Why did New Century not disclose its retained interest in mortgage loans held for investment?
3. Evaluate the $ 191.6 million allowance for uncollectible mortgages on September 30, 2006, and the $ 198.1 million allowance on December 31, 2005.
4. How did New Century earn a profit in 2006 and in prior years? Explain in detail.
5. How did New Century go from a highly profitable firm on September 30, 2006, to filing for bankruptcy on April 2, 2007? From a firm with high cash flows from operations to bankruptcy?
6. What additional information in its 10-Q would help investors better understand New Century’s financial condition? Is that information available in financial reports from other firms?
In the mid-1960s, U.S. 30-year conventional (fixed) mortgage rates were relatively stable in the 5.5% range. Homebuyers typically paid 20% of the purchase price in cash, and followed the rule of thumb that homeowners should not spend more than 25% of their after- tax income on housing costs.
Local banks and savings and loan institutions made mortgage loans only to local buyers because of restrictive banking laws and because most individuals had strong relationships with local financial institutions. Housing prices rose moderately during the 1960s, mortgage default rates were low, and in cases of a mortgage default the house’s value often exceeded the mortgage due. Serious problems usually arose only if a bank’s region suffered a serious recession, but those occurrences were rare.
In 1983, Solomon Brothers and First Boston developed the first collateralized mortgage obligations (CMOs). A financial institution establishes a CMO by acquiring a group of similar mortgages. It then bundles them into a separate legal entity, a securitization pool, which owns the mortgages. The securitization pool sells notes backed (collateralized) by its mortgages to institutional investors with excess funds, such as insurance firms, commercial banks, pension funds, foundations, and endowments. Those notes trade as marketable securities so the individual mortgages, which can-not trade like securities, are said to have been securitized (converted into marketable securities).