The Wall Street Journal reported that an analyst with the Center for Financial Research and Analysis found an interesting item in an earnings report from New Century Financial Corporation, a mortgage lending company specializing in “subprime” loans to borrowers with checkered credit histories. The analyst discovered that New Century had for the first time combined two categories of reserves for losses. New Century combined the reserve for losses on defaulted loans with a reserve for losses on real estate that had been acquired through foreclosure. By putting the two reserve accounts together, New Century could show that total reserves for losses had increased only slightly from the prior period. Hidden, though, was the fact that the reserve for losses on bad loans actually dropped by 8.7 percent. The Center for Financial Research and Analysis pointed out the discrepancy of a drop in reserves at a time when defaults on subprime mortgages were increasing across the country.

REQUIRED:
Discuss the effect of “reserves for loan losses” on the financial statements and why a company such as New Century might be reluctant to increase the reserve. Discuss what economic factors influence loan defaults (and especially loans in the subprime mortgage market).