Week 4- Case Study and Two discussions

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Two discussions – 1 paragraph and 1 reference per discussion

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Instructions

Complete “New Century Financial Corporation” Case (109034-PDF-ENG) from your Harvard Case Studies Course Pack. The questions you will need to specifically answer are:

What appeared to be New Century’s strategic objectives? Describe and evaluate the business model the company had adopted to achieve these objectives.
What were the primary risks that New Century faces?
What were the company’s critical performance variables? How well was the company performing with respect to these critical performance variables?
What were the primary reporting items within New Century’s financial statements? Using the bank examiner’s report, what were the key reporting errors identified?
Why did New Century fail?
Based on information in the case, what is your assessment of the quality of oversight provided by NCF’s board? Do you think it should be blamed for the accounting failures at the company?
Why do you think the accounting failures of New Century went undetected for so long despite all the changes in governance in the post-SOX era?
What are the general lessons, if any, that the NCF case provides for boards and audit committees?
Use the Case Study Guidelines under the “Start Here” tab as a guide on writing this.

Comment #1 to JP

In auditing, quantitative measures could be “generic empirical information (e.g. physical metrics) or monetary values (e.g. financial metrics) that signal a certain magnitude of financial effect on the reporting organization” (“Qualitative vs Quantitative”). It is very common that audit firms will develop guidelines to test out the quantitative aspects of a company. This has the advantage that it tends to be more consistent since they are using the guidelines across the board. Another advantage to this approach is that there is less probability of the auditor loosing their independence since they are working strictly with the numbers to come up with their opinion. The disadvantage of this approach would be that since the analysis will be uniform, it won’t allow for any special attention to be given to any specific areas.

The individual partner approach to the audit is good because it allows the auditor to look at certain areas that they already know need special attention to. This means that certain areas that already have problems or that are more prone to problems could be looked at closer. However, the disadvantage with this approach would be that it could be easy for auditor bias to slip in. Because of this, I would favor a combination of both approaches. To perform the quantitative tests across the board just to get a good baseline to work with and then take a closer look at the areas that I know need more attention.

Comment # 2 to AH

A simple random sample is simply defined as “A simple random sample is a subset of a statistical population in which each member of the subset has an equal probability of being chosen.” (Hayes, 2019). This means that in a set of 100 population and a desired sample of 25 each member of the population has a 25% chance of being chosen. This is the most common form of sampling and is used when there is low risk and an auditor needs to test a few accounts to gain assurance.

Systematic sampling is also known as interval sampling where “sample members from a larger population are selected according to a random starting point but with a fixed, periodic interval.” (Hayes, 2019). This means in the same sample as above where we test a population of 100, we pick a random number, say member 7, and test every member that is an interval away from that. If the interval is 10 in the same example, we would test member 7, 17, 27, 37, etc. This is most common with invoice testing when there is moderate to low risk.

Systematic random sampling is when the starting point referred to with systematic sampling is chosen not by humans but by the simple random sampling technique. This is used when there is moderate risk over the same accounts that are tested by systematic sampling, by using random sampling techniques it takes out any bias or human error caused by just systematic sampling.

Haphazard sampling is similar to monkeys throwing darts. Haphazard sampling “though it is nonstatistical in nature, the intent is to approximate a random selection by picking items without any conscious bias, which the auditor intends to be representative of the population” (Bragg, 2019). This is explained as when a population is presented and an induvial randomly picks a sample without rhyme or reason. This is used in situations when there is low risk, as this is not a statistical measure it has to be used with skepticism.

Block sampling is “where a sequential series of selections is made.” (Bragg, 2018). This means that to find a sample of 25 in a population of 100 the auditor will pull all members numbered 50 to 74. This is used in situations when there is moderate to high risk over accounts with large populations. If the auditor is worried that there is a series of inaccurate transactions then this is the one to use.

There are a few situations where you would use multiple techniques. The one I saw at PwC was a mix of systematic random sampling and block sampling where we would determine a large interval and would pick a block of members after the chosen intervals. We used this for an account that had a massive amount of transactions that we had a low level of comfort over and believed there was a number of transactions around the same time frame that were entered incorrectly.

9 – 1 0 9 – 0 3

R E V : O C T O B E R 1 4 , 2 0 0 9

________________________________________________________________________________________________________________

Professors Krishna Palepu and Suraj Srinivasan and Senior Researcher Aldo Sesia, Jr. of the Global Research Group prepared this case. This case
was developed from published sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as
endorsements, sources of primary data, or illustrations of effective or ineffective management.

Copyright © 2008, 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-
7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
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K R I S H N A P A L E P U

S U R A J S R I N I V A S A N

A L D O S E S I A J R .

New Century Financial Corporation

New Century had a brazen obsession with increasing loan originations, without regard to the risks
associated with that business strategy. . . . The increasingly risky nature of New Century’s loan originations
created a ticking time bomb that detonated in 2007.

— Bankruptcy Examiner’s Final Report, February 29, 200

In early 2005, New Century Financial Corporation (New Century) was flying high. The company,
founded 10 years earlier, had become one of the largest subprime loan originators in the U.S. Its
stock price was trading at historical highs, and earnings per share for 2004 were 80% higher than in
2002. Yet barely 15 months later, New Century was in a liquidity crisis.

In November 2006, Taj Bindra became the new CFO at New Century; one month later, he started
asking questions about the company’s mortgage loan repurchase reserves. In February 2007, the
company announced that it needed to restate its financial results for the first three quarters of fiscal
year 2006 because of accounting errors related to its mortgage loan repurchase obligations.1 The news
drove New Century’s lenders to initiate margin calls and refuse to provide any new financing. In
March, management announced that the company had stopped taking mortgage loan applications
and would not file its 2006 annual report on time. On April 2, 2007, New Century filed for Chapter

bankruptcy protection.

U.S. Subprime Mortgage Industry—Early 1990s to 2008

In the early 1990s, subprime mortgages were a small percentage of the total number and value of
mortgages originated in the U.S. But by 2005 subprime mortgage lending had become a $625 billion
industry, accounting for 20% of all mortgage originations.2 In the new millennium alone, subprime
mortgage originations grew 216% from 2001 to 2006 (see Exhibit 1). While there were different
definitions of a subprime mortgage, it was generally considered a loan to an individual with a FICOa
credit score of 620 or below; in other words, to a person whose risk profile did not qualify for a prime
mortgage. Typically, subprime borrowers, because they were at higher risk of default, paid 200 to 300

a FICO was an acronym for the Fair Isaac Corporation, which created the scoring system to measure an individual’s
creditworthiness. FICO scores ranged from 300 to 850.

For the exclusive use of A. Caceres, 2020.

This document is authorized for use only by Ana Caceres in Advanced Auditing Theory and Application-7-1-19-1 taught by BUNNEY SCHMIDT, Keiser University from Jan 2020 to Jul 2020.

109-034 New Century Financial Corporation

basis pointsb over prime rates and higher up-front origination fees.3 Subprime mortgages included
loans to purchase homes and to refinance pre-existing mortgages.c

The subprime industry’s growth was driven by an increase in access to capital markets through
loan securitization—the pooling and reselling of loans to investors—in the 1990s and early 2000s.
Securitization of loans backed by real assets such as automobiles and homes experienced significant
growth, since these assets were homogenous and credit risk was spread over a large number of
individuals (and was thus diversifiable). With growth in a liquid market for mortgage-backed
securities, mortgage originators could sell the loans, transfer the credit risk to other investors, and
gain liquidity to originate more loans. Other factors also oiled the industry’s growth. Legislation in
the 1980s removed interest-rate caps, which meant that lenders could charge higher rates for
mortgage and home equity loans and, therefore, lend to borrowers with higher risk profiles. The Tax
Reform Act of 1986 prevented individuals from deducting interest they paid on consumer loans but
allowed them to deduct interest they paid on loans secured by their homes and a second residence.
Low interest rates, rising house values, and a proliferation of nontraditional mortgages (e.g., hybrid
mortgages where the borrower paid a fixed rate for the first few years and then a variable rate for the
remainder of the loan’s maturity) also hastened the industry’s growth.

By 1997 subprime mortgage originations constituted about $125 billion, or 15%, of the $859 billion
mortgage originations in the U.S. The industry hit a bump during the Russian debt crisis of 1998. The
flight to higher-quality credit by debt investors reduced demand for subprime mortgage
securitizations, creating liquidity problems for subprime mortgage originators. This slowed industry
growth; some subprime lenders went bankrupt and the surviving firms focused more on credit
quality. However, damage was limited, in part because the increase in home prices in the late 1990s
limited defaults by borrowers, reducing losses for investors. Between 2001 and 2003, subprime
mortgage originations were only around 8% of all residential mortgage originations. By 2003, a
combination of factors—rising home prices, increasing focus of commercial banks toward retail
lending, fairly low loan default rates among subprime borrowers, availability of many nontraditional
mortgage products (such as interest-only mortgages or adjustable rate mortgages), and historically low
mortgage-interest rates—led to a rapid increase in subprime mortgage originations, and consequently,
in subprime securitizations.4 (See Exhibit 2 for subprime securitizations from 2001 to 2006.)

The subprime mortgage industry involved numerous parties that included borrowers
(mortgagors), mortgage brokers, lenders (banks, credit unions, mortgage companies), investment
banks, rating agencies, and investors. Subprime mortgage lending companies conducted three lines
of business—loan origination, loan sale or securitization, and loan servicing. Loan origination
involved the selling of mortgage loans, processing the loan applications, and funding the mortgages
based on lenders’ underwriting standards. While some loans remained on the balance sheets of the
originators, many were either sold outright primarily to investment banks, which then moved them
into a special purpose entity (SPE), or to SPEs that the originators themselves had established. In both
cases, pools of loans were securitized and sold as mortgage-backed securities (MBSs) to investors,
such as pension funds and hedge funds.d As borrowers made principal and interest payments, the
funds were passed through to the investors. Loan servicing referred to collecting payments from
mortgagors and paying the holders of the loans, as well as paying real estate taxes and insurance to

b A unit that is equal to 1/100th of 1%. 300 basis points = 3%.

c Alt-A was a category of mortgage that fell between prime and subprime. Borrowers with good current credit scores but who
did not provide sufficient verification of their income, or had high debt-to-income ratios, could qualify for Alt-A mortgages.
Rates and fees for Alt-A mortgages were higher than those for prime borrowers but lower than those for subprime borrowers.

d In some cases, large investors turned MBSs into collateralized mortgage obligations (CMOs), which were more complex
forms of MBSs.

For the exclusive use of A. Caceres, 2020.
This document is authorized for use only by Ana Caceres in Advanced Auditing Theory and Application-7-1-19-1 taught by BUNNEY SCHMIDT, Keiser University from Jan 2020 to Jul 2020.

New Century Financial Corporation 109-03

the appropriate parties. Most originators did this before a loan sale or securitization; some did it
afterward and received a fee for the service.

After more than a decade of strong, if not spectacular, growth, the subprime market weakened in
2006 and collapsed in the fall of 2007 as interest rates increased and home prices dropped. Loan
delinquencies and home foreclosures were on the rise. Investors’ appetite for subprime
securitizations waned, which meant the liquidity that was so vital to the rapid growth became
constrained. (Exhibit 3 illustrates simplistically the industry’s troubles.) The collapse reverberated
across the financial services industry and financial markets. Hardest hit were some of the biggest
names in the financial services industry including Citigroup, Bear Stearns, UBS, and Merrill Lynch,
each absorbing devastating losses. The deterioration in market conditions had a huge impact on the
mortgage lending industry in 2006 and 2007. Many companies undertook large write-downs in the
value of their mortgage-related assets. One of the largest mortgage lenders in the U.S., Countrywide
Financial Corp., was acquired by Bank of America. Over 150 companies, both subprime and prime
lenders, were reported to have failed in 2007. While other subprime mortgage lenders also failed in
2007, New Century’s troubles “were an early contributor to the subprime meltdown,” according to
the bankruptcy court examiner.

Company Background

In 1995, Brad Morrice, Edward Gotschall, and Robert Cole founded New Century. In 2005, Cole
was the chairman and chief executive officer, Morrice was vice chairman and chief operating officer,
and Gotschall was vice chairman–finance of New Century. Before starting New Century, all three
had extensive experience in the real estate industry and had worked together as senior executives in
Plaza Home Mortgage Corp., a publicly traded savings and loan company specializing in the
origination and servicing of residential mortgage loans. Cole had earlier been the president of an
international real estate development company and president of operating subsidiaries of NBD
Bancorp and Public Storage, Inc. From 1990 to 1993, Morrice was a partner in a law firm where he
specialized in legal representation of mortgage banking companies. Similarly, Gotschall had
mortgage banking experience as chief financial officer of Mortgage Network Inc, a retail mortgage
banking company.

New Century originated, retained, sold, and serviced home mortgage loans designed for
subprime borrowers.6 In 1996, the company originated over $350 million in loans in its first full year
of operation.7 The next year, New Century went public and was listed on NASDAQ. In 2001, the
company’s subprime loan originations and purchases exceeded $6.2 billion and continued to grow at
a fast pace, reaching $56 billion in 2005 (see Exhibit 4). The company grew its product offerings such
that by 2006, New Century provided fixed-rate mortgages, adjustable rate mortgages (ARMs), hybrid
mortgages (adjustable rates converting to fixed rates at a later date), and interest-only (IO) mortgages,
whereby the borrower paid interest only and no principal for the first few years. The new products
also changed the risk profile of New Century loans: ARMs, IO products, 100% loan-to-value loans,
and stated income loans were considered more risky than fixed-rate fully amortizing loans.8 (See
Exhibit 5 for a breakdown of originations by loan type from 2004 to Q1–Q3 2006.) In 2004, New
Century restructured into a real estate investment trust (REIT)e and began trading on the NYSE.

e New Century became an REIT in 2004. REITs were entities that invested in different kinds of real estate or real estate assets.
Mortgage REITs lent money to property owners and developers or invested in financial instruments secured by mortgages.
According to the Internal Revenue Code, REITs were required to pay out at least 90% of their income before taxes to
shareholders. (Source: U.S. Securities and Exchange Commission at http://www.sec.gov/answers/reits.htm, accessed June 2,
2008.)

109-034 New Century Financial Corporation
4

The company operated two loan divisions: The Wholesale Loan Division (named New Century
Mortgage Corporation) and the Retail Mortgage Loan Division (named Home123 Corporation). (See
Appendix A for an overview of New Century’s loan origination process.) The Wholesale Loan
Division operated 33 centers in 19 U.S. states and originated around 85% of the company’s loans
using a network of almost 1,000 account executives and about 50,000 independent mortgage brokers,
who were responsible for identifying potential borrowers, assisting them in completing loan
applications, and acting as liaison between borrowers and New Century until the loans closed. The
division also purchased funded loans from other lenders. Further, New Century maintained a web-
based loan underwriting process called FastQual. The Retail Mortgage Loan Division, which
operated 235 sales offices in 35 states, plus a telemarketing unit and website, worked directly with
potential borrowers. The drive to sign mortgages was so fierce that New Century dubbed its loan
department “CloseMore University.” 9,10

Investors richly rewarded New Century for this growth with a compounded annual return of
about 70% from December 31, 2000 to December 31, 2004. (See Exhibit 6 for historical stock prices,
Exhibit 7 for annual sales and diluted earnings per share 1997 to 2005, and Exhibit 8 for the
company’s income statements and balance sheets from 1999 to Q3 2006.)

By late 2005, several analysts following New Century recognized difficulties and competitive
pressures in the subprime market but believed that New Century was well positioned relative to its
peers. One analyst commented in September 2005, “Based on available data, [New Century] is one of
the lowest cost originators in the space which is a good sign for their long term mortgage banking
profitability.”11 Early in 2006, one analyst expressed surprise that “despite the company’s aggressive
growth, we have found little evidence of deterioration in underwriting and [New Century’s] credit
trends remain above industry averages.” However, others started raising concerns about the
company’s loan quality. Wrote one analyst in September 2006 about New Century’s loan quality
versus its competitors: “[New Century’s loan] pools generally showed higher levels of asset quality
deterioration as measured by the sum of seriously delinquent and foreclosed loans.” Another analyst
wrote in October 2006: “The [loans] most susceptible to credit deterioration at the company were the
2005 and 2006 vintages, which we would contend are those that benefited most from increasingly
more lax underwriting standards.” Further, The Center for Financial Research and Analysis (CFRA),
a unit of RiskMetrics Group that identifies and reports on companies showing early warning signals
of financial or operational distress, had raised concerns about New Century’s earnings quality in a
report it published on November 6, 2006.12,

Business and Accounting Policies

New Century temporarily financed the mortgage loans it made using short-term credit from other
financial institutions, called “warehouse loans,” which provided liquidity to continue loan originations
while earlier loans were being sold. To maintain credit facilities with warehouse lenders, New
Century was required to maintain certain liquidity and debt-ratio covenants and to be subject to
margin calls.14 The lenders needed to be provided with timely financial statements that conformed to
U.S. generally accepted accounting principles (GAAP), and many lenders required that New Century
report at least $1 of net income for any rolling two-quarter period.15

Loans were typically sold or securitized within 30 to 90 days of origination.16 While New Century
sold the majority of its loans as whole loans or as securitized loans, it also retained loans on its
balance sheet through securitizations structured as financings. (See Exhibit 9 for a breakdown of
New Century’s whole loan sales and securitizations.) New Century derived income from the
difference between its lending rate and the rate at which it could either sell the loans or borrow to
finance them. It also received income from servicing the loans it had sold or securitized.

New Century Financial Corporation 109-034

Whole loan sales New Century sold mortgages in loan pools to investors—financial
institutions such as Goldman Sachs, JP Morgan Chase, Lehman Bros., and Morgan Stanley. Buyers
would perform due diligence on the loans by reviewing about 25% of the pool, after which both
parties would negotiate the final composition of the pool and the price. If during due diligence the
investors found the loans unsatisfactory (e.g., due to faulty documentation, unacceptable exceptions
to underwriting guidelines, or incorrect appraisal), they could reject or “kick-out” a portion of the
package.17 New Century sold the loans at a premium above the par value of the loan because the
interest rate paid by mortgagors was higher than the rate at which New Century sold the loans to the
investors.f

New Century’s loan purchase agreements with investment banks required the company to
repurchase the loans if they suffered an early payment default or “EPD” (when a borrower defaulted
on any of the first three loan payments), if it was found that New Century misrepresented its loans
(e.g., overstated the value of the property used as collateral), or in the case of borrower fraud. In fact,
about 90% of New Century’s repurchases were caused by first-payment defaults where the borrower
failed to make their first payment. The value of such repurchased loans were substantially impaired
and typically resold at steep discounts.18 New Century sold these repurchased and kicked-out loans
as “scratch-and-dent” loan pools at discount to their outstanding principal. (See Exhibit 10 for loan
quality indicators—first and early payment defaults, loan sale premiums, kick-outs, loans sold at a
discount (i.e., scratch-and-dent loans), and the percent of stated income and 80/20 loans originated.)

Accounting rules required companies to establish loss reserves for repurchases of loans. New
Century estimated future repurchases based on the amount of loans sold in the prior three months
and its actual historical repurchase rate. The loss reserves needed to cover (1) premium recapture,
(2) interest recapture, and (3) future loss severity. “Premium recapture” was the amount of the
premium over par that New Century received when it sold the loan and was required to return in the
event of a default. “Interest recapture” was the amount of interest the investor should have received
but did not because the mortgagor failed to make loan payments. New Century needed to pay the
loan purchaser for the interest the purchaser did not receive. “Future loss severity” was the expected
loss due to the difference between the principal to be repaid and the fair value of the repurchased
loan at the repurchase date.

Securitizations structured as sales In securitizations structured as sales, New Century sold
loans to an SPE trust created for the purpose of securitization. The trust then sold securities based on
the loan pools to investors. New Century provided credit enhancement (CE) by providing additional
collateral above the aggregate principal value of the securitization (called “overcollateralization” or
OC), in case the loans in the securitization pool failed to generate the expected cash flows. Therefore,
the lowest tranches in the securitization pool and the first risk of loss belonged to New Century. New
Century was eligible to receive payments from the OC loans after payment of principal, interest,
servicing fees, and other trust expenses. The expected cash flow and net interest receivable on these
OC loans constituted New Century’s “residual interest” in the securitization. New Century
sometimes securitized and sold the expected cash flows from the OC loans as Net Interest Margin
Securities (NIMS) but would retain a residual interest in the NIMS pool; this formed part of the
residual interest asset on its balance sheet.

Accounting rules required that when sold, the securitized loans were removed and residual
interests recorded on the balance sheet and the securitization sale proceeds reported as sales revenue
on the income statement. According to U.S. GAAP (FAS 140), residual interests were to be valued at

f For example, New Century charged a 1.59% premium, on average, during the first nine months of 2006. That is, for a
mortgage with a principal of $100,000, the company charged the investment banks $101,590 for the loan.

109-034 New Century Financial Corporation

their fair value, i.e., the value at which the asset could be bought or sold in a current transaction
between willing parties. Since there was no market price for the residual interests, New Century
valued them based on the present value of their estimated future cash flows. This required making
estimates for many variables: risk-adjusted discount rates, prepayment rates and expected losses on
the loans held in the securitization pools, dates when the securitization trusts would be terminated,
and the value of the loans in the CE pool at the time of termination.1

Securitizations structured as financing With securitizations structured as financings, New
Century retained the securities backed by the securitized loans labeled “mortgage loans held for
investment” (LFHI) as assets on its balance sheet and the bonds used to finance them as liabilities.
The company received interest from the mortgagor (recorded as interest income) and paid out
interest to the bondholders (recorded) as interest expense. It created an Allowance for Loan Losses
(ALL)—a reserve to provide for losses on loans held for investment. New Century estimated ALL
monthly by calculating the potential for losses in the LHFI account over the next 18 months, based on
projected loss rates, prepayment rates, and interest rates. Provisions for losses were expensed, and
actual losses were charged to the allowance account.

Lower of cost or market (LCM) valuation of loans held for sale All loans that New
Century did not classify as “mortgage loans held for investments,” including repurchased loans that
it intended to sell, were classified as “loans held for sale.” Accounting rules required that loans held
for sale were reported at the LCM (lower of cost or fair market value) as of the balance sheet date.
The amount by which the original cost exceeded the fair value was to be recorded as a valuation
allowance on the balance sheet. Changes in the valuation allowance were to be included as part of net
income of the period in which the change occurred (Statement of Financial Accounting Standards No.
65).

Board of Directors

In March 2007, the New Century board included the company’s three founders and eight other
independent directors including a lead independent director. (See Exhibit 11 for information on the
independent board members.) The board averaged 2.5 meetings per month from 2005 to early 200

and had seven committees: audit; compensation; executive; finance; governance and nominating;
public and community affairs; and stock option.20

New Century’s audit committee consisted of four members—Marilyn Alexander, a certified
public accountant (CPA) and an MBA from Wharton; Donald Lange, president and CEO of Pacific
Financial Services, a mortgage banking company and a former president of the Mortgage Bankers
Association of America; Richard Zona, former vice chairman and CFO of U.S. Bancorp and former
partner of Ernst and Young; and Michael Sachs, chair of the audit committee, who was a CPA and an
attorney. All four members of the audit committee satisfied SEC requirements for being considered
financial experts. The committee met 21 times between May 2005 and December 2006. The internal
audit function reported to the audit committee, and the external auditors were invited to (and
attended) all audit committee meetings.

The compensation committee of the board consisted of five independent directors and was
responsible for executive compensation at New Century. The compensation plan for senior
management included an annual salary, a performance-based annual bonus plan and a long-term
incentive plan that consisted of restricted stock, stock options, and dividend equivalent rights (DER),
which was an annual cash payout linked to dividend payouts. In 2005 Cole, Morrice and Gotschall
each earned identical amounts—a salary of $569,250, bonus of $1,070,235, and DER payout of
$230,113. In addition, each of them received restricted stock grants of 15,628 shares and stock option
grants of 39,568 shares with a five-year vesting period.

New Century Financial Corporation 109-034
7

Independent Auditor

New Century retained KPMG as the company’s outside auditors from its inception in 1995 until
April 2007, when KPMG resigned. KPMG did not complete the 2006 fiscal year-end audit and
consequently, no audit report was filed. The last set of financial statements for which KPMG filed its
audit report was for fiscal year 2005. KPMG had several different engagement partners with varying
degrees of experience in the mortgage industry heading the New Century account over the years. In
2005, John Donovan became the new engagement partner with a largely new team of auditors.
Donovan, new to KPMG—previously he was a partner at Arthur Andersen until the firm folded—did
not have substantial experience auditing mortgage companies.22 In addition to the engagement team,
specialists within KPMG, such as those from the Structured Finance Group, sometimes provided help
and expert advice during quarterly reviews and annual audits of New Century’s accounting
practices.

New Century Announces Restatement

In late January 2007, management informed the audit committee and the board of directors that
the company had been incorrectly calculating its loan repurchase reserves since Q2 2006, when it had
changed its methodology. On February 7, 2007, New Century announced that it would restate its Q1–
Q3 2006 financial statements to correct errors related to its accounting of allowances for loan
repurchase losses. In addition, the company announced that the restatement would reduce earnings
and that it expected to record a loss for Q4 2006. On February 8, 2007, New Century’s stock price
closed at $19.24—a drop of 36% from the prior day’s close. On March 2, 2007, the company
announced it would not file its 2006 10-K on time, and it had asked its warehouse lenders to waive or
amend some loan covenants. On March 5, the first day of trading after the announcement, New
Century’s stock price closed at $4.56.

As a result of these accounting problems, the company faced a liquidity crisis. On March 8, 2007,
the company stopped accepting new loan applications and disclosed that it had been unable to satisfy
$70 million of the $150 million in margin calls from its warehouse lenders. NYSE delisted the
company’s securities on March 13, 2007. On April 2, 2007, New Century filed Chapter 11. KPMG
resigned as independent auditor on April 27, 2007. Then, on May 24, 2007, New Century announced
that its 2005 financial results were also inaccurate.

Bankruptcy Examiner’s Investigation

On June 1, 2007, subsequent to the company’s Chapter 11 filing, the U.S. Bankruptcy Court for the
District of Delaware ordered the appointment of a bankruptcy examiner to investigate “accounting
and financial statement irregularities, errors or misstatements” at New Century. On February 29, 2008,
the examiner filed his final report which focused on the period from 2004 to 2007. The examiner’s
report concluded that there were serious problems with New Century’s monitoring of loan quality as
well as its key accounting estimates.

Monitoring of Loan Quality

Although senior management had identified loan quality as an issue as early as 2004, the
examiner concluded that the company did not devote sufficient attention to loan quality until Q4
2006. New Century was not worried about loan quality as long as it was successful in selling loans to
investors (even as prices investors paid for the loans declined in 2004 and 2005). New Century’s
quality assurance (QA) department had found that “severe” errors had occurred in 12%–25% of

109-034 New Century Financial Corporation
8

originations between June 2003 and December 2003. The internal audit department audited loans
originated in late 2004 and found “high risk” problems that could affect sales of the loans.25 In April
2004, the chief credit officer reported that kick-outs were increasing and that quality assurance results
pertaining to loan originations were at “unacceptable levels.” While loan quality was frequently
discussed among senior management and in the audit committee, no meaningful action was taken to
rectify the problems.

A plan by the credit department in 2005 to monitor and identify underwriters who approved
defective loans was not approved by senior management. The chief credit officer speculated to the
examiner that a possible reason was resistance from the production department. According to the
examiner’s report, Patrick Flanagan, head of the Wholesale Division (who was in charge of the
company’s loan origination and production at the time), had “unmistakable” disdain for internal
audit and emphasized loan production even when field audits revealed there were loan quality
issues.26 The examiner wrote: “Senior Management may have abdicated its responsibility to manage
the day-to-day affairs” particularly with respect to its failure to address kick-outs. . . . As a result,
New Century lost millions, possibly hundreds of millions, of dollars in revenues.

Accounting Practices

The examiner identified seven types of improper accounting practices not in conformity with
GAAP. Of these, mistakes in calculating repurchase reserve, LCM valuation of loans held for sale,
and residual interest valuation led to material misstatements in the financial statements for 2005 and
first three quarters of 2006. Overall, the examiner estimated that the misstatement of the allowance for
loan repurchases, the LCM valuation allowance, and the value of the residual interest resulted in an
overstatement of earnings before income taxes of $263 million over the seven quarters from Q1 2005
to Q3 2006 (see Exhibit 12). Of this, the amount pertaining to fiscal year 2005, the last audited
financial statement, was $63.6 million, compared with total reported earnings before income taxes of
$443.4 million for that year.

Repurchase reserve The examiner determined that New Century calculated the repurchase
reserve incorrectly. The company calculated its repurchase rate using historical repurchase data. For
example, in the fourth quarter of 2005, this rate was based on historic averages from 2001 resulting in
a rate of 0.659%. This rate was applied to the quantum of loans it sold in the prior three months
because management assumed that repurchases would be made within three months. In the fourth
quarter of 2005, whole loan sales amounted to $10.7 billion, resulting in a repurchase estimate of $70.6
million and a repurchase allowance of $7.0 million as of December 31, 2005, which was included as
part of accounts payable and accrued liabilities in the company’s fiscal-year 2005 consolidated
balance sheet. However, New Century did not have reliable data on the quantity of repurchase claims
received. Repurchase claims were handled by different departments within New Century depending
on the issue involved in the claim (e.g., fraud issues were handled by the legal department,
underwriting issues by the loan production department, etc.). Over time, the decentralization created
a backlog of repurchase claims that were unresolved beyond three month; this totaled about $188
million by the end of 2005. Significantly, the internal audit department never audited the processing
of repurchase claims and New Century did not possess adequate control systems to log, process, and
track repurchase requests. The backlog increased quickly and reached $421 million by October 31,
2006. In the second quarter of 2006, the historical look-back for the repurchase calculation was
changed from 2001 to the beginning of 2004, resulting in an estimated repurchase rate of 1.0% for the
second quarter of 2006, and was further increased to 1.75% in the third quarter of 2006 to better reflect
the current market environment.28

New Century Financial Corporation 109-034
9

Between 2004 and 2007, New Century included “premium recapture” but never included “interest
recapture,” and beginning in Q3 2006 it dropped “future loss severity” from the repurchase reserve
calculations. (Exhibit 13 shows New Century’s calculation methodology. Exhibit 14 highlights the
company’s calculation in fiscal year 2005 through the third quarter of fiscal year 2006.) The company
wrongly included “inventory severity” (the adjustment in the value of repurchased loans on the
company’s balance sheet) as part of its repurchase reserve calculation, although it was to be a
valuation-allowance account related to loans held for sale. New Century stopped including inventory
severity in the repurchase reserve in Q2 of 2006.

Residual interest in off-balance-sheet securitizations The examiner found that New
Century used “flawed and antiquated internally developed Excel-based valuation models to value
residual interests.”29 There was a serious lack of documentation about the working of residual
interest valuation models or how the models assumptions were established or approved by senior
management.

New Century’s management and independent directors “repeatedly resisted warnings from
specialists at KPMG, who warned that the discount rates New Century was using to compute
residual interests were below those used by most of its peers.”30 In 2005, New Century used a
discount rate of between 12% and 14%, while its competitors used discount rates of 15% to 21%. By
using a lower discount rate than its competitors, the company had reported higher estimates of the
value of its residual interests. However, as required by SFAS 140, New Century disclosed, in the
footnotes to its 2005 10-K, the sensitivity of residual interest fair values to its discount rate
assumptions. It provided the percentage change in residual interest fair values for a 10% and 20%
adverse change in the discount rates it had used in the 2005 financial statements. New Century
estimated prepayment rates and loss rates based on the average historical performance of its
collateral from 1997 to 2002, not taking into account changing market conditions. The company also
assumed that the value of all loans remaining in the CE loan pools could be sold at par regardless of
their delinquency status or market conditions. These assumptions were modified only in February
2007 to reflect more recent data.

The examiner wrote:

Everyone at New Century who was familiar with the Company’s models for valuing its
residual interests—including members of the board, the highest levels of senior management,
the Company’s chief financial and accounting officers, and the people within New Century’s
Secondary Marketing Department who built and operated the residual interest models—
understood that the accuracy of results produced by those models depended heavily upon key
assumptions. Yet many of those assumptions were flawed in ways that tended to result in
inflated valuations.31

Loans held for sale (LHFS) According to the examiner, New Century failed to apply LCM
valuation on loans held for sale, which would have been consistent not only with industry practice
but even with its own LCM policy. In order to conduct LCM analysis, industry accounting practices
required that firms grouped loans by categories (e.g., performing versus nonperforming loans) and
conduct LCM analysis separately on the various groups (e.g., FAS 65 required firms to group
residential and commercial loans separately). For loan types where market value was below cost, a
valuation allowance was used to write the value down to market value. While New Century
disaggregated loans to conduct the LCM analysis, it then regrouped the loans into one single
category for valuation, thereby offsetting losses in certain loan groups (e.g., scratch-and-dent loans)
using gains in better-performing loan pools. As a result, the appropriate valuation allowance was not
applied to reduce net income, New Century’s LHFS portfolio was overvalued, and the values of
scratch-and-dent and other nonperforming loan pools were not written down on a timely basis.32

109-034 New Century Financial Corporation

Allowance for loan losses (ALL) As New Century grew its portfolio of loans held on the
balance sheet, ALL became a critical accounting estimate for the company. The examiner identified
several inadequacies relating to improper documentation of calculation methodology and lack of
regular updating to reflect actual loan loss performance. The company believed that ALL was over-
reserved since losses in the past had been lower than expected. But it expected loan losses to increase
in the future, and therefore did not adjust the allowance downward. The examiner found that New
Century was aware that its ALL calculation models were poor predictors of actual losses but made no
changes to modify its practices. The examiner, however, did not consider the ALL misstatement to be
a material error.

Role of the Board and Audit Committee

The examiner found that while the audit committee had “expressed concerns” about loan quality,
the committee did not consider it a priority during 2004 and 2005 and its attempts to address loan
quality issues were not effective.33 For example, in August 2004 the audit committee was informed
that bonuses of region managers would be based partly on loan quality (the compensation system
had historically been tied to loan origination volume). However, the bonus compensation system in
2005 and 2006 made no reference to loan quality. While the board reviewed QA reports and asked
for periodic loan quality updates from management in 2004, the examiner found no evidence that
troubling trends in EPD and kick-out rates were discussed at board meetings.

Even as loan quality problems continued, the examiner found no discussion of loan quality issues
in seven audit committee meetings in 2005 until a “reasonably robust” discussion of loan quality in
October 2005 between senior management and several directors, in which it was acknowledged that
the company had a problem.34 Even this, the examiner concluded, led to no “meaningful action”
since no one was made responsible for addressing the problems and reporting back to the audit
committee.35 The audit committee made loan quality a priority and instructed management to put an
improvement plan in place, but not until January 2006; even then, the committee “failed to follow up
to ensure that the effort was a top priority.”36 The examiner wrote:

[T]he Board could have paid closer attention to loan quality issues during much of 2004 and
through 2007. However, the Examiner recognizes that the Board is entitled to rely on Senior
Management to run the day-to-day affairs of the Company. Further, the Board, through the
Audit Committee, periodically did give some attention to loan quality issues. . . . In 2006, the
Audit Committee gave rather extensive attention to loan quality issues. . . . In such instances,
particularly in 2006, Senior Management repeatedly assured the Board that New Century’s
loan quality problems were being addressed.

Richard Zona, an independent director since 2000, had considered resigning from the board on
two occasions in late 2005. In drafts of letters of resignation, Zona outlined that he was concerned that
the management team was dysfunctional, Gotschall did not respect outside directors, Cole was not
fully engaged, and Zona suspected that “management constructed barriers to implementing board
decisions instead of determining the best way to implement them.” In addition, Zona argued that
accounting for loan losses was improper and expressed concern that the management had proposed
reversing the ALL by 26 cents per share to meet analysts’ consensus forecast in the third quarter of
2005. The “bleeding down” of the reserve was dropped following Zona’s opposition. Zona remained
on the board after being persuaded by other independent directors.37

With respect to accounting estimates, the board and the audit committee had relied on the
auditors for assurances that accounting estimates were appropriate and that accounting rules were
followed. The examiner determined that the audit committee asked the auditors each quarter if the
repurchase reserves were adequate, and the auditors had told the committee that they were. The

New Century Financial Corporation 109-034
11

audit committee had not been informed of the change in the repurchase reserve methodology that
eventually triggered the initial restatement announcement. At the January 2007 meeting, Zona asked
why the audit committee had not been informed of the change sooner, to which the company’s
controller explained that it was an inadvertent oversight and that the auditors had been informed of
the change.

According to the examiner, residual interest valuation was a topic at every board meeting and was
discussed in-depth between the audit committee and the auditors. Zona was known to direct pointed
questions to the CEO, controller, and the auditors about several facets of the residual interest
calculation methodology, including the discount rate. According to one director, the board relied on
the auditors to provide assurances that residual interests were adequately stated, which the auditors
did at audit committee meetings. The auditors also assured the audit committee that ALL was
reasonably stated.

Role of the Auditor

The examiner blamed New Century’s auditors for failing to question important assumptions and
departures from prescribed accounting methods.

The examiner claimed that the auditors were aware of the repurchase claims backlog as of
December 31, 2005, but did not question the repurchase reserve calculations made by the company.
He also reported that the auditors knew of the improper changes to the repurchase reserve
calculation methodology made in the third quarter of 2006. Further, New Century’s controller
informed the examiner that the auditors approved of the aggregation of loan categories while
undertaking LCM valuation of loans held for sale. On the issue of ALL, the examiner determined that
“KPMG allowed New Century to utilize poor documentation policies and improper modeling
methodology without testing the significance of the variances.”38 The examiner claimed that the
auditors signed off on the financial statements even though the auditors’ internal experts expressed
concerns with the flaws in the models and assumptions used by New Century’s management in
valuing residual interests.

The examiner wrote:

[H]ad KPMG conducted its audits and reviews prudently and in accordance with
professional standards, the misstatements included in New Century’s financial statements
would have been detected long before February 2007.39 The 2005 [KPMG] engagement team,
in particular, was not staffed with auditors with sufficient experience in the client’s industry
and/or relating to the particular tasks to which they were assigned. . . . The team also consisted
of auditors who were relatively inexperienced in the mortgage banking industry.40 The
engagement team’s lack of experience was compounded by the fact that New Century’s
accounting function was weak and was led by a domineering and difficult controller.41

Some accounting experts disagreed with the examiner’s assessment. Roman Weil, an accounting
professor at the University of Chicago, said: “The business model of New Century depended on real
estate values that would continue to go up and certainly not go down. The economic model here is
what is at fault. It’s the cause of what happened, not anything KPMG did.”42 Others questioned the
using of hindsight by the examiner to blame auditors for hard-to-make judgments.

A spokesperson for KPMG pointed out that the bankruptcy examiner might be motivated to
maximize the estate for the creditors and was perhaps not unbiased, stating: “The examiner was
appointed by the court to identify potential lawsuits in a bankruptcy case. Consistent with that
charge, he has prepared an advocacy piece, which has many one-sided statements and significant

109-034 New Century Financial Corporation

omissions. In the end, the examiner concluded that the bankruptcy estate may be able to file a lawsuit
against KPMG for negligence—a claim we strongly dispute—and a claim even the examiner notes in
his report for which KPMG has strong defenses.”43 Another spokesperson added, “We strongly
disagree with the report’s allegations concerning KPMG and we believe that an objective review of
the facts and circumstances will affirm our position.”44

Conclusion

According to the examiner, the corporate culture at New Century was focused on and encouraged
loan production, sales, and growth. He blamed senior management for ignoring warning signs of
deteriorating loan quality and not investing in necessary technologies and personnel to meet its
growing needs. He did not, however, find any evidence of intent by the company to manipulate the
numbers. He asserted that a lack of internal controls, particularly the absence of written accounting
policies with regard to financial reporting, “substantially” contributed to the company’s problems.45
In the examiner’s view, New Century’s audit committee did not address key operational risks,
inadequately supervised the company’s internal audit department, and failed to pay sustained
attention to loan quality until 2006. And while the internal audit department did identify issues about
loan quality, servicing, and appraisals, it did not, in the examiner’s estimation, address internal
controls over financial reporting. Given that New Century was in an industry that faced high risks,
the examiner found it unfortunate that New Century did not have effective internal control systems
and a strong internal audit department.

Upon revelation of the failures at New Century, observers were left wondering why these
problems had occurred despite the enhanced governance and disclosure requirements imposed by
the Sarbanes-Oxley Act on management, boards, audit committees, and auditors. Regardless of
where the blame lay, the damage had been done. The bank examiner wrote: “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.”46

New Century Financial Corporation 109-034
13

Exhibit 1 Growth in U.S. Subprime Mortgages (2001 to 2006)

Source: Adapted from “The Subprime Lending Crisis,” Report and Recommendations by the Majority Staff of the
Joint Economic Committee, Senator Charles E. Schumer, Chairman, Rep. Carolyn B. Maloney, Vice Chair,
October 2007, p. 18. (Source: Inside Mortgage Finance, The 2007 Mortgage Market Statistical Annual, Top
Subprime Mortgage Market Players & Key Data (2006).)

Exhibit 2 Growth in U.S. Subprime Mortgage-Backed Securitizations (2001 to 2006)

2001 2002 2003 2004 2005 2006

Subprime mortgage-backed

securities (billions) $95 $121 $202 $401 $507 $483

Percent of subprime
mortgages securitized 50.4% 52.7% 60.5% 74.3% 81.2% 80.5%

Source: Casewriter. Data from “The Subprime Lending Crisis,” Report and Recommendation by the
Majority Staff of the Joint Economic Committee, October 2007, via http://www.senate.gov/general/
search/search_cfm.cfm?q=subprime&site=default_collection&num=10&filter=0, accessed May
30, 2008.

109-034 New Century Financial Corporation

Exhibit 3 Illustration of How the Subprime Market Works

Source: The Washington Post at http://www.washingtonpost.com/wp-dyn/content/graphic/2007/03/14/GR2007031400174.
html, accessed June 4, 2008.

New Century Financial Corporation 109-034

Exhibit 4 New Century Loan Originations and Purchases (2001 to 2005)

Source: Casewriter. Data from New Century 2005 10-K Report, p. 54, via http://www.sec.gov/
Archives/edgar/data, accessed May 6, 2008.

Exhibit 5 New Century Loan Originations and Purchases (2004, 2005, Q1 to Q3 2006)

2004 2005 2006 (Q1 to Q3)
Loan Type Total $M % Total $M % Total $M %

Fixed Rate

15- to 30-Year $11,086.4 26.3% $13,845.6 24.6% $10,453.8 23.0%
Interest Only 0.0 0.0 671.8 1.2 1,097.0 2.4
40-Year 0.0 0.0 489.7 0.9 2,403.6 5.3
HELOC

a
0.0 0.0 0.0 0.0 0.2 0.0

Subtotal 11,086.4 26.3 15,007.1 26.7 13,945.6 30.7

Adjustable Rate (ARM)
15- to 30-Year 22,969.2 54.4 21,194.1 37.8 9,161.1 20.2
Interest Only 8,144.0 19.3 16,580.5 29.6 6,621.0 14.6
40-Year 0.0 0.0 3,298.9 5.9 15,653.4 34.4
HELOC 0.0 0.0 27.6 0.0 53.1 0.1

Subtotal 31,113.2 73.7 41,101.1 73.3 31,488.7 69.3

Total $42,199.6 100.0% $56,108.2 100.0% $45,443.3 100.0%

Weighted Average FICO
score of loans 627 634 634

Source: Bankruptcy Examiner’s Final Report, p. 57.

a Home equity line-of-credit loans.

109-034 New Century Financial Corporation

Exhibit 6 New Century Historical Stock Price (June 1997 to December 2007)

$63.9

$0.0

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Source: Thomson One Banker, accessed June 27, 2008.

Exhibit 7 New Century Annual Sales and Earnings per Share (1997 to 2005)

$0.93
$1.35 $1.33

-$1.17

$1.52

$4.62

$6.56

$8.29

$7.17

–

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1997 1998 1999 2000 2001 2002 2003 2004 2005

EPSSales ($mil)

EPS (right axis) Sales (left axis)

Source: Thomson One Banker, accessed June 27, 2008.

Note: The company misstated its 2005 results.

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New Century Financial Corporation 109-034

Exhibit 9 New Century Activity in the Secondary Market (2003 to Q3 2006)

84%

94%

81% 75%

67%

92%

12%

0%0% 0%

19%

25%
21%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2001 2002 2003 2004 2005 2006 (Q1-Q3)

Percent of Total
Whole Loan Sales Securitizations as Sales Securitzations as Financings

Activity ($ millions) 2001 2002 2003 2004 2005
2006

(Q1–Q3)

Whole loan sales $4,723 $12,420 $20,835 $30,329 $35,315 $41,143

Securitizations structured as sales 898 846 0 0 6,442 0

Securitizations structured as financings 0 0 4,947 10,111 10,962 3,394

Total secondary market activity $5,626 $13,265 $25,782 $40,440 $52,719 $44,538

Source: Casewriter. Data from New Century 2005 10-K Report, p. 61, via http://www.sec.gov/Archives/edgar/data,
accessed May 6, 2008; New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court
Examiner, United States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008,
pp. 67 and 68.

109-034 New Century Financial Corporation

Exhibit 10 Loan Quality Indicators

Exhibit 10a Early Payment Defaults, Loan Sale Premiums, Kickouts, and Loans Sold at Discount
(2003 to 2006)

2003 2004 2005 2006

Early Payment Defaults (EPD) 4.38% 7.24% 8.30% 11.96%

Loan Sale Premiums 4.18% 3.58% 2.06% 1.59%

Kickouts ($ billions) n.a. $1.5 $2.3 $5.1

Loans Sold at a Discount

$ millions $247.2 $148.1 $246.5 $916.3a
Percent of Total Secondary Market Activity 1.0% 0.4% 0.5% 2.1%a

Source: Bankruptcy Examiner’s Final Report, pp. 67–68, 111, 119, 137, 143 and 162; 10-K Reports 2004 and 2005.

Note: EPD for 2006 is the monthly average for the year.

a For the first nine months of the year.

Exhibit 10b First Payment Defaults and Early Payment Defaults (January 2004 to February 2007)

2004 2005 2006 2007

FDP EPD FDP EPD FDP EPD FDP EPD

January 1.02% 6.40% 8.05% 1.07% 1.18% 8.37% 2.20% 13.09%

February 0.71% 6.32% __ __ 1.67% 8.83% 1.99% 13.14%

March 0.53% 4.23% 4.47% 0.64% 1.57% 7.76%

April 0.62% 4.53% 0.97% 6.58% 2.00% 12.30%

May 0.86% 8.20% 0.80% 6.66% 1.67% 10.58%

June 0.92% 7.62% 1.06% 7.00% 1.98% 11.19%

July 1.13% 7.91% 1.20% 7.76% 1.94% 12.85%

August 0.94% 7.06% 1.02% 7.28% 2.08% 13.42%

September 1.20% 8.76% 1.37% 8.70% 2.05% 14.88%

October 1.39% 9.70% 1.15% 8.81% 2.29% 12.94%

November 1.35% 10.02% 0.95% 8.72% 2.26% 14.16%

December 1.31% 8.72% 1.42% 9.24% 2.58% 16.92%

Source: Bankruptcy Examiner’s Final Report, pp. 141, 148–149, 159.

New Century Financial Corporation 109-034
21

Exhibit 10c Kick-out Rates (January 2004 to January 2007)

2004 2005 2006 2007

% of
Whole
Loan
Sales $M

% of
Whole
Loan
Sales $M
% of
Whole
Loan
Sales $M

January 6.35% $172.6 5.64% $147.3 6.92% $239.2 11.75% __

February 5.45% 164.2 5.92% 40.8 6.38% 246.0

March 6.92% 132.7 4.98% 180.6 5.67% 330.5

April __ __ 5.59% 48.0 8.27% 131.0

May 5.22% __ 6.03% 202.5 7.54% 319.6

June __ __ 5.59% 136.1 6.61% 477.1

July 7.17% 250.6 5.92% 169.2 9.90% 340.3

August 5.56% 211.4 4.57% 129.9 9.62% 316.8

September 5.65% 94.9 5.62% 283.4 11.48% 979.0

October 5.55% 185.8 8.11% 285.7 11.89% 612.3

November 5.15% 120.6 6.59% 171.8 12.12% 312.9

December 5.35% 172.6 8.77% 486.9 14.95% 804.6

TOTAL $1,505.6 $2,281.7 $5,109.5

Source: Bankruptcy Examiner’s Final Report, pp. 143, 150–152, 161–162.

Exhibit 10d Stated Income and 80/20 Loans (2002 to 2006)

As a Percent of Total Loans Originated
As of December Stated Income Loans 80/20 Loansa

2002 34.1% 7.9%

2003 42.5% 9.1%

2004 43.5% 23.5%

2005 45.5% 35.2%

2006 47.2% 29.2%

Source: Bankruptcy Examiner’s Final Report, pp. 127–128.

a 80/20 loans involved two separate loans for the same transaction resulting in 100%
financing of the property: a first lien mortgage with an 80% loan-to-value ratio and a
second lien with a 20% loan-to-value ratio. The value of the 80/20 loan for 2002 is as of
3/03.

109-034 New Century Financial Corporation

Exhibit 11 The Eight Independent Directors on New Century’s Board (May 2006)

NAME—DIRECTOR SINCE—COMMITTEES

Marilyn A. Alexander—2005—Audit, Finance (Chair), Governance and Nominating, Public and Community Affairs

Alexander, a certified public accountant, was a strategy, diagnostics, and process design consultant to corporations and
nonprofits. Previously she held senior marketing and financial positions at Walt Disney and Marriott Corporation and was on
several boards. She had a bachelor’s degree from Georgetown Univ. and an MBA from the Wharton Graduate School of
the Univ. of Pennsylvania.

Harold A. Black—2004—Compensation, Public and Community Affairs (Chair)

Black, a professor of finance at the Univ. of Tennessee, Knoxville, was previously on the faculties of several U.S.
universities. He had held several government positions, including deputy director, Department of Economic Research and
Analysis/Office of the Comptroller of the Currency, and director/chair of the Nashville Branch of the Federal Reserve Bank
of Atlanta. Black received his undergraduate degree from the Univ. of Georgia and his MA and Ph.D. from Ohio State Univ.

David Einhorn—2006

Einhorn was co-founder, president and a director of Greenlight Capital, Inc., which provided investment advice or
management services to three companies (Greenlight Capital Offshore, Ltd., Greenlight Capital, L.P., and Greenlight
Capital Qualified, L.P. ) that invested in and held securities of various types. Previously, Einhorn worked as an investment
analyst at an investment firm and in the Investment Banking Group of Donaldson, Lufkin & Jenrette. He received his B.A. in
Government from Cornell Univ.

Frederic J. Forster—2002—Compensation, Executive, Governance and Nominating

Forster was a private investor and consultant. Previously, he was a director of and consultant to LoanTrader, a private
company that developed a website which serviced mortgage brokers and lenders, a principal of Financial Institutional
Investors, and president and chief operating officer of H.S. Ahmanson and Company, and its subsidiary, Home Savings of
America. Forster received a B.S. in physics from Princeton Univ. and an MBA from Harvard Business School.

Donald E. Lange—2002—Audit, Compensation (Chair), Governance and Nominating

Lange was the president and CEO of Pacific Financial Services, a mortgage banking and specialty finance company.
Previously, he was president and CEO of OptiFI, a private company specializing in prepayment analytics and of several
specialty finance subsidiaries of Weyerhaeuser Company. In addition, Lange had been a director of Mortgage Electronic
Registration System, Pacific Gulf Properties, and Pedestal, and was the president of the Mortgage Bankers Association of
America. He received a bachelor’s degree in Business and Agriculture from the Univ. of Wisconsin.

William J. Popejoy—2002—Compensation, Governance and Nominating (Chair), Public and Community Affairs

Popejoy was the managing member of Pacific Capital Investors, an investment partnership, and was a member of the board
of trustees of PIMCO Funds and PIMCO Commercial Mortgage Securities, Inc. Previously, he was the CEO and a director
of the California State Lottery; CEO of the County of Orange CA; chairman and CEO of Financial Corporation of America;
president and CEO of Financial Federation, Inc.; president of Far West Savings, First Charter Financial and its subsidiary,
American Savings & Loan Assoc.; and president and CEO of Freddie Mac. He had a bachelors and masters degree from
Sacramento State Univ.

Michael M. Sachs—1995— Audit (Chair), Compensation, Executive, Finance

Sachs, a certified public accountant and attorney, had been chairman and CEO of Westrec Financial, an operator of
marinas and related businesses, and of Pinpoint Integrated Systems, a manufacturer of high tech systems primarily for the
government. Sachs had a B.S. in accounting from the Univ. of Illinois and J.D. from Stanford Univ.

Richard A. Zona—2000— Audit, Executive, Finance

Zona was chairman and CEO of Zona Financial, a private financial advisory firm. In addition he was on the boards of Piper
Jaffray Companies (a public securities firm) and Polaris Industries (a manufacturer of snowmobiles and all-terrain vehicles).
Previously, he was vice chairman and chief financial officer of U.S. Bancorp and a director of ING Direct Bank, Shopko
Stores, and a partner at Ernst & Young.

Source: New Century Financial Corporation, Form DEF 14A, filed April 4, 2006 (period: May 10, 2006).

Note: The Finance Committee was formed in early 2006.

New Century Financial Corporation 109-034
23

Exhibit 12 Estimated Impact of Misstatements on Earnings ($ millions, except for EPS)

2006 7-Qtr
FY 2005 Q1 Q2 Q3 Total

Reported earnings before income taxes $443.4 $115.7 $134.8 $90.2 $784.1

Adjusted for misstatements:

Allowance for repurchase losses (11.5) (12.9) 3.0 (83.4) (104.8)
LCM valuation allowance (9.8) (8.6) (63.4) (3.9) (85.7)
Valuation of residual interest (42.3) 14.1 (15.2) (29.1) (72.5)

Total identified misstatements (63.6) (7.4) (75.6) (116.4) (263.0)

Revised earnings before income taxes 379.8 108.3 59.2 (26.2) 521.1

Reported net earnings $411.1 $101.2 $103.0 $63.5 $678.8

Revised net earnings $372.9 $96.8 $7.6 ($6.3) $471.0

Reported diluted earnings per share (EPS) $7.17 $1.79 $1.81 $1.12

Revised diluted earnings per share (EPS) $6.51 $1.71 $1.01 ($0.11)

Percent overstatement 9% 4% 44% 110%

Analysts’ estimates $6.73 to
$8.88

$1.78 to
$1.79

$1.85 to
$1.89

$1.65 to
$1.98

Source: Bankruptcy Examiner’s Final Report, pp. 383 and 386.

109-034 New Century Financial Corporation
24

Exhibit 13 New Century’s Repurchase Reserve Calculation Methodology

Premium Recapture

Prior three months loan sales $1,000,000

Estimated repurchase percentage rate 1%

Average premium received from loan purchaser 2%

Estimated premium recapture ($1 million * 1% * 2%) $200

Interest Recapture

Prior three months loan sales $1,000,000
Estimated repurchase percentage rate 1%

Average coupon interest rate 10%

Assumed annualized missing interesta $1,000
Estimated interest recapture ($1 million /12) *3 $250

a Typically assumed that the borrower missed three month of payments.

Future Loss Severity

Prior three months loan sales $1,000,000
Estimated repurchase percentage rate 1%

Historical % of repurchased loans repurchased at a loss 50%

Historical loss rate on repurchase loans 20%

Estimated interest recapture ($1 million * 1%* 50% * 20%) $1,000

Source: Bankruptcy Examiner’s Final Report, p. 184.

Exhibit 14 Components of New Century’s Loan Repurchase Reserve (FY 2005 to Q3 FY 2006)

FY 2006

Description FY 2005 Q1 Q2 Q3

Allowance for loan repurchase losses

Interest Recapture Excluded Excluded Excluded Included

Premium Recapture Included Included Included Included

Future Loss Severity Included Included Included Excluded

Backlog Claims a Excluded Excluded Excluded Excluded

Inventory Severity Included Included Excluded Excluded

Source: Bankruptcy Examiner’s Final Report, p. 213.

Note: New Century had included Inventory Severity in its repurchase reserve through Q1 2006, although it was not
by accounting standards a component of a repurchase reserve.

a Backlog claims represented repurchase requests later than 90 days after the loans were sold.

New Century Financial Corporation 109-034

Appendix A

New Century’s Loan Origination Process

Step Description

1. Independent brokers or New Century brokers identified potential borrowers, completed loan
applications, which they submitted to New Century account executives or through its web-based
loan underwriting process called FastQual. The company had established relationships with nearly
50,000 independent brokers and had about 1,000 account executives.

2. Account executives submitted loan applications to New Century account managers, who
reviewed the applications to ensure all documentation was in place. The company had three levels
of income documentation: full, limited, and stated. With full, the applicant was required to submit two
written forms of income verification showing stable income for at least 12 months. With limited, the
applicant was generally required to submit six months of bank statements. With stated, the company
did not require verification of the amount of monthly income the applicant stated on the loan
application. In all cases, the applicant’s employment status, if a salaried employee, was verified by
telephone. Within the industry, stated income mortgages were called “liar loans.”

3. If applications and documentation were in place, account managers sent loans to New Century
underwriters. Loans the company purchased from other mortgage bankers and financial
institutions also went through the underwriting process, called re-underwriting.

Underwriters reviewed loans for compliance to New Century’s underwriting standards and decided
whether to approve or deny the loans. Underwriters set the interest rate and the terms of the loan.
The company’s underwriting guidelines required a credit report on all applicants from a credit
reporting company. The company also reviewed all of the applicant’s prior mortgage payment
histories.

During the underwriting process, the collateral (i.e., home) was appraised. According to New
Century’s 2005 10-K report: “A qualified independent appraiser inspected each mortgage property
and gave an opinion of value and condition. Following each appraisal, the appraiser prepared a
report that included a market value analysis based on recent sales of comparable homes in the
area…. All appraisals must conform to the Uniform Standards of Professional Appraisal Practice
adopted by the Appraisal Foundation’s Appraisal Standards Board and are generally on forms
acceptable by Fannie Mae and Freddie Mac….Our underwriting guidelines then require our
underwriters be satisfied that the value of the property being financed, as indicated by the appraisal,
would support the requested loan amount.”

4. If approved, underwriters sent loans to closing agents for execution.

5. After loan documents were executed, closing agents sent the documents to New Century funding
officers, who would contact accounting department and request a wire to the funding officers.

Source: Casewriter. Bankruptcy Examiner’s Final Report, pp. 58–59; New Century Financial 10-K Report (2005), pp. 5–7, via
http://www.sec.gov/Archives/edgar/data, accessed May 6, 2008.

Note: Fannie Mae and Freddie Mac were stockholder companies chartered by the U.S. government to help provide
liquidity to the mortgage industry by participating in the secondary market. Both companies primarily purchased
mortgages from lenders and resold them with guarantees as mortgage-backed securities.

109-034 New Century Financial Corporation

Endnotes

1 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, pp. 1 and 40.

2 “The Subprime Lending Industry: A Look At The Restructuring of a Market in Turmoil,” prepared for the
American Bar Association Annual Meeting Section of Business Law, Sponsored by the Business Bankruptcy
Committee, at American Bar Association website, http://www.abanet.org/buslaw/newsletter/0063/materials/
pp1a , accessed May 7, 2008, p. 1.

3 Sumit Agarwal and Calvin T. Ho, “Comparing the Prime and Subprime Mortgage Markets,” The Federal
Reserve Bank of Chicago, Chicago Fed Letter, August 2007, Number 214, via http://www.chicagofed.org/
publications/fedletter/cflaugust2007_241 , accessed May 22, 2008.

4 Information for this paragraph obtained from Stephen G. Ryan, “Accounting in and for Subprime Crisis,”
March 2008,” New York University, SRRN Working Paper Series, at http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1115323, accessed September 25, 2008.

5 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 10.

6 Ibid., p. 40.

7 Ibid., p. 41.

8 Ibid., pp. 126–128.

9 Jill Riepenhoff and Doug Haddix, “Risky refinancings deepen financial hole,” Columbus Dispatch, June 2,
2008, p. 1A, via Factiva, accessed September 18, 2008.

10 Unless cited otherwise, information in this paragraph from New Century TRS Holdings, Inc., Final Report
of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 55–56, and 116.

11 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 84.

12 Zach Gast, “New Century: Presentation of Loan Loss Allowance in Earnings Release Obfuscates 8.7%
Decline in Allowance and Understates Charge-Offs by 50+%,” RiskMetrics Group Center for Financial Research
and Analysis, November 6, 2006, p. 1.

13 Unless cited otherwise information in this paragraph from New Century TRS Holdings, Inc., Final Report
of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 84 and 87.

14 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 62.

15 New Century NT-10K 2007.

16 New Century TRS Holdings, Inc., Final Report of Michael J. Missal Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 64.

17 Ibid., p. 66.

18 Ibid., p. 71 and 121.

New Century Financial Corporation 109-034
27

19 Unless otherwise cited information for this section from New Century TRS Holdings, Inc., Final Report of
Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 230–240.

20 New Century TRS Holdings, Inc., Final Report of Michael J. Missal Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, pp. 75–76.

21 Ibid., p. 75.

22 Ibid., p. 456.

23 Unless otherwise cited, information for this section from New Century TRS Holdings, Inc., Final Report of
Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 101, 102, 104, 105.

24 Ibid., pp. 10, 49, 89, 113, 114, 146, 147, 154–156, 165, 180, 205, 222, 229, 230-240, 256–258, 277–278, 297, 336,
389, 429, 443, 457–458, 471, 473.

25 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 152.

26 Ibid., p. 89 and 165.

27 Ibid., pp. 175–176.

28 Unless otherwise cited, information for this paragraph from New Century TRS Holdings, Inc., Final Report
of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 70, 193, 201, 221.

29 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 229.

30 Ibid., p. 230.

31 Ibid., p. 229.

32 Unless otherwise cited, information for this paragraph from New Century TRS Holdings, Inc., Final Report
of Michael J. Missal, Bankruptcy Court Examiner, United States Bankruptcy Court for the District of Delaware,
Case No. 07-10416 (KJC), February 29, 2008, pp. 223–225.

33 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 140.

34 Ibid., p. 154.

35 Ibid., p. 156.

36 Ibid., p. 146.

37 Ibid., pp. 90–91 and 339.

38 Ibid., p. 342.

39 Ibid., p. 458.

40 Ibid., p. 471.

41 Ibid., p. 473.

109-034 New Century Financial Corporation

42 Vikas Bajaj and Julie Creswell, “A Lender Failed. Did Its Auditor?” The New York Times, April 13, 2008.

43 Ibid.

44 Jessica C. Lee, “New Century Report Likely Read for Prosecutors,” Orange County Business Journal, Volume
31; Issue 14; ISSN: 10517480, April 7, 2008, p. 3, via Factiva, accessed June 10, 2008.

45 New Century TRS Holdings, Inc., Final Report of Michael J. Missal, Bankruptcy Court Examiner, United
States Bankruptcy Court for the District of Delaware, Case No. 07-10416 (KJC), February 29, 2008, p. 389.

46 Ibid., p. 10.

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Case Study Analysis

Case study analysis gives students an opportunity to apply theory learned in the classroom to real world situations. Case studies do not have discrete answers. Rather, they challenge students to exercise their own business judgment in a supportive, educational environment. Students test their knowledge by analyzing situations; defining problems or issues; evaluating alternatives and/or forming conclusions to resolve the problem or issue; and making recommendations.

Types of case study assignments:

Students may be asked to

· Prepare a case in advance, based on criteria developed by the instructor. The case would then be used as a basis for discussion.

· Write a case analysis paper, based on criteria developed by the instructor. The paper may be presented or reviewed by peers.

· Analyze a case that is threaded throughout the course. As part of the learning process, students acquire knowledge during the course and apply that knowledge to different aspects of the case.

Case study analysis steps:

Cases used in the classroom vary from short vignettes to dense, multi page volumes. It is the responsibility of the instructor to teach a process which, while useful in the classroom, can be applied to the real world after the student graduates. Real world application of the steps used in case study analysis will vary from those found in the safety of the academia; employees will gather the information, found conveniently in an academic written case study, from a dynamic environment.

Here are some recommended steps for successful case analysis:

1. Gain familiarity with the case situation. This can be accomplished by reading the case several times. Read the first time to appreciate the general story before you begin to form conclusions or make analysis.

2. Define the issue or problem. To make an analysis or recommendation, one must first determine what the issue or problem is. As in the real world, note there may be more than one problem in a case study analysis. (You can appreciate the importance of this step if you ever took your car in because it was running rough and paid for several repairs because the mechanic didn’t correctly diagnose the problem in the beginning.)

3. Conduct your analysis. What are the possible causes of the problem or issue? What alternatives are possible given the facts presented? This is the most time consuming step, and the step with the greatest variation. There may be many possibilities. It might be helpful to list all solutions you can think of before focusing on the most useful or valid. There is not necessarily a right answer, but there may be several alternatives that lead to varying outcomes. The quality of analysis will depend upon application of theory learned in the classroom and through research.

4. Make recommendations. Choose the recommendation you believe to be the best, justify it, and develop it. Recommendations may be made in the form of an action plan to solve the problem or issue. Or, recommendations may involve the choice of the best alternative for resolving the issue or problem. Recommendations made must be thoroughly developed and supported.

References:

ICFAI Center for Management Research. (nd). Learning with cases. Retrieved June 22, 2007 from

http://www.icmr.icfai.org/casestudies/learn_case.htm

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