ABOUT THE AUTHOR

Donald R. Van Deventer, Ph.D.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

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Lesson 4 from Failures in Silo Risk Management: New Century Financial Corporation

07/16/2009 05:19 AM

The original Reuters story on the demise of New Century can be bound at the following link:

http://www.reuters.com/article/topNews/idUSN0242080520070402?feedType=RSS

We turn the clock back and again take on the role of a potential investor in New Century who has at his disposal the company’s financial reports as filed with the SEC on www.sec.gov and nothing else—no insider’s knowledge, no particular fingers on the pulse of the mortgage market, etc.  Were there any signs in these financial statements that bankruptcy was near at hand?  That is the question we are seeking to answer in today’s post.  Why ask that question?  For an incredibly important reason: as risk experts and as taxpayers, we need to ensure that this massive credit crisis is never repeated on our watch again.  Unless we analyze the process of failure and what chances were missed to prevent it from happening, we haven’t learned the lessons offered by this $1 trillion dollar tuition payment of U.S. taxpayer funds.

Earlier in this series, Lessons 1 and 2 in Failures in Silo Risk Management focused on Countrywide Financial Corporation and Washington Mutual.  In both cases, the financial statements contained no stress tests (like those now mandated by US bank regulators) with respect to home prices. In Countrywide’s financial statements, there were no hints about whether or not risk management staff had warned senior management about the risks of a home price decline or not.  Later, documents in the U.S. government’s fraud suit against former CEO Angelo Mozilo and two others made it clear that management was indeed aware of the risks.  What internal analysis was done with respect to home price sensitivity hasn’t yet been disclosed.  In the case of Washington Mutual, it was much more clear in the financial statements that there were some very talented risk managers on board.  We guessed that management had been warned of the risk and these warnings had been ignored.  Feedback to our blog post from Dale George and others confirmed this was indeed the case.

What about New Century, which used the same interest rate risk systems infrastructure as Countrywide and Washington Mutual?  It’s a case of de ja vu all over again, as Yogi Berra would have put it.  We follow with some key quotes from the company’s 10-k filing of December 31, 2005 and its 10-q of September 30, 2006.  The 10-k for December 31, 2006 is not available on www.sec.gov and we presume that it was never filed due to the bankruptcy of the firm.

Key Quotes from the December 31, 2005 10-k Filing

Management makes it clear at the outset that they are focusing on a riskier segment of the mortgage market than other firms:

Page 1

Historically, we have focused on lending to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers. In September 2005, we acquired a mortgage origination platform from RBC Mortgage Company, or RBC Mortgage, that expands our offerings to include conventional mortgage loans, including “Alt-A” mortgage loans, loans insured by the Federal Housing Administration, or FHA, and loans guaranteed by the Veterans Administration, or VA.

Management expresses pride in its credit assessment technology, although as we show below there was nothing in the 10-k to indicate special insights or techniques that were employed:

Page 3

Automated credit grading capability. We have created a proprietary automated credit grading and pricing methodology that we believe gives us the ability to more effectively evaluate credit risk and more efficiently price our products, as validated by our historical loan performance.

Management expresses its hedging approach with respect to interest rate risk in detail, but the 10-k contains no language about hedging with credit risk in general or home price risk in particular:

Page 4

Hedging policy

We intend to use a variety of risk management strategies to monitor and address interest rate risk. We believe that these strategies will allow us to monitor and evaluate our exposure to interest rates and to manage the risk profile of our mortgage loans held for investment, mortgage loans held for sale and our residual interests in securitizations in response to changes in market conditions. As part of our interest rate risk management process, we may continue to use derivative financial instruments such as Euro Dollar futures contracts, interest rate cap agreements and interest rate swap agreements and may start using Treasury futures and options on interest rates. We may also use other hedging instruments including mortgage derivative securities, as necessary. These derivative instruments currently have an active secondary market, and are intended to offset potential reduced income and cash flow under certain interest rate environments. Hedging strategies involve transaction and other costs. We engage in hedging for the sole purpose of protecting against interest rate risk and not for the purpose of speculating on changes in interest rates.

Management then reemphasizes that they are making risky mortgage loans:

Page 5

Most of our loan production consists of subprime mortgage loans originated through our Wholesale Division. Subprime mortgage loans are made to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers. Our acquisition of the mortgage origination platform of RBC Mortgage has expanded our product offerings to include conventional mortgage loans, including “Alt-A” mortgage loans, loans insured by the FHA and loans guaranteed by the VA.

Then, I don’t know about you, but I get confused with the following assertion that the firm seeks to originate “high quality” loans.  The continuation is the first significant mention of home prices in the 10-k:

Page 8

Our loan origination standards and procedures are designed to produce high quality loans. These standards and procedures encompass underwriter qualifications and authority levels, appraisal review requirements, fraud prevention, funds disbursement controls, training of our employees and ongoing review of our employees’ work. We help to ensure that our origination standards are met by employing accomplished and seasoned managers, underwriters and processors and through the extensive use of technology. We also have a comprehensive training program for the continuing development of both our existing staff and new hires. In addition, we employ proprietary underwriting systems in our loan origination process that improve the consistency of underwriting standards, assess collateral adequacy and help to prevent fraud, while at the same time increasing productivity.

A qualified independent appraiser inspects and appraises each mortgage property and gives an opinion of value and condition. Following each appraisal, the appraiser prepares a report that includes a market value analysis based on recent sales of comparable homes in the area and, when appropriate, replacement cost analysis based on the current cost of constructing a similar home. 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 to Fannie Mae and Freddie Mac.

Page 28, for the most part, has the only multi-sentence discussion of the fact that home price declines are bad for New Century:

Page 28

The risks associated with our business are more acute during periods of economic slowdown or recession because these periods may be accompanied by decreased demand for consumer credit and declining real estate values. Declining real estate values reduce the ability of borrowers to use home equity to support borrowings because they reduce the LTV of the home equity collateral. In addition, because we make a substantial number of mortgage loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these mortgage loans could be higher during economic slowdowns. Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to sell mortgage loans, the prices we receive for our mortgage loans, or the values of our mortgage loans held for investment or our residual interests in securitizations, which could harm our results of operations, financial condition and business prospects.

On page 29, management does make the more conventional point that increases in mortgage payments lead to higher defaults:

Page 29

An increase in interest rates could increase the delinquency and default rates on the adjustable-rate mortgage loans that we originate and hold because the borrowers’ monthly payments under such mortgage loans may increase beyond the borrowers’ ability to pay. Our portfolio of mortgage-related assets includes a significant number of mortgage loans that were originated in 2004 and 2005 that are adjustable-rate mortgage loans. Due to significant increases in interest rates since those mortgage loans were originated, the borrowers may be facing a larger-than-expected payment increase once the initial two or three-year fixed period ends. This may result in higher delinquencies and/or faster prepayment speeds, both of which could harm our profitability. High delinquencies or losses may decrease our cash flows or impair our ability to sell or securitize mortgage loans in the future, which could harm our results of operations, financial condition and business prospects.

On page 31, management devotes one bullet point to home price decline risk:

Page 31

The mortgage loans that we hold are subject to the risks of delinquency and foreclosure loss, which could result in losses to us.

Our mortgage loans are secured by residential properties and are subject to risks of loss from delinquencies and foreclosures. The ability of a borrower to repay a mortgage loan secured by residential property typically is dependent primarily upon the income or assets of the borrower. In addition, the ability of borrowers to repay their mortgage loans may be affected by, among other things:

property location and condition;
competition and demand for comparable properties;
changes in zoning laws for the property or its surrounding area;
environmental contamination at the property;
the occurrence of any uninsured casualty at the property;
changes in national, regional or local economic conditions;
declines in regional or local real estate values;
increases in interest rates or real estate taxes;
availability and costs of municipal services;
changes in governmental rules, regulations and fiscal policies, including environmental legislation and changes in tax laws; and
acts of God, war or other conflict, terrorism, social unrest and civil disturbances and natural disasters, such as hurricanes.

In the event of a default under a mortgage loan held directly by us, we will bear a risk of loss of principal to the extent of any deficiency between the value of the collateral that we can realize upon foreclosure and sale, and the principal and accrued interest of the mortgage loan and the cost of foreclosing on the related property.

In discussing risk factors affecting share price on page 41, home prices are not listed as a concern of management at New Century:

Page 41

Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of New Century common stock include:

general market and economic conditions;
actual or anticipated changes in our future financial performance;
changes in market interest rates;
competitive developments, including announcements by us or our competitors of new products or services or significant contracts, acquisitions, strategic partnerships or capital commitments;
the operations and stock performance of our competitors;
developments in the mortgage lending industry or the financial services sector generally;
the impact of new state or federal legislation or court decisions restricting the activities of lenders or suppliers of credit in our market;
fluctuations in our quarterly operating results;
changes in financial estimates by securities analysts;
additions or departures of senior management and key personnel; and
actions by institutional stockholders. 

At first glance, page 79 seems to provide some support for the argument that management was aware of the risks and was acting to bolster capital with this preferred stock issue.  That argument, however, is shown to be wrong below.

Page 79

In June 2005, we sold 4,500,000 shares of our 9.125% Series A Cumulative Redeemable Preferred Stock, raising $108.7 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.125% and are not convertible into any other securities.

Page 81 makes it clear that management, in the fourth quarter of 2005, was so unconcerned with the risk level of the firm that they committed to repurchase common stock, decreasing the capital of the firm:

Page 81

In the fourth quarter of 2005, our board of directors approved a new share repurchase program for up to 5 million shares of New Century common stock over the following 12 months. In the fourth quarter of 2005, we repurchased 879,200 shares at an average price of $33.52 per share for an aggregate amount of $29.5 million pursuant to this share repurchase program. We periodically direct our stock transfer agent to cancel repurchased shares. All repurchased common shares were canceled as of December 31, 2005.

The company reported standard late 1970s/early 1980s interest rate stress tests, but they reported no stress tests with respect to home prices, one of the two macro risk factors (along with interest rates) that any mortgage lender faces.  The tables, on pages 88 and 89 of the 10-k, show the estimated market value impact for up and down shifts in interest rates of 50 and 100 basis points.

On page F-26 of the financial statements, the company says that interest only mortgage loans are safe, but the company notes it has no data to support that assertion:

Page F-26

The Company believes its strict underwriting guidelines and the stronger credit characteristics of these [author’s note: interest only] mortgage loans mitigate their perceived higher risk. Due to the Company’s lack of significant historical experience with interest-only mortgage loans, credit performance has not yet been established.

Page F-49 explains that it continued to repurchase common stock in the fourth quarter of 2005, only 16 months before the bankruptcy of the company:

Page F-49

The Company’s Stock Repurchase Program, or the Program, originally authorized the repurchase of up to 5.8 million shares. From inception of the Program through September 30, 2005, the Company had repurchased 4.2 million shares. During the fourth quarter of 2005, the Company’s Board of Directors approved a share repurchase program for up to 5 million shares of common stock over the following 12 months. The Company expects to fund these repurchases with excess corporate liquidity. Stock repurchases may be made on the open market through block trades or in privately negotiated sales in accordance with applicable law. The number of shares to be purchased and the timing of the purchases will be based upon the level of the Company’s cash balances, general business conditions and other factors including alternative investment opportunities. The Company may terminate, suspend, reduce or increase the size of the stock repurchase program at any time. In the fourth quarter of 2005, the Company repurchased 879,200 shares at an average price of $33.52 per share for an aggregate amount of $29.5 million. The Company periodically directs its stock transfer agent to cancel repurchased shares. All repurchased common shares were canceled as of December 31, 2005.

In the September 30, 2006 10-q filing, a strong sign that the Company perceived trouble near at hand is a reversal of course; the company issued preferred shares to bolster capital:

10-q page 21

In August 2006, the Company sold 2,300,000 shares of its Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”), including 300,000 shares to cover overallotments. The offering provided $55.6 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.75% and are not convertible into any other securities

On page 40 of the 10-q, the Company expresses optimism about the future:

We believe that we are well positioned to meet the challenges next year. We expect overall mortgage market volume to decline in 2007, yet we believe our size, scale, financial resources, low loan acquisition costs and reputation will enable us to compete successfully and profitably gain market share in this consolidating industry

The Company felt enough confidence in the future to continue its cash dividend:

10-q page 76

On August 2, 2006, we declared a quarterly cash dividend at the rate of $1.85 per share that was paid on October 31, 2006 to stockholders of record at the close of business on September 29, 2006. On October 31, 2006, we declared a quarterly cash dividend at the rate of $1.90 per share that will be paid on January 31, 2007 to stockholders of record at the close of business on December 29, 2006.

It isn’t until page 80 of the 10-q that this expression of concern is presented:

10-q page 80

The proceeds that we receive from whole loan sales in the secondary market are reduced when we are forced to sell loans at a discount, typically due to defects in the documentation of the loans and credit quality of the underlying borrowers. In recent months, buyers of whole loans have become more cautious about purchasing loans and have been increasingly attentive to loan documentation in their pre-purchase due diligence reviews. Thus, we have increasingly had to sell these less desirable loans at discounted prices and the discount amounts have become more severe. Additionally, we may incur greater expenses in marketing and selling these loans and, during that time, we are faced with the market and interest-rate risks with respect to the loans. Furthermore, there has been an increase in the number of loans we have had to repurchase from buyers pursuant to the terms of the sales agreements, including due to early payment defaults due to the current economic conditions, as described in the risk factor titled “We may be required to repurchase mortgage loans or indemnify investors if we breach representations and warranties, which could harm our earnings” in our Annual Report on Form 10-K for the year ended December 31, 2005. We expect that the trend of selling more of our mortgage loans in whole loan sales, rather than adding the loans to our REIT portfolio, will continue in the near term. Accordingly, if these trends of reduced prices and increased discounts in our whole loan sales and increased repurchases of previously-sold loans continue, our liquidity position, results of operations, financial condition and business prospects could be harmed.

New Century’s Board of Directors

While New Century was sliding toward bankruptcy, how strong was the board of directors that was overseeing the firm?  In two words, “very strong.”  It is a much stronger and more experienced slate of directors than either the Countrywide or Washington Mutual board of directors.

Among the non-executive directors listed on New Century’s Board was a very experienced mortgage executive.  William J. Popejoy’s accomplishments were summarized this way in a 2005 press release by the company:

IRVINE, Calif., Feb. 24 /PRNewswire-FirstCall/ — New Century Financial Corporation (NYSE: NEW), a real estate investment trust and the parent company of one of the nation’s largest non-prime mortgage finance companies, congratulates William J. Popejoy, a member of New Century Financial Corporation’s board of directors, for receiving the Forum for Corporate Directors’ “Director of the Year for Corporate Citizenship” award at its 10th annual awards presentation at the Ritz Carlton Hotel in Laguna Niguel, Calif., on February 23, 2005.

Mr. Popejoy has served on the New Century board of directors since November 2002 and is the chairman of the company’s Governance and Nominating Committee and a member of the company’s Compensation Committee.

In addition, he is the Managing Member of Pacific Capital Investors and serves as trustee of PIMCO Funds, which directs $400 billion in assets. He gained his broad expertise in mortgage banking and financial services from his role as chief executive officer for several publicly traded companies, including Freddie Mac, American Savings, Far West Savings and Financial Federation. In addition, he has served as chairman of the California League of Savings Institutions.

“This honor is no surprise to anyone who knows Bill,” said Robert K. Cole, chairman and chief executive officer of New Century Financial Corporation.

Another director, Marilyn A. Alexander, had significant mortgage expertise and was named as a director of one of PIMCO’s mortgage funds as described in this 2006 press release:

PIMCO Appoints Marilyn Alexander as Additional Fund Director for the PIMCO Commercial Mortgage Securities Trust

NEWPORT BEACH, CA, October 6 / MARKET WIRE/ —

PIMCO, one of the world’s leading fixed-income managers, announced today that three registered investment companies managed by PIMCO, PIMCO Funds, PIMCO Variable Insurance Trust, and PIMCO Commercial Mortgage Securities Trust, Inc. (NYSE: PCM) (the “Funds”), have increased the size of their Boards to seven, and appointed Ms. Marilyn A. Alexander to their Boards. Ms. Alexander has also been appointed to each Fund’s Audit and Governance Committees.

Ms. Alexander is a consultant with Alexander & Friedman, LLC, which provides general and financial management consulting services to senior executives of corporations and not-for-profit organizations. Previously, Ms. Alexander was Senior Vice President and Chief Financial Officer of the Disneyland Resort in California, and held various senior positions with the Walt Disney World Resort in Florida. Prior to that, Ms. Alexander was Vice President of Financial Planning and Analysis with the Marriott Corporation. Ms. Alexander has over 25 years of finance, marketing, and strategic planning experience.

“We are pleased to welcome Marilyn, and especially her expertise, to the board,” said Brent Harris, chairman of the PIMCO Funds. “Our investors will benefit most.”

Ms. Alexander also serves on the Board of Directors of Equity Office Properties, Inc., where she serves as a member of the Audit and Nominating and Governance Committees, and serves on the Board of Directors of New Century Financial Corporation, where she is a member of the Audit, Nominating and Governance, and Public Affairs and Community Relations Committees, and chair of the Finance Committee. Ms. Alexander is a member of the Board of Governors, and a member of the Finance and Audit Committee of the Board of Trustees of Chapman University.

Ms. Alexander holds a bachelor’s degree from Georgetown University, where she graduated Magna Cum Laude and was a member of Phi Beta Kappa, and an MBA from the Wharton Graduate School of the University of Pennsylvania. She is a licensed CPA in the Commonwealth of Virginia.

Another director, Harold A. Black, is a Ph.D. and professor of financial institutions at the University of Tennessee. Lead director Frederic J. Forster also has an impressive resume as described in this 2005 press release.

New Century Financial Corporation Appoints Fredric J. Forster as Lead Director

IRVINE, Calif., Sept. 20 /PRNewswire-FirstCall/ — New Century Financial Corporation (NYSE: NEW), a real estate investment trust and parent company of one of the nation’s premier full-service mortgage finance companies, today announced the appointment of Fredric J. Forster to the newly created position of Lead Director of New Century’s Board of Directors. Mr. Forster has been a member of New Century’s Board since July 1997.He currently serves as the Chairman of the Compensation Committee and is a member of the Governance and Nominating Committee and the Executive Committee and is a former member of the Audit Committee.

As Lead Director, Mr. Forster will be principally responsible for coordinating the activities of the independent directors and presiding over executive sessions of that group. In addition, he will be facilitating communication between the independent directors and the Chairman, as well as other duties specified by the Board.

Mr. Forster has extensive mortgage industry experience, spending 9 years at ITT Financial Corporation, most recently as President and Chief Executive Officer of ITT Federal Bank. He later served as President and Chief Operating Officer of H. F. Ahmanson and Company and its subsidiary, Home Savings of America, and as a founding Managing Principal of Financial Institutional Partners. In addition, Mr. Forster spent nearly a decade as a director of the Federal Home Loan Bank of San Francisco. He received his Masters Degree in Business Administration from Harvard Business School in Cambridge, Mass., and his Bachelor’s degree in Physics from Princeton University in Princeton, N.J.

“I am delighted by the opportunity to play a leadership role on New Century’s Board of Directors,” said Forster.”This company has made steady progress in executing the REIT strategy that its shareholders approved in September, 2004, and I look forward to serving the Board of New Century as we continue to build shareholder value.”

Robert K. Cole, Chairman of the Board and Chief Executive Officer said, “Fred has been a valuable and resourceful contributor to the Board since he joined in 1997, the year we went public.

Director Donald E. Lange was a former president of the Mortgage Bankers Association.  His biography as listed on spoke.com is as follows:

Donald E. Lange Director Mr. Lange (60) has served on our board of directors since November 2002. Mr. Lange has served as the President and Chief Executive Officer of Pacific Financial Services, a mortgage banking and specialty finance company, since 1999. From March 2001 to February 2002, Mr. Lange served as President and Chief Executive Officer of OptiFI, a private company specializing in prepayment analytics. Previously, he served as the President and Chief Executive Officer of several specialty finance subsidiaries of Weyerhaeuser Company, including Weyerhaeuser Financial Services, Weyerhaeuser Mortgage Company and Weyerhaeuser Venture Company. Mr. Lange served as a director of Mortgage Electronic Registration System (MERS) from 1995 until 2002. In addition, he was a director of Pacific Gulf Properties from 1998 until 2001 and a director of Pedestal from 1999 until 2001. Mr. Lange was the President of the Mortgage Bankers Association of America in 1999. Mr. Lange received a bachelor’s degree in Business and Agriculture from the University of Wisconsin.

Outside director Michael M. Sachs is both a lawyer and a CPA, as described in this biography on Zoominfo.com from a New Century press release:

 

Mr. Sachs (64) has served on our board of directors since November 1995.Mr. Sachs has been Chairman of the board of directors and Chief Executive Officer of Westrec Financial, an operator of marinas and related businesses, since 1990.He has also served as Chairman of the board of directors and Chief Executive Officer of Pinpoint Integrated Systems, a manufacturer of various high tech systems used primarily by the military, since December 1995.Mr. Sachs received his Bachelors of Science degree in Accounting from the University of Illinois and his Juris Doctorate degree from Stanford University. He is a Certified Public Accountant and an attorney.

 

Finally, outside director Richard A. Zona is a former Vice Chairman and chief financial officer of U.S. Bancorp, as described in his bio on zoominfo.com:

 

Mr. Zona (61) has served on our board of directors since June 2000.Mr. Zona has been Chairman and Chief Executive Officer of Zona Financial, a private financial advisory firm, since 2000.Previously, Mr. Zona was Vice Chairman of U.S. Bancorp, a bank holding company, from 1996 to 2000, and Chief Financial Officer of U.S. Bancorp from 1989 to 1996.He currently serves as a director of Piper Jaffray Companies, a public securities firm, a director of Polaris Industries, a public company that manufactures snowmobiles, all-terrain vehicles and related equipment and an advisory board member of Goldner, Hahn, Johnson and Morrison, a private equity firm. Mr. Zona served as a director of ING Direct Bank until June 2005 and a director of Shopko Stores, a public company and retailer of goods and services, until December 2005.Mr. Zona was a partner at Ernst & Young from 1979 to 1989.Mr. Zona received his Bachelors of Science in Business Administration degree from the Roosevelt University and is a Certified Public Accountant.

 

Post Mortem

It’s humbling that an institution with such a strong board of directors could fail with so little warning to shareholders.  After wandering through the financial statements, we’ve reached these working conclusions based solely on outside information.  We appreciate feedback from those who were on the inside as to why any of these logical conclusions based on public information might be incorrect; please e-mail us at info@kamakuraco.com.  Here are our working conclusions:

  • Management and the Board felt the company was so strong that they authorized a shrinkage of the company’s capital through the end of 2005
  • Management made no quantitative disclosure of the risk of home price changes in the December 31, 2005 10-k and September 30, 2006 and 10-q
  • If management was aware of impending troubles, through September 30, 2006 only the page 80 paragraph hints at what is to come
  • If management was aware that the risk was great, this is not obvious in the 10-k or 10-q
  • If the risk management staff of the firm measured home price risk and informed management of the risk, management did not deem it important enough to report to shareholders
  • If the risk systems vendor to New Century was capable of measuring home price risk, the company chose not to disclose it.  The name of the vendor to New Century is public information reported by the Securities and Exchange Commission here:

http://www.sec.gov/Archives/edgar/data/1287286/000129993306008334/exhibit10.htm

  • If Board members were concerned about the risk level of the Company, they were not concerned enough to resign their posts.  We are extremely curious about the nature of conversations at the Board level during the last 2-3 years of the company’s life.

One passionate reader of this blog argued in a fiery e-mail that no person and no risk system could have saved Countrywide or (by logical extension) New Century or Washington Mutual.  We beg to differ.  The coming crash in U.S. home prices was nicely described in the June 16, 2005 issue of the Economist.  For the full text of that story, click here:

https://lists.resist.ca/pipermail/project-x/2005-June/010180.html

The December 10, 2003 Loss Distribution Model of the FDIC by our colleague Robert A. Jarrow et al listed home prices as one of three key risk factors driving correlated defaults of U.S. banks.  My modest book, (written in 2002 and published in 2003) with Kenji Imai Credit Risk Models and the Basel Accords illustrated the impact of macroeconomic factors on bank default with Australian data.  Home prices in Sydney, Perth and Melbourne were statistically significant drivers of bank stock returns (and by extension, default risk) in Australia.

Given that we know macro factors are important, what questions should the Board be asking and should management be answering?  We listed those questions in our blog post of April 27, 2009.  The four most important are these:

Question 1: What happens to the market capitalization and net income of the firm if any of these risk factors change: home prices, foreign exchange rates, commercial real estate prices, stock index levels, interest rates, commodity prices?

Question 2: Using an insider’s knowledge of the assets and liabilities of the firm, both “on balance sheet” and “off balance sheet,” what is the best estimate, monthly for the next ten years, of the probability that the firm will fail in each of these 120 monthly periods?

Question 3: Using only information available to an outsider, what is the best estimate of the probability of the failure of the firm in both the short run and the long run?

Question 4: If the firm is able to answer Questions 1, 2, and 3, what hedging position is necessary to insure that the macro factor sensitivity of the firm and default probability of the firm reach the target levels set by the Board of Directors?

The Consequences of Ignoring These Questions are Dire

Justia.com, on this link

http://dockets.justia.com/search?q=NEW+CENTURY+FINANCIAL+CORPORATION

reported 513 federal lawsuits that involve the name “New Century Financial”.  On April 1, 2009, Reuters reported that the prestigious auditing firm to New Century has been named in a billion dollar lawsuit.  For the full text of the story, click here:

http://www.reuters.com/article/GCA-Housing/idUSTRE53061920090402

But something much more important has been lost by the failure of the Board and the management team at New Century.  Every single shareholder of the firm lost 100% of their investment.  7,000 employees have lost their jobs.  Saying “There’s nothing I could have done” isn’t good enough.  We can’t let this happen again.

Donald R. van Deventer
Kamakura Corporation
Honolulu, July 16, 2009

ABOUT THE AUTHOR

Donald R. Van Deventer, Ph.D.

Don founded Kamakura Corporation in April 1990 and currently serves as its chairman and chief executive officer where he focuses on enterprise wide risk management and modern credit risk technology. His primary financial consulting and research interests involve the practical application of leading edge financial theory to solve critical financial risk management problems. Don was elected to the 50 member RISK Magazine Hall of Fame in 2002 for his work at Kamakura.

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