Monday, December 21, 2009

Securitization: BIS Examines New Century Capital

Original posted on Prefbog:

The Bank for International Settlements has released a working paper by Allen B Frankel titled The risk of relying on reputational capital: a case study of the 2007 failure of New Century Financial:
The quality of newly originated subprime mortgages had been visibly deteriorating for some time before the window for such loans was shut in 2007. Nevertheless, a bankruptcy court’s directed ex post examination of New Century Financial, one of the largest originators of subprime mortgages, discovered no change, over time, in how that firm went about its business. This paper employs the court examiner’s findings in a critical review of the procedures used by various agents involved in the origination and securitisation of subprime mortgages. A contribution of this paper is its elaboration of the choices and incentives faced by the various types of institutions involved in those linked processes of origination and securitisation. It highlights the limited roles played by the originators of subprime loans in screening borrowers and in bearing losses on defective loans that had been sold to securitisers of pooled loan packages (ie, mortgage-backed securities). It also illustrates the willingness of the management of those institutions that became key players in that market to put their reputations with fixed-income investor clients in jeopardy. What is perplexing is that such risk exposures were accepted by investing firms that had the wherewithal and knowledge to appreciate the overall paucity of due diligence in the loan origination processes. This observation, in turn, points to the conclusion that the subprime episode is a case in which reputational capital, a presumptively effective motivator of market discipline, was not an effective incentive device.

The end of the road for New Century came when:

Purchasers of New Century’s loan production normally conducted a due diligence examination after a sales agreement had been reached. The investor, or a due diligence firm hired by the investor, would review loan files to determine whether the loan was underwritten according to the pool’s guidelines. Loans not meeting guidelines could be excluded from the loan bundle (kicked out) and returned to the originator.

Once kicked out, the mortgages were known as a “scratch and dent” (S&D) loans, which were purchased by specialised investors at a large discount to their principal balance. Consequently, one measure of the deterioration of the quality of New Century’s loan production is the percentage of S&D loan sales. In 2004 and 2005, such sales amounted to less than 0.5% of New Century’s secondary market transactions. By contrast, in the first three quarters of 2006, S&D loan sales accounted for 2.1% of such transactions (Missal (2008, p. 68)).

The upsurge in loan repurchase requests to New Century coincided with a change in the methodology employed to estimate its allowance for loan repurchase losses. New Century’s board learned of the change after a considerable delay. This discovery was followed, after a few days, by a public announcement on 7 February 2007 that New Century’s results for the three quarters of 2006 needed to be restated. It also noted an expectation that losses would continue due to heightened early payment default (EPD) rates.

New Century’s announcement prompted margin calls by many of its warehouse lenders and requests for accelerated loan repurchases. Soon, all of New Century’s warehouse lenders ceased providing new funding. Because simultaneous margin calls by its warehouse lenders could not be met, New Century filed for bankruptcy on April 2, 2007. It ceased to originate mortgages and entered into an agreement to sell off its loan servicing businesses.

Amusingly, in the light of the current bonus hysteria:

The examiner’s access to internal New Century documents provided valuable insights into how the appearance of the warning flags influenced, or did not influence, management. For example, the examiner could find no reference to loan quality in the internal documents that described New Century’s bonus compensation system for regional managers for 2005 and 2006 (Missal (2008, p. 147)). The examiner says that the compensation of New Century’s loan production executives was directly and solely related to the amount of mortgage loans originated, loans that, in turn, were subsequently sold or securitised.32 Likewise, the examiner found no mention of penalties (reduced commission payments to loan production staff) that would be assessed against defective loans that required price discounts for secondary market sale.

Heightened investor concerns about the performance of subprime loans were reflected in changes in their due diligence processes (Missal (2008, p. 165)). Historically, investors would ask due diligence firms to examine, on their behalf, only a small sample of loans in a particular pool. The character of the process first changed in 2006 when most investors began to look at the appraisal documents in all loan files in a loan pool. Investors then increased the share of loan files examined. This intensification of due diligence efforts was responsible for a sharp increase in New Century’s kickout rate from 6.9% in January 2006 to 14.95% in December 2006 (Missal (2008, p. 161)).

The author concludes:

The examiner’s report suggests that some of the actions undertaken to improve loan quality in late 2006 and early 2007 were designed to anticipate new credit risk concerns among New Century’s counterparties. Nonetheless, when New Century announced a need to recast its financial reports, there had not yet been a defection by any of its largest counterparties. Not surprisingly, defections ensued immediately after the announcement. In those circumstances, the bunching of defections probably signalled an absence of attention on the part of counterparties to the mounting risks of ongoing transactions with New Century. In turn, the evidence of ineffective counterparty risk management has led to concerns about the effectiveness of existing governance structures (corporate and regulatory) and, in particular, reputational capital as an incentive device. Can those structures now be relied on to discipline the risk-taking incentives of those involved in underwriting securities backed by subprime (and other risky) assets?

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