Ncf Case Study

I. What Primary business risks did NFC face?

New Century Financial Corporation was a company which had experienced rapid periods of growth, which made their primary goal to continue at a similar growth rate by selling more and more mortgages. This aggressive manner, however, led to the company making loans at such disastrous levels that it ultimately led to the company's failure. In a mindset to increase sales and profits, New Century Financial Corporation disregarded apparent business risks. As stated by the examiner's report, these primary business risks are as follows:

1. Credit risk involving mortgage loan borrowers

* "Our inability to realize cash proceeds from mortgage loan sales and securitizations in excess of the loan acquisition cost could harm our financial position" (NCF 2005 10K) NCF's adjustable rate mortgages were exposed to greater borrower default risk. It is assumed that since monthly payments on adjustable rate mortgage were a high fraction of borrowers' income, increase in interest rate would make the loans unaffordable to them. Thus, the borrowers had two options; to refinance their mortgage with a loan at a lower interest and use capital gains on lower interest rates, or to default on the mortgage in case real estate market does not provide any capital gain to lower interest payments. Nevertheless, New Century Financial was able to delay the negative impact of the increased rate on its adjustable rate mortgages for one year by issuing hybrid adjustable rate mortgages, which came with a two-year of payments based on the fixed interest rate.

2. Market risk involving changes in interest rates, housing values, warehouse lenders' willingness to finance New Century's mortgage lending operations, and secondary market investors' appetites for whole loan sales and securitization offered by the Corporation

* In 2006, baseline interest rates increased from 1.5% to more than 5%. As a result, the company's assets became riskier and more prone to financial distress. Increased exposure of New Century Financial Corporation's assets to the risks endangered NCF assets to the effects of real price decreases. NCF had issued many loans on a fixed interest rate, but had financed its investments and inventories using a variable rate debt, which had a vast effect on NCF's assets when interest rates increased. It was estimated that the hike in interest rate and, thus, in current risk-free rate, dropped the value of the NCF's assets by approximately 11.3%. Since short-term debt was little affected, the direct effect of monetary policy was reduced equity and increased debt-to-equity ratio of NCF by roughly 30% from 6.5 to 8.5.

* In their 2004 10K filing, acknowledged that interest income to interest expense ratio had dropped dramatically from 3.02 in 2003 to 2.45 in 2004, and 1.78 in 2005. Despite that NCF attempted to