Question 1
New Century Financial Corp., formed in 1995, was a large mortgage lender in the United States. Many of these mortgages were securitized and transferred to investors. New Century accounted for the proceeds of these securitizations as sales. However, New Century committed to buy back mortgages that became troubled within up to a year after transfer.
New Century would retain some mortgages for itself (called retained interests), from which it would receive future cash flows. Also, the transfer agreements included the right to service the mortgages, for which New Century charged a fee. New Century valued these retained interests and servicing rights at current value, based on their discounted expected future cash flows. Thus, revenue from retained interests was recognized at the time of retention, and servicing revenue was recognized at the time of mortgage transfer. These policies required numerous estimates, as compared to a more conservative policy of recognizing revenues as cash flows (when retained interests were received and when servicing responsibilities were rendered).
The company's share price increased dramatically, to a high of US$64 in 2004. Its reported net income reached $1.4 billion in 2005.
However, New Century seriously underestimated the extent of its mortgage buybacks and resulting credit losses. Of $40 billion of mortgages granted in the first three quarters of 2006, it provided only $13.9 million for buybacks. Investor concerns about increasing buybacks rose in 2006 as the 2007-2008 market meltdowns approached. These buyback concerns added to concerns about early revenue recognition from retained interests and servicing. Also, the company failed to write down its retained interests as the current value of the underlying mortgages decreased.
New Century was soon unable to borrow money to finance mortgage buybacks. Its shares lost 90% of their value, and the company was delisted from the New York Stock Exchange. In April 2007, it filed for bankruptcy protection.
New Century's auditor (KPMG) was drawn into the lawsuits that followed. KPMG denied liability, claiming that the provisions for buybacks were deemed adequate at the time and blaming New Century's failure on the market meltdowns of 2007-2008. In December 2009, the SEC filed civil fraud charges against three former executives of New Century, seeking damages and return of bonuses. Several other lawsuits followed. In November 2010, financial media reported final settlement of a class action lawsuit that included a payment of over $65 million by former company officers and directors, and a payment of $44.75 million by auditor KPMG.
Required:
1. Use the concept of relevance to defend New Century's policy of recognizing revenue as it securitized and sold mortgages. What was the policy's major weakness?
2. Outline a more conservative accounting policy for New Century's mortgage sale transactions. Consider both statement of financial position and net income effects of your policy. (Hint: Read Theory in Practice 8.3, textbook, p. 314.)
3. Use two characteristics of investor behaviour based on psychology to explain the rapid rise in New Century's share price. Be sure to identify the specific behavioural characteristics you draw on in your answer.
4. Despite your answer in part (c), is the rapid rise in New Century's share price necessarily inconsistent with (semi-strong) securities market efficiency? Explain.
5. Note that retained interests meet the definition of a financial instrument. How would these financial instruments be accounted for under IAS 39?