Finanacial Fantasy Land

After watching in disbelief how long the sub-prime ponzi scheme continued to receive the support of regulators, creditors and investors. It's amazing how rapidly New Century's house of cards has come crashing down. All at once:
Regulators are seeking to stop New Century from performing their primary business.
Creditors are considering cutting off short term credit to the company.
Stock Market Investors are beating the crap out of the stock.
Mortgage Backed Security Investors are beating the crap out of their securitizations.

I seriously doubt NEW will survive this attack from all sides. Just as Enron and World Com crumbled when creditors pulled the plug, so too (I expect) will New Century.

Here's a post I made to the Mish board on the Motley Fool on 2/3/05 about New Century.
If you are a Fool member, the link is: http://boards.fool.com/Message.asp?mid=22012317&sort=whole#22020551

Financial Fantasy Land

I listened to the New Century Financial conference call today, and I'm convinced the executives of that company are from another planet. I think most of the analysts who called in would agree with me. They seem to be from a fantasy world where financial results according to GAAP are all that matters, and to the extent they can manipulate earnings, they are able to manipulate the truth.

When the call started, the stock was already down about 3.7%, having missed their estimates for the first time in ages. As the call went on and one amazing revelation after another came out, the stock kept dropping and now is down about 10%. Among the things that were revealed:

1. They borrow $1 Billion for 1 day every quarter so that they can show that Cash on their balance sheet.

The Billion dollars they borrow for a day is to help them "explain" their financial situation better. If they didn't borrow that money, then people might be confused and think they didn't have that much cash. As we all know, the amount of cash you own is of course equal to the amount of money people are willing to loan you. We should thank them for simplifying their accounting for us by borrowing money they don't really need right now and putting it where we can see it on their balance sheet.


2. They sell mortgages to themselves because they can report higher gains on the sales than if they sold them on the open market.

They were especially proud of becoming a REIT and all the imaginary benefits that bestowed on their results. While selling mortgages from their lending unit to their REIT unit resulted in nice gains on their income statement, the gains weren't taxable because they weren't real. Talk about the best of both worlds!


3. They aren't assuming any losses on certain portions of their loan portfolios now because most defaults occur later in the life of the loans.

The business of profiting from making bad loans depends on lending more money each and every quarter. People don't usually buy homes if they are already in deep financial trouble. It takes them awhile to get in trouble, so new loans rarely default. Therefore, new loans don't need to allow for losses because losses won't happen until the future. Since there's no guarantee there will even be a future, what's the point in allowing for such losses anyway?


4. They lowered their assumptions of future defaults which boosted earnings by 8 cents per share, and they now think $90 Million is enough reserves for future defaults on $19 Billion worth of loans.

Sure, some of their loans are delinquent, and while its nice to report late fees on these loans as profits, some allowance should probably be made for the remote possibility that there is a tiny inkling of a chance that they might lose money on these a minute faction of these loans, so it wouldn't do too much harm if they reserved a little bit of money for these loans when earnings are good. If they ever have a need, they can lower their assumptions to inflate their earnings, like they did this quarter.

What's that? All you banking analysts don't think they're setting aside enough reserves? By an order of magnitude? Well, let me assure you that their experience during the last 8 years (the greatest housing boom, HELOC expansion and cash out refinancing surge of all time) indicates that loans almost never go bad. All they have to do is rely on past results to indicate what will happen forever into the future. So obviously you are all wrong!


5. They believe that their customers can handle a 34% increase in mortgage fees on their ARMS.

20% of their loans over the past 2 quarters have been interest only, so obviously their customers understand interest. Besides, they have a lot of customers who actually have decent credit ratings. These types of people know how to budget and plan for the future.


6. They believe that housing prices can't go down by 10% and even if they do, their customers won't walk away from loans.

It's never happened before on a national level, and they say that all the talk about a housing bubble is dying down. Besides, they aren't making any more land and housing prices always go up. Plus, once customers learn to account like New Century, nobody will ever have to lose money again!


7. The compression of margins is temporary.

As rising short term rates crashed head long into falling 10-year bond rates, and as increasing competitiveness among mortgage lenders crashed head long into declining demand, margins were squeezed. But relax, this is temporary. It will only last until the weak links are squeezed out of the market. NEW tried to "lead the way" by raising rates higher, but their competitors didn't follow. When they lowered rates back down again, their competitors lowered rates further. Even though demand for loans is still slowing, and the lenders all depend on increasing originations to avoid blowing up their business models, the pressure on margins must decrease!


8. They can hedge away the risk of rising interest rates.

They buy derivatives that pay off if interest rates rise. If rates rise slowly over time, they get clobbered like CFC did. If rates rise rapidly they get to report a nice short term gain, then buy new derivatives at higher prices. If interest rates rise so quickly that their counterparties can't make their payments, then the housing market is doomed anyway, so there's no point in worrying about that single aspect of a meltdown.


In a sense, the views of the NEW executives typifies what is wrong with our entire financial system. Risk has been imagined away, and the resulting imaginary profits are taken as reality. Level upon level of creditors has leveraged themselves into the false reality that will one day come crashing down. We have:

1. Interest rates at suppressed levels because the Fed has injected record amounts of liquidity and foreign central banks have bought treasuries disproportionately to keep their currencies week, while propping up a US Government that is bound for bankruptcy.

2. We have homeowners borrowing more than they can afford at these temporarily reduced adjustable rates who are bound to default once rising payments and their inability to borrow new funds push them past the breaking point.

3. We have crazed mortgage lenders like NEW, CFC, IFC, NFI and others making bad loans at an accelerating rates to stave off the inevitable.

4. We have mutual and pension funds throwing other people's money at the crazed lenders to purchase exploding corporate bonds.

5. We have hedge funds selling derivatives to soak up interest rate risk in search of short term profits and higher NAV based fees.

In short, we have one domino after the next, all lined up ready to topple once the kindness of foreign governments runs out and the unsustainability of our twin deficits comes home to roost and the fantasy world we live in is exposed.

New Century Criminal Probe & Fantasy Land CC
http://globaleconomicanalysis.blogspot.com/2007/03/new-century-criminal-probe-fantasy-land.html

Thanks RR

Mish, You should make clear in your blog that my post was from over 2 years ago. We all saw this collapse coming long ago, when much of the damage could have been prevented, and analysts, regulators, investors and creditors should have seen it too. Why didn't they pull the plug two years ago is the real question. The answer has something to do with greed. Rodg

Also, Mike Klein had these comments to add two years ago:

I took the time to listen to the call myself tonight. I'll just add a little to Rodger's excellent comments.

Clearly the impression they want to give is that everything is about growth, growth, growth. Not one single concrete warning about potential downsides, even while starting off the conference call summarizing the competitive environment as challenging with both rising interest rates and increased competition. But they can grow, improve their operations, sign up more loan officers, get higher productivity, continue to increase borrower quality. The only half-way acknowledgements of possible problems were when pressed really hard by analyst questions (who were actually very polite but they were clearly unhappy with the depth of answers). Every last risk brought up by analysts was waved off with something New Century could do better than the competition, or that just didn't matter because the analyst must have interpreted their data wrong.

Numerous analysts tried to ask how New Century would achieve their guidance given that margins had recently suffered and the conditions causing that were not improving, in fact may get worse. For questions like this, they handed the mic over to Patti Dodge the CFO who went into such mind-numbing incomprehensible detail that analysts, in every case, just responded with "Uh... thanks." It didn't help that the company's structure is incredibly complex with a REIT subsidiary and many other things I can't begin to comprehend (you just have got to see the company description in the 10-Qs and 8-Ks to get a flavor of this).

On the whole, not being that familiar with the industry, I thought at the time the presenteres did a pretty good job. They had answers for everything and were consistent. But after letting it sink in for a few hours, the consistent focus on absolutely certain growth in the face of the fully admitted challenging environment of the next year was just bizarre, even without understanding half the terms used. At least half a dozen analysts tried to pry more out of them and they didn't give an inch. Everything would work out fine.

I did not get the impression that these people are crooks. I think they are simply on drugs. They appear to believe what they say.

Now, there was one other funny thing. After the conference call ended the mic was still on for a few seconds. The CEO can be heard saying "Despite being down 5 bucks, my compliments..." and then some laughing. They must have been watching the stock price.

It's unclear when this thing blows up, but I am now totally certain it will. Whether crooks or just stupid, I am certain this management will drive NEW into the ground.

Oh BTW, did anyone notice that the CEO is the Co-Chairman of the Compensation Committee?

-Mike (Klein, not Mish)

Addendum:
Rodger Rafter asked me to make it clear that what he stated we knew over two years ago. In editing down his comments I inadvertently took out that explanation. For those with access to the Motley Fool here is the complete thread on New Century posted on my board on the Fool on 2/3/2005. Rodger Rafter's comments today... "We all saw this collapse coming long ago, when much of the damage could have been prevented, and analysts, regulators, investors and creditors should have seen it too. Why didn't they pull the plug two years ago is the real question. The answer has something to do with greed." Here is an additional post from the thread on The Market Traders made today, showing our thinking at the time.

The 2007/02/07 New Century Finance conference call is also quite interesting. This quote sums it up nicely: "The company expects that the errors leading to restatements constitute material weakness in its internal control over financial reporting for the year ended December 31, 2006. "

Is that "material weakness" or purposeful securities fraud?

LawersAndSettlements.Com has these comments on New Century Finance Securities fraud.

New Century and certain of its officers and directors are charged with issuing a series of materially false and misleading statements in violation of Section 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder. Particularly, late on February 7, 2007, New Century announced that it will have to restate its consolidated financial results for the first three quarters of 2006 to correct errors the Company discovered in its application of generally accepted accounting principles regarding the Company's allowance for loan repurchase losses.

Bear markets (and subprime lending is surely in one) expose all sorts of frauds and schemes for what they are. No one cared as long as share price was rising. Now that share price has completely collapsed and subprime lenders are imploding everywhere, lawsuits have started. Numerous people are likely to end up in jail over this.

There is no doubt that there will be some pain that will be incurred.  Lessons are being learned every day as foolish behaviors are being punished.  But your doomsday scenario RR - it just ain't gonna happen.

By the way, say "hi" to Chicken Little for me. -35offsuit

 

http://www.gold-eagle.com/editorials_01/seymour062001.html

1927-1933 Chart of Pompous Prognosticators

Chart locations are an approximate indication only

 

1. "We will not have any more crashes in our time."
   - John Maynard Keynes in 1927

    

2. "I cannot help but raise a dissenting voice to statements that we are living in a fool's paradise, and that prosperity in this country must necessarily diminish and recede in the near future."
   - E. H. H. Simmons, President, New York Stock Exchange, January 12, 1928

   "There will be no interruption of our permanent prosperity."
   - Myron E. Forbes, President, Pierce Arrow Motor Car Co., January 12, 1928

    

3. "No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. In the domestic field there is tranquility and contentment...and the highest record of years of prosperity. In the foreign field there is peace, the goodwill which comes from mutual understanding."
   - Calvin Coolidge December 4, 1928

    

4. "There may be a recession in stock prices, but not anything in the nature of a crash."
   - Irving Fisher, leading U.S. economist , New York Times, Sept. 5, 1929

    

5. "Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months."
   - Irving Fisher, Ph.D. in economics, Oct. 17, 1929

   "This crash is not going to have much effect on business."
   - Arthur Reynolds, Chairman of Continental Illinois Bank of Chicago, October 24, 1929

   "There will be no repetition of the break of yesterday... I have no fear of another comparable decline."
   - Arthur W. Loasby (President of the Equitable Trust Company), quoted in NYT, Friday, October 25, 1929

   "We feel that fundamentally Wall Street is sound, and that for people who can afford to pay for them outright, good stocks are cheap at these prices."
   - Goodbody and Company market-letter quoted in The New York Times, Friday, October 25, 1929

    

6. "This is the time to buy stocks. This is the time to recall the words of the late J. P. Morgan... that any man who is bearish on America will go broke. Within a few days there is likely to be a bear panic rather than a bull panic. Many of the low prices as a result of this hysterical selling are not likely to be reached again in many years."
   - R. W. McNeel, market analyst, as quoted in the New York Herald Tribune, October 30, 1929

   "Buying of sound, seasoned issues now will not be regretted"
   - E. A. Pearce market letter quoted in the New York Herald Tribune, October 30, 1929

   "Some pretty intelligent people are now buying stocks... Unless we are to have a panic -- which no one seriously believes, stocks have hit bottom."
   - R. W. McNeal, financial analyst in October 1929

    

7. "The decline is in paper values, not in tangible goods and services...America is now in the eighth year of prosperity as commercially defined. The former great periods of prosperity in America averaged eleven years. On this basis we now have three more years to go before the tailspin."
   - Stuart Chase (American economist and author), NY Herald Tribune, November 1, 1929

   "Hysteria has now disappeared from Wall Street."
   - The Times of London, November 2, 1929

   "The Wall Street crash doesn't mean that there will be any general or serious business depression... For six years American business has been diverting a substantial part of its attention, its energies and its resources on the speculative game... Now that irrelevant, alien and hazardous adventure is over. Business has come home again, back to its job, providentially unscathed, sound in wind and limb, financially stronger than ever before."
   - Business Week, November 2, 1929

   "...despite its severity, we believe that the slump in stock prices will prove an intermediate movement and not the precursor of a business depression such as would entail prolonged further liquidation..."
   - Harvard Economic Society (HES), November 2, 1929

    

8. "... a serious depression seems improbable; [we expect] recovery of business next spring, with further improvement in the fall."
   - HES, November 10, 1929

   "The end of the decline of the Stock Market will probably not be long, only a few more days at most."
   - Irving Fisher, Professor of Economics at Yale University, November 14, 1929

   "In most of the cities and towns of this country, this Wall Street panic will have no effect."
   - Paul Block (President of the Block newspaper chain), editorial, November 15, 1929

   "Financial storm definitely passed."
   - Bernard Baruch, cablegram to Winston Churchill, November 15, 1929

    

9. "I see nothing in the present situation that is either menacing or warrants pessimism... I have every confidence that there will be a revival of activity in the spring, and that during this coming year the country will make steady progress."
   - Andrew W. Mellon, U.S. Secretary of the Treasury December 31, 1929

   "I am convinced that through these measures we have reestablished confidence."
   - Herbert Hoover, December 1929

   "[1930 will be] a splendid employment year."
   - U.S. Dept. of Labor, New Year's Forecast, December 1929

    

10. "For the immediate future, at least, the outlook (stocks) is bright."
    - Irving Fisher, Ph.D. in Economics, in early 1930

     

11. "...there are indications that the severest phase of the recession is over..."
    - Harvard Economic Society (HES) Jan 18, 1930

     

12. "There is nothing in the situation to be disturbed about."
    - Secretary of the Treasury Andrew Mellon, Feb 1930

     

13. "The spring of 1930 marks the end of a period of grave concern...American business is steadily coming back to a normal level of prosperity."
    - Julius Barnes, head of Hoover's National Business Survey Conference, Mar 16, 1930

    "... the outlook continues favorable..."
    - HES Mar 29, 1930

     

14. "... the outlook is favorable..."
    - HES Apr 19, 1930

     

15. "While the crash only took place six months ago, I am convinced we have now passed through the worst -- and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger, too, is safely behind us."
    - Herbert Hoover, President of the United States, May 1, 1930

    "...by May or June the spring recovery forecast in our letters of last December and November should clearly be apparent..."
    - HES May 17, 1930

    "Gentleman, you have come sixty days too late. The depression is over."
    - Herbert Hoover, responding to a delegation requesting a public works program to help speed the recovery, June 1930

     

16. "... irregular and conflicting movements of business should soon give way to a sustained recovery..."
    - HES June 28, 1930

     

17. "... the present depression has about spent its force..."
    - HES, Aug 30, 1930

     

18. "We are now near the end of the declining phase of the depression."
    - HES Nov 15, 1930

     

19. "Stabilization at [present] levels is clearly possible."
    - HES Oct 31, 1931

     

20. "All safe deposit boxes in banks or financial institutions have been sealed... and may only be opened in the presence of an agent of the I.R.S."
    - President F.D. Roosevelt, 1933

Colin J. Seymour, June 2001
http://www.users.dircon.co.uk/~netking
20 June 2001

Thought RR would like to know...

Someone linked to this thread on Ask Fleck. Fleck's reply:

<<That was a great post by whoever did that...loved his conclusion...sad to say.>>