New York, NY – In a widely expected move, New Century Financial Corp., once the country’s second largest sub-prime mortgage lender, filed for Chapter 11 bankruptcy protection on Monday, April 2, 2007.
However, the developments at New Century are not merely the story of another high flying company that came crashing to the ground amid hard times and reports of financial shenanigans. Instead, the New Century bankruptcy, like the Enron and WorldCom debacles before, provides another example of the bias that still infects the research at many sell-side firms and the value that high quality independent or alternative research can provide investors.
The Background
New Century was formed in 1995 by Robert K. Cole, Edward Gotschall, and Brad Morrice after the trio raised close to $3 million in venture capital financing. The firm went public in 1997.
However, early on New Century suffered difficulties when defaults on Russian loans prompted many investors to steer clear of companies with risky loan portfolios. As a result, some sub-prime lenders went out of business. Fortunately, U.S. Bancorp bailed the firm out by investing $20 million into the company.
New Century was able to grow quickly by relying on mortgage brokers and a hot housing market to expand its loan originations from $6.3 billion in 2001 to $59.8 billion in 2006. However, the firm’s REIT structure forced the company to regularly raise capital in the public markets. Consequently, New Century became a lucrative Wall Street client as it spent more than $38 million in banking fees over the past nine years.
Unfortunately, in the summer of 2006 market conditions started to turn ugly for New Century as home sales started to flatten or fall and delinquencies on sub-prime mortgages started rising rapidly. Despite this, very few investors or analysts thought that New Century was in any serious difficulty – particularly given the firm’s ability to continually raise capital with Wall Street’s help.
Some Alternative Research Firms Warn of the Troubles
A few alternative research firms, however, did see the wheels coming off the New Century bus relatively early on. For example, in August of 2005, Scottsdale Arizona based research firm, Gradient Analytics, noticed that heavy insider selling of New Century’s shares were a sign that future prospects for the company were slowing.
In November 2006, CFRA, a Rockville Maryland based forensic accounting firm, raised concerns about New Century’s third-quarter earnings release. CFRA analyst Zach Gast explained that, for the first time, the company had combined two reserve categories, one for losses on defaulted loans and a second for losses on real estate that had been acquired through foreclosure.
The combination of these two loss categories enabled the company to show a small increase in reserves from a quarter earlier. However, Gast calculated that this move hid the fact the reserve for losses on bad loans had actually fallen 8.7% to $191.6 million.
CFRA’s Mr. Gast thought it should be concerning that New Century was lowering reserves at a time when defaults on sub-prime loans were rising. He estimated that if New Century had kept its loan loss reserves at levels equal to the level seen in the second quarter, the firm’s earnings per share would have been 50% lower than the $1.12 that had been reported.
Some Sell-Side Analysts Still Like What They See
Interestingly, a few sell-side analysts were not concerned about New Century’s financial struggles. In fact, as recently as a few months ago, analysts from both UBS and Bear Stearns were actually upgrading their recommendations on New Century.
For example, on February 22, 2007 UBS analyst Omotayo Okusanya upgraded New Century Financial to “neutral 2” suggesting that investors hold on to their shares. The UBS research report noted that the recent drop in New Century’s stock price had “improved NEW’s risk/reward profile”. This led the UBS analyst to upgrade the stock to “neutral 2” rating based on the fact that the company was severely undervalued.
On March 1, 2007 Bear Stearns analyst Scott R. Coren upgraded his rating on New Century Financial’s stock from “underperform” to “peer perform”. To be fair, Coren’s March 1st report was not entirely bullish as he said investors should “…stay on the sidelines for now until we are able to see a complete and restated set of financial statements and management opens up its communications lines again.”
Bear Stearns’ Coren also stated in this report that New Century’s stock “could rally” if management “has a sound strategy to stabilize the business and improve liquidity; and/or if pending earnings restatement proves to be less onerous than expected.”
Regulators Question Analyst Credibility
As a result of the timing of these two upgrades, Massachusetts’ Secretary of State, William Gavin, recently issued subpoenas to Bear Stearns and UBS as part of an investigation into whether these firms’ research analysts ignored New Century’s mounting financial problems.
Gavin’s investigation has resulted from his view that these investment banks’ rosy recommendations about New Century (even though the firm was experiencing obvious financial difficulties) could have been prompted by a desire to support the share price of an important customer.
Galvin contends that such a development could raise the question about whether these investment banks are complying with the terms of the 2003 Global Research Analyst Settlement. The Settlement was established specifically with the aim to eliminate the conflicts of interest that existed where sell-side analysts were motivated to intentionally overvalue the stocks they covered in the hope of getting those firms’ investment banking business.
Galvin said, “Recent revelations that research analysts issued positive reports on mortgage lenders to those with less than solid credit ratings even as those companies faced more and more defaults suggests that the commitment of 2003 has not been met.”
New Century Finally Crashes and Burns
Despite the rosy outlook held by UBS and Bear Stearns analysts, New Century recently announced that it had stopped making loans because too many creditors had cut off funding.
In addition, in a securities filing on March 2, New Century said that its audit committee had hired independent lawyers and forensic accountants to look into the company’s methods for valuing the “residuals” that it kept on its books. The company also has said it will need to correct errors in its accounting for losses on defaulted loans it has been forced to buy back from investors. These moves are expected to significantly reduce earnings for the first nine months of 2006.
Finally, last Monday, New Century management filed for Chapter 11 bankruptcy protection. The company’s first official move after having declared bankruptcy was to fire 3,200 workers – more than half of its work force.
New Century management also has explained that it intends to sell off its major assets. For example, the firm said it had agreed to sell its loan servicing business to Carrington Capital Management LLC and its affiliate for about $139 million, subject to the approval of the bankruptcy court.
CIT Group and Greenwich Capital Financial Products Inc. have agreed to provide up to $150 million in working capital to facilitate the reorganization process, the company said. New Century has also agreed to sell certain loans and residual interest in some trusts to Greenwich Capital for $50 million.
Unfortunately, the bankruptcy proceedings aren’t the only thing New Century has to worry about. The firm also faces federal probes by the SEC and the U.S. Justice Department regarding inappropriate accounting. In addition, angry shareholders have initiated several lawsuits alleging mismanagement by the company’s directors and officers.
Summary
As a result of the recent bankruptcy at New Century Financial, the good calls made by several alternative research firms, and the overly optimistic recommendations made by several investment banks, investors could jump to the conclusion that little has changed in the research business in the past five years.
On the one hand, it appears that several sell-side firms continue to issue biased stock recommendations that will meet with management approval based on the hope that they will be able to win lucrative investment banking business.
On the other hand, several alternative research firms have stuck their necks out by releasing unconventionally negative ratings on publicly traded companies that have eventually failed.
Consequently, one could argue that investors would be well suited to using alternative research as a way to warn them if a company’s prospects were suddenly turning sour.
Comment by Bill George:
If the inferences and implications in this article aren’t enough to convince you of the continuing very high potential for conflicts-of-interest in the research issued by full-service and investment banking brokerage firms’ “research analysts” you might also want to read an article published in the Wall Street Journal – March 29, 2007 – titled, How Street Hit Lender: How ‘Sub-Prime’ King New Century was Down but Not Out; Then, Banks Shut The Cash Spigot – by Gregory Zuckerman. It seems many of the same brokerage firms mentioned in the above ResearchWatch article, which were issuing positive research recommendations on New Century Financial, were also advancing working capital to New Century Financial, and at the same time packaging and underwriting CMO’s containing New Century Financial loans. (All of these activities would have produced fee income and relationship preferences for the brokerage firms)
After I read this Wall Street Journal article I kept thinking to myself, “I wonder what the ‘shorts’ looked like in the last few weeks before these brokerage firms cut-off their funding?”
To see the above referenced Wall Street Journal article go to the site.