Leverage Blackens a Blue Chip
New Century Financial Corp. has gained notoriety as the biggest blowup in the unfolding subprime mortgage debacle.
With hubris reminiscent of Enron, New Century came up with the corporate motto, “A New Shade of Blue Chip.” But this business wasn’t your parents’ or grandparents’ idea of “blue chip.” Blue chip normally refers to companies with priceless brands, dominant market positions, and/or rock-solid balance sheets.
New Century’s management and board must have viewed their business model as revolutionary and deserving of the “new shade” motto. Unfortunately for their shareholders, it more closely parallels Enron’s revolutionary “asset-lite” business model than that of a real blue chip.
New Century was involved in a market with few barriers to entry (writing loans — anybody with capital and experience can do this). And it was managed in a slipshod manner with the added pressure of a grossly overleveraged balance sheet.
To complicate things even further, a few years ago, New Century opted to transform itself into a tax-advantaged real estate investment trust (REIT), thereby committing most future earnings to dividend payouts. This took away management’s ability to conserve cash when business would inevitably worsen.
As I wrote in “Accounting Reflects Housing Market Reality,” New Century “has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.” On Feb. 15, the day this article was published, New Century stock closed at $18.78 per share. It has since been delisted from the NYSE. Several million shares per day now trade in the $1 per share range on the Pink Sheets.
In the Feb. 15 article, I wrote: “New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees (we’d hope) and are likely to balk at extending credit at the time New Century needs it the most.”
Within a few weeks, New Century needed credit to continue operations. But pleas for a financial lifeline were met with silence. Most recall what unfolded as soon as the Wall Street-sourced “liquidity” was shut off in early March:
The knockout blow arrived early this week as New Century filed Chapter 11 bankruptcy. The April 3 edition of The Wall Street Journal reported on the filing:
“New Century Financial Corp.’s bankruptcy court filing, announced yesterday, is the latest sign of a shakeout drastically shrinking the business of making home mortgage loans to people with weak personal finances.
“After weeks of courting buyers for its main lending operation, which reaches consumers through brokers, New Century filed for protection from creditors under Chapter 11 of U.S. bankruptcy law. The filing gives the Irvine, Calif., company time to try to sell the lending business. But that is likely to be difficult amid soaring defaults on subprime loans and a loss of confidence among investors who buy such mortgages.
“New Century recently negotiated with Bear Stearns Cos. about further financing, but those talks fell through, and New Century directors, faced with an inability to meet the payroll this week, decided Sunday to make the bankruptcy filing, said a person close to the matter. A Bear Stearns representative declined to comment.”
The Bear Stearns representative probably declined to comment because the firm upgraded the stock when it was trading in the $15 range on March 1, alleging New Century would be worth $10 or $11 per share even in a liquidation scenario. The WSJ article continues:
“New Century is slashing its work force by 3,200 jobs, or 54% of the total, as it seeks a buyer for the lending business. The company hopes it can make the business more appealing to suitors by cutting overhead costs…
“Most of New Century’s borrowings are short-term credits from such institutions as Morgan Stanley, Goldman Sachs Group Inc., and Barclays. Those credits are backed by mortgage loans, and the lenders have begun seizing that collateral and in some cases putting it up for sale.
“In a bankruptcy filing, such lenders are ‘in a very protected position’ and their losses ‘will be quite minor…assuming the collateral has decent value,’ [emphasis added] said Ronald Greenspan, a senior managing director with FTI Consulting Inc., Annapolis, Md., which is acting as financial adviser to unsecured creditors in three subprime bankruptcies.”
Describing the value of New Century’s collateral — a portfolio of subprime mortgages — as “decent” is quite a euphemism. “Decent” is in the eye of the beholder. While the collateral is very difficult to value, it certainly has some value — perhaps a bit more than creditors’ claims. That’s why a few bold speculators are still trading New Century stock. They believe the collateral’s value exceeds the claims of creditors by more than $1 per share. But if they really appreciate New Century’s reckless lending practices, these speculators shouldn’t be surprised if the stock goes to $0.
Corporate Autopsy Reveals Red Flags
Let’s skim New Century’s latest available financial statements for hints of a potential corporate blowup. Corporate autopsies can help investors avoid situations like this in the future.
The first clue lies at the heart of New Century’s business: a snazzy automated credit-grading model hyped as a competitive advantage. New Century’s latest 10-K explains what it calls an “automated credit grading capability. We have created a proprietary automated credit grading and pricing methodology that we believe gives us the ability to more effectively evaluate credit risk and more efficiently price our products, as validated by our historical loan performance.”
Unfortunately, these types of mathematical models are used widely on Wall Street and are only as good as the assumptions that go into them. A model built upon the history of the last 20 years of U.S. housing and employment markets will not function smoothly through the uncertainty of the next 20.
For example, what if a borrower’s income looks good because he is a realtor whose income was inflated by a few years of red-hot home sales? How can a model capture the effect of a housing market downturn on this borrower’s personal balance sheet and income statement? Yet this type of model prompted New Century to write the toxic loans that were “held for sale” (to fixed-income investors) and “held for investment (“speculation” is a more appropriate word than “investment”). Here’s an abridged version of the balance sheet as of September 2006:
The returns from successfully navigating the high-risk mortgage market are high as long as the positive of receiving high interest rates in an inflating housing environment more than offsets the negative of high default rates. But these returns apparently weren’t high enough. Management clearly wanted to “juice” shareholder returns by employing tons of leverage.
You can see that New Century management was in a position where they were controlling $25 billion worth of assets with a $2 billion sliver of equity. There’s very little margin for error when using this degree of financial leverage.
If business is humming along nicely, the returns for shareholders can be huge. But if New Century’s assets were to fall just 8% in value, bankruptcy would become likely unless a new investor provided “loan shark” financing or offers to refinance its entire balance sheet (hypothetically, New Century could outright admit an 8% hit to assets by taking an “impairment charge,” but the market has already anticipated it by severely punishing its stock).
Leverage was the key ingredient that set New Century up to fail. The growing number and size of “early payment defaults” — described in my Feb. 15 article — merely pushed the company over the edge of insolvency. Early payment defaults triggered an off-balance sheet liability that hardly anyone was thinking about as recently as January.
The real tragedy lies in the fact that a syndicate of banks was foolish enough to lend New Century $13.8 billion to speculate on high-risk mortgages in the first place. It’s yet another credit bubble symptom.
The balance sheet also shows that banks and Wall Street brokerages provided an extra $8.5 billion worth of short-term financing to New Century in order to facilitate the “origination” business. Firms like Bear Stearns did this so they could be first in line to slice and dice toxic waste subprime mortgages into collateralized debt obligations (CDOs). Institutions were hungry for CDOs up until about a month ago, so Wall Street made a killing as a middleman.
For a thorough yet entertaining primer on CDOs, I direct you to Bill Bonner’s piece “Loans From Hell” in The Daily Reckoning archives. Bill neatly puts to rest the idea that “a new shade of blue chip” appropriately describes highly engineered securities. New Century was an incredibly complex business that set itself up to be one hiccup away from bankruptcy. In most cases, avoiding stock in leveraged, complex business will serve you well.
Dan Amoss, CFA
April 5, 2007