Irvine-based New Century Financial’s start was meteoric. By design. We charged out of the gate, raising venture capital in late 1995, making loans in early 1996, $1 billion subprime mortgages in our first 18 months. That burst supported our IPO in June 1997 and Ernst & Young named us Orange County Entrepreneurs of the Year in 1998.
It felt good to be on top.
The good times couldn’t last. A liquidity squeeze in the fall of 1998, triggered by jitters in international debt markets, brought that initial period of growth to an end.
New Century survived, but for the next few years we treaded water.
Everything changed after 9/11. The Federal Reserve lowered interest rates to stimulate the economy which created the conditions that led to the housing boom. And New Century introduced “FastQual,” the first automated underwriting engine for subprime loans.
Our growth exploded.
By 2006, New Century was originating $5 billion in subprime loans per month, making us the largest subprime lender in the world. From 2001 through early 2006 there were virtually no defaults on subprime loans. Between low interest rates and climbing housing prices, a borrower who ran into trouble paying their mortgage could refinance their loan or sell their house at a profit.
The voracious appetite of Wall Street to buy loans, very few defaults, and the intense competition to increase loan volume led lenders like New Century to fatally lower credit standards.
In 2006, the Federal Reserve began to increase interest rates. By Labor Day, Option One Mortgage Corp. in Irvine, another large subprime lender, announced a spike in defaults. It was the initial shot across the bow. Problems were building. I began an internal review process of our underwriting standards and loan performance, known as “Storm Watch.”
I was acutely concerned that loan-to-value ratios—a way of assessing the safety of a loan by comparing mortgage balances to the value of the house—had increased so significantly. If borrowers ran into trouble they no longer had the same equity available to refinance or sell their home at a profit to pay off the loan.
Our efforts in late 2006 to identify issues and tighten underwriting standards proved too little and too late.
In early 2007, New Century’s outside auditors declined to sign off on our 2006 financials. They demanded we change our methods of accounting for loan-loss reserves, and restate our prior earnings. New Century no longer had access to lines of credit we needed to operate. The company quickly unraveled.
New Century declared bankruptcy April 2, 2007.
The end was caused by accounting issues rather than loan performance. But even without these errors, New Century would never have been able to survive the tsunami of subprime defaults that was coming.
Right after New Century crashed, the ABX Index tanked. The ABX Index was the starting point for valuing subprime deals by Wall Street traders. Readers will recall a scene in “The Big Short” where news coverage of New Century’s fall bolsters the faith of the “shorts” that their big bet on the market failing is about to pay off.
Still, throughout 2007 and much of 2008, most political, business and economic leaders, including Federal Reserve Chairman Ben Bernanke, assured constituents that the “subprime contagion was contained,” and wouldn’t affect them or the broader economy.
They were wrong.
Subprime was declared the word of the year in 2007. The housing bubble burst, subprime defaults surged and one by one the subprime-focused lenders failed. Due to New Century’s public prominence, size, and well-known accounting errors, it became the poster child for all the problems of subprime practices. A wave of well-publicized lawsuits and investigations ensured the New Century name remained in the headlines throughout the crisis.
In retrospect, it seems obvious that housing prices wouldn’t keep rising forever, that credit standards deteriorated past the breaking point and that the loans were structured in a way that made borrowers extremely vulnerable to rising interest rates. We were caught up in the “irrational exuberance” of the housing bubble and the urging of Wall Street to keep loan volume flowing.
There’s plenty of blame to go around: subprime lenders, including New Century; governmental policies; loan brokers; the rating agencies and borrowers themselves, played key roles in the crisis.
In my opinion, however, the primary driver of the rise of subprime and the primary culprit of its meltdown was Wall Street.
Wall Street firms raised capital to fund the subprime lenders, and then lent the money used to buy subprime loans. They dictated the structure of the teaser-rate adjustable loans that subprime lenders used and then bought the loans lenders produced. After buying these loans, they created a maze of complicated securitization deals and credit default swaps that ultimately caused subprime losses to be much steeper than they otherwise would have been.
New Century and others arguably acted like addicted gamblers, but Wall Street built and operated the casino.
The collapse of housing prices struck at the heart of the most valuable asset owned by most ordinary Americans, the American Dream.
The crisis peaked in the fall of 2008 and it really did seem as if the world economy was teetering. The moment that most scared me was local. Watching on television as a classic run on the bank played out at Pasadena-based IndyMac made me wonder if all banks might be shut down and the financial system unravel entirely.
Through TARP and other programs that stimulated the economy, Bernanke crafted a softer landing. Credit standards surely slipped too far before the meltdown, and the term subprime remains so tainted that it can’t be used—but lending to people with less than perfect credit has its place and can be a sustainable business.
I am often asked if the subprime meltdown could happen again. I see little risk of a repeat of that particular crisis. But various forms of borrowing by governments, businesses and individuals have climbed to a point that is likely to lead to numerous defaults when interest rates begin to rise.
Booms and busts in the economy and financial markets will always exist, but it’s likely that the next crisis will look different than the last one.
Brad Morrice was CEO of New Century Financial from 1995 to 2007. He’s currently an angel investor as a member of Tech Coast Angels and provides consulting services.
