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| Federal prosecutors and securities regulators investigating stock sales and accounting errors. |
For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges. But, he says, that was nothing compared with the private jets that executives at other companies had.
“You just lost touch with reality after a while because that’s just how people were living,” said Mr. Elsayed, 42, who spent nine years at New Century before leaving to start his own mortgage firm in 2005. “We made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up.”
Just as the technology boom of the late 1990s turned twenty-something programmers into dot-com billionaires, and leveraged buyouts a decade earlier turned Wall Street bankers into Masters of the Universe, the explosive growth in subprime lending turned mortgage bankers and brokers into multimillionaires seemingly overnight.
Now an escalating crisis in the market, which seemed to reach a new crescendo late last week, is threatening a wide band of people. Foremost are the poor and minority homeowners who used easy credit to buy houses that are turning out to be too expensive for them now that mortgage rates are going up, but the pain is also being felt widely throughout the business world.
Large companies that bought subprime lenders during the boom, like H&R Block and HSBC, are now scrambling to sell them or scale back their exposure. Many investors are also likely to suffer: Wall Street firms made billions in fees, commissions and trading revenue from packaging and selling subprime mortgages to them as bonds.
New Century has emerged as a poster child for the lenders that rode that boom to the top and are now in free fall. The company disclosed on Friday that federal prosecutors and securities regulators were investigating stock sales and accounting errors. The latter could jeopardize billions of dollars in financing for the company, which issued $39.4 billion in subprime loans in the first nine months of last year.
Weakening home prices and rising default rates have rocked the subprime business. But for those who cashed out before the market turned, the ride up was particularly sweet. The three founders of New Century, for example, together made more than $40.5 million in profits from selling shares in the company from 2004 to 2006, according to an analysis by Thomson Financial. They collected millions of dollars more in dividends, salaries, bonuses and perks.
The company said in a statement yesterday that the founders were “still significant shareholders,” noting that they collectively owned about 7 percent of the company at the end of last year.
New Century’s stock price, which seemed to mirror the trajectory of the subprime business, peaked at nearly $66 a share in December of 2004 and traded in the $40s most of last year; on Friday, it was trading at $11 a share after the market closed. In a series of sales from August to November, two of the company’s founders sold shares for an average price of about $40 a share, for a total profit of $21.4 million.
It is not known whether the stock sales by the founders are among the sales being examined by federal investigators. Some of them had been part of scheduled stock sales that are often used by executives to diversify their portfolios. But some of the sales occurred on the same day that the executives entered the plans. A New Century spokeswoman, Laura Oberhelman, said that executives declined further comment.
The founders’ stock also rose in the social circles of southern California, the epicenter of the boom in subprime. Five of the 10 biggest providers of subprime mortgages last year had their headquarters in the region.
Robert K. Cole, 60, a co-founder who retired as chairman and chief executive last year, lives in a 6,100-square-foot oceanfront home in Laguna Beach that is valued at tens of millions of dollars and was once owned by the chief executive of Pimco Advisors, the giant bond trading and management firm. Edward F. Gotschall, 52, another co-founder who is vice chairman of the board, donated $3 million for an expanded trauma center at Mission Hospital that will be named for him and his wife Susan.
The executives from New Century are by no means alone in cashing in on the bonanza, and they do not appear to have scored the biggest profits. That title may be claimed by Angelo R. Mozilo, the chief executive of Countrywide Financial, the nation’s largest stand-alone mortgage company and one of the largest subprime lenders last year. He reaped more than $270 million in profits from sales of stock and the exercise of stock options from 2004 to the start of this year, according to the Thompson analysis.
Of course, most of the 500,000 people who work in the mortgage industry did not cash in so grandly. The wealth was concentrated among executives, loan officers and brokers, because the greatest rewards were meted out in the form of commissions, bonuses and stock awards.
“In the hot times, it was not unusual to see a broker make a million bucks,” said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication. “You can carry that up further to people who ran the companies. The whole business revolves around personal compensation.”
The hot times are clearly over.
New Century’s disclosure of the federal investigations on Friday was the most serious in a string of shocks to have rocked the industry in the last three months.
A handful of lenders have sought bankruptcy protection, several have been acquired and a few have been shut down. Also on Friday, Fremont General, a top-five lender, said it planned to leave the business.
Industry officials say they are seeing an exodus of executives and salespeople as companies fold, cut jobs and push out early leaders.
“Everyone has run for the hills,” said William D. Dallas, whose company, Ownit Mortgage, filed for bankruptcy protection in December after it lost financing from Merrill Lynch and other banks.
For the borrowers of these mortgages, it may become more difficult to refinance if lending standards are tightened significantly. Many are already facing the prospect of payment shock when low, fixed-interest mortgage rates adjust to higher, variable rates.
On Wall Street, big investment banks could lose a significant source of revenue if the appetite for bonds backed by mortgages dries up.
In the last two years many skeptics began warning that the red-hot housing market and adjustable-rate loans would blend into a toxic brew. Last year, subprime loans totaled $600 billion, or about 20 percent of all mortgages, up from $120 billion and 5 percent in 2001, according to Inside Mortgage Finance. More than half of subprime loans have adjustable rates.
Many of the problems that have surfaced thus far are not tied to the resetting of rates. Rather, they stem from a sharp and early spike in the default rates among loans issued last year.
For example, about 13.8 percent of the loans in a group of mortgages New Century sold to investors in April were behind in payments or in foreclosure by January. By comparison, only 6 percent of loans in a pool sold to investors in March 2005 had met that same fate by January 2006.
Investors and regulators fear that the problems will only worsen as so many borrowers have fallen behind so quickly, especially at a time when the overall economy is healthy. The phenomenon suggests that lending standards were significantly weakened last year and that lenders were not as watchful for fraudulent transactions.
For New Century, the early payment defaults pose significant financial problems. In the first nine months of last year, Wall Street banks and investors that it does business with forced it to buy back $469 million in loans it had sold to them, up from $240 million for the same period in 2005.
The company was able to sell back about half of those loans at a discount of 26.5 percent. How it handled the remainder — about $227 million — is now under scrutiny. According to accounting rules the company should have valued the loans on its books for what they were worth today, not their previous face value. But it did not.
If it had, the company would have seen its earnings fall by about $60 million before taxes, wiping out most of its profit in the third quarter, according to Zach Gast, an analyst at the Center for Financial Research and Analysis, a forensic accounting firm.
This is important, because the company’s financing agreements require that it not lose money for any rolling six-month period. On Friday, New Century said it did not expect to make a profit in the six months that ended in December and that it was negotiating with lenders to waive the requirement but has only secured six of 11 waivers it needs.
“They had losses sitting on their balance sheets,” Mr. Gast said.
In August, the company’s chief financial officer, Patti M. Dodge, announced she was stepping down from her post to oversee investor relations, a department that typically reports to the chief financial officer. Taj S. Bindra, a former executive at Washington Mutual, replaced her in November.
For the second time in a decade, New Century finds itself fighting to survive. The firm’s roots were planted at Plaza Home Mortgage Bank where the three founders of New Century — Mr. Cole, a longtime mortgage executive; Mr. Gotschall; and a lawyer named Bradley A. Morrice — worked together. The three formed New Century in 1995 after Plaza was sold to Fleet Mortgage Group, now a part of Washington Mutual.
In the late 1990s, New Century narrowly survived accounting concerns and a scare in the bond market after Russia’ s default in 1998. It pulled through thanks to an investment by U.S. Bancorp, a bank based in Minneapolis.
With interest rates at historic lows, it quickly grabbed a big share of the fast-growing subprime market during the housing boom.
“They walked into a niche industry at a time when everything was lining up perfectly for what they did,” said W. Scott Simon, a managing director at Pimco Advisors. “In 2001, 2002 and 2003 the subprime business was just phenomenally profitable. Home prices kept appreciating and it seemed that no loans ever went bad.”
