The limits of having skin in the game

The SEC’s charges against three former New Century executives are a reminder that, for all of its faults, the subprime lender had plenty of “skin in the game.”

The case undermines the oversimplified -- and overstated -- notion that lenders who sell their production have no stake in the performance of the loans. New Century knew it was on the hook to buy back loans it had sold that defaulted quickly -- the SEC's charge is that the company failed to make clear how big a liability that was.

The agency alleges in its complaint that, “In the face of dramatically increasing loan repurchases and repurchase requests, [former controller David N.] Kenneally, with [former CFO Patti M.] Dodge’s knowledge, changed in both the second and third quarters of 2006 New Century’s repurchase reserve accounting to reduce the reserve provision (or expense).”

The complaint says these undisclosed accounting changes violated GAAP and resulted in New Century “improperly avoiding substantial expenses, understating its repurchase reserve, and materially overstating its financial results.”

In other words, New Century had more skin in the game than the executives cared to admit.

During the boom years, lenders kept stakes in loans both by promising to buy back loans if a default occurred and underwriting errors or fraud were discovered and by holding on to the lower-rated pieces of their securitizations (though these were often later resecuritized through another now-tainted structure, the collateralized debt obligation).

And plenty of lenders -- Countrywide, Washington Mutual, and IndyMac, to name a few -- kept some loans on their balance sheets.

None of this provided enough incentive to hinder disastrous lending practices.

New Century’s arrangements with investors were typical. According to the SEC’s complaint, it “sold whole loans pursuant to purchase agreements in which the Company provided customary representations and warranties regarding its loan characteristics and origination process.  New Century could be required to repurchase or substitute loans in the event of a breach of those representations and warranties.”

In addition, New Century “generally committed to repurchase or substitute a loan if a payment default occurred within the first month or two following the date the loan is sold.”

Dodge's legal counsel, Terry Bird of Bird, Marella, Boxer, Wolpert, Nessim, Drooks & Lincenberg, PC, said the former executive plans to contest the SEC's allegations. "We believe the evidence will show that Mrs. Dodge fully and completely fulfilled all her fiduciary and corporate obligations to New Century and its shareholders," he said in an emailed statement. 

Counsel for Kenneally could not be reached. Counsel for former New Century CEO Brad A. Morrice, the third person named in the complaint, did not return a phone call.

Say what you will about New Century, the company certainly had a financial interest in seeing its loans perform well -- even if, as the bankruptcy examiner's report last year concluded, its managers were more interested in maximizing volume.

BankThink is a collective byline used by American Banker editors to make observations and weigh in on big ideas shaping the industry.