Orange County Business Journal
By Jessica C. Lee
April 7, 2008

A recently unsealed bankruptcy court report on accounting issues at Irvine’s
New Century Financial Corp. could become part of a criminal probe into the
bankrupt subprime mortgage lender.

In the report, court-appointed examiner Michael Missal blamed New Century’s
senior management and auditor KPMG LLC for creating a “ticking time bomb” of
risky loans and improper accounting.

Missal’s preliminary report was issued in November with a final version
submitted and made public late last month.

New Century, once the nation’s second largest subprime mortgage lender,
spiraled in early 2007 when executives warned of a quarterly loss, projected a
big drop in 2007 loans and said some results would need to be restated to fix
accounting errors.

The company filed for bankruptcy in April 2007.

New Century, the poster child for the mortgage boom and subsequent meltdown,
is under investigation by the U.S. Attorney’s Office in Santa Ana.

The probe includes once top executives, including former chief executives
Brad Morrice and Robert Cole.

The U.S. Attorney’s Office declined to comment for this story, as did many
representatives of local law firms due to work they have related to the New
Century case or because of the sensitivity of the matter.

Other white-collar crime lawyers offered input on how an investigation into a
company like New Century could play out.

Companies that do their own internal probes into accounting issues and that
share information with federal regulators can end up avoiding indictments or
harsh penalties, according to legal sources.

That’s been the case with scores of companies that did their own probes into
stock options backdating. Out of some 150 that have been investigated by the
government, only a handful has seen indictments, including Irvine’s Broadcom
Corp.

But there won’t be any company probe into accounting issues at New Century,
which is liquidating assets and winding down operations in bankruptcy court. The
company didn’t even restate past results amid its rapid unwinding.

The demise of New Century as a company makes its former executives the likely
focus of federal investigators, sources said.

The company’s senior management team could face criminal charges if
prosecutors conclude they knowingly and willingly committed wrongdoing, they
said.

In his report, Missal, a partner with Kirkpatrick & Lockhart Preston Gates
Ellis LLP’s office in Washington, D.C., accuses New Century executives of
mismanagement and raises the specter of possible fraud at the company.

In an interview last week, Missal declined to comment on whether he’s working
with federal prosecutors looking into New Century. He was appointed as examiner
in the case by Delaware’s bankruptcy court last year to look into allegations of
mismanagement and possible wrongdoing.

Bad Risk Management

New Century executives failed to take steps to manage rising risks in making
loans to borrowers with imperfect credit, Missal said in his report.

Instead of focusing on whether borrowers could pay their mortgages, members
of New Century’s board and senior management team told Missal that their
standard for loan quality was whether the loans could be packaged and sold as
bonds to Wall Street, according to the report.

“New Century had a brazen obsession with increasing loan origination, without
due regard to the risks associated with that business strategy,” Missal said.

The failed company was aware of an “alarming and steady increase in early
payment defaults” on its loans done no later than mid-2004, he said.

Yet “senior management turned a blind eye to the increasing risks of New
Century’s loan originations and did not take appropriate steps to manage those
risks,” Missal said.

The company opted to “feed eagerly the wave of investor demands without
anticipating the inevitable requirement to repurchase an increasing number of
bad loans,” he said.

New Century went bankrupt after Wall Street buyers of loans packaged as bonds
forced them back on the company as defaults started rising.

Missal’s report accuses New Century of at least seven wide-ranging improper
accounting practices in 2005 and 2006 that resulted in misstatements of
financial results for 2005 and the first three quarters of 2006.

The report contends that New Century calculated its buyback reserve
incorrectly by not accounting for the growing backlog of claims related to older
loan sales. In the company’s calculations, it also excluded interest that needed
to be paid to investors when loans were repurchased.

“These critical omissions and changes were a violation of (generally accepted
accounting principals),” Missal said.

KPMG, which served as New Century’s outside auditor since the company went
public in 1997 to early 2007, allowed some of the improper accounting practices
to continue, according to Missal.

Several people who Missal interviewed claimed that KPMG recommended the
improper changes to New Century’s repurchase reserve calculation for its second
and third quarters of 2006.

“New Century is ultimately responsible for the accuracy of its financial
statements but KPMG bears responsibility at a minimum,” Missal said.

KPMG refutes Missal’s report.

“We strongly disagree with the report’s allegations concerning KPMG and we
believe that an objective review of the facts and circumstances will affirm our
position,” spokesman Dan Ginsburg said.

New Century’s accounting irregularities almost always resulted in increased
earnings, according to Missal. But he said his investigation didn’t find
evidence to conclude that New Century executives manipulated results.

Fraud?

Whether New Century’s accounting practices broke the law is up to prosecutors
to determine. Missal’s report stops short of alleging fraud by New Century and
KPMG.

Wayne Gross, head of the U.S. Attorney’s Office in Santa Ana until last year,
declined to comment on New Century but weighed in on criminal probes into
subprime mortgage companies. He now heads a white-collar criminal defense
practice for the Costa Mesa office of Snell & Wilmer LLP.

The FBI’s announcement earlier this year that it opened 14 criminal
investigations stemming from the subprime mortgage crisis may have some in OC
wondering if they could face potential criminal liability, according to Gross.

“Orange County companies and professional service providers that have been
involved in the subprime crisis need to be particularly careful in an
environment where law enforcement, regulators and even bankruptcy examiners are
focusing like a laser on perceived misconduct,” Gross said.

Missal, the lead counsel to the examiner in the 2002 WorldCom bankruptcy
proceeding, said he hopes the media buzz surrounding New Century sends a
message.

“Hopefully lessons can be learned from the New Century situation,” he said.