UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

COMMISSION FILE NUMBER: 001-32314

 

NEW CENTURY FINANCIAL CORPORATION

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

 

18400 VON KARMAN, SUITE 1000,

IRVINE, CALIFORNIA 92612

(Address of principal executive offices)(Zip Code)

 

(949) 440-7030

(Registrant’s telephone number, including area code)

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. þ Yes o No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

 

As of October 31, 2006, the registrant had 55,470,607 shares of common stock outstanding.

 

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

FORM 10-Q

 

QUARTER ENDED SEPTEMBER 30, 2006

 

INDEX

 

Certain information included in this Quarterly Report on Form 10-Q may include “forward-looking” statements under federal securities laws, and the company intends that such forward-looking statements be subject to the safe-harbor created thereby. Such statements include, without limitation, (i) the company’s business strategies; (ii) the company’s expectations with respect to market trends; (iii) the company’s projected sources and uses of funds from operations; (iv) the potential liability the company faces with respect to its legal proceedings; (v) the potential effects of proposed legislation and regulatory actions; (vi) the company’s expectation that its adoption of SFAS 155 will not have a material impact on its financial statements; (vii) the company’s expectation that its initial adoption of SFAS 156 will not have a material impact to its retained earnings; (viii) the company’s expectation that its adoption of FIN 48 will not have a significant impact on its financial statements; (ix) the company’s expectation that its initial adoption of SAB 108 will not have a material impact on its financial results; (x) the estimates the company uses to establish its allowance for loan losses; (xi) the estimates the company uses to determine the value of its residual assets including the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows; (xii) the company’s estimates with respect to average cumulative losses as a percentage of the original principal balance of mortgage loans for adjustable-rate and fixed-rate securities; (xiii) the company’s estimates with respect to its prepayments and the prepayment characteristics of its mortgage loans; (xiv) the company’s expectations with respect to the performance of the mortgage loans held in securitization trusts and the ability of the company to realize the current estimated fair value of its residual assets; (xv) the company’s expectations with respect to renewing or extending its various credit facilities; (xvi) the company’s expectation that it will reclassify an additional $21.0 million from OCI into earnings during the remainder of 2006 related to expiring contracts; (xvii) the company’s expectation that the remaining OCI will be reclassified into earnings by September 2009; (xviii) the company’s expectation that the earnings attributable to the REIT will not be taxable due to the benefit of the REIT’s dividend paid deduction; (xix) the company’s estimates with respect to the fair value of its stock options; (xx) the company’s expectation that its decisions regarding secondary marketing transactions in 2006 will be influenced by market conditions and the company’s ability to access external sources of capital; (xxi) the company’s expectation that a significant source of its revenue will continue to be interest income generated from its portfolio of mortgage loans held by the company’s REIT and its taxable REIT subsidiaries; (xxii) the company’s expectation that it will continue to generate revenue through its taxable REIT subsidiaries from the sale of loans, servicing income and loan origination fees; (xxiii) the company’s expectation that the primary components of its expenses will be (a) interest expense on its credit facilities, securitizations and other borrowings, (b) general and administrative expenses and (c) payroll and related expenses arising from its origination and servicing businesses; (xxiv) the company’s expectation that industry consolidation will continue into 2007; (xxv) the company’s belief that its hedging strategies are effective on an economic basis; (xxvi) the company’s expectation that the operating environment will continue to be challenging in the fourth quarter of 2006; (xxvii) the company’s expectation that loan production volume in the fourth quarter will be moderately lower than the third quarter and the company’s non-prime net operating margin will be reduced in the fourth quarter as a result of higher discounted loan sales; (xxviii) the company’s expectation that mortgage loan portfolio income in the fourth quarter of 2006 will be lower than the third quarter as the portfolio balance continues to decline; (xxix) the company’s strategy for next year focusing on maximizing its core mortgage origination franchise through loan origination process improvement, enhanced productivity and increased efficiencies; (xxx) the company’s expectation that it will not add to the mortgage loan portfolio simply to support a dividend target; (xxxi) the company’s expectation that it will continue to evaluate whole loan sales versus securitizations on a case-by-case basis based on whole loan prices relative to its view of the risk-adjusted returns on capital available through securitization; (xxxii) the company’s belief that the current environment calls for a financial strategy that is flexible enough to capitalize on the opportunities that arise during 2007 giving consideration to secondary and capital market conditions; (xxxiii) the company’s belief that it is well-positioned to meet the challenges next year; (xxxiv) the company’s expectation that overall mortgage market volume will decline in 2007; (xxxv) the company’s belief that its size, scale, financial resources, low loan acquisition costs and reputation will enable it to compete successfully and profitably gain market share in the consolidating mortgage industry; (xxxvi) the company’s expectation that, going forward, it will continue to be opportunistic about whole loan sales versus securitization, taking into account secondary market conditions and its capital allocation strategy; (xxxvii) the company’s belief that it is adequately reserved for the expected higher level of loan losses after giving consideration to the performance of its newer vintages; (xxxviii) the execution of the company’s hedging strategies to mitigate the interest rate risk associated with its loans and reduce the variability in its interest margin over the period of each securitization; (xxxix) the company’s belief that the steps it is taking with respect to its underwriting

guidelines are prudent in light of the current market environment and will help ensure that specific loan products are appropriate for the circumstances of individual borrowers and will improve the overall credit quality of the company’s loans; (xl) the company’s plan to continue evaluating its product line; (xli) the company’s expectation that its underwriting changes may result in a modest decline in volume, but will not have a meaningful impact to profitability; (xlii) the company’s plan to manage the timing of its whole loan sales to enhance the net interest income it earns on its loans, while preserving the company’s ability to sell the loans at the maximum price; (xliii) the company’s expectation that the volume of discounted sales and the severity of the discount will continue to challenge originators in the Company’s industry; (xliv) the company’s belief that its ongoing refinement of its underwriting guidelines and continual focus on loan origination process improvement will help mitigate the industry trend relating to higher discounted loan sales; (xlv) the company’s belief that the lower initial payment requirements of pay-option loans may increase the credit risk inherent in its loans held for sale; (xlvi) the company’s design of its underwriting standards, including its recently adopted guidelines for adjustable-rate and interest-only loans, and quality assurance programs to ensure that loan quality is consistent and meets the company’s guidelines, even as the mix of documentation type varies; (xlvii) the company’s beliefs, estimates and assumptions with respect to its critical accounting policies; (xlviii) the company’s estimates and assumptions relating to the interest rate environment, the economic environment, secondary market conditions and the performance of the loans underlying its residual assets and mortgage loans held for investment; (il) the company’s use of a prepayment curve to estimate the prepayment characteristics of its mortgage loans; (l) the company’s right to terminate, reduce or increase the size of its stock purchase program at any time; (li) the company’s execution of its principal strategies to effectively manage its liquidity and capital; (lii) the company’s target levels of liquidity and capital; (liii) the company’s expectation that prepayment speeds will continue to be at more normal levels through the fourth quarter of 2006; (liv) the company’s intention to access the capital markets when appropriate to support its business operations; (lv) the company’s intention to execute its stock repurchase program while maintaining its targeted cash and liquidity levels; (lvi) the company’s plan to return capital to shareholders through a capital distribution program; (lvii) the company’s belief that the cash to fund its stock repurchase and capital distribution program can come from a variety of sources, including, but not limited to, cash flow from its taxable REIT subsidiaries and mortgage banking operations, cash flow from its portfolio of mortgage securities, including the release of over-collateralization from such securities, and through external capital sources; (lviii) the company’s expectation that its liquidity, credit facilities and capital resources will be sufficient to fund its operations for the foreseeable future, while enabling the company to maintain its qualification as a REIT under the requirements of the Code; (lix) the company’s expectation that its fourth quarter dividend will be paid in the amount of $1.90 per share on January 31, 2007 to stockholders of record at the close of business on December 29, 2006; and (lx) the company’s expectation that any future declarations of dividends on its common stock will be subject to its earnings, financial position, capital requirements, contractual restrictions and other relevant factors. The company cautions that these statements are qualified by important factors that could cause its actual results to differ materially from expected results in the forward-looking statements. Such factors include, but are not limited to, (i) the condition of the U.S. economy and financial system; (ii) the interest rate environment; (iii) the effect of increasing competition in the company’s sector; (iv) the condition of the markets for whole loans and mortgage-backed securities; (v) the stability of residential property values; (vi) the company’s ability to comply with the requirements applicable to REITs; (vii) the company’s ability to increase its portfolio income; (viii) the company’s ability to continue to maintain low loan acquisition costs; (ix) the potential effect of new state or federal laws and regulations; (x) the company’s ability to maintain adequate credit facilities to finance its business; (xi) the outcome of litigation or regulatory actions pending against the company; (xii) the company’s ability to adequately hedge its residual values, cash flows and fair values; (xiii) the accuracy of the assumptions regarding the company’s repurchase allowance and residual valuations, prepayment speeds and loan loss allowance; (xiv) the ability to finalize its forward sale commitments; (xv) the ability to deliver loans in accordance with the terms of forward sale commitments; (xvi) the assumptions underlying the company’s risk management practices; and (xvii) the ability of the company’s servicing platform to maintain high performance standards. Additional information on these and other factors is contained in the company’s Annual Report on Form 10-K for the year ended December 31, 2005 and the company’s other periodic filings with the Securities and Exchange Commission. The company assumes no, and hereby disclaims any, obligation to update the forward-looking statements contained in this Quarterly Report on Form 10-Q.

PART I — FINANCIAL INFORMATION

 

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

Condensed Consolidated Balance Sheets

September 30, 2006 and December 31, 2005

(Dollars in thousands)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

Condensed Consolidated Statements Of Earnings

(Dollars in thousands, except per share amounts)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

Condensed Consolidated Statements Of Comprehensive Income

(Dollars in thousands)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

Consolidated Statements Of Changes In Stockholders’ Equity

Year Ended December 31, 2005 and Nine Months Ended September 30, 2006

(In thousands, except per share amounts)

(Nine Months Ended September 30, 2006 Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

 

Condensed Consolidated Statements of Cash Flows

(Dollars in thousands)

(Unaudited)

 

 

See accompanying notes to unaudited condensed consolidated financial statements.

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

September 30, 2006 and 2005

 

 

New Century TRS Holdings, Inc. (formerly known as New Century Financial Corporation), a Delaware corporation (“New Century TRS”), was formed on November 17, 1995. On April 5, 2004, New Century TRS’s board of directors approved a plan to change New Century TRS’s capital structure to enable it to qualify as a real estate investment trust, or REIT, for United States federal income tax purposes. On April 12, 2004, New Century TRS formed New Century Financial Corporation (formerly known as New Century REIT, Inc.), a Maryland corporation (“New Century”). As used herein, except where the context suggests otherwise, for time periods before October 1, 2004, the terms “the Company,” “our,” “its,” “we,” “the group,” and “us” mean New Century TRS Holdings, Inc., and its consolidated subsidiaries, and for time periods on and after October 1, 2004, the terms “the Company,” “our,” “its,” “we,” “the group,” and “us” refer to New Century Financial Corporation and its consolidated subsidiaries.

 

Pursuant to the merger that implemented the restructuring of New Century TRS in order for it to qualify as a REIT (the “Merger”), New Century became the publicly-traded parent listed on the New York Stock Exchange, or NYSE, began trading under the ticker symbol “NEW,” and succeeded to and continued to operate substantially all of the existing businesses of New Century TRS and its subsidiaries. The Merger was consummated and became effective on October 1, 2004, and was accounted for on an “as if pooling basis.” These consolidated financial statements give retroactive effect to the Merger for the periods presented. Accordingly, under “as if pooling accounting,” the assets and liabilities of New Century TRS transferred to New Century in connection with the Merger have been accounted for at historical amounts as if New Century TRS was transferred to New Century as of the earliest date presented and the consolidated financial statements of New Century prior to the Merger include the results of operations of New Century TRS. Stockholders’ equity amounts presented for years prior to the formation of New Century are those of New Century TRS, adjusted for the Merger exchange rate.

 

New Century Mortgage Corporation, a wholly-owned subsidiary of New Century TRS (“New Century Mortgage”), commenced operations in February 1996 and is a mortgage finance company engaged in the business of originating, purchasing, selling and servicing mortgage loans secured primarily by first and second mortgages on single-family residences. NC Capital Corporation, a wholly-owned subsidiary of New Century Mortgage (“NC Capital”), was formed in December 1998 to conduct the secondary marketing activities of New Century. New Century Credit Corporation (formerly known as Worth Funding Incorporated), a wholly-owned subsidiary of New Century (“New Century Credit”), was acquired in March 2000 by New Century Mortgage. NC Residual IV Corporation, a wholly-owned subsidiary of New Century (“NCRIV”) was formed in September 2004 to hold a portfolio of mortgage loans held for investment. After consummation of the Merger, New Century purchased New Century Credit from New Century Mortgage.

 

On September 2, 2005, Home123 Corporation, an indirect wholly owned subsidiary of New Century (“Home123”), purchased the origination platform of RBC Mortgage Company, or RBC Mortgage, that expanded the Company’s retail presence on a nationwide basis, its channels of distribution and its mortgage product offerings to include conventional mortgage loans, loans insured by the Federal Housing Administration and loans guaranteed by the Veterans Administration. The purchase price for the net assets was $80.6 million, and was accounted for using the purchase method. Of the aggregate amount, $7.6 million was the fair value of assets acquired and $4.1 million was the fair value of liabilities assumed. The excess of the purchase price over the fair value of assets acquired and liabilities assumed was $77.1 million and was allocated and recorded as goodwill at Home123.

 

On February 3, 2006, one of New Century’s indirect subsidiaries, New Century Warehouse Corporation, completed the purchase of the platform of Access Lending Corporation, or Access Lending, that provides warehouse lending services to middle-market residential mortgage bankers. The purchase price for the net

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

assets was $9.8 million, and was accounted for using the purchase method. The fair value of the assets acquired was $94.3 million and the fair value of the liabilities assumed was $87.7 million. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was allocated to and recorded as goodwill. Additionally, pursuant to the terms of the purchase and assumption agreement governing the transaction, Access Lending is entitled to receive additional payments for two years following the consummation of the transaction, based upon profitability. The results of operations for the acquired platform have been included in the Company’s condensed consolidated financial statements since the date of acquisition.

 

The accompanying condensed consolidated financial statements include the consolidated financial statements of New Century’s wholly-owned subsidiaries, New Century TRS, New Century Credit, and NCRIV. All material intercompany balances and transactions are eliminated in consolidation.

 

The Company has prepared the accompanying unaudited condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, the statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and notes thereto included in New Century’s Annual Report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission.

 

Reclassification

 

Certain amounts from the prior year’s presentation have been reclassified to conform to the current year’s presentation.

 

Recent Accounting Developments

 

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which provides the following: (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit in the form of subordination are not embedded derivatives and (5) amends Statement of Financial Accounting Standards No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a replacement of FASB Statement 125,” to eliminate the prohibition of a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 accounting for certain hybrid financial instruments is effective for the Company beginning January 1, 2007. Adoption of SFAS 155 is not expected to have a material impact on the Company’s financial statements.

 

In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), which provides the following: (1) revised guidance on when a servicing asset and servicing liability should be recognized, (2) requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable, (3) permits an entity to elect

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

to measure servicing assets and servicing liabilities at fair value each reporting date and report changes in fair value in earnings in the period in which the changes occur, (4) upon initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities for securities that are identified as offsetting the entity’s exposure to changes in the fair value of servicing assets or liabilities that a servicer elects to subsequently measure at fair value and (5) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional footnote disclosures. SFAS 156 is effective for the Company beginning January 1, 2007, with the effects of initial adoption being reported as a cumulative-effect adjustment to retained earnings. The impact to retained earnings as a result of the initial adoption of SFAS 156 is expected to be immaterial.

 

FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” was issued in June 2006. FIN 48 clarifies the accounting for uncertainty in tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition, and is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of FIN 48 is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period FIN 48 is adopted. The Company’s accounting for its income tax contingency reserves is not based on the provisions of FIN 48 because its financial statements for the first quarter of 2006 have been issued without the early adoption of the provisions of FIN 48. Management is currently evaluating the impact of adopting FIN 48; however, it is not expected to have a significant impact on the Company’s financial statements.

 

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. The Company is currently evaluating the impact, if any, that SFAS 157 will have on its financial condition and results of operations.

 

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 must be applied to annual financial statements for their first fiscal year ending after November 15, 2006. SAB 108 will be effective beginning January 1, 2007. The Company is evaluating the impact of adopting SAB 108 on the Company’s financial results.

 

Cash and Cash Equivalents

 

For purposes of the statements of cash flows, the Company considers all highly-liquid debt instruments with original maturities of three months or less to be cash equivalents. Cash equivalents consist of cash on hand and cash due from banks.

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

Restricted Cash

 

As of September 30, 2006, restricted cash totaled $572.8 million, and included $55.9 million in cash held in margin accounts associated with the Company’s interest rate risk management activities, $443.0 million in cash held in custodial accounts associated with its mortgage loans held for investment, $37.5 million in cash held in a cash reserve account and $34.7 million in cash held in a funding trust account in connection with its asset-backed commercial paper facility and $1.7 million in cash held in trust accounts on behalf of borrowers. As of December 31, 2005, restricted cash totaled $726.7 million, and included $73.4 million in cash held in a margin account associated with the Company’s interest rate risk management activities, $633.0 million in cash held in custodial accounts associated with its mortgage loans held for investment, $20.0 million in cash held in a cash reserve account in connection with its asset-backed commercial paper facility and $0.3 million in cash held in trust accounts on behalf of borrowers.

 

Mortgage Loans Held for Sale

 

Mortgage loans held for sale are stated at the lower of amortized cost or fair value as determined by outstanding commitments from investors or current investor-yield requirements, calculated on an aggregate basis.

 

Mortgage Loans Held for Investment

 

Mortgage loans held for investment represent loans securitized through transactions structured as financings, or pending securitization through transactions that are expected to be structured as financings. Mortgage loans held for investment are stated at amortized cost, including the outstanding principal balance, less the allowance for loan losses, plus net deferred origination costs. The financing related to these securitizations is included in the Company’s condensed consolidated balance sheet as financing on mortgage loans held for investment.

 

Allowance for Losses on Mortgage Loans Held for Investment

 

In connection with its mortgage loans held for investment, the Company establishes an allowance for loan losses based on its estimate of losses inherent and probable as of the balance sheet date. The Company charges off uncollectible loans at the time of liquidation. The Company evaluates the adequacy of this allowance each quarter, giving consideration to factors such as the current performance of the loans, characteristics of the portfolio, the value of the underlying collateral and the general economic environment. In order to estimate an appropriate allowance for losses for loans held for investment, the Company estimates losses using “static pooling,” which stratifies the loans held for investment into separately identified vintage pools. Provision for losses is charged to the Company’s consolidated statement of income. Losses incurred are charged to the allowance. Management considers the current allowance to be adequate.

 

Residual Interests in Securitizations

 

Residual interests in securitizations (the “Residuals”) are recorded by the Company as a result of the sale of loans through securitizations that the Company structures as sales rather than financings, referred to as “off-balance sheet securitizations.” Residuals include the present value of the expected future cash flows that the Company will receive as described below (the “Cash Flows”). The Company may sell Residuals through net interest margin securities (“NIMS”).

 

The Company generally structures off-balance sheet securitizations as follows: first, it sells a portfolio of mortgage loans to a special purpose entity (“SPE”) that has been established for the limited purpose of buying

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

and reselling mortgage loans; then the SPE transfers the same mortgage loans to a Real Estate Mortgage Investment Conduit (the “REMIC”) or Owners Trust (the “Trust”), which is a qualifying special purpose entity (“QSPE”) as defined under Statement of Financial Accounting Standards No. 140 (“SFAS 140”); and, finally, the Trust issues (i) interest-bearing asset-backed securities (the “Bonds and Certificates”) generally in an amount equal to the aggregate principal balance of the mortgage loans and (ii) a certificate to the Company representing a residual interest in Cash Flows related to the payments made on the securitized loans. The Bonds and Certificates are typically sold at face value on a non-recourse basis, except that the Company provides to the Trust representations and warranties customary in the mortgage banking industry. One or more investors typically purchase these Bonds and Certificates for cash. The Trust uses the cash proceeds to pay the Company the cash portion of the purchase price for the mortgage loans. In addition, the Company may provide a credit enhancement in the form of additional collateral (the “OC Account”) held by the Trust. The servicing agreements typically require that the OC Account be maintained at certain levels.

 

At the closing of each off-balance sheet securitization, the Company removes from its consolidated balance sheet the mortgage loans held for sale and adds to its consolidated balance sheet (i) the cash received, (ii) the fair value of the Residuals and (iii) the estimated fair value of the servicing asset, if applicable. The excess of the cash received and the assets retained over the carrying value of the loans sold, less transaction costs, equals the net gain on sale of mortgage loans recorded by the Company in its consolidated statement of earnings.

 

NIMS transactions are generally structured as follows: first, the Company sells or contributes the Residuals to a SPE established for the limited purpose of receiving and selling asset-backed residual interests-in-securitization certificates; then, the SPE transfers the Residuals to the Trust; and, finally, the Trust, which is a QSPE as defined under SFAS 140, issues the Bonds and Certificates. The Company sells the Residuals on a non-recourse basis, except that it provides to the Trust representations and warranties customary in the mortgage banking industry. One or more investors typically purchase the Bonds and Certificates and the proceeds from the sale of the Bonds and Certificates, along with a residual interest certificate that is subordinate to the Bonds and Certificates, represent the consideration received by the Company for the sale of the Residuals.

 

At the closing of each NIMS transaction, the Company removes from its consolidated balance sheet the carrying value of the Residuals sold and adds to its consolidated balance sheet (i) the cash received and (ii) the estimated fair value of the portion of the Residuals retained. The excess of the cash received and assets retained over the carrying value of the Residuals sold, less transaction costs, equals the net gain or loss on the sale of Residuals recorded by the Company in its consolidated statement of earnings.

 

The Company allocates its basis in the mortgage loans and Residuals between the portion of the mortgage loans and Residuals sold through the Bonds and Certificates and the portion retained based on the relative fair values of those portions on the date of sale. The Company recognizes gains or losses attributable to the changes in the fair value of the Residuals in the consolidated statement of income, as the Residuals are classified as trading securities as permitted by SFAS 140. The Company is not aware of an active market for the purchase or sale of Residuals and, accordingly, it determines the estimated fair value of the Residuals by discounting the expected cash flows released from the REMIC or Trust (the cash out method) using a discount rate commensurate with the then-perceived risks involved. The Company utilizes a discount rate of 12.0% on the estimated cash flows released from the REMIC or Trust to value the Residuals through securitization transactions and 14.0% on the estimated cash flows released from the Trust to value Residuals through NIMS transactions. The Company releases substantially all servicing rights related to its securitizations structured as sales.

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company is entitled to the cash flows from the Residuals that represent collections on the mortgage loans in excess of the amounts required to pay the Bonds and Certificates’ principal and interest, pay servicing fees and certain other fees, such as trustee and custodial fees, and satisfy OC requirements. At the end of each collection period, the aggregate cash collections from the mortgage loans are allocated first to the base servicing fees and certain other fees, such as trustee and custodial fees, for the period, then to the holders of Bonds and Certificates for interest at the pass-through rate on the Bonds and Certificates plus principal as defined in the servicing agreements. If the amount of cash required for the above allocations exceeds the amount collected during the collection period, a shortfall may occur which will have to be reimbursed from future cash flows, if any. If the cash collected during the period exceeds the amount necessary for the above allocation, and there is no shortfall in the OC requirement, the excess is released to the Company. If the OC balance is not at the required credit enhancement level, the excess cash collected is retained by the Trusts until the specified OC requirement is achieved. The Company is restricted from using the excess collateral in the OC. Pursuant to certain servicing agreements, the Company may be required to use cash in excess of amounts required to make accelerated principal paydowns to the holders of Bonds and Certificates that have the effect of creating additional excess collateral in the OC, which is held by the Trusts on its behalf as the Residual holder. The specified credit enhancement levels are defined in these servicing agreements as the OC balance expressed generally as a percentage of the current collateral principal balance. For NIMS transactions, the Company receives cash flows once the holders of the Bonds and Certificates created in the NIMS transaction are fully paid.

 

The annual percentage rate (the “APR”) on the mortgage loans is relatively high in comparison to the investor pass-through interest rate on the Bonds and Certificates. Accordingly, the Residuals described above are a significant asset of the Company. In determining the value of the Residuals, the Company estimates the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows. The Company estimates that average cumulative losses as a percentage of the original principal balance of the mortgage loans range from 1.89% to 5.1% for adjustable-rate securities and 1.44% to 5.68% for fixed-rate securities. The Company bases these estimates on historical loss data for the loans, the specific characteristics of the loans, and the general economic environment. While the range of estimated cumulative pool losses is fairly broad, the weighted average cumulative pool loss estimate for the entire portfolio of residual assets was 3.75% at September 30, 2006. The Company estimates prepayments by evaluating historical prepayment performance of its loans and the impact of current trends. The Company uses a prepayment curve to estimate the prepayment characteristics of the mortgage loans. The rate of increase, duration, severity, and decrease along the curve depends on the age and nature of the mortgage loans, primarily whether the mortgage loans are fixed or adjustable, and the interest rate adjustment characteristics of the mortgage loans (i.e., 6-month, 1-year, 2-year, 3-year or 5-year adjustment periods). These prepayment curve and default estimates have resulted in weighted average lives of between 2.19 and 2.58 years for the Company’s adjustable-rate securities and between 2.23 and 3.50 years for its fixed-rate securities.

 

Real Estate Owned

 

Real estate acquired through foreclosure is initially recorded at the lower of cost or estimated fair value, net of an allowance for estimated selling costs, on the date of foreclosure and a mortgage loan charge-off is recorded.

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

A summary of real estate owned at September 30, 2006 and December 31, 2005 at estimated fair value, is as follows (dollars in thousands):

 

 

The following table presents a summary of the activity for the valuation allowance for real estate owned for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

 

 

Derivative Instruments

 

The Company accounts for certain Euro Dollar futures contracts, interest rate cap contracts and interest rate swap contracts, designated and documented as hedges, pursuant to the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” or SFAS 133. Pursuant to SFAS 133, these contracts have been designated as hedging the exposure to variability of cash flows from the Company’s financing on mortgage loans held for investment attributable to changes in interest rates. Cash flow hedge accounting requires that the effective portion of the gain or loss in the fair value of a derivative instrument designated as a cash flow hedge be reported in other comprehensive income and the ineffective portion be reported in current earnings. For those derivative instruments not designated as hedges, changes in the fair value of the derivative instrument are recorded through earnings each period.

 

Interest Rate Lock and Forward Sale Commitments

 

The Company is exposed to interest rate risk from the time an interest rate lock commitment (“IRLC”) is made to a residential mortgage applicant to the time the related mortgage loan is sold. IRLCs are derivative instruments under SFAS 133 and are recorded at fair value with the changes in the fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The Company also uses forward sale commitments for its mortgage loan originations to manage interest rate risk. The Company enters into forward sale commitments on a significant portion of production for which there is no offsetting interest rate

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

lock. The forward sale commitments are derivatives under SFAS 133 and recorded at fair value with the changes in fair value recognized in current period earnings as a component of gain on sale of mortgage loans.

 

Income Taxes

 

New Century is a REIT for federal income tax purposes and is not generally required to pay federal and most state income taxes on the income that it distributes to stockholders if it meets the REIT requirements of the Internal Revenue Code of 1986, as amended (the “Code”). Also, each of New Century’s subsidiaries that meet the requirements of the Code to be a qualified REIT subsidiary (“QRS”) is not generally required to pay federal and most state income taxes. However, New Century must recognize income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) for each of its taxable REIT subsidiaries (“TRS”) whose income is fully taxable at regular corporate rates.

 

SFAS 109 requires that inter-period income tax allocation be based on the asset and liability method. Accordingly, New Century recognizes the tax effects of temporary differences between its tax and financial reporting bases of assets and liabilities that will result in taxable or deductible amounts in future periods.

 

 

A summary of mortgage loans held for sale, at the lower of cost or fair value at September 30, 2006 and December 31, 2005, is as follows (dollars in thousands):

 

 

 

 

At September 30, 2006, the Company had mortgage loans held for sale having an unpaid principal balance of approximately $235.0 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $10.1 million for the nine months ended September 30, 2006. At September 30, 2005, the Company had mortgage loans held for sale of approximately $58.6 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $2.8 million for the nine months ended September 30, 2005.

 

 

During the nine months ended September 30, 2006, the Company securitized $3.4 billion in loans through transactions structured as financings. There were no securitizations structured as financings for the three

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

months ended September 30, 2006. A summary of the components of mortgage loans held for investment at September 30, 2006 and December 31, 2005 is as follows (dollars in thousands):

 

 

At September 30, 2006, the Company had mortgage loans held for investment having an unpaid principal balance of approximately $817.8 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $25.5 million for the nine months ended September 30, 2006. At September 30, 2005, the Company had mortgage loans held for investment having an unpaid principal balance of approximately $423.4 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $15.3 million for the nine months ended September 30, 2005.

 

The following table presents a summary of the activity for the allowance for losses on mortgage loans held for investment for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

 

Residual interests in securitizations were $223.7 million at September 30, 2006 and $172.1 million at September 30, 2005 and consisted of the present value of expected cash flows that the Company will receive in the future.

 

During the nine months ended September 30, 2006, the Company did not complete any securitizations structured as sales. During the nine months ended September 30, 2005, the Company completed two securitizations structured as sales totaling $3.0 billion. The gain on sale recorded for the two securitizations was $71.6 million and the residual interest created by the two securitizations totaled $34.8 million.

 

During the nine months ended September 30, 2006, the Residuals provided the Company with $2.1 million in cash. The Company performs an evaluation of the Residuals quarterly, taking into consideration trends in actual cash flow performance and industry and economic developments, as well as other relevant factors. During the nine months ended September 30, 2006, the Company increased its prepayment rate assumptions

 

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

based upon actual performance and made minor adjustments to certain other assumptions, resulting in a $28.1 million downward fair value adjustment.

 

Neither the Trusts nor the holders of the Bonds and Certificates have recourse to the Company for failure of mortgage loan borrowers to pay their obligations when due. The Company’s Residuals are subordinate to the Bonds and Certificates until the holders of the Bonds and Certificates are fully paid.

 

The Company is a party to various transactions that have an off-balance sheet component. In connection with the Company’s off-balance sheet securitization transactions, as of September 30, 2006, there were $5.7 billion in loans owned by the Trusts. The Trusts have issued Bonds and Certificates secured by these loans. The holders of the Bonds and Certificates generally do not have recourse to the Company in the event that the loans in the various Trusts do not perform as expected. Because these Trusts are “qualifying special purpose entities,” in accordance with generally accepted accounting principles, the Company has included only its Residual interest in these loans on its condensed consolidated balance sheet. The performance of the loans in the Trusts could impact the Company’s ability to realize the current estimated fair value of the Residuals.

 

In determining the value of the Residuals, the Company estimates the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows. The Company utilizes a discount rate of 12.0% on the estimated cash flows released from the REMIC or Trust to value the Residuals through securitization transactions and 14.0% on the estimated cash flows released from the Trust to value Residuals through NIMS transactions. The following table summarizes the activity for the Residuals for the nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

 

The following table summarizes activity in the Company’s mortgage servicing assets for the nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company records mortgage servicing assets when it sells loans on a servicing-retained basis and when it sells loans through whole loan sales to an investor in the current period and sells the servicing rights to a third party in a subsequent period.

 

The addition of $30.0 million for the nine months ended September 30, 2006 primarily represents servicing rights retained by the Company in certain of its whole loan sales to Carrington Mortgage Credit Fund I, LP (“Carrington”). The $24.5 million in sales of servicing rights for the nine months ended September 30, 2006 relates to the two securitizations structured as sales completed in December 2005 for which the mortgage servicing rights were sold during the first quarter of 2006. The addition of $60.9 million for the nine months ended September 30, 2005 includes: (i) $35.8 million of servicing rights retained by the Company in certain of its whole loan sales to Carrington, (ii) $8.7 million of servicing rights related to the securitization structured as a sale completed in June 2005 for which the mortgage servicing rights were subsequently sold to a third party in August 2005 for $8.5 million and (iii) $16.4 million of servicing rights related to the securitization structured as a sale completed in September 2005 for which the mortgage servicing rights were subsequently sold to a third party in November 2005 for $16.4 million.

 

 

Goodwill is recorded in connection with the acquisition of new subsidiaries or net assets. As of September 30, 2006 and December 31, 2005, the Company had goodwill of $95.8 million and $93.0 million, respectively. No impairment was recognized during the nine months ended September 30, 2006.

 

On February 3, 2006, one of the Company’s indirect wholly-owned subsidiaries, New Century Warehouse Corporation, completed the purchase of Access Lending’s platform that provides warehouse lending services to middle market residential mortgage bankers. The purchase price for the net assets was $9.8 million, and was accounted for using the purchase method. The fair value of the assets acquired was $94.3 million and the fair value of the liabilities assumed was $87.7 million. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was allocated to and recorded as goodwill. Additionally, pursuant to the terms of the purchase and assumption agreement governing the transaction, Access Lending is entitled to receive additional payments for two years following the consummation of the transaction, based upon profitability. The results of operations for the acquired platform have been included in the Company’s condensed consolidated financial statements since the date of acquisition.

 

The following table presents changes in the carrying amount of goodwill as of September 30, 2006 (dollars in thousands):

 

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

 

Credit facilities and other short-term borrowings consisted of the following at September 30, 2006 and December 31, 2005 (dollars in thousands):

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

 

The various credit facilities contain certain restrictive financial and other covenants that require the Company to, among other things, restrict dividends, maintain certain levels of net worth, liquidity, available borrowing capacity and debt-to-net worth ratios and comply with regulatory and investor requirements. The Company was in compliance with these covenants at September 30, 2006.

 

 

When the Company sells mortgage loans through securitizations structured as financings, the related bonds are added to its balance sheet. As of September 30, 2006 and December 31, 2005, the financing on mortgage loans held for investment consisted of the following (dollars in thousands):

 

 

The maturity of the Company’s financing on mortgage loans held for investment is based on certain prepayment assumptions. The Company estimates the average life of its various securitized loan pools to be between 1.3 and 3.8 years. The following table reflects the estimated maturity of the financing on mortgage loans held for investment as of September 30, 2006 (dollars in thousands):

 

 

 

On July 8, 2003, New Century TRS closed a private offering of $210.0 million of 3.50% convertible senior notes due July 3, 2008 pursuant to Rule 144A under the Securities Act of 1933. On March 17, 2004, the convertible senior notes became convertible into New Century TRS common stock at a conversion price of $34.80 per share. As a result of the Merger, the convertible senior notes became convertible into shares of New Century common stock. In December 2004 and June 2005, through a series of transactions, all but $5,000,000 of the original outstanding principal balance of the convertible senior notes was converted into common stock of New Century. On February 17, 2006, the holder of the remaining $5,000,000 aggregate

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

principal amount of convertible senior notes elected to convert the convertible senior notes into 165,815 shares of New Century’s common stock.

 

 

On September 13, 2006, the Company sold through New Century Capital Trust I, a Delaware statutory trust (the “Trust”), $50,000,000 in aggregate liquidation amount of preferred securities of the Trust (the “Preferred Securities”) in a private placement transaction. The Preferred Securities require quarterly distributions at a fixed rate of 8.65% through the distribution payment date in September 2011, whereupon the rate floats at three-month LIBOR plus 3.50% thereafter.

 

The Trust simultaneously issued and sold 1,545 shares of common securities of the Trust (the “Common Securities”) to the Company for $1,545,000 in aggregate liquidation amount. The 1,545 Common Securities constitute all of the issued and outstanding Common Securities of the Trust. The Trust used the proceeds from the sales of the Preferred Securities and the Common Securities to purchase $51,545,000 aggregate principal amount of the Company’s junior subordinated notes due 2036 (the “Junior Subordinated Notes”). The terms of the Junior Subordinated Notes are substantially the same as the terms of the Preferred Securities.

 

The Junior Subordinated Notes mature on September 30, 2036, but the Company may redeem the Junior Subordinated Notes, in whole or in part, on or after September 30, 2011 without penalty. If the Junior Subordinated Notes are redeemed, the Trust must redeem a like amount of the Preferred Securities.

 

The assets and liabilities of the Trust are not consolidated into the consolidated financial statements of the Company. Accordingly, the Company’s equity interest in the Trust is accounted for using the equity method. Interest on the junior subordinated debentures are presented on the consolidated statements of income as a component of interest expense and the Junior Subordinated Notes are presented as a separate category on the consolidated balance sheets.

 

 

In June 2005, the Company sold 4,500,000 shares of its Series A Cumulative Redeemable Preferred Stock (the “Series A Preferred Stock”) including 300,000 shares to cover overallotments. The offering provided $108.7 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.125% and are not convertible into any other securities. The Company may, at its option, redeem the Series A Preferred Stock, in the aggregate or in part, at any time on or after June 21, 2010. As such, this stock is not considered mandatorily or contingently redeemable under the provisions of Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Investments with Characteristics of both Liabilities and Equity” (“SFAS 150”), and is therefore classified as a component of equity. The Company paid preferred stock dividends of $2.6 million for the third quarter of 2006 on September 29, 2006, and, as a result, there were no accrued preferred stock dividends related to the Series A Preferred Stock as of September 30, 2006.

 

In August 2006, the Company sold 2,300,000 shares of its Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”), including 300,000 shares to cover overallotments. The offering provided $55.6 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.75% and are not convertible into any other securities. The Company may, at its option, redeem the Series B Preferred Stock, in the aggregate or in part, at any time on or after August 22, 2011. As such, this stock is not considered mandatorily or contingently redeemable under the provisions of SFAS 150, and is therefore classified as a component of equity. The Company had an accrual for preferred stock dividends related to the Series B Preferred Stock of $0.6 million as of September 30, 2006.

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

 

The following table presents the components of interest income for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

 

The following table presents the components of interest expense for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):

 

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

 

The following table presents the fair value of the Company’s derivative instruments as of the periods indicated (dollars in thousands):

 

 

The following table presents derivative gains (losses) for the periods indicated (dollars in thousands):

 

 

In connection with the Company’s strategy to mitigate interest rate risk on its financing on mortgage loans held for sale, mortgage loans held for investment and its Residuals, the Company uses derivative financial instruments such as Euro Dollar futures contracts, interest rate cap contracts, interest rate swap contracts, purchased options on Euro Dollar futures contracts, interest rate locks and forward sale commitments. These derivative instruments are intended to provide income and cash flow to offset potential reduced interest income and cash flow under certain interest rate environments. In accordance with SFAS 133, the derivative

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

financial instruments and any related margin accounts are reported on the condensed consolidated balance sheets at their fair value. It is not the Company’s policy to use derivatives to speculate on interest rates.

 

In 2003, the Company began applying hedge accounting as defined by SFAS 133 for certain derivative financial instruments used to hedge cash flows related to its financing on mortgage loans held for investment. In June 2004, the Company began applying hedge accounting to certain derivative financial instruments used to hedge the fair value of certain of its mortgage loans held for sale. The Company designates certain derivative financial instruments, such as Euro Dollar futures contracts, interest rate cap contracts and beginning in the quarter ended September 30, 2006, certain of its interest rate swap contracts, as hedge instruments under SFAS 133. At the inception of the hedge, these instruments and their hedging relationship are identified, designated and documented. The Company documents the relationships between hedging instruments and hedged items, as well as its risk management objectives and strategies for undertaking various hedge transactions. The Company also assesses, both at the inception of the hedge and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in cash flows or fair value of the hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting.

 

When hedge accounting is discontinued because the Company determines that the derivative no longer qualifies as a hedge, the derivative will continue to be recorded on the condensed consolidated balance sheet at its fair value. Any change in the fair value of a derivative no longer qualifying as a hedge is recognized in current period earnings. When a derivative is terminated, it is derecognized at the time of termination. For terminated cash flow hedges or cash flow hedges that no longer qualify as effective, the effective position previously recorded in accumulated other comprehensive income, or OCI, is recorded in earnings when the hedged item affects earnings.

 

Cash Flow Hedge Instruments — For derivative financial instruments designated as cash flow hedge instruments, the Company evaluates the effectiveness of these hedges against the variable-rate interest payments related to its financing on mortgage loans held for investment being hedged to ensure that there remains a highly effective correlation in the hedge relationship. To hedge the adverse effect of interest rate changes on the cash flows as a result of changes in the benchmark LIBOR interest rate, which affect the interest payments related to its financing on mortgage loans held for investment (variable-rate debt) being hedged, the Company uses derivatives classified as cash flow hedges under SFAS 133. Once the hedge relationship is established, for those derivative instruments designated as qualifying cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of accumulated OCI during the current period, and reclassified into earnings as part of interest expense in the period(s) during which the hedged transaction affects earnings pursuant to SFAS 133. The ineffective portion of the derivative instrument is recognized in earnings in the current period and is included in other income.

 

Euro Dollar futures contracts — As of September 30, 2006, the Company had open Euro Dollar futures contracts that are designated as hedging the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment. The fair value of these Euro Dollar futures contracts at September 30, 2006 and 2005 was a $30.7 million and a $79.5 million asset, respectively, and is included in prepaid expenses and other assets. During the three and nine months ended September 30, 2006, the Company recognized a gain of $28.5 million and $78.9 million, respectively, attributable to these Euro Dollar futures contracts, which has been recorded as a reduction of interest expense related to the Company’s financing on mortgage loans held for investment. For the three and nine months ended September 30, 2005, the Company recognized a gain of $11.3 million and $31.9 million, respectively, attributable to cash flow hedges, which has been recorded as a reduction of interest expense. Additionally, certain Euro Dollar futures contracts were terminated during the fourth quarter of 2004 in connection with the transfer of certain assets

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

from New Century TRS to New Century. The fair value of the contracts at the termination date of ($30.9) million is being reclassified from OCI over the original hedge period, as the hedged transaction affects future earnings. Interest expense increased by $1.8 million and $7.9 million for the three and nine months ended September 30, 2006, respectively, related to the reclassification of the terminated contracts. For the three and nine months ended September 30, 2005, the Company reclassified into interest expense $3.2 million and $9.3 million, respectively, related to these terminated contracts. As of September 30, 2006, the related OCI balance was ($8.0) million.

 

Ineffectiveness — During the nine months ended September 30, 2006, the Company recognized other income of $13.7 million from the ineffective portion of these hedges. There was no ineffectiveness for the three months ended September 30, 2006. For the three and nine months ended September 30, 2005, the Company recognized other income of $2.2 million and $5.8 million, respectively, from the ineffective portion of these hedges.

 

Interest Rate Swap Contracts — As of September 30, 2006, the Company also had interest rate swap contracts that are designated as hedging the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment. The fair value of interest rate swap contracts designated as cash flow hedges at September 30, 2006 was an ($11.3) million liability and is included in accounts payable and accrued liabilities. There were no interest rate swap contracts designated as hedge instruments during the nine months ended September 30, 2005.

 

Interest Rate Cap Contracts — Certain of the Company’s securitizations structured as financings are subject to interest rate cap contracts (the “Caplets”) designated and documented as cash flow hedges used to mitigate interest rate risk. The change in the fair value of these Caplets is recorded in OCI each period. Amounts are reclassified out of OCI as the hedged transactions impact earnings. During the three and nine months ended September 30, 2006, the Company recorded $0.9 million and $2.6 million, respectively, as an increase to interest expense related to the effective portion of the Caplets. For the three and nine months ended September 30, 2005, the Company recorded $1.3 million and $6.3 million, respectively, as an increase to interest expense related to the effective portion of the Caplets. The fair value of these Caplets at September 30, 2006 and 2005 was $38,000 and $1.1 million, respectively, and is included in prepaid expenses and other assets.

 

Accumulated Other Comprehensive Income — As of September 30, 2006, the balance of accumulated OCI was $23.5 million, which relates to the fair value of cash flow hedges. The Company expects to reclassify $21.0 million from OCI into earnings during the remainder of 2006. The remaining OCI will be reclassified into earnings by September 2009.

 

Fair Value Hedge Instruments — For derivative financial instruments designated as fair value hedge instruments, the Company evaluates the effectiveness of these hedges against the fair value of the asset being hedged to ensure that there remains a highly effective correlation in the hedge relationship. To hedge the adverse effect of interest rate changes on the fair value of the hedged assets as a result of changes in the benchmark LIBOR interest rate, the Company uses derivative instruments classified as fair value hedges under SFAS 133. Once the hedge relationship is established, for those derivative instruments designated as qualifying fair value hedges, changes in the fair value of the derivative instruments and changes in the fair value of the hedged asset or liability attributable to the hedged risk are recorded in current earnings pursuant to SFAS 133. For the three and nine months ended September 30, 2006, the Company recognized a loss of $1.4 million and $3.1 million, respectively, which losses were substantially offset by changes in the fair value of the hedged assets. At September 30, 2006, these contracts were settled, and, as such, there were no fair value hedges outstanding as of that date. For the three and nine months ended September 30, 2005, the Company recognized a gain of $6.2 million and $11.0 million, respectively, related to fair value hedges. These gains or losses, as

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

applicable, have been included as a component of gain on sale of mortgage loans. The fair value of these contracts at September 30, 2005 was $0.5 million.

 

Free-standing derivatives

 

Euro Dollar futures contracts — As of September 30, 2006, the Company had certain open Euro Dollar futures contracts used to economically hedge the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment and to economically hedge the fair value of the Company’s residual interests in securitizations that are not designated as hedges under SFAS 133. During the three and nine months ended September 30, 2006, the Company recognized a loss of $17.8 million and a gain of $11.6 million, respectively, related to the change in fair value of Euro Dollar futures contracts used to economically hedge the interest rate risk related to the Company’s financing on mortgage loans held for investment and residual interests. The fair value of these contracts at September 30, 2006 was $0.8 million and is included in prepaid expenses and other assets. For the three and nine months ended September 30, 2005, the Company recognized a loss of $3.0 million and $2.6 million, respectively, related to the change in fair value of these contracts. The fair value of Euro Dollar futures contracts at September 30, 2005 was $0.7 million.

 

Purchased options on Euro Dollar futures contracts — The Company utilizes purchased options on Euro Dollar futures contracts not designated as economic hedge instruments related to the Company’s financing on mortgage loans held for investment. The change in fair value relating to purchased options on Euro Dollar futures contracts that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $0.7 million and $5.8 million, respectively, and was included in other income. The fair value of the purchased options on Euro Dollar futures contracts at September 30, 2006 was $2.7 million. There were no purchased options of Euro Dollar futures contracts at September 30, 2005.

 

Interest Rate Swap contracts — Also included in free-standing derivatives as of September 2006 were certain interest rate swap contracts not designated as hedge instruments related to the Company’s financing on mortgage loans held for investment. The change in fair value relating to interest rate swap contracts not designated as hedges that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $15.1 million and $3.4 million, respectively, and is included in other income. The fair value of interest rate swap contracts not designated as hedges was $0.4 million at September 30, 2006. There were no interest rate swap contracts at September 30, 2005.

 

Interest Rate Locks — The Company is exposed to interest rate risk from the time an IRLC is made to a residential mortgage applicant to the time the related mortgage loan is sold. IRLCs are derivative instruments under SFAS 133 and are recorded at fair value with the changes in the fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The change in fair value relating to IRLCs that was recognized in earnings during the three and nine months ended September 30, 2006 was a gain of $4.9 million and $4.6 million, respectively. The fair value of IRLCs at September 30, 2006 was $4.6 million. The change in fair value relating to IRLCs during the three and nine months ended September 30, 2005 was a loss of $4.9 million. The fair value of IRLCs at September 30, 2005 was ($2.3) million.

 

Forward Sale Commitments — The Company also utilizes forward sales commitments to manage the interest rate risk related to the Company’s financing on mortgage loans held for sale. The forward sale commitments are derivatives under SFAS 133 and are recorded at fair value with the changes in fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The Company enters into forward sale commitments on a significant portion of mortgage loan production for which there is no offsetting interest rate lock. The change in fair value relating to forward sale commitments that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $33.8 million and $9.2 million, respectively. The fair value of forward sale commitments at September 30, 2006 was a ($10.2)

 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

million liability and is included in accounts payable and accrued liabilities. The change in fair value relating to forward sale commitments for the three and nine months ended September 30, 2005 was a gain of $7.7 million. The fair value of forward sale commitments at September 30, 2005 was $5.2 million.

 

 

Commencing in 2004, the Company has operated so as to qualify as a REIT for U.S. federal income tax purposes. Provided that the Company complies with the REIT provisions of the Code, it is not subject to corporate level income taxes on REIT taxable income distributed in the form of dividends to stockholders. Operations of the TRS, including transactions by and between the TRS-level and REIT-level companies, are fully taxable and are filed on a separate federal consolidated income tax return.

 

During the three months ended September 30, 2006 and 2005, the Company recorded an income tax provision of $23.6 million and $2.9 million, respectively. The provision for income taxes during the nine months ended September 30, 2006 and 2005 was $64.8 million and $7.6 million, respectively.