The Pebble and the Avalanche

Ghost Mortgages: Was New Century Plagued by Fraud?

This is a tale of disaggregation, fraud, and meaningless numbers.

First, the disaggregation. New Century Financial Corporation, which is now struggling in its subprime mortgage market niche, specialized in the financial end of the mortgages and relied on hundreds of small brokerage firms to actually sell the mortgage. This is familiar business model — the disaggregation of sales, marketing, and manufacturing — and often a quite successful one.

But what happens if the mortgages are made to ghosts? According to the Wall Street Journal [the online version is subscription only, sorry!], a substantial fraction of the mortgages were made to people who never even made their first payments:

Borrowers failed to make even the first payment on 2.5% of New Century's loans.

Since most people who borrow in good faith will typically make at least a few payments before defaulting, the Journal raises the suspicion that New Century was careless in its selection of mortgage brokers and as a result suffered fraud.

I'm going to raise two different issues. First, disaggregation almost always requires some feedback, some way of tying the disaggregated parts together. If I decide to make bolts in one factory and nuts in another, I need to find a way to test to make certain the nuts and bolts fit together. Similarly, if New Century decides to allow outside brokers to sell New Century mortgages, then New Century must make certain that the mortgages these brokers generate meet New Century's standards.

Secondly, the number "2.5%" is utterly meaningless without any context. What is the first-payment default rate for "normal," non-sub-prime mortgages? What is the rate for other sub-prime mortgage lenders? Without any context, I don't know if this shocking number represents the worst in the entire sub-prime loan industry — or the very best. And given that New Century turned a profit until its recent problems, it may be that their business model allowed them to absorb the costs of a higher-than-usual rate in return for a higher number of profitable mortgages. That is, they knowingly accepted a higher rate because it permitted them to capture higher profits by reducing overall costs and increasing overall sales.

So, while the Journal article is filled with the usual pathos of senior citizens who can't afford their mortgage payments, one of the central indictments of the article — that New Century allowed itself to be defrauded, and that the fraud they permitted was bad for the company — remains unsupported to date.

Topics:  · finance · security

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