New Century Execs' Multimillion-Dollar Bonuses Tied to Lowballing Risks, Highballing Income From Subprime Mortgages, FinancialWeek Reports

Bankrupt Company's Old-Style Bonus Plan Was Incentive to Keep Earnings Up

Even as Subprime Market Crashed

    NEW YORK, May 6 /PRNewswire/ -- New Century Financial, the
 highest-profile casualty of the subprime lending meltdown to date, had an
 old-style bonus formula that may have fueled management's overstating of
 income and understating of risks for the subprime loans it was feeding into
 Wall Street's securitization machine, FinancialWeek reports in its May 7
 issue.
     According to proxy filings for 2005 reviewed by the newspaper -- the
 company will not be issuing 2006 financials or a proxy statement since it
 filed for Chapter 11 protection on April 2 -- the Irvine, Calif.-based
 company's bonus plan was structured to pay the company's top four
 executives a percentage of pretax income if the company exceeded an 18%
 return on shareholder equity.
     Per a plan adopted in 2004, chief executive Robert Cole, chief
 operating officer Brad Morrice, finance chief Edward Gotschall and
 executive vice president Patrick Flanagan -- all co-founders of the company
 in 1995 -- were paid 1.125% of pretax income above the return on equity
 threshold of 18% and below a 28% ceiling. On pretax income between 28% and
 38% ROE thresholds, they received a 0.75% cut. And if the company returned
 better than 38% on equity, they got another 0.6% on that amount.
     The formula resulted in bonuses of $2.4 million for each of the four
 executives in 2003, $3.4 million in 2004, and $1.1 million in 2005. The
 amounts for 2003 and 2004 were roughly six times the executives' salaries
 for those years. The plan also enabled the company to comply with IRS
 regulation 162m, which limits tax-deductible compensation for individuals
 to $1 million. Any compensation above $1 million has to be linked to
 meeting performance targets.
     "It's an older pay-for-results plan that you often find at investment
 firms, particularly where company founders are still involved in
 management," Pearl Meyer, a partner at compensation consultant Stephen Hall
 & Partners, told FinancialWeek. "The problem with flat-out pay-for-results
 formulas is that there is no judgment factor by the board to evaluate the
 quality of the earnings. It's automatic."
     At New Century, the quality of earnings should have been a concern for
 the board, writes FinancialWeek accounting reporter Andrew Osterland.
     For one thing, the bonus formula gave a strong incentive for managers
 to inflate earnings, and when combined with the latitude in making
 judgments on securitization transactions, which fueled New Century's and
 the rest of the subprime sector's growth, it can lead to problems.
     The last time the subprime sector blew up, in the late 1990s, so-called
 gain-on-sale accounting rules, which require companies to book the expected
 future income from long-term loans immediately when they are securitized
 and sold to investors, were a major factor in the collapse. Companies had
 to book more and more loans and make more and more aggressive assumptions
 about how the loans would perform in order to keep showing growth.
     The situation, this time around is slightly different. Gain-on-sale
 accounting became anathema in the market and most companies -- including
 New Century -- no longer account for securitizations using that method.
 Instead, they account for them as financings and recognize interest income
 from the loans and interest expense on the mortgage-backed securities as it
 comes in and goes out.
     The incentives to executives on pay-for-results bonus plans, however,
 are the same: originate lots and lots of loans. The more loans made and
 securitized, the more income can be recognized in the financial statements.
 Secondly, keep hoping for the best when it comes to the quality of the
 loans. Increasing loan loss provisions when the credit quality of the pool
 of loans deteriorates results in lower income -- and smaller bonuses.
     It's on this front that New Century executives may have pushed the
 accounting envelope, Zach Gast, an analyst with the Center for Financial
 Research and Analysis, told FinancialWeek. "Even if a company doesn't
 overstate income through gain-on-sale assumptions, if it doesn't make an
 adequate provision for loan losses, it overstates the value of the residual
 interests of securities it holds [and thereby income]."
     While the entire subprime lending sector could have made overly
 optimistic assumptions about the loans they were underwriting, New Century
 Financial appears to have used accounting gimmickry to reduce the
 provisions it should have been taking on shaky loans last year, according
 to Mr. Gast. He said the company changed the presentation of its loan loss
 data in the third quarter of last year and masked the deteriorating quality
 of the portfolio.
     "Their actual loan loss provision declined from $209 million in the
 second quarter to $192 million in the third quarter as loan delinquencies
 were rising rapidly," Mr. Gast explained.
     The company also failed to book a contingent liability for the
 possibility that it would have to repurchase loans that quickly went bad
 from the banks that sold the loans on to investors. The volume of such
 loans thrown back at New Century this year eventually sent it into
 bankruptcy.
     A lot of subprime lenders didn't book that liability, said Mr. Gast,
 but New Century didn't even book losses after the company began
 repurchasing bad loans last year. "In that regard they were different from
 the other lenders," he said.
     Why? Writing down the loans would have reduced income -- and executive
 bonuses. Dan Gagnier, an outside public relations spokesman for New
 Century, said the company's audit committee is currently conducting an
 internal investigation into the firm's lending and accounting practices and
 could not comment on the situation.
     "The game is 'grab as much as you can and then fold up the tent,'" said
 Richard Benson, president of Specialty Finance Group, a financial broker to
 private finance companies.
     New Century executives seemed to have had a good grasp of the game. But
 with 34 securities class-action suits now filed against the company,
 investors may get the last grab. FW
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SOURCE FinancialWeek