New Century Case

New Century’s residual interests in off-balance sheet securitizations were the only ones that were reported as separate assets on New Century’s financial statements. Under FAS 140, when there is a transfer of financial assets (the sale of mortgage loans to a securitization trust) which can be viewed as a sale, the transferor should initially measured at “fair value” and the residual interests obtained as a result of the transfer, which also required to be measured at “fair value”.

Since residual interests were not traded on an exchange during the relevant time period, New Century valued the residual interests in off-balance sheet securitization based upon the present value of the estimated future cash flow generated with those residual interests. FAS 140 gave the guidelines for residual interests valuation: 1) Assumptions used for interest rates, default rates, and prepayment rates should include what market participants would use in similar circumstances. 2) Estimates of expected cash flows should be based on reasonable and assumptions and projections. 3) All available evidence should be considered in determining the assumptions.

However, during New Century’s estimation process for residual interests, it revealed some issues which did not follow the instructions under FAS 140.

First of all, New Century continued to rely on its internally-developed Excel-based models to value its residual interests, even though the third-party method became available in the industry. Licata, who became a Senior Vice President of Secondary Marketing, developed new models for pre-2003 securitization deals with his team. The models still relied on Excel spreadsheet and on estimates of prepayment rates and loan defaults. The models were not very precise because they did not accommodate all of the information available on the securitization trustee statements. Also, his models did not manage over-collateralization account numbers well, which...