Going for Broke : NewCentury Financial Corporation (2004-2006)

Abstract

Using loan level data, we investigate the lending behavior of a large subprime mortgage originator, New Century, prior to its bankruptcy in the beginning of 2007. We provide evidence of sudden risk-shifting in New Century’s lending behavior in 2004. This change follows the sharp monetary policy tightening implemented by the Fed in the spring of 2004, which resulted in an adverse shock to the large portfolio of loans New Century was holding for investment. Most notably, New Century reacted to the shock by massively resorting to deferred amortization loan contracts ("interest-only" loans). We show that these loans were not only riskier, but also that their returns were by design more sensitive to real estate prices than standard contracts. New Century was thus financing projects with a high beta on its own survival, as predicted by a standard model of portfolio selection in financial distress. Our findings shed new light on the relationship between monetary policy and risk taking by financial institutions. They also contribute to better characterizing the type of risk taken by financially distressed firms.