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It’s stress-testing time in the subprime market.

On Wednesday, mortgage finance REIT New Century Financial (NEW) issued a non-reliance 8-K, revoking investor reliance on all its quarterly financials issued in 2006.

The subprime market has been a concern for months now, as housing slowed down. Yesterday’s news from HSBC that they’d drastically underestimated their bad loan exposure from subprime lending only reinforced fears. And the fear is almost palpable in the stock prices of HSBC and New Century.

Good batting can cover up for bad pitching, they say. But when the bats go cold, the bad pitching makes for managers’ headaches. And that’s just what may be happening here: when the subprime market was hot and growing, things like loss reserves seemed to take care of themselves. Now that the lending-go-round has stopped and the payments aren’t coming in, the weaknesses in the accounting for loss reserves show up. And they show up ugly.

From the New Century 8-K:

“The company establishes an allowance for repurchase losses on loans sold, which is a reserve for expenses and losses that may be incurred by the company due to the potential repurchase of loans resulting from early-payment defaults by the underlying borrowers or based on alleged violations of representations and warranties in connection with the sale of these loans. When the company repurchases loans, it adds the repurchased loans to its balance sheet as mortgage loans held for sale at their estimated fair values, and reduces the repurchase reserve by the amount the repurchase prices exceed the fair values. During the second and third quarters of 2006, the company’s accounting policies incorrectly applied Statement of Financial Accounting Standards No. 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. Specifically, the company did not include the expected discount upon disposition of loans when estimating its allowance for loan repurchase losses.

In addition, the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculation did not properly consider, in each of the first three quarters of 2006, the growing volume of repurchase claims outstanding that resulted from the increasing pace of repurchase requests that occurred in 2006, compounded by the increasing length of time between the whole loan sales and the receipt and processing of the repurchase request.” [Emphasis added.]

Translated:

The firm buys back subprime loans that it sold to securitization trusts, a la Statement 140. That keeps the securitization trust in the pink; it’ll have the cash it needs to keep the security holders happy. At the outset of securitizations, the company is supposed to set up an allowance for the expected losses it would incur when it “takes back” the unhealthy loans. Apparently, this didn’t happen. Putting such loans back on the balance sheet at fair value would cause them to reverse such an allowance, and there was nothing to reverse. It also seems that the company didn’t expect things to turn out badly quite so fast:

“The company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculation did not properly consider … the growing volume of repurchase claims outstanding that resulted from the increasing pace of repurchase requests that occurred in 2006.”

The mid-1990’s saw many firms hit the wall when their securitization assumptions turned out flawed. It’s almost as if nothing was learned from the past. It’s early to say that this is going to be a widespread problem, in that these errors seem to be of New Century’s own doing.

And they seem pretty basic: when you have a loan, you set up a reserve for some of the bad apples. Period. It’s a basic principle of lending accounting, and it’s embedded in Statement 140, too. Which, by the way, has been around for over six years.. No bye should be given for the issuance of a new and complex standard that wasn’t fully understood.