10-Q 1 a24944e10vq.htm FORM 10-Q e10vq
 

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
     
(Mark One)    
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the quarterly period ended September 30, 2006.
     
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
    For the transition period from            to           
 
COMMISSION FILE NUMBER: 001-32314
 
NEW CENTURY FINANCIAL CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
     
MARYLAND
  56-2451736
(State of Incorporation)   (I.R.S. Employer Identification No.)
 
18400 VON KARMAN, SUITE 1000,
IRVINE, CALIFORNIA 92612
(Address of principal executive offices)(Zip Code)
 
(949) 440-7030
(Registrant’s telephone number, including area code)
 
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days. þ Yes o No
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer þ Accelerated filer o Non accelerated filer o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No
 
As of October 31, 2006, the registrant had 55,470,607 shares of common stock outstanding.
 


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
FORM 10-Q
 
QUARTER ENDED SEPTEMBER 30, 2006
 
INDEX
 
         
 
         
  Financial Statements   1
         
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   38
         
  Quantitative and Qualitative Disclosures About Market Risk   76
         
  Controls and Procedures   77
 
         
  Legal Proceedings   77
         
  Risk Factors   79
         
  Unregistered Sales of Equity Securities and Use of Proceeds   80
         
  Submission of Matters to a Vote of Security Holders   81
         
  Exhibits   81
     
  82
     
  83


i


 

Certain information included in this Quarterly Report on Form 10-Q may include “forward-looking” statements under federal securities laws, and the company intends that such forward-looking statements be subject to the safe-harbor created thereby. Such statements include, without limitation, (i) the company’s business strategies; (ii) the company’s expectations with respect to market trends; (iii) the company’s projected sources and uses of funds from operations; (iv) the potential liability the company faces with respect to its legal proceedings; (v) the potential effects of proposed legislation and regulatory actions; (vi) the company’s expectation that its adoption of SFAS 155 will not have a material impact on its financial statements; (vii) the company’s expectation that its initial adoption of SFAS 156 will not have a material impact to its retained earnings; (viii) the company’s expectation that its adoption of FIN 48 will not have a significant impact on its financial statements; (ix) the company’s expectation that its initial adoption of SAB 108 will not have a material impact on its financial results; (x) the estimates the company uses to establish its allowance for loan losses; (xi) the estimates the company uses to determine the value of its residual assets including the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows; (xii) the company’s estimates with respect to average cumulative losses as a percentage of the original principal balance of mortgage loans for adjustable-rate and fixed-rate securities; (xiii) the company’s estimates with respect to its prepayments and the prepayment characteristics of its mortgage loans; (xiv) the company’s expectations with respect to the performance of the mortgage loans held in securitization trusts and the ability of the company to realize the current estimated fair value of its residual assets; (xv) the company’s expectations with respect to renewing or extending its various credit facilities; (xvi) the company’s expectation that it will reclassify an additional $21.0 million from OCI into earnings during the remainder of 2006 related to expiring contracts; (xvii) the company’s expectation that the remaining OCI will be reclassified into earnings by September 2009; (xviii) the company’s expectation that the earnings attributable to the REIT will not be taxable due to the benefit of the REIT’s dividend paid deduction; (xix) the company’s estimates with respect to the fair value of its stock options; (xx) the company’s expectation that its decisions regarding secondary marketing transactions in 2006 will be influenced by market conditions and the company’s ability to access external sources of capital; (xxi) the company’s expectation that a significant source of its revenue will continue to be interest income generated from its portfolio of mortgage loans held by the company’s REIT and its taxable REIT subsidiaries; (xxii) the company’s expectation that it will continue to generate revenue through its taxable REIT subsidiaries from the sale of loans, servicing income and loan origination fees; (xxiii) the company’s expectation that the primary components of its expenses will be (a) interest expense on its credit facilities, securitizations and other borrowings, (b) general and administrative expenses and (c) payroll and related expenses arising from its origination and servicing businesses; (xxiv) the company’s expectation that industry consolidation will continue into 2007; (xxv) the company’s belief that its hedging strategies are effective on an economic basis; (xxvi) the company’s expectation that the operating environment will continue to be challenging in the fourth quarter of 2006; (xxvii) the company’s expectation that loan production volume in the fourth quarter will be moderately lower than the third quarter and the company’s non-prime net operating margin will be reduced in the fourth quarter as a result of higher discounted loan sales; (xxviii) the company’s expectation that mortgage loan portfolio income in the fourth quarter of 2006 will be lower than the third quarter as the portfolio balance continues to decline; (xxix) the company’s strategy for next year focusing on maximizing its core mortgage origination franchise through loan origination process improvement, enhanced productivity and increased efficiencies; (xxx) the company’s expectation that it will not add to the mortgage loan portfolio simply to support a dividend target; (xxxi) the company’s expectation that it will continue to evaluate whole loan sales versus securitizations on a case-by-case basis based on whole loan prices relative to its view of the risk-adjusted returns on capital available through securitization; (xxxii) the company’s belief that the current environment calls for a financial strategy that is flexible enough to capitalize on the opportunities that arise during 2007 giving consideration to secondary and capital market conditions; (xxxiii) the company’s belief that it is well-positioned to meet the challenges next year; (xxxiv) the company’s expectation that overall mortgage market volume will decline in 2007; (xxxv) the company’s belief that its size, scale, financial resources, low loan acquisition costs and reputation will enable it to compete successfully and profitably gain market share in the consolidating mortgage industry; (xxxvi) the company’s expectation that, going forward, it will continue to be opportunistic about whole loan sales versus securitization, taking into account secondary market conditions and its capital allocation strategy; (xxxvii) the company’s belief that it is adequately reserved for the expected higher level of loan losses after giving consideration to the performance of its newer vintages; (xxxviii) the execution of the company’s hedging strategies to mitigate the interest rate risk associated with its loans and reduce the variability in its interest margin over the period of each securitization; (xxxix) the company’s belief that the steps it is taking with respect to its underwriting


ii


 

guidelines are prudent in light of the current market environment and will help ensure that specific loan products are appropriate for the circumstances of individual borrowers and will improve the overall credit quality of the company’s loans; (xl) the company’s plan to continue evaluating its product line; (xli) the company’s expectation that its underwriting changes may result in a modest decline in volume, but will not have a meaningful impact to profitability; (xlii) the company’s plan to manage the timing of its whole loan sales to enhance the net interest income it earns on its loans, while preserving the company’s ability to sell the loans at the maximum price; (xliii) the company’s expectation that the volume of discounted sales and the severity of the discount will continue to challenge originators in the Company’s industry; (xliv) the company’s belief that its ongoing refinement of its underwriting guidelines and continual focus on loan origination process improvement will help mitigate the industry trend relating to higher discounted loan sales; (xlv) the company’s belief that the lower initial payment requirements of pay-option loans may increase the credit risk inherent in its loans held for sale; (xlvi) the company’s design of its underwriting standards, including its recently adopted guidelines for adjustable-rate and interest-only loans, and quality assurance programs to ensure that loan quality is consistent and meets the company’s guidelines, even as the mix of documentation type varies; (xlvii) the company’s beliefs, estimates and assumptions with respect to its critical accounting policies; (xlviii) the company’s estimates and assumptions relating to the interest rate environment, the economic environment, secondary market conditions and the performance of the loans underlying its residual assets and mortgage loans held for investment; (il) the company’s use of a prepayment curve to estimate the prepayment characteristics of its mortgage loans; (l) the company’s right to terminate, reduce or increase the size of its stock purchase program at any time; (li) the company’s execution of its principal strategies to effectively manage its liquidity and capital; (lii) the company’s target levels of liquidity and capital; (liii) the company’s expectation that prepayment speeds will continue to be at more normal levels through the fourth quarter of 2006; (liv) the company’s intention to access the capital markets when appropriate to support its business operations; (lv) the company’s intention to execute its stock repurchase program while maintaining its targeted cash and liquidity levels; (lvi) the company’s plan to return capital to shareholders through a capital distribution program; (lvii) the company’s belief that the cash to fund its stock repurchase and capital distribution program can come from a variety of sources, including, but not limited to, cash flow from its taxable REIT subsidiaries and mortgage banking operations, cash flow from its portfolio of mortgage securities, including the release of over-collateralization from such securities, and through external capital sources; (lviii) the company’s expectation that its liquidity, credit facilities and capital resources will be sufficient to fund its operations for the foreseeable future, while enabling the company to maintain its qualification as a REIT under the requirements of the Code; (lix) the company’s expectation that its fourth quarter dividend will be paid in the amount of $1.90 per share on January 31, 2007 to stockholders of record at the close of business on December 29, 2006; and (lx) the company’s expectation that any future declarations of dividends on its common stock will be subject to its earnings, financial position, capital requirements, contractual restrictions and other relevant factors. The company cautions that these statements are qualified by important factors that could cause its actual results to differ materially from expected results in the forward-looking statements. Such factors include, but are not limited to, (i) the condition of the U.S. economy and financial system; (ii) the interest rate environment; (iii) the effect of increasing competition in the company’s sector; (iv) the condition of the markets for whole loans and mortgage-backed securities; (v) the stability of residential property values; (vi) the company’s ability to comply with the requirements applicable to REITs; (vii) the company’s ability to increase its portfolio income; (viii) the company’s ability to continue to maintain low loan acquisition costs; (ix) the potential effect of new state or federal laws and regulations; (x) the company’s ability to maintain adequate credit facilities to finance its business; (xi) the outcome of litigation or regulatory actions pending against the company; (xii) the company’s ability to adequately hedge its residual values, cash flows and fair values; (xiii) the accuracy of the assumptions regarding the company’s repurchase allowance and residual valuations, prepayment speeds and loan loss allowance; (xiv) the ability to finalize its forward sale commitments; (xv) the ability to deliver loans in accordance with the terms of forward sale commitments; (xvi) the assumptions underlying the company’s risk management practices; and (xvii) the ability of the company’s servicing platform to maintain high performance standards. Additional information on these and other factors is contained in the company’s Annual Report on Form 10-K for the year ended December 31, 2005 and the company’s other periodic filings with the Securities and Exchange Commission. The company assumes no, and hereby disclaims any, obligation to update the forward-looking statements contained in this Quarterly Report on Form 10-Q.


iii


 

 
Item 1.   Financial Statements
 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
Condensed Consolidated Balance Sheets
September 30, 2006 and December 31, 2005
(Dollars in thousands)
 
                 
    September 30,
    December 31,
 
    2006     2005  
    (Unaudited)        
 
ASSETS
Cash and cash equivalents
  $ 408,860       503,723  
Restricted cash
    572,847       726,697  
Mortgage loans held for sale at lower of cost or market
    8,945,134       7,825,175  
Mortgage loans held for investment, net of allowance of $191,561 and $198,131, respectively
    14,030,999       16,143,865  
Residual interests in securitizations — held-for-trading
    223,680       234,930  
Mortgage servicing assets
    59,878       69,315  
Real estate owned, net of allowance of $56,318 and $18,196, respectively
    84,021       37,642  
Accrued interest receivable
    109,598       101,945  
Income taxes, net
    80,551       80,823  
Office property and equipment, net
    87,736       86,886  
Goodwill
    95,792       92,980  
Prepaid expenses and other assets
    360,672       243,109  
                 
Total assets
  $ 25,059,768       26,147,090  
                 
LIABILITIES AND STOCKHOLDERS’ EQUITY
Credit facilities on mortgage loans held for sale
  $ 8,487,850       7,439,685  
Financing on mortgage loans held for investment, net
    13,858,940       16,045,459  
Accounts payable and accrued liabilities
    574,258       508,163  
Junior subordinated notes
    51,545        
Convertible senior notes, net
          4,943  
Notes payable
    22,826       39,140  
                 
Total liabilities
    22,995,419       24,037,390  
Commitments and contingencies
               
Stockholders’ equity:
               
Preferred stock, $0.01 par value. Authorized 25,000,000 shares at September 30, 2006 and 10,000,000 shares at December 31, 2005;
               
Series A preferred stock; issued and outstanding 4,500,000 shares at September 30, 2006 and December 31, 2005
    45       45  
Series B preferred stock; issued and outstanding 2,300,000 shares at September 30, 2006 and none at December 31, 2005
    23        
Common stock, $0.01 par value. Authorized 300,000,000 shares at September 30, 2006 and December 31, 2005; issued and outstanding 55,329,184 and 55,723,267 shares at September 30, 2006 and December 31, 2005, respectively
    553       557  
Additional paid-in capital
    1,246,451       1,234,362  
Accumulated other comprehensive income
    23,450       61,045  
Retained earnings
    793,827       828,270  
                 
      2,064,349       2,124,279  
Deferred compensation costs
          (14,579 )
                 
Total stockholders’ equity
    2,064,349       2,109,700  
                 
Total liabilities and stockholders’ equity
  $ 25,059,768       26,147,090  
                 
 
See accompanying notes to unaudited condensed consolidated financial statements.
 


1


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
Condensed Consolidated Statements Of Earnings
(Dollars in thousands, except per share amounts)
(Unaudited)
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Interest income
  $ 514,172       494,621       1,478,288       1,246,553  
Interest expense
    (375,228 )     (290,899 )     (1,019,552 )     (671,535 )
                                 
Net interest income
    138,944       203,722       458,736       575,018  
Provision for losses on mortgage loans held for investment
    (20,756 )     (38,542 )     (80,906 )     (105,655 )
                                 
Net interest income after provision for losses
    118,188       165,180       377,830       469,363  
Other operating income:
                               
Gain on sale of mortgage loans
    173,045       176,241       497,732       409,797  
Servicing income
    17,770       10,203       47,424       23,556  
Other income (loss)
    (20,747 )     4,986       18,845       12,257  
                                 
Total other operating income
    170,068       191,430       564,001       445,610  
Operating expenses:
                               
Personnel
    112,575       146,575       356,218       378,258  
General and administrative
    57,498       49,823       170,086       133,922  
Advertising and promotion
    14,643       25,661       41,197       66,204  
Professional services
    13,295       11,580       33,588       29,063  
                                 
Total operating expenses
    198,011       233,639       601,089       607,447  
                                 
Earnings before income taxes
    90,245       122,971       340,742       307,526  
Income tax expense
    23,603       2,867       64,822       7,583  
                                 
Net earnings
    66,642       120,104       275,920       299,943  
Dividends paid on preferred stock
    3,174       2,567       8,307       2,852  
                                 
Net earnings available to common stockholders
  $ 63,468       117,537       267,613       297,091  
                                 
Basic earnings per share
  $ 1.14       2.10       4.81       5.37  
Diluted earnings per share
  $ 1.12       2.04       4.72       5.18  
Basic weighted average shares outstanding
    55,512,895       55,870,410       55,605,770       55,345,952  
Diluted weighted average shares outstanding
    56,529,650       57,598,055       56,719,551       57,421,474  
 
See accompanying notes to unaudited condensed consolidated financial statements.


2


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
Condensed Consolidated Statements Of Comprehensive Income
(Dollars in thousands)
(Unaudited)
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Net earnings
  $ 66,642       120,104       275,920       299,943  
Net unrealized gains (losses) on derivative instruments designated as hedges
    (60,792 )     66,977       (40,396 )     44,371  
Reclassification adjustment into earnings for derivative instruments
    781       2,375       2,386       9,862  
Tax effect
    421       (600 )     415       (1,449 )
                                 
Comprehensive income
  $ 7,052       188,856       238,325       352,727  
                                 
 
See accompanying notes to unaudited condensed consolidated financial statements.


3


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
Consolidated Statements Of Changes In Stockholders’ Equity
Year Ended December 31, 2005 and Nine Months Ended September 30, 2006
(In thousands, except per share amounts)
(Nine Months Ended September 30, 2006 Unaudited)
 
                                                                         
                                  Accumulated
                   
                                  Other
                   
    Preferred
    Preferred
    Common
    Common
    Additional
    Comprehensive
                   
    Shares
    Stock
    Shares
    Stock
    Paid-In
    Income
    Retained
    Deferred
       
    Outstanding     Amount     Outstanding     Amount     Capital     (Loss)     Earnings     Compensation     Total  
       
 
Balance at December 31, 2004
                54,703       547       1,108,590       (4,700 )     781,627       (7,499 )     1,878,565  
Proceeds from issuance of common stock
                1,880       19       26,440                         26,459  
Proceeds from issuance of preferred stock
    4,500       45                   108,619                         108,664  
Repurchases and cancellation of treasury stock
                (879 )     (9 )     (29,465 )                       (29,474 )
Cancelled shares related to stock options
                (244 )     (2 )     (12,414 )                       (12,416 )
Conversion of convertible senior notes
                15             500                         500  
Issuance of restricted stock, net
                248       2       14,493                   (14,495 )      
Amortization of deferred compensation
                                              7,415       7,415  
Net earnings
                                        416,543             416,543  
Tax benefit related to non-qualified stock options
                            17,599                         17,599  
Other comprehensive income, net of tax
                                  65,745                   65,745  
Dividends declared on common stock,
$6.50 per share
                                        (364,482 )           (364,482 )
Dividends declared on preferred stock,
$1.20 per share
                                        (5,418 )           (5,418 )
                                                                         
Balance at December 31, 2005
    4,500       45       55,723       557       1,234,362       61,045       828,270       (14,579 )     2,109,700  
Proceeds from issuance of common stock
                827       8       14,706                         14,714  
Proceeds from issuance of preferred stock
    2,300       23                   55,580                         55,603  
Repurchases and cancellation of treasury stock
                (1,544 )     (15 )     (66,476 )                       (66,491 )
Cancelled shares related to stock options
                (93 )     (1 )     (1,355 )                       (1,356 )
Compensation expense related to common
stock options
                            8,318                         8,318  
Excess tax benefits related to non-qualified
stock options
                            5,037                         5,037  
Conversion of convertible senior notes
                166       2       4,998                         5,000  
Restricted stock, net
                250       2       (2,480 )                       (2,478 )
Compensation expense related to restricted stock
                            8,340                         8,340  
Reclassification of deferred compensation
related to adoption of SFAS 123R
                            (14,579 )                 14,579        
Net earnings
                                        275,920             275,920  
Other comprehensive income, net of tax
                                  (37,595 )                 (37,595 )
Dividends declared on common stock,
$5.40 per share
                                        (302,056 )           (302,056 )
Dividends declared on Series A preferred stock, $1.71 per share
                                        (7,700 )           (7,700 )
Dividends declared on Series B preferred stock, $0.26 per share
                                        (607 )           (607 )
                                                                         
Balance at September 30, 2006
    6,800       68       55,329       553       1,246,451       23,450       793,827             2,064,349  
                                                                         
 
See accompanying notes to unaudited condensed consolidated financial statements.


4


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES
 
Condensed Consolidated Statements of Cash Flows
(Dollars in thousands)
(Unaudited)
 
                 
    Nine Months Ended
 
    September 30,  
    2006     2005  
Cash flows from operating activities:
               
Net earnings
  $ 275,920       299,943  
Adjustments to reconcile net earnings to net cash provided by operating activities:
               
Depreciation and amortization of office property and equipment
    22,669       16,048  
Amortization of deferred costs related to mortgage loans held for investment
    64,984       65,072  
Amortization related to mortgage servicing rights and other
    15,004       8,634  
Stock-based compensation
    16,658       5,657  
Cash flows received from residual interests in securitizations
    2,113       15,021  
Accretion of Net Interest Receivables, or “NIR”
    (18,986 )     (11,949 )
NIR gains
          (34,807 )
Servicing gains
    (30,026 )     (60,927 )
Fair value adjustment of residual interests in securitizations
    28,123       7,645  
Provision for losses on mortgage loans held for investment
    80,906       105,655  
Provision for repurchase losses
    5,261       4,300  
Increase in real estate owned, net
    (46,379 )     (16,558 )
Mortgage loans originated or acquired for sale
    (42,077,479 )     (30,215,340 )
Mortgage loan sales, net
    40,630,368       25,453,537  
Principal payments on mortgage loans held for sale
    446,841       209,084  
Increase in credit facilities on mortgage loans held for sale
    1,048,165       4,513,854  
Tax benefit (change) related to non-qualified stock options
    (5,037 )      
Net change in other assets and liabilities
    (249,179 )     77,391  
                 
Net cash provided by operating activities
    209,926       442,260  
                 
Cash flows from investing activities:
               
Mortgage loans originated or acquired for investment, net
    (3,376,627 )     (10,273,642 )
Principal payments on mortgage loans held for investment
    5,370,993       4,984,710  
Sale of mortgage servicing rights
    29,479       8,477  
Purchase of office property and equipment
    (23,519 )     (46,761 )
Acquisition of net assets
    9,795       (80,573 )
                 
Net cash provided by (used in) investing activities
    2,010,121       (5,407,789 )
                 
Cash flows from financing activities:
               
Proceeds from issuance of financing on mortgage loans held for investment, net
    3,280,904       9,792,230  
Repayments of financing on mortgage loans held for investment
    (5,488,031 )     (4,688,033 )
(Increase) decrease in restricted cash
    153,850       (317,306 )
Proceeds from issuance of junior subordinated notes
    51,545        
Net proceeds from issuance of common stock
    14,714       25,368  
Net proceeds from issuance of preferred stock
    55,603       108,664  
Increase (decrease) in notes payable, net
    (16,314 )     7,680  
Payment of dividends on common stock
    (294,193 )     (259,067 )
Payment of dividends on preferred stock
    (7,700 )     (2,852 )
Excess tax benefits from stock-based compensation
    5,037        
Purchase of common stock
    (70,325 )     (13,950 )
                 
Net cash provided by (used in) financing activities
    (2,314,910 )     4,652,734  
                 
Net decrease in cash and cash equivalents
    (94,863 )     (312,795 )
Cash and cash equivalents, beginning of year
    503,723       842,854  
                 
Cash and cash equivalents, end of period
  $ 408,860       530,059  
                 
Supplemental cash flow disclosure:
               
Interest paid
  $ 1,014,275       652,937  
Income taxes paid
    60,720       24,746  
Supplemental noncash financing activity:
               
Restricted stock issued
  $ 8,340       14,866  
Restricted stock cancelled
    2,478       5,896  
Accrued dividends on common stock
    102,400       93,183  
Accrued dividends on preferred stock
    607        
 
See accompanying notes to unaudited condensed consolidated financial statements.


5


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

September 30, 2006 and 2005
 
1.   Basis of Presentation
 
New Century TRS Holdings, Inc. (formerly known as New Century Financial Corporation), a Delaware corporation (“New Century TRS”), was formed on November 17, 1995. On April 5, 2004, New Century TRS’s board of directors approved a plan to change New Century TRS’s capital structure to enable it to qualify as a real estate investment trust, or REIT, for United States federal income tax purposes. On April 12, 2004, New Century TRS formed New Century Financial Corporation (formerly known as New Century REIT, Inc.), a Maryland corporation (“New Century”). As used herein, except where the context suggests otherwise, for time periods before October 1, 2004, the terms “the Company,” “our,” “its,” “we,” “the group,” and “us” mean New Century TRS Holdings, Inc., and its consolidated subsidiaries, and for time periods on and after October 1, 2004, the terms “the Company,” “our,” “its,” “we,” “the group,” and “us” refer to New Century Financial Corporation and its consolidated subsidiaries.
 
Pursuant to the merger that implemented the restructuring of New Century TRS in order for it to qualify as a REIT (the “Merger”), New Century became the publicly-traded parent listed on the New York Stock Exchange, or NYSE, began trading under the ticker symbol “NEW,” and succeeded to and continued to operate substantially all of the existing businesses of New Century TRS and its subsidiaries. The Merger was consummated and became effective on October 1, 2004, and was accounted for on an “as if pooling basis.” These consolidated financial statements give retroactive effect to the Merger for the periods presented. Accordingly, under “as if pooling accounting,” the assets and liabilities of New Century TRS transferred to New Century in connection with the Merger have been accounted for at historical amounts as if New Century TRS was transferred to New Century as of the earliest date presented and the consolidated financial statements of New Century prior to the Merger include the results of operations of New Century TRS. Stockholders’ equity amounts presented for years prior to the formation of New Century are those of New Century TRS, adjusted for the Merger exchange rate.
 
New Century Mortgage Corporation, a wholly-owned subsidiary of New Century TRS (“New Century Mortgage”), commenced operations in February 1996 and is a mortgage finance company engaged in the business of originating, purchasing, selling and servicing mortgage loans secured primarily by first and second mortgages on single-family residences. NC Capital Corporation, a wholly-owned subsidiary of New Century Mortgage (“NC Capital”), was formed in December 1998 to conduct the secondary marketing activities of New Century. New Century Credit Corporation (formerly known as Worth Funding Incorporated), a wholly-owned subsidiary of New Century (“New Century Credit”), was acquired in March 2000 by New Century Mortgage. NC Residual IV Corporation, a wholly-owned subsidiary of New Century (“NCRIV”) was formed in September 2004 to hold a portfolio of mortgage loans held for investment. After consummation of the Merger, New Century purchased New Century Credit from New Century Mortgage.
 
On September 2, 2005, Home123 Corporation, an indirect wholly owned subsidiary of New Century (“Home123”), purchased the origination platform of RBC Mortgage Company, or RBC Mortgage, that expanded the Company’s retail presence on a nationwide basis, its channels of distribution and its mortgage product offerings to include conventional mortgage loans, loans insured by the Federal Housing Administration and loans guaranteed by the Veterans Administration. The purchase price for the net assets was $80.6 million, and was accounted for using the purchase method. Of the aggregate amount, $7.6 million was the fair value of assets acquired and $4.1 million was the fair value of liabilities assumed. The excess of the purchase price over the fair value of assets acquired and liabilities assumed was $77.1 million and was allocated and recorded as goodwill at Home123.
 
On February 3, 2006, one of New Century’s indirect subsidiaries, New Century Warehouse Corporation, completed the purchase of the platform of Access Lending Corporation, or Access Lending, that provides warehouse lending services to middle-market residential mortgage bankers. The purchase price for the net


6


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

assets was $9.8 million, and was accounted for using the purchase method. The fair value of the assets acquired was $94.3 million and the fair value of the liabilities assumed was $87.7 million. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was allocated to and recorded as goodwill. Additionally, pursuant to the terms of the purchase and assumption agreement governing the transaction, Access Lending is entitled to receive additional payments for two years following the consummation of the transaction, based upon profitability. The results of operations for the acquired platform have been included in the Company’s condensed consolidated financial statements since the date of acquisition.
 
The accompanying condensed consolidated financial statements include the consolidated financial statements of New Century’s wholly-owned subsidiaries, New Century TRS, New Century Credit, and NCRIV. All material intercompany balances and transactions are eliminated in consolidation.
 
The Company has prepared the accompanying unaudited condensed consolidated financial statements in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, the statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information, refer to the consolidated financial statements and notes thereto included in New Century’s Annual Report on Form 10-K for the year ended December 31, 2005 filed with the Securities and Exchange Commission.
 
Reclassification
 
Certain amounts from the prior year’s presentation have been reclassified to conform to the current year’s presentation.
 
Recent Accounting Developments
 
In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”), which provides the following: (1) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation, (4) clarifies that concentrations of credit in the form of subordination are not embedded derivatives and (5) amends Statement of Financial Accounting Standards No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities a replacement of FASB Statement 125,” to eliminate the prohibition of a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 accounting for certain hybrid financial instruments is effective for the Company beginning January 1, 2007. Adoption of SFAS 155 is not expected to have a material impact on the Company’s financial statements.
 
In March 2006, the FASB issued Statement of Financial Accounting Standards No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), which provides the following: (1) revised guidance on when a servicing asset and servicing liability should be recognized, (2) requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable, (3) permits an entity to elect


7


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

to measure servicing assets and servicing liabilities at fair value each reporting date and report changes in fair value in earnings in the period in which the changes occur, (4) upon initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities for securities that are identified as offsetting the entity’s exposure to changes in the fair value of servicing assets or liabilities that a servicer elects to subsequently measure at fair value and (5) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional footnote disclosures. SFAS 156 is effective for the Company beginning January 1, 2007, with the effects of initial adoption being reported as a cumulative-effect adjustment to retained earnings. The impact to retained earnings as a result of the initial adoption of SFAS 156 is expected to be immaterial.
 
FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” was issued in June 2006. FIN 48 clarifies the accounting for uncertainty in tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition, and is effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of FIN 48 is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period FIN 48 is adopted. The Company’s accounting for its income tax contingency reserves is not based on the provisions of FIN 48 because its financial statements for the first quarter of 2006 have been issued without the early adoption of the provisions of FIN 48. Management is currently evaluating the impact of adopting FIN 48; however, it is not expected to have a significant impact on the Company’s financial statements.
 
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements required under other accounting pronouncements, but does not change existing guidance as to whether or not an instrument is carried at fair value. Additionally, it establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Earlier application is encouraged, provided that the reporting entity has not yet issued financial statements for that fiscal year, including financial statements for an interim period within that fiscal year. The Company is currently evaluating the impact, if any, that SFAS 157 will have on its financial condition and results of operations.
 
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 must be applied to annual financial statements for their first fiscal year ending after November 15, 2006. SAB 108 will be effective beginning January 1, 2007. The Company is evaluating the impact of adopting SAB 108 on the Company’s financial results.
 
Cash and Cash Equivalents
 
For purposes of the statements of cash flows, the Company considers all highly-liquid debt instruments with original maturities of three months or less to be cash equivalents. Cash equivalents consist of cash on hand and cash due from banks.


8


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

Restricted Cash
 
As of September 30, 2006, restricted cash totaled $572.8 million, and included $55.9 million in cash held in margin accounts associated with the Company’s interest rate risk management activities, $443.0 million in cash held in custodial accounts associated with its mortgage loans held for investment, $37.5 million in cash held in a cash reserve account and $34.7 million in cash held in a funding trust account in connection with its asset-backed commercial paper facility and $1.7 million in cash held in trust accounts on behalf of borrowers. As of December 31, 2005, restricted cash totaled $726.7 million, and included $73.4 million in cash held in a margin account associated with the Company’s interest rate risk management activities, $633.0 million in cash held in custodial accounts associated with its mortgage loans held for investment, $20.0 million in cash held in a cash reserve account in connection with its asset-backed commercial paper facility and $0.3 million in cash held in trust accounts on behalf of borrowers.
 
Mortgage Loans Held for Sale
 
Mortgage loans held for sale are stated at the lower of amortized cost or fair value as determined by outstanding commitments from investors or current investor-yield requirements, calculated on an aggregate basis.
 
Mortgage Loans Held for Investment
 
Mortgage loans held for investment represent loans securitized through transactions structured as financings, or pending securitization through transactions that are expected to be structured as financings. Mortgage loans held for investment are stated at amortized cost, including the outstanding principal balance, less the allowance for loan losses, plus net deferred origination costs. The financing related to these securitizations is included in the Company’s condensed consolidated balance sheet as financing on mortgage loans held for investment.
 
Allowance for Losses on Mortgage Loans Held for Investment
 
In connection with its mortgage loans held for investment, the Company establishes an allowance for loan losses based on its estimate of losses inherent and probable as of the balance sheet date. The Company charges off uncollectible loans at the time of liquidation. The Company evaluates the adequacy of this allowance each quarter, giving consideration to factors such as the current performance of the loans, characteristics of the portfolio, the value of the underlying collateral and the general economic environment. In order to estimate an appropriate allowance for losses for loans held for investment, the Company estimates losses using “static pooling,” which stratifies the loans held for investment into separately identified vintage pools. Provision for losses is charged to the Company’s consolidated statement of income. Losses incurred are charged to the allowance. Management considers the current allowance to be adequate.
 
Residual Interests in Securitizations
 
Residual interests in securitizations (the “Residuals”) are recorded by the Company as a result of the sale of loans through securitizations that the Company structures as sales rather than financings, referred to as “off-balance sheet securitizations.” Residuals include the present value of the expected future cash flows that the Company will receive as described below (the “Cash Flows”). The Company may sell Residuals through net interest margin securities (“NIMS”).
 
The Company generally structures off-balance sheet securitizations as follows: first, it sells a portfolio of mortgage loans to a special purpose entity (“SPE”) that has been established for the limited purpose of buying


9


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

and reselling mortgage loans; then the SPE transfers the same mortgage loans to a Real Estate Mortgage Investment Conduit (the “REMIC”) or Owners Trust (the “Trust”), which is a qualifying special purpose entity (“QSPE”) as defined under Statement of Financial Accounting Standards No. 140 (“SFAS 140”); and, finally, the Trust issues (i) interest-bearing asset-backed securities (the “Bonds and Certificates”) generally in an amount equal to the aggregate principal balance of the mortgage loans and (ii) a certificate to the Company representing a residual interest in Cash Flows related to the payments made on the securitized loans. The Bonds and Certificates are typically sold at face value on a non-recourse basis, except that the Company provides to the Trust representations and warranties customary in the mortgage banking industry. One or more investors typically purchase these Bonds and Certificates for cash. The Trust uses the cash proceeds to pay the Company the cash portion of the purchase price for the mortgage loans. In addition, the Company may provide a credit enhancement in the form of additional collateral (the “OC Account”) held by the Trust. The servicing agreements typically require that the OC Account be maintained at certain levels.
 
At the closing of each off-balance sheet securitization, the Company removes from its consolidated balance sheet the mortgage loans held for sale and adds to its consolidated balance sheet (i) the cash received, (ii) the fair value of the Residuals and (iii) the estimated fair value of the servicing asset, if applicable. The excess of the cash received and the assets retained over the carrying value of the loans sold, less transaction costs, equals the net gain on sale of mortgage loans recorded by the Company in its consolidated statement of earnings.
 
NIMS transactions are generally structured as follows: first, the Company sells or contributes the Residuals to a SPE established for the limited purpose of receiving and selling asset-backed residual interests-in-securitization certificates; then, the SPE transfers the Residuals to the Trust; and, finally, the Trust, which is a QSPE as defined under SFAS 140, issues the Bonds and Certificates. The Company sells the Residuals on a non-recourse basis, except that it provides to the Trust representations and warranties customary in the mortgage banking industry. One or more investors typically purchase the Bonds and Certificates and the proceeds from the sale of the Bonds and Certificates, along with a residual interest certificate that is subordinate to the Bonds and Certificates, represent the consideration received by the Company for the sale of the Residuals.
 
At the closing of each NIMS transaction, the Company removes from its consolidated balance sheet the carrying value of the Residuals sold and adds to its consolidated balance sheet (i) the cash received and (ii) the estimated fair value of the portion of the Residuals retained. The excess of the cash received and assets retained over the carrying value of the Residuals sold, less transaction costs, equals the net gain or loss on the sale of Residuals recorded by the Company in its consolidated statement of earnings.
 
The Company allocates its basis in the mortgage loans and Residuals between the portion of the mortgage loans and Residuals sold through the Bonds and Certificates and the portion retained based on the relative fair values of those portions on the date of sale. The Company recognizes gains or losses attributable to the changes in the fair value of the Residuals in the consolidated statement of income, as the Residuals are classified as trading securities as permitted by SFAS 140. The Company is not aware of an active market for the purchase or sale of Residuals and, accordingly, it determines the estimated fair value of the Residuals by discounting the expected cash flows released from the REMIC or Trust (the cash out method) using a discount rate commensurate with the then-perceived risks involved. The Company utilizes a discount rate of 12.0% on the estimated cash flows released from the REMIC or Trust to value the Residuals through securitization transactions and 14.0% on the estimated cash flows released from the Trust to value Residuals through NIMS transactions. The Company releases substantially all servicing rights related to its securitizations structured as sales.


10


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company is entitled to the cash flows from the Residuals that represent collections on the mortgage loans in excess of the amounts required to pay the Bonds and Certificates’ principal and interest, pay servicing fees and certain other fees, such as trustee and custodial fees, and satisfy OC requirements. At the end of each collection period, the aggregate cash collections from the mortgage loans are allocated first to the base servicing fees and certain other fees, such as trustee and custodial fees, for the period, then to the holders of Bonds and Certificates for interest at the pass-through rate on the Bonds and Certificates plus principal as defined in the servicing agreements. If the amount of cash required for the above allocations exceeds the amount collected during the collection period, a shortfall may occur which will have to be reimbursed from future cash flows, if any. If the cash collected during the period exceeds the amount necessary for the above allocation, and there is no shortfall in the OC requirement, the excess is released to the Company. If the OC balance is not at the required credit enhancement level, the excess cash collected is retained by the Trusts until the specified OC requirement is achieved. The Company is restricted from using the excess collateral in the OC. Pursuant to certain servicing agreements, the Company may be required to use cash in excess of amounts required to make accelerated principal paydowns to the holders of Bonds and Certificates that have the effect of creating additional excess collateral in the OC, which is held by the Trusts on its behalf as the Residual holder. The specified credit enhancement levels are defined in these servicing agreements as the OC balance expressed generally as a percentage of the current collateral principal balance. For NIMS transactions, the Company receives cash flows once the holders of the Bonds and Certificates created in the NIMS transaction are fully paid.
 
The annual percentage rate (the “APR”) on the mortgage loans is relatively high in comparison to the investor pass-through interest rate on the Bonds and Certificates. Accordingly, the Residuals described above are a significant asset of the Company. In determining the value of the Residuals, the Company estimates the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows. The Company estimates that average cumulative losses as a percentage of the original principal balance of the mortgage loans range from 1.89% to 5.1% for adjustable-rate securities and 1.44% to 5.68% for fixed-rate securities. The Company bases these estimates on historical loss data for the loans, the specific characteristics of the loans, and the general economic environment. While the range of estimated cumulative pool losses is fairly broad, the weighted average cumulative pool loss estimate for the entire portfolio of residual assets was 3.75% at September 30, 2006. The Company estimates prepayments by evaluating historical prepayment performance of its loans and the impact of current trends. The Company uses a prepayment curve to estimate the prepayment characteristics of the mortgage loans. The rate of increase, duration, severity, and decrease along the curve depends on the age and nature of the mortgage loans, primarily whether the mortgage loans are fixed or adjustable, and the interest rate adjustment characteristics of the mortgage loans (i.e., 6-month, 1-year, 2-year, 3-year or 5-year adjustment periods). These prepayment curve and default estimates have resulted in weighted average lives of between 2.19 and 2.58 years for the Company’s adjustable-rate securities and between 2.23 and 3.50 years for its fixed-rate securities.
 
Real Estate Owned
 
Real estate acquired through foreclosure is initially recorded at the lower of cost or estimated fair value, net of an allowance for estimated selling costs, on the date of foreclosure and a mortgage loan charge-off is recorded.


11


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

A summary of real estate owned at September 30, 2006 and December 31, 2005 at estimated fair value, is as follows (dollars in thousands):
 
                 
    September 30,
    December 31,
 
    2006     2005  
 
Real estate owned, net
               
Real estate owned
  $ 140,339       55,838  
Valuation allowance
    (56,318 )     (18,196 )
                 
    $ 84,021       37,642  
                 
 
The following table presents a summary of the activity for the valuation allowance for real estate owned for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Balance, beginning of period
  $ 32,068       12,170       18,196       6,576  
Additions(1)
    41,885       6,006       88,764       18,948  
Charge-offs(2)
    (17,635 )     (5,977 )     (50,642 )     (13,325 )
                                 
Balance, end of period
  $ 56,318       12,199       56,318       12,199  
                                 
 
 
(1) Additions to the valuation allowance consist of amounts reclassified from the allowance for losses on mortgage loans held for investment at the time the related mortgage loans are foreclosed upon and reclassified from mortgage loans held for investment to real estate owned.
 
(2) Charge-off amounts presented above represent a portion of the charge-offs included in the rollfoward of the allowance for losses on mortgage loans held for investment.
 
Derivative Instruments
 
The Company accounts for certain Euro Dollar futures contracts, interest rate cap contracts and interest rate swap contracts, designated and documented as hedges, pursuant to the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” or SFAS 133. Pursuant to SFAS 133, these contracts have been designated as hedging the exposure to variability of cash flows from the Company’s financing on mortgage loans held for investment attributable to changes in interest rates. Cash flow hedge accounting requires that the effective portion of the gain or loss in the fair value of a derivative instrument designated as a cash flow hedge be reported in other comprehensive income and the ineffective portion be reported in current earnings. For those derivative instruments not designated as hedges, changes in the fair value of the derivative instrument are recorded through earnings each period.
 
Interest Rate Lock and Forward Sale Commitments
 
The Company is exposed to interest rate risk from the time an interest rate lock commitment (“IRLC”) is made to a residential mortgage applicant to the time the related mortgage loan is sold. IRLCs are derivative instruments under SFAS 133 and are recorded at fair value with the changes in the fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The Company also uses forward sale commitments for its mortgage loan originations to manage interest rate risk. The Company enters into forward sale commitments on a significant portion of production for which there is no offsetting interest rate


12


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

lock. The forward sale commitments are derivatives under SFAS 133 and recorded at fair value with the changes in fair value recognized in current period earnings as a component of gain on sale of mortgage loans.
 
Income Taxes
 
New Century is a REIT for federal income tax purposes and is not generally required to pay federal and most state income taxes on the income that it distributes to stockholders if it meets the REIT requirements of the Internal Revenue Code of 1986, as amended (the “Code”). Also, each of New Century’s subsidiaries that meet the requirements of the Code to be a qualified REIT subsidiary (“QRS”) is not generally required to pay federal and most state income taxes. However, New Century must recognize income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”) for each of its taxable REIT subsidiaries (“TRS”) whose income is fully taxable at regular corporate rates.
 
SFAS 109 requires that inter-period income tax allocation be based on the asset and liability method. Accordingly, New Century recognizes the tax effects of temporary differences between its tax and financial reporting bases of assets and liabilities that will result in taxable or deductible amounts in future periods.
 
2.   Mortgage Loans Held for Sale
 
A summary of mortgage loans held for sale, at the lower of cost or fair value at September 30, 2006 and December 31, 2005, is as follows (dollars in thousands):
 
                 
    September 30,
    December 31,
 
    2006     2005  
 
Mortgage loans held for sale:
               
First trust deeds
  $ 8,022,396       7,110,722  
Second trust deeds
    884,854       704,430  
Net deferred origination costs and other(1)
    37,884       9,973  
                 
    $ 8,945,134       7,825,125  
                 
 
 
(1) Other includes approximately $10.0 million of lower of cost or market valuation allowance, primarily related to hurricane exposure, at December 31, 2005. The amount is immaterial at September 30, 2006.
 
At September 30, 2006, the Company had mortgage loans held for sale having an unpaid principal balance of approximately $235.0 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $10.1 million for the nine months ended September 30, 2006. At September 30, 2005, the Company had mortgage loans held for sale of approximately $58.6 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $2.8 million for the nine months ended September 30, 2005.
 
3.   Mortgage Loans Held for Investment
 
During the nine months ended September 30, 2006, the Company securitized $3.4 billion in loans through transactions structured as financings. There were no securitizations structured as financings for the three


13


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

months ended September 30, 2006. A summary of the components of mortgage loans held for investment at September 30, 2006 and December 31, 2005 is as follows (dollars in thousands):
 
                 
    September 30,
    December 31,
 
    2006     2005  
 
Mortgage loans held for investment:
               
First trust deeds
  $ 13,560,995       15,877,535  
Second trust deeds
    570,299       334,689  
Allowance for loan losses
    (191,561 )     (198,131 )
Net deferred origination costs
    91,266       129,772  
                 
    $ 14,030,999       16,143,865  
                 
 
At September 30, 2006, the Company had mortgage loans held for investment having an unpaid principal balance of approximately $817.8 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $25.5 million for the nine months ended September 30, 2006. At September 30, 2005, the Company had mortgage loans held for investment having an unpaid principal balance of approximately $423.4 million on which the accrual of interest had been discontinued. If these mortgage loans had been current throughout their terms, interest income would have increased by approximately $15.3 million for the nine months ended September 30, 2005.
 
The following table presents a summary of the activity for the allowance for losses on mortgage loans held for investment for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Balance, beginning of period
  $ 209,889       145,565       198,131       90,227  
Additions
    20,756       38,542       80,906       105,655  
Charge-offs, net
    (39,084 )     (6,348 )     (87,476 )     (18,123 )
                                 
Balance, end of period
  $ 191,561       177,759       191,561       177,759  
                                 
 
4.   Residual Interests in Securitizations
 
Residual interests in securitizations were $223.7 million at September 30, 2006 and $172.1 million at September 30, 2005 and consisted of the present value of expected cash flows that the Company will receive in the future.
 
During the nine months ended September 30, 2006, the Company did not complete any securitizations structured as sales. During the nine months ended September 30, 2005, the Company completed two securitizations structured as sales totaling $3.0 billion. The gain on sale recorded for the two securitizations was $71.6 million and the residual interest created by the two securitizations totaled $34.8 million.
 
During the nine months ended September 30, 2006, the Residuals provided the Company with $2.1 million in cash. The Company performs an evaluation of the Residuals quarterly, taking into consideration trends in actual cash flow performance and industry and economic developments, as well as other relevant factors. During the nine months ended September 30, 2006, the Company increased its prepayment rate assumptions


14


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

based upon actual performance and made minor adjustments to certain other assumptions, resulting in a $28.1 million downward fair value adjustment.
 
Neither the Trusts nor the holders of the Bonds and Certificates have recourse to the Company for failure of mortgage loan borrowers to pay their obligations when due. The Company’s Residuals are subordinate to the Bonds and Certificates until the holders of the Bonds and Certificates are fully paid.
 
The Company is a party to various transactions that have an off-balance sheet component. In connection with the Company’s off-balance sheet securitization transactions, as of September 30, 2006, there were $5.7 billion in loans owned by the Trusts. The Trusts have issued Bonds and Certificates secured by these loans. The holders of the Bonds and Certificates generally do not have recourse to the Company in the event that the loans in the various Trusts do not perform as expected. Because these Trusts are “qualifying special purpose entities,” in accordance with generally accepted accounting principles, the Company has included only its Residual interest in these loans on its condensed consolidated balance sheet. The performance of the loans in the Trusts could impact the Company’s ability to realize the current estimated fair value of the Residuals.
 
In determining the value of the Residuals, the Company estimates the future rate of prepayments, the prepayment premiums that it expects to receive and the manner in which expected delinquencies, default and default loss severity are expected to affect the amount and timing of the estimated cash flows. The Company utilizes a discount rate of 12.0% on the estimated cash flows released from the REMIC or Trust to value the Residuals through securitization transactions and 14.0% on the estimated cash flows released from the Trust to value Residuals through NIMS transactions. The following table summarizes the activity for the Residuals for the nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                 
    Nine Months Ended
 
    September 30,  
    2006     2005  
 
Balance, beginning of period
  $ 234,930       148,021  
Additions
          34,807  
Cash received
    (2,113 )     (15,021 )
Accretion
    18,986       11,949  
Fair value adjustment
    (28,123 )     (7,645 )
                 
Balance, end of period
  $ 223,680       172,111  
                 
 
5.   Mortgage Servicing Assets
 
The following table summarizes activity in the Company’s mortgage servicing assets for the nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                 
    Nine Months Ended
 
    September 30,  
    2006     2005  
 
Balance, beginning of period
  $ 69,315       8,249  
Additions
    30,026       60,927  
Sales of servicing rights
    (24,516 )     (8,477 )
Amortization
    (14,947 )     (6,389 )
                 
Balance, end of period
  $ 59,878       54,310  
                 


15


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company records mortgage servicing assets when it sells loans on a servicing-retained basis and when it sells loans through whole loan sales to an investor in the current period and sells the servicing rights to a third party in a subsequent period.
 
The addition of $30.0 million for the nine months ended September 30, 2006 primarily represents servicing rights retained by the Company in certain of its whole loan sales to Carrington Mortgage Credit Fund I, LP (“Carrington”). The $24.5 million in sales of servicing rights for the nine months ended September 30, 2006 relates to the two securitizations structured as sales completed in December 2005 for which the mortgage servicing rights were sold during the first quarter of 2006. The addition of $60.9 million for the nine months ended September 30, 2005 includes: (i) $35.8 million of servicing rights retained by the Company in certain of its whole loan sales to Carrington, (ii) $8.7 million of servicing rights related to the securitization structured as a sale completed in June 2005 for which the mortgage servicing rights were subsequently sold to a third party in August 2005 for $8.5 million and (iii) $16.4 million of servicing rights related to the securitization structured as a sale completed in September 2005 for which the mortgage servicing rights were subsequently sold to a third party in November 2005 for $16.4 million.
 
6.   Goodwill
 
Goodwill is recorded in connection with the acquisition of new subsidiaries or net assets. As of September 30, 2006 and December 31, 2005, the Company had goodwill of $95.8 million and $93.0 million, respectively. No impairment was recognized during the nine months ended September 30, 2006.
 
On February 3, 2006, one of the Company’s indirect wholly-owned subsidiaries, New Century Warehouse Corporation, completed the purchase of Access Lending’s platform that provides warehouse lending services to middle market residential mortgage bankers. The purchase price for the net assets was $9.8 million, and was accounted for using the purchase method. The fair value of the assets acquired was $94.3 million and the fair value of the liabilities assumed was $87.7 million. The excess of the purchase price over the fair value of the assets acquired and liabilities assumed was allocated to and recorded as goodwill. Additionally, pursuant to the terms of the purchase and assumption agreement governing the transaction, Access Lending is entitled to receive additional payments for two years following the consummation of the transaction, based upon profitability. The results of operations for the acquired platform have been included in the Company’s condensed consolidated financial statements since the date of acquisition.
 
The following table presents changes in the carrying amount of goodwill as of September 30, 2006 (dollars in thousands):
 
         
Balance, beginning of period
  $ 92,980  
Acquisition of Access Lending operating platform
    3,200  
Purchase price allocation adjustment related to acquisition of RBC Mortgage origination platform
    (388 )
         
Balance, end of period
  $ 95,792  
         


16


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

7.   Credit Facilities and Other Short-Term Borrowings

 
Credit facilities and other short-term borrowings consisted of the following at September 30, 2006 and December 31, 2005 (dollars in thousands):
 
                     
        September 30,
  December 31,
        2006   2005
 
             
A
  $2.0 billion asset-backed commercial paper facility for Von Karman Funding Trust, a wholly-owned subsidiary of New Century Mortgage, expiring in February 2009, secured by mortgage loans held for sale and cash, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration   $ 1,316,746        
             
A
  $2.0 billion master repurchase agreement ($1 billion of which is uncommitted) among New Century Mortgage, NC Capital, Home 123, New Century Credit and Bank of America, N.A. expiring in September 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     876,350       916,714  
             
A
  $1.0 billion master repurchase agreement among New Century Mortgage, Home 123 and Bank of America, N.A. expiring in September 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     394,085       277,484  
             
A
  $1.0 billion master repurchase agreement among New Century Credit, NC Asset Holding, New Century Mortgage, NC Capital and Barclays Bank PLC expiring in March 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     217,701       821,856  
             
An
  $800 million master repurchase agreement ($400 million of which is uncommitted) among NC Capital, NC Asset Holding, New Century Credit and Bear Stearns Mortgage Capital expiring in November 2006, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR     636,333       610,365  
             
A
  $650 million master repurchase agreement among New Century Credit, NC Capital and Citigroup Global Markets Realty Corp., which expired in July 2006, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company did not renew this facility as it has been replaced by a new Citigroup master repurchase agreement           276,816  


17


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

                     
        September 30,
  December 31,
        2006   2005
 
             
A
  $250 million master repurchase agreement among New Century Mortgage, NC Capital, New Century and Citigroup Global Markets Realty Corp., which expired in July 2006, secured by delinquent loans and real estate owned, or REO, properties, bearing interest based on a margin over one-month LIBOR. The Company did not renew this facility as it has been replaced by a new Citigroup master repurchase agreement           109,076  
             
A
  $950 million uncommitted master repurchase agreement among New Century Financial, New Century Mortgage, Home123, NC Capital, New Century Credit and Citigroup Global Markets Realty Corp., expiring in July 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company has the ability, at any one time, to secure up to $150 million with delinquent loans and real estate owned, or REO, properties. The Company expects to renew or extend this facility prior to its expiration     137,653        
             
A
  $1.5 billion master repurchase agreement ($500 million of which is uncommitted) among New Century Credit, New Century Mortgage, NC Capital, Home123 and Credit Suisse First Boston Mortgage Capital LLC expiring in December 2006, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     546,479       452,239  
             
A
  $1.0 billion master repurchase agreement among New Century Credit, New Century Mortgage, NC Capital, Home123 and Deutsche Bank expiring in November 2006, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     582,545       441,227  
             
A
  $150 million master repurchase agreement among New Century Mortgage, Home 123, NC Capital, and Deutsche Bank, Aspen Funding Corp., Newport Funding Corp. and Gemini Securitization Corp., LLC expiring in April 2007, secured by delinquent loans or REO properties, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     129,371        

18


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

                     
        September 30,
  December 31,
        2006   2005
 
             
An
  $850 million master repurchase agreement ($150 million of which is uncommitted) among New Century Credit, New Century Mortgage, NC Capital, NC Asset Holding, Home123, and IXIS Real Estate Capital Inc. expiring in November 2006, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     449,333       404,696  
             
A
  $3.0 billion master repurchase agreement among New Century Credit, New Century Mortgage, NC Capital, NC Asset Holding, Morgan Stanley Bank, and Morgan Stanley Mortgage Capital Inc. expiring in February 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     1,509,478       1,469,860  
             
A
  $2.0 billion master repurchase agreement ($500 million of which is uncommitted) between New Century Funding I, a special-purpose vehicle established as a Delaware statutory trust, which is a wholly-owned subsidiary of New Century Mortgage, and UBS Real Estate Securities Inc. expiring in June 2008, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     1,480,379       1,673,225  
             
A
  $450 million master repurchase agreement ($250 million of which is uncommitted) among New Century Warehouse, New Century Mortgage, New Century, and Goldman Sachs Mortgage Company expiring in February 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     91,173        
             
A
  $100 million master repurchase agreement among New Century, New Century Warehouse, Access Investments II L.L.C., a direct subsidiary of New Century Warehouse, Access Lending, Galleon Capital Corporation, State Street Capital Markets, LLC and State Street Bank and Trust Company expiring in August 2008, secured by mortgage loans held for sale, bearing interest based on a margin over the one-month commercial paper rate. The Company expects to renew or extend this facility prior to its expiration     48,701        
             
A
  $125 million master repurchase agreement among New Century Warehouse and Guaranty Bank expiring in February 2007, secured by mortgage loans held for sale, bearing interest based on a margin over one-month LIBOR. The Company expects to renew or extend this facility prior to its expiration     71,523        

19


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

                     
        September 30,
  December 31,
        2006   2005
 
             
    Less: Credit facility amounts reclassified to financing on mortgage loans held for investment           (13,873 )
                     
             
        $ 8,487,850       7,439,685  
                     

 
The various credit facilities contain certain restrictive financial and other covenants that require the Company to, among other things, restrict dividends, maintain certain levels of net worth, liquidity, available borrowing capacity and debt-to-net worth ratios and comply with regulatory and investor requirements. The Company was in compliance with these covenants at September 30, 2006.
 
8.   Financing on Mortgage Loans Held for Investment
 
When the Company sells mortgage loans through securitizations structured as financings, the related bonds are added to its balance sheet. As of September 30, 2006 and December 31, 2005, the financing on mortgage loans held for investment consisted of the following (dollars in thousands):
 
                 
    September 30,
    December 31,
 
    2006     2005  
 
Securitized bonds
  $ 13,895,512       16,071,460  
Short-term financing on retained bonds
          1,903  
2005-NC3 NIM bond
    23,784       21,405  
Debt issuance costs
    (60,356 )     (63,182 )
Credit facility amounts reclassified from warehouse credit facilities
          13,873  
                 
Total financing on mortgage loans held for investment
  $ 13,858,940       16,045,459  
                 
 
The maturity of the Company’s financing on mortgage loans held for investment is based on certain prepayment assumptions. The Company estimates the average life of its various securitized loan pools to be between 1.3 and 3.8 years. The following table reflects the estimated maturity of the financing on mortgage loans held for investment as of September 30, 2006 (dollars in thousands):
 
         
Due in less than 1 year
  $ 5,066,814  
Due in 2 years
    2,919,213  
Due in 3 years
    1,517,554  
Due thereafter
    4,355,359  
         
    $ 13,858,940  
         
 
9.   Convertible Senior Notes
 
On July 8, 2003, New Century TRS closed a private offering of $210.0 million of 3.50% convertible senior notes due July 3, 2008 pursuant to Rule 144A under the Securities Act of 1933. On March 17, 2004, the convertible senior notes became convertible into New Century TRS common stock at a conversion price of $34.80 per share. As a result of the Merger, the convertible senior notes became convertible into shares of New Century common stock. In December 2004 and June 2005, through a series of transactions, all but $5,000,000 of the original outstanding principal balance of the convertible senior notes was converted into common stock of New Century. On February 17, 2006, the holder of the remaining $5,000,000 aggregate

20


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

principal amount of convertible senior notes elected to convert the convertible senior notes into 165,815 shares of New Century’s common stock.
 
10.   Junior Subordinated Notes
 
On September 13, 2006, the Company sold through New Century Capital Trust I, a Delaware statutory trust (the “Trust”), $50,000,000 in aggregate liquidation amount of preferred securities of the Trust (the “Preferred Securities”) in a private placement transaction. The Preferred Securities require quarterly distributions at a fixed rate of 8.65% through the distribution payment date in September 2011, whereupon the rate floats at three-month LIBOR plus 3.50% thereafter.
 
The Trust simultaneously issued and sold 1,545 shares of common securities of the Trust (the “Common Securities”) to the Company for $1,545,000 in aggregate liquidation amount. The 1,545 Common Securities constitute all of the issued and outstanding Common Securities of the Trust. The Trust used the proceeds from the sales of the Preferred Securities and the Common Securities to purchase $51,545,000 aggregate principal amount of the Company’s junior subordinated notes due 2036 (the “Junior Subordinated Notes”). The terms of the Junior Subordinated Notes are substantially the same as the terms of the Preferred Securities.
 
The Junior Subordinated Notes mature on September 30, 2036, but the Company may redeem the Junior Subordinated Notes, in whole or in part, on or after September 30, 2011 without penalty. If the Junior Subordinated Notes are redeemed, the Trust must redeem a like amount of the Preferred Securities.
 
The assets and liabilities of the Trust are not consolidated into the consolidated financial statements of the Company. Accordingly, the Company’s equity interest in the Trust is accounted for using the equity method. Interest on the junior subordinated debentures are presented on the consolidated statements of income as a component of interest expense and the Junior Subordinated Notes are presented as a separate category on the consolidated balance sheets.
 
11.   Cumulative Redeemable Preferred Stock
 
In June 2005, the Company sold 4,500,000 shares of its Series A Cumulative Redeemable Preferred Stock (the “Series A Preferred Stock”) including 300,000 shares to cover overallotments. The offering provided $108.7 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.125% and are not convertible into any other securities. The Company may, at its option, redeem the Series A Preferred Stock, in the aggregate or in part, at any time on or after June 21, 2010. As such, this stock is not considered mandatorily or contingently redeemable under the provisions of Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Investments with Characteristics of both Liabilities and Equity” (“SFAS 150”), and is therefore classified as a component of equity. The Company paid preferred stock dividends of $2.6 million for the third quarter of 2006 on September 29, 2006, and, as a result, there were no accrued preferred stock dividends related to the Series A Preferred Stock as of September 30, 2006.
 
In August 2006, the Company sold 2,300,000 shares of its Series B Cumulative Redeemable Preferred Stock (the “Series B Preferred Stock”), including 300,000 shares to cover overallotments. The offering provided $55.6 million in net proceeds. The shares have a liquidation value of $25.00 per share, pay an annual coupon of 9.75% and are not convertible into any other securities. The Company may, at its option, redeem the Series B Preferred Stock, in the aggregate or in part, at any time on or after August 22, 2011. As such, this stock is not considered mandatorily or contingently redeemable under the provisions of SFAS 150, and is therefore classified as a component of equity. The Company had an accrual for preferred stock dividends related to the Series B Preferred Stock of $0.6 million as of September 30, 2006.


21


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

12.   Interest Income

 
The following table presents the components of interest income for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Interest on mortgage loans held for investment
  $ 287,372       342,105       878,859       905,652  
Interest on mortgage loans held for sale
    220,404       145,876       575,914       320,906  
Residual interest income
    5,249       4,022       18,986       11,949  
Other interest income
    1,147       2,618       4,529       8,046  
                                 
    $ 514,172       494,621       1,478,288       1,246,553  
                                 
 
13.   Interest Expense
 
The following table presents the components of interest expense for the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Interest on financing on mortgage loans held for investment
  $ 205,555       196,376       591,652       474,742  
Interest on credit facilities and other short-term borrowings
    157,975       85,930       398,046       182,986  
Interest on junior subordinated notes
    215             215        
Interest on convertible senior notes
          67       64       190  
Other interest expense
    11,483       8,526       29,575       13,617  
                                 
    $ 375,228       290,899       1,019,552       671,535  
                                 


22


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

14.   Derivative Activities

 
The following table presents the fair value of the Company’s derivative instruments as of the periods indicated (dollars in thousands):
 
                 
    September 30,  
    2006     2005  
 
Cash flow hedges:
               
Euro Dollar futures contracts
  $ 30,706       79,508  
Interest rate swap contracts
    (11,265 )      
Interest rate cap contracts
    38       1,104  
Fair value hedges
          517  
Free-standing derivatives:
               
Euro Dollar futures contracts
    800       663  
Purchased options on Euro Dollar futures contracts
    2,749        
Interest rate swap contracts
    377        
Interest rate locks
    4,571       (2,257 )
Forward sale commitments
    (10,238 )     5,200  
                 
    $ 17,738       84,735  
                 
 
The following table presents derivative gains (losses) for the periods indicated (dollars in thousands):
 
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2006     2005     2006     2005  
 
Cash flow hedges:
                               
Euro Dollar futures contracts
  $ 26,728       8,142       71,013       22,636  
Ineffectiveness
          2,160       13,726       5,776  
Interest rate cap contracts
    (939 )     (1,346 )     (2,602 )     (6,340 )
Fair value hedge
    (1,396 )     6,232       (3,112 )     10,994  
Free-standing derivatives:
                               
Euro Dollar futures contracts
    (17,830 )     (3,029 )     11,645       (2,612 )
Purchased options on Euro Dollar futures contracts
    (701 )           (5,754 )      
Interest rate swap contracts
    (15,084 )           (3,402 )      
Interest rate locks
    4,875       (4,938 )     4,578       (4,938 )
Forward sale commitments
    (33,818 )     7,703       (9,195 )     7,703  
                                 
Total derivative gains (losses)
  $ (38,165 )     14,924       76,897       33,219  
                                 
 
In connection with the Company’s strategy to mitigate interest rate risk on its financing on mortgage loans held for sale, mortgage loans held for investment and its Residuals, the Company uses derivative financial instruments such as Euro Dollar futures contracts, interest rate cap contracts, interest rate swap contracts, purchased options on Euro Dollar futures contracts, interest rate locks and forward sale commitments. These derivative instruments are intended to provide income and cash flow to offset potential reduced interest income and cash flow under certain interest rate environments. In accordance with SFAS 133, the derivative


23


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

financial instruments and any related margin accounts are reported on the condensed consolidated balance sheets at their fair value. It is not the Company’s policy to use derivatives to speculate on interest rates.
 
In 2003, the Company began applying hedge accounting as defined by SFAS 133 for certain derivative financial instruments used to hedge cash flows related to its financing on mortgage loans held for investment. In June 2004, the Company began applying hedge accounting to certain derivative financial instruments used to hedge the fair value of certain of its mortgage loans held for sale. The Company designates certain derivative financial instruments, such as Euro Dollar futures contracts, interest rate cap contracts and beginning in the quarter ended September 30, 2006, certain of its interest rate swap contracts, as hedge instruments under SFAS 133. At the inception of the hedge, these instruments and their hedging relationship are identified, designated and documented. The Company documents the relationships between hedging instruments and hedged items, as well as its risk management objectives and strategies for undertaking various hedge transactions. The Company also assesses, both at the inception of the hedge and on an ongoing basis, whether the derivatives used in hedging transactions are highly effective in offsetting changes in cash flows or fair value of the hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting.
 
When hedge accounting is discontinued because the Company determines that the derivative no longer qualifies as a hedge, the derivative will continue to be recorded on the condensed consolidated balance sheet at its fair value. Any change in the fair value of a derivative no longer qualifying as a hedge is recognized in current period earnings. When a derivative is terminated, it is derecognized at the time of termination. For terminated cash flow hedges or cash flow hedges that no longer qualify as effective, the effective position previously recorded in accumulated other comprehensive income, or OCI, is recorded in earnings when the hedged item affects earnings.
 
Cash Flow Hedge Instruments — For derivative financial instruments designated as cash flow hedge instruments, the Company evaluates the effectiveness of these hedges against the variable-rate interest payments related to its financing on mortgage loans held for investment being hedged to ensure that there remains a highly effective correlation in the hedge relationship. To hedge the adverse effect of interest rate changes on the cash flows as a result of changes in the benchmark LIBOR interest rate, which affect the interest payments related to its financing on mortgage loans held for investment (variable-rate debt) being hedged, the Company uses derivatives classified as cash flow hedges under SFAS 133. Once the hedge relationship is established, for those derivative instruments designated as qualifying cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of accumulated OCI during the current period, and reclassified into earnings as part of interest expense in the period(s) during which the hedged transaction affects earnings pursuant to SFAS 133. The ineffective portion of the derivative instrument is recognized in earnings in the current period and is included in other income.
 
Euro Dollar futures contracts — As of September 30, 2006, the Company had open Euro Dollar futures contracts that are designated as hedging the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment. The fair value of these Euro Dollar futures contracts at September 30, 2006 and 2005 was a $30.7 million and a $79.5 million asset, respectively, and is included in prepaid expenses and other assets. During the three and nine months ended September 30, 2006, the Company recognized a gain of $28.5 million and $78.9 million, respectively, attributable to these Euro Dollar futures contracts, which has been recorded as a reduction of interest expense related to the Company’s financing on mortgage loans held for investment. For the three and nine months ended September 30, 2005, the Company recognized a gain of $11.3 million and $31.9 million, respectively, attributable to cash flow hedges, which has been recorded as a reduction of interest expense. Additionally, certain Euro Dollar futures contracts were terminated during the fourth quarter of 2004 in connection with the transfer of certain assets


24


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

from New Century TRS to New Century. The fair value of the contracts at the termination date of ($30.9) million is being reclassified from OCI over the original hedge period, as the hedged transaction affects future earnings. Interest expense increased by $1.8 million and $7.9 million for the three and nine months ended September 30, 2006, respectively, related to the reclassification of the terminated contracts. For the three and nine months ended September 30, 2005, the Company reclassified into interest expense $3.2 million and $9.3 million, respectively, related to these terminated contracts. As of September 30, 2006, the related OCI balance was ($8.0) million.
 
Ineffectiveness — During the nine months ended September 30, 2006, the Company recognized other income of $13.7 million from the ineffective portion of these hedges. There was no ineffectiveness for the three months ended September 30, 2006. For the three and nine months ended September 30, 2005, the Company recognized other income of $2.2 million and $5.8 million, respectively, from the ineffective portion of these hedges.
 
Interest Rate Swap Contracts — As of September 30, 2006, the Company also had interest rate swap contracts that are designated as hedging the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment. The fair value of interest rate swap contracts designated as cash flow hedges at September 30, 2006 was an ($11.3) million liability and is included in accounts payable and accrued liabilities. There were no interest rate swap contracts designated as hedge instruments during the nine months ended September 30, 2005.
 
Interest Rate Cap Contracts — Certain of the Company’s securitizations structured as financings are subject to interest rate cap contracts (the “Caplets”) designated and documented as cash flow hedges used to mitigate interest rate risk. The change in the fair value of these Caplets is recorded in OCI each period. Amounts are reclassified out of OCI as the hedged transactions impact earnings. During the three and nine months ended September 30, 2006, the Company recorded $0.9 million and $2.6 million, respectively, as an increase to interest expense related to the effective portion of the Caplets. For the three and nine months ended September 30, 2005, the Company recorded $1.3 million and $6.3 million, respectively, as an increase to interest expense related to the effective portion of the Caplets. The fair value of these Caplets at September 30, 2006 and 2005 was $38,000 and $1.1 million, respectively, and is included in prepaid expenses and other assets.
 
Accumulated Other Comprehensive Income — As of September 30, 2006, the balance of accumulated OCI was $23.5 million, which relates to the fair value of cash flow hedges. The Company expects to reclassify $21.0 million from OCI into earnings during the remainder of 2006. The remaining OCI will be reclassified into earnings by September 2009.
 
Fair Value Hedge Instruments — For derivative financial instruments designated as fair value hedge instruments, the Company evaluates the effectiveness of these hedges against the fair value of the asset being hedged to ensure that there remains a highly effective correlation in the hedge relationship. To hedge the adverse effect of interest rate changes on the fair value of the hedged assets as a result of changes in the benchmark LIBOR interest rate, the Company uses derivative instruments classified as fair value hedges under SFAS 133. Once the hedge relationship is established, for those derivative instruments designated as qualifying fair value hedges, changes in the fair value of the derivative instruments and changes in the fair value of the hedged asset or liability attributable to the hedged risk are recorded in current earnings pursuant to SFAS 133. For the three and nine months ended September 30, 2006, the Company recognized a loss of $1.4 million and $3.1 million, respectively, which losses were substantially offset by changes in the fair value of the hedged assets. At September 30, 2006, these contracts were settled, and, as such, there were no fair value hedges outstanding as of that date. For the three and nine months ended September 30, 2005, the Company recognized a gain of $6.2 million and $11.0 million, respectively, related to fair value hedges. These gains or losses, as


25


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

applicable, have been included as a component of gain on sale of mortgage loans. The fair value of these contracts at September 30, 2005 was $0.5 million.
 
Free-standing derivatives
 
Euro Dollar futures contracts — As of September 30, 2006, the Company had certain open Euro Dollar futures contracts used to economically hedge the variability in expected cash flows from the variable-rate debt related to its financing on mortgage loans held for investment and to economically hedge the fair value of the Company’s residual interests in securitizations that are not designated as hedges under SFAS 133. During the three and nine months ended September 30, 2006, the Company recognized a loss of $17.8 million and a gain of $11.6 million, respectively, related to the change in fair value of Euro Dollar futures contracts used to economically hedge the interest rate risk related to the Company’s financing on mortgage loans held for investment and residual interests. The fair value of these contracts at September 30, 2006 was $0.8 million and is included in prepaid expenses and other assets. For the three and nine months ended September 30, 2005, the Company recognized a loss of $3.0 million and $2.6 million, respectively, related to the change in fair value of these contracts. The fair value of Euro Dollar futures contracts at September 30, 2005 was $0.7 million.
 
Purchased options on Euro Dollar futures contracts — The Company utilizes purchased options on Euro Dollar futures contracts not designated as economic hedge instruments related to the Company’s financing on mortgage loans held for investment. The change in fair value relating to purchased options on Euro Dollar futures contracts that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $0.7 million and $5.8 million, respectively, and was included in other income. The fair value of the purchased options on Euro Dollar futures contracts at September 30, 2006 was $2.7 million. There were no purchased options of Euro Dollar futures contracts at September 30, 2005.
 
Interest Rate Swap contracts — Also included in free-standing derivatives as of September 2006 were certain interest rate swap contracts not designated as hedge instruments related to the Company’s financing on mortgage loans held for investment. The change in fair value relating to interest rate swap contracts not designated as hedges that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $15.1 million and $3.4 million, respectively, and is included in other income. The fair value of interest rate swap contracts not designated as hedges was $0.4 million at September 30, 2006. There were no interest rate swap contracts at September 30, 2005.
 
Interest Rate Locks — The Company is exposed to interest rate risk from the time an IRLC is made to a residential mortgage applicant to the time the related mortgage loan is sold. IRLCs are derivative instruments under SFAS 133 and are recorded at fair value with the changes in the fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The change in fair value relating to IRLCs that was recognized in earnings during the three and nine months ended September 30, 2006 was a gain of $4.9 million and $4.6 million, respectively. The fair value of IRLCs at September 30, 2006 was $4.6 million. The change in fair value relating to IRLCs during the three and nine months ended September 30, 2005 was a loss of $4.9 million. The fair value of IRLCs at September 30, 2005 was ($2.3) million.
 
Forward Sale Commitments — The Company also utilizes forward sales commitments to manage the interest rate risk related to the Company’s financing on mortgage loans held for sale. The forward sale commitments are derivatives under SFAS 133 and are recorded at fair value with the changes in fair value recognized in current period earnings as a component of gain on sale of mortgage loans. The Company enters into forward sale commitments on a significant portion of mortgage loan production for which there is no offsetting interest rate lock. The change in fair value relating to forward sale commitments that was recognized in earnings during the three and nine months ended September 30, 2006 was a loss of $33.8 million and $9.2 million, respectively. The fair value of forward sale commitments at September 30, 2006 was a ($10.2)


26


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

million liability and is included in accounts payable and accrued liabilities. The change in fair value relating to forward sale commitments for the three and nine months ended September 30, 2005 was a gain of $7.7 million. The fair value of forward sale commitments at September 30, 2005 was $5.2 million.
 
15.   Income Taxes
 
Commencing in 2004, the Company has operated so as to qualify as a REIT for U.S. federal income tax purposes. Provided that the Company complies with the REIT provisions of the Code, it is not subject to corporate level income taxes on REIT taxable income distributed in the form of dividends to stockholders. Operations of the TRS, including transactions by and between the TRS-level and REIT-level companies, are fully taxable and are filed on a separate federal consolidated income tax return.
 
During the three months ended September 30, 2006 and 2005, the Company recorded an income tax provision of $23.6 million and $2.9 million, respectively. The provision for income taxes during the nine months ended September 30, 2006 and 2005 was $64.8 million and $7.6 million, respectively.
 
Taxes are provided on substantially all income and expense items included in the earnings of the TRS, at a combined federal and state rate of 40% for the three and nine months ended September 30, 2006 and 41% for the three and nine months ended September 30, 2005. Any deviation from the federal statutory rate of 35% relates primarily to state and local income taxes. In contrast, the earnings attributable to the REIT are not expected to be taxable due to the benefit of the REIT’s dividend paid deduction. Accordingly, the effective tax rate for the consolidated Company (REIT and TRS consolidated) will vary from period to period as summarized in the table below depending almost exclusively on the relative contribution to consolidated earnings before income taxes by the two separate federal tax reporting groups.
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Federal statutory rate
    35.0%       35.0%       35.0%       35.0%  
State and local taxes, net of federal benefit
    5.0%       6.0%       5.0%       6.0%  
Benefit of REIT election
    −14.2%       −34.8%       −21.3%       −33.3%  
Recapture of tax reserve
    −2.4%       −12.0%       −0.6%       −4.8%  
Other
    2.8%       8.1%       0.9%       −0.4%  
                                 
Consolidated effective tax rate
    26.2%       2.3%       19.0%       2.5%  
                                 


27


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

16.   Earnings per Share

 
The following table illustrates the computation of basic and diluted earnings per share for the periods indicated (dollars in thousands, except per share amounts):
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Basic:
                               
Net earnings
  $ 66,642       120,104       275,920       299,943  
Less: Preferred stock dividends
    3,174       2,567       8,307       2,852  
                                 
Net earnings available to common stock holders
  $ 63,468       117,537       267,613       297,091  
                                 
Weighted average number of common shares outstanding
    55,513       55,870       55,606       55,346  
Earnings per share
  $ 1.14       2.10       4.81       5.37  
                                 
Diluted:
                               
Net earnings available to common stockholders
  $ 63,468       117,537       267,613       297,091  
Add: Interest and amortization of debt issuance costs on convertible senior notes, net of tax
    (16 )     (30 )     86       65  
                                 
Diluted net earnings
  $ 63,452       117,507       267,699       297,156  
                                 
Basic weighted average number of common shares outstanding
    55,513       55,870       55,606       55,346  
Effect of dilutive securities:
                               
Restricted stock awards
    150       103       136       135  
Stock options
    864       1,468       948       1,778  
Convertible senior notes
          155       27       160  
Directors’ deferred compensation plan awards
    3       2       3       2  
                                 
      56,530       57,598       56,720       57,421  
                                 
Earnings per share
  $ 1.12       2.04       4.72       5.18  
 
For the nine months ended September 30, 2006, the Company has included the effect of the issuance of approximately 27,000 shares of common stock related to the conversion of the New Century TRS convertible senior notes, weighted for the portion of the period prior to the actual conversion of the remaining notes. There were no such issuances for the three months ended September 30, 2006. For the three and nine months ended September 30, 2005, the Company has included the effect of the issuance of approximately 155,000 and 160,000 shares of common stock, respectively, issuable upon conversion of the New Century TRS convertible senior notes in the computation of diluted earnings per share. Diluted earnings have been adjusted to add the interest expense and amortization of debt issuance costs recorded related to the convertible senior notes, net of the applicable income tax effect.
 
For the three months ended September 30, 2006 and 2005, options to purchase approximately 1,778,000 and 1,100,000 shares, respectively, of common stock were excluded from the calculation of diluted earnings per share because their effect was anti-dilutive. For the nine months ended September 30, 2006 and 2005, options to purchase approximately 1,628,000 and 489,000 shares, respectively, of common stock were excluded from the calculation of diluted earnings per share because their effect was anti-dilutive.


28


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

17.   Stock-Based Compensation

 
Through December 31, 2005, the Company accounted for stock-based compensation using the intrinsic value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and, accordingly, recognized no compensation expense related to stock options and employee stock purchases. For grants of restricted stock, the fair value of the shares at the date of grant was amortized to compensation expense over the award’s vesting period. The Company historically reported pro forma results under the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.”
 
On December 16, 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R is a revision of SFAS 123, supersedes APB 25 and amends Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows.” SFAS 123R is similar to SFAS 123, however, SFAS 123R requires all stock-based payments to employees, including grants of employee stock options and discounts associated with employee stock purchases, to be recognized as compensation expense in the income statement based on their fair values. Pro forma disclosure of compensation expense is no longer an alternative. Additionally, excess tax benefits, which result from actual tax benefits exceeding deferred tax benefits previously recognized based on grant date fair value, are recognized as additional paid-in-capital and are classified as financing cash flows in the consolidated statement of cash flows.
 
The Company adopted SFAS 123R on January 1, 2006, using the modified prospective transition method. Under the modified prospective transition method, fair value accounting and recognition provisions of SFAS 123R are applied to stock-based awards granted on or modified subsequent to the date of adoption and prior periods presented are not restated. In addition, for awards granted prior to the effective date, the unvested portion of the awards are recognized in periods subsequent to the adoption based on the grant date fair value determined for pro forma disclosure purposes under SFAS 123.
 
In 2004, the Company adopted and received stockholders’ approval of the qualified 2004 Performance Incentive Plan (the “Plan”) pursuant to which the Company’s board of directors may grant equity awards, including stock options and other forms of awards, to officers and key employees. The Plan authorizes grants of equity awards, including stock options.
 
Stock options are granted for a fixed number of shares with an exercise price at least equal to the market value of the shares at the grant date. Stock options generally vest over a period of three to five years. Certain of the stock options granted during 2005 and the nine months ended September 30, 2006 contain cliff vesting provisions, with vesting acceleration conditions. Such conditions provide for varying degrees of partial vesting in the event that certain market prices for the Company’s common stock are maintained for ten consecutive trading days. Stock options granted have contractual terms of ten years.
 
Restricted stock awards are issued at the fair value of the Company’s common stock on the grant date. The restrictions generally lapse over a period of three to seven years. During 2005, the Company began granting certain restricted stock awards containing financial performance conditions, which, if met, result in partial acceleration of the lapse of the award’s restrictions. Prior to the adoption of SFAS 123R, unearned compensation for grants of restricted stock equivalent to the fair value of the shares at the date of grant was recorded as a separate component of stockholders’ equity and subsequently amortized to compensation expense over the award’s vesting period. In accordance with SFAS 123R, stockholders’ equity is credited commensurate with the recognition of compensation expense. All deferred compensation at January 1, 2006 was reclassified to additional paid-in-capital.


29


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company’s Employee Stock Purchase Plan defines purchase price per share as 90% of the fair value of a share of common stock on the last trading day of the plan quarter.
 
During the three and nine months ended September 30, 2006, the Company recognized stock-based compensation expense of $4.1 million and $16.7 million, respectively, as well as related tax benefits of $1.0 million and $3.0 million, respectively, associated with the Company’s stock-based awards. For the three and nine months ended September 30, 2005, the Company recognized stock-based compensation expense of $1.9 million and $5.7 million, respectively, as well as related tax benefits of $1.1 million and $2.4 million, respectively, associated with the Company’s stock-based awards. As a result of the adoption of SFAS 123R effective January 1, 2006, the Company’s income before taxes for the three and nine months ended September 30, 2006 was $2.3 million and $11.6 million lower, respectively, than if the Company had continued to account for the stock-based compensation programs under APB 25. The Company’s net income for the three and nine months ended September 30, 2006 was $1.9 million and $10.3 million lower, respectively, than if the Company had continued to account for the stock-based compensation programs under APB 25.
 
SFAS 123R requires the disclosure of pro forma information for periods prior to adoption. The following table illustrates the effect on net income and earnings per share for the three and nine months ended September 30, 2005 if the Company had recognized compensation expense for all stock-based payments to employees based on their fair values (dollars in thousands, except per share amounts):
 
                 
    Three Months
    Nine Months
 
    Ended
    Ended
 
    September 30,
    September 30,
 
    2005     2005  
 
Basic earnings available to common stockholders:
               
As reported
  $ 117,537       297,091  
Compensation expense, net of related tax effects
    (1,782 )     (4,971 )
                 
Pro forma
  $ 115,755       292,120  
                 
Diluted earnings available to common stockholders:
               
As reported
  $ 117,507       297,156  
Compensation expense, net of related tax effects
    (1,782 )     (4,971 )
                 
Pro forma
  $ 115,725       292,185  
                 
Basic earnings per share:
               
As reported
  $ 2.10       5.37  
Pro forma
    2.07       5.28  
Diluted earnings per share:
               
As reported
  $ 2.04       5.18  
Pro forma
    2.03       5.15  
Basic weighted average shares outstanding:
               
As reported
    55,870       55,346  
Pro forma
    55,870       55,346  
Diluted weighted average shares outstanding:
               
As reported
    57,598       57,421  
Pro forma
    56,909       56,747  


30


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

The Company historically used a Black-Scholes option pricing model to estimate the fair value of stock options. The inputs for volatility and expected term of the options were primarily based on historical information. As of January 1, 2006, the Company switched from the Black-Scholes pricing model to a lattice model to estimate fair value at grant date for future option grants. The lattice model is believed to provide a more accurate estimate of the fair values of employee stock options as it incorporates the impact of employee exercise behavior and allows for the input of a range of assumptions. Expected volatility assumptions used in the models are based on an analysis of implied volatilities of publicly traded options on the Company’s common stock and historical volatility of the Company’s stock price. The range of risk-free interest rates is based on a yield curve of interest rates at the time of the grant based on the contractual life of the option. The expected term of the options was derived from the outputs of the lattice model, which incorporates post-vesting forfeiture assumptions based on an analysis of historical data. The dividend yield was based on the Company’s estimate of future dividend yields. Similar groups of employees that have dissimilar exercise behavior are considered separately for valuation purposes.
 
The following weighted-average assumptions were used to estimate the fair values of options granted during the three and nine months ended September 30, 2006 and 2005:
 
                                 
    Three Months Ended
    Nine Months Ended
 
    September 30,     September 30,  
    2006     2005     2006     2005  
 
Fair value
  $ 8.01       10.87       6.32       9.23  
Expected life (years)
    4.0       4.5       4.0       4.5  
Risk-free interest rate
    4.8-5.1 %     3.9 %     4.4-4.7 %     4.2 %
Volatility
    41.7 %     59.4 %     40.9 %     60.5 %
Expected annual dividend yield
    11.1 %     12.5 %     11.1 %     13.7 %
Expected annual forfeiture rate
    %     %     11.0 %     %
 
Stock option activity during the nine months ended September 30, 2006 was as follows:
 
                 
          Weighted
 
          Average
 
    Number of
    Exercise
 
    Shares     Price  
 
Balance, beginning of period
    3,819,533     $ 27.29  
Granted
    388,459       40.27  
Exercised
    (660,120 )     12.44  
Cancelled
    (274,589 )     37.51  
                 
Balance, end of period
    3,273,283       30.89  
                 


31


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

At September 30, 2006, the range of exercise prices, the number outstanding, weighted average remaining term and weighted average exercise price of options outstanding and the number exercisable and weighted average price of options currently exercisable were as follows:
 
                                             
      Outstanding     Exercisable  
            Average
    Weighted
          Weighted
 
      Number of
    Remaining
    Average
    Number of
    Average
 
      Stock
    Term
    Exercise
    Stock
    Exercise
 
Range of Exercise Prices
    Options     (in years)     Price     Options     Price  
 
$ 6.00 - 6.79       349,768       4.77     $ 6.58       349,768     $ 6.58  
  7.33 - 9.27       160,000       4.86       8.71       64,599       8.47  
  10.47 - 12.17       240,418       5.37       10.49       206,668       10.49  
  14.43 - 17.83       202,331       5.96       15.15       91,706       15.38  
  18.65 - 18.66       343,347       6.24       18.66       181,797       18.66  
  19.47 - 26.97       192,939       6.71       26.22       98,349       26.53  
  35.74 - 39.10       366,425       9.00       38.32       100,293       38.30  
  41.60 - 44.06       405,169       8.47       44.01       33,391       43.96  
  45.04 - 45.96       364,496       7.35       45.86       316,362       45.87  
  46.02 - 46.78       306,760       8.13       46.60       218,129       46.63  
  47.00 - 49.92       226,525       8.56       49.16       16,194       47.59  
  50.47 - 60.47       115,105       8.00       55.18       91,117       56.09  
                                             
          3,273,283                       1,768,373          
                                             
 
At September 30, 2006, the total intrinsic value of stock options outstanding and exercisable was $27.6 million and $21.2 million, respectively.
 
Stock option information related to unvested shares for the nine months ended September 30, 2006 was as follows:
 
                 
          Weighted
 
          Average
 
          Grant
 
    Number of
    Date Fair
 
    Options     Value  
 
Balance, beginning of period
    2,075,965     $ 11.26  
Granted
    388,459       6.32  
Vested
    (768,483 )     10.95  
Forfeited
    (191,031 )     10.92  
                 
Balance, end of period
    1,504,910       10.19  
                 


32


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

A summary of unvested restricted stock activity for the nine months ended September 30, 2006 is presented below:
 
                 
          Weighted
 
          Average
 
          Grant
 
    Number of
    Date Fair
 
    Shares     Value  
 
Balance, beginning of period
    441,630     $ 45.03  
Granted
    285,907       41.57  
Vested
    (161,719 )     36.30  
Forfeited
    (35,451 )     41.09  
                 
Balance, end of period
    530,367       46.09  
                 
 
The total intrinsic value of stock options exercised during the nine months ended September 30, 2006 and 2005 was $20.2 million and $64.2 million, respectively. During the nine months ended September 30, 2006 and 2005, the Company received cash of $8.2 million and $16.2 million, respectively, from exercises of stock options and recognized related tax benefits of $5.0 million and $17.3 million, respectively.
 
During the three and nine months ended September 30, 2006, 38,049 and 126,959 shares of common stock, respectively, were purchased under the Company’s Employee Stock Purchase Plan resulting in compensation cost of approximately $192,000 and $875,000, respectively.
 
As of September 30, 2006, the total remaining unrecognized cost related to unvested stock options and restricted stock amounted to $13.0 million and $14.3 million, respectively, which will be amortized over the weighted-average remaining requisite service period of 29 months and 46 months, respectively.
 
The Company issues new shares of common stock to satisfy stock-based awards. At September 30, 2006, there were approximately 1,737,000 shares available for grant under the Plan. As of September 30, 2006, approximately 1.9 million shares were available for issuance under the Company’s Employee Stock Purchase Plan.
 
18.   Segment Reporting
 
The Company has three operating segments: portfolio, mortgage loan operations and servicing and other. Management tracks and evaluates these three segments separately in deciding how to allocate resources and assess performance.
 
  •  The portfolio segment reflects the Company’s investment in its mortgage loan portfolio, which produces net interest income consisting of interest income less interest expense and a provision for mortgage loan losses on mortgage loans it holds in its portfolio.
 
  •  The mortgage loan operations segment, consisting of the Wholesale and Retail origination divisions, reflects purchases and originations of residential mortgage loans and records (i) net interest income comprised of interest income and interest expense on the mortgage loans the Company holds prior to selling its loans to the portfolio segment or in the whole loan market and (ii) gain on sale of mortgage loans less expenses to originate the mortgage loans.
 
  •  The servicing and other segment services loans, seeking to ensure that loans are repaid in accordance with their terms and the Company earns a servicing fee based upon the dollar amount of the servicing portfolio. Operations not included in the portfolio, mortgage loan operations or servicing segments are considered other and are included in the servicing and other segment. The Company’s recently acquired


33


 

 
NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

  Access Lending platform is included in the servicing and other segment, although it has not had a material impact on the Company’s results of operations or financial position for the first nine months of 2006.

 
The elimination column in the table below represents:  (i) the difference between the segment’s fair value of mortgage loans originated as if they were sold and the actual gain recorded on loans sold by the Company and (ii) the elimination of inter-company gains.
 
For the Company’s portfolio segment, management evaluates mortgage assets at the segment level. As such, the quarter end balances of these assets are included in the table below.
 
For the three and nine months ended September 30, 2006 and 2005 (dollars in thousands):
 
                                                         
    Three Months Ended September 30, 2006  
    REIT &
                                     
    Qualified
    Taxable REIT Subsidiary              
    REIT
          Mortgage Loan Operations                    
    Subsidiaries
          Total
    Total
    Servicing
             
    Portfolio     Portfolio     Wholesale     Retail     and Other     Eliminations     Consolidated  
 
Interest income
  $ 258,233       30,176       176,676       37,035       12,052             514,172  
Interest expense
    (178,283 )     (24,384 )     (120,743 )     (31,386 )     (20,432 )           (375,228 )
                                                         
Net interest income
    79,950       5,792       55,933       5,649       (8,380 )           138,944  
Provision for losses on mortgage loans held for investment
    (22,500 )     1,744                               (20,756 )
                                                         
Net interest income after provision for losses
    57,450       7,536       55,933       5,649       (8,380 )           118,188  
Other operating income (loss):
                                                       
Gain on sale of mortgage loans
                197,310       90,676       (67,517 )     (47,424 )     173,045  
Servicing & other income (loss)
    (30,168 )                 (66 )     27,257             (2,977 )
                                                         
Total other operating income (loss)
    (30,168 )           197,310       90,610       (40,260 )     (47,424 )     170,068  
Operating expenses
    4,246             158,202       98,116       (62,553 )           198,011  
                                                         
Earnings before income taxes
  $ 23,036       7,536       95,041       (1,857 )     13,913       (47,424 )     90,245  
                                                         
Funding volume
  $             13,482,612       2,349,903                   15,832,515  
                                                         
Securitizations structured as financings
  $                                      
                                                         
Total assets at September 30, 2006
  $ 11,426,092       1,683,192       10,196,797       1,781,636             (27,949 )     25,059,768  
                                                         
 


34


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

                                                         
    Nine Months Ended September 30, 2006  
    REIT &
                                     
    Qualified
    Taxable REIT Subsidiary              
    REIT
          Mortgage Loan Operations                    
    Subsidiaries
          Total
    Total
    Servicing
             
    Portfolio     Portfolio     Wholesale     Retail     and Other     Eliminations     Consolidated  
 
Interest income
  $ 777,928       112,077       473,807       90,166       24,310             1,478,288  
Interest expense
    (510,021 )     (76,286 )     (315,344 )     (73,784 )     (44,117 )           (1,019,552 )
                                                         
Net interest income
    267,907       35,791       158,463       16,382       (19,807 )           458,736  
Provision for losses on mortgage loans held for investment
    (82,200 )     1,294                               (80,906 )
                                                         
Net interest income after provision for losses
    185,707       37,085       158,463       16,382       (19,807 )           377,830  
Other operating income (loss):
                                                       
Gain on sale of mortgage loans
                610,717       257,837       (205,513 )     (165,309 )     497,732  
Servicing & other income (loss)
    (7,169 )           (144 )     (608 )     74,190             66,269  
                                                         
Total other operating income (loss)
    (7,169 )           610,573       257,229       (131,323 )     (165,309 )     564,001  
Operating expenses
    17,860             459,129       285,482       (161,382 )           601,089  
                                                         
Earnings before income taxes
  $ 160,678       37,085       309,907       (11,871 )     10,252       (165,309 )     340,742  
                                                         
Funding volume
  $             38,684,177       6,759,095                   45,443,272  
                                                         
Securitizations structured as financings
  $ 3,393,531                                     3,393,531  
                                                         
Total assets at September 30, 2006
  $ 11,426,092       1,683,192       10,196,797       1,781,636             (27,949 )     25,059,768  
                                                         

 

35


 

NEW CENTURY FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(Unaudited)

September 30, 2006 and 2005

                                                         
    Three Months Ended September 30, 2005  
    REIT &
                                     
    Qualified
    Taxable REIT Subsidiary              
    REIT
          Mortgage Loan Operations                    
    Subsidiaries
          Total
    Total
    Servicing
             
    Portfolio     Portfolio     Wholesale     Retail     and Other     Eliminations     Consolidated  
 
Interest income
  $ 293,706       52,414       132,085       13,814       2,602             494,621  
Interest expense
    (159,022 )     (37,354 )     (77,602 )     (8,386 )     (8,535 )           (290,899 )
                                                         
Net interest income
    134,684       15,060       54,483       5,428       (5,933 )           203,722  
Provision for losses on mortgage loans held for investment
    (38,500 )     (42 )                             (38,542 )
                                                         
Net interest income after provision for losses
    96,184       15,018       54,483       5,428       (5,933 )           165,180  
Other operating income (loss):
                                                       
Gain on sale of mortgage loans
                165,399       75,394       (10,703 )     (53,849 )     176,241  
Servicing & other income (loss)
    11,579             (5 )     404       3,211             15,189  
                                                         
Total other operating income (loss)
    11,579             165,394       75,798       (7,492 )     (53,849 )     191,430  
Operating expenses
    2,836             161,880       92,588       (23,665 )           233,639  
                                                         
Earnings before income taxes
  $ 104,927       15,018       57,997       (11,362 )     10,240       (53,849 )     122,971  
                                                         
Funding volume
  $             14,859,085       1,852,513                   16,711,598  
                                                         
Securitizations structured as financings
  $ 2,080,230                                     2,080,230  
                                                         
Total assets at September 30, 2005
  $ 15,110,803       2,611,568       10,194,849       1,227,874             (57,851 )     29,087,243  
                                                         

 

36


 

                                                         
    Nine Months Ended September 30, 2005  
    REIT &
                                     
    Qualified
    Taxable REIT Subsidiary              
    REIT
          Mortgage Loan Operations              
    Subsidiaries
          Total
    Total
    Servicing
             
    Portfolio     Portfolio     Wholesale     Retail     and Other     Eliminations     Consolidated  
 
Interest income
  $ 739,470       178,131       289,204       32,619       7,129             1,246,553  
Interest expense
    (360,569 )     (114,173 )     (164,067 )     (18,805 )     (13,921 )           (671,535 )
                                                         
Net interest income
    378,901       63,958       125,137       13,814       (6,792 )           575,018  
Provision for losses on mortgage loans held for investment
    (104,201 )     (1,454 )                             (105,655 )
                                                         
Net interest income after provision for losses
    274,700       62,504       125,137       13,814       (6,792 )           469,363  
Other operating income (loss):
                                                       
Gain on sale of mortgage loans
                588,805       208,432       (231,754 )     (155,686 )     409,797  
Servicing & other income (loss)
    (10,705 )           (4 )     404       46,118             35,813  
                                                         
Total other operating income (loss)
    (10,705 )           588,801       208,836       (185,636 )     (155,686 )     445,610  
Operating expenses
    15,760             452,782       218,552       (79,647 )           607,447  
                                                         
Earnings before income taxes
  $ 248,235       62,504       261,156       4,098       (112,781 )     (155,686 )     307,526  
                                                         
Funding volume
  $             36,063,790       4,343,545                   40,407,335  
                                                         
Securitizations structured as financings
  $ 10,961,958                                     10,961,958  
                                                         
Total assets at September 30, 2005
  $ 15,110,803       2,611,568       10,194,849       1,227,874             (57,851 )     29,087,243  
                                                         

37


 

 
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
This Quarterly Report on Form 10-Q represents an update to the more detailed and comprehensive disclosures included in our Annual Report on Form 10-K for the year ended December 31, 2005. As such, a reading of the Annual Report on Form 10-K is necessary to an informed understanding of the following discussions.
 
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes contained elsewhere herein. As used herein, except where the context suggests otherwise, for time periods on and after October 1, 2004, the terms “the company,” “our,” “its,” “we,” “the group,” and “us” refer to New Century Financial Corporation and its consolidated subsidiaries and, for the time periods before October 1, 2004, the terms “the company,” “our,” “its,” “we,” “the group,” and “us” mean New Century TRS Holdings, Inc. and its consolidated subsidiaries.
 
General
 
New Century Financial Corporation is a real estate investment trust, or REIT, that, through its taxable REIT subsidiaries, operates one of the nation’s largest mortgage finance companies. We began originating and purchasing loans in 1996, and, in the fourth quarter of 2004, we began operating our business as a REIT. We originate and purchase primarily first mortgage loans nationwide. Historically, we have focused on lending to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers. In September 2005, we acquired a mortgage origination platform from RBC Mortgage Company, or RBC Mortgage, that expanded our offerings to include conventional mortgage loans, including Alt-A mortgage loans, loans insured by the Federal Housing Administration, or FHA, and loans guaranteed by the Veterans Administration, or VA. A significant portion of the conventional loans, which are generally referred to as “conforming loans,” we produce qualify for inclusion in guaranteed mortgage securities backed by the Federal National Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage Corp., or Freddie Mac. At the same time, some of the conventional loans we produce either have an original loan amount in excess of the Fannie Mae and Freddie Mac loan limit for single-family loans or otherwise do not meet Fannie Mae or Freddie Mac guidelines.
 
Prior to 2003, we sold our loans through both whole loan sales and securitizations structured as sales. Since 2003, we have also retained a portion of our loan production for investment on our balance sheet through securitizations structured as financings rather than sales. Our decisions regarding secondary marketing transactions in 2006 have been, and will continue to be, influenced by market conditions and our ability to access external sources of capital.
 
On April 5, 2004, the board of directors of New Century TRS Holdings, Inc., or New Century TRS, formerly known as New Century Financial Corporation, approved a plan to change its capital structure to enable it to qualify as a REIT for U.S. federal income tax purposes. On April 12, 2004, New Century TRS formed New Century Financial Corporation, or New Century, a Maryland corporation formerly known as New Century REIT, Inc.
 
Pursuant to the merger that implemented the restructuring of New Century TRS in order for it to qualify as a REIT, New Century became the publicly-traded parent listed on the New York Stock Exchange, or NYSE, began trading under the ticker symbol “NEW,” and which succeeded to and continued to operate substantially all of the existing businesses of New Century TRS and its subsidiaries.
 
As a result of the merger and the related capital-raising activities, a significant source of our revenue is the interest income generated from our portfolio of mortgage loans held by our REIT and our taxable REIT subsidiaries. We also continue to generate revenue through our taxable REIT subsidiaries from the sale of loans, servicing income and loan origination fees. We expect the primary components of our expenses to be (i) interest expense on our credit facilities, securitizations, and other borrowings, (ii) general and administrative expenses and (iii) payroll and related expenses arising from our origination and servicing businesses.


38


 

Recent Acquisitions
 
During the third quarter of 2005, Home123 Corporation, one of New Century’s wholly owned subsidiaries, purchased the origination platform of RBC Mortgage, which has enabled us to expand our mortgage product offerings, our retail presence on a nationwide basis and our channels of distribution, particularly into the builder and realtor channels.
 
This origination platform, which is more heavily weighted towards purchase financing as opposed to refinancing transactions, included approximately 140 branches nationwide and originates residential mortgage loans, consisting primarily of “Alt-A,” “jumbo” and “conforming” mortgages, as well as home equity lines of credit.
 
In February 2006, we purchased from Access Lending Corporation a platform that provides warehouse lines of credit to middle-market residential mortgage bankers. This acquisition enables us to offer warehouse lending services to our Wholesale customers and to other middle-market mortgage bankers.
 
Executive Summary
 
The first nine months of 2006 have been challenging for originators of mortgage loans. Interest rates, while declining slightly in the third quarter, steadily increased over the first half of the year and remain at higher levels than the last few years. Higher interest rates have caused consumer demand for home purchase financings and refinancings to decrease from the levels the industry enjoyed in the recent past. Lower consumer demand for mortgage products has also created intense pricing competition within the industry. The increasingly competitive environment has lead to industry consolidation, which we expect will continue into 2007.
 
Despite the difficult macroeconomic environment, many of our key business metrics were solid in the third quarter of 2006. During the quarter, we maintained loan production volume at a level comparable to the second quarter of 2006. We also achieved record low loan acquisition costs in the quarter and, while the interest spread earned by our mortgage loan portfolio in the third quarter decreased when compared with the second quarter, the decrease was primary as a result of a loss from hedging-related activities, a component unrelated to our core business operations. Partially offsetting these positive trends, gain-on-sale declined in the quarter as a result of changes to rating agency credit enhancement levels and higher loan repurchases and discounted loan sales. In addition, our gain-on-sale for the quarter was affected by the accounting impact of the value of the company’s forward sale commitments and interest rate locks, which are treated as derivative instruments for accounting purposes but do not currently qualify for hedge accounting. While our mortgage loan portfolio spread and gain-on-sale in the quarter were negatively affected by our hedging-related activities, we still believe that our hedging strategies are effective on an economic basis. Since we have little control over the macroeconomic factors that affect the income we receive from our hedging-related activities and the related accounting impact, we will continue to focus on the factors affecting our business that we can influence including our pricing strategy, credit quality and cost reduction strategies.
 
For the fourth quarter of 2006, we expect the operating environment to continue to be challenging. We expect our loan production volume to be moderately lower than the third quarter and our non-prime net operating margin to be reduced in the fourth quarter as a result of higher discounted loan sales. Additionally, we expect mortgage loan portfolio income to be lower than the third quarter as the portfolio balance continues to decline.
 
We expect 2007 will be a year of continued industry evolution and opportunity. Our strategy for next year focuses on maximizing our core mortgage origination franchise through loan origination process improvement, enhanced productivity and increased efficiencies. Our REIT status and the mortgage loan portfolio are tools that help us execute our mortgage banking strategy but we do not expect to add to the portfolio simply to support a specific dividend target. We expect to continue to evaluate whole loan sales versus securitizations on a case-by-case basis based on whole loan prices relative to our view of the risk-adjusted returns on capital available through securitization. The current economic environment calls for a financial strategy that is flexible


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enough to capitalize on the opportunities that arise during 2007 giving consideration to secondary and capital market conditions.
 
We believe that we are well positioned to meet the challenges next year. We expect overall mortgage market volume to decline in 2007, yet we believe our size, scale, financial resources, low loan acquisition costs and reputation will enable us to compete successfully and profitably gain market share in this consolidating industry.
 
Overview
 
Our two key business components are: (i) our mortgage loan portfolio held by our REIT and our taxable REIT subsidiaries; and (ii) our origination, sales and servicing activities conducted through certain of our taxable REIT subsidiaries.
 
REIT and TRS Mortgage Loan Portfolios
 
One of the largest components of our revenue is derived from the interest income we earn on our portfolio of mortgage loans held for investment, which totaled $14.0 billion at September 30, 2006 and generated $81.8 million and $287.2 million of interest income for the three and nine month periods ended September 30, 2006, respectively.
 
During 2003, we shifted our strategy to hold loans on our balance sheet. Because our credit facilities are short-term in nature and generally do not allow loans to be financed through the facility for longer than 180 days, a securitization structure currently offers the most attractive means to finance loans on our balance sheet. Therefore, we began to structure our securitizations as financings during 2003. During the nine months ended September 30, 2006 and 2005, we completed four securitizations totaling $3.4 billion and four securitizations totaling $11.0 billion, respectively, which were structured as on-balance sheet financings. In a securitization structured as a financing, we make an initial cash investment so that the securitization trusts begin to return cash flow to us in the first month following securitization. Therefore, we require cash and capital to make the initial investment, as well as to support the loans on our balance sheet. During the nine months ended September 30, 2006, we retained approximately 7.50% of our total loan production on our balance sheet. During the third quarter of 2006, we chose to sell loans in the whole loan market rather than adding assets to our REIT portfolio, resulting in a decline in the portfolio balance. Going forward, we will continue to evaluate the relative advantages and disadvantages of whole loan sales versus securitizations, taking into account secondary market conditions and our capital allocation strategy.
 
We measure the performance of the loans in the portfolio by monitoring prepayment rates and credit losses. Faster prepayments reduce the weighted average life of the portfolio, thereby reducing net interest income and credit losses. During the first six months of 2006, prepayment speeds were faster than originally expected. However, in the third quarter of 2006, the prepayment speeds decreased to more normal levels. We anticipate this trend to continue through the fourth quarter of 2006.
 
Cumulative credit losses, which we generally assume to be in the range of 0.9% and 5.1% of the original balance of the pool of loans, also reduce net interest income. While the range of estimated cumulative credit losses is fairly broad, the weighted average cumulative credit loss estimate for the entire portfolio of mortgage loans held for investment was 2.24% at September 30, 2006. At September 30, 2006, the allowance for losses on mortgage loans held for investment was $191.6 million compared with $209.9 million at June 30, 2006. These amounts represent 1.36% and 1.31% of the unpaid principal balance of the mortgage loan portfolio, respectively. Our 60-day-plus delinquency rate as of September 30, 2006 was 5.95% compared with 4.61% as of June 30, 2006. The higher delinquency rate as of the end of the third quarter was the result of normal portfolio seasoning and higher delinquencies in the 2005 and 2006 vintages compared with the 2003 and 2004 vintages. We planned for these higher delinquency rates and believe we are adequately reserved for the expected higher level of loan losses after giving consideration to the seasoning of the portfolio and the performance of our newer vintages.


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Generally, our loans have a fixed-rate for a period of time, while the underlying bonds that finance those loans are variable-rate based on one-month LIBOR, resulting in interest rate risk. Our hedging strategies to mitigate this interest rate risk are designed to reduce variability in our interest margin over the period of each securitization.
 
Originations and Sales
 
The other major component of our business is our ability to originate and purchase mortgage loans at a reasonable cost and to sell those loans in the secondary mortgage market. For the past several years, our secondary marketing strategy has included a combination of both whole loan sales and securitizations.
 
Loan origination volume in our industry has historically fluctuated from year to year and is affected by external factors such as home values, the level of interest rates, consumer debt and the overall condition of the economy. In addition, the premiums we receive from the secondary market for our loans have also fluctuated, predominately as a result of the interest rate environment and, to a lesser extent, the other factors mentioned above. As a consequence, the business of originating and selling loans is cyclical.
 
We recently announced our adoption of additional guidelines with respect to our lending best practices. These guidelines include heightened underwriting requirements for our adjustable-rate and interest-only mortgage loan programs for potential borrowers in owner-occupied properties who have FICO scores below 580 and loan-to-value ratios greater than 80%. We are requiring these borrowers to qualify with a debt-to-income ratio that is less than 50% and use the fully-indexed rate minus 100 basis points rather than qualifying at the initial interest rate. Less than 4 percent of our recent loan production volume would not have qualified for a 30-year adjustable-rate or interest-only loan under these guidelines. We believe the steps we are taking are prudent in light of the current market environment and are designed to help ensure that specific loan products are appropriate for the circumstances of individual borrowers and improve the overall credit quality of our loans. We plan to continue evaluating our product line with these goals in mind. While these underwriting changes may result in a modest decline in volume, we do not expect a meaningful impact to profitability.
 
The operating margin of our loan origination franchise has three components: (i) net interest income, (ii) gain on sale of mortgage loans and (iii) loan origination or acquisition costs. We use operating margin as our principal metric to measure the value of our loan origination franchise.
 
Net interest income on mortgage loans held for sale — We typically retain our mortgage loans held for sale for a period of 30 to 50 days before they are sold in the secondary market or securitized. During that time, we earn the coupon rate of interest paid by the borrower, and we pay interest to the lenders that provide our financing facilities. During the nine months ended September 30, 2005, the difference between these interest rates was approximately 2.9%. During the nine months ended September 30, 2006, this margin decreased to 2.3% as a result of short-term interest rates increasing more rapidly than our average coupon rates. We seek to manage the timing of our whole loan sales to enhance the net interest income we earn on the loans, while preserving the ability to sell the loans at the maximum price.
 
Gain on sale of mortgage loans — Gain on sale of mortgage loans is affected by the condition of the secondary market for our loans. Beginning in the latter half of 2004, as interest rates began to rise and short-term rates rose faster than long-term rates (a flatter yield curve), the prices we received for our loans began to decline relative to historic levels. Beginning in the first quarter of 2006, we began to see some improvement in our gain on sale as a result of improved secondary market execution, which was primarily driven by a higher weighted average coupon on our loans, a more favorable product mix and stronger secondary market appetite for our loans. During the third quarter of 2006, our gain on sale executions were negatively impacted as a result of increased rating agency credit enhancement levels, the volume of repurchases, discounted sales and the severity of the discount and the accounting impact of the value of our forward sale and interest rate lock commitments, which are treated as derivative instruments for accounting purposes but do not currently qualify for hedge accounting. We expect the volume of repurchases, discounted sales and the severity of the discount to continue to challenge originators in our industry. Loan buyers have increased the number of loan files reviewed in their due diligence process and decreased the percentage of loans they ultimately purchase. In


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addition, repurchases have increased as a result of higher early payment defaults. While we expect this industry trend to continue in the near-term, we believe the ongoing refinement of our underwriting guidelines and continual focus on loan origination process improvement will help mitigate this trend.
 
Loan origination or acquisition cost — We also monitor the cost to originate our loans. We typically refer to this as our loan acquisition costs. Loan acquisition costs are comprised of the following: fees paid to wholesale brokers and correspondents, plus direct loan origination costs, including commissions and corporate overhead costs, less points and fees received from borrowers, divided by total loan production volume. Loan acquisition costs do not include profit-based compensation, servicing division overhead, and certain professional fees. During 2004 and through the first quarter of 2005, our loan acquisition costs remained relatively stable and generally fluctuated inversely with our loan production volume. As a result of the competitive environment and its impact on the value of our loans in 2005, we began implementing cost-cutting measures designed to reduce our loan acquisition costs. The cost-cutting measures we implemented during 2005 have continued through the first nine months of 2006 and include changes to our sales compensation, controlling growth in non-sales overhead and more closely scrutinizing our discretionary spending. These cost-cutting measures resulted in a significant reduction of our loan acquisition costs for the three and nine months ended September 30, 2006 compared to previous quarters.
 
These two components of our business, our portfolio of mortgage loans held for investment and our originations and sales, account for most of our operating revenues and expenses. Our origination platform provides the source of the loan volume to conduct both parts of our business.
 
Loan Originations and Purchases
 
Historically, we have focused on lending to individuals whose borrowing needs are generally not fulfilled by traditional financial institutions because they do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers. In connection with the loan origination platform acquired from RBC Mortgage, we also originate “Alt-A,” “jumbo” and “conforming” mortgages, as well as home equity lines of credit. As a result of the integration of our non-prime and prime/Alt-A loan origination platforms, both our Wholesale and Retail Divisions offer non-prime, prime and Alt-A products.
 
As of September 30, 2006, our Wholesale Division operated through 33 regional operating centers in 19 states and originated or purchased $38.6 billion in loans during the nine months ended September 30, 2006. Of the $38.6 billion in mortgage loans originated or purchased, $36.3 billion, or 94.0%, were non-prime loans and $2.3 billion, or 6.0%, were prime or Alt-A loans. Our Retail Division, which has a Builder Realtor channel and a Consumer Direct channel, originated loans through 235 sales offices in 36 states, including our centralized telemarketing unit, and originated $6.8 billion in mortgage loans during the nine months ended September 30, 2006. Of the $6.8 billion in loans originated, $3.9 billion, or 57.2%, was originated through our Builder Realtor channel and $2.9 billion, or 42.8%, was originated through our Consumer Direct channel. In addition, $3.1 billion, or 45.7%, of total retail originations were non-prime loans and $3.7 billion, or 54.3%, were prime or Alt-A loans.
 
As of September 30, 2005, our Wholesale Division operated through 34 regional operating centers in 17 states and originated or purchased $36.1 billion in loans during the nine months ended September 30, 2005. Of the $36.1 billion in mortgage loans originated or purchased, $35.7 billion, or 99.0%, were non-prime loans and $360.6 million, or 1%, were prime or Alt-A loans. Our Retail Division originated loans through 216 sales offices in 35 states, including our centralized telemarketing unit, and originated $4.3 billion in loans during the nine months ended September 30, 2005. Of the $4.3 billion in loans originated, $494.0 million, or 11.4%, was originated through our Builder Realtor channel, all of which were prime and Alt-A loans, and $3.8 billion, or 88.6%, was originated through our Consumer Direct channel, all of which were non-prime loans.
 
During the nine months ended September 30, 2006, approximately $20.3 billion, or 44.8%, of our total mortgage loan production consisted of cash-out refinancings, where the borrowers refinanced their existing mortgages and received cash representing a portion of the equity in their homes. For the same period, approximately $20.0 billion, or 44.1%, of our total mortgage loan production consisted of home purchase


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finance loans. The remainder of our loan production, $5.1 billion, or 11.1%, consisted of rate and term transactions, which are transactions in which borrowers refinanced their existing mortgages to obtain a better interest rate, a lower payment or different loan maturity. For the nine months ended September 30, 2005, total originations consisted of $20.3 billion, or 50.3%, of cash-out refinancings, $16.5 billion, or 40.8%, of home purchase financings, and $3.6 billion, or 8.9%, of rate and term refinance transactions. Over the last 12 months, we have made a concerted effort to increase our home purchase business. These efforts, coupled with market and economic conditions and the addition of the RBC Mortgage loan origination platform, have enabled us to decrease the percentage of cash-out refinancings as compared to home purchase finance loans.
 
During the nine months ended September 30, 2006, originations of interest-only mortgage loans totaled $7.7 billion, or 17.0%, of total originations. Interest-only originations during the nine months ended September 30, 2005 totaled $13.7 billion, or 34.0%, of total originations. In the latter part of 2005, we began implementing strategies to maintain the mortgage loan production volume of our interest-only product at a level no greater than 25% of total mortgage loan production in order to increase our secondary market execution. These strategies included pricing increases and underwriting changes for the interest-only product and the introduction of new alternative products, including a 40-year mortgage product, that are in greater demand in the secondary market.
 
For the nine months ended September 30, 2006, originations of pay-option loans totaled $231.6 million. For the nine months ended September 30, 2005, originations of pay-option loans totaled $36.4 million. Pay-option loans differ from “traditional” monthly-amortizing loans by providing borrowers with the option to make fully amortizing interest-only, or “negative-amortizing,” payments. We view these loans as a profitable product that does not create disproportionate credit risk. Our pay-option loan portfolio has a high initial loan quality, with original average FICO scores (a measure of credit rating) of 711 and combined loan-to-values of 75.1%, respectively. We originate pay-option loans only to borrowers who can qualify at the loan’s fully indexed interest rates. This high credit quality notwithstanding, lower initial payment requirements of pay-option loans may increase the credit risk inherent in our loans held for sale. Since the required monthly payments for pay-option loans will eventually increase, borrowers who initially decide to make “negative-amortizing” payments may be less able to pay the increased amounts and, therefore, may be more likely to default on the loan than a borrower using a more traditional monthly-amortizing loan.
 
For the nine months ended September 30, 2006, full documentation loans as a percentage of total mortgage loan originations were $25.3 billion, or 55.7%, limited documentation loans were $922.0 million, or 2.0%, and stated documentation loans were $19.2 billion, or 42.3%. Full documentation loans generally require applicants to submit two written forms of verification of stable income for at least twelve months. Limited documentation loans generally require applicants to submit twelve consecutive monthly bank statements on their individual bank accounts. Stated income documentation loans are based upon stated monthly income if the applicant meets certain criteria. For the nine months ended September 30, 2005, full documentation loans as a percentage of total mortgage loan originations were $21.6 billion, or 53.4%, limited documentation loans were $1.2 billion, or 3.0%, and stated documentation loans were $17.6 billion, or 43.6%. Generally, economic and market conditions, including product introductions and offerings by competitors, influence our product mix. The documentation that we require of our borrowers is affected by these fluctuations in product mix. We designed our underwriting standards, including our recently adopted guidelines for adjustable-rate and interest-only loans, and quality assurance programs to ensure that loan quality is consistent and meets our guidelines, even as the mix of documentation type varies. To further enhance loan quality, we have also adopted additional steps and verifications for our stated income documentation loans designed to decrease the likelihood of borrower fraud or abuse.


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The following tables set forth selected information relating to loan originations and purchases during the periods shown (dollars in thousands):
 
                                                                         
    For the Three Months Ended        
    September 30, 2006     September 30, 2005        
          Prime &
                      Prime &
                   
    Non-Prime     Alt-A     Total     %     Non-Prime     Alt-A     Total     %        
 
Wholesale
  $ 12,727,703       754,909       13,482,612       85.2       14,498,442       360,643       14,859,085       88.9          
Retail
    1,099,510       1,250,393       2,349,903       14.8       1,358,536       493,977       1,852,513       11.1          
                                                                         
Total originations and purchases
    13,827,213       2,005,302       15,832,515       100.0       15,856,978       854,620       16,711,598       100.0          
                                                                         
Fixed-rate mortgages:
                                                                       
15 — 30 year
    2,200,129       1,386,982       3,587,111       22.7       4,263,060       516,122       4,779,182       28.6          
Interest-Only
    93,831       216,480       310,311       2.0                                  
40-Year
    843,288       85,042       928,330       5.8                                  
HELOC
                                                       
                                                                         
Sub-total Fixed
    3,137,248       1,688,504       4,825,752       30.5       4,263,060       516,122       4,779,182       28.6          
Adjustable-rate mortgages:
                                                                       
Hybrid — 30 year(1)
    2,796,291       179,867       2,976,158       18.8       5,986,780       30,514       6,017,294       36.0          
Interest-Only
    2,394,570       116,452       2,511,022       15.9       5,607,138       307,984       5,915,122       35.4          
Hybrid — 40 year(1)
    5,499,104             5,499,104       34.7                                  
HELOC
          20,479       20,479       0.1                                  
                                                                         
Sub-total ARM
    10,689,965       316,798       11,006,763       69.5       11,593,918       338,498       11,932,416       71.4          
                                                                         
Total originations and purchases
    13,827,213       2,005,302       15,832,515       100.0       15,856,978       854,620       16,711,598       100.0          
                                                                         
Purchases
    5,469,518       1,312,972       6,782,490       42.8       6,730,049       510,493       7,240,542       43.3          
Refinances:
                                                                       
Cash-out refinances
    7,082,991       198,009       7,281,000       46.0       7,809,407       89,346       7,898,753       47.3          
Rate/term refinances
    1,274,704       494,321       1,769,025       11.2       1,317,522       254,781       1,572,303       9.4          
                                                                         
Total originations and purchases
    13,827,213       2,005,302       15,832,515       100.0       15,856,978       854,620       16,711,598       100.0          
                                                                         
Full documentation
    7,628,488       1,228,637       8,857,125       55.9       8,663,510       576,456       9,239,966       55.3          
Limited documentation
    294,317             294,317       1.9       276,062             276,062       1.7          
Stated documentation
    5,904,408       776,665       6,681,073       42.2       6,917,406       278,164       7,195,570       43.0          
                                                                         
Total originations and purchases
  $ 13,827,213       2,005,302       15,832,515       100.0       15,856,978       854,620       16,711,598       100.0          
                                                                         
Average principal balance of loans originated and purchased
  $ 191       177       189               181       182       181                  
Weighted average FICO score of loans originated and purchased
    624       712       635               631       718       636                  
Percent of loans secured by first mortgages
    94.0 %     92.9 %     93.8 %             93.3 %     94.0 %     93.4 %                
Weighted average loan-to-value ratio(2)
    81.7 %     79.1 %     81.4 %             81.3 %     76.3 %     81.1 %                
Weighted average interest rates:
                                                                       
Fixed-rate mortgages
    8.9 %     7.1 %     8.3 %             7.7 %     6.1 %     7.5 %                
Adjustable-rate mortgages — initial rate
    8.4 %     5.8 %     8.3 %             7.1 %     5.3 %     7.1 %                
Adjustable-rate mortgages — margin over index
    6.2 %     2.7 %     6.1 %             5.9 %     2.9 %     5.8 %                
Total originations and purchases
    8.5 %     6.9 %     8.3 %             7.3 %     5.9 %     7.2 %                
Percentage of loans originated in “AAA”, “AA” and “A+” credit grades
    87.4 %     N/A       N/A               90.4 %     N/A       N/A                  
Percentage of loans originated in bottom two credit grades
    2.9 %     N/A       N/A               2.3 %     N/A       N/A                  
 
 
(1) Majority of hybrid products have a fixed rate for 2 or 3 years.


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(2) Weighted average loan-to-value (LTV) is the LTV of the first lien mortgages and combined LTV of the second lien mortgages.
 
                                                                 
    For the Nine Months Ended  
    September 30, 2006     September 30, 2005  
          Prime &
                      Prime &
             
    Non-Prime     Alt-A     Total     %     Non-Prime     Alt-A     Total     %  
 
Wholesale
  $ 36,347,510       2,336,667       38,684,177       85.1       35,703,147       360,643       36,063,790       89.3  
Retail
    3,090,039       3,669,056       6,759,095       14.9       3,849,568       493,977       4,343,545       10.7  
                                                                 
Total originations and purchases
    39,437,549       6,005,723       45,443,272       100.0       39,552,715       854,620       40,407,335       100.0  
                                                                 
Fixed-rate mortgages:
                                                               
15-30 year
    6,349,325       4,104,443       10,453,768       23.0       9,622,637       516,122       10,138,759       25.1  
Interest-Only
    248,234       848,717       1,096,951       2.4                          
40-Year
    2,182,322       221,282       2,403,604       5.3                          
HELOC
          239       239                                
                                                                 
Sub-total Fixed
    8,779,881       5,174,681       13,954,562       30.7       9,622,637       516,122       10,138,759       25.1  
Adjustable-rate mortgages:
                                                               
Hybrid — 30 year(1)
    8,719,296       441,844       9,161,140       20.2       16,502,073       30,514       16,532,587       40.9  
Interest-Only
    6,284,923       336,086       6,621,009       14.6       13,428,005       307,984       13,735,989       34.0  
Hybrid — 40 year(1)
    15,653,449             15,653,449       34.4                          
HELOC
          53,112       53,112       0.1                          
                                                                 
Sub-total ARM
    30,657,668       831,042       31,488,710       69.3       29,930,078       338,498       30,268,576       74.9  
                                                                 
Total originations and purchases
    39,437,549       6,005,723       45,443,272       100.0       39,552,715       854,620       40,407,335       100.0  
                                                                 
Purchases
    16,220,611       3,818,747       20,039,358       44.1       15,956,704       510,493       16,467,197       40.8  
Refinances:
                                                               
Cash-out refinances
    19,728,437       610,304       20,338,741       44.8       20,251,060       89,346       20,340,406       50.3  
Rate/term refinances
    3,488,501       1,576,672       5,065,173       11.1       3,344,951       254,781       3,599,732       8.9  
                                                                 
Total originations and purchases
    39,437,549       6,005,723       45,443,272       100.0       39,552,715       854,620       40,407,335       100.0  
                                                                 
Full documentation
    21,505,862       3,797,574       25,303,436       55.7       21,013,295       576,456       21,589,751       53.4  
Limited documentation
    922,042             922,042       2.0       1,198,654             1,198,654       3.0  
Stated documentation
    17,009,645       2,208,149       19,217,794       42.3       17,340,766       278,164       17,618,930       43.6  
                                                                 
Total originations and purchases
  $ 39,437,549       6,005,723       45,443,272       100.0       39,552,715       854,620       40,407,335       100.0  
                                                                 
Average principal balance of loans originated and purchased
  $ 186       176       185               181       182       181          
Weighted average FICO score of loans originated and purchased
    623       710       634               631       718       632          
Percent of loans secured by first mortgages
    93.7 %     92.7 %     93.5 %             94.0 %     94.0 %     94.0 %        
Weighted average loan-to-value ratio(2)
    81.6 %     78.4 %     81.1 %             81.3 %     76.3 %     81.2 %        
Weighted average interest rates:
                                                               
Fixed-rate mortgages
    8.9 %     6.9 %     8.1 %             7.7 %     6.1 %     7.6 %        
Adjustable-rate mortgages — initial rate
    8.4 %     5.4 %     8.3 %             7.1 %     5.3 %     7.1 %        
Adjustable-rate mortgages — margin over index
    6.2 %     2.7 %     6.1 %             5.8 %     2.9 %     5.7 %        
Total originations and purchases
    6.7 %     8.5 %     8.2 %             7.2 %     5.9 %     7.2 %        
Percentage of loans originated in “AAA”, “AA” and “A+” credit grades
    87.6 %     N/A       N/A               89.9 %     N/A       N/A          
Percentage of loans originated in bottom two credit grades
    3.0 %     N/A       N/A               2.4 %     N/A       N/A          
 
 
(1) Majority of hybrid adjustable-rate mortgage products have a fixed rate for 2 or 3 years.
 
(2) Weighted average loan-to-value (LTV) is the LTV of the first lien mortgages and combined LTV of the second lien mortgages.


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Secondary Market Transactions
 
Historically, one of our major components of revenue has been the recognition of gain on sale of our loans through whole loan sales and securitizations structured as sales for financial reporting purposes. In a whole loan sale, we recognize and receive a cash gain upon the sale. In a securitization structured as a sale, we typically recognize a gain on sale at the time the loans are sold, and receive cash flows over the actual life of the loans.
 
Since the first quarter of 2003, we have structured most of our securitizations as financings for financial reporting purposes rather than as sales. Such structures do not result in gain on sale at the time of the transaction, but rather yield interest income as the payments on the underlying mortgages are received. The following table sets forth secondary marketing transactions for the periods indicated (dollars in thousands):
 
                                                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2006     2005     2006     2005  
          % of
          % of
          % of
          % of
 
    Amount     Sales     Amount     Sales     Amount     Sales     Amount     Sales  
 
Non-prime whole loan sales
  $ 13,877,545       87.5 %     9,983,362       71.3 %     35,170,037       79.8 %     22,507,439       61.8 %
Prime and Alt-A whole loan sales
    1,715,503       10.8 %     19,358       0.1 %     5,058,310       11.5 %     19,358       0.1 %
Securitizations structured as sales
          0.0 %     1,999,959       14.3 %           0.0 %     2,989,181       8.2 %
                                                                 
Total premium sales
    15,593,048       98.3 %     12,002,679       85.7 %     40,228,347       91.3 %     25,515,978       70.1 %
Discounted whole loan sales
    409,896       2.6 %     32,081       0.2 %     916,340       2.1 %     178,525       0.5 %
                                                                 
Total sales
    16,002,944       100.9 %     12,034,760       85.9 %     41,144,687       93.4 %     25,694,503       70.6 %
Securitizations structured as financings
          0.0 %     2,080,230       14.8 %     3,393,531       7.7 %     10,961,958       30.1 %
Repurchases
    (150,974 )     (0.9 )%     (102,027 )     (0.7 )%     (469,342 )     (1.1 )%     (240,966 )     (0.7 )%
                                                                 
Total secondary market transactions
  $ 15,851,970       100.0 %     14,012,963       100.0 %     44,068,876       100.0 %     36,415,495       100.0 %
                                                                 
 
Whole Loan Sales
 
During the three months ended September 30, 2006, non-prime whole loan sales accounted for $13.9 billion, or 87.5%, of our total secondary market transactions. The weighted average premium received on the non-prime whole loan sales for the three months ended September 30, 2006, including certain hedge gains and premiums received for servicing rights, was 1.59% of the original principal balance of the loans sold. For the same period in 2005, non-prime whole loan sales and securitizations structured as sales accounted for $12.0 billion, or 85.5%, of our total secondary market transactions and the weighted average premium, including certain hedge gains and premiums received for servicing rights, was 2.05%.
 
During the three months ended September 30, 2006, prime and Alt-A whole loan sales accounted for $1.7 billion, or 10.8%, of our secondary market transactions. The weighted average premium received on prime and Alt-A whole loan sales was 0.7% of the original principal balance of the loans sold, including certain hedge gains and pair-off fees for the three months ended September 30, 2006. For the same period in 2005, the weighted average premium received on prime and Alt-A whole loan sales was 0.6% of the original principal balance of the loans sold, including certain hedge gains.
 
During the nine months ended September 30, 2006, non-prime whole loan sales accounted for $35.2 billion, or 79.8%, of our total secondary market transactions. The weighted average premium received on the non-prime whole loan sales for the three months ended September 30, 2005, including certain hedge gains and premiums received for servicing rights, was 1.77% of the original principal balance of the loans sold. For the


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same period in 2005, non-prime whole loan sales and securitizations structured as sales accounted for $25.5 billion, or 70.0%, of our total secondary market transactions and the weighted average premium, including certain hedge gains and premiums received for servicing rights, was 2.36%. The increase in whole loan sales for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005 was due to our executing a greater amount of securitizations structured as financings during 2005 to build our REIT mortgage loan portfolio.
 
During the nine months ended September 30, 2006, prime and Alt-A whole loan sales accounted for $5.1 billion, or 11.5%, of our secondary market transactions. The weighted average premium received on prime and Alt-A whole loan sales was 1.0% of the original principal balance of the loans sold, including certain hedge gains and pair-off fees, for the nine months ended September 30, 2006. For the same period in 2005, the weighted average premium received on prime and Alt-A whole loan sales was 0.6% of the original principal balance of the loans sold, including certain hedge gains and pair-off fees.
 
Discounted Loan Sales
 
During the three and nine months ended September 30, 2006, we sold $409.9 million and $916.3 million, respectively, in mortgage loans at a discount to their outstanding principal balance. Included in discounted loan sales for the three and nine months ended September 30, 2006 is approximately $152.1 million and $447.4 million, respectively, of second lien mortgage loans that were sold at a slight discount. There were no discounted second lien sales for the same period in 2005. The remaining $257.7 million and $468.9 million of discounted loan sales loans for the three and nine months ended September 30, 2006, respectively, consisted of repurchased loans, loans with documentation defects or loans that whole loan buyers rejected because of certain characteristics. For the three and nine months ended September 30, 2005, discounted loan sales totaled $32.1 million and $178.5 million, respectively. As a percentage of secondary market transactions, when adjusting for the second lien transaction, discounted sales increased from 0.2% for the three months ended September 30, 2005 to 1.6% for the three months ended September 30, 2006. The severity of the discount increased from 3.5% for the three months ended September 30, 2005 to 12.9% for the three months ended September 30, 2006. As a percentage of secondary market transactions, when adjusting for the second lien transaction, discounted sales increased from 0.5% for the nine months ended September 30, 2005 to 1.1% for the nine months ended September 30, 2006. The severity of the discount increased from 3.9% for the nine months ended September 30, 2005 to 8.7% for the nine months ended September 30, 2006 due to a less favorable secondary market for these types of loans as well as the mix of loans sold as discounted sales.
 
The table below illustrates the composition of discounted loan sales for each of the periods indicated (dollars in thousands):
 
                                                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2006     2005     2006     2005  
    Principal     Discount     Principal     Discount     Principal     Discount     Principal     Discount  
 
Repurchases from whole loan investors
  $ 181,871       (26.7 )%     32,081       (3.5 )%     242,248       (26.5 )%     90,453       (8.1 )%
Other discounted sales
    228,025       (1.8 )%                 674,093       (2.3 )%     88,072       0.5 %
                                                                 
Total discounted sales
  $ 409,896       (12.9 )%     32,081       (3.5 )%     916,341       (8.7 )%     178,525       (3.9 )%
                                                                 
 
Securitizations Structured as Financings
 
During the three months ended September 30, 2006, we did not complete any securitizations structured as financings as we decided to sell our loans in the whole loan market. During the nine months ended September 30, 2006, we completed four securitizations structured as financings totaling $3.4 billion. The “portfolio-based” accounting treatment for securitizations structured as financings and recorded on-balance sheet is designed to more closely match the recognition of income with the receipt of cash payments. Because we do not record gain on sale revenue in the period in which the securitization structured as a financing occurs, the use of such portfolio-based accounting structures will result in lower income in the period in which the securitization occurs than would a traditional securitization structured as a sale. However, the recognition


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of income as interest payments are received on the underlying mortgage loans is expected to result in higher income recognition in future periods than would a securitization structured as a sale. During the three months ended September 30, 2005, we completed one securitization totaling $2.1 billion, and during the nine months ended September 30, 2005, we completed four securitizations totaling $11.0 billion, which we structured as financings. The higher amount of securitizations structured as financings in 2005 was the result of our strategy to build our REIT portfolio of mortgage loans.
 
Securitizations Structured as Sales
 
During the nine months ended September 30, 2006, we did not complete any securitizations structured as sales. During the nine months ended September 30, 2005, we completed two securitizations structured as sales totaling $3.0 billion and resulting in gain on sale of $71.6 million. In addition, we continue to hold residual interests on our balance sheet related to securitizations structured as sales closed in previous periods. The mortgage servicing rights related to the securitizations structured as sales are typically sold within 30 to 60 days after securitization. Purchasers of securitization bonds and certificates have no recourse against our other assets, other than the assets of the trust. The value of our retained interests is subject to credit, prepayment and interest rate risk on the transferred financial assets.
 
At the closing of a securitization structured as a sale, we remove from our consolidated balance sheet the mortgage loans held for sale and add to our consolidated balance sheet (i) the cash received, (ii) the fair value of the Residuals (as defined in “Critical Accounting Policies-Residual Interests in Securitizations” below) and (iii) the estimated fair value of the servicing asset, if applicable. The excess of the cash received and the assets retained over the carrying value of the loans sold, less transactions costs, equals the net gain on sale of mortgage loans recorded by us in our consolidated statement of earnings. Residuals are subsequently carried at estimated fair value and accounted for as “held-for-trading” securities as permitted by SFAS 140. We are not aware of an active market for the purchase or sale of NIR or OC assets and, accordingly, determine the estimated fair value of the NIR and OC by discounting the expected cash flows released from the transactions (the cash out method) using a discount rate commensurate with the risks involved. We currently utilize a discount rate of 12.0% for estimated cash flows released from mortgage loan securitizations and 14.0% for estimated cash flows released from net interest margin securities, or NIMS, transactions.
 
On a quarterly basis, we review the underlying assumptions to value each Residual and adjust the carrying value of the securities based on actual experience and industry trends. To determine the value of the Residual we project the cash flow for each security. To project cash flow, we use base assumptions for the constant prepayment rate, or CPR, and losses for each product type based on historical performance. We update each security to reflect actual performance to date and we adjust base assumptions for CPR and losses based on historical experience to project performance of the security from that date forward. Then, we use the LIBOR forward curve to project future interest rates and compute cash flow projections for each security. Next, we discount the projected cash flows at a rate commensurate with the risk involved.
 
During the nine months ended September 30, 2006 and 2005, as a result of our quarterly evaluations of the Residuals, we recorded a $28.1 million and a $7.6 million decrease in the fair value of the Residuals, respectively. During the three months ended September 30, 2006, we recorded a $10.6 million increase to the fair value of the Residuals. This increase was offset by a corresponding decrease in the fair value of the Euro Dollar future contracts used to mitigate interest rate risk related to the Residuals. During the three months ended September 30, 2005, we recorded a $3.2 million decrease in the fair value of the Residuals. These fair value adjustments represent the change in the estimated present value of future cash flows from the Residuals and are recorded as a reduction to gain on sale.
 
Non-Performing Assets
 
Non-performing assets consist of loans that have ceased accruing interest. Loans are placed on non-accrual status when any portion of principal or interest is 90 days past due, or earlier when concern exists as to the ultimate collection of principal or interest. We expect the amount of mortgage loans on non-accrual status will change from time to time depending on a number of factors, including the growth or decline of the


48


 

portfolio, the maturity, or seasoning, of the portfolio, the number and dollar value of problem loans that are recognized and resolved through collections, the amount of loan sales and the amount of charge-offs. The performance of any mortgage loan can be affected by external factors, such as economic and employment conditions or factors related to a particular borrower. The table below shows the comparative data for the dates shown of non-accrual loans and delinquent loans for our mortgage loans held for sale and mortgage loans held for investment:
 
                                 
    September 30,
    December 31,
 
    2006     2005  
          %
          %
 
    Principal     Principal     Principal     Principal  
 
Mortgage loans held for investment: (1)
                               
Current
  $ 12,954,903       91.68 %   $ 15,231,245       93.95 %
Delinquent — 30-60 days (excluding non-accrual)
    358,613       2.54 %     314,416       1.94 %
Non-Accrual
    817,778       5.78 %     666,563       4.11 %
                                 
Total
  $ 14,131,294       100.00 %   $ 16,212,224       100.00 %
                                 
Allowance for losses on mortgage loans held of investment
  $ 191,561       1.36 %   $ 198,131       1.22 %
Charge-offs, net of recoveries
    87,476