If you think lending money to people who can't afford to pay it back is a bad business idea, you don't know much about the stock market.
As the scandal breaking at
New Century Financial
shows, subprime mortgage lending can be very profitable ... for some.
After all, when interest rates were just 1%, the vig on a $1 million loan only came to $10,000 a year. There are people on welfare who can afford to pay that, even if there is no chance whatsoever they could ever repay the principal. And there are plenty of analysts on Wall Street who won't notice the problem till it's too late.
The trick, when making bad loans, is to get out before the loan book hits the fan. Which brings us to New Century.
The company has admitted to bookkeeping "errors" going back to early last year. It admits bad debts are far higher than thought. Lenders have cut off funds, the company has suspended new loans, and bankruptcy is an imminent possibility. The shares have collapsed in the scandal and were suspended this week at just $1.66.
The Justice Department and the
Securities and Exchange Commission
are both investigating. Class-action suits are flying, and New Century has received a grand jury subpoena. Among the issues being examined are insider stock sales.
One thing that has drawn the authorities' attention is that in the eight months leading up to the recent disaster, New Century insiders were dumping stock like it was going out of fashion.
Which, of course, it was.
Between August of last year and early February, directors and executives, a group usually known on Wall Street as "the insiders," sold $29 million worth of shares to ordinary investors and mutual funds, a group usually known as "the suckers."
Average price paid: $36.29 a share.
Today, of course, those shares seem pretty much worthless.
But that's not the half of it. It's not even a third of it. I looked back through company filings dating back to early 2003 -- just around the time New Century stock first began skyrocketing on Wall Street euphoria about all the customers who could afford the cheap, upfront interest payments on adjustable-rate mortgages.
Guess what? Over the past four years, New Century insiders cashed out a remarkable $103 million in stock. At an average price of $42.56 a share. That's some getaway ... er, "exit."
Altogether they unloaded 2.4 million shares. By comparison, New Century currently has about 55.47 million shares available for trading.
Special mention goes to the three co-founders and top executives. Vice-Chairman-Finance Edward Gotschall sold $39 million in total. Even after paying for share options, his net profit comes to about $32 million.
Chief Executive Robert Cole cashed out $29.64 million. All but a couple of million was profit.
And Vice-Chairman and Chief Operating Officer Brad Morrice sold shares for $18 million, pocketing more than $13 million after stock option costs.
None of this is any proof that the insiders did anything illegal. That would require proof that they knew about the accounting problems and the looming cash crunch at the time of the sales. The company, of course, isn't commenting on anything related to the investigations. Some of these stock sales go back four years.
Nonetheless, it does prove that lending money to people who cannot afford to pay it back can still prove very profitable ... for some.
Morrice may have sold the least, but he may yet prove the smartest. The reason? He sold early. His last sale was in July of last year. That's a full eight months before the executives discovered their published accounts were wrong. That sort of time lag can prove very useful when you're talking to, say, a grand jury.
The New Century scandal comes at an awkward moment for both the
and the SEC, as the heads of both institutions shake their fists at London's "casino" market and brag about the glorious era of corporate governance that the Sarbanes-Oxley had brought to Wall Street.
And the fiasco is hardly the best advertisement for company awards. New Century was named to
magazine's 100 Fastest Growing Companies in 2003 and 2004. The
Wall Street Journal
named the company one of its Top Guns for 2005. In 2004 the company also earned an Ethics in America award from the Passkeys Foundation and Chapman University. Previous honors include an Entrepreneur of the Year Award from Ernst & Young way back in 1999.
In keeping with TSC's editorial policy, Brett Arends doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Arends takes a critical look inside mutual funds and the personal finance industry in a twice-weekly column that ranges from investment advice for the general reader to the industry's latest scoop. Prior to joining TheStreet.com in 2006, he worked for more than two years at the Boston Herald, where he revived the paper's well-known 'On State Street' finance column and was part of a team that won two SABEW awards in 2005. He had previously written for the Daily Telegraph and Daily Mail newspapers in London, the magazine Private Eye, and for Global Agenda, the official magazine of the World Economic Summit in Davos, Switzerland. Arends has also written a book on sports 'futures' betting.