On the eve of the financial crisis, the hedge fund manager Bruce M. Rose did a surprising deal that took his firm into the business of collecting mortgage payments from people with tainted credit.
Now, seven years later, securities regulators are scrutinizing the deal, looking in particular at how part of it was financed.
The Securities and Exchange Commission last fall began to subpoena documents from Mr. Rose’s Carrington Holding Company about the purchase of mortgage servicing operations from the failed subprime lender New Century Financial, according to regulatory filings. The previously unreported investigation is seeking information about how Carrington financed the $188 million deal, which relied in part on the firm’s later issuing special securities to the investors in its hedge fund.
Lightly regulated firms are moving into mortgage servicing, buying batches of the business from established banks. Regulators have recently expressed some concerns about how these new servicers are performing and their dealings with borrowers. In addition, the servicers’ financial strength has yet to be fully tested by a big drop in home prices.
Carrington services mortgages for tens of thousands of homeowners across the United States.
The firm was founded in 2003 by Mr. Rose, a former top mortgage trader at Salomon Brothers and later at Citigroup. The S.E.C.’s inquiry presents a challenge for Carrington, which started as a hedge fund that mainly invested in subprime mortgage debt but now is something of a full-service real estate company. The firm, with more than 2,900 employees, manages $17.6 billion in mortgages and more than 4,000 rental homes across the United States. Carrington has said in regulatory filings that the investigation could hamper its ability to raise capital.
Richard Horowitz, Carrington’s general counsel, declined to comment on the investigation. John Nester, an S.E.C. spokesman, also declined to comment.
A person briefed on the matter who spoke on the condition of anonymity said the S.E.C. investigation was being led by the agency’s Boston regional office. Carrington’s principal offices are in Greenwich, Conn., and Santa Ana, Calif.
The firm’s regulatory filings said that the S.E.C. also broadly requested information about Carrington’s business of servicing mortgages for itself and other firms.
It is not clear why the S.E.C., which issued its first subpoena in the matter in September, is looking into Carrington’s purchase of the New Century mortgage servicing platform now, given that New Century collapsed in bankruptcy in April 2007. In an investor letter in November, Carrington said that the S.E.C.’s subpoena requested documents relating to the New Century acquisition and the valuation of securities that Carrington issued to investors to help pay for the purchase.
The failure of New Century, a highflying subprime home lender from Southern California that provided $25 million in seed money to Mr. Rose to set up his hedge fund, was an early sign of the trouble to come for the housing market. Before the collapse of New Century, Carrington had $1 billion in assets under management and specialized in turning subprime loans issued by the firm and other mortgage lenders into mortgage securities.
In 2010, three former top executives of New Century reached a settlement with the S.E.C. over a lawsuit that alleged the mortgage lender had misled investors about the firm’s subprime mortgage business. The S.E.C. lawsuit against the former New Century executives ranks as one of the more notable cases from the financial crisis brought by securities regulators.
Around the time that New Century failed and the housing market went into a tailspin, Carrington prohibited its hedge fund investors from withdrawing money because the firm was heavily invested in mortgage bonds that had also lost much of their value and could not be easily sold. Carrington said at the time that its freeze on redemptions, something other hedge funds that invested in mortgage securities did as well, was an attempt to keep the firm afloat.
Hedge funds generally have broad powers to suspend investor redemptions during a time of crisis. But in recent years, the S.E.C. has penalized a few managers for freezing redemptions and giving some investors preferential treatment to withdraw their money. There has been no suggestion that any investors in Carrington got special treatment.
To buy New Century’s mortgage servicing business, Carrington issued preferred equity securities to its hedge fund that were used to refinance a note that the firm used to cover a portion of the purchase. The S.E.C. is looking into the valuation of these securities, according to the Carrington investor letter.
Last December, after a vote of the fund’s investors, Carrington effectively replaced those securities with $530 million of other securities that come due in 2021, though the firm can extend the maturation date until 2026. The new debt notes are listed for trading on the Irish Stock Exchange. The interest paid on the notes gradually rises to 6.5 percent from 2 percent.
But it is not clear just how good a deal the investors got.
The debt is unsecured, meaning that in the event of a bankruptcy, the investors will be paid after secured lenders like banks that provide financing to Carrington. Until January 2016, interest on the notes can be paid in either cash or alternative forms of payment, including additional securities or increases in the principal. (Carrington said in the investor letter that it opted for more flexibility in its payment terms because of the uncertainty surrounding the investigation.) After January 2016, all interest must be paid in cash. In the firm’s 2013 annual report, Carrington places a low valuation on the notes, giving them a fair market value of $374 million — a roughly 29 percent discount to their face value.
Carrington reported a net income of $119.5 million last year, but that included a $155 million accounting gain associated with the decline in value on the notes it sold to investors. Carrington’s operations consumed $15 million of cash last year.
“Normally, when you suspend redemptions, you don’t have a right to take that money to reinvest in brand-new ventures,” said Robert Mottern, a lawyer in Atlanta whose firm is overseeing the liquidation of two funds that invested with Carrington before the financial crisis. “That’s not the way these things work.”
One investor, Joseph Umbach, the founder of Mistic Beverages, which he sold in 1995, has been fighting with Carrington for six years in federal court to get back the original $1 million he invested with the firm in 2005. Mr. Umbach claims that Carrington improperly rescinded the redemption notice he submitted in the summer of 2007.
It has been a protracted legal battle that has produced a voluminous docket of court filings and acrimony on both sides. In a June 2 court filing, Mr. Umbach’s lawyer, Edward G. Toptani, noted that his client did not want to go along with the exchange of his preferred stock for the newly issued debt notes because the deal “was not accompanied by a fairness opinion.”
But lawyers for Carrington counter that Mr. Umbach’s complaints are misguided. “He has fared far better than investors in the other hedge funds employing the same investment strategy who lost everything during the historic subprime mortgage collapse,” said Sean F. O’Shea, an outside lawyer for Carrington.