This morning in a filing with the Securities and Exchange Commission, New Century Finance indicated that substantially all of its short-term creditors are cutting off credit. The filing indicates lenders under its short-term repurchase agreements and aggregation credit facilities had either discontinued their financing or notified the company they plan to do so. These firms are said to include Morgan Stanley, Goldman Sachs, Citigroup, Bank of America, Barclays and IXIS Real Estate Capital.

What is the total amount of short-term funding being pulled? Oh, about $8.4 billion or so… Of course, much of it is collateralized by either sub-prime mortgage loans or New Century's right to service existing mortgage loans. These sub-prime mortgage loans used as collateral include those that already have defaulted, those that have been put back to New Century for not meeting certain terms and conditions of pooling agreements for various mortgage securitizations, those that recently have been originated, and those that are in the pipeline for various securitizations. One has to wonder just how much of a discount to par these loans eventually will be sold for.

One way lenders protect themselves is to demand that their loans be over-collateralized. Such a credit facility might require 105-150% in current assets to secure or collateralize each dollar in short-term debt. Assuming that the homeowners pay the mortgage servicing company in a timely basis, and that the mortgage servicer then passes on the aggregated principal and interest payments to the rightful owners, there is sufficient funds available each month to service the short-term debt.

The over-collateralization protects the lenders against a sharp decline in the value of the assets backing their short-term loans. Say the loan required 125% over-collateralization, the underlying assets would need to decline to less than 80% of face value before full repayment of the principal balance was impaired. Of course, if the loans were to stop paying principal and interest, the expense of short-term funding costs would need to be factored in and the impairment point may rise to 85%, 90% or even higher.

Fraud has always been an issue in the origination of mortgage loans. As a result, securitization and short-term funding vehicles have long been suspicious about whether a newly issued loan is real. As a result, the terms and conditions documentation almost always requires that an originator of a loan (generally the seller) repurchase the loan during some period following its sale if something materially wrong is found in the loan documentation or the loan does not make its required nth number of payments.

These loan repurchase obligations in the terms and conditions documentation have been the source of much of the recent stress sub-prime originators have recently experienced. With these lenders falling or failing more and more quickly, Wall Street and the banks shortly will not have any sellers to put the non-performing loans back to. The interesting question then is what will "poorly originated" sub-prime mortgages really be worth? Is the correct bid 50%, 60%, 70% or 80% of each dollar of principal?

Toomre Capital Markets LLC foresees more pain ahead. With this news today about the second largest sub-prime originator being cut off from short-term funding, Wall Street and other short-term lenders, their hedge fund clients and various CDO investors are about to experience another downward leg in the correction of the 2001-2006 real estate market excesses. How far is left to go? That is anybody's guess. speculation is that the mortgage market is only about a third of the way through the correction to equilibrium. Reader's comments and thoughts are welcome.

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