360 Degrees of Subprime Lending

I want to go through why I bought some shares of New Century (NEW Quote) after its recent decline from above $30 to below $20, sparked by a warning of an unexpected fourth-quarter loss.

I'm not suggesting this trade, as I believe owning these shares involves far too much homework for nonprofessional investors. Instead, I'd like to use it as a talking point for why the short thesis may have run its course for these names.

New Century was the second-largest originator of subprime loans in the third quarter, with $13.8 billion (behind Wells Fargo (WFC Quote)). It's also a large servicer of subprime mortgages, although not in the top 10. In addition, New Century is a real estate investment trust, which means that it must distribute more than 90% of its taxable income to shareholders but that it's not taxed at the corporate level.

Given the recent news at the company, its competitors and the market in general, I asked myself three questions: Will this company survive? What is its "true" book value? What can it earn off that book value in 2008 and beyond, after the subprime crunch abates? Let's try to answer them.

Survivability

With most lenders, survivability is about confidence in whether it will retain its funding during times of distress. New Century stated it had cash and excess liquidity of $350 million (not a tremendous amount) as of Dec. 31. It does have substantial room (multiple billions) in its warehouse facilities, which are lending arrangements with firms like Morgan Stanley (MS Quote) and UBS that agree to finance New Century's originations until New Century can sell or securitize those loans.

Because New Century's current financials will require restatement, it is likely in violation of covenants on those facilities, but there may be room for negotiation, as Wall Street probably wants to keep the major players standing. Surely, the eventual investors will want the ability to put defaulted loans back to their originator.

Generally, if a lender is to be shuttered, it happens quickly. This is intensely speculative, but I believe New Century has already passed the point where if it were to be closed, we'd know. I believe even plain survivability could prompt a rally in the shares.