A look into the collapse of New Century

New Century Financial Corporation (OTC: NEWC) is a stock to stay away from. However, looking into what is going on at this mortgage provider can teach investors how the industry works and possibly how to play an industry upturn when it occurs.

New Century is a subprime mortgage loan originator, meaning New Century underwrites mortgages that are provided to home buyers.

In 2006, New Century underwrote $60 billion in mortgages, a large number. To buy these mortgages and package them to be securitized, New Century needs large lines of credits from big banks. However, last week, their bankers withdrew their lines of credit, so they cannot underwrite any new mortgages. Which is fine as long as they can profitable sell the mortgages they still have to place.

However, there is one more catch. These subprime mortgages all have contracts which forces New Century to take back mortgages that go into early default. With short-term interest rates having shot up the past few years, more mortgages are going into early default and are being pushed back to New Century, creating a problem for this company.

New Century's creditors currently want $8.4 billion in cash back for loans provided due in part because of early prepayment defaults. This $8.4 billion loan is collateralized by $9.0 billion in mortgages. So there is serious collateral. However, traders are using the current tight liquidity conditions and concerns about higher early prepayment defaults to place New Century in a difficult liquidity situation.

But, at the end of day, there are real assets collateralizing these bank loans. The questions are how bad the early prepayment default rates are, how much and how quickly do the banks want their loans back and how much pressure traders will place on mortgage pricing in the market.

In the collapse of the subprime credit card and the subprime auto businesses, companies stayed afloat by large investors willing to put up a lot of cash to recapitalize the company. When this happened, investors who purchased the stocks of these companies post-recap made a lot of money.

Wait for these companies to complete large equity recaps as a sign to start looking at these stocks. Then there might be some money to be made without taking a lot of risk.