Moody's Investors Service late last Wednesday put on watch for downgrade a handful of subprime lenders' servicing operations, helping to roil the already volatile ABX.HE 06-2 index, which broke below 80 last week. The move prompted perhaps the biggest concern among home equity ABS investors already holding securities to the forefront - that the recent challenging atmosphere for subprime lenders could bleed through to loan servicing quality. In subprime lending, servicer quality is considered one of the most crucial aspects of loan performance, particularly as borrowers' monthly payments go up as a result of rate resets and other structural nuances.

Citing a challenging subprime lending atmosphere and limited liquidity, Moody's threatened to lower the servicer ratings of Accredited Home Lenders, Ameriquest Mortgage Co., New Century Financial Corp., Novastar Mortgage and Terwin - each by about one notch. Accredited's SQ2' servicer rating could be lowered to SQ2-'; Ameriquest's SQ2+' rating could be lowered to SQ2'; New Century's SQ3+' rating could be lowered to SQ3'; Novastar's SQ2' rating could be lowered to SQ2-'; and Terwin's Specialized Loan Servicing shop could be lowered from SQ3' to SQ3-'. Moody's servicer ratings range from SQ1,' indicating a strong ability to mitigate or prevent pool losses, to SQ5.'

Moody's said the move was prompted by the "heightened level of volatility in the Alt-A and subprime mortgage markets." The five lenders with servicing operations put on review were described by the rating agency as "facing lower profitability as well as potentially an increased level of liquidity risk given current market conditions."

Accredited, New Century and Novastar have all announced fourth- quarter losses over recent weeks, citing loan buyback pressure and the overall poor performance of subprime loans issued in 2006. Ameriquest is widely rumored as being up for sale, although the suite of potential buyers ranges from hedge fund Ellington Management Group to a handful of investment banks. The Winter Group, parent of Terwin, is also rumored to be under pressure, as its office has seen a number of departures this year, sources said. The concerns for each of the companies are amplified by rumors of liquidity providers tightening up cash flows - or in the case of the recently bankrupt, stopping them altogether.

In terms of the immediate impact of any servicing downgrade, some, such as Credit Suisse, speculated the headline itself could be more damaging than the actual news, as none of the one-notch downgrades would result in the inability to service. The more money investors demand for loans issued by the affected servicers, the less money the already ailing companies have to work with. Pressure on the equity side is also mounting. New Century's stock price plummeted to levels it hasn't seen since the late 1990s, after the company announced it would be restating earnings for all of 2006. Novastar's stock also dropped by 40% last week after it released fourth-quarter earnings and said it was considering dropping its REIT status next year.

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