Transfer Case SLUDGE

I took my NP231 apart (in the XJ) and I can't believe the sludge in there. I'm trying to locate a new filter cor it as the old one is caked solid. I'm going to have to really clean it well before putting it back together. Where does sludge come from in a T/C?? I understand in a motor but my 69 was spotless inside compared to this 95.

Is the sludge magnetic? If not it's from water if it's magnetic then it could have been run dry at least once.

The plastic pads on the range forks are wearable items and if the fluid level gets low the pads will disintigrate. I learned this the hard way with a low fluid level. Good reason for a rebuild and sye.